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FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: June 30, 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)
(508) 855-1000
(Registrant's telephone number, including area code)
_________________________________________________________________
(Former name, former address and former fiscal year, if changed since last
report)
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 [ ]
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the registrant's classes of
common stock as of the latest practicable date: 53,090,634 shares of common
stock outstanding, as of August 1, 2002.
40
Total Number of Pages Included in This Document
Exhibit Index is on Page 41
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Income 3
Consolidated Balance Sheets 4
Consolidated Statements of Shareholders' Equity 5
Consolidated Statements of Comprehensive Income 6
Consolidated Statements of Cash Flows 7
Notes to Interim Consolidated Financial Statements 8 - 15
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16 - 36
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 37
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 38
Item 6. Exhibits and Reports on Form 8-K 39
SIGNATURES 40
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------------------------------------------
(In millions, except per share data) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums................................................... $ 577.4 $ 562.0 $ 1,160.0 $ 1,125.5
Universal life and investment product policy fees.... 98.8 99.2 194.8 199.6
Net investment income................................ 149.6 165.7 300.1 331.5
Net realized investment losses....................... (63.8) (67.3) (76.1) (84.7)
Other income............................................... 36.4 35.6 68.9 69.2
----------- ----------- ------------ -----------
Total revenues................................... 798.4 795.2 1,647.7 1,641.1
----------- ----------- ------------ -----------
Benefits, losses and expenses
Policy benefits, claims, losses and loss adjustment
expenses................................................. 517.1 521.4 1,053.5 1,078.1
Policy acquisition expenses................................ 258.8 114.3 370.3 230.4
Net gains on derivative instruments........................ (14.1) (0.4) (30.4) (2.9)
Other operating expenses................................... 149.7 144.4 302.3 283.2
----------- ----------- ------------ -----------
Total benefits, losses and expenses.................. 911.5 779.7 1,695.7 1,588.8
----------- ----------- ------------ -----------
(Loss) income before federal income taxes.................. (113.1) 15.5 (48.0) 52.3
----------- ----------- ------------ -----------
Federal income tax benefit (expense)
Current................................................. 13.2 22.8 3.4 28.2
Deferred................................................ 48.4 (21.1) 48.7 (32.9)
----------- ----------- ------------ -----------
Total federal income tax benefit (expense)............ 61.6 1.7 52.1 (4.7)
----------- ----------- ------------ -----------
(Loss) income before minority interest and cumulative
effect of change in accounting principle................. (51.5) 17.2 4.1 47.6
Minority interest:
Distributions on mandatorily redeemable preferred
securities of a subsidiary trust holding solely
junior subordinated debentures of the Company......... (4.0) (4.0) (8.0) (8.0)
----------- ----------- ------------ -----------
(Loss) income before cumulative effect of change in
accounting principle.................................... (55.5) 13.2 (3.9) 39.6
Cumulative effect of change in accounting principle (less
applicable income tax benefit of $2.0 and $1.7 for
the six months ended June 30, 2002 and 2001)............ - - (3.7) (3.2)
----------- ----------- ------------ -----------
Net (loss) income....................................... $ (55.5) $ 13.2 $ (7.6) $ 36.4
=========== =========== ============ ===========
PER SHARE DATA
Basic
(Loss) income before cumulative effect of change in
accounting principle................................ $ (1.05) $ 0.25 $ (0.07) $ 0.75
Cumulative effect of change in accounting principle
(less applicable income tax benefit of $0.04 and $0.03
for the six months ended June 30, 2002 and 2001).... - - (0.07) (0.06)
----------- ----------- ------------ -----------
Net (loss) income................................... $ (1.05) $ 0.25 $ (0.14) $ 0.69
=========== =========== ============ ===========
Weighted average shares outstanding .................. 52.9 52.6 52.8 52.6
=========== =========== ============ ===========
Diluted
(Loss) income before cumulative effect of change in
accounting principle................................. $ (1.05) $ 0.25 $ (0.07) $ 0.75
Cumulative effect of change in accounting principle
(less applicable income tax benefit of $0.04 and
$0.03 for the six months ended June 30, 2002 and 2001) - - (0.07) (0.06)
----------- ----------- ------------ -----------
Net (loss) income .................................. $ (1.05) $ 0.25 $ (0.14) $ 0.69
=========== =========== ============ ===========
Weighted average shares outstanding................. 52.9 53.1 52.8 53.1
=========== =========== ============ ===========
The accompanying notes are an integral part of these consolidated financial statements.
3
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30, December 31,
(In millions, except per share data) 2002 2001
- ----------------------------------------------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities-at fair value (amortized cost of $8,797.3 and $9,294.0).. $ 8,938.3 $ 9,401.7
Equity securities-at fair value (cost of $53.3 and $61.2)................. 54.7 62.1
Mortgage loans............................................................ 309.0 321.6
Policy loans.............................................................. 372.6 379.6
Other long-term investments............................................... 170.3 161.2
---------- -----------
Total investments....................................................... 9,844.9 10,326.2
---------- -----------
Cash and cash equivalents.................................................... 376.1 350.2
Accrued investment income.................................................... 143.2 152.3
Premiums, accounts and notes receivable, net................................. 584.6 628.4
Reinsurance receivable on paid and unpaid losses,
benefits and unearned premiums............................................ 1,422.5 1,426.8
Deferred policy acquisition costs............................................ 1,802.9 1,784.2
Deferred federal income taxes................................................ 220.6 168.1
Goodwill..................................................................... 131.2 139.2
Other assets................................................................. 577.0 522.3
Separate account assets...................................................... 14,054.3 14,838.4
---------- -----------
Total assets.............................................................. $ 29,157.3 $ 30,336.1
========== ===========
Liabilities
Policy liabilities and accruals:
Future policy benefits.................................................... $ 4,291.7 $ 4,099.6
Outstanding claims, losses and loss adjustment expenses................... 3,042.1 3,029.8
Unearned premiums......................................................... 1,057.2 1,052.5
Contractholder deposit funds and other policy liabilities................. 1,178.2 1,763.9
---------- -----------
Total policy liabilities and accruals................................... 9,569.2 9,945.8
---------- -----------
Expenses and taxes payable................................................... 830.6 934.1
Reinsurance premiums payable................................................. 102.4 125.3
Trust instruments supported by funding obligations........................... 1,635.2 1,518.6
Short-term debt.............................................................. 74.4 83.3
Long-term debt............................................................... 199.5 199.5
Separate account liabilities................................................. 14,054.3 14,838.4
---------- -----------
Total liabilities......................................................... 26,465.6 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 (Note 10)
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................................................... 1,759.1 1,758.4
Accumulated other comprehensive loss......................................... (13.6) (13.7)
Retained earnings............................................................ 1,044.7 1,052.3
Treasury stock at cost (7.3 and 7.5 million shares).......................... (399.1) (406.5)
---------- -----------
Total shareholders' equity................................................ 2,391.7 2,391.1
---------- -----------
Total liabilities and shareholders' equity.............................. $ 29,157.3 $ 30,336.1
========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
4
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited)
Six Months Ended
June 30,
---------------------------
(In millions) 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Preferred Stock
Balance at beginning and end of period....................................... $ - $ -
--------- ----------
Common Stock
Balance at beginning and end of period....................................... 0.6 0.6
--------- ----------
Additional paid-in capital
Balance at beginning of period............................................... 1,758.4 1,765.3
Unearned compensation related to restricted stock and other........... 0.7 (1.8)
--------- ----------
Balance at end of period..................................................... 1,759.1 1,763.5
--------- ----------
Accumulated Other Comprehensive Income
Net unrealized appreciation (depreciation) on investments:
Balance at beginning of period............................................... 28.4 (5.2)
Net appreciation on available-for-sale securities......................... 22.3 72.6
Provision for deferred federal income taxes.......................... (7.8) (25.4)
--------- ----------
14.5 47.2
--------- ----------
Net (depreciation) appreciation on derivative instruments................. (22.2) 5.5
Benefit (provision) for deferred federal income taxes................ 7.8 (1.9)
--------- ----------
(14.4) 3.6
--------- ----------
Balance at end of period................................................... 28.5 45.6
--------- ----------
Minimum Pension Liability:
Balance at beginning and end of period..................................... (42.1) -
--------- ----------
Total accumulated other comprehensive (loss) income........................ (13.6) 45.6
--------- ----------
Retained earnings
Balance at beginning of period............................................... 1,052.3 1,068.7
Net (loss) income....................................................... (7.6) 36.4
--------- ----------
Balance at end of period..................................................... 1,044.7 1,105.1
--------- ----------
Treasury Stock
Balance at beginning of period............................................... (406.5) (420.3)
Shares reissued at cost............................................... 7.4 8.2
--------- ----------
Balance at end of period..................................................... (399.1) (412.1)
--------- ----------
Total shareholders' equity............................................ $ 2,391.7 $ 2,502.7
========= ==========
The accompanying notes are an integral part of these consolidated financial statements.
5
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Net (loss) income.................................. $ (55.5) $ 13.2 $ (7.6) $ 36.4
Other comprehensive income (loss):
Available-for-sale securities:
Net appreciation (depreciation) during the
period................................... 123.2 (42.4) 22.3 72.6
(Provision) benefit for deferred federal
income taxes............................. (43.1) 14.8 (7.8) (25.4)
----------- ----------- ----------- -----------
Total available-for-sale securities............. 80.1 (27.6) 14.5 47.2
----------- ----------- ----------- -----------
Derivative instruments:
Net (depreciation) appreciation during the
period.................................. (35.1) 14.4 (22.2) 5.5
Benefit (provision) for deferred federal
income taxes............................ 12.3 (5.0) 7.8 (1.9)
----------- ----------- ----------- -----------
Total derivative instruments.................... (22.8) 9.4 (14.4) 3.6
----------- ----------- ----------- -----------
Other comprehensive income (loss).................. 57.3 (18.2) 0.1 50.8
----------- ----------- ----------- -----------
Comprehensive income (loss)........................ $ 1.8 $ (5.0) $ (7.5) $ 87.2
=========== =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
6
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
--------------------------------
(In millions) 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities
Net (loss) income....................................................... $ (7.6) $ 36.4
Adjustments to reconcile net (loss) income to net cash provided by
operating activities:
Net realized losses.................................................. 76.1 84.7
Gains on derivative instruments...................................... (30.4) (2.9)
Net amortization and depreciation.................................... 11.6 8.9
Deferred federal income taxes........................................ (48.7) 32.9
Change in deferred acquisition costs................................. (30.3) (86.0)
Change in premiums and notes receivable,
net of reinsurance payable......................................... 5.2 (18.1)
Change in accrued investment income.................................. 9.1 (1.3)
Change in policy liabilities and accruals, net....................... 206.0 409.9
Change in reinsurance receivable..................................... 4.3 19.3
Change in expenses and taxes payable................................. (15.0) (171.3)
Other, net........................................................... (30.7) (34.8)
------------- -------------
Net cash provided by operating activities...................... 149.6 277.7
------------- -------------
Cash flows from investing activities
Proceeds from disposals and maturities of available-for-sale fixed
maturities............................................................ 1,972.3 870.9
Proceeds from disposals of equity securities............................ 13.4 26.9
Proceeds from disposals of other investments............................ 15.9 30.0
Proceeds from mortgages matured or collected............................ 13.1 48.1
Proceeds from collections of installment finance and notes receivable... 170.1 99.5
Purchase of available-for-sale fixed maturities......................... (1,525.7) (1,726.0)
Purchase of equity securities........................................... (0.7) (9.7)
Purchase of other investments........................................... (21.0) (11.9)
Disbursements to fund installment finance and notes receivable.......... (154.5) (113.8)
Capital expenditures.................................................... (3.5) (14.6)
Other, net.............................................................. - 1.4
------------- -------------
Net cash provided by (used in) investing activities............ 479.4 (799.2)
------------- -------------
Cash flows from financing activities
Deposits and interest credited to contractholder deposit funds.......... 109.9 153.0
Withdrawals from contractholder deposit funds........................... (692.2) (270.7)
Deposits to trust instruments supported by funding obligations.......... 81.3 895.3
Withdrawals from trust instruments supported by funding obligations..... (94.2) (71.2)
Change in short-term debt............................................... (8.9) 12.7
Treasury stock reissued at cost......................................... 1.0 4.0
------------- -------------
Net cash (used in) provided by financing activities............ (603.1) 723.1
------------- -------------
Net change in cash and cash equivalents.................................... 25.9 201.6
Cash and cash equivalents, beginning of period............................. 350.2 281.1
------------- -------------
Cash and cash equivalents, end of period................................... $ 376.1 $ 482.7
============= =============
The accompanying notes are an integral part of these consolidated financial statements.
