-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Qh8ABcR1XQf48YsE9cOmjbVkxEU+8pd/6chA3T6l0vy36dilLAWlrcyF03mPbHcA S5NrkxbxHo+tN0XPVpEo6A== 0000927016-97-000864.txt : 19970325 0000927016-97-000864.hdr.sgml : 19970325 ACCESSION NUMBER: 0000927016-97-000864 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970324 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALLMERICA FINANCIAL CORP CENTRAL INDEX KEY: 0000944695 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 043263626 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-13754 FILM NUMBER: 97561777 BUSINESS ADDRESS: STREET 1: 440 LINCOLN ST CITY: WORCESTER STATE: MA ZIP: 01653 BUSINESS PHONE: 5088551000 MAIL ADDRESS: STREET 1: 440 LINCOLN ST CITY: WORCESTER STATE: MA ZIP: 01653 10-K 1 FORM 10-K - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1996 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 IDENTIFICATION INCORPORATION OR ORGANIZATION) NUMBER) 440 LINCOLN STREET, WORCESTER, 01653 MASSACHUSETTS (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) Registrant's telephone number, including area code: (508) 855-1000 Securities registered pursuant to Section 12(b) of the Act: Title of each class of securities Name of Exchange on which Registered COMMON STOCK, $.01 PAR VALUE NEW YORK STOCK EXCHANGE 7 5/8% SENIOR DEBENTURES DUE 2025 NEW YORK STOCK EXCHANGE Securities registered pursuant to Section 12(g) of the Act: NONE 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 check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] Based on the closing sales price of February 28, 1997 the aggregate market value of the voting stock held by nonaffiliates of the registrant was $1,873,782,581. The number of shares outstanding of the registrant's common stock, $.01 par value, was 50,134,651 shares outstanding as of February 28, 1997. DOCUMENTS INCORPORATED BY REFERENCE Portions of Allmerica Financial Corporation's Annual Report to Shareholders for 1996 are incorporated by reference in Parts I, II, and IV. Total number of pages, including cover page: 170 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PART I ITEM I BUSINESS ORGANIZATION Allmerica Financial Corporation ("AFC" or the "Company") is a non-insurance holding company organized as a Delaware corporation in 1995 to hold all of the outstanding shares of First Allmerica Financial Life Insurance Company ("FAFLIC"). The consolidated financial statements of AFC include the accounts of FAFLIC, its wholly owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries (principally brokerage and investment advisory subsidiaries), and Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a 59.5%-owned non-insurance holding company). On February 19, 1997, AFC and Allmerica P&C entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which AFC will acquire all of the outstanding Common Stock, $1.00 par value per share, of Allmerica P&C that it does not already own for consideration consisting of $33.00 per share of Common Stock, subject to adjustment, payable in cash and shares of common stock, par value $0.01 per share, of AFC (the "AFC Common Stock"). In addition, a shareholder of Allmerica P&C may elect to receive the consideration in cash, without interest, or in shares of AFC Common Stock, subject to proration as set forth in the Merger Agreement. The maximum number of shares of AFC Common Stock to be issued in the Merger is approximately 9.67 million shares. The acquisition will be accomplished by merging a newly created, wholly-owned subsidiary of AFC with and into Allmerica P&C (the "Merger") resulting in Allmerica P&C becoming a wholly-owned subsidiary of AFC. Also, immediately prior to the Merger, Allmerica P&C's Certificate of Incorporation will be amended to authorize a new class of Common Stock, one share of which will be exchanged for each share of Common Stock currently held by SMA Financial Corp., a wholly-owned subsidiary of AFC. The consummation of the Merger is subject to the satisfaction of various conditions, including the approval of regulatory authorities. On February 3, 1997, AFC Capital Trust (the "Trust"), a subsidiary business trust of AFC, issued $300.0 million Series A Capital Securities, which pay cumulative dividends at a rate of 8.207% semiannually commencing August 15, 1997. The Trust exists for the sole purpose of issuing the Capital Securities and investing the proceeds thereof in an equivalent amount of 8.207% Junior Subordinated Deferrable Interest Debentures due 2027 of AFC (the "Subordinated Debentures"). Through certain guarantees, the Subordinated Debentures and the terms of related agreements, AFC has irrevocably and unconditionally guaranteed the obligations of the Trust under the Capital Securities. Net proceeds from the offering of approximately $296.3 million are intended to fund a portion of the acquisition of the 24.2 million publicly held shares of Allmerica P&C pursuant to the Merger Agreement. FAFLIC was organized as a mutual life insurance company until October 16, 1995. FAFLIC converted to a stock life insurance company pursuant to a plan of reorganization ("the Plan") effective October 16, 1995 and became a wholly owned subsidiary of AFC. Pursuant to the plan of reorganization, the Company issued 37.5 million shares of its common stock to eligible policyholders. The Company also issued 12.6 million shares of its common stock at a price of $21.00 per share in a public offering, resulting in net proceeds of $248.0 million, and issued Senior Debentures in the principal amount of $200.0 million which resulted in net proceeds of $197.2 million. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Management. Within these broad areas, the Company operates principally in five operating segments. These segments are Regional Property and Casualty; Corporate Risk Management Services ("CRMS"); Retail 2 Financial Services ("RFS"); Institutional Services; and Allmerica Asset Management ("AAM"). The Regional Property and Casualty segment consists of the Company's 59.5% ownership of Allmerica P&C; however, all property and casualty results presented include 100% of Allmerica P&C's pre-tax results of operations, consistent with the presentation in the Company's consolidated financial statements. The other segments are all owned and operated by FAFLIC and its wholly owned subsidiaries. In addition to the five operating segments, the Company also has a Corporate segment, which consists primarily of Senior Debentures and a portion of the net proceeds from the Company's initial public offering. These proceeds are invested primarily in fixed maturities at December 31, 1996. Information with respect to each of the Company's segments is included in "Segment Results" on pages 35-45 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 14 on page 71 of the Notes to the Consolidated Financial Statements included in the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. DESCRIPTION OF BUSINESS BY SEGMENT The Company offers financial products and services in two major areas, operating principally in five segments as described above. Following is a discussion of each segment. RISK MANAGEMENT REGIONAL PROPERTY AND CASUALTY General The Company's Regional Property and Casualty segment is composed of FAFLIC's 59.5% ownership of Allmerica P&C. The Company's interest in Allmerica P&C is composed of Hanover and Hanover's 82.5%-owned subsidiary, Citizens. For the year ended December 31, 1996, the Regional Property and Casualty segment accounted for approximately $2,193.7 million, or 67.0%, of consolidated revenues and approximately $197.7 million, or 59.6%, of consolidated income before taxes. The Company primarily underwrites personal and commercial property and casualty insurance through this segment, with Hanover's principal operations located in the Northeast and Citizens' in Michigan. Both Hanover and Citizens Insurance have an historically strong regional focus and both place heavy emphasis on underwriting profitability and loss reserve adequacy. As of December 31, 1995, according to A.M. Best, the Regional Property and Casualty segment ranks as one of the 30 largest property and casualty insurance groups in the United States based on net premiums written. The Company strives to maintain a clear focus on the core disciplines of underwriting, pricing, claims adjusting, marketing and sales. In particular, the Regional Property and Casualty segment seeks to achieve and maintain underwriting profitability in each of its five major product lines. The Company's overall strategy is to improve profitability through operating efficiencies and to pursue measured growth in profitable markets. Hanover's average premium growth rate for the ten-year period ended December 31, 1996 was 3.2% compared to an industry average of 6.2% for the same period. Hanover's average statutory combined ratio for the same ten-year period was 107.1, compared to an industry average of 108.2. Over the last ten years, Citizens has consistently reported stronger growth in statutory net premiums written than the property and casualty industry as a whole. Citizens' average premium growth rate was 8.9% for the ten-year period ended December 31, 1996 and its average statutory combined ratio for the same period was 100.1. (Industry estimates are based on data published by A.M. Best.) The industry's profitability can be affected significantly by price competition, volatile and unpredictable developments such as extreme weather conditions and natural disasters, legal developments affecting insurer liability and the size of jury awards, fluctuations in interest rates and other factors that may affect investment returns and other general economic conditions and trends, such as inflationary pressures that may affect the adequacy of reserves. 3 Lines of Business Hanover and Citizens both underwrite personal and commercial property and casualty insurance coverage. The personal segment principally includes personal automobile and homeowners' coverage. The commercial segment principally includes workers' compensation, commercial automobile and commercial multiple peril coverage. Personal automobile coverage insures individuals against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured's vehicle, and property damage to other vehicles and other property. Homeowners coverage insures individuals for losses to their residences and personal property, such as those caused by fire, wind, hail, water damage (except for flooding), theft and vandalism, and against third party liability claims. Commercial automobile coverage insures businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured's vehicle, and property damage to other vehicles and other property. Workers' compensation coverage insures employers against employee medical and indemnity claims resulting from injuries related to work. Workers' compensation policies are often written in conjunction with other commercial policies. Commercial multiple peril coverage insures businesses against third party liability from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold. It also insures business property for damage, such as that caused by fire, wind, hail, water damage (except for flooding), theft and vandalism. Both Hanover and Citizens Insurance also offer a variety of other products, such as inland marine, fire, and fidelity and surety insurance. The Company, through the Regional Property and Casualty segment, provides self-insurance administration services for individual and group risks and writes excess reinsurance coverage for the self-insurance programs it administers through its wholly-owned subsidiary, Citizens Management, Inc. Hanover's Amgro, Inc. ("Amgro"), is an insurance premium finance company which provides short-term installment loans to small and medium-sized businesses that do not wish to prepay property and casualty insurance premiums. In exchange for advancing full policy premiums to the insurance carrier or its agent, the insured executes a promissory note with Amgro which enables Amgro to cancel the insurance and receive the unearned premium in the event of default in payment by the insured. Customers, Marketing and Distribution Through its property and casualty insurance subsidiaries, the Company is licensed to sell property and casualty insurance in all fifty states in the United States, as well as the District of Columbia and all provinces of Canada except Prince Edward Island. Hanover's business is concentrated in the Northeast, primarily Massachusetts, New York, New Jersey and Maine. Citizens' business is predominantly in Michigan and has recently expanded into Indiana and Ohio. The Company markets property and casualty insurance products through approximately 2,600 independent insurance agencies and seeks to establish long-term relationships with larger, well-established agencies. In selecting agencies for new appointments, the Company considers the following criteria: a record of profitability and financial stability, an experienced and professional staff, a marketing plan for future growth and a succession plan for management. Once appointed, each agency's performance is carefully monitored. 4 Since the Company offers property and casualty insurance products predominately through independent agents, fostering a close, supportive relationship with each agency is critical to the continued growth of the business. The Company, in the Regional Property and Casualty segment, compensates agents based on profitability, in addition to regular commission. This practice motivates its agents to write policies for customers with above- average profit characteristics. By offering its independent agents a consistent source of products demanded by the agents' customers, the Company believes that an increasing number of its agents will rely on it as their principal supplier of insurance products. Hanover has implemented a number of programs designed to strengthen its relationship with its agencies. These initiatives include the formation of a National Agency Advisory Council, which is intended to provide agents a role in coordinating marketing efforts and implementing Hanover strategies, as well as remaining committed to maintaining the local market presence which provides agents access to experienced Company personnel with expertise in the local markets. Citizens' position as a preferred provider with many of its agencies is evidenced by its high average premiums written per agency of over $1.2 million in 1996. In 1995, Hanover began to exploit the benefits of worksite marketing as a distribution channel for personal property and casualty lines. This worksite distribution channel offers discounted insurance products that are individually written to employees and members of organizations which have established a marketing agreement with the Company. Management believes that advantages of competitive pricing, effective consumer awareness campaigns at sponsoring organizations, the convenience of payroll deducted premiums and word of mouth advertising will contribute to the effectiveness of the worksite distribution channel. Additionally, the Company expects to be well positioned to integrate other insurance products offered by other subsidiaries of AFC in order to maximize corporate worksite marketing relationships. Citizens also develops and markets franchise programs that are tailored for members of associations and organizations, including its Citizens Best program for senior citizens. The Company, in the Regional Property and Casualty segment, is not dependent upon a single customer or a few customers, for which the loss of any one or more would have an adverse effect upon the segment's insurance operations. Hanover Hanover accounted for approximately $1,062.8 million, or 56.0%, of the Regional Property and Casualty segment's consolidated net premium earned in 1996. Hanover's products are marketed through independent agencies which provide specialized knowledge of property and casualty products, local market conditions and targeted customer characteristics. Hanover seeks to pursue measured growth in existing markets through local management operations that apply extensive knowledge of markets to offer competitive products and services. Hanover also seeks to increase operating efficiencies through centralized strategic planning, marketing and administrative support functions and increased use of sophisticated risk selection and operational technologies. During 1996, the Company began the process of consolidating certain operations of Hanover and Citizens which is intended to achieve process improvements and efficiencies in operations. These operations include claims, finance, policy processing and administration functions. Hanover has substantially enhanced the level of automation of functions such as risk selection, policy processing, customer service and claims settlement. Over the past few years, Hanover introduced an automated risk selection program for the private passenger automobile business which rates the probability of future claims potential and increases the efficiency of the underwriting process. Hanover also introduced a similar program for its homeowners' business. Hanover is also expanding its use of agency-company interface ("ACI") technology, which enables agents to electronically submit personal lines policies for review and rating. In addition, Hanover has established automated client centers for centralizing the back office processing functions of most of its branches. The Company believes that these investments in technology will, over time, create technological efficiencies and provide capacity for enhanced service to customers. 5 Although Hanover's strategic planning and certain of its administrative functions are centralized in the home office, the Company is committed to maintaining the local market presence afforded by Hanover's twelve branch offices. These branches provide knowledge of local regulatory and competitive conditions, and have developed close relationships with Hanover's independent agents, who provide specialized knowledge of property and casualty products, local market conditions and target market characteristics. Hanover believes that the selection of attractive markets in which to pursue profitable growth depends upon maintaining its local market presence to enhance underwriting results and identify favorable markets. Citizens Citizens' insurance products are marketed in Michigan through approximately 3,800 licensed independent insurance agents, who are paid on a commission basis, associated with approximately 525 insurance agencies. Citizens also markets its products in Indiana and Ohio through approximately 1,700 licensed independent insurance agents associated with approximately 200 insurance agencies. In 1996, each agency representing Citizens wrote an average of approximately $1.2 million of Company premiums. The three largest agencies wrote approximately $19.3 million, $12.9 million, and $10.7 million of Company premiums, respectively. Citizens seeks to establish long-term relationships with larger, well- established agencies. In selecting agencies for new appointments, Citizens considers the following criteria: a record of profitability and financial stability; an experienced and professional staff; a marketing plan for future growth; and a perpetuation plan for successor management. Citizens believes that by improving its relationship and stature with its most productive agents, it will receive a greater share of its agent's higher quality writings. To solidify its relationships with higher quality agencies and take advantage of local knowledge of operating territories, Citizens maintains four branch offices and twenty five claims offices located throughout Michigan, one branch office and three claims offices in Indiana and one branch office in Ohio. Since Citizens offers its products only through independent insurance agencies, its relationships with those agencies is critical to the continued growth of its business. Accordingly, Citizens establishes strong relationships with quality agencies by offering enhanced profit sharing arrangements, recognition awards and internal support for agency operations. Citizens seeks to become the preferred provider for quality insurance agents who Citizens believes will provide it with customers with average or above-average profit characteristics. Citizens has a comprehensive program to recognize and honor those agents who excel, as measured by profitability and premium volume. By offering its independent agents a consistent source of personal and commercial property and casualty insurance products, Citizens believes that an increasing number of its agents will rely on Citizens as their principal supplier of insurance products. Citizens has been successful in developing and marketing affinity franchise programs in both the personal and commercial segments that are tailored for members of associations and organizations in Indiana and Michigan. The associations may choose to make Citizens' programs available to their members based on an evaluation of Citizens' rates, service and regulation, but each risk is individually underwritten and each customer is issued a separate policy. Associations and organizations receive no payment for making Citizens' franchise programs available to their members. As of December 31, 1996, Citizens had approximately 110 affinity franchise programs in-force, 82 of which were in personal lines and 28 of which were in commercial lines. Agents are authorized to bind Citizens on risks. The agents are guided by Citizens' written underwriting rules and practices. These rules and practices set forth eligibility rules for various policies and coverages, unacceptable risks, and maximum and minimum limits of liability. Violation of these rules and practices is grounds for termination of the agency's contract to represent Citizens. Residual Markets and Pooling Arrangements As a condition of its license to do business in various states, the Company is required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements which provide various 6 insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. For example, since most states compel the purchase of a minimal level of automobile liability insurance, states have developed shared market mechanisms to provide the required coverages and in many cases, optional coverages, to those drivers who, because of their driving records or other factors, cannot find insurers who will write them voluntarily. The Company's participation in such shared markets or pooling mechanisms is generally in amounts related to the amount of the Regional Property and Casualty segment's direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. The Company, in the Regional Property and Casualty segment, incurred an underwriting loss from participation in such mechanisms, mandatory pools and underwriting associations of $0.2 million and $0.7 million in 1996 and 1995, and underwriting profit of $1.3 million in 1994 relating primarily to coverages for personal and commercial automobile, personal and commercial property, and workers' compensation. Assigned Risk Plans Assigned risk plans are the most common type of shared market mechanism. Many states, including California, Illinois, New Jersey, New York, and Texas operate assigned risk plans. The plan assigns applications from drivers who are unable to obtain insurance in the voluntary market to insurers licensed in the applicant's state. Each insurer is required to accept a specific percentage of applications based on its market share of voluntary business in the state. Once an application has been assigned to an insurer, the insurer issues a policy under its own name and retains premiums and pays losses as if the policy were voluntarily written. Reinsurance Facilities and Pools Reinsurance facilities are currently in operation in various states and require an insurer to write all applications submitted by an agent. As a result, an insurer could be writing policies for applicants with a higher risk of loss than it would normally accept. The reinsurance facility allows the insurer to cede this high risk business to the reinsurance facility, thus sharing the underwriting experience with all other insurers in the state. If a claim is paid on a policy issued in this market, the facility will reimburse the insurer. Typically, reinsurance facilities operate at a deficit, which is then recouped by levying assessments against the same insurers. A type of reinsurance mechanism that exists in New Jersey, The New Jersey Unsatisfied Claim and Judgment Fund ("NJUCJF"), covers no-fault first party losses in excess of $0.3 million. All no-fault insurers in this state are required to participate in the reinsurance mechanism. Insurers are reimbursed for their covered losses in excess of the threshold. Funding for such facilities comes from assessments against automobile insurers based upon their proportionate market share of the state's no-fault insurance market. The NJUCJF currently has an unfunded liability for future payment years. It calculates assessments against insurers on the basis of a two-year cash flow analysis. Michigan's no-fault law requires insurers to provide unlimited medical coverage to automobile accident victims. In response, the Michigan Catastrophic Claims Association (MCCA) was established to spread the costs of medical coverage to all insureds. The MCCA acts as a reinsurer for all Michigan automobile insurers, reimbursing for amounts paid on personal protection insurance losses in excess of $0.25 million. Participation is required for all Michigan-licensed automobile and motorcycle insurers. The MCCA assesses its member companies an annual premium on each of such member company's policies covering automobile and motorcycles written in Michigan. The assessment is passed on directly to policyholders. The Company, in the Regional Property and Casualty segment, cedes a significant portion of its private passenger automobile premiums to the MCCA. Ceded premiums earned to MCCA in 1996, 1995, and 1994 were $50.5 million, $66.8 million and $80.0 million, respectively. Losses and LAE ceded to MCCA in 1996, 1995, and 1994 were ($52.9) million, $62.9 million and $24.2 million, respectively. In 1996, the MCCA's favorable development on prior year reserves exceeded the losses and LAE incurred during the year. The aggregate losses and LAE ceded to the MCCA have no impact on the Regional Property and Casualty segment's statements of income. 7 At December 31, 1996 and 1995, the Company, in the Regional Property and Casualty segment, had reinsurance recoverable on paid and unpaid losses of $292.0 million and $355.0 million, respectively, from the MCCA. The amount recoverable from the MCCA is a current estimate of future payments to be made to the Company, in the Regional Property and Casualty segment, by the MCCA for reimbursements of amounts for currently pending personal protection insurance (PIP) claims and PIP claims incurred but not yet reported. The Regional Property and Casualty segment bills the MCCA on a quarterly basis and all amounts have been paid when due. Because PIP claims, whose payments will be reimbursed by the MCCA, involve amounts to be paid over many years, actual amounts to be owed to the Company, in the Regional Property and Casualty segment, by the MCCA in the future are subject to change based on claims paid. The Regional Property and Casualty segment bills the MCCA based upon amounts actually paid by the Regional Property and Casualty segment to policyholders, however, there can be no assurance that the Company will recover the full amount of reinsurance payments owed to it by the MCCA. As of June 30, 1996 and 1995, the MCCA estimated surplus of $1.7 billion and $666.2 million, respectively, compared to an estimated deficit of $22.0 million, as of December 31, 1994. Management believes that in the current regulatory climate, the Company, in the Regional Property and Casualty segment, is unlikely to incur any material loss or become unable to pay claims as a result of nonpayment of amounts owed to it by the MCCA because (i) the MCCA is currently in a surplus position, (ii) the payment obligations of the MCCA are extended over many years, resulting in relatively small current payment obligations in terms of MCCA total assets, (iii) all amounts owed to the Company by the MCCA have been paid when due, and (iv) the MCCA is supported by assessments permitted by statute. From 1988 through 1992, the Company was a servicing carrier in Maine, and ceded a significant portion of its workers' compensation premiums to the Maine Workers' Compensation Residual Market Pool ("MWCRP"), which is administered by The National Council on Compensation Insurance ("NCCI"). The Company was involved in legal proceedings regarding the MWCRP's deficit which through a legislative settlement issued on June 23, 1995, provided for an initial funding of $220.0 million of which the insurance carriers were responsible for $65.0 million. Hanover paid its allocation of $4.2 million in December 1995. Some of the smaller carriers appealed this decision. See "Legal Proceedings" on page 28 of this Form 10-K which is incorporated herein by reference. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to the Massachusetts Commonwealth Automobile Reinsurers ("CAR"). Net premiums earned and losses and loss adjustment expenses ceded to CAR in 1996, 1995 and 1994 were $38.0 million and $21.8 million, $49.1 million and $33.7 million, and $50.0 million and $29.8 million, respectively. At December 31, 1996, CAR and the MCCA were the only two reinsurers which represented 10% or more of the Regional Property and Casualty segment's reinsurance business. Reference is made to Note 16 on pages 72 and 73 and Note 20 on page 75 of the Notes to Consolidated Financial Statements of the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Joint Underwriting Associations A joint underwriting association ("JUA") is similar to a reinsurance pool. Generally, a JUA allows an insurer to share with other insurers the underwriting experience of drivers that reflect a higher risk of loss than the insurer would normally accept. Under a JUA, a limited number of insurers are designated as "servicing carriers." The servicing carrier is responsible for collecting premiums and paying claims for the policies issued in the JUA, and such insurers receive a fee for these administrative services. The underwriting results of the servicing carrier are then shared with all insurers in the state. Like reinsurance facilities, JUA's typically operate at a deficit, and fund that deficit by levying assessments on insurers. The New Jersey legislature passed automobile insurance reform legislation that eliminated the New Jersey JUA ("NJJUA") and imposed taxes and assessments on the insurance industry to fund a portion of the NJJUA deficit. The deficit resulted primarily from the inadequate rate level of the NJJUA and the contraction of the 8 voluntary auto market, which increased the number of risks requiring insurance through the NJJUA. The reform legislation also established a Market Transition Facility ("MTF") to manage business from the NJJUA that is not transferred to the voluntary market. During 1994, the Company, in the Regional Property and Casualty segment, released a reserve of $7.0 million as a result of the resolution of the funding of the New Jersey Market Transition Facility deficit. Legislation passed in New Jersey during the third quarter of 1994 substantially relieved insurers of responsibility for funding the deficit. Other Mechanisms The principal shared market mechanisms for property insurance are the Fair Access to Insurance Requirements Plans ("FAIR Plans"), the formation of which was required by the federal government as a condition to an insurer's ability to obtain federal riot reinsurance coverage following the riots and civil disorder that occurred during the 1960's. These plans, created as mechanisms similar to automobile assigned risk plans, were designed to increase the availability of property insurance in urban areas. The federal government reinsures those insurers participating in FAIR Plans against excess losses sustained from riots and civil disorders. The individual state FAIR Plans are created pursuant to statute or regulation. The property shares market mechanisms provide basic fire insurance and extended coverage protection for dwellings and certain commercial properties that could not be insured in the voluntary market. A few states also include a basic homeowners form of coverage in their shared market mechanism. With respect to commercial automobile coverage, another pooling mechanism, a Commercial Auto Insurance Plan ("CAIP"), uses a limited number of servicing carriers to handle assignments from other insurers. The CAIP servicing carrier is paid a fee by the insurer who otherwise would be assigned the responsibility of handling the commercial automobile policy and paying claims. Approximately 40 states have CAIP mechanisms, including California, Connecticut, Illinois, New Hampshire, New Jersey, New York and Rhode Island. Competition The property and casualty industry is highly competitive among national agency companies, direct writers, and regional and local insurers on the bases of both price and service. Many of these companies are larger and have greater financial and technical resources than Hanover and Citizens. National agency companies sell insurance through independent agents and usually concentrate on commercial lines of property and casualty insurance. Direct writers dominate the personal lines of property and casualty insurance and operate on a national, regional or single state basis. Regional and local companies sell through independent agents in one or several states in the same region and compete in both personal and commercial lines. In addition, because both companies market through independent agents, Hanover and Citizens compete with other independent agency companies for business in each of the agencies representing them. Hanover faces competition in personal lines primarily from direct writers and regional and local companies. In its commercial lines, Hanover faces competition primarily from national agency companies and regional and local companies. Due to the number of companies in Hanover's principal property and casualty insurance marketplace, there is no single dominant competitor in any of Hanover's markets. Management believes that its emphasis on maintaining a local presence in its markets, coupled with investments in operating and client technologies, will enable Hanover to compete effectively. During the past two years, the competitive environment in Massachusetts has increased substantially. Approximately 39% of Hanover's personal automobile business is currently written in this state. In 1995 and 1996, Massachusetts personal automobile rates decreased 4.5% and 6.2%, respectively, as mandated by the Massachusetts Division of Insurance. In 1995, the Massachusetts Division of Insurance began to allow sponsoring organizations to receive discounts on their auto insurance. Today, Hanover currently offers more than 70 group programs throughout the state, including the second largest group plan in the state with approximately 347,000 eligible members. On February 24, 1997, Hanover submitted its request to the Massachusetts Division of Insurance to offer a 10% discount on automobile insurance for its safest drivers. If approved, qualified 9 Hanover policyholders would reduce their insurance premiums by as much as 20% by combining "safe driver" and "group" discounts. Management has implemented these discounts in an effort to retain the Regional Property and Casualty segment's market share in Massachusetts. These discounts, together with mandated rate decreases, may unfavorably impact premium growth. In Michigan, Citizens competes in personal segments with a number of direct writers and regional and local companies, several of which are larger than Citizens. National agency companies have not been important factors in Michigan in the personal segments of property and casualty insurance because of their tendency to emphasize commercial segments and because Michigan's insurance regulatory environment would require such companies to develop and implement special incentive programs designed to encourage agents to identify and sell insurance to individuals with lower risk profiles consistent with the constraints of Michigan law. However, in February 1996, an amendment to the Essential Insurance Act became effective in Michigan. This amendment eliminates personal automobile and homeowners insurance territorial rating restrictions and limits merit ratings for automobile policies. The Company cannot predict the effect of this new legislation, but believes this law may encourage national companies to return or enter into the state in commercial and personal lines. Citizens also faces competition from the two largest direct writers in Michigan, Auto Club Michigan Group and State Farm Group companies, in the personal automobile line. In the homeowners line, Citizens' principal competition in Michigan is also from direct writers, including State Farm Group. Citizens is the second leading writer in Michigan in its three primary commercial lines combined: commercial automobile, workers' compensation, and commercial multiple peril. Citizens faces competition principally from national agency companies, and regional and local companies, many of which have financial resources substantially greater than those of Citizens. The industry has been in a downturn over the past several years due primarily to price competition. Premium rate levels are related to the availability of insurance coverage, which varies according to the level of excess capacity in the industry. The current commercial lines market is extremely competitive due to a continuing soft market in which capacity is high and prices are low. Because of the commitment at both Hanover and Citizens to focus on underwriting profitability and a refusal to write business at inadequate prices, this highly competitive commercial lines market has impacted the Regional Property and Casualty segment's growth in commercial lines. In Michigan, Citizens workers' compensation line is the largest commercial line in terms of premiums written. Over the past few years, competition has caused Citizens to reduce rates four times; 8.5%, 7.0%, 6.4% and 8.7% effective May 1, 1995, December 1, 1995, June 1, 1996, and March 1, 1997 respectively. Management believes that competition for premiums in the Regional Property and Casualty segment's markets may continue to have an adverse impact on rates and profitability. Since there is no one dominant competitor in any of the markets in which the Regional Property and Casualty segment competes, management believes there is opportunity for future growth. Underwriting Pricing The manner in which the Company prices products takes into consideration the expected frequency and severity of losses, the costs of providing the necessary coverage (including the cost of administering policy benefits, sales and other administrative and overhead costs) and a margin for profit. The Company, in the Regional Property and Casualty segment, seeks to achieve an underwriting profit in each of its product lines regardless of market conditions. This strategy seeks to achieve consistent profitability with substantial growth in net premiums written during hard markets and more modest growth during soft markets. The Company concentrates on its established major product lines, and accordingly, does not typically pursue the development of products with relatively unpredictable risk profiles. In addition, the Company utilizes its extensive knowledge of local markets, including knowledge of regulatory requirements, to achieve superior 10 underwriting results. Hanover and Citizens rely on information provided by their local agents and Hanover also relies on the knowledge of its staff in the local branch offices. As a regional company with significant market share, Citizens can apply its extensive knowledge and experience in making underwriting and rate setting decisions. Claims The Company employs experienced claims adjusters, appraisers, medical specialists, managers and attorneys in order to manage its claims. The Company, in the Regional Property and Casualty segment, has field claims offices strategically located throughout its operating territories. All claims office staff members work closely with the agents to settle claims rapidly and cost-effectively. Claims office adjusting staff are supported by general adjusters on large property losses, automobile and heavy equipment damage appraisers on automobile material damage losses and medical specialists whose principal concentration is in workers' compensation and no-fault automobile injury cases. In addition, the claims offices are supported by staff attorneys who specialize in litigation defense and claim settlements. The Regional Property and Casualty segment also has special units which investigate suspected insurance fraud and abuse. Hanover utilizes advanced claims processing technology to allow smaller and more routine claims to be processed at centralized locations. Hanover expects that approximately 70% of its personal lines claims will be processed at these locations in the future, thereby increasing efficiency and reducing operating costs. Citizens has instituted a program under which participating agents have settlement authority for small property loss claims. Based upon program experience, the Regional Property and Casualty segment believes that this program contributes to low loss adjustment expense ("LAE") experience and to its higher customer satisfaction ratings by permitting the early and direct settlement of such small claims. Approximately 26.6% and 28.1% of the number of total paid claims reported to Citizens in the years ended December 31, 1996 and 1995, respectively, were settled under this program. Hanover and Citizens have also begun using the managed care expertise of the Allmerica Financial's Corporate Risk Management Services ("CRMS") segment in the analysis of the provision of medical services in the management of workers' compensation and medical claims on its automobile policies. Hanover and Citizens believe that their use of this capability reduces costs and serves their customers more efficiently. Property and casualty insurers are subject to claims arising out of catastrophes which may have a significant impact on their results of operations and financial condition. The Company, in the Regional Property and Casualty segment, may experience catastrophe losses in the future which could have a material adverse impact on the Company. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires and explosions, and the incidence and severity of catastrophes are inherently unpredictable. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and business property insurance have in the past generated the vast majority of catastrophe-related claims. Reserve for Unpaid Losses and Loss Adjustment Expenses Reference is made to "Reserve for Losses and Loss Adjustment Expenses" on pages 40, 41 and 42 of Management's Discussion and Analysis of Financial Condition and Results of Operations of the 1996 Annual Report to Shareholders, which is incorporated herein by reference. The Company's actuaries, in the Regional Property and Casualty segment, review the reserves each quarter and certify the reserves annually as required for statutory filings. 11 The Regional Property and Casualty segment regularly reviews its reserving techniques, its overall reserving position and its reinsurance. Based on (i) review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages, changes in political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Regional Property and Casualty segment and the industry, (iv) the relatively short-term nature of most policies and (v) internal estimates of required reserves, management believes that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on the results of operations. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company's payment of that loss. To recognize liabilities for unpaid losses, the Company establishes reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. The Company, in the Regional Property and Casualty segment, does not use discounting techniques in establishing reserves for losses and LAE, nor has it participated in any loss portfolio transfers or other similar transactions. The following table reconciles reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance statutory authorities ("Statutory Reserve") to reserves determined in accordance with generally accepted accounting principles ("GAAP Reserve") at December 31, as follows:
1996 1995 1994 -------- -------- -------- (IN MILLIONS) Statutory reserve for losses and LAE............. $2,113.2 $2,123.0 $2,093.6 GAAP adjustments: Reinsurance recoverable on unpaid losses....... 626.9 763.5 712.4 Other(*)....................................... 4.0 9.5 15.7 ======== ======== ======== GAAP reserve for losses and LAE.................. $2,744.1 $2,896.0 $2,821.7 ======== ======== ========
- -------- (*) Primarily other statutory liabilities reclassified as loss adjustment expense reserves for GAAP reporting. 12 Analysis of Losses and Loss Adjustment Expenses Reserve Development The following table sets forth the development of net reserves for unpaid losses and LAE from 1986 through 1996 for the Company.
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- ------- (IN MILLIONS) YEAR ENDED DECEMBER 31, Net reserve for losses and LAE(1)......... $2,117.2 $2,132.5 $2,109.3 $2,019.6 $1,936.9 $1,772.4 $1,550.6 $1,326.3 $1,150.9 $1,008.0 $ 793.0 Cumulative amount paid as of(2): One year later.. -- 627.6 614.3 566.9 564.3 569.0 561.5 521.1 465.3 384.3 319.6 Two years later.......... -- -- 940.7 884.4 862.7 888.0 874.5 820.2 725.3 616.4 509.9 Three years later.......... -- -- -- 1,078.1 1,068.4 1,077.1 1,074.3 1,009.3 901.5 764.5 643.6 Four years later.......... -- -- -- -- 1,184.1 1,207.1 1,186.4 1,130.1 1,009.7 862.1 722.3 Five years later.......... -- -- -- -- -- 1,279.4 1,265.4 1,192.7 1,078.8 926.0 780.8 Six years later.......... -- -- -- -- -- -- 1,314.2 1,240.9 1,116.2 969.7 817.3 Seven years later.......... -- -- -- -- -- -- -- 1,271.4 1,147.4 993.5 844.5 Eight years later.......... -- -- -- -- -- -- -- -- 1,170.4 1,016.5 860.5 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,034.6 878.1 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 892.9 Net reserve re- estimated as of(3): End of year..... 2,117.2 2,132.5 2,109.3 2,019.6 1,936.9 1,772.4 1,550.6 1,326.3 1,150.9 1,008.0 793.0 One year later.. -- 1,991.1 1,971.7 1,891.5 1,868.1 1,755.0 1,601.5 1,412.4 1,220.4 1,058.3 865.0 Two years later.......... -- -- 1,859.4 1,767.4 1,762.8 1,717.7 1,601.9 1,449.0 1,262.0 1,096.4 904.4 Three years later.......... -- -- -- 1,691.5 1,703.3 1,670.8 1,614.3 1,471.7 1,290.2 1,125.3 937.0 Four years later.......... -- -- -- -- 1,658.9 1,654.1 1,597.6 1,484.7 1,312.3 1,155.1 963.5 Five years later.......... -- -- -- -- -- 1,634.6 1,594.3 1,482.3 1,322.1 1,175.2 983.3 Six years later.......... -- -- -- -- -- -- 1,588.7 1,486.9 1,328.6 1,188.5 999.5 Seven years later.......... -- -- -- -- -- -- -- 1,488.4 1,340.7 1,201.2 1,009.5 Eight years later.......... -- -- -- -- -- -- -- -- 1,403.7 1,215.4 1,025.0 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,226.8 1,039.6 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 1,056.1 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- ------- (Deficiency) Redundancy, net(4,5,6)..... $ -- $ 141.4 $ 249.9 $ 328.1 $ 278.0 $ 137.8 $ (38.1) $ (162.1) $ (252.8) $ (218.8) $(263.1) ======== ======== ======== ======== ======== ======== ======== ======== ======== ======== =======
- -------- (1) Sets forth the estimated net liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years; represents the estimated amount of net losses and LAE for claims arising in the current and all prior years that are unpaid at the balance sheet date, including incurred but not reported ("IBNR") reserves. (2) Cumulative loss and LAE payments made in succeeding years for losses incurred prior to the balance sheet date. (3) Re-estimated amount of the previously recorded liability based on experience for each succeeding year; increased or decreased as payments are made and more information becomes known about the severity of remaining unpaid claims. (4) In 1987, Hanover adopted a new actuarial-based reserve methodology designed to result in a more accurate reflection of underwriting trends and a more appropriate basis for assessing current reserve adequacy. The new method is based on groupings of claims using the period in which the accident occurred rather than loss experience in the financial reporting period. This method tracks the development of claims from a given accident period and provides management with continuous updates of losses incurred. Management believes that this change to actuarial reserving methodologies has resulted in improved reserve adequacy. (5) Cumulative deficiency or redundancy at December 31, 1996 of the net reserve amounts shown on the top line of the corresponding column. A redundancy in reserves means the reserves established in prior years exceeded actual losses and LAE or were reevaluated at less than the original reserved amount. A deficiency in reserves means the reserves established in prior years were less than actual losses and LAE or were reevaluated at more than the original reserved amount. (6) The following table sets forth the development of gross reserve for unpaid losses and LAE from 1992 through 1996 for the Company: 13
YEAR ENDED DECEMBER 31, -------------------------------------------- 1996 1995 1994 1993 1992 -------- -------- -------- -------- -------- (IN MILLIONS) Reserve for losses and LAE: Gross liability................ $2,744.1 $2,896.0 $2,821.7 $2,717.3 $2,598.9 Reinsurance recoverable........ 626.9 763.5 712.4 697.7 662.0 -------- -------- -------- -------- -------- Net liability................ $2,117.2 $2,132.5 $2,109.3 $2,019.6 $1,936.9 ======== ======== ======== ======== ======== One year later: Gross re-estimated liability... $2,587.8 $2,593.5 $2,500.5 $2,460.5 Re-estimated recoverable....... 596.7 621.8 609.0 592.4 -------- -------- -------- -------- Net re-estimated liability... $1,991.1 $1,971.7 $1,891.5 $1,868.1 ======== ======== ======== ======== Two years later: Gross re-estimated liability... $2,339.2 $2,333.3 $2,341.9 Re-estimated recoverable....... 479.8 565.9 579.1 -------- -------- -------- Net re-estimated liability... $1,859.4 $1,767.4 $1,762.8 ======== ======== ======== Three years later: Gross re-estimated liability... $2,145.5 $2,257.3 Re-estimated recoverable....... 454.0 554.0 -------- -------- Net re-estimated liability... $1,691.5 $1,703.3 ======== ======== Four years later: Gross re-estimated liability... $2,168.2 Re-estimated recoverable....... 509.3 -------- Net re-estimated liability... $1,658.9 ========
Reinsurance The Company, in the Regional Property and Casualty segment, maintains a reinsurance program designed to protect against large or unusual losses and LAE activity. This includes both excess of loss reinsurance and catastrophe reinsurance. Catastrophe reinsurance serves to protect the ceding insurer from significant aggregate losses arising from a single event such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. The Company determines the appropriate amount of reinsurance based on the Company's evaluation of the risks accepted and analysis prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. The Company, in the Regional Property and Casualty segment, has reinsurance for casualty business. Under the 1996 casualty program, the reinsurers are responsible for 100% of the amount of each loss in excess of $1.0 million per occurrence up to $30.5 million for general liability and workers' compensation. Additionally, this reinsurance covers workers' compensation losses in excess of $30.5 million to $60.5 million per occurrence. Under the Company's 1996 catastrophe reinsurance program, in the Regional Property and Casualty segment, Hanover and Citizens retain the first $25.0 million of loss per occurrence, all amounts in excess of $180.0 million per occurrence and 10% of all aggregate loss amounts in excess of $25.0 million up to $180.0 million. In addition, Citizens retains 5% of losses in excess of $10.0 million, up to $25.0 million. In 1996, Citizens purchased aggregate catastrophe coverage which reinsures 90% of $5.0 million for aggregated catastrophe losses in excess of $5.0 million which individually exceed $1.0 million. Under this aggregate catastrophe coverage, Citizens is expected to recover $4.5 million. In the years ended December 31, 1996, 1995 and 1994, the Company, in the Regional Property and Casualty segment, did not exceed the minimum catastrophe levels, either individually or in the aggregate, to obtain recovery under its reinsurance agreements, except as described above. Effective January 1, 1997, the Company, in the Regional Property and Casualty segment, modified its reinsurance program. The 1997 modifications include the purchase of additional casualty reinsurance and higher 14 retention under the Company's catastrophe reinsurance program. Under the 1997 casualty reinsurance program, the Company added a layer which reinsured 100% of each loss in excess of $.5 million up to $1.0 million per occurrence. Under the 1997 catastrophe reinsurance program, Hanover and Citizens retain the first $25.0 million of loss per occurrence and all amounts in excess of $180.0 million per occurrence, 55% of all aggregate loss amounts in excess of $25.0 million up to $45.0 million, and 10% of all aggregate loss amounts in excess of $45.0 million up to $180.0 million. In addition, Citizens retains 5% of losses in excess of $10.0 million, up to $25.0 million. The Company, in the Regional Property and Casualty segment, cedes to reinsurers a portion of its risk and pays a fee based upon premiums received on all policies subject to such reinsurance. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company determines the appropriate amount of reinsurance based on evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions (including the availability and pricing of reinsurance). The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. The Company, in the Regional Property and Casualty segment, is subject to concentration of risk with respect to reinsurance ceded to various residual market mechanisms. As a condition to the ability to conduct certain business in various states, the Company is required to participate in various residual market mechanisms and pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage voluntarily provided by private insurers. These market mechanisms and pooling arrangements include the Massachusetts Commonwealth Automobile Reinsurers ("CAR"), the Maine Workers' Compensation Residual Market Pool ("MWCRP") and the Michigan Catastrophic Claims Association ("MCCA"). At December 31, 1996, the MCCA and CAR were the only two reinsurers which represented 10% or more of the Regional Property and Casualty segment's reinsurance business. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to CAR. Net premiums earned and losses and loss adjustment expenses ceded to CAR for the years ended December 31, 1996, 1995 and 1994 were $38.0 million and $21.8 million, $49.1 million and $33.7 million, and $50.0 million and $29.8 million, respectively. From 1988 through 1992, the Company, in the Regional Property and Casualty segment, was a servicing carrier in Maine, and ceded a significant portion of its workers' compensation premiums to the Maine Workers' Compensation Residual Market Pool, which is administered by The National Council on Compensation Insurance ("NCCI"). The Company was involved in legal proceedings regarding the MWCRP's deficit which through a legislative settlement issued on June 23, 1995, provided for an initial funding of $220.0 million of which the insurance carriers were responsible for $65.0 million. Hanover paid its allocation of $4.2 million in December 1995. Some of the smaller carriers appealed this decision. The Company's right to recover reinsurance balances for claims properly paid is not at issue in any such proceedings. The Company expects to collect its reinsurance balance; however, funding of the cash flow needs of the MWCRP may in the future be affected by issues related to certain litigation, the outcome of which the Company cannot predict. See "Legal Proceedings" on page 28 of this Form 10-K which is incorporated herein by reference. The Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 1996, 1995 and 1994 of $50.5 million and $(52.9) million, $66.8 million and $62.9 million, and $80.0 million and $24.2 million, respectively. Because the MCCA is supported by assessments permitted by statute and all amounts billed by the Company to CAR, MWCRP and MCCA have been paid when due, the Company believes that it has no significant exposure to uncollectible reinsurance balances. The reserve for losses and loss adjustment expenses at December 31, 1996 and 1995 is shown gross of recoverable on unpaid losses of $626.9 million and $763.5 million, respectively. The significant decrease in the reinsurance recoverable on unpaid losses is primarily attributable to an overall decrease in reinsurance activity at both Hanover and Citizens. The decrease at Hanover is specifically related to a decrease in ceded losses on its 15 servicing carrier business. The decrease at Citizens in 1996 is due to the MCCA's favorable development on prior year reserves exceeding the losses and LAE incurred during the current year. The aggregate losses and LAE ceded have no impact on the Company's consolidated statements of income. Losses and LAE ceded were $2.2 million, $229.1 million and $160.4 million in 1996, 1995 and 1994, respectively. Ceded premiums earned were $232.6 million, $296.2 million and $291.9 million in 1996, 1995 and 1994, respectively. Reference is made to "Reinsurance" in Note 16 on pages 72 and 73 of the Notes to Consolidated Financial Statements of the 1996 Annual Report to Shareholders, which is incorporated herein by reference. Reference is also made to "Reinsurance Facilities" on page 7 of this Form 10-K which is incorporated herein by reference. CORPORATE RISK MANAGEMENT SERVICES General The Corporate Risk Management Services segment provides managed care medical group insurance products and administrative services as well as other group insurance coverages, such as group life, dental and disability products, to corporate employers. As of December 31, 1996, this segment insured and/or provided administrative services to the employee benefit plans of over 2,700 employers covering 619,435 employee lives. For the year ended December 31, 1996, this segment accounted for approximately $361.5 million, or 11.0%, of consolidated revenues and $20.7 million, or 6.2%, of consolidated income before taxes. The Company's strategy emphasizes risk sharing arrangements rather than traditional indemnity medical insurance products. The Company's risk sharing arrangements consist of providing stop-loss indemnity insurance coverage for self-insured employers with 100 to 5,000 employees together with managed care and administrative services for coverage provided by the employer and the Company. This risk sharing approach enables the Company to provide more managed care, administrative and other services with less exposure to losses than traditional indemnity medical insurance. In addition, by emphasizing risk sharing arrangements, the segment has demonstrated more stable profitability by decreasing its exposure to unpredictable increases in health care costs. As a result of this strategy, revenues from risk sharing arrangements and administrative service only contracts have increased $24.1 million, or 23.0%, from $104.2 million in 1994 to $128.3 million in 1996. Traditional indemnity medical product revenues decreased $19.7 million, or 32.7%, from 1994 to 1996. The Company is also leveraging the CRMS segment's managed care and claims management expertise to capitalize on emerging opportunities with its Regional Property and Casualty segment affiliates. New legislation in many states will permit the cost containment approaches that have been used to manage employee medical and disability costs to be applied to control workers' compensation and the medical component of automobile insurance. In response, the Company has collaborated with its affiliated Regional Property and Casualty segment's claims operations to apply CRMS' expertise in medical management and claims processing to the Company's workers' compensation business and the medical component of its automobile insurance business. Claims examiners ensure that appropriate medical care is provided to insureds and that bills from health care providers are reasonable. This integrated managed care and claims adjudication system can now manage medical claims covered by workers' compensation, automobile insurance or a health benefit plan. The Company believes that its capability of providing 24-hour managed care to effectively manage claims for both casualty and employee benefit products is a competitive advantage. The Company is also emphasizing the CRMS segment's group life, dental and disability products. These lines of coverage have historically provided more stable profitability for the Company than medical coverages, by decreasing the Company's exposure to unpredictable increases in healthcare costs and the underlying risks which are assumed by employers. In order to enhance sales of these products, each has been redesigned to be available as part of a full service package or on a stand-alone basis. Health Care Regulation and Reform There continue to be a number of legislative and regulatory proposals introduced at the federal and state level to reform the current health care system. At the federal level, recent proposals have focused on benefits, confidentiality and Medicare reform. State legislation adopted over the past few years generally limits the flexibility of insurers with respect to rating and underwriting practices for employer groups with less than 50 employees, or in some states, less than 100 employees. In addition, several states have enacted so-called "any 16 willing provider" laws and managed care reform legislation which may decrease the demand for managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that market health insurance to small employers will increase. It is also possible that many states will increase the size of the employers considered a protected class and will expand reforms to include the non-group market. However, the Company's rating and underwriting practices are consistent with the objectives of small group reform. For example, the Company does not experience rate small cases, nor does it refuse coverage to newly eligible individuals within small employer groups because of medical histories. Because of its emphasis on managed care, management believes that it will continue to be able to operate effectively in the event of small group reform, even if specific states expand the existing limitations. The Company believes that the proposed federal and state level health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurers' underwriting flexibility and restrict the level of profitability of health insurers and managed care providers. The Company cannot predict whether any of the current proposals will be enacted and what particular impact such proposals may have on the Company's employee benefit services business. Products The following table summarizes premiums by product line for the CRMS segment for the years ended December 31.
