-----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, Qu5FpQYXBdTwS3jDhdRHCh98VJ5KnHgepX7Km77E2yn7pKy4COZYGn1soAbuueti oqnJd5MKMA4pfgtcdgO/aw== 0000927016-98-001218.txt : 19980331 0000927016-98-001218.hdr.sgml : 19980331 ACCESSION NUMBER: 0000927016-98-001218 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 13 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980327 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: SEC FILE NUMBER: 001-13754 FILM NUMBER: 98577282 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, 1997 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM: TO COMMISSION FILE NUMBER: 1-13754 ALLMERICA FINANCIAL CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 04-3263626 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER) 440 LINCOLN STREET, WORCESTER, 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, TOGETHER WITH STOCK PURCHASE RIGHTS 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 March 13, 1998 the aggregate market value of the voting and non-voting stock held by nonaffiliates of the registrant was $3,315,209,036. The number of shares outstanding of the registrant's common stock, $.01 par value, was 59,979,641 shares outstanding as of March 13, 1998. DOCUMENTS INCORPORATED BY REFERENCE Portions of Allmerica Financial Corporation's Annual Report to Shareholders for 1997 are incorporated by reference in Parts I, II, and IV. Portions of Allmerica Financial Corporation's Proxy Statement of Annual Meeting of Shareholders to be held May 12, 1998 are incorporated by reference in Part III. Total number of pages, including cover page: - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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. The consolidated financial statements of AFC include the accounts of First Allmerica Financial Life Insurance Company ("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 wholly-owned non-insurance holding company). Allmerica P&C and a wholly-owned subsidiary of the Company merged on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash of $425.6 million and approximately 9.7 million shares of AFC stock valued at $372.5 million. Total consideration was allocated to the minority interest in the assets and liabilities based on their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million, representing the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. 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 funded a portion of the aforementioned acquisition of the 24.2 million publicly held shares of Allmerica P&C. On August 7, 1997, AFC and the Trust exchanged the Series A Capital Securities for a like amount of Series B Capital Securities and related guarantees which are registered under the Securities Act of 1933 as required under the terms of the initial transaction. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company operates principally in five operating segments. These segments are Regional Property and Casualty; Corporate Risk Management Services ("CRMS"); Allmerica Financial Services ("AFS"); Institutional Services; and Allmerica Asset Management ("AAM"). In addition to the five operating segments, the Company also has a Corporate segment, which consists primarily of cash, investments, corporate debt and Capital Securities. Information with respect to each of the Company's segments is included in "Segment Results" on pages 30-40 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 14 on page 70 of the Notes to the Consolidated Financial Statements included in the 1997 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. DESCRIPTION OF BUSINESS BY SEGMENT Following is a discussion of each of the Company's five operating segments. 2 RISK MANAGEMENT REGIONAL PROPERTY AND CASUALTY General The Company's Regional Property and Casualty segment is composed of its wholly-owned subsidiary, Allmerica P&C, which consists of The Hanover Insurance Company ("Hanover") and Hanover's 82.5%-owned subsidiary, Citizens Corporation ("Citizens"). For the year ended December 31, 1997, the Regional Property and Casualty segment accounted for approximately $2,275.3 million, or 67.0%, of consolidated revenues and approximately $158.2 million, or 52.2%, 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 have an historically strong regional focus and both place heavy emphasis on underwriting profitability and loss reserve adequacy. As of December 31, 1996, 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. 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. In 1996, the Company, in the Regional Property and Casualty segment, began the process of consolidating certain operations of Hanover and Citizens which are intended to achieve process improvements and efficiencies in operations. These operations include claims, finance, policy processing and administrative functions. In 1997, Citizens upgraded its claims processing automation and consolidated many of its Michigan claims offices into a regional claims center based in Howell. At Hanover, claim office consolidation also occurred into central locations reducing the number of offices from twenty-eight to nineteen. Additionally, Citizens increased claim draft authority for its agents and implemented a network of auto repair facilities to streamline damage appraisal and repair. Citizens and Hanover also began reengineering its processing of commercial lines business, redefining underwriting roles and providing more authority to agents to price and bind standard accounts. 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. 3 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 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. Amgro also offers loans to independent agencies at competitive rates. 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. Hanover's business is concentrated in the Northeast, primarily Massachusetts, New York, New Jersey and Maine. Citizens' business is predominantly in Michigan and continues to expand into Indiana and Ohio. The Company markets property and casualty insurance products through approximately 2,500 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. 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. The Regional Property and Casualty segment 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 at Hanover, and a Regional Agents Advisory Council at Citizens, consisting of agent representatives. These councils seek to coordinate marketing efforts, support implementation of the Company's strategies and enhance local market presence. Citizens' position as a principal provider with many of its agencies is evidenced by its high average premiums written per agency of approximately $1.6 million in 1997 in Michigan. Over the past few years, Hanover has begun 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. Also, the Company, through the Regional Property and Casualty segment, is exploring sales through banks and electronic commerce. 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. 4 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 $1,097.8 million, or 56.2%, of the Regional Property and Casualty segment's consolidated net premium earned in 1997. 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 1997, the Company completed 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. 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. The Company believes that these investments in technology will, over time, create technological efficiencies and provide capacity for enhanced service to customers. 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 eleven branch/sales underwriting 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. In 1997, Hanover reached an agreement with Travelers Property Casualty to facilitate Travelers' writing of certain Hanover Insurance policies, as they expire, in Alabama, California, Kansas, Mississippi, Missouri, Texas and Vermont. In these seven states, Hanover has approximately 250 agents generating approximately $90 million in premium annually. Hanover has ceased writing substantially all personal and commercial policies in these states except for employer and association-sponsored group property and casualty business, surety bonds and specialty program commercial policies. The plan was conditioned upon the appropriate regulatory approval in each state. The Company has received substantially all of the appropriate regulatory approvals as of December 31, 1997. Citizens Citizens accounted for approximately $855.3 million, or 43.8%, of the Regional Property and Casualty segment's consolidated net premium earned in 1997. Citizens' products are also marketed through independent agencies which provide specialized knowledge of property and casualty products, local market conditions and targeted customer characteristics. Citizens seeks to pursue profitable growth in existing markets by establishing long-term relationships with larger, well-established agencies. To solidify its relationship with higher quality agents, Citizens offers enhanced profit sharing agreements, recognition awards and maintains local presence through five branch offices and three claims offices in Michigan, Indiana and Ohio. In addition, Citizens continues to maintain long-term pricing and underwriting integrity to remain a stable market for the independent agents. 5 In 1997, Citizens completed the process of consolidating certain operations with Hanover to achieve process improvements and efficiencies in operations including claims, finance, policy processing and administrative functions. Additionally, during 1997 Citizens relocated many of its claims functions to a regional office in Michigan to provide for better client service and gain operational efficiencies. Citizens has been successful in developing and marketing groups in both personal and commercial segments that are tailored for members of associations, financial institutions and employers in Michigan, Indiana and Ohio. The organizations may choose to make Citizens' programs available to their members or employees 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 or employees. As of December 31, 1997, Citizens had approximately 144 group programs in-force, 114 of which were in personal lines and 30 of which were in commercial lines. Revenue from personal and commercial lines groups accounts for nearly 50 percent of Citizens' total premium volume. Citizens continues its use of agency-company interface ("ACI") technology, which enables agents to electronically submit personal lines policies for review and rating. In addition, 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 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 proportional to 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 incurred an underwriting loss from participation in such mechanisms, mandatory pools and underwriting associations of $12.9 million, $5.3 million and $2.8 million in 1997, 1996 and 1995 relating primarily to coverages for personal and commercial automobile, personal and commercial property, and workers' compensation. The increase in the underwriting loss is primarily related to Hanover's participation in the Massachusetts Commonwealth Automobile Reinsurers ("CAR") pool which is consistent with the rate decrease and higher actual loss activity experienced in the overall Massachusetts automobile market. Assigned Risk Plans Assigned risk plans are the most common type of shared market mechanism. Many states, including Massachusetts, Illinois, New Jersey and New York 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 that 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. 6 A type of reinsurance mechanism that exists in New Jersey, The New Jersey Unsatisfied Claim and Judgment Fund ("NJUCJF"), covers no-fault first party medical losses in excess of $0.8 million. All automobile 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 this fund comes from assessments against automobile insurers based upon their proportionate market share of the state's automobile liability 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. At December 31, 1997, CAR was the only reinsurer 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, 1997, 1996 and 1995 were $32.3 million and $28.2 million, $38.0 million and $21.8 million, and $49.1 million and $33.7 million, respectively. The Company ceded to the Michigan Catastrophic Claims Association ("MCCA") premiums earned of $9.8 million, $50.5 million and $66.8 million in 1997, 1996 and 1995, respectively. Losses and loss adjustment expenses ceded in 1997, 1996 and 1995 were $(0.8) million, $(52.9) million and $62.9 million, respectively. The decrease in earned premiums ceded to MCCA reflects a reduction in premiums charged per policyholder by MCCA. In 1997 and 1996, the MCCA's favorable development on prior year reserves exceeded the losses and LAE incurred during the year. At December 31, 1997 and 1996, the Company, in the Regional Property and Casualty segment, had reinsurance recoverable on paid and unpaid losses from CAR of $45.7 million and $57.6 million and from MCCA of $280.2 million and $292.0 million, respectively. 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 CAR, because CAR is a mandated pool supported by all insurance companies licensed to write automobile insurance in the Commonwealth of Massachusetts. In addition, the MCCA (i) 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. Reference is made to Note 16 on pages 71 and 72 and Note 20 on pages 74 and 75 of the Notes to Consolidated Financial Statements of the 1997 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. 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, 7 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 shared 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 Connecticut, Illinois, New Hampshire, Maine, New Jersey 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 basis 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, including those with exclusive agent representation, 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 usually compete in both personal and commercial lines. Hanover and Citizens market through independent agents and therefore 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 few years, the competitive environment in Massachusetts has increased substantially. Approximately 34% of Hanover's personal automobile business is currently written in this state. Effective January 1, 1998 and January 1, 1997, Massachusetts personal automobile rates decreased 4.0% 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 100 group programs throughout the state, including a large group plan in the state with approximately 347,000 eligible members. In 1997, Hanover began offering a 10% discount on automobile insurance for its safest drivers. As a result, policyholders have the ability to 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 Massachusetts. In Michigan, Citizens competes in personal lines with a number of direct writers and regional and local companies, several of which are larger than Citizens. Citizens is the largest writer of property and casualty insurance in Michigan through independent agents. Citizens' principal competition in the Michigan homeowners line is from direct writers, including State Farm Group. Citizens also faces competition from the two largest direct writers in Michigan, Auto Club Michigan Group and State Farm Group, in the personal automobile line. 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. This new legislation has removed barriers to entrance into the market for national agency 8 companies, which have not been significant competitive forces in Michigan in the personal lines of property and casualty insurance in previous years. This was, in part, due to Michigan's prior insurance regulatory environment which required 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. Although the Company believes that this new legislation will encourage national companies to return or enter into the state, the Company has not assessed the impact of this law. Citizens faces commercial lines competition principally from national agency companies, and regional and local companies, many of which have financial resources substantially greater than those of Citizens. Citizens is the second leading writer in Michigan in its three primary commercial lines combined: commercial automobile, workers' compensation, and commercial multiple peril. The commercial 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 workers' compensation insurance 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. In March 1997, Citizens introduced workers' compensation product and pricing alternatives, written through Citizens Insurance Company of Ohio and Citizens Insurance Company of the Midwest. These vehicles enable greater pricing flexibility, particularly for writing preferred risks in medium and large workers' compensation accounts. By the end of 1997, rate filings effective January 1, 1998 by companies indicated either small decreases for selected classes of business or even some rate increases. 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 a target combined ratio in each of its product lines regardless of market conditions. This strategy seeks to achieve measured growth and consistent profitability on a continuing basis. 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 underwriting results. Hanover and Citizens rely on information provided by their local agents and both also rely 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 staff strategically located throughout its operating territories. All claims staff members work closely with the agents to settle claims rapidly and cost- effectively. 9 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. The Company, in the Regional Property and Casualty segment, utilizes claims processing technology which allows smaller and more routine claims to be processed at centralized locations. The Company expects that approximately 70% of its personal lines claims will be processed at these locations, thereby increasing efficiency and reducing operating costs. Citizens has instituted a program under which participating agents have settlement authority for many property loss claims. Based upon the program experience, the Regional Property and Casualty segment believes that this program contributes to lower LAE experience and to its higher customer satisfaction ratings by permitting the early and direct settlement of such small claims. Approximately 30.1% and 26.6% of the number of total paid claims reported to Citizens in the years ended December 31, 1997 and 1996, respectively, were settled under this program. Hanover and Citizens have increased usage of the managed care expertise of the Allmerica Financial's Corporate Risk Management Services segment in the analysis of medical services and pricing in the management of workers' compensation and medical claims on its automobile policies. Hanover and Citizens' use of this capability has demonstrated reduced 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 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 34, 35 and 36 of Management's Discussion and Analysis of Financial Condition and Results of Operations of the 1997 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. 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. 10 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:
1997 1996 1995 -------- -------- -------- (IN MILLIONS) Statutory reserve for losses and LAE............ $2,047.2 $2,113.2 $2,123.0 GAAP adjustments: Reinsurance recoverable on unpaid losses...... 576.7 626.9 763.5 Other(*)...................................... (8.5) 4.0 9.5 -------- -------- -------- GAAP reserve for losses and LAE................. $2,615.4 $2,744.1 $2,896.0 ======== ======== ========
- -------- (*) Primarily represents other statutory liabilities reclassified as loss adjustment expense reserves for GAAP reporting and purchase accounting adjustments. 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 1987 through 1997 for the Company.
1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (IN MILLIONS) YEAR ENDED DECEMBER 31, Net reserve for losses and LAE(1)......... $2,038.7 $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 Cumulative amount paid as of(2): One year later ............... -- 732.1 627.6 614.3 566.9 564.3 569.0 561.5 521.1 465.3 384.3 Two years later ............... -- -- 1,008.3 940.7 884.4 862.7 888.0 874.5 820.2 725.3 616.4 Three years later ......... -- -- -- 1,172.8 1,078.1 1,068.4 1,077.1 1,074.3 1,009.3 901.5 764.5 Four years later ............... -- -- -- -- 1,210.9 1,184.1 1,207.1 1,186.4 1,130.1 1,009.7 862.1 Five years later ............... -- -- -- -- -- 1,267.5 1,279.4 1,265.4 1,192.7 1,078.8 926.0 Six years later ............... -- -- -- -- -- -- 1,337.2 1,314.2 1,240.9 1,116.2 969.7 Seven years later ......... -- -- -- -- -- -- -- 1,355.3 1,271.4 1,147.4 993.5 Eight years later ......... -- -- -- -- -- -- -- -- 1,301.6 1,170.4 1,016.5 Nine years later ............... -- -- -- -- -- -- -- -- -- 1,192.5 1,034.6 Ten years later-- ....... -- -- -- -- -- -- -- -- -- -- 1,052.0 Net reserve re- estimated as of(3): End of year..... 2,038.7 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 One year later ............... -- 1,989.3 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 Two years later ............... -- -- 1,874.3 1,859.4 1,767.4 1,762.8 1,717.7 1,601.9 1,449.0 1,262.0 1,096.4 Three years later ......... -- -- -- 1,780.3 1,691.5 1,703.3 1,670.8 1,614.3 1,471.7 1,290.2 1,125.3 Four years later ............... -- -- -- -- 1,676.3 1,658.9 1,654.1 1,597.6 1,484.7 1,312.3 1,155.1 Five years later ............... -- -- -- -- -- 1,637.3 1,634.6 1,594.3 1,482.3 1,322.1 1,175.2 Six years later ............... -- -- -- -- -- -- 1,630.6 1,588.7 1,486.9 1,328.6 1,188.5 Seven years later ......... -- -- -- -- -- -- -- 1,593.1 1,488.4 1,340.7 1,201.2 Eight years later ......... -- -- -- -- -- -- -- -- 1,552.1 1,403.7 1,215.4 Nine years later ............... -- -- -- -- -- -- -- -- -- 1,412.8 1,226.8 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 1,238.6 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (Deficiency) Redundancy, net(4,5,6)..... $ -- $ 127.9 $ 258.2 $ 329.0 $ 343.3 $ 299.6 $ 141.8 $ (42.5) $ (225.8) $ (261.9) $ (230.6) ======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
- -------- (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. 11 (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, 1997 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 1997 for the Company:
YEAR ENDED DECEMBER 31, ------------------------------------------------------ 1997 1996 1995 1994 1993 1992 -------- -------- -------- -------- --------- -------- (IN MILLIONS) Reserve for losses and LAE: Gross liability....... $2,615.4 $2,744.1 $2,896.0 $2,821.7 $2,717.3 $2,598.9 Reinsurance recoverable.......... 576.7 626.9 763.5 712.4 697.7 662.0 -------- -------- -------- -------- --------- -------- Net liability....... $2,038.7 $2,117.2 $2,132.5 $2,109.3 $2,019.6 $1,936.9 ======== ======== ======== ======== ========= ======== One year later: Gross re-estimated liability............ $2,541.9 $2,587.8 $2,593.5 $2,500.5 $2,460.5 Re-estimated recoverable.......... 552.7 596.7 621.8 609.0 592.4 -------- -------- -------- --------- -------- Net re-estimated liability.......... $1,989.2 $1,991.1 $1,971.7 $1,891.5 $1,868.1 ======== ======== ======== ========= ======== Two years later: Gross re-estimated liability............ $2,427.7 $2,339.2 $2,333.3 $2,341.9 Re-estimated recoverable.......... 553.5 479.8 565.9 579.1 -------- -------- --------- -------- Net re-estimated liability.......... $1,874.2 $1,859.4 $1,767.4 $1,762.8 ======== ======== ========= ======== Three years later: Gross re-estimated liability............ $2,227.0 $2,145.5 $2,257.3 Re-estimated recoverable.......... 446.8 454.0 554.0 -------- --------- -------- Net re-estimated liability.......... $1,780.2 $1,691.5 $1,703.3 ======== ========= ======== Four years later: Gross re-estimated liability............ $2,102.0 $2,168.2 Re-estimated recoverable.......... 425.7 509.3 --------- -------- Net re-estimated liability.......... $1,676.3 $1,658.9 ========= ======== Five years later: Gross re-estimated liability............ $2,027.3 Re-estimated recoverable.......... 390.0 -------- Net re-estimated liability.......... $1,637.3 ========
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. 12 The Company determines the appropriate amount of reinsurance based on the Company's 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, in the Regional Property and Casualty segment, has reinsurance for casualty business. Under the 1997 casualty reinsurance program, the reinsurers are responsible for 100% of the amount of each loss in excess of $0.5 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. Amounts in excess of $60.5 million are retained 100% by the Company. Under the 1997 catastrophe reinsurance program Hanover retains the first $25.0 million of loss per occurrence and all amounts in excess of $180.0 million, 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. Citizens retains 5% of losses in excess of $10.0 million, up to $25.0 million, and 10% of losses in excess of $25.0 million up to $180.0 million. Amounts in excess of $180.0 million are retained 100% by Citizens. In 1996, Citizens had additional catastrophe coverage which reinsured 90% of $5.0 million for aggregated catastrophe losses in excess of $5.0 million which individually exceed $1.0 million. In 1997 and 1996, the Company, in the Regional Property and Casualty segment, recovered $1.2 million and $4.6 million on its catastrophe coverage, respectively. In 1995, the Company, in the Regional Property and Casualty segment did not exceed the minimum catastrophe levels. Effective January 1, 1998, the Company, in the Regional Property and Casualty segment, modified its catastrophe reinsurance program to include a higher retention. Under the 1998 catastrophe reinsurance program, the Company retains the first $45.0 million. For losses in excess of $45.0 million and up to $180.0 million, the Company, in the Regional Property and Casualty segment, retains 10% of the loss. Amounts in excess of $180.0 million are retained 100% by the Company, in the Regional Property and Casualty segment. The casualty reinsurance program for 1998 is consistent with the program utilized in 1997. 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 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 CAR and MCCA. The reserve for losses and loss adjustment expenses at December 31, 1997 and 1996 is shown gross of recoverable on unpaid losses of $576.7 million and $626.9 million, respectively. The 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 servicing carrier business. The decrease at Citizens in 1997 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 $120.6 million, $2.2 million and $229.1 million in 1997, 1996 and 1995, respectively. Earned premiums ceded were $195.1 million, $232.6 million and $296.2 million in 1997, 1996 and 1995, respectively. 13 Reference is made to "Reinsurance" in Note 16 on pages 71 and 72 of the Notes to Consolidated Financial Statements of the 1997 Annual Report to Shareholders, which is incorporated herein by reference. Reference is also made to "Reinsurance Facilities and Pools" on pages 7 and 8 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, 1997, this segment insured and/or provided administrative services to the employee benefit plans of over 2,700 employers covering 630,467 employee lives. For the year ended December 31, 1997, this segment accounted for approximately $396.1 million, or 11.7%, of consolidated revenues and $19.3 million, or 6.4%, of consolidated income before taxes. The Company's strategy emphasizes risk sharing and administrative services only 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 and administrative service arrangements, the segment has demonstrated more stable profitability by decreasing its exposure to unpredictable increases in health care costs. The Company continues to leverage the CRMS segment's managed care and claims management expertise to capitalize on opportunities with its Regional Property and Casualty segment affiliates. Legislation in many states permits 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 utilized CRMS' expertise in medical management and claims processing for its Regional Property and Casualty segment's workers' compensation business and the medical component of its automobile insurance business. Health care and other claims professionals 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 now manages medical claims covered by workers' compensation, automobile insurance and health benefit plans. The Company's capability of providing 24-hour managed care to effectively manage claims for both casualty and health benefit products has demonstrated reduced costs, serves its customers more efficiently and is a competitive advantage. In addition, the Company is focusing on its integrated claims handling and claims management services provided to employers through its MedCompONE product. MedCompONE is a totally integrated claim management program designed to minimize the overall costs of occupational and non-occupational illness and injury. MedCompONE can be provided as a service only agreement or in conjunction with the Company's stop loss or fully insured indemnity coverage. 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 health care costs and the underlying risks which are assumed by employers. In order to enhance sales of these products, each product is available as part of a full service package or on a stand-alone basis. On January 1, 1998, the Company assumed a block of the Affinity Group Underwriter business consisting of life, disability, and medical coverages written and administered through several Third Party Administrators ("TPAs") in order to expand the marketing possibilities for CRMS' life and health and property and casualty products. 14 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 managed care reform, and patient protection and advocacy. State and federal legislation adopted over the past few years generally limits the flexibility of insurers with respect to underwriting practices for small employer plans that contain less than 50 employees, provides for crediting previous coverage for the purposes of determining pre-existing conditions, and limits the ability to medically underwrite individual risks in the group market. In addition, several states have enacted managed care reform legislation which may change managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that utilize managed care programs or market health insurance to small employers will continue. However, the Company's rating, underwriting practices, and managed care programs are consistent with the objectives of current reform initiatives. For example, the Company does not experience rate small cases, nor does it refuse coverage to eligible individuals because of medical histories. Also, its managed care programs provide for coverage outside of the preferred network and allow for open communication between a doctor and his/her patient. Because of its emphasis on managed care and risk sharing partnerships, management believes that it will continue to be able to operate effectively in the event of further reform, even if specific states expand the existing limitations. The Company believes that the proposed federal and state health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurer's flexibility and restrict the profitability of health insurers and managed care providers. The Company cannot predict whether any of the current proposals will be enacted or access the particular impact such proposals may have on the Company's Corporate Risk Management Services' business. Products The following table summarizes premiums by product line for the CRMS segment for the years ended December 31.
1997 1996 1995 ------ ------ ------ (IN MILLIONS) Health Medical Fully insured...................................... $ 41.9 $ 40.6 $ 44.6 Risk sharing....................................... 81.1 83.2 83.0 Dental Fully insured...................................... 30.0 21.3 13.1 Risk sharing....................................... 2.4 2.7 2.8 Short-term disability Fully insured...................................... 6.8 6.5 5.5 Risk sharing....................................... 0.3 0.5 0.5 Long-term disability Fully insured...................................... 9.2 8.5 9.0 Reinsurance assumed (1)................................ 69.3 57.5 44.9 Stop loss (2).......................................... 31.0 26.4 21.4 ------ ------ ------ Total health........................................... 272.0 247.2 224.8 Accidental death & dismemberment....................... 5.3 5.0 4.5 Other reinsurance assumed.............................. 5.5 0.4 1.1 Life................................................... 50.2 50.3 42.3 ------ ------ ------ Total CRMS premiums.................................... $333.0 $302.9 $272.7 ====== ====== ====== ASO (3)................................................ $ 27.6 $ 23.8 $ 18.7 ====== ====== ====== Total premiums and premium equivalents................. $936.3 $884.3 $786.1 ====== ====== ======
- -------- (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. 15 (2) Represents premiums primarily related to customized products sold to customers providing for stop loss coverage only or in conjunction with administrative services. (3) Administrative services only ("ASO") fees are included in other income in the financial information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Annual Report to Shareholders, which is incorporated herein by reference. 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. AD&D 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 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, 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 40 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 distribution through growth and leverage of its existing non-traditional distribution channels. The Company focuses on three distribution channels to enhance the growth of its non-medical insurance coverages. 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. 16 Reinsurance The Company purchases reinsurance for the CRMS segment's group life insurance, AD&D, group health, stop-loss and occupational accident coverages. The Company retains a maximum 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 insurer 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 substantially all of its long term disability payments, covering a specific percent, which generally approximates 50%, of each long term disability policy. Additionally, the Company purchases reinsurance for medical claims involving certain 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, 1997, the Company ceded approximately $93.9 million of premiums associated with its aggregate stop loss policies and approximately $10.3 million of premiums for the remaining direct insurance coverages. As of December 31, 1997, 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 17 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 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. RETIREMENT AND ASSET ACCUMULATION ALLMERICA FINANCIAL SERVICES General The Allmerica 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 625 agents, to mutual funds for their variable annuity customers, and on a wholesale basis to financial planners and broker-dealers. For the year ended December 31, 1997, the Allmerica Financial Services segment accounted for $470.6 million, or 13.9%, of consolidated revenues and $87.4 million, or 28.9%, 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 alternative distribution channels. The Company's primary distribution system in this segment is its career agent sales force. Virtually all of the Company's career agents are registered broker-dealer representatives, licensed to sell all of Allmerica Financial Services 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"). New deposits of these alternative distribution channels have grown from 35.9% of statutory annuity premiums and deposits in 1995 to 66.4% in 1997. 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 18 presentations and seminar programs to address different client needs. In order to identify a favorable prospective 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 1997, the Company delivered approximately 400 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 re-balancing capabilities and graphical quarterly report statements which are used to establish and monitor the desired mix of investments by individual contract and policyholders. According to 1997 A.M Best's Policy Reports, the Company is among the twenty largest writers of individual variable annuity contracts and individual variable universal life insurance policies in the United States in 1996, based on statutory premiums and deposits. Sales of variable products represented approximately 94.8%, 89.7% and 84.1% of this segment's statutory premiums and deposits in 1997, 1996 and 1995, respectively. From 1995 to 1997, income before taxes from this segment improved $52.2 million, from $35.2 million to $87.4 million. Statutory premiums and deposits, a common industry benchmark for sales achievement, totaled $2,733.3 million, $1,616.9 million and $1,060.8 million in 1997, 1996 and 1995, respectively. Currently, under the Internal Revenue 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, however, such proposals or similar proposals are currently under consideration by Congress. 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. The Company cannot predict the impact of such effects. 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 1997, 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.
