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FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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: 53,035,644 shares of common
stock outstanding, as of November 1, 2003.
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.......................... 17-48
Item 3. Quantitative and Qualitative Disclosures About
Market Risk.................................................. 49
Item 4. Controls and Procedures...................................... 49
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K............................. 50
SIGNATURES................................................................ 51
2
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------
(In millions, except per share data) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------------
REVENUES
Premiums................................................... $ 568.2 $ 576.2 $ 1,711.8 $ 1,736.2
Universal life and investment product policy fees.......... 75.8 97.1 242.7 291.9
Net investment income...................................... 110.5 152.8 346.6 452.9
Net realized investment (losses) gains..................... (8.0) (7.8) 18.4 (83.9)
Other income............................................... 41.1 36.6 140.4 105.5
---------- ---------- ---------- ----------
Total revenues......................................... 787.6 854.9 2,459.9 2,502.6
---------- ---------- ---------- ----------
BENEFITS, LOSSES AND EXPENSES
Policy benefits, claims, losses and loss adjustment
expenses......... 473.5 616.4 1,457.8 1,669.9
Policy acquisition expenses................................ 146.8 542.3 460.3 912.6
Gain from retirement of trust instruments supported by
funding obligations...................................... (0.7) - (5.7) -
Income from sale of universal life business................ - - (5.5) -
Net (gains) losses on derivative instruments............... (0.5) 0.1 (1.4) (30.3)
Restructuring costs........................................ 1.2 - 5.8 -
Other operating expenses................................... 163.4 187.2 477.5 489.5
---------- ---------- ---------- ----------
783.7 1,346.0 2,388.8 3,041.7
Total benefits, losses and expenses.................... ---------- ---------- ---------- ----------
Income (loss) before federal income taxes.................. 3.9 (491.1) 71.1 (539.1)
---------- ---------- ---------- ----------
Federal income tax (benefit) expense
Current................................................. (23.0) 15.9 2.1 12.5
Deferred................................................ 15.5 (197.6) (3.9) (246.3)
---------- ---------- ---------- ----------
Total federal income tax benefit..................... (7.5) (181.7) (1.8) (233.8)
---------- ---------- ---------- ----------
Income (loss) before minority interest and cumulative
effect of change in accounting principle................ 11.4 (309.4) 72.9 (305.3)
Minority interest:
Distributions on mandatorily redeemable preferred
securities of a subsidiary trust holding solely
junior subordinated debentures of the Company........... - (4.0) - (12.0)
---------- ---------- ---------- ----------
Income (loss) before cumulative effect of change in
accounting principle.................................... 11.4 (313.4) 72.9 (317.3)
Cumulative effect of change in accounting principle (less
income tax benefit of $2.0 for the nine months
ended September 30, 2002)............................... - - - (3.7)
---------- ---------- ---------- ----------
Net income (loss).......................................... $ 11.4 $ (313.4) $ 72.9 $ (321.0)
========== ========== ========== ==========
PER SHARE DATA
Basic
Income (loss) before cumulative effect of change in
accounting principle................................... $ 0.22 $ (5.93) $ 1.38 $ (6.00)
Cumulative effect of change in accounting principle
(less income tax benefit of $0.04 for the nine
months ended September 30, 2002)....................... - - - (0.07)
---------- ---------- ---------- ----------
Net income (loss)........................................ $ 0.22 $ (5.93) $ 1.38 $ (6.07)
========== ========== ========== ==========
Weighted average shares outstanding ..................... 52.9 52.9 52.9 52.9
========== ========== ========== ==========
Diluted
Income (loss) before cumulative effect of change in
accounting principle................................... $ 0.21 $ (5.93) $ 1.37 $ (6.00)
Cumulative effect of change in accounting principle
(less income tax benefit of $0.04 for the nine
months ended September 30, 2002)....................... - - - (0.07)
---------- ---------- ---------- ----------
Net income (loss) ....................................... $ 0.21 $ (5.93) $ 1.37 $ (6.07)
========== ========== ========== ==========
Weighted average shares outstanding...................... 53.3 52.9 53.1 52.9
========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
3
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(In millions, except per share data) 2003 2002
- ------------------------------------------------------------------------------------------------------------------------
ASSETS
Investments:
Fixed maturities-at fair value (amortized cost of $7,326.5 and $7,715.9)... $ 7,688.0 $ 8,003.1
Equity securities-at fair value (cost of $7.2 and $49.1)................... 8.7 52.8
Mortgage loans............................................................. 221.8 259.8
Policy loans............................................................... 272.1 361.4
Other long-term investments................................................ 88.9 129.7
----------- -----------
Total investments........................................................ 8,279.5 8,806.8
----------- -----------
Cash and cash equivalents..................................................... 326.1 389.8
Accrued investment income..................................................... 122.1 138.3
Premiums, accounts and notes receivable, net.................................. 524.6 564.7
Reinsurance receivable on paid and unpaid losses,
benefits and unearned premiums............................................. 2,080.5 2,075.8
Deferred policy acquisition costs............................................. 1,135.0 1,242.2
Deferred federal income taxes................................................. 391.6 413.2
Goodwill...................................................................... 131.2 131.2
Other assets.................................................................. 471.4 473.5
Separate account assets....................................................... 11,546.0 12,343.4
----------- -----------
Total assets............................................................... $ 25,008.0 $ 26,578.9
=========== ===========
LIABILITIES
Policy liabilities and accruals:
Future policy benefits..................................................... $ 3,563.7 $ 3,900.1
Outstanding claims, losses and loss adjustment expenses.................... 3,087.6 3,066.5
Unearned premiums.......................................................... 1,075.9 1,047.0
Contractholder deposit funds and other policy liabilities.................. 812.7 772.8
----------- ----------
Total policy liabilities and accruals.................................... 8,539.9 8,786.4
----------- ----------
Expenses and taxes payable.................................................... 925.3 1,115.5
Reinsurance premiums payable.................................................. 133.9 559.1
Trust instruments supported by funding obligations............................ 1,166.8 1,202.8
Long-term debt................................................................ 499.5 199.5
Separate account liabilities.................................................. 11,546.0 12,343.4
----------- ----------
Total liabilities.......................................................... 22,811.4 24,206.7
----------- ----------
Minority interest:
Mandatorily redeemable preferred securities of a subsidiary trust holding
solely junior subordinated debentures of the Company..................... - 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.................................................... 1,774.2 1,768.4
Accumulated other comprehensive income (loss)................................. 6.4 (37.4)
Retained earnings............................................................. 819.1 746.2
Treasury stock at cost (7.4 and 7.5 million shares)........................... (403.7) (405.6)
----------- -----------
Total shareholders' equity................................................. 2,196.6 2,072.2
----------- -----------
Total liabilities and shareholders' equity............................... $ 25,008.0 $ 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)
Nine Months Ended
September 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........... 5.8 3.9
---------- ----------
Balance at end of period..................................................... 1,774.2 1,762.3
---------- ----------
ACCUMULATED OTHER COMPREHENSIVE INCOME
NET UNREALIZED APPRECIATION ON INVESTMENTS AND DERIVATIVE
INSTRUMENTS:
Balance at beginning of period............................................... 83.4 28.4
Net appreciation on available-for-sale securities and derivative
instruments............................................................. 67.4 38.7
Provision for deferred federal income taxes.............................. (23.6) (13.5)
---------- ----------
43.8 25.2
---------- ----------
Balance at end of period..................................................... 127.2 53.6
---------- ----------
MINIMUM PENSION LIABILITY:
Balance at beginning and end of period....................................... (120.8) (42.1)
---------- ----------
Total accumulated other comprehensive income................................. 6.4 11.5
---------- ----------
RETAINED EARNINGS
Balance at beginning of period............................................... 746.2 1,052.3
Net income (loss)....................................................... 72.9 (321.0)
---------- ----------
Balance at end of period..................................................... 819.1 731.3
---------- ----------
TREASURY STOCK
Balance at beginning of period............................................... (405.6) (406.5)
Shares reissued at cost.................................................... 1.9 6.2
---------- ----------
Balance at end of period..................................................... (403.7) (400.3)
---------- ----------
Total shareholders' equity............................................ $ 2,196.6 $ 2,105.4
========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
5
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Net income (loss)...................................... $ 11.4 $ (313.4) $ 72.9 $ (321.0)
Other comprehensive (loss) income:
Available-for-sale securities:
Net (depreciation) appreciation during the
period......................................... (76.9) 75.8 56.4 98.1
Benefit (provision) for deferred federal income
taxes.......................................... 26.9 (26.5) (19.7) (34.3)
---------- ---------- ---------- ----------
Total available-for-sale securities................. (50.0) 49.3 36.7 63.8
---------- ---------- ---------- ----------
Derivative instruments:
Net appreciation (depreciation) during the
period......................................... 14.0 (37.2) 11.0 (59.4)
(Provision) benefit for deferred federal
income taxes................................... (4.9) 13.0 (3.9) 20.8
---------- ----------- ---------- ----------
Total derivative instruments........................ 9.1 (24.2) 7.1 (38.6)
---------- ----------- ---------- ----------
Other comprehensive (loss) income ..................... (40.9) 25.1 43.8 25.2
---------- ----------- ---------- ----------
Comprehensive (loss) income............................ $ (29.5) $ (288.3) $ 116.7 $ (295.8)
========== =========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements.
6
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
--------------------------------
(In millions) 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)........................................................ $ 72.9 $ (321.0)
Adjustments to reconcile net income (loss) to net cash (used in)
provided by operating activities:
Net realized investment (gains) losses ............................... (18.4) 83.9
Net gains on derivative instruments................................... (1.4) (30.3)
Impairment of capitalized technology costs............................ 2.9 29.8
Net amortization and depreciation..................................... 24.0 14.0
Interest credited to contractholder deposit funds and trust
instruments supported by funding obligations........................ 43.2 67.5
Deferred federal income taxes......................................... (3.9) (246.3)
Change in deferred acquisition costs.................................. 103.0 320.5
Change in premiums and notes receivable, net of reinsurance payable... 86.9 0.3
Change in accrued investment income................................... 16.2 10.9
Change in policy liabilities and accruals, net........................ (232.1) 728.0
Change in reinsurance receivable...................................... (4.8) (10.2)
Change in expenses and taxes payable.................................. (232.5) 74.8
Other, net............................................................ (13.9) 18.8
----------- -----------
Net cash (used in) provided by operating activities............. (157.9) 740.7
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from disposals and maturities of available-for-sale fixed
maturities........................................................... 2,092.0 2,957.5
Proceeds from disposals of equity securities............................. 81.3 16.5
Proceeds from disposals of other investments............................. 69.0 34.4
Proceeds from mortgages matured or collected............................. 41.7 35.9
Proceeds from collections of installment finance and notes receivable.... 236.3 267.2
Purchase of available-for-sale fixed maturities.......................... (2,032.0) (2,342.4)
Purchase of equity securities............................................ (36.0) (1.7)
Purchase of other investments............................................ (24.0) (27.6)
Capital expenditures..................................................... (3.2) (6.9)
Net receipts (payments) related to margin deposits on derivative
instruments.......................................................... 48.8 (37.4)
Disbursements to fund installment finance and notes receivable........... (229.9) (232.3)
Other investing activities, net.......................................... 2.3 -
----------- -----------
Net cash provided by investing activities....................... 246.3 663.2
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES
Deposits to contractholder deposit funds................................. - 100.0
Withdrawals from contractholder deposit funds............................ (27.5) (822.1)
Deposits to trust instruments supported by funding obligations........... - 111.9
Withdrawals from trust instruments supported by funding obligations...... (124.6) (109.4)
Change in short-term debt................................................ - (83.3)
Treasury stock reissued at cost.......................................... - 1.1
----------- -----------
Net cash used in financing activities........................... (152.1) (801.8)
----------- -----------
Net change in cash and cash equivalents..................................... (63.7) 602.1
Cash and cash equivalents, beginning of period.............................. 389.8 350.2
----------- -----------
Cash and cash equivalents, end of period.................................... $ 326.1 $ 952.3
=========== ===========
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 The
Hanover Insurance Company ("Hanover") and Citizens Insurance Company of America
("Citizens"), AFC's principal property and casualty companies; Allmerica
Financial Life Insurance and Annuity Company ("AFLIAC") and First Allmerica
Financial Life Insurance Company ("FAFLIC"), AFC's principal life insurance and
annuity 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 nine months ended September 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.
On October 27, 2003, the Company announced the cessation of retail sales through
its independent broker/dealer. These operations were conducted through VeraVest
Investments, Inc. ("VeraVest") and consisted of the distribution of third party
investment and insurance products. VeraVest is a wholly-owned subsidiary of
AFLIAC.