1996 1995 1994 ------ ------ ------ (IN MILLIONS) Health Medical Fully insured...................................... $ 40.6 $ 44.6 $ 60.3 Risk sharing....................................... 83.2 83.0 77.1 Dental Fully insured...................................... 21.3 13.1 11.3 Risk sharing....................................... 2.7 2.8 2.8 Short-term disability Fully insured...................................... 6.5 5.5 4.1 Risk sharing....................................... 0.5 0.5 0.6 Long-term disability Fully insured...................................... 8.5 9.0 7.6 Reinsurance assumed (1)................................ 57.5 44.9 43.4 Other (2) Fully insured...................................... 8.3 8.1 8.1 Risk sharing....................................... 18.1 13.3 9.0 ------ ------ ------ Total health........................................... 247.2 224.8 224.3 Accidental death & dismemberment....................... 5.0 4.5 3.8 Other reinsurance assumed.............................. 0.4 1.1 1.9 Life................................................... 50.3 42.3 38.0 ------ ------ ------ Total CRMS premiums.................................... $302.9 $272.7 $268.0 ====== ====== ====== ASO (3)................................................ $ 23.8 $ 18.7 $ 14.7 ====== ====== ====== Total premiums and premium equivalents................. $884.3 $786.1 $727.7 ====== ====== ======
- -------- (1) Represents special risk arrangements whereby the Company assumes a limited amount of risk by participating in a pool administered by a third party. Such arrangements provide insurance coverage to companies for certain high limit and excess loss risks. (2) Represents premiums primarily related to customized products sold to customers providing for stop-loss coverage and/or administrative services. (3) Administrative services only ("ASO") fees are included in other income in the financial information contained elsewhere herein. 17 Risk Sharing Arrangements The Company participates in risk sharing arrangements primarily for medical, dental and short-term disability coverage. In accordance with its strategy to emphasize risk sharing arrangements with its customers, the Company offers several funding options that allow employers to share in the risk of their plan. ASO plans provide employers with a self-funded arrangement in which the Company provides claims administration and other services selected by the employer. The Company also provides specific and aggregate stop-loss insurance coverage for its ASO plans. Other Group Coverage The Company's group life, accidental death and dismemberment ("AD&D"), disability and dental products are offered in conjunction with medical insurance coverages or as stand alone products. The Company offers features in its group life insurance which include fixed or variable pricing, or traditional and supplemental contributory group term life insurance. Accidental death and dismemberment insurance may be included with group term life insurance to pay additional amounts for losses due to an accident. The Company offers weekly disability income insurance to cover employees for loss of wages during a short period of disability, long term disability insurance either with weekly coverage or on a stand-alone basis and dental insurance for preventive and diagnostic services, routine restorative services and major restorative services. Special Risk Arrangements The Company also provides other special risk arrangements, often taking a limited share of the risk through reinsurance pools (administered through Third Party Administrators ("TPAs") or managing general underwriters), to spread risk and limit exposure in each arrangement. These programs provide a variety of insurance coverages, including high limit AD&D, high limit disability income, excess loss medical reinsurance for self-funded plans, aviation, organ transplant, occupational accident and travel accident. Traditional Products The Company offers full indemnity products for medical, surgical and hospital expense coverage resulting from illness or injury. Many options are available for deductible amounts and coinsurance levels. Marketing The Company sells its CRMS segment's products and services primarily through approximately 50 sales representatives employed by the Company. These representatives assist independent producers (for example, agents, brokers and consultants who represent the purchasers of the Company's products) in the marketing of these products, and provide assistance with plan design issues and ongoing service. The Company continues to expand its distribution channels primarily to enhance the growth of its non-medical insurance coverages. The Company is focusing on three distribution channels. First, the Company is capitalizing on its special risk arrangements with TPAs to promote sales of group life and disability coverages. Second, the Company continues to form strategic alliances with Health Maintenance Organizations ("HMOs") and other managed care entities to distribute group life, disability and dental plans. Third, the Company is building cross-marketing programs with other segments to capitalize on divisional distribution systems and products already in place. The Company has also established regional offices to market non-medical products through these new distribution channels and added three offices in 1996. The Company plans to open additional regional offices in the future. Reinsurance The Company purchases reinsurance for the CRMS segment's group life insurance, accidental death and dismemberment, group health, stop-loss and occupational accident coverages. The Company retains a maximum 18 exposure of $500,000 on life policies and $250,000 on AD&D policies. The Company also has reinsurance arrangements to further limit the Company's liability with respect to policies for certain employers and groups. Although reinsurance does not legally discharge the ceding insurer from its primary liability for the full amount of policies reinsured, it does make the assuming insurer liable to the ceding unsurer to the extent of the reinsurance ceded. The Company maintains a gross reserve for reinsured liabilities. The Company participates in a catastrophic reinsurance pool for this segment for coverage against catastrophic life losses from the same event. Under the pool arrangement, the Company shares in approximately 1.5% of the pool's losses. The Company purchases reinsurance which limits the Company's share of annual pool claim losses to $500,000. With respect to this segment's group health policies, the Company purchases specific stop-loss coverage for individual major medical claims over $350,000 once such excess claims exceed a minimum aggregate limit of $5.8 million. The Company also purchases catastrophic coverage for three or more claims arising from the same event. Under this coverage the Company is reimbursed for medical and long term disability claims paid in excess of $500,000 in total as a result of the event. The Company purchases reinsurance protection for long term disability payments, covering a specific percent, generally approximately 50%, of each long term disability policy, with a few exceptions, and purchases reinsurance for organ transplants. The Company reinsures 90% of the risk associated with its specific and aggregate stop-loss insurance policies issued as part of risk sharing arrangements. This reinsurance is ceded to a group of ten reinsurers, including FAFLIC, who share in the risk assumed. Stop-loss coverage provided under Competitive Funding Option plans is not included in this reinsurance coverage. The Company also reinsures 100% of the risk associated with its occupational accident policies. This risk is ceded to a reinsurance pool consisting of twelve reinsurers, including FAFLIC, who share in the risk assumed. As a member in this reinsurance pool, FAFLIC assumes 12.5% of the overall risk. For the year ended December 31, 1996, the Company ceded approximately $74.5 million of premiums associated with its aggregate stop-loss policies and approximately $8.0 million of premiums for the remaining direct insurance coverages. As of December 31, 1996, the Company had no material amounts due from reinsurers. Competition The Company competes with many insurance companies and other entities in selling its CRMS products. Competition exists for employer groups, for the employees who are the ultimate consumers of the Company's products sold through the CRMS segment and for the independent producers who represent purchasers of the Company's products. Additionally, most currently insured employer groups receive annual rate adjustments, and employers may seek competitive quotations from several sources prior to renewal. The Company competes primarily with national and regional health insurance companies and other managed care providers. Many of the Company's competitors have greater capital resources, local market presence and greater name recognition than the Company. The Company also competes with Blue Cross and Blue Shield plans, which in some markets have dominant market share. Most Blue Cross and Blue Shield plans are non-profit enterprises that do not necessarily pursue profitability to the same extent as for-profit competitors do. The Company also competes with HMOs, some of which are non-profit enterprises. In addition, in its risk sharing and administrative service businesses, the Company also competes with TPAs. The Company believes, based upon its knowledge of the market, that in the current environment, the principal competitive factors in the sale of managed care medical products are price, breadth of managed care network arrangements, name recognition, technology and management information systems, distribution systems, quality of customer service, product line flexibility and variety, and financial stability. As a result, the Company believes that its managed care expertise, access to managed care networks, commitment to claims management 19 and customer service, and its advanced claims management and information systems enable it to compete effectively in these markets. Although the Company cannot predict the effect of current federal and state health care reform proposals, the Company believes that such reform measures may increase competition in the sale of health care products by limiting the ability of the Company's customers to purchase health care coverage from a wide variety of health care providers and insurers, by mandating participation by insurers in regional health care alliances or pools and by limiting rating and underwriting practices. ASSET MANAGEMENT RETAIL FINANCIAL SERVICES General The Retail Financial Services segment includes the individual financial products businesses of FAFLIC and its wholly owned subsidiary AFLIAC, as well as the Company's registered investment advisor and broker-dealer affiliates. Through this segment, the Company is a leading provider of investment-oriented life insurance and annuities to upper income individuals and small businesses throughout the United States. These products are marketed through the Company's career agency force of 576 agents and on a wholesale basis to financial planners and broker/dealers. For the year ended December 31, 1996, the Retail Financial Services segment accounted for $450.9 million, or 13.8%, of consolidated revenues and $76.2 million, or 23.0%, of consolidated income before taxes. The Company offers a diverse line of products tailored to its customer market, including variable universal life, variable annuities, universal life and retirement plan funding products. The main components of the Company's current strategy in this segment are to: (i) emphasize investment-oriented insurance products, particularly variable annuities and variable universal life insurance, (ii) improve the productivity of the career agency distribution system, (iii) implement a targeted marketing approach emphasizing value-added service, (iv) leverage the Company's technological resources to support marketing and client service initiatives and (v) continue to develop new distribution systems. The Company is seeking to improve the productivity of its career agents, the Company's primary distribution system in this segment. Virtually all of the Company's career agents are registered broker-dealer representatives, licensed to sell all of the Company's investment products as well as its insurance products. The Company has implemented a performance-based compensation system which rewards agents and agencies based upon sales of products which provide greater profits for the Company. The Company has also instituted higher performance standards for agency retention, and requires that such standards be achieved earlier, in order to elevate the productivity of its agent sales force. In addition to its agency distribution system, the Company has established several alternative distribution channels which have made significant contributions to the overall growth of variable product sales in this segment. Products sold through these channels include Allmerica Select life and annuity products, which are distributed through independent broker-dealers and financial planners, as well as annuity products sold through alliances with mutual fund partners such as Delaware Group ("Delaware"), Pioneer Group ("Pioneer") and Zurich Kemper Investments ("Kemper"). The contribution of these alternative distribution channels has grown from 34.3% of statutory annuity premiums and deposits in 1994 to 46.5% in 1996. The Company's strategy is to pursue additional alternative distribution channels and to seek to increase sales under existing distribution channels. The Company has developed a number of new marketing and client service initiatives in order to encourage sales of its products and improve customer satisfaction. As part of its focus on the sale of investment-oriented insurance products, the Company has emphasized a financial planning approach utilizing face-to-face presentations and seminar programs to address different client needs. In order to identify a favorable prospective 20 client base, the Company has developed a system utilizing advanced demographic screening and telemarketing techniques. The Company also regularly delivers seminars focused on retirement planning to these prospective clients. During 1996, the Company delivered approximately 300 seminars nationally with an average of more than 60 attendees. The Company has also utilized its technological resources to support its marketing and client service initiatives in this segment. The Company has developed automated portfolio rebalancing capabilities and graphical quarterly report statements which are used to establish and monitor the desired mix of investments by individual contract and policyholder. According to 1996 A.M Best's Policy Reports, the Company is among the twenty largest writers of individual variable annuity contracts and of individual variable universal life insurance policies in the United States in 1995, based on statutory separate account premiums and deposits. Sales of variable products represented approximately 89.7%, 84.1% and 80.1% of this segment's statutory premiums and deposits in 1996, 1995 and 1994, respectively. From 1994 to 1996, income before taxes from this segment improved $62.0 million, from $14.2 million to $76.2 million. Statutory premiums and deposits, a common industry benchmark for sales achievement, totalled $1,616.9 million, $1,060.8 million and $1,063.3 million in 1996, 1995 and 1994, respectively. Products The following table reflects premiums and deposits on a statutory accounting practices ("SAP") basis, including universal life and investment-oriented contract deposits, for the segment's major product lines for the years ended December 31. For 1996 and 1995, Closed Block premiums and deposits have been combined on a line-by-line basis with premiums and deposits outside the Closed Block for comparability purposes. Receipts from various products are treated differently under GAAP and SAP. Under GAAP, universal life, variable universal life and annuity deposits are not included in revenues but are recorded directly to policyholder account balances.
1996 1995 1994 -------- -------- -------- (IN MILLIONS) Statutory Premiums and Deposits Variable universal life........................ $ 117.2 $ 90.4 $ 86.2 Separate account annuities..................... 1,160.9 647.8 564.6 General account annuities...................... 147.9 128.8 173.5 Retirement investment account annuities........ 24.5 25.6 27.1 Universal life................................. 71.6 77.2 93.0 Traditional life............................... 61.9 59.1 86.8 Individual health.............................. 32.9 31.9 32.0 Other.......................................... -- -- 0.1 -------- -------- -------- Total premiums and deposits.................. $1,616.9 $1,060.8 $1,063.3 ======== ======== ========
While the Company continues to offer certain traditional insurance products, its current focus for new business in this segment is on the sale of variable products. Variable Products The Company's variable products offered through this segment include variable universal life insurance and variable annuities. The Company's variable universal life insurance products combine the flexible terms of the Company's universal life insurance policy with separate account investment opportunities. The Company also offers a variable joint life product through this segment. The Company's variable annuities offer the investment opportunities of the Company's separate accounts and provide a vehicle for tax-deferred savings. These products are sold pursuant to registration statements under the Securities Act or exemptions from registration thereunder. 21 The Company seeks to achieve product distinction with respect to its variable products on the basis of quality and diversity of the separate account investment options underlying these products. The Company's variable universal life and annuity products offer a variety of account investment options with choices ranging from money market funds to international equity funds. The number of these investment options has increased, from 33 in 1994 to 60 in 1996, including those underlying the products sold through alternative distribution channels. For management of these separate accounts, the Company supplements its in-house expertise in managing fixed income assets with the equity management expertise of well-known mutual fund advisors, such as Fidelity Investments, as well as other independent management firms who specialize in the management of institutional assets. Additionally, the Company utilizes the services of an experienced investment consultant to the pension industry to assist it in the selection of these institutional managers and in the ongoing monitoring of their performance. Traditional Products Historically, the Company's primary insurance products offered in this segment were traditional life insurance products, including whole life, universal life and term life insurance, as well as fixed annuities, disability income policies and retirement plan funding products. Upon completion of the Company's demutualization in October 1995, a Closed Block of all existing traditional participating life and annuity policies was established for the payment of future benefits, policyholders' dividends and certain expenses and taxes relating to these policies. As a result of the Company's conversion to a stock life insurance company, participating policies are no longer offered. The Company ceased offering term life insurance in March 1995 and ceased offering its single premium fixed annuity product in the fourth quarter of 1995. In addition, the Company ceased offering its disability income products in January, 1996. The Company's universal life insurance product is an interest-sensitive product which offers flexibility in arranging the amount of insurance coverage, the premium level and the premium payment period. The Company also offers joint life products through this segment designed to meet estate planning needs. These products offer flexible premiums and benefits and cover two lives, with benefits paid at the first or second death, depending on the policy. In addition, the Company offers a funding vehicle for pension plans of small to medium-sized employers which provides both general account and separate account investment options. Distribution The Company's primary distribution channel for this segment is its national career agency sales force of 576 agents, housed in 24 general agencies located in or adjacent to most of the major metropolitan centers in the United States. Virtually all of these agents are licensed both as insurance agents and securities broker-dealers by the National Association of Securities Dealers ("NASD"), qualifying them to sell the full range of the Company's products. The Company has focused on improving the productivity and reducing the cost of its career agency system through performance-based compensation, higher performance standards for agency retention and agency training programs. As part of this strategy, the Company has decreased the number of agents from 800 at the end of 1994 to 576 at December 31, 1996. The Company also regularly conducts comprehensive financial planning seminars and face-to-face presentations to address different investment objectives of clients. The Company has established several alternative distribution channels for this segment's products utilizing independent broker-dealers and financial planners. Through these distribution channels, the Company has obtained access to over 260 distribution firms employing over 40,000 sales personnel. In addition, establishment of these channels has enabled the Company to offer a broader range of investment options through alliances with Delaware, Pioneer and Kemper mutual funds. During 1996, total statutory premiums and deposits from sales of variable annuities through these channels totalled $619.8 million, compared to $262.8 million in 1994. 22 Underwriting Life insurance underwriting involves a determination of the type and amount of risk which an insurer is willing to accept and the price charged to do so. The Company's insurance underwriting standards for this segment attempt to produce mortality results consistent with the assumptions used in product pricing. Underwriting also determines the amount and type of reinsurance levels appropriate for a particular risk profile and thereby allows competitive risk selection. Underwriting rules and guidelines are based on the mortality experience of the Company, as well as of the insurance industry and the general population. The Company also uses a variety of medical tests to evaluate certain policy applications, based on the size of the policy, the age of the applicant and other factors. The Company's product specifications are designed to prevent anti-selection. Mortality assumptions are thoroughly communicated and monitored. The underwriting department tracks the profitability indicators of business by each general agent, including the mix of business, percentage of substandard and declined cases and placement ratio. Ongoing internal underwriting audits, conducted at multiple levels, monitor consistency of underwriting requirements and philosophy. Routine independent underwriting audits conducted by its reinsurers have supported the Company's underwriting policies and procedures. Insurance Reserves The Company has established liabilities for policyholders' account balances and future policy benefits in the consolidated balance sheets included in the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference, to meet obligations on various policies and contracts. Policyholders' account balances for universal life and investment- type policies are equal to cumulative account balances: deposits plus credited interest, less expense and mortality charges and withdrawals. Future policy benefits for traditional products are computed on the basis of assumed investment yields, mortality, persistency, morbidity and expenses (including a margin for adverse deviation), which are established at the time of issuance of a policy and generally vary by product, year of issue and policy duration. Reinsurance Consistent with the general practice in the life insurance industry, the Company has reinsured portions of the coverage provided by this segment's insurance products with other insurance companies. Insurance is ceded principally to reduce net liability on individual risks, to provide protection against large losses and to obtain a greater diversification of risk. Although reinsurance does not legally discharge the ceding insurer from its primary liability for the full amount of policies reinsured, it does make the reinsurers liable to the insurer to the extent of the reinsurance ceded. The Company maintains a gross reserve for reinsurance liabilities. The Company ceded approximately 2.8% of this segment's total statutory life insurance premiums in 1996. With respect to life policies of the Retail Financial Services segment, the Company has reinsurance agreements in place, established on an annual term, for both automatic and facultative reinsurance. Under automatic reinsurance, the reinsurer is automatically bound for up to three times the Company's retention, which currently is $2 million per life, with certain restrictions that determine the binding authority with the various reinsurers. For life policies greater than $8 million, the Company obtains facultative reinsurance. Prior to issuing facultative reinsurance, the facultative reinsurer reviews all of the underwriting information relating to the policies and reinsures on a policy by policy basis. Depending on the nature of the risk and the size of the policy, the facultative reinsurance could be provided by one company or several. The Company sometimes facultatively reinsures certain policies under $2 million which do not satisfy the Company's underwriting guidelines. The Company seeks to enter into reinsurance treaties with highly rated reinsurers. In 1996, the two largest reinsurers for life insurance in this segment, Connecticut General and St. Louis Re, represented 55.3% of this segment's life reinsurance ceded based upon statutory premium in that year. All of the reinsurers utilized by this 23 segment have received an A.M. Best rating of "A- (Excellent)" or better (Best's Insurance Reports 1996 edition). The Company believes that it has established appropriate reinsurance coverage for this segment based upon its net retained insured liabilities compared to its surplus. Based on its review of its reinsurers' financial positions and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. In 1995, the Company entered into two 100% coinsurance agreements. One was with Protective Life Insurance Company to reinsure its yearly renewable term business. The other was with American Heritage Life Insurance Company to reinsure its non-qualified payroll universal life business. The Company also obtains catastrophe reinsurance for life insurance in this segment through a catastrophe accident pool. The maximum pool reinsurance available per company is $50 million and the maximum pool reinsurance available for a single event is $125 million. Any amounts in excess of these limits are the responsibility of the company suffering the loss. Each participant in the pool pays a premium based on the share of claims paid by the pool. The Company's share of pool losses is approximately 2.5%. There have been three claims for which the Company's share was approximately $80,000 since the Company entered the pool on January 1, 1989. The pool is administered by Lincoln National, and approximately 125 companies currently participate. For its disability income coverages, the company purchases reinsurance for 100% of coverage over a specified retention, generally between $1,000 and $5,000 per month, per policy. This coverage is provided by Lincoln National, Mercantile and General Life Reassurance Company of America, and North American Reassurance Company, depending on the dates policies are or were issued. In 1995, the Company entered into a 100% coinsurance agreement with Protective Life Insurance Company for the Company's yearly renewable term life insurance. Competition There is strong competition among insurance companies seeking clients for the types of insurance, annuities and investment products sold by the Company in this segment. As of December 31, 1996, there were over 1,700 companies that offer life insurance in the United States, most of which offer one or more products similar to those offered by the Company. In some cases these products are offered through similar marketing techniques. In addition, the Company may face additional competition from banks and other financial institutions should current regulatory restrictions on the sale of insurance and securities by these institutions be repealed. The Company believes that, based upon its extensive experience in the market, the principal competitive factors affecting the sale of its life insurance and related investment products are price, financial strength and claims-paying ratings, size and strength of agency force, range of product lines, product quality, reputation and name recognition, value-added service and, with respect to variable insurance and annuity products, investment management performance of the underlying separate accounts. Accordingly, management believes that the Company's strong financial strength and claims- paying ratings, the quality and diversity of the separate accounts underlying its investment-based products, the NASD licensing of approximately ninety-five percent (95%) of its agents and its reputation in the insurance industry enable it to compete effectively in the markets in which it operates. INSTITUTIONAL SERVICES General The Company has historically offered plan design, investment and participant recordkeeping services to defined benefit and defined contribution retirement plans of corporate employers and sold GICs and annuities to corporate retirement plans. The Company conducts its operations in this segment through FAFLIC and its subsidiaries. For the year ended December 31, 1996, this segment accounted for approximately $266.7 million, or 8.1%, of consolidated revenues, and income before taxes of $52.8 million, or 15.9%, of consolidated income before taxes. 24 The Company provides consulting and investment services to defined benefit and defined contribution retirement plans of corporate employers, as well as the sale of group annuities to corporate pension plans. The Company also offers participant recordkeeping and administrative services to defined benefit retirement plans. The Company provides administration and recordkeeping for approximately 553 qualified pension and profit sharing plans which have assets totaling $2.5 billion and cover approximately 105,000 participants. To address the decrease in the market for defined benefit plans sponsored by employers, the Company has focused on increasing sales to defined contribution plans, targeting plans with 25 to 1,500 participants. Based upon internal studies, management believes the size of this market provides the greatest opportunity in this line of business. In addition, the Company provides investment only plan services to approximately 210 plans with aggregate assets under management of $1.1 billion. Since late 1995, the Company has offered its products for sale directly at the worksite through trained and licensed sales representatives. By using education and personalized consulting to increase employee purchases, the Company seeks to lower acquisition costs and increase employee participation levels. In March 1995, the Company entered into an agreement with TSSG, a subsidiary of First Data Corporation, pursuant to which the Company sold its mutual fund processing business and agreed not to engage in this business for four years after closing. In 1996, the Company received a non-recurring $4.8 million contingent payment related to this sale. Products and Services Retirement Plan Products and Services Through the Institutional Services segment, the Company offers defined contribution and defined benefit retirement plan investment options, as well as compliance support, asset allocation services and actuarial benefit calculations. The Company also offers full service recordkeeping for defined benefit retirement plans. Participants in defined contribution plans serviced by the Company have the option to invest their contributions to the plan in the Company's general account or choose from one of the Company's separate account investment options. The Company targets plans covering 25 to 1,500 employees. The Company also offers annuity products to retiring participants in serviced defined benefit plans and to fund terminating benefit plans. Historically, the Company offered two types of Guaranteed Investment Contracts, or GICs. One is the traditional GIC; the other is the synthetic GIC. The traditional GIC provides a fixed guaranteed interest rate and fixed maturity for each contract. Some of the traditional GICs provide for a specific lump sum deposit and no withdrawals prior to maturity. Other traditional GICs allow for window deposits and/or benefit-sensitive withdrawals prior to maturity, for which the Company builds an additional risk charge into the guaranteed interest rate. The synthetic GIC is similar to the traditional GIC, except that the underlying investments are generally held and managed by a third party, in accordance with specific investment guidelines, and the Company periodically resets the guaranteed interest rate for in-force funds, based on the actual investment experience of the funds. In 1996, total traditional GIC sales were less than $10.0 million, and total synthetic GIC sales were less than $20.0 million. These amounts are immaterial to the Company's operating income. The low volume of new GIC business reflects the reduced focus on these products since the reduction of the Company's financial strength ratings in 1995. Management believes that due to the reduced ratings, it is currently not economical for the Company to compete in this market. Other Services The Company also offers telemarketing services through this segment which utilize experienced telemarketing management and program execution. The Company offers these services to retail and financial clients. 25 Distribution The Company distributes retirement products through a dedicated salesforce that sells directly to customers and through intermediaries. In addition to the Home Office, the Company maintains seven regional sales and service offices located in strategic financial markets. Competition The principal competitive factors in the Company's retirement services provided to defined benefit and defined contribution customers are price, fund performance, and the ability to provide high quality service. Competition comes from other insurance companies, mutual fund companies and banks. The sector of the retirement services market in which the Company most often competes is the market for small to medium plans that desire a full spectrum of investment and recordkeeping services. In March 1995, the recordkeeping function was outsourced to a third party administrator. INVESTMENT PORTFOLIO General At December 31, 1996, the Company managed $9.9 billion of investment assets, including $772.7 million of investment assets in the Closed Block. These investments are generally of high quality and broadly diversified across asset classes and individual investment risks. The major categories of investment assets are: fixed maturities, which includes both investment grade and below investment grade public and private debt securities; equity securities; mortgage loans, principally on commercial properties; real estate, which consists primarily of investments in commercial properties; policy loans and other long-term investments. The remainder of the investment assets is comprised of cash and cash equivalents. Management has an integrated approach to developing an investment strategy for the Company that maximizes income, while incorporating overall asset allocation, business segment objectives, and asset/liability management tailored to specific insurance or investment product requirements. The Company's integrated approach and the execution of the investment strategy is founded upon a value orientation. The Company's investment professionals seek to identify undervalued securities in the markets through extensive fundamental research and credit analysis. Management believes this research- driven, value orientation is a key to achieving the overall investment objectives of producing superior rates of return, preserving capital, and meeting the financial goals of the Company's business segments. The appropriate asset allocation for the Company (the selection of broad investment categories such as fixed maturities, equity securities, mortgages and real estate) is determined by management initially through a process that focuses overall on the types of businesses in each segment that the Company engages in and the level of surplus (net worth) required to support these businesses. Next, at the segment level, asset classes are selected to produce cash flows and have maturities which match product requirements. At the segment level, the Company has developed an asset/liability management approach tailored to specific insurance, investment product, and income objectives. The investment assets of the Company are then managed in over 33 portfolio segments consistent with specific products or groups of products having similar liability characteristics. As part of this approach, management develops investment guidelines for each portfolio consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. Specific investments frequently meet the requirements of, and are acquired by, more than one investment portfolio (or investment segment of the general account of FAFLIC or AFLIAC, with each investment segment holding a pro rata interest in such investments and the cash flows therefrom). Management has a general policy of diversifying investments both within and across all portfolios. The Company monitors the credit quality of its investments and its exposure to individual borrowers, industries, sectors, and, in the case of mortgages and real estate, property types and geographic locations. In 1996, management made further investments in fixed maturities with lower credit quality and longer durations, as well as incremental investments in limited partnerships, to meet income objectives. All investments are subject to diversification requirements under insurance laws. 26 Consistent with this management approach, portfolio managers maintain close working relationships with the managers of related product lines within the Regional Property and Casualty, Corporate Risk Management Services, Retail Financial Services, Institutional Services, and Allmerica Asset Management segments. Changes in the outlook for investment markets or the returns generated by portfolio holdings are reflected as appropriate on a timely basis in the pricing of the Company's products and services. RATING AGENCIES Insurance companies are rated by rating agencies to provide both industry and participants and insurance consumers meaningful information on specific insurance companies. Higher ratings generally indicate financial stability and a stronger ability to pay claims. Hanover received an A.M. Best financial condition rating of A (Excellent) in 1996. Citizens has received an A.M. Best financial condition rating of A+ (Superior) in each year since 1968. FAFLIC and AFLIAC received A.M. Best financial condition ratings of A (Excellent) in 1996 (Best's Insurance Reports, 1996 edition). FAFLIC was given a Duff & Phelps claims-paying ability rating of AA (Very High) in September 1996 (Duff & Phelps Credit Rating Company, September 1996). FAFLIC and AFLIAC were given Moody's financial strength ratings of A1 (Good) in September 1996 (Moody's Investment Credit Reports, September 1996). In September 1996, FAFLIC and AFLIAC received S&P claims-paying ability ratings of A+ (Good). Hanover, together with its subsidiaries, including Citizens Insurance, was given an AA- (Excellent) S&P claims-paying ability rating (Standard & Poor's Insurance Rating Analysis, September, 1996). Management believes that its strong ratings are important factors in marketing the products of its insurance companies to its agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company ratings are assigned to an insurer based upon factors relevant to policyholders and are not directed toward protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. EMPLOYEES The Company has approximately 6,800 employees located throughout the country. Management believes relations with employees and agents are good. ITEM 2 PROPERTIES The Company's headquarters are located at 440 Lincoln Street, Worcester, Massachusetts and consist primarily of approximately 727,000 square feet of office and conference space owned in fee and include the headquarters of Hanover. Citizens Insurance owns its home office, located at 645 W. Grand River, Howell, Michigan, which is approximately 119,000 square feet. Citizens also owns a three-building complex located at 808 North Highlander Way, Howell, Michigan, with 155,000 square feet, where various business operations are conducted. The Company leases office space for its sales force throughout the United States. The leased property houses agency offices and group insurance sales offices. Hanover also leases offices throughout the country for its field employees. The Company believes that its facilities are adequate for its present needs in all material respects. 27 ITEM 3 LEGAL PROCEEDINGS Reference is made to Note 20 on page 75 of the Notes to Consolidated Financial Statements of the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. MAINE WORKERS COMPENSATION RESIDUAL MARKET POOL On June 23, 1995, the governor of Maine approved a legislative settlement for the Maine Workers' Compensation Residual Market Pool deficit for the Years 1988 through 1992. The settlement provides for an initial funding of $220.0 million toward the deficit. The insurance carriers were liable for $65.0 million and employers would contribute $110.0 million payable through surcharges on premiums over the course of the next ten years. The major insurers are responsible for 90% of the $65.0 million. Hanover's allocated share of the settlement is approximately $4.2 million, which was paid in December 1995. The remainder of the deficit of $45.0 million will be paid by the Maine Guaranty Fund, payable in quarterly contributions over ten years. A group of smaller carriers filed litigation to appeal the settlement. The Company believes that adequate reserves have been established for any additional liability. ALLMERICA P&C AND AFC MERGER Shortly after AFC publicly disclosed its proposal regarding the Merger, three separate stockholders of Allmerica P&C, Leslie Susser, Harbor Finance Partners and William A. Kass, IRA-Simplified Employee Pension, filed lawsuits in the Delaware Chancery Court against AFC, Allmerica P&C and the directors of Allmerica P&C and the directors of AFC who are also on the board of directors of Allmerica P&C (the "Delaware Actions"). An additional lawsuit challenging the Merger was filed by another stockholder of Allmerica P&C, Daniel Bruno, in the Worcester County (Massachusetts) Superior Court (the "Massachusetts Action" and , together with the Delaware Actions, the "Actions"). The named plaintiff in each of the Actions purports to maintain each individual action as a class action on behalf of the public stockholders of Allmerica P&C (excluding AFC, Allmerica P&C and the other defendants and any person, firm, trust, corporation or any other entity related to or affiliated with any of the defendants) (the "Public Stockholders"). In each of the Actions, the plaintiff alleged that under the terms of the proposed Merger AFC would acquire the Allmerica P&C Common Stock at a price that is substantially below the fair price of such stock and that certain officers and/or directors of AFC and/or Allmerica P&C breached fiduciary duties owed to Allmerica P&C and the Public Stockholders in connection with the proposed Merger. The plaintiffs sought injunctive relief prohibiting AFC from completing the Merger or, in the alternative, compensatory damages. On February 19, 1997, the parties to the Delaware Actions executed a Memorandum of Understanding (the "MOU") memorializing an agreement-in-principle to settle the Delaware Actions. Under the terms of the MOU, the parties to the Delaware Action have agreed to use their best efforts to execute and present to the Delaware Chancery Court on or before April 30, 1997, a formal Stipulation of Settlement. In the event that the Delaware Chancery Court approves the proposed settlement, it is anticipated that the Delaware Actions will be dismissed with prejudice as to the individual plaintiffs and the class of Public Stockholders. In connection with the MOU, AFC and Allmerica P&C have agreed that they will not oppose an application to the court by plaintiffs' counsel for an aggregate award of attorneys' fees and expenses in an amount not to exceed $995,000.00. SALES PRACTICES A number of civil jury verdicts have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. The Company and its subsidiaries, like other life and health insurers, from time to time are involved in such litigation. Although the outcome of any litigation cannot be predicted with certainty, to date, no such lawsuit has resulted in the award of any material amount of damages against the Company. 28 In December 1996, the Company received notice from the Securities and Exchange Commission (the "Commission") that it would be conducting a limited inspection concerning the Company's marketing and sales practices associated with variable insurance products. The Commission requested that certain information be provided to it by the Company, which the Company promptly complied with. No litigation has been instituted, nor has the Commission initiated any further action with respect to this matter. OTHER The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the opinion of management, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K. 29 PART II ITEM 5 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Reference is made to the "Shareholder Information" on page 78 of the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference, which displays (i) the principal market for the common stock of AFC, (ii) the frequency and amount of dividends paid thereon during such period, and (iii) the approximate number of holders of common shares as of February 28, 1997. Dividends by the Company are funded from dividends paid to the Company from FAFLIC, which are subject to restrictions imposed by state insurance laws and regulations with respect to dividends paid to the Company. Reference is made to "Liquidity and Capital Resources" on pages 48-49 of Management's Discussion and Analysis of Financial Condition and Results of Operations and to Note 13 on page 70 of the Notes to Consolidated Financial Statements of the 1996 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. The payment of future dividends, if any, on the Company's Common Stock will be a business decision made by the Board of Directors from time to time based upon the results of operations and financial condition of the Company and such other factors as the Board of Directors considers relevant. ITEM 6 SELECTED FINANCIAL DATA Reference is made to the "Five Year Summary of Selected Financial Highlights" on page 31 of the 1996 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 32-49 of the 1996 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Consolidated Financial Statements on pages 51-54 and the accompanying Notes to Consolidated Financial Statements on pages 55-76 of the 1996 Annual Report to Shareholders which meet the requirements of Regulation S-X, and which include a summary of quarterly results of consolidated operations (see Note 22 of Notes to Consolidated Financial Statements--page 76), which is incorporated herein by reference. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 30 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE REGISTRANT Set forth below is biographical information concerning the directors of the Company. MICHAEL P. ANGELINI, 54 Director since February 1995 Chairman, Audit Committee Mr. Angelini has been a Director of AFC since February 1995, of FAFLIC from August 1984 to April 1996, and of Allmerica P&C since August 1992. He served as a Director of Hanover from December 1991 through December 1992. Mr. Angelini is a partner at the law firm of Bowditch & Dewey, with which he has been associated since 1968, and is a Director of Flagship Bank & Trust Company. DAVID A. BARRETT, 69 Director since February 1995 Audit Committee Mr. Barrett has been a Director of AFC since February 1995, of FAFLIC from March 1976 to April 1996, of Allmerica P&C since August 1992 and of Hanover from December 1991 to December 1992. Mr. Barrett was executive director of Worcester Memorial Hospital, Inc. from 1968 until January 1983, and served as President and Chief Executive Officer of that organization until October 1988. Mr. Barrett served as President and Chief Executive Officer of Medical Center of Central Mass., Inc. from October 1988 to April 1992, and currently is a consultant to that organization, now known as Memorial Health Care. GAIL L. HARRISON, 49 Director since February 1995 Ms. Harrison has been a Director of AFC since February 1995, of FAFLIC from March 1986 to April 1996, of Allmerica P&C since August 1992, and of Hanover from December 1991 to December 1992. Since February 1981, Ms. Harrison has been affiliated with The Wexler Group (formerly Wexler, Reynolds, Harrison & Shule, Inc.), a government relations consulting firm. ROBERT P. HENDERSON, 65 Director since September 1996 Mr. Henderson has been a Director of AFC since September 1996. Mr. Henderson has been the Chairman of Greylock Management Corporation, a venture capital firm, since 1983. Mr. Henderson is also a Director of Cabot Corporation and Filenes Basement, a Trustee of the Museum of Fine Arts in Boston, Massachusetts, and a Member of Corporation of the New England Deaconess Hospital. Mr. Henderson is a former Chairman of the Federal Reserve Bank of Boston. J. TERRENCE MURRAY, 57 Director since February 1995 Mr. Murray has been a Director of AFC since February 1995 and of FAFLIC from January 1992 to April 1996. Mr. Murray is the Chairman, President and Chief Executive Officer of Fleet Financial Group, Inc., a bank holding company, where he has been employed since July 1962. Mr. Murray is also a Director of A.T. Cross Co., a writing instrument company, and CVS Corporation, a drugstore chain. 31 ROBERT J. MURRAY, 55 Director since May 1996 Mr. Murray has been a Director of AFC since May 1996. He has been Chairman, President and Chief Executive Officer of New England Business Service, Inc. ("NEBS"), a supplier of business forms, since December 1995 and has served on the Board of Directors of NEBS since 1991. Prior to joining NEBS, Mr. Murray was employed by The Gillette Company, Inc. ("Gillette"), a manufacturing company, beginning in 1961. He served as a Corporate Vice President of Gillette beginning in 1987 and as the Executive Vice President of Gillette's North Atlantic Group from January 1991 to December 1995. Mr. Murray is also a Director of North American Mortgage Company, LoJack Corporation and Fleet National Bank, as well as a Trustee of Boston College. JOHN F. O'BRIEN, 53 Director, Chief Executive Officer and President of the Company since February 1995 Mr. O'Brien has been a Director, Chief Executive Officer and President of AFC since February 1995. He has also served as a Director, Chief Executive Officer and President of FAFLIC since August 1989. In addition to his positions with AFC and FAFLIC, Mr. O'Brien has served as a Director, President and Chief Executive Officer of Allmerica P&C since August 1992, and has been a Director of Hanover since September 1989, Citizens Insurance since March 1992 and Citizens, for which he also serves as Chief Executive Officer, since December 1992. Mr. O'Brien is also a trustee or director and executive officer of Allmerica Investment Trust, Allmerica Securities Trust, and Allmerica Funds. Additionally, Mr. O'Brien is a director and/or holds offices at various other non-public FAFLIC affiliates including SMA Financial Corp. and AFLIAC. Mr. O'Brien also currently serves as a Director of The TJX Companies, Inc., an off-price family apparel retailer, ABIOMED, Inc., a medical device company, Cabot Corporation, a diversified specialty chemicals and materials and energy company, The Life Insurance Association of Massachusetts, and The American Council of Life Insurance. He also currently serves as a member of the executive committee of the Mass Capital Resource Company, a Massachusetts investment partnership. Prior to joining FAFLIC, Mr. O'Brien served as an officer of FMR Corp., the parent company of various financial services companies in the Fidelity Group and a director and/or an executive officer at various other of FMR Corp.'s affiliates. JOHN L. SPRAGUE, 66 Director since February 1995 Audit Committee Mr. Sprague has been a Director of AFC since February 1995 and of FAFLIC from September 1972 to April 1996. Mr. Sprague has been President of John L. Sprague Associates, Inc., a consulting company for technology companies, since January 1988. He served as President and Chief Executive Officer of Sprague Electric Company, a semiconductor company, from December 1980 to January 1988. Mr. Sprague is also a Director of Aerovox Corp., a manufacturing company, Sipex Corporation and California MicroDevices Corporation, an electronic components manufacturer. ROBERT G. STACHLER, 67 Director since February 1995 Compensation Committee Mr. Stachler has been a Director of AFC since February 1995, of FAFLIC from March 1978 to April 1996, of Allmerica P&C since August 1992, and of Hanover from April 1990 to December 1992. Mr. Stachler has been a partner at the law firm of Taft, Stettinius & Hollister since 1964. 32 HERBERT M. VARNUM, 59 Director since February 1995 Compensation Committee Mr. Varnum has been a Director of AFC since February 1995, of FAFLIC from March 1979 to April 1996, of Allmerica P&C since August 1992, and of Hanover from December 1991 through December 1992. Mr. Varnum was employed by Quabaug Corporation, a manufacturing company, beginning in 1960 and served as President and Chief Executive Officer from 1982 to 1989, and as Chairman and Chief Executive Officer from January 1990 until his retirement in June 1995. RICHARD M. WALL, 68 Director since February 1995 Compensation Committee Mr. Wall has been a Director of AFC since February 1995, of FAFLIC from March 1986 to April 1996, of Allmerica P&C since August 1992, and of Hanover from December 1991 through December 1992. Mr. Wall has been General Counsel and assistant to the Chairman and Chief Executive Officer of FLEXcon Company, Inc., a plastics manufacturing company, since November 1985. EXECUTIVE OFFICERS OF THE REGISTRANT JOHN F. O'BRIEN, 53 Director, Chief Executive Officer and President of the Company since February 1995 See biography under "Directors of the Registrant" above. BRUCE C. ANDERSON, 53 Vice President of the Company since February 1995 Mr. Anderson has been Vice President of AFC since February 1995 and Vice President of Allmerica P&C and Citizens since March 1997. Mr. Anderson has been employed by FAFLIC since 1967 and has been Vice President of FAFLIC since October 1984. RICHARD J. BAKER, 65 Vice President and Secretary of the Company since February 1995 Mr. Baker has been Vice President and Secretary of AFC since February 1995, Vice President and Assistant Secretary of FAFLIC since 1973 and April 1996, respectively, and has been employed by FAFLIC since 1959. He has served as Assistant Secretary of Allmerica P&C since October 1992, Vice President and Secretary of Allmerica P&C since May 1995, and as Vice President and Secretary of Citizens since September 1993 and January 1993, respectively. Mr. Baker has also served as Vice President of AFLIAC since January 1982 and as Director from June 1993 to April 1996. In addition, Mr. Baker is a director and/or executive officer at various other non-public affiliates. JOHN P. KAVANAUGH, 42 Vice President and Chief Investment Officer of the Company since 1996 Mr. Kavanaugh has been Vice President and Chief Investment Officer of AFC since September 1996, has been employed by FAFLIC since 1983, and has been Vice President of FAFLIC since December 1991 and Vice President of AFLIAC since January 1992. Mr. Kavanaugh has also served as Director and Chief Investment Officer of FAFLIC, Hanover, Citizens Insurance and AFLIAC since August 1996, and Vice President and Chief Investment Officer of Allmerica P&C and Citizens since September 1996. Mr. Kavanaugh is also a director and/or executive officer at various other non-public affiliates. 33 JOHN F. KELLY, 58 Vice President and General Counsel of the Company since February 1995 Mr. Kelly has been Vice President, General Counsel and Assistant Secretary of AFC since February 1995, has been employed by FAFLIC since July 1968, and has been Senior Vice President and General Counsel of FAFLIC since February 1986. In addition to his positions with AFC and FAFLIC, Mr. Kelly has been Vice President and General Counsel of Allmerica P&C since August 1992, Assistant Secretary of Allmerica P&C since May 1995, Assistant Secretary of Citizens since December 1992, and Vice President, General Counsel and Assistant Secretary of Citizens since September 1993. Mr. Kelly was Secretary of Allmerica P&C from August 1992 to May 1995. Mr. Kelly has been a Director of AFLIAC since October 1982 and is a director and/or executive officer at various other non-public affiliates. J. BARRY MAY, 49 Vice President of the Company since February 1997 Mr. May has been Vice President of AFC since February 1997, Vice President of Allmerica P&C and President of Hanover since September 1996 and Vice President of Citizens since March 1997. He has been a Director of Hanover and Citizens Insurance since September 1996. Mr. May served as Vice President of Hanover from May 1995 to September 1996, as Regional Vice President from February 1993 to May 1995 and as a General Manager of Hanover from June 1989 to May 1995. Mr. May has been employed by Hanover since 1985. JAMES R. MCAULIFFE, 52 Vice President of the Company since February 1995 Mr. McAuliffe has been Vice President of AFC from February 1995 through December 1995 and since February 1997, Vice President of Allmerica P&C since August 1992, a Director of Allmerica P&C from August 1992 through December 1994, a Director and Vice President of Citizens since December 1992, and a Director of AFLIAC from April 1987 through May 1995 and since May 1996. Mr. McAuliffe has been President of Citizens Insurance since December 1994. Mr. McAuliffe has been employed by FAFLIC since 1968, and served as Vice President and Chief Investment Officer of FAFLIC from November 1986 through December 1994. Mr. McAuliffe also served as Vice President and Chief Investment Officer of Allmerica P&C from August 1992 through December 1994, and Vice President and Chief Investment Officer of AFLIAC from December 1986 through May 1995. Additionally, Mr. McAuliffe is a director and/or executive officer at various other non-public affiliates. EDWARD J. PARRY, III, 37 Vice President and Treasurer of the Company since February 1995 Chief Financial Officer of the Company since December 1996 Mr. Parry has been Chief Financial Officer of AFC since December 1996. He has also been Vice President and Treasurer of AFC since February 1995. He has served as Chief Financial Officer of FAFLIC, AFLIAC, Allmerica P&C, Hanover, Citizens and Citizens Insurance since December 1996 and as Vice President and Treasurer of FAFLIC, AFLIAC, Allmerica P&C and Hanover since February 1993 and of Citizens since September 1993 and December 1992, respectively. Mr. Parry is also a director and/or executive officer at various other non-public affiliates. Prior to joining FAFLIC in July 1992, Mr. Parry was employed by the accounting firm of Price Waterhouse from July 1987 through July 1992. RICHARD M. REILLY, 58 Vice President of the Company since February 1997 Mr. Reilly has been Vice President of AFC and FAFLIC since February 1997 and November 1990, respectively, and Vice President of Allmerica P&C and Citizens since March 1997. He has also been a Director and Vice President of AFLIAC since November 1990 and President and Chief Executive Officer of AFLIAC since August 1995. Mr. Reilly was Vice President of AFC from February 1995 through December 1995. 34 Additionally, Mr. Reilly has been the President of Allmerica Investment Trust, Allmerica Funds, and Allmerica Securities Trust, each a registered investment company, since February 1991, April 1991 and February 1991, respectively. Mr. Reilly is also a director and/or holds an executive office at various other non-public affiliates. Prior to his affiliation with FAFLIC, he was executive officer of Fidelity Management and Research Company from 1969 to 1987 and Oppenheimer Capital from 1987 to 1990. LARRY C. RENFRO, 46 Vice President of the Company since February 1997 Mr. Renfro has been a Vice President of AFC and FAFLIC since February 1997 and April 1990, respectively, and Vice President of Allmerica P&C and Citizens since March 1997. He has served as Director, President and Chief Executive Officer of 440 Financial Group of Worcester, Inc. (a former subsidiary of FAFLIC) from May 1990 to March 1995. Mr. Renfro has also served as Vice President of Allmerica P&C from October 1992 through December 1995 and as Vice President of AFC from February 1995 through December 1995. From August 1989 through March 1990, Mr. Renfro was an Executive Vice President at State Street Bank & Trust Company. From March 1988 through July 1989, Mr. Renfro served as President and Chief Executive Officer of Boston Financial Data Services, Incorporated, a subsidiary of State Street Bank & Trust Company. From April 1981 through March 1988, Mr. Renfro held various executive offices at Fidelity Investments, including Managing Director of Fidelity Management & Research Company. Mr. Renfro is currently a Director of LoJack Corporation, a manufacturer of anti-theft systems. ERIC A. SIMONSEN, 51 Vice President of the Company since February 1995 Mr. Simonsen has been Vice President of AFC since February 1995. He has been a Director and Vice President of APY since August 1992, of Citizens since December 1992 and of AFLIAC since September 1990. He has served as Vice President and as a Director of FAFLIC since September 1990 and April 1996, respectively. Mr. Simonsen has been President of Allmerica Service Company, Inc. since December 1996. Mr. Simonsen was Chief Financial Officer of AFC from February 1995 to December 1996, of FAFLIC and AFLIAC from September 1990 to December 1996, of Allmerica P&C from August 1992 to December 1996 and of Citizens from December 1992 to December 1996. Mr. Simonsen is also a director and/or executive officer at various other non-public affiliates. From April 1987 to September 1990, Mr. Simonsen served as a Principal and Chief Financial Officer of The Lincoln Group, Inc., a privately owned group of manufacturing companies. PHILLIP E. SOULE, 47 Vice President of the Company since February 1997 Mr. Soule has been Vice President of AFC, Citizens, and FAFLIC since February 1997, March 1997 and February 1987, respectively, and of Allmerica P&C since September 1996. He was Vice President of AFC from February 1995 through December 1995. Mr. Soule has been employed by FAFLIC since 1972 in various capacities. 35 ITEM 11 EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The following table sets forth all plan and non-plan compensation awarded to, earned by, or paid to the Chief Executive Officer of AFC, and the four other most highly compensated executive officers of AFC (collectively, the "Named Executive Officers"). Because AFC is a holding company, it does not pay any compensation to its executive officers. The Named Executive Officers, unless otherwise indicated, receive compensation in their capacities as executive officers of FAFLIC, which is then reimbursed, in accordance with AFC's policy and intercompany service agreements, by its various subsidiaries for services rendered to such subsidiaries.