1997 1996 1995 -------- -------- -------- (IN MILLIONS) Statutory Premiums and Deposits Variable universal life........................ $ 148.8 $ 117.2 $ 90.4 Separate account annuities..................... 2,186.1 1,160.9 647.8 General account annuities...................... 234.7 147.9 128.8 Retirement investment account annuities........ 21.8 24.5 25.6 Universal life................................. 60.7 71.6 77.2 Traditional life............................... 58.4 61.9 59.1 Individual health.............................. 22.8 32.9 31.9 -------- -------- -------- Total premiums and deposits.................. $2,733.3 $1,616.9 $1,060.8 ======== ======== ========
19 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. 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 41 in 1995 to 69 in 1997, 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 625 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. The Company also regularly conducts comprehensive financial planning seminars and face-to-face presentations to address different investment objectives of clients. 20 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 300 distribution firms employing over 45,000 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 1997, total statutory premiums and deposits from sales of variable annuities through these channels totalled $1,621.6 million, compared to $287.8 million in 1995. 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 1997 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 2.6% of this segment's total statutory life insurance premiums in 1997. With respect to life policies of the Allmerica 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 $2.0 million per life, with certain restrictions that determine the binding authority with the various reinsurers. For life policies greater than $8.0 million, the Company obtains facultative reinsurance. Prior to issuing facultative reinsurance, the facultative reinsurer reviews all of the underwriting information relating to the 21 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 $2.0 million which do not satisfy the Company's underwriting guidelines. The Company seeks to enter into reinsurance treaties with highly rated reinsurers. In 1997, the two largest reinsurers for life insurance in this segment, Connecticut General and St. Louis Re, represented 51.5% of this segment's life reinsurance ceded based upon statutory premium in that year. All of the reinsurers utilized by this segment have received an A.M. Best rating of "A- (Excellent)" or better (Best's Insurance Reports, 1997 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. 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 $50.0 million and the maximum pool reinsurance available for a single event is $125.0 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. 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. In 1997, the Company entered into a 100% coinsurance agreement with Metropolitan Life Insurance Company to reinsure substantially all of its individual disability income business. Effective January 1, 1998, the Company entered into an agreement with Reinsurance Group of America, Inc. to reinsure the mortality risk on the universal life and variable universal life lines of business. Management believes that this agreement will not have a material effect on the results of operations or financial position of the Company. 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, 1997, there were approximately 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 substantially all of its agents and its reputation in the insurance industry enable it to compete effectively in the markets in which it operates. 22 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 Guaranteed Investment Contracts ("GICs") and annuities to corporate retirement plans. During 1997, the Company began offering GICs beyond the corporate retirement market, into the non-qualified market which includes money market funds, corporate cash management programs and securities lending collateral programs. The Company conducts its operations in this segment through FAFLIC and its subsidiaries. For the year ended December 31, 1997, this segment accounted for approximately $243.4 million, or 7.2%, of consolidated revenues, and income before taxes of $62.4 million, or 20.6%, of consolidated income before taxes. 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 and defined contribution retirement plans. Currently, the Company provides administration and recordkeeping for approximately 611 qualified pension and profit sharing plans which have assets totaling $2.9 billion and cover approximately 117,000 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 178 plans with aggregate assets under management of $1.0 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. 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 and defined contribution 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 GICs; the traditional GIC and 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. 23 In 1997, the Company expanded its offering of GICs to include non-qualified GICs. These non-qualified GICs, often referred to as "Funding Agreements" or "floating rate GICs", typically provide for a guaranteed interest rate which is associated with an interest rate index, such as LIBOR, with the accrued interest periodically being paid out and the interest rate reset on predetermined dates. No other withdrawals are permitted prior to maturity. Typical maturities are one year or less, but most arrangements provide for repeated extensions of the maturity upon mutual agreement of both parties. During 1997, total traditional GIC sales were less than $10.0 million and floating rate GIC sales were approximately $250 million. There were no sales of synthetic GICs. The continued low volume of traditional and synthetic GIC sales reflects the Company's decision to sell these products only when the profit margins meet the Company's standards. Approximately $225 million of the floating rate GIC sales occurred in the fourth quarter of 1997. The Company expects sales growth with respect to the floating rate GICs to continue during 1998. Other Services Through this segment, the Company also offers telemarketing services to retail and financial clients, which utilize experienced telemarketing management and program execution. Distribution The Company distributes retirement products through a dedicated sales force 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. The recordkeeping function is outsourced to a third party administrator. INVESTMENT PORTFOLIO General At December 31, 1997, the Company held $9.7 billion of investment assets, including $768.7 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. 24 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. 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 20 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 1997, 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 held by the Company's insurance subsidiaries are subject to diversification requirements under insurance laws. 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, Allmerica 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. FAFLIC, AFLIAC, Hanover and Citizens all received an A.M. Best financial condition rating of A (Excellent) in 1997. FAFLIC and AFLIAC were given Duff & Phelps claims-paying ability ratings of AA (Very High) in August 1997. FAFLIC, AFLIAC and Hanover were given Moody's financial strength ratings of A1 (Good) in November 1997. In October 1997, Standard and Poor's upgraded its claims-paying ability rating for FAFLIC and AFLIAC to AA- (Excellent) from A+ (Good). Hanover, together with its subsidiaries, including Citizens Insurance, was given an AA- (Excellent) S&P claims-paying ability rating. 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 6,300 employees located throughout the country. Management believes relations with employees and agents are good. 25 ITEM 2 PROPERTIES The Company's headquarters are located at 440 Lincoln Street, Worcester, Massachusetts and consist primarily of approximately 758,000 rentable square feet of office and conference space owned in fee and include the headquarters of Hanover. Citizens owns its home office, located at 645 W. Grand River, Howell, Michigan, which is approximately 119,000 rentable square feet. Citizens also owns a three-building complex located at 808 North Highlander Way, Howell, Michigan, with 156,000 rentable 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. ITEM 3 LEGAL PROCEEDINGS Reference is made to Note 20 on page 74 of the Notes to Consolidated Financial Statements of the 1997 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. 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 July 1997, a lawsuit was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and refiled the action in Federal District Court in Worcester, Massachusetts. The plaintiffs seek to be certified as a class. The case is in early stages of discovery and the Company is evaluating the claims. Although the Company believes it has meritorious defenses to plaintiffs' claims, there can be no assurance that the claims will be resolved on a basis which is satisfactory to the Company. 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. Although the Company believes that adequate reserves have been established for any additional liability, there can be no assurance that the appeal will be resolved on a basis which is satisfactory to the Company. 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. 26 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. 27 PART II ITEM 5 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS COMMON STOCK AND SHAREHOLDER OWNERSHIP The common stock of Allmerica Financial Corporation is traded on the New York Stock Exchange under the symbol "AFC". On March 13, 1998, the Company had 62,233 shareholders of record and 60.0 million shares outstanding. On the same date, the trading price of the Company's common stock was $63 3/4 per share. COMMON STOCK PRICES AND DIVIDENDS
HIGH LOW DIVIDENDS ---- ---- --------- 1997 First Quarter....................................... $40 1/4 $32 5/8 $0.05 Second Quarter...................................... $40 3/8 $33 1/2 $0.05 Third Quarter....................................... $45 1/4 $39 1/4 $0.05 Fourth Quarter...................................... $ 51 $42 7/8 $0.05 1996 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
1998 DIVIDEND SCHEDULE Allmerica Financial Corporation declared a cash dividend of $0.05 per share on December 16, 1997, which was paid on February 16, 1998. The record date for such dividend was February 2, 1998. Dividends paid by the Company may be funded from dividends paid to the Company from its subsidiaries. Dividends from insurance subsidiaries are subject to restrictions imposed by state insurance laws and regulations. Reference is made to "Liquidity and Capital Resources" on pages 42-43 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 1997 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 25 of the 1997 Annual Report to Shareholders, which is incorporated herein by reference. 28 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 26-45 of the 1997 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 47-50 and the accompanying Notes to Consolidated Financial Statements on pages 51-75 of the 1997 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 75), which is incorporated herein by reference. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 29 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE REGISTRANT Information regarding Directors of the Company is incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 12, 1998, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below is biographical information concerning the executive officers of the Company. JOHN F. O'BRIEN, 54 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 and Director of FAFLIC since October 1984 and April 1996, respectively. In addition, Mr. Anderson is a director and/or executive officer at various other non-public affiliates. RICHARD J. BAKER, 66 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 Secretary of FAFLIC from 1973 to April 1996, Vice President and Assistant Secretary since April 1996, 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. ROBERT E. BRUCE, 47 Vice President of the Company since July 1997 Mr. Bruce has been Vice President of AFC and Citizens since July 1997 and Vice President and Director of Citizens and Hanover since August 1997. In addition, Mr. Bruce has served as Vice President and Director of FAFLIC since May 1995 and August 1997, respectively, and Chief Information Officer of FAFLIC since February 1997. Mr. Bruce is also a director and/or executive officer at various other non-public affiliates. Prior to joining FAFLIC in May 1995, Mr. Bruce was Corporate Manager at Digital Equipment Corporation, a computer manufacturer, from May 1979 to March 1995. JOHN P. KAVANAUGH, 43 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 30 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. JOHN F. KELLY, 59 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 and Director of FAFLIC since April 1996. 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, 50 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 Director 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. In addition, Mr. May is a director and/or executive officer at various other non-public affiliates. JAMES R. MCAULIFFE, 53 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, 38 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. RICHARD M. REILLY, 59 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 31 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. 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. ERIC A. SIMONSEN, 52 Vice President of the Company since February 1995 Mr. Simonsen has been Vice President of AFC since February 1995. He has been a Vice President of APY since August 1992, of Citizens since December 1992 and of AFLIAC since September 1990. He also served as a director of APY from August of 1992 to July 1997. In addition, 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 Services Corporation 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. PHILLIP E. SOULE, 48 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. ITEM 11 EXECUTIVE COMPENSATION Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 12, 1998, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 12, 1998, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 12, 1998, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. 32 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 47 through 75 of the 1997 Annual Report to Shareholders have been incorporated herein by reference in their entirety.
ANNUAL REPORT PAGE(S) ------- Report of Independent Accountants.................................. 46 Consolidated Statements of Income for the years ended December 31, 1997, 1996 and 1995............................................... 47 Consolidated Balance Sheets as of December 31, 1997 and 1996....... 48 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995.................................. 49 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995..................................................... 50 Notes to Consolidated Financial Statements......................... 51-75
(A)(2) FINANCIAL STATEMENT SCHEDULES
PAGE NO. IN SCHEDULE THIS REPORT -------- ----------- Report of Independent Accountants on Financial Statement Schedules.................................... 39 Summary of Investments--Other than Investments in I Related Parties........................................ 40 II Condensed Financial Information of Registrant.......... 41-43 III Supplementary Insurance Information.................... 44-46 IV Reinsurance............................................ 47 V Valuation and Qualifying Accounts...................... 48 Supplemental Information concerning Property/Casualty VI Insurance Operations................................... 49
(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.+++++ 4.5 Series A Capital Securities Guarantee Agreement dated February 3, 1997.+++++ 4.6 Common Securities Guarantee Agreement dated February 3, 1997.+++++
33 4.7 Registration Rights Agreement dated February 3, 1997.+++++ 4.8 Rights Agreement dated as of December 16, 1997, between the Registrant and First Chicago Trust Company of New York as Rights Agent, filed as Exhibit 1 to the Company's Form 8-A dated December 17, 1997 is incorporated herein by reference. 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 Amended and Restated Form of Non-Solicitation Agreement executed by substantially all of the executive officers of AFC incorporated by reference to Exhibit 10.21 to the Allmerica Financial Corporation June 30, 1997 report on Form 10-Q and incorporated herein by reference.
34 10.22 Credit agreement dated as of June 17, 1997 between the Registrant and the Chase Manhattan Bank incorporated by reference to Exhibit 10.22 to the Allmerica Financial Corporation June 30, 1997 report on Form 10-Q and incorporated herein by reference. 10.23 Amended Allmerica Financial Corporation Long-Term Stock Incentive Plan. 10.24 The Allmerica Financial Corporation Director Stock Ownership Plan incorporated by reference to Exhibit 10.21 to the Allmerica Financial Corporation June 30, 1996 report on Form 10-Q and incorporated herein by reference. 10.25 Reinsurance Agreement dated September 29, 1997 between First Allmerica Financial Life Insurance Company and Metropolitan Life Insurance Company. 10.26 Consolidated Service Agreement between Allmerica Financial Corporation and its subsidiaries, dated January 1, 1998. 10.27 Deferral Agreement, dated April 4, 1997, between Allmerica Financial Corporation and John F. O'Brien. 10.28 Severance Agreement, dated September 25, 1997, between First Allmerica Financial Life Insurance Company and Larry C. Renfro. 11 Statement regarding computation of per share earnings. 13 The following sections of the Annual Report to Shareholders for 1997 ("1997 Annual Report") which are expressly incorporated by reference into this Annual Report on Form 10-K: . Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 26 through 45 of the 1997 Annual Report. . Consolidated Financial Statements and Notes thereto at pages 47 through 75 of the 1997 Annual Report. . Independent Auditors' Report at page 46 of the 1997 Annual Report. . The information appearing under the caption "Five Year Summary of Selected Financial Highlights" at page 25 of the 1997 Annual Report. . The information appearing under the caption "Shareholder Information" at page 77 of the 1997 Annual Report. 21 Subsidiaries of AFC. 23 Consent of Price Waterhouse LLP. 24 Power of Attorney. 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. ++++++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1996 Annual Report on Form 10-K originally filed with the Commission on March 24, 1997. 35 (B) REPORTS ON FORM 8-K On December 17, 1997, the Registrant filed a report on Form 8-K relating to the declaration by its Board of Directors of one purchase right for every outstanding share of its common stock, $.01 par value (the "Rights"). The Rights were distributed to stockholders of record as of the close of business on December 29, 1997. The terms of the Rights are set forth in a Rights Agreement dated as of December 16, 1997 (the "Rights Agreement") between the Registrant and First Chicago Trust Company of New York. The Rights Agreement also provides for the issuance of one Right for every share of Common Stock which is issued or sold after that date. 36 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, 1998 /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, 1998 /s/ John F. O'Brien By: _________________________________ JOHN F. O'BRIEN, CHAIRMAN OF THE BOARD, CHIEF EXECUTIVE OFFICER AND PRESIDENT Date: March 18, 1998 /s/ Edward J. Parry, III By: _________________________________ EDWARD J. PARRY III, VICE PRESIDENT, CHIEF FINANCIAL OFFICER, TREASURER AND PRINCIPAL ACCOUNTING OFFICER Date: March 18, 1998 * By: _________________________________ MICHAEL P. ANGELINI, DIRECTOR Date: March 18, 1998 * By: _________________________________ GAIL L. HARRISON, DIRECTOR Date: March 18, 1998 * By: _________________________________ ROBERT P. HENDERSON, DIRECTOR Date: March 18, 1998 * By: _________________________________ M HOWARD JACOBSON, DIRECTOR 37 Date: March 18, 1998 By: _________________________________ J. TERRENCE MURRAY, DIRECTOR Date: March 18, 1998 * By: _________________________________ ROBERT J. MURRAY, DIRECTOR Date: March 18, 1998 * By: _________________________________ JOHN L. SPRAGUE, DIRECTOR Date: March 18, 1998 * By: _________________________________ ROBERT G. STACHLER, DIRECTOR Date: March 18, 1998 * By: _________________________________ HERBERT M. VARNUM, DIRECTOR Date: March 18, 1998 * By: _________________________________ RICHARD M. WALL, DIRECTOR /s/ John F. O'Brien *By: ________________________________ JOHN F. O'BRIEN, ATTORNEY-IN-FACT 38 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, 1998, appearing in the Allmerica Financial Corporation 1997 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. /s/ Price Waterhouse LLP _____________________________________ Price Waterhouse LLP Boston, Massachusetts February 3, 1998 39 SCHEDULE I ALLMERICA FINANCIAL CORPORATION SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1997
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 ................ $ 293.5 $ 302.8 $ 302.8 States, municipalities and political subdivisions ............................ 2,200.6 2,275.8 2,275.8 Foreign governments ...................... 111.6 118.0 118.0 Public utilities ......................... 384.9 397.4 397.4 All other corporate bonds ................ 3,802.3 3,949.5 3,949.5 Redeemable preferred stocks ................ 260.0 270.2 270.2 --------- ------- --------- Total fixed maturities ................... 7,052.9 7,313.7 7,313.7 --------- ------- --------- Equity securities: Common stocks: Public utilities ......................... 4.3 4.6 4.6 Banks, trust and insurance companies ..... 35.9 62.5 62.5 Industrial, miscellaneous and all other .. 281.3 395.1 395.1 Nonredeemable preferred stocks ............. 19.6 16.8 16.8 --------- ------- --------- Total equity securities .................. 341.1 479.0 479.0 --------- ------- --------- Mortgage loans on real estate ................ 567.5 XXXXXX 567.5 Real estate (2) .............................. 50.3 XXXXXX 50.3 Policy loans ................................. 141.9 XXXXXX 141.9 Other long-term investments .................. 148.3 XXXXXX 148.3 --------- --------- Total investments ........................ $ 8,302.0 XXXXXX $ 8,700.7 ========= =========
- -------- (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 $35.8 million of real estate acquired through foreclosure. 40 SCHEDULE II ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995 ------ ------ ------ (IN MILLIONS) Revenues Net investment income............................... $ 11.4 $ 2.7 $ 0.4 Net realized investment losses...................... (0.2) (0.9) -- ------ ------ ------ Total revenues.................................... 11.2 1.8 0.4 ------ ------ ------ Expenses Interest expense.................................... 41.1 15.3 3.2 Operating expenses.................................. 5.0 3.3 0.3 ------ ------ ------ Total expenses.................................... 46.1 18.6 3.5 ------ ------ ------ Net income before federal income taxes and equity in net income of unconsolidated subsidiaries............ (34.9) (16.8) (3.1) Income tax benefit: Federal............................................. 11.8 5.9 -- State............................................... 0.5 -- -- Equity in net income of unconsolidated subsidiaries prior to demutualization............................. -- -- 93.2 Equity in net income of unconsolidated subsidiaries subsequent to demutualization........................ 231.8 192.8 43.8 ------ ------ ------ Net income............................................ $209.2 $181.9 $133.9 ====== ====== ======
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. 41 SCHEDULE II (CONTINUED) ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY BALANCE SHEETS
DECEMBER 31, --------------------------- 1997 1996 ------------- ------------- (IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA) ASSETS Fixed maturities-at fair value (amortized cost of $3.4)........................................... $ 3.5 $ 26.2 Equity securities-at fair value.................. -- 0.6 Cash............................................. 0.9 2.5 Investment in unconsolidated subsidiaries........ 2,898.7 1,896.3 Accrued investment income........................ 0.1 0.4 Other assets..................................... 4.7 5.1 ------------- ------------- Total assets................................... $2,907.9 $1,931.1 ============= ============= LIABILITIES Expenses and taxes payable....................... $ 2.0 $ 1.1 Deferred income taxes............................ -- -- Dividends payable................................ 3.0 2.5 Interest payable................................. 12.8 3.3 Long-term debt................................... 508.8 199.5 ------------- ------------- Total liabilities.............................. 526.6 206.4 ------------- ------------- 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, 60.0 million and 50.1 million shares issued and outstanding at Decem- ber 31, 1997 and December 31, 1996, respective- ly.............................................. 0.6 0.5 Additional paid-in capital....................... 1,755.1 1,382.5 Unrealized appreciation on investments, net...... 217.3 131.6 Retained earnings................................ 408.3 210.1 ------------- ------------- Total shareholders' equity..................... 2,381.3 1,724.7 ------------- ------------- Total liabilities and shareholders' equity..... $2,907.9 $1,931.1 ============= =============
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 42 SCHEDULE II (CONTINUED) ALLMERICA FINANCIAL CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995 ------- ------- ------- (IN MILLIONS) Cash flows from operating activities Net income, including net income prior to demutualization................................... $ 209.2 $ 181.9 $ 133.9 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed income of subsidiaries.... (231.8) (192.8) (137.0) Net realized investment losses.................... 0.2 0.9 -- Change in accrued investment income............... 0.3 (0.2) (0.2) Change in expenses and taxes payable.............. 0.9 0.9 0.2 Change in dividends payable....................... 0.5 -- 2.5 Change in debt interest payable................... 9.5 0.1 3.2 Other, net........................................ (0.6) (3.6) (2.5) ------- ------- ------- Net cash (used in) provided by operating activi- ties............................................... (11.8) (12.8) 0.1 ------- ------- ------- Cash flows from investing activities Capital contributed to unconsolidated subsidiar- ies............................................... (79.9) -- (392.4) Proceeds from disposals and maturities of available-for-sale fixed maturities............... 98.7 32.7 -- Purchase of available-for-sale fixed maturities.... (74.9) (59.6) -- Purchase of minority interest in Allmerica P&C..... (425.6) -- -- Proceeds from sale of common stock of subsidiary... 195.0 -- -- Purchase of equity securities...................... -- (0.7) -- ------- ------- ------- Net cash used in investing activities............... (286.7) (27.6) (392.4) ------- ------- ------- Cash flow from financing activities Increase in long-term debt......................... 9.3 -- -- Net proceeds from issuance of common stock......... 2.8 -- 248.0 Proceeds from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company......................... 296.3 -- -- Net proceeds from issuance of debt securities...... -- -- 197.2 Dividends paid to shareholders..................... (11.5) (10.0) -- ------- ------- ------- Net cash provided by (used in) financing activi- ties............................................... 296.9 (10.0) 445.2 ------- ------- ------- Net change in cash and cash equivalents............. (1.6) (50.4) 52.9 Cash and cash equivalents at beginning of the peri- od................................................. 2.5 52.9 -- ------- ------- ------- Cash and cash equivalents at end of the period...... $ 0.9 $ 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. 43 SCHEDULE III ALLMERICA FINANCIAL CORPORATION SUPPLEMENTARY INSURANCE INFORMATION DECEMBER 31, 1997
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.... $167.2 $2,615.4 $838.3 $ 10.8 $1,953.1 $255.7 $1,445.5 $413.2 $210.2 $1,991.8 Corporate Risk Management Services........ 2.9 331.4 6.3 9.2 333.0 22.7 238.9 3.3 134.8 -- RETIREMENT AND ASSET ACCUMULATION Allmerica Finan- cial Services... 788.0 2,193.8 2.2 104.8 24.0 183.5 195.2 5.7 182.3 -- Institutional Services........ 7.4 283.1 -- 1,727.9 1.0 180.9 125.1 2.9 53.0 -- Allmerica Asset Management...... -- -- -- -- -- 0.2 -- -- 7.3 -- Corporate........ -- -- -- -- -- 11.5 -- -- 22.6 -- Eliminations..... -- -- -- -- -- (1.1) -- -- (9.9) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $965.5 $5,423.7 $846.8 $1,852.7 $2,311.1 $653.4 $2,004.7 $425.1 $600.3 $1,991.8 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
44 SCHEDULE III (CONTINUED) 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 $409.2 $206.3 $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 ACCUMULATION Allmerica Finan- cial 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 $470.1 $518.8 $1,914.4 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
45 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 $409.7 $192.7 $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 ACCUMULATION Allmerica Finan- cial 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 $470.9 $471.8 $1,885.3 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
46 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) 1997 Life insurance in force $44,902.9 $7,237.1 $308.9 $37,974.7 0.81% ========= ======== ====== ========= ===== Premiums: Life insurance............ $ 70.0 $ 15.6 $ 8.7 $ 63.1 13.79% Accident and health insur- ance..................... 347.4 154.5 102.0 294.9 34.59% Property and casualty in- surance.................. 2,046.2 195.1 102.0 1,953.1 5.22% --------- -------- ------ --------- Total premiums.............. $2,463.6 $ 365.2 $212.7 $ 2,311.1 9.20% ========= ======== ====== ========= ===== 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 9.87% Accident and health insur- ance..................... 317.1 120.8 81.9 278.2 29.44% Property and casualty in- surance.................. 2,018.5 232.6 112.4 1,898.3 5.92% --------- -------- ------ --------- Total premiums.............. $ 2,407.6 $ 371.5 $200.2 $ 2,236.3 8.95% ========= ======== ====== ========= ===== 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 insur- ance..................... 307.5 116.5 69.2 260.2 26.59% Property and casualty in- surance.................. 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% ========= ======== ====== ========= =====
47 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) 1997 Mortgage loans.......... $19.6 $ 2.5 $-- $ 1.4 $20.7 Real estate............. 14.9 6.0 -- 20.9 -- Allowance for doubtful accounts............... 4.5 5.7 -- 4.1 6.1 ----- ----- ---- ----- ----- $39.0 $14.2 $-- $26.4 $26.8 ===== ===== ==== ===== ===== 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 ===== ===== ==== ===== =====
48 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 1997................... $167.2 $2,615.4 $-- $838.3 $1,953.1 $255.7 ====== ======== ==== ====== ======== ====== 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 ====== ======== ==== ====== ======== ======
LOSSES AND LOSS ADJUSTMENT EXPENSES ------------------------ AMORTIZATION OF DEFERRED PAID LOSSES POLICY AND LOSS ACQUISITION ADJUSTMENT NET PREMIUMS CURRENT YEAR PRIOR YEARS EXPENSES EXPENSES WRITTEN ------------ ----------- ------------ ----------- ------------ 1997......... $1,564.1 $(127.9) $413.2 $1,507.2 $1,991.8 ======== ======= ====== ======== ======== 1996......... $1,513.3 $(141.4) $409.2 $1,387.2 $1,914.4 ======== ======= ====== ======== ======== 1995......... $1,427.3 $(137.6) $409.7 $1,266.5 $1,885.3 ======== ======= ====== ======== ========
- -------- (1) The Company does not employ any discounting techniques. (2) Reserves for losses and loss adjustment expenses are shown gross of $576.7 million, $626.9 million and $763.5 million of reinsurance recoverable on unpaid losses in 1997, 1996 and 1995, respectively. Unearned premiums are shown gross of prepaid premiums of $30.0 million, $45.5 million and $43.8 million in 1997, 1996 and 1995, respectively. 49 LOGO AFC9610K EX-10.23 2 AMENDED LONG-TERM STOCK INCENTIVE PLAN Exhibit 10.23 ALLMERICA FINANCIAL CORPORATION LONG-TERM STOCK INCENTIVE PLAN Section 1. Purpose. The Allmerica Financial Long-Term Stock Incentive --------- ------- Plan (the "Plan") has been adopted to encourage and create significant ownership of the Company's Common Stock among executive officers, other key employees and certain insurance agents and brokers of the Company and its Subsidiaries and Affiliates. The Plan may be adopted by any Subsidiary of the Company, including, but not limited to, First Allmerica Financial Life Insurance Company, The Hanover Insurance Company and Citizens Insurance Company of America. Any Subsidiary adopting the Plan agrees to adhere to the terms and conditions of the Plan as set forth below. Additional purposes of the Plan include: (a) To provide a meaningful incentive to Participants for making substantial contributions to the Company's long-term business growth; (b) To enhance the Company's and its Subsidiaries' ability to attract and retain executive officers, other key employees and certain insurance agents and brokers who will make such contributions; and (c) To closely align the interests of these executive officers and other key employees with those of Company stockholders by providing opportunities for them to obtain significant longer term rewards through stock ownership. Section 2. Definitions. --------- ----------- (a) "Affiliate" means any entity, other than a Subsidiary, that is directly or indirectly controlled by the Company or in which the Company has a significant equity interest as determined by the Committee. (b) "Award" means any Stock Option, Stock Appreciation Right or Stock Award granted under the Plan. (c) "Board" means the Company's Board of Directors. (d) "Cause" shall mean (i) the willful failure by the Participant to - perform substantially the Participant's duties as an employee of the Company (other than due to physical or mental illness), (ii) the Participant's engaging -- in serious misconduct that is injurious to the Company, any Subsidiary or any Affiliate, (iii) the Participant's having been convicted of, or entered a plea --- of nolo contendere to, a crime that constitutes a felony, (iv) the breach by the -- Participant of any written or unwritten covenant or agreement not to compete with the Company, any Subsidiary or any Affiliate or (v) the breach by the - Participant of his or her duty of loyalty to the Company, any Subsidiary or any Affiliate. (e) "Change in Control" means the occurrence of any of the following events: (i) the members of the Board at the beginning of any consecutive twenty- - four calendar month period (the "Incumbent Directors") cease for any reason other than due to death or retirement 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 a least a majority of the members of the Board at the beginning of such twenty-four calendar month period 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, any of its Subsidiaries, any employee benefit plan of the Company or any of its Subsidiaries) 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; or (iii) the stockholders of the Company --- 53 shall approve a definitive agreement (1) for the merger or other business - combination of the Company with or into another corporation, a majority of the directors of which were not directors of the Company immediately prior to the merger or other business combination and in which the stockholders of the Company immediately prior to the effective date of such merger or other business combination own less than 50% of the voting power in such corporation or (2) for - the sale or other disposition of all or substantially all of the assets of the Company. (f) "Change in Control Price" means the highest price per Share offered in conjunction with any transaction resulting in a Change in Control (as determined in good faith by the Committee if any part of the offered price is payable other than in cash) or, in the case of a Change in Control occurring solely by reason of a change in the composition of the Board, the highest Fair Market Value of the Stock on any of the 30 trading days immediately preceding the date on which a Change in Control occurs. (g) "Code" means the Internal Revenue Code of 1986, as amended from time to time. (h) "Committee" means a committee of not less than two non-employee members of the Board, appointed by the Board to administer the Plan. The Committee shall be comprised of members who qualify to administer this Plan as contemplated by Rule 16b-3 under the 1934 Act (or any successor rule thereto). (i) "Common Stock" means the common stock, par value $.01 per share, of the Company. (j) "Company" means Allmerica Financial Corporation, a corporation established under the laws of the State of Delaware. (k) "Disability" shall mean long-term disability as defined under the terms of the Company's or any Subsidiaries' applicable long term disability plans or policies. (l) "Early Retirement" with respect to a Participant shall mean retirement under any qualified pension plan maintained by the Company or any of its Subsidiaries or Affiliates at or after the earliest age at which a Participant may retire and receive an immediate, but actuarially reduced, retirement benefit under such plan. If a Participant is not a participant in such a plan, "Early Retirement" shall mean retirement at or after age 55 with at least 15 years of service with the Company or a Subsidiary. (m) "Fair Market Value" means, with respect to Common Stock, the fair market value of a Share as determined by the Committee in good faith in such manner as shall be established by the Committee from time to time; provided that at any time that the Common Stock is traded on an established securities market, Fair Market Value means the last reported sale price at which the Common Stock is traded on such date or, if no Common Stock is traded on such date, the most recent date on which Common Stock was traded, as reflected on such public market. Under no circumstances shall the Fair Market Value be less than the par value of the Common Stock. (n) "Incentive Stock Option" or "ISO" means a Stock Option to purchase Shares awarded to a Participant which is intended to meet the requirements of Section 422 of the Code or any successor provision. (o) "Non-Qualified Stock Option" or "NQSO" means a Stock Option to purchase Shares of Common Stock awarded to a Participant which is not intended to meet the requirements of Section 422 of the Code or any successor provision. (p) "1934 Act" means the Securities Exchange Act of 1934, as amended from time to time. (q) "Normal Retirement" with respect to a Participant shall mean retirement under any qualified pension plan maintained by the Company or any of its Subsidiaries or Affiliates at or after the earliest age at which a Participant may retire and receive a retirement benefit under such plan without an actuarial reduction for early commencement of benefits. If a Participant is not a participant in such a plan, "Normal Retirement" shall mean retirement at or after age 65 with no minimum service requirement. 