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FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2003
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 No.)
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 [ ]
Indicate by a check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ X ] No [ ]
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the registrant's classes of
common stock as of the latest practicable date: 53,039,795 shares of common
stock outstanding, as of August 1, 2003.
49
Total Number of Pages Included in This Document
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 17-45
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 46
Item 4. Controls and Procedures 46
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 47
Item 6. Exhibits and Reports on Form 8-K 48
SIGNATURES 49
2
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------------------------------------------
(In millions, except per share data) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums............................................. $ 568.4 $ 577.4 $ 1,143.6 $ 1,160.0
Universal life and investment product policy fees.... 76.6 98.8 166.9 194.8
Net investment income................................ 117.4 149.6 236.1 300.1
Net realized investment gains (losses)............... 13.2 (63.8) 26.4 (76.1)
Other income......................................... 46.9 36.4 99.3 68.9
----------- ----------- ------------ -----------
Total revenues................................... 822.5 798.4 1,672.3 1,647.7
----------- ----------- ------------ -----------
Benefits, losses and expenses
Policy benefits, claims, losses and loss adjustment
expenses................................................. 497.6 517.1 984.3 1,053.5
Policy acquisition expenses................................ 142.2 258.8 313.5 370.3
Gain from retirement of trust instruments supported by
funding obligations..................................... (0.3) - (5.0) -
Income from sale of universal life business................ - - (5.5) -
Net losses (gains) on derivative instruments............... 0.6 (14.1) (0.9) (30.4)
Restructuring costs........................................ 1.3 - 4.6 -
Other operating expenses................................... 150.2 149.7 301.8 302.3
----------- ----------- ------------ -----------
Total benefits, losses and expenses.................. 791.6 911.5 1,592.8 1,695.7
----------- ----------- ------------ -----------
Income (loss) before federal income taxes.................. 30.9 (113.1) 79.5 (48.0)
----------- ----------- ------------ -----------
Federal income tax expense (benefit)
Current.............................................. 57.8 (13.2) 29.4 (3.4)
Deferred............................................. (55.3) (48.4) (19.4) (48.7)
----------- ----------- ------------ -----------
Total federal income tax expense (benefit)........ 2.5 (61.6) 10.0 (52.1)
----------- ----------- ------------ -----------
Income(loss) before minority interest and cumulative effect
of change in accounting principle..................... 28.4 (51.5) 69.5 4.1
Minority interest:
Distributions on mandatorily redeemable preferred
securities of a subsidiary trust holding solely
junior subordinated debentures of the Company...... (4.0) (4.0) (8.0) (8.0)
----------- ----------- ------------ -----------
Income (loss) before cumulative effect of change in
accounting principle.................................. 24.4 (55.5) 61.5 (3.9)
Cumulative effect of change in accounting principle (less
income tax benefit of $2.0 for the six months ended
June 30, 2002)......................................... - - - (3.7)
----------- ----------- ------------ -----------
Net income (loss)............................................ $ 24.4 $ (55.5) $ 61.5 $ (7.6)
=========== =========== ============ ===========
PER SHARE DATA
Basic
Income (loss) before cumulative effect of change in
accounting principle.................................. $ 0.46 $ (1.05) $ 1.16 $ (0.07)
Cumulative effect of change in accounting principle (less
income tax benefit of $0.04 for the six months ended
June 30, 2002)........................................ - - - (0.07)
----------- ----------- ------------ -----------
Net income (loss)......................................... $ 0.46 $ (1.05) $ 1.16 $ (0.14)
=========== =========== ============ ===========
Weighted average shares outstanding ...................... 52.9 52.9 52.9 52.8
=========== =========== ============ ===========
Diluted
Income (loss) before cumulative effect of change in
accounting principle.................................. $ 0.46 $ (1.05) $ 1.16 $ (0.07)
Cumulative effect of change in accounting principle
(less income tax benefit of $0.04 for the six months
ended June 30,2002).................................. - - - (0.07)
----------- ----------- ------------ -----------
Net income (loss) ........................................ $ 0.46 $ (1.05) $ 1.16 $ (0.14)
=========== =========== ============ ===========
Weighted average shares outstanding....................... 53.0 52.9 53.0 52.8
=========== =========== ============ ===========
The accompanying notes are an integral part of these consolidated financial statements.
3
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30, December 31,
(In millions, except per share data) 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Assets
Investments:
Fixed maturities-at fair value (amortized cost of $7,121.9 and $7,715.9).... $ 7,578.4 $ 8,003.1
Equity securities-at fair value (cost of $17.1 and $49.1)................... 21.3 52.8
Mortgage loans.............................................................. 237.9 259.8
Policy loans................................................................ 276.7 361.4
Other long-term investments................................................. 104.7 129.7
----------- -----------
Total investments......................................................... 8,219.0 8,806.8
----------- -----------
Cash and cash equivalents...................................................... 351.5 389.8
Accrued investment income...................................................... 121.3 138.3
Premiums, accounts and notes receivable, net................................... 513.2 564.7
Reinsurance receivable on paid and unpaid losses,
benefits and unearned premiums.............................................. 2,096.0 2,075.8
Deferred policy acquisition costs.............................................. 1,155.2 1,242.2
Deferred federal income taxes.................................................. 386.0 413.2
Goodwill....................................................................... 131.2 131.2
Other assets................................................................... 480.8 473.5
Separate account assets........................................................ 11,719.0 12,343.4
----------- -----------
Total assets................................................................ $ 25,173.2 $ 26,578.9
=========== ===========
Liabilities
Policy liabilities and accruals:
Future policy benefits...................................................... $ 3,624.1 $ 3,900.1
Outstanding claims, losses and loss adjustment expenses..................... 3,052.5 3,066.5
Unearned premiums........................................................... 1,046.3 1,047.0
Contractholder deposit funds and other policy liabilities................... 829.9 772.8
----------- -----------
Total policy liabilities and accruals..................................... 8,552.8 8,786.4
----------- -----------
Expenses and taxes payable..................................................... 955.3 1,115.5
Reinsurance premiums payable................................................... 94.6 559.1
Trust instruments supported by funding obligations............................. 1,126.4 1,202.8
Long-term debt................................................................. 199.5 199.5
Separate account liabilities................................................... 11,719.0 12,343.4
----------- -----------
Total liabilities........................................................... 22,647.6 24,206.7
----------- -----------
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..................................................... 1,773.4 1,768.4
Accumulated other comprehensive income (loss).................................. 47.3 (37.4)
Retained earnings.............................................................. 807.7 746.2
Treasury stock at cost (7.4 and 7.5 million shares)............................ (403.4) (405.6)
----------- -----------
Total shareholders' equity.................................................. 2,225.6 2,072.2
----------- -----------
Total liabilities and shareholders' equity................................ $ 25,173.2 $ 26,578.9
=========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
4
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited)
Six Months Ended
June 30,
--------------------------
(In millions) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
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............................................... 1,768.4 1,758.4
Unearned compensation related to restricted stock and other.............. 5.0 0.7
--------- ----------
Balance at end of period..................................................... 1,773.4 1,759.1
--------- ----------
Accumulated Other Comprehensive Income (Loss)
Net unrealized appreciation on investments and derivative
instruments:
Balance at beginning of period............................................... 83.4 28.4
Appreciation during the period:
Net appreciation on available-for-sale securities and derivative
instruments.............................................................. 130.3 0.1
Provision for deferred federal income taxes............................... (45.6) -
--------- ----------
84.7 0.1
--------- ----------
Balance at end of period..................................................... 168.1 28.5
--------- ----------
Minimum Pension Liability:
Balance at beginning and end of period....................................... (120.8) (42.1)
--------- ----------
Total accumulated other comprehensive income (loss).......................... 47.3 (13.6)
--------- ----------
Retained Earnings
Balance at beginning of period............................................... 746.2 1,052.3
Net income (loss)......................................................... 61.5 (7.6)
--------- ----------
Balance at end of period..................................................... 807.7 1,044.7
--------- ----------
Treasury Stock
Balance at beginning of period............................................... (405.6) (406.5)
Shares reissued at cost................................................... 2.2 7.4
--------- ----------
Balance at end of period..................................................... (403.4) (399.1)
--------- ----------
Total shareholders' equity............................................ $ 2,225.6 $ 2,391.7
========= ==========
The accompanying notes are an integral part of these consolidated financial statements.
5
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
---------------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------
Net income (loss)................................... $ 24.4 $ (55.5) $ 61.5 $ (7.6)
Other comprehensive income (loss):
Available-for-sale securities:
Net appreciation during the period ............ 136.2 123.2 133.3 22.3
Provision for deferred federal income taxes.... (47.6) (43.1) (46.6) (7.8)
----------- ----------- ----------- -----------
Total available-for-sale securities............... 88.6 80.1 86.7 14.5
----------- ----------- ----------- -----------
Derivative instruments:
Net depreciation during the period............. (4.0) (35.1) (3.0) (22.2)
Benefit for deferred federal income taxes...... 1.3 12.3 1.0 7.8
----------- ----------- ----------- -----------
Total derivative instruments...................... (2.7) (22.8) (2.0) (14.4)
----------- ----------- ----------- -----------
Other comprehensive income .......................... 85.9 57.3 84.7 0.1
----------- ----------- ----------- -----------
Comprehensive income (loss)......................... $ 110.3 $ 1.8 $ 146.2 $ (7.5)
=========== =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial statements.
6
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
June 30,
--------------------------------
(In millions) 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------
Cash flows from operating activities
Net income (loss)....................................................... $ 61.5 $ (7.6)
Adjustments to reconcile net income (loss) to net cash (used in)
provided by operating activities:
Net realized investment (gains) losses .............................. (26.4) 76.1
Net gains on derivative instruments.................................. (0.9) (30.4)
Net amortization and depreciation.................................... 14.6 11.6
Interest credited to contractholder deposit funds and trust
instruments supported by funding obligations....................... 29.0 45.9
Deferred federal income taxes........................................ (19.4) (48.7)
Change in deferred acquisition costs................................. 78.2 (30.3)
Change in premiums and notes receivable,
net of reinsurance payable......................................... 68.0 5.2
Change in accrued investment income.................................. 17.0 9.1
Change in policy liabilities and accruals, net....................... (254.1) 208.6
Change in reinsurance receivable..................................... (20.2) 4.3
Change in expenses and taxes payable................................. (209.7) (15.0)
Other, net........................................................... (0.9) 4.3
------------- -------------
Net cash (used in) provided by operating activities............ (263.3) 233.1
------------- -------------
Cash flows from investing activities
Proceeds from disposals and maturities of available-for-sale fixed
maturities.......................................................... 1,733.4 1,972.3
Proceeds from disposals of equity securities............................ 71.3 13.4
Proceeds from disposals of other investments............................ 44.9 15.9
Proceeds from mortgages matured or collected............................ 22.9 13.1
Proceeds from collections of installment finance and notes receivable... 150.8 170.1
Purchase of available-for-sale fixed maturities......................... (1,463.2) (1,525.7)
Purchase of equity securities........................................... (35.9) (0.7)
Purchase of other investments........................................... (16.9) (21.0)
Capital expenditures.................................................... (2.3) (3.5)
Payments related to terminated derivative instruments................... (5.2) (37.4)
Disbursements to fund installment finance and notes receivable.......... (153.6) (154.5)
Other investing activities, net......................................... 0.5 -
------------- -------------
Net cash provided by investing activities...................... 346.7 442.0
------------- -------------
Cash flows from financing activities
Deposits to contractholder deposit funds................................ - 100.0
Withdrawals from contractholder deposit funds........................... (17.2) (692.2)
Deposits to trust instruments supported by funding obligations.......... - 45.1
Withdrawals from trust instruments supported by funding obligations..... (104.5) (94.2)
Change in short-term debt............................................... - (8.9)
Treasury stock reissued at cost......................................... - 1.0
------------- -------------
Net cash used in financing activities.......................... (121.7) (649.2)
------------- -------------
Net change in cash and cash equivalents.................................... (38.3) 25.9
Cash and cash equivalents, beginning of period............................. 389.8 350.2
------------- -------------
Cash and cash equivalents, end of period................................... $ 351.5 $ 376.1
============= =============
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
Allmerica Financial Life Insurance and Annuity Company ("AFLIAC") and First
Allmerica Financial Life Insurance Company ("FAFLIC"), AFC's principal life
insurance and annuity companies; The Hanover Insurance Company ("Hanover") and
Citizens Insurance Company of America ("Citizens"), AFC's principal property and
casualty companies; and certain other insurance and non-insurance subsidiaries.
These legal entities conduct their operations through several business segments
discussed in Note 8. All significant intercompany accounts and transactions have
been eliminated.
The accompanying interim consolidated financial statements reflect, in the
opinion of the Company's management, all adjustments necessary for a fair
presentation of the financial position and results of operations. The results of
operations for the six months ended June 30, 2003 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 2002 Annual Report on Form 10-K
filed with the Securities and Exchange Commission.
2. New Accounting Pronouncements
In July 2003, the American Institute of Certified Public Accountants issued
Statement of Position 03-1, "Accounting and Reporting by Insurance Enterprises
for Certain Nontraditional Long-Duration Contracts and for Separate Accounts"
("SOP 03-1"). SOP 03-1 is applicable to all insurance enterprises as defined by
Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by
Insurance Enterprises". This statement provides guidance regarding accounting
and disclosures of separate account assets and liabilities and an insurance
company's interest in such separate accounts. It further provides for the
accounting and disclosures related to contractholder transfers to separate
accounts from a company's general account and the determination of the balance
that accrues to the benefit of the contractholder. In addition, SOP 03-1
provides guidance for determining any additional liabilities for guaranteed
minimum death benefits or other insurance benefit features, potential benefits
available only on annuitization and liabilities related to sales inducements,
such as immediate bonus payments, pesistancy bonuses, and enhanced crediting
rates or "bonus interest" rates, as well as the required disclosures related to
these items. This statement is effective for fiscal years beginning after
December 15, 2003. The Company is currently assessing the effect that adoption
of SOP 03-1 will have on its financial position and results of operations.
In May 2003, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("Statement No.
150"). This statement establishes standards for how an issuer classifies and
measures in its statement of financial position certain financial instruments
with characteristics of both liabilities and equity. It requires that an issuer
classify mandatorily redeemable financial instruments and other financial
instruments that embody an obligation of the issuer as liabilities. At
inception, these liabilities shall initially be measured at fair value.
Mandatorily redeemable financial instruments and certain forward contracts in
which both the amount to be paid and the settlement date are fixed shall be
subsequently measured at the present value of the amount to be paid at
settlement, accruing interest cost using the rate implicit at inception. Other
financial instruments shall be subsequently measured at fair value.
Additionally, mandatorily redeemable financial instruments and certain forward
contracts shall, on a prospective basis, reflect any amounts paid or to be paid
to holders of these instruments in excess of the initial measurement amount as
interest cost. For financial instruments created before the issuance date of
Statement No. 150 and still existing at the beginning of the interim period of
adoption, any changes between carrying value and fair value or other measurement
attribute provided for by this statement, upon adoption of this statement, shall
be reflected as a cumulative effect of a change in accounting principle. This
statement is effective for interim periods beginning after June 15, 2003. The
Company currently holds $300.0 million of mandatorily redeemable preferred
securities of a subsidiary trust holding solely junior subordinated debentures
of the Company, which are required to be classified as liabilities in the third
quarter of 2003.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities - an interpretation of ARB No. 51" ("FIN 46"). FIN 46
provides guidance regarding the application of Accounting Research Bulletin No.
51, "Consolidated Financial Statements", specifically as it relates to the
identification of entities for which control is achieved through a means other
than voting rights ("variable interest entities") and the determination of which
party is responsible for consolidating the variable interest entities (the
"primary beneficiary"). In addition to mandating that the primary beneficiary
consolidate the variable interest entity, FIN 46 also requires disclosures by
companies that hold a significant variable interest, even if they are not the
primary
8
beneficiary. Certain financial statement disclosures are applicable immediately
for those entities for which it is reasonably possible that the enterprise will
consolidate any variable interest entities. This interpretation also applies
immediately to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after that
date. For those variable interest entities in which an enterprise holds a
variable interest that it acquired before February 1, 2003, the provisions of
this interpretation shall be applied no later than the first reporting period
after June 15, 2003. The Company performed a review of potential variable
interest entities and concluded that as of June 30, 2003, AFC was not the
primary beneficiary of any material variable interest entities; and, therefore
would not be required to consolidate those entities as a result of implementing
FIN 46. However, the Company does hold a significant variable interest in a
limited partnership. In 1997, the Company invested in the McDonald Corporate Tax
Credit Fund - 1996 Limited Partnership, which was organized to invest in low
income housing projects which qualify for tax credits under the Internal Revenue
Code. The Company's investment in this limited partnership, which represents
approximately 36% of the partnership, is not a controlling interest; it entitles
the Company to tax credits to be applied against its federal income tax
liability in addition to tax losses to offset taxable income. The Company's
maximum exposure to loss on this investment is limited to its carrying value,
which is $10.0 million at June 30, 2003.