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 ("GMDB")or other insurance benefit features, potential
benefits available only on annuitization and liabilities related to sales
inducements, such as immediate bonus payments, persistency 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, but expects that a substantial increase in the GMDB reserve will be
required. The determination of the GMDB reserve under SOP 03-1 is complex and
requires various assumptions including, among other items, estimates of future
market returns and expected contract persistency. Based on the equity market
level as of October 31, 2003, the Company currently estimates that the impact of
adopting SOP 03-1 could require the recording of an additional $80 million to
$120 million pre-tax charge to earnings. This reflects adjustments to the
Company's GMDB reserves and its Deferred Acquisition Cost asset. The actual
effect of adoption may differ from the current estimates based on actual market
returns, persistency and other matters.
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. On
November 7, 2003, the FASB
8
deferred the aforementioned measurement provisions of Statement No. 150 for
securities issued before November 5, 2003. The Company has $300 million of
mandatorily redeemable preferred securities of a subsidiary trust holding solely
junior subordinated debentures of the Company. These securities embody an
unconditional obligation that requires the Company to redeem the securities on a
stated maturity date. As such, the securities have been reclassified from the
mezzanine level of the balance sheet to debt, at face value. Dividends on the
securities are classified as interest expense in the current year. In addition,
these instruments contain a settlement alternative which occurs as a result of a
"Special Event." A special event could occur if a change in laws and/or
regulations or the application or interpretation of these laws and/or
regulations causes the interest from these debentures to become taxable income
(or non-deductible expense), or for the subsidiary trust to become deemed an
"investment company" and subject to the filing requirements of Registered
Investment Companies.
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 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 September 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 $10.2 million at September 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" ("EITF No. 94-3").
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.
9
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 $12.0 million of the
aforementioned $46.9 million loss has been generated from the operations of the
discontinued business.
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 $88.1
million at September 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 September 30,
2003 and 2002, the discontinued segment had assets of $291.3 million and $305.2
million, respectively, and assets at December 31, 2002 of $290.4 million. Assets
in this segment consist primarily of invested assets and reinsurance
recoverables. Liabilities at September 30, 2003 and 2002 totaled $357.4 million
and $361.7 million, respectively, and $347.5 million at December 31, 2002.
Liabilities consist primarily of policy liabilities. Revenues for the
discontinued operations were $3.4 million and $6.0 million for the quarters
ended September 30, 2003 and 2002, respectively, and $11.2 million and $18.0
million for the nine months ended September 30, 2003 and 2002, respectively.
4. Significant Transactions
In October 2003, the Company announced the cessation of its Allmerica Financial
Services ("AFS")segment retail broker/dealer operations. These operations had
distributed third-party investment and insurance products through VeraVest.
Results as of September 30, 2003 include a pre-tax charge of $11.0 million for
asset impairments in connection with this action. The Company expects to incur
an estimated additional pre-tax charge of $25 to $30 million for severance and
other expenses related to this decision, primarily in the fourth quarter of
2003, and to a lesser extent in the first quarter of 2004.
In the first nine months of 2003, the Company retired $78.8 million of long-term
funding agreement obligations which resulted in a pre-tax gain of $5.7 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 $6.4
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.
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 nine months of 2003 related
to the settlement of post-closing items.
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 which has been accounted
for under the guidance of EITF No. 94-3. 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 408 employees have
been terminated as of September 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
September 30, 2003, the Company has made payments of approximately $13.1 million
related to this restructuring plan, of which approximately $11.2
10
million relates to severance and other employee related costs. During the first
nine months of 2003, the Company eliminated an additional 158 positions related
to this restructuring, of which 132 employees have been terminated as of
September 30, 2003. The Company recorded a pre-tax charge of $6.0 million,
consisting of $5.7 million of employee-related costs and $0.3 million related to
contract cancellations, during the first nine months of 2003.
5. Federal Income Taxes
Federal income tax expense for the nine months ended September 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.
It is the Company's policy to estimate taxes for interim periods based on
estimated annual effective tax rates which are derived, in part, from expected
annual pre-tax income. However, the federal income tax benefit for the nine
months ended September 30, 2002 was computed based on the first nine months of
2002 as a discrete period due to the uncertainty regarding the Company's ability
to reliably estimate pre-tax income for the remainder of the year. The Company
could not reliably estimate pre-tax income for the remainder 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 nine
months ended September 30, 2002, the Company recognized a benefit of $11.6
million related to a settlement of certain prior years' federal income tax
returns.
6. Other Comprehensive (Loss) Income
The following table provides a reconciliation of gross unrealized (losses) gains
to the net balance shown in the Statements of Comprehensive Income:
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------------------------------
(In millions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
Unrealized (losses) gains on available-for-sale securities:
Unrealized holding (losses) gains arising during period (net
of income tax benefit (expense) of $29.5 million and ($23.0)
million for the quarters ended September 30, 2003 and 2002
and ($27.5) million and ($16.0) million for the nine months
ended September 30, 2003 and 2002)............................... $ (54.9) $ 42.9 $ 51.1 $ 30.0
Less: reclassification adjustment for (losses) gains included
in net income (net of income tax benefit (expense) of $2.6
million and $3.5 million for the quarters ended September 30,
2003 and 2002 and ($7.8) million and $18.3 million for the
nine months ended September 30, 2003 and 2002)................... (4.9) (6.4) 14.4 (33.8)
--------- --------- --------- ---------
Total available-for-sale securities.................................. (50.0) 49.3 36.7 63.8
--------- --------- --------- ---------
Unrealized gains (losses) on derivative instruments:
Unrealized holding gains (losses) arising during period (net
of income tax (expense) benefit of ($5.6) million and $7.8
million for the quarters ended September 30, 2003 and 2002
and ($7.5) million and $54.6 million for the nine months
ended September 30, 2003 and 2002)............................... 10.4 (14.7) 13.9 (101.4)
Less: reclassification adjustment for gains (losses) included
in net income (net of income tax (expense) benefit of ($0.7)
million and ($5.2) million for the quarters ended September
30, 2003 and 2002 and ($3.6) million and $33.8 million for
the nine months ended September 30, 2003 and 2002)............... 1.3 9.5 6.8 (62.8)
--------- --------- --------- ---------
Total derivative instruments......................................... 9.1 (24.2) 7.1 (38.6)
--------- --------- --------- ---------
Other comprehensive (loss) income.................................... $ (40.9) $ 25.1 $ 43.8 $ 25.2
========= ========= ========= =========
11
7. Closed Block
Summarized financial information of the Closed Block, established in 1995 upon
demutualization, is as follows for the periods indicated:
(Unaudited)
September 30, December 31,
(In millions) 2003 2002
--------------------------------------------------------------------------------------------------------
ASSETS
Fixed maturities-at fair value (amortized cost of $513.4 and $498.1)... $ 547.8 $ 542.4
Mortgage loans......................................................... 45.4 46.6
Policy loans........................................................... 158.8 167.4
Cash and cash equivalents.............................................. 1.0 0.3
Accrued investment income.............................................. 13.4 13.1
Deferred policy acquisition costs...................................... 6.8 8.2
Deferred federal income taxes.......................................... 0.9 5.4
Other assets........................................................... 3.8 4.7
--------- ---------
Total assets....................................................... $ 777.9 $ 788.1
========= =========
LIABILITIES
Policy liabilities and accruals....................................... $ 756.3 $ 767.5
Policyholder dividends................................................ 70.4 57.1
Other liabilities..................................................... 2.7 23.8
--------- ---------
Total liabilities.................................................. $ 829.4 $ 848.4
========= =========
Excess of Closed Block liabilities over assets designated to the
Closed Block.......................................................... $ 51.5 $ 60.3
Amounts included in accumulated other comprehensive income:
Net unrealized investment losses, net of deferred federal income
tax benefit of $6.7 million and $5.2 million.......................... (12.4) (9.6)
--------- ---------
Maximum future earnings to be recognized from Closed Block
assets and liabilities................................................ $ 39.1 $ 50.7
========= =========
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------------------------------------
(In millions) 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------
REVENUES
Premiums........................................................ $ 6.6 $ 7.5 $ 33.5 $ 38.3
Net investment income........................................... 11.6 13.0 35.4 39.0
Net realized investment (losses) gains.......................... - (2.2) 4.3 (4.0)
-------- -------- -------- --------
Total revenues............................................... 18.2 18.3 73.2 73.3
-------- -------- -------- --------
BENEFITS AND EXPENSES
Policy benefits................................................. 15.9 16.4 65.5 64.0
Policy acquisition expenses..................................... 0.8 0.6 1.2 1.8
Other operating expenses........................................ 0.2 0.1 0.5 0.5
-------- -------- -------- --------
Total benefits and expenses.................................. 16.9 17.1 67.2 66.3
-------- -------- -------- --------
Contribution from the Closed Block........................ $ 1.3 $ 1.2 $ 6.0 $ 7.0
======== ======== ======== ========
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, 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 maker 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 consisted of two
components. First, the segment included its independent broker/dealer, VeraVest,
which distributed third-party investment and insurance products. On October 27,
2003, the Company announced the cessation of retail sales through its
independent broker/dealer operations. Second, this segment retains and services
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 nine months 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. During 2003, the Company adopted
Statement No. 150 (see Note 2 - New Accounting Pronouncements) which resulted in
the reclassification of dividends on the Company's mandatorily redeemable
preferred securities to interest expense in the Corporate segment. In accordance
with Statement No. 131, all periods have been restated to reflect current
presentation.
Management evaluates the results of the aforementioned segments based on a
pre-tax 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 Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues:
Property and Casualty..................................... $ 612.3 $ 624.1 $ 1,836.6 $ 1,865.5
Allmerica Financial Services.............................. 162.0 204.3 544.4 624.0
Asset Management.......................................... 24.0 32.0 68.3 96.0
Corporate................................................. 0.4 1.1 1.4 4.3
Intersegment revenues..................................... (3.1) (2.3) (9.2) (6.8)
--------- --------- ---------- ----------
Total segment revenues.................................. 795.6 859.2 2,441.5 2,583.0
Adjustments to segment revenues:
Net realized investment (losses) gains.................... (8.0) (7.8) 18.4 (83.9)
Consideration from sale of defined contribution
business................................................ - 3.5 - 3.5
--------- --------- ---------- ----------
Total revenues.......................................... $ 787.6 $ 854.9 $ 2,459.9 $ 2,502.6
========= ========= ========== ==========
Segment income (loss) before federal income taxes and the
cumulative effect of change in accounting principle:
Property and Casualty.................................... $ 38.6 $ 58.5 $ 103.4 $ 149.1
Allmerica Financial Services............................. (5.8) (540.2) 15.0 (624.3)
Asset Management......................................... 5.2 5.7 10.2 15.9
Corporate................................................ (23.9) (23.7) (71.8) (67.6)
--------- --------- ---------- ----------
Segment income (loss) before federal income taxes...... 14.1 (499.7) 56.8 (526.9)
Adjustments to segment income (loss):
Net realized investment (losses) gains, net of
deferred acquisition cost amortization................ (10.2) (1.0) 7.5 (67.0)
Gain from retirement of trust instruments supported
by funding obligations................................ 0.7 - 5.7 -
Income from sale of universal life business.............. - - 5.5 -
Net gains (losses) on derivative instruments............. 0.5 (0.1) 1.4 30.3
Restructuring costs...................................... (1.2) - (5.8) -
Consideration from sale of defined contribution
business.............................................. - 3.5 - 3.5
Sales practice litigation................................ - - - 2.5
Other (1)................................................ - 6.2 - 18.5
--------- --------- ---------- ----------
Income (loss) before federal income taxes and the
cumulative effect of change in accounting
principle............................................ $ 3.9 $ (491.1) $ 71.1 $ (539.1)
========= ========= ========== ==========
(1) Reflects an adjustment for the reclassification, in accordance with Statement No. 131, of costs that were
classified as minority interest prior to the adoption of Statement No. 150.