54 (r) "Participant" means a person selected by the Committee (or its delegate as provided under Section 4) to receive an Award under the Plan. (s) "Reporting Person" means an individual who is subject to Section 16 of the 1934 Act by virtue of his or her relationship with the Company. (t) "Senior Management" means the executive officers (within the meaning of Rule 3b-7 under the 1934 Act) of the Company from time to time, whether such persons are officers of the Company or of a Subsidiary. (u) "Shares" means shares of the Common Stock of the Company. (v) "Stock Appreciation Right" or "SAR" means an Award in the form of a right to receive a payment equal to the excess of Fair Market Value as of the date of exercise over the base value of the SAR. (w) "Stock Award" means an Award to a Participant comprised of Common Stock or valued by reference to Common Stock granted under Section 7 of the Plan. (x) "Stock Option" means an Award in the form of the right to purchase a specified number of Shares at a specified price during a specified period. (y) "Subsidiary" shall mean any entity of which the Company possesses directly or indirectly fifty percent (50%) or more of the total combined voting power of all classes of stock of such entity. Section 3. Effective Date. Subject to the approval of the stockholders of --------- -------------- the Company, the Plan shall be effective as of May 22, 1996. Senior Management, however, shall not be eligible to participate until the later of the date the Board adopts the Plan with respect to Senior Management or October 17, 1996. No Awards may be made under the Plan after ten years from the effective date or earlier termination of the Plan by the Board. Section 4. Administration. The Plan shall be administered by the --------- -------------- Committee. The Committee shall have the authority to adopt, alter and repeal such administrative rules, guidelines and practices governing the operation of the Plan as it shall from time to time consider advisable. The Committee shall also have full discretion to interpret the provisions of the Plan. Any decision or action taken or to be taken by the Committee, arising out of or in connection with the construction, administration, interpretation and effect of the Plan and of its rules and regulations, shall, to the maximum extent permitted by applicable law, be within its absolute discretion (except as otherwise specifically provided herein) and shall be conclusive and binding upon all Participants and any person claiming under or through any Participant. To the extent permitted by applicable law and the provisions of the Plan, the Committee may delegate to one or more employee members of the Board the power to make Awards to Participants who are not Reporting Persons. Section 5. Eligibility. Any executive officer or other key employee --------- ----------- (including, without limitation, insurance agents, brokers and independent agents) of the Company, any Subsidiary or any Affiliates shall be eligible to receive an Award under the Plan, provided that such participation would not jeopardize (i) the Plan's compliance with Rule 16b-3 under the 1934 Act or any successor rule, and (ii) the Company's ability to register shares underlying the Plan on Registration Statements on Form S-8 pursuant to the Securities Act of 1933, as amended, or any successor form. Directors who are not employees shall not be eligible to be granted Awards under the Plan. Section 6. Stock Available for Awards. --------- -------------------------- (a) Common Shares Available. The maximum number of Shares available for ----------------------- Awards under the Plan with respect to each fiscal year the Plan is in effect will be 2.25% of the total Shares of outstanding Common Stock of the Company as of the start of each such fiscal year plus any Shares available for Awards under the Plan in prior fiscal years but not used. Shares of Common Stock underlying any Awards which are forfeited, canceled, 55 reacquired by the Company, satisfied without the issuance of Common Stock or otherwise terminated (other than by exercise) shall be added back to the Shares of Common Stock available for issuance under the Plan. (b) Share Usage Limits. For the period that the Plan is in effect, the ------------------ aggregate number of Shares that may be issued on exercise of Stock Options and as Stock Awards shall be as follows: (i) an amount equal to the sum of (a) five percent (5%) of the number of Shares outstanding at the close of business on May 20, 1997, plus (b) an amount, not to exceed 1,172,000 Shares, equal to the number of Shares underlying Awards granted under the Plan and not surrendered as of May 20, 1997; and (ii) thereafter, commencing with the annual meeting of shareholders in 1998, increasing annually the maximum number of Shares that may be issued under the Plan by an amount equal to one and one-quarter percent (1.25%) of the number of Shares outstanding at the close of business on the day of each annual meeting of shareholders for the term of the Plan. Additionally, the aggregate number of Shares that may be covered by Awards for any one Participant over the period that the Plan is in effect shall not exceed 500,000 Shares. (c) Adjustments. In the event of any stock dividend, stock split, ----------- combination or exchange of Shares, merger, consolidation, spin-off or other distribution (other than normal cash dividends) of Company assets to stockholders, or any other change affecting Shares, such proportionate adjustments, if any, as the Committee in its discretion may deem appropriate to reflect such change shall be made with respect to (i) the aggregate number of Shares that may be issued under the Plan; (ii) the number of Shares covered by each outstanding Award made under the Plan; and (iii) the option, base or purchase price per Share for any outstanding Stock Options, Stock Appreciation Rights and other Awards granted under the Plan, provided that any such actions are consistently and equitably applicable to all affected Participants. In addition, any Shares issued by the Company through the assumption or substitution of outstanding grants or grant commitments from an acquired entity shall not reduce the Shares available for issuance under the Plan. Section 7. Awards. --------- ------ (a) General. The Committee (or its delegate, as permitted under Section ------- 4), shall determine the type or types of Award(s) (as set forth below) to be made to each Participant and shall approve the terms and conditions of all such Awards in accordance with Sections 4 and 8 of the Plan. Awards may be granted singularly, in combination, or in tandem such that the settlement of one Award automatically reduces or cancels the other. Awards may also be made in replacement of, as alternatives to, or as form of payment for grants or rights under any other employee compensation plan or arrangement of the Company, including the plans of any acquired entity. (b) Stock Option. A Stock Option shall confer on a Participant the right ------------ to purchase a specified number of Shares from the Company subject to the terms and conditions of the Stock Option grant. Stock Options may be in the form of ISOs or NQSOs. The terms and conditions of ISOs shall be subject to and comply with Section 422 of the Code, or any successor provision, and any regulations thereunder. Anything in the Plan notwithstanding, no term of the Plan relating to ISOs shall be interpreted, amended or altered, nor shall any discretion or authority granted to the Committee under the Plan be so exercised, so as to disqualify the Plan or, without the consent of the optionee, any ISO granted under the Plan, under Section 422 of the Code. The Committee shall establish the option price at the time each Stock Option is awarded, provided that such price shall not be less than 100% of the Fair Market Value of the Common Stock on the date the Stock Option is granted. If a Participant owns or is deemed to own (by reason of the attribution rules applicable under Section 424(d) of the Code) more than 10% of the combined voting power of all classes of stock of the Company or any subsidiary or parent corporation and an ISO is awarded to such Participant, the option price shall not be less than 110% of the Fair Market Value at the time such ISO is awarded. The aggregate Fair Market Value at time of grant of the Shares covered by ISOs exercisable by any one optionee in any calendar year shall not exceed $100,000 (or such other limit as may be required by the Code). The maximum number of Shares that may be issued as ISOs is 2,350,000 Shares. Each Stock Option shall be exercisable at such times and subject to such terms and conditions as the Committee may specify at or after the time of grant; provided, however, that if the Committee does not establish a different exercise schedule at or after the date of grant of a Stock Option, such Stock Option shall become 56 exercisable in five approximately equal annual installments on each of the first, second, third, fourth and fifth anniversaries of the date the Stock Option is granted. A Stock Option shall not be exercisable after the expiration of ten years from the date of grant. The recipient of a Stock Option shall pay the exercise price for the Shares in cash or pursuant to such other arrangements as are satisfactory to the Committee, including, without limitation, using Shares valued at Fair Market Value on the date of exercise. The Committee may also permit Participants to have the option price delivered to the Company by a broker pursuant to an arrangement whereby the Company, upon irrevocable instructions from a Participant, delivers the exercised Shares to the broker. A Stock Option may include forfeitability contingencies based on continued employment with the Company or a Subsidiary. In addition, a violation of a continued employment provision may entitle the Company or a Subsidiary to repurchase the Shares obtained through the Stock Option at the original exercise price, without interest. Unless the Committee shall otherwise permit a Stock Option to remain exercisable for such greater or lesser period (but not beyond its otherwise stated term) as the Committee shall specify at or after the grant of such Stock Option, a Stock Option shall be exercisable following the termination of a Participant's employment with the Company and each Subsidiary and Affiliate only to the extent provided in this paragraph. If a Participant's employment terminates due to the Participant's death, Disability, Normal Retirement or Early Retirement with the consent of the Committee, the Participant (or, in the event of the Participant's death or Disability during employment or during the period during which a Stock Option is exercisable under this sentence, the Participant's beneficiary or legal representative) may exercise any Option held by the Participant at the time of such termination, regardless of whether then exercisable, for up to three years (or such greater or lesser period as the Committee shall determine at or after grant) following the date of such termination, but in no event after the date the Stock Option otherwise expires. If a Participant's employment is terminated for Cause or, if following the Participant's termination of employment, the Committee determines that the Participant's employment could have been terminated for Cause, all Stock Options held by the Participant shall immediately terminate, regardless of whether then exercisable and any Stock Option exercised by the Participant in anticipation of his/her For Cause termination shall be rescinded and the stock returned to the Company and/or its Subsidiary and the exercise price returned to the Participant. Any option exercised 60 days before notice of termination and all options exercised after notice of termination shall be considered to be exercised in anticipation of termination. (c) Stock Appreciation Rights (SARs). An SAR grant shall confer on a -------------------------------- Participant the right to receive in Shares, cash or a combination, up to the positive difference, if any, between the Fair Market Value of a designated number of Shares when the SARs are exercised and the base price of the SAR contained in the terms and conditions of the Award. The Committee shall have the authority to grant an SAR in tandem with a Stock Option, in addition to a Stock Option, or freestanding and unrelated to a Stock Option. An SAR granted in tandem or in addition to a Stock Option may be granted either at the same time as the Stock Option or at a later time. An SAR shall not be exercisable after the expiration of ten years from the date of grant. Shares issued in settlement of the exercise of SARs shall be valued at their Fair Market Value on the date of exercise. The Committee shall establish the base price of the SAR at the time the SARs are awarded; provided that the price of an SAR shall not be less than 100% of the Fair Market Value of Common Stock on the date the SAR is granted. The Committee shall determine the time or times at which or the event or events (including, without limitation, a Change in Control) upon which an SAR may be exercised in whole or in part; provided, however, that unless otherwise specified by the Committee at or after grant, an SAR granted in tandem with a Stock Option shall be exercisable at the same time or times as the related Stock Option is exercisable. (d) Stock Awards. A Stock Award shall confer on a Participant the right to ------------ acquire a specified number of Shares for a purchase price (which may be zero) or the right to receive a cash equivalent payment or a combination of both subject to the terms and conditions of the Award, which must include forfeitability contingencies based on continued employment with the Company or a Subsidiary or on meeting performance criteria or both. A Stock Award based on continued employment must have a minimum vesting period of three years from the date of the Stock Award and a Stock Award based on performance must have a minimum vesting period of one year from the date of the Stock Award. The minimum vesting provision may not, under any circumstances, be waived. A Stock Award may be in the form of Shares or share units. In no event shall more than 57 25% of the total amount of Shares available under the Plan be granted as Stock Awards. Such 25% limit shall be subject to the replenishment provision in Section 6(a). If the vesting of a Stock Award is conditioned in whole or in part upon the attainment of specified performance goals or targets (or if the vesting of a Stock Award that will vest upon the passage of time and the Participant's continued employment is accelerated upon the attainment of such goals or targets), such goals and targets shall be determined by the Committee and set forth in the specific Award agreements. Such performance goals or targets may be related to the performance of (i) the Company; (ii) a Subsidiary or an Affiliate, (iii) a division or unit of the Company, any Subsidiary or any Affiliate, (iv) the Participant or (v) any combination of the foregoing, over a performance period or periods established by the Committee. Except to the extent otherwise expressly provided herein, the Committee may, at any time and from time to time, change the performance objectives applicable with respect to any Stock Award to reflect such factors, including, without limitation, changes in a Participant's duties or responsibilities or changes in business objectives (e.g., from corporate to Subsidiary or business unit performance or vice versa), as the Committee shall deem necessary or appropriate. In making any such adjustment, the Committee shall adjust the number of Shares subject to any such Stock Award or take other appropriate actions to prevent any enlargement or diminution of the Participant's rights related to service rendered and performance attained prior to the effective date of such adjustment. Unless the Committee otherwise determines at or after grant, the rights of a Participant with respect to a Stock Award outstanding at the time of the Participant's termination of employment with the Company and each Subsidiary and Affiliate shall be determined pursuant to this paragraph. In the event that a Participant's employment terminates due to the Participant's (i) death, (ii) disability, (iii) retirement; or, (iv) early retirement with the consent of the Committee, a pro-rated portion of any unvested Shares subject to a Stock Award shall become vested based on the number of days the Participant actually worked since the date the Stock Award was granted (or in the case of any award which becomes vested in installments, since the date, if any, on which the last installment of such Stock Award became vested); provided that, in the case of an award with respect to which the restrictions will lapse, if at all, based on the attainment of performance goals or targets, such vesting shall be deferred until the end of the applicable performance period and be based on that number of Shares of such Stock Award, if any, that would have been earned based on the attainment or partial attainment of such performance goals or targets. Any portion of any Stock Award that has not vested at the date of a Participant's termination of employment (or which does not become vested until after such date under the preceding sentence) shall be forfeited as of such termination date (or, if applicable, such deferred vesting date). Section 8. General Provisions Applicable to Awards. --------- --------------------------------------- (a) Transferability and Exercisability. Unless the Committee shall permit ---------------------------------- (on such terms and conditions as it shall establish) an Award to be transferred to a member of the Participant's immediate family, a Guardian, or to a trust or similar vehicle for the benefit of such immediate family members ("Permitted Transferees"), any Award under this Plan will be non-transferable and accordingly shall not be assignable, alienable, saleable or otherwise transferable by the Participant other than by will or the laws of descent and distribution; provided, however, that in no event shall the Committee permit any Award to be transferable if the effect thereof would be to cause any other nontransferable Award to fail to qualify for the exemptive relief available under Rule 16b-3 promulgated under the 1934 Act. During the Participant's lifetime, only the Participant (or the Participant's Permitted Transferees, if any) shall be able to exercise any Stock Option or SAR awarded to the Participant. If so permitted by the Committee, a Participant may designate a beneficiary or beneficiaries to exercise the Participant's rights and receive any distribution under this Plan upon the Participant's death. (b) General Restriction. Each Award shall be subject to the requirement ------------------- that, if at any time the Committee shall determine, in its sole discretion, that the listing, registration, exemption or qualification of any Award under the Plan upon any securities exchange or under any state or federal law, or the consent or approval of any government regulatory body, is necessary or desirable as a condition of, or in connection with, the granting of such Award or the grant or settlement thereof, such Award may not be exercised or settled in whole or in part unless 58 such listing, registration, qualification, exemption, consent or approval has been effected or obtained free of any conditions not acceptable to the Committee. (c) Tax Withholding. The Company or any Subsidiary which adopts the Plan --------------- shall have the right to deduct from any settlement of an Award, including the delivery or vesting of Shares, made under the Plan, a sufficient amount to cover withholding of any federal, state or local taxes required by law or to take such other actions as may be necessary to satisfy any such withholding obligations. The Committee may require or permit Shares to be used to satisfy required tax withholding and such Shares shall be valued at their Fair Market Value on the date the tax withholding is effective. (d) Documentation of Grants. Awards made under the Plan shall be evidenced ----------------------- by written agreements or such other appropriate documentation as the Committee shall prescribe. Any written agreement or other such documentation shall be delivered to the Participant and shall incorporate the terms of the Plan by reference and specify the terms and conditions thereof and any rules applicable thereto. The Committee need not require the execution of any instrument or acknowledgment of notice of an Award under the Plan, in which case acceptance of such Award by the respective Participant will constitute agreement to the terms of the Award and acceptance of the Award in accordance with the terms of this Agreement (e) Settlement. The Committee shall determine whether Awards are settled ---------- in whole or in part in cash, Shares or other Awards. The Committee may require or permit a Participant to defer all or any portion of a payment under the Plan, including the crediting of interest on deferred amounts denominated in cash. (f) Change in Control. Except as provided below, in the event of a Change ----------------- in Control, each Stock Option (including, for this purpose, any SAR granted in tandem with such Stock Option) and each freestanding SAR (whether or not then exercisable) shall be cancelled in exchange for a payment in cash of an amount equal to the excess of the Change in Control Price (or, in the case of any ISO, the excess of the Fair Market Value on the date of exercise) over the exercise or base price thereof and all Stock Awards shall become nonforfeitable. Notwithstanding the immediately preceding sentence, no cancellation, cash settlement or acceleration of vesting shall occur with respect to any Award or any class of Awards if the Committee reasonably determines in good faith prior to the occurrence of a Change in Control that such Award or Awards shall be honored or assumed, or new rights substituted therefor (such honored, assumed or substituted award hereinafter called an "Alternative Award"), by a Participant's employer (or the parent or a subsidiary of such employer) immediately following the Change in Control, provided that any such Alternative Award must: (i) be based on stock which is traded on an established securities market, or which will be so traded within 60 days of the Change in Control; (ii) provide such Participant (or each Participant in a class of Participants) with rights and entitlements substantially equivalent to or better than the rights, terms and conditions applicable under such Award, including, but not limited to, an identical or better exercise or vesting schedule and identical or better timing and methods of payment; (iii) have substantially equivalent economic value to such Award (determined at the time of the Change in Control); and (iv) have terms and conditions which provide that in the event that the Participant's employment is involuntarily terminated or constructively terminated, any conditions on a Participant's rights under, or any restrictions on transfer or exercisability applicable to, each such Alternative Award shall be waived or shall lapse, as the case may be. For this purpose, a constructive termination shall mean a termination by a Participant following a material reduction in the Participant's compensation, a material reduction in the Participant's responsibilities or the relocation of the 59 Participant's principal place of employment to another location, in each case without the Participant's written consent. Section 9. Miscellaneous. --------- ------------- (a) Plan Amendment. The Board or the Committee may amend the Plan as it -------------- deems necessary or appropriate to better achieve the purposes of the Plan, except that no amendment without the approval of the Company's stockholders shall be made which would (i) increase the total number of Shares available for issuance under the Plan, (ii) materially increase the benefits accruing to Participants under the Plan, or (iii) materially modify the requirements as to eligibility for participation in the Plan. (b) No Right to Employment. No person shall have any claim or right to be ---------------------- granted an Award, and the grant of an Award shall not be construed as giving a Participant the right to continued employment. The Company expressly reserves the right at any time to dismiss a Participant free from any liability or claim under the Plan, except as expressly provided by an applicable agreement or other documentation of an Award. (c) No Rights as Shareholder. Only upon issuance of Shares to a ------------------------ Participant (and only in respect to such Shares) shall the Participant obtain the rights of a shareholder, subject, however, to any limitations imposed by the terms of the applicable Award. (d) No Fractional Shares. No fractional shares shall be issued under the -------------------- Plan, however, the Committee may provide for a cash payment as settlement in lieu of any fractional shares. (e) Other Company Benefit and Compensation Programs. Except as expressly ----------------------------------------------- determined by the Committee, settlements of Awards received by Participants under this Plan shall not be deemed as part of a Participant's regular, recurring compensation for purposes of calculating payments or benefits from any Company or Subsidiary benefit or severance program (or severance pay law of any country). The above programs notwithstanding, the Company may adopt other compensation plans or arrangements as it deems appropriate or necessary. (f) Unfunded Plan. The Plan shall be unfunded and shall not create (or be ------------- construed to create) a trust or a separate fund(s). Likewise, the Plan shall not establish any fiduciary relationship between the Company, any Subsidiary or Affiliate and any Participant or other person. To the extent any person holds any rights by virtue of an Award granted under the Plan, such rights shall be no greater than the rights of an unsecured general creditor of the Company, any Subsidiary or Affiliate. (g) Successors and Assignees. The Plan shall be binding on all successors ------------------------ and assignees of a Participant, including, without limitation, the estate or beneficiaries of such Participant and the executor, administrator or trustee of such estate, or any receiver or trustee in bankruptcy or representative of the Participant's creditors. (h) 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. 60 EX-10.25 3 REINSURANCE PLAN DATED 29-SEP-1997 EXHIBIT 10.25 REINSURANCE AGREEMENT This Agreement is made as of September 29, 1997, between FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY, 440 Lincoln Street, Worcester, MA 01653, a stock life insurance corporation organized under the laws of the Commonwealth of Massachusetts (the "Company"), and METROPOLITAN LIFE INSURANCE COMPANY, One Madison Avenue, New York, NY 10010, a mutual life insurance company organized under the laws of the State of New York (the "Reinsurer"). The background of this Agreement is that the Company previously provided certain individual disability income policies that it no longer underwrites and wishes to cede as indemnity reinsurance those that are still in force with a view toward a later assumption reinsurance cession and the Reinsurer, which currently provides similar policies on a direct basis, wishes to assume as indemnity reinsurance such in-force policies from the Company with a view toward their future assumption reinsurance. The Company and the Reinsurer are concurrently entering into an Administrative Services Agreement dated as of the date hereof relating to the administration of such individual disability income policies. In consideration of the promises set forth in this Agreement, the parties agree as follows: ARTICLE I. DEFINITION OF TERMS 1.01 GENERAL. The following capitalized words and terms, when used in this Agreement, shall have the following meanings, unless the context clearly indicates otherwise: (a) AGREEMENT. This Reinsurance Agreement and all schedules attached thereto. (b) EFFECTIVE DATE. The Effective Date shall be October 1, 1997, unless the parties mutually agree in writing to a different date. (c) PRODUCERS. The agents, general agents, brokers, representatives or sub- agents of any such persons under contract with the Company and entitled to receive compensation from the Company for the solicitation, sale, marketing or production of any of the Reinsured Policies. (d) REINSURED POLICY/POLICIES. Those policies issued by the Company in the United States or Puerto Rico that contain the policy form numbers and/or plan codes set forth on Schedule A of this Agreement that as of the Effective Date are in force or not more than 60 days in arrears, including any related conversion or reinstated policies (or policies reissued pursuant to the exercise of any additional insurance benefit) that may be issued by the Company on or after the Effective Date either (1) in accordance with policy terms and conditions or (2) as may be specially accepted by the Reinsurer in accordance with Article 10.20. The term "Reinsured Policies" shall not include any policies excluded pursuant to Article 2.04. On or before the Effective Date, the Company shall provide the Reinsurer with a report setting forth, with respect to the Reinsured Policies, each policy number, insured's name and address, policy form, face amount, ancillary benefits, and any considerations for the policy. (e) STATUTORY RESERVES. All of the reserves and liabilities the Company maintains for Reinsured Policies as of the Effective Date on its financial statements filed with the Massachusetts Division of Insurance, calculated in accordance with generally accepted actuarial principles and practices and statutory accounting principles and practices consistently applied on the basis used in the Company's 1996 Annual Statement (or as otherwise agreed to in this Agreement), including but not limited to: 1) the total aggregate reserves and liabilities as shown on Exhibit 1, Part 2, relating to dividends; Exhibit 5, line 12, relating to claims settlement expenses; Exhibit 9 relating to policy reserves (including additional insurance benefits) and claim reserves; Exhibit 11, Part I, line 4(d) relating to liabilities for benefits as shown on Schedule B; 2) advance premium reserves; and 3) deposit funds and other liabilities without life contingencies, less premiums due up to 60 days in arrears. In no event shall Statutory Reserves include any amount attributable to a future year for any non-guaranteed increase in benefits under the Reinsured Policies. (f) CLOSING DATE. The Closing Date shall be the Effective Date, unless the parties mutually agree in writing to a different date. ARTICLE II. BASIS OF REINSURANCE 2.01 TYPE OF REINSURANCE. This reinsurance is 100% indemnity coinsurance. 2.02 REINSURED POLICIES. The Company cedes and the Reinsurer accepts as indemnity reinsurance, in accordance with the terms and conditions hereof, all of the underlying risks, including any investment risk, of the Reinsured Policies. 2.03 PARTIES TO THE AGREEMENT. This Agreement is solely between the Company and the Reinsurer. Performance of the obligations of each party under this Agreement shall be rendered solely to the other party. The acceptance of reinsurance hereunder shall not create any right or legal relation whatever between the Reinsurer and the insured, owner, beneficiary or any other party under any Reinsured Policies and the Company shall be and remain solely liable to the insured, owner, beneficiary or any other party under such policies. 2.04 EXCLUSIONS. The Reinsurer shall not accept any liability for or reinsure any policy that is the subject of pending or threatened litigation against the Company as of the Effective Date; such policies (each an "Excluded Policy" and collectively the "Excluded Policies") shall be listed on Schedule C, with a description of the pending or threatened litigation. For purposes of this provision, a policy is the subject of threatened litigation if, as of the Effective Date, the Company is on notice that a dispute exists with regard to a claim under the policy, and within the prior six months the Company was contacted by an attorney representing the insured with respect to such dispute. With respect to a policy excluded hereunder because it is the subject of pending or threatened litigation, upon resolution of the pending or threatened litigation, if the policy remains in force it shall automatically as of that time become a Reinsured Policy hereunder. Threatened litigation with respect to a policy will be considered to be resolved if litigation is not commenced with respect to the dispute within twelve months after the Effective Date, or if the Company and the Reinsurer agree at an earlier time that there is no longer a reasonable likelihood of litigation ensuing with respect to such dispute. At the time that any Excluded Policy becomes a Reinsured Policy hereunder, the statutory reserve attributable to such policy shall be promptly transferred to the Reinsurer. In addition to the foregoing, any policy with respect to which the Company is contacted by an attorney representing the insured within ninety days after the Effective Date disputing an action taken or determination made with respect to such policy prior to the Effective Date shall be treated in accordance with the preceding paragraph as a policy which was the subject of threatened litigation as of the Effective Date. In accordance with Article 4.03(a) of this Agreement, Schedule C will be revised to reflect any such policies and the considerations with respect to such policies shall be promptly returned. ARTICLE III. DURATION OF RISK 3.01 DURATION. Except as may herein be specified, this Agreement will continue in effect unless and until there are no longer any Reinsured Policies in effect (including reinstatements and policies which subsequently become Reinsured Policies pursuant to Article 2.04) and all claim liabilities thereunder have been discharged. 3.02 REINSURER'S LIABILITY. The liability of the Reinsurer, with respect to any Reinsured Policy, will begin simultaneously with that of the Company, but not prior to the Effective Date. The Reinsurer's liability with respect to an Excluded Policy will begin on the date such policy becomes a Reinsured Policy pursuant to the terms of Article 2.04. The Reinsurer's liability with respect to any Reinsured Policy will end on the date that such Reinsured Policy is terminated (unless reinstated in accordance with the policy terms and conditions or specially accepted pursuant to Article 10.20); provided, however, that the Reinsurer's liability to the Company will continue until all claim liabilities under such Reinsured Policy have been discharged. A Reinsured Policy that becomes covered under an assumption reinsurance agreement between the parties will be deemed for purposes of this Agreement to terminate (without regard to any subsequent reinstatement) as of the effective date of its assumption. 3.03 RECAPTURE BY THE COMPANY. Reinsured Policies are not eligible for recapture by the Company; provided, however, that the Company shall have the option to recapture in the event of the insolvency of the Reinsurer. Upon recapture, the Reinsurer will return to the Company assets to support the recaptured Statutory Reserves, subject to a recapture fee based on the Ceding Commission, subject to True-Up Adjustments, reduced evenly over a period of ten years. In the event of the disallowance of Annual Statement credit for this reinsurance by the Massachusetts Division of Insurance, the parties will negotiate in good faith to reform the Agreement to carry out its original purposes. If the parties are unable to agree on a reformed contract, the Company will be allowed to recapture subject to the provisions of the previous paragraph. ARTICLE IV. PREMIUMS AND CONSIDERATIONS 4.01 REINSURANCE PREMIUMS. (a) INITIAL REINSURANCE PREMIUM. The Initial Reinsurance Premium is an amount equal to the Statutory Reserves (net of any receivables arising on risks prior to the Effective Date). The Company's best estimation of the Initial Reinsurance Premium is set forth on Schedule A. (b) REMITTANCE OF INITIAL REINSURANCE PREMIUM. On the Closing Date, the Company shall remit to the Reinsurer by wire transfer of federal funds an amount equal to the Initial Reinsurance Premium less the amount designated as Funds Withheld pursuant to Article 4.01(c). The Reinsurer will provide wire transfer instructions and bank routing numbers to the Company for this payment at least 24 hours prior to the Closing Date. (c) FUNDS WITHHELD. The Funds Withheld shall equal, with respect to the Reinsured Policies, 10% of the net earned premium (as used in the Life and Accident and Health Annual Statement Schedule H) during the twelve month period immediately prior to the Effective Date plus 20% of the full tabular reserves for Pending Claims on the Effective Date as calculated in Schedule B. (d) ADDITIONAL REINSURANCE PREMIUMS. In addition to the Initial Reinsurance Premium the Reinsurer will be entitled, as additional Reinsurance Premiums, to an amount equal to all premiums received on any Reinsured Policy on or after the date upon which such policy becomes a Reinsured Policy. 4.02 RETURN OF PREMIUMS AND CONSIDERATIONS PAYABLE BY THE REINSURER (a) CEDING COMMISSION. The Reinsurer will pay to the Company a Ceding Commission (the "Ceding Commission") of negative $18,000 subject to the following adjustment: The amount will be increased (decreased) by $1,500 for each five basis point increase (decrease) in the yield of the U.S. Treasury Note maturing on October 1, 2006 over (below) 6.74 (the yield in effect shortly before the parties' April 9, 1997 letter of intent with respect to the Agreement) on the Closing Date. (By way of illustration only, if on the Closing Date the aforementioned yield is five basis points above 6.74, the Ceding Commission will be negative $16,500. If on the Closing Date the aforementioned yield is five basis points below 6.74, the Ceding Commission will be negative $19,500.) Changes of less than five basis points will be calculated proportionately. The Ceding Commission will be paid by wire transfer simultaneously with the Company's payment of the Initial Reinsurance Premium. (b) REIMBURSEMENT FOR AGENT COMMISSIONS. The Reinsurer will pay to the Company an amount equal to any commissions, overriding commissions, and service fees that the Company shall pay to Producers in accordance with the terms of Producer Compensation Agreements, as currently in force on the Effective Date, on all premiums due and payable on Reinsured Policies on and after the Effective Date. Only those items that would be properly reported in the Life and Accident and Health Annual Statement Exhibit 1 will be eligible for reimbursement under this provision. (c) REIMBURSEMENT FOR OTHER AGENT COMPENSATION. The Reinsurer will pay to the Company an amount equal to 11% of the amount payable by the Reinsurer pursuant to Article 4.02(b), to compensate the Company for other agent compensation (e.g., employer's share of FICA, pension contributions, and expense reimbursement allowances) associated with the Reinsured Policies. (d) TAXES AND ASSESSMENTS. The Company is liable for all premium taxes, statutory pool and association assessments and state guaranty fund assessments on Reinsured Policy premiums. The Reinsurer will reimburse the Company for such taxes and assessments that are levied or assessed on premiums written on the Reinsured Policies on or after the Effective Date and the Company will refund to the Reinsurer any refunds or distributions on any reimbursed taxes or assessments. 4.03 TRUE-UP AND RETROSPECTIVE EXPERIENCE CREDIT (a) TRUE-UP. Ninety days following the Effective Date or such earlier date as the parties shall agree, there will be a true-up of the initial Statutory Reserves as of the Effective Date to correct any errors or omissions discovered since the Effective Date. (b) RETROSPECTIVE EXPERIENCE CREDIT. Within sixty days after the one year anniversary of the Effective Date (the "Anniversary Date") or such other date as the parties shall agree, the Reinsurer will determine the amount of any Retrospective Experience Credit to which the Company is entitled. Said credit will be based on the actual experience, from the Effective Date through the Anniversary Date, of reported claims which have not been adjudicated ("Pending Claims") and Incurred but not Reported Claims ("IBNR Claims"). IBNR Claims shall include all claims for which a specific claim reserve was not held on the Effective Date. (This shall include claims which were closed or declined on the Effective Date as well as claims that had not yet been reported.) The Company shall be entitled to said credit to the extent that the reserves as of the Effective Date for Pending Claims and IBNR Claims exceed the Experience Adjusted Reserve with respect to such claims, as determined in accordance with generally accepted actuarial principles and practices and as described in Article 4.04. 4.04 EXPERIENCE ADJUSTED RESERVE CALCULATION. This provision shall describe the method used to determine, in accordance with Article 4.03(b), the amount of the Experience Adjusted Reserve with respect to the set of claims described therein. The following assumptions shall be made: The experience period will be one year after the initial determination of the reserve, the tabular interest rate will be 7% compounded annually, and the weighted average payment date will be equivalent to a single payment half-way through the experience period. For the claims that are subject to this calculation, the Experience Adjusted Reserve shall be the sum of: 1) The total payments made on these claims multiplied by .96674; and 2) The ending claim reserves for these claims multiplied by .93458. For purposes of the foregoing calculation, the tabular reserve factors will be determined as described in Schedule B. Adjustments to these factors for Pending status will be based on Company experience after the Effective Date. Adjustments for statuses other than Pending and Open (i.e., in payment) will be the same as the Reinsurer uses for its own Exhibit 9 Reserves and Exhibit 11 Liabilities, both direct and reinsurance assumed. 