In December 2002, the FASB issued Statement of Financial Accounting Standards
No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure"
("Statement No. 148"). This statement amends FASB Statement No. 123, "Accounting
for Stock-Based Compensation" ("Statement No. 123"), to provide alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, this statement
amends the disclosure requirements of Statement No. 123 to require more
prominent disclosures, in both annual and interim financial statements,
regarding the proforma effects of using the fair value method of accounting for
stock-based compensation. The provisions of this statement are effective for
fiscal years ending after December 15, 2002. The Company has elected to continue
applying the provisions of Accounting Principles Board Opinion No. 25 for
stock-based employee compensation.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others - an interpretation of FASB Statements No. 5, 57, and 107
and rescission of FASB Interpretation No. 34" ("FIN 45"). FIN 45 provides
guidance regarding financial statement disclosure requirements for guarantors
related to obligations under guarantees. FIN 45 also clarifies the requirements
related to the recognition of a liability by the guarantor, at the inception of
a guarantee, for these obligations under guarantees. This interpretation also
incorporates, without change, the guidance in FASB Interpretation No. 34,
"Disclosure of Indirect Guarantees of Indebtedness of Others", which is being
superseded. The initial recognition and measurement provisions of this
interpretation are required to be applied only on a prospective basis to
guarantees issued or modified after December 31, 2002. The disclosure
requirements are effective for financial statements of reporting periods ending
after December 15, 2002. The adoption of FIN 45 did not have a material effect
on the Company's financial position or results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standards No.
146, "Accounting for Costs Associated with Exit or Disposal Activities"
("Statement No. 146"). This statement requires that a liability for costs
associated with an exit or disposal activity is recognized and measured
initially at its fair value in the period the liability is incurred. This
statement supersedes Emerging Issues Task Force Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity including Certain Costs Incurred in a Restructuring". Additionally, the
statement requires financial statement disclosures about the description of the
exit or disposal activity, including for each major type of cost, the total
amount expected to be incurred and a reconciliation of the beginning and ending
liability balances. The provisions of this statement are effective for all exit
and disposal activities initiated after December 31, 2002.
3. Discontinued Operations
During 1999, the Company approved a plan to exit its group life and health
insurance business, consisting of its Employee Benefit Services ("EBS")
business, its Affinity Group Underwriters business and its accident and health
assumed reinsurance pool business ("reinsurance pool business"). During 1998,
the Company ceased writing new premiums in the reinsurance pool business,
subject to certain contractual obligations. Prior to 1999, these businesses
comprised substantially all of the former Corporate Risk Management Services
segment. Accordingly, the operating results of the discontinued segment,
including its reinsurance pool business, have been reported in the Consolidated
Statements of Income as discontinued operations in accordance with Accounting
Principles Board Opinion No. 30, "Reporting the Results of Operations -
Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and Transactions" ("APB Opinion No.
30"). In 1999, the Company recorded a $30.5 million loss, net of taxes, on the
disposal of this segment, consisting of after-tax losses from the run-off of the
group life and health business of $46.9 million, partially offset by net
proceeds from the sale of the EBS business of $16.4 million. Subsequent to the
measurement date of June 30, 1999, approximately $10.3 million of the
aforementioned $46.9 million loss has been generated from the operations of the
discontinued business.
9
In 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 $90.9
million at June 30, 2003 related to this business.
As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not
been segregated between continuing and discontinued operations. At June 30, 2003
and 2002, the discontinued segment had assets of approximately $300.3 million
and $307.9 million, respectively, consisting primarily of invested assets and
reinsurance recoverables, and liabilities of approximately $366.1 million and
$364.5 million, respectively, consisting primarily of policy liabilities.
Revenues for the discontinued operations were $3.3 million and $5.2 million for
the quarters ended June 30, 2003 and 2002, respectively, and $7.9 million and
$12.0 million for the six months ended June 30, 2003 and 2002, respectively.
4. Significant Transactions
Effective December 31, 2002, the Company effectively sold, through a 100%
coinsurance agreement, substantially all of its fixed universal life insurance
business. Under the agreement, the Company ceded approximately $660 million of
universal life insurance reserves in exchange for the transfer of approximately
$550 million of investment assets with an amortized cost of approximately $525
million and was subject to certain post-closing adjustments. At December 31,
2002, the Company recorded a pre-tax loss of $31.3 million. Subsequently, the
Company transferred cash and other investment assets of approximately $100
million and $450 million, respectively, during 2003, for the settlement of the
net payable associated with this transaction. In addition, the Company recorded
incremental income of $5.5 million during the first half of 2003 related to the
settlement of post-closing items.
In the first six months of 2003, the Company retired $65.6 million of long-term
funding agreement obligations which resulted in a pre-tax gain of $5.0 million
and is reported as gain from retirement of trust instruments supported by
funding obligations in the Consolidated Statements of Income. Certain amounts
related to the termination of derivative instruments used to hedge the retired
funding agreements were reported in separate line items in the Consolidated
Statements of Income. The net market value loss on the early termination of
derivative instruments used to hedge the retired funding agreements of $5.7
million was recorded as net realized investment gains in the Consolidated
Statements of Income. The net foreign currency transaction gain on the retired
foreign-denominated funding agreements of $3.6 million was recorded as other
income in the Consolidated Statements of Income.
In the fourth quarter of 2002, the Company recognized a pre-tax charge of $15.0
million related to the restructuring of its AFS segment and has been accounted
for under the guidance of 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)". Approximately
$11.7 million of this charge relates to severance and other employee and agent
related costs resulting from the elimination of approximately 475 positions, of
which 407 employees have been terminated as of June 30, 2003 and 63 vacant
positions have been eliminated. All levels of employees, from staff to senior
management, were affected by the restructuring. Approximately $3.3 million of
this charge relates to other restructuring costs, consisting of lease and
contract cancellations and the present value of idle leased space. Additionally,
the Company terminated all life insurance and annuity agent contracts effective
December 31, 2002. As of June 30, 2003, the Company has made payments of
approximately $12.4 million related to this restructuring plan, of which
approximately $10.4 million relates to severance and other employee related
costs. During the first six months of 2003, the Company eliminated an additional
73 positions related to this restructuring, of which 65 employees have been
terminated as of June 30, 2003. The Company recorded a pre-tax charge of $4.6
million, consisting of $4.4 million of employee related costs and $0.2 million
related to contract cancellations, during the first six months of 2003.
5. Federal Income Taxes
Federal income tax expense for the six months ended June 30, 2003 has been
computed using estimated effective tax rates. These rates are revised, if
necessary, at the end of each successive interim period to reflect the current
estimates of the annual effective tax rates.
10
It is the Company's policy to estimate taxes for interim periods based on
estimated annual effective tax rates which are derived, in part, from expected
annual pre-tax income. However, the federal income tax benefit for the six
months ended June 30, 2002 was computed based on the first half of 2002 as a
discrete period due to the uncertainty regarding the Company's ability to
reliably estimate pre-tax income for the remainder of the year. The Company
could not reliably estimate pre-tax income for the second half of 2002
principally due to the impact of the equity market on the Company, including
possible additional amortization of deferred policy acquisition costs. Because
of this uncertainty, the Company was unable to develop a reasonable estimate of
the annual effective tax rate for the full year 2002. In addition, during the
six months ended June 30, 2002, the Company recognized a benefit of $12.1
million related to a settlement of certain prior years' federal income tax
returns.
6. Other Comprehensive Income
The following table provides a reconciliation of gross unrealized gains (losses)
to the net balance shown in the Statements of Comprehensive Income:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Unrealized gains on available-for-sale securities:
Unrealized holding gains (losses) arising during period
(net of income tax benefit (expense)of $19.8 million
and $(28.8)million for the quarters ended June 30, 2003
and 2002 and$(57.0) million and $7.0 million for the six
months ended June 30, 2003 and 2002)......................... $ 166.2 $ 51.5 $ 106.0 $ (12.9)
Less: reclassification adjustment for losses included in
net income (net of income tax benefit (expense) of $67.4
million and $14.3 million for the quarters ended June 30,
2003 and 2002 and $(10.4) million and $14.8 million for
the six months ended June 30, 2003 and 2002)................. 77.6 (28.6) 19.3 (27.4)
--------- --------- ---------- ----------
Total available-for-sale securities............................... 88.6 80.1 86.7 14.5
--------- --------- ---------- ----------
Unrealized losses on derivative instruments:
Unrealized holding (losses) gains arising during period
(net of income tax benefit of $27.8 million and $36.0
million for the quarters ended June 30, 2003 and 2002
and $1.9 million and $31.2 million for the six months
ended June 30,2003 and 2002).................................. (19.6) 63.2 3.5 57.9
Less: reclassification adjustment for (losses) gains included
in net income (net of income tax benefit of $29.1 million and
$48.3 million for the quarters ended June 30, 2003 and 2002
and $2.9 million and $39.0 million for the six months ended
June 30, 2003 and 2002)....................................... (16.9) 86.0 5.5 72.3
--------- --------- ---------- ----------
Total derivative instruments....................................... (2.7) (22.8) (2.0) (14.4)
--------- --------- ---------- ----------
Other comprehensive income ....................................... $ 85.9 $ 57.3 $ 84.7 $ 0.1
========= ========= ========== ==========
11
7. Closed Block
Summarized financial information of the Closed Block, established in 1995 upon
demutualization, is as follows for the periods indicated:
Unaudited)
June 30, December 31,
(In millions) 2003 2002
------------------------------------------------------------------------------------------------------
Assets
Fixed maturities-at fair value (amortized cost of $504.9 and $498.1). $ 547.6 $ 542.4
Mortgage loans....................................................... 45.8 46.6
Policy loans......................................................... 162.6 167.4
Cash and cash equivalents............................................ 1.0 0.3
Accrued investment income............................................ 12.8 13.1
Deferred policy acquisition costs.................................... 7.5 8.2
Deferred federal income taxes........................................ 4.6 5.4
Other assets......................................................... 10.1 4.7
--------- ---------
Total assets...................................................... $ 792.0 $ 788.1
========= =========
Liabilities
Policy liabilities and accruals...................................... $ 764.5 $ 767.5
Policyholder dividends............................................... 78.0 57.1
Other liabilities.................................................... 1.2 23.8
--------- ---------
Total liabilities................................................. $ 843.7 $ 848.4
========= =========
Excess of Closed Block liabilities over assets designated to the
Closed Block......................................................... $ 51.7 $ 60.3
Amounts included in accumulated other comprehensive income:
Net unrealized investment losses, net of deferred federal income
tax benefit of $8.1 million and $5.2 million......................... (15.1) (9.6)
--------- ---------
Maximum future earnings to be recognized from Closed Block
assets and liabilities............................................... $ 36.6 $ 50.7
========= =========
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
----------------------- ---------------------
(In millions) 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------
Revenues
Premiums.............................................................. $ 6.0 $ 6.4 $ 26.9 $ 30.8
Net investment income................................................. 11.8 13.1 23.8 26.0
Net realized investment(losses)gains.................................. (0.7) (1.7) 4.3 (1.8)
-------- --------- ------- -------
Total revenues..................................................... 17.1 17.8 55.0 55.0
-------- --------- ------- -------
Benefits and expenses
Policy benefits....................................................... 15.8 13.7 49.6 47.6
Policy acquisition expenses........................................... 0.7 0.7 0.4 1.2
Other operating expenses.............................................. (0.1) 0.1 0.3 0.4
-------- --------- ------- -------
Total benefits and expenses........................................ 16.4 14.5 50.3 49.2
-------- --------- ------- -------
Contribution from the Closed Block.............................. $ 0.7 $ 3.3 $ 4.7 $ 5.8
======== ========= ======= =======
Many expenses related to Closed Block operations are charged to operations
outside the Closed Block; accordingly, the contribution from the Closed Block
does not represent the actual profitability of the Closed Block operations.
Operating costs and expenses outside of the Closed Block are, therefore,
disproportionate to the business outside the Closed Block.
12
8. Segment Information
The Company offers financial products and services and conducts business
principally in three operating segments. These segments are Property and
Casualty (formerly "Risk Management"), Allmerica Financial Services ("AFS"), and
Asset Management (formerly "Allmerica Asset Management"). Prior to 2003,
Allmerica Financial Services and Asset Management comprised the Asset
Accumulation group. In accordance with Statement of Financial Accounting
Standards No. 131, "Disclosures About Segments of an Enterprise and Related
Information", the separate financial information of each segment is presented
consistent with the way results are regularly evaluated by the chief operating
decision makers in deciding how to allocate resources and in assessing
performance. A summary of the Company's reportable segments is included below.
The Property and Casualty segment manages its operations through two lines of
business based upon product and identified as Personal Lines and Commercial
Lines. Personal Lines include property and casualty coverages such as personal
automobile, homeowners and other personal policies, while Commercial Lines
include property and casualty coverages such as workers' compensation,
commercial automobile, commercial multiple peril and other commercial policies.
Prior to September 30, 2002, the Allmerica Financial Services segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and life insurance products. Subsequently, the
Company ceased all new sales of proprietary variable annuities and life
insurance products. After September 30, 2002, the AFS business consists of two
components. First, the segment includes its independent broker/dealer, VeraVest
Investments, Inc., ("VeraVest"), which distributes third-party investment and
insurance products. The Company has entered into agreements with leading
investment product and insurance providers whereby these providers compensate
the Company for non-proprietary product sales by VeraVest's registered
representatives. Second, this segment will retain and service existing variable
annuity and variable universal life accounts, as well as its remaining
traditional life and group retirement accounts, which were issued by its life
insurance subsidiaries, AFLIAC and FAFLIC.
Through its Asset Management segment, prior to September 2002, FAFLIC offered
guaranteed investment contracts ("GICs"). GICs, also referred to as funding
agreements, are investment contracts with either short-term or long-term
maturities, which are issued to institutional buyers or to various business or
charitable trusts. Declining financial strength ratings from various rating
agencies during 2002 resulted in GIC contractholders terminating all remaining
short-term funding agreements and made it impractical to continue selling new
long-term funding agreements. Furthermore, the Company retired certain long-term
funding agreements, at discounts, during the first half of 2003 and the fourth
quarter of 2002 (see Note 4 - Significant Transactions). This segment continues
to be a Registered Investment Advisor providing investment advisory services,
primarily to affiliates and to third parties, such as money market and other
fixed income clients through its subsidiary, Opus Investment Management, Inc.
Additionally, this segment includes AMGRO, Inc., the Company's property and
casualty insurance premium financing business.
In addition to the three operating segments, the Company has a Corporate
segment, which consists primarily of cash, investments, corporate debt, Capital
Securities (mandatorily redeemable preferred securities of a subsidiary trust
holding solely junior subordinated debentures of the Company) and corporate
overhead expenses. Corporate overhead expenses reflect costs not attributable to
a particular segment, such as those related to certain officers and directors,
technology, finance, human resources and legal.
Management evaluates the results of the aforementioned segments based on a
pre-tax and pre-minority interest basis. Segment income excludes certain items,
which are included in net income, 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, segment income excludes net
gains and losses on disposals of businesses, discontinued operations,
restructuring and reorganization costs, extraordinary items, the cumulative
effect of accounting changes and certain other items.