Identifiable Assets Deferred Acquisition Costs
- --------------------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
September 30, December 31, September 30, December 31,
(In millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Property and Casualty (1).................. $ 6,240.6 $ 6,056.1 $ 225.8 $ 215.1
Allmerica Financial Services............... 17,349.4 1 8,971.6 909.2 1,027.1
Asset Management........................... 1,414.8 1 ,559.8 - -
Corporate and intersegment eliminations.... 3.2 (8.6) - -
------------- ------------- ------------- -------------
Total................................... $ 25,008.0 $ 26,578.9 $ 1,135.0 $ 1,242.2
============= ============= ============= =============
(1) Includes assets related to the Company's discontinued operations of $291.3 million and $290.4 million at
September 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 Nine Months Ended
September 30, September 30,
-------------------------------------------------------
(In millions) 2003 2002 2003 2002
- -------------------------------------------------------------------------------------------------------------------------
Basic shares used in the calculation of earnings per share...... 52.9 52.9 52.9 52.9
Dilutive effect of securities (1):
Employee stock options..................................... 0.3 - 0.1 -
Non-vested stock grants.................................... 0.1 - 0.1 -
--------- --------- --------- ---------
Diluted shares used in the calculation of earnings per share.... 53.3 52.9 53.1 52.9
========= ========= ========= =========
(1) Excludes 0.1 million and 0.3 million shares due to antidilution for the quarter and nine months ended September 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" ("Statement No. 123"), to stock-based compensation.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------------------------------------------
(In millions, except per share data) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------
Net income (loss), as reported................................. $ 11.4 $ (313.4) $ 72.9 $ (321.0)
Stock-based compensation expense included in
reported net income, net of taxes....................... 0.1 0.2 0.3 0.5
Total stock-based compensation expense
determined under fair value based method for all
awards, net of taxes.................................... (2.9) (3.3) (8.4) (9.8)
--------- --------- --------- ---------
Net income (loss), after effect of Statement No. 123........... $ 8.6 $ (316.5) $ 64.8 $ (330.3)
========= ========= ========= =========
Earnings per share:
Basic - as reported........................................ $ 0.22 $ (5.93) $ 1.38 $ (6.07)
========= ========= ========= =========
Basic - after effect of Statement No. 123.................. $ 0.16 $ (5.99) $ 1.22 $ (6.25)
========= ========= ========= =========
Diluted - as reported...................................... $ 0.21 $ (5.93) $ 1.37 $ (6.07)
========= ========= ========= =========
Diluted - after effect of Statement No. 123................ $ 0.16 $ (5.99) $ 1.22 $ (6.25)
========= ========= ========= =========
15
11. Commitments and Contingencies
Litigation and Regulatory Actions
In November 2003, VeraVest, along with approximately 450 other broker/dealer
firms, was directed by the National Association of Securities Dealers, Inc.
("NASD"), to advise each of its customers who purchased Class A mutual fund
shares through VeraVest from January 1, 1999 through November 3, 2003 that an
NASD industry-wide survey indicated that customers did not uniformly receive
elegible breakpoint discounts and that as a result, the customer may be entitled
to a refund. The Company intends to comply and pay any refunds which may be due.
At this time the Company is unable to estimate the amount of any such refunds.
Although they are not expected to be material to the Company's financial
position, the refunds could have a material effect on the results of operations
for a particular quarter.
On July 24, 2002, an action captioned "American National Bank and Trust Company
of Chicago, as Trustee f/b/o Emerald Investments Limited Partnership, and
Emerald Investments Limited Partnership v. Allmerica Financial Life Insurance
and Annuity Company" was commenced in the United States District Court for the
Northern District of Illinois, Eastern Division. In 1999, plaintiffs purchased
two variable annuity contracts with initial premiums of $2.5 million each.
Plaintiffs, who AFLIAC identified as engaging in frequent transfers of
significant sums between sub-accounts that in its opinion constituted "market
timing", were subject to restrictions upon such trading that AFLIAC imposed in
2001. Plaintiffs allege that such restrictions constitute a breach of the terms
of the annuity contracts and seek unspecified damages, including lost profits
and prejudgment interest. Plaintiffs have filed a motion for summary judgment as
to liability, which AFLIAC has opposed. AFLIAC has filed a counterclaim against
plaintiffs, alleging breach of the duty of good faith and fair dealing. No
discovery on these matters has ensued to date and it is too early in the
proceedings for the Company to assess its likelihood of prevailing or the amount
of potential damages if it should ultimately be unsuccessful in defending this
lawsuit. The outcome is not expected to be material to the Company's financial
position, although it could have a material effect on the results of operations
for a particular quarter.
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 and is involved, from time to time, in
investigations and proceedings by governmental and self-regulatory agencies. In
the Company's opinion, based on the advice of legal counsel, the ultimate
resolutions of such proceedings will not have a material effect on the Company's
financial position, although they could have a material effect on the results of
operations for a particular quarter.
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................................................. 18-38
Consolidated Overview............................................... 18-22
Segment Results..................................................... 22-38
Property and Casualty............................................ 22-30
Allmerica Financial Services..................................... 31-36
Asset Management................................................. 37-38
Corporate........................................................ 38
Investment Portfolio.................................................. 39-41
Derivative Instruments................................................ 41
Income Taxes.......................................................... 42
Statutory Capital of Insurance Subsidiaries........................... 43
Liquidity and Capital Resources....................................... 43-44
Contingencies......................................................... 44
Insurance Ratings..................................................... 45
Recent Developments................................................... 45
Forward-Looking Statements............................................ 45-46
Glossary.............................................................. 47-48
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 The Hanover Insurance Company
("Hanover") and Citizens Insurance Company of America ("Citizens"), our
principal property and casualty companies. Our results of operations also
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; 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 maker
evaluates 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" ("Statement No. 131").
On October 27, 2003, we announced the cessation of retail sales through our
independent broker/dealer operations in the fourth quarter of 2003. These
operations were conducted through VeraVest Investments, Inc. ("VeraVest") and
consisted of the distribution of third party investment and insurance products.
Earnings from VeraVest were reflected in our AFS segment. VeraVest is a
wholly-owned subsidiary of AFLIAC.
Segment income excludes certain items which are included in net income, such as
federal income taxes and 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. In addition, as a result of adopting Statement of Financial
Accounting Standards No. 150, "Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity", we have reclassified dividends
on our Capital Securities (mandatorily redeemable preferred securities of a
subsidiary trust holding solely junior subordinated debentures of the Company)
to interest expense in the Corporate segment (see Corporate Segment). In
accordance with Statement No. 131, we have restated prior periods to reflect
current presentation.
Results of Operations
Consolidated Overview
Our consolidated net income for the third quarter of 2003 was $11.4 million,
compared to a net loss of $313.4 million for the same period in 2002. The
increase in the third quarter resulted primarily from a $513.8 million
improvement in segment income principally related to AFS, partially offset by a
$179.1 million decrease in the corresponding federal income tax benefit. The
federal income tax benefit on segment income declined from $184.7 million in the
third quarter of 2002 to $5.6 million in 2003.
Consolidated net income for the first nine months of 2003 was $72.9 million,
compared to a net loss of $321.0 million for the first nine months of 2002. This
increase again resulted primarily from a $583.7 million improvement in segment
income, principally related to AFS, partially offset by a $224.3 million
reduction in the corresponding federal income tax benefit. The federal income
tax benefit on segment income declined from $229.6 million in the first nine
months of 2002 to $5.3 million for the same period in 2003. Also contributing to
the increase in net income was a $50.0 million change in net realized investment
gains (losses) to a net gain of $6.4 million for the first nine months of 2003,
from a net loss of $43.6 million for the comparable period of 2002.
18
The following table reflects segment income (loss) and a reconciliation to
consolidated net income (loss).
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Segment income (loss) before federal income taxes:
Property and Casualty.................................... $ 38.6 $ 58.5 $ 103.4 $ 149.1
Allmerica Financial Services............................. (5.8) (540.2) 15.0 (624.3)
Asset Management......................................... 5.2 5.7 10.2 15.9
Corporate................................................ (23.9) (23.7) (71.8) (67.6)
----------- ----------- ----------- -----------
Segment income (loss) before federal income taxes........... 14.1 (499.7) 56.8 (526.9)
----------- ----------- ----------- -----------
Federal income tax benefit on segment income............. 5.6 184.7 5.3 229.6
Net realized investment (losses) gains, net of taxes
and deferred acquisition cost amortization........... (8.2) (0.7) 6.4 (43.6)
Net gains on derivative instruments, net of taxes........ 0.3 - 0.9 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.................... 0.4 - 3.7 -
Restructuring costs, net of taxes........................ (0.8) - (3.8) -
Additional consideration received from sale of
defined contribution business, net of taxes.......... - 2.3 - 2.3
Sales practice litigation, net of taxes.................. - - - 1.6
----------- ----------- ----------- -----------
Income (loss) before cumulative effect of change in
accounting principle...................................... 11.4 313.4) 72.9 (317.3)
Cumulative effect of change in accounting principle,
net of taxes........................................ - - - (3.7)
----------- ----------- ----------- -----------
Net income (loss)........................................... $ 11.4 $ (313.4) $ 72.9 $ (321.0)
=========== =========== =========== ===========
Net income (loss) includes the following items (net of taxes) by segment:
Quarter Ended September 30, 2003
---------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- -------------------------------------------------------------------------------------------------------------------
Net realized investment (losses) gains,
net of taxes and deferred acquisition
cost amortization.......................... $(4.3) $(4.3) $0.4 $ - $(8.2)
Net gains on derivative instruments.......... - - 0.3 - 0.3
Gain from retirement of trust instruments
supported by funding obligations........... - - 0.4 - 0.4
Restructuring costs.......................... - (0.8) - - (0.8)
Quarter Ended September 30, 2002
---------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- -------------------------------------------------------------------------------------------------------------------
Net realized investment (losses) gains, net
of taxes and deferred acquisition cost
amortization............................... $(0.3) $(2.1) $0.6 $1.1 $(0.7)
Additional consideration received from sale
of defined contribution business........... - 2.3 - - 2.3
19
Nine Months Ended September 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............................... $5.4 $(5.8) $9.9 $(3.1) $6.4
Net gains on derivative instruments........... - - 0.9 - 0.9
Income from sale of universal life business... - 3.6 - - 3.6
Gain from retirement of trust instruments
supported by funding obligations........... - - 3.7 - 3.7
Restructuring costs........................... 0.2 (4.0) - - (3.8)
Nine Months Ended September 30, 2002
---------------------------------------------------------------------
Property Allmerica
and Financial Asset
(In millions) Casualty Services Management Corporate Total
- -------------------------------------------------------------------------------------------------------------------
Net realized investment (losses) gains, net
of taxes and deferred acquisition cost
amortization.............................. $(0.9) $(25.9) $(19.1) $2.3 $(43.6)
Net gains on derivative instruments.......... - - 19.7 - 19.7
Additional consideration received from sale
of defined contribution business.......... - 2.3 - - 2.3
Sales practice litigation.................... - 1.6 - - 1.6
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Our segment income before federal income taxes was $14.1 million in the third
quarter of 2003, compared to a loss of $499.7 million during the same period of
2002. This increase was primarily attributable to a $534.4 million improvement
from the AFS segment, partially offset by lower segment income from the Property
and Casualty segment of $19.9 million.
AFS segment income in 2003 reflects a charge of $11.0 million relating to the
impairment of assets resulting from our decision to cease all retail sales of
VeraVest. The loss from the AFS segment in 2002 reflects net charges of $556.4
million resulting from additional declines in equity market values during the
third quarter, ratings downgrades and our decision to cease sales of proprietary
life insurance and annuity products. These charges include $487.5 million of
additional amortization of the deferred policy acquisition cost ("DAC") asset
and $39.1 million due to a change in the assumptions related to the long-term
cost of guaranteed minimum death benefits ("GMDB") for variable annuity
products. In addition, in 2002 we recognized impairments of capitalized
technology costs associated with variable products totaling $29.8 million.
The decrease in Property and Casualty segment income in the quarter was
principally due to an increase in catastrophe losses of $12.9 million. In
addition, segment income decreased due to adverse development on prior years'
loss and loss adjustment expense ("LAE") reserves of $15.3 million in the third
quarter of 2003, compared to $7.9 million of favorable development for the same
period in 2002. Net investment income also decreased $5.9 million during the
third quarter of 2003. These decreases were partially offset by estimated net
premium rate increases of approximately $24 million, as well as a slight
improvement in current accident year non-catastrophe claims.
Our federal income tax benefit on segment income was $5.6 million for the third
quarter of 2003 compared to $184.7 million for the third quarter of 2002. The
large tax benefit in 2002 resulted from the significant loss recognized by the
AFS segment last year.
Net realized losses on investments, after taxes and deferred acquisition cost
amortization, were $8.2 million in the third quarter of 2003, primarily due to
losses recognized from impairments of fixed maturities and equity securities.
During the third quarter of 2002, we recognized net realized losses on
investments, after taxes and deferred acquisition cost amortization, of $0.7
million, primarily due to impairments of fixed maturities and equity securities,
largely offset by gains recognized from sales of fixed maturities.
20
Net gains on derivative instruments, net of taxes, for the third quarter of 2003
were $0.3 million as a result of derivative activity that does not meet the
requirements of hedge accounting. There were no gains or losses on derivative
instruments for the third quarter of 2002.
During the third quarter of 2003, we retired $13.2 million of long-term funding
agreement obligations, resulting in a gain of $0.4 million, net of taxes.