4.05 RETROSPECTIVE EXPERIENCE CREDIT DETERMINATION; PROCEDURE AND PAYMENT. Upon receipt by the Company from the Reinsurer of the Reinsurer's determination as described in Article 4.03(b), the Company will then have thirty days to review said determination and to request any information it may reasonably require from the Reinsurer to assist the Company in its review; the Reinsurer shall promptly and at the Reinsurer's expense provide the Company with any such information, including, without limitation, work papers and actuarial assumptions, methodology and memoranda. Within thirty days of the Company's receipt of said determination (or if later, within thirty days of the Company's receipt of the information described above), the Company shall communicate to the Reinsurer either its agreement or disagreement with the determination. If the Company agrees with the Reinsurer's determination regarding the amount of the Retrospective Experience Credit, if any, that amount shall be credited against the Funds Withheld, and the balance of the Funds Withheld, if any, shall immediately be paid by the Company to the Reinsurer, along with interest calculated in accordance with Article 5.01. (Should the Retrospective Experience Credit exceed the Funds Withheld, the excess, along with interest calculated in accordance with Article 5.01, shall immediately be paid by the Reinsurer to the Company.) If the Company disagrees with the Reinsurer's determination, the Company and the Reinsurer will attempt to resolve the dispute by negotiation. If despite the reasonable efforts of the Company and the Reinsurer they cannot resolve the dispute within sixty days after the Company communicated to the Reinsurer its disagreement with the Reinsurer's determination, the dispute will be resolved in accordance with Article VIII. In the event that the Reinsurer does not timely make and communicate to the Company the determination required by Article 4.03(b), the Company may make such determination; the Reinsurer shall in this case promptly provide at its expense any information the Company may reasonably require to perform such determination. The Reinsurer will then have thirty days from receipt of the Company's calculations to communicate its agreement or Exhibit 10.25 disagreement, with application of the Retrospective Experience Credit, and resolution of any disagreement with respect thereto, to be handled in accordance with the preceding paragraph. ARTICLE V. ACCOUNTING AND SETTLEMENTS 5.01 INTEREST ADJUSTMENT. Interest will be paid on any adjustments that may be required in the administration of this agreement at an annual rate of 7%, without compounding, from the date of the adjusted obligation to the date of the adjustment. This adjustment will not apply to payments made within thirty days after they become due except for those payments that are effective as of the Effective Date. 5.02 REINSURANCE SETTLEMENTS. All reinsurance settlements will be effected through offsetting balances, electronic funds transfers or as the parties may otherwise agree in writing in order to carry out the purposes of this Agreement. Settlements will be made quarterly or more frequently. 5.03 OFFSET OF PAYMENTS. All monies due either the Company or the Reinsurer under this Agreement shall be offset against each other, dollar for dollar, regardless of any insolvency of either party. ARTICLE VI. PAYMENT OF BENEFITS 6.01 ADMINISTRATION. The Company is responsible for the investigation, settlement and payment of claims under the Reinsured Policies. 6.02 POLICY RESERVES AND LIABILITIES. The reports of claims experience and the financial and reserve information provided by the Company to the Reinsurer in connection with the Reinsured Policies, to the best of the Company's knowledge, information and belief, will fairly present Reinsured Policy claims experience, liabilities, reserves and other material information. The Company's Statutory Reserves will comply with applicable state requirements on and after the Effective Date. ARTICLE VII. EXTRA-CONTRACTUAL OBLIGATIONS 7.01 EXTRA-CONTRACTUAL DAMAGES. The Reinsurer assumes no liability under this Agreement for any damages, fines, penalties, costs or expenses, or portion thereof, assessed against the Company by any court or regulatory body on the basis of negligence, oppression, malice, fraud, fault, wrongdoing or bad faith by the Company in connection with any claim or for any other act or omission, unless the Reinsurer shall have received prior notice of and shall have concurred prior to the actions taken or not taken by the Company that led to the assessment, in which case the Reinsurer shall pay its share of such assessment. The Reinsurer's share of such assessment will be the proportional amount determined by the ratio of reinsurance held by the Reinsurer to the total limit of liability of the Reinsured Policy or Policies under which the claim or claims occurred which gave rise to the assessment. The Reinsurer shall be deemed to have notice of and have concurred in any actions or inactions that it may take as third party administrator with respect to the Reinsured Policies. ARTICLE VIII. ARBITRATION 8.01 ARBITRATION. All disputes and differences between the parties will be decided by arbitration, regardless of the insolvency of either party, unless the conservator, receiver, liquidator or statutory successor is specifically exempted from an arbitration proceeding by applicable state law. 8.02 DEMAND. Either party may initiate arbitration by providing written notification to the other party. Such written notice shall set forth: (1) a brief statement of the issue(s); (2) the failure of the parties to reach agreement; and (3) the date of the demand for arbitration. 8.03 ARBITRATION PANEL. The arbitration panel shall consist of three arbitrators. The arbitrators must be impartial and must be or must have been officers of life insurance companies other than the parties or their affiliates. 8.04 SELECTION. Each party shall select an arbitrator within thirty days from the date of the demand. If either party shall refuse or fail to appoint an arbitrator within the time allowed, the party that has appointed an arbitrator may notify the other party that, if it has not appointed its arbitrator within the following ten days, the arbitrator will appoint an arbitrator on its behalf. The two arbitrators shall select the third arbitrator within thirty days of the appointment of the second arbitrator. If the two arbitrators fail to agree on the selection of the third arbitrator within the time allowed, either party may ask ARIAS.US to appoint the third arbitrator. However, if ARIAS.US is unable to appoint an arbitrator who is impartial and who is or was an officer of a life insurance company other than the parties or their affiliates, then each of the other two arbitrators shall submit to the other a list of three candidates, after which each arbitrator shall select one name from the list submitted by the other and the third arbitrator shall be selected from the two names chosen by drawing lots. 8.05 INTERPRETATION. The arbitration panel shall interpret this Agreement as an honorable engagement rather than merely as a legal obligation and shall consider practical business and equitable principles as well as industry custom and practice regarding the applicable insurance and reinsurance business. The arbitration panel is released from judicial formalities and shall not be bound by strict rules of procedure and evidence. 8.06 PROCEDURES. The arbitration panel shall determine all arbitration schedules and procedural rules. Organizational and other meetings will be held in New York, NY, unless the panel shall select another location. The arbitration panel shall decide all matters by majority vote. 8.07 FINALITY AND ENFORCEMENT. The decisions of the arbitration panel shall be final and binding on both parties. The arbitration panel may, at its discretion, award costs and expenses as they deem appropriate, including but not limited to attorneys fees and interest. Judgment may be entered upon the final decision of the arbitration panel in any court of competent jurisdiction. The arbitration panel may not award any exemplary or punitive damages. 8.08 EXPENSES. The parties will bear the expenses of the arbitration equally unless the arbitration panel shall decide otherwise. ARTICLE IX. INSOLVENCY 9.01 PAYMENTS OF BENEFITS UNDER AN INSOLVENCY. In the event of the insolvency of the Company, all reinsurance made, ceded, renewed or otherwise becoming effective under this Agreement shall be payable by the Reinsurer directly to the Company or its liquidator, receiver or statutory successor on the basis of the liability of the Company under the contract or contracts reinsured without diminution because of the insolvency of the Company. 9.02 NOTICE TO REINSURER. The liquidator, receiver or statutory successor of the Company shall give the Reinsurer written notice of the pendency of a claim for a benefit against the Company on any Reinsured Policy within a reasonable time after such claim is filed in the insolvency proceeding. During the pendency of any such claim, the Reinsurer may investigate such claim and interpose in the Company's name (or in the name of the liquidator, receiver or statutory successor) in the proceeding in which such claim is to be adjudicated any defense or defenses that the Reinsurer may deem available to the Company or its liquidator, receiver or statutory successor. The expense thus incurred by the Reinsurer shall be chargeable, subject to court approval, against the Company as a part of the expense of liquidation to the extent of a proportionate share of the benefit that may accrue to the Company solely as a result of the defense undertaken by the Reinsurer. 9.03 INTENT. Nothing in this Article shall in any way change the relationship or status of the parties or enlarge the obligations of either party to each other, except as specifically herein provided, nor, except as herein specifically provided, shall anything in this Article in any manner create any obligations or establish any right against the Reinsurer in favor of any third parties or any other persons not parties to this Agreement. Any dispute as to any of the liabilities or the operation of any provision contained herein, not specifically reserved by this Article or applicable state law, shall be subject to the arbitration provisions set forth in Article VIII. ARTICLE X. GENERAL PROVISIONS 10.01 REGULATORY APPROVALS. This Agreement shall not take effect until all required regulatory approvals have been obtained. 10.02 CONFIDENTIALITY. Each party shall maintain the confidentiality of all information that is provided to it by the other party in connection with this Agreement and shall not further disclose or make other use of such information without prior written consent, except as may be required by law; provided, however, that this provision shall not apply to information that is or otherwise becomes available to the public or that was previously available on a non- confidential basis. 10.03 MISUNDERSTANDINGS AND OVERSIGHTS. If the Company should inadvertently fail to cede reinsurance that otherwise would have been ceded in accordance with the provisions of this Agreement or if either the Company or the Reinsurer should fail to pay amounts due or to perform any other act required by the Agreement as a result of a misunderstanding or oversight, the Company and the Reinsurer shall adjust the situation to what it would have been had the inadvertent failure, misunderstanding or oversight not occurred, provided that the inadvertent failure, misunderstanding or oversight is rectified promptly after discovery. 10.04 REINSTATEMENTS. If a Reinsured Policy that was reduced, terminated or lapsed is reinstated after the Effective Date, the reinsurance for such policy will be reinstated automatically to the amount that would have been in force if the policy had not been reduced, terminated or lapsed. If a Reinsured policy converts to another policy or has additional insurance benefits exercised after the Effective Date, the reinsurance for such policy will automatically be changed to the amount that would have been in force for the new policy. Automatic reinsurance of reinstatements, conversions and exercises of additional insurance benefits is subject to fulfillment of all requirements necessary to procure reinstatement or conversion of the Reinsured Policy or to exercise the additional insurance benefit of such Reinsured Policy under its terms. 10.05 OTHER REINSURANCE. The Company hereby assigns the reinsurance agreements in effect with regard to the Reinsured Policies, as described in Schedule D. The Reinsurer hereby accepts such assignment. (To the extent that consent of a reinsurer is required in order to perfect such assignment, the Company shall use its best efforts to promptly obtain such consent.) The assignment will take effect on the Effective Date. The assignment does not apply with respect to any policy that is not a Reinsured Policy hereunder. 10.06 DIVIDENDS. As of the Effective Date the Reinsurer shall, with respect to the Reinsured Policies, assume the Company's obligations under the "New York Undertaking", a copy of which is attached to this Agreement as Exhibit 1. 10.07 POLICY CHANGES. The Company shall not make any material changes in the provisions and conditions of the Reinsured Policies after the Effective Date, other than as may be legally mandated, without the express written consent of the Reinsurer, which consent shall not be unreasonably withheld. Upon receipt of such consent or mandated change, there shall be a corresponding change in the related reinsurance and appropriate cash adjustments shall be made consistent with the Company's changes. In the event that the Company makes any change in Reinsured Policies that is not accepted by the Reinsurer, the Company will bear for its own account any additional cost or expense of such change so that the change will not adversely affect the Reinsurer. 10.08 AUDIT. The Company or the Reinsurer and their employees and authorized representatives, respectively, may audit, inspect and examine, during regular business hours, at the usual business office of the other party, provided that reasonable advance notice has been given, any and all books, records, statements, correspondence, reports, trust accounts and their related documents or other documents that relate to the Reinsured Policies. The audited party agrees to provide a reasonable work space for such audit, inspection or examination, to cooperate fully and to disclose the existence of and produce any and all necessary and reasonable materials requested by such auditors, investigators or examiners. Each party will bear its own audit expenses. All such information, including audit reports and analyses, will be kept confidential in accordance with Article 10.02. 10.09 INTEGRATION. This Agreement, including the Schedules attached hereto, supersedes all prior discussions and agreements and constitutes the sole and entire agreement between the parties with respect to the business being reinsured and there are no understandings between the parties other than as expressed in the Agreement with respect to the business being reinsured. However, nothing in the foregoing is intended to affect the validity or enforceability of any Confidentiality Agreements the parties have entered or may enter into with respect to the business being reinsured (including, without limitation, the Confidentiality Agreement dated November 25, 1996), and the parties recognize that various issues regarding administration of said business are to be governed by a separate Administrative Services Agreement or Agreements between the parties, which shall likewise be valid and enforceable. 10.10 LAW AND VENUE. While the parties anticipate that any disputes under this Agreement will be resolved via arbitration pursuant to Article VIII, to the extent a question should arise as to the laws of which state govern this Agreement, said state shall be the State of New York without regard to New York choice of law rules. 10.11 NON-WAIVER. No waiver by either party of any default by the other party in the performance of any promise, term or condition of this Agreement shall be construed to be a waiver by such party of any other or subsequent default in performance of the same or any other promise, term or condition of this Agreement. No prior transactions or dealings between the parties shall be deemed to establish any custom or usage waiving or modifying any provision hereof. The failure of either party to enforce any part of this Agreement shall not constitute a waiver by such party of its right to do so, nor shall it be deemed to be an act of ratification or consent. 10.12 COUNTERPARTS. This Agreement may be executed simultaneously in any number of counterparts, each of which shall be deemed an original, but all of which shall constitute one and the same instrument. 10.13 SEVERABILITY. In the event that any provision or term of this Agreement shall be held by any court to be invalid, illegal or unenforceable, all of the other terms and provisions shall remain in full force and effect to the extent that their continuance is practicable and consistent with the original intent of the parties, and the parties will attempt in good faith to renegotiate the Agreement to carry out its original intent. 10.14 AMENDMENTS. Any change or modification to the Agreement shall be null and void unless made by amendment to the Agreement and signed by both parties. 10.15 SCHEDULES AND PARAGRAPH HEADINGS. Schedules attached hereto are made a part of this Agreement. Paragraph headings are provided for reference purposes only and are not made a part of this Agreement. 10.16 SURVIVAL. All of the provisions of this Agreement shall, to the extent necessary to carry out the purposes of this Agreement or to ascertain and enforce the parties' rights thereunder, survive its termination. 10.17 NOTICES. All notices and other communications by one party under this Agreement must be in writing and will be deemed effective upon delivery to the other party at the address designated in Schedule E. Either party may upon notice to the other change its designee to receive future notices. 10.18 FULL POWER AND AUTHORITY. Each party represents that it has full power and authority to enter into and to perform this Agreement and that the person signing this Agreement on its behalf has been properly authorized and empowered to do so. Each party further acknowledges that it has read this Agreement, understands it and agrees to be bound by it. The Reinsurer also represents that it is licensed to sell disability insurance in all fifty states and the District of Columbia, and in Puerto Rico. 10.19 REPLACEMENT. Neither the Company nor the Reinsurer will initiate any general offer of conversion or replacement under which it would offer to policyholders whose policies are Reinsured Policies any inducement to surrender their policies or offer them replacement policies without the written approval of the other party. 10.20 SPECIAL ACCEPTANCES. Policies not within the terms of this Agreement may be submitted to the Reinsurer for special acceptance and, if accepted by the Reinsurer, shall be subject to all of the terms of this Agreement, except as modified by the special acceptance. 10.21 COMPANY DATA. The Company acknowledges that, at the request of the Reinsurer, it has provided certain data related to the Reinsured Policies for its review prior to entry into this Agreement and hereby affirms that all factual information so provided was, to the best of the Company's knowledge and belief, complete and accurate, as of the date provided, in all material respects. The Reinsurer will not use, without the express prior consent of the Company, the records of policyholders and claimants under the Policies to solicit the sale of insurance or any other products or services; provided, however, that this provision shall not otherwise preclude such solicitations by the Reinsurer in the ordinary course of business. In no event, however, will the Reinsurer provide its agents with records of policyholders and claimants under the Reinsured Policies nor with a customer list with respect thereto, without the prior written consent of the Company. 10.22 SETTLEMENT OF CLAIMS. Claim settlements made by the Company in good faith, including compromises, shall be unconditionally binding upon the Reinsurer. 10.23 INTERMEDIARIES. All negotiations relative to this Agreement and the transactions contemplated hereby have been carried out by the Company and the Reinsurer directly and without the intervention of any person in such manner as to give rise to any valid claim by any other person for a finder's fee, brokerage commission or similar payment, provided, however, that the Reinsurer acknowledges a contractual finder's fee obligation with respect to this Agreement as to which the Reinsurer shall indemnify and hold the Company harmless. Each party will bear the costs of its professional advisors, if any, involved in the negotiation and implementation of this Agreement. 10.24 CONTINUITY. The Company will continue to administer the Reinsured Policies in the ordinary course of business and will neither change any method of doing business, accounting or operation nor enter into any transaction that has a material adverse effect on the Reinsurer after the date hereof, except with the prior written consent of the Reinsurer, which consent will not be unreasonably withheld. 10.25 ASSUMPTION REINSURANCE. The Company and the Reinsurer agree to negotiate in good faith an assumption reinsurance agreement with respect to the Reinsured Policies. Any Reinsured Policies that do not become covered under said assumption reinsurance agreement will continue to be reinsured under this Agreement subject to the terms and conditions thereof. 10.26 CONSTRUCTION AND REPRESENTATION BY COUNSEL. The parties hereto represent that in the negotiation and drafting of this Agreement they have been represented by and relied upon the advice of counsel of their choice. The parties affirm that their counsel have had a substantial role in the drafting and negotiation of this Agreement and, therefore, the rule of construction that any ambiguities are to be resolved against the drafting party shall not be employed in the interpretation of this Agreement or any Schedule attached hereto. ARTICLE XI. TAX ELECTION 11.01 TAX ELECTION. The parties will make a joint election, in accordance with Treas. Reg. Section 1.848-2(g)(8) (the "Regulation"), issued December 28, 1992, under Section 848 of the Internal Revenue Code (the "Code") and: (a) the party with the net positive consideration under this Agreement for each taxable year will capitalize specified policy acquisition expenses with respect to this Agreement without regard to the general deductions limitation of Section 848(c)(1) of the Code; (b) the election will take effect on the Effective Date for the taxable year ending December 31, 1997, and will remain in effect for all subsequent years that this Agreement remains in effect; and (c) each party shall attach a schedule to its federal income tax return for its first taxable year ending after the election becomes effective that identifies the agreements (including this Agreement) for which joint elections have been made under the Regulation. 11.02 ADMINISTRATION. Pursuant to this joint election: (a) the parties will exchange information pertaining to the amount of net consideration under this Agreement to assure consistency or as may otherwise be required by the Internal Revenue Service; (b) the Company will submit its calculation of the "net consideration" as defined under the above referenced regulation to the Reinsurer not later than May 1 for each and every tax year for which this Agreement is in effect; (c) the Reinsurer may challenge such calculation within ten working days of receipt of the Company's calculation; and (d) the parties will act in good faith to reach agreement as to the correct amount of net consideration whenever there is disagreement as to the amount of net consideration as determined under Treas. Reg. Section 1.848-2(f). 11.03 REPRESENTATIONS. The Company and the Reinsurer represent and warrant that they are subject to U.S. taxation under Subchapter L of Chapter 1 of the Code. IN WITNESS WHEREOF, the parties have caused this Agreement to be executed in duplicate as of the date first above written. METROPOLITAN LIFE INSURANCE COMPANY By: Title: FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY By: Title: ADMINISTRATIVE SERVICES AGREEMENT This Agreement is by and between, on the one hand, Metropolitan Life Insurance Company (the "Administrator"), a mutual life insurance company organized and existing under the laws of the State of New York, with a principal place of business at One Madison Avenue, New York, NY 10010 and, on the other hand, Allmerica Financial Life Insurance and Annuity Company, a stock life insurance company organized and existing under the laws of the State of Delaware, and First Allmerica Financial Life Insurance Company, a stock life insurance company organized and existing under the laws of the Commonwealth of Massachusetts (together or separately as their interests may appear, the "Company"), each with a principal place of business at 440 Lincoln Street, Worcester, MA 01653. The background of this Agreement is that the parties have entered into indemnity reinsurance agreements (the "Reinsurance Agreements") with respect to the Company's liabilities under certain closed blocks of Disability Income policies (the "Policies"), as described in Schedule 1.01 and wish to consolidate administrative services for this business in order to achieve economies and efficiencies of operation and to identify the services to be rendered to the Company by the Administrator with respect to the Policies. In consideration of the mutual promises set forth herein, the parties hereto agree as follows: ARTICLE 1 SERVICES 1.01 In General. During the term of this Agreement, the Administrator is authorized and agrees to provide the Company, at the Administrator's expense, all services or duties necessary, customary, or advisable relating to the Policies, including, without limitation, the underwriting, issue, servicing, claims, computer system and other administrative services more fully described in detail in Schedules 2.01(A) and (B) (collectively, the "Policy Services"), subject to the terms and conditions set forth in this Agreement. The parties shall abide by and conform to all state laws, rules and regulations of the various states in which they do business pursuant to this Agreement. 1.02 Phases. The performance of Policy Services shall occur in two phases. Throughout each such phase, the parties agree to discharge their respective obligations as further specified herein. The phases shall consist of: (a) The Transition Phase. This phase will consist of the personnel training and installation (including any necessary modifications) by the Administrator of a system necessary for the Administrator to perform Policy Services, system testing, business workflow testing, financial control and compliance testing and Administrator/Company systems interface testing and implementation and delivery of the system. The parties shall each use their best efforts to complete the Transition Phase by the date specified in Article 4.01. (b) The Operational Phase. This phase will consist of the Administrator's performance of Policy Services utilizing the accepted system, all Policy Services to be accomplished in accordance with the Service Standards. 1.03 Roles of Parties. The Administrator shall be considered an independent contractor, with full control over its business affairs and operations, having the responsibility for the management of the Policies. The Company will provide oversight in general terms, consistent with the Policyholder's interests and with the directives of regulatory agencies. The Company shall retain the authority to make all final decisions with respect to the administration of the Policies. The failure of the Company affirmatively to exercise such authority shall not constitute a waiver of such authority or an omission for purposes of Article 6 relating to indemnification. ARTICLE 2 DEFINITIONS 2.01 Definitions. As used in this Agreement, the following terms shall have the following meanings: (a) "Computer System" shall refer to all computer systems and related materials used by the Administrator to administer the Policies, including the Administrator's proprietary software and third party licensed software comprised of computer programs and supporting documentation, including, but not limited to, source code, object code input and output formats, program listings, narrative descriptions and operating instructions and shall include the tangible media upon which the computer programs and supporting documentation are recorded as well as the deliverable forms and documents. (b) "Functional Outline Documents" shall mean the detailed written description of the functions and features being added to the Computer System in support of the Company. (c) "Specifications" shall mean Functional Outline Documents, Policyholder Documents, Policy Forms, Schedules, Company screens, Reports and Data Dictionary and the requirements specified in Schedule 2.01(A) and B. (d) "Service Standards" shall mean the time frames for various Policy Services as described in Schedule 2.01(B). ARTICLE 3 THE TRANSITION PHASE 3.01 Development of Project Plans. As soon as reasonably possible, the Company and the Administrator shall jointly develop: (a) The Functional Outline Documents as described in Article 2.01(b). These documents will be the detailed business specifications for all product and service modifications to the Computer System; and (b) An implementation plan and schedule which will specify the activities and time frame required for completion of the implementation work as provided for in Articles 3.02 through 3.04 below. 3.02 Computer System Development and Implementation. (a) The Company and the Administrator shall jointly develop the Computer System interfaces (if any) between the Company and the Administrator. (b) The Administrator will at its expense modify and implement the Computer System as necessary to support the Policy Services, which Computer System, including all improvements thereto, shall be the property of the Administrator. (c) The Administrator and the Company shall coordinate as necessary all aspects of their information processing systems so that the Administrator shall have necessary access to the Company's policy and claims systems, and other ancillary systems with respect to the Policies, to fulfill its responsibilities under this Agreement. 3.03 Acceptance Testing. (a) The Administrator will develop a fully operational Computer System for pre-production use for acceptance testing as set forth in (b) below. The Administrator shall provide the pre-production testing facilities and jointly conduct with the Company the mutually agreed upon tests. (b) The Administrator and the Company shall jointly conduct acceptance tests of the Computer System, after they have developed test plans which specify the types of testing to be performed and the schedule. The standard to be used to determine the successful completion for all tests shall be the Computer System's performance of the functions and features described in the Specifications. 3.04 Conversion Testing. Upon the successful completion of acceptance testing, preparations for the transfer of servicing (conversion) of the Policies shall begin. The Administrator shall conduct and the Company shall review conversion tests of the Computer System, after the Administrator has developed and the Company has reviewed test plans which specify the types of testing to be performed. The standards to be used to determine the successful completion for all tests shall be specified in the test plans. Unless the parties agree otherwise, the conversion will occur over a weekend, to avoid disruption to the business. ARTICLE 4 THE OPERATIONAL PHASE 4.01 Commencement of Operational Phase. The parties intend the Operational Phase to commence November 1, 1997, or such other date as may be mutually agreed to in writing by the parties. 4.02 Applicability of Service Standards. The Administrator shall perform the Policy Services within the time frames described in the Service Standards. In those instances where no express Service Standard applies, the Administrator shall use at least the same standard of care it exercises in the performance of its own insurance business, so long as such standard is consistent with prudent administrative practices in the life insurance industry generally and with any applicable legal requirements. During the first twelve months of the Operational Phase, the Administrator shall, within ten business days of the end of each month, provide the Company with a report that documents the extent to which the Administrator has satisfied the Service Standards for the just completed month. The report shall contain the total volume of transactions and the volume within the standard. After twelve months, said reports shall be furnished within ten business days of the end of each calendar quarter, unless the Company notifies the Administrator it has a good faith belief that the Administrator is not satisfying the Service Standards, in which case the Company may require that monthly reporting continue until it can be demonstrated that the Service Standards are being satisfied. In no event, however, shall the Administrator have any further reporting obligation under this paragraph if there are fewer than five thousand Policies in force. If the Company reasonably believes at any time that the Policy Services are not being performed within the requirements of the Service Standards, it shall so notify the Administrator, who shall promptly use its best efforts to correct any failure to comply with the Service Standards. At the request of either the Company or the Administrator, each shall make available appropriate personnel of at least a Vice Presidential level to discuss and attempt to promptly resolve any alleged failure to comply with the Service Standards. 4.03 Computer System Operation. Upon the successful completion of data conversion and the implementation of the Computer System, the Administrator's duties required pursuant to this Agreement include, without limitation: (a) Operation of the Computer System and processing the Company's business and data in accordance with the Specifications. (In the event that the services and standards provided for in the Specifications are not being performed as specified, the Administrator shall use its best efforts to within thirty days institute corrective action, or sooner if possible); (b) Providing all necessary labor to maintain the Computer System in accordance with the Specifications by making routine corrections and by accomplishing ordinary day-to-day changes to the computer programs in the Computer System; (c) Storing the Company's data under the Administrator's retention schedule on magnetic tapes and disc packs when in the possession or custody of the Administrator in accordance with the confidentiality and security safeguards specified in this Agreement. In the event a longer retention schedule is desired by the Company, the Administrator shall comply with such requirements, and the Company shall reimburse the Administrator at an agreed upon rate for any additional costs reasonably incurred by the Administrator; (d) Making no modifications to the Computer System (i) that change the interfaces to the Company's computer systems without the Company's express written consent; (ii) that substantially change its functionality with respect to the Policies without the Company's express written consent, which will not be unreasonably withheld; and (iii) without performing appropriate comprehensive testing of the modifications (both positive and negative); and (e) Tracking and reporting all errors in accordance with an error correction tracking plan to be established by the Administrator and the Company. 4.04 Personnel. The Administrator shall assign adequate personnel to perform the services required under this Agreement, to include a Project/Account Manager and the staffing levels needed in order to achieve the Service Standards. At least quarterly, appropriate representatives of the Company and the Administrator will discuss with each other the quality of service being provided and issues or problems that may reasonably be perceived to exist with respect to the performance of the Policy Services. 4.05 Records. The Company shall transfer to the Administrator all original files or suitable copies, including but not limited to, correspondence, records or other material related to the Policies. If the application for disability coverage was made in conjunction with another type of coverage provided or administered by the Company, the original of any information submitted or obtained in connection therewith shall be retained by the Company, who shall provide suitable copies to the Administrator and who shall, within five business days, provide the Administrator with access to the original to the extent the Administrator reasonably requires such access. With respect to ongoing information to be supplied by the Company (e.g., agent licensing), the Administrator may rely upon the most recent information that is in its possession. The Administrator will maintain all records in accordance with New York Regulation 152. 4.06 Communication of the Parties' Relationship to Policyholders, Agents and Regulators. The parties shall cooperate to see to it that sufficiently in advance of the transfer of Policy Services, policyholders and agents are notified of the upcoming transfer. In conjunction with the transfer, the Administrator shall take all reasonable measures necessary to ensure that policyholders and agents have the correct address and toll-free telephone number to be used by the Administrator in servicing the Policies. To the extent that it is or should be reasonably anticipated that information will be requested by regulators with respect to the Policies, the Administrator shall in conjunction with the transfer see to it that the regulators are provided with this new address and/or telephone number. The Administrator shall state in all correspondence with the Company's policyholders and claimants that it is acting as Administrator for the Company with respect to the Policies and shall include in such correspondence and related forms a statement reasonably designed to indicate clearly that the coverage is provided under a Company policy. Any letter sent to any Company policyholder or claimant shall contain the name, address and telephone number of the Company and, if the number of the Company policy is contained therein, will state the name of the Company next to the Company policy number. If the Administrator's address is included in any form (other than claim forms for Company claims) indicating where the completed form should be sent, it will indicate that the completed form is to be sent to the Company in care of the Administrator or to the Administrator as Administrator for the Company. If any correspondence or related forms state that the Administrator can be called for further information, the Administrator's telephone number can be given; provided, however, that the Administrator shall answer either in the name of the Company or in its name as Administrator for the Company. 4.07 Bonds. In those states where by statute or regulation a bond is required, the Administrator shall provide a bond in an amount at least sufficient to satisfy applicable legal requirements. 4.08 Policy Reserves and Liabilities. The reports of claim experience and the financial and reserve information provided by the Administrator to the Company in connection with the Policies, to the best of the Administrator's knowledge, information, and belief, will fairly present the Policy claims experience, liabilities, reserves, and other material information. Statutory reserves, as recommended by the Administrator, will comply with applicable state requirements on and after the effective date. 4.09 Compensation. The Company shall have no obligation to compensate the Administrator for the services provided herein. If, while this Agreement is in effect, there are any time periods during which the Administrator is not providing the Policy Services, the Company shall be entitled to retain an amount equal to 15% of the premiums due on the Policies for said time periods, to compensate the Company for the cost of providing these services. ARTICLE 5 SAFEGUARDING THE COMPANY DATA AND AUDIT RIGHTS 5.01 Safeguarding the Company Data. In order to properly safeguard the Company data in its possession, the Administrator will establish and maintain full and complete safeguards no less rigorous than those utilized by the Administrator to protect its own confidential data against destruction, loss, alteration or unauthorized access. 