7
ALLMERICA FINANCIAL CORPORATION
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation and Principles of Consolidation
The accompanying unaudited consolidated financial statements of Allmerica
Financial Corporation ("AFC" or the "Company") have been prepared in accordance
with generally accepted accounting principles for interim financial information
and with the requirements of Form 10-Q.
The interim consolidated financial statements of AFC include the accounts of
First Allmerica Financial Life Insurance Company ("FAFLIC"); Allmerica Financial
Life Insurance and Annuity Company ("AFLIAC"); The Hanover Insurance Company
("Hanover"); Citizens Insurance Company of America ('Citizens"), and other
insurance and non-insurance subsidiaries. All significant intercompany accounts
and transactions have been eliminated.
The accompanying interim consolidated financial statements reflect, in the
opinion of the Company's management, all adjustments necessary for a fair
presentation of the financial position and results of operations. The results of
operations for the six months ended June 30, 2002 are not necessarily indicative
of the results to be expected for the full year. These financial statements
should be read in conjunction with the Company's 2001 Annual Report to
Shareholders, as filed on Form 10-K with the Securities and Exchange Commission.
2. New Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets
("Statement 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.
8
Effective January 1, 2002, the Company ceased its amortization of goodwill in
accordance with Statement No. 142. Amortization expense in the second quarter
and the first six months of 2001 was $1.0 million and $2.0 million,
respectively, net-of-taxes. In accordance with Statement No. 142, the following
table provides income before the cumulative effect of a change in accounting
principle, net (loss) income, and related per-share amounts as of June 30, 2002
and 2001, as reported and adjusted as if the Company had ceased amortizing
goodwill effective January 1, 2001.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------------------------------------------------------
(In millions, except per share data) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (55.5) $ 13.2 $ (3.9) $ 39.6
Goodwill amortization................................... - 1.0 - 2.0
--------------- -------------- -------------- ------------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (55.5) $ 14.2 $ (3.9) $ 41.6
=============== ============== ============== ============
Reported net (loss) income................................. $ (55.5) $ 13.2 $ (7.6) $ 36.4
Goodwill amortization................................... - 1.0 - 2.0
--------------- -------------- -------------- ------------
Adjusted net (loss) income................................. $ (55.5) $ 14.2 $ (7.6) $ 38.4
=============== ============== ============== ============
Per Share Information
Basic
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (1.05) $ 0.25 $ (0.07) $ 0.75
Goodwill amortization................................... - 0.02 - 0.04
--------------- -------------- -------------- ------------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (1.05) $ 0.27 $ (0.07) $ 0.79
=============== ============== ============== ============
Reported net (loss) income................................. $ (1.05) $ 0.25 $ (0.14) $ 0.69
Goodwill amortization................................... - 0.02 - 0.04
--------------- -------------- -------------- ------------
Adjusted net (loss) income................................. $ (1.05) $ 0.27 $ (0.14) $ 0.73
=============== ============== ============== ============
Diluted
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (1.05) $ 0.25 $ (0.07) $ 0.75
Goodwill amortization................................... - 0.02 - 0.04
--------------- -------------- -------------- ------------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (1.05) $ 0.27 $ (0.07) $ 0.79
=============== ============== ============== ============
Reported net (loss) income................................. $ (1.05) $ 0.25 $ (0.14) $ 0.69
Goodwill amortization................................... - 0.02 - 0.04
--------------- -------------- -------------- ------------
Adjusted net (loss) income................................. $ (1.05) $ 0.27 $ (0.14) $ 0.73
=============== ============== ============== ============
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 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
became 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-tax, to recognize these derivative instruments.
9
3. Discontinued Operations
During the second quarter of 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 the third quarter of 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 the Consolidated Statements of Income as discontinued
operations 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 the third quarter of 1999,
the operating results from the discontinued segment were adjusted to reflect the
recording of additional reserves related to accident claims from prior years.
The Company also 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 $8.2 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 $79.1 million at June 30, 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 June 30, 2002
and 2001, the discontinued segment had assets of approximately $307.9 million
and $435.8 million, respectively, consisting primarily of invested assets and
reinsurance recoverables, and liabilities of approximately $364.5 million and
$424.7 million, respectively, consisting primarily of policy liabilities.
Revenues for the discontinued operations were $5.2 million and $10.8 million for
the quarters ended June 30, 2002 and 2001, respectively, and $12.0 million and
$19.8 million for the six months ended June 30, 2002 and 2001, respectively.
4. Significant Transactions
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 positions have
been eliminated as a result of this restructuring plan, of which 81 employees
have been terminated as of June 30, 2002. The Company has made payments of $2.2
million related to this restructuring plan as of June 30, 2002.
5. Federal Income Taxes
It is the Company's policy to estimate taxes for interim periods based on
estimated annual effective tax rates which are derived, in part, from expected
annual pre-tax income. However, the federal income tax benefit for the six
months ended June 30, 2002 has been computed based on the first half of 2002 as
a discrete period due to the uncertainty regarding the Company's ability to
reliably estimate pre-tax income for the remainder of the year. The Company
cannot reliably estimate pre-tax income for the second half of 2002 principally
due to the impact of the equity markets on the Company, including possible
additional amortization of deferred policy acquisition costs. Because of this
uncertainty, the Company is unable to develop a reasonable estimate of the
annual effective tax rate for the full year 2002. In addition, during the six
months ended June 30, 2002, the Company recognized a benefit of $12.1 million
related to a settlement of certain prior years' federal income tax returns.
Federal income tax expense for the six months ended June 30, 2001 has been
computed using estimated effective tax rates. The rates, in 2001, were revised,
if necessary, at the end of each successive interim period to reflect the
current estimates of the annual effective tax rates.
10
6. Other Comprehensive Income (Loss)
The following table provides a reconciliation of gross unrealized gains (losses)
to the net balance shown in the Statements of Comprehensive Income:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------------------------
Unrealized gains (losses) on available-for-sale securities:
Unrealized holding gains (losses) arising during period
(net of income tax (expense) benefit of $(28.8) million
and $29.3 million for the quarters ended June 30, 2002 and
2001 and $7.0 million and $(8.1) million for the six months
ended June 30, 2002 and 2001).................................. $ 51.5 $ (78.3) $ (12.9) $ (14.5)
Less: reclassification adjustment for losses included in
net income (net of income tax benefit of $14.3 million and
$14.5 million for the quarters ended June 30, 2002 and 2001 and
$14.8 million and $17.3 million for the six months ended
June 30, 2002 and 2001)........................................ (28.6) (50.7) (27.4) (61.7)
--------- --------- ---------- ----------
Total unrealized gains (losses) on available-for-sale
securities........................................................... 80.1 (27.6) 14.5 47.2
--------- --------- ---------- ----------
Unrealized (losses) gains on derivative instruments:
Unrealized holding gains arising during period (net of
income tax (expense) benefit of $(36.0) million and
$5.1 million for the quarters ended June 30, 2002 and 2001
and $(31.2) million and $0.9 million for the six months
ended June 30, 2002 and 2001).................................. 63.2 9.1 57.9 1.6
Less: reclassification adjustment for gains (losses)
included in net income (net of income tax (expense)
benefit of $(48.3) million and $(0.1) million for the
quarters ended June 30, 2002 and 2001 and $(39.0) million
and $1.0 million for the six months ended June 30, 2002 and
2001)......................................................... 86.0 (0.3) 72.3 (2.0)
--------- --------- ---------- ----------
Total unrealized (losses) gains on derivative instruments........... (22.8) 9.4 (14.4) 3.6
--------- --------- ---------- ----------
Other comprehensive income (loss)................................... $ 57.3 $ (18.2) $ 0.1 $ 50.8
========= ========= ========== ==========
11
7. Closed Block
Summarized financial information of the Closed Block is as follows for the
periods indicated:
(Unaudited)
June 30, December 31,
(In millions) 2002 2001
------------------------------------------------------------------------------------------------------
Assets
Fixed maturities-at fair value (amortized cost of $518.9 and
$498.1)............................................................ $ 526.1 $ 504.2
Mortgage loans....................................................... 51.0 55.7
Policy loans......................................................... 177.2 182.1
Cash and cash equivalents............................................ - 9.2
Accrued investment income............................................ 14.1 14.6
Deferred policy acquisition costs.................................... 8.8 10.4
Other assets......................................................... 7.8 6.2
--------- ---------
Total assets...................................................... $ 785.0 $ 782.4
========= =========
Liabilities
Policy liabilities and accruals...................................... $ 793.5 $ 798.2
Policyholder dividends............................................... 24.4 30.7
Other liabilities.................................................... 17.0 7.0
--------- ---------
Total liabilities................................................. $ 834.9 $ 835.9
========= =========
Excess of Closed Block liabilities over assets designated to the
Closed Block......................................................... $ 49.9 $ 53.5
Amounts included in accumulated other comprehensive income:
Net unrealized investment losses, net of deferred federal income
tax benefit of $2.1 million and $8.8 million.......................... (4.0) (16.4)
--------- ---------
Maximum future earnings to be recognized from Closed Block
assets and liabilities............................................... $ 45.9 $ 37.1
========= =========
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------- ---------------------
(In millions) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums............................................................. $ 6.4 $ 7.3 $ 30.8 $ 32.4
Net investment income................................................ 13.1 13.6 26.0 27.6
Net realized investment losses....................................... (1.7) (1.2) (1.8) (1.2)
-------- --------- ------- -------
Total revenues.................................................... 17.8 19.7 55.0 58.8
-------- --------- ------- -------
Benefits and expenses
Policy benefits...................................................... 13.7 14.0 47.6 47.5
Policy acquisition expenses.......................................... 0.7 0.1 1.2 0.1
Other operating expenses............................................. 0.1 - 0.4 0.3
-------- --------- ------- -------
Total benefits and expenses....................................... 14.5 14.1 49.2 47.9
-------- --------- ------- -------
Contribution from the Closed Block............................. $ 3.3 $ 5.6 $ 5.8 $ 10.9
======== ========= ======= =======
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.
