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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: September 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: 52,900,919 shares of common
stock outstanding, as of November 1, 2002.
53
Total Number of Pages Included in This Document
Exhibit Index is on Page 54
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 - 16
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 17 - 47
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 48
Item 4. Controls and Procedures 48
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 49
SIGNATURES 50
CERTIFICATIONS 51 - 53
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------------------------------------------
(In millions, except per share data) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums................................................... $ 576.2 $ 559.9 $ 1,736.2 $ 1,685.4
Universal life and investment product policy fees.......... 97.1 95.0 291.9 294.6
Net investment income...................................... 152.8 169.6 452.9 501.1
Net realized investment losses............................. (7.8) (4.9) (83.9) (89.6)
Other income............................................... 36.6 33.4 105.5 102.6
----------- ----------- ------------ -----------
Total revenues........................................ 854.9 853.0 2,502.6 2,494.1
----------- ----------- ------------ -----------
Benefits, losses and expenses
Policy benefits, claims, losses and loss adjustment
expenses................................................. 616.4 558.6 1,669.9 1,636.7
Policy acquisition expenses................................ 542.3 125.4 912.6 355.8
Net losses (gains) on derivative instruments............... 0.1 0.6 (30.3) (2.3)
Other operating expenses................................... 187.2 144.6 489.5 427.8
----------- ----------- ------------ -----------
Total benefits, losses and expenses.................. 1,346.0 829.2 3,041.7 2,418.0
----------- ----------- ------------ -----------
(Loss) income before federal income taxes.................. (491.1) 23.8 (539.1) 76.1
----------- ----------- ------------ -----------
Federal income tax (expense) benefit:
Current................................................. (15.9) 71.4 (12.5) 99.6
Deferred................................................ 197.6 (60.0) 246.3 (92.9)
----------- ----------- ------------ -----------
Total federal income tax benefit..................... 181.7 11.4 233.8 6.7
----------- ----------- ------------ -----------
(Loss) income before minority interest and cumulative
effect of change in accounting principle................ (309.4) 35.2 (305.3) 82.8
Minority interest:
Distributions on mandatorily redeemable preferred
securities of a subsidiary trust holding solely
junior subordinated debentures of the Company......... (4.0) (4.0) (12.0) (12.0)
----------- ----------- ------------ -----------
(Loss) income before cumulative effect of change in
accounting principle.................................... (313.4) 31.2 (317.3) 70.8
Cumulative effect of change in accounting principle (less
applicable income tax benefit of $2.0 and $1.7 for the
nine months ended September 30, 2002 and 2001).......... - - (3.7) (3.2)
----------- ----------- ------------ -----------
Net (loss) income.......................................... $ (313.4) $ 31.2 $ (321.0) $ 67.6
=========== =========== ============ ===========
PER SHARE DATA
Basic
(Loss) income before cumulative effect of change in
accounting principle.................................. $ (5.93) $ 0.59 $ (6.00) $ 1.34
Cumulative effect of change in accounting principle
(less applicable income tax benefit of $0.04 and $0.03
for the nine months ended September 30, 2002 and 2001) - - (0.07) (0.06)
----------- ----------- ------------ -----------
Net (loss) income....................................... $ (5.93) $ 0.59 $ (6.07) $ 1.28
=========== =========== ============ ===========
Weighted average shares outstanding .................... 52.9 52.7 52.9 52.6
=========== =========== ============ ===========
Diluted
(Loss) income before cumulative effect of change in
accounting principle.................................. $ (5.93) $ 0.59 $ (6.00) $ 1.33
Cumulative effect of change in accounting principle
(less applicable income tax benefit of $0.04 and $0.03
for the nine months ended September 30, 2002 and 2001) - - (0.07) (0.06)
----------- ----------- ------------ -----------
Net (loss) income ...................................... $ (5.93) $ 0.59 $ (6.07) $ 1.27
=========== =========== ============ ===========
Weighted average shares outstanding..................... 52.9 53.1 52.9 53.1
=========== =========== ============ ===========
The accompanying notes are an integral part of these consolidated financial statements.
3
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(In millions, except per share data) 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities-at fair value (amortized cost of $8,677.7 and $9,294.0).. $ 8,949.2 $ 9,401.7
Equity securities-at fair value (cost of $50.4 and $61.2)................. 50.4 62.1
Mortgage loans............................................................ 286.7 321.6
Policy loans.............................................................. 360.4 379.6
Other long-term investments............................................... 169.3 161.2
---------- -----------
Total investments....................................................... 9,816.0 10,326.2
---------- -----------
Cash and cash equivalents.................................................... 952.3 350.2
Accrued investment income.................................................... 141.4 152.3
Premiums, accounts and notes receivable, net................................. 581.2 628.4
Reinsurance receivable on paid and unpaid losses,
benefits and unearned premiums............................................ 1,437.0 1,426.8
Deferred policy acquisition costs............................................ 1,417.6 1,784.2
Deferred federal income taxes................................................ 406.0 168.1
Goodwill..................................................................... 131.2 139.2
Other assets................................................................. 493.0 522.3
Separate account assets...................................................... 12,152.9 14,838.4
---------- -----------
Total assets.............................................................. $ 27,528.6 $ 30,336.1
========== ===========
Liabilities
Policy liabilities and accruals:
Future policy benefits.................................................... $ 4,766.3 $ 4,099.6
Outstanding claims, losses and loss adjustment expenses................... 3,040.1 3,029.8
Unearned premiums......................................................... 1,083.8 1,052.5
Contractholder deposit funds and other policy liabilities................. 1,083.9 1,763.9
---------- -----------
Total policy liabilities and accruals................................... 9,974.1 9,945.8
---------- -----------
Expenses and taxes payable................................................... 987.2 934.1
Reinsurance premiums payable................................................. 113.3 125.3
Trust instruments supported by funding obligations........................... 1,696.2 1,518.6
Short-term debt.............................................................. - 83.3
Long-term debt............................................................... 199.5 199.5
Separate account liabilities................................................. 12,152.9 14,838.4
---------- -----------
Total liabilities......................................................... 25,123.2 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 11)
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................................................... 1,762.3 1,758.4
Accumulated other comprehensive income (loss)................................ 11.5 (13.7)
Retained earnings............................................................ 731.3 1,052.3
Treasury stock at cost (7.4 and 7.5 million shares).......................... (400.3) (406.5)
---------- -----------
Total shareholders' equity................................................ 2,105.4 2,391.1
---------- -----------
Total liabilities and shareholders' equity.............................. $ 27,528.6 $ 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)
Nine Months Ended
September 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............... 3.9 (9.3)
-------- ---------
Balance at end of period..................................................... 1,762.3 1,756.0
-------- ---------
Accumulated Other Comprehensive Income
Net unrealized appreciation (deppreciation) on investments:
Balance at beginning of period............................................... 28.4 (5.2)
Net appreciation on available-for-sale securities......................... 98.1 151.4
Provision for deferred federal income taxes............................... (34.3) (53.0)
-------- ---------
63.8 98.4
-------- ---------
Net depreciation on derivative instruments................................ (59.4) (74.6)
Benefit for deferred federal income taxes................................. 20.8 26.1
-------- ---------
(38.6) (48.5)
-------- ---------
Balance at end of period..................................................... 53.6 44.7
-------- ---------
Minimum Pension Liability:
Balance at beginning and end of period....................................... (42.1) -
-------- ---------
Total accumulated other comprehensive income................................. 11.5 44.7
-------- ---------
Retained earnings
Balance at beginning of period............................................... 1,052.3 1,068.7
Net (loss) income......................................................... (321.0) 67.6
-------- ---------
Balance at end of period..................................................... 731.3 1,136.3
-------- ---------
Treasury Stock
Balance at beginning of period............................................... (406.5) (420.3)
Shares reissued at cost.................................................... 6.2 12.5
-------- ---------
Balance at end of period..................................................... (400.3) (407.8)
-------- ---------
Total shareholders' equity............................................ $ 2,105.4 $ 2,529.8
======== =========
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 Nine Months Ended
September 30, September 30,
----------------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Net (loss) income................................. $ (313.4) $ 31.2 $ (321.0) $ 67.6
Other comprehensive income (loss):
Available-for-sale securities:
Net appreciation during the period............ 75.8 78.8 98.1 151.4
Provision for deferred federal income taxes... (26.5) (27.6) (34.3) (53.0)
----------- ----------- ----------- -----------
Total available-for-sale securities............. 49.3 51.2 63.8 98.4
----------- ----------- ----------- -----------
Derivative instruments:
Net depreciation during the period............ (37.2) (80.1) (59.4) (74.6)
Benefit for deferred federal income taxes..... 13.0 28.0 20.8 26.1
----------- ----------- ----------- -----------
Total derivative instruments.................... (24.2) (52.1) (38.6) (48.5)
----------- ----------- ----------- -----------
Other comprehensive income (loss)................. 25.1 (0.9) 25.2 49.9
----------- ----------- ----------- -----------
Comprehensive (loss) income....................... $ (288.3) $ 30.3 $ (295.8) $ 117.5
=========== =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
6
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
--------------------------------
(In millions) 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities
Net (loss) income....................................................... $ (321.0) $ 67.6
Adjustments to reconcile net (loss) income to net cash provided by
operating activities:
Net realized investment losses....................................... 83.9 89.6
Gains on derivative instruments...................................... (30.3) (2.3)
Impairment of capitalized technology costs........................... 29.8 -
Net amortization and depreciation.................................... 14.0 14.5
Deferred federal income taxes........................................ (246.3) 92.9
Change in deferred acquisition costs................................. 320.5 (133.0)
Change in premiums and notes receivable,
net of reinsurance payable......................................... 0.3 (4.2)
Change in accrued investment income.................................. 10.9 5.2
Change in policy liabilities and accruals, net....................... 728.0 504.3
Change in reinsurance receivable..................................... (10.2) 36.3
Change in expenses and taxes payable................................. 74.8 (201.1)
Other, net........................................................... 18.4 (24.5)
------------- -------------
Net cash provided by operating activities...................... 672.8 445.3
------------- -------------
Cash flows from investing activities
Proceeds from disposals and maturities of available-for-sale fixed
maturities............................................................ 2,957.5 1,836.9
Proceeds from disposals of equity securities............................ 16.5 41.7
Proceeds from disposals of other investments............................ 34.4 42.2
Proceeds from mortgages matured or collected............................ 35.9 68.6
Proceeds from collections of installment finance and notes receivable... 267.2 153.6
Purchase of available-for-sale fixed maturities......................... (2,342.4) (2,740.4)
Purchase of equity securities........................................... (1.7) (10.4)
Purchase of other investments........................................... (27.6) (19.5)
Payments related to terminated swap agreements.......................... (37.4) (7.2)
Disbursements to fund installment finance and notes receivable.......... (232.3) (169.5)
Capital expenditures.................................................... (6.9) (22.7)
Other, net.............................................................. - 1.5
------------- -------------
Net cash provided by (used in) investing activities............ 663.2 (825.2)
------------- -------------
Cash flows from financing activities
Deposits and interest credited to contractholder deposit funds.......... 114.0 148.4
Withdrawals from contractholder deposit funds........................... (822.1) (490.4)
Deposits to trust instruments supported by funding obligations.......... 165.8 1,109.2
Withdrawals from trust instruments supported by funding obligations..... (109.4) (86.3)
Change in short-term debt............................................... (83.3) 14.4
Treasury stock reissued at cost......................................... 1.1 4.4
------------- -------------
Net cash (used in) provided by financing activities............ (733.9) 699.7
------------- -------------
Net change in cash and cash equivalents.................................... 602.1 319.8
Cash and cash equivalents, beginning of period............................. 350.2 281.1
------------- -------------
Cash and cash equivalents, end of period................................... $ 952.3 $ 600.9
============= =============
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") and its subsidiary,
Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"); The Hanover
Insurance Company ("Hanover")and its subsidiary, 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 nine months ended September 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.
On September 27, 2002, the Company announced plans to consider strategic
alternatives, including a significant reduction of sales of proprietary variable
annuities and life insurance products. This resulted from the cumulative effect
of the significant, persistent decline in the equity market, particularly the
significant decline in the third quarter of 2002 that followed the decline in
the second quarter, as well as the rating agency actions. Susequently, the
Company ceased all new sales of proprietary variable annuities and life
insurance products. In addition, the Company will not pursue new sales in
FAFLIC's funding agreement business (See Note 9). FAFLIC and AFLIAC will retain
and service existing customer accounts while utilizing existing agents to
distribute third party investment and insurance products.
Thus, the future profitability of FAFLIC and AFLIAC is dependent upon, among
other things, the ability to generate non-proprietary sales, the persistency of
existing customer accounts, equity market levels, and the ability to rationalize
an expense structure consistent with the new business model. The Company
believes the earnings of these entities will be substantially less than those in
years prior to 2002.
2. New Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 146, "Accounting for Costs Associated with
Exit or Disposal Activities" ("Statement No. 146"). This Statement requires that
a liability for costs associated with an exit or disposal activity is recognized
and measured initially at its fair value in the period the liability is
incurred. This statement supercedes Emerging Issues Task Force Issue No. 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)".
Additionally, the Statement requires financial statement disclosures about the
description of the exit or disposal activity, including for each major type of
cost, the total amount expected to be incurred and a reconciliation of the
beginning and ending liability balances. The provisions of this statement are
effective for all exit and disposal activities initiated after December 31,
2002. The adoption of Statement No. 146 is not expected to have a material
effect on the Company's financial statements.
In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement No. 144"). This statement addresses significant issues relating to
the implementation of Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of" ("Statement No. 121"), by developing a single accounting model,
based on the framework established in Statement No. 121, for long-lived assets
to be disposed of by sale, whether previously held and used or newly acquired.
In addition, Statement No. 144 supercedes the accounting and reporting
provisions of Accounting Principles Board Opinion No. 30 ("APB No. 30"),
"Reporting the Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions", for the disposal of a segment of a business and amends
Accounting Research Bulletin No. 51, "Consolidated Financial Statements", to
eliminate the exception to consolidation for a subsidiary for which control is
likely to be temporary. The provisions of this statement are effective for
fiscal years beginning after December 15, 2001. The adoption of Statement No.
144 did not have a material effect on the Company's financial statements.
8
In June 2001, the FASB 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.