5.02 Audit Rights. The Administrator shall provide reasonable access during normal business hours to any location from which the Administrator conducts its business and provides services to the Company pursuant to this Agreement to auditors and inspectors designated in writing by the Company at any time for the purposes of performing audits or inspections for the Company. The Company shall give reasonable advance notice of an audit and include in that notice the issues which it will audit. The Company and the Administrator will jointly determine the appropriate site(s) at which to perform the audit. The Administrator shall provide the auditors and inspectors any assistance they may reasonably require. The Administrator shall also provide such reasonable access in response to a legally valid request from any governmental agency having jurisdiction over the Company; the Administrator shall promptly notify the Company of any such request. If the Company determines, following an audit, that errors have been made in the Administrator's records, the Administrator will make prompt correction and forward evidence of such corrections to the Company. The Administrator will use its best efforts to make all such corrections within thirty business days. ARTICLE 6 INDEMNITIES AND LIABILITY 6.01 Indemnification. The Company and the Administrator shall each indemnify and hold harmless the other (including the other's affiliates, subsidiaries, employees, agents, and directors) against any and all liability, loss, damage, fines, penalties, assessments, taxes and costs (including reasonable legal expenses) arising out of or attributable to its negligence or wrongful conduct (or that of its employees, agents, and directors) in performing or satisfying its obligations under this Agreement. 6.02 Processing Liability. The Administrator shall be fully liable for all processing errors or omissions, unless they arise out of, or are attributable to: (a) actions of the Company, its employees, agents or representatives; (b) the reasonable reliance by the Administrator, its employees, agents, or representatives on information, records or documents furnished to it by or on behalf of the Company; or (c) the reasonable reliance on, or the carrying out by the Administrator, its employees, agents, or representatives of any written instructions or written requests of authorized personnel of the Company. ARTICLE 7 TERMINATION 7.01 Termination for Material Breach. This Agreement may be terminated immediately by either the Company or the Administrator in the event the other is in material breach of the terms or conditions of this Agreement, provided the terminating party has notified the breaching party of the breach and the breaching party has not initiated the cure of such breach within thirty days of such notice. 7.02 Termination of Reinsurance Agreements. Unless the parties mutually agree otherwise in writing, this Agreement will automatically terminate upon termination of the Reinsurance Agreements (or the recapture of the Policies by the Company). 7.03 Termination of Policies. If not terminated earlier in accordance with the foregoing provisions, this Agreement shall terminate following the completion of all residual responsibilities of both parties after the latter of the date the last of the Policies terminates or the date that all claim liabilities thereunder have been discharged. 7.04 Post-Termination Transition. In the event this Agreement terminates but any Policies remain in effect (not including any Policies assumed by the Administrator pursuant to an assumption reinsurance agreement), the Company and the Administrator will cooperate in effecting a smooth transition of the Policy Services back to the Company and of minimizing any disruption or inconvenience to the Company and its policyholders and agents. Except for a termination that occurs pursuant to Article 7.01 due to the Company's material breach of this Agreement, the Company may at its option require the Administrator to continue to provide Policy Services for up to six months following the termination. ARTICLE 8 FINANCIAL INFORMATION 8.01 Fiduciary Capacity. All premiums collected on behalf of the Company shall be held in a fiduciary capacity and be promptly deposited in a separate bank account for premium receipts and the payment of claims and expenses in connection with the Policies. 8.02 Accounting Feeds. The quarterly cash accounting feeds described in Schedule 2.01(A) shall be provided by the Administrator to the Company within three business days following the end of the quarter. 8.03 Annual Statement Information. The Annual Statement schedules and entries described in Schedule 2.01(A) (except for the NAIC and New York Accident & Health Policy Experience Exhibits) shall be provided by the Administrator to the Company within fourteen business days following year end. The NAIC and New York Accident and Health Policy Experience Exhibits shall be provided by the Administrator to the Company within twenty business days following year end. 8.04 Actuarial Accruals. The report of actuarial accruals described in Schedule 2.01(A) shall be provided by the Administrator to the Company within five business days following the end of the quarter. 8.05 Accounting and Settlements. Net amounts due the Company or the Administrator in accordance with this Agreement for any month shall be promptly settled no later than ten days after the last day of each month. 8.06 Transition Period Reporting. The information provided by the Administrator pursuant to Articles 8.02 through 8.04 above shall include only activity and balances subsequent to the commencement of the Operational Phase of this Agreement. Information relating to activity prior to that time shall be the responsibility of the Company. ARTICLE 9 RECORDS 9.01 Maintenance of Records. The Administrator's records relating to the services provided under this Agreement will be maintained by the Administrator for the duration of this Agreement plus seven years thereafter, or longer if required by statute or regulations. The Administrator shall provide the Company with reasonable advance notice before destroying or disposing of any such records. The Administrator shall maintain, in accordance with prudent standards of record keeping and with all applicable laws and regulations, complete and accurate records, including all documents, pertaining to the services and functions the Administrator has agreed to provide hereunder for the Policies. 9.02 Records Management. The Administrator shall: (a) maintain all paper-based files and records provided to the Administrator on behalf of the Company, including, but not limited to, applications, transaction documents and authorizations, correspondence, beneficiary designations and all other relevant servicing documents. (b) maintain electronic media information with respect to the Policies, including options, status and payments. (c) maintain all such records and files as the property of the Company and, to the extent required by Article 7.04, promptly return such property to the Company upon termination of this Agreement. 9.03 Records Access. Each party shall take all reasonable actions necessary to ensure that at all times the Company has timely access to all records relating to the Policies. ARTICLE 10 CONFIDENTIALITY AND NONCOMPETITION 10.01 Confidentiality. Except as otherwise provided in this Agreement, all information communicated by the Company to the Administrator and by the Administrator to the Company shall be and is received in confidence and shall be used only for purposes of this Agreement. No such information shall be disclosed by the Administrator, by the Company, or by their respective agents or employees without the prior written consent of the other party, except as may be necessary by reason of legal, accounting, reinsurance reporting, or regulatory requirements. Without limiting the foregoing, the Administrator agrees that it shall not use customer information received from the Company to solicit new business, and shall not disclose any Company customer lists to its field force. 10.02 Information. The information referred to in Article 10.01 shall include, but not be limited to, marketing information and materials, administrative procedures, sales data, customer lists, financial plans, investment strategies, policyholder data, and data regarding agents, agencies and distribution systems. 10.03 Exception. Articles 10.01 and 10.02 shall not apply to information publicly available or generally known within the life insurance industry, nor to information obtained from other sources not under a duty of confidentiality to the Company or the Administrator with respect to such information. 10.04 Non-Solicitation. During the term of this Agreement and for a period of twenty-four months thereafter, the Administrator shall not without the written consent of the Company, directly or indirectly or through any third party, use any information obtained pursuant to this Agreement to recruit or hire any agents or employees of the Company (provided that the foregoing will not prevent the Administrator, with the Company's permission, from licensing any of the Company's agents so as to allow them to continue servicing the Policies after said Policies have become subject to an assumption reinsurance agreement between the Company and the Administrator.) The foregoing shall not prevent the Administrator from hiring any employees of the Company who, without being solicited or recruited, approach the Administrator about an employment opportunity. ARTICLE 11 MISCELLANEOUS 11.01 Binding Nature and Assignment. This Agreement shall be binding on the parties and their respective successors and assigns. Neither the Company nor the Administrator may subcontract or assign this Agreement without the prior written consent of the other. 11.02 Notices. Any notice or other instrument authorized or required by this Agreement shall be deemed given upon receipt and shall be effective only if it is in writing and delivered personally, by facsimile transmission with telephone confirmation, by registered or certified return receipt mail, postage prepaid, or by nationally recognized overnight courier service addressed as set forth below or to such other person or address as the Company or the Administrator may from time to time designate by notice to the other. In the case of the Administrator: The Metropolitan One Madison Avenue New York, NY 10010 Attention: Jon M. Piano Vice President Copy to: J. Gilbert Stallings, Esq. Assistant General Counsel In the case of the Company: Allmerica Financial 440 Lincoln Street Worcester, Massachusetts 01653 Attention: Edward J. Parry, III Vice President and Treasurer Copy to: Mark H. Stepakoff, Esq. Assistant Vice President & Counsel 11.03 Amendment. This Agreement may be amended or modified only by a written agreement executed by the parties, as evidenced in writings signed by authorized officers of the Administrator and the Company. 11.04 Counterparts. This Agreement may be executed simultaneously in multiple counterparts, each of which shall be deemed an original, but all of which taken together shall constitute one and the same instrument. 11.05 Certain Construction Rules. All Schedules attached hereto and referred to herein, are hereby incorporated in and made a part of this Agreement as if set forth herein. Any matter disclosed on any Schedule referred to herein shall be deemed also to have been disclosed on any other applicable Schedule referred to herein. All Article titles or captions contained in this Agreement or in any Schedule are for convenience only, shall not be deemed a part of this Agreement and shall not affect the meaning or interpretation of this Agreement. The recitals set forth on the first page of this Agreement are incorporated into and made a part of this Agreement. Unless the context clearly indicates, words used in the singular include the plural, and words in the plural include the singular. 11.06 Changes in Control Structure. The Administrator will inform the Company in writing, with six months advance notice if feasible, in the event of any changes in ownership, management or control of the Administrator's operation, organization or corporate structure affecting Policy administration. 11.07 Approvals and Similar Actions. Where agreement, approval, acceptance, consent or similar action is required by any provision of this Agreement, such action shall not be unreasonably delayed or withheld. 11.08 Force Majeure. Each party shall be excused from performance for any period and to the extent that the party is prevented from performing any services, in whole or in part, as a result of delays caused by a war, civil disturbance, court order, labor dispute, or other cause beyond that party's reasonable control, including failures or fluctuations in electrical power, heat, light, air conditioning or telecommunications equipment and such nonperformance shall not be a default or a ground for termination. Notwithstanding the above, the Administrator agrees that it will establish and maintain reasonable recovery steps as specified in Schedule 3.01, including technical disaster recovery facilities, uninterruptable power supplies for computer equipment and communications and that as a result thereof the Administrator will use its best efforts to ensure that the Computer System and its facilities shall be operational within thirty hours of a performance failure. 11.09 Severability. In the event that any provision or term of this Agreement shall be held by any court to be invalid, illegal, or unenforceable, all of the other terms and provisions shall remain in full force and effect to the extent that their continuance is practicable and consistent with the original intent of the parties, and the parties will attempt in good faith to renegotiate the Agreement to carry out its original intent. 11.10 Construction and Representation by Counsel. The parties hereto represent that in the negotiation and drafting of this Agreement they have been represented by and relied upon the advice of counsel of their choice. The parties affirm that their counsel have had a substantial role in the drafting and negotiation of this Agreement and, therefore, the rule of construction to the effect that any ambiguities are to be resolved against the drafting party shall not be employed in the interpretation of this Agreement or any Schedule attached hereto. 11.11 Media Releases. The Company and the Administrator shall consult with each other as to the form, substance and timing of any press release or other public disclosure of matters related to this Agreement or any of the transactions contemplated hereby, and no such press release or other public disclosure shall be made without the consent of the other party, which shall not be unreasonably withheld or delayed; provided, however, that either the Administrator or the Company may make such disclosures as are required by legal, accounting or regulatory requirements after making reasonable efforts in the circumstances to consult in advance with the other party. 11.12 Waiver. Unless this Agreement provides expressly to the contrary, no delay or omission by a party to exercise any right or power shall impair such right or power or be construed as a waiver. A waiver by a party of any of the covenants to be performed by the other or any breach shall not be construed to be a waiver of any succeeding breach or of any other covenant. 11.13 Entire Agreement. This Agreement constitutes the entire agreement between the parties with respect to the subject matter hereof. Notwithstanding the foregoing, the parties recognize that their rights and obligations with respect to the reinsurance of the Policies are to be governed by the Reinsurance Agreements, and nothing in this provision is intended to affect the validity or enforceability of the Reinsurance Agreements nor of any Confidentiality Agreement between the parties with respect to the Policies including, without limitation, the Confidentiality Agreement dated November 25, 1996. 11.14 Taxes. Any taxes or similar assessments charged against the Administrator or charged in connection with the services provided under this Agreement shall be the responsibility of the Administrator, whether such tax or assessment is imposed by the federal government, a state, a municipality or an administrative organization thereof. 11.15 Arbitration. All disputes and differences between the Administrator and the Company will be decided by arbitration, regardless of the insolvency of the other party, unless the conservator, receiver, liquidator or statutory successor is specifically exempted from an arbitration proceeding by applicable state law. The Administrator or the Company may initiate arbitration by providing written notification to the other party. Such written notice shall set forth: (1) a brief statement of the issue(s); (2) the failure of the parties to reach agreement; and (3) the date of the demand for arbitration. The arbitration panel shall consist of three arbitrators. The arbitrators must be impartial and must be or must have been officers of life insurance companies other than the parties or their affiliates. The Administrator and the Company shall each select an arbitrator within thirty days from the date of the demand. If either party shall refuse or fail to appoint an arbitrator within the time allowed, the party that has appointed an arbitrator may notify the other party that, if it has not appointed its arbitrator within the following ten days, the arbitrator will appoint an arbitrator on its behalf. The two arbitrators shall select the third arbitrator within thirty days of the selection of the second arbitrator. If the two arbitrators fail to agree on the selection of the third arbitrator within the time allowed, the Administrator or the Company may ask ARIAS.US to appoint the third arbitrator. However, if ARIAS.US is unable to appoint an arbitrator who is impartial and who is or was an officer of a life insurance company other than the parties or their affiliates, then each of the other two arbitrators shall submit to the other a list of three candidates, after which each arbitrator shall select one name from the list submitted by the other and the third arbitrator shall be selected from the two names chosen by drawing lots. The arbitration panel shall interpret this Agreement as an honorable engagement rather than as merely a legal obligation and shall consider practical business and equitable principles as well as industry custom and practice regarding the applicable insurance and reinsurance business. The arbitration panel is released from judicial formalities and shall not be bound by strict rules of procedure and evidence. The arbitration panel shall determine all arbitration schedules and procedural rules. Organizational and other meetings shall be held in New York, NY, unless the arbitration panel shall select another location. The arbitration panel shall decide all matters by majority vote. The decisions of the arbitration panel shall be final and binding on the parties. The arbitration panel may, at its discretion, award costs and expenses as they deem appropriate, including but not limited to attorneys fees and interest. Judgment may be entered upon the final decision of the arbitration panel in any court of competent jurisdiction. The arbitration panel may not award any exemplary or punitive damages. The Administrator and the Company will bear the expenses of the arbitration equally unless the arbitration panel shall decide otherwise. 11.16 Legal Proceedings and Regulatory Complaints. The Administrator shall at its expense defend or handle any legal or regulatory matter involving any Policy or Policies (other than a Policy excluded under the Reinsurance Agreement) in the name and on behalf of the Company, unless the Company chooses to assume the direct handling of such matter at its own expense, in which case the Administrator shall be relieved of further liability. The Administrator and the Company will each notify the other of the commencement of a legal proceeding or regulatory complaint involving a Policy or Policies within two business days from the date the party learns of its commencement. The parties will cooperate to make certain that any such legal or regulatory complaint is responded to within all required time periods. The Administrator shall be responsible for drafting the response to any regulatory complaint involving a Policy or Policies, subject to the approval of the Company, which shall not be unreasonably withheld. If the Company does not respond to a request by the Administrator for approval of a proposed response to a regulatory complaint within two business days of the Company's receipt of the proposed response, the Company shall be deemed to have approved the proposed response. 11.17 Agent Conduct. The Company shall use its best efforts to prevent any of its agents from taking any action detrimental to the proper administration of the Policies. The Company and the Administrator shall cooperate in the investigation of any matter involving suspected misconduct of any Company agent with respect to a Policy. However, all responsibility for disciplinary action with respect to the misconduct of any of the Company's agents shall rest with the Company and not the Administrator. 11.18 Trademarks and Tradenames. Except as expressly provided under this Agreement, the Administrator will not use the Company's name, trademarks, logo, or the name of any affiliate of the Company in any way or manner not specifically authorized in writing by the Company, and the Company will not use the Administrator's name, trademarks, logo or the name of any affiliate of the Administrator in any way or manner not specifically authorized in writing by the Administrator. 11.19 Choice of Law. While the parties anticipate that any disputes under this Agreement will be resolved via arbitration pursuant to Section 11.15, to the extent a question should arise as to the laws of which state govern this Agreement, said state shall be the State of New York without regard to New York choice of law rules. 11.20 Misunderstandings and Oversights. If the Company should inadvertently fail to include in Schedule 1.01 a policy that otherwise would have been included as a Policy in accordance with this Agreement or if either the Company or the Administrator should fail to pay amounts due or to perform any other act required by the Agreement as a result of misunderstanding or oversight, the Company and the Administrator shall adjust the situation to what it would have been had the inadvertent failure, misunderstanding or oversight not occurred, provided that the inadvertent, failure, misunderstanding or oversight is rectified promptly upon discovery. 11.21 Authority. Each party represents that it has full power and authority to enter into and perform this Agreement and that the person signing this Agreement on its behalf has been properly authorized and empowered to do so. Each party further acknowledges that it has read this Agreement, understands it, and agrees to be bound by it. The Administrator also shall obtain and maintain all licenses, permits, authorizations and approvals that are necessary for the Administrator to perform its duties under this Agreement. 11.22 Survival. All provisions of this Agreement shall, to the extent necessary to carry out the purposes of this Agreement or to ascertain and enforce the parties' rights thereunder, survive its termination. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of September 29, 1997. ALLMERICA FINANCIAL LIFE INSURANCE AND ANNUITY COMPANY By: ----------------------------------- Name: ----------------------------------- Title: ----------------------------------- FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY By: ----------------------------------- Name: ----------------------------------- Title: ----------------------------------- METROPOLITAN LIFE INSURANCE COMPANY By: ----------------------------------- Name: ----------------------------------- Title: ----------------------------------- EX-10.26 4 CONSOLIDATED SERVICE AGREEMENT DATED 1-JAN-1998 Exhibit 10.26 CONSOLIDATED SERVICE AGREEMENT AGREEMENT effective January 1, 1998, between ALLMERICA FINANCIAL CORPORATION ("Parent") and AAM GROWTH & INCOME FUND L.L.C., AAM HIGH YIELD FUND, L.L.C., AAM EQUITY FUND, AFC CAPITAL TRUST I, ALLMERICA ASSET MANAGEMENT, INC., ALLMERICA BENEFITS, INC., ALLMERICA EQUITY INDEX POOL, ALLMERICA FINANCIAL ALLIANCE INSURANCE COMPANY, ALLMERICA FINANCIAL BENEFIT INSURANCE COMPANY, ALLMERICA FINANCIAL INSURANCE BROKERS, INC., ALLMERICA FINANCIAL LIFE INSURANCE AND ANNUITY COMPANY, ALLMERICA FINANCIAL SERVICES INSURANCE AGENCY, INC., ALLMERICA FUNDING CORP., ALLMERICA FUNDS, ALLMERICA, INC., ALLMERICA INSTITUTIONAL SERVICES, INC., ALLMERICA INVESTMENT MANAGEMENT COMPANY, INC., ALLMERICA INVESTMENTS, INC., ALLMERICA INVESTMENT TRUST, ALLMERICA PLUS INSURANCE AGENCY, INC., ALLMERICA PROPERTY & CASUALTY COMPANIES, INC., ALLMERICA SECURITIES TRUST, ALLMERICA SERVICES CORPORATION, ALLMERICA TRUST COMPANY, N.A., AMGRO, INC., APC FUNDING CORP., CITIZENS CORPORATION, CITIZENS INSURANCE COMPANY OF AMERICA, CITIZENS INSURANCE COMPANY OF ILLINOIS, CITIZENS INSURANCE COMPANY OF THE MIDWEST, CITIZENS INSURANCE COMPANY OF OHIO, CITIZENS MANAGEMENT INC., FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY, GREENDALE SPECIAL PLACEMENTS FUND, THE HANOVER AMERICAN INSURANCE COMPANY, THE HANOVER INSURANCE COMPANY, HANOVER TEXAS INSURANCE MANAGEMENT COMPANY, INC., HANOVER LLOYD'S INSURANCE COMPANY, LOGAN WELLS WATER COMPANY, INC., LLOYDS CREDIT CORP., MASSACHUSETTS BAY INSURANCE COMPANY, SMA FINANCIAL CORP., SOMERSET SQUARE, INC., STERLING RISK MANAGEMENT SERVICES, INC. The above listed companies known collectively as "Affiliated Group". WHEREAS, the Cost Distribution Policy adopted by the Affiliated Group on June 15, 1993 and amended as of October 21, 1997, for implementation in calendar year 1998 ("Policy"), and as supplemented by the Cost Distribution Policy Implementation Manual, as may be created or amended by Parent's management from time to time to conform to State or Federal law, regulation or requirement or for other sound reason "Implementation Manual") has been determined to be an appropriate method of achieving fair distribution of servicing costs between the Affiliated Group. NOW, THEREFORE, the Affiliated Group hereby agree as follows: 1. Each Company hereby agrees to provide any other Company in the Affiliated Group with such services as it may require for its operations. The Policy and Implementation Manual shall be the basis for allocating cost for various services between each Company. The Policy and Implementation Manual will become a part of this Agreement. 2. The servicing company agrees to provide each serviced company with a quarterly report covering the items of service performed on behalf of serviced company. 3. This Agreement may be canceled in whole upon 60 days written notice by any party delivered to the other members of the Affiliated Group, or in part by any party giving the other 60 days written notice that certain services will no longer be performed by the servicing company or will no longer be purchased by the serviced company. This Agreement will automatically be canceled with respect to a company that leaves the Affiliated Group. 4. The parties to the Agreement acknowledge that First Allmerica Financial Life Insurance Company ("FAFLIC") shall be the single employer within the Affiliated Group and that all employment costs shall be paid by FAFLIC. Each member of the Affiliated Group shall then be charged by FAFLIC for services performed by employees of FAFLIC on behalf of such affiliate. Employees of FAFLIC shall not be directly compensated by an affiliate under this Agreement. 5. The parties hereto specifically recognize that from time to time other companies may become members of the Affiliated Group and hereby agree that such new members must become parties to this Agreement. Such new members should execute the master copy of this Agreement (or a counterpart thereto, which shall be deemed to be the original agreement) and it will not be necessary for all the other members to sign the agreement, but it will be effective as if the old members had signed the agreement. 6. For the convenience of the parties, any number of counterparts of this Agreement may be executed by the parties hereto, and each such executed counterpart shall be, and shall be deemed to be, an original instrument. 7. This Agreement supersedes all previous agreements or understandings of any nature whatsoever regarding the subject matter of this Agreement. 8. This Agreement shall be governed by and construed and enforced in accordance with the laws of the Commonwealth of Massachusetts. IN WITNESS WHEREOF, the parties hereto have executed this Agreement by their duly authorized officers as of the 1st day of January, 1998. ALLMERICA FINANCIAL CORPORATION By: /s/ Richard J. Baker ---------------------- Richard J. Baker Secretary 2 AAM GROWTH & INCOME FUND L.L.C. By: Allmerica Asset Management, Investment Manager By: /s/ Henry L. Ferguson III --------------------------- Henry L. Ferguson III Clerk AAM HIGH YIELD FUND, L.L.C. By: First Allmerica Financial Life Insurance Company, Member By: Citizens Insurance Company of America, Member By: The Hanover Insurance Company, Member By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Assistant Secretary/Secretary/Clerk AAM EQUITY FUND By: Allmerica Asset Management, Inc., Trustee By: /s/ Henry L. Ferguson III --------------------------- Henry L. Ferguson III Clerk AFC CAPITAL TRUST I By: /s/ John P. Kavanaugh ----------------------- John P. Kavanaugh Administrative Trustee ALLMERICA ASSET MANAGEMENT, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk 3 ALLMERICA BENEFITS, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary ALLMERICA EQUITY INDEX POOL By: Allmerica Asset Management, Inc. Trustee By: /s/ Henry L. Ferguson III --------------------------- Henry L. Ferguson III Clerk ALLMERICA FINANCIAL ALLIANCE INSURANCE COMPANY By: /s/ William J. Cahill, Jr. --------------------------- William J. Cahill, Jr. Secretary ALLMERICA FINANCIAL BENEFIT INSURANCE COMPANY By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary ALLMERICA FINANCIAL INSURANCE BROKERS, INC. By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Clerk ALLMERICA FINANCIAL LIFE INSURANCE AND ANNUITY COMPANY By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary 4 ALLMERICA FINANCIAL SERVICES INSURANCE AGENCY, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA FUNDING CORP. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA FUNDS By: /s/ George M. Boyd -------------------- George M. Boyd Secretary ALLMERICA, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA INSTITUTIONAL SERVICES, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA INVESTMENT MANAGEMENT COMPANY, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk 5 ALLMERICA INVESTMENTS, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA INVESTMENT TRUST By: /s/ George M. Boyd -------------------- George M. Boyd Secretary ALLMERICA PLUS INSURANCE AGENCY, INC. By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Clerk ALLMERICA PROPERTY & CASUALTY COMPANIES, INC. By: /s/ Richard J. Baker ---------------------- Richard J. Baker Secretary ALLMERICA SECURITIES TRUST By: /s/ George M. Boyd -------------------- George M. Boyd Secretary ALLMERICA SERVICES CORPORATION By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk ALLMERICA TRUST COMPANY, N.A. By: /s/ Charles F. Cronin ----------------------- Charles F. Cronin Secretary 6 AMGRO, INC. By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Clerk APC FUNDING CORP. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk CITIZENS CORPORATION By: /s/ Richard J. Baker ---------------------- Richard J. Baker Secretary CITIZENS INSURANCE COMPANY OF AMERICA By: /s/ Karen Livingston-Wilson ----------------------------- Karen E. Livingston-Wilson Secretary CITIZENS INSURANCE COMPANY OF ILLINOIS By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary CITIZENS INSURANCE COMPANY OF THE MIDWEST By: /s/ Karen E. Livingston-Wilson -------------------------------- Karen E. Livingston-Wilson Secretary 7 CITIZENS INSURANCE COMPANY OF OHIO By: /s/ Karen E. Livingston-Wilson -------------------------------- Karen E. Livingston-Wilson Secretary CITIZENS MANAGEMENT INC. By: /s/ Karen E. Livingston-Wilson -------------------------------- Karen E. Livingston-Wilson Secretary FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary GREENDALE SPECIAL PLACEMENTS FUND By: Allmerica Asset Management, Inc., Trustee By: /s/ Henry L. Ferguson III --------------------------- Henry L. Ferguson III Clerk THE HANOVER AMERICAN INSURANCE COMPANY By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary THE HANOVER INSURANCE COMPANY By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary 8 HANOVER TEXAS INSURANCE MANAGEMENT COMPANY, INC. By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary HANOVER TEXAS INSURANCE MANAGEMENT COMPANY, INC. ATTORNEY-IN-FACT FOR HANOVER LLOYD'S INSURANCE COMPANY By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary LOGAN WELLS WATER COMPANY, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk LLOYDS CREDIT CORP. By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Clerk MASSACHUSETTS BAY INSURANCE COMPANY By: /s/ William J. Cahill, Jr. ---------------------------- William J. Cahill, Jr. Secretary SMA FINANCIAL CORP. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary/Clerk 9 SOMERSET SQUARE, INC. By: /s/ Henry L. Ferguson III --------------------------- Henry L. Ferguson III Secretary/Clerk STERLING RISK MANAGEMENT SERVICES, INC. By: /s/ Abigail M. Armstrong -------------------------- Abigail M. Armstrong Secretary 10 Allmerica Financial Corporation ("Parent") AAM Growth & Income Fund L.L.C. AAM High Yield Fund, L.L.C. AAM Equity Fund AFC CAPITAL TRUST I Allmerica Asset Management, Inc. Allmerica Benefits, Inc. Allmerica Equity Index Pool Allmerica Financial Alliance Insurance Company Allmerica Financial Benefit Insurance Company Allmerica Financial Insurance Brokers, Inc. Allmerica Financial Life Insurance and Annuity Company Allmerica Financial Services Insurance Agency, Inc. Allmerica Funding Corp. Allmerica Funds Allmerica, Inc. Allmerica Institutional Services, Inc. Allmerica Investment Management Company, Inc. Allmerica Investments, Inc. Allmerica Investment Trust Allmerica Plus Insurance Agency, Inc. Allmerica Property & Casualty Companies, Inc. Allmerica Securities Trust Allmerica Services Corporation Allmerica Trust Company, N.A. AMGRO, Inc. APC Funding Corp. Citizens Corporation Citizens Insurance Company of America Citizens Insurance Company of Illinois Citizens Insurance Company of the Midwest Citizens Insurance Company of Ohio Citizens Management Inc. First Allmerica Financial Life Insurance Company Greendale Special Placements Fund The Hanover American Insurance Company The Hanover Insurance Company Hanover Texas Insurance Management Company, Inc. Hanover Lloyd's Insurance Company Logan Wells Water Company, Inc. Lloyds Credit Corp. Massachusetts Bay Insurance Company SMA Financial Corp. Somerset Square, Inc. Sterling Risk Management Services, Inc. 11 EX-10.27 5 DEFERRAL AGREEMENT DATED 4-APR-1997 Exhibit 10.27 DEFERRAL AGREEMENT ------------------ This Deferral Agreement is entered into this 4th day of April, 1997, and is between JOHN F. O'BRIEN (hereinafter referred to as "JOB") and ALLMERICA FINANCIAL CORPORATION, Worcester, Massachusetts (hereinafter referred to as the "Company"). This Agreement is entered into before JOB has any right, title or interest in the shares of the Company (the "Shares") which are the subject matter of this Deferral Agreement. The Shares will, for a period of three years, be restricted in accordance with the terms and conditions of a certain Restricted Stock Agreement between the Company and JOB dated April 4, 1997 (the "Restricted Stock Agreement"). JOB and the Company wish to defer JOB's receipt of the Shares until JOB is no longer a "covered employee" as that term is currently and as may be defined in Internal Revenue Code Section 162(m). ARTICLE I --------- Definitions ----------- 1.01 "Beneficiary" shall mean any person, corporation or trust, or combination of these, last designated by JOB in writing and filed with the Company by JOB during his lifetime. Any such designation or designations shall be revocable at any time or times, without the consent of any beneficiary, by a written instrument or nomination of beneficiary made by JOB and similarly filed with the Company by him during his lifetime. In the absence of living designated beneficiaries, the corpus due hereunder shall be distributed to JOB's estate pursuant to the terms hereof in one single distribution. 1.02 "Interest Rate" shall mean the percentage used in determining the amount of Interest each year. The Interest Rate shall be the annual rate the Company is crediting on January 1 of each year for the Fixed Interest Account under the Retirement Investment Funding Agreement. "Interest" shall mean the amount credited to any Dividends, accrued interest or other cash sums payable in connection with the Shares and deferred pursuant to the terms of this Deferral Agreement. 1.03 "Account" shall mean a special memorandum account created by the Company on its books. 1.04 "Dividends" shall mean any dividends declared in connection with the Shares. 1.05 "Deferred Corpus" shall mean the Shares JOB is entitled to receive under the Restricted Stock Agreement, the Deferred Amount and any other cash payments and interest thereon made in connection with the Shares. 1.06 "Deferred Amount" shall mean the Dividends deferred hereunder plus interest accrued on such Dividends compounded annually. 1.07 "Internal Revenue Code" shall mean the Internal Revenue Code of 1986 (as amended). 1.08 "The singular as used herein shall include the plural, the plural shall refer to the singular, and any pronoun shall refer to any gender when the context so permits. ARTICLE II ---------- Deferred Corpus and Deferred Amount ----------------------------------- 2.01 JOB hereby elects to defer in accordance with the terms of this Deferral Agreement the receipt of the Shares that may be delivered to him in accordance with the terms of the Restricted Stock Agreement. In addition, JOB hereby elects to defer in accordance with the terms of this Deferral Agreement the receipt of any Dividends that may be due him at any time on the Shares. 2.02 The Company annually, on January 1st of each year, shall credit to the Account an amount of Interest determined by applying the then-prevailing Interest Rate to the Deferred Amount. However, Dividends paid during the preceding calendar year shall be credited with Interest only for the amount of time during the pervious calendar year that such Dividends were credited to the Account. 2.03 If JOB shall die prior to the date this Agreement is terminated, any such Interest shall be credited to the Account until the Deferral Agreement is paid over to the Beneficiary. ARTICLE III ----------- Manner of Payment ----------------- 3.01 Upon the first to occur of JOB's death or the first business day in the year following the date that JOB is no longer a "covered employee" as defined in Internal Revenue Code Section 162(m), the Deferred Corpus shall be delivered/paid to JOB. 3.02 If JOB dies prior to no longer being a covered employee, the Company shall deliver/pay to the Beneficiary the Deferred Corpus on the first day of the year immediately following JOB's death. 3.03 In the event JOB ceases to be an employee of the Company, or any subsidiary of the Company, for any reason other than death, the Company shall, on the first day of the year following such event, deliver/pay to JOB the Deferred Corpus with Interest credited on the Deferred Amount until the date of payment. In the event JOB ceases to be an employee for any reason other than death and the Shares have not or do not vest pursuant to the terms of the Restricted Stock Agreement, the Deferred Amount plus any Interest due will be paid to JOB on the first business day in the calendar year following the termination of his employment. ARTICLE IV ---------- Further Provisions ------------------ 4.01 The Shares shall receive the benefit of any stock, securities and/or cash received by shareholders of the Company pursuant to a plan of merger, consolidation, recapitalization or reorganization of the Company. The Shares shall also include any security received as a result of a stock split or stock dividend received by shareholders of the Company. If any cash is received in addition to Dividends, such cash shall also be deferred and be credited with Interest in the same manner as Dividends are credited with Interest. Any stock, securities and/or cash received, in connection with the Shares due to a plan of merger, consolidation, recapitalization, reorganization of the Company and/or as a result of a stock split or stock dividend shall be added to the Deferred 2 Corpus and deferred pursuant to the terms of this Deferral Agreement. Any stock, securities and/or cash received pursuant to this Section shall be considered part of the Shares and shall not vest unless JOB becomes vested in the Shares pursuant to the Restricted Stock Agreement. 