LONG-TERM ANNUAL COMPENSATION COMPENSATION ---------------------------- ------------ OTHER ANNUAL LTIP ALL OTHER COMPEN- PAY- COMPEN- NAME AND BONUS SATION OUTS SATION PRINCIPAL POSITION YEAR SALARY ($) ($)(1) ($)(2) ($)(3) ($)(4) ------------------ ---- ---------- --------- ------- ------------ --------- John F. O'Brien....... 1996 850,000 1,816,000 109,422 500,000 120,227 President and Chief 1995 775,000 775,000 109,422 250,000 120,227 Executive Officer 1994 725,000 400,000 132,922 0 161,402 Larry C. Renfro....... 1996 370,000 667,609 11,275 160,000 4,500 Vice President 1995 340,000 390,150 17,070 200,000 0 1994 340,000 95,000 10,250 240,000 21,420 Eric A. Simonsen...... 1996 370,000 406,436 12,215 160,000 4,500 Vice President 1995 305,000 99,430 18,492 210,000 4,500 1994 305,000 81,282 -- 260,000 19,215 Phillip E. Soule...... 1996 295,000 254,991 6,577 120,000 4,500 Vice President 1995 265,000 85,993 9,958 120,000 4,500 1994 245,000 91,508 3,208 140,000 15,435 Richard M. Reilly..... 1996 270,000 256,893 7,517 120,000 4,500 Vice President 1995 210,000 58,380 8,463 130,000 4,500 1994 210,000 74,760 -- 130,000 13,230
- -------- (1) Amounts shown for 1996 include the following special bonus payments, discussed in more detail in the Compensation Committee Report, which payments are intended by the Company to facilitate the purchase of AFC common stock by the executive officers in 1997: $1,000,000 for Mr. O'Brien, $150,000 for Mr. Renfro, $250,000 for Mr. Simonsen, $150,000 for Mr. Soule and $150,000 for Mr. Reilly. All other amounts shown are bonuses earned pursuant to FAFLIC's Incentive Compensation Plan, except with respect to the amounts reported for Mr. Renfro in 1996 and 1995, which also include payments of $335,384 and $255,000, respectively, in connection with the sale of FAFLIC's mutual fund servicing business, discussed below. (2) The amounts shown reflect the payment of taxes in the amount of $109,422 in 1996, $109,422 in 1995 and $109,850 in 1994 in connection with the payment by FAFLIC of a life insurance premium on behalf of Mr. O'Brien. All other amounts shown include interest earned on long-term incentive compensation paid, or deferred at the election of the Named Executive Officer, in the respective year. No Named Executive Officer received any perquisites or other personal benefits from any source for his services to FAFLIC or any subsidiary with an aggregate value exceeding the lesser of $50,000 or 10% of cash compensation. (3) Amounts shown include installment payments vesting and received by the Named Executive Officers in the respective year pursuant to awards which were earned in 1992, 1993, 1995 and 1996 under FAFLIC's Long-Term Performance Unit Plan (the "Long-Term Performance Plan"). No such cash amounts were earned in 1994 by the Named Executive Officers in respect of units granted under the Long-Term Performance Plan with values determinable based on FAFLIC's surplus level at the end of 1994. 36 (4) Amounts shown include $4,500 paid to each of the Named Executive Officers by FAFLIC during 1996 in the form of employer contributions to each Named Executive Officer's 401(k) and related post-retirement accounts pursuant to FAFLIC's 401(k) Matched Savings Plan ("Matched Savings Plan") (in effect beginning in 1995) (except amounts contributed on behalf of Messrs. O'Brien and Reilly in 1996, which are attributable to the Executive Non- Qualified Retirement Plan) as well as pursuant to FAFLIC's Excess Benefit Retirement Plan ("Excess Benefit Plan") as described more fully below. The amount shown for Mr. O'Brien in 1996 also reflects the payment by FAFLIC of a life insurance premium of $115,727. OPTION GRANTS The Company maintains a long-term stock incentive plan pursuant to which stock options covering shares of the Company's Common Stock may be granted to key employees. In 1996, the Company did not grant any options to the Named Executive Officers. LONG-TERM INCENTIVE AWARDS Neither the Company nor FAFLIC made any awards to Named Executive Officers under the Long-Term Performance Plan in 1996. EMPLOYMENT AGREEMENTS AND NON-SOLICITATION AGREEMENTS In connection with the sale of FAFLIC's mutual fund servicing business to The Shareholder Services Group, Inc. ("TSSG") and related transactions in March 1995, and in consideration of the agreement by Mr. Renfro not to engage in this business for four years, AFC agreed to pay Mr. Renfro (i) a one-time bonus payment of $350,000 in 1995 ($95,000 of which represents a payment under FAFLIC's Incentive Compensation Plan in respect of his 1994 performance), and (ii) annual contingent payments based upon the prospective performance of the businesses sold or assigned in the TSSG transactions for four years with certain guaranteed minimum payments up to a maximum aggregate amount for four years of $3.7 million. The agreement also provides that, in the event Mr. Renfro is terminated without cause, he will receive $25,000 per month until March 31, 1998 plus $600,000 (less any contingent payments made under (ii) above). In the event of any such termination without cause, the agreement provides that Mr. Renfro would be subject to confidentiality and non- competition restrictions during the payment period. As of December 31, 1996, substantially all of the Company's executive officers had entered into non-solicitation agreements ("Non-Solicitation Agreements") with the Company. The Non-Solicitation Agreements provide that, during employment and for a period of two years after termination, the executive officer will not recruit or solicit, attempt to induce, or assist or encourage others to recruit or solicit, any employee, agent or broker of the Company to terminate employment with the Company. The Non-Solicitation Agreements prohibit the executive officers from soliciting the business or patronage of any policyholders or existing or prospective clients, customers or accounts of the Company that were contacted, solicited or served while the executive officer was employed by the Company. Finally, the Non-Solicitation Agreements provide that all proprietary information relating to the Company's business and all software, works of authorship and other developments created during employment by the Company are the sole property of the Company. EMPLOYMENT CONTINUITY PLAN In December 1996 the AFC Board of Directors voted to adopt the Allmerica Financial Corporation Employment Continuity Plan (the "Employment Continuity Plan"). The purposes of the Employment Continuity Plan are (i) to secure senior management's objectivity and ensure focus on behalf of shareholder interest in the event of actions or occurrences that could lead to a Change of Control, and (ii) to ensure, in the event of a Change in Control resulting in payment under the Employment Continuity Plan, that senior management does not 37 compete in the business of the Company, solicit Company employees or disclose any confidential or propriety information of the Company. The Employment Continuity Plan is administered by the AFC Board of Directors. All of the Named Executive Officers were named as participants in the Employment Continuity Plan at its adoption. In the event of a Change in Control (defined below) of the Company and subsequent involuntary termination of a participant within a two year period after the Change in Control, or voluntary termination of the participant in the 13th month after a Change in Control, the Employment Continuity Plan authorizes the payment of specified benefits to eligible participants. These include a lump-sum cash payment equal to a Multiplier (defined below) times a participant's base salary, average bonus for the preceding three years, and the amount that would be credited under a cash balance pension plan sponsored by the Company or its affiliates. The Multiplier is three (3) for the Chief Executive Office and two (2) for all other participants. Additionally, the Employment Continuity Plan provides for continued coverage under the health and welfare benefit plans sponsored by the Company and its affiliates, the lump-sum actuarial equivalent for grandfathered benefits earned under the retirement plan for "transition group" employees for the number of years commensurate with the Multiplier, 75% of a participant's maximum bonus potential pro-rated for service performed in the year of termination, and outplacement services. The Chief Executive Officer is also entitled to a gross-up payment when the Change in Control payment or other benefit under the plan is subject to the excise tax imposed by section 4999 of the Internal Revenue Code. For purposes of the Employment Continuity Plan, a Change in Control is defined as follows: (i) a change in the composition of the Board of Directors such that the Incumbent Directors (as defined in the Employment Continuity Plan) at the beginning of any consecutive twenty-four month period cease to constitute a majority of the Board; (ii) any person or group is or becomes the beneficial owner of 35% or more of the Company's voting stock outstanding; (iii) a merger or consolidation of the Company or any affiliate that requires shareholder approval, unless the shareholders immediately prior to the merger or consolidation own more than 50% of the total voting stock of the successor corporation or a majority of the board of directors of the successor corporation were Incumbent Directors immediately prior to the merger or consolidation; or (iv) the approval by shareholders of a plan of liquidation or dissolution of the Company or the sale of all or substantially all of the Company's assets. In the event of a Change of Control, for all stock awards and stock options granted to a participant pursuant to the Company's Long-Term Stock Incentive Plan that do not otherwise vest immediately after the Change of Control, the participant will be paid a lump sum amount equal to (i) the fair market value of all stock awards as of the date of the Change of Control (excluding stock options) and (ii) with respect to stock options, the excess of the fair market value of the Company's common stock as of the date of the Change of Control over the stock option exercise price. The payment of benefits under the Employment Continuity Plan is contingent upon the Company's receipt of a signed waiver and release from the participant that release certain claims the participant may have and precludes the participant from competing with the Company for a period of two years. PENSION BENEFITS FAFLIC, Hanover and Citizens each maintain a tax-qualified, non-contributory defined benefit retirement plan ("Pension Plan") for the benefit of eligible employees. Until December 31, 1994, annual benefits under the Pension Plan were based primarily upon each employee's years of service and compensation during the highest five consecutive plan years of employment or the last 60 months if greater. Such benefits under the Pension Plan were frozen as of December 31, 1994 for most participants, with the exception of certain grandfathered employees, including Mr. Soule. These benefits will be paid to participants as a monthly annuity at age 65 unless a participant terminates with 15 or more years of service in which case monthly benefits may commence anytime after the participant's 55th birthday. Effective as of January 1, 1995, the Pension Plan was converted into a cash balance plan, such that benefits are no longer determined primarily by final average compensation and years of service. Instead, annually each employee 38 accrues a benefit that is equal to a percentage of the employee's salary, similar to a defined contribution plan arrangement. Amounts contributed by the employer to an employee are allocated to a memorandum account as to which the employee is permitted to make investment elections from among choices provided by the employer. Upon termination of employment of a participant, the amount in the participant's memorandum account as of such date is eligible for distribution. If the amount in the participant's memorandum account plus the present value of the benefit frozen under the Pension Plan as of December 31, 1994 is less than $3,500, all benefits are distributed immediately in a lump sum. The estimated annual benefits payable under the Pension Plan upon retirement at normal retirement age for each of the Named Executive Officers is as follows: Mr. O'Brien: $428,138; Mr. Renfro: $258,033; Mr. Simonsen: $151,262; Mr. Soule: $491,745; Mr. Reilly: $53,640. Such figures include amounts that have accrued under the Pension Plan as in effect on December 31, 1994, including, $355,841 for Mr. Soule. With respect to benefits attributable to the cash balance component of the Pension Plan, it was assumed that each individual's salary and bonus for the years until retirement were as shown in the Summary Compensation Table; that employer allocations were made to the Pension Plan at a rate of 7% of eligible compensation (7% is the actual amount accrued in 1996, although the plan only guarantees an accrual rate of 0.5%); and that investment earnings accrued to each participant's memorandum account under the Pension Plan at a rate of 6% per year. The estimated annual benefits under the Pension Plan shown for each of the Named Executive Officers are not reduced to reflect the limitations imposed by Federal tax laws, which place upper limits on the benefits which may be provided to any individual by tax-qualified pension plans. FAFLIC, Hanover and Citizens Insurance each have adopted an Excess Benefit Plan, an unfunded, non- qualified plan, which provides that it will pay directly the difference between the retirement benefit normally calculated under the Pension Plan and the maximum amount which may be paid from the Pension Plan consistent with Federal tax law. In addition, certain employees of FAFLIC and its subsidiaries may participate, in the discretion of the Board of Directors, in either an unfunded, Non-Qualified Executive Retirement Plan or an unfunded, Non- Qualified Executive Deferred Compensation Plan. Under the Non-Qualified Executive Retirement Plan, participating employees may (i) elect to defer compensation in an amount not to exceed the annual dollar limitation set forth in the Internal Revenue Code in respect of defined contribution plans, (ii) elect to defer additional compensation in an amount not to exceed 12.5% of the participant's annual salary, (iii) receive and defer the amount, if any, that the participant would have received as a matching employer's contribution under his employer's 401(k) Matched Savings Plan, and (iv) receive and defer the amount, if any, that the participant would have been credited under his employer's Cash Balance and Excess Benefit Plans had the participant participated in such plan during the year. Under the Non-Qualified Executive Deferred Compensation Plan, certain other employees may elect to defer up to 12.5% of their annual salaries. In both cases, AFC shall from time to time designate one or more investments in which each participant's accounts shall be deemed to be invested for the purpose of determining the participant's gains and income on such account. Participation in the Non-Qualified Executive Retirement Plan is in lieu of participation in the corresponding qualified retirement and/or pension plans of FAFLIC, Hanover or Citizens. COMPENSATION COMMITTEE REPORT General. The Compensation Committee ("Committee") of the Board of Directors is comprised of the Directors whose names appear at the end of this report, none of whom is an employee of AFC or of any affiliate or subsidiary of AFC. Among other duties, the Committee has oversight responsibility with respect to compensation matters involving Directors and executive officers of AFC. As a holding company, AFC has no employees of its own and does not pay any compensation to its officers. Officers who are employees of FAFLIC, Hanover or Citizens Insurance are compensated directly by their respective employers. In addition, a portion of the salaries and other compensation paid by FAFLIC to its employees, who provide services to Hanover or Citizens Insurance, is allocated to such companies. This report reflects the compensation philosophy of AFC, FAFLIC, Hanover and Citizens Insurance as endorsed by the Committee. 39 Compensation Philosophy. The Executive Compensation Program is designed to support the following objectives: .to attract and retain individuals key to the future success of AFC and its subsidiaries; .to align the interests of executives with those of shareholders; .to motivate and reward the profitable growth of AFC; .to ensure that AFC has competitive opportunities for key personnel. The key elements of the Executive Compensation Program consist of base salary, annual incentive compensation and long-term incentive compensation. A general description of each element and the review taken by the Committee for the 1996 fiscal period is presented in the following material. Base Salary. The chief goals of AFC and its subsidiaries are to improve market focus in order to identify profitable opportunities that capitalize on competitive strengths; to provide quality, value-added services that are flexible and responsive to customer needs; to capitalize on growth opportunities in targeted markets with innovative, market-driven products and services that can be distributed broadly and cost-effectively; and to build financial strength with effective business strategies that generate superior financial performance and deliver solid returns on capital. In furtherance of these goals, annual base salaries of the Named Executive Officers and other key executives are set at levels considered to be competitive with amounts paid to executive officers with comparable qualifications, experience and responsibilities at competing companies, based on published surveys and proxy information, which include base salary, total cash compensation data, and other SEC required salary disclosures. Annual Incentive Compensation. Annual incentive compensation for employees of FAFLIC, Hanover and Citizens Insurance is tied to the achievement of significant financial performance goals. FAFLIC, Hanover and Citizens Insurance maintain a consolidated incentive plan which provides supplementary cash compensation as an incentive to key employees who, through exceptional performance, contribute materially to the success of the companies. For 1996, the incentive plan had two components: (a) the corporate and business unit return on equity; and (b) the successful completion of individual performance goals. Awards under the incentive plan may range from 0% to 100% of a participant's base salary. Long-Term Compensation. FAFLIC maintains a Long-Term Performance Unit Plan ("Long-Term Performance Plan"). The Boards of both Hanover and Citizens Insurance have ratified the participation of certain of their officers in the Long-Term Performance Plan. The objectives of the Long-Term Performance Plan include providing incentives to attract and retain top executives and achieving significant long-term financial results for FAFLIC and its subsidiaries. Criteria considered in determining participation in the Long-Term Performance Plan include the direct and measurable impact the executive has on longer-term financial results, the influence the individual has on strategic direction and the degree of risk inherent in the individual's business decisions. Previously awarded units are payable dependent upon specific increases in capital, surplus and equity position determined at of the end of a three-year plan cycle and payments are made subject to a subsequent three-year vesting cycle. The last three-year plan cycle under the Long-Term Performance Plan began in 1995. Therefore, no Named Executive Officers were awarded Long-Term Performance Plan units in 1996, although certain awards made in 1995 will continue to vest through 1999. Commencing in 1997, long-term incentive compensation awards will be made to the Named Executive Officers pursuant to AFC's Long-Term Stock Incentive Plan. AFC, Allmerica P&C and Citizens Corporation each have in place Long Term Stock Incentive Plans (the "Stock Plans"). The objectives of each of the Stock Plans include providing incentives for participants to make substantial contributions to the company's long-term business growth, enhancing the company's ability to attract and retain executive officers and other key employees, rewarding participants for their contributions to the success of the company, and aligning the interests of executive officers and other key employees with those of 40 the company's stockholders. Up to 2,350,000 shares are available for awards under the AFC plan, up to 1,000,000 shares are available for awards under Allmerica P&C's plan and up to 200,000 shares are available for awards under Citizens Corporation's plan. In connection with its conversion from a mutual life insurance company to a stock life insurance company in October 1995, State Mutual Life Assurance Company of America, FAFLIC's predecessor, agreed with the Commissioner of Insurance of the Commonwealth of Massachusetts, in the Plan of Reorganization dated February 28, 1995 (the "Plan of Reorganization"), that certain executive officers of FAFLIC and AFC would not be permitted to acquire AFC stock, and would not be eligible to participate in any stock-based compensation plan, until one year after the demutualization was completed. As a result, during 1996 no stock-based awards were made to the ineligible executive officers, which included the Named Executive Officers. Factors to be considered in determining the grant of options under the respective stock plans include the contribution of each executive to the long- term performance of AFC, Allmerica P&C or Citizens Corporation, respectively, and the importance of such executive's responsibilities within the organization. Special Cash Bonus. In evaluating the total compensation of the Named Executive Officers and certain other executive officers of FAFLIC and Hanover, the Compensation Committee also considered the importance of individual stock ownership of executive officers to the future performance of the Company. Due to the restrictions imposed by the Plan of Reorganization prohibiting the Named Executive Officers and certain other executive officers of AFC and FAFLIC from acquiring AFC stock or participating in AFC's Stock Plan until October 1996, the Compensation Committee approved a special cash bonus payment to these executives with the intent that the bonus be used to purchase an equal amount of AFC Common Stock. As an incentive to encourage such purchases, for each share of AFC Common Stock purchased with such bonus funds, certain of the Named Executive Officers will be awarded one share of restricted stock pursuant to the AFC Stock Plan. Compensation of the Chief Executive Officer. John F. O'Brien, President and Chief Executive Officer of AFC, serves as President and Chief Executive Officer of FAFLIC, and as Chairman of the Board of Hanover and of Citizens Insurance. In approving the 1996 compensation package for Mr. O'Brien, the Compensation Committee compared Mr. O'Brien's compensation against the comparative base salaries, annual and long-term incentives and other compensation of chief executives of a peer group of companies. The peer goup companies included (i) insurance companies identified as having distribution systems, products/product mix and/or markets similar to FAFLIC and its subsidiaries; (ii) a subset of insurance companies that were identified by scope of financial activity (such as assets, revenue, and net written premium); and (iii) a subset of financial service companies that provide for a stratification of salary data based on similarity in the nature and scope of business activities. The Compensation Committee assumes (a) that such independent variables are meaningful in determining CEO compensation, and (b) that a correlation exists between pay and such variables. However, the approach does not consider variances in the business strategies and goals of each company, the relative competitive positions of the companies, and the personal characteristics and accomplishments of the individual executives. Therefore, the review of Mr. O'Brien's compensation by the Compensation Committee also included an assessment of the performance of FAFLIC and its subsidiaries in terms of profitability and growth in the various business lines, as well as an evaluation of the capital positions of the companies, the implementation of significant cost controls and other strategic initiatives. In comparison to the peer group of companies, Mr. O'Brien's base salary was near the median, while the potential for incentive compensation, as a percentage of base salary, was below the median. Mr. O'Brien's 1996 incentive compensation performance measures included a corporate goal based upon GAAP Consolidated Net Income Return on Equity of AFC, business unit Return on Equity, focus goals relating to earnings per share, revenue, AFC's stock price and individual performance goals. Individual performance goals included significant improvement in earnings and capital; development of alternate distribution systems; initiatives to improve technology; and continued development and implementation of a strategic plan for the Company. Achievement of individual performance goals and other initiatives undertaken by Mr. O'Brien in 1996 resulted in performance that exceeded expectations. 41 The Compensation Committee carefully reviewed Mr. O'Brien's personal achievements against his 1996 goals and based on its evaluation, the Committee approved Mr. O'Brien's annual incentive compensation award of 96% of his base salary, out of a maximum potential of 100% of base salary. In addition, the Committee approved a special bonus award to Mr. O'Brien in the amount of $1,000,000, based on the reasons discussed in the paragraph entitled "Special Cash Bonus" above. The Committee believes that the executive compensation policies of AFC and its subsidiaries are appropriate both to attract and retain corporate officers and other key employees of outstanding abilities and to motivate them to perform to the full extent of their abilities. Compliance with Internal Revenue Code Section 162(m). Section 162(m) of the Internal Revenue Code, enacted in 1993, generally disallows a tax deduction to public companies for compensation over $1 million paid to the corporation's Chief Executive Officer and its four other most highly compensated executive officers. Qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met. In 1996, the compensation paid to the Chief Executive Officer exceeded the limit imposed by Section 162(m). The Committee monitors the impact of Section 162(m) in order to balance the benefits of favorable tax treatment with a need to apply prudent judgment in carrying out AFC's compensation philosophy, recognizing that under certain circumstances it may be appropriate to exceed the deduction limit. Members of the Compensation Committee: Herbert M. Varnum, Chair Robert G. Stachler Richard M. Wall DIRECTOR COMPENSATION Non-employee Directors of AFC who are not also directors of APY receive an annual retainer of $20,000. Non-employee Directors of AFC who are also directors of APY receive an aggregate retainer of $30,000. In addition, non- employee Directors of AFC receive $1,500 per meeting of the Board of Directors and $1,000 for each meeting of a committee thereof that they attend. Mr. O'Brien, the only Employee Director, is not paid any fees or additional compensation for service as a member of the Board of Directors or any of its committees. All Directors are reimbursed for reasonable travel and other expenses of attending meetings of the Board of Directors and committees of the Board of Directors. As of the date of the annual meeting in 1997, Non-employee Directors of AFC will receive an annual retainer of 1,400 shares of AFC stock payable on the first business day following the annual meeting. Chairpersons of committees will receive a $4,000 annual retainer. In addition, Non-employee Directors of AFC will receive $1,500 per meeting of the Board of Directors and $1,000 for each meeting of a committee thereof that they attend. SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE Section 16(a) of the Securities Exchange Act of 1934 requires executive officers and Directors, and persons who beneficially own more than ten percent (10%) of the Common Stock, to file initial reports of ownership and reports of changes in ownership with the Securities and Exchange Commission (the "SEC") and the New York Stock Exchange (the "NYSE"). Such persons are required by SEC regulations to provide to AFC copies of all their Section 16(a) filings. Based solely on a review of the forms furnished to AFC and written representations from AFC's executive officers and Directors, AFC believes that during 1996 there was full compliance with all Section 16(a) filing requirements. CERTAIN BUSINESS RELATIONSHIPS The Company's subsidiaries or affiliates have, from time to time, retained the services of Bowditch & Dewey, LLP, a law firm in which Mr. Angelini, a Director of the Company, is a partner. 42 COMMON STOCK PERFORMANCE CHART The following graph compares the performance of the Company's Common Stock since its initial public offering on October 11, 1995 with the performance of the S&P 500 Index and with the performance of an industry peer group comprised of a composite of two published indices--the S&P Property-Casualty Insurance Index and the S&P Life Insurance Index. Returns of the latter two indices have been weighted according to their respective aggregate market capitalization at the beginning of each period shown on the graph. The graph plots the changes in the value of an initial $100 investment over the indicated time periods, assuming reinvestment of all dividends. COMPARISON OF 14 MONTH CUMULATIVE TOTAL RETURN * AMONG ALLMERICA FINANCIAL CORPORATION, THE S&P 500 INDEX AND A PEER GROUP [GRAPH APPEARS HERE] - -------- * $100 invested on 10/11/95 in stock or index--including reinvestment of dividends. Fiscal year ending December 31. The insurance composite is a market value weighted composite of the S&P Property-Casualty Insurance and the S&P Life Insurance indices. The components of the insurance composite have been weighted in accordance with the respective aggregate market capitalization of the companies in each index as of the date of Allmerica Financial Corporation's public offering and at the beginning of each period shown on the graph, as indicated below:
10/11/95 12/95 3/96 6/96 9/96 12/96 -------- ------ ------ ------ ------ ------ S&P Property-Casualty.......... 62.09% 62.73% 61.13% 60.78% 59.62% 61.47% S&P Life....................... 37.91% 37.27% 38.87% 39.22% 40.38% 38.53% ------ ------ ------ ------ ------ ------ Total.......................... 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% ====== ====== ====== ====== ====== ======
The Compensation Committee Report and Stock Price Performance Graph above shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that AFC specifically incorporates this information by reference, and shall not otherwise be deemed filed under such acts. 43 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the number of shares of Common Stock of AFC, APY and Citizens Corporation owned as of March 17, 1997 by (i) each Director of AFC, (ii) the named executive officers in the Summary Compensation Table appearing later in this Proxy Statement, (iii) all officers and directors of AFC as a group and (iv) each person who is known by AFC to be the beneficial owner of more than five percent of the Common Stock as of such date. This information has been furnished by the persons listed in the table.
NUMBER OF SHARES OF NUMBER OF SHARES OF NUMBER OF SHARES OF NAME OF COMMON STOCK OF COMMON STOCK OF COMMON STOCK OF BENEFICIAL OWNER AFC* APY* CITIZENS* ---------------- ------------------- ------------------- ------------------- Michael P. Angelini..... 54 3,000 -- David A. Barrett........ 285 600 1,000(1) Gail L. Harrison........ 82 450 -- Robert P. Henderson..... -- -- -- J. Terrence Murray...... 69 -- -- Robert J. Murray........ -- -- -- John F. O'Brien......... 270(2) 16,000 1,000 Richard M. Reilly....... 98(3) -- -- Larry C. Renfro......... 88(4) -- -- Eric A. Simonsen........ 146(5) 9,000(6) 3,000(7) Phillip E. Soule........ 652(8) 300 100 John L. Sprague......... 220 -- -- Robert G. Stachler...... 171 -- -- Herbert M. Varnum....... 76 600 -- Richard M. Wall......... 180 -- -- Directors and executive officers as a group (22 persons)............... 21,674(9) 40,400 12,500 Holder of Greater Than Five Percent of Common Stock 10.43% of shares of AFC Common FMR Corp................ 5,233,970(10) Stock outstanding 82 Devonshire Street Boston MA 02109
- -------- * With the exception of FMR Corp.'s holdings of AFC Common Stock, each of the amounts represents less than 1% of the outstanding shares of Common Stock as of March 22, 1996. As to shares beneficially owned, each person has sole voting and investment power, except as indicated in other footnotes to this table. (1) Shares owned by Mr. Barrett's spouse. Mr. Barrett disclaims beneficial ownership with respect to such shares. (2) Includes 198 shares held for the benefit of Mr. O'Brien by the trustees of the First Allmerica Financial Life Insurance Company's Employees' 401(k) Matched Savings Plan (the "FAFLIC Plan"). (3) Shares held for the benefit of Mr. Reilly by the trustees of the FAFLIC Plan. (4) Shares held for the benefit of Mr. Renfro by the trustees of the FAFLIC Plan. (5) Shares held for the benefit of Mr. Simonsen by the trustees of the FAFLIC Plan. (6) Includes an aggregate of 3,000 shares of Common Stock of APY held in trusts for the benefit of Mr. Simonsen's children. Mr. Simonsen is trustee of the trusts and he disclaims beneficial ownership of the shares held in the trusts. (7) Includes an aggregate of 1,000 shares of Common Stock of Citizens held in trusts for the benefit of Mr. Simonsen's children. Mr. Simonsen is trustee of the trusts and he disclaims beneficial ownership of the shares held in the trusts. 44 (8) Includes 596 shares held for the benefit of Mr. Soule by the trustees of the FAFLIC Plan. (9) Includes 18,683 shares held by the trustees of the FAFLIC Plan. See notes 2-5 and 8 above. (10) Based on a Schedule 13G dated February 14, 1997 filed by FMR Corp., which has sole dispositive power overall 5,226,920 shares and sole voting power over 289,820 shares. As of March 17, 1997, there were no persons other than FMR Corp. known to AFC to be the beneficial owners of more than 5% of the outstanding shares of Common Stock. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AFC's subsidiary, FAFLIC, currently provides various centralized administrative and management services, operating support and office space to Allmerica P&C and its subsidiaries, as well as to other FAFLIC subsidiaries. Effective in 1970, Allmerica P&C's predecessor entered into an agreement with FAFLIC pursuant to which FAFLIC agreed to provide services to Allmerica P&C in accordance with FAFLIC's cost allocation policy. FAFLIC's cost allocation policy is based on state insurance law requirements that all cost allocations be on a fair and reasonable basis between entities and product lines within FAFLIC's holding company structure and also are designed to meet regulations imposed by taxing authorities. Services provided by FAFLIC include investment services, portfolio management, and a certain amount of accounting, financial, legal and administrative services, operations relating to servicing and underwriting of policies and information and data systems. FAFLIC's cost allocation and distribution policies are subject to review by various state and federal regulatory agencies. AFC intends to continue to provide such services on the same cost allocation basis to Allmerica P&C and its subsidiaries immediately following the Merger Transactions. Administrative charges (excluding rental charges) incurred by FAFLIC and charged to Allmerica P&C were $58.0 million, $50.8 million and $63.1 million for the years ended December 31, 1996, 1995 and 1994, respectively. Allmerica P&C leases its principal office from FAFLIC, with which it shares most of the facility. The annual rental charge was $1.3 million for each of the years ended December 31, 1996, 1995 and 1994. The rent is triple net, with rent based on cost using a fluctuating interest rate. FAFLIC believes that such terms are no less favorable to Allmerica P&C than if the property was leased to a non-affiliate. In April 1996, Ms. Harrison and Messrs. Angelini, Barrett, J.T. Murray, Sprague, Stachler, Varnum and Wall resigned their positions as Directors of FAFLIC, the Company's operating subsidiary, in connection with the Company's restructuring following the demutualization of FAFLIC's predecessor, State Mutual Life Assurance Company of America. FAFLIC's subsequent Board of Directors, consisting of insiders, terminated a FAFLIC policy that provided FAFLIC's directors with periodic cash payments upon retirement from the FAFLIC Board based on years of service with that company. Accrued benefits under the terminated policy, which will be paid to the former FAFLIC directors in one lump sum in 1997, had the following values as of December 17, 1996: $33,074 for Mr. Angelini; $166,851 for Mr. Barrett; $23,910 for Ms. Harrison; $18,417 for Mr. J.T. Murray; $137,745 for Mr. Sprague; $126,798 for Mr. Stachler; $72,913 for Mr. Varnum; and $76,229 for Mr. Wall. Until the amounts above are disbursed, the funds are accruing interest at the rate of 7% per annum. 45 PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS The consolidated financial statements and accompanying notes thereto on pages 51 through 76 of the 1996 Annual Report to Shareholders have been incorporated herein by reference in their entirety.
ANNUAL REPORT PAGE(S) -------- Report of Independent Accountants................................. 50 Consolidated Statements of Income for the years ended December 31, 1996, 1995 and 1994.............................................. 51 Consolidated Balance Sheets as of December 31, 1996 and 1995...... 52 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994................................. 53 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994.......................................... 54 Notes to Consolidated Financial Statements........................ 55-76
(A)(2) FINANCIAL STATEMENT SCHEDULES
PAGE NO. IN SCHEDULE THIS REPORT -------- ----------- Report of Independent Accountants on Financial Statement Schedules.................................... 51 Summary of Investments--Other than Investments in I Related Parties........................................ 52 II Condensed Financial Information of Registrant.......... 53-55 III Supplementary Insurance Information.................... 56-58 IV Reinsurance............................................ 59 V Valuation and Qualifying Accounts...................... 60 VI Supplemental Information concerning Property/Casualty Insurance Operations................................... 61
(A)(3) EXHIBIT INDEX Exhibits filed as part of this Form 10-K are as follows: 2.1 Plan of Reorganization.+ 2.2 Stock and Asset Purchase Agreement by an among State Mutual Life Assurance Company of America, 440 Financial Group of Worcester, Inc., and The Shareholder Services Group, Inc. dated as of March 9, 1995.+ 2.3 Agreement and Plan of Merger, dated as of February 19, 1997, among AFC, Allmerica Property and Casualty Companies, Inc. and APY Acquisition, Inc.++++ 3.1 Certificate of Incorporation of AFC.+ 3.2 By-Laws of AFC.+ 4 Specimen Certificate of Common Stock.+ 4.1 Form of Indenture relating to the Debentures between the Registrant and State Street Bank & Trust Company, as trustee.++ 4.2 Form of Global Debenture.++ 4.3 Amended and Restated Declaration of Trust of AFC Capital Trust I dated February 3, 1997.+++++ 4.4 Indenture dated February 3, 1997 relating to the Junior Subordinated Debentures of AFC.+++++
46 4.5 Series A Capital Securities Guarantee Agreement dated February 3, 1997.+++++ 4.6 Common Securities Guarantee Agreement dated February 3, 1997.+++++ 4.7 Registration Rights Agreement dated February 3, 1997.+++++ 10.1 Consolidated Income Tax Agreement between Allmerica Financial Corporation and certain subsidiaries dated January 1, 1996.+++ 10.2 Consolidated Service Agreement between State Mutual Life Assurance Company of America and its subsidiaries, dated September 30, 1993.+ 10.2.1 Addendum to the Consolidated Service Agreement between State Mutual Life Assurance Company of America and its subsidiaries, dated October 9, 1995.+++ 10.2.2 Addendum to the Consolidated Service Agreement between State Mutual Life Assurance Company of America and its subsidiaries, dated November 30, 1995.+++ 10.3 Administrative Services Agreement between State Mutual Life Assurance Company of America and The Hanover Insurance Company, dated July 19, 1989.+ 10.4 First Allmerica Financial Life Insurance Company Employees' 401(k) Matched Savings Plan incorporated by reference to Exhibit 10.1 to the Allmerica Financial Corporation Registration Statement on Form 8-K (No. 333-576) and incorporated herein by reference originally filed with the Commission on January 24, 1996. 10.5 State Mutual Life Assurance Company of America Excess Benefit Retirement Plan.+ 10.6 State Mutual Life Assurance Company of America Supplemental Executive Retirement Plan.+ 10.7 State Mutual Incentive Compensation Plan.+ 10.8 State Mutual Companies Long-Term Performance Unit Plan.+ 10.9 Indenture of Lease between State Mutual Life Assurance Company of America and the Hanover Insurance Company dated July 3, 1984 and corrected First Amendment to Indenture of Lease dated December 20, 1993.+ 10.11 Lease dated November 1993 by and between Connecticut General Life Insurance Company and State Mutual Life Assurance Company of America, including amendments thereto, relating to property in Marlborough, Massachusetts.+ 10.12 Lease dated March 23, 1993 by and between Aetna Life Insurance Company and State Mutual Life Assurance Company of America, including amendments thereto, relating to property in Atlanta, Georgia.+ 10.13 Stockholder Services Agreement dated as of January 1, 1992 between Private Healthcare Systems, Inc. and Group Healthcare Network, Inc., a wholly-owned subsidiary of State Mutual Life Assurance Company of America.+ 10.14 Lease dated January 26, 1995 by and between Citizens Insurance and Upper Peninsula Commission for Area Progress, Inc., including amendments thereto, relating to property in Escanaba, Michigan.+ 10.15 Compensation Agreement between State Mutual Life Assurance of America and Larry E. Renfro.+ 10.16 Trust Indenture for the State Mutual Life Assurance Company of America Employees' 401(k) Matched Savings Plan between State Mutual Life Assurance Company of America and Bank of Boston/Worcester.+ 10.17 State Mutual Life Assurance Company of America Non-Qualified Executive Retirement Plan.+ 10.18 State Mutual Life Assurance Company of America Non-Qualified Executive Deferred Compensation Plan.+ 10.19 The Allmerica Financial Cash Balance Pension Plan incorporated by reference to Exhibit 10.19 to the Allmerica Financial Corporation September 30, 1995 report on Form 10-Q and incorporated herein by reference. 10.20 The Allmerica Financial Corporation Employment Continuity Plan 10.21 Form of Non-Solicitation Agreement executed by substantially all of the executive officers of AFC. 11 Statement regarding computation of per share earnings. 13 Annual Report to Shareholders for 1996. 21 Subsidiaries of AFC. 23 Consent of Price Waterhouse LLP. 24 Power of Attorney.
47 27 Financial Data Schedule. 99.1 Internal Revenue Service Ruling dated April 15, 1995.+ 99.2 Important Factors Regarding Forward Looking Statements.
- -------- + Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's Registration Statement on Form S-1 (No. 33-91766) originally filed with the Commission on May 1, 1995. ++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's Registration Statement on Form S-1 (No. 33-96764) originally filed with the Commission on September 11, 1995. +++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1995 Annual Report on Form 10-K originally filed with the Commission on March 28, 1996. ++++ Incorporated by herein by reference to Exhibit I of the Current Report of the Registrant (Commission File No. 1-13754) filed February 20, 1997. +++++ Incorporated herein by reference to Exhibits 2, 3, 4, 5 and 6, respectively, contained in the Registrant's Current Report on Form 8-K filed on February 5, 1997. (B) REPORTS ON FORM 8-K On December 18, 1996, a report on Form 8-K was filed reporting under item 5, Other Events, the announcement by the Registrant that AFC's Board of Directors had made a proposal to the Board of Directors of Allmerica P&C to acquire the shares of Common Stock of Allmerica P&C that AFC and its subsidiaries do not already own. On February 5, 1997, a report on Form 8-K was filed reporting under item 5, Other Events, the announcement of the sale of $300 million of Capital Securities issued by AFC Capital Trust I. On February 20, 1997, a report on Form 8-K was filed reporting under item 5, Other Events, the announcement that the Company and Allmerica P&C entered into an Agreement and Plan of Merger. 48 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES AND 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 Date: March 18, 1997 /s/ John F. O'Brien By: _________________________________ JOHN F. O'BRIEN, CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND PRESIDENT PURSUANT TO THE REQUIREMENTS OF THE SECURITIES AND EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. Date: March 18, 1997 /s/ John F. O'Brien By: _________________________________ JOHN F. O'BRIEN, CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND PRESIDENT Date: March 18, 1997 /s/ Edward J. Parry, III By: _________________________________ EDWARD J. PARRY III, VICE PRESIDENT, CHIEF FINANCIAL OFFICER AND PRINCIPAL ACCOUNTING OFFICER Date: March 18, 1997 * By: _________________________________ MICHAEL P. ANGELINI, DIRECTOR Date: March 18, 1997 By: _________________________________ DAVID A. BARRETT, DIRECTOR Date: March 18, 1997 * By: _________________________________ GAIL L. HARRISON, DIRECTOR Date: March 18, 1997 By: _________________________________ ROBERT P. HENDERSON, DIRECTOR 49 Date: March 18, 1997 * By: _________________________________ J. TERRENCE MURRAY, DIRECTOR Date: March 18, 1997 * By: _________________________________ ROBERT J. MURRAY, DIRECTOR Date: March 18, 1997 * By: _________________________________ JOHN L. SPRAGUE, DIRECTOR Date: March 18, 1997 * By: _________________________________ ROBERT G. STACHLER, DIRECTOR Date: March 18, 1997 * By: _________________________________ HERBERT M. VARNUM, DIRECTOR Date: March 18, 1997 * By: _________________________________ RICHARD M. WALL, DIRECTOR /s/ John F. O'Brien *By: ________________________________ JOHN F. O'BRIEN, ATTORNEY-IN-FACT 50 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Allmerica Financial Corporation Our audits of the consolidated financial statements referred to in our report dated February 3, 1997, except as to Notes 1 and 2, which are as of February 19, 1997, appearing in the Allmerica Financial Corporation 1996 Annual Report to Shareholders (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. As discussed in the accompanying notes to the consolidated financial statements, the Company changed its method of accounting for investments (Note 1) and postemployment benefits (Note 11) in 1994. /s/ Price Waterhouse LLP _____________________________________ Price Waterhouse LLP Boston, Massachusetts February 3, 1997, except as to Notes 1 and 2, which are as of February 19, 1997 51 SCHEDULE I ALLMERICA FINANCIAL CORPORATION SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1996
AMOUNT AT WHICH SHOWN IN THE BALANCE TYPE OF INVESTMENT COST (1) VALUE SHEET - ------------------ -------- ------- -------------- (IN MILLIONS) Fixed maturities: Bonds: United States Government and government agencies and authorities.................. $ 520.8 $ 530.7 $ 530.7 States, municipalities and political subdi- visions................................... 2,228.8 2,269.6 2,269.6 Foreign governments........................ 108.8 116.2 116.2 Public utilities........................... 495.7 508.3 508.3 Convertibles and bonds with warrants at- tached.................................... 1.1 1.3 1.3 All other corporate bonds.................. 3,844.8 3,952.8 3,952.8 Redeemable preferred stocks.................. 105.5 108.9 108.9 -------- ------- -------- Total fixed maturities..................... 7,305.5 7,487.8 7,487.8 -------- ------- -------- Equity securities: Common stocks: Public utilities........................... 4.9 5.5 5.5 Banks, trust and insurance companies....... 30.6 55.1 55.1 Industrial, miscellaneous and all other.... 281.4 401.5 401.5 Nonredeemable preferred stocks............... 11.3 11.5 11.5 -------- ------- -------- Total equity securities.................... 328.2 473.6 473.6 -------- ------- -------- Mortgage loans on real estate.................. 650.1 XXXXXX 650.1 Real estate (2)................................ 120.7 XXXXXX 120.7 Policy loans................................... 132.4 XXXXXX 132.4 Other long-term investments.................... 128.8 XXXXXX 128.8 -------- -------- Total investments.......................... $8,665.7 XXXXXX $8,993.4 ======== ========
- -------- (1) Original cost of equity securities and, as to fixed maturities, original cost reduced by repayments and adjusted for amortization of premiums and accretion of discounts. (2) Includes $106.6 million of real estate acquired through foreclosure. 52 SCHEDULE II ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31,
1996 1995 1994 ------ ------ ----- (IN MILLIONS) Revenues Net investment income................................. $ 2.7 $ 0.4 $ -- Net realized investment losses........................ (0.9) -- -- ------ ------ ----- Total revenues...................................... 1.8 0.4 38.0 ------ ------ ----- Expenses Interest expense...................................... 15.3 3.2 -- Operating expenses.................................... 3.3 0.3 -- ------ ------ ----- Total expenses...................................... 18.6 3.5 -- ------ ------ ----- Net income before federal income taxes and equity in net income of unconsolidated subsidiaries.................. (16.8) (3.1) 38.0 Federal income tax benefit.............................. 5.9 -- -- Equity in net income of unconsolidated subsidiaries prior to demutualization............................... -- 93.2 38.0 Equity in net income of unconsolidated subsidiaries subsequent to demutualization.......................... 192.8 43.8 -- ------ ------ ----- Net income.............................................. $181.9 $133.9 $38.0 ====== ====== =====
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. Allmerica Financial Corporation ("AFC") was incorporated under Delaware law on January 12, 1995, for the purpose of becoming the parent holding company of First Allmerica Financial Insurance Company ("FAFLIC"). Accordingly, the financial information reflects the equity in the financial position and results of operations of FAFLIC for the periods prior to the date of demutualization as if AFC had been the parent of FAFLIC at that time. 53 SCHEDULE II (CONTINUED) ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY BALANCE SHEETS
DECEMBER 31, --------------------------- 1996 1995 ------------- ------------- (IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) ASSETS Fixed maturities-at fair value (amortized cost of $26.4).......................................... $ 26.2 $ -- Equity securities-at fair value (amortized cost of $0.4)........................................ 0.6 -- Cash............................................. 2.5 52.9 Investment in unconsolidated subsidiaries........ 1,896.3 1,724.2 Accrued investment income........................ 0.4 0.2 Other assets..................................... 5.2 2.3 ------------- ------------- Total assets................................... $1,931.2 $1,779.6 ============= ============= LIABILITIES Expenses and taxes payable....................... $ 1.1 $ 0.2 Deferred income taxes............................ 0.1 -- Dividends payable................................ 2.5 2.5 Interest payable................................. 3.3 3.2 Long-term debt................................... 199.5 199.5 ------------- ------------- Total liabilities.............................. 206.5 205.4 ------------- ------------- Shareholders' Equity Preferred stock, par value $0.01 per share, 20.0 million shares authorized, none issued.......... -- -- Common stock, par value $0.01 per share, 300.0 million shares authorized, 50.1 million shares issued and outstanding at December 31, 1996 and December 31, 1995............................... 0.5 0.5 Additional paid-in-capital....................... 1,382.5 1,382.5 Unrealized appreciation on investments, net...... 131.6 153.0 Retained earnings................................ 210.1 38.2 ------------- ------------- Total shareholders' equity..................... 1,724.7 1,574.2 ------------- ------------- Total liabilities and shareholders' equity..... $1,931.2 $1,779.6 ============= =============
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. Allmerica Financial Corporation ("AFC") was incorporated under Delaware law on January 12, 1995, for the purpose of becoming the parent holding company of First Allmerica Financial Insurance Company ("FAFLIC"). Accordingly, the financial information reflects the equity in the financial position and results of operations of FAFLIC for the periods prior to the date of demutualization as if AFC had been the parent of FAFLIC at that time. 54 SCHEDULE II (CONTINUED) ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,
1996 1995 1994 ------- ------- ------ (IN MILLIONS) Cash flows from operating activities Net income, including net income prior to demutualization................................... $ 181.9 $ 133.9 $ 38.0 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed income of First Allmerica Financial Life Insurance Company................. (192.8) (137.0) (38.0) Net realized investment losses.................... 0.9 -- -- Change in accrued investment income............... (0.2) (0.2) -- Change in expenses and taxes payable.............. 0.9 0.2 -- Change in dividends payable....................... -- 2.5 -- Change in debt interest payable................... 0.1 3.2 -- Other, net........................................ (3.6) (2.5) ------- ------- ------ Net cash (used in) provided by operating activities......................................... (12.8) 0.1 -- ------- ------- ------ Cash flows from investing activities Capital contributed to unconsolidated subsidiaries......... -- (392.4) -- Proceeds from disposals and maturities of available-for- sale fixed maturities.............. 32.7 -- -- Purchase of available-for-sale fixed maturities.... (59.6) -- -- Purchase of equity securities...................... (0.7) -- -- ------- ------- ------ Net cash used in investing activities............... (27.6) (392.4) -- ------- ------- ------ Cash flow from financing activities Net proceeds from issuance of common stock...................... -- 248.0 -- Net proceeds from issuance of debt securities...... -- 197.2 -- Dividends paid to shareholders..................... (10.0) -- -- ------- ------- ------ Net cash (used in) provided by financing activities......................................... (10.0) 445.2 -- ------- ------- ------ Net change in cash and cash equivalents............. (50.4) 52.9 -- Cash and cash equivalents at beginning of the period............................................. 52.9 -- -- ------- ------- ------ Cash and cash equivalents at end of the period...... $ 2.5 $ 52.9 $ -- ======= ======= ======
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. Allmerica Financial Corporation ("AFC") was incorporated under Delaware law on January 12, 1995, for the purpose of becoming the parent holding company of First Allmerica Financial Insurance Company ("FAFLIC"). Accordingly, the financial information reflects the equity in the financial position and results of operations of FAFLIC for the periods prior to the date of demutualization as if AFC had been the parent of FAFLIC at that time. 55 SCHEDULE III ALLMERICA FINANCIAL CORPORATION SUPPLEMENTARY INSURANCE INFORMATION DECEMBER 31, 1996
FUTURE POLICY AMORTIZA- BENEFITS, OTHER BENEFITS, TION OF DEFERRED LOSSES, POLICY CLAIMS, DEFERRED POLICY CLAIMS AND CLAIMS AND NET INVEST- LOSSES AND POLICY OTHER PREM- ACQUISI- LOSS UNEARNED BENEFITS PREMIUM MENT SETTLEMENT ACQUISI- OPERATING IUMS TION COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES TION COSTS EXPENSES WRITTEN ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (IN MILLIONS) RISK MANAGEMENT Regional Property and Casualty.... $164.2 $2,744.1 $815.1 $12.8 $1,898.3 $235.4 $1,383.4 $422.6 $190.0 $1,914.4 Corporate Risk Management Services........ 2.9 299.0 4.7 11.1 302.9 21.7 211.3 3.1 126.4 -- RETIREMENT AND ASSET MANAGEMENT Retail Financial Services........ 649.0 2,225.5 2.7 120.1 34.0 198.7 202.2 54.9 117.6 -- Institutional Services........ 6.6 289.2 -- 1,916.4 1.1 214.0 160.1 2.9 50.9 -- Allmerica Asset Management...... -- -- -- -- -- 0.1 -- -- 7.7 -- Corporate........ -- -- -- -- -- 2.7 -- -- 18.6 -- Eliminations..... -- -- -- -- -- -- -- -- (8.7) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $822.7 $5,557.8 $822.5 $2,060.4 $2,236.3 $672.6 $1,957.0 $483.5 $502.5 $1,914.4 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
56 SCHEDULE III (CONTINUED) ALLMERICA FINANCIAL CORPORATION SUPPLEMENTARY INSURANCE INFORMATION DECEMBER 31, 1995
FUTURE POLICY AMORTIZA- BENEFITS, OTHER BENEFITS, TION OF DEFERRED LOSSES, POLICY CLAIMS, DEFERRED POLICY CLAIMS AND CLAIMS AND NET INVEST- LOSSES AND POLICY OTHER PREM- ACQUISI- LOSS UNEARNED BENEFITS PREMIUM MENT SETTLEMENT ACQUISI- OPERATING IUMS TION COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES TION COSTS EXPENSES WRITTEN ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (IN MILLIONS) RISK MANAGEMENT Regional Property and Casualty.... $157.5 $2,896.0 $797.3 $ 12.8 $1,863.2 $209.6 $1,300.3 $409.1 $179.4 $1,885.3 Corporate Risk Management Services........ 2.3 282.4 0.8 9.4 272.7 17.6 197.2 2.7 110.3 -- RETIREMENT AND ASSET MANAGEMENT Retail Financial Services........ 569.4 2,248.2 2.8 148.7 86.6 216.3 295.0 55.3 101.2 -- Institutional Services........ 6.5 294.0 -- 2,566.5 0.3 266.4 217.8 3.2 66.4 -- Allmerica Asset Management...... -- -- -- -- -- 0.2 -- -- 2.1 -- Corporate........ -- -- -- -- -- 0.4 -- -- 3.5 -- Eliminations..... -- -- -- -- -- -- -- -- (4.4) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $735.7 $5,720.6 $800.9 $2,737.4 $2,222.8 $710.5 $2,010.3 $470.3 $458.5 $1,885.3 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
57 SCHEDULE III (CONTINUED) ALLMERICA FINANCIAL CORPORATION SUPPLEMENTARY INSURANCE INFORMATION DECEMBER 31, 1994
FUTURE POLICY AMORTIZA- BENEFITS, OTHER BENEFITS, TION OF DEFERRED LOSSES, POLICY CLAIMS, DEFERRED POLICY CLAIMS AND CLAIMS AND NET INVEST- LOSSES AND POLICY OTHER PREM- ACQUISI- LOSS UNEARNED BENEFITS PREMIUM MENT SETTLEMENT ACQUISI- OPERATING IUMS TION COSTS EXPENSES PREMIUMS PAYABLE REVENUE INCOME EXPENSES TION COSTS EXPENSES WRITTEN ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (IN MILLIONS) RISK MANAGEMENT Regional Property and Casualty.... $155.0 $2,821.7 $793.2 $11.9 $1,791.3 $202.4 $1,315.5 $390.3 $185.9 $1,822.9 Corporate Risk Management Services........ 2.2 248.1 0.6 10.0 268.0 14.0 182.6 2.5 97.4 -- RETIREMENT AND ASSET MANAGEMENT Retail Financial Services........ 637.5 3,037.2 2.8 260.5 121.6 223.9 300.8 79.5 113.4 -- Institutional Services........ 8.1 300.9 -- 3,153.3 0.9 302.8 248.1 3.4 142.0 -- Allmerica Asset Management...... -- -- -- -- -- -- -- -- 2.1 -- Eliminations..... -- -- -- -- -- -- -- -- (21.9) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $802.8 $6,407.9 $796.6 $3,435.7 $2,181.8 $743.1 $2,047.0 $475.7 $518.9 $1,822.9 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
58 SCHEDULE IV ALLMERICA FINANCIAL CORPORATION REINSURANCE DECEMBER 31,
ASSUMED PERCENTAGE CEDED TO FROM OF AMOUNT GROSS OTHER OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET --------- --------- ---------- --------- ----------- (IN MILLIONS) 1996 Life insurance in force... $41,943.1 $7,135.8 $559.2 $35,366.5 1.58% ========= ======== ====== ========= ===== Premiums: Life insurance.......... $ 72.0 $ 18.1 $ 5.9 $ 59.8 9.85% Accident and health insurance.............. 317.1 120.8 81.9 278.2 29.41% Property and casualty insurance.............. 2,018.5 232.6 112.4 1,898.3 5.92% --------- -------- ------ --------- Total premiums............ $ 2,407.6 $ 371.5 $200.2 $ 2,236.3 8.78% ========= ======== ====== ========= ===== 1995 Life insurance in force... $40,274.2 $8,003.1 $585.6 $32,856.7 1.78% ========= ======== ====== ========= ===== Premiums: Life insurance.......... $ 131.4 $ 33.8 $ 1.8 $ 99.4 1.80% Accident and health insurance.............. 307.5 116.5 69.2 260.2 26.59% Property and casualty insurance.............. 2,021.7 296.2 137.7 1,863.2 7.39% --------- -------- ------ --------- Total premiums............ $ 2,460.6 $ 446.5 $208.7 $ 2,222.8 9.39% ========= ======== ====== ========= ===== 1994 Life insurance in force... $41,812.5 $2,301.2 $649.1 $40,160.4 1.62% Premiums: Life insurance.......... $ 144.4 $ 9.5 $ 2.5 $ 137.4 1.80% Accident and health insurance.............. 302.8 101.5 51.8 253.1 20.47% Property and casualty insurance.............. 1,967.1 291.9 116.1 1,791.3 6.48% --------- -------- ------ --------- Total premiums............ $ 2,414.3 $ 402.9 $170.4 $ 2,181.8 7.81% ========= ======== ====== ========= =====
59 SCHEDULE V ALLMERICA FINANCIAL CORPORATION VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31,
ADDITIONS --------------------- DEDUCTIONS BALANCE AT CHARGED TO CHARGED TO FROM BALANCE AT BEGINNING OF COSTS AND OTHER ALLOWANCE END OF PERIOD EXPENSE ACCOUNTS ACCOUNT PERIOD ------------ ---------- ---------- ---------- ---------- (IN MILLIONS) 1996 Mortgage loans.......... $33.8 $ 5.5 $-- $19.7 $19.6 Real estate............. 19.6 -- -- 4.7 14.9 Allowance for doubtful accounts............... 4.6 6.8 -- 6.9 4.5 ----- ----- ---- ----- ----- $58.0 $12.3 $-- $31.3 $39.0 ===== ===== ==== ===== ===== 1995 Mortgage loans.......... $47.2 $ 1.5 $-- $14.9 $33.8 Real estate............. 22.9 (0.6) -- 2.7 19.6 Allowance for doubtful accounts............... 4.7 5.3 -- 5.4 4.6 ----- ----- ---- ----- ----- $74.8 $ 6.2 $-- $23.0 $58.0 ===== ===== ==== ===== ===== 1994 Mortgage loans.......... $73.8 $14.6 $-- $41.2 $47.2 Real estate............. 21.0 3.2 -- 1.3 22.9 Allowance for doubtful accounts............... 3.5 4.1 -- 2.9 4.7 ----- ----- ---- ----- ----- $98.3 $21.9 $-- $45.4 $74.8 ===== ===== ==== ===== =====
60 SCHEDULE VI ALLMERICA FINANCIAL CORPORATION SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS FOR THE YEARS ENDED DECEMBER 31,
DISCOUNT, IF RESERVES FOR ANY, DEFERRED LOSSES AND DEDUCTED POLICY LOSS FROM NET NET ACQUISITION ADJUSTMENT PREVIOUS UNEARNED PREMIUMS INVESTMENT AFFILIATION WITH REGISTRANT COSTS EXPENSES(2) COLUMN(1) PREMIUMS(2) EARNED INCOME --------------------------- ----------- ------------ ------------ ----------- -------- ---------- (IN MILLIONS) Consolidated Property and Casualty Subsidiaries 1996................... $164.2 $2,744.1 $-- $815.1 $1,898.3 $235.4 ====== ======== ==== ====== ======== ====== 1995................... $157.5 $2,896.0 $-- $797.3 $1,863.2 $209.6 ====== ======== ==== ====== ======== ====== 1994................... $155.0 $2,821.7 $-- $793.2 $1,791.3 $202.4 ====== ======== ==== ====== ======== ======
