Note 2.   Securities

During the first quarter, one corporate debt security with an amortized cost of $1.1 million was transferred to available for sale from held to maturity due to evidence of significant deterioration in the issuer’s credit worthiness. The transfer resulted in an additional unrealized loss of $206 thousand (net of income taxes of $143 thousand) which was recorded as an increase in the accumulated other comprehensive loss.

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Note 3.   Nonperforming Loans

Note 4.   Allowance for Loan Losses

Note 5.   Recent Statements of Accounting Standards

In July 2001, the Financial Accounting Standards Board (“FASB”) issued statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, which addresses financial accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion No. 17, Intangible Assets. SFAS No. 142 requires that goodwill no longer be amortized to earnings, but instead be reviewed at least annually for impairment. Impairment losses would be charged to earnings when they occur. SFAS No. 142 requires that intangible assets other than goodwill (such as core deposit intangibles) continue to be amortized to expense over their estimated useful lives. Alliance adopted SFAS No. 142 on January 1, 2002. Alliance had intangible assets of $57,000 at December 31, 2001 of which $8,000 of intangible mortgage servicing rights will continue to amortize and $49,000 of goodwill, which under SFAS 142, will not be amortized.

In August 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002. Earlier adoption is permitted. The Company does not expect that the adoption of this statement will have a material impact on its consolidated financial statements.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment and Disposal of Long-Lived Assets, which is effective for financial statements issued for fiscal years beginning after December 15, 2001 and interim periods within those fiscal years. The provisions of this statement are to be applied prospectively. The adoption of this statement did not affect the Company’s consolidated financial statements.

In April 2002, the FASB issued SFAS No 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which updates, clarifies and simplifies several existing accounting pronouncements. SFAS No. 4 required all gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. Other provisions of SFAS No. 145 are not pertinent to the Company’s operations. SFAS No. 145 is effective for financial statements issued on or after May 15, 2002 except that the provisions related to SFAS No. 4 and No. 64 are effective for fiscal years beginning after May 15, 2002. Early adoption is encouraged. The adoption of this statement has not and is not expected to have a material impact on its consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires that a liability be recognized for these costs only when incurred, while existing practice calls for recognition of a liability when an entity commits to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002 and is not expected to have a material impact on the Company’s consolidated financial statements.

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ITEM 2    MANAGEMENT’S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS

Special Note Regarding Forward-Looking Statements

This report contains certain “forward-looking statements”. These forward-looking statements, which are included in Management’s Discussion and Analysis, describe future plans or strategies and include the Company’s expectations of future financial results. The words “believe,” “expect,” “anticipate,” “estimate,” “project” and similar expressions identify forward-looking statements. The Company’s ability to predict results or the effect of future plans or strategies or qualitative or quantitative changes based on market risk exposure is inherently uncertain. Factors which could affect actual results include but are not limited to change in general market interest rates, general economic conditions, legislative/regulatory changes, fluctuations of interest rates, changes in the quality or composition of the Company’s loan and investment portfolios, deposit flows, competition, demand for financial services in the Company’s markets, and changes in the accounting principles, policies, and guidelines. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements.

SUMMARY

Alliance reported 5% earnings growth for the second quarter of 2002. Net income totaled $865 thousand ($.32 per share), compared to $821 thousand ($.31 per share) a year earlier. Earnings grew by 4% for the first half of the year. Net income totaled $1.715 million ($.63 per share), compared to $1.647 million ($.63 per share) a year earlier.

Alliance retained the quarterly cash dividend at 7.5 cents per share, payable on August 20, 2002 to shareholders of record as of August 6, 2002. In May, 2002, Alliance completed a 10% stock split effected as a stock dividend. By retaining the cash dividend at 7.5 cents per share after the split, the Company has increased its cash dividend payout by 10%, beginning in August.