Effective January 1, 2002, the Company ceased its amortization of goodwill in
accordance with Statement No. 142. Amortization expense in the third quarter and
the first nine months of 2001 was $1.0 million and $3.0 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 September 30, 2002 and 2001,
as reported and adjusted as if the Company had ceased amortizing goodwill
effective January 1, 2001.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------------------------------
(In millions, except per share data) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (313.4) $ 31.2 $ (317.3) $ 70.8
Goodwill amortization................................... - 1.0 - 3.0
----------- ---------- ----------- ----------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (313.4) $ 32.2 $ (317.3) $ 73.8
=========== ========== =========== ==========
Reported net (loss) income................................. $ (313.4) $ 31.2 $ (321.0) $ 67.6
Goodwill amortization................................... - 1.0 - 3.0
----------- ---------- ----------- ----------
Adjusted net (loss) income................................. $ (313.4) $ 32.2 $ (321.0) $ 70.6
=========== ========== =========== ==========
Per Share Information
Basic
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (5.93) $ 0.59 $ (6.00) $ 1.34
Goodwill amortization................................... - 0.02 - 0.05
----------- ---------- ----------- ----------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (5.93) $ 0.61 $ (6.00) $ 1.39
=========== ========== =========== ==========
Reported net (loss) income................................. $ (5.93) $ 0.59 $ (6.07) $ 1.28
Goodwill amortization................................... - 0.02 - 0.05
----------- ---------- ----------- ----------
Adjusted net (loss) income................................. $ (5.93) $ 0.61 $ (6.07) $ 1.33
=========== ========== =========== ==========
Diluted
Reported (loss) income before cumulative effect of change
in accounting principle................................. $ (5.93) $ 0.59 $ (6.00) $ 1.33
Goodwill amortization................................... - 0.02 - 0.05
----------- ---------- ----------- ----------
Adjusted (loss) income before cumulative effect of change
in accounting principle................................. $ (5.93) $ 0.61 $ (6.00) $ 1.38
=========== ========== =========== ==========
Reported net (loss) income................................. $ (5.93) $ 0.59 $ (6.07) $ 1.27
Goodwill amortization................................... - 0.02 - 0.05
----------- ---------- ----------- ----------
Adjusted net (loss) income................................. $ (5.93) $ 0.61 $ (6.07) $ 1.32
=========== ========== =========== ==========
Note: Due to the use of weighted average shares outstanding when calculating earnings per common share, the sum of the
quarterly per common share data may not equal the per common share data for the year.
9
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.
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 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 $6.1 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 $76.0 million at September 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 September 30,
2002 and 2001, the discontinued segment had assets of approximately $305.2
million and $397.1 million, respectively, consisting primarily of invested
assets and reinsurance recoverables, and liabilities of approximately $361.7
million and $367.6 million, respectively, consisting primarily of policy
liabilities. Revenues for the discontinued operations were $6.0 million and $8.1
million for the quarters ended September 30, 2002 and 2001, respectively, and
$18.0 million and $27.9 million for the nine months ended September 30, 2002 and
2001, respectively.
4. Third Quarter Events
Prior to September 30, 2002, the Allmerica Financial Services ("AFS") segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and life insurance products. This resulted from
the cumulative effect of the significant, persistent decline in the equity
market, particularly the significant decline in the third quarter of 2002 that
followed the decline in the second quarter, as well as the rating agency
actions. Subsequently, the Company ceased all new sales of proprietary variable
annuities and life insurance products.
10
Consistent with its accounting policies, the Company evaluated the impact of the
aforementioned third quarter 2002 events. As a result of the significant decline
in the equity market during the third quarter of 2002, that followed the decline
in the second quarter, and the decision to cease new sales of proprietary
variable annuities and life insurance products, the Company re-evaluated and
revised its assumptions including its estimates of persistency, asset growth
rates and asset-based fees. These revisions significantly reduced the total
estimated gross profits and expected life of these contracts.
Accordingly, the Company recorded the following charges during the quarter ended
September 30, 2002 (unaudited):
(In millions)
- -----------------------------------------------------------------------------------------
Additional deferred policy acquisition cost ("DAC")
amortization:
Revision of surrender rate assumptions.................... $ 171.1
Equity market depreciation................................ 65.7
Revision of market-related appreciation assumptions....... 43.3
Revision of guaranteed minimum death benefits
("GMDB") long-term cost assumptions................... 48.4
Impairment of DAC asset................................... 159.0
---------------
487.5
---------------
GMDB:
Revision of long-term cost assumptions.................... 106.7
Reduction of DAC amortization............................. (67.6)
---------------
39.1
---------------
Impairment of capitalized technology costs................... 29.8
---------------
Total............................................................. $ 556.4
===============
In connection with the aforementioned decision to cease new sales of proprietary
variable annuities and life insurance products and as a result of the
significant, sustained decline in the equity market, the Company reviewed its
estimate of future gross profits to be realized from the AFS products. Based on
this review, the Company revised certain of its long-term assumptions related to
DAC and GMDB reserves. Accordingly, the Company recorded additional DAC
amortization of $487.5 million in the quarter ended September 30, 2002. The
Company also recognized an increase to its GMDB reserve of $106.7 million for
the quarter ended September 30, 2002, which was partially offset by a reduction
in DAC amortization of $67.6 million.
Additionally, as a result of the aforementioned change in business strategy of
the AFS business segment, certain capitalized software and other capitalzied
technology costs were reviewed for impairment in accordance with Statement No.
144. The fair value of these assets was estimated using a traditional present
value technique in which a single set of estimated cash flows and a single
interest rate were used. This review resulted in the recognition of a $29.8
million charge in the third quarter of 2002 which is reflected in Other
Operating Expenses in the Consolidated Statements of Income. This charge is
comprised of $29.1 million of capitalized software and $0.7 million related to
mid-range equipment that were deemed to be impaired.
5. Restructuring
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 September 30, 2002. The Company has made payments of
$2.2 million related to this restructuring plan as of September 30, 2002.
6. 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 nine
months ended September 30, 2002 has been computed based on the first nine months
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 remainder 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, for the nine
months ended September 30, 2002, the Company recognized a benefit of $11.6
million related to the settlement of prior years' federal income tax returns.
Federal income tax expense for the nine months ended September 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.
11
7. 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 Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------------------------
Unrealized gains on available-for-sale securities:
Unrealized holding gains arising during period (net of
income tax expense of $23.0 million and $30.4 million for
the quarters ended September 30, 2002 and 2001 and $16.0
million and $38.5 million for the nine months ended
September 30, 2002 and 2001).............................. $ 42.9 $ 61.3 $ 30.0 $ 46.8
Less: reclassification adjustment for (losses) gains
included in net income (net of income tax benefit
(expense) of $3.5 and $(2.8) million for the quarters
ended September 30, 2002 and 2001 and $18.3 million and
$14.5 million for the nine months ended September 30, 2002
and 2001)................................................. (6.4) 10.1 (33.8) (51.6)
--------- --------- ---------- ----------
Total unrealized gains on available-for-sale securities........ 49.3 51.2 63.8 98.4
--------- --------- ---------- ----------
Unrealized losses on derivative instruments:
Unrealized holding losses arising during period (net of
income tax benefit of $7.8 million and $33.6 million
for the quarters ended September 30, 2002 and 2001
and $54.6 million and $32.7 million for the nine months
ended September 30, 2002 and 2001)........................ (14.7) (62.2) (101.4) (60.6)
Less: reclassification adjustment for gains (losses)
included in net income (net of income tax (expense)
benefit of $(5.2) million and $5.6 million for the
quarters ended September 30, 2002 and 2001 and $33.8
million and $6.6 million for the nine months ended
September 30, 2002 and 2001).............................. 9.5 (10.1) (62.8) (12.1)
--------- --------- ---------- ----------
Total unrealized losses on derivative instruments.............. (24.2) (52.1) (38.6) (48.5)
--------- --------- ---------- ----------
Other comprehensive income (loss)................................. $ 25.1 $ (0.9) $ 25.2 $ 49.9
========= ========= ========== ==========
12
8. Closed Block
Summarized financial information of the Closed Block is as follows for the periods indicated:
(Unaudited)
September 30, December 31,
(In millions) 2002 2001
- -----------------------------------------------------------------------------------------------------------
Assets
Fixed maturities-at fair value (amortized cost of $517.5 and
$498.1)............................................................ $ 540.3 $ 504.2
Mortgage loans....................................................... 50.6 55.7
Policy loans......................................................... 167.5 182.1
Cash and cash equivalents............................................ 5.8 9.2
Accrued investment income............................................ 14.3 14.6
Deferred policy acquisition costs.................................... 8.4 10.4
Other assets......................................................... 9.8 6.2
--------- ----------
Total assets...................................................... $ 796.7 $ 782.4
========= ==========
Liabilities
Policy liabilities and accruals...................................... $ 783.0 $ 798.2
Policyholder dividends............................................... 49.8 30.7
Other liabilities.................................................... 17.9 7.0
--------- ----------
Total liabilities................................................. $ 850.7 $ 835.9
========= ==========
Excess of Closed Block liabilities over assets designated to the
Closed Block......................................................... $ 54.0 $ 53.5
Amounts included in accumulated other comprehensive income:
Net unrealized investment losses, net of deferred federal income
tax benefit of $4.8 million and $8.8 million......................... (8.8) (16.4)
--------- ----------
Maximum future earnings to be recognized from Closed Block
assets and liabilities............................................... $ 45.2 $ 37.1
========= ==========
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
(In millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums............................................................. $ 7.5 $ 7.2 $ 38.3 $ 39.6
Net investment income................................................ 13.0 14.1 39.0 41.7
Net realized investment (losses) gains............................... (2.2) 0.3 (4.0) (0.9)
-------- --------- -------- ---------
Total revenues.................................................... 18.3 21.6 73.3 80.4
-------- --------- -------- ---------
Benefits and expenses
Policy benefits...................................................... 16.4 19.4 64.0 66.9
Policy acquisition expenses.......................................... 0.6 0.2 1.8 0.3
Other operating expenses............................................. 0.1 - 0.5 0.3
-------- --------- -------- ---------
Total benefits and expenses....................................... 17.1 19.6 66.3 67.5
-------- --------- -------- ---------
Contribution from the Closed Block............................ $ 1.2 $ 2.0 $ 7.0 $ 12.9
======== ========= ======== =========
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.
13
9. 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 makers
in deciding how to allocate resources and in assessing performance. A summary of
the Company's reportable segments is included below.
The Risk Management Segment 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
("AFS") and Allmerica Asset Management. Prior to September 30, 2002, the AFS
segment manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and life insurance products. Subsequently, the
Company ceased all new sales of proprietary variable annuities and life
insurance products.
In the future, the AFS business model will consist of two components. First, the
Company plans to retain and utilize its existing agency distribution channel to
distribute third-party investment and insurance products. The Company is seeking
alliances with leading investment product and insurance providers whereby these
providers would compensate the Company for product sales by the Company's
agents. Second, the Company plans to retain and service existing customer
accounts. These include variable annuity and variable universal life accounts,
as well as certain remaining traditional life and group retirement accounts. AFS
also will continue to provide brokerage and non-institutional investment
advisory services.
Through its Allmerica Asset Management segment, the Company offered 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. Due to rating
agency actions, the Company will not pursue new GIC sales. 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) gains 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.
14
Summarized below is financial information with respect to business segments for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------
Segment revenues:
Risk Management......................................... $ 624.1 $ 615.0 $ 1,865.5 $ 1,833.3
---------- ---------- ----------- -----------
Asset Accumulation:
Allmerica Financial Services........................ 204.3 202.5 624.0 630.0
Allmerica Asset Management.......................... 32.0 40.1 96.0 121.4
---------- ---------- ----------- -----------
Subtotal........................................ 236.3 242.6 720.0 751.4
---------- ---------- ----------- -----------
Corporate............................................... 1.1 2.1 4.3 4.6
Intersegment revenues................................... (2.3) (1.8) (6.8) (5.6)
---------- ---------- ----------- -----------
Total segment revenues.............................. 859.2 857.9 2,583.0 2,583.7
Adjustments to segment revenues:
Net realized investment losses.......................... (7.8) (4.9) (83.9) (89.6)
Consideration from sale of defined
contribution business................................ 3.5 - 3.5 -
---------- ---------- ----------- -----------
Total revenues....................................... $ 854.9 $ 853.0 $ 2,502.6 $ 2,494.1
========== ========== =========== ===========
Segment (loss) income before federal income taxes, minority
interest and cumulative effect of change in accounting
principle:
Risk Management......................................... $ 58.5 $ 6.8 $ 149.1 $ 64.5
---------- ---------- ----------- -----------
Asset Accumulation:
Allmerica Financial Services......................... (540.2) 34.4 (624.3) 121.3
Allmerica Asset Management........................... 5.7 6.1 15.9 16.5
---------- ---------- ----------- -----------
Subtotal......................................... (534.5) 40.5 (608.4) 137.8
---------- ---------- ----------- -----------
Corporate............................................... (17.5) (15.7) (49.1) (47.5)
---------- ---------- ----------- -----------
Segment (loss) income before federal income taxes
and minority interest............................. (493.5) 31.6 (508.4) 154.8
Adjustments to segment (loss) income:
Net realized investment losses, net of amortization..... (1.0) (7.2) (67.0) (88.7)
Consideration from sale of defined
contribution business................................ 3.5 - 3.5 -
(Losses) gains on derivatives........................... (0.1) (0.6) 30.3 2.3
Sales practice litigation............................... - - 2.5 7.7
---------- ---------- ----------- -----------
(Loss) income before federal income taxes, minority
interest and cumulative effect of change in
accounting principle.............................. $ (491.1) $ 23.8 $ (539.1) $ 76.1
========== ========== =========== ===========
Identifiable Assets Deferred Acquisition Costs
- ---------------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
September 30, December 31, September 30, December 31,
(In millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------------------
Risk Management........................... $ 6,119.4 $ 6,239.8 $ 214.2 $ 199.0
------------- -------------- -------------- --------------
Asset Accumulation
Allmerica Financial Services........... 19,099.9 21,113.0 1,203.4 1,585.2
Allmerica Asset Management............. 2,214.8 2,829.3 - -
------------- -------------- -------------- --------------
Subtotal............................ 21,314.7 23,942.3 1,203.4 1,585.2
Corporate................................. 94.5 154.0 - -
------------- -------------- -------------- --------------
Total.................................. $ 27,528.6 $ 30,336.1 $ 1,417.6 $ 1,784.2
============= ============== ============== ==============
15
10. 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 Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------------------------------------
Basic shares used in the calculation of earnings per share.... 52.9 52.7 52.9 52.6
Dilutive effect of securities (1):
Employee stock options..................................... - 0.2 - 0.3
Non-vested stock grants.................................... - 0.2 - 0.2
---------- --------- ---------- -----------
Diluted shares used in the calculation of earnings per share.. 52.9 53.1 52.9 53.1
========== ========= ========== ===========
Per share effect of dilutive securities on income before
cumulative effect of change in accounting principle
and net income............................................. $ - $ - $ - $ 0.01
========== ========= ========== ===========
(1) Excludes 0.1 million and 0.3 million shares due to antidilution for the quarter and nine months ended September 30,
2002, respectively.