LOSSES AND LOSS ADJUSTMENT EXPENSES ------------------------ AMORTIZATION OF DEFERRED PAID LOSSES POLICY AND LOSS ACQUISITION ADJUSTMENT NET PREMIUMS CURRENT YEAR PRIOR YEARS EXPENSES EXPENSES WRITTEN ------------ ----------- ------------ ----------- ------------ 1996......... $1,513.3 $(141.4) $422.6 $1,387.2 $1,914.4 ======== ======= ====== ======== ======== 1995......... $1,427.3 $(137.6) $409.1 $1,266.5 $1,885.3 ======== ======= ====== ======== ======== 1994......... $1,434.8 $(128.1) $390.3 $1,217.1 $1,822.9 ======== ======= ====== ======== ========
- -------- (1) The Company does not employ any discounting techniques. (2) Reserves for losses and loss adjustment expenses are shown gross of $626.9 million, $763.5 million and $712.5 million of reinsurance recoverable on unpaid losses in 1996, 1995 and 1994, respectively. Unearned premiums are shown gross of prepaid premiums of $45.5 million, $43.8 million and $61.9 million in 1996, 1995 and 1994, respectively. 61 LOGO AFC9610K EX-10.20 2 EMPLOYMENT CONTINUITY PLAN EXHIBIT 10.20 THE ALLMERICA FINANCIAL CORPORATION EMPLOYMENT CONTINUITY PLAN ARTICLE 1 PURPOSE 1.1The purpose of the Plan is (a) to keep top management employees focused on the interests of the Company's shareholders and to secure their continued services in addition to their undivided dedication and objectivity in the event of any threat or occurrence of, or negotiation or other action that could lead to the possibility of, a Change in Control; and (b) to ensure top management employees do not, in the event of a Change in Control resulting in the payment of benefits hereunder, (i) compete in the businesses of the Company or any affiliate for a specified period, (ii) solicit or assist in the solicitation of employees of the Company or any affiliate for a specified period, or (iii) disclose any confidential or proprietary information of the Company or any affiliate. ARTICLE 2 DEFINITIONS The following capitalized terms used in the Plan have the respective meanings set forth in this Article: 2.1 Actuarial Equivalent: The actuarial equivalent determined in accordance with the methodology specified in the Retirement Plan(s). 2.2 Anticipatory Change in Control: (i) Any "person" including a "group" (as such terms are used in Section 13(d) and 14(d)(2) of the 1934 Act, but excluding the Company, its affiliates (including without limitation, Allmerica Financial Corporation, Allmerica Property & Casualty Companies, Inc., Citizens Corporation, or any newly organized or incorporated affiliate), any employee benefit plan of the Company or any affiliate, and an underwriter temporarily holding securities pursuant to an offering of such securities) commences a tender offer for securities, which if consummated, would result in such person owning 20% or more of the combined voting power of the Company's then outstanding securities, (ii) the Company enters into an agreement the consummation of which would constitute a Change in Control, (iii) proxies for the election of directors of the Company are solicited by anyone other than the Company, (iv) any "person" including a "group" (as such terms are used in Section 13(d) and 14(d)(2) of the 1934 Act, but excluding the Company, its affiliates (including without limitation, Allmerica Financial Corporation, Allmerica Property & Casualty Companies, Inc., Citizens Corporation, or any newly organized or incorporated affiliate), any employee benefit plan of the Company or any affiliate, and an underwriter temporarily holding securities pursuant to an offering of such securities) is required to file a statement under Rule 13d-1(b)(2) of the 1934 Act, or (v) any other event occurs which is deemed to be an Anticipatory Change in Control by the Committee. 2.3 Board: The Board of Directors of Allmerica Financial Corporation or any successor entity thereto. 2.4 Cause: (i) The willful failure of a Participant to perform substantially his or her duties with the Company or any affiliate (other than any such failure resulting from the Participant's incapacity due to disability within the meaning of the Company's long term disability plan as in effect at the time such determination is made); (ii) the Participant's conviction of, or plea of guilty or nolo contendere to, a felony; (iii) the willful engaging by the Participant in illegal conduct or gross misconduct which is demonstrably and materially injurious to the Company or any affiliate; or (iv) the breach by the Participant of any written or 1 unwritten noncompetition, nondisclosure or nonsolicitation agreement with the Company or any affiliate, including but not limited to the agreements provided under sections 5.2 and 6.5 hereof. 2.5 Cash Balance Plan: The Allmerica Financial Corporation Cash Balance Retirement Plan, as from time to time amended. 2.6 Change in Control: (i) The members of the Board at the beginning of any consecutive twenty-four (24) calendar month period (the "Incumbent Directors") cease at any time during such period for any reason other than due to death, Disability or Retirement (in the event of a member's death, Disability or Retirement, such member shall be deemed to continue as an Incumbent Director until such member's seat on the Board is filled) to constitute at least a majority of the members of the Board, provided that any director whose election or nomination for election by the Company's stockholders was approved by a vote of at least a majority of such Incumbent Directors shall be treated as an Incumbent Director; (ii) any "person" including a "group" (as such terms are used in Section 13(d) and 14(d)(2) of the 1934 Act, but excluding the Company, its affiliates (including without limitation, Allmerica Financial Corporation, Allmerica Property & Casualty Companies, Inc., Citizens Corporation, or any newly organized or incorporated affiliate), any employee benefit plan of the Company or any affiliate, and an underwriter temporarily holding securities pursuant to an offering of such securities) is or becomes the "beneficial owner" (as defined in Rule 13(d)(3) under the 1934 Act), directly or indirectly, of securities of the Company representing 35% or more of the combined voting power of the Company's then outstanding securities; (iii) the consummation of a merger, consolidation, share exchange or similar form of corporate transaction involving the Company or any affiliate that requires the approval of the Company's stockholders (excluding a corporate transaction involving solely the Company and its affiliates, including without limitation, Allmerica Financial Corporation, Allmerica Property & Casualty Companies, Inc., Citizens Corporation, or any newly organized or incorporated affiliate) (a "Business Combination"), unless the stockholders immediately prior to such Business Combination own more than 50% of the total voting power of the successor corporation resulting from such Business Combination or a majority of the board of directors of the successor corporation were Incumbent Directors immediately prior to such Business Combination; or (iv) the stockholders of the Company approve a plan of complete liquidation or dissolution of the Company or a sale of all or substantially all of the Company's assets. 2.7 Code: The Internal Revenue Code of 1986, as amended from time to time. 2.8 Committee: The Board or such other persons designated by the Board. 2.9 Company: Allmerica Financial Corporation or any successor entity thereto, including without limitation, the transferee of all or substantially all of the stock or assets of the Company. 2.10 Coverage Period: The three-year period commencing on the date of termination of employment with the Company and its affiliates for Category 1 Participants; the two-year period commencing on the date of termination of employment with the Company and its affiliates for Category 2 Participants. 2.11 Disability: With respect to members of the Board, the inability to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can be expected to result in death or which can be expected to last for a continuous period of not less than twelve (12) months. 2.12 Early Retirement Age: Early retirement age as defined in the Retirement Plan(s). 2.13 Effective Date: The date on which the Plan becomes effective as set forth in section 3.1 hereof. 2.14 Excess Plan: Any nonqualified plan which provides supplementary retirement benefits for participants in the Cash Balance Plan with compensation in excess of the section 401(a)(17) and section 415 limits of the Code, as from time to time amended. 2 2.15 Executive Plan: The First Allmerica Financial Executive Plan, as from time to time amended or The Hanover Executive Plan, as from time to time amended. 2.16 Good Reason: Upon or subsequent to a Change in Control, without the Participant's express written consent, (i) any change in the duties or responsibilities of the Participant that are inconsistent in any material and adverse respect with the Participant's duties or responsibilities immediately prior to the Change in Control; provided, that no change in the Participant's responsibilities that occurs as a result of the Company no longer being a public company or becoming a subsidiary after the Change in Control shall constitute Good Reason hereunder, (ii) a material reduction in the Participant's rate of annual base salary and annual target bonus opportunity (including any adverse change in the formula for such annual bonus target but excluding the conversion of any cash bonus arrangement into an equity incentive arrangement of commensurate value) as in effect immediately prior to such Change in Control; (iii) a failure to provide benefits which are substantially similar in the aggregate to the benefits under any employee benefit plan, compensation plan, welfare benefit plan or material fringe benefit plan in which the Participant is participating immediately prior to the Change in Control (excluding any across-the-board reduction in benefits effected with respect to all executive employees of the Company after the Change in Control); (iv) any requirement that the Participant relocate to an office more than 35 miles from the facility where the Participant is located immediately prior to the Change in Control; or (v) the failure of the Company to cause any successor entity to the Company to assume all obligations under the Plan as set forth in section 8.3 hereof. 2.17 Multiplier: Three (3) for Category 1 Participants; two (2) for Category 2 Participants. 2.18 Net After-Tax Benefit: The sum of (i) the total amount payable to the Participant hereunder, plus (ii) all other payments and benefits which the Participant receives or is entitled to receive from the Company that would constitute "parachute payments" within the meaning of section 280G of the Code, less (iii) the amount of federal, state and local income and other taxes (including the excise tax under section 4999 of the Code) payable with respect to the foregoing amounts calculated at the maximum income tax rates applicable to such Participant for each year in which the foregoing amounts shall be paid. 2.19 1934 Act: The Securities Exchange Act of 1934, as amended from time to time. 2.20 Normal Retirement Age: Normal retirement age as defined in the Retirement Plan(s). 2.21 Participant: Any individual specified on Appendix A attached hereto in accordance with Article 4 hereof. 2.22 Plan: The Allmerica Financial Corporation Employment Continuity Plan, as from time to time amended. 2.23 Protection Period: The period beginning with a Change in Control and ending on the second anniversary thereof. 2.24 Rate of Reserves Increase: With respect to a period of plan months in a Long-Term Performance Unit Plan cycle, the percentage rate equal to (i) the consolidated combined contingency reserves at the end of the last plan month in such period, minus the consolidated combined contingency reserves at the beginning of the first plan month in such period, divided by (ii)(A) the consolidated combined contingency reserves at the beginning of such first plan month, times (B) the number of plan months in such period. 2.24 Retirement: With respect to employees, separation from service with the Company and its affiliates in accordance with a retirement plan maintained by the Company (as in existence immediately prior to the Change in Control) or in accordance with any retirement arrangement established with respect to the Participant with the Participant's consent; with respect to members of the Board, retirement pursuant to a retirement policy then in effect for members of the Board. 3 2.25 Retirement Plan(s): To the extent a Participant is eligible for retirement benefits thereunder, the Cash Balance Plan, the Excess Plan and the Executive Plan as applicable. 2.26 Stock Incentive Plans: Allmerica Financial Corporation Long-Term Stock Incentive Plan, the 1994 Long Term Stock Incentive Plan of Citizens Corporation, the Allmerica Property & Casualty Companies, Inc. 1995 Long- Term Stock Incentive Plan and any successor(s) to such plans. 2.27 Transition Group: Participants who have attained an age as of December 31, 1994, which when added with two (2) times their service as of December 31, 1994 under the Cash Balance Plan, equals or exceeds eighty- five (85). ARTICLE 3 PLAN TERM 3.1 Effective Date: The Plan shall be effective as of December 17, 1996. 3.2 Expiration: Except as provided in sections 3.3, 3.4 and 3.5 hereof, the Plan shall terminate on the December 31st of the calendar year in which the notice requirement of section 3.6 hereof has been satisfied. 3.3 Initial Term: In no event shall the Plan terminate prior to December 31, 1998. 3.4 Anticipatory Change in Control: In the event the Plan would otherwise terminate pursuant to section 3.2 hereof during any one-year period commencing upon an Anticipatory Change in Control, the Plan shall terminate on the first anniversary of such Anticipatory Change in Control; provided, however, in the event of a Change in Control during the one-year period commencing upon such Anticipatory Change in Control, the Plan shall terminate on the last day of the Protection Period. 3.5 Change in Control: In the event the Plan would otherwise terminate pursuant to section 3.2 hereof during the Protection Period commencing upon a Change in Control, the Plan shall terminate on the last day of the Protection Period. 3.6 Notice: The notice requirement of this section shall be satisfied on the September 30th coincident with or next following the date on which all Participants have received written notice from the Committee of its desire to terminate the Plan. 4 ARTICLE 4 ELIGIBILITY 4.1 General: Any individual specified on Appendix A attached hereto shall be a Participant eligible to receive benefits and payments hereunder. Participants shall be designated as either "Category 1" or "Category 2" on Appendix A and shall receive benefits and payments hereunder in accordance with such designation. 4.2 Addition or Move: The Committee in its sole discretion may add the names of additional employees of the Company or any affiliate to Appendix A or move the name of a Participant from Category 2 to Category 1 at any time, or subject to the provisions of section 4.3 hereof, move the name of a Participant from Category 1 to Category 2. Each such employee shall be eligible to receive benefits and payments hereunder in accordance with the employee's designation on Appendix A. 4.3 Removal: Except as provided in sections 4.4, 4.5 and 4.6 hereof, the Committee in its sole discretion may remove the name of any individual specified on Appendix A or move the name of a Participant from Category 1 to Category 2 on the December 31st of the calendar year in which the notice requirement of section 4.7 hereof has been satisfied. An individual removed from Appendix A shall cease to be eligible to receive benefits and payments hereunder and all rights thereto shall be without further force or effect upon removal from Appendix A. An individual moved from Category 1 to Category 2 shall be eligible to receive benefits and payments hereunder in accordance with such individual's designation on Appendix A. Notwithstanding any provision in the Plan to the contrary, the Committee may remove the name of any individual specified on Appendix A or move the name of a Participant from Category 1 to Category 2 at any time with such individual's written consent. 4.4 Initial Term: In no event shall the name of any Participant be removed from Appendix A prior to December 31, 1998. 4.5 Anticipatory Change in Control: In the event of an Anticipatory Change in Control, any name which would otherwise be removed from Appendix A pursuant to section 4.3 hereof during the one-year period commencing upon such Anticipatory Change in Control shall be removed on the first anniversary of such Anticipatory Change in Control; provided, however, in the event of a Change in Control during the one-year period commencing upon such Anticipatory Change in Control, such name shall be removed from Appendix A on the last day of the Protection Period. 4.6 Change in Control: In the event of a Change in Control, any name which would otherwise be removed from Appendix A or moved from Category 1 to Category 2 pursuant to section 4.3 hereof during the Protection Period shall be so removed from Appendix A or moved from Category 1 to Category 2, as the case may be, on the last day of the Protection Period. 4.7 Notice: The notice requirement of this section shall be satisfied on the September 30th coincident with or next following the date on which the Participant has received written notice from the Committee of its desire to remove such individual's name from the list of Participants on Appendix A or to move such individual from Category 1 to Category 2, as the case may be. ARTICLE 5 CHANGE IN CONTROL PAYMENTS 5.1 General: In the event of a Change in Control, the Company shall pay to each Participant within ten (10) days following such Change in Control, a lump-sum cash amount equal to the sum of (a) the fair market value (determined in accordance with the applicable Stock Incentive Plans as of the date of the Change in Control) of shares of common stock awarded to the Participant under the Stock Incentive Plans which are not vested immediately after the Change in Control; and 5 (b) the excess of (i) the fair market value (determined in accordance with the applicable Stock Incentive Plans as of the date of the Change in Control) of the shares of common stock designated to a stock option (or stock appreciation right) granted to the Participant under the Stock Incentive Plans and with respect to which, such stock option (or stock appreciation right) is not exercisable immediately after the Change in Control, over (ii) the exercise price (or base price) for such shares. 5.2 Release: Notwithstanding the foregoing, no amount shall be payable under section 5.1 hereof unless the Participant executes a Waiver and Release in the form provided in Appendix B attached hereto or as otherwise amended by the Company in accordance with section 8.5 hereof, and such agreement becomes effective waiving and extinguishing any further rights or benefits under the Stock Incentive Plans. ARTICLE 6 PROTECTED TERMINATION BENEFITS AND PAYMENTS 6.1 General: Except as provided in section 6.2(b) hereof, in the event of a Change in Control, the Company shall pay the benefits and payments specified in sections 6.3 and 6.4 hereof if, (a) the Company or any affiliate terminates a Participant's employment with the Company and its affiliates without Cause during the Protection Period, (b) the Participant terminates employment with the Company and its affiliates with Good Reason during the Protection Period, or (c) the Participant terminates employment with the Company and its affiliates for any reason at any time during the thirteenth calendar month commencing after the Change in Control. 6.2 Retirement, Death or Disability: (a) For purposes of section 6.1 hereof, any termination of employment by reason of Retirement without Good Reason shall be deemed to be a termination of employment by the Participant without Good Reason. (b) Notwithstanding the foregoing, no benefits or payments shall be payable to a Participant under this Article in the event the Participant's employment is terminated by reason of death or such Participant becomes eligible for disability benefits under the Company's long-term disability plan. 6.3 Lump-Sum Benefits: In the event of a termination of employment specified in section 6.1 hereof, the Company shall pay to each Participant within thirty (30) days following such termination, a lump-sum cash amount equal to the sum of (a) the Multiplier times the sum of (i) the greater of (A) the Participant's annual base salary in effect on the date of termination of employment or (B) the Participant's annual base salary for the calendar year immediately preceding the year in which the Participant's employment is terminated; and (ii) the average bonus paid to the Participant under the Short Term Incentive Plan for the three (3) plan years preceding the year in which the Participant's employment is terminated (if the Participant was eligible for a bonus during only a portion of such three-year period, the average of the annualized bonuses paid to the Participant for the plan years in such three-year period in which the Participant was eligible for a bonus); (b) the product of (i) seventy-five (75) percent of the maximum bonus potential under the Short Term Incentive Plan for the plan year in which the Participant's employment is terminated, times (ii) a fraction (less than one (1)), the numerator of which shall be the number of days the Participant is 6 employed by the Company or any affiliate during the plan year in which the Participant's employment is terminated and the denominator of which shall be 365; (c) (i) to the extent not paid, the remaining balance of the total potential awards under the Term Performance Unit Plan payable to the Participant for plan cycles completed on or before the Change in Control, and (ii) with respect to each plan cycle ending after the Change in Control, an amount equal to the product of (A) the total potential award under the Long-Term Performance Unit Plan which would be payable to the Participant upon completion of such plan cycle, if the Rate of Reserves Increase for the plan cycle months completed after the Change in Control were equal to the average Rate of Reserves Increase experienced for the plan cycle months completed on or prior to the Change in Control, times (B) a fraction (less than one (1)), the numerator of which shall be the number of full calendar months completed during the plan cycle prior to the date of the Participant's termination of employment and the denominator of which shall be thirty-six (36); (d) the Multiplier times the amount which would be credited to the Participant's account balance(s) under the Retirement Plan(s) in the plan year in which the Participant's employment is terminated, assuming the Participant's account balance(s) is credited in such year with seven (7) percent of compensation as defined in the Retirement Plan(s) at the greater of (A) the annualized rate of compensation in effect on the date of termination of employment or (B) the compensation for the plan year immediately preceding the year in which the Participant's employment is terminated; and (e) with respect to any member of the Transition Group, the excess of (i) the Actuarial Equivalent of the final average pay benefit under the Retirement Plan(s) at Normal Retirement Age assuming such member were credited with two (2) additional years of service, over (ii) the Actuarial Equivalent of the actual final average pay benefit under the Retirement Plan(s) at Normal Retirement Age; 6.4 Other Benefits: In the event of a termination of employment specified in section 6.1 hereof, the Company shall (a) continue for the Coverage Period to cover the Participant under those employee benefit plans (including but not limited to life and disability insurance coverage but excluding health plan coverage which is otherwise provided for in sections 6.4(d) and 6.4(e) hereof) which were applicable to the Participant immediately prior to the Change in Control at the same benefit levels then in effect (or shall provide their equivalent); (b) provide outplacement services to the Participant at a cost of no more than 17% of the greater of the Participant's annual base salary in effect on the date of termination of employment or the Participant's annual base salary for the calendar year immediately preceding the year in which the Participant's employment is terminated, or at the Participant's election, in lieu of such outplacement services, pay to the Participant within thirty (30) days following such termination, a lump-sum cash amount equal to $20,000; (c) with respect to any member of the Transition Group who does not satisfy the age and service requirements for early retirement benefits without actuarial reduction under the Retirement Plan(s) upon termination of employment but would satisfy such requirements if such member were two (2) years older than such member actually is on the date of such termination and such member were credited with two (2) additional years of service, provide supplemental payments hereunder at the same time and in the same manner as the payments payable under the Retirement Plan(s) to the Participant so that the Participant receives in the aggregate the benefit (calculated using the Participant's actual age and years 7 of service) that would be payable if the Participant were entitled to an early retirement benefit without actuarial reduction under such Retirement Plan(s); and (d) with respect to any Participant who is entitled to post-retirement medical benefits under the post-retirement medical plan or arrangement in effect immediately prior to the Change in Control or who would be entitled to such benefits if such Participant were older than such Participant actually is on the date of the Participant's termination of employment by a number of years equal to the Multiplier and such Participant were credited with a number of additional years of service equal to the Multiplier, (i) provide coverage for the Participant and the applicable dependents under the group health plan maintained by the Company or any affiliate at the same level of coverage in effect immediately prior to the Change in Control for the eighteen-month period commencing upon termination of employment, and (ii) upon expiration of such eighteen-month period, provide the Participant and applicable dependents with coverage under the post-retirement medical plan or arrangement at a level substantially similar to the level in effect immediately prior to termination of employment, subject to retiree contributions at a rate no greater than that in effect (as the same may be adjusted from time to time) for all similarly situated retirees with comparable age, health background and coverage (or shall provide their equivalent); (e) with respect to any Participant who is not eligible for the benefits specified in section 6.4(d) hereof, (i) provide coverage for the Participant and the applicable dependents under the group health plan maintained by the Company or any affiliate at the same level of coverage in effect immediately prior to the Change in Control for the eighteen-month period commencing upon termination of employment, and (ii) upon expiration of such period and provided the Participant submits evidence to the satisfaction of the Committee that he or she is not eligible for comparable coverage as a participant or dependent under a plan maintained by another employer, pay to the Participant a lump-sum cash amount equal to the product of (A) the number of calendar months remaining in the Coverage Period at such time, times (B) 102% of the "applicable premium" (as defined in section 4980B of the Code) payable for the group health plan maintained by the Company or any affiliate for the benefit of the Participant and applicable dependents at such time. 6.5 Release: Notwithstanding the foregoing, no amounts shall be payable under sections 6.3 and 6.4 hereof unless the Participant executes a Waiver and General Release, in the form provided in Appendix C attached hereto or as otherwise amended by the Company in accordance with section 8.5 hereof, and such agreement becomes effective. ARTICLE 7 TAXATION OF BENEFITS AND PAYMENTS 7.1 Withholding Taxes: The Company may withhold from the Participant's benefits and payments payable hereunder the amount which it determines is necessary to satisfy its obligation to withhold federal, state and local income taxes or other taxes or amounts required to be withheld. 7.2 Gross-Up Payment: In the event it shall be determined that any benefit or payment payable hereunder to a Category 1 Participant would be subject to the excise tax imposed by section 4999 of the Code, the Company shall pay to the Participant (or to the Internal Revenue Service on behalf of the Participant) in any taxable year for which the excise tax is payable an additional payment (a "Gross-Up Payment") in an amount such that after payment by the Participant of all taxes (including but not limited to federal, state and local income taxes, excise taxes, and FICA taxes including hospital insurance taxes) imposed on the 8 Gross-Up Payment, the Participant retains (or has had paid to the Internal Revenue Service on his or her behalf) an amount of the Gross-Up Payment equal to the sum of (a) the excise tax imposed by section 4999 of the Code, and (b) the product of (i) any deductions disallowed because of the inclusion of the Gross-Up Payment in the Participant's adjusted gross income, times (ii) the highest applicable marginal rate of federal income taxation for the calendar year in which the Gross-Up Payment is to be made. For purposes of determining the amount of the Gross-Up Payment, the Participant shall be deemed to (a) pay federal, state and local income taxes (for the residence where the Participant most recently filed a return for such taxes) at the highest marginal rate of taxation for the calendar year in which the Gross-Up Payment is to be made and (b) have otherwise allowable deductions for federal income tax purposes at least equal to the Gross-Up Payment. 7.3 Best Payment: In the event it shall be determined that any benefit or payment payable hereunder to a Category 2 Participant would be subject to the excise tax imposed by section 4999 of the Code, such benefits and payments shall be reduced to the extent necessary so that no portion thereof shall be subject to the excise tax, but only if by reason of such reduction, the Net After-Tax Benefit without such reduction does not exceed 110% of the Net After-tax Benefit with such reduction. 7.4 Determination of Excise Tax: All determinations of gross-up payments and best payments that are required to be made under sections 7.2 and 7.3 hereof shall be made by Price Waterhouse LLP or such other public accounting firm as may be retained by the Company. The determination by such accounting firm shall be final and conclusive. 7.5 Claim by Internal Revenue Service: As soon as practicable, a Participant shall notify the Company in writing of any claim by the Internal Revenue Service that, if successful, would result in the imposition of the excise tax under section 4999 of the Code. If the Company notifies the Participant in writing that it desires to contest such claim, the Participant shall cooperate in all reasonable ways with the Company in such contest and the Company shall be entitled to participate in all proceedings relating to such claim; provided, however, that the Company shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Participant harmless, on an after-tax basis, for any excise tax or income tax (including interest and penalties with respect thereto) imposed as a result of such representation and payment of costs and expenses. Without limitation on the foregoing, the Company shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forego any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Participant to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Participant agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Company shall determine; provided, however, that if the Company directs the Participant to pay such claim and sue for a refund, the Company shall advance the amount of such payment to the Participant on an interest-free basis, and shall indemnify and hold the Participant harmless, on an after- tax basis, from any excise tax or income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance; and provided, further, that if the Participant is required to extend the statute of limitations to enable the Company to contest such claim, the Participant may limit this extension solely to such contested amount. The Company's control of the contest shall be limited to issues with respect to the imposition of the excise tax under section 4999 of the Code and the Participant shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. 9 ARTICLE 8 MISCELLANEOUS 8.1 No Mitigation: No benefit or payment payable hereunder shall be subject to offset including, but not limited to, amounts in respect of any claims which the Company may have against the Participant, provided, however, the amount payable hereunder to any Participant shall be reduced by any amounts payable to such Participant from the Company or any affiliate pursuant to any other severance plan or policy (including any employment agreement) that first becomes effective after the Effective Date. 8.2 Legal Fees: The Company shall reimburse all costs and expenses, including attorneys' fees, of the Participant in connection with any legal proceedings relating to the Plan, any plan listed on Appendix D, or any successor plans; provided, however, the Company shall not reimburse such costs and expenses for the Participant if (a) prior to the initiation of any proceedings by the Participant, such Participant fails to specify in writing all claims relating to the Plan, any plan listed on Appendix D, or any successor plans and to provide the Committee with thirty (30) days to address such claims, or (b) the judge or other individual presiding over the proceedings affirmatively finds that (i) the Participant initiated such proceedings in bad faith, or (ii) the Participant violated the terms of the Waiver and Release required under section 5.2 hereof or the Waiver and General Release required under section 6.5 hereof. 8.3 Successors: If the Company shall be merged into or consolidated with another entity, the provisions of this Plan shall be binding upon and inure to the benefit of the entity surviving such merger or resulting from such consolidation. The Company shall require any successor (whether direct or indirect, by purchase, merger, consolidation or otherwise) to all or substantially all of the business or assets of the Company to expressly assume and agree to perform the duties set forth hereunder in the same manner and to the same extent that the Company would be required to perform if no such succession had taken place (including but not limited to section 8.7 hereof). 8.4 Indemnification. In addition to such other rights of indemnification as they may have as members of the Board or the Committee, the members of the Board and the Committee shall be indemnified by the Company against all costs and expenses reasonably incurred by them in connection with any action, suit or proceeding to which they or any of them may be party by reason of any action taken or failure to act under or in connection with the Plan and against all amounts paid by them in settlement thereof (provided such settlement is approved by independent legal counsel selected by the Company) or paid by them in satisfaction of a judgment in any such action, suit or proceeding, except a judgment based upon a finding that such member was not acting in good faith on the reasonable belief that he or she was acting in the best interests of the Company; provided that upon the institution of any such action, suit or proceeding, a Committee or Board member shall, in writing, give the Company notice thereof and an opportunity, at its own expense, to handle and defend the same before such Committee or Board member undertakes to handle and defend it on such member's own behalf. 8.5 Amendments: The Board may at any time, or from time to time, amend the Plan in whole or in part or amend it in such respects as the Board may deem appropriate; provided, however, that no amendment to the Plan (including the waiver and release agreements provided in sections 5.2 and 6.5 hereof) shall, without the affected Participant's written consent, impair any rights or obligations hereunder except as provided in section 4.3 hereof. 8.6 Plan Expenses: Any expenses of administering the Plan shall be borne by the Company. 8.7 Survival: Notwithstanding any provision in the Plan to the contrary, the obligations hereunder to the Participants shall survive any termination of the Plan and shall be binding upon the Company. 10 8.8 Notice: All notices and other communications required or permitted hereunder shall be in writing and shall be deemed to have been duly given when actually delivered or three (3) days after deposit in the United States mail, certified and return receipt requested, for delivery to (a) the Committee at Allmerica Financial, 440 Lincoln Street, Worcester, MA 01653; or (b) the Participant at the last known address specified in the Company's records. 8.9 Governing Law: The validity, construction and effect to the Plan and any actions taken under or relating to the Plan shall be determined in accordance with the laws of the State of Delaware. 11 APPENDIX A
CATEGORY 1 CATEGORY 2 ---------- ------------------- John F. O'Brien Bruce C. Anderson John P. Kavanaugh John F. Kelly J. Barry May James R. McAuliffe Edward J. Parry III Richard M. Reilly Larry C. Renfro Eric A. Simonsen Phillip E. Soule
12 APPENDIX B WAIVER AND RELEASE In exchange for the benefits and payments offered to me by Allmerica Financial Corporation as set forth in section 5.1 of The Allmerica Financial Corporation Employment Continuity Plan (the "Plan"), I hereby release Allmerica Financial Corporation and all of its past and/or present divisions, affiliates, subsidiaries, officers, directors, stockholders, trustees, employees, agents, representatives, administrators, attorneys, insurers, fiduciaries, successors and assigns, in their individual and/or representative capacities (the "Company") from any and all causes of action, suits, agreements, promises, damages, disputes, controversies, contentions, differences, judgments, claims and demands of any kind whatsoever which I or my heirs, executors, administrators, successors and assigns ever had, now have or may have against the Company, whether known or unknown to me, under the Allmerica Financial Corporation Long-Term Stock Incentive Plan, the 1994 Long Term Stock Incentive Plan of Citizens Corporation, the Allmerica Property & Casualty Companies, Inc. 1995 Long-Term Stock Incentive Plan and any successor(s) to such plans. I represent that I have not filed, and will not hereafter file, any claim against the Company relating to such plans. I understand and agree that if (i) I commence, continue, join in , or in any other manner attempt to assert any claim released herein against the Company, or otherwise violate the terms of this Waiver and Release; (ii) without prior written consent from the Company, I disclose to any other person or entity any non-public information concerning the Company's financial data, strategic business plans, product development (or other proprietary product data), customer lists, marketing plans and other proprietary information, except for specific items which have become publicly available information other than through a breach by me of my fiduciary duties to the Company or which cannot reasonably be expected to adversely affect the business of the Company, unless required to do so by a court of competent jurisdiction or other governmental authority with purported or apparent jurisdiction; (iii) upon termination of employment, I directly or indirectly (whether as owner, partner, consultant, employee or otherwise) engage in any major business segment or any other business of the Company that produces (or is projected to produce in any of the three succeeding fiscal years after the date of termination of employment) over five (5) percent of the revenues of the Company as of the date of termination of employment during the two-year period commencing on the date of termination of employment; (iv) upon termination of employment, I employ, solicit for employment, or recommend for employment any officer of the Company during the two-year period commencing on the date of termination of employment; or (v) I violate the terms of any noncompetition and nonsolicitation agreement between myself and the Company, the Company shall have the right to the return of the benefits and payments paid to me by the Company under section 5.1 of the Plan (together with interest thereon at the rate of six (6) percent per annum from the date of receipt by me to the date of payment by me). Notwithstanding the foregoing, in no event shall this Waiver and Release be construed so as to preclude me from investing in any publicly or privately held company, so long as my beneficial ownership of any class of such company's securities does not exceed 1% of the outstanding securities of such class. I understand and agree that I shall notify the Company in writing, as soon as practicable, of any claim by the Internal Revenue Service that, if successful, would result in the imposition of the excise tax under section 4999 of the Code. I further understand and agree that if the Company notifies me in writing that it desires to contest such claim, I shall cooperate in all reasonable ways with the Company in accordance with the provisions of section 7.5 of the Plan. 13 IN WITNESS WHEREOF, the Company has caused this Waiver and Release to be executed by a duly authorized officer of the Company and I have executed this Waiver and Release as of the date set forth below. _____________________________________ Name of Participant _____________________________________ Signature _____________________________________ Date Allmerica Financial Corporation By:__________________________________ _____________________________________ Title _____________________________________ Date 14 APPENDIX C WAIVER AND GENERAL RELEASE In exchange for the benefits and payments offered to me by Allmerica Financial Corporation as set forth in The Allmerica Financial Corporation Employment Continuity Plan (the "Plan"), I hereby release Allmerica Financial Corporation and all of its past and/or present divisions, affiliates, subsidiaries, officers, directors, stockholders, trustees, employees, agents, representatives, administrators, attorneys, insurers, fiduciaries, successors and assigns, in their individual and/or representative capacities (the "Company") from any and all causes of action, suits, agreements, promises, damages, disputes, controversies, contentions, differences, judgments, claims and demands of any kind whatsoever which I or my heirs, executors, administrators, successors and assigns ever had, now have or my have against the Company, whether known or unknown to me, (a) by reason of my employment and/or cessation of employment with the Company or otherwise involving facts which occurred on or prior to the date that I have signed this Release, including without limitation all claims under Title VII of the Civil Rights Act of 1964, the Age Discrimination in Employment Act of 1967, the Reconstruction Era Civil Rights Act, the Civil Rights Act of 1991, the Fair Labor Standards Act, the Employee Retirement Income Security Act, the Americans with Disabilities Act, the Family and Medical Leave Act of 1993, and any and all other federal, state and local laws, statutes, rules and regulations pertaining to employment, as well as any and all claims under state contract or tort law; and (b) under any employee benefit plan maintained by the Company (including but not limited to the Allmerica Financial Corporation Long-Term Stock Incentive Plan, the 1994 Long Term Stock Incentive Plan of Citizens Corporation, the Allmerica Property & Casualty Companies, Inc. 1995 Long- Term Stock Incentive Plan, the Short Term Incentive Plan, the Long-Term Performance Unit Plan, and the successor(s) to such plans), other than any claim relating to the benefits and payments described in the Plan or any claim relating to the benefits and payments payable to me under the Company's nonqualified retirement plans. I represent that I have not filed, and will not hereafter file, any claim against the Company relating to my employment and/or cessation of employment with the Company, or otherwise specified above involving facts which occurred on or prior to the date that I have signed this Waiver and General Release. I understand and agree that if (i) I commence, continue, join in, or in any other manner attempt to assert any claim released herein against the Company, or otherwise violate the terms of this Waiver and General Release, (ii) without prior written consent from the Company, I disclose to any other person or entity any non-public information concerning the Company's financial data, strategic business plans, product development (or other proprietary product data), customer lists, marketing plans and other proprietary information, except for specific items which have become publicly available information other than through a breach by me of my fiduciary duties to the Company or which cannot reasonably be expected to adversely affect the business of the Company, unless required to do so by a court of competent jurisdiction or other governmental authority with purported or apparent jurisdiction; (iii) I directly or indirectly (whether as owner, partner, consultant, employee or otherwise) engage in any major business segment or any other business of the Company that produces (or is projected to produce in any of the three succeeding fiscal years after the date of termination of employment) over five (5) percent of the revenues of the Company as of the date of termination of employment during the two-year period commencing on the date of termination of employment; (iv) I employ, solicit for employment, or recommend for employment any officer of the Company during the two-year period commencing on the date of termination of employment; or (v) I violate the terms of any noncompetition and nonsolicitation agreement between myself and the Company, the Company shall have the right to the return of the benefits and payments paid to me by the Company 15 under the Plan (together with interest thereon at the rate of six (6) percent per annum from the date of receipt by me to the date of payment by me). Notwithstanding the foregoing, in no event shall this Waiver and General Release be construed so as to preclude me from investing in any publicly or privately held company, so long as my beneficial ownership of any class of such company's securities does not exceed 1% of the outstanding securities of such class. I understand and agree that I shall notify the Company in writing, as soon as practicable, of any claim by the Internal Revenue Service that, if successful, would result in the imposition of the excise tax under section 4999 of the Code. I further understand and agree that if the Company notifies me in writing that it desires to contest such claim, I shall cooperate in all reasonable ways with the Company in accordance with the provisions of section 7.5 of the Plan. I have read this Waiver and General Release carefully, have been given at least 21 days to consider all of its terms, have been advised to consult with an attorney and any other advisors of my choice, and fully understand that by signing below I am, to the extent provided herein, giving up any right which I may have to sue or bring any other claims against the Company. I have not been forced or pressured in any manner whatsoever to sign this Waiver and General Release, and I agree to all of its terms voluntarily. I understand that I have seven days from the date I have signed this Waiver and General Release below to revoke this Waiver and General Release, that this Waiver and General Release will not become effective until the 8th day following the date that I have signed this Waiver and General Release, and that the Company will have no obligation to pay me the benefits and payments under the Plan as agreed unless this Waiver and General Release becomes effective. I further understand that this Waiver and General Release is the complete and exclusive statement of its terms and any waiver prior to the date of my signature below with respect to the Plan shall be without further force or effect on the effective date of this Waiver and General Release. IN WITNESS WHEREOF, the Company has caused this Waiver and General Release to be executed by a duly authorized officer of the Company and I have executed this Waiver and General Release as of the date set forth below. ________________________________________ Name of Participant ________________________________________ Signature ________________________________________ Date Allmerica Financial Corporation By:________________________________ ___________________________________ Title ___________________________________ Date 16 APPENDIX D FIRST ALLMERICA First Allmerica Financial Life Insurance Company Non-Qualified Executive Deferred Compensation Plan First Allmerica Financial Life Insurance Company Non-Qualified Executive Retirement Plan First Allmerica Financial Life Insurance Company Excess Benefit Retirement Plan First Allmerica Financial Life Insurance Company Deferred Compensation Agreements HANOVER The Hanover Insurance Company Non-Qualified Executive Deferred Compensation Plan The Hanover Insurance Company Non-Qualified Executive Retirement Plan The Hanover Insurance Company Excess Benefit Retirement Plan The Hanover Insurance Company Deferred Compensation Agreements CITIZENS Citizens Insurance Company of America Non-Qualified Executive Deferred Compensation Plan Citizens Insurance Company of America Non-Qualified Executive Retirement Plan Citizens Insurance Company of America Excess Benefit Retirement Plan Citizens Insurance Company of America Deferred Compensation Agreements 17 EX-10.21 3 FORM OF NON-SOLICITATION AGREEMENT EXHIBIT 10.21 NON-SOLICITATION AGREEMENT This Agreement is made this day of , 1996, between ALLMERICA FINANCIAL CORPORATION, a Delaware corporation (hereinafter referred to collectively with its subsidiaries, as the "Company"), and (the "Employee"). WHEREAS, Employee acknowledges that the Company could be significantly harmed if the Employee solicits the Company's employees, agents, brokers, or clients, or discloses any proprietary or confidential business information of the Company. NOW, THEREFORE, in consideration of the continued employment of the Employee by the Company and the Employee being selected to be a participant in the Company's Employment Continuity Plan and the receipt of a cash bonus payment upon the execution of this Agreement, the Employee and the Company agree as follows: 1.NON-SOLICITATION. During the period that the Employee is employed by the Company and for a period of two (2) years after the termination or expiration thereof, the Employee will not directly or indirectly: (a) recruit, solicit or induce, attempt to induce, or assist or encourage a third party to solicit or recruit any employee(s), agent(s) or broker(s) of the Company to terminate their employment with, or otherwise cease their relationship with the Company; or (b) solicit, divert or take away, attempt to divert or to take away, or assist or encourage a third party to solicit or divert the business or patronage of any of the policyholders, clients, customers or accounts of the Company which were contacted, solicited or served while the Employee was employed by the Company. 2.UNENFORCEABILITY. (a) If any restriction set forth in Section 1 is found by any court of competent jurisdiction to be unenforceable because it extends for too long a period of time or over too great a range of activities or in too broad a geographic area, it shall be interpreted to extend only over the maximum period of time, range of activities or geographic area as to which it may be enforceable. (b) The restrictions contained in Section 1 are necessary for the protection of the business and goodwill of the Company and are considered by the Employee to be reasonable for such purpose. The Employee agrees that any breach of Section 1 will cause the Company substantial and irrevocable damage and therefore, in the event of any such breach, in addition to such other remedies which may be available, the Company shall have the right to seek specific performance and injunctive relief. 3.PROPRIETARY INFORMATION AND DEVELOPMENTS. 3.1 Proprietary Information. (a) Employee agrees that all information and know-how, whether or not in writing, of a private, secret or confidential nature concerning the Company's products, servicers, customers or business or financial affairs (collectively, "Proprietary Information") is and shall be the exclusive property of the Company. By way of illustration, but not limitation, Proprietary Information may include products, processes, methods, techniques, projects, plans, research data, financial data, personnel data, computer programs, and policyholders, client, agent, broker and supplier lists. Employee will 1 not disclose any Proprietary Information to others outside the Company or use the same for any unauthorized purposes without written approval by a vice president of the Company, either during or after his/her employment, unless and until such Proprietary Information has become public knowledge without fault by the Employee. (b) Employee agrees that all files, letters, memoranda, reports, records, data or other written, photographic, or other tangible material containing Proprietary Information, whether created by the Employee or others, which shall come into his/her custody or possession, shall be and are the exclusive property of the Company to be used by the Employee only in the performance of his/her duties for the Company. (c) Employee agrees that his/her obligation not to disclose or use information, know-how and records of the types set forth in paragraphs (a) and (b) above, also extends to such types of information, know- how, records and tangible property of clients of the Company or suppliers to the Company or other third parties who may have disclosed or entrusted the same to the Company or to the Employee in the course of the Company's business. 3.2 DEVELOPMENTS. (a) Employee agrees that all inventions, improvements, discoveries, methods, developments, software, and works of authorship, whether patentable or not, which are created, made, conceived or reduced to practice by the Employee or under his/her direction or jointly with others during his/her employment by the Company, whether or not during normal working hours or on the premises of the Company (all of which are collectively referred to in this Agreement as "Developments") shall be the sole property of the Company. (b) Employee agrees to assign and does hereby assign to the Company (or any person or entity designated by the Company) all his/her right, title and interest in and to all Developments and all related patents, patent applications, copyrights and copyright applications. However, this Section 3(b) shall not apply to Developments which do not relate to the present or planned business of the Company and which are made and conceived by the Employee not during normal working hours, not on the Company's premises and not using the Company's tools, devices, equipment or Proprietary Information. (c) Employee agrees to cooperate fully with the Company, both during and after his/her employment with the Company, with respect to the procurement, maintenance and enforcement of copyrights and patents (both in the United States and foreign countries) relating to Developments. Employee shall sign all papers, including, without limitation, copyright applications, patent applications, declarations, oaths, formal assignments, assignment of priority rights, and powers of attorney, which the Company may deem are reasonably necessary or desirable in order to protect its rights and interests in any Development. 4.OTHER AGREEMENTS. Employee hereby represents that he/she is not bound by the terms of any agreement with any previous employer or other party to refrain from using or disclosing any trade secret or confidential or proprietary information in the course of his/her employment with the Company or to refrain from competing, directly or indirectly, with the business of such previous employer or any other party. Employee further represents that his/her performance of all the terms of this Agreement and as an employee of the Company does not and will not breach any agreement to keep in confidence proprietary information, knowledge or data acquired by him/her in confidence or in trust prior to his/her employment with the Company. 5.NOTICES. All notices required or permitted under this Agreement shall be in writing and shall be deemed effective upon personal delivery or upon deposit in the United States Post Office, by registered or certified 2 mail, postage prepaid, addressed to the other party at the address shown below, or at such other address or addresses as either party shall designate to the other in accordance with this Section. The Company:Allmerica Financial Corporation 440 Lincoln Street Worcester, MA 01653 Attention: Law Department The Employee:Home Address as reflected on Company records. 6.PRONOUNS. Whenever the context may require, any pronouns used in this Agreement shall include the corresponding masculine, feminine or neuter forms, and the singular forms of nouns and pronouns shall include the plural, and vice versa. 7.ENTIRE AGREEMENT. This Agreement constitutes the entire agreement between the parties and supersedes all prior agreements and understandings, whether written or oral, relating to the subject this of this Agreement. 8.AMENDMENT. This Agreement may be amended or modified only by a written instrument executed by both the Company and the Employee. 9.EMPLOYMENT CONTINUITY PLAN. The Employee's selection to be a participant in the Company's Employment Continuity Plan (the "Plan") does not mean that the Employee cannot be removed as a Participant in the Plan. Participation in the Plan is in accordance with the Plan's provisions and as determined by the Committee (as defined in the Plan). Removal as a Participant in the Plan does not affect your obligations under this Agreement. 10.GOVERNING LAW. This Agreement shall be construed, interpreted and enforced in accordance with the laws of the Commonwealth of Massachusetts. 11.SUCCESSORS AND ASSIGNS. This Agreement shall be binding upon and inure to the benefit of both parties and their respective successors and assigns, including any corporation with which or into which the Company may be merged or which may succeed to its assets or business, provided, however, that the obligations of the Employee are personal and shall not be assigned by him. 12.MISCELLANEOUS. 12.1 No delay or omission by the Company in exercising any right under this Agreement shall operate as a waiver of that or any other right. A waiver or consent given by the Company on any one occasion shall be effective only in that instance and shall not be construed as a bar or waiver of any right on any other occasion. 12.2 The captions of the sections of this Agreement are for convenience of reference only and in no way define, limit or affect the scope or substance of any section of this Agreement. 3 12.3 In case any provision of this Agreement shall be invalid, illegal or otherwise unenforceable, the validity, legality and enforceability of the remaining provisions shall in no way be affected or impaired thereby. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date and year set forth above. ALLMERICA FINANCIAL CORPORATION By: _________________________________ Bruce C. Anderson Vice President EMPLOYEE _____________________________________ Printed Name: _______________________ 4 EX-11 4 STATEMENT REGARDING COMPUTATION OF PER SHARE EARN EXHIBIT 11 ALLMERICA FINANCIAL CORPORATION STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS FOR THE PERIOD ENDED DECEMBER 31, 1996 (UNAUDITED)
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, 1996 1996 --------------------- ------------------ (IN MILLIONS, EXCEPT PER SHARE DATA) PRIMARY: Average shares outstanding............ 50.1 50.1 Net effect of dilutive stock options based on the treasury stock method using average market price(1)........ -- -- ----------------- ------------------ TOTALS................... 50.1 50.1 ================= ================== Net income.............. $ 45.3 $ 181.9 Per share amount........ $ 0.91 $ 3.63 FULLY DILUTED: Average shares outstanding............ 50.1 50.1 Net effect of dilutive stock options based on the treasury stock method using the higher of period end or average market price(2)............... -- -- ----------------- ------------------ TOTALS................... 50.1 50.1 ================= ================== Net income.............. $ 45.3 $ 181.9 Per share amount........ $ 0.91 $ 3.63