The increased dividend payout reflects the continued operating growth produced by Alliance. Quarter-end total assets exceeded $400 million for the first time due to ongoing deposit growth this year and last year. Alliance recently announced plans to open a new full service office in Enfield at the intersection of Hazard Avenue (Route 190) and Palomba Drive. Planned for a Spring 2003 opening, this office will serve the Company’s expanding customer base in this important town, adjacent to its existing Tolland County market. With new offices in South Windsor and Enfield, Tolland Bank will have a major presence along both interstate highways (I-84 and I-91) serving northeastern Connecticut.

Alliance was recently ranked among the 15 highest performers nationally in its peer group, based on profitability, growth, efficiency, and loan quality. This annual performance ranking was published by SNL Financial in its May, 2002 issue of Thrift Investor based on the 218 smaller public thrifts (excluding the 100 largest thrifts). Loan performance remained good, with no net chargeoffs in the most recent quarter and only $12 thousand in net chargeoffs for the first half of 2002. Despite the impact of low interest rates, return on equity remained above 15%, and Alliance was positioned to benefit from any future increase in interest rates. New account activity has been strong for the Company’s competitive home equity lines of credit and its time deposit account promotions.

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Net interest income increased by $60 thousand (2%) in the second quarter and by $164 thousand (3%) in the first half, compared to the prior year. Net interest income growth reflected an 11% annualized growth rate in earning assets during the first six months of this year. Most asset growth was held in short term investments at quarter-end. Due primarily to the comparatively lower yield on short term investments, the net interest margin declined to 3.37% in the most recent quarter from 3.63% in the fourth quarter of 2001. For the first six months of 2002, the net interest margin was 3.52%, compared to 3.84% in the same period of the prior year.

Service charges and other income increased by $118 thousand (27%) and by $282 thousand (37%) in the second quarter and first six months of 2002 compared to 2001. Income increased in all major loan and deposit fee income categories due to higher volume, together with higher bank owned life insurance income. Net securities gains of $300 thousand were recorded in the first six months of 2002 due to sales of equity securities which were viewed as fully valued.

Non-interest expense increased by $356 thousand (17%) in the second quarter and by $605 thousand (14%) in the first half of 2002 compared to 2001. Compensation expense grew by 20% for the first six months, reflecting staff and salary increases, together with higher pension and benefits expense. Other expense increases were generally related to higher business volumes.

Total regular loans (excluding government guaranteed loans) increased at a 3% annualized rate during the most recent six months and total deposits increased at an 18% annualized rate. Deposit growth was recorded in all major categories, and was concentrated in short term municipal deposits, personal savings accounts, and time accounts reflecting promotions of medium term maturities. Average transactions accounts increased at a 10% annualized rate from the fourth quarter of 2001 to the second quarter of 2002, providing the additional benefit of these low cost funds.

Nonperforming assets totaled $2.8 million at June 30, 2002, measuring .70% of total assets. The loan loss allowance measured 1.70% of total regular loans and 139% of nonperforming loans at the end of the quarter, compared to 1.62% and 172% at year-end 2001, respectively. The higher allowance resulted in a $237 thousand first half loan loss provision, compared to $134 thousand in the first half of 2001.

Shareholders’ equity totaling $23.2 million at quarter-end measured 5.7% of total assets, which was unchanged from year-end 2001. Book value per share was $8.96 at quarter-end. Return on shareholders’ equity measured 15.4% during the second quarter and first half of 2002. The Company’s capital remained in excess of all regulatory requirements at June 30, 2002.

This discussion and analysis updates, and should be read in conjunction with, Management’s Discussion and Analysis included in the 2001 Annual Report on Form 10-K filed by Alliance on March 6, 2002. In the following discussion, income statement comparisons are against the same period of the previous year and balance sheet comparisons are against the previous fiscal year-end, unless otherwise noted.

Net Interest Income: As noted above, growth in net interest income has been produced by balance sheet growth. Higher income in the first half of 2002 includes the benefit of loan growth booked in the second half of 2001. Quarterly net interest income peaked in the first quarter of 2002, and decreased by $125 thousand in the most recent quarter.