11. 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.
16
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 its subsidiary, Allmerica Financial Life
Insurance and Annuity Company ("AFLIAC"), AFC's principal life insurance and
annuity companies; The Hanover Insurance Company ("Hanover") and its subsidiary,
Citizens Insurance Company of America ("Citizens"), AFC's principal property and
casualty companies; and certain other insurance and non-insurance subsidiaries.
FAFLIC, AFLIAC, Hanover and Citizens are domiciled in the states of
Massachusetts, Delaware, New Hampshire and Michigan, respectively.
Description of Operating Segments
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services ("AFS"), and Allmerica Asset
Management ("AAM"). The separate financial information of each segment is
presented consistent with the way results are regularly evaluated by the chief
operating decision makers in deciding how to allocate resources and in assessing
performance.
Prior to September 30, 2002, the Allmerica Financial Services segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and life insurance products. This resulted from
the cumulative effect of the significant, persistent decline in the equity
market, particularly the significant decline in the third quarter of 2002 that
followed the decline in the second quarter, as well as the rating agency actions
(see Rating Agency Actions). Subsequently, the Company ceased all new sales of
proprietary variable annuities and life insurance products.
In the future, the AFS business model will consist of two components. First, the
Company plans to retain and utilize its existing Agency distribution channel
(see Allmerica Financial Services - Statutory Premiums and Deposits for a
description of the distribution channels) to distribute third-party investment
and insurance products. The Company is seeking alliances with leading investment
product and insurance providers whereby these providers would compensate the
Company for product sales by the Company's agents. Second, the Company plans to
retain and service existing customer accounts. These include variable annuity
and variable universal life accounts, as well as certain remaining traditional
life and group retirement accounts. However, the Company expects that the
persistency of its existing customer accounts will be less than its historical
experience.
Thus, the future profitability of the AFS segment is dependent upon, among other
things, its ability to generate non-proprietary sales, the persistency of
existing customer accounts, equity market levels, and its ability to rationalize
its expense structure consistent with its new business model. The Company
believes the earnings of this segment will be substantially less than those in
years prior to 2002.
Also, due to the rating agency actions, sales of AAM's funding agreements have
ceased and sales of certain Risk Management products may be reduced.
17
Results of Operations
Consolidated Overview
Consolidated net (loss) income includes the results of each segment of the
Company, which management evaluates on a pre-tax and pre-minority interest
basis. In addition, net (loss) income is adjusted for certain items which
management believes are not indicative of the Company's core operations.
Adjusted net (loss) income excludes items such as net realized investment gains
and losses, including certain gains or losses on derivative instruments, because
fluctuations in these gains and losses are determined by interest rates,
financial markets and the timing of sales. Also, adjusted net (loss) income
excludes net gains and losses on disposals of businesses, discontinued
operations, extraordinary items, the cumulative effect of accounting changes and
certain other items, which in each case, are neither normal nor recurring.
Although the items excluded from adjusted net (loss) income may be significant
components in understanding and assessing the Company's financial performance,
management believes adjusted net (loss) income enhances an investor's
understanding of the Company's results of operations by highlighting net (loss)
income attributable to the normal, recurring operations of the business,
consistent with industry practice. However, adjusted net (loss) income should
not be construed as a substitute for net (loss) income determined in accordance
with generally accepted accounting principles ("GAAP").
The Company's consolidated net income for the third quarter of 2002 decreased
$344.6 million, to a net loss of $313.4 million, compared to net income of $31.2
million for the same period in 2001. The decline in the third quarter resulted
from a decrease in adjusted net income of $349.4 million, which resulted from a
significant segment loss in AFS. Consolidated net income for the first nine
months of 2002 decreased $388.6 million, to a net loss of $321.0 million,
compared to net income of $67.6 million for the first nine months of 2001. The
reduction resulted from a decrease in adjusted net income of $427.8 million,
principally due to the aforementioned segment loss in AFS, partially offset by a
$22.6 million decrease in net realized investment losses and a $18.2 million
increase in gains on derivative instruments, net of taxes.
The following table reflects adjusted net (loss) income and a reconciliation to
consolidated net (loss) income. Adjusted net (loss) income consists of segment
(loss) income, federal income tax benefit (expense) on segment (loss) income and
minority interest on Capital Securities (mandatorily redeemable preferred
securities of a subsidiary trust holding solely junior subordinated debentures
of the Company).
Quarter Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Segment (loss) income before federal income taxes and
minority interest:
Risk Management......................................... $ 58.5 $ 6.8 $ 149.1 $ 64.5
------------ ----------- ----------- ------------
Asset Accumulation:
Allmerica Financial Services.......................... (540.2) 34.4 (624.3) 121.3
Allmerica Asset Management............................ 5.7 6.1 15.9 16.5
------------ ----------- ----------- ------------
(534.5) 40.5 (608.4) 137.8
Corporate............................................... (17.5) (15.7) (49.1) (47.5)
------------ ----------- ----------- ------------
Segment (loss) income before federal income tax
benefit (expense) and minority interest............. (493.5) 31.6 (508.4) 154.8
Federal income tax benefit (expense) on segment (loss)
income................................................ 182.5 6.8 223.1 (12.3)
Minority interest on Capital Securities.................. (4.0) (4.0) (12.0) (12.0)
------------ ----------- ----------- ------------
Adjusted net (loss) income................................. (315.0) 34.4 (297.3) 130.5
Adjustments (net of taxes and amortization, as applicable):
Net realized investment losses.......................... (0.7) (2.8) (43.6) (66.2)
Consideration from sale of defined
contribution business................................. 2.3 - 2.3 -
Net gains (losses) on derivatives....................... - (0.4) 19.7 1.5
Sales practice litigation............................... - - 1.6 5.0
------------ ----------- ----------- ------------
(Loss) income before cumulative effect of change in
accounting principle.................................... (313.4) 31.2 (317.3) 70.8
Cumulative effect of change in accounting principle,
net of applicable taxes.............................. - - (3.7) (3.2)
------------ ----------- ----------- ------------
Net (loss) income.......................................... $ (313.4) $ 31.2 $ (321.0) $ 67.6
============ =========== =========== ============
18
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
The Company's segment income before federal taxes and minority interest
decreased $525.1 million, to a loss of $493.5 million, in the third quarter of
2002. This decline was attributable to a significant decrease from the AFS
segment of $574.6 million, partially offset by an increase from the Risk
Management segment of $51.7 million.
The decrease in the AFS segment reflects net charges of $556.4 million resulting
from additional declines in equity market values during the third quarter,
rating agency actions (see Rating Agency Actions), and the Company's decision to
cease sales of proprietary life insurance and annuity products (see Description
of Operating Segments). These charges include $487.5 million of additional
amortization of the deferred policy acquisition cost ("DAC") asset and $39.1
million due to a change in the assumptions related to the long-term cost of
guaranteed minimum death benefits ("GMDB") for variable annuity products. In
addition, the Company recognized impairments of capitalized technology costs
associated with variable products totaling $29.8 million. The charges related to
the DAC asset included $171.1 million related to future persistency of existing
customer accounts and $65.7 million of additional amortization due to the equity
market decline during the third quarter of 2002. In addition, as a result of
these significant third quarter events, the Company reviewed and reset its
assumptions related to future market-related appreciation and the long-term cost
of GMDB for variable annuity products, which resulted in $43.3 million and $48.4
million of additional DAC amortization, respectively. Finally, the Company
recognized an impairment, which resulted in additional DAC amortization of
$159.0 million related to its Partners distribution channel (see Allmerica
Financial Services - Statutory Premiums and Deposits for a description of the
distribution channels), which resulted from reviewing the assumptions affecting
future profits and the effects of the aforementioned charges.
The increase in Risk Management segment income is primarily attributable to an
increase in favorable development on prior years loss and loss adjustment
expense ("LAE") reserves from $15.8 million of adverse development in the third
quarter of 2001 to $7.9 million of favorable development in the same period in
2002. In addition, segment results reflected a benefit of approximately $22
million related to estimated net premium rate increases and a decrease in
catastrophe losses of $11.6 million, partially offset by increased policy
acquisition and other operating expenses of $8.8 million and a decrease in net
investment income of $3.4 million.
The federal income tax benefit on segment (loss) income was $182.5 million and
$6.8 million for the third quarter of 2002 and 2001, respectively. The increase
in the tax benefit is primarily the result of the significant loss recognized by
the AFS segment.
Net realized losses on investments, after taxes, were $0.7 million in the third
quarter of 2002, resulting primarily from impairments of fixed maturities,
partially offset by gains recognized from the sale of fixed maturities. During
the third quarter of 2001, the Company recognized net realized losses on
investments, after taxes, of $2.8 million, primarily due to impairments of fixed
maturities and losses related to the termination of certain derivative
instruments, partially offset by gains from sales of fixed maturities.
During the third quarter of 2002, the Company received additional consideration
of $2.3 million, net of taxes, related to the sale of the defined contribution
business in 2001.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
The Company's segment income before federal income taxes and minority interest
decreased $663.2 million to a loss of $508.4 million, in the first nine months
of 2002. This decrease was primarily attributable to the aforementioned
significant decrease from the AFS segment totaling $745.6 million, partially
offset by an increase from the Risk Management segment of $84.6 million.
19
The decrease in the AFS segment reflects net charges of $698.3 million resulting
from additional declines in equity market values during the third quarter,
rating agency actions (see Rating Agency Actions), and the Company's decision to
cease sales of proprietary life insurance and annuity products (see Description
of Operating Segments). These charges include $629.4 million of additional
amortization of the DAC asset and $39.1 million due to a change in the
assumptions related to the long-term cost of GMDB for variable annuity products.
In addition, the Company recognized impairments of capitalized technology costs
associated with variable products totaling $29.8 million. The charges related to
the DAC asset included $171.1 million related to future persistency of existing
customer accounts and $202.8 million of additional amortization due to equity
market declines. In addition, as a result of these significant third quarter
events, the Company reviewed and reset its assumptions related to future
market-related appreciation and the long-term cost of GMDB for variable annuity
products, which resulted in $43.3 million and $61.7 million of additional DAC
amortization, respectively. Additionally, during the second quarter of 2002, the
Company changed its estimate of future fees from certain variable annuity
products, which decreased DAC amortization by $8.5 million. Finally, the Company
recognized an impairment of the DAC asset, which resulted in additional
amortization of $159.0 million, related to its Partners distribution channel
(see Allmerica Financial Services - Statutory Premiums and Deposits for a
description of the distribution channels), which resulted from reviewing the
assumptions affecting future profits and the effects of the aforementioned
charges.
The increase in Risk Management segment income is primarily attributable to a
benefit of approximately $53 million related to estimated net premium rate
increases, a $32.9 million decrease in the adverse development of prior years'
reserves and an approximate $29 million decrease in current accident year
non-catastrophe claims. Partially offsetting these items is an increase in
policy acquisition expenses of $19.0 million and a decrease in net investment
income of $10.6 million.
The federal income tax benefit on segment loss was $223.1 million for the first
nine months of 2002 compared to an income tax expense of $12.3 million for the
same period of 2001. The increase in the tax benefit is primarily the result of
the significant loss recognized by the AFS segment, as well as an $11.6 million
favorable settlement of certain prior years' federal income tax returns.
Net realized losses on investments, after taxes, were $43.6 million for the
first nine months of 2002, resulting primarily from impairments of fixed
maturities and losses related to the termination of certain derivative
instruments, partially offset by gains recognized from the sale of fixed
maturities. During the first nine months of 2001, net realized losses on
investments, after taxes, of $66.2 million resulted primarily from impairments
of fixed maturities. Net gains on derivatives, after taxes, increased $18.2
million, to $19.7 million in the first nine months of 2002, resulting primarily
from the aforementioned termination of certain derivatives.
During the third quarter of 2002, the Company received additional consideration
of $2.3 million, net of taxes, from the sale of the defined contribution
business in 2001.
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".
The Company recognized a benefit of $1.6 million and $5.0 million, net of taxes,
for the first nine months of 2002 and 2001, respectively, as a result of
refining cost estimates related to a class action lawsuit.
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.
20
Risk Management
The following table summarizes the results of operations for the Risk Management segment:
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Segment revenues
Net premiums written.................................. $ 596.8 $ 586.7 $ 1,723.8 $ 1,734.8
========== ========== ========== ==========
Net premiums earned................................... $ 568.3 $ 552.5 $ 1,697.0 $ 1,644.9
Net investment income................................. 50.8 54.2 153.4 164.0
Other income.......................................... 5.0 8.3 15.1 24.4
---------- ---------- ---------- ----------
Total segment revenues.................. 624.1 615.0 1,865.5 1,833.3
---------- ---------- ---------- ----------
Losses and operating expenses
Losses and LAE (1).................................... 405.6 457.0 1,246.2 1,321.0
Policy acquisition expenses........................... 105.7 101.7 316.2 297.2
Other operating expenses.............................. 54.3 49.5 154.0 150.6
---------- ---------- ---------- ----------
Total losses and operating expenses........ 565.6 608.2 1,716.4 1,768.8
---------- ---------- ---------- ----------
Segment income............................................. $ 58.5 $ 6.8 $ 149.1 $ 64.5
========== ========== ========== ==========
(1) Includes policyholders' dividends of $0.6 million and $2.3 million for the quarters ended September
30, 2002 and 2001, respectively, and $0.8 million and $6.2 million for the nine months ended September 30,
2002 and 2001, respectively.
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
Risk Management's segment income increased $51.7 million to $58.5 million for
the third quarter of 2002. The increase in segment income is primarily
attributable to an increase in favorable development on prior years' reserves,
from $15.8 million of adverse development in the third quarter of 2001 to $7.9
million of favorable development in the same period in 2002. The favorable
development in 2002 is primarily the result of decreased claim severity,
primarily in the workers' compensation and commercial automobile lines,
partially offset by adverse development in the personal automobile line. Segment
results also benefited from approximately $22 million of net 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. Third quarter of 2002 segment income
also reflected a decrease in current year non-catastrophe claims activity
primarily in the commercial automobile, commercial multiple peril and workers'
compensation lines. In addition, catastrophe losses decreased $11.6 million, to
$4.0 million for the third quarter of 2002, compared to $15.6 million for the
same period in 2001. Catastrophes during 2001 included approximately $15 million
of losses related to the events of September 11, 2001. Partially offsetting
these items is a decrease in net investment income of $3.4 million for the
quarter ended September 30, 2002. Policy acquisition expenses increased
proportionally with the growth in net premiums earned. Other operating expenses
increased over the same period in 2001, primarily due to an increase in agents
contingent commissions, as a result of the expected improvement in underwriting
results in most territories in 2002.