- -------- (1) The weighted average incremental options used to calculate primary earnings per share were 20,947 and 2,482 for the quarter and year ended December 31, 1996, respectively. (2) The weighted average incremental options used to calculate fully diluted earnings per share were 24,898 and 8,773 for the quarter and year ended December 31, 1996, respectively. 1 EX-13 5 ANNUAL REPORT TO SHAREHOLDERS FOR 1996 Understanding what makes people secure is our business. What is security? 1 a bank? [PHOTO OF PIGGY BANK APPEARS HERE] 2 Most of us learned to save the same way. We put spare coins into a glass jar or ceramic copy of a pink barnyard animal--a piggy bank. Eventually, when the piggybank was full, we took what we had saved to a nearby savings institution. That was where we first planted our money, expecting it to grow. And savings do grow, but slowly. Very, very slowly. Over the years, savers have realized that while a bank can keep funds secure, just opening an account may not maximize the growth of their savings. Building financial security takes more. These days, true security lies in building a solid base of diversified assets, with promising growth potential. Variable annuity products give those who want their savings to grow into a secure nest egg the ability to build security using fund managers with years of experience in money management. [PHOTO APPEARS HERE] 3 A strong knot is tied securely and stays tied as long as you want it to. However, trying to untie the knot can be frustrating-- sometimes seeming impossible if it has been tied too tightly, or if its ends become frayed. A financial plan can also be tied too tightly. If it's not flexible, no amount of tugging at it is going to help. A successful financial plan must easily allow for changes and new options as market conditions or personal circumstances dictate. Providing for the future means taking into consideration that times change and that the unexpected often does occur. One of the many benefits of variable life insurance is that in addition to estate value protection, it has the flexibility to address many of the financial needs that arise from time to time. [PHOTO APPEARS HERE] 4 [PHOTO OF A ROPE TIED IN A KNOT APPEARS HERE] a knot? 5 [PHOTO OF A HOUSE APPEARS HERE] a house? 6 For many, a home represents basic security. Buying a home is very often the single most significant investment we make in our lives. And we may depend on that investment to provide comfort for today, and equity for retirement needs. That may have once been a reasonable strategy, but times have changed. Owning a home may not provide the financial assurance of satisfying as many concerns as it once did. To gain more security, consumers have to invest more widely--beyond their own backyard--in a well-diversified portfolio that is focused on growth. Consumers also need to be sure that their home and families are protected from risk of loss. [PHOTO APPEARS HERE] 7 Few things are more comfortable than an old shoe. It's soft and cozy, and feels secure on your foot. Nothing feels better. Or so it seems. But the most comfortable shoe can't always take you where you need to go. Comfortable shoes don't always work at the office, a nice restaurant or a fancy party. Comfortable, traditional methods of saving are like old shoes. They no longer meet the security needs they were once supposed to fulfill. In fact, just having a savings nest egg may give people a false sense of security. What seems the most comfortable ways to save may not take investors where they want to go. New styles of investing, like a new pair of shoes, are a smart choice to reach the important destinations of a secure retirement and financial well-being. [PHOTO APPEARS HERE] 8 [PHOTO OF AN OLD SHOE APPEARS HERE] an old shoe? 9 a paycheck? [PHOTO OF A PAYROLL CHECK APPEARS HERE] 10 [PHOTO APPEARS HERE] A paycheck is the ultimate foundation of financial security; it buys food, shelter and comfort. But a paycheck is also often a key to the quality of financial security after we stop working. Future financial security begins when a part of each current paycheck is invested for the future. While millions of Americans follow this philosophy, many don't. They need a partner to show them the most effective way, providing them with convenient opportunities to make choices at the worksite or through an agent or other financial advisor. A paycheck by itself doesn't guarantee future financial security. If opportunities aren't available or are limited, it can turn out to be just a piece of paper with not enough numbers on it. But, for those who actively look for the best ways to maximize their future, a paycheck can be stretched a long way toward achieving financial goals. 11 To Our Shareholders [PHOTO OF PRESIDENT AND CHIEF EXECUTIVE OFFICER APPEARS HERE] John F. O'Brien The merger of Allmerica Financial with its property and casualty subsidiary is an important step which will make Allmerica Financial a larger and more powerful financial services group, with greater financial flexibility to fund growth plans. Allmerica Financial achieved record earnings in 1996. We also substantially advanced three major initiatives to significantly increase our capital base, position the company for leadership in worksite marketing, and restructure operations for greater efficiency. Progress made by Allmerica Financial on these initiatives includes: . Initiating the pending merger with Allmerica Property & Casualty, which will increase Allmerica Financial's ownership to 100 percent and increase shareholders' equity by more than 20 percent . Signing agreements with banks and businesses to provide worksite-sold products in order to establish a solid base for growth through this attractive marketing channel . Shifting all processing operations into a Service Company, which allows us to consolidate process improvement and expense reduction efforts Record Earnings 1996 operating earnings were $2.75 per share, up 18.5 percent from $2.32 per share in 1995. Growth was achieved largely from our Retirement and Asset Management segment, which nearly doubled pre-tax income in 1996. This strong result more than offset a difficult catastrophe year for our property and casualty operations. Net income of $3.63 per share was up 36 percent over the prior year. With the proceeds from realized gains on the sale of part of our equity portfolio, we invested in higher-yielding, fixed income securities to enhance current income. Shareholders' equity grew 9.6 percent in 1996. Including proceeds from Allmerica Financial's initial public offering in October of 1995, shareholders' equity increased 40 percent, to $1.7 billion in just over a year. With the equity from the merger with Allmerica Property & Casualty in 1997, Allmerica Financial's five-year growth in shareholders' equity will exceed 230 percent-- from $900 million in 1992, to approximately $2.1 billion. By any financial measure, our capital base is dramatically stronger than it has ever been. Our capital position affords assurance to policyholders and shareholders alike that we can continue to provide quality service and products, backed by solid asset liability management strategies. The merger also gives Allmerica Financial greater financial flexibility and a more diverse earnings base. It also gives investors ownership in a larger organization, whose stock has greater liquidity than ever before. These accomplishments--record earnings, a pending merger, worksite agreements, and service company 12 [BAR GRAPH APPEARS HERE] Shareholders' Equity (In Millions) 96 - $1,725 95 - $1,574 94 - $992 93 - $1,051 initiatives--are the result of strategies developed several years ago to enhance our product offerings, develop new distribution channels, and focus on processing efficiencies required to compete in today's marketplace. Merger With Allmerica P&C Expense reduction and higher revenue growth are primary drivers of acquisitions in any industry. With these goals in mind, in December of 1996, we offered to buy all of the minority-held shares in Allmerica P&C. Terms were reached in February and the transaction should close by the third quarter of 1997. This merger presents unique advantages. Allmerica Financial has managed Allmerica P&C's operations for many years, as majority shareholder. The two "home office" buildings are literally side-by-side. Because the operations of both companies have been so close, the assimilation period typical to a merger of unrelated parties simply does not exist for us. We gain a head start at achieving advantages normally associated with combining business operations and strategies. Since we are so familiar with Allmerica P&C, we know that there are major challenges ahead in the property and casualty industry. Competition in two of our key states--Michigan and Massachusetts--eroded premium growth last year, and rate pressures continue nationally as companies strive to maintain market share. Investments in technology are absolutely necessary to give us the proper information systems required to effectively service and maintain our market share, and we must be diligent in identifying offsetting expense reductions. We plan to address high expenses by sharpening our regional focus in order to devote the most cost-effective resources to profitable markets. In 1997, we will review our current markets to ensure that we can achieve required returns in a reasonable time frame. Key initiatives for our property and casualty segments are affinity group and worksite marketing. Our Michigan-based company, Citizens Corporation, has been a leader in affinity group marketing for a number of years. Currently, nearly 50 percent of Citizens' premium comes from affinity groups such as the Society of Automotive Engineers. During 1996, Citizens added several groups including the University of Michigan Alumni Association, which has approximately 400,000 members. Hanover Insurance, which is regionally focused in the Northeast, signed a group arrangement with BJ's Wholesale Club to market to its 347,000 Massachusetts members. [BAR GRAPH APPEARS HERE] Net Operating Income Per Share* 96 - $2.75 95 - $2.32 94 - $1.80 93 - $2.38 * Per share data reflects outstanding shares of 50.1 million in all periods presented. Strong underwriting discipline and a regional focus have helped keep our combined ratio below the industry average. Citizens leads this success, with a combined ratio that has consecutively outperformed the industry average for nearly two decades. 13 [BAR GRAPH APPEARS HERE] Total Assets (In billions) 96 - $19.0 95 - $17.8 94 - $15.9 93 - $15.4 Worksite Marketing Property and casualty products are the lead offerings for our worksite program, but our asset accumulation products are also an excellent fit for this market. There is a growing consumer demand for investment-type products, including variable annuities and variable universal life insurance. The need is especially great for millions of baby boomers who realize they are not financially prepared for retirement. The time-pressured consumer also needs convenient product delivery. Worksite marketing affords that convenience. Employees are accustomed to purchasing benefits at work, and it is equally convenient for them to address other financial needs at their place of employment. Our Retirement and Asset Management products have demonstrated value and solid appeal through our retail sales channel. Our variable products business has grown rapidly over the past five years. In 1996, total variable product assets increased nearly 45 percent, to $6.2 billion. Retail sales alone were up nearly 70 percent, to $1.3 billion. Worksite relationships established this year are expected to substantially contribute to continued growth in these product lines. [BAR GRAPH APPEARS HERE] Total Revenues (In millions) 96 - $3,275 95 - $3,241 94 - $3,195 93 - $3,239 In 1996, we refocused the efforts of our Institutional Services segment, making it responsible for coordinating the worksite marketing and cross-selling efforts for both property and casualty insurance and variable products. This strategy is an outgrowth of our long history of marketing to small businesses. Across our asset accumulation, Corporate Risk Management Services, and commercial property and casualty lines, Allmerica Financial serves thousands of businesses with at least one product. Each of these clients represents a satisfied relationship on which we can build. Key to worksite selling is our knowledge of this market, and our ability to assist current customers by expanding the relationship to include new product offerings and services. In 1996, Institutional Services hired more than a dozen experienced marketing professionals to sell core products for worksite distribution. This effort generated worksite relationships with more than 60 companies--including many clients we already serve who agreed to add additional Allmerica Financial product offerings. We also forged new relationships with several banks, including Chase Manhattan, Fleet Financial and First of America. With each bank, we are developing strategies for worksite sales to their employees and potentially to their commercial customers as well. 14 The investment we are making in our worksite distribution channel is a viable remedy for a major problem facing our industry--cost-effective lead generation. We have made substantial investments over the past five years in sophisticated telephone marketing capabilities, policy automation, payroll systems and claims management. As a result, we are confident that we will be able to benefit from worksite sales as enrollments grow into a profitable revenue stream. The Service Company In 1996, we significantly advanced our service strategies with the expansion of Allmerica's Service Company. The concept of consolidating all processing activities into a single service unit has been used successfully by many leading companies in the banking, mutual fund and other service industries. Allmerica Financial first implemented this concept in 1992, by combining all corporate services, including human resources, legal, accounting and technology into a single structure, and mandating process improvements. That effort proved successful in improving service levels, leading us to enter the next phase. In 1996, we added to the Service Company all other processing activities, including applications, endorsements, claims and many aspects of customer service. The Service Company's role was expanded for two key reasons: to enable distribution units to focus on sales, marketing and point-of-sale services; and to consolidate all service improvement and expense control programs. The Service Company will evaluate the cost and effectiveness of each core process impacting a distribution unit, to ensure that we can satisfy operational needs at the lowest possible cost. Outlook Allmerica Financial has enhanced its products, distribution strategies, operating systems and corporate structure. Those efforts have produced profitable results, and positioned Allmerica Financial to deliver even greater returns. Our products are attractive, our worksite distribution strategy is off and running, our earnings base is solid, and our Service Company is moving rapidly to establish targets for cost-effective process improvement. The transformation of Allmerica Financial into a competitive financial services provider continues to be exciting and challenging. Both the pace and scope of change in this industry continue to increase. We view change as a positive and integral part of our commitment to deliver value to clients and healthy growth to shareholders. Going forward, we intend to continue to achieve profitable growth, and to ensure that shareholders' confidence in our strategies is rewarded. /s/ John F. O'Brien John F. O'Brien President and Chief Executive Officer The mandate of our Service Company is to improve our business processes and reduce operating costs. [BAR GRAPH APPEARS HERE] Net Income (In millions) 96 - $182 95 - $134 94 - $38 93 - $157 15 Allmerica Financial At A Glance Retirement and Asset Management Competitive Position RETAIL . Strong growth achieved through diversified distribution using agency, broker/dealer and financial planner channels. . Excellent variable product offerings employing a diverse group of quality funds and investment managers generate a marketing advantage. . Products developed in partnership with leading mutual fund families. . Emphasis on investment-oriented insurance products which offer a strong growth outlook. . Sourced in traditional insurance products from leading providers. INSTITUTIONAL . Full service provider of employee retirement plan services to a solid base of institutional clients. . Telemarketing expertise to reach retail customers. . Coordination of direct worksite sales of Allmerica Financial products through trained and licensed sales representatives. . Variable products provide a broad array of quality funds and investment managers to the group market. . Providing education and personalized servicing to clients through worksite marketing. ASSET MANAGEMENT . Successful long-term record in fixed income portfolio management. . Strong fundamental research orientation. . Comprehensive client service and support capability. 1997 Outlook RETAIL . Continue strong growth and market share gains in variable annuities and variable universal life insurance products. . Cost effectively grow agency system. . Develop additional "wrapper" arrangements and broaden existing relationships by expanding product offerings. . Manage profitability through focus on cost control. . Emphasis on customer needs through further enhancements to existing products. INSTITUTIONAL . Continued focus on cross-selling initiatives and worksite marketing sales of Allmerica Financial products. . Focus on the corporate special benefits market with group variable life and other products. . Partnering with banks for expanded worksite distribution. . Manage profitability in traditional spread based business. ASSET MANAGEMENT . Continue targeting institutional clients, including other insurance companies and pension funds for investment management services. [BAR GRAPH APPEARS HERE] Retail - Life & Annuity Sales By Channel (In millions) 96 - $1,350 95 - $813 94 - $790 93 - $710 92 - $406 [BAR GRAPH APPEARS HERE] Institutional Variable Product Assets (In millions) 96 - $1,429 95 - $1,190 94 - $991 93 - $845 92 - $606 [BAR GRAPH APPEARS HERE] Asset Management Assets Managed (In millions) 96 - $1,557 95 - $1,232 94 - $1,024 93 - $942 92 - $537 16 Risk Management Competitive Position HANOVER . Regional property and casualty insurer with distribution through a network of over 1,900 quality independent agencies. . Strong local market expertise with Northeast concentration. . Emerging employer-sponsored group business offers strong future growth outlook and marketing advantage. . Disciplined underwriter; small environmental exposure. . Service capacity enhanced by on-line policy processing and automated underwriting technology. . Solid financial position; high degree of liquidity within well managed investment portfolio. CITIZENS . Leading Michigan property and casualty insurer, with nearly 10 percent market share. . Disciplined underwriter; consistently outperforms industry. . Regionally focused with Michigan concentration; expansion into Indiana and Ohio. . Company of choice through over 700 productive independent agencies. . Successful affinity group marketing programs constitute nearly 50 percent of earned premiums. . Solid reputation; ranked among top insurers in the nation for claims service. . Strong financial position; conservative investment and reserving practices. CORPORATE RISK MANAGEMENT . Leading provider of Risk Sharing Employee Benefit programs to the mid-sized employer. . Managed Care plans offer one of the largest national Preferred Provider organizations (PPO) serving over 200 markets. . Products include a broad array of managed health and disability plans along with all forms of non-medical insurance coverages. . Capabilities include services for self-insured Workers' Compensation programs which enable us to administer Workers' Comp and Employee Benefit plans on a fully integrated "24-hour" basis. . Emerging leader in the Voluntary Employee Benefit marketplace with group auto and homeowners as our lead product offerings. 1997 Outlook HANOVER . Increase efficiencies by leveraging shared resources and new technologies with Citizens and other Allmerica Financial marketing units. . Broaden distribution through expanding group business via employer-sponsored worksite marketing. . Maintain strong regional focus and disciplined underwriting through local market knowledge and expertise. . Growth in market share from continued worksite sales of personal automobile and homeowners business. . Technology enhancements to support further claims processing automation. CITIZENS . Maintain regional focus and disciplined underwriting. . Increase efficiencies by leveraging shared resources and new technologies with Hanover and other Allmerica Financial marketing units. . Develop new bank relationships and additional affinity and employer group marketing programs, while increasing enrollment in existing programs. . Continue providing successful managed care solutions for medical claims through Citizens Care program. . Technology enhancements to support further claims processing automation. . Further penetration of Indiana and Ohio market share through strong relationships with existing agents. CORPORATE RISK MANAGEMENT . Further develop our on-line information system to continue providing employers' with administrative benefit plan processing capabilities. . Focus on expanding distribution through cross selling more products to existing customers and building on existing third party administrator relationships to sell non-medical products. . Expand our sales growth of integrated Workers' Compensation and Employee Benefit plans ("24-hour"). . Introduce Voluntary Life and Health products in conjunction with group auto and homeowners business. . Maintain our focus in the Alternative market for Workers' Comp and Employee Benefit plans. [BAR GRAPH APPEARS HERE] Hanover % of Agencies Using Electronic Processing --------------------- 96 - 87% 95 - 80% 94 - 62% 93 - 30% 92 - 20% [BAR GRAPH APPEARS HERE] Citizens Statutory Combined Ratio ------------------------ Citizens Industry -------- -------- 96 100.4 107.0 95 98.6 106.5 94 104.5 108.5 93 98.9 106.9 92 97.9 115.8 [BAR GRAPH APPEARS HERE] Corporate Risk Management - Covered Lives (in thousands) -------------------------------------------------------- 96 - 620 95 - 547 94 - 497 93 - 387 92 - 325 17 Retirement and Asset Management The transformation of Allmerica Financial that began six years ago continues. We are focused on two distinct business segments: Retirement and Asset Management, and Risk Management. With a goal of improving growth and increasing profit margins, we have altered our product mix, exited low-return businesses, aggressively expanded our distribution channels and improved internal processing systems and technology. Work on all of these strategies is ongoing, but we are proceeding with great confidence in our mission of growth and increased [PHOTO APPEARS HERE] profitability. In the Retirement and Asset Management business, we are dedicated to meeting the needs of baby boomers--to achieve financial security by managing today's risks, and saving for tomorrow's retirement rewards. Many boomers believe that Social Security will not be there for them come retirement, and feel insecure because they don't quite know how to even begin saving enough to be prepared. We have products that can help, which are broadly available through convenient distribution channels. It is good news that baby boomers have been improving their savings habits in the last few years. That makes them more attuned than ever to our mix of variable annuities and variable universal life products. Beginning six years ago, we shifted our focus to these products, thereby emphasizing the areas of our core competency. This has proven to be a sound decision from both a marketing and financial perspective. While traditional insurance product sales have essentially stagnated over this period, the variable product marketplace has seen impressive growth. In 1996, our Retirement and Asset Management segment produced a pre-tax operating profit of $104.1 million, up from $54.6 million in 1995, and variable assets under management exceed $6.2 Baby boomers are looking for ways to effectively save for retirement or to fund their childrens' education. We offer smart choices with flexible, high-quality variable annuities and variable life products--our fastest growing product lines. 18 Our variable annuity sales continue to outpace that of the industry. In 1996, Allmerica ranked 15th in annual variable annuity sales among U.S. companies, up from 19th in 1995. [PHOTO APPEARS HERE] billion, compared with $800 million just five years ago. Not only is this business growing, it is also fundamentally a better business. Variable products require less capital support than traditional insurance because they are fee-based businesses rather than "spread" products. This corporate transformation required discipline, and a willingness to stop doing the same old things the same old way. We have sold off marginal operations such as a mutual-fund processing unit in 1995, and reinvested the proceeds in the variable products business. We have exited slow-growth, low- profit businesses and will continue to do so, redeploying the assets into core businesses that are more promising. In some aspects, we have been slower to transform the company than we would have liked. Allmerica Financial is a fine, solid company, but it cannot be considered a great one until it operates more efficiently and reduces its costs of doing business. These issues will be addressed in several ways, through the newly expanded scope of our Service Company. For example, in the property and casualty operations, our Service Company oversees client centers in Worcester and in Howell, Michigan. These two locations now encompass many administrative functions previously handled within branches. Although investments at this point are ongoing, process consolidation should result in future cost savings, and should also free branch management to concentrate fully on strategic field marketing and underwriting. During 1997, [BAR CHART APPEARS HERE] Retail Variable Product Assets (in millions) -------------------- 96 - $4,804 95 - $3,159 94 - $1,975 93 - $1,373 92 - $ 666 19 RETIREMENT AND ASSET MANAGEMENT CONTINUED [PHOTO APPEARS HERE] Distribution, distribution, distribution--our focus on broadening distribution for asset management and risk products is key for future growth. RETAIL VARIABLE PRODUCT SALES [PIE CHART APPEARS HERE] Agency 53% Broker/Dealers & Other 47% the Service Company will focus on production support initiatives necessary to run our day-to-day operations, such as policy processing systems used by independent agents. Success In Multi-Channel Distribution In our business, good products at competitive prices are not enough. Increasingly, success is determined by distribution. In recent years, Allmerica Financial has been a leader in creating new distribution opportunities on both the retail and institutional side. Our Retail Financial Services division once depended primarily on career agents, but no longer. Agents are still important to us, and their sales volumes have shown impressive growth. At the same time, we have developed many new methods for reaching the expanding market for our products and services. We now market products through broker-dealers, financial planners and a growing number of private labeling arrangements. Last fall, Kemper began selling our variable annuities as a wrapper around its mutual funds and is expected to make a strong contribution to sales in 1997. New avenues of distribution now account for close to 50 percent of our retail variable sales and have helped us grow variable product sales at a pace far greater than the industry. When 1996 began, Allmerica Financial was ranked 19th in variable annuity sales by the Variable Annuity Research and Data Service (VARDS), a major tracking and reporting service. Our strong performance in 1996 now puts us in the number 15 spot. Retail variable sales rose 66 percent last year, from $802 million to $1.3 20 billion. In 1997, we should approach $2 billion in variable sales. We expect some of this growth to come from new third-party distribution agreements. These marketing arrangements have two distinct advantages. First, they allow us to reach a large number of potential clients without making major marketing investments. Second, by partnering with these distributors, we potentially gain access to their clients for additional product offerings. Along with creating new distribution opportunities, career agents have been more productive as well. In 1990, 1,400 agents generated $290 million in variable sales. Today, our agent force consists of 700 agents who produced more than $720 million in variable sales during 1996. We continue to believe that an effectively managed agency force is a key to successful growth. Accordingly, we completed a major revision of our general agency structure, linking agents more closely to the company from both an operational and compensation perspective. The revisions made to our agency system enable us to grow that distribution channel on a basis that will contribute significantly to the profitability of our company. Worksite Marketing One of the most promising growth areas in our business is worksite distribution. Several forces are converging to make it particularly attractive. Busy employees are finding it convenient to do more of their financial shopping at work, when such opportunities are presented by employers as a benefit option. Employees appreciate insurance offered in partnership with their employer, especially since it comes with a discount and the convenience of payments made via payroll deduction--ensuring that each paycheck is used to buy a little extra security. Worksite marketing has similar appeal to employers as it does employees. At a time when many companies must do more with less, employers are eager to [PHOTO APPEARS HERE] Whether a consumer wants to buy variable insurance products from an agent, a broker, or directly from a mutual fund, Allmerica offers the choice. Today, half of our variable annuity sales are made by agents, and the remainder are made through a regional broker or mutual fund provider. 21 RETIREMENT AND ASSET MANAGEMENT CONTINUED treat their employees well while keeping a tight rein on costs. This is one reason the ability to offer a perceived benefit to employees--at no cost--is very attractive to employers. Allmerica Financial sells at the worksite in a variety of different ways. In some cases, we will establish an on-site financial center for employees. It would be similar to the full-service financial center we run for our employees at our Worcester home office. In a second format, we first make an institutional sale, for example, to manage a company's 401(k) plan. Then we would begin a retail sales effort directed at the companys' employees, with periodic on-site financial seminars, but not necessarily a permanent presence. A third format, which developed during 1996, also offers opportunity. We have formed strategic partnerships with several banks to sell Allmerica Financial, Hanover and Citizens products to their employees and to potentially sell our insurance products to some of the banks' commercial customers. We intend to collaborate with banks of all sizes, and those with which we already have agreements represent a broad spectrum of U.S. banking. They include community banks, such as Safety Fund National Bank of Fitchburg, MA, regional banks, such as Fleet Financial, and the largest money center institution, Chase Manhattan Bank. In 1997, we anticipate signing agreements with additional banks and credit unions. At Chase, we expect to begin selling our group P&C and group variable life products. We will customize variable products so the investment choices include funds Chase directly markets to its customers and employees. We have experience in product customization to meet the needs of our marketing partners, and we believe that our flexibility and speed in doing so are a [PHOTO APPEARS HERE] In today's fast-paced society, consumers are looking for convenience wherever they can find it. We make our products available at the workplace, with easy enrollment and time-saving payment options such as payroll deduction or electronic funds transfer. 22 [PHOTO APPEARS HERE] Our experience and flexibility in product customization, to meet the needs of our marketing partners, gives us a competitive advantage. competitive strength. We believe this strength and our flexible approach are qualities that help us win business when we go head-to-head with larger competitors. In all three worksite formats, our representatives can conduct seminars for employees and offer financial counseling. Our products are highlighted in communications with employees, via benefits communications, such as employee newsletters, paycheck inserts and other similar means. Worksite sales represent an enormous opportunity, and we expect it to account for a substantial part of our business by the end of the decade. Our Corporate Risk Management Services unit is also successfully using third parties to broaden distribution. It has broadened alliances with plan administrators and health maintenance organizations (HMO's) to help distribute non-medical products, such as group life and disability, and dental insurance. We are also using an old distribution approach in new ways. It is called strategic cross-selling. Historically, it has often been true that when an insurance company starts referring to cross-selling, or selling additional products to existing clients, it is a sign that the company has run out of meaningful things to say. At Allmerica Financial, we have something meaningful to add on the subject. In 1996, we started an institutional sales committee to focus on cross-selling--and it is delivering results. Last year, the number of institutional accounts to which we sell multiple products doubled, and we are looking for an increase of an additional 50 percent in 1997. More importantly, the cross-sell effort has broadened our clients' awareness of our capabilities, and has made it easier for the joint development 23 RETIREMENT AND ASSET MANAGEMENT CONTINUED of one-stop solutions to a number of benefit issues. Corporate Risk Management Services This segment continues to undergo significant transformation. Not long ago, Corporate Risk Management specialized in traditional indemnity health insurance. Currently, most of its business falls within the realm of managed care, usually provided to employers on a risk-sharing basis. We continue to offer indemnity products, but growth lies elsewhere. Managed care solutions are a more profitable and stable business. Since 1992, we have increased our covered lives in health care by 91 percent, from 325,000 to 620,000 at the end of 1996, by seeking to provide cost-effective alternatives to full-indemnity insurance. Further enhancing profitability is the new marketing emphasis that has accompanied our move into the managed care arena. In the past, our health care business came primarily from small employers. Now the majority of our business comes from mid-sized companies with up to 2,000 employees. That is where Corporate Risk Management Services is putting its marketing effort. Additionally, we are leveraging this group's expertise by having it manage medical costs that arise from workers' compensation and auto insurance claims in our P&C segment. Financial Strength Allmerica Financial has become a more aggressive marketer in recent years, yet it remains conservative and prudent in its financial structure. As we look toward completing the merger with Allmerica Property & Casualty, we are constituted as an organization that has over $2.6 billion in total capitalization, and we are in the position of achieving our greatest increase in capital flexibility in our 153-year history. Since 1990, Allmerica Financial's capital has grown by 500 percent. We are proud of that [PHOTO APPEARS HERE] Alliances with third parties to market non-medical products, including group life and disability, and dental insurance, have generated solid sales growth and increased market penetration. 24 Conservative underwriting and prudent investment policies add to our financial strength, and position us to take advantage of new growth opportunities. [PHOTO APPEARS HERE] achievement and excited that Allmerica Financial can demonstrate the capital strength and flexibility needed to fuel future growth. Total assets now exceed $18 billion, a gain of more than 20 percent since 1993. The Company's $10 billion investment portfolio is weighted toward high- quality bonds with very little real estate or mortgage loan exposure. Over 85 percent of our bond holdings are rated investment grade. Our well- diversified mortgage portfolio of $764.6 million represents less than five percent of total assets, while real estate of less than $121 million continues to demonstrate embedded gains at its current carrying value. In addition to establishing a successful underwriting record, Allmerica Financial has also earned a reputation for conservative reserving against property and casualty exposures. Loss reserves in our P&C business have exceeded actual losses in each of the last five years. Because the duration of our liabilities is a relatively short average of about two years, we have been able to validate our policy of conservatism as cases close and claims are settled. [PIE CHART APPEARS HERE] Investment Portfolio $9.9 Billion Includes closed block -------------------------- Bonds -- 79% Mortgage loans -- 8% Equities -- 5% Policy loans -- 4% Real Estate -- 1% Cash & other -- 3% 25 [PIE CHART APPEARS HERE] Property and Casualty Regional Focus --------------------- Michigan -- 41% New York/ New Jersey -- 15% New England -- 19% Other States -- 25% Property & Casualty Leveraging Strengths The intense regional focus of our property and casualty segment gives us an advantage in the marketplace. Most of our business is conducted in markets we know very well, with independent agents with whom we have built strong ties, and where our share is large enough to permit economies of scale. Hanover, which has been in the business of helping make people secure since 1852, gets approximately two-thirds of its premiums from the Northeast, where it holds market shares of six percent in Maine and nearly five percent in Massachusetts. Hanover is also strong and growing in New Hampshire, New Jersey, New York, Rhode Island and Vermont, meeting the needs of its customers through 1,900 independent agents. Hanover owns 82.5 percent of Citizens Corporation, the third largest property and casualty competitor in Michigan with a market share of nearly 10 percent. Although Citizens has been a Michigan success story since 1915, its more recent performance has been particularly noteworthy. Since 1980, Citizens' market share has more than tripled. Our regional focus yields rewards in many different ways. Knowing our markets means that we have a thorough understanding of the regulatory and competitive climate we face. This allows us to assess underwriting risks more accurately and to price products appropriately. Over the last five years, our consolidated P&C segments' combined ratio has outperformed the industry average. Citizens' combined ratio has continued to trend at or below 100, outperforming the industry average for 18 consecutive years. Our regional focus also helps provide customers with a feeling of security. We do most of our business in markets where we are very well known, where consumers have experienced our quality service and have heard of our good reputation. We believe we have [PHOTO APPEARS HERE] In 1996, Hanover partnered with BJ's Wholesale Club to market auto insurance to BJ's 347,000 Massachusetts members, while Citizens added the University of Michigan Alumni Association to its large affinity group base. 26 [PIE CHART APPEARS HERE] Property and Casualty Product Mix ------------------------------- Personal Auto -- 47% Homeowners -- 12% Workers' Comp. -- 12% Commercial Auto -- 9% Commercial Multiple Peril -- 13% All other -- 7% established generations of goodwill in key markets. This geographic focus also helps us target profitable niches, and we are adept at acting quickly when circumstances warrant. We are disciplined underwriters, prepared to walk away from business when pricing gets overly ambitious. And we have done a good job of communicating this philosophy to our agents, giving them appropriate incentives for bringing us preferred business. We continually refine product features to meet our target market needs. For example, Hanover is in the midst of a program designed to improve its underwriting profitability in the homeowners market. It has offered renewals with a higher deductible and more stable, yet lower rates--a welcomed prospect to policyholders. By allowing policyholders the option of self-insuring small potential losses, we can ensure that major claims receive the utmost service and attention. New Market Opportunities Analysts estimate that, industry-wide, P&C premiums will rise only about two percent a year for the next few years. Both Hanover and Citizens intend to grow more rapidly in total over that time frame, primarily through even more focus on our strongest regional markets. Driving this growth will be selective regional expansion along with worksite and other group marketing initiatives. We expect to increase market share by operating more efficiently and delivering better products in a variety of ways. We believe that worksite sales may ultimately represent a substantial portion of the P&C business-based on our current aggressive pursuit of this market. In worksite marketing, we offer our products to employees under the sponsorship of their employer. Employers like the arrangement because there is no cost to provide a valued benefit to their New technology solutions will improve our claims processing efficiency. In policy processing, Hanover and Citizens are among the national leaders in on-line connectivity with agents. [PHOTO APPEARS HERE] 27 RISK MANAGEMENT CONTINUED workforce. Employees value it because they can purchase insurance conveniently at work, at a discount, and pay via payroll deduction or electronic funds transfer. With worksite enrollment and product sales, we are able to offer financial planning programs, and, in some instances, may establish a permanent on-site presence to serve employees. In other cases, we will sell an institutional product to a company with the right to market directly to employees. In a third approach, we enter into marketing partnerships with banks to sell products to their employees and, potentially, to their corporate customers. In 1996, Citizens signed three bank marketing partnerships, while Hanover signed many new worksite clients, including state employee groups, large corporations and professional associations. Hanover is increasing its efforts to penetrate the group employee market. This business is appealing because we can underwrite policies twice, the first time based on the employee groups' overall risk profile and, secondly based on each individual. Both Hanover and Citizens have found that the group market offers better underwriting characteristics, lower acquisition costs and higher retention. Hanover has had recent success pursuing joint marketing arrangements with large companies. In 1996, it won the right to market auto insurance to the 347,000 Massachusetts members of BJ's Wholesale Club, the largest warehouse club in New England. Hanover is actively seeking to increase its six percent market share of the workers' compensation business in Maine during 1997. Regulatory reform has made this business attractive in many states and Hanover is well positioned to gain a sizable share of the market. [PHOTO APPEARS HERE] Citizens' affinity group marketing offers personal lines products to more than one hundred affinity groups and professional associations, throughout Michigan, Indiana, and Ohio. Affinity marketing accounts for nearly half of Citizens' premiums. 28 [PHOTO APPEARS HERE] Citizens has grown from expansion in Indiana and Ohio by partnering with quality, independent agencies. Premiums written in Indiana grew 15 percent in 1996, while premiums in Ohio reached $10 million in its first full year of operations. Technological Enhancements Among insurers, our P&C segment is one of the nation's leading users of technology solutions to improve strong relationships with independent agents. We rely on our strong network of independent agents and are aware that agents may elect to sell a competitor's product rather than our own. Like many business people, they often follow the easiest path to do business. Our objective is to provide that pathway. We believe that the appropriate use of technology makes it easier for agents to do business with us through systems that speed transactions, eliminate guesswork, and reduce errors. We use technology strateg- ically to increase information processing, reduce costs wherever possible, and to improve our competitive position with independent insurance agents. So far, the agents' response indicates that we are on the right track. We are among the top insurers in the country in terms of on-line connectivity to agencies. The system allows both the agent and the company to speed the exchange of information. As a result, agents can serve their customers more promptly. Currently, the majority of all personal line policies are approved and processed directly through the agency-company on-line management system. In 1996, we also made progress in our effort to handle more of our commercial lines in the same manner, a process we'll complete in late 1997. In addition to front-line technology enhancements for agents, we are focused on administrative process reengineering. Client service centers in Worcester and Howell, Michigan, now handle many [BAR GRAPH APPEARS HERE] Citizens affinity Group Premium In millions ----------------- 96 -- $414 95 -- $406 94 -- $383 93 -- $345 92 -- $317 29 RISK MANAGEMENT CONTINUED Citizens Care case management program has received national praise for handling policyholder injuries promptly and effectively. We help people get the care that will allow them to return to a normal lifestyle as soon as possible. [PHOTO APPEARS HERE] administrative functions, which is changing how the Hanover and Citizens branches do business. Branch management can now better focus on strategic, field-based marketing and underwriting support to the independent agency sales force which actually sells our products. Financial Strength Financially, our P&C segment is in excellent shape, a result of strong market performance and conservative fiscal management. Assets total $5.7 billion, and investments are largely in high-quality municipal government and corporate bonds. Almost 85 percent of the bonds we hold are investment grade. Our P&C business has been conservative in its management of loss reserves, and that policy continues. Our financial strength is further enhanced by the nature of our underwriting. Most business lines are short-tail, with limited exposure to potential lingering losses. Similarly, we have low environmental exposures. Our conservative reinsurance activity minimizes risk while allowing for solid profitability. 30 Five Year Summary of Selected Financial Highlights
- ------------------------------------------------------------------------------------------------------- FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 1993 1992 ======================================================================================================= STATEMENT OF INCOME - ------------------- Revenues Premiums $ 2,236.3 $ 2,222.8 $ 2,181.8 $ 2,079.3 $ 2,172.4 Universal life and investment product policy fees 197.2 172.4 156.8 143.7 132.9 Net investment income 672.6 710.5 743.1 782.8 823.7 Net realized gains 65.9 39.8 1.1 159.6 9.6 Other income 102.7 95.4 112.3 73.8 37.1 - ------------------------------------------------------------------------------------------------------- Total revenues 3,274.7 3,240.9 3,195.1 3,239.2 3,175.7 - ------------------------------------------------------------------------------------------------------- Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 1,957.0 2,010.3 2,047.0 1,987.2 2,163.8 Policy acquisition expenses 483.5 470.3 475.7 435.8 424.1 Other operating expenses 502.5 458.5 518.9 421.3 373.5 - ------------------------------------------------------------------------------------------------------- Total benefits, losses and expenses 2,943.0 2,939.1 3,041.6 2,844.3 2,961.4 - ------------------------------------------------------------------------------------------------------- Income before federal income taxes 331.7 301.8 153.5 394.9 214.3 Federal income tax expense 75.2 82.7 53.4 74.7 62.7 - ------------------------------------------------------------------------------------------------------- Income before minority interest, extraordinary item and cumulative effect of accounting changes 256.5 219.1 100.1 320.2 151.6 Minority interest (74.6) (73.1) (51.0) (122.8) (54.4) - ------------------------------------------------------------------------------------------------------- Income before extraordinary item and cumulative effect of accounting changes 181.9 146.0 49.1 197.4 97.2 Extraordinary item - demutualization expenses -- (12.1) (9.2) (4.6) -- Cumulative effect of accounting changes -- -- (1.9) (35.4) -- - ------------------------------------------------------------------------------------------------------- Net income $ 181.9 $ 133.9 $ 38.0 $ 157.4 $ 97.2 ======================================================================================================= Adjusted Net Income (1) $ 137.9 $ 116.4 $ 90.4 $ 119.1 $ 109.9 ========================================================================================================== BALANCE SHEET (AT DECEMBER 31) - ------------------------------ Total assets $18,997.7 $17,757.7 $15,921.5 $15,378.4 $14,083.1 Long-term debt 202.2 202.3 2.7 -- -- Total liabilities 16,489.0 15,425.0 14,299.4 13,711.7 12,764.1 Minority interest 784.0 758.5 629.7 615.8 422.4 Shareholders' equity 1,724.7 1,574.2 992.4 1,050.9 896.6
(1) Represents net income adjusted for certain items which management believes are not indicative of overall operating trends, including net realized investment gains (losses), net gains and losses on disposals of businesses, extraordinary items, the cumulative effect of accounting changes and differential earnings tax adjustments. - -------------------------------------------------------------------------------- 31 Management's Discussion and Analysis of Financial Condition and Results of Operations - ------------------------------------------------------------------------------- The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Consolidated Financial Statements and related consolidated footnotes included elsewhere herein. Introduction - ------------ The results of operations for Allmerica Financial Corporation and subsidiaries ("AFC" or "the Company") include the accounts of AFC, First Allmerica Financial Life Insurance Company ("FAFLIC"), its wholly owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a 59.5%-owned non- insurance holding company), The Hanover Insurance Company ("Hanover", a wholly owned subsidiary of Allmerica P&C), Citizens Corporation ("Citizens", an 82.5%- owned subsidiary of Hanover), Citizens Insurance Company of America (a wholly owned subsidiary of Citizens) and certain other insurance and non-insurance subsidiaries. Closed Block - ------------ On completion of its demutualization, FAFLIC established a Closed Block for the payment of future benefits, policyholders' dividends and certain expenses and taxes relating to certain classes of policies. FAFLIC allocated to the Closed Block an amount of assets expected to produce cash flows which, together with anticipated revenues from the Closed Block business, are reasonably expected to be sufficient to support the Closed Block business. The Closed Block includes only those revenues, benefit payments, dividends and premium taxes considered in funding the Closed Block and excludes many costs and expenses associated with operating the Closed Block and administering the policies included therein. Since many expenses related to the Closed Block were excluded from the calculation of the Closed Block contribution, the contribution from the Closed Block does not represent the actual profitability of the Closed Block. As a result of such exclusion, operating costs and expenses outside the Closed Block are disproportionate to the business outside of the Closed Block. The contribution from the Closed Block is included in 'Other income' in the Consolidated Financial Statements. The pre-tax contribution from the Closed Block was $8.6 million for the year ended December 31, 1996 and $2.9 million for the period October 1, 1995 (date used to estimate financial information for the date of establishment of October 16, 1995) through December 31, 1995. FAFLIC's conversion to a stock life insurance company, which was completed on October 16, 1995, and the establishment of the Closed Block have affected the presentation of the Company's Consolidated Financial Statements. For comparability with prior periods, the following table presents the results of operations of the Closed Block for the year ended December 31, 1996 and the period October 1, 1995 through December 31, 1995 combined with the results of operations outside the Closed Block for the years then ended. Management's discussion and analysis addresses the results of operations as combined unless otherwise noted.
For the Years Ended December 31 (In millions) 1996 1995 1994 - ------------------------------------------------------------------------------- Revenues Premiums $2,298.0 $2,234.3 $2,181.8 Universal life and investment product policy fees 197.2 172.4 156.8 Net investment income 725.2 723.3 743.1 Net realized investment gains 65.2 19.1 1.1 Realized gain on sale of mutual fund processing business -- 20.7 -- Other income 94.1 92.5 112.3 - ------------------------------------------------------------------------------- Total revenues 3,379.7 3,262.3 3,195.1 - ------------------------------------------------------------------------------- Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 2,058.2 2,030.9 2,047.0 Policy acquisition expenses 486.7 471.1 475.7 Other operating expenses 503.1 458.5 518.9 - ------------------------------------------------------------------------------- Total benefits, losses and expenses 3,048.0 2,960.5 3,041.6 - ------------------------------------------------------------------------------- Income before federal income taxes 331.7 301.8 153.5 - ------------------------------------------------------------------------------- Federal income tax expense (benefit) Current 90.9 119.7 45.4 Deferred (15.7) (37.0) 8.0 - ------------------------------------------------------------------------------- Total federal income tax expense 75.2 82.7 53.4 - ------------------------------------------------------------------------------- Income before minority interest, extraordinary item, and cumulative effect of accounting change 256.5 219.1 100.1 Minority interest (74.6) (73.1) (51.0) - ------------------------------------------------------------------------------- Income before extraordinary item and cumulative effect of accounting change 181.9 146.0 49.1 Extraordinary item - demutualization expenses -- (12.1) (9.2) Cumulative effect of change in accounting principle -- -- (1.9) - ------------------------------------------------------------------------------- Net income $ 181.9 $ 133.9 $ 38.0 ===============================================================================
32 Results of Operations - --------------------- Consolidated Overview - --------------------- 1996 Compared to 1995 - --------------------- The Company's consolidated net income increased $48.0 million to $181.9 million in 1996. Net income includes certain items which management believes are not indicative of overall operating trends. The following table reflects consolidated net income adjusted for these items, all net of taxes and minority interest as applicable.
For the Years Ended December 31 (In millions) 1996 1995 ============================================================================== Net income $181.9 $133.9 Adjustments: Net realized investment gains (31.0) (8.5) Net gain on sale of mutual fund processing business -- (13.5) Extraordinary item- demutualization expense -- 12.1 Contingency payment from sale of mutual fund processing business (3.1) -- Restructuring costs 0.3 -- Differential earnings tax adjustment (10.2) (7.6) - ------------------------------------------------------------------------------- Adjusted net income $137.9 $116.4 ===============================================================================
The increase in adjusted net income of $21.5 million is primarily attributable to pre-tax increases of $39.6 million and $11.1 million in the Retail Financial Services and Institutional Services segments, respectively, partially offset by pre-tax decreases of $12.8 million and $43.2 million in the Corporate and Regional Property and Casualty segments, respectively. The increase in the Retail Financial Services segment resulted primarily from increased fees from strong variable product growth, decreased losses in the disability income line and income earned on proceeds from the Company's October, 1995 initial public offering. The increase in the Institutional Services segment related principally to exiting certain unprofitable businesses in 1995. These increases were partially offset by losses in the Corporate segment primarily due to interest expense on the Company's 7 5/8% Senior Debentures issued in October 1995. Additionally, the Regional Property and Casualty segment's adjusted net income decreased primarily due to severe weather-related claims during 1996, partially offset by an increase in net investment income of $25.8 million, as well as a $5.7 million arbitrated settlement from a voluntary pool. Premium revenue increased $63.7 million, or 2.9%, to $2,298.0 million during 1996. Property and casualty premiums earned increased $35.1 million, or 1.9%, to $1,898.3 million, reflecting the accounting effects of restructuring a reinsurance contract at Hanover, increasing net premiums earned by approximately $19.0 million. In addition, a 2.0% increase in policies in force in the homeowners line as well as moderate price increases in this line contributed to the increase in net premiums earned. The growth in Citizens' personal lines is due to increases in net premiums earned in Ohio and Indiana resulting from expansion in these states as well as price increases in the personal automobile and homeowners lines. These increases were partially offset by decreases in the commercial line due to rate decreases in workers' compensation, Hanover's withdrawal from a large voluntary pool and continued competitive market conditions. Premiums in the Corporate Risk Management Services segment increased $30.2 million, or 11.1%, to $302.9 million due to increases in reinsurance, fully insured group dental, group life, and stop loss product lines totaling $33.1 million. These increases were partially offset by a $4.0 million decrease in fully insured group medical premiums. Premiums in the Retail Financial Services segment decreased $2.4 million, or 2.4%, to $95.7 million, primarily reflecting the Company's continued shift in focus from traditional life insurance products to variable life insurance and annuity products. Universal life and investment product policy fees increased $24.8 million, or 14.4%, to $197.2 million in 1996. This reflected additional deposits and appreciation on variable products account balances. Net investment income before taxes was relatively flat, increasing 0.3% to $725.2 million during 1996. This increase primarily reflects approximately $20.0 million of incremental income in 1996 on proceeds from the Company's initial public offering and from the issuance of Senior Debentures in October 1995, as well as approximately $17.2 million in income from increases in short-term debt used to finance additions to the investment portfolio. In addition, the Regional Property and Casualty segment had $10.0 million of income from limited partnerships in 1996. These increases were substantially offset by a reduction in invested assets due to declining Guaranteed Investment Contracts ("GICs") deposits resulting in a decline in investment income of $54.4 million. The average gross yield of the portfolio was 7.2% in 1996 and 1995. Net realized gains on investments were $65.2 million and $19.1 million, before taxes, and $42.4 million and $12.4 million, after taxes, in 1996 and 1995, respectively. In 1996, the Regional Property and Casualty segment revised its investment strategy, resulting in the sale of a portion of its equity portfolio and the purchase of tax-exempt securities. Consequently, Regional Property and Casualty segment realized gains increased $22.5 million, to $31.3 million on an after-tax basis in 1996. Additionally, Institutional Services segment realized investment 33 gains increased $8.9 million on an after-tax basis in 1996, primarily reflecting additional real estate sales in favorable market conditions. Results in 1995 included a $20.7 million pre-tax gain from the March 1995 sale of the Company's mutual fund processing business. Other income increased $1.6 million, or 1.7%, to $94.1 million in 1996. Other income from the Retail Financial Services segment increased $6.8 million, primarily attributable to increased investment management income. Additionally, other income in the Allmerica Asset Management and Regional Property and Casualty segments increased $4.4 million and $3.1 million, respectively. These increases were partially offset by decreases in the Institutional Services segment resulting primarily from the sale of the mutual fund processing business in March of 1995, which had contributed revenues of approximately $13.7 million in that year. Also, 1996 results included a non-recurring $4.8 million pre-tax contingent payment related to the aforementioned sale. Other income attributable to the Corporate Risk Management Services segment decreased $2.1 million, primarily due to an $11.1 million litigation settlement recognized in the fourth quarter of 1995, partially offset by growth in Administrative Services Only ("ASO") and contract fees totaling $7.9 million. Policy benefits, claims, losses and loss adjustment expenses ("LAE") increased $27.3 million, or 1.3%, to $2,058.2 million during 1996. This increase is primarily attributable to an $83.1 million, or 6.4%, increase in losses and LAE in the Company's Regional Property and Casualty segment as a result of catastrophe losses and severe weather in 1996. Additionally, policy benefits, claims, losses and LAE increased $14.1 million, or 7.2%, in the Corporate Risk Management Services segment resulting primarily from product growth. These increases were partially offset by decreased policy benefits of $57.7 million, or 26.5%, in the Institutional Services segment primarily resulting from the continuing decline of GICs during 1996 and decreases in the Retail Financial Services segment of $12.2 million, or 3.9%, due primarily to reserve strengthening in the disability income line in 1995. Policy acquisition expenses consist primarily of commissions, premium taxes and other policy issuance costs. Policy acquisition expenses increased $15.6 million, or 3.3%, to $486.7 million during 1996. This was primarily due to an increase of $13.5 million, or 3.3%, to $422.6 million in the Regional Property and Casualty segment primarily reflecting growth in net premiums earned. Other operating expenses increased $44.6 million, or 9.7%, to $503.1 million in 1996 across all major segments, except the Institutional Services segment. Other operating expenses in the Retail Financial Services segment increased $17.0 million, or 16.8%, to $118.2 million in 1996, primarily from an $8.3 million increase in short-term borrowing costs used to finance additions to the investment portfolio. Other operating expenses in the Corporate Risk Management Services segment increased $16.1 million, or 14.6%, to $126.4 million in 1996 as a result of increased commissions, claims processing expenses and field office expenses, resulting from the increased volume of both premiums and claims. The Corporate segment's other operating expenses increased $15.1 million in 1996, principally related to interest expense on the Company's Senior Debentures for a full year in 1996 versus one quarter in 1995. Additionally, the Regional Property and Casualty segment's other operating expenses increased $10.6 million due primarily to technology and other administrative expenses. These increases were partially offset by a decrease of $19.8 million in the Institutional Services segment related to the sale of the mutual fund processing business in March 1995. Federal income tax expense decreased $7.5 million in 1996, while the effective tax rate decreased from 27.4% to 22.7% in the same period. For the life insurance subsidiaries, the effective rate decreased slightly from 32.0% to 28.9%, primarily due to additional reserves provided for revisions of estimated prior year tax liabilities in 1995, as well as an increase of $2.6 million in the differential earnings benefit from 1995 to 1996. For the property and casualty subsidiaries, a decrease in the effective rate from 25.3% to 18.4% resulted from a higher underwriting loss and a greater proportion of pre-tax income from tax-exempt bonds in 1996, and to reserves provided for revisions of estimated prior year tax liabilities in 1995. 1995 Compared to 1994 - --------------------- The Company's consolidated net income increased $95.9 million to $133.9 million in 1995. Net income includes certain items which management believes are not indicative of overall operating trends. The following table reflects consolidated net income adjusted for these items, all net of taxes and minority interest.