13
Summarized below is financial information with respect to business segments:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
---------------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
Segment revenues:
Property and Casualty................................... $ 615.3 $ 626.7 $ 1,224.3 $ 1,241.4
Allmerica Financial Services............................ 174.4 204.8 382.4 419.7
Asset Management........................................ 22.2 31.8 44.3 64.0
Corporate............................................... 0.5 1.5 1.0 3.2
Intersegment revenues................................... (3.1) (2.6) (6.1) (4.5)
---------- ---------- ----------- ---------
Total segment revenues................................ 809.3 862.2 1,645.9 1,723.8
Adjustments to segment revenues:
Net realized investment gains (losses).................. 13.2 (63.8) 26.4 (76.1)
---------- ---------- ----------- ---------
Total revenues........................................ $ 822.5 $ 798.4 $ 1,672.3 $ 1,647.7
========== ========== =========== =========
Segment income(loss) before federal income taxes, minority
interest and cumulative effect of change in accounting
principle:
Property and Casualty................................... $ 20.6 $ 51.6 $ 64.8 $ 90.6
Allmerica Financial Services............................ 18.4 (113.8) 20.8 (84.1)
Asset Management........................................ 2.5 5.1 5.0 10.2
Corporate............................................... (18.5) (15.2) (35.6) (31.6)
---------- ---------- ----------- ---------
Segment income (loss) before federal income taxes
and minority interest............................... 23.0 (72.3) 55.0 (14.9)
Adjustments to segment income:
Net realized investment gains(losses),net of deferred
acquisition cost amortization......................... 9.5 (57.4) 17.7 (66.0)
Gain from retirement of trust instruments supported by
funding obligations................................... 0.3 - 5.0 -
Income from sale of universal life business............. - - 5.5 -
Net (losses) gains on derivative instruments............ (0.6) 14.1 0.9 30.4
Sales practice litigation............................... - 2.5 - 2.5
Restructuring costs..................................... (1.3) - (4.6) -
---------- ---------- ----------- ---------
Income (loss) before federal income taxes, minority
interest and cumulative effect of change in
accounting principle................................ $ 30.9 $ (113.1) $ 79.5 $ (48.0)
========== ========== =========== =========
Identifiable Assets Deferred Acquisition Costs
- -------------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
June 30, December 31, June 30, December 31,
(In millions) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------------
Property and Casualty (1)................... $ 6,184.6 $ 6,056.1 $ 220.3 $ 215.1
Allmerica Financial Services................ 17,651.7 18,971.6 934.9 1,027.1
Asset Management............................ 1,332.3 1,559.8 - -
Corporate and intersegment eliminations..... 4.6 (8.6) - -
------------- -------------- -------------- --------------
Total.................................... $ 25,173.2 $ 26,578.9 $ 1,155.2 $ 1,242.2
============= ============== ============== ==============
(1) Includes assets related to the Company's discontinued operations of $300.3 million and $290.4 million at June 30, 2003 and
December 31, 2002, respectively.
14
9. Earnings Per Share
The following table provides share information used in the calculation of the
Company's basic and diluted earnings per share:
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
---------------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
Basic shares used in the calculation of earnings per share...... 52.9 52.9 52.9 52.8
Dilutive effect of securities (1):
Employee stock options..................................... 0.1 - 0.1 -
---------- ---------- ---------- ----------
Diluted shares used in the calculation of earnings per share.... 53.0 52.9 53.0 52.8
========== ========== ========== ==========
(1) Excludes 0.4 million shares due to antidilution for the quarter and six months ended June 30, 2002.
10. Stock-Based Compensation Plans
The Company applies the provisions of Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees, and Related Interpretations"
("APB Opinion No. 25"), in accounting for its stock-based compensation plans,
and thus compensation cost is not generally required to be recognized in the
financial statements for the Company's stock options issued to employees.
However, costs associated with the issuance of stock options to certain agents
who did not qualify as employees were recognized in 2003 and 2002.
The following table illustrates the effect on net income and net income per
share if the Company had applied the fair value recognition provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation", to stock-based compensation.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
---------------------------------------------------------
(In millions, except per share data) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------------
Net income (loss), as reported................................. $ 24.4 $ (55.5) $ 61.5 $ (7.6)
Stock-based compensation expense included in reported net
income, net of taxes.................................... 0.1 0.1 0.2 0.3
Total stock-based compensation expense determined under
fair value based method for all awards, net of taxes..... (2.8) (3.2) (5.5) (6.5)
---------- ----------- ---------- ----------
Proforma net income (loss)..................................... $ 21.7 $ (58.6) $ 56.2 $ (13.8)
========== =========== ========== ==========
Earnings per share:
Basic- as reported........................................ $ 0.46 $ (1.05) $ 1.16 $ (0.14)
========== =========== ========= ==========
Basic- proforma........................................... $ 0.41 $ (1.11) $ 1.06 $ (0.26)
========== =========== ========= ==========
Diluted- as reported...................................... $ 0.46 $ (1.05) $ 1.16 $ (0.14)
========== =========== ========== ==========
Diluted- proforma......................................... $ 0.41 $ (1.11) $ 1.06 $ (0.26)
========== =========== ========== ==========
15
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. Subsequently, the Company has recognized pre-tax benefits totaling
$10.2 million resulting from the refinement of cost estimates. Although the
Company believes that it has appropriately recognized its obligation under the
settlement, this estimate may be revised based on the amount of reimbursement
actually tendered by AFC's insurance carriers.
The Company has been named a defendant in various other legal proceedings
arising in the normal course of business. In the Company's opinion, based on the
advice of legal counsel, the ultimate resolution of these proceedings will not
have a material effect on the Company's consolidated financial statements.
16
PART I
ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
TABLE OF CONTENTS
Introduction..........................................................18
Description of Operating Segments.....................................18
Results of Operations..............................................18-37
Consolidated Overview........................................18-21
Segment Results..............................................22-37
Property and Casualty.....................................22-30
Allmerica Financial Services..............................31-35
Asset Management..........................................36-37
Corporate....................................................37
Investment Portfolio...............................................38-40
Derivative Instruments................................................40
Income Taxes..........................................................41
Statutory Capital of Insurance Subsidiaries...........................41
Liquidity and Capital Resources.......................................42
Rating Agency Actions..............................................42-43
Recent Developments...................................................43
Forward-Looking Statements............................................43
Glossary...........................................................44-45
17
INTRODUCTION
The following analysis of the interim consolidated results of operations and
financial condition of Allmerica Financial Corporation and subsidiaries ("AFC")
should be read in conjunction with the interim Consolidated Financial Statements
and related footnotes included elsewhere in this Quarterly Report and the
Management's Discussion and Analysis of Financial Condition and Results of
Operations contained in our 2002 Annual Report on Form 10-K filed with the
Securities and Exchange Commission.
Our results of operations include the accounts of Allmerica Financial Life
Insurance and Annuity Company ("AFLIAC") and First Allmerica Financial Life
Insurance Company ("FAFLIC"), our principal life insurance and annuity
companies. Our results of operations also include the accounts of The Hanover
Insurance Company ("Hanover") and Citizens Insurance Company of America
("Citizens"), our principal property and casualty companies; and other insurance
and non-insurance subsidiaries.
Description of Operating Segments
We offer financial products and services in three operating segments. These
segments are Property and Casualty (formerly "Risk Management"), Allmerica
Financial Services ("AFS"), and Asset Management (formerly "Allmerica Asset
Management"). Before 2003, AFS and Asset Management comprised the Asset
Accumulation group. We present the separate financial information of each
segment consistent with the manner in which our chief operating decision makers
evaluate results in deciding how to allocate resources and in assessing
performance. This presentation complies with Statement of Financial Accounting
Standards No. 131, "Disclosures About Segments of an Enterprise and Related
Information". Segment income excludes certain items which are included in net
income, 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, segment income excludes net gains and losses on disposals of
businesses, discontinued operations, restructuring and reorganization costs,
extraordinary items, the cumulative effect of accounting changes and certain
other items.
Results of Operations
Consolidated Overview
Our consolidated net income for the second quarter of 2003 increased $79.9
million, to net income of $24.4 million, compared to a net loss of $55.5 million
for the same period in 2002. The increase in the second quarter resulted
primarily from a $95.3 million increase in segment income principally related to
AFS, partially offset by a $48.9 million change in corresponding federal income
taxes. Federal income taxes on segment income changed from a benefit of $48.6
million in the second quarter of 2002 to an expense of $0.3 million in 2003. In
addition, net income increased from a $45.1 million change in net realized
investment gains (losses) from a net loss of $38.5 million in the second quarter
of 2002 to a $6.6 million net gain in 2003.
Consolidated net income for the first six months of 2003 increased $69.1
million, to net income of $61.5 million, compared to a net loss of $7.6 million
for the first six months of 2002. This increase resulted primarily from a $69.9
million increase in segment income principally related to AFS, partially offset
by a $45.2 million change in corresponding federal income taxes. Federal income
taxes on segment income changed from a benefit of $40.6 million in the first
half of 2002 to an expense of $4.6 million in 2003. Additionally, net income
increased from a $57.5 million change in net realized investment gains (losses)
to a net gain of $14.6 million in the first half of 2003, from a net loss of
$42.9 million in the comparable period of 2002.
18
The following table reflects segment income (loss) and a reconciliation to
consolidated net income (loss).
Quarter Ended Six Months Ended
June 30, June 30,
-------------------------------------------------------
(In millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Segment income (loss) before federal income taxes and
minority interest:
Property and Casualty.................................... $ 20.6 $ 51.6 $ 64.8 $ 90.6
Allmerica Financial Services............................. 18.4 (113.8) 20.8 (84.1)
Asset Management......................................... 2.5 5.1 5.0 10.2
Corporate................................................ (18.5) (15.2) (35.6) (31.6)
------------ ----------- ----------- ------------
Segment income (loss) before federal income taxes and
minority interest........................................... 23.0 (72.3) 55.0 (14.9)
------------ ----------- ----------- ------------
Federal income tax (expense) benefit on segment income... (0.3) 48.6 (4.6) 40.6
Minority interest on Capital Securities.................. (4.0) (4.0) (8.0) (8.0)
Net realized investment gains (losses), net of taxes
and deferred acquisition cost amortization........... 6.6 (38.5) 14.6 (42.9)
Net(losses)gains on derivative instruments,net of taxes.. (0.4) 9.1 0.6 19.7
Income from sale of universal life business,net of taxes. - - 3.6 -
Gain from retirement of trust instruments supported by
funding obligations, net of taxes.................... 0.3 - 3.3 -
Restructuring costs, net of taxes........................ (0.8) - (3.0) -
Sales practice litigation, net of taxes.................. - 1.6 - 1.6
------------ ----------- ----------- ------------
Income (loss) before cumulative effect of change in
accounting principle....................................... 24.4 (55.5) 61.5 (3.9)
Cumulative effect of change in accounting principle,
net of taxes.......................................... - - - (3.7)
------------ ----------- ----------- ------------
Net income (loss)............................................. $ 24.4 $ (55.5) $ 61.5 $ (7.6)
============ =========== =========== ============
Net income (loss) includes the following items (net of taxes) by segment:
Quarter ended June 30, 2003
----------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- --------------------------------------------------------------------------------------------------------------------
Net realized investment gains (losses), net
of taxes and deferred acquisition
cost amortization........................... $1.5 $(1.4) $ 6.6 $(0.1) $ 6.6
Net (losses) gains on derivative instruments.. - - (0.4) - (0.4)
Gain from retirement of trust instruments
supported by funding obligations............ - - 0.3 - 0.3
Restructuring costs........................... - (0.8) - - (0.8)
Quarter ended June 30, 2002
----------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- --------------------------------------------------------------------------------------------------------------------
Net realized investment gains (losses), net
of taxes and deferred acquisition cost
amortization................................ $(2.3) $(19.7) $(17.7) $1.2 $(38.5)
Net (losses) gains on derivative instruments.. - - 9.1 - 9.1
Sales practice litigation..................... - 1.6 - - 1.6
19
Six Months ended June 30, 2003
----------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- --------------------------------------------------------------------------------------------------------------------
Net realized investment gains (losses), net
of taxes and deferred acquisition cost
amortization............................... $9.7 $(1.5) $9.5 $(3.1) $14.6
Net(losses)gains on derivative instruments.... - - 0.6 - 0.6
Income from sale of universal life business... - 3.6 - - 3.6
Gain from retirement of trust instruments
supported by funding obligations........... - - 3.3 - 3.3
Restructuring costs........................... 0.2 (3.2) - - (3.0)
Six Months ended June 30, 2002
----------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- --------------------------------------------------------------------------------------------------------------------
Net realized investment gains (losses), net
of taxes and deferred acquisition cost
amortization........................... $(0.6) $(23.8) $(19.7) $1.2 $(42.9)
Net (losses) gains on derivative instruments - - 19.7 - 19.7
Sales practice litigation................. - 1.6 - - 1.6
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
Our segment income before federal income taxes and minority interest increased
$95.3 million, to $23.0 million in the second quarter of 2003, compared to a
loss of $72.3 million during the same period of 2002. This increase was
primarily attributable to $132.2 million of increased earnings from the AFS
segment, partially offset by a $31.0 million decrease from the Property and
Casualty segment. AFS segment income for 2002 primarily includes additional
amortization of the deferred acquisition cost ("DAC") asset of $137.1 million,
which reflected the significant decline in equity market values. The decrease in
Property and Casualty segment income in the quarter was principally due to a $23
million charge resulting from an adverse arbitration decision related to a
single large property claim within a voluntary insurance pool. We exited this
pool in 1996. Also contributing to the decrease were higher catastrophe losses
of $12.6 million, increased current year non-catastrophe claims totaling $7.3
million, primarily in the personal automobile line, and $7.2 million of
increased policy acquisition expenses. These decreases were partially offset by
estimated net premium rate increases of approximately $26 million.
Our federal income tax expense on segment income was $0.3 million for the second
quarter of 2003 compared to an income tax benefit of $48.6 million for the
second quarter of 2002. The change in federal income tax expense is primarily
the result of an increase in estimated segment income. In 2002, we recognized a
tax benefit on the loss recognized by the AFS segment, as well as a $12.1
million favorable tax settlement of federal income tax returns related to 1977
through 1981.
Net realized gains on investments, after taxes, were $6.6 million in the second
quarter of 2003, primarily due to gains recognized from the sale of both below
investment grade and investment grade fixed maturities, partially offset by
impairments of fixed maturities. During the second quarter of 2002, we
recognized net realized losses on investments, after taxes, of $38.5 million,
primarily due to impairments of fixed maturities and equity securities and
losses related to the termination of certain derivative instruments, partially
offset by gains recognized from sales of fixed maturities.
Net losses on derivative instruments, net of taxes, for the second quarter of
2003 were $0.4 million compared to net gains of $9.1 million for the same period
in 2002 as a result of derivative activity that does not meet the requirements
of hedge accounting.
During the second quarter of 2003, we retired $12.9 million of long-term funding
agreement obligations, resulting in a gain of $0.3 million, net of taxes.
20
During 2002, we began restructuring efforts of our AFS segment following our
decision to cease new sales of our proprietary life insurance and annuity
products. In the second quarter of 2003, we recognized $0.8 million of these
costs, net of taxes, primarily resulting from AFS related position eliminations.
We recognized a benefit of $1.6 million in the second quarter of 2002 as a
result of refining cost estimates related to a class action lawsuit which was
settled in 1999.
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
Our segment income before federal income taxes and minority interest increased
$69.9 million, to $55.0 million for the first six months of 2003, compared to a
loss of $14.9 million for the same period during 2002. This increase was
primarily attributable to an increase in income from the AFS segment of $104.9
million, partially offset by a decrease in income from the Property and Casualty
segment of $25.8 million. AFS segment income for 2002 primarily reflects the
aforementioned $137.1 million of additional amortization of the DAC asset
incurred during the first six months of 2002. This was partially offset by
higher ongoing DAC amortization in 2003, which resulted from our application of
a higher amortization percentage as mandated by our current DAC assumptions, to
current gross profits generated by existing annuity accounts. Existing annuity
account balances and related gross profits have declined primarily due to
surrenders following ratings downgrades in 2002 and our decision, in the third
quarter of 2002, to cease sales of proprietary life insurance and annuity
products. The decrease in Property and Casualty segment income is primarily
attributable to approximately $48 million of estimated increased current
accident year non-catastrophe claims, primarily in personal lines, the
aforementioned $23 million charge from the voluntary pool arbitration decision
and to a $12.6 million increase in catastrophe losses. The decrease is also
attributable to an $8.9 million increase in expenses. Partially offsetting these
decreases were estimated net premium rate increases of approximately $53
million, as well as favorable development on prior year reserves. Favorable
development, excluding the aforementioned $23 million arbitration settlement,
increased $28.6 million in the first half of 2003.