As a result of the rating downgrades of the property and casualty companies in
October 2002 (see Rating Agency Actions), the Company expects that future sales
and operating income will be adversely affected. The Company is currently
assessing the expected adverse effect on operating results. The Company believes
the rating downgrades will primarily affect certain classes of commercial lines
business. In addition, the Company believes the rating downgrades may
unfavorably affect agency relationships and retention of certain homeowners
policies, and may result in adverse selection. The Company expects to incur
additional costs as it pursues various measures, including obtaining third-party
financial guarantees and providing proof of reinsurance, to seek to minimize the
loss of sales as a result of the downgrades. These measures are primarily
intended to reduce the risk of cancellation or non-renewal of commercial
policies, having estimated annual premium of approximately $60 million to $75
million, which are considered most at risk. The Company believes that the longer
the ratings remain at the current level, the greater the adverse effect of the
lower ratings on the operating results of the Risk Management segment. There can
be no assurance that these downgrades, or any further downgrades that may occur,
will not have a material adverse effect on the results of operations or
financial condition of the Company.
21
Underwriting results are reported using statutory accounting principles, which
are prescribed by state insurance regulators. The primary difference between
statutory accounting principles and GAAP is the deferral of certain underwriting
costs under GAAP that are amortized over the life of the policy. Under statutory
accounting principles, these costs are recognized when incurred or paid.
Management reviews the operations of this business based upon statutory results.
In 2002, the Company reorganized its Risk Management segment. Under the new
structure, the Risk Management segment manages its operations through two lines
of business based upon product offerings and identified as Personal Lines and
Commercial Lines. Personal Lines include personal automobile, homeowners and
other personal policies, while Commercial Lines include workers' compensation,
commercial automobile, commercial multiple peril and other commercial policies.
The following tables summarize the results of operations for the Risk Management segment:
Quarter Ended September 30,
--------------------------------------------------------------------------
2002 2001
----------------------------------- -----------------------------------
Statutory Statutory
Net Net
Premiums Statutory Loss Premiums Statutory Loss
(In millions, except ratios) Written Ratio (1) Written Ratio (1)
- ---------------------------------------------------------------------------- -----------------------------------
Personal automobile................. $ 285.3 71.5 $ 268.2 72.5
Homeowners.......................... 102.5 61.6 93.5 63.1
Other personal...................... 12.1 29.6 12.3 55.6
----------- -----------
Total personal...................... 399.9 68.1 374.0 69.9
----------- -----------
Workers' compensation............... 38.4 45.3 44.6 71.0
Commercial automobile............... 48.5 48.4 56.1 79.6
Commercial multiple peril........... 84.7 56.8 86.6 87.7
Other commercial.................... 26.1 60.8 26.4 65.8
----------- -----------
Total commercial.................... 197.7 52.9 213.7 79.4
----------- -----------
Total............................... $ 597.6 62.7 $ 587.7 73.6
=========== ===========
Statutory combined ratio (2):
Personal lines...................... 103.9 101.6
Commercial lines.................... 93.1 120.0
Total............................... 100.0 108.6
Statutory underwriting (loss) gain:
Personal lines...................... $ (23.1) $ (14.8)
Commercial lines.................... 14.8 (42.5)
----------- -----------
Total............................... (8.3) (57.3)
Reconciliation to segment income:
Net investment income............... 50.8 54.2
Other income and expenses, net...... 3.7 5.3
Other Statutory to GAAP adjustments. 12.3 4.6
----------- -----------
Segment income......................... $ 58.5 $ 6.8
=========== ===========
- -------------------------------------------------------------------------------------------------------------------
(1) Statutory loss ratio is a common industry measurement of the results of property and casualty insurance
underwriting. This ratio reflects incurred claims compared to premiums earned.
(2) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance
underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned
and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment
income and other non-underwriting expenses are not reflected in the statutory combined ratio.
Personal Lines
Personal lines' net premiums written increased $25.9 million, or 6.9%, to $399.9
million for the third quarter of 2002. This is primarily the result of increases
of $17.1 million, or 6.4%, and $9.0 million, or 9.6%, in the personal automobile
and homeowners lines, respectively. The increase in the personal automobile line
is primarily the result of 6.1% and 6.4% net premium rate increases in Michigan
and New York, respectively, and an overall increase of 0.3% in policies in force
since September 30, 2001. The increase in the homeowners line resulted primarily
from a rate increase of 19.6% in Michigan since September 30, 2001.
22
Personal lines' underwriting results declined $8.3 million to an underwriting
loss of $23.1 million for the third quarter of 2002. The decline in underwriting
results is primarily attributable to approximately $11 million of increased
underwriting expenses, primarily related to increased cession expenses for
mandatory assigned risk personal automobile business in New York. Management
expects this cession expense to increase, in the aggregate for 2002,
approximately $13 million as compared to 2001 due to unsatisfactory underwriting
results in this personal automobile assigned risk pool. Underwriting expenses
were also unfavorably affected by increased agents contingent commissions as a
result of the expected improvements in underwriting results in most territories
in 2002. Underwriting results were also unfavorably affected by a $4.2 million
increase in adverse development, from $4.2 million of adverse development for
the third quarter of 2001 to $8.4 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 $10 million of estimated net premium rate increases
in 2002. In addition, catastrophe losses decreased $0.4 million, to $2.2 million
for the third quarter of 2002, compared to $2.6 million for the same period in
2001.
Commercial Lines
Commercial lines' net premiums written decreased $16.0 million, or 7.5%, to
$197.7 million for the third 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 21.7%, 17.1% and 6.8% in the
commercial automobile, workers' compensation, and commercial multiple peril
lines, respectively, since September 30, 2001 primarily as the result of the
aforementioned agency management actions. Management believes the impact of the
agency actions will have a diminishing effect on policies in force, since the
agency actions are substantially complete. Partially offsetting these decreases
in policies in force were rate increases in all of the commercial lines since
September 30, 2001.
Commercial lines' underwriting results improved $57.3 million to an underwriting
gain of $14.8 million in the third quarter of 2002. The improvement in
underwriting results is primarily attributable to a $28.0 million increase in
favorable development on prior years' reserves, from $11.6 million of adverse
development in the third quarter of 2001 to $16.4 million of favorable
development for the same period in 2002, primarily in the workers' compensation
line. In addition, catastrophe losses decreased $11.2 million, to $1.8 million
for the third quarter of 2002, compared to $13.0 million for the same period in
2001, which included $11.9 million of losses for the events of September 11,
2001. Also, segment results included approximately $10 million of estimated net
premium rate increases during the third quarter of 2002. In addition, a decrease
in current year non-catastrophe claims severity in the commercial automobile and
commercial multiple peril lines of approximately $5 million and $2 million,
respectively, favorably affected results in 2002.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
Risk Management's segment income increased $84.6 million to $149.1 million for
the nine months ended September 30, 2002. The increase in segment income is
primarily attributable to approximately $53 million of estimated net premium
rate increases. In addition, personal lines non-catastrophe weather related
losses decreased approximately $15 million for the nine months ended September
30, 2002, compared to the same period in the prior year. Development on prior
years' reserves improved $32.9 million to $1.5 million of favorable development
for the nine months ended September 30, 2002, from $31.4 million of adverse
development for the same period in 2001. This improvement includes approximately
$15 million of weather related adverse development on prior years' reserves
during the nine months ended September 30, 2001. Also, segment income for the
nine months ended September 30, 2002 was favorably affected by approximately $29
million of estimated improved current accident year non-catastrophe claims
activity, primarily in commercial lines. In addition, policyholder dividends
decreased $5.4 million when comparing the nine months ended September 30, 2002
to the same period in 2001. Partially offsetting these items is a decrease in
net investment income of $10.6 million for the nine months ended September 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 increased slightly over prior year despite the
decrease in written policies, due to certain underwriting initiatives, increased
agency contingent commission and employee related expenses.
23
The following tables summarize the results of operations for the Risk Management segment:
Nine Months Ended September 30,
--------------------------------------------------------------------------
2002 2001
----------------------------------- -----------------------------------
Statutory Statutory
Net Net
Premiums Statutory Loss Premiums Statutory Loss
(In millions, except ratios) Written Ratio (1) Written Ratio (1)
- ---------------------------------------------------------------------------- -----------------------------------
Personal automobile................. $ 837.7 70.9 $ 779.6 72.5
Homeowners.......................... 262.4 63.8 233.8 73.2
Other personal...................... 33.2 42.6 33.7 35.2
----------- -----------
Total personal...................... 1,133.3 68.4 1,047.1 71.5
----------- -----------
Workers' compensation............... 117.8 69.1 153.0 78.9
Commercial automobile............... 149.0 59.4 192.4 71.4
Commercial multiple peril........... 248.7 56.3 262.5 76.1
Other commercial.................... 75.7 41.9 77.9 49.6
----------- -----------
Total commercial.................... 591.2 58.0 685.8 72.5
----------- -----------
Total............................... $ 1,724.5 64.6 $ 1,732.9 71.9
=========== ===========
Statutory combined ratio (2):
Personal lines...................... 103.3 103.0
Commercial lines.................... 99.9 112.1
Total............................... 102.0 106.5
Statutory underwriting (loss) gain:
Personal lines...................... $ (51.5) $ (44.3)
Commercial lines.................... 10.9 (88.2)
----------- -----------
Total............................... (40.6) (132.5)
Reconciliation to segment income:
Net investment income............... 153.4 164.0
Other income and expenses, net...... 11.3 15.0
Other Statutory to GAAP adjustments. 25.0 18.0
----------- -----------
Segment income......................... $ 149.1 $ 64.5
=========== ===========
- -------------------------------------------------------------------------------------------------------------------
(1) Statutory loss ratio is a common industry measurement of the results of property and casualty insurance
underwriting. This ratio reflects incurred claims compared to premiums earned.
(2) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance
underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned
and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment
income and other non-underwriting expenses are not reflected in the statutory combined ratio.
Personal Lines
Personal lines' net premiums written increased $86.2 million, or 8.2%, to
$1,133.3 million for the nine months ended September 30, 2002. This is primarily
the result of increases of $58.1 million, or 7.5%, and $28.6 million, or 12.2%,
in the personal automobile and homeowners lines, respectively. The increase in
the personal automobile line is primarily the result of 6.1% and 6.4% net
premium rate increases in Michigan and New York, respectively, and an overall
increase of 0.3% in policies in force since September 30, 2001. The increase in
the homeowners line resulted primarily from rate increases of 19.6% and 9.9% in
Michigan and New York, respectively.
Personal lines' underwriting results deteriorated $7.2 million, or 16.3%, to an
underwriting loss of $51.5 million for the nine months ended September 30, 2002.
The deterioration in underwriting results is primarily attributable to increased
underwriting expenses, primarily related to the aforementioned increases in
cession expenses for New York assigned risk business and agents contingent
commission, as a result of the expected improvements in underwriting results in
most territories in 2002. In addition, underwriting expenses increased due to
higher premium tax expenses. Underwriting results were also unfavorably affected
by increased current year claims severity in the personal automobile line for
the nine months ended September 30, 2002. These items are partially offset by a
$7.9 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 nine months ended September 30, 2002 also reflected
approximately $20 million of estimated net premium rate increases. In addition,
catastrophe losses decreased $2.9 million, to $17.9 million for the nine months
ended September 30, 2002, compared to $20.8 million for the same period in 2001.
24
Commercial Lines
Commercial lines' net premiums written decreased $94.6 million, or 13.8%, to
$591.2 million for the nine months ended September 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 21.7%, 17.1% and 6.8% in the commercial automobile, workers'
compensation, and commercial multiple peril lines, respectively, since September
30, 2001. Management believes the impact of the agency actions will have a
diminishing effect on policies in force, since the agency actions are
substantially complete. Partially offsetting these decreases in policies in
force were rate increases in all of the commercial lines since September 30,
2001.
Commercial lines' underwriting results improved $99.1 million to an underwriting
gain of $10.9 million for the nine months ended September 30, 2002. The
improvement in underwriting results is primarily attributable to approximately
$40 million of net premium rate increases during the nine months ended September
30, 2002. Development on prior years' reserves improved $24.8 million to $13.9
million of favorable development for the nine months ended September 30, 2002
from $10.9 million of adverse development for the same period in 2001. In
addition, catastrophe losses decreased $11.0 million, to $5.9 million for the
nine months ended September 30, 2002, compared to $16.9 million for the same
period in 2001. The nine months ended September 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.
Investment Results
Net investment income before taxes declined $10.6 million, or 6.5%, to $153.4
million for the nine months ended September 30, 2002. The decrease in net
investment income primarily reflects a reduction in average pre-tax yields on
debt securities and a $92 million dividend from the property and casualty
companies to the holding company. Also, the decrease in net investment income
reflects a transfer of approximately $55 million to fund the property and
casualty companies' portion of the additional minimum pension liability recorded
by AFC at December 31, 2001 pursuant to the cost allocation policy under the
Company's Consolidated Service Agreement. In addition, net investment income
decreased due to the impact of defaults on high yield bonds. Average pre-tax
yields on debt securities decreased to 6.5% 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.
25
The table below provides a reconciliation of the beginning and ending reserve for unpaid losses
and LAE as follows:
Nine Months Ended
September 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............... 1,247.4 1,283.4
(Decrease) increase in provision for insured events of
prior years.............................................. (1.5) 31.4
------------ -------------
Total incurred losses and LAE................................ 1,245.9 1,314.8
------------ -------------
Payments, net of reinsurance recoverable:
Losses and LAE attributable to insured events of current
year..................................................... 610.3 599.3
Losses and LAE attributable to insured events of prior
years.................................................... 619.7 643.2
------------ -------------
Total payments............................................... 1,230.0 1,242.5
------------ -------------
Change in reinsurance recoverable on unpaid losses........... (7.7) (10.4)
------------ -------------
Reserve for losses and LAE, end of period....................... $ 2,929.7 $ 2,781.0
============ =============
As part of an ongoing process, the reserves have been re-estimated for all prior
accident years and were decreased by $1.5 million for the nine months ended
September 30, 2002. This reflects $15.7 million of increased prior years' loss
reserves, offset by $17.2 million of decreased prior years' LAE reserves. For
the nine months ended September 30, 2001, prior years' reserves were increased
by $31.4 million. This reflects $62.9 million of increased prior years' loss
reserves, partially offset by $31.5 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
personal automobile, homeowners, and commercial multiple peril lines, partially
offset by a decrease in workers' compensation 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 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.