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 third quarter of 2003, we recognized $0.8 million of these
costs, net of taxes, primarily resulting from position eliminations in the AFS
segment.
During the third quarter of 2002, we received additional consideration of $2.3
million, net of taxes, related to the sale of our defined contribution business
in 2001.
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
Our segment income before federal income taxes was $56.8 million for the first
nine months of 2003, compared to a loss of $526.9 million for the same period
during 2002. This increase was primarily attributable to improved earnings from
the AFS segment of $639.3 million, partially offset by a decrease in income from
the Property and Casualty segment of $45.7 million.
AFS segment loss in 2003 reflects a charge of $11.0 million relating to the
impairment of assets resulting from our decision to cease all retail sales of
VeraVest. The 2002 loss in the AFS segment reflects net charges of $698.3
million resulting from additional declines in equity market values during the
third quarter, ratings downgrades and our decision to cease sales of proprietary
life insurance and annuity products. These charges include $629.4 million of
additional amortization of the DAC asset and $39.1 million due to a change in
the assumptions related to the long-term cost of GMDB for variable annuity
products. In addition, we recognized impairments of capitalized technology costs
associated with variable products totaling $29.8 million.
The decrease in Property and Casualty segment income is primarily attributable
to approximately $41 million of estimated increased current accident year
non-catastrophe claims, primarily in personal lines. In addition, policy
acquisition and other underwriting expenses increased $25.8 million, and
catastrophe losses increased $25.5 million in the first nine months of 2003. The
decrease is also attributable to a $21.9 million charge resulting from an
adverse arbitration decision within a voluntary insurance pool that we exited in
1996. Partially offsetting these decreases were estimated net premium rate
increases of approximately $77 million.
Our federal income tax benefit on segment income was $5.3 million for the first
nine months of 2003 compared to an income tax benefit of $229.6 million for the
same period of 2002. The tax benefit in 2002 is primarily the result of the loss
recognized by the AFS segment, as well as an $11.6 million favorable settlement
of federal income tax returns related to 1977 through 1981.
Net realized gains on investments, after taxes and deferred acquisition cost
amortization, were $6.4 million for the first nine months of 2003, primarily due
to gains recognized from the sale of fixed maturities, partially offset by
impairments of fixed maturities and equity securities. During the first nine
months of 2002, we recognized net realized losses on investments, after taxes
and deferred acquisition cost amortization, of $43.6 million, primarily due to
impairments of fixed maturities and losses related to the termination of certain
derivative instruments, partially offset by gains recognized from the sale of
fixed maturities.
Net gains on derivative instruments, after taxes, for the first nine months of
2003 were $0.9 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 nine months 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 nine months of 2003, we retired $78.8 million of long-term
funding agreement obligations, resulting in a gain of $3.7 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 nine months of 2003, we recognized $3.8 million of
costs, net of taxes, primarily resulting from position eliminations in the AFS
segment.
In addition, during the third quarter of 2002, we received additional
consideration of $2.3 million, net of taxes, related to the sale of the defined
contribution business in 2001.
21
We also recognized a benefit of $1.6 million in the first nine months of 2002 as
a result of refining cost estimates related to a class action lawsuit which was
settled in 1999.
Additionally, we recognized a $3.7 million loss, net of taxes, during the first
quarter of 2002 resulting from the adoption of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets".
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 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 for the periods indicated:
Quarter Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net premiums written.................................. $ 588.7 $ 596.8 $ 1,710.2 $ 1,723.8
========== ========== ========== ==========
Net premiums earned................................... $ 561.2 $ 568.3 $ 1,677.2 $ 1,697.0
Net investment income................................. 44.9 50.8 136.7 153.4
Other income.......................................... 6.2 5.0 22.7 15.1
---------- ---------- ---------- ----------
Total segment revenues.................. 612.3 624.1 1,836.6 1,865.5
---------- ---------- ---------- ----------
Losses and operating expenses
Losses and loss adjustment expense (1)................ 411.3 405.6 1,251.7 1,246.2
Policy acquisition expenses........................... 113.7 105.7 338.6 316.2
Other operating expenses.............................. 48.7 54.3 142.9 154.0
---------- ---------- ---------- ----------
Total losses and operating expenses........ 573.7 565.6 1,733.2 1,716.4
---------- ---------- ---------- ----------
Segment income............................................. $ 38.6 $ 58.5 $ 103.4 $ 149.1
========== ========== ========== ==========
(1) Includes policyholders' dividends of $0.2 million and $0.6 million for the quarters ended September 30, 2003 and 2002,
respectively, and $0.9 million and $0.8 million for the nine months ended September 30, 2003 and 2002, respectively.
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Property and Casualty's segment income decreased $19.9 million to $38.6 million
for the third quarter of 2003. Catastrophe losses increased $12.9 million, to
$16.9 million for the third quarter of 2003, compared to an unusually low $4.0
million for the same period in 2002. In addition, the decrease in segment income
was attributable to adverse development on prior years' reserves of $15.3
million in the third quarter of 2003, compared to $7.9 million of favorable
development for the same period in 2002. The unfavorable change in development
is primarily in the workers' compensation line. Segment income also reflected a
decrease in net investment income of $5.9 million. The net increase in policy
acquisition expenses and other operating expenses was primarily due to increased
commissions and pension costs. Partially offsetting these items was a benefit
from an estimated $24 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. In addition, we experienced a slight improvement in
current accident year non-catastrophe claims, primarily in the workers'
compensation line.
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 September 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................. $ 283.3 71.0 $ 285.3 71.5
Homeowners.......................... 114.5 64.6 102.5 61.6
Other personal...................... 12.0 50.5 12.1 29.6
----------- -----------
Total personal........................ 409.8 68.8 399.9 68.1
----------- -----------
Commercial Lines:
Workers' compensation............... 30.0 81.3 38.4 45.3
Commercial automobile............... 44.2 42.4 48.5 48.4
Commercial multiple peril........... 83.0 53.9 84.7 56.8
Other commercial.................... 22.4 73.8 26.1 60.8
----------- -----------
Total commercial...................... 179.6 58.2 197.7 52.9
----------- -----------
Total.................................. $ 589.4 65.4 $ 597.6 62.7
=========== ===========
Statutory combined ratio (2):
Personal lines...................... 104.0 103.9
Commercial lines.................... 99.7 93.1
Total............................... 102.4 100.0
Statutory underwriting (loss) gain:
Personal lines...................... $ (23.2) $ (23.1)
Commercial lines.................... 1.4 14.8
----------- -----------
Total............................... (21.8) (8.3)
Reconciliation to segment income:
Net investment income............... 44.9 50.8
Other income and expenses, net...... 4.9 3.9
Corporate overhead expenses (3)..... 8.6 8.1
Net deferred acquisition expenses... 5.3 9.0
Other Statutory to GAAP adjustments. (3.3) (5.0)
----------- -----------
Segment income.......................... $ 38.6 $ 58.5
=========== ===========
(1) Statutory loss ratio is a common industry measurement of the results of property and casualty insurance underwriting.
This ratio reflects incurred claims compared to premiums earned.
(2) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting.
This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting
expenses incurred to premiums written. Federal income taxes, net investment income and other non-underwriting expenses are
not reflected in the statutory combined ratio.
(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 $9.9 million, or 2.5%, to $409.8
million for the third quarter of 2003. This was primarily the result of an
increase of $12.0 million, or 11.7%, in the homeowners 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. These favorable items were partially offset by a
$2.0 million, or 0.7% decrease in the personal automobile line attributable to a
decrease in policies in force, primarily in the Northeast since September 30,
2002.
Personal lines' statutory underwriting results decreased $0.1 million to an
underwriting loss of $23.2 million for the third quarter of 2003. The increase
in the underwriting loss was primarily attributable to increased catastrophe
losses of $10.3 million, to $12.5 million for the third quarter of 2003,
compared to $2.2 million for the same period in 2002. This was partially offset
by approximately $11 million of estimated net premium rate increases earned
during the third quarter of 2003. Also, development on prior years' reserves
improved $2.2 million, to $6.2 million of adverse development for the third
quarter of 2003, from $8.4 million of adverse development for the same period in
2002, primarily in the personal automobile line.
Commercial Lines
Commercial lines' net premiums written decreased $18.1 million, or 9.2%, to
$179.6 million for the third quarter of 2003. This was primarily the result of a
decrease of $8.4 million, or 21.9%, in the workers' compensation line and
decreases of $4.3 million, or 8.9%, and $1.7 million, or 2.0%, in the commercial
automobile and commercial multiple peril lines, respectively, since September
30, 2002. Policies in force decreased 5.6%, 10.6% and 4.4% in the workers'
compensation, commercial automobile and commercial multiple peril lines,
respectively, since September 30, 2002, primarily as a result of the agency
management actions initiated in 2001, and our continuing reunderwriting efforts.
Partially offsetting these decreases in policies in force were rate increases in
all of the commercial lines since September 30, 2002.
Commercial lines' statutory underwriting gain decreased $13.4 million to an
underwriting gain of $1.4 million in the third quarter of 2003. Development on
prior years' reserves deteriorated $25.5 million, to $9.1 million of adverse
development for the third quarter of 2003, from $16.4 million of favorable
development for the same period in 2002. The unfavorable change in development
is primarily in the workers' compensation line. In addition, catastrophe losses
increased $2.6 million, to $4.4 million for the third quarter of 2003, compared
to $1.8 million for the same period in 2002. The decrease in underwriting
results also reflected approximately a $5 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 $13 million of estimated net premium rate increases during the
third quarter of 2003. In addition, current accident year non-catastrophe claims
improved approximately $5 million, primarily in the workers' compensation and
commercial automobile lines.
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
Property and Casualty's segment income decreased $45.7 million, or 30.7%, to
$103.4 million for the nine months ended September 30, 2003. The decrease was
primarily due to $41 million of estimated increased current accident year
non-catastrophe claims, primarily in personal lines principally attributable to
the adverse weather in the first quarter of 2003. There was also a $25.5 million
increase in catastrophe losses, to $49.3 million for the nine months ended
September 30, 2003, compared to $23.8 million for the same period in 2002. Also,
segment income for the nine months ended September 30, 2003 was negatively
affected by a charge of $21.9 million from the arbitration decision related to a
single large property claim within a voluntary insurance pool. We exited this
pool in 1996. Segment income also reflected a decrease in net investment income
of $16.7 million for the nine months ended September 30, 2003. Additionally,
segment income for the nine months ended September 30, 2003 was negatively
affected by a $25.8 million increase in policy acquisition and other
underwriting expenses primarily due to an increase in commissions, 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. Partially offsetting these negative items was approximately $77 million
of estimated net premium rate increases. In addition, other income has increased
by $7.6 million due to increased fee income from third party claim
administration, interest income on an intercompany loan to AMGRO, Inc., a
premium financing subsidiary, and an escheatment settlement.
24
The following tables summarize the results of operations for the Property and
Casualty Segment:
Nine Months Ended September 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................... $ 834.6 74.0 $ 837.7 70.9
Homeowners............................ 287.5 65.9 262.4 63.8
Other personal........................ 32.3 38.2 33.2 42.6
----------- -----------
Total personal.......................... 1,154.4 71.0 1,133.3 68.4
----------- -----------
Commercial Lines:
Workers' compensation................. 101.2 73.2 117.8 69.1
Commercial automobile................. 133.7 49.6 149.0 59.4
Commercial multiple peril............. 253.3 51.1 248.7 56.3
Other commercial...................... 68.0 70.4 75.7 41.9
----------- -----------
Total commercial........................ 556.2 57.2 591.2 58.0
----------- -----------
Total.................................... $ 1,710.6 66.4 $ 1,724.5 64.6
=========== ===========
Statutory combined ratio (2):
Personal lines........................ 106.8 103.3
Commercial lines...................... 98.3 99.9
Total................................. 103.9 102.0
Statutory underwriting (loss) gain:
Personal lines........................ $ (86.2) $ (51.5)
Commercial lines...................... 10.6 10.9
----------- -----------
Total................................. (75.6) (40.6)
Reconciliation to segment income:
Net investment income................. 136.7 153.4
Other income and expenses, net........ 18.5 12.5
Corporate overhead expenses (3)....... 25.1 21.8
Net deferred acquisition expenses..... 10.7 15.2
Other Statutory to GAAP adjustments... (12.0) (13.2)
----------- -----------
Segment income........................... $ 103.4 $ 149.1
=========== ===========
(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 $21.1 million, or 1.9%, to $1.2
billion for the nine months ended September 30, 2003. This is primarily the
result of an increase of $25.1 million, or 9.6% in the homeowners line,
partially offset by a $3.1 million, or 0.4%, 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 5.2% in policies in force
since September 30, 2002, primarily in the Northeast.