Our federal income tax expense on segment income was $4.6 million for the first
six months of 2003 compared to an income tax benefit of $40.6 million for the
same period of 2002. The change in tax expense is primarily the result of an
increase in estimated segment income. In 2002, we recognized a tax benefit on
the loss recognized by the AFS segment, as well as the $12.1 million favorable
tax settlement, discussed above.
Net realized gains on investments, after taxes, were $14.6 million for the first
six months of 2003, primarily due to gains recognized from the sale of both
investment grade and below investment grade fixed maturities, partially offset
by impairments of fixed maturities. During the first six months of 2002, we
recognized net realized losses on investments, after taxes, of $42.9 million,
primarily due to impairments of fixed maturities and equity securities and
losses related to the termination of certain derivative instruments, partially
offset by gains recognized from sales of fixed maturities.
Net gains on derivative instruments, after taxes, for the first six months of
2003 were $0.6 million compared to $19.7 million for the same period in 2002 as
a result of derivative activity that does not meet the requirements of hedge
accounting.
During the first half of 2003, we recognized income of $3.6 million, net of
taxes, from the settlement of post-closing items related to the December 2002
sale of our universal life business, through a 100% coinsurance agreement.
During the first six months of 2003, we retired $65.6 million of long-term
funding agreement obligations, resulting in a gain of $3.3 million, net of
taxes.
During 2002, we began restructuring efforts of our AFS segment after a decision
was made to cease new sales of our proprietary life insurance and annuity
products. During the first six months of 2003, we recognized $3.0 million of
costs, net of taxes, primarily resulting from AFS related position eliminations.
We recognized a benefit of $1.6 million in the first half of 2002 as a result of
refining cost estimates related to a class action lawsuit which was settled in
1999.
21
Segment Results
The following is our discussion and analysis of the results of operations by
business segment. The segment results are presented before taxes and minority
interest and other items which we believe are not indicative of overall
operating trends, including realized gains and losses.
Property and Casualty
The following table summarizes the results of operations for the Property and
Casualty segment:
Quarter Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net premiums written.................................... $ 571.0 $ 572.1 $ 1,121.5 $ 1,127.0
========== ========== ========== ==========
Net premiums earned..................................... $ 561.8 $ 570.6 $ 1,116.0 $ 1,128.7
Net investment income................................... 46.5 50.8 91.8 102.6
Other income............................................ 7.0 5.3 16.5 10.1
---------- ---------- ---------- ----------
Total segment revenues....................... 615.3 626.7 1,224.3 1,241.4
---------- ---------- ---------- ----------
Losses and operating expenses
Losses and loss adjustment expense (1)................... 435.2 419.5 840.4 840.6
Policy acquisition expenses.............................. 113.1 105.9 224.9 210.5
Other operating expenses................................. 46.4 49.7 94.2 99.7
---------- ---------- ---------- ----------
Total losses and operating expenses........... 594.7 575.1 1,159.5 1,150.8
---------- ---------- ---------- ----------
Segment income............................................... $ 20.6 $ 51.6 $ 64.8 $ 90.6
========== ========== ========== ==========
(1) Includes policyholders' dividends of $0.4 million and $0.5 million for the
quarters ended June 30, 2003 and 2002, respectively, and $0.8 million and
$0.2 million for the six months ended June 30, 2003 and 2002, respectively.
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
Property and Casualty's segment income decreased $31.0 million to $20.6 million
for the second quarter of 2003. The decrease in segment income was primarily
attributable to a charge of $23 million resulting from an adverse arbitration
decision related to a single large property claim within a voluntary insurance
pool. We exited this pool in 1996. In addition, catastrophe losses increased
$12.6 million, to $21.2 million for the second quarter of 2003, compared to $8.6
million for the same period in 2002. Catastrophe losses in 2002 were unusually
low. Second quarter of 2003 segment income was also affected by a $7.3 million
increase in current year non-catastrophe claims activity, primarily in the
personal automobile line. The $7.2 million increase in policy acquisition
expenses was primarily due to increases in commissions and pension costs.
Segment income also reflected a decrease in net investment income of $4.2
million for the quarter ended June 30, 2003. Partially offsetting these items
was a benefit from an estimated $26 million of net premium rate increases. Net
premium rate increases reflect base rate actions, discretionary pricing
adjustments, inflation and changes in exposure, net of estimated impact of loss
inflation and policy acquisition costs. Segment income was also favorably
affected by a $3.3 million decrease in other operating expenses primarily due to
decreases in consulting expenses and uncollectable premiums.
We report underwriting results using statutory accounting principles, which are
prescribed by state insurance regulators. The primary difference between
statutory accounting principles and generally accepted accounting principles
("GAAP") is the deferral of certain underwriting costs under GAAP that are
amortized over the life of the policy. Under statutory accounting principles,
these costs are recognized when incurred or paid. We review the operations of
this business based upon statutory results.
22
We manage this segment's operations through two lines of business based upon
product offerings: Personal Lines and Commercial Lines. Personal Lines include
personal automobile, homeowners and other personal policies. Commercial Lines
include workers' compensation, commercial automobile, commercial multiple peril
and other commercial policies.
The following tables summarize the results of operations for the Property and
Casualty segment:
Quarter Ended June 30,
--------------------------------------------------------------------
2003 2002
--------------------------------------------------------------------
Statutory Statutory
Net Statutory Net Statutory
Premiums Loss Ratios Premiums Loss Ratios
(In millions, except ratios) Written (1) Written (1)
- -------------------------------------------------------------------------------------------------------------
Personal Lines:
Personal automobile...................$ 267.9 73.8 $ 267.2 68.4
Homeowners............................ 102.5 68.9 94.4 64.1
Other personal........................ 12.1 29.9 12.5 45.9
----------- -----------
Total personal.......................... 382.5 71.3 374.1 66.7
----------- -----------
Commercial Lines:
Workers' compensation................. 32.2 71.7 37.4 83.4
Commercial automobile................. 45.3 55.9 49.0 66.9
Commercial multiple peril............. 86.9 49.9 84.3 50.5
Other commercial...................... 24.1 123.6 27.9 38.7
----------- -----------
Total commercial........................ 188.5 64.9 198.6 60.3
----------- -----------
Total....................................$ 571.0 69.1 $ 572.7 64.4
=========== ===========
Statutory combined ratio (2):
Personal lines........................ 107.3 100.9
Commercial lines...................... 106.1 102.8
Total................................. 106.8 101.6
Statutory underwriting (loss) gain:
Personal lines........................$ (30.1) $ (6.7)
Commercial lines...................... (11.1) (2.3)
----------- -----------
Total................................. (41.2) (9.0)
----------- -----------
Reconciliation to segment income:
Net investment income................. 46.5 50.8
Other income and expenses, net........ 5.5 4.2
Corporate overhead expenses (3)....... 8.4 6.4
Net deferred acquisition expenses..... 5.1 4.0
Other Statutory to GAAP adjustments... (3.7) (4.8)
----------- -----------
Segment income...........................$ 20.6 $ 51.6
=========== ===========
(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.
(3) Statutory underwriting results include certain overhead expenses, which on
a GAAP basis are reflected in the Corporate Segment.
23
Personal Lines
Personal lines' net premiums written increased $8.4 million, or 2.2%, to $382.5
million for the second quarter of 2003. This was primarily the result of an
increase of $8.1 million, or 8.6%, in the homeowners line, as well as rate
increases in the personal automobile line. The increase in the homeowners line
resulted primarily from a 10.0% rate increase in Michigan and a 7.9% rate
increase in New York.
Personal lines' statutory underwriting results decreased $23.4 million to an
underwriting loss of $30.1 million for the second quarter of 2003. The increase
in the underwriting loss was primarily attributable to increased current year
claims in the personal automobile line of approximately $16 million due to
significant increases in the severity of medical costs related to personal
injury protection coverage in Michigan and an increase in frequency of bodily
injury claims, primarily in Massachusetts. Development on prior years' reserves
decreased $8.9 million, to $12.1 million of adverse development for the second
quarter of 2003, from $3.2 million of adverse development for the same period in
2002. In addition, catastrophe losses increased $7.4 million, to $13.6 million
for the second quarter of 2003, compared to $6.2 million for the same period in
2002. These unfavorable items were partially offset by approximately $12 million
of estimated net premium rate increases earned during the second quarter of
2003.
Commercial Lines
Commercial lines' net premiums written decreased $10.1 million, or 5.1%, to
$188.5 million for the second quarter of 2003. This was primarily the result of
a decrease of $5.2 million, or 13.9%, in the workers' compensation line and a
decrease of $3.7 million, or 7.6%, in the commercial automobile line. These
decreases were partially offset by an increase in the commercial multiple peril
line of $2.6 million since June 30, 2002. Policies in force decreased 6.9%,
14.0% and 5.3% in the workers' compensation, commercial automobile and
commercial multiple peril lines, respectively, since June 30, 2002, primarily as
a result of the agency management actions initiated in 2001. Partially
offsetting these decreases in policies in force were rate increases in all of
the commercial lines since June 30, 2002.
Commercial lines' statutory underwriting results decreased $8.8 million to an
underwriting loss of $11.1 million in the second quarter of 2003. Development on
prior years' reserves deteriorated $13.8 million, to $20.5 million of adverse
development for the second quarter of 2003, from $6.7 million of adverse
development for the same period in 2002. This was primarily due to the
aforementioned charge of $23 million from the voluntary pool arbitration
decision, partially offset by $9.2 million of improved development, primarily in
the workers' compensation and commercial multiple peril lines. In addition,
catastrophe losses increased $5.1 million, to $7.5 million for the second
quarter of 2003, compared to $2.4 million for the same period in 2002. The
decrease in underwriting results also reflected an approximately $3 million
increase in expenses primarily due to pension costs, expenses associated with
third party guarantees purchased to minimize the loss of commercial lines
business as a result of the ratings downgrades and technology costs. Partially
offsetting these unfavorable items was approximately $14 million of estimated
net premium rate increases during the second quarter of 2003.
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
Property and Casualty's segment income decreased $25.8 million, or 28.5%, to
$64.8 million for the six months ended June 30, 2003. The decrease was primarily
due to approximately $48 million of estimated increased current accident year
non-catastrophe claims, primarily in personal lines. Also, segment income for
the six months ended June 30, 2003 was negatively affected by the aforementioned
charge of $23 million from the voluntary pool arbitration decision. There was
also a $12.6 million increase in catastrophe losses, to $32.4 million for the
six months ended June 30, 2003, compared to $19.8 million for the same period in
2002. Additionally, segment income for the six months ended June 30, 2003 was
negatively affected by an $8.9 million increase in expenses primarily due to an
increase in commissions, expenses for mandatory assigned risk personal
automobile business in New York, expenses associated with third party guarantees
purchased to minimize the loss of commercial lines business as a result of the
ratings downgrades and pension costs. Segment income also reflected a decrease
in net investment income of $10.8 million for the six months ended June 30,
2003. Partially offsetting these negative items was approximately $53 million of
estimated net premium rates increases. In addition, excluding the aforementioned
$23 million charge for the voluntary pool arbitration decision, development on
prior years' reserves improved $28.6 million, to $22.2 million of favorable
development for the six months ended June 30, 2003, from $6.4 million of adverse
development for the same period in 2002. Additionally, other income has
increased by $6.4 million due to interest income on an intercompany loan to
AMGRO, a premium financing subsidiary, an escheatment settlement and increased
fee income from third party claim administration.
24
The following tables summarize the results of operations for the Property and
Casualty Segment:
Six Months Ended June 30,
--------------------------------------------------------------------
2003 2002
--------------------------------------------------------------------
Statutory Statutory
Net Statutory Net Statutory
Premiums Loss Ratios Premiums Loss Ratios
(In millions, except ratios) Written (1) Written (1)
- --------------------------------------------------------------------------------------------------------------
Personal Lines:
Personal automobile...................$ 551.3 75.5 $ 552.4 70.6
Homeowners............................ 173.0 66.6 159.9 64.9
Other personal........................ 20.3 31.9 21.1 49.1
----------- -----------
Total personal.......................... 744.6 72.1 733.4 68.6
----------- -----------
Commercial Lines:
Workers' compensation................. 71.2 69.5 79.4 79.5
Commercial automobile................. 89.5 53.1 100.5 64.5
Commercial multiple peril............. 170.3 49.7 164.0 56.1
Other commercial...................... 45.6 68.9 49.6 32.8
----------- -----------
Total commercial........................ 376.6 56.7 393.5 60.4
----------- -----------
Total...................................$ 1,121.2 66.9 $ 1,126.9 65.5
=========== ===========
Statutory combined ratio (2):
Personal lines........................ 108.3 103.0
Commercial lines...................... 97.6 103.2
Total................................. 104.6 102.9
Statutory underwriting (loss) gain:
Personal lines........................ $ (63.0) $ (28.4)
Commercial lines...................... 9.2 (3.9)
----------- -----------
Total................................. (53.8) (32.3)
----------- -----------
Reconciliation to segment income:
Net investment income................. 91.8 102.6
Other income and expenses, net........ 13.6 7.6
Corporate overhead expenses (3)....... 16.4 13.7
Net deferred acquisition expenses..... 5.4 6.2
Other Statutory to GAAP adjustments... (8.6) (7.2)
----------- -----------
Segment income...........................$ 64.8 $ 90.6
=========== ===========
(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.
(3) Statutory underwriting results include certain overhead expenses, which on
a GAAP basis are reflected in the Corporate Segment.
Personal Lines
Personal lines' net premiums written increased $11.2 million, or 1.5%, to $744.6
million for the six months ended June 30, 2003. This is primarily the result of
an increase of $13.1 million, or 8.2%, in the homeowners line, partially offset
by a $1.1 million, or 0.2%, decrease in the personal automobile line. The
increase in the homeowners line resulted primarily from rate increases of 10.0%
and 7.9% in Michigan and New York, respectively, partially offset by a 1.9%
decrease in policies in force. The decrease in the personal automobile line is
primarily the result of an overall decrease of 5.0% in policies in force since
June 30, 2002.
25
Personal lines' statutory underwriting results decreased $34.6 million, or
121.8%, to an underwriting loss of $63.0 million for the six months ended June
30, 2003. The increase in the underwriting loss is primarily attributable to a
significant increase in severity of personal automobile medical costs related to
personal injury protection coverage in Michigan. In addition, both our personal
automobile and homeowners lines experienced an increase in claim frequency and
severity due to the harsher winter weather during the first quarter, especially
in the Northeast. Underwriting results were also unfavorably affected by an $8.6
million increase in adverse development in 2003 and a $3.9 million increase in
underwriting loss related to the residual market facility in Massachusetts. In
addition, catastrophe losses increased $2.7 million, to $18.4 million for the
six months ended June 30, 2003, compared to $15.7 million for the same period in
2002. Additionally, policy acquisition expenses increased due to higher pension
costs and commissions. Partially offsetting these items was approximately $21
million of estimated net premium rate increases.
Commercial Lines
Commercial lines' net premiums written decreased $16.9 million, or 4.3%, to
$376.6 million for the six months ended June 30, 2003. This is primarily the
result of the agency management actions we took in 2001 and our continuing
re-underwriting efforts. As a result of these actions, policies in force
decreased 6.9%, 14.0% and 5.3% in the workers' compensation, commercial
automobile, and commercial multiple peril lines, respectively, since June 30,
2002. Partially offsetting these decreases in policies in force were rate
increases in all of the commercial lines since June 30, 2002.
Commercial lines' underwriting results improved $13.1 million to an underwriting
gain of $9.2 million for the six months ended June 30, 2003. The improvement in
underwriting results is primarily attributable to approximately $33 million of
net premium rate increases during the six months ended June 30, 2003.
Development on prior years' reserves improved $14.2 million, to $11.9 million of
favorable development for the six months ended June 30, 2003, from $2.3 million
of adverse development for the same period in 2002, primarily due to improved
reserve development principally in the commercial multiple peril and workers'
compensation lines, partially offset by the aforementioned charge of $23 million
from the voluntary pool arbitration decision. Catastrophe losses increased $9.8
million, to $13.9 million for the six months ended June 30, 2003, compared to
$4.1 million for the same period in 2002. The underwriting results were also
negatively affected by an approximate $7 million increase in expenses, primarily
due to pension costs, expenses associated with third party guarantees purchased
to minimize the loss of commercial lines business as a result of the ratings
downgrades and technology costs. In addition, current year claims severity
increased primarily in the commercial multiple peril line.