4.02 It is agreed that neither JOB nor any other payee hereunder shall have any right to commute, sell, assign, transfer or otherwise convey the right to receive any payments hereunder, which payments and the right thereto are expressly declared to be non-assignable and non-transferrable, and in the event of any attempted assignment or transfer, the Company shall have no liability for failure to recognize any such assignment. 4.03 This Agreement shall be binding upon the parties hereto, their beneficiaries, heirs, executors, administrators or successors. 4.04 This Agreement shall be executed in duplicate counterparts, and each copy shall serve as an original for all purposes, but both counterpart copies shall constitute one and the same agreement. 4.05 All headings set forth in this Agreement are intended for convenience only, and shall not control or affect the meaning, constructions, or effect of this Agreement or of any of the provisions hereof. 4.06 It is understood and agreed that the Deferred Corpus, Deferred Amount and the Account are and shall be owned by the Company and not by JOB or by any other payee who shall be entitled to any payments under this Agreement. The Deferred Corpus and the Deferred Amount hereunder shall belong to the Company as part of its funds and for its own use and benefit. A trust is not created by this Agreement, nor shall a constructive trust be imposed. All payments payable and Shares to be distributed under this Agreement to JOB or to any other payee shall be made by the Company, and both JOB and any other payee always shall be general, unsecured creditors of the Company. All reference in this Agreement to the Account, to the Deferred Corpus and to the Deferred Amount are made herein solely as a means of measuring and determining the amount that the Company is to pay and the number of Shares that the Company is to deliver under this Deferral Agreement. ALLMERICA FINANCIAL Attest: CORPORATION By: /s/ Bruce C. Anderson - ---------------------- ------------------------- Name: Bruce C. Anderson Title: Vice President /s/ John F. O'Brien ---------------------------- John F. O'Brien 3 EX-10.28 6 SEVERANCE AGREEMENT DATED 25-SEP-1997 Exhibit 10.28 [LETTERHEAD OF FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY APPEARS HERE] September 25, 1997 Larry C. Renfro Dear Larry: This letter agreement sets forth the relationship between yourself and First Allmerica Financial Life Insurance Company (together with its affiliates and subsidiaries, hereinafter referred to as the "Company") for the period September 2nd through November 30, 1997. In addition, this letter agreement sets forth the terms and conditions of the severance agreement between yourself and the Company terminating your employment relationship with the Company as of the close of business on November 30, 1997. Finally, this agreement also sets forth the terms and conditions of a so-called independent producer agreement between yourself and the Company. September 2nd through November 30, 1997 Period (the "Interim Period") - --------------------------------------------------------------------- 1. Effective at the close of business on September 2, 1997, you were relieved of your management or administrative responsibilities which you had in your capacity as a Vice President of the Company and as a member of the so-called "Operating Committee". Notwithstanding your having been relieved of these duties and responsibilities, you agree to assist the Company in making a smooth and orderly transition of your management/administrative duties and responsibilities to new individuals. You agree to resign as a Director of the Company and as an officer and/or Director of any subsidiary of the Company, and as an officer of Allmerica Financial Corporation ("AFC") as soon as possible, but in no event later than September 30, 1997. Your resignation of these positions shall be in the form of Exhibit A. 2. Notwithstanding your transition assistance as set forth in paragraph 1 above, you acknowledge and agree that your primary responsibility during the September 2 through November 30 time frame will be to devote your energies to the sale of the Company's products and/or services. You agree to use your best efforts to pursue existing contacts and to develop any new contacts that may arise in the normal course of your activities during this Interim Period. Any and all business flowing from your efforts during this Interim Period shall be considered to be an asset of the Company and any sales resulting from your efforts during this Interim Period will belong to the Company without any additional consideration having to be paid to you. A sale resulting Larry C. Renfro September 25, 1997 Page 2 from your efforts shall mean any sale which is initiated or consummated during the Interim Period or any sales resulting within twelve months thereafter from a contact made by you before or during the Interim Period. Any sale resulting from your efforts which is placed with or by the Company shall be without any commission or payments of any kind or nature being owed to you by the Company, except as set forth in the following paragraph. 3. During the Interim Period you will be compensated at your current rate of compensation and you will be entitled to receive all existing fringe benefits which you are currently entitled to receive as an employee. 4. During the Interim Period, your current office space will be available to you and you may utilize your current secretarial assistance. However, you agree to use your current office space only as needed to fulfill your Interim Period responsibilities. To the extent you do not need to use your current office space, you agree not to use such office space during the Interim Period. 5. If during the Interim Period your performance is unacceptable, the employment relationship between you and the Company may be terminated immediately. The decision as to whether your performance during the Interim Period is unacceptable will be made by John F. O'Brien. Mr. O'Brien's decision shall be final and shall be made at his sole discretion. It is hereby agreed that you will receive two week notice of and an opportunity to discuss any termination with Mr. O'Brien if Mr. O'Brien wishes to terminate your employment during the Interim Period. In the event Mr. O'Brien terminates your employment prior to November 30, 1997, Mr. O'Brien may also at that time terminate the Independent Producer Agreements (as defined below) between you and the Company. In the event your employment is terminated by Mr. O'Brien before the end of the Interim Period, or when your employment terminates at the end of the Interim Period, you shall be entitled to the severance benefits set forth below provided you adhere to the terms and conditions attached to your receipt of those severance benefits. Except for the benefits set forth in the Severance Terms and Conditions, you shall not be entitled to any benefits at the time your employment is terminated. 6. You also agree during the Interim Period to allow an individual or individuals of the Company's choosing to accompany you to meetings with existing or potential clients or contacts. You acknowledge that the intent of this provision is to assist the Company in making an orderly transition from your being responsible for Allmerica Financial Institutional Services to your role as an independent producer. You agree to use your best efforts to communicate to this individual or individuals information that is needed to continue the relationships that may exist between yourself or your former area of responsibility and the Company's existing and/or potential clients and contacts. 7. During the Interim Period, you agree to use your best efforts to obtain any licenses that you will need to fulfill the functions required of you under the Independent Producer Agreements. The Larry C. Renfro September 25, 1997 Page 3 Company recognizes that your current travel schedule and other demands placed upon you during the Interim Period may preclude you from obtaining any licenses during the Interim Period. Severance Terms and Conditions - ------------------------------ 1. Resignation. With the close of business on November 30, 1997, you agree to ----------- resign as an officer of the Company. Your officer resignation will be in accordance with Exhibit B. 2. Health Benefits. For the period December 1, 1997 through May 31, 1999, the ---------------- Company will provide medical coverage to you and your dependents. This coverage will be provided either through the health benefits set forth in section 2(c) of the Independent Producer Terms and Conditions or by the Company providing benefits through COBRA. The benefits to be provided will be similar to the health benefits which you currently are receiving as an employee of the Company. The cost of benefits provided under this section shall be paid partly by the Company and partly by you. The Company's share shall be the same dollar cost that the Company would pay for such benefits if you had remained an employee of the Company. Your share would be the amount you would have paid if you remained an employee of the Company. 3. Monthly Payments. Assuming you have agreed to and this letter agreement has ----------------- become effective, then commencing on January 1, 1998, the Company will pay you monthly in advance $50,000. These payments will be paid to you until December 1, 1998 provided you do not violate paragraph 10, 11, and/or 12 as set forth below in this portion of the agreement called Severance Terms and Conditions. If you die before you have received all the payments you are due pursuant to the provisions of this section entitled Severance Terms and Conditions, the Company agrees to pay to your spouse, or anyone else you inform the Company is your beneficiary, the unpaid portion of the payments due you pursuant to the provisions of this paragraph. Notwithstanding the foregoing, if this agreement is terminated due to your violation of the provisions of paragraph 10, 11, and/or 12 hereof, then you, your spouse or your beneficiary shall not receive or be entitled to receive any payments to be made subsequent to the date of such violation. Any payments made prior to such violation shall, at the sole discretion of the Company, be returned to the Company by you, your spouse or your beneficiary. In the event you or the Company terminates the Independent Producer Agreements (as defined in section 1 of the Independent Producer Terms and Conditions), you will still be entitled to the payments due pursuant to the terms of this section. 4. Termination Date. Your termination date with the Company shall be November ----------------- 30, 1997 unless John F. O'Brien in his sole discretion decides to terminate your employment during the Interim Period. In such an event, your termination date shall be the date that John F. O'Brien terminates your employment. If your employment is terminated before November 30, 1997, you shall still Larry C. Renfro September 25, 1997 Page 4 be entitled to receive the payments due under paragraph 3 hereof in accordance with the terms of paragraph 3. 5. Vacation Entitlement. The Company will pay you for any unused accrued -------------------- vacation time which you may have as of November 30, 1997, or if your employment is terminated prior to November 30, 1997, you will be paid for any unused accrued vacation time which you may have as of the last day of the month preceding the date that your employment is terminated. 6. Incentive Compensation. You acknowledge that you will not be entitled to a ----------------------- payment under the 1997 Short Term Incentive Compensation Plan of the Company. 7. Stock Option Plan. You acknowledge that you are currently a participant in ----------------- the Allmerica Financial Corporation Long Term Stock Incentive Plan (the "AFC Plan"). In light of the fact that your employment will terminate on or before November 30, 1997, you acknowledge and agree that pursuant to the terms of the AFC Plan you will forfeit all unvested options which you have under the Plan. At the present time, all options which you have under the Plan are unvested; thus, your entire interest in the AFC Plan shall be forfeited upon the termination of your employment. 8. Restricted Stock. Pursuant to the terms of a certain restricted stock ----------------- agreement dated April 4, 1997 between Allmerica Financial Corporation and you (the "Restricted Stock Agreement"), the Company has the right upon the termination of your employment prior to April 4, 2000 to have the so-called Match Shares (as defined in the Restricted Stock Agreement) returned to the Company for no consideration. The Company hereby exercises its right to have you return to it the Match Shares for no consideration. You acknowledge and agree to return to the Company the Match Shares for no consideration on or before November 30, 1997. 9. Release. In consideration of the Company's agreement as set forth herein, ------- you hereby knowingly and voluntarily agree to release the Company, Allmerica Financial Corporation ("AFC"), its subsidiaries and affiliates, its and their present and former officers, directors, employees, agents and their successors and assigns (collectively "Releasees") from any and all liabilities, demands, debts, damages, suits, covenants, agreements, contracts, benefits, promises, claims, including, but not limited to, claims for payment under the Company's 1997 Short Term Incentive Compensation Plan, the third payment under the Company's 1995 Long Term Incentive Compensation Plan, the second and third payments under the Company's 1996 Long Term Incentive Compensation Plan, and the first, second and third payments under the Company's 1997 Long Term Incentive Compensation Plan, and the right to all options issued to you under the AFC Plan, and the right to the Match Shares (as defined in the Restricted Stock Agreement) and claims arising under Title VII of the Civil Rights Act of 1964, as amended, including, but not limited to, any and all claims which you may have for age, race or sex discrimination and rights or claims arising under the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Americans With Disabilities Act, the Family and Medical Larry C. Renfro September 25, 1997 Page 5 Leave Act and claims, if any, for wrongful termination or any claim arising out of or in any way relating to your employment with the Company. Your release (the "Renfro Release") shall be in the form attached hereto as Exhibit C. However, the Renfro Release shall not affect any obligations of the Company made pursuant to the terms of this letter agreement. THE FOREGOING MEANS THAT BY SIGNING THE RENFRO RELEASE YOU WILL HAVE WAIVED ANY RIGHT YOU HAVE TO BRING A LAWSUIT OR MAKE A LEGAL CLAIM AGAINST ALLMERICA FINANCIAL CORPORATION, THE COMPANY OR ANY OF THE RELEASEES UP TO THE SIGNING OF THE RENFRO RELEASE, AND THAT YOU WILL HAVE RELEASED THE RELEASEES OF ANY AND ALL CLAIMS OF ANY NATURE ARISING ON OR BEFORE THE SIGNING OF THE RENFRO RELEASE. In addition, the Renfro Release does not waive any rights or claims that arise after the date the Renfro Release is executed. You agree to execute the Renfro Release as of your Termination Date as defined in paragraph 4 of this section. 10. Confidentiality. The terms and conditions of this letter agreement shall be --------------- held in confidence by the Company and by you, except as may be required by law, by state or federal tax or regulatory agencies, by an order of a court of competent jurisdiction, or as may be necessary by either party in connection with the enforcement of the terms hereof. You agree not to directly or indirectly discuss with or provide information to the news media, legislative or regulatory bodies, the brokerage, financial or insurance communities, or in any form of communication reveal in any way information which is detrimental to the best interest of the Company, Allmerica Financial Corporation, its subsidiaries and its/their directors, officers and employees. 11. Non-Solicitation/Competition. You acknowledge and reaffirm that you have ---------------------------- entered into a certain Compensation Agreement between the Company and yourself, a copy of which Compensation Agreement is attached hereto as Exhibit D (the "Compensation Agreement"). Pursuant to section 3 of the Compensation Agreement, you have agreed not to recruit or solicit employees or customers of the Company, all as more fully set forth in Section 3 of the Compensation Agreement. You further acknowledge that the payments to be made pursuant to paragraph 2 of this section entitled Severance Terms and Conditions will satisfy any and all payment obligations which the Company may have to you pursuant to section 3 of the Compensation Agreement, and accordingly, the terms of section 3 of the Compensation Agreement shall remain in full force and effect. You also acknowledge and reaffirm that you have entered into a certain Non- Solicitation Agreement with Allmerica Financial Corporation dated April 4, 1997 (a copy of that agreement is attached hereto as Exhibit E, the "Non- Solicitation Agreement"). You hereby acknowledge and reaffirm that that Non- Solicitation Agreement pursuant to its terms and conditions remains Larry C. Renfro September 25, 1997 Page 6 in full force and effect and that the payments you will receive under this Agreement shall be additional consideration for the Non-Solicitation Agreement. The Non-Solicitation Agreement would be effective for the two year period following the termination of your employment. To the extent, if any, that there is an inconsistency between the Compensation Agreement and the Non-Solicitation Agreement, the more restrictive provision concerning your solicitation shall be applicable. You also agree for the period December 1, 1997 through November 30, 1998, not to directly or indirectly, as an individual, sole proprietor, partner, stockholder, officer, employee, director, joint venturer, investor, lender or any other capacity whatsoever (other than as the holder of not more than 1% of the total outstanding stock of a publicly held company) engage in the business of developing, producing, marketing, selling or servicing products and/or services of the kind or type developed or being developed, produced, marketed, sold or serviced by the Company while you were employed by the Company. In addition you agree for the period December 1, 1997 through November 30, 1998, not to accept employment with, provide consulting services to or in any other capacity provide services directly or indirectly to a competitor of the Company or any of its subsidiary or affiliated companies without the prior written consent of the Company. If any restriction set forth in this paragraph is found by any court of competent jurisdiction to be unenforceable because it extends for too long a period 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. You agree and acknowledge that the restrictions contained in this section are necessary for the protection of the business and good will of the Company and its subsidiaries and affiliates and are considered by you to be reasonable for such purpose. 12. Proprietary Information. You acknowledge that your position with the ----------------------- Company has been one of high trust and confidence and that in the course of your services to the Company you have had access to and contact with Proprietary Information. You agree not to disclose to others, or use for your benefit or the benefit of others, any Proprietary Information. For purposes of this Agreement, Proprietary Information shall mean confidential information concerning the business, prospects and goodwill of the Company and/or its subsidiaries and affiliates, including, by way of illustration and not limitation, all information (whether or not patentable and whether or not copyrightable) owned, possessed or used by the Company and/or its subsidiaries and affiliates, including, without limitation, distribution plans including plans or strategies to be used in the distribution of products or services to banks or through banks or the distribution of products or services through the so-called work site methods, vendor information, customer/client information, potential clients or contacts, trade secrets, reports, new product information, marketing or business plans, unpublished financial information, budgetary/price/cost information or agent, broker, employee or insured lists. Larry C. Renfro September 25, 1997 Page 7 13. Remedies. You acknowledge that any breach of the provisions of paragraph -------- 10, 11 and/or 12 of this section of the agreement entitled Severance Terms and Conditions shall result in serious and irreparable injury to the Company and/or its subsidiaries and affiliates for which the Company cannot be adequately compensated by monetary damages alone. You agree, therefore, that in addition to any other remedy which it may have, the Company shall be entitled to specific performance of paragraph 10, 11 and/or 12 of this section of the letter agreement by you and to seek both temporary and permanent injunctive relief (to the extent permitted by law) without the necessity of proving actual damages. 14. Advice of Counsel. You acknowledge that you have been advised by the ----------------- Company to consult with an attorney prior to executing this letter agreement and that you have been given at least twenty-one (21) days in which to consider this agreement. You acknowledge that you were given a copy of this agreement on September 6, 1997. 15. Revocation Period. Upon your execution of this letter agreement, you shall ----------------- have seven days in which you may revoke this agreement. In addition, this agreement will not become effective or enforceable until this revocation period has elapsed. 16. Withholding. You acknowledge that any payments made pursuant to this ----------- agreement will be subject to appropriate federal and state withholding in the year in which paid. 17. Arbitration. If any dispute shall arise between you and the Company with ----------- reference to the interpretation of this agreement or the rights of either party with respect to any transaction under this letter agreement, the dispute shall be referred to an arbitrator who is mutually acceptable to you and the Company. If the parties are unable to agree upon a mutually acceptable arbitrator, then the arbitrator shall be selected pursuant to the Commercial Arbitration Rules of the American Arbitration Association. The arbitration shall take place in the Commonwealth of Massachusetts and the arbitration proceedings are to be governed by the rules of the American Arbitration Association and the Massachusetts Arbitration Law. The decision of the arbitrator shall be final and binding upon both you and the Company and judgment upon the award rendered by the arbitrator may be entered into any court having jurisdiction thereof. The expense of the arbitrator and of the arbitration shall be paid by the party who loses such arbitration. In the event the arbitrator determines that neither party has lost the arbitration, the expense shall be paid equally by you and the Company. Arbitration is the sole remedy for disputes arising under this letter agreement. 18. Successors and Assigns. This letter agreement shall be binding upon you, ---------------------- your heirs, executors, administrators and assigns and upon the Company, its successors and assigns. Larry C. Renfro September 25, 1997 Page 8 Independent Producer Terms and Conditions: - ----------------------------------------- 1. You and the Company (and such subsidiaries and affiliates as are appropriate) shall enter into agreements substantially in accordance with the terms and conditions contained in Exhibits F and G attached hereto (Exhibits F and G hereinafter collectively referred to as the "Independent Producer Agreements"). 2. Notwithstanding the terms and conditions set forth in the attached Independent Producer Agreements, the Independent Producer Agreements that will be signed by you and the Company shall contain the following terms and conditions: (a) For a period up to 12 months, the Company will provide you on a monthly basis an allowance of $2,000 a month to reimburse you for the cost of leasing office space of up to 1,000 square feet in Andover, Massachusetts or other mutually agreeable location. In addition, the Company will give to you your existing office and conference room furniture. In addition, the Company will supply you with secretarial furniture and related computer equipment. You may purchase the secretarial furniture and related computer equipment at the end of the 12 month period for its then current fair market value. The Company will also provide you a monthly allowance to reimburse you for leasing a copy machine and a fax machine for a period of up to 12 months. However, in no event shall the allowance for leasing such copy and fax machines exceed $208 per month. In addition, the Company will provide you an allowance of $4,000 per month for up to 12 months to hire a secretary or other administrative assistant that you feel is appropriate. (b) Jack O'Brien, in his sole discretion, may terminate the Independent Producer Agreements during the period December 1, 1997 through November 30, 1998. In the event these Agreements are terminated, all allowances provided by the Company will terminate as of the first day of the month succeeding such termination. (c) The Company, in its sole discretion, may allow you to be a participating employer in its group term and health plans as those plans relate to general agents of the Company. However, if the Independent Producer Agreements are terminated on or before November 30, 1998, the benefits provided under this section shall also terminate as of the first day of the month following such termination. In such an event you will still be entitled to the COBRA benefits set forth in section 2 of the Severance Terms and Conditions if such termination occurs prior to May 31, 1999. (d) Due to the fact that the Independent Contractor Agreements are unique and the services you will provide do not necessarily coincide with services provided under existing sales arrangements that the Company may have with agents and/or brokers, the commissions that Larry C. Renfro September 25, 1997 Page 9 would be payable to you may in many cases have to be negotiated on a case by case basis. The Company will work with you to establish commission rates. However, to the extent the standard commission rates are not appropriate or applicable, you agree to negotiate with the Company on a case by case basis commissions that may be due you from the sale of various products and services. (e) During the period December 1, 1997 to November 30, 1998, all business that is generated by you must be presented to the Company. If the Company decides not to accept such business, you agree not to place such business with another company without the Company's prior written approval. You agree that the Company may accept certain types or kinds of business without accepting all business generated by you. For example, if you sell a case involving P&C, 401(k) and EPLI coverage, the Company may accept the P&C and 401(k) business without accepting the EPLI coverage. For the period December 1, 1998 through November 30, 1999, any business that you write shall be first offered to the Company. If the Company refuses to accept such business you may place such business with other companies on the same terms and conditions as was offered to the Company. For the period December 1, 1997 through November 30, 1998, any business that is generated by you and another person or entity must be presented to the Company. If the Company decides not to accept such business you may place such business with another company on the same terms and conditions as offered to the Company. As set forth above, the Company may accept certain types or kinds of business without accepting all business generated by you and another person or entity. (f) Your status under the Independent Producer Agreements shall be that of an independent contractor and your compensation will only be in the form of commissions. (g) The Company's obligations as set forth in section 2(a) above shall in no event extend beyond November 30, 1998. Any commitment for benefits after November 30, 1998 is subject to future negotiation between you and the Company. (h) You and the Company agree to use your/its best efforts to enter into Independent Producer Agreements containing the above terms and conditions as soon as possible, but in no event later than November 30, 1997. (i) You agree to give the Company at least 30 days notice in the event you wish to terminate the Independent Produce Agreements. If the Company, within a reasonable period of time, addresses the reasons you have given for terminating the Independent Producer Agreements, you agree not to terminate the Independent Producer Agreements. Larry C. Renfro September 25, 1997 Page 10 Very truly yours, FIRST ALLMERICA FINANCIAL LIFE INSURANCE COMPANY By /s/ Bruce C. Anderson ---------------------- Vice President Accepted: / /97 I knowingly understand and voluntarily agree to, and accept the terms and conditions set forth herein. /s/ Larry C. Renfro - ----------------------------------- Larry C. Renfro Date September 26, 1997 ------------------------------- This agreement shall not be effective or enforceable until seven days following its execution and may be revoked by Larry C. Renfro prior to its effective date. Exhibit A John F. O'Brien, President First Allmerica Financial Life Insurance Company 440 Lincoln Street Worcester MA 01653 Dear Jack: I hereby resign, effective as of September 2, 1997, as Vice President of Allmerica Financial Corporation. In addition, I also resign, effective September 2, 1997, any other officer and/or director positions which I may hold in any subsidiary or affiliate of Allmerica Financial Corporation, except for my title as a Vice President of First Allmerica Financial Life Insurance Company. Very truly yours, /s/ Larry C. Renfro Larry C. Renfro Exhibit B John F. O'Brien, President First Allmerica Financial Life Insurance Company 440 Lincoln Street Worcester MA 01653 Dear Jack: I hereby resign, effective as of November 30, 1997, as Vice President of First Allmerica Financial Life Insurance Company. Very truly yours, /s/ Larry C. Renfro Larry C. Renfro Exhibit C RELEASE ------- In consideration of the payments to be made by First Allmerica Financial Life Insurance Company ("the Company"), pursuant to the terms of a specific letter agreement between the undersigned (as hereinafter defined) and the Company dated September 25, 1997 (the "Letter Agreement") I, Larry C. Renfro, (the "Undersigned"), hereby knowingly and voluntarily release the Company, Allmerica Financial Corporation ("AFC"), its subsidiaries and affiliates, its and their present and former officers, directors, employees, agents and their successors and assigns (collectively "Releasees") from any and all liabilities, demands, debts, damages, suits, covenants, agreements, contracts, benefits, promises, claims, including, but not limited to, claims for payment under the Company's 1997 Short Term Incentive Compensation Plan, the third payment under the Company's 1995 Long Term Incentive Compensation Plan, the second and third payments under the Company's 1996 Long Term Incentive Compensation Plan, and the first, second and third payments under the Company's 1997 Long Term Incentive Compensation Plan, and the right to all options issued to the undersigned under the AFC Plan, and the right to the Match Shares (as defined in the Restricted Stock Agreement) and claims arising under Title VII of the Civil Rights Act of 1964, as amended, including, but not limited to, any and all claims which the undersigned may have for age, race or sex discrimination and rights or claims arising under the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Americans With Disabilities Act, the Family and Medical Leave Act and claims, if any, for wrongful termination or any claim arising out of or in any way relating to the undersigned's employment with the Company. THE FOREGOING MEANS THAT BY SIGNING THIS RELEASE THE UNDERSIGNED WILL HAVE WAIVED ANY RIGHT THE UNDERSIGNED HAS TO BRING A LAWSUIT OR MAKE A LEGAL CLAIM AGAINST ALLMERICA FINANCIAL CORPORATION, THE COMPANY OR ANY OF THE RELEASEES UP TO THE SIGNING OF THIS RELEASE, AND THAT THE UNDERSIGNED WILL HAVE RELEASED THE RELEASEES OF ANY AND ALL CLAIMS OF ANY NATURE ARISING ON OR BEFORE THE SIGNING OF THIS RELEASE. In addition, this Release does not waive any rights or claims that arise after the date this Release is executed. There is specially excluded from this Release the undersigned's right to enforce the provisions of the Letter Agreement. /s/ Larry C. Renfro ---------------------------- Larry C. Renfro Date: ------------------------ EX-11 7 STATEMENT RE COMPUTATION OF PER SHARE EARNINGS Exhibit 11 ALLMERICA FINANCIAL CORPORATION STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS For the Year Ended December 31, 1997 (in millions, except per share data) (Unaudited)
Year Ended Year Ended December 31, December 31, 1997 1996 ------------ ------------ Basic: Average shares outstanding........................................ 54.7 50.1 Net effect of dilutive stock options based on the treasury stock - - method using average market price................................ ------------ ------------ TOTALS............................................................. 54.7 50.1 ============ ============ Net income........................................................ $209.2 $181.9 ============ ============ Per share amount.................................................. $ 3.83 $ 3.63 Diluted: Average shares outstanding........................................ 54.7 50.1 Net effect of dilutive stock options based on the treasury stock method using the higher of period end or average market price.... 0.1 - ------------ ------------ TOTALS............................................................. 54.8 50.1 ============ ============ Net income........................................................ $209.2 $181.9 ============ ============ Per share amount.................................................. $ 3.82 $ 3.63
61 EX-13 8 1997 ANNUAL REPORT Five Year Summary of Selected Financial Highlights
For the Years Ended December 31 (In millions) 1997 1996 1995 1994 1993 ================================================================================================================================ Statement of Income ................................................................................................................................ Revenues Premiums $ 2,311.1 $ 2,236.3 $ 2,222.8 $ 2,181.8 $ 2,079.3 Universal life and investment product policy fees 237.3 197.2 172.4 156.8 143.7 Net investment income 653.4 672.6 710.5 743.1 782.8 Net realized gains 76.2 65.9 39.8 1.1 159.6 Other income 117.6 105.6 109.3 124.7 82.8 ................................................................................................................................ Total revenues 3,395.6 3,277.6 3,254.8 3,207.5 3,248.2 ................................................................................................................................ Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 2,004.7 1,957.0 2,010.3 2,047.0 1,987.2 Policy acquisition expenses 425.1 470.1 470.9 475.7 435.8 Loss from cession of disability income business 53.9 -- -- -- -- Other operating expenses 546.4 518.8 471.8 531.3 430.3 ................................................................................................................................ Total benefits, losses and expenses 3,030.1 2,945.9 2,953.0 3,054.0 2,853.3 ................................................................................................................................ Income before federal income taxes 365.5 331.7 301.8 153.5 394.9 Federal income tax expense 93.6 75.2 82.7 53.4 74.7 ................................................................................................................................ Income before minority interest, extraordinary item and cumulative effect of accounting changes 271.9 256.5 219.1 100.1 320.2 Minority interest (62.7) (74.6) (73.1) (51.0) (122.8) ................................................................................................................................ Income before extraordinary item and cumulative effect of accounting changes 209.2 181.9 146.0 49.1 197.4 Extraordinary item - demutualization expenses -- -- (12.1) (9.2) (4.6) Cumulative effect of accounting changes -- -- -- (1.9) (35.4) ................................................................................................................................ Net income $ 209.2 $ 181.9 $ 133.9 $ 38.0 $ 157.4 ================================================================================================================================ Adjusted Net Income (1) $ 181.0 $ 137.9 $ 116.4 $ 90.4 $ 119.1 ================================================================================================================================ Balance Sheet (at December 31) ................................................................................................................................ Total assets $ 22,549.0 $ 18,970.3 $ 17,757.7 $ 15,921.5 $ 15,378.4 Long-term debt 202.1 202.2 202.3 2.7 -- Total liabilities 19,714.8 16,461.6 15,425.0 14,299.4 13,711.7 Minority interest 452.9 784.0 758.5 629.7 615.8 Shareholders' equity 2,381.3 1,724.7 1,574.2 992.4 1,050.9