Personal lines' statutory underwriting loss increased $34.7 million, or 67.2%,
to an underwriting loss of $86.2 million for the nine months ended September 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. 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. Catastrophe losses increased $13.0 million, to $30.9 million for the
nine months ended September 30, 2003, compared to $17.9 million for the same
period in 2002. In addition, underwriting results were unfavorably affected by a
$6.4 million increase in adverse development in 2003. Additionally, policy
acquisition expenses increased due to higher pension costs and commissions.
Partially offsetting these items was approximately $33 million of estimated net
premium rate increases.
25
Commercial Lines
Commercial lines' net premiums written decreased $35.0 million, or 5.9%, to
$556.2 million for the nine months ended September 30, 2003. This is primarily
the result of the agency management actions we initiated in 2001 and our
continuing re-underwriting efforts. As a result of these actions, policies in
force decreased 5.6%, 10.6% and 4.4% in the workers' compensation, commercial
automobile, and commercial multiple peril lines, respectively, since September
30, 2002. Partially offsetting these decreases in policies in force were rate
increases in all of the commercial lines since September 30, 2002.
Commercial lines' underwriting gains decreased $0.3 million to an underwriting
gain of $10.6 million for the nine months ended September 30, 2003. This year's
results reflect the aforementioned charge of $21.9 million from the voluntary
pool arbitration decision. Catastrophe losses increased $12.4 million, to $18.3
million for the nine months ended September 30, 2003, compared to $5.9 million
for the same period in 2002. The underwriting results were also negatively
affected by an approximate $12 million increase in expenses, primarily due to
commissions, 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 to these unfavorable items,
development on prior years' reserves deteriorated $11.1 million, to $2.8 million
of favorable development for the nine months ended September 30, 2003, from
$13.9 million of favorable development for the same period in 2002. Largely
offsetting these items was approximately $44 million of net premium rate
increases during the nine months ended September 30, 2003 and improvement in
current accident year non-catastrophe claims frequency, primarily in the
commercial automobile and workers' compensation lines.
Investment Results
Net investment income before taxes declined $16.7 million, or 10.9%, to $136.7
million for the nine months ended September 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 6.1% in 2003 compared to
6.5% 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 our investment results will continue to be
negatively affected by lower prevailing fixed maturity investment rates.
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 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.
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.
26
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, primarily in the state of Michigan. 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.
27
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.
The table below provides a reconciliation of the beginning and ending reserve
for unpaid losses and LAE as follows:
Nine Months Ended
September 30,
-------------------------------
(In millions) 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.................... 1,233.7 1,247.4
Increase in provision for insured events of prior years......... 16.1 (1.5)
----------- -----------
Total incurred losses and LAE..................................... 1,249.8 1,245.9
----------- -----------
Payments, net of reinsurance recoverable:
Losses and LAE attributable to insured events of current year... 608.7 610.3
Losses and LAE attributable to insured events of prior years.... 642.8 619.7
----------- -----------
Total payments.................................................... 1,251.5 1,230.0
----------- -----------
Change in reinsurance recoverable on unpaid losses................ 28.4 (7.7)
----------- -----------
Reserve for losses and LAE, end of period............................ $ 2,988.4 $ 2,929.7
=========== ===========
As part of an ongoing process, we have re-estimated reserves for all prior
accident years and the reserves were increased by $16.1 million for the nine
months ended September 30, 2003 and decreased by $1.5 million for the nine
months ended September 30, 2002.
The table below summarizes the reserve for losses and LAE by line of business:
September 30, December 31,
(In millions) 2003 2002
- -----------------------------------------------------------------------------
Personal automobile.............. $ 1,102.9 $ 1,018.5
Homeowners and other............. 225.2 246.3
------------ ------------
Total personal................ 1,328.1 1,264.8
Workers' compensation............ 605.6 637.7
Commercial automobile............ 303.1 327.4
Commercial multiple peril........ 554.5 566.3
Other commercial................. 197.1 165.5
------------ ------------
Total commercial.............. 1,660.3 1,696.9
------------ ------------
Total reserve for losses and LAE.... $ 2,988.4 $ 2,961.7
============ ============
28
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.
The table below summarizes the change in provision for insured events of prior
years by line of business.
Nine Months
Ended September 30,
(In millions) 2003 2002
- ------------------------------------------------------------------------------
Increase (decrease) in loss provision for
insured events of prior years:
Personal automobile........................... $ 17.1 $ 11.7
Homeowners and other.......................... 6.7 6.2
--------- ---------
Total personal............................... 23.8 17.9
Workers' compensation......................... 7.5 (3.7)
Commercial automobile......................... (4.1) 0.3
Commercial multiple peril..................... (10.8) 2.3
Other commercial.............................. 23.7 (1.1)
--------- ---------
Total commercial............................. 16.3 (2.2)
--------- ---------
Increase in loss provision for
insured events of prior years................. 40.1 15.7
Decrease in LAE provision for
insured events of prior years................. (24.0) (17.2)
--------- ---------
Increase (decrease) in total loss and LAE
provision for insured events of prior years... $ 16.1 $ (1.5)
========= =========
Estimated loss reserves for claims occurring in prior years developed
unfavorably by $16.1 million during the first nine months of 2003 and favorably
by $1.5 million during the first nine months of 2002. The unfavorable loss
reserve development during the first nine months of 2003 is primarily the result
of the $21.9 million charge in the other commercial line resulting from the
aforementioned voluntary pool arbitration decision. Adverse development in the
workers' compensation line was primarily due to increased claim severity.
Additionally, loss reserve development was affected by an increase in personal
automobile claim severity related to medical settlements in Michigan. Because
these settlements have risen beyond previous estimates, reserve increases have
been recognized in the period in which the information was 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 resulted from increased severity on
personal lines prior years' reserves.
During the first nine months of 2003 and 2002, estimated LAE reserves for claims
occurring in prior years developed favorably by $24.0 million and $17.2 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, among other items, 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 show improvement in 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 on prior years' LAE reserves for the nine months ended
September 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 $25.4 million at September 30, 2003 and $25.6 million
at December 31, 2002, net of reinsurance of $16.6 million and $16.0 million at
September 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 $46.8 million at September 30, 2003 and $45.2 million at 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.
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 the September 27, 2002 cessation of
sales of proprietary products are substantially different from those in effect
prior to that date. Before this date, 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.
In addition, on October 27, 2003, we announced our decision to discontinue the
retail sales operations of our broker/dealer, VeraVest. As a result, we will no
longer sell non-proprietary products through our brokerage sales force, and we
will terminate all contracts with VeraVest's registered representatives. These
registered representatives consisted primarily of advisors who constituted our
former Agency channel. A small registered broker/dealer infrastructure will
continue in order to support the existing variable proprietary business of AFS.
In the quarter ended September 30, 2003, we recognized $11.0 million of asset
impairments as a result of this decision. Of this amount, $8.1 million relates
to receivables and fixed assets and $2.9 million relates to capitalized software
development costs. Further, we expect to incur an additional pre-tax charge of
approximately $25 million to $30 million for severance and other expenses
related to this decision, primarily in the fourth quarter of 2003, and to a
lesser extent in the first quarter of 2004. We expect that brokerage and
investment management income and brokerage and investment management variable
expenses will be significantly lower than in the past. Other operating expenses
may also be affected. In addition, this decision may have a negative impact on
persistency and financial results in the Agency distribution channel. Although
we believe that our current, overall DAC assumptions remain reasonable, we
cannot provide assurance that persistency in this channel will not differ from
our assumptions, and therefore DAC amortization may be affected in future
periods.
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
Segment revenues
Premiums........................................... $ 7.0 $ 7.9 $ 34.6 $ 39.2
Fees:
Fees from surrenders............................. 13.3 11.5 54.3 27.4
Other proprietary product fees................... 62.5 85.6 188.4 264.5
Net investment income.............................. 48.3 76.6 154.0 220.0
Brokerage and investment management income (1)..... 24.0 16.2 86.6 53.7
Other income....................................... 6.9 6.5 26.5 19.2
--------- --------- --------- ---------
Total segment revenues................................ 162.0 204.3 544.4 624.0
Policy benefits, claims and losses................. 60.9 209.2 197.2 414.1
Policy acquisition expenses........................ 31.0 441.2 115.2 609.2
Brokerage and investment management variable
expenses (1)..................................... 14.4 10.9 56.2 34.9
Other operating expenses........................... 61.5 83.2 160.8 190.1
--------- --------- --------- ---------
Segment (loss) income................................. $ (5.8) $ (540.2) $ 15.0 $ (624.3)
========= ========= ========= =========
(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. Each of these items primarily relates
to the operations of VeraVest.
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Allmerica Financial Services segment loss was $5.8 million in the third quarter
of 2003 compared to a loss of $540.2 million in the third quarter of 2002. The
third quarter of 2003 includes the aforementioned charge of $11.0 million
relating to the impairment of assets resulting from our decision to discontinue
the retail operations of VeraVest. The loss in the third quarter of 2002
reflects net charges of $556.4 million resulting from additional declines in
equity market values during the quarter, ratings downgrades, and our decision to
cease sales of proprietary life insurance and annuity products. These charges
included $487.5 million of additional amortization of the DAC asset, a change in
the assumptions related to the long-term cost of GMDB for variable annuity
products resulting in a reserve of $106.7 million, partially offset by a
reduction in DAC amortization of $67.6 million, and the recognition of
impairments of capitalized technology costs associated with variable products
totaling $29.8 million.
31
Annuity redemptions during the third quarter of 2003 were $493.6 million,
compared to $477.7 million during the third quarter of 2002. Increased
redemptions resulted in additional surrender fees of $1.8 million, from $11.5
million in the third quarter of 2002, to $13.3 million in the third quarter of
2003. However, the additional surrender fees were substantially offset by
additional DAC amortization of $1.6 million, reflecting our current DAC
assumptions, which mandate a higher amortization level as a percentage of gross
annuity profits.
Other proprietary product fees decreased $23.1 million, to $62.5 million in the
third 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 $28.3
million, to $48.3 million in the third quarter of 2003, primarily due to lower
average invested general account assets. This resulted primarily from increased
redemptions and the transfer of assets related to the sale of our universal life
insurance business. In addition, net investment income decreased due to the
replacement of high-yield investments with lower yielding, higher quality fixed
income securities (see Investment Portfolio).
Brokerage and investment management income increased $7.8 million, to $24.0
million in the third quarter of 2003. Increased sales of non-proprietary
products made through VeraVest, resulted in additional brokerage income of $11.2
million in the third quarter of 2003. The fees generated from these sales were
partially offset by additional commissions of $5.7 million paid to registered
representatives. Investment management income declined $1.6 million due to lower
average assets under management.
Policy benefits decreased $148.3 million, to $60.9 million in the third quarter
of 2003. At September 30, 2002, based on our revised expectations for the
long-term cost of GMDB, we recorded a reserve increase of $106.7 million.
Excluding the effect of the reserve adjustment in 2002, policy benefits would
have decreased $41.6 million. This decline is primarily the result of lower
expenses related to GMDB, the sale of our universal life insurance business and
lower interest credited on general account assets. Expenses related to GMDB,
excluding the aforementioned $106.7 million reserve adjustment, declined $17.2
million, from $28.7 million in the quarter ended September 30, 2002 to $11.5
million in the quarter ended September 30, 2003. See also "Guaranteed Minimum
Death Benefits" below.
Policy acquisition expenses decreased $410.2 million, to $31.0 million in the
third quarter of 2003. In the third quarter of 2002, we recorded five separate
adjustments totaling $487.5 million which increased DAC amortization. See
"Deferred Acquisition Costs" below for a detailed discussion of these
adjustments to the DAC asset in 2002. In addition, as a result of the $106.7
million GMDB reserve adjustment mentioned above, DAC amortization was reduced by
$67.6 million as of September 30, 2002. 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 $9.7 million in
the third quarter of 2003 versus the same period in 2002. The primary reason for
this $9.7 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.
Brokerage and investment management variable expenses increased $3.5 million, to
$14.4 million in the third quarter of 2003. The increase primarily reflects the
aforementioned $5.7 million increase in commissions paid to registered
representatives, partially offset by lower investment management expenses due to
lower average assets under management.
Other operating expenses decreased $21.7 million, to $61.5 million in the third
quarter of 2003. The decrease is primarily due to a $29.8 million impairment
expense in the third quarter of 2002 related to technology used in our
proprietary variable annuity and variable universal life business. Of this
amount, $29.1 million relates to capitalized software development costs. The
remaining $0.7 million relates to technology hardware. In the third quarter of
2003, we recognized the aforementioned $11.0 million charge related to asset
impairments resulting from our decision to discontinue retail sales operations
of VeraVest. Excluding the asset impairments of 2003 and 2002, other operating
expenses would have decreased $2.9 million. This 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 deferring these types of costs.