Investment Results
Net investment income before taxes declined $10.8 million, or 10.5%, to $91.8
million for the six months ended June 30, 2003. The decrease in net investment
income primarily reflects a reduction in average invested assets as a result of
a $92.1 million dividend from the property and casualty companies to the holding
company in July 2002 and a transfer of $73.7 million in January 2003 to fund the
property and casualty companies' portion of the additional minimum pension
liability we recognized at December 31, 2002. In addition, net investment income
decreased due to a reduction in average pre-tax yields on fixed maturities and
an increased emphasis on higher credit quality bonds. Average pre-tax yields on
debt securities decreased to 6.2% in 2003 compared to 6.4% in 2002 due to the
lower prevailing fixed maturity investment rates since the first quarter of 2002
and the aforementioned increased emphasis on higher credit quality bonds. We
expect that our investment results will continue to be negatively affected by
lower prevailing fixed maturity investment rates in 2003.
Reserve for Losses and Loss Adjustment Expenses
Overview of Loss Reserve Estimation Process
We maintain reserves for our property and casualty products to provide for our
ultimate liability for losses and loss adjustment expenses ("LAE") 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 we expect the ultimate settlement and administration of
claims will cost based on facts and circumstances then known, estimates of
future trends in claim severity and frequency, judicial theories of liability
and policy coverage, and other factors.
26
We determine the amount of loss and loss adjustment expense reserves based on a
very complex estimation process that uses information obtained from both company
specific and industry data, as well as general economic information. The
estimation process is judgmental, and requires us 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,
we develop information about the size of ultimate claims based on our historical
experience and other available market information. The most significant
assumptions, which vary by line of business, that we use in the estimation
process include determining the trend in loss costs, the expected consistency in
the frequency and severity of claims incurred but not yet reported to prior year
claims, changes in the timing of the reporting of losses from the loss date to
the notification date and the expected costs to settle unpaid claims. Because
the amount of the loss and LAE reserves are sensitive to our assumptions, we do
not completely rely on only one estimate to determine our loss and LAE reserves.
We develop several estimates using generally recognized actuarial projection
methodologies that result in a range of possible loss and LAE reserve outcomes
and we adopt the best estimate within that range. We may determine that the low
or high end estimate calculated by the method does not represent a reasonable
estimate because certain projection methodologies may not result in a reasonable
reserve estimate for a particular line of business due to certain underlying
data or assumptions. When trends emerge that we believe affect the future
settlement of claims, we adjust our reserves accordingly.
Management's Review of Judgments and Key Assumptions
The inherent uncertainty of estimating insurance reserves is greater for certain
types of property and casualty insurance lines. These lines include workers'
compensation and other liability lines, where a longer period of time may elapse
before a definitive determination of ultimate liability may be made. In
addition, the technological, judicial and political climates involving these
types of claims change regularly. We maintain our practice of significantly
limiting the issuance of long-tailed other liability policies, including
directors and officers ("D&O") liability, errors and omissions ("E&O") liability
and medical malpractice liability. The industry has experienced recent adverse
loss trends in these lines of business.
We regularly update our reserve estimates as new information becomes available
and further events occur which may affect 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 to our financial results.
Inflation generally increases the cost of losses covered by insurance contracts.
The effect of inflation varies by product. Our 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, we attempt in
establishing rates and reserves to anticipate the potential impact of inflation
in the projection of ultimate costs. Recently, we have experienced increasing
medical costs associated with personal automobile personal injury protection
claims. This increase is reflected in our reserve estimates, but continued
increases could contribute to increased losses and LAE in the future.
We regularly review our reserving techniques, our overall reserving position and
our reinsurance. Based on (i) our 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) our review of per claim information, (iii) our historical loss experience
and that of the industry, (iv) the relatively short-term nature of most policies
and (v) our internal estimates of required reserves, we believe that adequate
provision has been made for loss reserves. However, establishment of appropriate
reserves is an inherently uncertain process and we cannot provide assurance 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 our results of operations.
Loss Reserves By Line of Business
We perform actuarial reviews on certain detailed line of business coverages.
These individual estimates are summarized into six broader lines of business:
personal automobile, homeowners, workers' compensation, commercial automobile,
commercial multiple peril and other lines.
27
The table below provides a reconciliation of the beginning and ending reserve
for unpaid losses and LAE as follows:
Six Months Ended
June 30,
----------------------------
(In millions) 2003 2002
- ---------------------------------------------------------------------------------------------------
Reserve for losses and LAE, beginning of period..................... $ 2,961.7 $ 2,921.5
Incurred losses and LAE, net of reinsurance recoverable:
Provision for insured events of current year................... 837.8 834.1
Increase in provision for insured events of prior years........ 0.8 6.4
------------ ------------
Total incurred losses and LAE.................................... 838.6 840.5
------------ ------------
Payments, net of reinsurance recoverable:
Losses and LAE attributable to insured events of current year.. 367.2 346.2
Losses and LAE attributable to insured events of prior years... 489.4 468.9
------------ ------------
Total payments................................................... 856.6 815.1
------------ ------------
Change in reinsurance recoverable on unpaid losses............... 3.1 (8.0)
------------ ------------
Reserve for losses and LAE, end of period........................... $ 2,946.8 $ 2,938.9
============ ============
As part of an ongoing process, we have re-estimated reserves for all prior
accident years and the reserves were increased by $0.8 million and $6.4 million
for the six months ended June 30, 2003 and 2002, respectively.
The table below summarizes the reserve for losses and LAE by line of business:
June 30, December 31,
(In millions) 2003 2002
- -----------------------------------------------------------------------------
Personal automobile.............. $ 1,069.1 $ 1,018.5
Homeowners and other............. 221.7 246.3
------------- ---------------
Total personal................ 1,290.8 1,264.8
Workers' compensation............ 616.0 637.7
Commercial automobile............ 313.9 327.4
Commercial multiple peril........ 551.2 566.3
Other commercial................. 174.9 165.5
------------- ---------------
Total commercial.............. 1,656.0 1,696.9
------------- ---------------
Total reserve for losses and LAE....$ 2,946.8 $ 2,961.7
============= ===============
Prior Year Development by Line of Business
When trends emerge that we believe affect the future settlement of claims, we
adjust our reserves accordingly. Reserve adjustments are reflected in the
Consolidated Statements of Income as adjustments to losses and loss adjustment
expenses. Often, we recognize these adjustments 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 our
financial results.
28
The table below summarizes the change in provision for insured events of prior
years by line of business.
Six Months
Ended June 30,
--------------------------------
(In millions) 2003 2002
- --------------------------------------------------------------------------
Increase (decrease) in loss provision for
insured events of prior years:
Personal automobile................... $ 12.2 $ 4.9
Homeowners and other.................. 3.5 3.6
--------- --------
Total personal....................... 15.7 8.5
Workers' compensation................. 1.9 11.1
Commercial automobile................. (2.0) 2.4
Commercial multiple peril............. (11.9) (1.1)
Other commercial...................... 14.0 (4.1)
--------- --------
Total commercial..................... 2.0 8.3
--------- --------
Increase in loss provision for
insured events of prior years......... 17.7 16.8
Decrease in LAE provision for
insured events of prior years......... (16.9) (10.4)
--------- --------
Increase in total loss and LAE provision
for insured events of prior years..... $ 0.8 $ 6.4
========= ========
Estimated loss reserves for claims occurring in prior years developed
unfavorably by $17.7 million during the first six months of 2003 and by $16.8
million during the first six months of 2002. The unfavorable loss reserve
development during the first six months of 2003 is primarily the result of the
$23 million charge in the other commercial line resulting from the
aforementioned voluntary pool arbitration decision. Additionally, loss reserve
development was affected by an increase in personal automobile claim severity
related to medical settlements in Michigan. Since these settlements have risen
beyond previous estimates, reserve increases have been recognized in the period
in which the information is obtained. Partially offsetting these items was
favorable development in the commercial multiple peril line due to improved
claim frequency in the 2002 accident year. The adverse loss reserve development
in 2002 is primarily the result of approximately $4 million of increased
reserves related to a judicial decision in Maine expanding eligibility for
permanent impairment status related to workers' compensation claims. This
judicial decision was subsequently reversed during the third quarter of 2002. In
addition, adverse loss reserve development in 2002 resulted from increased
severity on personal lines prior years' reserves.
During the first six months of 2003 and 2002, estimated LAE reserves for claims
occurring in prior years developed favorably by $16.9 million and $10.4 million,
respectively. The favorable development in both periods is primarily
attributable to claims process improvement initiatives taken by us during the
1997 to 2001 calendar year period. Since 1997, we have lowered claim settlement
costs through increased utilization of in-house attorneys and consolidation of
claim offices. As actual experience begins to establish trends inherent within
the claim settlement process, the actuarial process recognizes these trends
within the reserving methodology affecting future claim settlement assumptions.
As these measures improved average settlement costs, the actuarial estimate of
future settlement costs are reduced and favorable development is recorded. These
measures are complete. The increase in favorable development for the six months
ended June 30, 2003, compared to the same period in 2002, is primarily the
result of the improved frequency of claims in commercial lines.
29
Asbestos and Environmental Reserves
We may be required to defend claims related to policies that include
environmental damage and toxic tort liability. Ending loss and LAE reserves for
all direct business written by our property and casualty companies related to
asbestos, environmental damage and toxic tort liability, included in the reserve
for losses and LAE, were $25.5 million at June 30, 2003 and $25.6 million at
December 31, 2002, net of reinsurance of $15.9 million and $16.0 million at June
30, 2003 and December 31, 2002, respectively. As a result of our historical
direct underwriting mix of commercial lines policies toward smaller and middle
market risks, past asbestos, environmental damage and toxic tort liability loss
experience has remained minimal in relation to our total loss and LAE incurred
experience. We estimate our 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. We
believe that, notwithstanding the evolution of case law expanding liability in
asbestos and environmental claims, recorded reserves related to these claims are
adequate. In addition, we are not aware of any litigation or pending claims that
we believe will result in additional material liabilities in excess of recorded
reserves. The environmental liability could be revised in the near term if the
estimates used in determining the liability are revised.
In addition, we have established loss and LAE reserves for assumed reinsurance
and pool business with asbestos, environmental damage and toxic tort liability
of $45.2 million at both June 30, 2003 and December 31, 2002. These reserves
relate to pools in which we have terminated our participation; however, we
continue to be subject to claims related to years in which we were a
participant. As part of our pool reserves we participated in Excess and Casualty
Reinsurance Association ("ECRA") from 1950 to 1982. In 1982, the pool was
dissolved and since that time the business has been in runoff. Our participation
in this pool has resulted in average paid losses of $2.3 million annually over
the past ten years. During 2001, the pool commissioned an independent actuarial
review of its then current reserve position, which noted a range of reserve
deficiency primarily as a result of adverse development of asbestos claims. As a
result of this study, we recorded an additional $33.0 million of losses in the
fourth quarter of 2001, which is included in the reported outstanding loss and
LAE reserves. Because of the inherent uncertainty regarding the types of claims
in these pools, we cannot provide assurance that these reserves will be
sufficient.
We estimated our 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 we discuss them
because of the possibility that they may become significant. We currently
believe that, notwithstanding the evolution of case law expanding liability in
environmental claims, recorded reserves related to these claims are adequate. In
addition, we are not aware of any litigation or pending claims that we believe
will result in additional material liabilities in excess of recorded reserves.
The environmental liability could be revised in the near term if the estimates
used in determining the liability are revised.
30
Allmerica Financial Services
The following table summarizes the results of operations for the Allmerica
Financial Services segment for the periods indicated. The factors that affect
this segment's results of operations after September 27, 2002 are substantially
different from those in effect prior to that date. Accordingly, we believe the
results of operations for the quarter ended June 30, 2003 and six months ended
June 30, 2003 are more indicative of results of operations to be expected for
the remainder of 2003. Before the cessation of sales of our proprietary
products, we distributed our annuity products primarily through three
distribution channels: (1) "Agency", which consisted of our former career agency
force; (2) "Select", which consisted of a network of third party broker/dealers;
and (3) "Partners", which included distributors of the mutual funds advised by
Scudder Investments, Pioneer Investment Management, Inc. and Delaware Management
Company.
Quarter Ended Six Months Ended
June 30, June 30,
-------------------------- ---------------------------
(In millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Segment revenues
Premiums...............................................$ 6.6 $ 6.8 $ 27.6 $ 31.3
Fees:
Fees from surrenders................................ 14.6 8.9 41.0 15.9
Other proprietary product fees...................... 62.0 89.9 125.9 178.9
Net investment income.................................. 52.5 72.7 105.7 143.4
Brokerage and investment management income (1)......... 29.0 18.7 61.5 36.8
Other income........................................... 9.7 7.8 20.7 13.4
--------- --------- --------- ----------
Total segment revenues.................................... 174.4 204.8 382.4 419.7
Policy benefits,claims and losses...................... 61.9 97.7 136.3 204.9
Policy acquisition expenses............................ 24.4 156.4 84.2 168.0
Brokerage and investment management variable
expenses (1)........................................ 19.4 12.2 41.6 24.0
Other operating expenses............................... 50.3 52.3 99.5 106.9
--------- --------- --------- ----------
Segment income (loss).....................................$ 18.4 $ (113.8) $ 20.8 $ (84.1)
========= ========= ========= ==========
(1) Brokerage and investment management income primarily reflects fees earned
from the distribution of non-proprietary insurance and investment products
as well as the management of assets for proprietary products. Variable
expenses related to this business primarily consist of commissions and
subadvisory fees.
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
Allmerica Financial Services segment income was $18.4 million in the second
quarter of 2003 compared to a loss of $113.8 million in the second quarter of
2002. The loss in the second quarter of 2002 included $137.1 million of
additional amortization of the DAC asset reflecting the significant decline in
equity market values during that quarter.
Our decision to cease sales of proprietary products and ratings downgrades
during 2002 resulted in a substantial increase in redemptions of variable
annuities, which was expected. Annuity redemptions during the second quarter of
2003 were $552.5 million, compared to $508.9 million during the second quarter
of 2002. The increased redemptions resulted in additional surrender fees of $5.7
million, from $8.9 million in the second quarter of 2002, to $14.6 million in
the second quarter of 2003. However, the additional surrender fees were
substantially offset by additional DAC amortization of $5.1 million, reflecting
our current DAC assumptions, which mandate a higher amortization level as a
percentage of gross annuity profits.
Other proprietary fees decreased $27.9 million, to $62.0 million in the second
quarter of 2003. This decrease was primarily due to the sale of the universal
life insurance business effective December 31, 2002, and to lower average
variable annuity asset levels resulting primarily from the cumulative
redemptions during the prior twelve months. Net investment income declined $20.2
million, to $52.5 million in the second quarter of 2003, primarily due to lower
average invested general account assets. This resulted primarily from increased
redemptions and the sale of our universal life insurance business. In addition,
net investment income decreased due to the sale of below investment grade fixed
maturities in order to improve the overall credit quality profile of our
investment portfolio (see Investment Portfolio).
31
Brokerage and investment management income increased $10.3 million, to $29.0
million in the second quarter of 2003. We have increased our sales of
non-proprietary products, consistent with our new strategy. These sales are made
through our broker/dealer, VeraVest Investments, Inc., and resulted in
additional brokerage income of $13.4 million in the second quarter of 2003. The
fees generated from these sales were partially offset by additional commissions
of $7.4 million paid to registered representatives. Investment management income
declined $3.1 million due to lower average assets under management.
Policy benefits in the second quarter of 2003 decreased $35.8 million, to $61.9
million. The decline is primarily the result of the sale of our universal life
insurance business, lower expenses related to guaranteed minimum death benefits
("GMDB") and lower interest credited on general account assets. Expenses related
to GMDB declined $10.7 million, from $22.1 million in the quarter ended June 30,
2002 to $11.4 million in the quarter ended June 30, 2003. See also "Guaranteed
Minimum Death Benefits" below.