12
8. 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.
The separate financial information of each segment is presented consistent with
the way results are regularly evaluated by the chief operating decision maker 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 sells property and casualty insurance products
through independent agents and brokers primarily in the Northeast, Midwest and
Southeast United States. In addition, the Risk Management Segment offers
property and casualty (automobile and homeowners) insurance through employer
sponsored programs, affinity groups and other organizations.
The Asset Accumulation group includes two segments: Allmerica Financial Services
and Allmerica Asset Management. The Allmerica Financial Services segment
includes variable annuities, variable universal life, universal life and
traditional life insurance products, as well as group retirement products.
Allmerica Financial Services also includes brokerage and non-institutional
investment advisory services. Through its Allmerica Asset Management segment,
the Company offers GICs, also referred to as funding agreements, which are
investment contracts that can contain either short-term or long-term maturities
and are issued to institutional buyers or to various business or charitable
trusts. Also, this segment includes a Registered Investment Advisor, providing
investment advisory services primarily to affiliates and to third parties, such
as money market and other fixed income clients.
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 generated by 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. In addition, segment (loss) income is
adjusted for certain items which management believes are not indicative of the
Company's core operations. Segment (loss) income excludes items such as net
realized investment gains and losses, including certain 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, 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 segment (loss) income may be significant
components in understanding and assessing the Company's financial performance,
management believes segment (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, segment (loss) income should not be construed
as a substitute for net (loss) income determined in accordance with generally
accepted accounting principles.
13
Summarized below is financial information with respect to business segments for
the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
---------------------------- -----------------------------
(In millions) 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Segment revenues:
Risk Management....................................... $ 626.7 $ 617.0 $ 1,241.4 $ 1,218.3
---------- ---------- ----------- ---------
Asset Accumulation:
Allmerica Financial Services.................. 204.8 204.3 419.7 427.5
Allmerica Asset Management.................... 31.8 41.6 64.0 81.3
---------- ---------- ----------- ---------
Subtotal...................................... 236.6 245.9 483.7 508.8
---------- ---------- ----------- ---------
Corporate............................................. 1.5 1.5 3.2 2.5
Intersegment revenues................................. (2.6) (1.9) (4.5) (3.8)
---------- ---------- ----------- ---------
Total segment revenues............................. 862.2 862.5 1,723.8 1,725.8
Adjustments to segment revenues:
Net realized losses................................... (63.8) (67.3) (76.1) (84.7)
---------- ---------- ----------- ---------
Total revenues..................................... $ 798.4 $ 795.2 $ 1,647.7 $ 1,641.1
========== ========== =========== =========
Segment (loss) income before federal income taxes, minority
interest and cumulative effect of change in accounting
principle:
Risk Management....................................... $ 51.6 $ 41.5 $ 90.6 $ 57.7
---------- ---------- ----------- ---------
Asset Accumulation:
Allmerica Financial Services....................... (113.8) 42.6 (84.1) 86.9
Allmerica Asset Management......................... 5.1 4.4 10.2 10.4
---------- ---------- ----------- ---------
Subtotal.......................................... (108.7) 47.0 (73.9) 97.3
---------- ---------- ----------- ---------
Corporate............................................. (15.2) (15.6) (31.6) (31.8)
---------- ---------- ----------- ---------
Segment (loss) income before federal income taxes
and minority interest............................ (72.3) 72.9 (14.9) 123.2
Adjustments to segment (loss) income:
Net realized investment losses, net of amortization... (57.4) (65.5) (66.0) (81.5)
Gains on derivatives.................................. 14.1 0.4 30.4 2.9
Sales practice litigation............................. 2.5 7.7 2.5 7.7
---------- ---------- ----------- ---------
(Loss) income before federal income taxes, minority
interest and cumulative effect of change in
accounting principle........................... $ (113.1) $ 15.5 $ (48.0) $ 52.3
========== ========== =========== =========
Identifiable Assets Deferred Acquisition Costs
- ---------------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
June 30, December 31, June 30, December 31,
(In millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Risk Management............................. $ 6,096.5 $ 6,239.8 $ 205.0 $ 199.0
------------- -------------- -------------- --------------
Asset Accumulation
Allmerica Financial Services............. 20,642.0 21,113.0 1,597.9 1,585.2
Allmerica Asset Management............... 2,326.9 2,829.3 - -
------------- -------------- -------------- --------------
Subtotal.............................. 22,968.9 23,942.3 1,597.9 1,585.2
Corporate................................... 91.9 154.0 - -
------------- -------------- -------------- --------------
Total.................................... $ 29,157.3 $ 30,336.1 $ 1,802.9 $ 1,784.2
============= ============== ============== ==============
14
9. Earnings Per Share
The following table provides share information used in the calculation of the
Company's basic and diluted earnings per share:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------------- ----------------------------
(In millions) 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Basic shares used in the calculation of earnings per share....... 52.9 52.6 52.8 52.6
Dilutive effect of securities (1):
Employee stock options.............................. - 0.3 - 0.3
Non-vested stock grants............................. - 0.2 - 0.2
---------- ---------- ---------- ----------
Diluted shares used in the calculation of earnings per share 52.9 53.1 52.8 53.1
========== ========== ========== ==========
(1) Excludes 0.4 million shares due to antidilution for the quarter and six months ended June 30, 2002.
10. Commitments and Contingencies
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 a pre-tax benefit 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, and based
on changes in the Company's estimate of the ultimate cost of the benefits to be
provided to members of the class.
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.
However, liabilities related to these proceedings could be established in the
near term if estimates of the ultimate resolution of these proceedings are
revised.
15
PART I
ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following analysis of the interim consolidated results of operations and
financial condition of the Company should be read in conjunction with the
interim Consolidated Financial Statements and related footnotes included
elsewhere herein and the Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in the 2001 Annual Report to
Shareholders, as filed on Form 10-K with the Securities and Exchange Commission.
INTRODUCTION
The results of operations for Allmerica Financial Corporation and subsidiaries
("AFC" or "the Company") include the accounts of First Allmerica Financial Life
Insurance Company ("FAFLIC") and Allmerica Financial Life Insurance and Annuity
Company ("AFLIAC"), 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.
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, and Allmerica Asset Management.
The separate financial information of each segment is presented consistent with
the way results are regularly evaluated by the chief operating decision maker in
deciding how to allocate resources and in assessing performance.
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 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, 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.
The Company's consolidated net income for the second quarter of 2002 decreased
$68.7 million, to a net loss of $55.5 million, compared to net income of $13.2
million for the same period in 2001. The decline in the second quarter resulted
primarily from a decrease in adjusted net income of $86.6 million, partially
offset by a decrease of net realized investment losses of $12.5 million, and an
increase in gains on derivative instruments of $8.8 million, net of taxes.
Consolidated net income for the first six months of 2002 decreased $44.0
million, to a net loss of $7.6 million, compared to net income of $36.4 million
for the first six months of 2001. The reduction resulted primarily from a
decrease in adjusted net income of $78.4 million, partially offset by a $20.5
million decrease in net realized investment losses and a $17.8 million increase
in gains on derivative instruments, net of taxes.
16
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 taxes on segment income and minority interest on
Capital Securities (mandatorily redeemable preferred securities of a subsidiary
trust holding solely junior subordinated debentures of the Company).
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
--------------------------- --------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Segment (loss) income before federal income taxes and
minority interest:
Risk Management.......................................... $ 51.6 $ 41.5 $ 90.6 $ 57.7
------------ ----------- ----------- ------------
Asset Accumulation:
Allmerica Financial Services......................... (113.8) 42.6 (84.1) 86.9
Allmerica Asset Management........................... 5.1 4.4 10.2 10.4
------------ ----------- ----------- ------------
(108.7) 47.0 (73.9) 97.3
Corporate................................................ (15.2) (15.6) (31.6) (31.8)
------------ ----------- ----------- ------------
Segment (loss) income before federal income tax
benefit (expense) and minority interest........... (72.3) 72.9 (14.9) 123.2
Federal income tax benefit (expense) on segment (loss)
income............................................. 48.6 (10.0) 40.6 (19.1)
Minority interest on Capital Securities.................. (4.0) (4.0) (8.0) (8.0)
------------ ----------- ----------- ------------
Adjusted net (loss) income.................................... (27.7) 58.9 17.7 96.1
Adjustments (net of taxes and amortization, as applicable):
Net realized investment losses........................... (38.5) (51.0) (42.9) (63.4)
Net gains on derivatives................................. 9.1 0.3 19.7 1.9
Sales practice litigation................................ 1.6 5.0 1.6 5.0
------------ ----------- ----------- ------------
(Loss) income before cumulative effect of change in
accounting principle..................................... (55.5) 13.2 (3.9) 39.6
Cumulative effect of change in accounting principle,
net of applicable taxes........................... - - (3.7) (3.2)
------------ ----------- ----------- ------------
Net (loss) income............................................. $ (55.5) $ 13.2 $ (7.6) $ 36.4
============ =========== =========== ============
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
The Company's segment income before federal taxes and minority interest
decreased $145.2 million, to a loss of $72.3 million, in the second quarter of
2002. This decrease was primarily attributable to a decrease of $156.4 million
from the Allmerica Financial Services segment, partially offset by an increase
in income from the Risk Management segment of $10.1 million. The decrease in
Allmerica Financial Services' segment reflects the cumulative effect of the
significant, persistent decline in equity market values during the most recent
two and one half years, particularly the relatively significant decline during
the second quarter of 2002. The decline resulted in additional amortization of
the deferred policy acquisition cost ("DAC") asset of $137.1 million, increased
guaranteed minimum death benefits ("GMDB") of $18.9 million, as well as reduced
fees and other income from certain products. The increase in Risk Management
segment income is primarily attributable to a benefit of approximately $18
million of estimated net premium rate increases, an approximate $12 million
improvement in current accident year non-catastrophe claims activity and a
decrease in catastrophe losses of $6.7 million. Partially offsetting these items
is a $13.6 million decrease in favorable development on prior years reserves and
an increase in policy acquisition expenses.
The federal income tax benefit on segment loss was $48.6 million for the second
quarter of 2002 compared to an income tax expense of $10.0 million for the
second quarter of 2001. The increase in the tax benefit is primarily the result
of the loss recognized by the Allmerica Financial Services segment, as well as a
$12.1 million favorable settlement of certain prior years' federal income tax
returns.
17
Net realized losses on investments, after taxes, were $38.5 million in the
second quarter of 2002, resulting primarily from impairments of fixed maturities
and equity securities and losses related to the termination of certain
derivative instruments, partially offset by gains recognized from the sale of
fixed maturities. During the second quarter of 2001, the Company recognized net
realized losses on investments, after taxes, of $51.0 million, primarily due to
impairments of fixed maturities, partially offset by gains from sales of equity
securities. Net gains on derivatives, after taxes, increased $8.8 million, to
$9.1 million in the second quarter of 2002, resulting primarily from the
aforementioned termination of certain derivatives.