32
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
Allmerica Financial Services segment income was $15.0 million in the first nine
months of 2003 compared to a loss of $624.3 million in the first nine months of
2002. Income in the first nine months of 2003 includes a charge of $11.0 million
relating to the impairment of assets resulting from our decision to discontinue
the retail operations of VeraVest. The loss in the first nine months of 2002
reflects net charges of $698.3 million resulting from the cumulative effect of
the significant, persistent decline in equity market values during the two years
and nine months immediately preceding this period, ratings downgrades, and our
decision to cease sales of proprietary life insurance and annuity products.
Theses charges included $629.4 million of additional amortization of the DAC
asset, a change in the assumptions related to the long-term cost of GMDB for
variable annuity products resulting in a reserve increase of $106.7 million,
partially offset by a reduction in DAC amortization of $67.6 million, and the
recognition of impairments of capitalized technology costs associated with
variable products totaling $29.8 million.
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 nine months of
2003 were $2.0 billion compared to $1.5 billion in the first nine months of
2002. The increased redemptions resulted in additional surrender fees of $26.9
million, from $27.4 million in the first nine months of 2002, to $54.3 million
in the first nine months of 2003. However, the additional surrender fees were
substantially offset by additional DAC amortization of approximately $24.3
million, reflecting our current DAC assumptions, which mandate a higher
amortization level as a percentage of gross annuity profits.
Other proprietary product fees decreased $76.1 million, to $188.4 million in the
first nine 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 $66.0 million, to $154.0 million
in the first nine months of 2003, primarily due to lower average invested
general account assets. This resulted primarily from increased redemptions and
the transfer of assets related to the sale of the universal life insurance
business. In addition, net investment income decreased due to the replacement of
high-yield investments with lower yielding, higher quality fixed income
securities (see Investment Portfolio).
Brokerage and investment management income increased $32.9 million, to $86.6
million in the first nine months of 2003. Increased sales of non-proprietary
products made through VeraVest resulted in additional brokerage income of $41.2
million in the first nine months of 2003. The fees generated from these sales
were partially offset by additional commissions of $24.6 million paid to
registered representatives. Investment management income declined $6.8 million
due to lower average assets under management.
Other income increased $7.3 million in the first nine months of 2003, to $26.5
million primarily due to a termination fee related to one large group variable
universal life insurance client, increased revenues generated by our financial
software subsidiary, and higher asset-based distribution fees.
Policy benefits decreased $216.9 million, to $197.2 million in the first nine
months of 2003. At September 30, 2002, based on our revised expectations for the
long-term cost of GMDB, we recorded a reserve increase of $106.7 million.
Excluding the effect of the reserve adjustments in 2002, policy benefits would
have decreased $110.2 million. This decline is primarily the result of the sale
of our universal life insurance business, lower expenses related to GMDB and
lower interest credited on general account assets. Expenses related to GMDB,
excluding the aforementioned $106.7 million reserve adjustment, declined $30.4
million, from $64.9 million in the first nine months of 2002 to $34.5 million in
the first nine months of 2003. See also "Guaranteed Minimum Death Benefits"
below.
Policy acquisition expenses decreased $494.0 million, to $115.2 million in the
first nine months of 2003. During the first nine months of 2002, we recorded six
separate adjustments to DAC amortization totaling $629.4 million. In addition,
as a result of the $106.7 million GMDB reserve adjustment mentioned above, DAC
amortization was reduced by $67.6 million as of September 30, 2002. 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 $67.8 million in the first nine months of 2003 versus the
same period in 2002. The primary reason for this $67.8 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 $9.2
million net decrease in DAC amortization in the first nine months of 2003. See
"Deferred Acquisition Costs" below for a detailed discussion of these additional
items and the adjustments to the DAC asset in 2002.
33
Brokerage and investment management variable expenses increased $21.3 million,
to $56.2 million in the first nine months of 2003. The increase primarily
reflects the aforementioned $24.6 million increase in commissions paid to
registered representatives, partially offset by lower investment management
expenses due to lower average assets under management.
Other operating expenses decreased $29.3 million, to $160.8 million in the first
nine months of 2003. The decrease is primarily due to a $29.8 million impairment
expense in the third quarter of 2002 related to technology used in our
proprietary variable annuity and variable universal life business. Of this
amount, $29.1 million relates to capitalized software development costs. The
remaining $0.7 million relates to technology hardware. In the third quarter of
2003, we recognized the aforementioned $11.0 million charge related to asset
impairments resulting from our decision to discontinue retail operations of
VeraVest. Excluding the asset impairments in 2003 and 2002, other operating
expenses would have decreased $10.5 million. This 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 deferring these types of costs.
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
estimated total gross profits from such products. 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 $487.5 million of DAC adjustments in the third quarter of
2002 consisted of five separate items while the $629.4 million of DAC
adjustments in 2002 consisted of six separate items. First, we anticipated that
our decision to cease new sales of proprietary life insurance and annuity
products would unfavorably affect the persistency of then existing customer
accounts. This resulted in the reduction of our estimate of future gross profits
and $171.1 million of additional DAC amortization in both the quarter and nine
months ended September 30, 2002.
Second, 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 $65.7 million for the third quarter of
2002 and $202.8 million for the first nine months of 2002, reflecting the
significant and sustained declines in equity market values.
Third, we reviewed and reset our assumptions regarding future market-related
appreciation of separate account assets and its application of the
reversion-to-the-mean accounting methodology. In view of the additional market
declines in the third quarter of 2002, as well as the reduced time horizon
resulting for the revised persistency expectations, we reduced our expected rate
of annual appreciation to 8 percent (2 percent per quarter), starting with
September 30, 2002 asset levels. This reduced expected future profits and
resulted in $43.3 million of additional DAC amortization for the quarter and
nine months ended September 30, 2002.
Fourth, we changed our estimates of future fees from certain annuity contracts,
which decreased amortization by $8.5 million for the nine months ended September
30, 2002.
The next DAC adjustment resulted in an increase in our estimate of the long-term
cost of GMDB, which increased DAC amortization by $48.4 million for the third
quarter of 2002 and $61.7 million for the first nine months of 2002.
Finally, we recognized additional amortization of $159.0 million for both the
quarter and nine months ended September 30, 2002 related to our Partners
distribution channel. After reviewing all assumptions affecting future profits
assumed in its DAC methodology, including the effect of the aforementioned
adjustments, we determined that the remaining DAC asset related to Partners
exceeded the present value of total expected gross profits by $159.0 million as
of September 30, 2002.
During the first nine months of 2003, we had three additional items which
reduced DAC amortization by a total of $9.2 million. First, because the equity
market returns in the first nine months of 2003 exceeded the assumptions in our
DAC estimation process, we recognized reduced DAC amortization of $8.2 million.
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.
34
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 in the first nine months of 2003.
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 in September 2002. This is primarily the
result of the significant decline in redemptions, from the first quarter to the
third 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 in the first
nine months of 2003. Changes in persistency, including changes resulting from
our decision to cease retail sales through VeraVest as described previously, 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 September 30, 2003, the difference
between the GMDB and the current account value (the "net amount at risk") for
all existing contracts was approximately $3.3 billion, compared to approximately
$3.6 billion at June 30, 2003 and $4.7 billion at March 31, 2003. 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 September 30, 2003
levels, the net amount at risk is estimated to decrease or increase,
respectively, 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 policy of providing reserves for GMDB based on our
best estimate of the long-term cost of GMDB. These reserves differ from the
statutory GMDB reserves disclosed in the section "Statutory Capital of Insurance
Subsidiaries", which are calculated using prescribed statutory accounting
principles. The following table provides a reconciliation of our beginning and
ending reserve for GMDB:
Nine Months
Quarter Ended Ended
------------------------------------
(In millions) September 30, 2003
- -------------------------------------------------------------------------------------------------
Reserve for GMDB, beginning of period...................... $ 41.4 $ 81.2
Provision for GMDB......................................... 11.5 34.5
Claims from policyholders.......................... (20.1) (75.8)
Claims ceded to reinsurers (1)..................... 18.8 58.4
--------- ---------
Claims, net of reinsurance (2)............................. (1.3) (17.4)
GMDB reinsurance premiums paid (2)......................... (19.6) (66.3)
--------- ---------
Reserve for GMDB, end of period............................ $ 32.0 $ 32.0
========= =========
(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.
35
Based on account values as of September 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.
In 2004, we will be adopting 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 provides guidance
for, among other items, determining liabilities for GMDB costs. Although we are
currently assessing the effect that adoption of SOP 03-1 will have on our
results of operations, we expect that a substantial increase in the GMDB reserve
will be required. The determination of the GMDB reserve under SOP 03-1 is
complex and requires various assumptions including, among other items, estimates
of future market returns and expected contract persistency. Based on the equity
market level as of October 31, 2003, we currently estimate that the impact of
adopting SOP 03-1 could require us to record an additional $80 million to $120
million pre-tax charge to earnings. This reflects adjustments to both our GMDB
reserve and our DAC asset. The actual effect of adoption may differ from our
current estimates based on actual market returns, persistency and other matters.
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
September 30,
--------------------------------------------------------------
2003 2002
- --------------------------------------------------------------------------------------------------
Account Account
(In millions) Values (1) Redemptions (2) Values (1) Redemptions (2)
- --------------------------------------------------------------------------------------------------
Agency $ 4,303.5 $ 218.5 $ 5,438.6 $ 146.8
Select 2,799.0 111.6 3,488.5 138.0
Partners 4,381.3 163.5 5,143.9 192.9
--------------------------------------------------------------
Total $ 11,483.8 $ 493.6 $ 14,071.0 $ 477.7
==============================================================
Nine Months Ended
September 30,
--------------------------------------------------------------
2003 2002
- --------------------------------------------------------------------------------------------------
Account Account
(In millions) Values (3) Redemptions (2) Values (3) Redemptions (2)
- --------------------------------------------------------------------------------------------------
Agency $ 4,623.6 $ 908.3 $ 5,993.8 $ 431.8
Select 2,995.3 510.1 3,406.0 437.8
Partners 4,507.2 618.1 5,123.3 623.9
--------------------------------------------------------------
Total $ 12,126.1 $ 2,036.5 $ 14,523.1 $ 1,493.5
==============================================================
(1) Account values at September 30 reflect market values as of July 1 of the year indicated.
(2) Redemptions reflect activity for the period indicated.
(3) Account values at September 30 reflect market values as of January 1 of the year indicated.
Redemptions in the third quarter and first nine months of 2003 are higher than
those in the third quarter and first nine months of 2002. 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 than we had
previously experienced. An increase in redemptions was expected. In addition, we
expect an increase in redemptions in the former Agency channel as a result of
our decision to cease retail sales through VeraVest and terminate the contracts
of the registered representatives who constituted the former Agency channel.
Nevertheless, we believe that our current, overall DAC assumptions include
reasonable redemption levels. However, we cannot provide assurance that
redemptions will not ultimately differ from our assumptions, and therefore DAC
amortization may be affected in future periods.
36
Asset Management
The following table summarizes the results of operations for the Asset
Management segment for the periods indicated.
Quarter Ended Nine Months Ended
September 30, September 30,
---------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
Interest margins on GICs:
Net investment income............................. $ 17.1 $ 24.4 $ 55.1 $ 75.8
Interest credited................................. (14.0) (21.9) (49.9) (68.1)
--------- --------- --------- ---------
Net interest margin................................. 3.1 2.5 5.2 7.7
--------- --------- --------- ---------
Premium financing business:
Fees.............................................. 3.9 4.1 10.6 10.0
Operating expenses................................ (2.8) (2.9) (8.9) (6.7)
--------- --------- --------- ---------
Net premium financing income........................ 1.1 1.2 1.7 3.3
--------- --------- --------- ---------
Fees and other income:
External.......................................... 1.1 2.1 5.4 6.1
Internal.......................................... 1.7 1.6 3.9 4.6
Other operating expenses............................ (1.8) (1.7) (6.0) (5.8)
--------- --------- --------- ---------
Segment income...................................... $ 5.2 $ 5.7 $ 10.2 $ 15.9
========= ========= ========= =========
Average GIC deposits outstanding.................... $ 1,333.7 $ 2,119.7 $ 1,356.0 $ 2,286.0
========= ========= ========= =========
Outstanding GIC deposits, end of period............. $ 1,371.5 $ 2,159.4 $ 1,371.5 $ 2,159.4
========= ========= ========= =========
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Asset Management segment income decreased $0.5 million, or 8.8%, to $5.2 million
during the third quarter of 2003. Earnings in the third quarter of 2003 include
a $2.9 million benefit related to favorable fluctuations in foreign currency
exchange rates. Excluding the effect of this benefit, segment income would have
decreased $3.4 million, or 59.6%, primarily due to lower average GIC deposits
outstanding and the effect of replacing high yield-investments with lower
yielding, higher quality fixed income securities. In addition, earnings from
external client asset management business decreased $0.7 million primarily due
to reduced average assets under management following the loss of one large
institutional client.