The net interest margin decreased to 3.37% in the most recent quarter, down substantially from the margin in the prior five quarters. Since the fourth quarter of 2001, the yield on earning assets has decreased by .58%, while the cost of funds has decreased by .41%. The interest rates on virtually all categories of interest bearing assets and deposits have decreased, reflecting the impact of securities sales, loan refinancings, rate adjustments, and competitive market conditions. Additionally, average short term investments were unusually high in the most recent quarter. Due to the steep yield curve, these investments earned a comparatively low 1.75% in the most recent quarter. At the end of 2001, the Company entered into contracts for the purchase of an additional $3 million of bank owned life insurance. This shifted income from net interest income to other non-interest income, reducing the net interest margin by about .05%.

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At June 30, 2002, Alliance held $25 million in short term investments. The Company plans to reinvest the majority of these funds in government agency and mortgage-backed securities with fixed interest rates in the two to five year range, together with originations of “free refinance” loans which the Company offers, with fixed rates in the three to fifteen year range.

Provision for Loan Losses: The provision is made to maintain the allowance for loan losses at a level deemed adequate by management. The provision was little changed in the second quarter. For the first six months, the provision increased by $103 thousand primarily due to higher provisioning in the first quarter related mostly to growth in commercial loans and to an increase in the impairment reserve on one loan. Please see the later discussion on the Allowance for Loan Losses.

Non-Interest Income: Second quarter service charges and other income grew by $118 thousand (27%), and six month results increased by $282 thousand (37%), with increases in all major categories. These increases primarily resulted from higher volume across a range of loan and deposit services, and included $81 thousand of additional income from the above-mentioned life insurance contracts in the first six months. Net gains on the sale of securities were recorded in both the first and second quarters of 2002, providing $300 thousand in net securities gains for the first six months. These gains were primarily due to the sale of two utility common equity securities due to favorable market conditions for these securities.

Non-Interest Expense and Tax Expense: Non-interest expense increased by $356 thousand (17%) and by $605 thousand (14%) for the second quarter and year-to-date, respectively. More than 75% of this increase was in compensation and benefits; all other non-staff related expenses grew by 7% for the first six months due primarily to volume increases. Year-to-date salary expense grew by $337 thousand (18%), including 10% growth in full time equivalent staff (for the twelve months ended June 30, 2002), 4% merit related increases, and 5% growth due to changes in bonuses and salary deferrals. Staff growth has been primarily related to initiatives to improve sales and service. Year-to-date benefits expense increased by $126 thousand, including $75 thousand in higher pension related expenses primarily reflecting the effect of capital market conditions on the value of plan assets.

Comprehensive Income: Comprehensive income includes changes (after tax) in the market valuation of investment securities available for sale. Six month comprehensive income was $1.34 million in 2002, compared to $3.38 million in 2001. The net unrealized loss on securities increased in 2002 due primarily to the transfer of one security from held to maturity to available for sale. Please see the following discussion on investment securities.

FINANCIAL CONDITION

Cash and Cash Equivalents: Total cash and equivalents increased by $25 million in 2002 due to unusually high commercial, savings, and municipal short term deposit activity. These funds were held in short term investments during the second quarter in anticipation of higher interest rates. Due to a moderation in forecasts of higher interest rates, the Company established plans to invest the majority of these funds into higher yielding investments in the third quarter.

Investment Securities: Total investment securities increased by $7 million in the second quarter due to purchases of government agency and mortgage backed securities with fixed interest rates in the two to three year range. Investment securities decreased by $11 million during the previous quarter primarily due to sales of $9 million in securities, comprised mainly of longer maturity debt securities sold in order to reduce the average life of the portfolio. Alliance also purchased $3 million of utility common stocks during the first quarter. The fully taxable equivalent yield on investment securities was 6.81% in the second quarter, down from 7.29% in the fourth quarter of 2001 due to the sale of higher rate, longer term securities.