26
Asbestos and 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 asbestos, environmental damage and
toxic tort liability, included in the reserve for losses and LAE, were $24.3
million and $27.6 million, net of reinsurance of $13.8 million and $12.1 million
for the nine months ended September 30, 2002 and 2001, respectively. Loss and
LAE reserves for assumed reinsurance pool business with asbestos, environmental
damage and toxic tort liability were $38.5 million and $9.0 million for the nine
months ended September 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, asbestos,
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"),
primarily for asbestos claims.
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 asbestos and environmental claims, recorded reserves
related to these claims are adequate. The asbestos and environmental liability
could be revised in the near term if the estimates used in determining the
liability are revised.
Asset Accumulation
Allmerica Financial Services
Prior to September 30, 2002 the Allmerica Financial Services segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and variable life insurance products. This
resulted from the cumulative effect of the significant, persistent decline in
the equity market, particularly the significant decline in the third quarter of
2002, that followed the decline in the second quarter, as well as the rating
agency actions (see Rating Agency Actions). Subsequently, the Company ceased all
new sales of proprietary variable annuities and life insurance products (see
Description of Operating Segments).
The following table summarizes the results of operations for the Allmerica Financial Services segment for the periods
indicated.
Quarter Ended Nine Months Ended
September 30, September 30,
-------------------------- ---------------------------
(In millions) 2002 2001 2002 2001
- --------------------------------------------------------------------------------------------------------------------------
Segment revenues
Premiums............................................... $ 7.9 $ 7.4 $ 39.2 $ 40.5
Fees................................................... 97.1 95.0 291.9 294.6
Net investment income.................................. 76.6 76.3 220.0 219.5
Other income........................................... 22.7 23.8 72.9 75.4
--------- --------- --------- ----------
Total segment revenues.................................... 204.3 202.5 624.0 630.0
Policy benefits, claims and losses........................ 209.2 86.1 414.1 258.3
Policy acquisition and other operating expenses........... 535.3 82.0 834.2 250.4
--------- --------- --------- ----------
Segment (loss) income .................................... $ (540.2) $ 34.4 $ (624.3) $ 121.3
========= ========= ========= ==========
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
Segment results deteriorated $574.6 million, to a loss of $540.2 million during
the third quarter of 2002. This loss reflects net charges of $556.4 million
resulting from additional declines in equity market values during the third
quarter, rating agency actions (see Rating Agency Actions), and the Company's
decision to cease sales of proprietary life insurance and annuity products.
These charges include $487.5 million of additional amortization of the DAC
asset, a change in the assumptions related to the long-term cost of GMDB for
variable annuity products resulting in a reserve of $106.7 million, partially
offset by a reduction in DAC amortization of $67.6 million, and the recognition
of impairments of capitalized technology costs associated with variable products
totaling $29.8 million.
27
The following table summarizes the aforementioned charges and benefits during
the third quarter of 2002. Each is explained in subsequent paragraphs.
(In millions)
- ----------------------------------------------------------------------
Additional DAC Amortization:
Revision of surrender rate assumptions................ $ 171.1
Equity market depreciation............................ 65.7
Revision of market-related appreciation assumptions... 43.3
Revision of GMDB long-term cost assumptions........... 48.4
Impairment of DAC asset............................... 159.0
---------
487.5
---------
GMDB:
Revision of long-term cost assumptions................ 106.7
Reduction of DAC amortization......................... (67.6)
---------
39.1
---------
Impairment of capitalized technology costs................ 29.8
---------
Total..................................................... $ 556.4
=========
Deferred Acquisition Costs
As discussed further in "Critical Accounting Policies" below, DAC for variable
life products and variable annuities consists of commissions, underwriting costs
and other costs which are amortized in proportion to the total gross profits
that the Company estimates will be earned over the expected life of the
insurance contracts to which such costs relate. To estimate the profitability of
its insurance contracts, the Company establishes and applies certain assumptions
relating to, among other matters, appreciation of account assets, contract
persistency and contract costs (such as those relating to any GMDB feature and
fees payable to distributors). The Company regularly evaluates these assumptions
to determine whether recent experience or anticipated trends merit adjustments
to such assumptions.
The substantial and sustained decline in the equity market in the third quarter
precipitated a number of significant events which caused the Company to incur
large increases in DAC amortization. These included, in large part, substantial
ratings downgrades, which contributed to the Company's decision to cease new
sales of proprietary variable annuity and life products. The Company believes
that this business decision will adversely affect the profitability of its
contracts by significantly decreasing the persistency of customer accounts.
Decreased persistency also will increase the cost of the GMDB feature of
variable annuity contracts, further reducing profitability. In addition, the
third quarter market decline resulted in significant differences in actual
account value investment returns in the third quarter from those assumed. This
required the Company to substantially increase the level of DAC amortization and
GMDB expense under existing assumptions and to re-assess the appropriate
long-term assumptions on account appreciation and GMDB cost. As a result, the
Company revised downward its assumptions regarding future account appreciation
and increased its expectations regarding the long-term cost of the GMDB feature.
Finally, the Company's evaluation of the compounding effects of the market
decline and AFS business model changes on the anticipated profitability of its
distribution channels caused the Company to determine that there had been a
permanent impairment of the remaining DAC asset related to its Partners
distribution channel (see Statutory Premiums and Deposits for a description of
the distribution channels). Each of these increased costs and changed
assumptions are discussed further below.
The aforementioned $487.5 million of additional DAC amortization consists of
five separate items. First, the Company anticipates that the rating agency
actions (see Rating Agency Actions) and the Company's decision to cease new
sales of proprietary life insurance and annuity products will unfavorably affect
the persistency of the existing customer accounts, as customers seek to transfer
their accounts to companies who are active in the marketplace and have higher
ratings. This reduces expected future profits, resulting in $171.1 million of
additional DAC amortization.
Second, the declines in equity market values during the third quarter resulted
in $65.7 million of additional amortization. This resulted from application of
the Company's reversion-to-the-mean accounting methodology. The Company
considers the recent declines to be suggestive of a permanent, partial reduction
in future profitability.
28
Third, as of September 30, 2002, the Company reviewed and reset its assumptions
regarding future market-related appreciation of separate account assets and its
application of the reversion-to-the-mean accounting methodology. In view of the
additional market declines in the third quarter, as well as the reduced time
horizon resulting from the revised persistency expectations, the Company reduced
its expected rate of annual appreciation to 8% (2% per quarter), starting with
September 30, 2002 asset levels. This reduces expected future profits, resulting
in $43.3 million of additional DAC amortization for the third quarter.
Fourth, as of September 30, 2002, the Company increased its assumptions related
to the long-term cost of GMDB for variable annuity products. (See the discussion
of the GMDB reserve below.) The increased cost estimate is reflected in the
Company's expectation of future gross profits, resulting in $48.4 million of
additional DAC amortization.
Finally, the Company recognized additional amortization of $159.0 million
related to its Partners distribution channel (see Statutory Premiums and
Deposits for a description of the distribution channels). After reviewing all
assumptions affecting future profits assumed in its DAC methodology, including
the effect of the aforementioned net charges, the Company determined that the
remaining DAC asset related to Partners exceeded the present value of total
expected gross profits by $159.0 million as of September 30, 2002. Accordingly,
the company recognized a permanent impairment to its DAC asset of this amount.
It should be noted that a permanent impairment is not required for the other
distribution channels because of their higher relative profitability. Relative
to the other distribution channels, Partners has the highest GMDB costs and the
lowest fees from its underlying mutual funds. However, although considered fully
recoverable, the Select DAC asset would be subject to impairment should actual
gross profits be less than anticipated.
After September 30, 2002, the Company expects that DAC amortization will be, in
general, higher than historical levels as a percentage of gross profits. This is
due to lower future gross profits, because of poorer persistency, lower expected
market-related appreciation and higher expected GMDB costs. However, as a result
of resetting the long-term assumption for market-related appreciation and
applying the reversion-to-the-mean accounting methodology, the Company believes
that DAC amortization will be less sensitive to short-term market movements than
in the first nine months of 2002. The Company is exposed to further impairments
to the DAC asset if actual experience is worse than the current assumptions, as
discussed above. Impairments would increase DAC amortization in the period that
they are recognized.
Guaranteed Minimum Death Benefits
As noted above, as of September 30, 2002, the Company increased its assumptions
related to the long-term cost of GMDB for variable annuity products. The GMDB
feature provides annuity contract holders with a guarantee that the benefit
received at death will be no less than a prescribed minimum amount. This minimum
amount is based on the net deposits paid into the contract, the net deposits
accumulated at a specified rate, the highest historical account value on a
contract anniversary, or more typically the greatest of these values. To the
extent that the GMDB is higher than the current account value at the time of
death, the Company incurs a cost. As of September 30, 2002, the difference
between the GMDB and the current account value (the "net amount at risk") for
all existing contracts was approximately $5.3 billion. For each one percent
change, either increase or decrease from September 30, 2002 levels in the S&P
500 Index, the net amount at risk is estimated to increase or decrease by
approximately $80 million to $100 million. This amount will gradually decline as
surrenders also reduce the net amount at risk.
To estimate the cost of the GMDB feature with respect to the profitability of
the related insurance contract, the Company establishes and applies certain
assumptions relating to the appreciation of related account assets, mortality
and contract persistency, among other matters. The Company regularly evaluates
these assumptions to determine whether recent experience or anticipated trends
merit adjustments to such assumptions. The compounding effects of the
significant third quarter market decline, the rating agency downgrades,
increased persistency and related AFS strategic business changes resulted in
significantly decreased account values and persistency assumptions which
required the Company to reassess, and increase, its assumptions related to the
long-term cost of GMDB.
The Company has had a consistent policy of providing reserves for GMDB based on
its best estimate of the long-term cost of GMDB. As of September 30, 2002, the
Company reassessed its expectation of the long-term cost of GMDB in view of the
current net amount at risk and the revised persistency expectations, as well as
the absence of additional deposits at current market levels. This resulted in
revised expectations for the long-term cost of GMDB. The Company calculated a
required reserve at September 30, 2002 of $106.7 million, and recognized this
amount in policy benefits. This was partially offset by a reduction in DAC
amortization of $67.6 million. It should be noted that in addition to the
reserve increase, policy benefits in the quarter include $28.7 million of
additional GMDB expense, versus $2.4 million in the prior year. These amounts
were partially offset by reduced DAC amortization of $15.6 million and $1.0
million, respectively.
29
Based on account values as of September 30, 2002, the estimated annual GMDB
expense would be approximately $45 million. In the near term, cash costs may
exceed the annual expense, thereby reducing the reserve. Expected assumed
appreciation in asset levels would gradually reduce, and eventually reverse,
this difference over time. There can be no assurance that the existing reserve
will be sufficient, or that the Company's estimate of long-term GMDB costs is
accurate or sufficient. Future changes in market levels, persistency of existing
accounts, mortality and other factors may result in material changes to GMDB
costs and related expenses.
Technology Costs
The Company also recognized $29.8 million of asset impairments related to
technology used in its variable annuity and variable universal life business. Of
this amount, $29.1 million relates to capitalized software development costs.
The remaining $0.7 million relates to technology hardware. During the past five
years, the Company has incurred costs to develop technology platforms for its
variable products. This includes the technology used to underwrite, issue and
maintain customer accounts, incorporating disparate and complex product
attributes. As a result of rating agency actions (see Rating Agency Actions),
and the Company's decision to cease new sales of proprietary life insurance and
annuity products, the Company determined that expected future cash flows do not
support continued capitalization of the entire cost of the technology assets.
Accordingly, the Company recognized the aforementioned permanent impairment in
other operating expenses.
Other
The future profitability of the AFS segment is dependent upon, among other
things, its ability to generate non-proprietary sales, the persistency of
existing customer accounts, equity market levels, and its ability to rationalize
its expense structure consistent with its new business model. The Company
believes the earnings of this segment will be substantially less than those in
years prior to 2002.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
Segment results deteriorated $745.6 million, to a loss of $624.3 million during
the first nine months of 2002. This loss reflects net charges of $698.3 million
resulting from the cumulative effect of the significant, persistent decline in
equity market values during the most recent two years and nine months, as well
as rating agency actions (see Rating Agency Actions), and the Company's decision
to cease new sales of proprietary life insurance and annuity products. These
charges include $629.4 million of additional amortization of the DAC asset, a
change in the assumptions related to the long-term cost of GMDB for variable
annuity products resulting in a reserve increase of $106.7 million, partially
offset by a reduction in DAC amortization of $67.6 million, and the recognition
of impairments of capitalized technology costs associated with variable products
totaling $29.8 million.
The following table summarizes the aforementioned charges and benefits for the
first nine months of 2002. Each is explained in subsequent paragraphs.
(In millions)
- ----------------------------------------------------------------------
Additional DAC Amortization:
Revision of surrender rate assumptions................ $ 171.1
Equity market depreciation............................ 202.8
Revision of market-related appreciation assumptions... 43.3
Revision of GMDB long-term cost assumptions........... 61.7
Revision of future fees assumption.................... (8.5)
Impairment of DAC asset............................... 159.0
---------
629.4
---------
GMDB:
Revision of long-term cost assumptions................ 106.7
Reduction of DAC amortization......................... (67.6)
---------
39.1
---------
Impairment of capitalized technology costs................ 29.8
---------
Total..................................................... $ 698.3
=========
30
Deferred Acquisition Costs
The aforementioned $629.4 million of additional DAC amortization consists of six
separate items. First, the Company anticipates that the rating agency actions
(see Rating Agency Actions) and the Company's decision to cease new sales of
proprietary life insurance and annuity products will unfavorably affect the
persistency of the existing customer accounts, as customers seek to transfer
their accounts to companies who are active in the marketplace and have higher
ratings. This reduces expected future profits, resulting in $171.1 million of
additional DAC amortization in the third quarter.
Second, significant declines in equity market values resulted in additional
amortization of $202.8 million in the first nine months of 2002. This resulted
from application of the Company's reversion-to-the-mean accounting methodology.
The Company considers the recent declines to be suggestive of a permanent,
partial reduction in future profitability.
Third, as of September 30, 2002, the Company reviewed and reset its assumptions
regarding future market-related appreciation of separate account assets and its
application of the reversion-to-the-mean accounting methodology. In view of the
additional market declines in the third quarter, as well as the reduced time
horizon resulting from the revised persistency expectations, the Company reduced
its expected rate of annual appreciation to 8% (2% per quarter), starting with
September 30, 2002 asset levels. This reduces expected future profits, resulting
in $43.3 million of additional DAC amortization.
Fourth, the Company increased its assumptions related to the long-term cost of
GMDB for variable annuity products as of September 30, 2002. (See the discussion
of the GMDB reserve below.) The increased cost estimates affected the Company's
expectation of future gross profits, resulting in additional DAC amortization of
$61.7 million in the first nine months of 2002.