The Company recognized a benefit of $1.6 million and $5.0 million, net of taxes,
in the second quarters of 2002 and 2001, respectively, as a result of refining
cost estimates related to a class action lawsuit.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
The Company's segment income before federal income taxes and minority interest
decreased $138.1 million to a loss of $14.9 million, in the first six months of
2002. This decrease was primarily attributable to lower income from the
Allmerica Financial Services segment of $171.0 million, partially offset by an
increase in income from the Risk Management segment of $32.9 million. The
decrease in Allmerica Financial Services' segment income reflects the
aforementioned persistent decline in equity market values during the most recent
two and one half years, particularly the relatively significant decline during
the second quarter. The decline resulted in additional amortization of the DAC
asset of $137.1 million, increased GMDB costs of $29.8 million, as well as
reduced fees and other income from certain products. The increase in Risk
Management segment income is primarily attributable to a benefit of
approximately $30 million of estimated net premium rate increases, an
approximate $21 million decrease in current accident year non-catastrophe claims
and $9.2 million decrease in the adverse development of prior years' reserves.
Partially offsetting these items is an increase in policy acquisition expenses
and a decrease in net investment income of $7.2 million.
The federal income tax benefit on segment loss was $40.6 million for the first
six months of 2002 compared to an income tax expense of $19.1 million for the
same period of 2001. The increase in the tax benefit is primarily the result of
the loss recognized by the Allmerica Financial Services segment, as well as a
$12.1 million favorable settlement of certain prior years' federal income tax
returns.
Net realized losses on investments, after taxes, were $42.9 million for the six
months of 2002, resulting primarily from impairments of fixed maturities and
equity securities and losses related to the termination of certain derivative
instruments, partially offset by gains recognized from the sale of fixed
maturities. During the first six months of 2001, net realized losses on
investments, after taxes, of $63.4 million resulted primarily from impairments
of fixed maturities. Net gains on derivatives, after taxes, increased $17.8
million, to $19.7 million in the first six months of 2002, resulting primarily
from the aforementioned termination of certain derivatives.
During the first quarter of 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 the first quarter of 2001, the
Company recognized a $3.2 million loss, net-of-taxes, upon adoption of Statement
of Financial Accounting Standards No. 133, Accounting for Derivative Instruments
and Hedging Activities.
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.
18
Risk Management
The following table summarizes the results of operations for the Risk Management
segment:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
(In millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net premiums written.................................... $ 572.1 $ 581.4 $ 1,127.0 $ 1,148.1
========== ========= ========== ==========
Net premiums earned..................................... $ 570.6 $ 554.4 $ 1,128.7 $ 1,092.4
Net investment income................................... 50.8 53.0 102.6 109.8
Other income............................................ 5.3 9.6 10.1 16.1
---------- --------- ---------- ----------
Total segment revenues.................... 626.7 617.0 1,241.4 1,218.3
---------- --------- ---------- ----------
Losses and operating expenses
Losses and LAE (1)...................................... 419.5 426.1 840.6 864.0
Policy acquisition expenses............................. 105.9 99.1 210.5 195.5
Other operating expenses................................ 49.7 50.3 99.7 101.1
---------- ---------- ---------- ----------
Total losses and operating expenses.......... 575.1 575.5 1,150.8 1,160.6
---------- ---------- ---------- ----------
Segment income............................................... $ 51.6 $ 41.5 $ 90.6 $ 57.7
========== ========== ========== ==========
(1) Includes policyholders' dividends of $0.5 million and $1.9 million for the
quarters ended June 30, 2002 and 2001, respectively, and $0.2 million and $4.0
million for the six months ended June 30, 2002 and 2001, respectively.
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
Risk Management's segment income increased $10.1 million to $51.6 million for
the second quarter of 2002. The increase in segment income is primarily
attributable to a benefit of approximately $18 million of net premium rate
increases. Net premium rate increases reflect base rate actions, discretionary
pricing adjustments, inflation and changes in exposure; net of estimated impact
of loss inflation and policy acquisition costs. Second quarter of 2002 segment
income also reflected a decrease in current year non-catastrophe claims activity
primarily in the commercial multiple peril, workers' compensation and personal
automobile lines. In addition, catastrophe losses decreased $6.7 million, to
$8.6 million for the second quarter of 2002, compared to $15.3 million for the
same period in 2001. Partially offsetting these items is a $13.6 million
decrease in favorable development on prior years' reserves, from $3.8 million of
favorable development in the second quarter of 2001 to $9.8 million of adverse
development in the same period in 2002. The adverse development in 2002 is
primarily the result of increased claims severity, primarily in the workers'
compensation and personal automobile lines. Segment income also reflected a
decrease in net investment income of $2.2 million for the quarter ended June 30,
2002. Policy acquisition expenses increased as a result of the aforementioned
net premium rate increases and due to an increase in premium tax expenses. Other
operating expenses in 2002 were consistent with the prior period despite the
decrease in written policies, primarily due to certain underwriting initiatives
and employee related expenses.
Underwriting results are reported using statutory accounting principles, which
are prescribed by state insurance regulators. The primary difference between
statutory and generally accepted accounting principles ("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.
19
The following tables summarize the results of operations for the Risk Management
segment:
(Unaudited)
Quarter Ended June 30,
--------------------------------------------------------------------
2002 2001
-------------------------------- --------------------------------
Statutory Statutory
Net Net
Premiums Statutory Premiums Statutory
(In millions, except ratios) Written Loss Ratios Written Loss Ratios
- ------------------------------------------------------------------------ --------------------------------
Personal automobile................... $ 267.2 68.4 $ 244.9 67.2
Homeowners............................ 94.4 64.1 81.8 78.8
Other personal........................ 12.5 45.9 12.7 22.4
Total personal........................ 374.1 66.7 339.4 68.3
----------- ------------- ----------- -------------
Workers' compensation................. 37.4 83.4 51.3 79.6
Commercial automobile................. 49.0 66.9 75.0 63.4
Commercial multiple peril............. 84.3 50.5 87.4 72.2
Other commercial...................... 27.9 38.7 26.8 51.1
----------- ------------- ----------- -------------
Total commercial...................... 198.6 60.3 240.5 69.3
----------- ------------- ----------- -------------
Total................................. $ 572.7 64.4 $ 579.9 68.7
=========== ------------- =========== -------------
Statutory combined ratio (1):
Personal lines........................ 100.9 99.9
Commercial lines...................... 102.8 108.2
----------- -----------
Total................................. 101.6 103.3
----------- -----------
Statutory underwriting loss:
Personal lines........................ $ (6.7) $ (2.5)
Commercial lines...................... (2.3) (22.9)
----------- -----------
Total................................. (9.0) (25.4)
Reconciliation to segment income:
Net investment income................. 50.8 53.0
Other income and expenses, net........ 4.2 6.2
Other Statutory to GAAP adjustments... 5.6 7.7
----------- -----------
Segment income........................... $ 51.6 $ 41.5
=========== ===========
- -------------------------------------------------------------------------------------------------------------
(1) 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.
Personal Lines
Personal lines' net premiums written increased $34.7 million, or 10.2%, to
$374.1 million for the second quarter of 2002. This is primarily the result of
increases of $22.3 million, or 9.1%, and $12.6 million, or 15.4%, in the
personal automobile and homeowners lines, respectively. The increase in the
personal automobile line is primarily the result of 2.0% and 0.6% net premium
rate increases in Michigan and Massachusetts, respectively, and an overall
increase of 2.1% in policies in force since June 30, 2001. The increase in the
homeowners line resulted primarily from rate increases of 19.6% and 9.9% in
Michigan and Massachusetts, respectively, in addition to an overall increase of
1.1% in policies in force since June 30, 2001.
Personal lines' underwriting results declined $4.2 million to an underwriting
loss of $6.7 million for the second quarter of 2002. The decline in underwriting
results is primarily attributable to approximately $10 million of increased
policy acquisition expenses, primarily related to increased cession expenses for
mandatory assigned risk personal automobile business in New York. Management
expects this cession expense to increase by approximately $10 million as
compared to 2001 due to unsatisfactory underwriting results in this personal
auto assigned risk pool. Policy acquisition expenses were also unfavorably
affected by increased premium taxes in 2002. Underwriting results were also
unfavorably affected by a $6.9 million decrease in favorable development, from
$3.7 million of favorable development for the second quarter of 2001 to $3.2
million of adverse development for the same period in 2002. This decrease is
primarily related to increased claims severity on prior years' reserves in the
personal automobile line. Partially offsetting these items is approximately $7
million of estimated net premium rate increases in 2002. In addition,
catastrophe losses decreased $5.8 million, to $6.2 million for the second
quarter of 2002, compared to $12.0 million for the same period in 2001.
20
Commercial Lines
Commercial lines' net premiums written decreased $41.9 million, or 17.4%, to
$198.6 million for the second quarter of 2002. This 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. Management believes
that premium level reductions from continuing agents may continue to unfavorably
affect future premiums. Policies in force decreased 18.6%, 17.7% and 4.3% in the
workers' compensation, commercial automobile, and commercial multiple peril
lines, respectively, since June 30, 2001 primarily as the result of the
aforementioned agency management actions. Partially offsetting these decreases
in policies in force were rate increases in all of the commercial lines since
June 30, 2001.
Commercial lines' underwriting results improved $20.6 million, or 90.0%, to an
underwriting loss of $2.3 million in the second quarter of 2002. The improvement
in underwriting results is primarily attributable to approximately $11 million
of estimated net premium rate increases during the second quarter of 2002. In
addition, a decrease in current year non-catastrophe claims severity in the
commercial multiple peril and workers' compensation lines of approximately $7
million and $5 million, respectively, favorably affected results in 2002. Second
quarter of 2002 underwriting results reflected approximately $2 million and $1.3
million of decreased underwriting expenses and policyholder dividends,
respectively, compared to the same period in 2001. In addition, catastrophe
losses decreased $0.9 million, to $2.4 million for the second quarter of 2002,
compared to $3.3 million for the same period in 2001. Partially offsetting these
items is a $6.7 million decrease in favorable development on prior years'
reserves, from $0.1 million of favorable development in the second quarter of
2001 to $6.6 million of adverse development for the same period in 2002. In
addition, increased current year claims severity in the commercial automobile
line unfavorably affected underwriting results in the second quarter of 2002.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
Risk Management's segment income increased $32.9 million, or 57.0%, to $90.6
million for the six months ended June 30, 2002. The increase in segment income
is primarily attributable to approximately $30 million of estimated net premium
rate increases. In addition, personal lines non-catastrophe weather related
losses decreased approximately $15 million for the six months ended June 30,
2002, compared to the same period in the prior year. Adverse development on
prior years' reserves improved $9.2 million to $6.4 million for the six months
ended June 30, 2002, from $15.6 million for the same period in 2001. This
improvement includes approximately $15 million of weather related adverse
development on prior years' reserves during the six months ended June 30, 2001.
Also, segment income for the six months ended June 30, 2002 was favorably
affected by approximately $6 million of estimated improved current accident year
non-catastrophe claims activity, primarily in commercial lines. In addition,
policyholder dividends decreased $3.8 million when comparing the six months
ended June 30, 2002 to the same period in 2001. Catastrophe losses decreased
$2.3 million, to $19.8 million for the six months ended June 30, 2002, compared
to $22.1 million for the same period in 2001. Partially offsetting these items
is a decrease in net investment income of $7.2 million for the six months ended
June 30, 2002. Policy acquisition expenses increased as a result of the
aforementioned net premium rate increases and due to an increase in premium tax
expenses. Other operating expenses in 2002 were consistent with the prior year
despite the decrease in written policies, due to certain underwriting
initiatives and employee related expenses.