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 nine months ended September 30, 2003 and in 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 and lower interest spreads
from the remaining GICs resulting from investments in lower yielding securities.
Excluding foreign currency fluctuations, we expect that net interest margins
from GICs will be break even or modestly negative in future quarters. In
addition, we expect the lower income from our external client asset management
business to continue.
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 an $1.4 million reduction in net investment
income during the third quarter of 2003, as compared to an $8.6 million
reduction in net investment income during the same period of 2002, offset by
similar reductions in GIC interest credited during both 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
$0.4 million increase in other income in the Consolidated Statements of Income
during the third 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 exchange rate fluctuations is currently
economically hedged, we cannot provide assurance that we will not experience
losses from ineffective hedges in the future. Also, the foreign currency futures
used to hedge certain yen-denominated liabilities and cash flows will continue
to generate earnings volatility, as in the current quarter.
37
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
Asset Management segment income decreased $5.7 million, or 35.8%, to $10.2
million during the nine months ended September 30, 2003. Earnings in the first
nine months of 2003 include an $1.4 million benefit related to favorable
fluctuations in foreign currency exchange rates. Excluding the effect of this
benefit, segment income would have decreased $7.1 million, or 44.7%, primarily
due to lower average GIC deposits outstanding and the effect of replacing
high-yield investments with lower yielding, higher quality fixed income
securities. In addition, net premium financing income decreased $1.6 million,
primarily due to higher interest costs, and earnings from external client asset
management business decreased $1.5 million, primarily due to the aforementioned
reduction in average assets under management and to higher expenses related to
managing external clients.
As noted above, we use derivative instruments to hedge our GIC portfolio (see
Derivative Instruments). These hedges resulted in a $4.4 million reduction in
net investment income during the first nine months of 2003, as compared to a
$34.7 million reduction in net investment income during the same period of 2002,
offset by similar reductions in GIC interest credited during both 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 $6.4 million reduction in other income in the Consolidated
Statements of Income during the first nine 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 Nine Months Ended
September 30, September 30,
-------------------------------------------------------------
(In millions) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------------------------------
Segment revenues
Net investment income.............................. $ 0.4 $ 1.1 $ 1.4 $ 4.3
Interest expense................................... 10.0 10.0 29.9 29.9
Other operating expenses........................... 14.3 14.8 43.3 42.0
---------- ---------- ---------- ----------
Segment loss......................................... $ (23.9) $ (23.7) $ (71.8) $ (67.6)
========== ========== ========== ==========
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
Segment loss increased $0.2 million, or 0.8%, to $23.9 million in the third
quarter of 2003, principally due to lower net investment income partially offset
by lower corporate overhead costs. Net investment income decreased principally
due to lower average invested assets.
Interest expense for both periods relates to the interest paid on our Capital
Securities and Senior Debentures. Prior to the adoption of Statement No. 150,
interest expense on our Capital Securities was reflected as minority interest
(see Description of Operating Segments).
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
Segment loss increased $4.2 million, or 6.2%, to $71.8 million in the first nine
months of 2003, principally due to lower net investment income and decreased
state income tax credits recognized by the holding company. Net investment
income decreased due to lower average invested assets.
Interest expense for both periods relates to the interest paid on our Capital
Securities and Senior Debentures.
38
Investment Portfolio
We held general account investment assets diversified across several asset
classes, as follows:
September 30, 2003 December 31, 2002
-----------------------------------------------------------------
% of Total % of Total
Carrying Carrying Carrying Carrying
(Dollars in millions) Value Value Value Value
- ------------------------------------------------------------------------------------------------------------------
Fixed maturities (1).......................... $ 7,688.0 89.3% $ 8,003.1 87.1%
Equity securities (1)......................... 8.7 0.1 52.8 0.6
Mortgages..................................... 221.8 2.6 259.8 2.8
Policy loans (1).............................. 272.1 3.2 361.4 3.9
Cash and cash equivalents (1)................. 326.1 3.8 389.8 4.2
Other long-term investments................... 88.9 1.0 129.7 1.4
----------- ---------- ----------- ----------
Total....................................... $ 8,605.6 100.0% $ 9,196.6 100.0%
=========== ========== =========== ==========
(1) We carry these investments at fair value.
Total investment assets decreased $591.0 million, or 6.4%, to $8.6 billion
during the first nine months of 2003, primarily as a result of a decrease in
fixed maturities of $315.1 million, of policy loans of $89.3 million and cash
and cash equivalents of $63.7 million. These decreases resulted primarily from
the sale of our universal life insurance business and annuity redemptions 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 94.2% at September 30, 2003 and 90.5% at December 31, 2002
of our total fixed maturity portfolio.
The following table provides information about the credit quality of our fixed
maturities at September 30, 2003 and December 31, 2002:
(In millions) September 30, 2003 December 31, 2002
- -----------------------------------------------------------------------------------------------------------------
Rating Agency Amortized Carrying Amortized Carrying
NAIC Designation Equivalent Designation Cost Value Cost Value
- -----------------------------------------------------------------------------------------------------------------
1 Aaa/Aa/A $ 4,652.7 $ 4,860.1 $ 4,818.3 $ 5,061.4
2 Baa 2,252.9 2,381.5 2,076.8 2,180.5
3 Ba 223.1 229.4 443.4 410.6
4 B 123.9 128.5 225.8 212.6
5 Caa and lower 56.0 67.8 119.2 110.5
6 In or near default 17.9 20.7 32.4 27.5
----------- ----------- ----------- -----------
Total fixed maturities $ 7,326.5 $ 7,688.0 $ 7,715.9 $ 8,003.1
=========== =========== =========== ===========
Although we expect to invest new funds 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 6.1% for the nine months ended September 30, 2003 and 6.8%
for the same period of 2002. This decline reflects lower prevailing fixed
maturity investment rates since the first nine months of 2002 and an increased
emphasis on higher credit quality bonds. We expect that the lower prevailing
fixed maturity investment rates reflected in the current interest rate
environment will continue to negatively affect our investment yield.
At September 30, 2003, $299.1 million of our fixed maturities were invested in
traditional private placement securities, as compared to $423.1 million at
December 31, 2002. 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.
We recognized $52.9 million of realized losses on other-than-temporary
impairments of fixed maturities during the first nine months of 2003,
principally resulting from our exposure to below investment grade securities, as
compared to $104.8 million for the same period of 2002. Other-than-temporary
impairments of fixed maturities for the first nine months of 2003 included $18.8
million related to the airline/transportation sector, $10.4 million related to
securitized investments, $8.5 million related to the
39
industrial sector, $7.1 million related to finance sector, and $4.7 million
related to the consumer non-cyclical sector. Other-than-temporary impairments of
fixed maturities for the first nine months of 2002 included $52.2 million
related to the communication sector, $15.3 million related to securitized
investments, $11.6 million related to the airline/transportation sector, $9.9
million related to the consumer cyclical sector, $5.6 million related to the
industrial sector, $4.8 million related to utilities, and $3.9 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 at September 30, 2003 and December 31, 2002 that have been
continuously in an unrealized loss position:
September 30, 2003 December 31, 2002
-----------------------------------------------------------------
Gross Gross
Unrealized Fair Unrealized Fair
(In millions) Losses Value Losses Value
- ------------------------------------------------------------------------------------------------------------------
Investment grade fixed maturities:
0-6 months................................... $ 19.8 $ 822.6 $ 13.4 $ 287.2
7-12 months.................................. 0.1 23.7 1.1 28.5
Greater than 12 months....................... 7.8 94.1 17.4 160.9
----------- ----------- ----------- -----------
Total investment grade fixed maturities........ 27.7 940.4 31.9 476.6
Below investment grade fixed maturities:
0-6 months................................... 1.8 41.1 15.9 120.4
7-12 months.................................. 4.5 20.5 17.4 139.1
Greater than 12 months....................... 8.1 29.9 41.1 156.1
----------- ----------- ----------- -----------
Total below investment grade fixed maturities.. 14.4 91.5 74.4 415.6
Equity securities.............................. 0.2 1.2 0.4 1.1
----------- ----------- ----------- -----------
Total fixed maturities and equity securities... $ 42.3 $ 1,033.1 $ 106.7 $ 893.3
=========== =========== =========== ===========
At September 30, 2003, we had $42.3 million of gross unrealized losses, as
compared to $106.7 million at December 31, 2002, on fixed maturities and equity
securities. Approximately $5.6 million of the gross unrealized losses at
September 30, 2003 relate to investment grade fixed maturity obligations of the
U.S. Treasury, U.S. government and agency securities, states and political
subdivisions, compared to $1.8 million at December 31, 2002. At both September
30, 2003 and December 31, 2002, substantially all below investment grade
securities with an unrealized loss had been rated by the NAIC, Standard & Poor's
or Moody's.
We view the gross unrealized losses of fixed maturities and equity securities as
being temporary as it is our assessment that these securities will recover in
the near-term. Furthermore, as of September 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 our 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.
40
The following table sets forth gross unrealized losses for fixed maturities by
maturity period, and equity securities at September 30, 2003 and December 31,
2002. 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.
September 30, December 31,
(In millions) 2003 2002
- --------------------------------------------------------------------------------------------------
Due in one year or less................................. $ 2.9 $ 3.2
Due after one year through five years................... 4.0 39.8
Due after five years through ten years.................. 18.0 36.7
Due after ten years..................................... 17.2 26.6
----------- ----------
Total fixed maturities.................................... 42.1 106.3
Equity securities......................................... 0.2 0.4
----------- -----------
Total fixed maturities and equity securities.............. $ 42.3 $ 106.7
=========== ===========
We had fixed maturity securities with a carrying value of $28.3 million on
non-accrual status at September 30, 2003, as compared to $39.9 million at
December 31, 2002. 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 $7.2 million for the
nine months ended September 30, 2003, as compared to a reduction of $13.8
million for the same period of 2002. 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 $0.6 million of net realized losses on derivatives for the third
quarter of 2003, as compared to $1.2 million of gains for the same period of
2002. Similarly, we recognized $4.8 million of losses for the nine months ended
September 30, 2003, as compared to $33.2 million of losses for the same period
of 2002. The realized losses during the third quarter of 2003 and the nine
months ended September 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
gains during the third quarter of 2002 were due to fluctuations in the value of
derivatives entered into for investment purposes, which were no longer held as
of September 30, 2002. The realized losses during the nine months ended
September 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 nine months ended September 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 (gains) losses on
derivatives instruments in the Consolidated Statements of Income. These
reclassifications, which occurred during the first quarter and second quarter of
2002, were due to the termination of interest rate swap contracts.
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. In accordance
with the provisions of Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative and Hedging Activities", which we adopted 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.
41
Income Taxes
We file a consolidated United States federal income tax return that includes AFC
and its domestic subsidiaries (including non-insurance operations). We segregate
the entities included within the consolidated group 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.
Quarter Ended September 30, 2003 Compared to Quarter Ended September 30, 2002
The provision for federal income taxes before minority interest and the effect
of a change in accounting principle was a benefit of $7.5 million during the
third quarter of 2003 compared to a benefit of $181.7 million during the same
period in 2002. These benefits resulted in a consolidated effective federal tax
benefit rate of 192.3% of pre-tax income for the quarter ended September 30,
2003, compared to a consolidated effective federal tax benefit rate of 37.0% of
pre-tax losses for the quarter ended September 30, 2002. The tax benefit in 2003
reflects a decrease in expected underwriting income relative to anticipated
dividends received deduction associated with our variable products and other
permanent differences. The large benefit in 2002 was primarily due to the
significant loss recognized by the AFS segment. 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 nine months 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 remainder of 2002, principally due to
the impact of the equity market on us.
Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30,
2002
The provision for federal income taxes before minority interest and the effect
of a change in accounting principle was a benefit of $1.8 million and a benefit
of $233.8 million during the first nine months of 2003 and 2002, respectively.
These benefits resulted in a consolidated effective federal tax benefit rate of
2.5% of pre-tax income for the nine months ended September 30, 2003 compared to
a consolidated effective federal income tax benefit rate of 43.4% of pre-tax
losses for the nine months ended September 30, 2002. The tax benefit in 2003
reflects a decrease in expected underwriting income relative to anticipated
dividends received deduction associated with our variable products and other
permanent differences. The large benefit in 2002 was primarily due to the
significant loss recognized by the AFS segment, as well as an $11.6 million
favorable settlement of certain federal income tax returns related to 1977
through 1981.