FOR THE YEARS ENDED DECMEBER 31 (IN MILLIONS) 1995 1994 =============================================================================== Net income $133.9 $38.0 Adjustments: Net realized investment (gains) losses (8.5) 0.1 Net (gain) loss on disposal of businesses (13.5) 6.2 Extraordinary item - demutualization expenses 12.1 9.2 Cumulative effect of accounting change -- 1.9 Differential earnings tax adjustment (7.6) 35.0 - ------------------------------------------------------------------------------- Adjusted net income $116.4 $90.4 ===============================================================================
The increase in adjusted net income of $26.0 million is primarily attributable to a pre-tax increase of $83.2 million in the Regional Property and Casualty segment due to improved underwriting results primarily attributable to favorable 1995 claims experience resulting from a return to more normal 34 - -------------------------------------------------------------------------------- weather conditions in the Northeast and in Michigan. Additionally, adjusted net income increased $17.3 million in the Retail Financial Services segment, resulting primarily from an increase in fee revenue from variable products and a decrease in policy acquisition expenses for all major products. These increases were partially offset by an increase in disability income policy benefits and decreased interest margins. Also, adjusted net income in the Institutional Services segment increased $13.8 million, primarily attributable to the sale of the Company's mutual fund processing business in March 1995, which decreased 1995 revenue from this business by $38.3 million and expenses by $49.3 million, contributing $11.0 million to adjusted net income before taxes for this period. Premium revenue increased $52.5 million, or 2.4%, to $2,234.3 million during 1995 as a result of increased property and casualty premiums earned, partially offset by a decrease in premiums from traditional life products. Regional Property and Casualty premiums earned increased $71.9 million, or 4.0%, to $1,863.2 million, as a result of growth in the personal lines. Premiums in the Retail Financial Services segment decreased $23.5 million, or 19.3%, to $98.1 million, reflecting the cession in January of 1995 of substantially all yearly renewable term ("term") insurance. Universal life and investment-type product policy fees increased $15.6 million, or 9.9%, to $172.4 million during 1995. This resulted from additional deposits and appreciation on variable products account balances. Net investment income before taxes decreased $19.8 million, or 2.7%, to $723.3 million during 1995. Although overall invested assets have remained at approximately the same level in 1995 versus 1994, net investment income has decreased due to decreases in the average portfolio yields. The average gross yield of the fixed maturity investment portfolio decreased from 7.5% during 1994, to 7.2% during 1995. Net realized gains on investments before taxes were $19.1 million during 1995, versus $1.1 million during 1994. After taxes, net realized gains on investments were $12.4 million during 1995, versus $0.7 million during 1994. This change is primarily attributable to gains taken on sales of equity securities and real estate, partially offset by losses on sales of fixed maturities. Results in 1995 include a $20.7 million pre-tax gain from the March 1995 sale of the Company's mutual fund processing business. Policy benefits, claims, losses and LAE decreased $16.1 million, or 0.8%, to $2,030.9 million during 1995. Property and casualty losses and LAE decreased $15.2 million, or 1.2%, to $1,300.3 million during 1995, primarily due to a return to more normal weather conditions during the first half of 1995 in the Northeast and in Michigan. Institutional Services policy benefits decreased $30.3 million, or 12.2%, to $217.8 million in 1995 as a result of the decrease in interest credited during 1995, due to declining GIC deposits. These decreases were partially offset by increases in Retail Financial Services policy benefits of $14.8 million, or 4.9%, to $315.6 million during 1995, reflecting increased policy benefits of $21.6 million due to adverse morbidity and reserve strengthening in the disability line in 1995, partially offset by a decline in traditional life benefits resulting from the cession of term insurance. Policy benefits in the Corporate Risk Management Services segment also increased by $14.6 million, or 8.0%, to $197.2 million during 1995, primarily due to a deterioration in claims experience in all major lines. Policy acquisition expenses decreased $4.6 million, or 1.0%, to $471.1 million during 1995. This was due primarily to a decrease of $23.4 million, or 29.4%, to $56.1 million in the Retail Financial Services segment due to reduced profit margins resulting from increased mortality and reduced investment margins, which resulted in a corresponding reduction in amortization, and due to the cession of term insurance, for which the amortization of deferred acquisition costs totaled $12.1 million in 1994. This decrease was mostly offset by an increase in policy acquisition expenses in the Regional Property and Casualty segment of $18.8 million, or 4.8%, to $409.1 million during 1995, primarily related to the increase in net premiums earned. Other operating expenses decreased $60.4 million, or 11.6%, to $458.5 million during 1995, resulting primarily from a decrease of $58.1 million in operating expenses in the Institutional Services segment, caused by the sale of the mutual fund processing business in March, 1995 and by reduced expenses resulting from exiting certain other product lines and businesses, primarily various processing services for defined contribution plans. Federal income tax expense increased $29.3 million in 1995, while the effective tax rate decreased from 34.8% in 1994 to 27.4% in 1995. The decrease in the effective tax rate resulted from a lower expected differential earnings charge for the life insurance subsidiaries in 1995, which was partially offset by an increase in the property and casualty effective tax rate due to improved underwriting results, a decrease in the proportion of pre-tax income attributable to tax-exempt interest, and to reserves provided for revisions in estimated prior year tax liabilities. SEGMENT RESULTS - --------------- The following is management's discussion and analysis of the Company's results of operations by business segment. The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Management. Within these broad areas, the Company conducts business principally in five operating segments. These segments are Regional Property and Casualty; Corporate Risk Management Services; Retail Financial Services; Institutional Services; and Allmerica Asset Management. The Regional Property and Casualty segment consists of the Company's 35 - -------------------------------------------------------------------------------- 59.5% ownership of Allmerica P&C; however, all property and casualty results presented include 100% of Allmerica P&C's pre-tax results of operations, consistent with the presentation in the Company's consolidated financial statements. The other segments are all owned and operated by FAFLIC and its wholly owned subsidiaries. In addition to the five operating segments, the Company also has a Corporate segment, which consists primarily of Senior Debentures and a portion of the net proceeds from the Company's initial public offering. These proceeds are invested primarily in fixed maturities at December 31, 1996. RISK MANAGEMENT - --------------- Regional Property and Casualty - ------------------------------ The following table summarizes the results of operations for the Regional Property and Casualty segment.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ============================================================================== Revenues Net premiums earned $1,898.3 $1,863.2 $1,791.3 Net investment income 235.4 209.6 202.4 Net realized gains 48.1 13.5 3.5 Other income 11.9 8.8 7.6 - ------------------------------------------------------------------------------ Total revenues 2,193.7 2,095.1 2,004.8 Losses and LAE (1) 1,383.4 1,300.3 1,315.5 Policy acquisition expenses 422.6 409.1 390.3 Other operating expenses 190.0 179.4 185.9 - ------------------------------------------------------------------------------ Income before taxes $ 197.7 $ 206.3 $ 113.1 ==============================================================================
(1) Includes policyholders' dividends of $11.5 million, $10.6 million and $8.8 million in 1996, 1995 and 1994, respectively. INCOME BEFORE TAXES - ------------------- 1996 Compared to 1995 - --------------------- Income before taxes decreased $8.6 million, or 4.2%, to $197.7 million in 1996. This decrease resulted from catastrophes and other severe weather related losses which contributed to an $83.1 million increase in losses and LAE to $1,383.4 million. Catastrophe losses increased $27.3 million, to $62.9 million in 1996 from $35.6 million during the previous year. The increase in losses and LAE was partially offset by an increase in net investment income of $25.8 million, or 12.3%, to $235.4 million, attributable to an increase in higher-yielding debt securities in the portfolio and earnings from a limited partnership. The decrease in income before tax was also offset by a $33.5 million increase in realized gains, primarily related to the sale of equity securities, reflecting the Regional Property and Casualty segment's decision during the first quarter of 1996 to increase the proportion of debt securities in the portfolio. Income was also favorably impacted by a $5.7 million arbitrated settlement from a voluntary pool during the third quarter. 1995 Compared to 1994 - --------------------- Income before taxes increased $93.2 million, or 82.4%, to $206.3 million in 1995. This increase resulted primarily from improved underwriting results attributable to favorable current year claims experience resulting from a return to more normal weather conditions in the Northeast and in Michigan. Catastrophe losses decreased $10.5 million, to $35.6 million in 1995, from $46.1 million during the previous year. LINES OF BUSINESS RESULTS - ------------------------- Personal Lines of Business - -------------------------- The personal lines represented 61.2%, 59.8% and 58.3% of total net premiums earned in 1996, 1995 and 1994, respectively.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 1996 1995 1994 1996 1995 1994 ============================================================================================================================== Total Regional Property Hanover Citizens and Casualty Net premiums earned $ 607.3 $ 577.1 $ 548.2 $ 554.6 $ 536.2 $ 496.1 $ 1,161.9 $ 1,113.3 $ 1,044.3 Losses and loss adjustment expenses incurred 452.0 368.6 366.0 404.1 413.6 391.0 856.1 782.2 757.0 Policy acquisition expenses 150.8 135.2 125.9 112.5 108.1 99.5 263.3 243.3 225.4 Other underwriting expenses 51.7 49.7 50.0 39.3 41.1 37.9 91.0 90.8 87.9 - ------------------------------------------------------------------------------------------------------------------------------ Underwriting (loss) profit $ (47.2) $ 23.6 $ 6.3 $ (1.3) $ (26.6) $ (32.3) $ (48.5) $ (3.0) $ (26.0) ==============================================================================================================================
36 1996 Compared to 1995 - --------------------- Revenues Net premiums earned by the personal lines increased $48.6 million, or 4.4%, to $1,161.9 million in 1996, compared to $1,113.3 million in 1995. Hanover's personal lines net premiums earned increased $30.2 million, or 5.2%, to $607.3 million during 1996. This increase is primarily attributable to an increase in the personal automobile line associated with the accounting effects of restructuring a reinsurance contract, increasing net premiums earned by $19.0 million. A 2.0% increase in policies in force in Hanover's homeowners line as well as moderate price increases in this line also contributed to the increase in net premiums earned. These increases were partially offset by a mandated 4.5% decrease in Massachusetts personal automobile rates which became effective January 1, 1996. Effective January 1, 1997, Massachusetts personal automobile rates were decreased an additional 6.2% as mandated by the Massachusetts Insurance Commissioner. In addition, in response to increasing price competition in Massachusetts, Hanover, in February 1997, requested the Massachusetts Division of Insurance to approve a plan to offer a safe driver's discount of 10% on automobile insurance premiums. Management believes these actions may unfavorably impact premium growth in Massachusetts. Approximately 39% of Hanover's personal automobile business is currently written in Massachusetts. [LINE GRAPH APPEARS HERE] Personal Lines Net Premiums Earned (In millions) 96 - $1,162 95 - $1,113 94 - $1,044 Citizens' personal lines' net premiums earned increased $18.4 million, or 3.4%, to $554.6 million in 1996. This growth is attributable to price increases in the personal automobile and homeowners lines. The growth is partially offset by a 3.0% decrease in policies in force in the personal automobile line, attributable to the segment's selective reduction of writings in Michigan when rates were viewed as inadequate, and to continued strong competition in Michigan. While management has taken steps to increase penetration in affinity groups and has initiated other marketing programs, heightened competition may continue to result in reduced growth in the personal lines. Underwriting results The personal lines' underwriting loss in 1996 increased $45.5 million, to a loss of $48.5 million. Hanover's underwriting results deteriorated $70.8 million to a loss of $47.2 million, while Citizens' underwriting loss improved $25.3 million to a loss of $1.3 million. Hanover's personal lines' losses and LAE increased $83.4 million, or 22.6%, to $452.0 million in 1996. This increase is partially attributable to a $28.8 million increase in losses and LAE in the homeowners line, resulting from increased catastrophes and severe weather. Catastrophe losses in Hanover's personal lines increased $17.2 million, to $30.6 million in 1996 from $13.4 million in 1995. Losses and LAE in the personal automobile line increased $49.6 million, or 17.8%, to $328.0 million, primarily reflecting the accounting effects of restructuring a reinsurance contract, increasing losses by $19.0 million, in addition to a moderate increase in claims frequency and a $4.7 million reduction in favorable reserve development. The improvement in Citizens' underwriting results reflects favorable claims activity in both current and prior accident years in the personal automobile line attributable to continued improvements in severity. This was partially offset by an increase in catastrophe losses of $6.2 million to $13.4 million, primarily in the homeowners line. Policy acquisition expenses in the personal lines increased $20.0 million, or 8.2%, to $263.3 million and other underwriting expenses increased $0.2 million to $91.0 million in 1996. This increase in policy acquisition expenses is primarily attributable to an increase of $15.6 million, or 11.5%, to $150.8 million at Hanover resulting from a reapportionment of certain acquisition expenses to the personal lines from the commercial lines, as well as an increase in net premiums earned. The $2.0 million increase in Hanover's other underwriting expenses resulted from an increase of approximately $4.0 million in expenses associated with the policy administration technology project, offset by a decrease in assessment expenses associated with the reapportionment of an involuntary pool. Policy acquisition expenses in the personal lines at Citizens increased $4.4 million, or 4.1%, to $112.5 million in 1996, reflecting growth in net premiums earned. The $1.8 million decline in Citizens' other underwriting expenses is primarily attributable to reductions in employee related expenses and commissions, partially offset by expenses associated with a policy administration technology project. Management anticipates an increase in this segment's expense levels due to further planned investments in technology. 1995 Compared to 1994 - --------------------- Revenues Net premiums earned by the personal lines increased $69.0 million, or 6.6%, to $1,113.3 million in 1995. Hanover's net premiums earned increased $28.9 million, or 5.3%, to $577.1 million in 1995. The increase is primarily attributable to a 2.0% and 1.3% increase in policies in force in the personal automobile and homeowners lines, respectively, and a 2.5% rate increase in the homeowners line. Hanover's premium growth in the personal lines in 1995 was partially offset by a mandated 6.5% decrease in Massachusetts automobile insurance rates, which was effective January 1, 1995. 37 Citizens' personal lines net premiums earned increased $40.1 million, or 8.1%, to $536.2 million in 1995. This increase reflects price increases in the personal automobile and homeowners lines, and was partially offset by a 5.8% decrease in personal automobile policies in force. This decrease is attributable to the Company's selective reduction of writings in Michigan when rates were viewed as inadequate, and to increased competition in affinity group franchise sales as a result of the January 1995 order by the Michigan Insurance Commissioner which has permitted competitors to offer similar products. Underwriting Results The personal lines underwriting loss decreased $23.0 million, from $26.0 million in 1994, to $3.0 million in 1995. Hanover's underwriting results improved $17.3 million, from a profit of $6.3 million in 1994, to a profit of $23.6 million in 1995. Citizens' underwriting loss improved $5.7 million, or 17.6%, from $32.3 million in 1994, to $26.6 million in 1995. The improvement in Hanover's underwriting results is primarily attributable to favorable claims experience on current years claims in the homeowners line resulting from a decrease in catastrophe losses from $27.2 million in 1994, to $13.4 million during 1995, and to a return to more normal weather conditions during the first half of 1995. This resulted in a decrease in losses and LAE in the homeowners line of $17.8 million, or 17.9%, from $99.2 million in 1994, to $81.4 million in 1995. The change in Citizens' underwriting results reflects a return to more normal weather conditions in Michigan as well as favorable claims activity in both current and prior accident years in the personal automobile line attributable to improvements in severity. Citizens' underwriting results improved despite a $3.4 million increase in catastrophe losses in the personal lines, primarily in the homeowners line. Catastrophe losses were $7.2 million and $3.8 million in Citizens' personal lines in 1995 and 1994, respectively. The increase in policy acquisition expenses in the personal lines of $17.9 million, or 7.9%, to $243.3 million in 1995, reflects the growth in net earned premiums at both Hanover and Citizens. Other underwriting expenses at Hanover remained relatively unchanged at $49.7 million in 1995, compared to $50.0 million in 1994. Other underwriting expenses at Citizens increased by $3.2 million, or 8.4%, to $41.1 million in 1995, reflecting the growth in net premiums earned in 1995. Commercial Lines of Business - ---------------------------- The commercial lines represented 38.8%, 40.2% and 41.7% of net premiums earned in 1996, 1995 and 1994, respectively.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 1996 1995 1994 1996 1995 1994 ==================================================================================================================================== Total Regional Property Hanover Citizens and Casualty Net premiums earned $455.5 $468.3 $480.4 $280.9 $281.6 $266.6 $736.4 $749.9 $747.0 Losses and loss adjustment expenses incurred 315.5 342.8 361.2 200.3 164.7 188.5 515.8 507.5 549.7 Policy acquisition expenses 107.7 114.3 117.6 51.6 51.5 47.3 159.3 165.8 164.9 Other underwriting expenses (1) 74.0 73.8 77.6 27.0 25.4 29.2 101.0 99.2 106.8 - ------------------------------------------------------------------------------------------------------------------------------------ Underwriting (loss) profit $(41.7) $(62.6) $(76.0) $ 2.0 $ 40.0 $ 1.6 $(39.7) $(22.6) $(74.4) ====================================================================================================================================
(1) Includes policyholders' dividends. 1996 Compared to 1995 - --------------------- Revenues Commercial lines' net premiums earned in 1996 decreased $13.5 million, or 1.8%, to $736.4 million. Hanover's commercial lines net premiums earned decreased $12.8 million, or 2.7%, to $455.5 million. This decrease is primarily attributable to Hanover's withdrawal from a large voluntary pool on December 1, 1995, and to aggregate rate decreases of 14.6% since January 1, 1995, in the workers' compensation line. Citizens' commercial lines' net premiums earned decreased $0.7 million, or 0.2%, to $280.9 million in 1996. This decrease primarily reflects rate reductions and a 1.4% decrease in policies in force in the workers' compensation line due to continuing competition in this line in Michigan. Rates in the workers' compensation line at Citizens were decreased 8.5%, 7.0% and 6.4% effective May 1, 1995, December 1, 1995, and June 1, 1996, respectively. This decrease is partially offset by an increase in policies in force in the commercial multiple peril and commercial automobile lines of 13.2% and 3.7%, respectively. Management believes competitive conditions in the workers' compensation line may impact future growth in net premiums earned. Underwriting results The commercial lines' underwriting loss for 1996 increased $17.1 million, or 75.7% to a loss of $39.7 million. Hanover's underwriting loss improved $20.9 million, or 33.4%, to a loss of $41.7 million and Citizens' underwriting profit decreased $38.0 million, to a profit of $2.0 million in 1996. Hanover's commercial lines losses and LAE decreased $27.3 million, or 8.0%, to $315.5 million in 1996. This improvement is primarily attributable to a $41.5 million decrease in losses and LAE resulting from the withdrawal from a large voluntary pool. 38 However, this decrease was partially offset by increased losses in the workers' compensation line of $17.9 million, primarily due to a $19.8 million decrease in favorable reserve development during 1996. Citizens' underwriting profit decreased primarily due to an increase in loss severity and frequency in the commercial multiple peril line. Commercial multiple peril losses and LAE increased $16.9 million, or 42.4%, to $56.8 million in 1996, partially offset by a $5.1 million, or 9.4% increase to $59.1 million in net premiums earned. Workers' compensation net premiums earned decreased $17.6 million, or 11.9%, to $130.7 million in 1996, while losses and LAE increased $9.6 million, or 15.0%, to $73.4 million in this line, primarily due to reduced favorable development of prior year reserves. Catastrophe losses in the commercial lines were $1.9 million in 1996 compared to $0.8 million during 1995. [LINE GRAPH APPEARS HERE] Commercial Lines Underwriting Loss ( In millions) 96 - $39.7 95 - $22.6 94 - $74.4 Policy acquisition expenses in the commercial lines decreased $6.5 million, or 3.9%, to $159.3 million in 1996 and other underwriting expenses increased $1.8 million, or 1.8%, to $101.0 million. Hanover's policy acquisition expenses decreased $6.6 million, or 5.8%, to $107.7 million, primarily attributable to a reapportionment of certain acquisition expenses from the commercial lines to the personal lines, as well as the decrease in net earned premium. Other underwriting expenses at Hanover increased $0.2 million, to $74.0 million as a result of an increase of approximately $3.0 million in expenses associated with the policy administration technology project, which were partially offset by a net decrease in assessment expenses associated with voluntary and involuntary pools. Citizens' policy acquisition expenses in the commercial lines remained consistent between years, primarily as a result of flat net earned premiums. Other underwriting expenses increased $1.6 million, or 6.3%, to $27.0 million in 1996, due to investments in technology and increased policyholders' dividends, partially offset by reductions in employee related expenses and commissions. Management anticipates an increase in its expense levels due to further planned investments in technology. 1995 Compared to 1994 - --------------------- Revenues Commercial lines' net premiums earned increased $2.9 million, to $749.9 million in 1995. Hanover's commercial lines net premiums earned decreased $12.1 million, or 2.5%, to $468.3 million in 1995, reflecting decreases in policies in force in all major commercial lines, particularly a $10.7 million, or 9.4%, decrease in commercial automobile net premiums earned to $103.1 million, resulting from continued competitive market conditions affecting Hanover. Workers' compensation net premiums earned at Hanover decreased $6.4 million, or 5.8%, to $104.4 million in 1995, primarily as a result of rate decreases and an increasing level of large deductible policies. Citizens' commercial lines' net premiums earned increased $15.0 million, or 5.6%, to $281.6 million in 1995. This increase primarily reflects growth of 8.1% in total commercial policies in force. The overall growth includes increases in policies in force in the commercial automobile and commercial multiple peril lines of 12.5% and 11.6%, respectively, along with a decrease in workers' compensation policies in force of 4.6% and rate decreases of 15.5% in the workers' compensation line in 1995. These decreases in workers' compensation premiums were more than offset by increased workforce coverage due to full employment in Michigan. Price increases in the commercial automobile line also contributed to the increase in net premiums earned. Underwriting Results The commercial lines' underwriting loss improved $51.8 million to $22.6 million in 1995. Hanover's underwriting loss improved to a loss of $62.6 million, from $76.0 million, and Citizens' underwriting profit increased from $1.6 million in 1994, to $40.0 million in 1995. Hanover's commercial lines' losses and LAE decreased by $18.4 million, or 5.1%, to $342.8 million in 1995. This improvement is primarily attributable to decreased losses and LAE in the workers' compensation and commercial automobile lines. Losses and LAE in the workers' compensation line decreased $34.7 million, or 47.6%, from $72.9 million in 1994 to $38.2 million in 1995. This decrease resulted from continued favorable claims experience for both the current and prior years. Commercial automobile losses and LAE decreased $14.9 million, or 17.0%, from $87.7 million in 1994 to $72.8 million in 1995. This decrease results from favorable claims experience in this line for both the current and prior years, and a decrease in premiums earned. Losses and LAE in Hanover's other commercial lines, which consist primarily of voluntary pools, general liability and inland marine, increased $28.9 million, or 55.0%, from $52.5 million in 1994, to $81.4 million in 1995. Commercial lines were also unfavorably impacted by a $25.9 million loss in an industrial voluntary pool, including a $12.0 million charge during the fourth quarter of 1995. The improvement in Citizens' underwriting results in 1995 reflects favorable claims activity in both current and prior accident years in the workers' compensation line attributable to improvements in severity and frequency, and to severe weather and large claims in the first half of 1994 which had an adverse impact on the commercial multiple peril and commercial automobile lines. 39 Policy acquisition expenses in the commercial lines decreased $0.9 million, or 0.5%, to $165.8 million in 1995. Policy acquisition expenses in the commercial lines at Citizens increased $4.2 million, or 8.9%, from $47.3 million in 1994, to $51.5 million in 1995, reflecting the growth in net premiums earned. Hanover's policy acquisition expenses decreased $3.3 million, or 2.8%, from $117.6 million in 1994, to $114.3 million in 1995, reflecting the decrease in net earned premiums. Other underwriting expenses at Hanover decreased $3.8 million, or 4.9%, from $77.6 million in 1994, to $73.8 million in 1995, reflecting the decrease in net premiums written. Other underwriting expenses at Citizens decreased $3.8 million, or 13.0%, from $29.2 million in 1994, to $25.4 million in 1995. This decrease reflects the unusually high level of expenses incurred during 1994 resulting from the expansion into Ohio including the cost of preparing to write multi-state and cross-state commercial line policies, as well as a reduction in 1995 administrative expenses resulting from process improvements in the commercial lines. INVESTMENT RESULTS - ------------------ Net investment income before tax was $235.4 million, $209.6 million and $202.4 million in 1996, 1995 and 1994, respectively. The increase from 1995 to 1996 represents an increase in average invested assets, $10.0 million of income from limited partnerships, and the Regional Property and Casualty segment's portfolio shift to higher yielding debt securities, including longer duration and non- investment grade securities. Also, the average pre-tax yield on debt securities increased from 6.1% in 1995 to 6.4% in 1996. Net investment income increased from 1994 to 1995 as a result of increased average invested assets partially offset by a decrease in the portfolio's average pre-tax yield from 6.2% in 1994 to 6.0% in 1995. This decrease resulted primarily from lower yields available on new investments relative to the yields on maturing investments. Net realized gains on investments before taxes were $48.1 million, $14.6 million and $3.5 million in 1996, 1995 and 1994, respectively. The high level of realized gains in 1996 was primarily the result of sales of appreciated equity securities due to the strategy of shifting to a higher level of debt securities. The $10.0 million increase in net realized gains in 1995 was due to increased gains on the sale of equity securities. RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES - ----------------------------------------------- The Regional Property and Casualty segment maintains reserves to provide for its estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given point in time, of what management expects the ultimate settlement and administration of claims will cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claim severity and judicial theories of liability and other factors. The inherent uncertainty of estimating insurance reserves is greater for certain types of property and casualty insurance lines, particularly workers' compensation and other liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and where the technological, judicial and political climates involving these types of claims are changing. The Regional Property and Casualty segment regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Changes in prior reserve estimates are reflected in results of operations in the year such changes are determined to be needed and recorded. The table below provides a reconciliation of the beginning and ending reserve for unpaid losses and LAE as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Reserve for losses and LAE, beginning of year $2,896.0 $2,821.7 $2,717.3 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,513.3 1,427.3 1,434.8 Decrease in provision for insured events of prior years (141.4) (137.6) (128.1) - -------------------------------------------------------------------------------- Total incurred losses and LAE 1,371.9 1,289.7 1,306.7 - -------------------------------------------------------------------------------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 759.6 652.2 650.2 Losses and LAE attributable to insured events of prior years 627.6 614.3 566.9 - -------------------------------------------------------------------------------- Total payments 1,387.2 1,266.5 1,217.1 - -------------------------------------------------------------------------------- Change in reinsurance recoverable on unpaid losses (136.6) 51.1 14.8 - -------------------------------------------------------------------------------- Reserve for losses and LAE, end of year $2,744.1 $2,896.0 $2,821.7 ================================================================================
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $141.4 million, $137.6 million and $128.1 million in 1996, 1995, and 1994, respectively. The increase in favorable development on prior years' reserves of $3.8 million in 1996 results primarily from an $11.4 million increase in favorable development at Citizens. The increase in Citizens' favorable development of $11.4 million in 1996 reflects improved severity in the personal automobile line, where favorable development increased $28.6 million to $33.0 million in 1996, partially offset by less favorable development in the workers' compensation 40 line. In 1995, the workers' compensation line had favorable development of $32.7 million, primarily as a result of Citizens re-estimating reserves to reflect the new claims cost management programs and the Michigan Supreme Court ruling, which decreases the maximum to be paid for indemnity cases on all existing and future claims. In 1996, the favorable development in the workers' compensation line of $21.8 million also reflected these developments. Hanover's favorable development, including voluntary and involuntary pools, decreased $7.7 million in 1996 to $82.9 million, primarily attributable to a decrease in favorable development in the workers' compensation line of $19.8 million. This decrease is primarily attributable to a re-estimate of reserves with respect to certain types of workers' compensation policies including large deductibles and excess of loss policies. In addition, during 1995 the Regional Property and Casualty segment refined its estimation of unallocated loss adjustment expenses which increased favorable development in that year. Favorable development in the personal automobile line also decreased $4.7 million, to $42.4 million in 1996. These decreases were offset by increases in favorable development of $1.9 million and $5.6 million, to $12.6 million and $5.7 million, in the commercial automobile and commercial multiple peril lines, respectively. Favorable development in other lines increased by $8.8 million, primarily as a result of environmental reserve strengthening in 1995. Favorable development in Hanover's voluntary and involuntary pools increased $3.7 million to $4.1 million during 1996. The Regional Property and Casualty segment expects reduced favorable development at Hanover to continue to impact future earnings. The increase in favorable development on prior years' reserves of $9.5 million in 1995 results primarily from a $34.6 million increase in favorable development at Citizens. Favorable development in Citizens' personal automobile and workers' compensation lines increased $16.6 million and $15.5 million, to favorable development of $4.4 million and $32.7 million, respectively, due to the aforementioned change in claims cost management and the Michigan Supreme Court ruling. Hanover's favorable development, not including the effect of voluntary and involuntary pools, was relatively unchanged at $90.2 million in 1995 compared to $91.7 million in 1994. Favorable development in Hanover's workers' compensation line increased $27.7 million to $31.0 million during 1995. This was offset by decreases of $14.6 million and $12.6 million, to $45.5 million and $0.1 million, in the personal automobile and commercial multiple peril lines, respectively. Favorable development in Hanover's voluntary and involuntary pools decreased $23.6 million to $0.4 million during 1995. This favorable development reflects the Regional Property and Casualty segment's reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Due to the nature of the business written by the Regional Property and Casualty segment, the exposure to environmental liabilities is relatively small and therefore its reserves are relatively small compared to other types of liabilities. Loss and LAE reserves related to environmental damage and toxic tort liability, included in the reserve for losses and LAE were $50.8 million and $43.2 million, net of reinsurance of $20.2 million and $8.4 million in 1996 and 1995, respectively. During 1995, the Regional Property and Casualty segment redefined its environmental liabilities in conformity with new guidelines issued by the NAIC. This had no impact on results of operations. The Regional Property and Casualty segment does not specifically underwrite policies that include this coverage, but as case law expands policy provisions and insurers' liability beyond the intended coverage, the Regional Property and Casualty segment may be required to defend such claims. During 1995, Hanover performed an actuarial review of its environmental reserves. This resulted in Hanover's providing additional reserves for "IBNR" (incurred but not reported) claims, in addition to existing reserves for reported claims. Although these claims are not material, their existence gives rise to uncertainty and is discussed because of the possibility, however remote, that they may become material. The Regional Property and Casualty segment believes that, notwithstanding the evolution of case law expanding liability in environmental claims, recorded reserves related to these claims are adequate. In addition, the Regional Property and Casualty segment is not aware of any litigation or pending claims that may result in additional material liabilities in excess of recorded reserves. The environmental liability could be revised in the near term if the estimates used in determining the liability are revised. Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation on the Regional Property and Casualty segment varies by product. Property and casualty insurance premiums are established before the amount of losses and LAE, and the extent to which inflation may affect such expenses, are known. Consequently, the Regional Property and Casualty segment attempts, in establishing rates, to anticipate the potential impact of inflation in the projection of ultimate costs. The impact of inflation has been relatively insignificant in recent years. However, inflation could contribute to increased losses and LAE in the future. The Regional Property and Casualty segment regularly reviews its reserving techniques, its overall reserving position and its reinsurance. Based on (i) review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages, changes in political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Regional Property and Casualty segment and the industry, (iv) the relatively short-term nature of most policies and (v) internal estimates of required reserves, management believes that adequate provision has been made for loss reserves. However, 41 establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on the results of operations. Corporate Risk Management Services - ---------------------------------- The following table summarizes the results of operations for the Corporate Risk Management Services ("CRMS") segment.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================ Premiums and premium equivalents Premiums $302.9 $272.7 $268.0 Premium equivalents 581.4 513.4 459.7 - ---------------------------------------------------------------- Total premiums and premium equivalents $884.3 $786.1 $727.7 ================================================================ Revenues Premiums $302.9 $272.7 $268.0 Net investment income 21.7 17.6 14.0 Net realized gains (losses) 0.3 (0.5) 0.1 Other income 36.6 38.7 20.3 - ---------------------------------------------------------------- Total revenues 361.5 328.5 302.4 Policy benefits, claims and losses 211.3 197.2 182.6 Policy acquisition expenses 3.1 2.7 2.5 Other operating expenses 126.4 110.3 97.4 - ---------------------------------------------------------------- Income before taxes $ 20.7 $ 18.3 $ 19.9 ================================================================
1996 Compared to 1995 - --------------------- Income before taxes increased $2.4 million, or 13.1%, to $20.7 million in 1996. In 1995, CRMS received a one time litigation settlement of $11.1 million. Excluding this item, income before taxes increased $13.5 million, or 187.5%. This increase is primarily attributable to premium growth in the Company's reinsurance, fully insured group dental and group life product lines, and to improved overall loss trends. Premiums increased $30.2 million, or 11.1%, to $302.9 million in 1996, primarily due to increases in reinsurance, fully insured group dental, group life and stop loss product lines totaling $33.1 million. These increases were partially offset by a decrease of $4.0 million in fully insured medical premiums. Net investment income increased $4.1 million, or 23.3%, to $21.7 million in 1996, due primarily to a $1.6 million increase in income earned on proceeds from the Company's October, 1995 initial public offerings and approximately $1.4 million from increases in short-term debt used to finance additions to the investment portfolio. In addition, net investment income increased approximately $1.2 million from growth in invested assets. Other income decreased $2.1 million, or 5.4%, to $36.6 million in 1996, due primarily to the absence in 1996 of the aforementioned $11.1 million litigation settlement. This decrease was partially offset by growth in ASO and contract fees of $7.9 million in 1996. Policy benefits, claims and losses increased $14.1 million, or 7.2%, to $211.3 million in 1996. This increase is principally related to the growth in premiums, partially offset by favorable claims experience overall. Other operating expenses increased $16.1 million, or 14.6%, to $126.4 million in 1996, due primarily to increases in commissions, claims processing expenses and field office expenses, resulting from the increased volume of both premiums and claims. In addition, other operating expenses includes approximately $1.0 million of short-term borrowing costs related to the short- term debt used to finance additions to the investment portfolio. 1995 Compared to 1994 - --------------------- Income before taxes decreased $1.6 million, or 8.0%, to $18.3 million in 1995. This decrease was primarily attributable to adverse claims experience in all major lines, partially offset by an $11.1 million fourth quarter litigation settlement representing the recovery of claims paid in prior years. Premiums increased $4.7 million, or 1.8%, in 1995 as a result of increases in risk sharing and stop loss products and other products such as group life, long term disability, and reinsurance, totaling $20.4 million. These increases were partially offset by decreases of $15.7 million in full indemnity medical products. The decrease in full indemnity health business is consistent with the Company's plan to de-emphasize these products in favor of the more profitable risk sharing arrangements. Net investment income increased $3.6 million, or 25.7%, to $17.6 million in 1995 due to growth in invested assets. Other income increased $18.3 million, or 89.7%, to $38.7 million in 1995. This change is primarily due to an $11.1 million litigation settlement, recognized in the fourth quarter of 1995, which represents the recovery of prior years' claims paid. In addition, fees from the administrative services only business increased $4.0 million, or 27.2%, to $18.7 million in 1995. Policy benefits, claims and losses increased $14.6 million, or 8.0% in 1995. This increase is principally due to a deterioration in long term disability, medical, and dental loss experience as well as to growth in substantially all products except full indemnity medical. Other operating expenses increased $12.8 million, or 13.1%, in 1995, primarily due to increases in commissions, increased employee costs, and increased expenses associated with the Company's client center in Atlanta, Georgia. 42 - -------------------------------------------------------------------------------- Retail Financial Services - ------------------------- The following table summarizes the results of operations for the Retail Financial Services segment.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ============================================================== Revenues Premiums $ 95.7 $ 98.1 $121.6 Fees 181.2 157.9 143.9 Net investment income 251.3 229.1 223.9 Net realized (losses) gains (1.5) 0.6 (3.1) Other income 29.2 22.4 21.6 - -------------------------------------------------------------- Total revenues 555.9 508.1 507.9 Policy benefits, claims and losses 303.4 315.6 300.8 Policy acquisition expenses 58.1 56.1 79.5 Other operating expenses 118.2 101.2 113.4 - -------------------------------------------------------------- Income before taxes $ 76.2 $ 35.2 $ 14.2 ==============================================================
1996 Compared to 1995 - --------------------- Income before taxes increased $41.0 million, or 116.5%, to $76.2 million in 1996 compared to 1995. This increase was primarily attributable to growth in variable products' fee revenue, decreased losses in the disability income line and income earned on the proceeds from the October, 1995 initial public offerings. [GRAPH APPEARS HERE] Policy Fees (In millions) 96 - $181 95 - $158 94 - $144 The decrease in premiums of $2.4 million, or 2.4%, to $95.7 million in 1996 is primarily due to the Company's shift in focus from traditional life insurance products to variable life insurance and annuity products. Premiums from traditional life products decreased $3.4 million, or 5.1%, to $62.8 million in 1996. The increase in fee revenue of $23.3 million, or 14.8%, to $181.2 million in 1996 is due to additional deposits and appreciation on variable products account balances. Fees from annuities increased $20.1 million, or 54.5%, to $57.0 million in 1996. Fees from variable universal life policies increased $8.0 million, or 22.7%, to $43.3 million in 1996. These increases were partially offset by a continued decline in fees from non-variable universal life of $4.8 million, to $80.9 million, in 1996. The Company expects fees on this product to decrease as policies in force and related contract values decline. Net investment income increased $22.2 million, or 9.7%, to $251.3 million in 1996 primarily from $15.4 million in additional income on proceeds from the October, 1995 initial public offerings. Also, increases in short-term debt used to finance additions to the investment portfolio resulted in approximately $10.9 million in additional investment income. Partially offsetting these increases was a slightly lower portfolio yield in 1996. Other income increased $6.8 million, or 30.4%, to $29.2 million in 1996. This increase was primarily attributable to increased investment management income. Policy benefits, claims, and losses decreased $12.2 million, or 3.9%, to $303.4 million in 1996. Losses in the disability income line decreased $16.3 million due primarily to reserve strengthening of $14.5 million in 1995. Additionally, non-variable universal life benefits decreased $2.5 million principally due to improved mortality experience in 1996. These decreases were partially offset by an increase in variable products' policy benefits of $6.2 million, which related primarily to growth in these product lines. Other operating expenses include insurance taxes, licenses, fees, and administrative expenses incurred to support sales and marketing of products sold in this segment. The increase of $17.0 million, or 16.8%, to $118.2 million in 1996 was primarily attributable to $8.3 million of additional interest expense in 1996 relating to the short-term debt used to finance additions to the investment portfolio. Additionally, other operating expenses in 1995 included a $7.5 million decrease due to the cession of substantially all term life insurance business. 1995 Compared to 1994 - --------------------- Income before taxes increased $21.0 million, or 147.9%, to $35.2 million in 1995. This increase was primarily attributable to an increase in fee revenue from variable products and a decrease in policy acquisition expenses for all major products. These increases were partially offset by an increase in disability income policy benefits and decreased interest margins. The decrease in premiums of $23.5 million during 1995 is primarily due to the Company's ceding substantially all of its term life insurance business, which contributed $18.7 million in premiums in 1994. The increase in fee revenue of $14.0 million in 1995 is due to additional deposits and appreciation on variable products account balances. Fees from variable universal life increased from $28.9 million during 1994 to $35.3 million in 1995. Fees from annuities increased from $24.1 million for 1994 to $36.9 million for 1995. Fees from non-variable universal life decreased $5.2 million in 1995 as a result of a decline in policies in force and related contract values. The Company expects fees on this product to decrease as policies in force and related contract values continue to decline. The increase in policy benefits, claims and losses of $14.8 million in 1995 is primarily a result of increases in disability income policy benefits, non- variable universal life policy benefits, annuity benefits and variable life benefits, partially offset by a decrease in traditional life benefits due to cession of substantially all of the term life insurance business. Disability 43 - -------------------------------------------------------------------------------- income policy benefits increased $21.6 million, reflecting reserve strengthening and adverse morbidity in 1995, including fourth quarter reserve strengthening of $11.7 million. Non-variable universal life policy benefits increased $1.8 million due to adverse mortality. Annuity benefits and variable universal life benefits increased by $3.7 million in total, due primarily to growth in business and higher crediting rates for annuities. Total traditional policy benefits, claims and losses decreased from $116.7 million during 1994 to $104.4 million during 1995. The largest component of this $12.3 million decrease is a $12.5 million decrease in term life insurance benefits due to the cession of substantially all of this block of business in 1995. The decrease in policy acquisition expenses of $23.4 million, or 29.4%, to $56.1 million in 1995 is primarily due to reduced profit margins resulting from increased mortality and reduced investment margins, which resulted in a corresponding reduction in amortization. In addition, the 1994 amortization includes an increase of $9.6 million for the term life insurance product due to revised estimates of future profits. Other operating expenses decreased $12.2 million, or 10.8%, to $101.2 million in 1995, resulting primarily from a $7.5 million decrease due to the cession of substantially all term life insurance business and to significant non-recurring 1994 expenses. Interest Margins - ---------------- The results of the Retail Financial Services segment depend, in part, on the maintenance of profitable margins between investment results from investment assets supporting universal life and general account annuity products and the interest credited on those products. The following table sets forth interest earned, interest credited and the related interest margin.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ======================================================================= Net investment income $145.9 $152.7 $157.5 Less: Interest credited 101.3 107.7 102.0 - ----------------------------------------------------------------------- Interest margins (1) $ 44.6 $ 45.0 $ 55.5 =======================================================================
(1) Interest margins represent the difference between income earned on investment assets and interest credited to customers' universal life and general account annuity policies. Interest margins were relatively consistent in 1996, as compared to 1995. The decrease in interest margins from 1994 to 1995 is a result of a decline in policies in force and higher crediting rates resulting from the competetive environment. Institutional Services - ---------------------- The following table summarizes the results of operations for the Institutional Services segment.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ============================================================ Revenues Fees, premiums and non-insurance income (1) $ 33.5 $ 37.6 $ 72.6 Net investment income GICs 98.5 152.9 188.2 Other 115.5 113.5 114.6 Net realized gains 19.2 5.5 0.6 Gain on sale of mutual fund processing business -- 20.7 -- - ------------------------------------------------------------ Total revenues 266.7 330.2 376.0 - ------------------------------------------------------------ Policy benefits, claims and losses Interest credited to GICs 89.2 137.2 166.6 Other 70.9 80.6 81.5 - ------------------------------------------------------------ Total policy benefits, claims and losses 160.1 217.8 248.1 Policy acquisition expenses 2.9 3.2 3.4 Other operating expenses 50.9 66.4 120.1 - ------------------------------------------------------------ Income before taxes $ 52.8 $ 42.8 $ 4.4 ============================================================
(1) Fees, premiums and non-insurance income includes fees from retirement services, mutual fund services, institutional 401(k) recordkeeping services and other miscellaneous non-insurance related fees. In March 1995, the Company sold its mutual fund processing business. 1996 Compared to 1995 - --------------------- Income before taxes increased $10.0 million, or 23.4%, to $52.8 million in 1996. This change was primarily attributable to increased realized gains of $13.7 million and to decreased other policy benefits, claims and losses of $9.7 million resulting from defined benefit and defined contribution plan cancellations. These items were partially offset by a net decline of $9.8 million related to the sale of the mutual fund processing business in 1995 and a decline in the interest margins on GICs of $6.4 million. Fees, premiums, non-insurance and other income decreased $4.1 million, or 10.9%, to $33.5 million in 1996. This decrease was primarily attributable to a $13.7 million decrease in revenues due to the absence of the mutual fund processing business in 1996, partially offset by the 1996 receipt of a non- recurring $4.8 million contingent payment related to the aforementioned sale and to $3.0 million from growth in retail telemarketing revenues. Additionally, fee income increased $1.5 million from the appreciation of separate account balances in related defined benefit and defined contribution plans. 44 - -------------------------------------------------------------------------------- Net investment income related to GICs and interest credited to GIC contractholders have declined in 1996 as a result of declining GIC deposits due to the downgrading in March 1995 of FAFLIC's S&P Rating to A+ (Good). As a result, sales of traditional GICs have substantially ceased. Management expects GIC deposits and related income to continue to decline. Net realized gains increased $13.7 million, to $19.2 million in 1996. This change resulted primarily from increased gains from sales of real estate properties totaling $12.2 million. Other policy benefits, claims and losses consist primarily of benefits provided by the Company's defined contribution and defined benefit plans, including annuity benefits for certain defined benefit plan participants electing that option. Other policy benefits, claims and losses declined from $80.6 million in 1995 to $70.9 million in 1996. This was primarily due to reductions in the interest credited to participants resulting from the aforementioned cancellations in defined benefit and defined contribution plans. Other operating expenses decreased $15.5 million, or 23.3%, to $50.9 million in 1996. This decrease was primarily attributable to the sale of the mutual fund processing business, which incurred $19.8 million of operating expenses in 1995. 1995 Compared to 1994 - --------------------- Income before taxes increased $38.4 million to $42.8 million in 1995. This increase was primarily attributable to the sale of the Company's mutual fund processing business in March 1995, resulting in a pre-tax gain of $20.7 million, and to a $4.9 million increase in realized investment gains. Additionally, in 1995 revenue from the mutual fund processing business decreased $38.3 million and expenses decreased $49.3 million, contributing another $11.0 million to the increase in net income before taxes for this period. Fees, premiums and non-insurance income decreased $35.0 million, or 48.2% in 1995. As noted above, this decrease was primarily attributable to the $38.3 million decrease in revenues from the mutual fund processing business, which was sold in March 1995. Net investment income related to GICs and interest credited to GIC contractholders have declined as a result of declining GIC deposits due to the downgrading in March 1995 of FAFLIC's S&P Rating to A+ (Good). Management expects GIC deposits and related income to continue to decline. Net realized gains increased $4.9 million, to $5.5 million in 1995 due to decreased mortgage loan impairments. Other operating expenses decreased $53.7 million, or 44.7% in 1995. This decrease was primarily attributable to the $49.3 million decrease in expenses for the mutual fund processing business. The remainder of the decrease was due primarily to decreases in consulting fees, system development costs, and employee costs as a result of exiting certain other product lines and businesses, primarily various processing services for defined contribution plans. Allmerica Asset Management - -------------------------- The following table summarizes the results of operations for the Allmerica Asset Management segment.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================= Fees and other income: External $ 1.1 $ 1.0 $ 0.7 Internal 7.7 3.4 3.3 - ----------------------------------------------------------------- Total revenues 8.8 4.4 4.0 Other operating expenses 7.7 2.1 2.1 - ----------------------------------------------------------------- Income before taxes $ 1.1 $ 2.3 $ 1.9 =================================================================
Since 1994, the Company has provided investment advisory and sub-advisory services, primarily to affiliates, through its registered investment advisor, Allmerica Asset Management ("AAM"). In the second quarter of 1996, AAM finalized contracts with two related parties, FAFLIC and AFLIAC, to provide investment advisory services at cost. The internal fees and corresponding operating expenses related to these contracts totaled $4.3 million for the year ended December 31, 1996. Corporate - --------- The following table summarizes the results of operations for the Corporate segment.
Period from October 1 through December 31 December 31 (IN MILLIONS) 1996 1995 ============================================================================== Revenues Investment and other income $ 2.7 $ 0.4 Realized loss (0.9) -- - ------------------------------------------------------------------------------ Total revenues 1.8 0.4 Other operating expenses 18.6 3.5 - ------------------------------------------------------------------------------ Loss before taxes $(16.8) $(3.1) ==============================================================================
This segment consists primarily of $32.9 million of cash, investments and other assets remaining from the $52.9 million in net proceeds retained by the holding company in the Company's initial public offerings. These investments earned $2.7 million in net investment income in 1996 and $0.4 million for the period from October 1, 1995 to December 31, 1995. The segment incurred $18.6 million and $3.5 million of other operating expenses in 1996 and for the period from October 1, 1995 to December 31, 1995, respectively, primarily $15.3 million and $3.2 million, respectively, in interest expense on the Company's 7 5/8% Senior Debentures issued in October 1995. 45 - -------------------------------------------------------------------------------- INVESTMENT PORTFOLIO - -------------------- The Company had investment assets diversified across several asset classes, as follows:
December 31 (Dollars in millions) 1996(1) 1995(1) ================================================================================ % of Total % of Total Carrying Carrying Carrying Carrying Value Value Value Value Fixed maturities (2) $7,891.7 79.4% $ 8,197.3 78.1% Equity securities (2) 473.6 4.8 517.2 4.9 Mortgages 764.6 7.7 856.5 8.2 Policy loans 362.6 3.6 365.7 3.5 Real estate 120.7 1.2 179.6 1.7 Cash and cash equivalents 202.6 2.0 307.1 2.9 Other invested assets 128.8 1.3 71.9 0.7 - -------------------------------------------------------------------------------- Total $9,944.6 100.0% $10,495.3 100.0% ================================================================================
(1) Includes Closed Block invested assets with a carrying value of $772.7 million and $775.1 million at December 31, 1996 and 1995, respectively. (2) The Company carries the fixed maturities and equity securities in its investment portfolio at market value. Total investment assets decreased $550.7 million, or 5.2%, to $9.9 billion during 1996. This decrease is primarily attributable to a decline in invested assets resulting from the settlement of GIC contracts and to market value depreciation in the fixed maturities portfolio. Equity securities decreased $43.6 million, or 8.4%, to $473.6 million, as a result of the Regional Property and Casualty segment's shift in portfolio holdings from equity securities to tax-exempt fixed maturity securities. Despite this portfolio shift, fixed maturities decreased $305.6 million, or 3.7%, due primarily to financing of net GIC withdrawals and to market value depreciation of $93.0 million. Additionally, mortgage loans decreased $91.9 million, or 10.7%, to $764.6 million caused primarily by loan repayments. The real estate portfolio decreased $58.9 million, or 32.8%, to $120.7 million during 1996 due to sales of investment properties. The increase in other invested assets of $56.9 million, or 79.1% to $128.8 million primarily relates to third and fourth quarter purchases of limited partnerships by FAFLIC. Cash and cash equivalents decreased $104.5 million, or 34.0%, to $202.6 million. [PIE CHART APPEARS HERE] Bond Portfolio Credit Quality Aaa/Aa/A -- 54% Baa -- 31% Ba & Below -- 15% The Company's fixed maturity portfolio is comprised of primarily investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners, investment grade securities comprised 84.8% and 88.7% of the Company's total fixed maturity portfolio at December 31, 1996 and December 31, 1995, respectively. In 1996, there was a modest shift to higher yielding debt securities, including longer duration and non-investment grade securities. The average yield on debt securities was 7.3% and 7.2% for 1996 and 1995, respectively. Although management expects that a substantial portion of new funds will be invested in investment grade fixed maturities, the Company may invest a portion of new funds in below investment grade fixed maturities or equity interests. 46 The following table illustrates asset valuation allowances and additions to or deductions from such allowances for the periods indicated.
For the Years Ended December 31 (Dollars in millions) ================================================================================ Other Real Invested 1995 Mortgages Estate Assets Total - ---- Beginning balance $ 47.2 $22.9 $ 3.7 $ 73.8 Provision (benefits) 1.5 (0.6) -- 0.9 Write-offs (1) (14.9) (2.7) -- (17.6) - -------------------------------------------------------------------------------- Ending balance $ 33.8 $19.6 $ 3.7 $ 57.1 Valuation allowance as a percentage of carrying value before reserves 3.8% 9.8% 4.9% 4.9% 1996 - ---- Provision 5.5 -- -- 5.5 Write-offs (1) (19.7) (4.7) (3.7) (28.1) - -------------------------------------------------------------------------------- Ending balance $ 19.6 $14.9 $ -- $ 34.5 Valuation allowance as a percentage of carrying value before reserves 2.5% 11.0% --% 3.8%
(1) Write-offs reflect asset sales, foreclosures and forgiveness of debt upon restructuring. The increase in write-offs of mortgages during 1996 as compared to 1995 reflects an increase in the disposal of modified loans which were previously impaired. Income Taxes - ------------ AFC and its life insurance subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Allmerica P&C and its subsidiaries file a separate United States federal income tax return. For the years ended December 31, 1995 and 1994, FAFLIC, as a mutual insurance company until October 1995, was required to adjust its deduction for policyholder dividends by the differential earnings amount under Section 809 of the Internal Revenue Code. This amount was computed, for each tax year, by multiplying the average equity base of the FAFLIC/AFLIAC consolidated group, as determined for tax purposes, by the estimate of an excess of an imputed earnings rate over the average mutual life insurance companies' earnings rate. The differential earnings amount for each tax year was subsequently recomputed when actual earnings rates were published by the IRS. As a stock company, AFC, including its life insurance subsidiaries, is no longer required to reduce its policyholder dividend deduction by the differential earnings amount. The differential earnings amount in the current period related to an adjustment for the 1994 tax year based on the actual average mutual life insurance companies' earnings rate issued by the IRS in 1996. Provision for federal income taxes before minority interest was $75.2 million during 1996 compared to $82.7 million during 1995. These provisions resulted in consolidated effective federal tax rates of 22.7% and 27.4%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non- insurance subsidiaries were 28.9% and 32.0% during 1996 and 1995, respectively. The effective tax rates for the Regional Property and Casualty subsidiaries were 18.4% and 25.3% during 1996 and 1995, respectively. The reduction in the rate for FAFLIC in 1996 resulted primarily from additional reserves provided for revisions of estimated prior year tax liabilities in 1995, as well as an increase of $2.6 million in the differential earnings benefit from 1995 to 1996. The decrease in the rate for Regional Property and Casualty subsidiaries reflects a higher underwriting loss and greater proportion of pre-tax income from tax-exempt bonds in 1996, and to reserves provided for revisions in estimated prior year tax liabilities in 1995. Provision for federal income taxes before minority interest was $82.7 million during 1995 compared to $53.4 million during 1994. These provisions resulted in consolidated effective federal tax rates of 27.4% and 34.8% in 1995 and 1994, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were 32.0% and 122.4% during 1995 and 1994, respectively. The effective tax rates for the Regional Property and Casualty subsidiaries were 25.3% and 3.5% during 1995 and 1994, respectively. The significant reduction in the rate for FAFLIC primarily resulted from a 47 - -------------------------------------------------------------------------------- differential earnings benefit of $7.6 million, or 7.9% of taxable income, during 1995, including a benefit of $15.2 million recognized during the fourth quarter, versus a charge of $35.0 million, or 86.5% of taxable income, during 1994. The increase in the rate for the Regional Property and Casualty subsidiaries is attributable to improved underwriting results, a decrease in the proportion of pre-tax income attributable to tax-exempt interest, and to reserves provided for revisions in estimated prior year tax liabilities, including $7.2 million provided during the fourth quarter of 1995. LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, AFC's primary source of cash is dividends from its insurance subsidiaries. However, dividend payments to AFC by its insurance subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus and restrictions on the payment of "extraordinary" dividends, as defined. Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claim losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash provided by operating activities was $156.0 million, $131.2 million and $331.7 million in 1996, 1995 and 1994, respectively. The increase in 1996 was primarily attributable to an increase in cash provided by the operations of the life insurance subsidiaries. This increase was partially offset by increased underwriting losses in the Regional Property and Casualty Insurance subsidiaries which resulted in an increase in claims payments. The decrease during 1995 was due primarily to the timing of payments of losses and LAE in the Regional Property and Casualty Insurance subsidiaries; the timing of cash receipts and payments relating to reinsurance due primarily to the cession of the yearly renewable term product in 1995; the decrease in investment income due to the decrease in GIC assets; and the decrease in other income resulting from the sale of the mutual fund processing business. Net cash provided by investing activities was $424.6 in 1996 and $327.2 million in 1994. Net cash used in investing activities was $128.1 million in 1995. The increase from 1995 to 1996 was primarily attributable to increased sales of investments used to finance net withdrawals from GICs partially offset by additional purchases of fixed maturities and other long-term investments financed through an increase in investable cash generated by operations. During 1996, cash flows from investing activities were impacted by delayed sales of investments financed instead with repurchase agreements. Although the repurchase agreements were entirely settled by year end, management may utilize this policy again in future periods. In 1995, the net cash used resulted from net purchases of fixed maturities and equity securities which were partially offset by mortgage loan repayments and proceeds from the sale of the mutual fund processing business. In 1994, a larger amount of mortgage loan repayments and net sales and maturities of fixed maturities resulted in the net cash provided. Net cash used for financing activities was $685.1 million, $235.7 million, and $410.6 million in 1996, 1995, and 1994 respectively. The Company made cash payments on withdrawals from GICs that exceeded cash received from deposits on these contracts by $636.3 million, $624.1 million and $400.7 million in 1996, 1995 and 1994, respectively. Although the Company expects this trend in negative financing cash flows from GIC withdrawals to continue, the Company does not expect GIC withdrawals to have a material impact on liquidity. Also, cash used to purchase subsidiary common stock increased $21.1 million, to $42.0 million during the year ended December 31, 1996. In 1995, the cash used for financing activities was positively impacted by the Company's receipt of proceeds of $248.0 million and $197.2 million from its initial public offering of stock and debt, respectively. On February 3, 1997, AFC Capital Trust (the "Trust"), a subsidiary business trust of AFC, issued $300 million Series A Capital Securities, which pay cumulative dividends at a rate of 8.207% semiannually commencing August 15, 1997. The Trust exists for the sole purpose of issuing the Capital Securities and investing the proceeds thereof in an equivalent amount of 8.207% Junior Subordinated Deferrable Interest Debentures due 2027 of AFC (the "Subordinated Debentures"). Through certain guarantees, the Subordinated Debentures and the terms of related agreements, AFC has irrevocably and unconditionally guaranteed the obligations of the Trust under the Capital Securities. Net proceeds from the offering of approximately $296.3 million are intended to fund a portion of the acquisition of the 24.2 million publicly held shares of Allmerica P&C pursuant to an Agreement and Plan of Merger dated February 19, 1997. On October 16, 1995, FAFLIC converted from a policyholder owned to stockholder owned insurance company and AFC became the holding company for FAFLIC. AFC also raised net proceeds of $248.0 million from the sale of Common Stock and issued $200.0 million principal amount 7 5/8% Senior 48 - -------------------------------------------------------------------------------- Debentures due 2025 with net proceeds to the Company of $197.2 million. The Company will also pay approximately $15.3 million per year in interest payments on the Senior Debentures. AFC has sufficient funds at the holding company or available through dividends from FAFLIC to meet its obligations to pay interest on the Senior Debentures, Subordinated Debentures and dividends, when and if declared by the Board of Directors, on the common stock. Whether the Company will pay dividends in the future depends upon the costs of administering a dividend program as compared to the benefits conferred, and upon the earnings and financial condition of AFC. Based on current trends, the Company expects to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. The Company maintains a high degree of liquidity within the investment portfolio in fixed maturity investments, common stock and short-term investments. FAFLIC and Allmerica P&C have $100.0 million and $40.0 million respectively, under various committed short-term lines of credit. At December 31, 1996, no amounts were outstanding and $90.2 million and $12.0 million were available for borrowing by FAFLIC and Allmerica P&C, respectively. FAFLIC and Allmerica P&C had $9.8 million and $28.0 million, respectively, of commercial paper borrowings outstanding at December 31, 1996. RECENT DEVELOPMENTS - ------------------- On February 19, 1997, the Company and Allmerica P&C entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which the Company will acquire all of the outstanding Common Stock, $1.00 par value per share, of Allmerica P&C that it does not already own for consideration consisting of $33.00 per share of Common Stock, subject to adjustment, payable in cash and shares of common stock, par value $0.01 per share, of the Company (the "AFC Common Stock"). In addition, a shareholder of Allmerica P&C may elect to receive the consideration in cash, without interest, or in shares of AFC Common Stock, subject to proration as set forth in the Merger Agreement. The maximum number of shares of AFC Common Stock to be issued in the Merger is approximately 9.67 million shares. The acquisition will be accomplished by merging a newly created, wholly-owned subsidiary of the Company with and into Allmerica P&C ( the "Merger") resulting in Allmerica P&C becoming a wholly-owned subsidiary of the Company. Also, immediately prior to the Merger, Allmerica P&C's Certificate of Incorporation will be amended to authorize a new class of Common Stock, one share of which will be exchanged for each share of Common Stock currently held by SMA Financial Corp., a wholly-owned subsidiary of the Company. The consummation of the Merger is subject to the satisfaction of various conditions, including the approval of regulatory authorities. FORWARD-LOOKING STATEMENTS - -------------------------- The Company wishes to caution readers that the following important factors, among others, in some cases have affected and in the future could affect, the Company's actual results and could cause the Company's actual results for 1996 and beyond to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. When used in the MD&A discussion, the words "believes," "anticipated," "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 1996. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward looking statements include among others, the following possibilities: (i) adverse catastrophe experience and severe weather; (ii) adverse loss development for events the Company insured in prior years or adverse trends in mortality and morbidity; (iii) heightened competition, including the intensification of price competition, the entry of new competitors, and the introduction of new products by new and existing competitors; (iv) 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, and tax treatment of insurance products; (v) changes in interest rates causing a reduction of investment income or in the market value of interest rate sensitive investments; (vi) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (vii) higher service, administrative, or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (viii) loss or retirement of key executives; (ix) increases in medical costs, including increases in utilization, costs of medical services, pharmaceuticals, durable medical equipment and other covered items; (x) termination of provider contracts or renegotiation at less cost-effective rates or terms of payment; (xi) changes in the Company's liquidity due to changes in asset and liability matching; (xii) restrictions on insurance underwriting, based on genetic testing and other criteria; (xiii) adverse changes in the ratings obtained from independent rating agencies, such as Moody's, Standard and Poors, A.M. Best, and Duff & Phelps; (xiv) lower appreciation on and decline in value of managed investments, resulting in reduced variable products, assets and related fees; and (xv) possible claims relating to sales practices for insurance products. 49 Report of Independent Accountants - -------------------------------------------------------------------------------- To the Board of Directors and Shareholders of Allmerica Financial Corporation In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholders' equity, and of cash flows present fairly, in all material respects, the financial position of Allmerica Financial Corporation and its subsidiaries at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in the accompanying notes to the consolidated financial statements, the Company changed its method of accounting for investments (Note 1) and postemployment benefits (Note 11) in 1994. /s/ Price Waterhouse LLP Boston, Massachusetts February 3, 1997, except as to Notes 1 and 2, which are as of February 19, 1997 Management Report on Responsibility For Financial Reporting - -------------------------------------------------------------------------------- The management of Allmerica Financial Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in conformity with generally accepted accounting principles and include amounts based on management's informed estimates and judgments. We believe that these statements present fairly the company's financial position and results of operations and that the other information contained in the annual report is accurate and consistent with the financial statements. Allmerica Financial Corporation's Board of Directors annually appoints independent accountants to perform an audit of its consolidated financial statements. The financial statements have been audited by Price Waterhouse LLP, independent accountants, in accordance with generally accepted auditing standards. Their audit included consideration of the company's system of internal control in order to determine the audit procedures required to express their opinion on the consolidated financial statements. Management of Allmerica Financial Corporation has established and maintains a system of internal control that provides reasonable assurance that assets are safeguarded and that transactions are properly authorized and recorded. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. Management continually monitors the system of internal control for compliance. Allmerica Financial Corporation and its subsidiaries maintain a strong internal audit program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. Management recognizes the inherent limitations in all internal control systems and believes that our system of internal control provides an appropriate balance between the costs and benefits desired. Management believes that the company's system of internal control provides reasonable assurance that errors or irregularities that would be material to the financial statements are prevented or detected in the normal course of business. The Audit Committee of the Board of Directors, composed solely of outside directors, oversees management's discharge of its financial reporting responsibilities. The committee meets periodically with management, our internal auditors and our independent accountants, Price Waterhouse LLP. Both our internal auditors and Price Waterhouse LLP have direct access to the Audit Committee. Management recognizes its responsibility for fostering a strong ethical climate. This responsibility is reflected in the Company's policies which address, among other things, potential conflicts of interest; compliance with all domestic and foreign laws including those relating to financial disclosure and the confidentiality of proprietary information. Allmerica Financial Corporation maintains a systematic program to assess compliance with these policies. /s/ John F. O'Brien /s/ Edward J. Parry, III John F. O'Brien Edward J. Parry, III President and Chief Vice President, Chief Financial Executive Officer Officer, Principal Accounting Officer 50 Consolidated Statements of Income