21
The following tables summarize the results of operations for the Risk Management
segment:
(Unaudited)
Six Months Ended June 30,
--------------------------------------------------------------------
2002 2001
-------------------------------- --------------------------------
Net Net
Premiums Statutory Premiums Statutory
(In millions, except ratios) Written Loss Ratios Written Loss Ratios
- ------------------------------------------------------------------------ --------------------------------
Personal automobile................... $ 552.4 70.6 $ 511.4 72.5
Homeowners............................ 159.9 64.9 140.3 78.4
Other personal........................ 21.1 49.1 21.4 24.8
----------- ------------- ----------- -------------
Total personal........................ 733.4 68.6 673.1 72.3
----------- ------------- ----------- -------------
Workers' compensation................. 79.4 79.5 108.4 82.6
Commercial automobile................. 100.5 64.5 136.3 67.5
Commercial multiple peril............. 164.0 56.1 175.9 70.0
Other commercial...................... 49.6 32.8 51.5 41.6
----------- ------------- ----------- -------------
Total commercial...................... 393.5 60.4 472.1 69.2
----------- ------------- ----------- -------------
Total................................. $ 1,126.9 65.5 $ 1,145.2 71.0
=========== ------------- =========== -------------
Statutory combined ratio (1):
Personal lines........................ 103.0 103.7
Commercial lines...................... 103.2 108.3
----------- -----------
Total................................. 102.9 105.4
----------- -----------
Statutory underwriting loss:
Personal lines........................ $ (28.4) $ (29.4)
Commercial lines...................... (3.9) (45.8)
----------- -----------
Total................................. (32.3) (75.2)
Reconciliation to segment income:
Net investment income................. 102.6 109.8
Other income and expenses, net........ 7.6 9.7
Other Statutory to GAAP adjustments... 12.7 13.4
----------- -----------
Segment income........................... $ 90.6 $ 57.7
=========== ===========
- ----------------------------------------------------------------------------------------------------------------
(1) 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.
Personal Lines
Personal lines' net premiums written increased $60.3 million, or 9.0%, to $733.4
million for the six months ended June 30, 2002. This is primarily the result of
increases of $41.0 million, or 8.0%, and $19.6 million, or 14.0%, in the
personal automobile and homeowners lines, respectively. The increase in the
personal automobile line is primarily the result of 2.0% and 0.6% net premium
rate increases in Michigan and Massachusetts, respectively, and an overall
increase of 2.1% in policies in force since June 30, 2001. The increase in the
homeowners line resulted primarily from rate increases of 19.6% and 9.9% in
Michigan and Massachusetts, respectively, in addition to an overall increase of
1.1% in policies in force since June 30, 2001.
Personal lines' underwriting results improved $1.0 million, or 3.4%, to an
underwriting loss of $28.4 million for the six months ended June 30, 2002. The
improvement in underwriting results is primarily attributable to a $12.7 million
decrease in adverse development in 2002 and the aforementioned combined effect
of adverse weather, in 2001 and mild weather in 2002. Underwriting results for
the six months ended June 30, 2002 also reflected approximately $10 million of
estimated net premium rate increases. In addition, catastrophe losses decreased
$2.5 million, to $15.7 million for the six months ended June 30, 2002, compared
to $18.2 million for the same period in 2001. These items are partially offset
by increased policy acquisition expenses, primarily related to the
aforementioned increases in cession expenses for New York assigned risk business
and premium tax expenses. Underwriting results were also unfavorably affected by
increased current year claims severity in the personal automobile line in the
six months ended June 30, 2002.
22
Commercial Lines
Commercial lines' net premiums written decreased $78.6 million, or 16.6%, to
$393.5 million for the six months ended June 30, 2002. This is primarily the
result of the Company's aforementioned agency management actions and the
continuing re-underwriting efforts. As a result of these actions, policies in
force decreased 18.6%, 17.7% and 4.3% in the workers' compensation, commercial
automobile, and commercial multiple peril lines, respectively, since June 30,
2001. Partially offsetting these decreases in policies in force were rate
increases in all of the commercial lines since June 30, 2001.
Commercial lines' underwriting results improved $41.9 million, or 91.5%, to an
underwriting loss of $3.9 million for the six months ended June 30, 2002. The
improvement in underwriting results is primarily attributable to approximately
$20 million of net premium rate increases during the six months ended June 30,
2002. In addition, approximately $5 million of decreases in current year claims
severity in both the commercial automobile and commercial multiple peril lines
favorably affected results in 2002. The six months ended June 30, 2002
underwriting results also included a net benefit, when compared to the same
period in 2001, as the result of exiting historically unprofitable business
under the aforementioned agency management actions. In addition, the six months
ended June 30, 2002 underwriting results reflected approximately $6 million and
$2.5 million of decreased underwriting expenses and policyholder dividends,
respectively, compared to the same period in 2001. Partially offsetting these
favorable items is a $3.5 million decrease in development on prior years'
reserves to $2.3 million of adverse development for the six months ended June
30, 2002 from $1.2 million of favorable development for the same period in 2001.
Investment Results
Net investment income before tax declined $7.2 million, or 6.6%, to $102.6
million for the six months ended June 30, 2002. The decrease in net investment
income primarily reflects the impact of defaults on high yield bonds, a
reduction in average pre-tax yields on debt securities and the transfer of
assets to the Corporate segment and the Allmerica Financial Services segment.
Average pre-tax yields on debt securities decreased to 6.4% in 2002 compared to
6.9% in 2001 due to the shift from higher yielding below investment grade
securities to lower yielding, but higher quality investment grade securities.
Due to the current interest rate environment, management expects its investment
yield to be negatively affected by lower prevailing fixed maturity investment
rates in 2002. In addition, management expects that defaults in the fixed
maturities portfolio may continue to negatively impact investment income.
Reserve for Losses and Loss Adjustment Expenses
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, predictions of future events, estimates of future
trends in claim severity and frequency, and judicial theories of liability and
policy coverage, and other factors. 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 regularly adjusts 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.
23
The table below provides a reconciliation of the beginning and ending reserve
for unpaid losses and LAE as follows:
(Unaudited)
Six Months Ended
June 30,
----------------------------
(In millions) 2002 2001
- ---------------------------------------------------------------------------------------------------
Reserve for losses and LAE, beginning of period............... $ 2,921.5 $ 2,719.1
Incurred losses and LAE, net of reinsurance recoverable:
Provision for insured events of current year............. 834.1 844.4
Increase in provision for insured events of prior years.. 6.4 15.6
------------ ------------
Total incurred losses and LAE.............................. 840.5 860.0
------------ ------------
Payments, net of reinsurance recoverable:
Losses and LAE attributable to insured events of
current year........................................... 346.2 342.6
Losses and LAE attributable to insured events of prior
years................................................. 468.9 486.8
------------ ------------
Total payments............................................. 815.1 829.4
------------ ------------
Change in reinsurance recoverable on unpaid losses......... (8.0) 1.8
------------ ------------
Reserve for losses and LAE, end of period..................... $ 2,938.9 $ 2,751.5
============ ============
As part of an ongoing process, the reserves have been re-estimated for all prior
accident years and were increased by $6.4 million for the six months ended June
30, 2002. This reflects $16.8 million of increased prior years' loss reserves,
partially offset by $10.4 million of decreased prior years' LAE reserves. For
the six months ended June 30, 2001, prior years' reserves were increased by
$15.6 million. This reflects $43.9 million of increased prior years' loss
reserves, partially offset by $28.3 million of decreased prior years' LAE
reserves.
The adverse loss reserve development in 2002 is primarily the result of
increased non-catastrophe claims severity on prior years' reserves in the
workers' compensation, personal automobile, homeowners, and commercial
automobile lines, partially offset by a decrease in commercial multiple peril
non-catastrophe claims severity. The adverse loss reserve development in 2001
was primarily related to fourth quarter 2000 non-catastrophe weather related
claims in Michigan. These claims primarily affected the personal automobile and
homeowners lines. The adverse loss development in 2001 is also attributable to
an increase in commercial lines' loss costs in the 1999 and 2000 accident years.
The favorable LAE reserve development in both 2002 and 2001 is primarily
attributable to claims process improvement initiatives taken by the Company over
the past four years. Since 1997, the Company has lowered claim settlement costs
through increased utilization of in-house attorneys and consolidation of claims
offices. These measures are complete.
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 auto
injury protection ("PIP") and workers' compensation 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.
Environmental Reserves
Although the Company does not specifically underwrite policies that include
environmental damage and toxic tort liability, the Company may be required to
defend such claims. Loss and LAE reserves for all direct business written by its
property and casualty companies related to environmental damage and toxic tort
liability, included in the reserve for losses and LAE, were $21.1 million and
$24.3 million, net of reinsurance of $12.0 million and $9.5 million for the six
months ended June 30,
24
2002 and 2001, respectively. Loss and LAE reserves for assumed reinsurance pool
business with environmental damage and toxic tort liability were $38.6 million
and $9.5 million for the six month ended June 30, 2002 and 2001, 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
prior years in which it was a participant. Because of the inherent uncertainty
regarding the types of claims in these pools, there can be no assurance that
these reserves will be sufficient. The increase in assumed reinsurance pool
business environmental damage and toxic tort liability reserves is primarily
related to a $33.0 million fourth quarter of 2001 adjustment for a voluntary
excess and casualty reinsurance pool (Excess and Casualty Reinsurance
Association "ECRA").
The Company estimated 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 currently 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.
Asset Accumulation
Allmerica Financial Services
The following table summarizes the results of operations for the Allmerica
Financial Services segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
-------------------------- ---------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Segment revenues
Premiums.................................................. $ 6.8 $ 7.6 $ 31.3 $ 33.1
Fees................................................... 98.8 99.2 194.8 199.6
Net investment income.................................. 72.7 72.0 143.4 143.2
Other income........................................... 26.5 25.5 50.2 51.6
--------- --------- --------- ----------
Total segment revenues.................................... 204.8 204.3 419.7 427.5
Policy benefits, claims and losses........................ 97.7 78.5 204.9 172.2
Policy acquisition and other operating expenses........... 220.9 83.2 298.9 168.4
--------- --------- --------- ----------
Segment (loss) income .................................... $ (113.8) $ 42.6 $ (84.1) $ 86.9
========= ========= ========= ==========
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
Segment income decreased $156.4 million, to a loss of $113.8 million, during the
second quarter of 2002. The decrease reflects the cumulative effect of the
significant, persistent decline in equity market values during the most recent
two and one half years, particularly the relatively significant decline during
the quarter. The decline resulted in additional amortization of the DAC asset of
$137.1 million, increased GMDB costs of $18.9 million, as well as reduced fees
and other income from certain products.
Segment revenues increased $0.5 million, or 0.2%, in the second quarter of 2002,
primarily due to higher income from transaction-based and asset-based fees.