Fifth, the Company changed its estimate of future fees from certain annuity
products in the second quarter of 2002. This decreased DAC amortization by $8.5
million in that quarter.
Finally, the Company recognized the aforementioned additional amortization of
$159.0 million related to its Partners distribution channel (see Statutory
Premiums and Deposits for a description of the distribution channels).
Guaranteed Minimum Death Benefits
As noted above, the Company reassessed its expectation of the long-term cost of
GMDB in view of the current net amount at risk, the revised persistency
expectations, as well as the absence of additional deposits at current market
levels. This resulted in revised expectations for the long-term cost of GMDB.
The Company calculated a reserve at September 30, 2002 of $106.7 million, and
recognized this amount in policy benefits. This was partially offset by a
reduction in DAC amortization of $67.6 million. It should be noted that in
addition to the reserve increase, policy benefits during the nine-month period
include $64.9 million of additional GMDB expense, versus $8.7 million in the
prior year. These amounts were partially offset by reduced DAC amortization of
$31.6 million and $3.5 million, respectively.
Technology Costs
The Company also recognized the aforementioned $29.8 million of asset
impairments related to technology used in its variable annuity and variable
universal life business.
31
Statutory Premiums and Deposits
The following table sets forth statutory premiums and deposits by product for the Allmerica Financial Services segment.
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
(In millions) 2002 2001 2002 2001
- ----------------------------------------------------------------------------------------------------------
Insurance:
Traditional life..................... $ 7.4 $ 7.5 $ 36.7 $ 31.5
Universal life....................... 1.8 2.8 9.7 12.2
Variable universal life.............. 53.4 47.8 186.6 149.1
Individual health.................... - - 0.1 0.2
Group variable universal life........ 13.1 8.1 39.0 67.4
---------- ---------- ---------- ---------
Total insurance................ 75.7 66.2 272.1 260.4
---------- ---------- ---------- ---------
Annuities:
Separate account annuities........... 436.9 435.3 1,819.2 1,414.6
General account annuities............ 331.8 180.8 793.7 737.2
Retirement investment accounts....... 1.2 1.3 4.7 5.2
---------- ---------- ---------- ---------
Total individual annuities..... 769.9 617.4 2,617.6 2,157.0
Group annuities...................... 19.1 19.8 56.5 185.0
---------- ---------- ---------- ---------
Total annuities................ 789.0 637.2 2,674.1 2,342.0
---------- ---------- ---------- ---------
Total premiums and deposits............... $ 864.7 $ 703.4 $ 2,946.2 $ 2,602.4
========== ========== ========== =========
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
For the quarter ended September 30, 2002, total premiums and deposits increased
$161.3 million, or 22.9%, to $864.7 million. These increases are primarily due
to higher general account annuity deposits. As a result of the rating agency
actions (see Rating Agency Actions) and the Company's decision to cease new
sales of proprietary life insurance and annuity products, AFS premiums and
deposits will decline significantly in the future. By October 31, 2002, new
sales of these products were virtually eliminated.
Annuity products were 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 Investments
("Scudder"), Pioneer Investment Management, Inc. ("Pioneer") and Delaware
Management Company ("Delaware"). Agency, Select, and Partners represented,
respectively, approximately 23%, 34%, and 43% of individual annuity deposits in
the third quarter of 2002, and Scudder represented 35% of all individual annuity
deposits. During the third quarter of 2001, Agency, Select, and Partners
represented, respectively, approximately 25%, 34%, and 41% of individual annuity
deposits, and Scudder represented 31% of all individual annuity deposits. In
future periods, the Company expects to generate revenues by the Agency channel
distributing non-proprietary investment and insurance products.
The Company also plans to retain and service its existing customer accounts,
including variable annuity, variable life and the remaining traditional life and
group retirement accounts. As of September 30, 2002, Agency, Select, Partners
and Other distribution channels represented, respectively, 46%, 16%, 23% and 15%
of the segment's total general and separate account assets.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
For the nine months ended September 30, 2002, total premiums and deposits
increased $343.8 million, or 13.2%, to $2.9 billion. These increases were
primarily due to higher annuity deposits into the Company's separate accounts
resulting, in part, from a continued emphasis by Scudder on marketing and sales
of the Company's annuity products as well as to higher general account annuity
deposits. These increases were partially offset by 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.
32
Agency, Select, and Partners represented, respectively, approximately 21%, 33%,
and 46% of individual annuity deposits in the first nine months of 2002, and
Scudder represented 39% of all individual annuity deposits. During the first
nine months of 2001, Agency, Select, and Partners represented, respectively,
approximately 25%, 38%, and 37% of individual annuity deposits, and Scudder
represented 27% 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.
Quarter Ended Nine Months Ended
September 30, September 30,
--------------------------- -------------------------
(In millions) 2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------------------
Interest margins on Guaranteed Investment
Contracts ("GICs"):
Net investment income.............................. $ 24.4 $ 37.1 $ 75.8 $ 113.5
Interest credited.................................. 21.9 32.2 68.1 99.8
--------- ---------- -------- ---------
Net interest margin................................... 2.5 4.9 7.7 13.7
Fees and other income:
External........................................... 5.9 1.7 16.1 4.5
Internal........................................... 1.9 1.3 4.6 4.0
Other operating expenses.............................. (4.6) (1.8) (12.5) (5.7)
--------- ---------- -------- ---------
Segment income........................................ $ 5.7 $ 6.1 $ 15.9 $ 16.5
========= ========== ======== =========
Average GIC deposits outstanding...................... $ 2,119.7 $ 2,910.0 $ 2,286.0 $ 2,704.6
========= ========== ======== =========
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
Segment income decreased $0.4 million, or 6.6%, to $5.7 million during the third
quarter of 2002, primarily due to decreased earnings on GICs. This decrease was
partially offset by the inclusion of earnings related to the Company's premium
financing subsidiary, AMGRO, in 2002 which was previously included in the Risk
Management segment, and by an increase in fees and other income related to
external clients. Earnings on GICs decreased $2.4 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 (see Investment Portfolio), 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 June 30, 2002, the Company held $291.1 million of short-term funding
agreements with put features which allow the policyholder to cancel the contract
prior to maturity. During the third quarter of 2002, payments related to
short-term funding agreement withdrawals were approximately $106 million. Also,
during the third quarter of 2002, the Company was notified of approximately $185
million of additional withdrawals, which represents the remaining outstanding
short-term funding agreements with put features. Payments related to these
remaining short-term funding agreements occurred 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,
due to rating agency actions (see Rating Agency Actions) management does not
expect to pursue future sales of short-term or long-term funding agreements. The
Company also expects assets of this segment to gradually decline as the existing
long-term funding agreements mature or are retired.
The Company uses derivative instruments to hedge its GIC portfolio. For floating
rate GIC liabilities that are matched with fixed rate securities, the Company
manages the interest rate risk by hedging with interest rate swap contracts
designed to pay fixed and receive floating interest. In addition, certain
funding agreements are denominated in foreign currencies. To mitigate the
short-term effect of changes in currency exchange rates, the Company regularly
hedges by entering into foreign exchange swap contracts and compound foreign
currency/interest rate swap contracts to hedge its net foreign currency
exposure. These hedges resulted in an $8.6 million and a $14.2 million reduction
in net investment income during the third quarter of 2002 and 2001,
respectively, offset by similar reductions in GIC interest credited during the
respective periods. The decrease is due to a decrease in average outstanding GIC
deposits and the associated hedges.
33
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
Segment income decreased $0.6 million, or 3.6%, to $15.9 million in the first
nine months of 2002, primarily due to decreased earnings on GICs. This decrease
is partially offset by the inclusion of earnings related to the Company's
premium financing subsidiary, AMGRO, in AAM's results beginning in 2002 and by
an increase in fees and other income related to external clients. Earnings on
GICs decreased in 2002 primarily due to the aforementioned 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 nine months of 2002, payments related to
short-term funding agreement withdrawals were approximately $582 million. Also,
during the third quarter of 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 occurred in the fourth quarter of 2002.
As noted above, the Company uses derivative instruments to hedge interest rate
and currency exchange rate risks related to its GIC portfolio. These hedges
resulted in a $34.7 million and a $31.6 million reduction in net investment
income for the nine months ended September 30, 2002 and 2001, respectively,
offset by similar reductions in GIC interest credited during the respective
periods.
Corporate
The following table summarizes the results of operations for the Corporate segment for the periods indicated.
Quarter Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------
(In millions) 2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net investment income.............................. $ 1.1 $ 2.1 $ 4.3 $ 4.6
Interest expense................................... 3.8 3.8 11.4 11.4
Other operating expenses........................... 14.8 14.0 42.0 40.7
---------- ---------- ---------- ---------
Segment loss......................................... $ (17.5) $ (15.7) $ (49.1) $ (47.5)
========== ========== ========== =========
Quarter Ended September 30, 2002 Compared to Quarter Ended September 30, 2001
The segment loss increased $1.8 million, or 11.5%, to $17.5 million in the third
quarter of 2002, primarily resulting from a decrease in net investment income
principally due to lower average invested assets and to lower investment yields.
In addition, segment loss increased due to higher spending in corporate overhead
costs.
Interest expense for both periods relates to the interest paid on the Senior
Debentures of the Company.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
Segment loss increased $1.6 million, or 3.4%, to $49.1 million in the first nine
months of 2002, primarily resulting from increased spending in corporate
overhead costs and lower net investment income. These increases were partially
offset by state tax credits recognized by the holding company.
Interest expense for both periods relates to the interest paid on the Senior
Debentures of the Company.
34
Investment Portfolio
The Company held general account investment assets diversified across several asset classes, as follows:
September 30, 2002 December 31, 2001
-----------------------------------------------------------------
Carrying % of Total Carrying % of Total
(In millions) Value Carrying Value Value Carrying Value
- --------------------------------------------------------------------------------------------------------------------
Fixed maturities (1)............................ $ 8,949.2 83.1% $ 9,401.7 88.1%
Equity securities (1)........................... 50.4 0.5 62.1 0.6
Mortgages....................................... 286.7 2.7 321.6 3.0
Policy loans.................................... 360.4 3.3 379.6 3.5
Cash and cash equivalents....................... 952.3 8.8 350.2 3.3
Other long-term investments..................... 169.3 1.6 161.2 1.5
-----------------------------------------------------------------
Total...................................... $ 10,768.3 100.0% $ 10,676.4 100.0%
=================================================================
- --------------------------------------------------------------------------------------------------------------------
(1) The Company carries fixed maturities and equity securities in its investment portfolio at market value.
Total investment assets increased $91.9 million, or 0.9%, to $10.8 billion
during the first nine months of 2002. This increase consisted primarily of an
increase in cash and cash equivalents of $602.1 million, partially offset by
decreases of $452.5 million in fixed maturities and $34.9 million from the
run-off of the mortgage portfolio. Cash and cash equivalents increased
principally from the sale of fixed maturities in the Risk Management and
Allmerica Financial Services segments. The decrease in fixed maturities is
primarily due to short term funding agreement withdrawals in the Allmerica Asset
Management segment and the aforementioned sale of fixed maturities in the Risk
Management and AFS segments. These decreases were partially offset by an
increase in fixed maturities in the AFS segment principally due to net deposits
into the general account.
The Company's fixed maturity portfolio is comprised primarily of investment
grade corporate securities, tax-exempt issues of state and local governments,
U.S. government and agency securities and other issues. Based on ratings by the
National Association of Insurance Commissioners ("NAIC"), investment grade
securities comprised 90.6% and 90.7% of the Company's total fixed maturity
portfolio at September 30, 2002 and December 31, 2001, respectively. Although
management expects that new funds will be invested primarily in cash, cash
equivalents and investment grade fixed maturities, the Company may invest a
portion of new funds in below investment grade fixed maturities or equity
interests. The average yield on fixed maturities was 6.8% and 7.4% for the nine
months ended September 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 September 30, 2002 and December 31, 2001, approximately $504.0 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 $104.8 million and $118.5 million of realized
losses on other-than-temporary impairments of fixed maturities during the first
nine months of 2002 and 2001, respectively. Other-than-temporary impairments in
2002 included $15.3 million from securitized investment portfolios and $10.1
million related to securities issued by WorldCom and affiliated companies.
Other-than-temporary impairments in 2001 included a $23.7 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
$9.1 million of realized losses on other-than-temporary impairments of equity
securities during the first nine months of 2002. There were no realized losses
on other-than-temporary impairments of equity securities during the first nine
months of 2001. 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.
35
In addition, the Company had fixed maturity securities with a carrying value of
$43.1 million and $9.8 million on non-accrual status at September 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 $13.8 million and
$9.2 million for the nine months ended September 30, 2002 and 2001,
respectively. This includes the impact of securities held as of the
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 as of September 30, 2002, the
Company has the intent and ability to retain such investments for a period of
time sufficient to allow for this anticipated recovery in market value. The
risks inherent in the assessment methodology include the risk that, subsequent
to the balance sheet date, market factors may differ from management's
expectations; management may decide to subsequently sell a security for
unforeseen business needs; or changes in the credit assessment or equity
characteristics from the Company's original assessment may lead the Company to
determine that a sale at the current value would maximize recovery on such
investments. To the extent that there are such adverse changes, the unrealized
loss would then be realized and the Company would record a charge to earnings.
The following table sets forth gross unrealized losses by maturity periods for
fixed maturities. Actual maturities may differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties, or the Company may have the right to put
or sell the obligations back to the issuers. Mortgage backed securities are
included in the category representing their ultimate maturity.
September 30, December 31,
(In millions) 2002 2001
- ------------------------------------------------------------------------------------------------
Due in one year or less............................ $ 6.3 $ 4.9
Due after one year through five years.............. 87.5 55.9
Due after five years through ten years............. 113.2 64.7
Due after ten years................................ 41.5 52.6
---------------- ----------------
Total $ 248.5 $ 178.1
================ ================
Of the $248.5 million and $178.1 million of gross unrealized losses on fixed
maturities, approximately $28.3 million and $45.6 million relates to fixed
maturity obligations of the U.S. Treasury, U.S. government and agency
securities, states and political subdivisions, as of September 30, 2002 and
December 31, 2001, respectively. An additional $62.3 million and $72.7 million
of gross unrealized losses relates to holdings of investment grade fixed
maturities in a variety of industries and sectors, while approximately $157.9
million and $59.8 million relates to holdings of below investment grade fixed
maturities in a variety of industries and sectors as of September 30, 2002 and
December 31, 2001, respectively. Substantially all below investment grade
securities with an unrealized loss have been rated by either the NAIC, S&P or
Moody's as of September 30, 2002 and December 31, 2001. Gross unrealized losses
relating to equity securities were $4.0 million and $9.1 million as of September
30, 2002 and December 31, 2001, respectively.