- ------------------------------------------------------------------------------ FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS, EXCEPT PER SHARE DATA) 1996 1995 1994 ============================================================================== REVENUES - -------- Premiums $2,236.3 $2,222.8 $2,181.8 Universal life and investment product policy fees 197.2 172.4 156.8 Net investment income 672.6 710.5 743.1 Net realized investment gains 65.9 19.1 1.1 Realized gain on sale of mutual fund processing business -- 20.7 -- Other income 102.7 95.4 112.3 - ------------------------------------------------------------------------------ Total revenues 3,274.7 3,240.9 3,195.1 - ------------------------------------------------------------------------------ BENEFITS, LOSSES AND EXPENSES - ----------------------------- Policy benefits, claims, losses and loss adjustment expenses 1,957.0 2,010.3 2,047.0 Policy acquisition expenses 483.5 470.3 475.7 Other operating expenses 502.5 458.5 518.9 - ------------------------------------------------------------------------------ Total benefits, losses and expenses 2,943.0 2,939.1 3,041.6 - ------------------------------------------------------------------------------ Income before federal income taxes 331.7 301.8 153.5 - ------------------------------------------------------------------------------ Federal income tax expense (benefit) Current 90.9 119.7 45.4 Deferred (15.7) (37.0) 8.0 - ------------------------------------------------------------------------------ Total federal income tax expense 75.2 82.7 53.4 - ------------------------------------------------------------------------------ Income before minority interest, extraordinary item and cumulative effect of accounting change 256.5 219.1 100.1 Minority interest (74.6) (73.1) (51.0) - ------------------------------------------------------------------------------ Income before extraordinary item and cumulative effect of accounting change 181.9 146.0 49.1 Extraordinary item - demutualization expenses -- (12.1) (9.2) Cumulative effect of change in accounting principle -- -- (1.9) - ------------------------------------------------------------------------------ Net income $ 181.9 $ 133.9 $ 38.0 ============================================================================== For the Period Year Ended October 1 December 31, Year Ended through 1995 December 31, December 31, Pro Forma* 1996 1995 (Unaudited) Net income after demutualization $ 181.9 $ 40.7 $ 130.6 =============================================================================== Net income after demutualization per share $ 3.63 $ 0.82 $ 2.61 =============================================================================== Weighted average shares outstanding 50.1 49.4 50.1 ===============================================================================
*The pro forma information gives effect to the transactions referred to in Note 1N. THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 51 Consolidated Balance Sheets
- ------------------------------------------------------------------------------------ DECEMBER 31 (IN MILLIONS, EXCEPT PER SHARE DATA) 1996 1995 ==================================================================================== ASSETS Investments: Fixed maturities-at fair value (amortized cost of $7,305.5 and $7,467.9) $ 7,487.8 $ 7,739.3 Equity securities-at fair value (cost of $328.2 and $410.6) 473.6 517.2 Mortgage loans 650.1 799.5 Real estate 120.7 179.6 Policy loans 132.4 123.2 Other long-term investments 128.8 71.9 - ------------------------------------------------------------------------------------ Total investments 8,993.4 9,430.7 - ------------------------------------------------------------------------------------ Cash and cash equivalents 178.5 289.5 Accrued investment income 149.0 163.2 Deferred policy acquisition costs 822.7 735.7 - ------------------------------------------------------------------------------------ Reinsurance receivables: Future policy benefits 102.8 97.1 Outstanding claims, losses and loss adjustment expenses 663.8 799.6 Unearned premiums 46.2 43.8 Other 62.8 58.9 - ------------------------------------------------------------------------------------ Total reinsurance receivables 875.6 999.4 - ------------------------------------------------------------------------------------ Deferred federal income taxes 93.2 81.2 Premiums, accounts and notes receivable 533.0 526.7 Other assets 307.5 363.6 Closed Block assets 811.8 818.9 Separate account assets 6,233.0 4,348.8 - ------------------------------------------------------------------------------------ Total assets $18,997.7 $17,757.7 ==================================================================================== LIABILITIES - ----------- Policy liabilities and accruals: Future policy benefits $ 2,613.7 $ 2,639.3 Outstanding claims, losses and loss adjustment expenses 2,944.1 3,081.3 Unearned premiums 822.5 800.9 Contractholder deposit funds and other policy liabilities 2,060.4 2,737.4 - ------------------------------------------------------------------------------------ Total policy liabilities and accruals 8,440.7 9,258.9 ==================================================================================== Expenses and taxes payable 622.3 603.0 Reinsurance premiums payable 31.4 42.0 Short-term debt 38.4 31.2 Deferred federal income taxes 34.7 47.8 Long-term debt 202.2 202.3 Closed Block liabilities 892.1 902.0 Separate account liabilities 6,227.2 4,337.8 - ------------------------------------------------------------------------------------ Total liabilities 16,489.0 15,425.0 - ------------------------------------------------------------------------------------ Minority interest 784.0 758.5 - ------------------------------------------------------------------------------------ Commitments and contingencies (Notes 15 and 20) 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, 50.1 million shares issued and outstanding 0.5 0.5 Additional paid-in capital 1,382.5 1,382.5 Unrealized appreciation on investments, net 131.6 153.0 Retained earnings 210.1 38.2 - ------------------------------------------------------------------------------------ Total shareholders' equity 1,724.7 1,574.2 - ------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $18,997.7 $17,757.7 ====================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 52 Consolidated Statements of Shareholders' Equity
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ COMMON STOCK - ------------ Balance at beginning of year $ 0.5 $ -- $ -- Demutualization transaction -- 0.4 -- Initial public offering -- 0.1 -- - -------------------------------------------------------------------------------- Balance at end of year 0.5 0.5 -- - -------------------------------------------------------------------------------- ADDITIONAL PAID-IN CAPITAL - -------------------------- Balance at beginning of year 1,382.5 -- -- Demutualization transaction -- 1,134.6 -- Initial public offering -- 247.9 -- - -------------------------------------------------------------------------------- Balance at end of year 1,382.5 1,382.5 -- - -------------------------------------------------------------------------------- RETAINED EARNINGS - ----------------- Balance at beginning of year 38.2 1,071.4 1,033.4 Net income prior to demutualization -- 93.2 38.0 - -------------------------------------------------------------------------------- 38.2 1,164.6 1,071.4 Demutualization transaction -- (1,164.6) -- Net income subsequent to demutualization 181.9 40.7 -- Dividends to shareholders (10.0) (2.5) -- - -------------------------------------------------------------------------------- Balance at end of year 210.1 38.2 1,071.4 - -------------------------------------------------------------------------------- NET UNREALIZED APPRECIATION - --------------------------- (DEPRECIATION) ON INVESTMENTS - ----------------------------- Balance at beginning of year 153.0 (79.0) 17.5 - -------------------------------------------------------------------------------- Cumulative effect of accounting change: Net appreciation on available-for-sale debt securities -- -- 296.1 Provision for deferred federal income taxes and minority interest -- -- (149.1) - -------------------------------------------------------------------------------- -- -- 147.0 - -------------------------------------------------------------------------------- Effect of transfer of securities from held-to-maturity to available-for-sale: Net appreciation on available-for-sale debt securities -- 22.4 -- Provision for deferred federal income taxes and minority interest -- (9.6) -- - -------------------------------------------------------------------------------- -- 12.8 -- - -------------------------------------------------------------------------------- (Depreciation) appreciation during the period: Net (depreciation) appreciation on available-for-sale securities (35.1) 466.0 (492.1) Benefit (provision) for deferred federal income taxes 12.3 (163.1) 171.9 Minority interest 1.4 (83.7) 76.7 - -------------------------------------------------------------------------------- (21.4) 219.2 (243.5) - -------------------------------------------------------------------------------- Balance at end of year 131.6 153.0 (79.0) - -------------------------------------------------------------------------------- Total shareholders' equity $1,724.7 $ 1,574.2 $ 992.4 ================================================================================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 53 Consolidated Statements of Cash Flows
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 199 ================================================================================ CASH FLOWS FROM OPERATING - ------------------------- ACTIVITIES - ---------- Net income $ 181.9 $ 133.9 $ 38.0 Adjustments to reconcile net income to net cash provided by operating activities: Minority interest 74.6 73.1 50.1 Net realized gains (65.2) (39.8) (1.1) Net amortization and depreciation 44.7 57.7 45.9 Deferred federal income taxes (15.7) (37.0) 8.0 Change in deferred acquisition costs (73.9) (38.4) (34.6) Change in premiums and notes receivable, net of reinsurance payable (16.7) (42.0) (25.6) Change in accrued investment income 16.5 6.8 4.6 Change in policy liabilities and accruals, net (184.3) 116.2 175.9 Change in reinsurance receivable 123.7 (75.6) (31.9) Change in expenses and taxes payable 27.1 7.7 88.0 Separate account activity, net 5.2 (0.1) 0.4 Other, net 38.1 (31.3) 14.0 - -------------------------------------------------------------------------------- Net cash provided by operating activities 156.0 131.2 331.7 - -------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES ------------------------------------ Proceeds from disposals and maturities of available-for-sale fixed maturities 4,018.5 2,738.4 2,097.8 Proceeds from disposals of held-to-maturity fixed maturities -- 271.3 304.4 Proceeds from disposals of equity securities 228.7 120.0 143.9 Proceeds from disposals of other investments 99.3 40.5 25.9 Proceeds from mortgages matured or collected 176.9 230.3 256.4 Purchase of available-for-sale fixed maturities (3,830.7) (3,273.3) (2,150.1) Purchase of held-to-maturity fixed maturities -- -- (111.6) Purchase of equity securities (91.6) (254.0) (172.2) Purchase of other investments (168.0) (24.8) (26.6) Proceeds from sale of mutual fund processing business -- 32.9 -- Capital expenditures (12.8) (14.1) (43.1) Other investing activities, net 4.3 4.7 2.4 - -------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 424.6 (128.1) 327.2 - -------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES - ------------------------------------ Deposits and interest credited to contractholder deposit funds 268.7 445.8 786.3 Withdrawals from contractholder deposit funds (905.0) (1,069.9) (1,187.0) Change in short-term debt 7.2 (1.6) (6.0) Change in long-term debt (0.1) 0.2 0.3 Dividends paid to shareholders (13.9) (6.6) (4.2) Net proceeds from issuance of common stock -- 248.0 -- Payments for policyholders' membership interests -- (27.9) -- Net proceeds from issuance of long-term debt -- 197.2 -- Subsidiary treasury stock purchased, at cost (42.0) (20.9) -- - -------------------------------------------------------------------------------- Net cash used in financing activities (685.1) (235.7) (410.6) - -------------------------------------------------------------------------------- Net change in cash and cash equivalents (104.5) (232.6) 248.3 Net change in cash held in the Closed Block (6.5) (17.6) -- Cash and cash equivalents, beginning of year 289.5 539.7 291.4 - -------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 178.5 $ 289.5 $ 539.7 ================================================================================ SUPPLEMENTAL CASH FLOW INFORMATION - ---------------------------------- Interest paid $ 33.8 $ 4.1 $ 4.3 Income taxes paid $ 68.1 $ 90.6 $ 46.1
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. 54 Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- 1. Summary of Significant Accounting Policies ------------------------------------------ A. Basis of Presentation and Principles of Consolidation - -------------------------------------------------------- First Allmerica Financial Life Insurance Company ("FAFLIC") was organized as a mutual life insurance company until October 16, 1995. FAFLIC converted to a stock life insurance company pursuant to a plan of reorganization effective October 16, 1995 and became a wholly owned subsidiary of Allmerica Financial Corporation ("AFC" or the "Company"). The consolidated financial statements have been prepared as if FAFLIC were organized as a stock life insurance company for all periods presented. Thus, generally accepted accounting principles for stock life insurance companies have been applied retroactively for all periods presented. The consolidated financial statements of AFC include the accounts of FAFLIC, its wholly owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries (principally brokerage and investment advisory subsidiaries), and Allmerica Property and Casualty Companies, Inc. ("Allmerica P&C", a 59.5%-owned non- insurance holding company). The Closed Block assets and liabilities at December 31, 1996 and 1995 and its results of operations subsequent to demutualization are presented in the consolidated financial statements as single line items. Prior to demutualization such amounts are presented line by line in the consolidated financial statements (see Note 6). Unless specifically stated, all disclosures contained herein supporting the consolidated financial statements at December 31, 1996 and 1995 and the years then ended exclude the Closed Block related amounts. All significant intercompany accounts and transactions have been eliminated. Minority interest relates to the Company's investment in Allmerica P&C and its only significant subsidiary, The Hanover Insurance Company ("Hanover"). Hanover's 82.5%-owned subsidiary is Citizens Corporation, the holding company for Citizens Insurance Company of America ("Citizens"). Minority interest also includes an amount related to the minority interest in Citizens Corporation. On February 19, 1997, the Company announced a definitive merger agreement under which it would acquire, at consideration of $33.00 per share, all of the shares of Allmerica P&C currently held by the minority stockholders. Additional information pertaining to the merger agreement is included in Note 2, Significant Transactions. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. B. Closed Block - --------------- As of October 16, 1995, FAFLIC established and began operating a closed block (the "Closed Block") for the benefit of the participating policies included therein, consisting of certain individual life insurance participating policies, individual deferred annuity contracts and supplementary contracts not involving life contingencies which were in force on October 16, 1995; such policies constitute the "Closed Block Business". The purpose of the Closed Block is to protect the policy dividend expectations of such FAFLIC dividend paying policies and contracts after the demutualization. Unless the Commissioner consents to an earlier termination, the Closed Block will continue to be in effect until the date none of the Closed Block policies is in force. On October 16, 1995, FAFLIC allocated to the Closed Block assets in an amount that is expected to produce cash flows which, together with future revenues from the Closed Block Business, are reasonably sufficient to support the Closed Block Business, including provision for payment of policy benefits, certain future expenses and taxes and for continuation of policyholder dividend scales payable in 1994 so long as the experience underlying such dividend scales continues. The Company expects that the factors underlying such experience will fluctuate in the future and policyholder dividend scales for Closed Block Business will be set accordingly. Although the assets and income allocated to the Closed Block inure solely to the benefit of the holders of policies included in the Closed Block, the excess of Closed Block liabilities over Closed Block assets at October 16, 1995 measured on a GAAP basis represent the expected future post-tax income from the Closed Block which may be recognized in income over the period the policies and contracts in the Closed Block remain in force. If the actual income from the Closed Block in any given period equals or exceeds the expected income for such period as determined at October 16, 1995, the expected income would be recognized in income for that period. Further, any excess of the actual income over the expected income would also be recognized in income to the extent that the aggregate expected income for all prior periods exceeded the aggregate actual income. Any remaining excess of actual income over expected income would be accrued as a liability for policyholder dividends in the Closed Block to be paid to the Closed Block policyholders. This accrual for future dividends effectively limits the actual Closed Block income recognized in income to the Closed Block income expected to emerge from operation of the Closed Block as determined as of October 16, 1995. If, over the period the policies and contracts in the Closed Block remain in force, the actual income from the Closed Block is less than the expected income from the Closed Block, only such actual income (which could reflect a loss) would be recognized in income. If the actual income from the Closed Block in any given period is less than the expected income for that period and changes in dividends scales are inadequate to 55 - -------------------------------------------------------------------------------- offset the negative performance in relation to the expected performance, the income inuring to shareholders of the Company will be reduced. If a policyholder dividend liability had been previously established in the Closed Block because the actual income to the relevant date had exceeded the expected income to such date, such liability would be reduced by this reduction in income (but not below zero) in any periods in which the actual income for that period is less than the expected income for such period. C. Valuation of Investments - --------------------------- Effective January 1, 1994, the Company adopted the provisions of Statement of Financial Accounting Standards No. 115 (SFAS No. 115), "Accounting for Certain Investments in Debt and Equity Securities", which requires investments be classified into one of three categories: held-to-maturity, available-for-sale or trading. The effect of implementing SFAS No. 115, as of January 1, 1994, was an increase in the carrying value of fixed maturity investments of $335.3 million, a decrease in deferred policy acquisition costs of $20.8 million, an increase in policyholder liabilities of $18.4 million, a net increase in deferred income tax liabilities of $103.7 million, an increase in minority interest of $45.4 million and an increase in shareholders' equity of $147.0 million, which resulted from changing the carrying value of certain fixed maturities from amortized cost to fair value and related adjustments. The implementation had no effect on net income. In November 1995, the Financial Accounting Standards Board issued a Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities, which permitted companies to reclassify securities, where appropriate, based on the new guidance. As a result, the Company transferred securities with amortized cost and fair value of $696.4 million and $725.6 million, respectively, from the held-to-maturity category to the available-for-sale category, which resulted in a net increase in shareholders' equity of $12.8 million. Realized gains and losses on sales of fixed maturities and equity securities are determined on the specific-identification basis using amortized cost for fixed maturities and cost for equity securities. Fixed maturities and equity securities with other than temporary declines in fair value are written down to estimated fair value resulting in the recognition of realized losses. Mortgage loans on real estate are stated at unpaid principal balances, net of unamortized discounts and reserves. Reserves on mortgage loans are based on losses expected by management to be realized on transfers of mortgage loans to real estate (upon foreclosure), on the disposition or settlement of mortgage loans and on mortgage loans which management believes may not be collectible in full. In establishing reserves, management considers, among other things, the estimated fair value of the underlying collateral. Fixed maturities and mortgage loans that are delinquent are placed on non- accrual status, and thereafter interest income is recognized only when cash payments are received. Policy loans are carried principally at unpaid principal balances. Real estate that has been acquired through the foreclosure of mortgage loans is valued at the estimated fair value at the time of foreclosure. The Company considers several methods in determining fair value at foreclosure, using primarily third-party appraisals and discounted cash flow analyses. After foreclosure, the Company makes a determination as to whether the asset should be held for production of income or held for sale. Real estate investments held for the production of income and held for sale are carried at depreciated cost less valuation allowances, if necessary, to reduce the carrying value to fair value. Depreciation is generally calculated using the straight-line method. Realized investment gains and losses, other than those related to separate accounts for which the Company does not bear the investment risk, are reported as a component of revenues based upon specific identification of the investment assets sold. When an other than temporary impairment of the value of a specific investment or a group of investments is determined, a realized investment loss is recorded. Changes in the valuation allowance for mortgage loans and real estate are included in realized investment gains or losses. D. Financial Instruments - ------------------------ In the normal course of business, the Company enters into transactions involving various types of financial instruments, including debt, investments such as fixed maturities, mortgage loans and equity securities, investment and loan commitments, swap contracts and interest rate futures contracts. These instruments involve credit risk and also may be subject to risk of loss due to interest rate fluctuation. The Company evaluates and monitors each financial instrument individually and, when appropriate, obtains collateral or other security to minimize losses. E. Cash and Cash Equivalents - ---------------------------- Cash and cash equivalents includes cash on hand, amounts due from banks and highly liquid debt instruments purchased with an original maturity of three months or less. F. Deferred Policy Acquisition Costs - ------------------------------------ Acquisition costs consist of commissions, underwriting costs and other costs, which vary with, and are primarily related to, the production of revenues. Property and casualty, group life and group health insurance business acquisition costs are deferred and amortized over the terms of the insurance policies. Acquisition costs related to universal life products and contractholder deposit funds are deferred and amortized in proportion to total estimated gross profits over the expected life of the contracts using a revised interest rate applied to the remaining benefit period. Acquisition costs related to annuity and other life insurance businesses are deferred and amortized, 56 - -------------------------------------------------------------------------------- generally in proportion to the ratio of annual revenue to the estimated total revenues over the contract periods based upon the same assumptions used in estimating the liability for future policy benefits. Deferred acquisition costs for each product are reviewed to determine if they are recoverable from future income, including investment income. If such costs are determined to be unrecoverable, they are expensed at the time of determination. Although realization of deferred policy acquisition costs is not assured, management believes it is more likely than not that all of these costs will be realized. The amount of deferred policy acquisition costs considered realizable, however, could be reduced in the near term if the estimates of gross profits or total revenues discussed above are reduced. The amount of amortization of deferred policy acquisition costs could be revised in the near term if any of the estimates discussed above are revised. G. Property and Equipment - ------------------------- Property, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is provided using the straight-line or accelerated method over the estimated useful lives of the related assets which generally range from 3 to 30 years. Amortization of leasehold improvements is provided using the straight-line method over the lesser of the term of the leases or the estimated useful life of the improvements. H. Separate Accounts - -------------------- Separate account assets and liabilities represent segregated funds administered and invested by the Company for the benefit of certain pension, variable annuity and variable life insurance contractholders. Assets consist principally of bonds, common stocks, mutual funds, and short-term obligations at market value. The investment income, gains, and losses of these accounts generally accrue to the contractholders and, therefore, are not included in the Company's net income. Appreciation and depreciation of the Company's interest in the separate accounts, including undistributed net investment income, is reflected in shareholders' equity or net investment income. I. Policy Liabilities and Accruals - ---------------------------------- Future policy benefits are liabilities for life, health and annuity products. Such liabilities are established in amounts adequate to meet the estimated future obligations of policies in force. The liabilities associated with traditional life insurance products are computed using the net level premium method for individual life and annuity policies, and are based upon estimates as to future investment yield, mortality and withdrawals that include provisions for adverse deviation. Future policy benefits for individual life insurance and annuity policies are computed using interest rates ranging from 2 1/2% to 6% for life insurance and 2% to 9 1/2% for annuities. Estimated liabilities are established for group life and health policies that contain experience rating provisions. Mortality, morbidity and withdrawal assumptions for all policies are based on the Company's own experience and industry standards. Liabilities for universal life include deposits received from customers and investment earnings on their fund balances, less administrative charges. Universal life fund balances are also assessed mortality and surrender charges. Liabilities for outstanding claims, losses and loss adjustment expenses are estimates of payments to be made on property and casualty and health insurance for reported losses and estimates of losses incurred but not reported. These liabilities are determined using case basis evaluations and statistical analyses and represent estimates of the ultimate cost of all losses incurred but not paid. These estimates are continually reviewed and adjusted as necessary; such adjustments are reflected in current operations. Estimated amounts of salvage and subrogation on unpaid property and casualty losses are deducted from the liability for unpaid claims. Premiums for property and casualty, group life, and accident and health insurance are reported as earned on a pro-rata basis over the contract period. The unexpired portion of these premiums is recorded as unearned premiums. Contractholder deposit funds and other policy liabilities include investment-related products such as guaranteed investment contracts, deposit administration funds and immediate participation guarantee funds and consist of deposits received from customers and investment earnings on their fund balances. All policy liabilities and accruals are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, management believes that it is more likely than not that policy liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near term if the estimates discussed above are revised. J. Premium and Fee Revenue and Related Expenses - ----------------------------------------------- Premiums for individual life and health insurance and individual and group annuity products, excluding universal life and investment-related products, are considered revenue when due. Property and casualty and group life, accident and health insurance premiums are recognized as revenue over the related contract periods. Benefits, losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through the provision for future benefits, estimated and unpaid losses and amortization of deferred policy acquisition costs. Revenues for investment-related products consist of net investment income and contract charges assessed against the fund values. Related benefit expenses primarily consist of net investment income credited to the fund values after deduction for investment and risk charges. Revenues for universal life products consist of net investment income, and mortality, administration and surrender charges assessed against the fund values. Related benefit expenses include universal life benefit claims in excess of fund values and net investment income credited to universal life fund values. 57 - -------------------------------------------------------------------------------- K. Policyholder Dividends - ------------------------- Prior to demutualization, certain life, health and annuity insurance policies contained dividend payment provisions that enabled the policyholder to participate in the earnings of the Company. The amount of policyholders' dividends was determined annually by the Board of Directors. The aggregate amount of policyholders' dividends was related to the actual interest, mortality, morbidity and expense experience for the year and the Company's judgment as to the appropriate level of statutory surplus to be retained. Upon demutualization, certain participating individual life insurance policies and individual annuity and supplemental contracts were transferred to the Closed Block. The Closed Block was funded to protect the dividend expectations of such policies and contracts. Accordingly, these policies no longer participate in the earnings and surplus of the Open Block. Subsequent to demutualization, the Company ceased issuance of participating policies. Prior to demutualization, the participating life insurance in force was 16.2% of the face value of total life insurance in force at December 31, 1994. The premiums on participating life, health and annuity policies were 11.3% and 6.4% of total life, health and annuity statutory premiums prior to demutualization in 1995 and 1994, respectively. Total policyholders' dividends were $23.3 million and $32.8 million prior to demutualization in 1995 and 1994, respectively. L. Federal Income Taxes - ----------------------- AFC, FAFLIC, AFLIAC and FAFLIC's non-insurance domestic subsidiaries file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Allmerica P&C and its subsidiaries file a separate United States federal income tax return. Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). These differences result primarily from loss reserves, policy acquisition expenses, and unrealized appreciation/depreciation on investments. M. New Accounting Pronouncements - -------------------------------- In March 1995, SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" was issued. This statement requires companies to write down to fair value long-lived assets whose carrying value is greater than the undiscounted cash flows of those assets. The statement also requires that long-lived assets of which management is committed to dispose, either by sale or abandonment, be valued at the lower of their carrying amount or fair value less costs to sell. This statement is effective for fiscal years beginning after December 15, 1995. The adoption of this statement has not had a material effect on the financial statements. N. Earnings Per Share - --------------------- Earnings per share for the year ended December 31, 1996 is based on a weighted average of the number of shares outstanding during 1996. Earnings per share for the period October 1, 1995 (date used to estimate financial information for the effective date of the demutualization transaction of October 16, 1995) through December 31, 1995 is based on a weighted average of the number of shares outstanding between October 16, 1995 and December 31, 1995. The unaudited pro forma earnings per share for the year ended December 31, 1995 is based on a weighted average of the number of shares that would have been outstanding between January 1, 1995 and December 31, 1995 had the demutualization transaction occurred as of January 1, 1995. The unaudited pro forma earnings and earnings per share information give effect to the demutualization transaction and the Senior Debentures transaction as if these transactions had occurred as of January 1, 1995. The effect on earnings is to eliminate demutualization expenses of $12.1 million, to eliminate a differential earnings adjustment tax credit of $7.6 million and to increase interest and amortization expense related to the Senior Debentures by $7.8 million, for a net decrease in pro forma earnings of $3.3 million. The unaudited pro forma information is provided for informational purposes only and should not be construed to be indicative of the Company's consolidated results of operations had the transactions been consummated on January 1, 1995, and does not represent a projection or forecast of the Company's consolidated results of operations for any future period. O. Reclassifications - -------------------- Certain prior year amounts have been reclassified to conform to the current year presentation. 2. SIGNIFICANT TRANSACTIONS ------------------------ On February 19, 1997, the Company and Allmerica P&C entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which the Company will acquire all of the outstanding Common Stock, $1.00 par value per share, of Allmerica P&C that it does not already own for consideration consisting of $33.00 per share of Common Stock, subject to adjustment, payable in cash and shares of common stock, par value $0.01 per share, of the Company (the "AFC Common Stock"). In addition, a shareholder of Allmerica P&C may elect to receive the consideration in cash, without interest, or in shares of AFC Common Stock, subject to proration as set forth in the Merger Agreement. The maximum number of shares of AFC Common Stock to be issued in the Merger is approximately 9.67 million shares. The acquisition will be accomplished by merging a newly created, wholly-owned subsidiary of the Company with and into Allmerica P&C ( the "Merger") 58 - -------------------------------------------------------------------------------- resulting in Allmerica P&C becoming a wholly-owned subsidiary of the Company. Also, immediately prior to the Merger, Allmerica P&C's Certificate of Incorporation will be amended to authorize a new class of Common Stock, one share of which will be exchanged for each share of Common Stock currently held by SMA Financial Corp., a wholly-owned subsidiary of the Company. The consummation of the Merger is subject to the satisfaction of various conditions, including the approval of regulatory authorities. On February 3, 1997, AFC Capital Trust (the "Trust"), a subsidiary business trust of AFC, issued $300 million Series A Capital Securities, which pay cumulative dividends at a rate of 8.207% semiannually commencing August 15, 1997. The Trust exists for the sole purpose of issuing the Capital Securities and investing the proceeds thereof in an equivalent amount of 8.207% Junior Subordinated Deferrable Interest Debentures due 2027 of AFC (the "Subordinated Debentures"). Through certain guarantees, the Subordinated Debentures and the terms of related agreements, AFC has irrevocably and unconditionally guaranteed the obligations of the Trust under the Capital Securities. Net proceeds from the offering of approximately $296.3 million are intended to fund a portion of the acquisition of the 24.2 million publicly held shares of Allmerica P&C pursuant to an Agreement and Plan of Merger dated February 19, 1997. Pursuant to the plan of reorganization effective October 16, 1995, the Company issued 37.5 million shares of its common stock to eligible policyholders. The Company also issued 12.6 million shares of its common stock at a price of $21.00 per share in a public offering, resulting in net proceeds of $248.0 million, and issued Senior Debentures in the principal amount of $200.0 million which resulted in net proceeds of $197.2 million. Effective March 31, 1995, the Company entered into an agreement with TSSG, a division of First Data Corporation, pursuant to which the Company sold its mutual fund processing business and agreed not to engage in this business for four years after that date. In accordance with this agreement, the Company received proceeds of $32.1 million. A gain of $13.5 million, net of taxes of $7.2 million, was recorded in March 1995. Additionally, the Company received a non-recurring $3.1 million contingent payment, net of taxes of $1.7 million, in 1996 related to the aforementioned sale. 3. INVESTMENTS ----------- A. Summary of Investments - ------------------------- The Company accounts for its investments, all of which are classified as available-for-sale, in accordance with the provisions of SFAS No. 115. The amortized cost and fair value of available-for-sale fixed maturities and equity securities were as follows:
DECEMBER 31 (IN MILLIONS) 1996 - -------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost (1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 279.1 $ 9.3 $ 1.6 $ 286.8 States and political subdivisions 2,236.9 48.5 7.7 2,277.7 Foreign governments 108.8 7.4 -- 116.2 Corporate fixed maturities 4,297.6 140.4 16.0 4,422.0 Mortgage-backed securities 383.1 4.7 2.7 385.1 - -------------------------------------------------------------------------------- Total fixed maturities $ 7,305.5 $ 210.3 $ 28.0 $ 7,487.8 ================================================================================ Equity securities $ 328.2 $ 149.1 $ 3.7 $ 473.6 ================================================================================ DECEMBER 31 (IN MILLIONS) 1995 - -------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost (1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 377.0 $ 21.0 $ -- $ 398.0 States and political subdivisions 2,110.6 60.7 4.0 2,167.3 Foreign governments 60.6 3.4 0.6 63.4 Corporate fixed maturities 4,582.1 200.8 16.4 4,766.5 Mortgage-backed securities 337.6 8.6 2.1 344.1 - -------------------------------------------------------------------------------- Total fixed maturities $ 7,467.9 $ 294.5 $ 23.1 $ 7,739.3 ================================================================================ Equity securities $ 410.6 $111.7 $ 5.1 $ 517.2 ================================================================================
(1) Amortized cost for fixed maturities and cost for equity securities. 59 - -------------------------------------------------------------------------------- In March 1994, AFLIAC voluntarily withdrew its license in New York in order to provide for certain commission arrangements prohibited by New York comparable to AFLIAC's competitors. In connection with the withdrawal, FAFLIC, which is licensed in New York, became qualified to sell the products previously sold by AFLIAC in New York. AFLIAC agreed with the New York Department of Insurance to maintain, through a custodial account in New York, a security deposit, the market value of which will at all times equal 102% of all outstanding general account liabilities of AFLIAC for New York policyholders, claimants and creditors. At December 31, 1996, the amortized cost and market value of assets on deposit were $284.9 million and $292.2 million, respectively. At December 31, 1995, the amortized cost and market value of assets on deposit were $295.0 million and $303.6 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $98.0 million and $82.2 million were on deposit with various state and governmental authorities at December 31, 1996 and 1995, respectively. There were no contractual fixed maturity investment commitments at December 31, 1996 and 1995, respectively. The amortized cost and fair value by maturity periods for fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage backed securities are included in the category representing their ultimate maturity.
December 31 (In millions) 1996 ================================================================================ AMORTIZED FAIR COST VALUE Due in one year or less $ 567.6 $ 571.2 Due after one year through five years 2,216.4 2,297.2 Due after five years through ten years 2,398.2 2,456.9 Due after ten years 2,123.3 2,162.5 - -------------------------------------------------------------------------------- Total $7,305.5 $7,487.8 ================================================================================
The proceeds from voluntary sales of available-for-sale securities and the gross realized gains and gross realized losses on those sales were as follows:
For the Years Ended December 31 (In millions) ================================================================================ Proceeds from Gross Gross 1996 Voluntary Sales Gains Losses - ---- Fixed maturities $2,463.3 $ 19.3 $ 31.0 ================================================================================ Equity securities $ 228.7 $ 56.3 $ 1.3 ================================================================================ 1995 - ---- Fixed maturities $1,612.3 $ 23.7 $ 33.0 ================================================================================ Equity securities $ 122.2 $ 23.1 $ 6.9 ================================================================================ 1994 - ---- Fixed maturities $1,026.2 $ 12.6 $ 21.6 ================================================================================ Equity securities $ 124.3 $ 17.4 $ 4.5 ================================================================================
Unrealized gains and losses on available-for-sale and other securities, are summarized as follows:
For the Years Ended December 31 (In millions) ================================================================================ Equity Fixed Securities 1996 Maturities and Other(1) Total - ---- Net appreciation, beginning of year $ 108.7 $ 44.3 $153.0 - -------------------------------------------------------------------------------- Net (depreciation) appreciation on available-for-sale securities (94.3) 36.1 (58.2) Net appreciation from the effect on deferred policy acquisition costs and on policy liabilities 23.1 -- 23.1 Benefit (provision) for deferred federal income taxes and minority interest 33.6 (19.9) 13.7 - -------------------------------------------------------------------------------- (37.6) 16.2 (21.4) - -------------------------------------------------------------------------------- Net appreciation, end of year $ 71.1 $ 60.5 $131.6 ================================================================================
60 - --------------------------------------------------------------------------------
Equity Fixed Securities 1995 Maturities and Other(1) Total - ---- Net (depreciation) appreciation, beginning of year $ (89.4) $ 10.4 $ (79.0) - -------------------------------------------------------------------------------- Effect of transfer of securities between classifications: Net appreciation on available- for-sale fixed maturities 29.2 -- 29.2 Effect of transfer on deferred policy acquisition costs and on policy liabilities (6.8) -- (6.8) Provision for deferred federal income taxes and minority interest (9.6) -- (9.6) - -------------------------------------------------------------------------------- 12.8 -- 12.8 - -------------------------------------------------------------------------------- Net appreciation on available-for-sale securities 465.4 87.5 552.9 Net depreciation from the effect on deferred policy acquisition costs and on policy liabilities (86.9) -- (86.9) Provision for deferred federal income taxes and minority interest (193.2) (53.6) (246.8) - -------------------------------------------------------------------------------- 185.3 33.9 219.2 - -------------------------------------------------------------------------------- Net appreciation, end of year $ 108.7 $ 44.3 $ 153.0 ================================================================================ 1994 - ---- Net appreciation, beginning of year $ -- $ 17.5 $ 17.5 - -------------------------------------------------------------------------------- Cumulative effect of accounting change: Net appreciation on available- for-sale fixed maturities 335.3 -- 335.3 Net depreciation from the effect of accounting change on deferred policy acquisition costs and on policy liabilities (39.2) -- (39.2) Provision for deferred federal income taxes and minority interest (149.1) -- (149.1) - -------------------------------------------------------------------------------- 147.0 17.5 164.5 - -------------------------------------------------------------------------------- Net depreciation on available-for-sale securities (547.9) (17.4) (565.3) Net appreciation from the effect on deferred policy acquisition costs and on policy liabilities 73.2 -- 73.2 Benefit for deferred federal income taxes and minority interest 238.3 10.3 248.6 - -------------------------------------------------------------------------------- (236.4) (7.1) (243.5) - -------------------------------------------------------------------------------- Net (depreciation) appreciation, end of year $ (89.4) $ 10.4 $ (79.0) ================================================================================
(1) Includes net appreciation on other investments of $0.6 million, $2.2 million, and $0.6 million in 1996, 1995, and 1994 respectively. B. Mortgage Loans and Real Estate - --------------------------------- AFC's mortgage loans and real estate are diversified by property type and location. Real estate investments have been obtained primarily through foreclosure. Mortgage loans are collateralized by the related properties and generally are no more than 75% of the property's value at the time the original loan is made. The carrying values of mortgage loans and real estate investments net of applicable reserves were as follows:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Mortgage loans $650.1 $799.5 - -------------------------------------------------------------------------------- Real estate: Held for sale 110.4 168.9 Held for production of income 10.3 10.7 - -------------------------------------------------------------------------------- Total real estate 120.7 179.6 - -------------------------------------------------------------------------------- Total mortgage loans and real estate $770.8 $979.1 ================================================================================
Reserves for mortgage loans were $19.6 million and $33.8 million at December 31, 1996 and 1995, respectively. During 1996, 1995 and 1994, non-cash investing activities included real estate acquired through foreclosure of mortgage loans, which had a fair value of $0.9 million, $26.1 million and $39.2 million, respectively. At December 31, 1996, contractual commitments to extend credit under commercial mortgage loan agreements amounted to approximately $22.1 million, of which $3.1 million related to the Closed Block. These commitments generally expire within one year. Mortgage loans and real estate investments comprised the following property types and geographic regions:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Property type: Office building $317.1 $435.9 Residential 95.4 145.3 Retail 177.0 205.6 Industrial / warehouse 124.8 93.8 Other 91.0 151.9 Valuation allowances (34.5) (53.4) - -------------------------------------------------------------------------------- Total $770.8 $979.1 ================================================================================ Geographic region: South Atlantic $227.0 $281.4 Pacific 154.4 191.9 East North Central 119.2 118.2 Middle Atlantic 112.6 148.9 West South Central 41.6 79.7 New England 50.9 94.9 Other 99.6 117.5 Valuation allowances (34.5) (53.4) - -------------------------------------------------------------------------------- Total $770.8 $979.1 ================================================================================
61 - -------------------------------------------------------------------------------- At December 31, 1996, scheduled mortgage loan maturities were as follows: 1997 - $131.9 million; 1998 - $161.7 million; 1999 - $99.9 million; 2000 - $138.0 million; 2001 - $34.4 million; and $84.2 million thereafter. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 1996, the Company refinanced $7.8 million of mortgage loans based on terms which differed from those granted to new borrowers. C. Investment Valuation Allowances - ---------------------------------- Investment valuation allowances which have been deducted in arriving at investment carrying values as presented in the consolidated balance sheets and changes thereto are shown below.
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) ================================================================================ Balance at Balance at 1996 January 1 Additions Deductions December 31 - ---- Mortgage loans $33.8 $ 5.5 $19.7 $19.6 Real estate 19.6 - 4.7 14.9 - -------------------------------------------------------------------------------- Total $53.4 $ 5.5 $24.4 $34.5 ================================================================================ 1995 - ---- Mortgage loans $47.2 $ 1.5 $14.9 $33.8 Real estate 22.9 (0.6) 2.7 19.6 - -------------------------------------------------------------------------------- Total $70.1 $ 0.9 $17.6 $53.4 ================================================================================ 1994 - ---- Mortgage loans $73.8 $14.6 $41.2 $47.2 Real estate 21.0 3.2 1.3 22.9 - -------------------------------------------------------------------------------- Total $94.8 $17.8 $42.5 $70.1 ================================================================================
The carrying value of impaired loans was $33.6 million and $55.7 million, with related reserves of $11.9 million and $22.3 million as of December 31, 1996 and 1995, respectively. All impaired loans were reserved as of December 31, 1996 and 1995. The average carrying value of impaired loans was $50.4 million, $117.9 million and $155.5 million, with related interest income while such loans were impaired, of $5.8 million, $9.3 million and $12.4 million as of December 31, 1996, 1995 and 1994 respectively. D. Futures Contracts - -------------------- AFC purchases long futures contracts and sells short futures contracts on margin to hedge against interest rate fluctuations and their effect on the net cash flows from the sales of guaranteed investment contracts. The notional amount of such futures contracts outstanding were $(40.0) million net short contracts and $74.7 million long contracts at December 31, 1996 and 1995, respectively. Because the Company purchases and sells futures contracts through brokers who assume the risk of loss, the Company's exposure to credit risk under futures contracts is limited to the margin deposited with the broker. The maturity of all futures contracts outstanding are less than one year. The fair value of futures contracts outstanding were $(39.4) million and $75.7 million at December 31, 1996 and 1995, respectively. Gains and losses on hedge contracts related to interest rate fluctuations are deferred and recognized in income over the period being hedged corresponding to related guaranteed investment contracts. Deferred hedging gains (losses) were $0.6 million, $5.6 million and $(7.7) million in 1996, 1995 and 1994, respectively. Gains and losses on hedge contracts that are deemed ineffective by management are realized immediately. A reconciliation of the notional amount of futures contracts is as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Contracts outstanding, beginning of year $ 74.7 $ 126.6 $ 141.7 New contracts (44.0) 349.2 816.0 Contracts terminated (70.7) (401.1) (831.1) - -------------------------------------------------------------------------------- Contracts outstanding, end of year $(40.0) $ 74.7 $ 126.6 ================================================================================
62 - -------------------------------------------------------------------------------- E. Foreign Currency Swap Contracts - ---------------------------------- The Company enters into foreign currency swap contracts to hedge exposure to currency risk on foreign fixed maturity investments. Interest and principal related to foreign fixed maturity investments payable in foreign currencies, at current exchange rates, are exchanged for the equivalent payment translated at a specific currency exchange rate. The Company's maximum exposure to counterparty credit risk is the difference between the foreign currency exchange rate, as agreed upon in the swap contract, and the foreign currency spot rate on the date of the exchange. The fair values of the foreign currency swap contracts outstanding were $(9.2) million and $(1.8) million at December 31, 1996 and 1995, respectively. The difference between amounts paid and received on foreign currency swap contracts is reflected in the net investment income related to the underlying assets and is not material in 1996, 1995 and 1994. The Company had no deferred gains or losses on foreign currency swap contracts. A reconciliation of the notional amount of swap contracts is as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Contracts outstanding, beginning of year $104.6 $118.7 $128.8 New contracts -- -- 10.1 Contracts expired (36.0) -- (15.1) Contracts terminated -- (14.1) (5.1) - -------------------------------------------------------------------------------- Contracts outstanding, end of year $ 68.6 $104.6 $118.7 ================================================================================
Expected maturities of foreign currency swap contracts are $18.2 million in 1997 and $50.4 million in 1999 and thereafter. There are no expected maturities of foreign currency swap contracts in 1998. F. Interest Rate and Other Swap Contracts - ----------------------------------------- The Company enters into interest rate swap contracts to hedge exposure to interest rate fluctuations. Under these swap contracts, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount. In addition, the Company has entered into two new types of swap contracts in 1996: security return-linked swap contracts and insurance portfolio-linked swap contracts for investment purposes. Under the security return-linked contracts, the Company agrees to exchange cash flows according to the performance of a specified security or portfolio of securities. Under the insurance portfolio- linked swap contracts, the Company agrees to exchange cash flows according to the performance of a specified underwriter's portfolio of insurance business. Because the underlying principal of swap contracts is not exchanged, the Company's maximum exposure to counterparty credit risk is the difference in payments exchanged. The net amount receivable or payable is recognized over the life of the swap contract as an adjustment to net investment income. The increase or (decrease) in net investment income related to interest rate and other swap contracts was $0.6 million, $0.7 million and $(1.3) million for the years ended December 31, 1996, 1995, and 1994, respectively. The Company had no deferred gains or losses relating to interest rate and other swap contracts. The fair values of interest rate and other swap contracts outstanding were $0.1 million, $0.4 million and $0.6 million at December 31, 1996, 1995 and 1994, respectively. A reconciliation of the notional amount of interest rate and other swap contracts is as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Contracts outstanding, beginning of year $ 17.5 $22.8 $22.8 New contracts 63.6 -- -- Contracts expired (17.5) (5.3) -- - -------------------------------------------------------------------------------- Contracts outstanding, end of year $ 63.6 $17.5 $22.8 ================================================================================
Expected maturities of interest rate and other swap contracts outstanding at December 31 are as follows: $43.6 million in 1997, $5.0 million in 1998, and $15.0 million in 1999 and thereafter. G. Other - -------- At December 31, 1996, AFC had no concentration of investments in a single investee exceeding 10% of shareholders' equity, except for investments with the U.S. Treasury with a carrying value of $268.3 million. 4. INVESTMENT INCOME AND GAINS AND LOSSES -------------------------------------- A. Net Investment Income - ------------------------ The components of net investment income were as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Fixed maturities $555.8 $555.1 $578.3 Mortgage loans 69.5 97.0 119.9 Equity securities 11.1 13.2 9.9 Policy loans 10.3 20.3 23.3 Real estate 40.8 48.7 44.6 Other long-term investments 19.0 7.1 5.7 Short-term investments 11.3 21.6 10.3 - -------------------------------------------------------------------------------- Gross investment income 717.8 763.0 792.0 Less investment expenses (45.2) (52.5) (48.9) - -------------------------------------------------------------------------------- Net investment income $672.6 $710.5 $743.1 ================================================================================
At December 31, 1996, fixed maturities and mortgage loans on non-accrual status were $2.0 million and $6.8 million, including restructured loans of $4.4 million. The effect of non- 63 - -------------------------------------------------------------------------------- accruals, compared with amounts that would have been recognized in accordance with the original terms of the investments, was to reduce net income by $0.5 million, $0.6 million and $5.1 million in 1996, 1995 and 1994, respectively. The payment terms of mortgage loans may from time to time be restructured or modified. The investment in restructured mortgage loans, based on amortized cost, amounted to $51.3 million, $98.9 million and $126.8 million at December 31, 1996, 1995 and 1994, respectively. Interest income on restructured mortgage loans that would have been recorded in accordance with the original terms of such loans amounted to $7.7 million, $11.1 million and $14.4 million in 1996, 1995 and 1994, respectively. Actual interest income on these loans included in net investment income aggregated $4.5 million, $7.1 million and $8.2 million in 1996, 1995 and 1994, respectively. At December 31, 1996, fixed maturities with a carrying value of $2.0 million were non-income producing for the twelve months ended December 31, 1996. There were no mortgage loans which were non-income producing for the twelve months ended December 31, 1996. Included in other long-term investments is income from limited partnerships of $13.7 million, $0.1 million and $0.6 million in 1996, 1995 and 1994 respectively. B. Realized Investment Gains and Losses - --------------------------------------- Realized gains (losses) on investments were as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ========================================================================== Fixed maturities $(10.1) $(7.0) $ 2.4 Mortgage loans (2.4) 1.4 (12.1) Equity securities 55.0 16.2 12.4 Real estate 21.1 5.3 1.4 Other 2.3 3.2 (3.0) - -------------------------------------------------------------------------- Net realized investment gains $ 65.9 $19.1 $ 1.1 ==========================================================================
Proceeds from voluntary sales of investments in fixed maturities were $2,463.3 million, $1,612.3 million and $1,036.5 million in 1996, 1995 and 1994, respectively. Realized gains on such sales were $19.3 million, $23.7 million and $12.9 million; and realized losses were $31.0 million, $33.0 million and $21.6 million for 1996, 1995 and 1994, respectively. 5. FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS ----------------------------------------------- SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet. The fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts which could be realized upon immediate liquidation. In cases where market prices are not available, estimates of fair value are based on discounted cash flow analyses which utilize current interest rates for similar financial instruments which have comparable terms and credit quality. Fair values of interest rate futures were not material at December 31, 1996 and 1995. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents For these short-term investments, the carrying amount approximates fair value. Fixed Maturities Fair values are based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using independent pricing sources or internally developed pricing models using discounted cash flow analyses. Equity Securities Fair values are based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using independent pricing sources or internally developed pricing models. Mortgage Loans Fair values are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of below investment grade mortgage loans are limited to the lesser of the present value of the cash flows or book value. Reinsurance Receivables The carrying amount reported in the consolidated balance sheets approximates fair value. Policy Loans The carrying amount reported in the consolidated balance sheets approximates fair value since policy loans have no defined maturity dates and are inseparable from the insurance contracts. Investment Contracts (Without Mortality Features) Fair values for the Company's liabilities under guaranteed investment type contracts are estimated using discounted cash flow calculations using current interest rates for similar contracts with maturities consistent with those remaining for the contracts being valued. Other liabilities are based on surrender values. Debt The carrying value of short-term debt reported in the balance sheet approximates fair value. The fair value of long-term debt was estimated using market quotes, when available, and, when not available, discounted cash flow analyses. 64 - -------------------------------------------------------------------------------- The estimated fair values of the financial instruments were as follows:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Carrying Fair Carrying Fair FINANCIAL ASSETS Value Value Value Value - ---------------- Cash and cash equivalents $ 178.5 $ 178.5 $ 289.5 $ 289.5 Fixed maturities 7,487.8 7,487.8 7,739.3 7,739.3 Equity securities 473.6 473.6 517.2 517.2 Mortgage loans 650.1 675.7 799.5 845.4 Policy loans 132.4 132.4 123.2 123.2 - -------------------------------------------------------------------------------- $8,922.4 $8,948.0 $9,468.7 $9,514.6 ================================================================================ FINANCIAL LIABILITIES - --------------------- Guaranteed investment contracts $1,101.3 $1,119.2 $1,632.8 $1,677.0 Supplemental contracts without life contingencies 23.1 23.1 24.4 24.4 Dividend accumulations 87.3 87.3 86.2 86.2 Other individual contract deposit funds 76.9 74.3 95.7 92.8 Other group contract deposit funds 789.1 788.3 894.0 902.8 Individual annuity contracts 935.6 719.0 966.3 810.0 Short-term debt 38.4 38.4 31.2 31.2 Long-term debt 202.2 199.1 202.3 212.4 - -------------------------------------------------------------------------------- $3,253.9 $3,048.7 $3,932.9 $3,836.8 ================================================================================
6. CLOSED BLOCK ------------ Included in other income in the Consolidated Statements of Income in 1996 and 1995 is a net pre-tax contribution from the Closed Block of $8.6 million and $2.9 million, respectively. Summarized financial information of the Closed Block as of December 31, 1996 and 1995 and for the period ended December 31, 1996 and the period from October 1, 1995 through December 31, 1995 is as follows:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================== Assets Fixed maturities, at fair value (amortized cost of $397.2 and $447.4, respectively) $403.9 $458.0 Mortgage loans 114.5 57.1 Policy loans 230.2 242.4 Cash and cash equivalents 24.1 17.6 Accrued investment income 14.3 16.6 Deferred policy acquisition costs 21.1 24.5 Other assets 3.7 2.7 - ----------------------------------------------------------------- Total assets $811.8 $818.9 ================================================================= Liabilities Policy liabilities and accruals $883.4 $899.2 Other liabilities 8.7 2.8 - ----------------------------------------------------------------- Total liabilities $892.1 $902.0 =================================================================
65 - --------------------------------------------------------------------------------
Period from October 1 through December 31 December 31 (In millions) 1996 1995 ================================================================================ Revenues Premiums $ 61.7 $ 11.5 Net investment income 52.6 12.8 Realized investment loss (0.7) -- - -------------------------------------------------------------------------------- Total revenues 113.6 24.3 - -------------------------------------------------------------------------------- Benefits and expenses Policy benefits 101.2 20.6 Policy acquisition expenses 3.2 0.8 Other operating expenses 0.6 -- - -------------------------------------------------------------------------------- Total benefits and expenses 105.0 21.4 - -------------------------------------------------------------------------------- Contribution from the Closed Block $ 8.6 $ 2.9 ================================================================================ Cash flows Cash flows from operating activities: Contribution from the Closed Block $ 8.6 $ 2.9 Initial cash transferred to the Closed Block -- 139.7 Change in deferred policy acquisition costs, net 3.4 0.4 Change in premiums and other receivables 0.2 (0.1) Change in policy liabilities and accruals (13.9) 2.0 Change in accrued investment income 2.3 (1.3) Other, net 2.5 0.8 - -------------------------------------------------------------------------------- Net cash provided by operating activities 3.1 144.4 - -------------------------------------------------------------------------------- Cash flows from investing activities: Sales, maturities and repayments of investments 188.1 29.0 Purchases of investments (196.9) (158.8) Other, net 12.2 3.0 - -------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 3.4 (126.8) - -------------------------------------------------------------------------------- Net increase in cash and cash equivalents 6.5 17.6 Cash and cash equivalents, beginning of the year 17.6 -- - -------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 24.1 $ 17.6 ================================================================================
On October 16, 1995, there were no valuation allowances transferred to the Closed Block on mortgage loans. There were no valuation allowances on mortgage loans at December 31, 1996 and 1995, respectively. 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. 7. DEBT ---- Short- and long-term debt consisted of the following:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Short-term Commercial paper $ 37.8 $ 27.7 Other 0.6 3.5 - -------------------------------------------------------------------------------- Total short-term debt $ 38.4 $ 31.2 ================================================================================ Long-term Senior Debentures (unsecured) $199.5 $199.5 Other 2.7 2.8 - -------------------------------------------------------------------------------- Total long-term debt $202.2 $202.3 ================================================================================
AFC issues commercial paper primarily to manage imbalances between operating cash flows and existing commitments. Commercial paper borrowing arrangements are supported by various lines of credit. At December 31, 1996, the weighted average interest rate for outstanding commercial paper was approximately 5.5%. At December 31, 1996, AFC had approximately $140.0 million in committed lines of credit provided by U.S. banks, of which $102.2 million was available for borrowing. These lines of credit generally have terms of less than one year, and require the Company to pay annual commitment fees of 0.07% of the available credit. Interest that would be charged for usage of these lines of credit is based upon negotiated arrangements. During 1996, the Company utilized repurchase agreements to finance certain investments. Although the repurchase agreements were entirely settled by year end, management may utilize this policy again in future periods. In October, 1995, AFC issued $200.0 million face amount of Senior Debentures for proceeds of $197.2 million net of discounts and issuance costs. These securities have an effective interest rate of 7.65%, and mature on October 16, 2025. Interest is payable semiannually on October 15 and April 15 of each year. The Senior Debentures are subject to certain restrictive covenants, including limitations on issuance of or disposition of stock of restricted subsidiaries and limitations on liens. The Company is in compliance with all covenants. 66 - -------------------------------------------------------------------------------- Interest expense was $32.1 million, $7.3 million and $4.3 million in 1996, 1995 and 1994, respectively. Interest expense in 1996 included $15.3 million related to the Company's Senior Debentures and $11.0 million related to interest payments on repurchase agreements. Interest expense in 1995 included $3.2 million related to the Company's Senior Debentures. All interest expense is recorded in other operating expenses. 8. Federal Income Taxes -------------------- Provisions for federal income taxes have been calculated in accordance with the provisions of SFAS No. 109. A summary of the federal income tax expense (benefit) in the consolidated statements of income is shown below:
For the Years Ended December 31 (In millions) 1996 1995 1994 ================================================================================ Federal income tax expense (benefit) Current $ 90.9 $119.7 $45.4 Deferred (15.7) (37.0) 8.0 - -------------------------------------------------------------------------------- Total $ 75.2 $ 82.7 $53.4 ================================================================================
The federal income taxes attributable to the consolidated results of operations are different from the amounts determined by multiplying income before federal income taxes by the expected federal income tax rate. The sources of the difference and the tax effects of each were as follows:
For the Years Ended December 31 (In millions) 1996 1995 1994 ================================================================================ Expected federal income tax expense $116.1 $105.6 $ 53.7 Tax-exempt interest (35.3) (32.2) (35.9) Differential earnings amount (10.2) (7.6) 35.0 Dividend received deduction (1.6) (4.0) (2.5) Changes in tax reserve estimates 4.7 19.3 4.0 Other, net 1.5 1.6 (0.9) - -------------------------------------------------------------------------------- Federal income tax expense $ 75.2 $ 82.7 $ 53.4 ================================================================================
Until conversion to a stock life insurance company, FAFLIC, as a mutual company, reduced its deduction for policyholder dividends by the differential earnings amount. This amount was computed, for each tax year, by multiplying the average equity base of the FAFLIC/AFLIAC consolidated group, as determined for tax purposes, by the estimate of an excess of an imputed earnings rate over the average mutual life insurance companies' earnings rate. The differential earnings amount for each tax year was subsequently recomputed when actual earnings rates were published by the Internal Revenue Service (IRS). The differential earnings amount included in 1996 related to an adjustment for the 1994 tax year based on the actual average mutual life insurance companies' earnings rate issued by the IRS in 1996. As a stock life company, FAFLIC is no longer required to reduce its policyholder dividend deduction by the differential earnings amount. The deferred income tax asset represents the tax effects of temporary differences attributable to Allmerica P&C, a separate consolidated group for federal tax return purposes. Its components were as follows:
December 31 (In millions) 1996 1995 ================================================================================ Deferred tax (assets) liabilities AMT carryforwards $ (16.3) $ (9.8) Loss reserve discounting (182.1) (178.3) Deferred acquisition costs 57.5 55.1 Employee benefit plans (25.1) (25.5) Investments, net 73.4 77.4 Bad debt reserve (1.7) (1.8) Other, net 1.1 1.7 - -------------------------------------------------------------------------------- Deferred tax asset, net $ (93.2) $ (81.2) ================================================================================
The deferred income tax liability represents the tax effects of temporary differences attributable to the FAFLIC/AFLIAC consolidated federal tax return group. Its components were as follows:
December 31 (In millions) 1996 1995 ================================================================================ Deferred tax (assets) liabilities Loss reserve discounting $(153.7) $(129.1) Deferred acquisition costs 189.6 169.7 Employee benefit plans (16.3) (14.6) Investments, net 55.2 67.0 Bad debt reserve (24.5) (26.3) Other, net (15.6) (18.9) - -------------------------------------------------------------------------------- Deferred tax liability, net $ 34.7 $ 47.8 ================================================================================
Gross deferred income tax assets totaled $435.3 million and $405.1 million at December 31, 1996 and 1995, respectively. Gross deferred income tax liabilities totaled $376.8 million and $371.7 million at December 31, 1996 and 1995, respectively. 67 Management believes, based on the Company's recent earnings history and its future expectations, that the Company's taxable income in future years will be sufficient to realize all deferred tax assets. In determining the adequacy of future income, management considered the future reversal of its existing temporary differences and available tax planning strategies that could be implemented, if necessary. At December 31, 1996, there are available non-life net operating loss carryforwards of $0.8 million, and alternative minimum tax credit carryforwards of $16.3 million. The Company's federal income tax returns are routinely audited by the IRS, and provisions are routinely made in the financial statements in anticipation of the results of these audits. The IRS has examined the FAFLIC/AFLIAC consolidated group's federal income tax returns through 1991. The IRS has also examined the Allmerica P&C consolidated group's federal income tax returns through 1991. The Company is currently considering its response to certain adjustments proposed by the IRS with respect to the federal income tax returns for 1989, 1990, and 1991 for both the FAFLIC/AFLIAC consolidated group as well as the Allmerica P&C consolidated group. Also, certain adjustments proposed by the IRS with respect to FAFLIC/AFLIAC's federal income tax returns for 1982 and 1983 remain unresolved. If upheld, these adjustments would result in additional payments; however, the Company will vigorously defend its position with respect to these adjustments. In management's opinion, adequate tax liabilities have been established for all years. However, the amount of these tax liabilities could be revised in the near term if estimates of the Company's ultimate liability are revised. 9. PENSION PLANS ------------- AFC provides retirement benefits to substantially all of its employees under three separate defined benefit pension plans. Through December 31, 1994, retirement benefits were based primarily on employees' years of service and compensation during the highest five consecutive plan years of employment. Benefits under this defined benefit formula were frozen for most employees (but not for eligible agents) effective December 31, 1994. In their place, the Company adopted a defined benefit cash balance formula, under which the Company annually provides an allocation to each eligible employee as a percentage of that employee's salary, similar to a defined contribution plan arrangement. The 1996 and 1995 allocations were based on 7.0% of each eligible employee's salary. The Company's policy for the plans is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974. Components of net pension expense were as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Service cost - benefits earned during the year $ 19.0 $ 19.7 $ 13.0 Interest accrued on projected benefit obligations 21.9 21.1 20.0 Actual return on assets (42.2) (89.3) (2.6) Net amortization and deferral 9.3 66.1 (16.3) - -------------------------------------------------------------------------------- Net pension expense $ 8.0 $ 17.6 $ 14.1 ================================================================================
The following table summarizes the combined status of the three pension plans. At December 31, 1996 the plans' assets exceeded their projected benefit obligations and in 1995 the plans' projected benefit obligation exceeded their assets.