Total other income increased $1.0 million, or 3.9%, to $26.5 million primarily
due to higher asset-based fees. Fee income decreased $0.4 million, or 0.4%, to
$98.8 million, primarily due to lower group annuity and group variable universal
life fees which decreased $3.1 million and $0.5 million, respectively. The
decline in group annuity fees was primarily due to lower average invested assets
resulting from the Company's exit from the defined contribution group retirement
business in 2001. This decrease was partially offset by a $3.2 million increase
in individual variable universal life fees principally due to higher insurance
fees and additional deposits. A decline in the market value of average
individual annuity separate account assets under management resulted in a $4.6
million decrease in annuity fee income, offset by an increase of $5.2 million
from additional deposits and insurance fees resulting from new sales.
Policy benefits, claims and losses increased $19.2 million, or 24.5%, to $97.7
million in the second quarter of 2002, primarily due to increased GMDB related
to variable annuities. 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
25
contract anniversary, or more typically the greatest of these values. To the
extent that the guaranteed minimum death benefit is higher than the current
account value at the time of death, the Company incurs a cost. This results in
increased annuity policy benefits in periods of declining financial markets and
in periods of stable financial markets following a decline. As of June 30, 2002
the difference between the GMDB and the current account value (the "net amount
at risk") for all existing contracts was $3.8 billion.
In the second quarter of 2002, the GMDB expense increased $18.9 million, to
$22.1 million, primarily due to the effects of the prolonged decline in the
financial markets. Unless equity market values appreciate from June 30, 2002
levels, the Company expects GMDB expenses to further increase and segment income
to be unfavorably affected during the remainder of 2002. At the equity market
values as of June 30, 2002, the expected GMDB expense for the year ending
December 31, 2002 would be approximately $76 million to $81 million. For each
one percent change, either increase or decrease in the S&P 500 Index, the net
amount at risk is estimated to increase or decrease by $100 million, and the
GMDB cost for a twelve-month period is estimated to increase or decrease by
approximately $2 million to $2.5 million.
Policy acquisition and other operating expenses increased $137.7 million, to
$220.9 million in the second quarter of 2002. This consists of an increase in
policy acquisition expenses of $140.6 million and a decrease in other operating
expenses of $2.9 million.
The increase in policy acquisition expenses resulted almost entirely from three
separate adjustments to amortization of DAC totaling $141.9 million. First, the
Company reduced its estimate of future gross profits expected from existing
variable annuity contracts and variable life insurance policies, resulting in
additional amortization of $137.1 million. The change in estimate resulted from
the significant decline in the equity markets during the quarter. Although
short-term market volatility does not change the Company's assessment of
long-term, future profitability, the Company considers the recent declines to be
suggestive of a permanent, partial reduction in future profitability. Should the
equity markets remain at, or decline from, levels existing at June 30, 2002,
additional amortization would be recognized. The converse is also true; a
significant market recovery would result in reduced or negative amortization.
At the current and expected equity market valuations, the Company's
reversion-to-the-mean accounting policy for DAC amortization assumes
appreciation in separate account values of 3% in each future quarter. In any
quarter, to the extent the change in separate account values deviates from the
3% assumption, for each 1% of deviation there would be an adjustment to DAC
amortization equal to $3 million to $5 million in the quarter. Accordingly, if
equity market values at September 30, 2002 remain the same as those at June 30,
2002, the Company expects additional DAC amortization in the third quarter of
2002 of approximately $9 million to $15 million.
The remaining two adjustments to DAC amortization result from the Company's
increasing its estimate of the long-term GMDB, which increased DAC amortization
by $13.3 million in the second quarter, and from the Company's changing its
estimate of future fees from certain annuity contracts, which decreased DAC
amortization by $8.5 million in the second quarter.
The $2.9 million decrease in other operating expenses is primarily due to the
Company's exit from the defined contribution group retirement business in July
2001.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
Segment income decreased $171.0 million, to a loss of $84.1 million, in the
first six months of 2002. The decrease reflects the cumulative effect of the
significant, persistent decline in equity market values during the most recent
two and one half years, particularly the relatively steep decline during the
second quarter. The decline resulted in additional amortization of the DAC asset
of $137.1 million, increased GMDB of $29.8 million, as well as reduced fees and
other income from certain products.
Segment revenues decreased $7.8 million, or 1.8%, in the first six months of
2002, primarily due to lower asset-based fees and other income. Fee income
decreased $4.8 million, or 2.4%, to $194.8 million, primarily due to lower group
annuity and group variable universal life fees which decreased $5.1 million and
$1.1 million, respectively. The decline in group annuity fees was primarily due
to lower average invested assets resulting from the Company's exit from the
defined contribution group retirement business. A decline in the market value of
average separate account assets under management resulted in a $9.8 million
decrease in fee income, partially offset by an increase of $7.3 million from
additional deposits and insurance fees. In addition, non-variable universal life
policy fees decreased $1.4 million in the first six months of 2002, primarily
due to a decline in average invested assets resulting from the continued shift
in focus to variable life insurance and annuity products. These decreases in fee
income were partially offset by a $5.3 million increase in fees from variable
universal life policies, primarily due to additional deposits. Other income
decreased $1.4 million, or 2.7%, to $50.2 million. This decline
26
was primarily due to decreased investment management fees resulting from
depreciation in variable product assets under management.
Policy benefits, claims and losses increased $32.7 million, or 19.0%, to $204.9
million in the first six months of 2002, primarily due to increased GMDB related
to variable annuities. In the first six months of 2002, the GMDB expense
increased $29.8 million primarily due to the effects of the prolonged decline in
the financial markets. Policy benefits, claims and losses also increased due to
interest credited on general account assets.
Policy acquisition and other operating expenses increased $130.5 million, to
$298.9 million in the first half of 2002. This consists of an increase in policy
acquisition expenses of $131.1 million and a decrease in other operating
expenses of $0.6 million. The increase in policy acquisition expenses resulted
entirely from the aforementioned three separate adjustments to amortization of
DAC, representing a total of $141.9 million of additional amortization. The
decrease in other operating expenses is due to the Company's exit from the
defined contribution group retirement business in July 2001, partially offset by
higher technology expenses.
Statutory Premiums and Deposits
The following table sets forth statutory premiums and deposits by product for
the Allmerica Financial Services segment.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------ -----------------------
(In millions) 2002 2001 2002 2001
------------------------------------------------------------------------------------------------------
Insurance:
Traditional life.................... $ 7.0 $ 7.8 $ 29.3 $ 24.0
Universal life...................... 3.7 4.8 7.9 9.4
Variable universal life............. 69.9 43.0 133.2 101.3
Individual health................... 0.1 0.1 0.1 0.2
Group variable universal life....... 0.6 20.9 25.9 59.3
---------- ---------- ---------- ---------
Total insurance............... 81.3 76.6 196.4 194.2
---------- ---------- ---------- ---------
Annuities:
Separate account annuities.......... 804.5 480.9 1,382.3 979.3
General account annuities........... 254.8 326.0 461.9 556.4
Retirement investment accounts...... 1.6 1.6 3.5 3.9
---------- ---------- ---------- ---------
Total individual annuities... 1,060.9 808.5 1,847.7 1,539.6
Group annuities..................... 13.0 70.3 37.4 165.2
---------- ---------- ---------- ---------
Total annuities............... 1,073.9 878.8 1,885.1 1,704.8
---------- ---------- ---------- ---------
Total premiums and deposits.............. $ 1,155.2 $ 955.4 $ 2,081.5 $ 1,899.0
========== ========== ========== =========
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
For the quarter ended June 30, 2002, total premiums and deposits increased
$199.8 million, or 20.9%, to $1,155.2 million. These increases are primarily due
to higher separate account annuity deposits partially offset by lower general
account annuity and group annuity deposits. The higher annuity deposits into the
Company's separate accounts were primarily due to a continued emphasis by
Scudder Investments ("Scudder") on marketing and sales of the Company's annuity
products. General account annuity deposits were higher in 2001 principally due
to a promotional annuity program offered for a limited period in 2001. Group
annuity deposits decreased due to the Company's exit from the defined
contribution retirement plan business and cessation of marketing activities for
new defined benefit retirement business. Variable universal life deposits
increased in the quarter due to increased sales of specialty variable life
products. Group variable universal life deposits decreased in the quarter due to
the cessation of marketing activities for this product.
Annuity products are distributed primarily through three distribution channels:
(1) "Agency", which consists of the Company's career agency force; (2) "Select",
which consists of a network of third party broker-dealers; and (3) "Partners",
which includes distributors of the mutual funds advised by Scudder, Pioneer
Investment Management, Inc. ("Pioneer") and Delaware Management Company
("Delaware"). Agency, Select, and Partners represented, respectively,
approximately 18%, 31%, and 51% of individual annuity deposits in the second
quarter of 2002, and Scudder represented 47% of all individual annuity deposits.
During the second quarter of 2001, Agency, Select, and Partners represented,
respectively, approximately 24%, 42%, and 34% of individual annuity deposits,
and Scudder represented 25% of all individual annuity deposits. The
27
Company's ability to distribute its products through the Partner channel is
highly dependent on its relationships with Scudder and Pioneer, respectively,
and, through both the Partner and Select channels, on its relationships and
reputation with the broker-dealer firms which distribute the products. Selling
agreements with broker-dealer firms, including those appointed through Scudder
and Pioneer, are generally terminable by either party upon 30 days notice.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
For the six months ended June 30, 2002, total premiums and deposits increased
$182.5 million, or 9.6%, to $2,081.5 million. These increases are primarily due
to higher annuity deposits into the Company's separate accounts resulting, in
part, from the aforementioned selling emphasis by Scudder. These increases were
partially offset by lower general account annuity deposits resulting from the
aforementioned promotional annuity program offered in 2001 and lower group
annuity deposits resulting from the Company's decision to cease marketing
activities for new group retirement business. Variable universal life deposits
increased due to increased sales of specialty variable life products. Group
variable universal life deposits decreased due to the cessation of marketing
activities for this product.
Agency, Select, and Partners represented, respectively, approximately 20%, 33%,
and 47% of individual annuity deposits in the first six months of 2002, and
Scudder represented 41% of all individual annuity deposits. During the first six
months of 2001, Agency, Select, and Partners represented, respectively,
approximately 25%, 40%, and 35% of individual annuity deposits, and Scudder
represented 25% of all individual annuity deposits.
Allmerica Asset Management
The following table summarizes the results of operations for the Allmerica Asset
Management segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
-------------------------- ---------------------------
(In millions) 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------------------
Interest margins on GICs:
Net investment income............................... $ 24.9 $ 39.5 $ 51.4 $ 76.4
Interest credited................................... 22.6 35.6 46.2 67.6
--------- --------- ---------- ---------
Net interest margin.................................... 2.3 3.9 5.2 8.8
--------- --------- ---------- ---------
Fees and other income
External............................................. 5.6 1.1 10.2 2.8
Internal............................................. 1.4 1.3 2.7 2.7
Other operating expenses............................... (4.2) (1.9) (7.9) (3.9)
--------- --------- ---------- ---------
Segment income......................................... $ 5.1 $ 4.4 $ 10.2 $ 10.4
========= ========= ========== =========
Average GIC deposits outstanding $ 2,271.4 $ 2,942.7 $ 2,370.5 $ 2,600.2
========= ========= ========== =========
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
Segment income increased $0.7 million, or 15.9%, to $5.1 million during the
second quarter of 2002. This increase is primarily due to the inclusion of
earnings related to Allmerica's premium financing subsidiary, AMGRO, which was
previously included in the Risk Management segment, in Allmerica Asset
Management's (AAM) results beginning in 2002. Also, segment income increased due
to increased earnings related to asset management services provided to external
clients, partially offset by decreased earnings on GICs. Earnings on GICs
decreased $1.6 million primarily due to withdrawals of short-term funding
agreements and to lower net investment income. Net investment income declined
primarily due to the shift from higher yielding below investment grade
securities to lower yielding, but higher quality investment grade securities
during 2002 and 2001, and to the effect of defaults on certain bonds supporting
GIC obligations. An increase in earnings from asset management services provided
to external clients resulted from new external assets under management.