In addition, of the $252.5 million and $187.2 million of gross unrealized losses
of fixed maturities and equity securities, $21.2 million and $16.6 million have
been in a significant unrealized loss position (typically those securities with
a market value less than 80% of amortized cost) for six months or longer as of
September 30, 2002 and December 31, 2001, respectively. The remaining unrealized
loss of $231.3 million and $170.6 million as of September 30, 2002 and December
31, 2001, respectively, represents securities that have been in an unrealized
loss position for less than six months or have a market value more than 80% of
amortized cost.
36
The Company enters into various types of interest rate swap contracts to hedge
exposure to interest rate fluctuations on floating rate funding agreement
liabilities that are matched with fixed rate securities. The Company also enters
into foreign currency swap contracts, as well as compound foreign
currency/interest rate swap contracts to hedge foreign currency and interest
rate exposure on specific funding agreement liabilities. Finally, the Company
enters into other swap contracts for investment purposes. These derivative
instruments, which are no longer held by the Company at September 30, 2002, are
not linked to specific assets and liabilities on the balance sheet or to a
forecasted transaction, and therefore do not qualify for hedge accounting. The
Company recognized $1.2 million of net realized gains compared to $15.4 million
of net realized losses on derivatives during the third quarter of 2002 and 2001,
respectively, and recognized $33.2 million and $18.4 million of net realized
losses on derivatives for the nine months ended September 30, 2002 and 2001,
respectively. The realized gains in the third quarter of 2002 and the realized
losses in the third quarter of 2001 were due primarily to fluctuations in the
value of derivatives entered into for investment purposes, which were no longer
held as of September 30, 2002, as well as losses in the third quarter of 2001 on
the termination of swap contracts used to hedge short-term funding agreements in
response to withdrawals. The realized losses during the nine months ended
September 30, 2002, were due primarily to the termination of derivative
instruments used to hedge short-term funding agreements, during a declining
interest rate environment, in response to short-term funding agreement
withdrawals. The realized losses during the nine months ended September 30,
2001, were due primarily to fluctuations in the value of derivatives entered
into for investment purposes, as well as losses on the termination of swap
contracts used to hedge short-term funding agreements in response to
withdrawals.
Income Taxes
AFC and its domestic subsidiaries 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 September 30, 2002 Compared to Quarter Ended September 30, 2001
The provision for federal income taxes was a benefit of $181.7 million during
the third quarter of 2002, compared to a benefit of $11.4 million during the
same period in 2001. These provisions resulted in consolidated effective federal
tax rates of (37.0%) and (47.9%) for the quarters ended September 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 nine months 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 remainder 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.
Included in the Company's deferred tax net asset as of September 30, 2002 is an
approximately $150 million asset related to federal income tax net operating
loss carryforwards ("NOL"). This NOL may be utilized in future years to offset
taxable income of approximately $428 million. In addition, there is an asset of
approximately $93 million related to alternative minimum tax credit
carryforwards at September 30, 2002. Although the Company believes that these
assets are fully recoverable, there can be no certainty that future events will
not affect their recoverability.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
2001
The provision for federal income taxes was a benefit of $233.8 million during
the first nine months of 2002, compared to a benefit of $6.7 million during the
same period in 2001. These provisions resulted in consolidated effective federal
tax rates of (43.4%) and (8.8%) for the nine months ended September 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 an
$11.6 million favorable settlement of certain prior years' federal income tax
returns.
37
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.
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.
38
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. In addition, the disposition of a
line of business can result in the permanent impairment of that line's DAC
asset.
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. 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.
Statutory Capital of Insurance Subsidiaries
The NAIC prescribes an annual calculation regarding Risk Based Capital ("RBC").
RBC is a method of measuring the minimum amount of capital appropriate for an
insurance company to support its overall business operations in consideration of
its size and risk profile. The RBC ratio for regulatory purposes is calculated
as total adjusted capital divided by required risk based capital. Total adjusted
capital for life insurance companies is defined as capital and surplus, plus
asset valuation reserve, plus 50% of dividends apportioned for payment. Total
adjusted capital for property and casualty companies is capital and surplus. The
Company Action Level is the first level at which regulatory involvement is
specified based upon the level of capital. Regulators may take action for
reasons other than triggering various action levels. The various action levels
are summarized as follows:
o The Company Action Level, which equals 200% of the Authorized Control Level,
requires the Company to prepare and submit a RBC plan to the commissioner of
the state of domicile. A RBC plan proposes actions which a company may take
in order to bring statutory capital above the Company Action Level. After
review, the commissioner will notify the Company if the plan is satisfactory.
o The Regulatory Action Level, which equals 150% of the Authorized Control
Level, requires the insurer to submit to the commissioner of the state of
domicile a RBC plan, or if applicable, a revised RBC plan. After examination
or analysis, the commissioner will issue an order specifying corrective
actions ("Corrective Order") to be taken.
o The Authorized Control Level authorizes the commissioner of the state of
domicile to take whatever regulatory actions considered necessary to protect
the best interest of the policyholders and creditors of the insurer.
o The Mandatory Control Level, which equals 70% of the Authorized Control
Level, authorizes the commissioner of the state of domicile to take actions
necessary to place the Company under regulatory control (i.e. rehabilitation
or liquidation).
o Life and health companies whose Total Adjusted Capital is between 200% and
250% of the Authorized Control Level are subject to a trend test. The trend
test calculates the greater of the decrease in the margin between the current
year and the prior year and the average of the past three years. It assumes
that the decrease could occur again in the coming year. Any company that
trends below 190% of the Authorized Control Level (i.e. demonstrates a
negative trend) would trigger the Company Action Level. In the event the
trend test were applied to FAFLIC or AFLIAC when the December 31, 2002
financial statements are filed, it is expected that there would be a negative
trend and therefore Total Adjusted Capital of less than 250% of the
Authorized Control Level would trigger the Company Action Level.
39
RBC ratios for regulatory purposes, as described above, are expressed as a
percentage of the capital required to be above the Authorized Control Level (the
"Regulatory Scale"); however, in the insurance industry RBC ratios are widely
expressed as a percentage of the Company Action Level (without regard to the
application of the negative trend test). Set forth below are estimated RBC
ratios for the Companies' life insurance subsidiaries and for Hanover as of
September 30, 2002, expressed both on the Industry Scale (Total Adjusted Capital
divided by the Company Action Level) and Regulatory Scale (Total Adjusted
Capital divided by Authorized Control Level):
Total Adjusted Company Action Authorized Control RBC Ratio RBC Ratio
(In millions, except ratios) Capital Level Level Industry Scale Regulatory Scale
- ------------------------------------------------------------------------------------------------------------------------------
FAFLIC (1)................. $326.4 $223.4 $111.7 146% 292%
AFLIAC..................... 148.7 111.8 55.9 133% 266%
Hanover (2)................ 892.6 367.9 183.9 243% 486%
(1) FAFLIC's Total Adjusted Capital includes $148.7 million related to its subsidiary, AFLIAC.
(2) Hanover's Total Adjusted Capital includes $483.9 million related to its subsidary, Citizens.
AFC has entered into an agreement with the Massachusetts Commissioner of
Insurance (the "Massachusetts Commissioner"), in consideration of the decision
not to write new business, whereby it will indefinitely maintain the RBC ratio
of FAFLIC at a minimum of 100% of the Company Action Level (on the Industry
Scale). This agreement replaces an earlier commitment that FAFLIC maintain a
225% RBC ratio (on the Industry Scale).
During 2002, AFC has made capital contributions to FAFLIC, which in turn
contributed capital to AFLIAC. Such contributions were necessary due to the
negative impact on statutory surplus of increased sales commissions, the effect
of declines in the equity market on GMDB reserves and an increased level of
realized investment losses. Such contributions were also made in consideration
of the ratings of the life companies and the 225% RBC agreeement described
above, which has since been superceded. For each contribution made, the amount
was accrued as of the end of the prior quarter and was therefore reflected in
the previous quarter's surplus balance in the corresponding Company's statutory
quarterly or annual statement. Hanover also paid an ordinary dividend to AFC in
July, 2002. Contributions made during 2002 were as follows:
Amount
Date of Contribution Path of Contribution (in millions) Effective Date (1)
-----------------------------------------------------------------------------------------------------------
February, 2002 AFC to FAFLIC $ 30 December 31, 2001
FAFLIC to AFLIAC 30
May, 2002 AFC to FAFLIC $ 10 March 31, 2002
FAFLIC to AFLIAC 18
July, 2002 Hanover to AFC $ 92 July, 2002
August, 2002 AFC to FAFLIC $158 June 30, 2002
FAFLIC to AFLIAC 35
October, 2002 FAFLIC to AFLIAC $171 September 30, 2002
(1) The effective date represents the date which these transactions were reflected in the Company's statutory
surplus balance.
The Company received approval by the Massachusetts Commissioner for the
contribution made from FAFLIC to AFLIAC in October, 2002, as required. This
contribution is reflected in the aforementioned RBC ratios. Any further capital
contributions from FAFLIC to AFLIAC prior to October, 2003 would require similar
approval from the Massachusetts Commissioner.
Additional capital contributions to the life companies may be required in the
future as statutory surplus may continue to be negatively impacted by an
increased level of realized investment losses, the impact of GMDB reserves due
to further declines in the equity market from September 30, 2002 levels, as
described below, increased expenses, including pension expenses which are also
subject to equity market fluctuations, and other factors. Such additional
capital contributions could be funded by the holding company. The holding
company's sources of capital include "extraordinary" dividends from the property
and casualty insurance subsidiaries, borrowing under the existing syndicated
credit agreement, and possible third party debt or equity financings. Also life
company capital could be favorably impacted by the sale of certain lines of
business in the AFS segment, reinsurance for certain lines of business in the
AFS segment, the retirement of funding agreemnents or an internal reorganization
of the Company's life insurance subsidiaries.
40
The statutory surplus of the life companies, particularly AFLIAC, which holds
approximately 90% of the annuity deposits with the GMDB feature, is highly
sensitive to movements in the equity market. This is due, in large part, to the
required methodology for calculating GMDB ("Actuarial Guideline 34") reserves
for statutory accounting purposes. As of September 30, 2002, the level of net
GMDB reserves in the life companies was approximately $250 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 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, discussed below. The DAC amortization adjustments described
earlier do not have an impact on statutory surplus, as DAC is not a concept
recognized under statutory accounting principles.
AFLIAC entered into a reinsurance agreement, in 2001, with an independent
reinsurer, to cede up to $40 million of its GMDB costs annually based upon
contract date, in excess of $40 million, for a three year period. Through the
nine months ended September 30, 2002, AFLIAC incurred GMDB costs of
approximately $63.1 million. Since 2001, the Company ceded approximately $33.6
million of GMDB costs under the agreement. As described under "Liquidity and
Capital Resources" below, AFC entered into a related agreement to reimburse
costs incurred by this independent reinsurer.
Liquidity and Capital Resources
Liquidity describes the ability of a company to generate sufficient cash flows
to meet the cash requirements of business operations. As a holding company,
AFC's primary source of cash is dividends from its insurance subsidiaries.
However, dividend payments to AFC by its insurance subsidiaries are subject to
limitations imposed by state regulators, such as the requirement that cash
dividends be paid out of unreserved and unrestricted earned surplus and
restrictions on the payment of "extraordinary" dividends, as defined. As
mentioned above (see Statutory Capital of Insurance Subsidiaries), AFC has
entered into an agreement with the Massachusetts Commissioner, in consideration
of the decision not to write new business, whereby it will indefinitely maintain
the RBC ratio of FAFLIC at a minimum of 100% of the Company Action Level (on the
Industry Scale).
During the first nine months of 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 nine months of 2002, AFC contributed $198 million to FAFLIC.
Such capital contributions were made due to the negative impact on statutory
surplus of increased sales commissions, GMDB reserves, an increased level of
realized investment losses, the level of premiums and deposits and in
consideration of the ratings of the life companies and the 225% RBC agreement,
as described above, which has since been superceded.
In 2001, AFLIAC entered into an agreement to cede its GMDB to an independent
reinsurer (see Statutory Capital of Insurance Subsidiaries). Under a related
agreement, AFC agreed to reimburse these costs to the reinsurer. Through the
nine months ended September 30, 2002, AFLIAC incurred GMDB costs of
approximately $63.1 million. Since 2001, AFLIAC ceded $33.6 million under the
agreement, of which AFC has reimbursed $7.2 million through September 30, 2002.
AFC expects to reimburse the remaining $26.4 million in the fourth quarter of
2002. Management believes that AFC will be required to reimburse up to $40
million in 2003 of 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 LAE, policy acquisition expenses,
other underwriting expenses and investment purchases. Cash outflows related to
benefits, claims, losses and LAE can be variable because of uncertainties
surrounding settlement dates for liabilities for unpaid losses and because of
the potential for large losses either individually or in the aggregate.
Management expects that, due to the decision to cease new sales of life and
annuity products, the expectation of increased policy surrenders in AFS products
and the retirement of funding agreements in AAM, significant net outflows of
cash will occur in the near term. These outflows will be funded with existing
cash and with proceeds from sales of cash equivalents and fixed maturities. The
Company periodically adjusts its investment policy to respond to changes in
short-term and long-term cash requirements.
Net cash provided by operating activities was $672.8 million and $445.3 million
during the first nine months of 2002 and 2001, respectively. Net cash was higher
primarily as a result of new deposits into the general account from the AFS
segment, partially offset by a corresponding increase in commissions. Loss and
LAE payments in the Company's property and casualty business also decreased
slightly from the prior year. Also contributing to the increase in cash was the
receipt of $11.6 million from federal income tax refunds.
41
Net cash provided by investing activities was $663.2 million for the first nine
months of 2002, compared to net cash used in investing activities of $825.2
million for the same period of 2001. The $1.5 billion increase in cash provided
is primarily the result of net sales of fixed maturities in 2002 primarily due
to funding agreement withdrawals and in anticipation of cash payments to be made
related to future surrenders in the AFS segment. In 2001, net purchases of fixed
maturities resulted from the investment of net deposits from funding agreements
and the investment of deposits into the general account related to a promotional
program in AFS.
Net cash used in financing activities was $733.9 million during the first nine
months of 2002, compared to net cash provided by financing activities of $699.7
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 $651.7 million as compared to net deposits of $680.9
million in 2001 and to the extinguishment of the Company's short term debt
obligation of $83.3 million in 2002.
At September 30, 2002, AFC, as a holding company, held $86.0 million of cash and
investments. 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, the aforementioned reimbursement related to
the AFLIAC GMDB reinsurance agreement and dividends, when and if declared by the
Board of Directors, on the common stock. The Company has recently decided to
suspend payment of its annual common stock dividend. Whether the Company will
pay dividends in the future depends upon the earnings and financial condition of
AFC.