42
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 statutory GMDB
reserves, Total Adjusted Capital and RBC ratios for our life insurance
subsidiaries and for Hanover, as applicable, as of September 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):
Statutory 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).......... $208.3 $149.8 $547.2 $156.6 $78.3 349% 699%
FAFLIC.............. 5.2 3.8 207.3 83.8 41.9 247% 495%
Hanover (2)......... - - 915.1 386.9 193.5 237% 473%
(1) AFLIAC's Total Adjusted Capital includes $207.3 million related to its subsidiary, FAFLIC.
(2) Hanover's Total Adjusted Capital includes $493.8 million related to its subsidiary, Citizens.
(3) AFLIAC statutory 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 lower required statutory GMDB
reserves primarily as a result of improvements in the equity market and
surrender activity.
Liquidity and Capital Resources
Net cash used for operating activities was $157.9 million during the first nine
months of 2003 versus cash provided of $740.7 million during the same period
last year. During the first nine months of 2003, cash was used as a result of
continued increased redemptions in AFS resulting from the ratings downgrades and
our decision to cease new sales of our life insurance and annuity products. In
addition, as noted below, included with the assets transferred as a result of
the sale of our universal life insurance business was approximately $100 million
of cash. Additionally, we contributed $23.0 million to our qualified pension
plan and 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, as well as a slight increase in property and casualty premium
collections.
Net cash provided by investing activities was $246.3 million during the first
nine months of 2003, compared to $663.2 million for the same period of 2002.
During 2003, net sales of fixed maturities and equity securities resulted from
increased surrenders in the AFS segment. Additionally, net receipts related to
margin deposits on futures contracts resulted from foreign currency rate
fluctuations in the Asset Management segment. Also, we received additional net
payments on mortgage loan investments as we continue to run off our existing
portfolio. In 2002, net sales of fixed maturities resulted from funding
agreement withdrawals.
Net cash used in financing activities was $152.1 million during the first nine
months of 2003, compared to net cash used in financing activities of $801.8
million for the same period of 2002. The $649.7 million decrease in cash used in
2003 is primarily due to $597.4 million of lower net funding agreement
withdrawals, including withdrawals from trust instruments supported by funding
obligations, as well as the extinguishment of our short-term debt obligation
totaling $83.3 million.
Additionally, during the first nine months of 2003, we transferred approximately
$450 million of investment assets and $100 million of cash to settle payables
related to the sale of our universal life insurance business.
43
At September 30, 2003, AFC, as a holding company, held $42.1 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 of approximately $5.0 million, net of taxes. AFC did not
receive any dividends from its insurance subsidiaries during the first nine
months of 2003. Approximately $83 million is currently available to dividend
from our property and casualty companies without prior approval from the
Insurance Commissioners in the states of domicile. Subsequent to the senior
debenture interest payment in the fourth quarter of 2003, the holding company
will hold approximately $37 million of cash and investments. Pre-tax obligations
in 2004 are expected to be consistent with those in 2003 and will total
approximately $40 million. We receive tax benefits of approximately $14 million
related to these obligations. In addition, the holding company may be required
to settle 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. In
addition, we had no commercial paper borrowings as of September 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).
Contingencies
In November 2003, VeraVest, along with approximately 450 other broker/dealer
firms, was directed by the National Association of Securities Dealers, Inc.
("NASD"), to advise each of its customers who purchased Class A mutual fund
shares through VeraVest from January 1, 1999 through November 3, 2003 that an
NASD industry-wide survey indicated that customers did not uniformly receive
eligible breakpoint discounts and that as a result, the customer may be entitled
to a refund. We intend to comply and pay any refunds which may be due. At this
time we are unable to estimate the amount of any such refunds. Although they are
not expected to be material to our financial position, the refunds could have a
material effect on our results of operations for a particular quarter.
On July 24, 2002, an action captioned "American National Bank and Trust Company
of Chicago, as Trustee f/b/o Emerald Investments Limited Partnership, and
Emerald Investments Limited Partnership v. Allmerica Financial Life Insurance
and Annuity Company" was commenced in the United States District Court for the
Northern District of Illinois, Eastern Division. In 1999, plaintiffs purchased
two variable annuity contracts with initial premiums of $2.5 million each.
Plaintiffs, who AFLIAC identified as engaging in frequent transfers of
significant sums between sub-accounts that in its opinion constituted "market
timing", were subject to restrictions upon such trading that AFLIAC imposed in
2001. Plaintiffs allege that such restrictions constitute a breach of the terms
of the annuity contracts and seek unspecified damages, including lost profits
and prejudgment interest. Plaintiffs have filed a motion for summary judgment as
to liability, which AFLIAC has opposed. AFLIAC has filed a counterclaim against
plaintiffs alleging breach of the duty of good faith and fair dealing. No
discovery on these matters has ensued to date and it is too early in the
proceedings for us to assess our likelihood of prevailing or the amount of
potential damages if we should ultimately be unsuccessful in defending this
lawsuit. The outcome is not expected to be material to our financial position,
although it could have a material effect on our results of operations for a
particular quarter.
We have been named a defendant in various other legal proceedings arising in the
normal course of business and are involved, from time to time, in investigations
and proceedings by governmental and self-regulatory agencies. Additional
information on other litigation and claims may be found in Note 11, "Commitments
and Contingencies" of the Notes to our Financial Statements of this Form 10-Q.
In our opinion, based on the advice of legal counsel, the ultimate resolutions
of such proceedings will not have a material effect on our financial position,
although they could have a material effect on our results of operations for a
particular quarter.
44
Insurance Ratings
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. As of October 15, 2003, Standard & Poor's no longer provides
ratings for our short-term debt.
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+.
The decrease in our property and casualty ratings, in particular the A.M. Best
rating, could continue to negatively affect growth, and ultimately earnings,
primarily in our commercial lines business. In addition, we could experience
lower persistency of our current commercial lines policies. We believe that the
longer the ratings remain at the current level, the greater the adverse effect
these lower ratings will have on the results of operations of our property and
casualty business. There can be no assurance that these downgrades, or any
further downgrades that may occur, will not have a material adverse effect on
our results of operations and financial position.
Recent Developments
Effective August 28, 2003, Frederick H. Eppinger, Jr. was elected as President
and Chief Executive Officer and director of Allmerica Financial Corporation. We
have initiated a review and analysis of various aspects of our operations. This
review will concentrate on operational matters relating to our business,
including a review of our markets, products, organization, financial
capabilities, agency management, regulatory environment, ancillary businesses
and service processes. It is possible that we may reorganize or restructure our
operations following the completion of such review and evaluation of our assets
and liabilities.
On October 21, 2003, Mr. John F. O'Brien resigned from our Board of Directors.
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 this Form 10-Q.
The following important factors, among others, in some cases have affected and
in the future could affect our actual results, and cause actual results to
differ materially from historical or projected results. While any of these
factors could affect our business as a whole, we have grouped certain factors by
the business segment to which we believe they are most likely to apply.
45
Risks Relating to Our Property and Casualty Insurance Business
We generate a significant portion of our total revenues through our property and
casualty insurance subsidiaries. The results of companies in the property and
casualty insurance industry historically have been subject to significant
fluctuations and uncertainties. Our profitability could be affected
significantly by (i) adverse catastrophe experience, severe weather or other
unanticipated significant losses; (ii) adverse loss development or loss
adjustment expense for events we have insured in either the current or in prior
years; (iii) increases in costs, particularly those occurring after the time our
products are priced and including construction, automobile, and medical and
rehabilitation costs; and (iv) restrictions on insurance underwriting.
Risks Relating to Our Financial Services and Asset Management Businesses
Our businesses may be affected by (i) lower appreciation 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; (ii) adverse trends
in mortality and morbidity; (iii) possible claims relating to sales practices
for insurance and investment products; (iv) earlier than expected withdrawals
from our general account annuities, GICs (including funding agreements) and
other insurance products; and (v) losses due to foreign currency fluctuations.
Risks Relating to Our Business Generally
Other market fluctuations and general economic, market and political conditions
also may negatively affect our business and profitability. These conditions
include (i) 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; (ii) 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; (iii) changes in interest rates causing a
reduction of investment income or in the market value of interest rate sensitive
investments; (iv) failure to obtain new customers, retain existing customers or
reductions in policies in force by existing customers; (v) higher service,
administrative or general expense due to the need for additional advertising,
marketing, administrative or management information systems expenditures; (vi)
the inability to attract, or the loss or retirement of key executives; (vii)
changes in our liquidity due to changes in asset and liability matching,
including the effect of defaults of debt securities; (viii) 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; (ix) 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; (x) changes in the mix of assets comprising our investment
portfolios and changes in general market conditions that may cause the market
value of our investment portfolio to fluctuate; (xi) losses resulting from our
participation in certain reinsurance pools; (xii) defaults or impairments of
debt securities held by us; (xiii) higher employee benefit costs due to changes
in market values of plan assets, interest rates and employee compensation
levels; (xiv) the effect of our restructuring actions, including any resulting
from the cessation of retail sales through VeraVest and any resulting from our
review of operational matters related to our business, including a review of our
markets, products, organization, financial capabilities, agency management,
regulatory environment, ancillary businesses and service processes; and (xv)
interruptions in our ability to conduct business as a result of terrorist
actions, catastrophes or other significant events affecting infrastructure, and
delays in recovery of our operating capabilities.
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 and DAC amortization, net amount at risk, and Actuarial Guideline 34
reserves for statutory accounting purposes. This information is an estimation
only and is based upon matters as in effect on September 30, 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.
46
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.
Loss reserves - Liabilities established by insurers to reflect the estimated
cost of claims payments and the related expenses that the insurer will
ultimately be required to pay in respect of insurance it has written. Reserves
are established for losses and for LAE.
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.
47
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.
Unearned premiums - The portion of a premium representing the unexpired amount
of the contract term as of a certain date.
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.
48
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 nine months of 2003 to
such risks or our management of such risks.
ITEM 4
CONTROLS AND PROCEDURES
Our management, including our Chief Executive Officer 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 Chief Executive Officer 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 Chief
Executive Officer 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.
49
PART II - OTHER INFORMATION
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EX-10.57 Employment Agreement, dated August 14, 2003, between the
Registrant and Frederick H. Eppinger, Jr.
EX-10.58 Separation Agreement, dated October 10, 2003, between First
Allmerica Financial Life Insurance Company and Robert P. Restrepo, Jr.
EX-10.59 Agreement dated October 10, 2003, between First Allmerica
Financial Life Insurance Company and Robert P. Restrepo, Jr. relating
to the Stock Pledge and Loan Agreement between AMGRO, Inc., a
subsidiary of the registrant, and Robert P. Restrepo, Jr.,
incorporated by reference as Exhibit 10.39 to the Allmerica Financial
Corporation June 30, 2001 report on Form 10-Q.
EX-31.1 Certification of the Chief Executive Officer, pursuant to 15
U.S.C. 78m, 78o(d), as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
EX-31.2 Certification of the 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-32.1 Certification of the Chief Executive Officer, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002.
EX-32.2 Certification of the Chief Financial Officer, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002.
EX-99.2 Important Factors Regarding Forward Looking Statements.
(b) Reports on Form 8-K
On August 19, 2003, Allmerica Financial Corporation filed a report on Form
8-K announcing that we had named Frederick Eppinger as President, Chief
Executive Officer and Director, effective September 8, 2003.
On August 28, 2003, Allmerica Financial Corporation filed a report on Form
8-K announcing the acceleration of the election of Frederick Eppinger as
President, Chief Executive Officer and Director from the previously announced
effective date of September 8, 2003 to August 28, 2003.
No other reports on Form 8-K were filed during the period covered by this
report, however:
On July 28, 2003, Allmerica Financial Corporation furnished a report on
Form 8-K under Item 12 thereof (but provided under Item 9 pursuant to SEC
interim guidance for Item 12) with respect to the issuance of a press release
announcing its financial results for the quarter ended June 30, 2003, as well as
the availability, on our website, of financial information contained in our
Statistical Supplement for the period ended June 30, 2003.
In addition:
On September 18, 2003, Allmerica Financial Corporation furnished a report
on Form 8-K under Item 9 with respect to the issuance of a press release
announcing that Robert P. Restrepo, Jr. had resigned as president of the
Allmerica Property and Casualty Companies.
50
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Allmerica Financial Corporation
Registrant
Dated November 13, 2003
/s/ Frederick H. Eppinger, Jr.
------------------------------
Frederick H. Eppinger, Jr.
President and Chief Executive Officer
Dated November 13, 2003
/s/ Edward J. Parry, III
------------------------
Edward J. Parry, III
Chief Financial Officer, Executive
Vice President and Principal
Accounting Officer
51