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Actuarial present value of benefit obligations: Vested benefit obligation $308.9 $325.6 Unvested benefit obligation 6.6 5.0 - -------------------------------------------------------------------------------- Accumulated benefit obligation $315.5 $330.6 ================================================================================ Pension liability included in Consolidated Balance Sheets: Projected benefit obligation $344.2 $367.1 Plan assets at fair value 347.8 321.2 - -------------------------------------------------------------------------------- Plan assets greater (less) than projected benefit obligation 3.6 (45.9) Unrecognized net (gain) loss from past experience (9.1) 48.8 Unrecognized prior service benefit (11.5) (13.8) Unamortized transition asset (24.7) (26.5) - -------------------------------------------------------------------------------- Net pension liability $(41.7) $(37.4) ================================================================================
Determination of the projected benefit obligations was based on a weighted average discount rate of 7.0% in 1996 and 1995, and the assumed long-term rate of return on plan assets was 9.0%. The actuarial present value of the projected benefit obligations was determined using assumed rates of increase in future compensation levels ranging from 5.5% to 6.5%. Plan assets are invested primarily in various separate accounts and the general account of FAFLIC. The plans also hold stock of AFC. The Company has a profit sharing and 401(k) plan for its employees. Effective for plan years beginning after 1994, the profit sharing formula for employees has been discontinued and a 401(k) match feature has been added to the continuing 401(k) 68 - -------------------------------------------------------------------------------- plan for the employees. Total plan expense in 1996, 1995 and 1994 was $5.5 million, $5.2 million and $12.6 million, respectively. In addition to this Plan, the Company has a defined contribution plan for substantially all of its agents. The Plan expense in 1996, 1995 and 1994 was $2.0 million, $3.5 million and $2.7 million, respectively. 10. OTHER POSTRETIREMENT BENEFIT PLANS ---------------------------------- In addition to the Company's pension plans, the Company currently provides postretirement medical and death benefits to certain full-time employees and dependents, under several plans sponsored by FAFLIC, Hanover and Citizens. Generally, employees become eligible at age 55 with at least 15 years of service. Spousal coverage is generally provided for up to two years after death of the retiree. Benefits include hospital, major medical and a payment at death equal to retirees' final compensation up to certain limits. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments and to restrict eligibility to current employees. The medical plans have varying copayments and deductibles, depending on the plan. These plans are unfunded. The plan changes effective January 1, 1996 resulted in a negative plan amendment (change in eligibility and medical benefits) of $26.8 million and curtailment (no future increases in life insurance) of $5.3 million. The negative plan amendment will be amortized as prior service cost over the average number of years to full eligibility (approximately 9 years or $3.0 million per year). Of the $5.3 million curtailment gain, $3.3 million has been deducted from unrecognized loss and $2.0 million has been recorded as a reduction of the net periodic postretirement benefit expense. The plans' funded status reconciled with amounts recognized in the Company's consolidated balance sheet were as follows:
DECEMBER 31 (IN MILLIONS) 1996 1995 ================================================================================ Accumulated postretirement benefit obligation: Retirees $40.4 $ 44.9 Fully eligible active plan participants 7.5 14.0 Other active plan participants 24.4 45.9 - -------------------------------------------------------------------------------- 72.3 104.8 Plan assets at fair value -- -- - -------------------------------------------------------------------------------- Accumulated postretirement benefit obligation in excess of plan assets 72.3 104.8 Unrecognized prior service benefit 23.8 -- Unrecognized loss (5.0) (13.4) - -------------------------------------------------------------------------------- Accrued postretirement benefit costs $91.1 $ 91.4 ================================================================================
The components of net periodic postretirement benefit expense were as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================================ Service cost $ 3.2 $ 4.2 $ 6.6 Interest cost 4.6 6.9 6.9 Amortization of (gain) loss (2.8) (0.5) 1.4 - -------------------------------------------------------------------------------- Net periodic postretirement benefit expense $ 5.0 $10.6 $14.9 ================================================================================
For purposes of measuring the accumulated postretirement benefit obligation at December 31, 1996, health care costs were assumed to increase 9.0% in 1997, declining thereafter until the ultimate rate of 5.5% is reached in 2001 and remains at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation at December 31, 1996 by $5.3 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 1996 by $0.7 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1996 and 1995. 11. POSTEMPLOYMENT BENEFITS ----------------------- Effective January 1, 1994, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112, (SFAS No. 112), "Employers' Accounting for Postemployment Benefits", which requires employers to recognize the costs and obligations of severance, disability and related life insurance and health care benefits to be paid to inactive or former employees after employment but before retirement. Prior to adoption, the Company had recognized the cost of these benefits on an accrual or paid basis, depending on the plan. Implementation of SFAS No. 112 resulted in a transition obligation of $1.9 million, net of federal income taxes and minority interest, and is reported as a cumulative effect of a change in accounting principle in the consolidated statement of income. The impact of this accounting change, after recognition of the cumulative effect, was not significant. 69 - -------------------------------------------------------------------------------- 12. STOCK-BASED COMPENSATION PLANS In October 1995 the FASB issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation"("SFAS 123"). The Standard is effective for fiscal years beginning after December 15, 1995, and requires the Company either to apply a fair value measure to any stock-based compensation granted by the Company, or continue to apply the valuation provisions of existing accounting standards, but with pro-forma net income and earnings per share disclosures using a fair value methodology to value the stock-based compensation. Beginning for the year ended December 31, 1996, the Company has elected to continue to apply the valuation provisions of existing accounting standards (APB 25). The pro forma effect of applying SFAS 123 is not material. Effective June 17, 1996, The Company adopted a Long Term Stock Incentive Plan for employees of the Company (the "Employees' Plan"). Key employees of the Company and its subsidiaries are eligible for awards pursuant to the Plan administered by the Compensation Committee of the Board of Directors (the "Committee") of the Company. Under the terms of the Employees' Plan, options may be granted to eligible employees at a price not less than the market price of the Company's common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Committee at the time of grant, otherwise options vest at the rate of 20% annually for five consecutive years and must be exercised not later than ten years from the date of grant. At June 17, 1996, 231,500 option shares were granted at an option price of $27.50. During 1996, 22,000 option shares were forfeited leaving 209,500 option shares outstanding at December 31, 1996. There were no options exercised during 1996. At December 31, 1996, there were no options exercisable and 2,140,500 option shares were available for future grant. 13. DIVIDEND RESTRICTIONS Massachusetts, Delaware, New Hampshire and Michigan have enacted laws governing the payment of dividends to stockholders by insurers. These laws affect the dividend paying ability of FAFLIC, AFLIAC, Hanover and Citizens, respectively. Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commonwealth of Massachusetts Insurance Commissioner, to the greater of (i) 10% of its statutory policyholder surplus as of the preceding December 31 or (ii) the individual company's statutory net gain from operations for the preceding calendar year (if such insurer is a life company), or its net income for the preceding calendar year (if such insurer is not a life company). In addition, under Massachusetts law, no domestic insurer shall pay a dividend or make any distribution to its shareholders from other than unassigned funds unless the Commissioner shall have approved such dividend or distribution. At January 1, 1997, FAFLIC could pay dividends of $151.8 million to AFC without prior approval of the Commissioner. Pursuant to Delaware's statute, the maximum amount of dividends and other distributions that an insurer may pay in any twelve month period, without the prior approval of the Delaware Commissioner of Insurance, is limited to the greater of (i) 10% of its policyholders' surplus as of the preceding December 31 or (ii) the individual company's statutory net gain from operations for the preceding calendar year (if such insurer is a life company) or its net income (not including realized capital gains) for the preceding calendar year (if such insurer is not a life company). Any dividends to be paid by an insurer, whether or not in excess of the aforementioned threshold, from a source other than statutory earned surplus would also require the prior approval of the Delaware Commissioner of Insurance. At January 1, 1997, AFLIAC could pay dividends of $11.9 million to FAFLIC without prior approval. Pursuant to New Hampshire's statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without the prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer's statutory policyholder surplus as of the preceding December 31. At January 1, 1997, the maximum dividend and other distributions that could be paid to Allmerica P&C by Hanover, without prior approval of the Insurance Commissioner, was approximately $15.4 million, which considers dividends declared to Allmerica P&C of $105.0 million during 1996, including $80.0 million which was declared in December. On January 2, 1997, Hanover declared an extraordinary dividend in the amount of $120.0 million, payable on or after January 21, 1997 to Allmerica P&C. The dividend which was approved by the New Hampshire Insurance Department on January 9, 1997 is to be paid in a lump sum or in such installments as Allmerica P&C, in its discretion, may determine. Pursuant to Michigan's statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders' surplus as of December 31 of the immediately preceding year or the statutory net income less realized gains, for the immediately preceding calendar year. At January 1, 1997, Citizens Insurance could pay dividends of $39.9 million to Citizens Corporation without prior approval. 70 - ------------------------------------------------------------------------------- 14. SEGMENT INFORMATION The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Management. Within these broad areas, the Company conducts business principally in five operating segments. The Risk Management group includes two segments: Regional Property and Casualty and Corporate Risk Management Services. The Regional Property and Casualty segment includes property and casualty insurance products, such as automobile insurance, homeowners insurance, commercial multiple-peril insurance, and workers' compensation insurance. These products are offered by Allmerica P&C through its operating subsidiaries, Hanover and Citizens. Substantially all of the Regional Property and Casualty segment's earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The Corporate Risk Management Services segment includes group life and health insurance products and services which assist employers in administering employee benefit programs and in managing the related risks. The Retirement and Asset Management group includes three segments: Retail Financial Services, Institutional Services and Allmerica Asset Management. The Retail Financial Services segment includes variable annuities, variable universal life-type, traditional and health insurance products distributed via retail channels to individuals across the country. The Institutional Services segment includes primarily group retirement products such as 401(k) plans, tax- sheltered annuities and GIC contracts which are distributed to institutions across the country via work-site marketing and other arrangements. Allmerica Asset Management is a Registered Investment Advisor which provides investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the five operating segments, the Company also has a Corporate segment, which consists primarily of Senior Debentures and a portion of the net proceeds from the Company's initial public offering. Summarized below is financial information with respect to business segments for the years ended and as of December 31.
(IN MILLIONS) 1996 1995 1994 - --------------------------------------------------------------------- Revenues: Risk Management Regional Property and Casualty $ 2,193.7 $ 2,095.1 $ 2,004.8 Corporate Risk Management 361.5 328.5 302.4 - --------------------------------------------------------------------- Subtotal 2,555.2 2,423.6 2,307.2 - --------------------------------------------------------------------- Retirement and Asset Management Retail Financial Services 450.9 486.7 507.9 Institutional Services 266.7 330.2 397.9 Allmerica Asset Management 8.8 4.4 4.0 - --------------------------------------------------------------------- Subtotal 726.4 821.3 909.8 - --------------------------------------------------------------------- Corporate 1.8 0.4 -- Eliminations (8.7) (4.4) (21.9) - --------------------------------------------------------------------- Total $ 3,274.7 $ 3,240.9 $ 3,195.1 ===================================================================== Income from continuing operations before income taxes: Risk Management Regional Property and Casualty $ 197.7 $ 206.3 $ 113.1 Corporate Risk Management 20.7 18.3 19.9 - --------------------------------------------------------------------- Subtotal 218.4 224.6 133.0 - --------------------------------------------------------------------- Retirement and Asset Management Retail Financial Services 76.2 35.2 14.2 Institutional Services 52.8 42.8 4.4 Allmerica Asset Management 1.1 2.3 1.9 - --------------------------------------------------------------------- Subtotal 130.1 80.3 20.5 - --------------------------------------------------------------------- Corporate (16.8) (3.1) -- - --------------------------------------------------------------------- Total $ 331.7 $ 301.8 $ 153.5 ===================================================================== Identifiable assets: Risk Management Regional Property and Casualty $ 5,703.9 $ 5,741.8 $ 5,408.7 Corporate Risk Management 506.0 458.9 386.3 - --------------------------------------------------------------------- Subtotal 6,209.9 6,200.7 5,795.0 - --------------------------------------------------------------------- Retirement and Asset Management Retail Financial Services 8,873.5 7,218.6 5,639.8 Institutional Services 3,879.0 4,280.9 4,484.5 Allmerica Asset Management 2.4 2.1 2.2 - --------------------------------------------------------------------- Subtotal 12,754.9 11,501.6 10,126.5 - --------------------------------------------------------------------- Corporate 32.9 55.4 -- - --------------------------------------------------------------------- Total $18,997.7 $17,757.7 $15,921.5 =====================================================================
71 - -------------------------------------------------------------------------------- 15. LEASE COMMITMENTS ----------------- Rental expenses for operating leases, principally with respect to buildings, amounted to $33.6 million, $36.4 million and $35.2 million in 1996, 1995 and 1994, respectively. At December 31, 1996, future minimum rental payments under non-cancellable operating leases were approximately $71.7 million, payable as follows: 1997 - $26.4 million; 1998 - $19.6 million; 1999 - $12.8 million; 2000 - - $8.0 million; and $5.0 million thereafter. It is expected that, in the normal course of business, leases that expire will be renewed or replaced by leases on other property and equipment; thus, it is anticipated that future minimum lease commitments will not be less than the amounts shown for 1997. 16. REINSURANCE ----------- In the normal course of business, the Company seeks to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance transactions are accounted for in accordance with the provisions of SFAS No. 113. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company determines the appropriate amount of reinsurance based on evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions (including the availability and pricing of reinsurance). The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. The Company is subject to concentration of risk with respect to reinsurance ceded to various residual market mechanisms. As a condition to the ability to conduct certain business in various states, the Company is required to participate in various residual market mechanisms and pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage voluntarily provided by private insurers. These market mechanisms and pooling arrangements include the Massachusetts Commonwealth Automobile Reinsurers ("CAR"), the Maine Workers' Compensation Residual Market Pool ("MWCRP") and the Michigan Catastrophic Claims Association ("MCCA"). At December 31, 1996, the MCCA and CAR were the only two reinsurers which represented 10% or more of the Company's reinsurance business. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to CAR. Net premiums earned and losses and loss adjustment expenses ceded to CAR in 1996, 1995 and 1994 were $38.0 million and $21.8 million, $49.1 million and $33.7 million, and $50.0 million and $29.8 million, respectively. From 1988 through 1992, the Company was a servicing carrier in Maine, and ceded a significant portion of its workers' compensation premiums to the Maine Workers' Compensation Residual Market Pool, which is administered by The National Council on Compensation Insurance ("NCCI"). The Company is currently involved in legal proceedings regarding the MWCRP's deficit which through a legislated settlement issued on June 23, 1995 provided for an initial funding of $220.0 million, of which the insurance carriers were responsible for $65.0 million. Hanover paid its allocation of $4.2 million in December 1995. Some of the small carriers appealed this decision. The Company's right to recover reinsurance balances for claims properly paid is not at issue in any such proceedings. The Company expects to collect its reinsurance balance; however, funding of the cash flow needs of the MWCRP may in the future be affected by issues related to certain litigation, the outcome of which the Company cannot predict. The Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 1996, 1995 and 1994 of $50.5 million and $(52.9) million, $66.8 million and $62.9 million, and $80.0 million and $24.2 million, respectively. Because the MCCA is supported by assessments permitted by statute, and all amounts billed by the Company to CAR, MWCRP and MCCA have been paid when due, the Company believes that it has no significant exposure to uncollectible reinsurance balances. 72 - -------------------------------------------------------------------------------- The effects of reinsurance were as follows:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ====================================================================== Life insurance premiums: Direct $ 389.1 $ 438.9 $ 447.2 Assumed 87.8 71.0 54.3 Ceded (138.9) (150.3) (111.0) - ---------------------------------------------------------------------- Net premiums $ 338.0 $ 359.6 $ 390.5 ====================================================================== Property and casualty premiums written: Direct $2,039.7 $2,039.4 $1,992.4 Assumed 108.7 125.0 128.6 Ceded (234.0) (279.1) (298.1) - ---------------------------------------------------------------------- Net premiums $1,914.4 $1,885.3 $1,822.9 ====================================================================== Property and casualty premiums earned: Direct $2,018.5 $2,021.7 $1,967.1 Assumed 112.4 137.7 116.1 Ceded (232.6) (296.2) (291.9) - ---------------------------------------------------------------------- Net premiums $1,898.3 $1,863.2 $1,791.3 ====================================================================== Life insurance and other individual policy benefits, claims, losses and loss adjustment expenses: Direct $ 618.0 $ 749.6 $ 773.0 Assumed 44.9 38.5 28.9 Ceded (77.8) (69.5) (61.6) - ---------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $ 585.1 $ 718.6 $ 740.3 ====================================================================== Property and casualty benefits, claims,losses and loss adjustment expenses: Direct $1,288.3 $1,372.7 $1,364.4 Assumed 85.8 146.1 102.7 Ceded (2.2) (229.1) (160.4) - ---------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $1,371.9 $1,289.7 $1,306.7 ======================================================================
17. DEFERRED POLICY ACQUISITION COSTS --------------------------------- The following reflects the changes to the deferred policy acquisition asset:
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ================================================================ Balance at beginning of year $ 735.7 $ 802.8 $ 746.9 Acquisition expenses deferred 560.8 504.8 510.3 Amortized to expense during the year (483.5) (470.3) (475.7) Adjustment to equity during the year 9.7 (50.4) 21.3 Transferred to the Closed Block -- (24.8) -- Adjustment for cession of term life insurance -- (26.4) -- - ---------------------------------------------------------------- Balance at end of year $ 822.7 $ 735.7 $ 802.8 ================================================================
18. LIABILITIES FOR OUTSTANDING CLAIMS, LOSSES AND LOSS ADJUSTMENT EXPENSES ----------------------------------------------------------------------- The Company regularly updates its estimates of liabilities for outstanding claims, losses and loss adjustment expenses as new information becomes available and further events occur which may impact the resolution of unsettled claims for its property and casualty and its accident and health lines of business. Changes in prior estimates are reflected in results of operations in the year such changes are determined to be needed and recorded. The liability for future policy benefits and outstanding claims, losses and loss adjustment expenses related to the Company's accident and health business was $471.7 million, $446.9 million and $371.4 million at December 31, 1996, 1995 and 1994, respectively. Accident and health claim liabilities have been re- estimated for all prior years and were decreased by $0.6 million and $2.2 million in 1996 and 1994, respectively, and increased by $17.6 million in 1995. Unfavorable development in the accident and health business during 1995 was primarily due to reserve strengthening and adverse experience in the Company's individual disability line of business. 73 - -------------------------------------------------------------------------------- The following table provides a reconciliation of the beginning and ending property and casualty reserve for unpaid losses and loss adjustment expenses (LAE):
FOR THE YEARS ENDED DECEMBER 31 (IN MILLIONS) 1996 1995 1994 ======================================================================= Reserve for losses and LAE, beginning of year $2,896.0 $2,821.7 $2,717.3 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,513.3 1,427.3 1,434.8 Decrease in provision for insured events of prior years (141.4) (137.6) (128.1) - ----------------------------------------------------------------------- Total incurred losses and LAE 1,371.9 1,289.7 1,306.7 - ----------------------------------------------------------------------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 759.6 652.2 650.2 Losses and LAE attributable to insured events of prior years 627.6 614.3 566.9 - ----------------------------------------------------------------------- Total payments 1,387.2 1,266.5 1,217.1 - ----------------------------------------------------------------------- Change in reinsurance recoverable on unpaid losses (136.6) 51.1 14.8 - ----------------------------------------------------------------------- Reserve for losses and LAE, end of year $2,744.1 $2,896.0 $2,821.7 =======================================================================
As part of an ongoing process, the property and casualty reserves have been re-estimated for all prior accident years and were decreased by $141.4 million, $137.6 million and $128.1 million in 1996, 1995 and 1994, respectively. The increase in favorable development on prior years' reserves of $3.8 million in 1996 results primarily from an $11.4 million increase in favorable development at Citizens. The increase in Citizens' favorable development of $11.4 million in 1996 reflects improved severity in the personal automobile line, where favorable development increased $28.6 million to $33.0 million in 1996, partially offset by less favorable development in the workers' compensation line. In 1995, the workers' compensation line had favorable development of $32.7 million, primarily as a result of Citizens re-estimating reserves to reflect the new claims cost management programs and the Michigan Supreme Court ruling, which decreases the maximum to be paid for indemnity cases on all existing and future claims. In 1996, the favorable development in the workers' compensation line of $21.8 million also reflected these developments. Hanover's favorable development, including voluntary and involuntary pools, decreased $7.7 million in 1996 to $82.9 million, primarily attributable to a decrease in favorable development in the workers' compensation line of $19.8 million. This decrease is primarily attributable to a re-estimate of reserves with respect to certain types of workers' compensation policies including large deductibles and excess of loss policies. In addition, during 1995 the Regional Property and Casualty subsidiaries refined their estimation of unallocated loss adjustment expenses which increased favorable development in that year. Favorable development in the personal automobile line also decreased $4.7 million, to $42.4 million in 1996. These decreases were offset by increases in favorable development of $1.9 million and $5.6 million, to $12.6 million and $5.7 million, in the commercial automobile and commercial multiple peril lines, respectively. Favorable development in other lines increased by $8.8 million, primarily as a result of environmental reserve strengthening in 1995. Favorable development in Hanover's voluntary and involuntary pools increased $3.7 million to $4.1 million during 1996. The increase in favorable development on prior years' reserves of $9.5 million in 1995 results primarily from a $34.6 million increase in favorable development at Citizens. Favorable development in Citizens' personal automobile and workers' compensation lines increased $16.6 million and $15.5 million, to favorable development of $4.4 million and $32.7 million, respectively, due to the aforementioned change in claims cost management and the Michigan Supreme Court ruling. Hanover's favorable development, not including the effect of voluntary and involuntary pools, was relatively unchanged at $90.2 million in 1995 compared to $91.7 million in 1994. Favorable development in Hanover's workers' compensation line increased $27.7 million to $31.0 million during 1995. This was offset by decreases of $14.6 million and $12.6 million, to $45.5 million and $0.1 million, in the personal automobile and commercial multiple peril lines, respectively. Favorable development in Hanover's voluntary and involuntary pools decreased $23.6 million to $0.4 million during 1995. This favorable development reflects the Regional Property and Casualty subsidiaries' reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Due to the nature of business written by the Regional Property and Casualty subsidiaries, the exposure to environmental liabilities is relatively small and therefore their reserves are relatively small compared to other types of 74 - -------------------------------------------------------------------------------- liabilities. Losses and LAE reserves related to environmental damage and toxic tort liability, included in the total reserve for losses and LAE, were $50.8 million and $43.2 million, net of reinsurance of $20.2 million and $8.4 million, at the end of 1996 and 1995, respectively. During 1995, the Regional Property and Casualty subsidiaries redefined their environmental liabilities in conformity with new guidelines issued by the NAIC. This had no impact on results of operations. The Regional Property and Casualty subsidiaries do not specifically underwrite policies that include this coverage, but as case law expands policy provisions and insurers' liability beyond the intended coverage, the Regional Property and Casualty subsidiaries may be required to defend such claims. During 1995, Hanover performed an actuarial review of its environmental reserves. This resulted in Hanover's providing additional reserves for "IBNR" (incurred but not reported) claims in addition to existing reserves for reported claims. Although these claims are not material, their existence gives rise to uncertainty and is discussed because of the possibility, however remote, that they may become material. Management believes that, notwithstanding the evolution of case law expanding liability in environmental claims, recorded reserves related to these claims for environmental liability are adequate. In addition, management is not aware of any litigation or pending claims that may result in additional material liabilities in excess of recorded reserves. The environmental liability could be revised in the near term if the estimates used in determining the liability are revised. 19. MINORITY INTEREST ----------------- The Company's interest in Allmerica P&C, through its wholly-owned subsidiary FAFLIC, is represented by ownership of 59.5%, 58.3% and 57.4% of the outstanding shares of common stock at December 31, 1996, 1995 and 1994, respectively. Earnings and shareholders' equity attributable to minority shareholders are included in minority interest in the consolidated financial statements. 20. CONTINGENCIES ------------- Regulatory and Industry Developments Unfavorable economic conditions may contribute to an increase in the number of insurance companies that are under regulatory supervision. This may result in an increase in mandatory assessments by state guaranty funds, or voluntary payments by, solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through a reduction in future premium taxes in some states. The Company is not able to reasonably estimate the potential effect on it of any such future assessments or voluntary payments. Litigation On June 23, 1995, the governor of Maine approved a legislative settlement for the Maine Workers' Compensation Residual Market Pool deficit for the years 1988 through 1992. The settlement provides for an initial funding of $220.0 million toward the deficit. The insurance carriers were liable for $65.0 million and employers would contribute $110.0 million payable through surcharges on premiums over the course of the next ten years. The major insurers are responsible for 90% of the $65.0 million. Hanover's allocated share of the settlement is approximately $4.2 million, which was paid in December 1995. The remainder of the deficit of $45.0 million will be paid by the Maine Guaranty Fund, payable in quarterly contributions over ten years. A group of smaller carriers filed litigation to appeal the settlement. The Company believes that adequate reserves have been established for any additional liability. The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the opinion of management, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. However, liabilities related to these proceedings could be established in the near term if estimates of the ultimate resolution of these proceedings are revised. Residual Markets The Company is required to participate in residual markets in various states. The results of the residual markets are not subject to the predictability associated with the Company's own managed business, and are significant to the workers' compensation line of business and both the private passenger and commercial automobile lines of business. 75 - -------------------------------------------------------------------------------- 21. Statutory Financial Information ------------------------------- The insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Statutory surplus differs from shareholders' equity reported in accordance with generally accepted accounting principles for stock life insurance companies primarily because policy acquisition costs are expensed when incurred, investment reserves are based on different assumptions, postretirement benefit costs are based on different assumptions and reflect a different method of adoption, life insurance reserves are based on different assumptions and income tax expense reflects only taxes paid or currently payable. Statutory net income and surplus are as follows:
(In millions) 1996 1995 1994 =========================================================== Statutory net income - -------------------- (combined) ---------- Property and Casualty Companies $ 155.3 $ 155.3 $ 79.9 Life and Health Companies 133.3 134.3 40.7 - ----------------------------------------------------------- Statutory Shareholders' - ----------------------- Surplus (combined) ------------------ Property and Casualty Companies $1,201.6 $1,128.4 $974.3 Life and Health Companies 1,120.1 965.6 465.3 - -----------------------------------------------------------
22. Quarterly Results of Operations (unaudited) ------------------------------------------- The quarterly results of operations for 1996 and 1995 are summarized below:
For the Three Months Ended (In millions) ================================================================================ 1996 MARCH 31 JUNE 30 SEPT. 30 DEC. 31 - ---- Total revenues $828.4 $800.3 $806.3 $839.7 ================================================================================ Net income $ 47.3 $ 42.6 $ 46.7 $ 45.3 ================================================================================ Net income per share $ 0.94 $ 0.85 $ 0.93 $ 0.91 ================================================================================ Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05 ================================================================================ 1995 - ---- Total revenues $841.4 $791.9 $822.8 $784.8 ================================================================================ Income before extraordinary item $ 39.2 $ 29.9 $ 34.8 $ 42.1 Extraordinary item - demutualization expense (2.5) (3.5) (4.7) (1.4) - -------------------------------------------------------------------------------- Net income $ 36.7 $ 26.4 $ 30.1 $ 40.7 ================================================================================ Net income after demutualization per share $ -- $ -- $ -- $ 0.82 ================================================================================ Dividends declared per share $ -- $ -- $ -- $ 0.05 ================================================================================
76 Allmerica Financial Corporation - -------------------------------------------------------------------------------- BOARD OF DIRECTORS Michael P. Angelini (A) Partner, Bowditch & Dewey DAVID A. BARRETT (A) Consultant, Memorial Health Care (MCCM, Inc.) GAIL L. HARRISON (D) Founding Principal, The Wexler Group ROBERT P. HENDERSON Chairman, Greylock Management Corporation ROBERT J. MURRAY (D) Chairman, President and Chief Executive Officer, New England Business Service, Inc. TERRENCE MURRAY (D) Chairman, President and Chief Executive Officer, Fleet Financial Group, Inc. JOHN F. O'BRIEN President and Chief Executive Officer, Allmerica Financial Corporation JOHN L. SPRAGUE (A) President, John L. Sprague Associates, Inc. ROBERT G. STACHLER (C) Partner, Taft, Stettinius & Hollister HERBERT M. VARNUM (A,C) Former Chairman and Chief Executive Officer, Quabaug Corporation RICHARD MANNING WALL (C) General Counsel and Assistant to the Chairman, Flexcon Company, Inc. (A) Audit Committee (C) Compensation Committee (D) Directors Committee OPERATING COMMITTEE BRUCE C. ANDERSON Vice President, Corporate Services JOHN P. KAVANAUGH Vice President and Chief Investment Officer JOHN F. KELLY Vice President, General Counsel and Assistant Secretary J. BARRY MAY President, The Hanover Insurance Company JAMES R. MCAULIFFE President, Citizens Insurance Company of America JOHN F. O'BRIEN President and Chief Executive Officer EDWARD J. PARRY III Vice President, Chief Financial Officer and Treasurer RICHARD M. REILLY Vice President, Retail Financial Services LARRY C. RENFRO Vice President, Institutional Services ERIC A. SIMONSEN President, Allmerica Services Corporation PHILLIP E. SOULE Vice President, Corporate Risk Management Services 77 Shareholder Information - -------------------------------------------------------------------------------- ANNUAL MEETING OF SHAREHOLDERS The management and Board of Directors of Allmerica Financial Corporation invite you to attend the Company's Annual Meeting of Shareholders. The meeting will be held on May 20, 1997, at 9:00 a.m. at Allmerica Financial, 440 Lincoln Street, Worcester, MA. COMMON STOCK AND SHAREHOLDER OWNERSHIP PROFILE The common stock of Allmerica Financial Corporation is traded on the New York Stock Exchange under the symbol "AFC." On February 28, 1997, the Company had 65,397 shareholders of record. On the same date, the trading price of the Company's common stock was $37 3/8 per share. DIVIDENDS Allmerica Financial Corporation declared a cash dividend of $0.05 on February 24, 1997, payable on May 15, 1997 for shareholders of record on May 1, 1997. COMMON STOCK PRICES AND DIVIDENDS
1996 HIGH LOW DIVIDENDS FIRST QUARTER $28 $24 3/4 $0.05 - ------------------------------------------------------------------- SECOND QUARTER $30 1/8 $25 1/4 $0.05 - ------------------------------------------------------------------- THIRD QUARTER $32 7/8 $27 1/2 $0.05 - ------------------------------------------------------------------- FOURTH QUARTER $33 3/4 $30 1/8 $0.05 - -------------------------------------------------------------------
REGISTRAR AND STOCK TRANSFER AGENT First Chicago Trust Company of New York 525 Washington Boulevard Jersey City, NJ 07303-2512 1-800-317-4454 INDEPENDENT ACCOUNTANTS Price Waterhouse LLP 160 Federal Street Boston, MA 02110 TOLL-FREE INVESTOR INFORMATION LINE Call our toll-free investor information line, 1-800-407-5222, to receive additional printed information, including the 1996 Form 10-K or quarterly reports on Form 10-Q filed with the Securities and Exchange Commission, fax-on- demand services, access to shareholder services, pre-recorded messages and other services. Alternatively, investors may address questions to: Jean Peters, Vice President - Investor Relations Allmerica Financial Corporation 440 Lincoln Street, Worcester, MA 01653 tel. (508) 855-1000 fax (508) 852-7588 MacArthur Starks, Jr., Director - Investor Relations tel. (508) 855-1000 fax (508) 855-3675 CORPORATE OFFICES AND PRINCIPAL SUBSIDIARIES Allmerica Financial Corporation 440 Lincoln Street Worcester, MA 01653 The Hanover Insurance Company 100 North Parkway Worcester, MA 01605 Citizens Insurance Company of America 645 West Grand River Howell, MI 48843 INDUSTRY RATINGS
A.M. Standard Duff & Claims Paying Ability Best & Poors Moody's Phelps - -------------------------------------------------------------------------------- First Allmerica Financial Life Insurance Company A A+ A1 AA - -------------------------------------------------------------------------------- Allmerica Financial Life Insurance and Annuity Company A A+ A1 - - -------------------------------------------------------------------------------- The Hanover Insurance Company A AA- A1 - - -------------------------------------------------------------------------------- Citizens Insurance Company of America A+ - - - - -------------------------------------------------------------------------------- Standard Duff & Debt Ratings & Poors Moody's Phelps - -------------------------------------------------------------------------------- Allmerica Financial Corporation Senior Debt A- A2 A+ - --------------------------------------------------------------------------------
PRINTED ENTIRELY ON RECYCLED PAPER DESIGN The Graphic Expression Inc., New York 78 EX-21 6 SUBSIDIARIES OF REGISTRANT EXHIBIT 21 DIRECT AND INDIRECT SUBSIDIARIES OF THE REGISTRANT I.Allmerica Financial Corporation (Delaware) A.Allmerica Funding Corp. (Massachusetts) B.First Allmerica Financial Life Insurance Company (Massachusetts) 1.Logan Wells Water Company, Inc. (New Jersey) 2.SMA Financial Corp. (Massachusetts) a.Allmerica Property & Casualty Companies, Inc. (Delaware) (59.5% owned) i.APC Funding Corp. (Massachusetts) ii.Allmerica Financial Insurance Brokers, Inc. (Massachusetts) iii.The Hanover Insurance Company (New Hampshire) 1.Allmerica Financial Benefit Insurance Company (Pennsylvania) 2.Allmerica Employees Insurance Agency, Inc. (Massachusetts) 3.The Hanover American Insurance Company (New Hampshire) 4.Hanover Texas Insurance Management Company, Inc. (Texas) 5.Citizens Corporation (Delaware) (82.5% owned) a.Citizens Insurance Company of Ohio (Ohio) b.Citizens Insurance Company of America (Michigan) i.Citizens Management Inc. (Michigan) c.Citizens Insurance Company of the Midwest (Indiana) 6.AMGRO, Inc. (Massachusetts) a.Lloyds Credit Corporation (Massachusetts) 7.Massachusetts Bay Insurance Company (New Hampshire) 8.Allmerica Financial Alliance Insurance Company (New Hampshire) b.Sterling Risk Management Services, Inc. (Delaware) c.Allmerica Trust Company, N.A. (Federally Chartered) (99.2% owned) d.Somerset Square, Inc. (Massachusetts) e.Allmerica Financial Life Insurance and Annuity Company (Delaware) f.Allmerica Institutional Services, Inc. (Massachusetts) g.Allmerica Investments, Inc. (Massachusetts) h.Allmerica Investment Management Company, Inc. (Massachusetts) i.Allmerica Asset Management, Inc. (Massachusetts) j.Allmerica Financial Services Insurance Agency, Inc. (Massachusetts) k.Linder Skokie Real Estate Corporation (Massachusetts) 1 EX-23 7 CONSENT OF PRICE WATERHOUSE LLP EXHIBIT 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-576, No. 333-578, No. 333-580 and No. 333-582) of Allmerica Financial Corporation of our report dated February 3, 1997, except as to Notes 1 and 2, which are as of February 19, 1997, appearing in the Allmerica Financial Corporation 1996 Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which also appears in this Form 10-K. /s/ Price Waterhouse LLP - ------------------------------- Price Waterhouse LLP Boston, Massachusetts March 17, 1997 1 EX-24 8 POWER OF ATTORNEY EXHIBIT 24 POWER OF ATTORNEY WE, THE UNDERSIGNED, HEREBY SEVERALLY CONSTITUTE AND APPOINT JOHN F. O'BRIEN, JOHN F. KELLY AND EDWARD J. PARRY III, AND EACH OF THEM SINGLY, OUR TRUE AND LAWFUL ATTORNEYS, WITH FULL POWER IN EACH OF THEM, SIGN FOR AND IN EACH OF OUR NAMES AND IN ANY AND ALL CAPACITIES, FORM 10-K OF ALLMERICA FINANCIAL CORPORATION (THE "COMPANY") AND ANY OTHER FILINGS MADE ON BEHALF OF SAID COMPANY PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, AND TO FILE THE SAME WITH ALL EXHIBITS AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND EXCHANGE COMMISSION, GRANTING UNTO SAID ATTORNEYS AND EACH OF THEM, ACTING ALONE, FULL POWER AND AUTHORITY TO DO AND PERFORM EACH AND EVERY ACT AND THING REQUISITE OR NECESSARY TO BE DONE, HEREBY RATIFYING AND CONFIRMING ALL THAT SAID ATTORNEYS OR ANY OF THEM MAY LAWFULLY DO OR CAUSE TO BE DONE BY VIRTUE HEREOF. WITNESS OUR HANDS AND COMMON SEAL ON THE DATE SET FORTH BELOW. SIGNATURE TITLE DATE /s/ John F. O'Brien Director, President 2/24/97 - ------------------------------------- and CEO JOHN F. O'BRIEN /s/ Michael P. Angelini Director 2/24/97 - ------------------------------------- MICHAEL P. ANGELINI - ------------------------------------- Director 2/24/97 DAVID A. BARRETT /s/ Gail L. Harrison Director 2/24/97 - ------------------------------------- GAIL L. HARRISON Director 2/24/97 - ------------------------------------- ROBERT P. HENDERSON /s/ J. Terrence Murray Director 2/24/97 - ------------------------------------- J. TERRENCE MURRAY /s/ Robert J. Murray Director 2/24/97 - ------------------------------------- ROBERT J. MURRAY 1 SIGNATURE TITLE DATE /s/ John L. Sprague Director 2/24/97 - ------------------------------------- JOHN L. SPRAGUE /s/ Robert G. Stachler Director 2/24/97 - ------------------------------------- ROBERT G. STACHLER /s/ Herbert M. Varnum Director 2/24/97 - ------------------------------------- HERBERT M. VARNUM /s/ Richard Manning Wall Director 2/24/97 - ------------------------------------- RICHARD MANNING WALL 2 EX-27 9 FINANCIAL DATA SCHEDULE
7 1,000,000 12-MOS DEC-31-1996 DEC-31-1996 7,488 0 0 474 650 121 8,993 179 876 823 18,998 2,614 823 2,944 2,060 241 0 0 1 1,724 18,998 2,236 673 66 300 1,957 484 502 332 75 257 0 0 0 182 3.63 3.63 2,896 1,513 (141) 760 627 2,744 (137)
EX-99.2 10 IMPORTANT FACTORS REGARDING FORWARD LOOKING STMTS. EXHIBIT 99.2 IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS The Company wishes to caution readers that the following important factors, among others, in some cases have affected the Company's results and in the future could cause actual results and needs of the Company to vary materially from forward-looking statements made from time to time by the Company on the basis of management's then-current expectations. The businesses in which the Company is engaged are in rapidly changing and competitive markets and involve a high degree of risk, and accuracy with respect to forward looking projections is difficult. GEOGRAPHIC CONCENTRATION IN THE PROPERTY AND CASUALTY INSURANCE BUSINESS Substantially all of the Company's property and casualty insurance subsidiaries net premiums written and earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The revenues and profitability of the Company's property and casualty insurance subsidiaries are therefore subject to prevailing economic, regulatory, demographic and other conditions, including adverse weather, in Michigan and the Northeast. CYCLICALITY IN THE PROPERTY AND CASUALTY INSURANCE INDUSTRY Historically, the property and casualty insurance industry has been highly cyclical. The property and casualty industry's profitability can be affected significantly by price competition, volatile and unpredictable developments such as extreme weather conditions and natural disasters, legal developments affecting insurer liability and the size of jury awards, fluctuations in interest rates and other factors that affect investment returns and other general economic conditions and trends that may affect the adequacy of reserves. Over the past several years, the property and casualty insurance industry as a whole has been in a soft market. Competition for premiums in the property and casualty insurance markets may continue to have an adverse impact on the Company's rates and profitability. CATASTROPHE LOSSES IN THE PROPERTY AND CASUALTY INSURANCE INDUSTRY Property and casualty insurers are subject to claims arising out of catastrophes, which may have a significant impact on their results of operations and financial condition. The Company may experience catastrophe losses in the future which could have a material adverse impact on the Company. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires, severe winter weather and explosions, and the frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of two factors: the total amount of insured exposure in the area affected by the event and the severity of the event. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and commercial property insurance have in the past generated the vast majority of the Company's catastrophe-related claims. The Company purchases catastrophe reinsurance as protection against catastrophe losses. The Company believes, based upon its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, that the financial condition of its reinsurers is sound. However, there can be no assurance that reinsurance will be adequate to protect the Company against such losses or that such reinsurance will continue to be available to the Company in the future at commercially reasonable rates. UNCERTAINTY REGARDING ADEQUACY OF PROPERTY AND CASUALTY LOSS RESERVES The Company's property and casualty insurance subsidiaries maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses ("LAE") with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given time, of what the Company's property and casualty insurance subsidiaries expect the ultimate settlement and administration of claims will cost based on facts and circumstances then known, 1 predictions of future events, estimates of future trends in claims severity and judicial theories of liability, legislative activity and other factors. The inherent uncertainties of estimating reserves are greater for certain types of property and casualty insurance lines, particularly workers' compensation, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and environmental liability, where the technological, judicial and political climates involving these types of claims are changing. The company's property and casualty insurance subsidiaries regularly review reserving techniques, reinsurance and overall reserve adequacy. Based upon (i) review of historical data, legislative enactments, judicial decisions, legal developments in imposition of damages, changes in political attitudes and trends in general economic conditions; (ii) review of per claim information; (iii) historical loss experience of the property and casualty insurance subsidiaries and the industry; and (iv) the relatively short-term nature of most of its property and casualty insurance policies, management believes that adequate provision has been made for reserves. However, establishment of appropriate reserves is an inherently uncertain process involving estimates of future losses and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. The Company's property and casualty insurance subsidiaries' reserves are annually certified as required by insurance regulatory authorities. SENSITIVITY TO INTEREST RATES RELATIVE TO LIFE INSURANCE SUBSIDIARIES The Company's life insurance subsidiaries are exposed to risk of disintermediation and reduction in interest spread or profit margins when interest rates fluctuate. Bond calls, mortgage prepayments, contract surrenders and withdrawals of life insurance policies, annuities and guaranteed investment contracts are influenced by the interest rate environment. Since the Company's life insurance subsidiaries' investment portfolios consist primarily of fixed income assets, the investment portfolio market value and the yields on newly invested and reinvested assets vary depending on interest rates. Management attempts to mitigate any negative impact of interest rate changes through asset/liability management, product design (including an increased focus on variable insurance products), management of crediting rates, use of hedging techniques, relatively high surrender charges and management of mortality charges and dividend scales with respect to its in force life insurance policies. REGULATORY, SURPLUS, CAPITAL, RATING AGENCY AND RELATED MATTERS Insurance companies are subject to supervision and regulation by the state insurance authority in each state in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company's business and financial condition, including limitations on the authorization of lines of business, underwriting limitations, the setting of premium rates, the establishment of standards of solvency, the licensing of insurers and agents, concentration of investments, levels of reserves, the payment of dividends, transactions with affiliates, changes of control and the approval of policy forms. Such regulation is concerned primarily with the protection of policyholders. State regulatory oversight and various proposals at the federal level (including the proposed adoption of a federal regulatory framework for insurance companies) may in the future adversely affect the Company's ability to sustain adequate returns in certain lines of business. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and certain state legislatures have considered or enacted laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioner ("NAIC") and state insurance regulators are reexamining existing laws and regulations, and as a condition to accreditation have required the adoption of certain model laws which specifically focus on insurance company investments, issues relating to the solvency of insurance companies, risk-based capital ("RBC") guidelines, interpretations of existing laws, the development of new laws, and the definition of extraordinary dividends. The capacity for an insurance company's growth in premiums is in part a function of its statutory surplus. Maintaining appropriate levels of statutory surplus, as measured by state insurance regulators, is considered 2 important by state insurance regulatory authorities and the private agencies that rate insurers' claims-paying abilities and financial strength. Failure to maintain certain levels of statutory surplus could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by the private rating agencies. The NAIC has created a new system for assessing the adequacy of statutory capital for life and health insurers and property and casualty insurers. The new system, known as risk-based capital, is in addition to the states' fixed dollar minimum capital and other requirements. The new system is based on risk-based formulas (separately defined for life and health insurers and property and casualty insurers) that apply prescribed factors to the various risk elements in an insurer's business to report a minimum capital requirement proportional to the amount of risk assumed by the insurer. Because the investment of First Allmerica Financial Life Insurance Company ("FAFLIC"), a life insurance subsidiary of the Company, in Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C") represents a significant percentage of FAFLIC's surplus, the trading price of the common stock of Allmerica P&C will affect FAFLIC's RBC calculations and may affect the FAFLIC's claims-paying ability and financial strength ratings. There can be no assurance that capital requirements applicable to the FAFLIC's businesses will not increase or that the FAFLIC will be able to meet minimum RBC requirements in the future. In addition, in March 1995, S&P lowered its claims-paying ability ratings of FAFLIC and Allmerica Financial Life Insurance and Annuity Company to A+ (Good), and Moody's reduced FAFLIC's FinancialStrength Rating From Aa3 (Excellent) to A1 (Good). Management believes that its strong ratings are important factors in marketing the products of its insurance companies to its agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company ratings are assigned to an insurer based upon factors relevant to policyholders and are not directed toward protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. Further downgrades may have a material adverse effect on the Company's business and prospects. STATE GUARANTY FUNDS, SHARED MARKETS MECHANISMS AND POOLING ARRANGEMENTS All fifty states of the United States have insurance guaranty fund laws requiring all life and health and property and casualty insurance companies doing business within the state to participate in guaranty associations, which are organized to pay contractual obligations under insurance policies issued by impaired or insolvent insurance companies. These associations levy assessments (up to prescribed limits) on all member insurers in a particular state on the basis of the proportionate share of the premiums written by member insurers in the lines of business in which the impaired or insolvent insurer is engaged. Mandatory assessments by state guaranty funds are used to cover losses to policyholders of insolvent or rehabilitated companies and can be partially recovered through a reduction in future premium taxes in many states. These assessments may increase in the future depending upon the rate of insolvencies of insurance companies. In addition, as a condition to the ability to conduct business in various states, the Company's property and casualty insurance subsidiaries are required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. The Company cannot predict whether its participation in these shared market mechanisms or pooling arrangements will provide underwriting profits or losses to the Company. COMPETITION The Company's business is composed of four principal segments: Property and Casualty Insurance, Corporate Risk Management Services, Retail Financial Services, and Institutional Services. Each of these industry segments in general is highly competitive. The Company's products and services compete not only with those offered by insurance companies but also with products offered by other financial institutions and health maintenance organizations. In all of its segments, many of the Company's competitors are larger and have greater 3 financial, technical and operating resources than those of the Company. In addition, the Company may face additional competition from banks and other financial institutions should current regulatory restrictions on the sale of insurance and securities by these institutions be repealed. RETENTION OF KEY EXECUTIVES The future success of the Company will be affected by its continued ability to attract and retain qualified executives. The Company's success is dependent in large part on John F. O'Brien, the loss of whom could adversely affect the Company's business. The Company does not have an employment agreement with Mr. O'Brien. FEDERAL INCOME TAX LEGISLATION Currently, under the Code, holders of certain life insurance and annuity products are entitled to tax-favored treatment on these products. For example, income tax payable by policyholders on investment earnings under certain life insurance and annuity products is deferred during the product's accumulation period and is payable, if at all, only when the insurance or annuity benefits are actually paid or to be paid. Also, for example, interest on loans up to $50,000 secured by the cash value of certain insurance policies owned by businesses is eligible for deduction even though investment earnings during the accumulation period are tax-deferred. In the past, legislation has been proposed that would have curtailed the tax-favored treatment of the life insurance and annuity products offered by the Company. These proposals were not enacted, and no such proposals or similar proposals are currently under active consideration by the Congress. Nevertheless, if these or similar proposals directed at limiting the tax- favored treatment of life insurance policies and annuity contracts were enacted, market demand for such products offered by the Company would be adversely affected. SALES PRACTICES A number of civil jury verdicts have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. The Company and its subsidiaries, like other life and health insurers, from time to time are involved in such litigation. Although the outcome of any litigation cannot be predicted with certainty, to date, no such lawsuit has resulted in the award of any material amount of damages against the Company. In December 1996, the Company received notice from the Securities and Exchange Commission (the "Commission") that it would be conducting a limited inspection concerning the Company's marketing and sales practices associated with variable insurance products. The Commission requested that certain information be provided to it by the Company, which the Company promptly complied with. No litigation has been instituted, nor has the Commission initiated any further action with respect to this matter. HEALTH CARE REFORM LEGISLATION In the past, there have been, and currently there are, a number of proposals introduced in the United States Congress and currently there are proposals pending in state legislatures to reform the current health care system. Many states have already enacted comprehensive health care reform legislation and a number of legislative and regulatory proposals are currently being considered at the state and federal level. Legislative proposals have included requirements with respect to mandated universal health insurance coverage, restrictions on preexisting condition limitations, community rating standards, guaranteed issue and renewal requirements and restrictions on premium increases. Some states have passed and many other states are considering legislation that include voluntary health care purchasing alliances, differential limitations in rates for new and renewal business or for 4 demographic groups, and underwriting practice restrictions. These reforms generally include the formation of voluntary purchasing alliances for small employers (typically with less than 50-100 employees) and require insurers to accept all qualified small employer groups as a condition of providing small group insurance, prohibit the imposition of preexisting condition limitations or medical condition terminations, and phase out experience-rating for small employer groups. Certain jurisdictions also have enacted so-called "any willing provider" laws which may decrease the demand for managed care plans. While the Company cannot predict whether any of the proposals currently being considered will be enacted or whether any new federal or state proposals will be considered, and thus cannot predict what specific effects health care reform may have on the Company's business, the Company's operations may be adversely affected by changes to the health care system. 5 -----END PRIVACY-ENHANCED MESSAGE-----