Policy acquisition expenses decreased $132.0 million, to $24.4 million in the
second quarter of 2003. In the second quarter of 2002, we recorded three
separate adjustments to DAC amortization totaling $141.9 million. These
adjustments during 2002 represent more than the entire difference from the
current quarter. In fact, absent these adjustments, policy acquisition expenses
would have increased $9.9 million in the second quarter of 2003 versus the same
period in 2002. The primary reason for this $9.9 million adjusted increase in
DAC amortization is that we now apply a higher amortization percentage, as
mandated by our current DAC assumptions, to current gross profits generated by
existing annuity accounts. Higher amortization percentages have been used since
the fourth quarter of 2002. This increase in DAC amortization was partially
offset by three additional items resulting in a $13.4 million net decrease in
DAC amortization in the current quarter. See "Deferred Acquisition Costs" below
for a detailed discussion of these additional items and the adjustments to DAC
in 2002.
Brokerage and investment management variable expenses increased $7.2 million, to
$19.4 million in the second quarter of 2003. The increase primarily reflects the
aforementioned $7.4 million increase in commissions paid to registered
representatives.
Other operating expenses decreased $2.0 million, to $50.3 million in the second
quarter of 2003. The decrease reflects lower distribution and insurance
operation expenses partially offset by acquisition costs that we had been
allowed to defer in 2002, as they related to proprietary annuity and insurance
sales. We no longer offer these products, so we are no longer allowed to defer
these types of costs under GAAP. Instead, our distribution efforts remain
focused on non-proprietary sales.
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
Allmerica Financial Services segment income was $20.8 million in the first six
months of 2003 compared to a loss of $84.1 million in the first six months of
2002. The loss in the first six months of 2002 included $137.1 million of
additional amortization of the DAC asset reflecting the significant decline in
equity market values during the first six months of 2002.
Our decision to cease sales of proprietary products and ratings downgrades
during 2002 resulted in a substantial increase in redemptions of variable
annuities, which was expected. Annuity redemptions in the first six months of
2003 were $1.5 billion compared to $1.0 billion in the first six months of 2002.
The increased redemptions resulted in additional surrender fees of $25.1
million, from $15.9 million in the first six months of 2002, to $41.0 million in
the first six months of 2003. However, the additional surrender fees were
substantially offset by additional DAC amortization of $22.7 million, reflecting
our current DAC assumptions, which mandate a higher amortization level as a
percentage of gross annuity profits.
Other proprietary fees decreased $53.0 million, to $125.9 million in the first
six months of 2003, primarily due to the sale of the universal life insurance
business and to lower average variable annuity asset levels. Average variable
annuity asset levels declined primarily as a result of the cumulative surrenders
during the prior twelve months, as well as the effect of lower equity market
values. Net investment income declined $37.7 million, to $105.7 million in the
first six months of 2003, primarily due to lower average invested general
account assets. This resulted primarily from increased redemptions and the sale
of the universal life insurance business. In addition, net investment income
decreased due to the sale of below investment grade fixed maturities in order to
improve the overall credit quality profile of our investment portfolio.
32
Brokerage and investment management income increased $24.7 million, to $61.5
million in the first six months of 2003. We have increased our sales of
non-proprietary products, consistent with our new strategy. These sales are made
through our broker/dealer, VeraVest Investments, Inc. and resulted in additional
brokerage income of $30.6 million in the first six months of 2003. The fees
generated from these sales were partially offset by additional commissions of
$18.9 million paid to registered representatives. Investment management income
declined $5.9 million due to lower average assets under management.
Other income increased $7.3 million in the first half of 2003, to $20.7 million
primarily due to increased revenues generated by our financial software
subsidiary, a termination fee related to one large group variable universal life
insurance client, and higher asset-based distribution fees.
Policy benefits in the first six months of 2003 decreased $68.6 million, to
$136.3 million. The decline is primarily the result of the sale of the universal
life insurance business, lower expenses related to GMDB and lower interest
credited on general account assets. In the first six months of 2003, expenses
related to GMDB declined $13.2 million, from $36.2 million in the first six
months of 2002 to $23.0 million. See also "Guaranteed Minimum Death Benefits"
below.
Policy acquisition expenses decreased $83.8 million, to $84.2 million in the
first six months of 2003. During the first six months of 2002, we recorded the
aforementioned adjustments to DAC amortization totaling $141.9 million. These
adjustments during 2002 represent more than the entire difference from the
current period. In fact, absent these adjustments, policy acquisition expenses
would have increased $58.1 million in the first six months of 2003 versus the
same period in 2002. The primary reason for this $58.1 million adjusted increase
in DAC amortization, is that we now apply a higher amortization percentage, as
mandated by our current DAC assumptions, to current gross profits generated by
existing annuity accounts. Higher amortization percentages have been used since
the fourth quarter of 2002. In addition, we had incremental DAC amortization
related to our higher redemptions, as described above. These increases in DAC
amortization were partially offset by three additional items resulting in a $6.2
million net decrease in DAC amortization in the first six months of 2003. See
"Deferred Acquisition Costs" below for a detailed discussion of these additional
items and the adjustments to DAC in 2002.
Brokerage and investment management variable expenses increased $17.6 million,
to $41.6 million in the first six months of 2003. The increase primarily
reflects the aforementioned $18.9 million increase in commissions paid to
registered representatives.
Other operating expenses decreased $7.4 million, to $99.5 million in the first
half of 2003. The decrease reflects lower distribution and insurance operation
expenses partially offset by acquisition costs that we had been allowed to defer
in 2002, as they related to proprietary annuity and insurance sales. We no
longer offer these products, so we are no longer allowed to defer these types of
costs under GAAP. Instead, our distribution efforts remain focused on
non-proprietary sales.
Deferred Acquisition Costs
DAC for variable life products and variable annuities consists of commissions,
underwriting costs and other costs that are amortized in proportion to the total
gross profits. We estimate that these costs will be earned over the expected
life of the insurance contracts to which such costs relate. To estimate the
profitability of our insurance contracts, we establish and apply 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). We regularly evaluate these assumptions to
determine whether recent experience or anticipated trends merit adjustments to
such assumptions. For additional information regarding our accounting policy
related to DAC, see "Critical Accounting Policies" in our 2002 Annual Report on
Form 10-K.
The aforementioned $141.9 million of DAC adjustments in 2002 consisted of three
separate items. First, we reduced our estimate of future gross profits expected
from our then existing variable annuity contracts and variable life insurance
policies, resulting in additional amortization of $137.1 million, reflecting the
significant decline in equity market values during that quarter. The remaining
two DAC adjustments in the second quarter of 2002 resulted from an increase in
our estimate of the long-term cost of GMDB, which increased DAC amortization by
$13.3 million and from a change in our estimate of future fees from certain
annuity contracts, which decreased DAC amortization by $8.5 million.
During the second quarter and first six months of 2003, we had three additional
items affecting DAC amortization. First, because the equity market returns in
the second quarter and first six months of 2003 exceeded the assumptions in our
DAC estimation process, we recognized reduced DAC amortization of $12.4 million
and $5.2 million, respectively. Our level of DAC amortization continues to be
sensitive to equity market returns, since equity market returns affect our
estimate of future gross profits from variable products. To the extent that the
return in any quarter is greater than the approximately 2 percent assumed in our
model, amortization is reduced, and vice versa. We believe each 1 percent
variation from expected market appreciation will affect DAC amortization and
segment income by approximately $1 million.
33
Second, to facilitate our ongoing recoverability testing for the Partners and
Select distribution channels, we refined our methodology concerning the
aggregation of annuity contracts for the purposes of estimating future gross
profits and current amortization. This refinement resulted in $19.2 million of
additional amortization.
Third, for all three distribution channels, we revised our estimate of
persistency of variable annuity contracts. Overall, we now expect better
persistency than we had anticipated previously. This is primarily the result of
the significant decline in redemptions, from the first quarter to the second
quarter of 2003. Although we had anticipated that redemptions would moderate
throughout the year, the degree of decline in the second quarter was greater
than expected and caused us to change our persistency expectations. This change
resulted in a $20.2 million decrease in DAC amortization. Changes in persistency
may continue to affect DAC amortization in future periods.
We will continue to evaluate our process for estimating future gross profits and
DAC amortization. These regular evaluations may result in future adjustments to
DAC amortization for a number of reasons, including permanent impairments to our
DAC asset if our actual experience is worse than our current assumptions.
Guaranteed Minimum Death Benefits
The GMDB feature provides annuity contractholders with a guarantee that the
benefit received at death will be no less than a prescribed minimum amount. This
minimum amount is based on either 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.
If the GMDB is higher than the current account value at the time of death, we
incur a cost equal to the difference. As of June 30, 2003, the difference
between the GMDB and the current account value (the "net amount at risk") for
all existing contracts was approximately $3.6 billion, compared to approximately
$4.7 billion at March 31, 2003 and $4.6 billion at December 31, 2002. The
decrease was the result of an increase in equity market values during the
quarter, as well as surrenders, which result in forfeitures of the GMDB benefit.
For each one percent increase or decrease in the S&P 500 Index from June 30,
2003 levels, the net amount at risk is estimated to increase or decrease by
approximately $50 million to $70 million.
To estimate the cost of the GMDB feature with respect to the profitability of
the related insurance contract, we establish and apply various assumptions
relating to the appreciation of related account assets, mortality and contract
persistency, among other matters. We regularly evaluate these assumptions to
determine whether recent experience or anticipated trends merit adjustments to
such assumptions. We have a consistent policy of providing reserves for GMDB
based on our best estimate of the long-term cost of GMDB. The following table
provides a reconciliation of our beginning and ending reserve for GMDB:
Quarter Six Months
Ended Ended
(In millions) June 30, 2003
- ------------------------------------------------------------------------------------------------
Reserve for GMDB, beginning of period..........................$ 55.9 $ 81.2
Provision for GMDB............................................. 11.4 23.0
Claims from policyholders.............................. (25.8) (55.7)
Claims ceded to reinsurers (1)......................... 21.2 39.6
---------- -----------
Claims, net of reinsurance (2)................................. (4.6) (16.1)
GMDB reinsurance premiums paid (2)............................. (21.3) (46.7)
---------- -----------
Reserve for GMDB, end of period................................$ 41.4 $ 41.4
========== ===========
(1) Claims ceded to reinsurers exclude those contracts with a date of death
prior to December 1, 2002 and certain other claims.
(2) We maintain a GMDB mortality reinsurance program with unaffiliated
reinsurers covering the incidence of mortality on variable annuity
policies. We pay the reinsurers monthly premiums based on variable annuity
net amount at risk in exchange for reimbursement of the net amount at risk
portion of qualified cash claims. We retain the market risk associated with
the net amount at risk on the variable annuity business.
34
Based on account values as of June 30, 2003, the estimated annual GMDB expense
would be approximately $45 million. In the near term, cash costs will likely
exceed the annual expense, thereby reducing the reserve. Expected appreciation
in asset levels would gradually reduce, and eventually reverse, this difference
over time. Future changes in market levels, persistency of existing accounts,
mortality and other factors may result in material changes to GMDB costs and
related expenses. We cannot provide assurance that the existing reserve will be
sufficient, or that our estimate of long-term GMDB costs is accurate or
sufficient.
Annuity Account Values and Redemptions
The following table summarizes annuity redemption activity for the AFS segment
for the periods indicated. Redemptions include both full policy and partial
policy surrenders, withdrawals and death benefits (to the extent equal to
account value).
Quarter Ended
---------------------------------------------------------------------------------------------
June 30, March 31, June 30,
2003 2003 2002
- -----------------------------------------------------------------------------------------------------------------
Account Account Account
(In millions) Values (1) Redemptions (2) Values (1) Redemptions (2) Values (1) Redemptions (2)
- -----------------------------------------------------------------------------------------------------------------
Agency $ 4,098.3 $ 259.4 $ 4,623.6 $ 430.4 $ 5,982.1 $ 142.0
Select 2,671.5 130.7 2,995.3 267.8 3,586.0 165.3
Partners 4,117.0 162.4 4,507.2 292.2 5,161.9 201.6
---------------------------------------------------------------------------------------------
Total $ 10,886.8 $ 552.5 $ 12,126.1 $ 990.4 $ 14,730.0 $ 508.9
=============================================================================================
Six Months Ended
June 30,
-------------------------------------------------------------
2003 2002
- -------------------------------------------------------------------------------------------------
Account Account
(In millions) Values (3) Redemptions (2) Values (3) Redemptions (2)
- -------------------------------------------------------------------------------------------------
Agency $ 4,623.6 $ 689.8 $ 5,993.8 $ 285.1
Select 2,995.3 398.5 3,406.0 299.7
Partners 4,507.2 454.6 5,123.3 431.0
-------------------------------------------------------------
Total $ 12,126.1 $ 1,542.9 $ 14,523.1 $ 1,015.8
=============================================================
(1) Account values at June 30 reflect market values as of April 1 of the year
indicated; account values at March 31 reflect market values as of January 1
of the year indicated.
(2) Redemptions reflect activity for the period indicated.
(3) Account values at June 30 reflect market values as of January 1 of the year
indicated.
Redemptions in the second quarter and first six months of 2003 are higher than
those in the second quarter and first six months of 2002. Redemptions in the
second quarter of 2003 are significantly lower as compared to redemptions in the
first quarter of 2003. Ratings downgrades during 2002 and our decision, in the
third quarter of 2002, to cease sales of proprietary products have resulted in a
higher level of redemptions during the past few quarters than we had previously
experienced. An increase in redemptions was expected.
35
Asset Management
The following table summarizes the results of operations for the Asset
Management segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
-------------------------- --------------------------
(In millions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
Interest margins on GICs:
Net investment income............................ $ 18.1 $ 24.9 $ 38.0 $ 51.4
Interest credited................................ (17.3) (22.6) (35.9) (46.2)
--------- --------- --------- ---------
Net interest margin................................. 0.8 2.3 2.1 5.2
--------- --------- --------- ---------
Premium financing business:
Fees............................................. 3.7 3.2 6.7 5.9
Operating expenses............................... (3.2) (2.1) (6.1) (3.8)
--------- --------- --------- ---------
Net premium financing income........................ 0.5 1.1 0.6 2.1
--------- --------- --------- ---------
Fees and other income:
External......................................... 2.1 2.1 4.3 4.0
Internal......................................... 1.1 1.7 2.2 3.0
Other operating expenses............................ (2.0) (2.1) (4.2) (4.1)
--------- --------- --------- ---------
Segment income...................................... $ 2.5 $ 5.1 $ 5.0 $ 10.2
========= ========= ========= =========
Average GIC deposits outstanding.................... $ 1,350.5 $ 2,293.7 $ 1,367.1 $ 2,365.6
========= ========= ========= =========
Outstanding GIC deposits, end of period............. $ 1,333.7 $ 2,224.1 $ 1,333.7 $ 2,224.1
========= ========= ========= =========
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
Asset Management segment income decreased $2.6 million, or 51.0%, to $2.5
million during the second quarter of 2003, primarily due to decreased earnings
from guaranteed investment contracts ("GICs"). Also, segment income declined due
to higher interest costs in our premium financing business and increased
expenses related to our external client asset management business. Earnings on
GICs decreased $1.5 million primarily due to lower average GIC deposits
outstanding and unfavorable fluctuations in foreign currency exchange rates.
These decreases were partially offset by the reinvestment of assets from the
retirement of funding agreements at discounts. Net premium financing income
decreased $0.6 million, primarily due to higher interest costs.
Ratings downgrades during 2002 resulted in the termination of all remaining
short-term funding agreements, and ultimately, we ceased selling new long-term
funding agreements. Furthermore, we retired some of our funding agreements at
discounts during the six months ended June 30, 2003 and the fourth quarter of
2002. Although these retirements resulted in gains for us, income from the GIC
product line will be unfavorably affected in future periods due to the declining
balance of outstanding GIC deposits. In addition, we expect lower income from
our external asset management business due to a significant decline in average
assets under management.