At March 31, 2002, the Company held $478.4 million of short-term funding
agreements with put features which allow the policyholder to cancel the contract
prior to maturity. During the second quarter of 2002, payments related to
short-term funding agreement withdrawals were approximately $190 million. Also,
during the second quarter of 2002, the Company was notified of approximately
$105 million of additional withdrawals. Payments related to these withdrawal
notifications are expected in the third quarter of 2002. Subsequent to June 30,
2002, the Company was notified of approximately $185 million of additional
withdrawals which represent the remaining outstanding short-term funding
agreements with put features. Payments related to these subsequent withdrawal
notifications are expected in the fourth quarter of 2002. Management expects
income from the GIC product line to be unfavorably affected in future periods
due to short-term funding agreement withdrawals. In addition, management does
not expect to pursue future sales of short-term or long-term funding agreements.
28
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
Segment income decreased $0.2 million, or 1.9%, to $10.2 million in the first
six months of 2002. This decrease is primarily due to decreased earnings on
GICs, partially offset by the inclusion of earnings related to Allmerica's
premium financing subsidiary, AMGRO, in AAM's results beginning in 2002 and an
increase in fees and other income related to external clients. Earnings on GICs
decreased in 2002 primarily due to withdrawals of short-term funding agreements
and to lower net investment income. Net investment income declined primarily due
to the shift from higher yielding below investment grade securities to lower
yielding, but higher quality investment grade securities during 2002 and 2001,
and to the effect of the aforementioned bond defaults. The increase in external
fees and other income primarily resulted from the aforementioned increase in
other external assets under management from additional deposits.
At December 31, 2001, the Company held $761.8 million of short-term funding
agreements with put features which allow the policyholder to cancel the contract
prior to maturity. During the first six months of 2002, payments related to
short-term funding agreement withdrawals were approximately $476 million. Also,
during the second quarter of 2002, the Company was notified of approximately
$105 million of additional withdrawals. Payments related to these withdrawal
notifications are expected in the third quarter of 2002. Subsequent to June 30,
2002, the Company was notified of approximately $185 million of additional
withdrawals which represent the remaining short-term funding agreements with put
features. Payments related to these subsequent withdrawal notifications are
expected in the fourth quarter of 2002.
Corporate
The following table summarizes the results of operations for the Corporate
segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------------------
Segment revenues
Net investment income.............................. $ 1.5 $ 1.5 $ 3.2 $ 2.5
Interest expense................................... 3.8 3.8 7.6 7.6
Other operating expenses........................... 12.9 13.3 27.2 26.7
---------- ---------- ---------- ---------
Segment loss......................................... $ (15.2) $ (15.6) $ (31.6) $ (31.8)
========== ========== ========== =========
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
The segment loss decreased $0.4 million, or 2.6%, to $15.2 million in the second
quarter of 2002, primarily resulting from state tax credits recognized by the
holding company, partially offset by increased spending in corporate overhead
costs.
Interest expense for both periods relates principally to the interest paid on
the Senior Debentures of the Company.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
Segment loss decreased $0.2 million, or 0.6%, to $31.6 million in the first six
months of 2002, primarily resulting from state tax credits recognized by the
holding company and higher net investment income. These increases were partially
offset by increased spending in corporate overhead costs.
Interest expense for both periods relates to the interest paid on the Senior
Debentures of the Company.
29
Investment Portfolio
The Company held general account investment assets diversified across several
asset classes, as follows:
(Unaudited)
June 30, 2002 December 31, 2001
--------------------------------- --------------------------------
Carrying % of Total Carrying % of Total
(In millions) Value Carrying Value Value Carrying Value
- -------------------------------------------------- ------------- ------------------- ------------- ------------------
Fixed maturities (1)............................ $ 8,938.3 87.5% $9,401.7 88.1%
Equity securities (1)........................... 54.7 0.5 62.1 0.6
Mortgages....................................... 309.0 3.0 321.6 3.0
Policy loans.................................... 372.6 3.6 379.6 3.5
Cash and cash equivalents....................... 376.1 3.7 350.2 3.3
Other long-term investments..................... 170.3 1.7 161.2 1.5
------------- ------------------- ------------- ------------------
Total...................................... $10,221.0 100.0% $10,676.4 100.0%
============= =================== ============= ==================
- ---------------------------------------------------------------------------------------------------------------------
(1) The Company carries fixed maturities and equity securities in its investment
portfolio at market value.
Total investment assets decreased $455.4 million, or 4.3%, to $10.2 billion
during the first six months of 2002. This decrease consisted primarily of
reductions in fixed maturities of $463.4 million, principally due to short-term
funding agreement withdrawals in the Allmerica Asset Management segment.
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, investment grade securities
comprised 89.5% and 90.7% of the Company's total fixed maturity portfolio at
June 30, 2002 and December 31, 2001, respectively. Although management expects
that new funds will be invested primarily in investment grade fixed maturities,
the Company may invest a portion of new funds in below investment grade fixed
maturities or equity interests. The average yield on fixed maturities was 6.8%
and 7.4% for the six months ended June 30, 2002 and 2001, respectively. This
decline reflects the shift from higher yielding below investment grade
securities to lower yielding, but higher quality investment grade securities, as
well as 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 2002.
As of June 30, 2002 and December 31, 2001, approximately $515.1 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 $59.4 million and $95.2 million of realized
losses on other-than-temporary impairments of fixed maturities during the first
six months of 2002 and 2001, respectively. Other-than-temporary impairments in
2002 included $10.4 million from securitized investment portfolios and $9.5
million related to securities issued by Worldcom and affiliated companies.
Other-than-temporary impairments in 2001 included a $21.9 million loss from a
securitized investment portfolio. The losses reflect the continued deterioration
of high-yield securities in our portfolio. In addition, the Company recognized
$8.0 million of realized losses on other-than-temporary impairments of equity
securities during the first six months of 2002. 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, 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 impact
net income and earnings per share but reduce other comprehensive income.
In addition, the Company had fixed maturity securities with a carrying value of
$39.5 million and $9.8 million on non-accrual status at June 30, 2002 and
December 31, 2001, respectively. No assurance can be given that the fixed
maturity impairments will, in-fact, be adequate to cover future losses or that
substantial additional impairments will not be required in the future.
The effect of holding securities for which income is not accrued, 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 $9.2 million and
$6.8 million for the six months ended June 30, 2002 and 2001, respectively. This
includes the impact of securities held as of the
30
aforementioned financial statement dates, as well as securities sold during
those periods. Management expects that defaults in the fixed maturities
portfolio may continue to negatively impact investment income.
The gross unrealized losses on our 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 and, further, that the Company has the intent and
ability to retain such investments for a period of time sufficient to allow for
this anticipated recovery in market value. The risks inherent in the assessment
methodology include the risk that market factors may differ from management's
expectations; management may decide to subsequently sell a security for
unforeseen liquidity needs; or the credit assessment or equity characteristics
may change from the Company's original assessment and the Company may 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.
Of the $185.1 million gross unrealized losses of fixed maturities as of June 30,
2002, approximately $34.9 million relates to fixed maturity obligations of the
U.S. Treasury, U.S. government and agency securities, states and political
subdivisions. An additional $57.8 million of gross unrealized losses relates to
holdings of investment grade fixed maturities in a variety of industries and
sectors, while approximately $92.4 million relates to holdings of below
investment grade fixed maturities in a variety of industries and sectors.
Substantially all below investment grade securities with an unrealized loss have
been rated by either the NAIC, S&P or Moody's as of June 30, 2002. Also, $2.3
million in gross unrealized losses related to equity securities.
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.
Quarter Ended June 30, 2002 Compared to Quarter Ended June 30, 2001
The provision for federal income taxes was a benefit of $61.6 million during the
second quarter of 2002, compared to a benefit of $1.7 million during the same
period in 2001. These provisions resulted in consolidated effective federal tax
rates of (54.5%) and (11.0%) for the quarters ended June 30, 2002 and 2001,
respectively. It is the Company's policy to estimate taxes for interim periods
based on estimated annual effective tax rates which are derived, in part, from
expected annual pre-tax income. However, the federal income tax benefit for 2002
has been computed based on the first half of 2002 as a discreet period due to
the uncertainty regarding the Company's ability to reliably estimate pre-tax
income for the remainder of the year. The Company cannot reliably estimate
pre-tax income for the second half of 2002 principally due to the impact of the
equity markets on the Company, including possible additional amortization of
DAC. The large benefit in the current quarter is primarily due to the
significant loss recognized by the AFS segment. The benefit also reflects a
$12.1 million favorable settlement of certain prior years' federal income tax
returns.
Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001
The provision for federal income taxes was a benefit of $52.1 million during the
first six months of 2002, compared to an expense of $4.7 million during the same
period in 2001. These provisions resulted in consolidated effective federal tax
rates of (108.5%) and 9.0% for the six months ended June 30, 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 a
$12.1 million favorable settlement of certain prior years' federal income tax
returns.
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 generally accepted accounting
principles which require 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" to the consolidated financial statements contained in the Company's
Annual Report on Form 10-K for the period ended December 31, 2001.
31
Property & Casualty Insurance Loss Reserves
The amount of loss and loss adjustment expense reserves (the "loss 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 highly 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 used in
the estimation process, which vary by line of business, 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
would react accordingly by adjusting its reserves. 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. As a result, when the Company experiences loss events
that are subject to the reinsurance contract, reinsurance recoverables 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 recoverable 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 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. 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 are from asset-based fees,
which can vary in relation to changes in the equity markets.
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 in a period would typically result in less amortization expense in that
period. The converse would also be true. However, if lower gross profits were to
continue into the future, additional amortization 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 realizable
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.
Other-Than-Temporary Impairments
The Company employs a systematic methodology to evaluate declines in market
values below cost or amortized cost for its investments. This methodology
ensures that available evidence concerning the declines is evaluated in a
disciplined manner.
32
In determining whether a decline in market value below amortized cost is
other-than-temporary, the Company evaluates the length of time and the extent to
which the market value has been less than amortized cost; the financial
condition and near-term prospects of the issuer; 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 investment to decline in value to be
other-than-temporary. When an other-than-temporary decline in value is deemed to
have occurred, the Company reduces the cost basis of the investment to the new
estimated realizable value. This reduction is permanent and is recognized as a
realized investment loss.
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. Further,
in connection with the transfer of FAFLIC's ownership of the Company's property
and casualty subsidiaries to AFC in 1999, it was agreed with the Massachusetts
Commissioner of Insurance (the "Massachusetts Commissioner") that FAFLIC's risk
based capital would be maintained at 225%, or higher, of the "Company Action
Level", which is the level of risk based capital generally required by state
regulation. The agreement provided that the Massachusetts Commissioner would
have the authority to require FAFLIC to increase its risk based capital to at
least 225% under a plan approved by the Commissioner in the event that FAFLIC
reported risk based capital below 225% through the year 2005.