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 their respective
investment portfolios 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.
The agreement provides covenants, including, but not limited to, requirements
that the Company maintain adjusted statutory surplus in all of its insurance
subsidiaries in excess of $1 billion; at September 30, 2002 the adjusted
statutory surplus was $1.2 billion. At September 30, 2002, no amounts were
outstanding under this agreement. In addition, the Company had no commercial
paper borrowing as of September 30, 2002.
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.
Rating Agency Actions
Insurance companies are rated by rating agencies to provide both industry
participants and insurance consumers information on specific insurance
companies. Higher ratings generally indicate the rating agencies' opinion
regarding financial stability and a stronger ability to pay claims.
Management believes that strong ratings are important factors in marketing the
Company's products to its agents and customers, since rating information is
broadly disseminated and generally used throughout the industry. Insurance
company ratings are assigned to an insurer based upon factors deemed by the
rating agencies to be relevant to policyholders and are not directed toward
protection of investors. Such ratings are neither a rating of securities nor a
recommendation to buy, hold or sell any security.
42
The following tables provide information about the Company's ratings at December
31, 2000 and 2001 and the rating agencies actions that have occurred in 2002:
Standard & Poor's Ratings
December December August September October
2000 2001 2002 2002 2002
----------------------------------------------------------------------------------------
Financial Strength Ratings
Property and Casualty Companies AA- AA- A+ A- BBB+
(Very Strong) (Very Strong) (Strong) (Strong) (Good)
with a negative
outlook
Life Companies AA- AA- A BB B+
(Very Strong) (Very Strong) (Strong) (Marginal) (Weak)
with a negative
outlook
Debt Ratings
AFC Senior Debt A- A- BBB BB BB-
(Strong) (Strong) (Good) (Marginal) (Marginal)
AFC Capital Securities BBB BBB BBB B- B-
(Good) (Good) (Good) (Weak) (Weak)
AFC Short-term Debt A1+ A2 A2 B1 B
(Strong) (Good) (Good) (Weak) (Weak)
with a negative
outlook
FAFLIC Short-term Debt and A1+ A1+ A1+ B B
Financial Strength Ratings (Strong) (Strong) (Strong) (Vulnerable) (Vulnerable)
43
Moody's Ratings
December December March July September October
2000 2001 2002 2002 2002 2002
-------------------------------------------------------------------------------------------------------
Financial Strength
Ratings
Property and Casualty A1 A1 A1 A2 A3 Baa3
Companies (Good) (Good) (Good) (Good) (Good) (Adequate)
with direction
uncertain
Life Companies A1 A1 A1 A3 Ba1 Ba3
(Good) (Good) (Good) (Good) (Questionable) (Questionable)
with direction
uncertain
Debt Ratings
AFC Senior Debt A2 A2 A3 Baa2 Ba1 B2
(Good) (Good) (Good) (Adequate) (Questionable) (Poor)
AFC Capital Securities a2 A3 Baa1 Baa3 Ba2 Caa1
(Good) (Good) (Adequate) (Adequate) (Questionable) (Very Poor)
with direction
uncertain
AFC Short-term Debt P1 P1 P2 P2 NP NP
(Superior) (Superior) (Strong) (Strong) (Not Prime) (Not Prime)
FAFLIC Short-term P1 P1 P1 P2 NP NP
Debt and Financial (Superior) (Superior) (Superior) (Strong) (Not Prime) (Not Prime)
Strength Ratings
44
A.M. Best's Ratings
December December July September October
2000 2001 2002 2002 2002
---------------------------------------------------------------------------------------
Financial Strength Ratings
Property and Casualty Companies A A A A- B++
(Excellent) (Excellent) (Excellent) (Excellent) (Very Good)
under review
with negative
implications
Life Companies A A A- B+ C++
(Excellent) (Excellent) (Excellent) (Very Good) (Marginal)
under review
with negative
implication
Debt Ratings
AFC Senior Debt Not Rated a- bbb+ bbb- bb+
under review
with negative
implication
AFC Capital Securities Not Rated bbb+ bbb bb bb-
under review
with negative
implication
AFC Short-term Debt Not Rated AMB-1 AMB-2 AMB-3 AMB-4
under review
with negative
implication
As a result of the aforementioned rating downgrades of the life insurance
companies, the Company is no longer able to generate new sales of proprietary
products in its AFS segment and believes that surrender rates in the life
insurance and annuity business will increase. In addition, the Company is no
longer able to sell its GIC product. These downgrades have also caused
counterparties to terminate certain swap agreements, which have been replaced
with alternative derivative instruments.
The decrease in the property and casualty ratings, in particular the A.M. Best
rating, could negatively impact earnings and growth in this business, primarily
in the Company's commercial lines.
Rating downgrades have also adversely affected the cost and availability of any
additional debt or equity financing and will continue to do so in the future
should ratings remain at current levels or decrease further.
45
Recent Developments
For the nine months ended September 30, 2002 and 2001, the Company recognized
net expenses of $16.5 million and $3.9 million, respectively, related to its
employee pension plans. The expense related to the pension plans results from
several factors, including changes in the market value of plan assets, interest
rates and employee compensation levels. The increase in the net expense in 2002
primarily reflected a decline in the market value of plan assets over 2001. In
2003, management expects a significant increase in employee pension plan costs
due to an expected decline in the market value of plan assets and interest rates
in 2002. Such increases may negatively affect the Company's results of
operations. Additionally, the Company expects to recognize a significant
increase in its minimum pension liability related to its qualified pension plan.
This increase results from a decrease in the market value of assets held by the
plan during 2002 due to a decline in the equity market. The amount of any
adjustment to be recorded as an increase to GAAP unrealized losses and a
decrease to statutory surplus is currently unknown and depends on the future
movement of the equity market.
In the fourth quarter of 2002, the Company expects to recognize a restructuring
charge related to its decision to cease the manufacture and sale of proprietary
variable products. This charge will consist primarily of severance and special
termination benefit costs covering approximately 400 to 500 positions, among
other things.
In addition to the decision to cease writing new proprietary variable annuity
and life insurance products, the Company is considering various other strategic
alternatives, including, but not limited to, possible third party debt or equity
financings, reinsurance for certain lines of business in the AFS segment, the
sale of certain lines of business in the AFS segment, the retirement of funding
agreements, and the reorganization of its life insurance subsidiaries. There can
be no assurance that the Company will be successful in pursuing these
alternatives or, if completed, there can be no assurance that the effect of
these alternatives will be on advantageous terms.
In connection with Mr. O'Brien's separation from the Company as President and
Chief Executive Officer, the Company is contractually obligated to fully
reimburse him for taxes incurred as a result of making a so-called 83(b)
election pursuant to Section 83(b) of the Internal Revenue Code, as amended (the
"IRC"), including any taxes arising from this reimbursement obligation. This
obligation arose pursuant to a reimbursement agreement made in 2000 for the
benefit of recipients of restricted stock awards issued under the Company's
Long-Term Stock Incentive Plan who elected to pay income and related taxes under
Section 83(b) of the IRC and whose shares are subsequently forfeited under
certain circumstances. It is estimated that Mr. O'Brien will be reimbursed
approximately $1.8 million. As a result of such separation, Mr. O'Brien will
forfeit 151,000 shares of restricted stock, which were not vested, as well as
all vested and unvested stock options.
In order to facilitate the transition following Mr. O'Brien's separation, the
Company entered into a consulting agreement with Mr. O'Brien for a period of six
months, which can be extended by mutual consent thereafter, at a rate of $15,000
per month and to reimburse him for reasonable business expenses. Mr. O'Brien
will not receive any director meeting fees from the Company so long as he
receives payments under this consulting agreeement.
On November 1, 2002, the Securities and Exchange Commission (the "SEC") advised
the Company that it is conducting an informal inquiry. The Company understands
that this inquiry is related to the Company's recent public disclosures
concerning its variable annuity and variable life insurance products business.
On October 28, 2002, the Company reported third quarter 2002 financial
information, including significant third quarter charges as a result of the
combined effects of the continued stock market decline, action by the major
rating agencies to lower the financial strength ratings of the Company's life
insurance companies, and the accounting for its related decision to cease
marketing its own life insurance and annuity products (See Asset Accumulation -
Allmerica Financial Services). The SEC has requested certain information,
including information about the Company's decision to cease the manufacture and
sale of its proprietary variable annuity and life insurance products and the
anticipated or actual losses related to such products. The Company is fully
cooperating with the SEC.
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.
46
Factors that may cause actual results to differ materially from historical
results and from those contemplated or projected, forecast, estimated or
budgeted in such forward looking statements include among others, the following
possibilities: (i) lower appreciation on or decline in value of the Company's
managed investments or the investment markets in general, resulting in reduced
variable product, assets and related variable product, management and brokerage
fees, lapses and increased surrenders, increased DAC amortization, as well as
increased cost of guaranteed minimum death benefits/decreased account balances
supporting our guaranteed benefits products; (ii) adverse catastrophe experience
and severe weather; (iii) adverse loss development for events the Company has
insured in either the current or in prior years or adverse trends in mortality
and morbidity; (iv) heightened competition, including the intensification of
price competition, the entry of new competitors, and the introduction of new
products by new and existing competitors, or as the result of consolidation
within the financial services industry and the entry of additional financial
institutions into the insurance industry; (v) adverse state and federal
legislation or regulation, including decreases in rates, limitations on premium
levels, increases in minimum capital and reserve requirements, benefit mandates,
limitations on the ability to manage care and utilization, requirements to write
certain classes of business and recent and future changes affecting the tax
treatment of insurance and annuity products, as well as continued compliance
with state and federal regulations; (vi) changes in interest rates causing a
reduction of investment 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 and wholesalers to support
the sale of non-proprietary 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 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, 2001 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; (xxii) higher employee benefit costs due to
changes in market values of plan assets, interest rates and employee
compensation levels, and (xxiii) the effect of the Company's restructuring
actions.
In addition, with respect to the Allmerica Financial Services segment, the
Company has provided forward looking information relating to the impact of
equity market values on certain financial metrics, including among other things,
GMDB expenses, net amount at risk, DAC amortization and Actuarial Guideline 34
reserves for statutory accounting purposes. This information is an estimation
only and is based upon matters as in effect on September 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 rates and patterns, investment experience and
performance of equity and financial markets throughout the period, as well as
from period to period.
47
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
nine months of 2002 to such risks or the management of such risks.
ITEM 4
CONTROLS AND PROCEDURES
Based on their evaluation, as of a date within 90 days of the filing of this
Form 10-Q, the Company's Executive Office of the Chairman and Chief Financial
Officer have concluded the Company's disclosure controls and procedures are
effective. There have been no significant changes in internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation.
48
PART II - OTHER INFORMATION
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EX - 10.43 Agreement dated October 24, 2002 with the Massachusetts
Department of Insurance.
EX - 10.44 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
John F. O'Brien.
EX - 10.45 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
Richard M. Reilly.
EX - 10.46 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
J. Kendall Huber.
EX - 10.47 Consulting Agreement, dated October 25, 2002, between
the Registrant and John F. O'Brien.
EX - 99.1 Certification of J. Kendall Huber, Executive Officer of
the Chairman pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to section 906 of the Sarbanes-Oxley Act
of 2002.
EX - 99.2 Certification of Edward J. Parry III, Executive
Officer of the Chairman and Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to section 906 of the Sarbanes-Oxley Act of 2002.
EX - 99.3 Certification of Robert P. Restrepo, Jr., Executive
Officer of the Chairman pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002.
(b) Reports on Form 8-K
On October 25, 2002, the Board of Directors of Allmerica Financial
Corporation announced they have accepted the resignation of John F.
O'Brien as President and Chief Executive Officer, effective immediately.
Mr. O'Brien will continue as a Director of the Company and will be
involved in the transition.
In addition, the Board of Directors elected Michael P. Angelini as its
Chairman and established an Office of the Chairman, comprised of Mr.
Angelini, J. Kendall Huber, Senior Vice President and General Counsel,
Edward J. Parry, III, newly appointed President of Allmerica Asset
Accumulation Companies and AFC's Chief Financial Officer, and Robert P.
Restrepo, Jr., President of Allmerica Property & Casualty Companies.
On September 27, 2002, Allmerica Financial Corporation announced plans to
consider strategic alternatives, including a significant reduction of
sales of proprietary products, with regard to its Allmerica Financial
Services business unit, which includes the Company's life insurance and
annuity operations.
On August 14, 2002, the Chief Executive Officer and the Chief Financial
Officer submitted to the SEC sworn statements pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
49
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 November 14, 2002
/s/ J. Kendall Huber
-------------------------------------------
J. Kendall Huber
Executive Officer of the Chairman
Dated November 14, 2002
/s/ Edward J. Parry III
-------------------------------------------
Edward J. Parry III
Executive Officer of the Chariman, Chief
Financial Officer and Principal Accounting
Officer
Dated November 14, 2002
/s/ Robert P. Restrepo, Jr.
-------------------------------------------
Robert P. Restrepo, Jr.
Executive Officer of the Chairman
50
CERTIFICATIONS
I, J. Kendall Huber, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Allmerica Financial
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ J. Kendall Huber
--------------------
J. Kendall Huber
Executive Officer of the Chairman
51
I, Edward J. Parry, III, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Allmerica Financial
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Edward J. Parry, III
------------------------
Edward J. Parry, III
Executive Officer of the Chairman and Chief Financial Officer
52
I, Robert P. Restrepo, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Allmerica Financial
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Robert P. Restrepo, Jr.
---------------------------
Robert P. Restrepo, Jr.
Executive Officer of the Chairman
53
EXHIBIT INDEX
Exhibit Number Exhibit
10.43 Agreement dated October 24 2002, with the Massachusetts
Department of Insurance.
10.44 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
John F. O'Brien.
10.45 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
Richard M. Reilly.
10.46 Section 83(b) Agreement, dated March 21, 2000, between
First Allmerica Financial Life Insurance Company and
J. Kendall Huber.
10.47 Consulting Agreement, dated October 25, 2002, between
the Registrant and John F. O'Brien.
99.1 Certification of J. Kendall Huber, Executive Officer of
the Chairman pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002.
99.2 Certification of Edward J. Parry III, Executive Officer
of the Chairman and Chief Financial Officer pursuant to
18 U.S.C. Section 1350, as adopted pursuant to section
906 of the Sarbanes-Oxley Act of 2002.
99.3 Certification of Robert P. Restrepo, Jr., Executive
Officer of the Chairman pursuant to 18 U.S.C. Section
1350, as adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
54