We use derivative instruments to hedge our GIC portfolio (see Derivative
Instruments). For floating rate GIC liabilities that are matched with fixed rate
securities, we manage the interest rate risk by hedging with interest rate swap
contracts designed to pay fixed and receive floating interest. In addition, some
funding agreements are denominated in foreign currencies. To mitigate the effect
of changes in currency exchange rates, we hedge this risk by entering into
foreign exchange swap, futures and options contracts, as well as compound
foreign currency/interest rate swap contracts to hedge our net foreign currency
exposure. These hedges resulted in a $1.5 million and a $11.4 million reduction
in net investment income during the second quarter of 2003 and 2002,
respectively, offset by similar reductions in GIC interest credited during the
respective periods. The decreased effect of derivative instruments was due to a
decrease in average outstanding GIC deposits and the associated hedges. In
addition, these hedges resulted in a $2.8 million reduction in other income
during the second quarter of 2003, resulting from exposure to foreign currency
fluctuations due to the termination of swap contracts in the fourth quarter of
2002, which were replaced with alternative derivatives. Although we believe our
exposure to foreign currency and interest rate fluctuations is currently
economically hedged, we cannot provide assurance that we will not experience
losses from ineffective hedges in the future.
36
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
Asset Management segment income decreased $5.2 million, or 51.0%, to $5.0
million during the six months ended June 30, 2003, primarily due to decreased
earnings from GICs and our premium financing business. Earnings on GICs
decreased $3.1 million primarily due to lower average GIC deposits outstanding
and unfavorable fluctuations in foreign currency exchange rates. These decreases
were partially offset by the reinvestment of assets from the retirement of
funding agreements at discounts. Net premium financing income decreased $1.5
million, primarily due to higher interest costs.
As noted above, we use derivative instruments to hedge our GIC portfolio (see
Derivative Instruments). These hedges resulted in a $3.0 million and a $26.1
million reduction in net investment income during the first six months of 2003
and 2002, respectively, offset by similar reductions in GIC interest credited
during the respective periods. The decreased effect of derivative instruments
was due to a decrease in average outstanding GIC deposits and the associated
hedges. In addition, these hedges resulted in a $6.8 million reduction in other
income during the first six months of 2003, resulting from exposure to foreign
currency fluctuations due to the termination of swap contracts in the fourth
quarter of 2002, which were replaced with alternative derivatives.
Corporate
The following table summarizes the results of operations for the Corporate
segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Six Months Ended
June 30, June 30,
-----------------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net investment income.............................. $ 0.5 $ 1.5 $ 1.0 $ 3.2
Interest expense................................... 3.8 3.8 7.6 7.6
Other operating expenses........................... 15.2 12.9 29.0 27.2
---------- ---------- ---------- ---------
Segment loss......................................... $ (18.5) $ (15.2) $ (35.6) $ (31.6)
========== ========== ========== =========
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
Segment loss increased $3.3 million, or 21.7%, to $18.5 million in the second
quarter of 2003, principally due to higher fringe benefit costs, primarily
pension related, and lower net investment income. Net investment income
decreased principally due to lower average invested assets.
Interest expense for both periods relates principally to the interest paid on
our Senior Debentures.
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
Segment loss increased $4.0 million, or 12.7%, to $35.6 million in the first six
months of 2003, principally due to higher fringe benefit costs, primarily
pension related, and lower net investment income. Net investment income
decreased due to lower average invested assets.
Interest expense for both periods relates principally to the interest paid on
our Senior Debentures.
37
Investment Portfolio
We held general account investment assets diversified across several asset
classes, as follows:
June 30, 2003 December 31, 2002
-------------------------------------------------------------------
Carrying % of Total Carrying % of Total
(Dollars in millions) Value Carrying Value Value Carrying Value
- -----------------------------------------------------------------------------------------------------------------------
Fixed maturities (1)............................ $7,578.4 88.4% $8,003.1 87.1%
Equity securities (1)........................... 21.3 0.3 52.8 0.6
Mortgages....................................... 237.9 2.8 259.8 2.8
Policy loans (1)................................ 276.7 3.2 361.4 3.9
Cash and cash equivalents (1)................... 351.5 4.1 389.8 4.2
Other long-term investments..................... 104.7 1.2 129.7 1.4
-------------------------------------------------------------------
Total...................................... $8,570.5 100.0% $9,196.6 100.0%
===================================================================
(1) We carry these investments at fair value.
Total investment assets decreased $626.1 million, or 6.8%, to $8.6 billion
during the first six months of 2003, primarily as a result of a decrease in
fixed maturities of $424.7 million, policy loans of $84.7 million and cash and
cash equivalents of $38.3 million. These decreases resulted primarily from the
sale of our universal life insurance business and annuity surrenders from the
general account in the AFS segment. In addition, fixed maturities decreased in
the Asset Management segment due to the retirement of certain long-term funding
agreements.
Our 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 93.8% and 90.5% of our total fixed maturity portfolio at
June 30, 2003 and December 31, 2002, respectively.
The following table provides information about the credit quality of our fixed
maturities.
(In millions) June 30, 2003 December 31, 2002
- --------------------------------------------------------------------------------------------------------
Rating Agency Amortized Carrying Amortized Carrying
NAIC Designation Equivalent Designation Cost Value Cost Value
- ---------------------------------------------------------------------------------------------------------
1 Aaa/Aa/A $ 4,520.9 $ 4,804.9 $ 4,818.3 $ 5,061.4
2 Baa 2,145.6 2,304.0 2,076.8 2,180.5
3 Ba 215.8 217.4 443.4 410.6
4 B 149.7 153.0 225.8 212.6
5 Caa and lower 69.7 76.4 119.2 110.5
6 In or near default 20.2 22.7 32.4 27.5
-----------------------------------------------
Total fixed maturities $ 7,121.9 $ 7,578.4 $ 7,715.9 $ 8,003.1
===============================================
Although we expect that new funds will be invested primarily in cash, cash
equivalents and investment grade fixed maturities, we may invest a portion of
new funds in below investment grade fixed maturities or equity securities. The
average yield on fixed maturities was 6.2% and 6.8% for the six months ended
June 30, 2003 and 2002, respectively. This decline reflects lower prevailing
fixed maturity investment rates since the first six months of 2002 and an
increased emphasis on higher credit quality bonds. Due to the current interest
rate environment, we expect our investment yield to be negatively affected by
lower prevailing fixed maturity investment rates in 2003.
As of June 30, 2003 and December 31, 2002, $334.8 million and $423.1 million,
respectively, of our fixed maturities were invested in traditional private
placement securities. Fair values of traditional private placement securities
are determined by either a third party broker or by internally developed pricing
models, including the use of discounted cash flow analyses.
38
Principally as a result of our exposure to below investment grade securities, we
recognized $42.7 million and $59.4 million of realized losses on
other-than-temporary impairments of fixed maturities during the first six months
of 2003 and 2002, respectively. Other-than-temporary impairments of fixed
maturities for the first six months of 2003 included $18.8 million related to
the airline/transportation sector, $8.4 million related to securitized
investments, $7.4 million related to the industrial sector, and $4.7 million
related to the consumer non-cyclical sector. Other-than-temporary impairments of
fixed maturities for the first six months of 2002 included $43.6 million related
to the communication sector, $10.4 million related to securitized investments,
$2.2 million related to the industrial sector, and $1.3 million related to the
finance sector. In our determination of other-than-temporary impairments, we
consider several factors and circumstances, including the issuer's overall
financial condition, the issuer's credit and financial strength ratings, the
issuer's financial performance, including earnings trends, dividend payments,
and asset quality, a weakening of the general market conditions in the industry
or geographic region in which the issuer operates, a prolonged period in which
the fair value of an issuer's securities remains below our 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.
We apply these factors to all securities. Other-than-temporary impairments are
recorded as a realized loss, which serves to reduce net income and earnings per
share. Temporary losses are recorded as unrealized losses, which do not affect
net income and earnings per share but reduce other comprehensive income. We
cannot provide assurance that the other-than-temporary impairments will,
in-fact, be adequate to cover future losses or that we will not have substantial
additional impairments in the future.
The following table provides information about our fixed maturities and equity
securities that have been continuously in an unrealized loss position.
June 30, 2003 December 31, 2002
---------------------------------------
Gross Gross
Unrealized Fair Unrealized Fair
(In millions) Losses Value Losses Value
- ------------------------------------------------------------------------------------------
Investment grade fixed maturities:
0-6 months................................... $ 6.3 $ 406.6 $ 13.4 $ 287.2
7-12 months.................................. 0.1 3.2 1.1 28.5
Greater than 12 months....................... 8.6 106.7 17.4 160.9
----------------------------------------
Total investment grade fixed maturities........ 15.0 516.5 31.9 476.6
Below investment grade fixed maturities:
0-6 months................................... 5.1 19.3 15.9 120.4
7-12 months.................................. 3.8 42.4 17.4 139.1
Greater than 12 months....................... 9.7 38.8 41.1 156.1
---------------------------------------
Total below investment grade fixed maturities.. 18.6 100.5 74.4 415.6
Equity securities.............................. 0.1 - 0.4 1.1
---------------------------------------
Total fixed maturities and equity securities... $ 33.7 $ 617.0 $ 106.7 $ 893.3
=======================================
Of the $33.7 million and $106.7 million of gross unrealized losses on fixed
maturities and equity securities, approximately $2.0 million and $1.8 million
relate to investment grade fixed maturity obligations of the U.S. Treasury, U.S.
government and agency securities, states and political subdivisions, as of June
30, 2003 and December 31, 2002, respectively. Substantially all below investment
grade securities with an unrealized loss have been rated by the NAIC, Standard &
Poor's or Moody's as of June 30, 2003 and December 31, 2002.
The gross unrealized losses of fixed maturities and equity securities are viewed
as being temporary as it is our assessment that these securities will recover in
the near-term. Furthermore, as of June 30, 2003, we had the intent and ability
to retain such investments for a period of time sufficient to allow for this
anticipated recovery in fair value. The risks inherent in the assessment
methodology include the risk that, subsequent to the balance sheet date, market
factors may differ from our expectations; we may decide to subsequently sell a
security for unforeseen business needs; or changes in the credit assessment or
equity characteristics from our original assessment may lead us 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 we would record a charge to earnings.
39
The following table sets forth gross unrealized losses for fixed maturities by
maturity period, and for equity securities. Actual maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties, or we 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.
June 30, December 31,
(In millions) 2003 2002
- ------------------------------------------------------------------------------------------------
Due in one year or less....................... $ 3.9 $ 3.2
Due after one year through five years......... 4.0 39.8
Due after five years through ten years........ 12.6 36.7
Due after ten years........................... 13.1 26.6
--------------------------
Total fixed maturities.......................... 33.6 106.3
Equity securities............................. 0.1 0.4
--------------------------
Total fixed maturities and equity securities.... $ 33.7 $ 106.7
==========================
At June 30, 2003 and December 31, 2002, respectively, we had fixed maturity
securities with a carrying value of $27.0 million and $39.9 million on
non-accrual status. The effect of non-accruals, compared with amounts that would
have been recognized in accordance with the original terms of the fixed
maturities, was a reduction in net investment income of $5.4 million and $9.2
million for the six months ended June 30, 2003 and 2002, respectively. We expect
that defaults in the fixed maturities portfolio may continue to negatively
affect investment income.
Derivative Instruments
We enter into foreign currency swap, futures and options contracts, as well as
compound foreign currency/interest rate swap contracts, to hedge foreign
currency and interest rate exposure on specific funding agreement liabilities.
We also entered into various types of interest rate swap contracts to hedge
exposure to interest rate fluctuations on floating rate funding agreement
liabilities that were matched with fixed rate securities. Finally, from time to
time we have entered into other swap contracts for investment purposes. We
recognized $2.0 million of net realized gains on derivatives for the second
quarter of 2003 compared to $21.0 million of net realized losses on derivatives
for the second quarter of 2002. Similarly, we recognized $4.2 million and $34.4
million of net realized losses on derivatives for the six months ended June 30,
2003 and 2002, respectively. The realized gains during the second quarter of
2003 and realized losses for the six months ended June 30, 2003, were primarily
due to the termination of derivative instruments used to hedge funding
agreements, in response to the retirement of certain long-term funding
agreements at discounts. The realized losses during the second quarter of 2002
and the six months ended June 30, 2002, were primarily due to the termination of
derivative instruments used to hedge funding agreements, during a declining
interest rate environment, in response to short-term funding agreement
withdrawals. During the second quarter of 2002, we reclassified a portion of
these losses, totaling $17.4 million, that were previously recognized as
ineffective hedges in the fourth quarter of 2001, to realized investment losses
from (losses) gains on derivatives instruments in the Consolidated Statements of
Income upon termination of the interest rate swap contracts in the second
quarter of 2002. Similarly, for the six months ended June 30, 2002, we
reclassified $30.7 million of losses that were previously recognized as
ineffective hedges in the fourth quarter of 2001, to realized investment losses
from (losses) gains on derivatives instruments in the Consolidated Statements of
Income upon termination of the interest rate swap contracts in 2002.
We manage the risk of cash flow variability on floating rate funding agreements
that are matched with fixed rate securities by hedging with interest rate swap
contracts designed to pay fixed and receive floating interest. With the adoption
of Statement No. 133 on January 1, 2001, the swap contracts were considered cash
flow hedges of the interest rate risk associated with the floating rate funding
agreements, including funding agreements with put features allowing the
policyholder to cancel the contract prior to maturity. We no longer have
outstanding floating rate funding agreements with put features. In addition, we
no longer offer long-term or short-term funding agreements.
Income Taxes
We file a consolidated United States federal income tax return that includes AFC
and its domestic subsidiaries (including non-insurance operations). 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 statutory restrictions on the percentage of eligible
non-life tax losses that can be applied to offset life company taxable income.
40
Quarter Ended June 30, 2003 Compared to Quarter Ended June 30, 2002
The provision for federal income taxes before minority interest and the effect
of a change in accounting principle was $2.5 million during the second quarter
of 2003 compared to a benefit of $61.6 million during the same period in 2002.
These provisions resulted in consolidated effective federal tax rates of 8.1%
and (54.5%) for the quarters ended June 30, 2003 and 2002, respectively. It is
our 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 was computed based on
the first half of 2002 as a discrete period due to the uncertainty regarding our
ability to reliably estimate pre-tax income for the remainder of the year. We
were unable to reliably estimate pre-tax income for the second half of 2002
principally due to the impact of the equity market on us, including possible
additional amortization of DAC. The tax rate in 2003 reflects expected
underwriting income for 2003, while the large benefit in 2002 was primarily due
to the significant loss recognized by the AFS segment, as well as a $12.1
million favorable settlement of federal income tax returns related to 1977
through 1981.
Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002
The provision for federal income taxes before minority interest and the effect
of a change in accounting principle was $10.0 million and a benefit of $52.1
million during the first six months of 2003 and 2002, respectively. These
provisions resulted in consolidated effective federal tax rates of 12.6% and
(108.5%) for the six months ended June 30, 2003 and 2002, respectively. The tax
rate in 2003 reflects expected underwriting income for 2003, while the large
benefit in 2002 was primarily due to the significant loss recognized by the AFS
segment, as well as the aforementioned $12.1 million favorable tax settlement.
Statutory Capital of Insurance Subsidiaries
The NAIC prescribes an annual calculation regarding risk based capital ("RBC").
RBC is a method of measuring the minimum amount of capital appropriate for an
insurance company to support its overall business operations in consideration of
its size and risk profile. The RBC ratio for regulatory purposes is calculated
as total adjusted capital divided by required risk based capital. Total adjusted
capital for life insurance companies is defined as capital and surplus, plus
asset valuation reserve, plus 50% of dividends apportioned for payment. Total
adjusted capital for property and casualty companies is capital and surplus. The
Company Action Level is the first level at which regulatory involvement is
specified based upon the level of capital. Regulators may take action for
reasons other than triggering various RBC action levels.
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 GMDB reserves,
Total Adjusted Capital and RBC ratios for our life insurance subsidiaries and
for Hanover, as applicable, as of June 30, 2003, 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):
GMDB Reserves (3)
-----------------------
Total Company Authorized RBC Ratio RBC Ratio
(In millions,except Gross of Net of Adjusted Action Control Industry Regulatory
ratios) Reinsurance Reinsurance Capital Level Level Scale Scale
- -----------------------------------------------------------------------------------------------------------------------
AFLIAC (1).............. $229.3 $163.9 $535.6 $155.9 $ 78.0 344% 687%
FAFLIC.................. 6.0 4.4 199.2 77.9 39.0 256% 511%
Hanover (2)............. - - 901.3 386.9 193.5 233% 466%
(1)AFLIAC's Total Adjusted Capital includes $199.2 million related to its
subsidiary, FAFLIC.
(2)Hanover's Total Adjusted Capital includes $533.0 million related to its
subsidiary, Citizens.