During the first six months of 2002, AFC did not receive any dividend payments
from its insurance subsidiaries. In July 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.
During the first six months of 2002, AFC contributed $40 million to FAFLIC. In
August 2002, AFC contributed an additional $158 million to FAFLIC. These
contributions were made in order to maintain FAFLIC's statutory surplus at
levels in consideration of its financial ratings with rating agencies and the
agreement with the Massachusetts Commissioner described above. Such capital
contributions were made due to the negative impact on statutory surplus of
increased GMDB reserves, an increased level of realized investment losses and
the level of premiums and deposits.
The statutory surplus of the life companies is highly sensitive to movements in
the equity markets. This is due to the required methodology for calculating GMDB
("Actuarial Guideline 34") reserves for statutory accounting purposes. As of
June 30, 2002, the level of net GMDB reserves in the life companies was
approximately $180 million. The 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 stock index, the
expected increase in required statutory GMDB reserves is approximately $6
million to $8 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, but to a lesser extent, due to the impact of the GMDB reinsurance
with an independent reinsurer, discussed below.
Management expects that additions to the statutory surplus of FAFLIC may be
required. Such additions could be funded by "extraordinary" dividends from the
property and casualty insurance subsidiaries, borrowing under the existing
syndicated credit agreement, reinsurance contracts, raising debt or equity in
the public or private markets, or an internal reorganization of certain
insurance entities. The Company could also reduce sales of variable insurance
products to help maintain statutory capital and risk based capital levels.
In 2001, AFLIAC agreed to cede its GMDB costs in excess of $40 million, but not
to exceed $80 million, annually for a three year period, to an independent
reinsurer. Under a related agreement, AFC agreed to reimburse these costs to the
reinsurer. Through the six months ended June 30, 2002, AFLIAC incurred GMDB
costs of approximately $47.2 million and ceded approximately $7.2 million under
the agreement. Management believes that unless equity market values appreciate
from June 30, 2002 levels, AFC will be required to reimburse additional GMDB
costs.
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
33
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. 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 $149.6 million and $277.7 million
during the first six months of 2002 and 2001, respectively. Net cash was higher
in 2001 compared to 2002 primarily as a result of the promotional annuity
program with enhanced crediting rates of 7% in 2001, which attracted higher
deposits into the Company's general accounts. This decrease in 2002 was
partially offset by lower loss and LAE payments in 2002 in the property and
casualty business.
Net cash provided by investing activities was $479.4 million for the first six
months of 2002, compared to net cash used in investing activities of $799.2
million for the same period of 2001. The $1.3 billion increase in cash provided
is primarily the result of net sales of fixed maturities in 2002 due to funding
agreement withdrawals. In 2001, net purchases of fixed maturities resulted from
the investment of net deposits from funding agreements.
Net cash used in financing activities was $603.1 million during the first six
months of 2002, compared to net cash provided by financing activities of $723.1
million for the same period of 2001. The decrease in 2002 is primarily due to
net funding agreement withdrawals, including trust instruments supported by
funding obligations, of $595.2 million as compared to net deposits of $706.4
million in 2001.
Management believes the holding company of AFC has the ability to meet its
obligations including, but not limited to, interest on the Senior Debentures and
Capital Securities, and dividends, when and if declared by the Board of
Directors, on the common stock. Whether the Company will pay dividends in the
future depends upon the earnings and financial condition of AFC.
Based on current trends, the Company expects to continue to generate sufficient
positive operating cash to meet all short-term and long-term cash requirements.
The Company's insurance subsidiaries maintain a high degree of liquidity within
the investment portfolio in fixed maturity investments, common stock and
short-term investments. AFC has $150.0 million available under a committed
syndicated credit agreement which expires on May 23, 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. At June 30, 2002, no amounts were outstanding under this agreement. The
Company had $74.4 million of commercial paper borrowings outstanding at June 30,
2002. These borrowings are used in connection with AMGRO's premium financing
business, which is included in the Allmerica Asset Management segment, and for
short-term funding requirements in the Allmerica Financial Services segment. The
Company also funds the premium financing business through sales of receivables
generated by this business.
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 10 "Commitments and Contingencies - Litigation"
to the consolidated financial statements. 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.
Recent Developments
Insurance companies are rated by rating agencies to provide both industry
participants and insurance consumers meaningful information on specific
insurance companies. Higher ratings generally indicate 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 ratings are assigned to an insurer based upon factors 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.
During August 2002, Standard & Poor's rating service revised downward its
financial strength rating of the property & casualty companies from "AA-" (Very
Strong) to "A+" (Strong) with a negative outlook as well as the life insurance
companies from "AA-" (Very Strong) to "A" (Strong) with a stable outlook. In
addition, Standard & Poor's downgraded its senior debt rating for the Company
from "A-" (Strong) to "BBB" (Good) with a stable outlook.
34
During July 2002, Moody's rating service revised downward its financial strength
rating of Hanover Insurance Company from "A1" (Good) to "A2" (Good) with a
negative outlook as well as the life insurance companies from "A1" (Good) to
"A3" (Good) with a stable outlook. In addition, Moody's downgraded its senior
debt rating for the Company from "A3" (Good) to "Baa2" (Adequate) and downgraded
its short-term insurance financial strength rating of FAFLIC from "P1"
(Superior) to "P2" (Strong) with a stable outlook.
Additionally, during July 2002, A.M. Best rating service revised downward its
financial strength ratings of the life insurance companies from "A" (Excellent)
to "A-" (Excellent). In addition, AFC's senior debt ratings were downgraded from
"a-" to "bbb+" with a negative outlook; the capital securities rating was
downgraded from "bbb+" to "bbb" with a negative outlook; and the commercial
paper rating was lowered from AMB-1 to AMB-2. A.M. Best maintained its financial
strength ratings for the property and casualty companies, but assigned a
negative outlook.
Rating downgrades from current levels may adversely affect the Company's product
sales. In addition, certain rating downgrades from current levels could
precipitate the payment of funds held by the Company related to its aggregate
excess of loss reinsurance treaty. Rating downgrades from current levels may
adversely affect the cost and availability of any additional debt financing.
The financial position and results of operations of the Allmerica Financial
Services segment are highly dependent on equity market valuations. From its peak
in March 2000 when the S&P 500 index was at 1,527.46 points, the market has
declined 35.2% at June 30, 2002 to 989.82 points. Of this decrease, 13.7%, or
157.57 points, occurred during the second quarter of 2002 alone. As of August
13, 2002, the S&P 500 index was at 884.21 points, down 10.7% from June 30, 2002.
As noted elsewhere in this Management's Discussion and Analysis, the decline in
equity market valuations have resulted in, and continue to result in, among
other things, increased GMDB expenses, lower fee income, higher DAC amortization
and higher statutory capital reserve requirements. These declines, together with
the increasing competitiveness in the variable product retirement market, may
result in changes in the Allmerica Financial Services business segment or the
Company, some of which could be material.
35
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 2002
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",
"anticipated", "expects" and similar expressions are intended to identify
forward looking statements. The Company describes these factors and
considerations in greater detail in "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, 2001. 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 sales, 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 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 career
agents, wholesalers, broker-dealers and partnership relations to support the
sale of variable 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) increases in costs, particularly those occurring after the time
our products are priced and including construction, automobile, and medical and
rehabilitation costs; (xii) changes in the Company's liquidity due to changes in
asset and liability matching; (xiii) restrictions on insurance underwriting;
(xiv) adverse changes in the ratings obtained from independent rating agencies,
such as Fitch, Moody's, Standard and Poor's and A.M. Best, (xv) possible claims
relating to sales practices for insurance products; (xvi) failure of a reinsurer
of the Company's policies to pay its liabilities under reinsurance contracts or
adverse effects on the cost and availability of reinsurance resulting from the
September 11 terrorist attack; (xvii) earlier than expected withdrawals from the
Company's general account annuities, GICs (including funding agreements), and
other insurance products; (xviii) changes in the mix of assets comprising the
Company's investment portfolio and the fluctuation of the market value of such
assets; (xix) losses resulting from the Company's participation in certain
reinsurance pools; (xx) losses due to foreign currency fluctuations; (xxi)
defaults in debt securities held by the Company, and (xxii) higher employee
benefit costs due to changes in market values of plan assets, interest rates and
employee compensation levels.
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 June 30, 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 patterns, level of sales of variable insurance products, investment
experience and performance of equity and financial markets throughout the
period, as well as from period to period.
36
PART I - FINANCIAL INFORMATION
ITEM 3
QUANTITATIVE AND QUALITATIVE DICLOSURES
ABOUT MARKET RISK
The Company's market risks, and the way the Company manages them, are summarized
in management's discussion and analysis of financial condition and results of
operations as of December 31, 2001, included in the Company's Form 10-K for the
year ended December 31, 2001. There have been no material changes in the first
six months of 2002 to such risks or the management of such risks.
37
PART II - OTHER INFORMATION
ITEM 4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
This registrant's annual shareholder's meeting was held on May 14, 2002. All
four directors nominated for re-election by the Board of Directors were named in
proxies for the meeting, which proxies were solicited pursuant to Regulations
14A of the Securities and Exchange Act of 1934.
VOTES FOR WITHHELD
Samuel J.Gerson 41,984,070 420,255
Wendell J. Knox 41,558,561 845,764
Robert J. Murray 42,012,777 391,548
John R. Towers 41,559,284 845,041
The other directors whose terms were continued after the Annual Meeting are Mr.
Michael P. Angelini, Mr. E. Gordon Gee, Ms. Gail L. Harrison, Mr. Robert P.
Henderson, Mr. M Howard Jacobson, Mr. Terrence Murray, Mr. John F. O'Brien and
Mr. Herbert M. Varnum.
Shareholders ratified the appointment of PricewaterhouseCoopers LLP as the
Independent Public Accountants of the Company for 2002: for 40,524,370; against
1,761,435; abstain 118,520.
38
PART II - OTHER INFORMATION
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EX - 10.38 Amendment to the Credit Agreement dated as of May 27, 2002
between the Registrant and JPMorgan Chase Bank
EX - 10.41 Stop/Loss Reinsurance Agreement effective September 30, 2001,
between Allmerica Financial Life Insurance and Annuity
Company and Lincoln National Reassurance Company
EX - 10.42 Amended and Restated Put Option Agreement dated September
30, 2001 between Allmerica Financial Corporation and Old Fort
Insurance Company, Ltd.
EX - 99.1 Certification of the Chief Executive Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002
EX - 99.2 Certification of the Chief Financial Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
None
39
SIGNATURES
Pursuant to the requirements of the Securities 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
Dated August 14, 2002
/s/ John F. O'Brien
John F. O'Brien
President and Chief Executive Officer
Dated August 14, 2002
/s/ Edward J. Parry III
Edward J. Parry III
Vice President, Chief Financial Officer and
Principal Accounting Officer
40
EXHIBIT INDEX
Exhibit Number Exhibit
10.38 Amendment to the Credit Agreement dated as of May 27, 2002
between the Registrant and JPMorgan Chase Bank
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.
99.1 Certification of the Chief Executive Officer prusuant to
18 U.S.C. Section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002
99.2 Certification of the Chief Financial Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002
41