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At June 30, 2002, the total net unrealized loss on available for sale securities (before tax) measured 4% of amortized cost, unchanged from year-end 2001. An improvement in the unrealized loss on debt securities was offset by an increase in the unrealized loss on equity securities due to stock market conditions. During the first quarter, one security with an amortized cost of $1.1 million and an unrealized loss of $351 thousand, as of March 31, 2002, was transferred from held to maturity to available for sale due to a decline in the issuer’s credit rating. This security was issued by an insurance company, which reported operating losses, exacerbated by claims related to World Trade Center attacks. At June 30, 2002, the Company owned seven securities with ratings/rankings below investment grade. The total net amortized cost of these securities was $5.6 million, with a net unrealized loss of $1.8 million, which was an improvement of $.2 million compared to year-end 2001. The individual unrealized losses ranged from 21% to 65% of amortized cost, which were judged to be temporary declines in value of debt securities which were expected to continue to perform in accordance with their terms.

Total Loans: Total loans decreased by $2 million in the second quarter, after increasing by $4 million in the first quarter. This was the first quarterly decrease in many quarters, resulting from commercial loan refinancings and a decline in loan originations due to lesser demand. Due to anticipated rate increases, Alliance sold a higher proportion of residential mortgage originations into the secondary market, and reduced purchases of government guaranteed loans. The yield on total loans decreased to 6.86% in the most recent quarter from 7.24% in the last quarter of 2001 due to the continuing effects of prime rate decreases in the previous quarter and to ongoing refinancings and rate resets. Average loans increased at a 3% annualized rate compared to the prior quarter and at an 8% annualized rate compared to the fourth quarter of 2001.

Nonperforming Assets: There were no foreclosed assets at June 30, 2002. Nonaccruing loans totaled $2.8 million, compared to $2.1 million at year-end 2001. Nonperforming assets were 0.70% of total assets at June 30, 2002. The increase in nonaccruing loans included $422 thousand in residential mortgages and a $259 thousand commercial mortgage. At June 30, 2002, nonaccruing loans included $0.8 million in residential mortgages, a $0.8 million current commercial mortgage, and a $0.6 million SBA guaranteed loan.

Allowance for Loan Losses: The allowance totaled $3.93 million (1.51% of total loans) at June 30, 2002, compared to $3.70 million (1.44% of total loans) at year-end 2001. During the quarter, gross chargeoffs were $10 thousand and gross recoveries were $20 thousand. The allowance measured 139% of nonaccruing loans at quarter-end.

Deposits and Borrowings: Total deposits increased by $6 million during the quarter and by $27 million (18% annualized) since year-end 2001. Most of this growth has been in savings and time deposits, with an additional $5 million of growth in money market deposits due to short term municipal balances. The $12 million increase in savings deposits represented unusual growth and was viewed by the Company as potentially related to conditions in the equity markets and was therefore potentially more susceptible to future outflow in response to changing market and interest rate conditions. The $8 million growth in time accounts was primarily due to promotions of time accounts with maturities in the two to five year range, as the Company raised funds in anticipation of higher interest rates and future loan bookings. Short term borrowings totaling $6.5 million at year-end 2001 were repaid from deposit funds.

The cost of interest bearing liabilities declined to 3.46% during the second quarter, from 3.87% in the fourth quarter of 2001, reflecting the ongoing benefit of time account repricings. The total average balance of deposits increased by 25% annualized in the second current quarter compared to the previous quarter, and by 16% annualized since the fourth quarter of 2001.

Interest Rate Sensitivity: The Company uses interest rate risk models to estimate earnings at risk and equity at risk, as further described in the 2001 annual report. The Company’s income and equity are expected to increase in a rising rate environment and to decrease in a decreasing rate environment, primarily due to its portfolio of prime based commercial and consumer loans. With interest rates at comparatively low levels and a steep current yield curve, the Company generally is cautious about the acquisition of net new long term fixed rate assets in order to control equity at risk in a rising rate environment.

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