(3)AFLIAC GMDB reserve balances exclude those reserves held by its subsidiary,
FAFLIC.
The RBC ratio of our lead life insurance company, AFLIAC, continued to improve
during 2003. This improvement reflects lower required risk based capital as a
result of sales of high yield securities and increased adjusted capital
primarily from improvements in the equity market.
41
Liquidity and Capital Resources
Net cash used for operating activities was $263.3 million during the first six
months of 2003 versus cash provided of $233.1 million during the same period
last year. During the first six months of 2003, cash was used as a result of
continued increased surrender activity in AFS resulting from the ratings
downgrades and our decision to cease new sales of our life insurance and annuity
products. Cash was also used to settle approximately $100 million of the payable
related to the sale of our universal life insurance business. Additionally,
there was a modest increase in cash used for the payment of losses and LAE in
our property and casualty business. These payments were partially offset by cash
receipts in the Property and Casualty segment related to funds held with a third
party reinsurer, which subsequently were disbursed to a successor third party
reinsurer.
Net cash provided by investing activities was $346.7 million and $442.0 million
during the first six months of 2003 and 2002, respectively. During 2003, net
sales of fixed maturities resulted from increased surrenders in the AFS segment.
In 2002, net sales of fixed maturities resulted from funding agreement
withdrawals.
Net cash used in financing activities was $121.7 million during the first six
months of 2003, compared to net cash used in financing activities of $649.2
million for the same period of 2002. The $527.5 million decrease in cash used in
2003 is primarily due to $519.6 million of lower net funding agreement
withdrawals, including withdrawals from trust instruments supported by funding
obligations.
Additionally, during the first half of 2003, we transferred approximately $450
million of investment assets to settle payables related to the sale of our
universal life insurance business.
At June 30, 2003, AFC, as a holding company, held $48.7 million of cash and
investments. We believe our holding company has the ability to meet its
obligations through the remainder of 2003, consisting primarily of interest on
the senior debentures and Capital Securities. Therefore, we currently do not
expect that it will be necessary to dividend funds from the property and
casualty companies in 2003 in order to fund 2003 holding company obligations.
Subsequent to July 11, 2003, approximately $83 million will be available to
dividend from our property and casualty insurance companies without prior
approval from the insurance commissioners in the states of domicile. AFC did not
receive any dividends from its insurance subsidiaries during the first half of
2003. The holding company will require additional funding in 2004 in order to
meet its obligations, which we expect will include approximately $40 million of
pre-tax obligations, consistent with those expected for 2003. We receive tax
benefits of approximately $14 million related to these obligations. In addition,
the holding company may require funding for certain federal income tax
liabilities of up to $15 million. In 2002, we suspended payment of our annual
common stock dividend.
We expect to continue to generate sufficient positive operating cash to meet all
short-term and long-term cash requirements. Our insurance subsidiaries maintain
a high degree of liquidity within their respective investment portfolios in
fixed maturity investments, common stock and short-term investments. We had
$150.0 million available under a committed syndicated credit agreement, which
expired on May 23, 2003. This agreement, which we never borrowed under, was not
renewed. In addition, we had no commercial paper borrowings as of June 30, 2003
and we do not anticipate utilizing commercial paper in 2003. Ratings downgrades
have adversely affected the cost and availability of additional debt and equity
financing and will continue to do so in the future should ratings remain at
current levels or decrease further (see Rating Agency Actions).
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.
We believe that strong ratings are important factors in marketing our products
to our agents and customers, since rating information is broadly disseminated
and generally used throughout the industry. Insurance company financial strength
ratings are assigned to an insurer based upon factors deemed by the rating
agencies to be relevant to policyholders and are not directed toward protection
of investors. Such ratings are neither a rating of securities nor a
recommendation to buy, hold or sell any security.
In August 2003, Standard & Poor's rating service reaffirmed our life companies
financial strength ratings of B+(weak), our Senior Debt ratings of BB-
(marginal), our Capital Securities ratings of B- (weak) and our short-term debt
ratings of B (vulnerable) and revised the outlook of these ratings from a
negative outlook to a positive outlook. In addition, Standard & Poor's
reaffirmed our property and casualty companies financial strength ratings of
BBB+ (good) and revised the outlook on this rating from a negative outlook to a
stable outlook.
42
During July 2003, Moody's Investors Service upgraded its financial strength
ratings of our life insurance companies from Ba2 (questionable) to Ba1
(questionable), our senior debt rating from B1 (poor) to Ba3 (questionable), and
our Capital Securities ratings from B3 (poor) to B2 (poor). Moody's also
confirmed the financial strength ratings of our property and casualty companies,
at Baa2 (adequate), and assigned all of our ratings a stable outlook.
During April 2003, A.M. Best rating service upgraded its financial strength
ratings of our life insurance companies from C++ (marginal) to B- (fair). In
addition, A.M. Best downgraded our senior debt rating from bb+ to bb and our
Capital Securities rating from bb- to b+.
Recent Developments
Subsequent to the Annual Meeting of Shareholders held on May 13, 2003, one
director, Mr. Terrence Murray, resigned from the Board. In addition, on July 12,
2003, another director, Mr. Samuel J. Gerson, passed away.
Forward-Looking Statements
We wish to caution readers that the following important factors, among others,
in some cases have affected and in the future could affect our actual results
and could cause our actual results for 2003 and beyond to differ materially from
historical results and from those expressed in any forward-looking statements
made by, or on our behalf. When used in Management's Discussion and Analysis,
the words "believes", "anticipates", "expects" and similar expressions are
intended to identify forward looking statements. See "Important Factors
Regarding Forward-Looking Statements" filed as Exhibit 99-2 to our Annual Report
on Form 10-K for the period ended December 31, 2002.
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 our 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 we have 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) our success in
implementing a profitable independent broker/dealer operation, including expense
management, sales of non-porprietary investment and insurance products, and the
recruitment of new or retainment of existing registered representatives and
wholesalers to support these sales;(ix) higher service, administrative, or
general expense due to the need for additional advertising, marketing,
administrative or management information systems expenditures; (x) loss or
retirement of key executives; (xi) our success in hiring a new president and
chief executive officer; (xii) increases in costs, particularly those occurring
after the time our products are priced and including construction, automobile,
and medical and rehabilitation costs; (xiii) changes in our liquidity due to
changes in asset and liability matching, including the effect of defaults of
debt securities; (xiv) restrictions on insurance underwriting; (xv) adverse
changes in the ratings obtained from independent rating agencies, such as
Moody's, Standard and Poor's and A.M. Best, or the inability to restore the
property and casualty subsidiaries' A.M. Best rating to the "A-" level or
higher; (xvi) possible claims relating to sales practices for insurance
products; (xvii) failure of a reinsurer of our policies to pay its liabilities
under reinsurance or coinsurance contracts or adverse effects on the cost and
availability of reinsurance; (xviii) earlier than expected withdrawals from our
general account annuities, GICs (including funding agreements), and other
insurance products; (xix) changes in the mix of assets comprising our investment
portfolio and the fluctuation of the market value of such assets; (xx) losses
resulting from our participation in certain reinsurance pools; (xxi) losses due
to foreign currency fluctuations; (xxii) defaults of debt securities held by us;
(xxiii) higher employee benefit costs due to changes in market values of plan
assets, interest rates and employee compensation levels, and (xxiv) the effect
of our restructuring actions.
In addition, with respect to the Allmerica Financial Services segment, we have
provided forward looking information relating to the impact of equity market
values on certain financial metrics, including among other things, GMDB
expenses, net amount at risk, DAC amortization and Actuarial Guideline 34
reserves for statutory accounting purposes. This information is an estimation
only and is based upon matters as in effect on June 30, 2003. 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.
43
Glossary of Selected Insurance Terms
Annuity contracts - An annuity contract is an arrangement whereby an annuitant
is guaranteed to receive a series of stipulated amounts commencing either
immediately or at some future date. Annuity contracts can be issued to
individuals or to groups.
Benefit payments - Payments made to an insured or their beneficiary in
accordance with the terms of an insurance policy.
Casualty insurance - Insurance that is primarily concerned with the losses
caused by injuries to third persons and their property (other than the
policyholder) and the related legal liability of the insured for such losses.
Catastrophe - A single event that causes the property and casualty industry both
a significant number of claims (1,000 or more) and $25 million or more in
insured property damage losses.
Cede; cedent; ceding company - When a party reinsures its liability with
another, it "cedes" business and is referred to as the "cedent" or "ceding
company".
Combined ratio, Statutory - This ratio is widely used as a benchmark for
determining an insurer's underwriting performance. A ratio below 100% generally
indicates profitable underwriting prior to the consideration of investment
income. A combined ratio over 100% generally indicates unprofitable underwriting
prior to the consideration of investment income. The combined ratio is the sum
of the loss ratio, the loss adjustment expense ratio, and the underwriting
expense ratio.
Earned premium - The portion of a premium that is recognized as income, or
earned, based on the expired portion of the policy period, that is, the period
for which loss coverage has actually been provided. For example, after six
months, $50 of a $100 annual premium is considered earned premium. The remaining
$50 of annual premium is unearned premium. Net earned premium is earned premium
net of reinsurance.
Excess of loss reinsurance - Reinsurance that indemnifies the insured against
all or a specific portion of losses under reinsured policies in excess of a
specified dollar amount or "retention".
Frequency - The number of claims occurring during a given coverage period.
Loss adjustment expenses (LAE) - Expenses incurred in the adjusting, recording,
and settlement of claims. These expenses include both internal company expenses
and outside services. Examples of LAE include claims adjustment services,
adjuster salaries and fringe benefits, legal fees and court costs, investigation
fees, and claims processing fees.
Loss adjustment expense ratio, Statutory - The ratio of loss adjustment expenses
to earned premiums for a given period.
Loss costs - An amount of money paid for a property and casualty claim.
Loss ratio, Statutory - The ratio of losses to premiums earned for a given
period.
Net premium rate increase - A measure of the estimated earnings impact of
increasing premium rates charged to property and casualty policyholders. This
measure includes the estimated increase in revenue associated with higher prices
(premiums), including those caused by price inflation and changes in exposure,
partially offset by higher volume driven expenses and inflation of loss costs.
Volume driven expenses include policy acquisition costs such as commissions paid
to property and casualty agents which are typically based on a percentage of
premium dollars.
Peril - A cause of loss.
Property insurance - Insurance that provides coverage for tangible property in
the event of loss, damage or loss of use.
Rates - The pricing factor upon which the policyholder's premium is based.
Registered representative - Salesperson of a broker/dealer. Salespeople are
registered with the Centralized Registration Depository, a system operated by
the National Association of Securities Dealers, that maintains registration
information regarding broker/dealers and their registered personnel.
44
Reinsurance - An arrangement in which an insurance company, the reinsurer,
agrees to indemnify another insurance or reinsurance company, the ceding
company, against all or a portion of the insurance or reinsurance risks
underwritten by the ceding company under one or more policies. Reinsurance can
provide a ceding company with several benefits, including a reduction in net
liability on risks and catastrophe protection from large or multiple losses.
Reinsurance does not legally discharge the primary insurer from its liability
with respect to its obligations to the insured.
Separate accounts - An investment account that is maintained separately from an
insurer's general investment portfolio and that allows the insurer to manage the
funds placed in variable life insurance policies and variable annuity policies.
Policyholders direct the investment of policy funds among the different types of
separate accounts available from the insurer.
Severity - A monetary increase in the loss costs associated with the same or
similar type of event or coverage.
Statutory accounting principles - Recording transactions and preparing financial
statements in accordance with the rules and procedures prescribed or permitted
by insurance regulatory authorities including the National Association of
Insurance Commissioners ("NAIC"), which in general reflect a liquidating, rather
than going concern, concept of accounting.
Surrender or withdrawal - Surrenders of life insurance policies and annuity
contracts for their entire net cash surrender values and withdrawals of a
portion of such values.
Underwriting - The process of selecting risks for insurance and determining in
what amounts and on what terms the insurance company will accept risks.
Underwriting expenses - Expenses incurred in connection with the acquisition,
pricing, and administration of a policy.
Underwriting expense ratio, Statutory - This ratio reflects underwriting
expenses to written premiums.
Variable annuity - An annuity which includes a provision for benefit payments to
vary according to the investment experience of the separate account in which the
amounts paid to provide for this annuity are allocated.
Written premium - The premium assessed for the entire coverage period of a
property and casualty policy without regard to how much of the premium has been
earned. See also earned premium. Net written premium is written premium net of
reinsurance.
45
PART I - FINANCIAL INFORMATION
ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Our market risks, and the ways we manage them, are summarized in Management's
Discussion and Analysis of Financial Condition and Results of Operations as of
December 31, 2002, included in our Form 10-K for the year ended December 31,
2002. There have been no material changes in the first six months of 2003 to
such risks or our management of such risks.
ITEM 4
CONTROLS AND PROCEDURES
Our management, including our Executive Officers of the Chairman and Chief
Financial Officer, conducted an evaluation as of the end of the period covered
by this report, of the effectiveness of our disclosure controls and procedures.
Based on that evaluation, the Executive Officers of the Chairman and Chief
Financial Officer concluded that our disclosure controls and procedures were
effective as of the end of the period covered by this report. Our management,
including our Executive Officers of the Chairman and Chief Financial Officer,
also conducted an evaluation of our internal controls over financial reporting
to determine whether any changes occurred during the quarter covered by this
report that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting. Based on that evaluation,
there has been no such change during the quarter covered by this report.
46
PART II - OTHER INFORMATION
ITEM 4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Election of Directors
Our annual shareholder's meeting was held on May 13, 2003. Two directors
nominated for re-election by the Board of Directors were named in proxies for
the meeting, which proxies were solicited pursuant to Regulations 14A of the
Securities and Exchange Act of 1934.
VOTES FOR WITHHELD
Gail L. Harrison 40,536,624 522,859
M Howard Jacobson 40,539,788 519,695
The other directors whose terms were continued after the Annual Meeting are Mr.
Michael P. Angelini, Mr. Samuel J. Gerson, Mr. Wendell J. Knox, Mr. Robert J.
Murray, Mr. Terrence Murray, Mr. John F. O'Brien, Mr. John R. Towers and Mr.
Herbert M. Varnum.
Mr. Terrence Murray has since resigned from the Board of Directors. Mr. Samuel
J. Gerson passed away on July 12, 2003.
Ratification of Independent Public Accountants
Shareholders ratified the appointment of PricewaterhouseCoopers LLP as our
Independent Public Accountants for 2003: for 39,717,926; against 1,243,316;
abstain 98,241.
Shareholder Proposal
Shareholders voted against the ratification of the Shareholder Proposal to
establish a policy of expensing in our annual income statement the costs of all
future stock options issued by us: for 10,127,226; against 19,236,061; abstain
637,575.
47
PART II - OTHER INFORMATION
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EX-10.56 First Amendment to Employment Agreement dated June 27, 2003
between First Allmerica Financial Life Insurance Company and
J. Kendall Huber.
EX-31.1 Certification of J. Kendall Huber, Executive Officer of
the Chairman, pursuant to 15 U.S.C. 78m, 78o(d), as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
EX-31.2 Certification of Edward J. Parry III, Executive Officer of
the Chairman and Chief Financial Officer, pursuant to 15 U.S.C.
78m, 78o(d), as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
EX-31.3 Certification of Robert P.Restrepo, Jr.,Executive Officer of the
Chairman, pursuant to 15 U.S.C. 78m, 78o(d), as adopted pursuant
to section 302 of the Sarbanes-Oxley Act of 2002.
EX-32.1 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- 32.2 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-32.3 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 April 28, 2003, Allmerica Financial Corporation announced its financial
results for the quarter ended March 31, 2003. Additionally, on April 28, 2003,
the Company made available on its website financial information contained in its
Statistical Supplement for the quarter ended March 31, 2003.
48
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Allmerica Financial Corporation
Registrant
Dated August 13, 2003
/s/ J. Kendall Huber
J. Kendall Huber
Executive Officer of the Chairman
Dated August 13, 2003
/s/ Edward J. Parry III
Edward J. Parry III
Executive Officer of the Chairman,Chief Financial Officer
and Principal Accounting Officer
Dated August 13, 2003
/s/ Robert P. Restrepo, Jr.
Robert P. Restrepo, Jr.
Executive Officer of the Chairman
49