(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. While these items may be significant components in understanding and assessing the Company's financial performance, management believes adjusted net income enhances an investor's understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, adjusted net income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. 25 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 wholly-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. The results of operations reflect minority interest in Allmerica P&C and its subsidiary, Hanover, of approximately 40.5% prior to the merger on July 16, 1997. The results of operations also reflect minority interest in Citizens. 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 $9.1 million and $8.6 million for the years ended December 31, 1997 and 1996, respectively, 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 years ended December 31, 1997 and 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) 1997 1996 1995 ================================================================================ Revenues Premiums $ 2,369.2 $ 2,298.0 $ 2,234.3 Universal life and investment product policy fees 237.3 197.2 172.4 Net investment income 706.8 725.2 723.3 Net realized investment gains 77.5 65.2 19.1 Realized gain on sale of mutual fund processing business -- -- 20.7 Other income 108.7 97.0 106.4 ................................................................................ Total revenues 3,499.5 3,382.6 3,276.2 ................................................................................ Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 2,105.2 2,058.2 2,030.9 Policy acquisition expenses 428.1 473.3 471.7 Loss from cession of disability income business 53.9 -- -- Other operating expenses 546.8 519.4 471.8 ................................................................................ Total benefits, losses and expenses 3,134.0 3,050.9 2,974.4 ................................................................................ Income before federal income taxes 365.5 331.7 301.8 ................................................................................ Federal income tax expense (benefit) Current 79.7 90.9 119.7 Deferred 13.9 (15.7) (37.0) ................................................................................ Total federal income tax expense 93.6 75.2 82.7 ................................................................................ Income before minority interest and extraordinary item 271.9 256.5 219.1 Minority interest (62.7) (74.6) (73.1) ................................................................................ Income before extraordinary item 209.2 181.9 146.0 Extraordinary item - demutualization expenses -- -- (12.1) ................................................................................ Net income $ 209.2 $ 181.9 $ 133.9 - -------------------------------------------------------------------------------- 26 Results Of Operations Consolidated Overview ................................................................................ The Company's consolidated net income increased $27.3 million to $209.2 million in 1997 and $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) 1997 1996 1995 ================================================================================ Net income $ 209.2 $ 181.9 $ 133.9 Adjustments: Net realized investment gains (37.5) (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 4.4 0.3 -- Loss from cession of disability income business 35.0 -- -- Gain from change in mortality assumptions (30.5) -- -- Differential earnings tax adjustment -- (10.2) (7.6) Other non-operating items 0.4 -- -- ................................................................................ Adjusted net income $ 181.0 $ 137.9 $ 116.4 ================================================================================ 1997 Compared to 1996 The increase in adjusted net income of $43.1 million, or 31.3% is primarily attributable to pre-tax increases of $20.6 million in the Allmerica Financial Services segment, $13.3 million in the Institutional Services segment, $7.4 million in the Regional Property and Casualty segment, and $24.7 million of reduced minority interest due to the recent merger with Allmerica P&C. These increases were partially offset by additional losses of $17.6 million in the Corporate segment. The increase in the Allmerica Financial Services segment was primarily attributable to growth in variable product lines, partially offset by lower net investment income due to a reduction in general account assets. The increase in the Institutional Services segment was primarily due to improved interest margins on Guaranteed Investment Contracts ("GICs"). Additionally, the Regional Property &Casualty segment's contribution increased primarily due to a $20.3 million growth of net investment income, partially offset by a $10.8 million increase in underwriting losses. These increases were partially offset by losses in the Corporate segment principally from distributions on the mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company ("Capital Securities") issued February 3, 1997. Premium revenue increased $71.2 million, or 3.1%, to $2,369.2 in 1997. Net premiums earned in the Regional Property and Casualty segment increased $54.8 million, or 2.9%, to $1,953.1 million, reflecting an increase in policies in force in the personal and commercial automobile lines at Hanover of 6.7% and 7.0%, respectively, as well as an increase in assumed commercial premiums in Hanover's reinsurance division. The growth in Citizens' personal lines is primarily due to rate increases in the personal automobile and homeowners lines and a 2.8% increase in policies in force in the homeowners line. These increases were partially offset by rate decreases in the workers' compensation lines at both Hanover and Citizens. Premiums in the Corporate Risk Management Services segment increased $30.1 million, or 9.9%, to $333.0 million, primarily due to growth in reinsurance, fully insured group dental and stop loss product lines. These increases were partially offset by decreases in the risk sharing product line, reflecting the Company's emphasis on stop loss coverage and administrative service only ("ASO") arrangements. Premiums in the Allmerica Financial Services segment decreased $13.6 million, or 14.2%, to $82.1 million, primarily due to the cession in the fourth quarter of 1997 of the Company's individual disability income line of business and 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 $40.1 million, or 20.3%, to $237.3 million in 1997. This was primarily the result of additional deposits and appreciation on variable products' account balances. Net investment income before taxes decreased $18.4 million, or 2.5%, to $706.8 million during 1997. This decrease primarily reflects a reduction in invested assets due to continued withdrawals of GIC deposits, the effect of the cession of the disability income line, the continued shift in focus from traditional life insurance products to variable life and annuity products and reduced partnership income. These decreases were partially offset by income earned from the temporary investment of the proceeds from the Company's February 1997 issuance of Capital Securities and an increase in average invested fixed maturities in the Regional Property and Casualty segment. The Company's average gross yields for the investment portfolio increased from 7.2% in 1996 to 7.3% in 1997. Net realized gains on investments were $77.5 million and $65.2 million, before taxes, and $50.4 million and $42.4 million, after taxes, in 1997 and 1996, respectively. Through the first quarter of 1997, the Regional Property and Casualty segment continued its investment strategy to shift its portfolio from equity investments to tax-exempt and higher-yielding debt securities. This resulted in the sale of a portion of its equity portfolio and consequently, the Regional Property and Casualty segment realized additional gains of $3.8 million on an after-tax basis in 1997. Realized gains, on an after-tax basis, in the Allmerica Financial Services and Institutional Services segments increased $2.1 million and $1.8 million, respectively. 27 Other income increased $11.7 million, or 12.1%, to $108.7 million in 1997. Other income from the Allmerica Financial Services segment increased $8.8 million, or 30.1%, to $38.0 million due to increased investment management fee income resulting from growth in assets under management. Additionally, other income increased $3.8 million, or 10.4%, to $40.4 million in the Corporate Risk Management Services segment due to growth in ASO and contract fees. Policy benefits, claims, losses and loss adjustment expenses ("LAE") increased $47.0 million, or 2.3%, to $2,105.2 million during 1997. This increase is primarily due to a $62.1 million, or 4.5%, increase in losses and LAE in the Company's Regional Property and Casualty segment primarily attributable to a decrease in favorable development on prior year reserves in Hanover's personal automobile, homeowners and commercial multiple peril lines, an increase in claims activity in Citizens' commercial multiple peril and homeowners lines, as well as increased current year's claim severity in Hanover's personal automobile and commercial automobile lines. These factors were partially offset by a $36.4 million decrease in catastrophe losses. Additionally, policy benefits increased $27.6 million, or 13.1% in the Corporate Risk Management Services segment due to the assumption of a block of affinity group life and health business, growth in the fully insured group dental product line and unfavorable mortality experience in the group life product line. These increases were partially offset by a decrease of $35.0 million, or 21.9% to $125.1 million in the Institutional Services segment primarily resulting from the continuing decline of traditional GIC deposits during 1997, and a decline in defined contribution and defined benefit policy benefits as a result of transfers to the separate accounts. The Allmerica Financial Services segment also had a decrease in policy benefits, claims, losses and LAE of $7.7 million, or 2.5%, due primarily to the cession in 1997 of the Company's individual disability income line of business. Policy acquisition expenses consist principally of commissions, premium taxes and other policy issuance costs which are deferred and amortized to expense over the term of the respective policies. Policy acquisition expenses decreased $45.2 million, or 9.5%, to $428.1 million during 1997. This was primarily due to the change in mortality assumptions used in the amortization of deferred acquisition costs for the universal life and variable universal life products in the Allmerica Financial Services segment. Other operating expenses increased $27.4 million, or 5.3%, to $546.8 million in 1997. Other operating expenses in the Allmerica Financial Services segment increased $10.6 million, or 9.0%, to $128.8 million in 1997 primarily from increased premium taxes and administrative expenses related to the growth in variable product lines. Other operating expenses in the Corporate Risk Management Services segment increased $8.4 million, or 6.6%, to $134.8 million in 1997 as a result of increased commissions and premium taxes resulting from the growth in premiums and ASO fees, as well as the expenses related to a block of affinity group life and health business assumed in 1997, partially offset by decreases in employee and administrative costs. Additionally, the Regional Property and Casualty segment's other operating expenses increased during 1997 primarily as a result of increased premiums. Federal income tax expense increased $18.4 million in 1997, while the effective tax rate increased from 22.7% to 25.6% in the same period. For the life insurance subsidiaries, the effective rate increased from 28.9% to 37.4%, primarily resulting from the absence, in 1997, of a $10.2 million differential earnings benefit recognized in 1996, as well as an increase in reserves for prior year tax liabilities. For the property and casualty subsidiaries, a decrease in the effective rate from 18.4% to 16.5% resulted from a higher underwriting loss and greater proportion of pre-tax income from tax-exempt bonds in 1997. 1996 Compared to 1995 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 Allmerica Financial Services and Institutional Services segments, respectively, partially offset by pre-tax decreases of $12.8 million and $40.9 million in the Corporate and Regional Property and Casualty segments, respectively. The increase in the Allmerica 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 offerings. 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 28 partially offset by a $4.0 million decrease in fully insured group medical premiums. Premiums in the Allmerica 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 offerings 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 GIC deposits resulting in a decline in investment income of $54.4 million. The Company's average gross yield for the investment 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 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 decreased $9.4 million, or 8.8%, to $97.0 million in 1996. Other income from the Institutional Services segment decreased $11.5 million, or 47.5% 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 in the Property and Casualty segment decreased $6.8 million due primarily to a reduction in premium finance and service charges. These decreases were partially offset by additional income of $6.8 million in the Allmerica Financial Services segment, primarily attributable to increased investment management income. Additionally, other income in the Allmerica Asset Management and Corporate Risk Management segments increased $4.4 million and $2.1 million, respectively. Policy benefits, claims, losses and 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 Allmerica 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 remained relatively consistent, increasing $1.6 million, or 0.3% to $473.3 million in 1996. Other operating expenses increased $47.6 million, or 10.1%, to $519.4 million in 1996 across all major segments, except the Institutional Services segment. Other operating expenses in the Allmerica 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 $13.6 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. 29 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 Accumulation. Within these broad areas, the Company conducts business principally in five operating segments. These segments are Regional Property and Casualty; Corporate Risk Management Services; Allmerica Financial Services; Institutional Services; and Allmerica Asset Management. The segment results are presented before taxes and minority interest. In addition to the five operating segments, the Company also has a Corporate segment, which consists primarily of cash, investments, corporate debt and Capital Securities. 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) 1997 1996 1995 ================================================================================ Revenues Net premiums earned $ 1,953.1 $ 1,898.3 $ 1,863.2 Net investment income 255.7 235.4 209.6 Net realized gains 53.9 48.1 14.6 Other income 12.6 14.8 21.6 ................................................................................ Total revenues 2,275.3 2,196.6 2,109.0 Losses and LAE (1) 1,445.5 1,383.4 1,300.3 Policy acquisition expenses 413.2 409.2 409.7 Other operating expenses 210.2 206.3 192.7 ................................................................................ Income before taxes $ 206.4 $ 197.7 $ 206.3 ================================================================================ (1) Includes policyholders' dividends of $9.3 million, $11.5 million and $10.6 million in 1997, 1996 and 1995, respectively. Statutory Combined Ratio 97 104.0 96 104.5 95 101.0 Income Before Taxes ................................................................................ 1997 Compared to 1996 Income before taxes increased $8.7 million, or 4.4%, to $206.4 million in 1997. Net realized gains were $53.9 million during 1997, versus $48.1 million during 1996, reflecting increased sales of equity securities at Citizens. Excluding realized gains and losses and restructuring charges, income before taxes increased $7.4 million to $158.2 million in 1997 versus $150.8 million in 1996. This increase is attributable to a $20.3 million increase in net investment income, partially offset by a $10.8 million increase in the underwriting loss. The growth in net investment income resulted primarily from an increase in average invested assets and the Company's portfolio shift from equity securities to higher yielding debt securities, begun in 1996 and substantially completed in the first quarter of 1997. This was partially offset by a $3.8 million decrease in partnership income in 1997. The decline in underwriting results is primarily attributable to a decrease in favorable development on prior year reserves in Hanover's personal automobile, homeowners and commercial multiple peril lines, as well as increased current year claims severity in Hanover's personal automobile and commercial automobile lines. These factors were partially offset by a $38.9 million decrease in catastrophe losses at Hanover. Citizens' underwriting results primarily reflect an increase in claims activity in the commercial multiple peril and homeowners lines and an increase in catastrophes, partially offset by favorable claims experience on current and prior accident years in the personal automobile and workers' compensation lines. Net income during 1996 was favorably impacted by a $5.7 million arbitrated settlement from a voluntary pool at Hanover, of which $2.9 million was included in losses and LAE and $2.8 million was included in other income. 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 during 1996 was favorably impacted by the aforementioned $5.7 million arbitrated settlement. In addition, premium finance and service charges decreased by $3.9 million in 1996. 30 Lines Of Business Results ................................................................................ Personal Lines of Business The personal lines represented 61.9%, 61.2% and 59.8% of total net premiums earned in 1997, 1996 and 1995, respectively.
For the Years Ended December 31 (In millions) 1997 1996 1995 1997 1996 1995 1997 1996 1995 ==================================================================================================================================== Hanover Citizens Total Regional Property and Casualty ------- ------- --------- Net premiums earned $ 625.7 $ 607.3 $ 577.1 $ 583.3 $ 554.6 $ 536.2 $ 1,209.0 $ 1,161.9 $ 1,113.3 Losses and loss adjustment expenses incurred 488.2 452.0 368.6 440.1 404.1 413.6 928.3 856.1 782.2 Policy acquisition expenses 144.3 144.0 135.5 112.1 112.5 108.1 256.4 256.5 243.6 Other underwriting expenses 60.3 58.5 49.4 40.2 39.3 41.1 100.5 97.8 90.5 .................................................................................................................................... Underwriting (loss) profit $ (67.1) $ (47.2) $ 23.6 $ (9.1) $ (1.3) $ (26.6) $ (76.2) $ (48.5) $ (3.0) - ------------------------------------------------------------------------------------------------------------------------------------
1997 Compared to 1996 Revenues Personal lines' net premiums earned increased $47.1 million, or 4.1%, to $1,209.0 million in 1997, compared to $1,161.9 million in 1996. Hanover's personal lines net premiums earned increased $18.4 million, or 3.0%, to $625.7 million during 1997. This increase is primarily attributable to a 6.7% increase in policies in force in the personal automobile line as well as a 1.5% increase in policies in force in the homeowners line, since December 31, 1996. These increases were partially offset by the effect of a mandated 6.2% decrease in Massachusetts personal automobile rates on January 1, 1997. Effective January 1, 1998, Massachusetts personal automobile rates were decreased an additional 4.0% as mandated by the Massachusetts Insurance Commissioner. In 1997, Hanover began offering a safe driver's discount of 10% on automobile insurance premiums. Management believes that rate changes and discounts may unfavorably impact premium growth in Massachusetts. At December 31, 1997, approximately 34% of Hanover's personal automobile business was written in Massachusetts. Citizens' personal lines' net premiums earned increased $28.7 million, or 5.2%, to $583.3 million in 1997. This growth is attributable to rate increases in the personal automobile and homeowners lines and a 2.8% increase in policies in force in the homeowners line. The growth is partially offset by a 0.6% 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 1997 increased $27.7 million, to a loss of $76.2 million. Hanover's underwriting results deteriorated $19.9 million to a loss of $67.1 million, while Citizens' underwriting loss deteriorated $7.8 million to a loss of $9.1 million. The decline in Hanover's underwriting results is primarily attributable to an increase in current year claims severity and a $25.0 million reduction in favorable development on prior year reserves in the personal automobile line. These factors were partially offset by a $25.8 million decrease in catastrophes, primarily in the homeowners line. The decline in Citizens' underwriting results reflects a decrease in prior year favorable development in the personal automobile line of $10.5 million and an increase in catastrophe losses of $0.9 million, to $14.3 million, primarily in the homeowners line. Policy acquisition expenses in the personal lines remained consistent between years while other underwriting expenses increased $2.7 million, or 2.8%, to $100.5 million in 1997. Hanover's policy acquisition expenses increased $0.3 million, or 0.2%, to $144.3 million in 1997. This increase resulted from increased net premiums earned, significantly offset by decreased commission rates in the personal automobile and homeowners lines and lower employee related expenses. The $1.8 million increase in Hanover's other underwriting expenses resulted from an increase in net premiums earned, partially offset by decreased employee related expenses, as well as reductions in contingent commissions. Policy acquisition expenses in the personal lines at Citizens decreased $0.4 million, or 0.4%, to $112.1 million in 1997, primarily reflecting lower commission rates for 1997, partially offset by higher earned premiums. Citizens' other underwriting expenses increased $0.9 million, or 2.3%, to $40.2 million due to an increase in net premiums earned offset by reductions in employee related expenses. 1996 Compared to 1995 Revenues Net premiums earned in 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, 31 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. At December 31, 1996, approximately 39% of Hanover's personal automobile business was written in Massachusetts. Citizens' personal lines' net premiums earned increased $18.4 million, or 3.4%, to $554.6 million in 1996. This growth is attributable to rate 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 aforementioned competitive rates in Michigan. 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 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 $12.9 million, or 5.3%, to $256.5 million and other underwriting expenses increased $7.3 million to $97.8 million in 1996. The increase in policy acquisition expenses is primarily attributable to an increase of $8.5 million, or 6.3%, to $144.0 million at Hanover, resulting from an increase in net premiums earned, as well as a reapportionment of certain acquisition expenses to the personal lines from the commercial lines, partially offset by a decrease in assessment expenses associated with the reapportionment of an involuntary pool. The $9.1 million increase in Hanover's other underwriting expenses resulted from an increase in net premiums earned, an increase in start-up expenses associated with group business and expenses associated with a policy administration technology project. 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. Commercial Lines of Business The commercial lines represented 38.1%, 38.8% and 40.2% of net premiums earned in 1997, 1996 and 1995, respectively.
For the Years Ended December 31 (In millions) 1997 1996 1995 1997 1996 1995 1997 1996 1995 =============================================================================================================================== Hanover Citizens Total Regional Property and Casualty -------- -------- -------- Net premiums earned $ 472.1 $ 455.5 $ 468.3 $ 272.0 $ 280.9 $ 281.6 $ 744.1 $ 736.4 $ 749.9 Losses and loss adjustment expenses incurred 307.3 315.5 342.8 197.0 200.3 164.7 504.3 515.8 507.5 Policy acquisition expenses 104.0 101.1 114.6 52.8 51.6 51.5 156.8 152.7 166.1 Other underwriting expenses(1) 80.9 80.6 73.5 24.9 27.0 25.4 105.8 107.6 98.9 ............................................................................................................................... Underwriting (loss) profit $ (20.1) $ (41.7) $ (62.6) $ (2.7) $ 2.0 $ 40.0 $ (22.8) $ (39.7) $ (22.6) - -------------------------------------------------------------------------------------------------------------------------------
(1) Includes policyholders' dividends. 32 1997 Compared to 1996 Revenues Commercial lines' net premiums earned in 1997 increased $7.7 million, or 1.0%, to $744.1 million in 1997, compared to $736.4 million in 1996. Hanover's commercial lines' net premiums earned increased $16.6 million, or 3.6%, to $472.1 million. This increase is primarily attributable to a $9.4 million increase in assumed premiums in Hanover's reinsurance division, as well as a 7.0% increase in policies in force in Hanover's commercial automobile line, since December 31, 1996. These increases were partially offset by the effect of an average rate decrease of 12.6%, since January 1, 1997, in Hanover's workers' compensation line. Effective July 1, 1997, the Company exited the assumed reinsurance business by entering into an agreement with USF RE Insurance Company ("USF RE") in which USF RE acquired the operations of Allmerica Re from Hanover. During 1997, assumed reinsurance business contributed $34.7 million in net premiums earned. Citizens' commercial lines' net premiums earned decreased $8.9 million, or 3.2%, to $272.0 million in 1997. This decrease primarily reflects rate reductions in the workers' compensation line. Rates in the workers' compensation line at Citizens were decreased 8.5%, 7.0%, 6.4% and 8.7% effective May 1, 1995, December 1, 1995, June 1, 1996 and March 1, 1997, respectively. This decrease is partially offset by an increase in policies in force in the commercial multiple peril and commercial automobile lines of 16.6% and 2.7%, respectively. Management believes competitive conditions in Michigan in the workers' compensation line may impact future growth in net premiums earned. Underwriting results The commercial lines' underwriting loss decreased $16.9 million, or 42.6% to a loss of $22.8 million in 1997. Hanover's underwriting results improved $21.6 million, or 51.8%, to a loss of $20.1 million and Citizens' underwriting results declined $4.7 million, to a loss of $2.7 million in 1997. The improvement in Hanover's underwriting results reflects an increase in favorable development on prior accident years in the workers' compensation and commercial automobile lines as well as a decrease in catastrophe losses of $13.1 million, primarily in the commercial multiple peril line. These factors were partially offset by a decrease in favorable development on prior accident years in the commercial multiple peril line as well as increased current year claim severity in the commercial automobile line. Citizens' underwriting results declined primarily due to lower net premiums earned in the workers' compensation line, an increase in current year severity and frequency in the commercial multiple peril line, less favorable development of prior year reserves in the commercial automobile line, and an increase in catastrophe losses of $1.6 million. These decreases were partially offset by a $13.9 million increase in favorable development of prior year claims in the workers' compensation line. Policy acquisition expenses in the commercial lines increased $4.1 million, or 2.7%, to $156.8 million in 1997 and other underwriting expenses decreased $1.8 million, or 1.7%, to $105.8 million. Hanover's policy acquisition expenses increased $2.9 million, or 2.9%, to $104.0 million, primarily attributable to growth in net premiums earned. Other underwriting expenses at Hanover increased $0.3 million, to $80.9 million as a result of higher net premiums earned and increased re-engineering costs associated with the underwriting and policy processing in the commercial underwriting segment, partially offset by decreased contingent commissions and employee related expenses. Citizens' policy acquisition expenses increased $1.2 million, or 2.3%, primarily as a result of higher commission rates, offset by a decrease in net premiums earned. Other underwriting expenses decreased $2.1 million, or 7.8%, to $24.9 million due to reductions in employee related expenses. 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 the aforementioned 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. 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. 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. 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, lower net premiums earned in the workers' compensation line, less favorable development of prior year reserves in the workers' compensation line, an increase in cat- 33 astrophe losses of $0.8 million, partially offset by an increase in net premiums earned in the commercial multiple peril line. Policy acquisition expenses in the commercial lines decreased $13.4 million, or 8.1%, to $152.7 million in 1996 and other underwriting expenses increased $8.7 million, or 8.8%, to $107.6 million. Hanover's policy acquisition expenses decreased $13.5 million, or 11.8%, to $101.1 million, primarily attributable to a reapportionment of certain acquisition expenses from the commercial lines to the personal lines, a net decrease in assessment expenses associated with voluntary and involuntary pools, as well as to the decrease in net earned premium. Other underwriting expenses at Hanover increased $7.1 million, to $80.6 million as a result of an increase in employee related expenses and an increase in expenses associated with the policy administration technology project. 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. Investment Results ................................................................................ Net investment income before tax was $255.7 million, $235.4 million and $209.6 million in 1997, 1996 and 1995, respectively. The increase from 1996 to 1997 represents an increase in average invested assets and the Company's portfolio shift, in this segment, to higher yielding debt securities, including longer duration and non-investment grade securities. Refer to the discussion in the Investment Portfolio section on page 41 for additional information about investment and non-investment grade debt securities. Net investment income in 1996 includes $10.0 million of income from partnerships compared to $6.2 million in 1997. Also, the average pre-tax yield on debt securities increased from 6.4% in 1996 to 6.8% in 1997. Average invested assets increased $174.2 million, or 4.5%, to $4,027.8 million in 1997 compared to $3,853.6 million in 1996. The increase from 1995 to 1996 represents an increase in average invested assets, $10.0 million of income from limited partnerships, and the Company's aforementioned portfolio shift, in this segment. Also, the average pre-tax yield on debt securities increased from 6.1% in 1995 to 6.4% in 1996. Net realized gains on investments before taxes were $53.9 million, $48.1 million and $14.6 million in 1997, 1996 and 1995, respectively. The increase in net realized gains in 1997 reflects increased sales of equity securities by Citizens. In both years, net realized investment gains resulted primarily from the sale of appreciated equity securities due to the Company's strategy of shifting to a higher proportion of debt 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) 1997 1996 1995 ========================================================================================== Reserve for losses and LAE, beginning of year $ 2,744.1 $ 2,896.0 $ 2,821.7 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,564.1 1,513.3 1,427.3 Decrease in provision for insured events of prior years (127.9) (141.4) (137.6) .......................................................................................... Total incurred losses and LAE 1,436.2 1,371.9 1,289.7 .......................................................................................... Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 775.1 759.6 652.2 Losses and LAE attributable to insured events of prior years 732.1 627.6 614.3 .......................................................................................... Total payments 1,507.2 1,387.2 1,266.5 .......................................................................................... Change in reinsurance recoverable on unpaid losses (50.2) (136.6) 51.1 Other (1) (7.5) -- -- .......................................................................................... Reserve for losses and LAE, end of year $ 2,615.4 $ 2,744.1 $ 2,896.0 - ------------------------------------------------------------------------------------------
(1) Includes purchase accounting adjustments. 34 As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $127.9 million, $141.4 million and $137.6 million in 1997, 1996 and 1995, respectively. The decrease in favorable development on prior years' reserves of $13.5 million in 1997 results primarily from a $24.6 million decrease in favorable development at Hanover to $58.4 million, partially offset by an $11.1 million increase in favorable development at Citizens to $69.5 million. The decrease in Hanover's favorable development of $24.6 million in 1997 reflects a decrease in favorable development of $25.0 million, to $17.4 million in the personal automobile line as well as a decrease in favorable development of $8.5 million to unfavorable development of $2.8 million in the commercial multiple peril line. These decreases were partially offset by an increase in favorable development in the workers' compensation line of $11.5 million, to $28.8 million. The increase in favorable development at Citizens in 1997 reflects improved severity in the workers' compensation line where favorable development increased $13.9 million, to $35.7 million and in the commercial multiple peril line where favorable development increased $7.0 million to $4.3 million, partially offset by less favorable development in the personal automobile line, where favorable development decreased $10.5 million to $22.5 million in 1997. 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 of $10.9 million. 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. 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. Citizens' favorable development in 1997 primarily reflects a modest shift over the past few years of the workers' compensation business to Western and Northern Michigan, which have demonstrated more favorable loss experience than Eastern Michigan. Citizens' favorable development in 1996 and 1995 primarily reflects the initiatives taken by the Company to manage medical costs in both the automobile and workers' compensation lines, as well as the impact of the Michigan Supreme Court ruling on workers' compensation indemnity payments in 1995, which decreases the maximum amount to be paid for indemnity cases on all existing and future claims. Hanover's favorable development from 1995 to 1997 primarily reflects favorable legislation related to workers' compensation, improved safety features in automobiles and a moderation of medical costs and inflation. In 1995, Hanover's favorable development was 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 Hanover refined its estimation of unallocated loss adjustment expenses which increased favorable development in that year. 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 $53.1 million and $50.8 million, net of reinsurance of $15.7 million and $20.2 million in 1997 and 1996, respectively. The Company does not specifically underwrite policies that include this coverage, but as case law expands policy provisions and insurers' liability beyond the intended coverage, the Company may be required to defend such claims. Due to their unusual nature and absence of historical claims data, reserves for these claims are not determined using historical experience to project future losses. The Company estimated its ultimate liability for these claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these 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 Company believes that, notwithstanding the evolution of case law expanding liability in environmental claims, recorded reserves related to these claims are adequate. In addition, the Company 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 Company varies by product. Property and casualty insurance premiums are established before the amount of losses and LAE, and the extent to which inflation may affect such expenses, are known. Consequently, the Company attempts, in establishing rates, 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. 35 The Company regularly reviews its reserving techniques, its overall reserving position and its reinsurance. Based on (i) review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages, changes in political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Company and the industry, (iv) the relatively short-term nature of most policies and (v) internal estimates of required reserves, management believes that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on the results of operations. Corporate Risk Management Services The following table summarizes the results of operations for the Corporate Risk Management Services segment. For the Years Ended December 31 (In millions) 1997 1996 1995 ================================================================================ Premiums and premium equivalents Premiums $ 333.0 $ 302.9 $ 272.7 Premium equivalents 603.6 581.4 513.4 ................................................................................ Total premiums and premium equivalents $ 936.6 $ 884.3 $ 786.1 - -------------------------------------------------------------------------------- Revenues Premiums $ 333.0 $ 302.9 $ 272.7 Net investment income 22.7 21.7 17.6 Net realized gains (losses) 0.2 0.3 (0.5) Other income 40.4 36.6 38.7 ................................................................................ Total revenues 396.3 361.5 328.5 Policy benefits, claims and losses 238.9 211.3 197.2 Policy acquisition expenses 3.3 3.1 2.7 Other operating expenses 134.8 126.4 110.3 ................................................................................ Income before taxes $ 19.3 $ 20.7 $ 18.3 - -------------------------------------------------------------------------------- 1997 Compared to 1996 Income before taxes decreased $1.4 million, or 6.8%, to $19.3 million in 1997. This decrease was primarily due to unfavorable mortality in the group life product line of $8.4 million, partially offset by a reduction in employee and administrative costs of $4.8 million, a $1.0 million contribution from the assumption of a block of affinity group life and health business in January 1997, and improved experience in the long-term disability, stop loss and risk sharing product lines. Premiums increased $30.1 million, or 9.9%, to $333.0 million in 1997 primarily due to increases in reinsurance, fully insured group dental and stop loss product lines totaling $30.2 million, including $18.9 million resulting from the aforementioned assumption of a block of affinity group life and health business. These increases were partially offset by decreases in the risk sharing product line of $2.6 million. The decline in risk sharing premiums primarily reflects the Company's emphasis on stop loss coverage and ASO arrangements. Other income increased $3.8 million, or 10.4%, to $40.4 million in 1997 due to growth in ASO and contract fees. Policy benefits, claims and losses increased $27.6 million, or 13.1%, to $238.9 million in 1997. This increase is primarily due to growth in reinsurance products, including the aforementioned assumption of a block of affinity group life and health business, which contributed $12.0 million in policy benefits during the year. Additionally, group life benefits increased $8.2 million due to unfavorable mortality experience in 1997. Fully insured group dental increased by $7.3 million due to growth in the product line. These increases were partially offset by decreased benefits in the fully insured medical product line and improved experience in the long-term disability, stop loss and risk sharing product lines. Other operating expenses increased $8.4 million, or 6.6%, to $134.8 in 1997 primarily due to increases of $6.2 million in premium taxes and commissions resulting from the growth in premiums and ASO fees. In addition, 1997 expenses included $5.9 million related to the aforementioned affinity group life and health business. These items were partially offset by decreases in employee and administrative costs of $4.8 million. 1996 Compared to 1995 Income before taxes increased $2.4 million, or 13.1%, to $20.7 million in 1996. In 1995, the Corporate Risk Management Services segment 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. 36 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. Retirement and Asset Accumulation ................................................................................ Allmerica Financial Services The following table summarizes the results of operations for the Allmerica Financial Services segment. For the Years Ended December 31 (In millions) 1997 1996 1995 ================================================================================ Revenues Premiums $ 82.1 $ 95.7 $ 98.1 Fees 215.7 181.2 157.9 Net investment income 236.9 251.3 229.1 Net realized gains (losses) 1.8 (1.5) 0.6 Other income 38.0 29.2 22.4 ................................................................................ Total revenues 574.5 555.9 508.1 Policy benefits, claims and losses 295.7 303.4 315.6 Policy acquisition expenses 8.7 58.1 56.1 Loss from cession of disability income business 53.9 -- -- Other operating expenses 128.8 118.2 101.2 ................................................................................ Income before taxes $ 87.4 $ 76.2 $ 35.2 ================================================================================ 1997 Compared to 1996 Income before taxes increased $11.2 million, or 14.7%, to $87.4 million in 1997. During 1997, the Allmerica Financial Services segment results were affected by two significant items. Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of business, which had generated $1.8 million and $0.8 million in losses during 1997 and 1996, respectively. The Company recognized a $53.9 million loss during the first quarter of 1997 upon entering into an agreement in principal to transfer this business. Additionally, effective October 1, 1997, the Company revised the mortality assumptions used to determine the amortization of policy acquisition costs and recognition of certain fees for this segment's universal life and variable universal life lines of business. As a result of this change in assumptions, the Company recorded a benefit of $47.0 million. Effective January 1, 1998, the Company entered into an agreement with a highly rated reinsurer to reinsure the mortality risk on the universal life and variable universal life lines of business. The terms and provisions of this reinsurance contract are consistent with the aforementioned change in mortality assumptions. Management believes that this agreement will not have a material effect on the results of operations or financial position of the Company. Financial Services Separate Account Assets in millions [BAR GRAPH APPEARS HERE] 97 $7,924 96 $4,804 95 $3,159 Excluding these significant items, income before taxes increased by $18.1 million, or 23.8% to $94.3 million. This increase is primarily attributable to growth in variable product lines, partially offset by lower net investment income due to a reduction in average fixed maturities invested. The decrease in premiums of $13.6 million, or 14.2%, to $82.1 million in 1997 is primarily due to the aforementioned cession of the Company's individual disability income line of business, which contributed premiums of $22.8 million in 1997 compared to $32.9 million in 1996. The remaining decrease reflects the Company's continued shift in focus from traditional life insurance products to variable life insurance and annuity products. The increase in fee revenue of $34.5 million, or 19.0%, to $215.7 million in 1997 is due to additional deposits and appreciation in variable products' account balances. Fees from variable annuities increased $32.9 million, or 57.7%, to $89.9 million in 1997. New distribution arrangements with several third party mutual fund advisors contributed to the increase in annuity sales in 1997. Fees from variable universal life policies increased $10.2 million, or 23.6%, to $53.5 million in 1997. These increases were partially offset by a decrease in fees from non-variable universal life of $4.8 million. The Company expects fees from this product to continue to decline as policies in force and related contract values decline. Additionally, the Company reduced certain other fees by $3.8 million due to the aforementioned change in mortality assumptions. 37 Net investment income decreased $14.4 million, or 5.7%, to $236.9 million in 1997. This decrease is primarily due to a reduction in average fixed maturities invested, partially offset by increased portfolio yields. The reduction in average fixed maturities invested was primarily a result of the aforementioned cession of the individual disability income line of business, as well as the shift in focus from traditional insurance products to variable life insurance and annuity products. Other income increased $8.8 million, or 30.1%, to $38.0 million in 1997. This increase was primarily attributable to increased investment management fee income resulting from growth in assets under management. Policy benefits, claims and losses decreased $7.7 million, or 2.5%, to $295.7 million in 1997. This decrease is due primarily to the aforementioned cession of the Company's individual disability income line of business, which incurred policy benefits of $32.3 million in 1997 compared to $38.5 million in 1996. The decrease in policy acquisition expenses of $49.4 million, or 85.0%, to $8.7 million in 1997 is primarily due to the aforementioned revision of mortality assumptions. This change resulted in a $50.8 million reduction in policy acquisition expenses at October 1, 1997, and reduced fourth quarter amortization by $2.2 million from that based on the Company's mortality assumptions prior to the revision. The increase in other operating expenses of $10.6 million, or 9.0%, to $128.8 million in 1997 was primarily attributable to the increased premium taxes and administrative expenses related to the significant growth in the variable product lines during 1997. 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. 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. 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. The increase in other operating expenses 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. Interest Margins The results of the Allmerica 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) 1997 1996 1995 ================================================================================ Net investment income $ 141.2 $ 145.9 $ 152.7 Less: Interest credited 99.2 101.3 107.7 ................................................................................ Interest margins (1) $ 42.0 $ 44.6 $ 45.0 - -------------------------------------------------------------------------------- (1) Interest margins represent the difference between income earned on investment assets and interest credited to customers' universal life and general account annuity policies. Earnings on surplus assets are excluded from net investment income in the calculation of the above interest margins. Interest margins decreased slightly in 1997 as a result of a decline in investment income and related policies in force in the universal life and general account annuity product lines. Interest margins were relatively consistent in 1996 as compared to 1995. 38 Institutional Services The following table summarizes the results of operations for the Institutional Services segment. For the Years Ended December 31 (In millions) 1997 1996 1995 ================================================================================ Revenues Fees, premiums and non-insurance income (1) $ 40.6 $ 36.6 $ 39.9 Net investment income GICs 82.3 98.5 152.9 Other 98.6 116.4 114.5 Net realized gains 21.9 19.2 5.5 Gain on sale of mutual fund processing business -- -- 20.7 ................................................................................ Total revenues 243.4 270.7 333.5 ................................................................................ Policy benefits, claims and losses Interest credited to GICs 64.1 89.2 137.2 Other 61.0 70.9 80.6 ................................................................................ Total policy benefits, claims and losses 125.1 160.1 217.8 Policy acquisition expenses 2.9 2.9 3.2 Other operating expenses 53.0 54.9 69.7 ................................................................................ Income before taxes $ 62.4 $ 52.8 $ 42.8 ================================================================================ (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. 1997 Compared to 1996 Income before taxes increased $9.6 million, or 18.2%, to $62.4 million in 1997. During 1996, Institutional Services recognized a contingency payment for the sale of the mutual fund processing business of $4.8 million. Excluding this item, income before taxes increased $14.4 million, or 30.0%. This increase was primarily attributable to an increase in the interest margins on GICs of $4.1 million, increased realized gains of $2.7 million and additional contribution from the defined benefit and defined contribution plan, group variable life and telemarketing product lines of $1.6 million, $1.4 million and $1.3 million, respectively. Fees, premiums and non-insurance income increased $4.0 million, or 10.9%, to $40.6 million in 1997. Excluding the aforementioned contingency payment, fees, premiums and non-insurance income increased $8.8 million or 27.7%. This increase was primarily due to growth in fees from the Company's group variable life and defined contribution separate account product lines of $4.4 million and $1.2 million, respectively. In addition, recordkeeping fees increased $2.3 million. Net investment income related to GICs and interest credited to GIC contractholders have declined as a result of declining traditional GIC deposits. During 1997, the interest margin on GICs increased $8.9 million due to a reallocation of general account assets to this line, and to the combination of slightly higher investment yields and lower average crediting rates on the remaining contracts. Effective January 1, 1997, capital and investment assets were reallocated between the defined benefit plan, defined contribution plan and GIC product lines. This reallocation resulted in an increase in GIC capital and investment assets of approximately $61.0 million. Had this reallocation occurred in 1996 and 1995, interest earned in the GIC product line for the years ended December 31, 1996 and 1995, would have been $103.3 million and $158.7 million, respectively. Management expects GIC margins to decline as the existing contracts continue to mature. Other net investment income decreased $17.8 million, or 15.3%, to $98.6 million in 1997. This decrease resulted from a decline in average invested assets due to cancellations of defined benefit plans, as well as transfers of certain plan assets to the separate accounts. Net realized gains increased $2.7 million, to $21.9 million in 1997. This change was due primarily to increased gains from the sale of fixed maturity investments. Other policy benefits, claims and losses consist primarily of interest credited to and benefits provided by the Company's defined contribution and defined benefit plan products, and group variable life product lines including annuity benefits for certain defined benefit plan participants electing that option. Other policy benefits, claims and losses declined from $70.9 million in 1996 to $61.0 million in 1997. This was primarily due to reductions in the interest credited to participants resulting from the aforementioned cancellations and transfers to the separate accounts. Other operating expenses decreased $1.9 million, or 3.5%, to $53.0 million in 1997. This decrease was primarily attributable to reductions in employee related costs. 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 and non-insurance income decreased $3.3 million, or 28.3%, to $36.6 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 $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. 39 Net investment income related to GICs and interest credited to GIC contractholders have declined in 1996 as a result of lower traditional GIC deposits as compared to 1995. 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 for defined benefit plans, defined contribution plans, and the group variable life product 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 $14.8 million, or 21.2%, to $54.9 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. 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) 1997 1996 1995 ================================================================================ Fees and other income: External $ 1.6 $ 1.1 $ 1.0 Internal 7.1 7.7 3.4 ................................................................................ Total revenues 8.7 8.8 4.4 Other operating expenses 7.3 7.7 2.1 ................................................................................ Income before taxes $ 1.4 $ 1.1 $ 2.3 ================================================================================ The Company provides 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 $3.4 million and $4.3 million for the years ended December 31, 1997 and 1996, respectively. Corporate The following table summarizes the results of operations for the Corporate segment. Period from October 1 through December 31 December 31 December 31 (In millions) 1997 1996 1995 =============================================================================== Revenues Investment and other income $ 11.5 $ 2.7 $ 0.4 Realized losses (0.3) (0.9) -- ................................................................................ Total revenues 11.2 1.8 0.4 Other operating expenses 22.6 18.6 3.5 ................................................................................ Loss before taxes and minority interest (11.4) (16.8) (3.1) Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (22.4) -- -- ................................................................................ Loss before taxes $ (33.8) $ (16.8) $ (3.1) ================================================================================ This segment consists primarily of $55.2 million of cash and investments, $202.1 million of Senior Debentures and $300.0 million of Capital Securities. Investment and other income increased $8.8 million in 1997 compared to 1996, primarily due to the investment of the net proceeds from the February 3, 1997 issuance of Capital Securities. These proceeds were invested in the short-term investment portfolio, and were used to finance the July 16 merger with Allmerica P&C. Other operating expenses in 1997 and 1996 principally reflect interest expense on the Company's 7-5/8% Senior Debentures. In 1997, other operating expenses also reflects $2.8 million of interest expense on the Company's short-term revolving credit loan which commenced August 15, 1997 and was repaid and matured on December 15, 1997. Additionally, minority interest represents distributions on the Capital Securities, which pay cumulative distributions at a rate of 8.207% semiannually, commencing August 15, 1997. 40 Investment Portfolio The Company had investment assets diversified across several asset classes, as follows: December 31 (Dollars in millions) 1997(1) 1996(1) ================================================================================ % of Total % of Total Carrying Carrying Carrying Carrying Value Value Value Value Fixed maturities (2) $ 7,726.6 79.8% $ 7,891.7 79.4% Equity securities (2) 479.0 4.9 473.6 4.8 Mortgages 679.5 7.0 764.6 7.7 Policy loans 360.7 3.7 362.6 3.6 Real estate 50.3 0.5 120.7 1.2 Cash and cash equivalents 240.1 2.5 202.6 2.0 Other invested assets 148.3 1.6 128.8 1.3 ................................................................................ Total $ 9,684.5 100.0% $ 9,944.6 100.0% - -------------------------------------------------------------------------------- (1) Includes Closed Block invested assets with a carrying value of $768.7 million and $772.7 million at December 31, 1997 and 1996, respectively. (2) The Company carries the fixed maturities and equity securities in its investment portfolio at market value. [PIE CHART APPEARS HERE] Bond Portfolio Credit Quality Aaa/Aa/A 52% Baa 30% Ba 9% B & Below 9% Total investment assets decreased $260.1 million, or 2.6%, to $9.7 billion during 1997. This decrease is primarily attributable to the sales of fixed maturities and loan repayments on outstanding mortgages. Fixed maturities decreased $165.1 million, or 2.1%, due primarily to the settlement of GIC contracts and to decreased assets resulting from the cession of the disability income line. This decrease was partially offset by market value appreciation in the fixed maturities portfolio of $134.3 million. Mortgage loans also decreased $85.1 million, or 11.1%, to $679.5 million caused primarily by loan repayments. Additionally, equity securities increased $5.4 million, or 1.1%, to $479.0 million, as a result of market value appreciation that more than offset the shift in the Regional Property and Casualty segment's portfolio holdings from equity securities to fixed maturity securities. The real estate portfolio decreased $70.4 million, or 58.3%, to $50.3 million during 1997 due to sales of investment properties. The Company intends to sell its remaining holdings in this portfolio. The increase in other invested assets of $19.5 million, or 15.1%, to $148.3 million primarily relates to purchases of limited partnerships. Cash and cash equivalents increased $37.5 million, or 18.5%, to $240.1 million. 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 82.5% and 84.8% of the Company's total fixed maturity portfolio at December 31, 1997 and 1996, respectively. In 1996 and 1997, there were modest shifts to higher yielding debt securities, including longer duration and non-investment grade securities. The average yield on debt securities was 7.6% and 7.3% for 1997 and 1996, respectively. Although management expects that new funds will be invested primarily in investment grade fixed maturities, the Company may invest a portion of new funds in below investment grade fixed maturities or equity interests. 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 1996 Mortgages Estate Assets Total ................................................................................ Beginning balance $ 33.8 $ 19.6 $ 3.7 $ 57.1 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% 1997 ................................................................................ Provision 2.5 6.0 -- 8.5 Write-offs (1) (1.4) (20.9) -- (22.3) ................................................................................ Ending balance $ 20.7 $ -- $ -- $ 20.7 Valuation allowance as a percentage of carrying value before reserves 3.0% --% --% 3.0% (1) Write-offs reflect asset sales, foreclosures, forgiveness of debt upon restructuring and reserve releases due to permanent impairments. 41 Write-offs of mortgages during 1996 reflect an increase in the disposal of modified loans which were previously impaired. The increase in write-offs of real estate reserves during 1997 reflects the permanent write down of all real estate assets to the estimated fair value less costs of disposal. During 1997, the Company adopted a definitive plan to sell its real estate holdings. Income Taxes AFC and its domestic 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. Prior to the merger, Allmerica P&C and its subsidiaries filed a separate United States federal income tax return. 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 Internal Revenue Service ("IRS"). As a stock company, FAFLIC is no longer required to reduce its policyholder dividend deduction by the differential earnings amount. The differential earnings amount 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. Provision for federal income taxes before minority interest was $93.6 million during 1997 compared to $75.2 million during 1996. These provisions resulted in consolidated effective federal tax rates of 25.6% and 22.7%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were 37.4% and 28.9% during 1997 and 1996, respectively. The increase in the rate for FAFLIC in 1997 resulted primarily from the absence, in 1997, of a $10.2 million differential earnings benefit recognized in 1996, and from an increase in reserves for prior year tax liabilities. The effective tax rates for Allmerica P&C and its subsidiaries were 16.5% and 18.4% during 1997 and 1996, respectively. The decrease in the rate for Allmerica P&C and its subsidiaries reflects a higher underwriting loss and greater proportion of pre-tax income from tax-exempt bonds in 1997. 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% in 1996 and 1995, 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 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 effective tax rates for Allmerica P&C and its subsidiaries were 18.4% and 25.3% during 1996 and 1995, respectively. The decrease in the rate for Allmerica P&C and its 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. 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, claims, 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 used in operating activities was $173.2 million in 1997, while net cash provided by operating activities was $156.0 million and $131.2 million in 1996 and 1995, respectively. The decrease in 1997 resulted primarily from a $207.0 million payment for the cession of the disability income line of business, a significant acceleration of claims payments in the Regional Property and Casualty segment and increased commissions and other deferrable expenses related to the growth in the annuity and variable universal life product lines. 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 property and casualty insurance subsidiaries which resulted from an increase in claims payments. 42 Net cash provided by investing activities was $120.5 million in 1997 and $424.6 million in 1996. Net cash used in investing activities was $128.1 million in 1995. The decrease from 1996 to 1997 primarily reflects the purchase of the minority interest of Allmerica P&C on July 16, 1997 for $425.6 million and fewer sales of investments used to finance net GIC withdrawals. The decrease was partially offset by increased sales of investments. The proceeds from these increased sales were used to finance the cession of the disability income line of business, $140.0 million of the aforementioned purchase price of the merger, and the acceleration of claims payments in the Regional Property and Casualty segment. In 1996, purchases of fixed maturities were unusually high due to the investment of the remaining net proceeds of the Company's initial public offerings of stock and debt. 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. Net cash provided by financing activities was $90.3 million in 1997. Net cash used for financing activities was $685.1 million, and $235.7 million in 1996 and 1995, respectively. In 1997, the primary source of cash provided by financing activities was the Company's receipt of proceeds of $296.3 million from the issuance of Capital Securities. In addition, the Company made cash payments on withdrawals from GICs that exceeded cash received from deposits on these contracts by $189.6 million, $636.3 million and $624.1 million in 1997, 1996 and 1995, respectively. In 1997, the Company received approximately $225.0 million of new deposits on floating rate GICs. In 1995, the cash used for financing activities was positively affected by the Company's receipt of proceeds of $248.0 million and $197.2 million from its initial public offerings of stock and debt, respectively. In June 1997, the Company entered into a credit agreement providing for a $225.0 million revolving line of credit which expired on December 15, 1997. Borrowings under that line of credit were unsecured and incurred interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. The Company borrowed and repaid approximately $140.0 million during the year and paid approximately $2.8 million in interest. On February 3, 1997, AFC Capital Trust (the "Trust"), a wholly-owned 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 funded a portion of the July 16, 1997 acquisition of the 24.2 million publicly held shares of Allmerica P&C. On August 7, 1997, AFC and the Trust exchanged the Series A Capital Securities for a like amount of Series B Capital Securities and related guarantees which are registered under the Securities Act of 1933 as required under the terms of the initial transaction. The Company pays approximately $24.6 million per year in interest payments on the Capital Securities, which are reflected in minority interest on an after-tax basis. 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 Debentures due 2025 with net proceeds to the Company of $197.2 million. The Company pays 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 and Allmerica P&C 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(see Note 14 of the Consolidated Financial Statements). 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, 1997, no amounts were outstanding and $100.0 million and $7.4 million were available for borrowing by FAFLIC and Allmerica P&C, respectively. FAFLIC had no commercial paper borrowings outstanding and Allmerica P&C had $32.9 million of commercial paper borrowings outstanding at December 31, 1997. 43 Recent Developments On October 23, 1997, Standard & Poor's upgraded its claims-paying ability rating for FAFLIC and AFLIAC to AA- (Excellent) from A+ (Good). In July 1997, a lawsuit was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and refiled the action in Federal District Court in Worcester, Massachusetts. The plaintiffs seek to be certified as a class. The case is in early stages of discovery and the Company is evaluating the claims. Although the Company believes it has meritorious defenses to plaintiffs' claims, there can be no assurance that the claims will be resolved on a basis which is satisfactory to the Company. The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was consummated on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash of $425.6 million and approximately 9.7 million shares of AFC stock. The merger has been accounted for as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million, representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. On April 14, 1997, the Company entered into an agreement in principle to cede substantially all of the Company's individual disability income line of business under a 100% coinsurance agreement to Metropolitan Life Insurance Company. The coinsurance agreement became effective October 1, 1997. The transaction has resulted in the recognition of a $53.9 million pre-tax loss in the first quarter of 1997. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on a recent assessment, the Company determined that it will be required to modify or replace significant portions of its software so that its computer systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 issue will be resolved. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 issue could have a material impact on the operations of the Company. The Company has initiated formal communications with all of its significant suppliers and large customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 issue. The Company's total Year 2000 project cost and estimates to complete the project include the estimated costs and time associated with the impact of a third party's Year 2000 issue, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have material adverse effect on the Company. The Company does not believe that it has material exposure to contingencies related to the Year 2000 issue for the products it has sold. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. The Company will utilize both internal and external resources to reprogram, or replace, and test the software for Year 2000 modifications. The Company plans to complete the mission critical elements of the Year 2000 project by December 31, 1998. The cost of the Year 2000 project will be expensed as incurred over the next two years and is being funded through a reallocation of resources from discretionary projects. Therefore, the Year 2000 project is not expected to result in significant incremental technology costs, or to have a material effect on the results of operations. Through December 31, 1997, the Company has incurred and expensed approximately $20 million related to the assessment of, and preliminary efforts in connection with, the project and the development of a remediation plan. The total remaining cost of the project is estimated at between $50-$70 million. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are 44 based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes and similar uncertainties. 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 1997 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" incorporated herein by reference and filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 1997. 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 and annuity 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 & Poor's, 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; (xv) possible claims relating to sales practices for insurance products; and (xvi) uncertainty related to the Year 2000 issue. 45 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, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, 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. /s/ Price Waterhouse LLP Boston, Massachusetts February 3, 1998 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, Executive Officer Chief Financial Officer and Principal Accounting Officer 46 Consolidated Statements of Income
For the Years Ended December 31 (In millions, except per share data) 1997 1996 1995 ==================================================================================================================== Revenues .................................................................................................................... Premiums $ 2,311.1 $ 2,236.3 $ 2,222.8 Universal life and investment product policy fees 237.3 197.2 172.4 Net investment income 653.4 672.6 710.5 Net realized investment gains 76.2 65.9 19.1 Realized gain on sale of mutual fund processing business -- -- 20.7 Other income 117.6 105.6 109.3 .................................................................................................................... Total revenues 3,395.6 3,277.6 3,254.8 .................................................................................................................... Benefits, Losses and Expenses .................................................................................................................... Policy benefits, claims, losses and loss adjustment expenses 2,004.7 1,957.0 2,010.3 Policy acquisition expenses 425.1 470.1 470.9 Loss from cession of disability income business 53.9 -- -- Other operating expenses 546.4 518.8 471.8 .................................................................................................................... Total benefits, losses and expenses 3,030.1 2,945.9 2,953.0 .................................................................................................................... Income before federal income taxes 365.5 331.7 301.8 .................................................................................................................... Federal income tax expense (benefit) .................................................................................................................... Current 79.7 90.9 119.7 Deferred 13.9 (15.7) (37.0) .................................................................................................................... Total federal income tax expense 93.6 75.2 82.7 .................................................................................................................... Income before minority interest and extraordinary item 271.9 256.5 219.1 Minority interest: Distributions on mandatorily redeemable preferred stock of a subsidiary trust holding solely junior subordinated debentures of the Company (14.5) -- -- Equity in earnings (48.2) (74.6) (73.1) .................................................................................................................... Total minority interest (62.7) (74.6) (73.1) .................................................................................................................... Income before extraordinary item 209.2 181.9 146.0 Extraordinary item - demutualization expenses -- -- (12.1) .................................................................................................................... Net income $ 209.2 $ 181.9 $ 133.9 ==================================================================================================================== For the Period Year Ended October 1 December 31, Year Ended Year Ended through 1995 December 31, December 31, December 31, Pro Forma* 1997 1996 1995 (Unaudited) ============================================================================================================= Net income after demutualization $ 209.2 $ 181.9 $ 40.7 $ 130.6 - ------------------------------------------------------------------------------------------------------------- Earnings per common share: - -------------------------- Basic: - ------ Net income after demutualization per share $ 3.83 $ 3.63 $ 0.82 $ 2.61 Weighted average shares outstanding 54.7 50.1 49.4 50.1 Diluted: - -------- Net income after demutualization per share $ 3.82 $ 3.63 $ 0.82 $ 2.61 Weighted average shares outstanding 54.8 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. 47 Consolidated Balance Sheets
December 31 (In millions, except per share data) 1997 1996 ============================================================================================================ Assets ............................................................................................................ Investments: Fixed maturities-at fair value (amortized cost of $7,052.9 and $7,305.5) $ 7,313.7 $ 7,487.8 Equity securities-at fair value (cost of $341.1 and $328.2) 479.0 473.6 Mortgage loans 567.5 650.1 Real estate 50.3 120.7 Policy loans 141.9 132.4 Other long-term investments 148.3 128.8 ............................................................................................................ Total investments 8,700.7 8,993.4 ............................................................................................................ Cash and cash equivalents 215.1 178.5 Accrued investment income 142.3 149.0 Deferred policy acquisition costs 965.5 822.7 Reinsurance receivable on unpaid losses, benefits and unearned premiums 1,040.3 875.6 Deferred federal income taxes -- 66.8 Premiums, accounts and notes receivable 554.4 533.0 Other assets 368.6 307.5 Closed Block assets 806.7 810.8 Separate account assets 9,755.4 6,233.0 ............................................................................................................ Total assets $ 22,549.0 $ 18,970.3 ============================================================================================================ Liabilities ............................................................................................................ Policy liabilities and accruals: Future policy benefits $ 2,598.6 $ 2,613.7 Outstanding claims, losses and loss adjustment expenses 2,825.1 2,944.1 Unearned premiums 846.8 822.5 Contractholder deposit funds and other policy liabilities 1,852.7 2,060.4 ............................................................................................................ Total policy liabilities and accruals 8,123.2 8,440.7 ............................................................................................................ Expenses and taxes payable 670.7 622.3 Reinsurance premiums payable 37.7 31.4 Short-term debt 33.0 38.4 Deferred federal income taxes 12.9 -- Long-term debt 202.1 202.2 Closed Block liabilities 885.5 899.4 Separate account liabilities 9,749.7 6,227.2 ............................................................................................................ Total liabilities 19,714.8 16,461.6 ............................................................................................................ Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 -- Common stock 152.9 784.0 ............................................................................................................ Minority interest 452.9 784.0 ............................................................................................................ 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, 60.0 million and 50.1 million shares issued and outstanding, respectively 0.6 0.5 Additional paid-in capital 1,755.0 1,382.5 Unrealized appreciation on investments, net 217.9 131.6 Retained earnings 407.8 210.1 ............................................................................................................ Total shareholders' equity 2,381.3 1,724.7 ............................................................................................................ Total liabilities and shareholders' equity $ 22,549.0 $ 18,970.3 ============================================================================================================
The accompanying notes are an integral part of these consolidated financial statements. 48 Consolidated Statements of Shareholders' Equity
For the Years Ended December 31 (In millions) 1997 1996 1995 ==================================================================================================================== Preferred Stock $ -- $ -- $ -- .................................................................................................................... Common Stock .................................................................................................................... Balance at beginning of year 0.5 0.5 -- Issuance of common stock 0.1 -- -- Demutualization transaction -- -- 0.4 Initial public offering -- -- 0.1 .................................................................................................................... Balance at end of year 0.6 0.5 0.5 .................................................................................................................... Additional Paid-In Capital .................................................................................................................... Balance at beginning of year 1,382.5 1,382.5 -- Issuance of common stock related to the merger with Allmerica P&C 372.5 -- -- Issuance of common stock 3.7 -- -- Issuance costs of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (3.7) -- -- Demutualization transaction -- -- 1,134.6 Initial public offering -- -- 247.9 .................................................................................................................... Balance at end of year 1,755.0 1,382.5 1,382.5 .................................................................................................................... Unrealized Appreciation on Investments, Net .................................................................................................................... Balance at beginning of year 131.6 153.0 (79.0) .................................................................................................................... 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 .................................................................................................................... Appreciation (depreciation) during the period: Net appreciation (depreciation) on available-for-sale securities 171.3 (35.1) 466.0 (Provision) Benefit for deferred federal income taxes (59.9) 12.3 (163.1) Minority interest (25.1) 1.4 (83.7) .................................................................................................................... 86.3 (21.4) 219.2 .................................................................................................................... Balance at end of year 217.9 131.6 153.0 .................................................................................................................... Retained Earnings .................................................................................................................... Balance at beginning of year 210.1 38.2 1,071.4 Net income prior to demutualization -- -- 93.2 .................................................................................................................... 210.1 38.2 1,164.6 Demutualization transaction -- -- (1,164.6) Net income subsequent to demutualization 209.2 181.9 40.7 Dividends to shareholders (11.5) (10.0) (2.5) .................................................................................................................... Balance at end of year 407.8 210.1 38.2 .................................................................................................................... Total shareholders' equity $ 2,381.3 $ 1,724.7 $ 1,574.2 ====================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements. 49 Consolidated Statements of Cash Flows
For the Years Ended December 31 (In millions) 1997 1996 1995 =============================================================================================================================== Cash Flows From Operating Activities ............................................................................................................................... Net income $ 209.2 $ 181.9 $ 133.9 Adjustments to reconcile net income to net cash provided by operating activities: Minority interest 48.2 74.6 73.1 Net realized gains (77.5) (65.2) (39.8) Net amortization and depreciation 31.6 44.7 57.7 Loss from cession of disability income business 53.9 -- -- Deferred federal income taxes 13.9 (15.7) (37.0) Payment related to cession of disability income business (207.0) -- -- Change in deferred acquisition costs (189.7) (73.9) (38.4) Change in premiums and notes receivable, net of reinsurance payable (15.1) (16.7) (42.0) Change in accrued investment income 7.0 16.5 6.8 Change in policy liabilities and accruals, net (134.7) (184.3) 116.2 Change in reinsurance receivable 27.1 123.7 (75.6) Change in expenses and taxes payable 52.5 27.1 7.7 Separate account activity, net -- 5.2 (0.1) Other, net 7.4 38.1 (31.3) ............................................................................................................................... Net cash (used in) provided by operating activities (173.2) 156.0 131.2 ............................................................................................................................... Cash Flows From Investing Activities ............................................................................................................................... Proceeds from disposals and maturities of available-for-sale fixed maturities 3,046.0 4,018.5 2,738.4 Proceeds from disposals of held-to-maturity fixed maturities -- -- 271.3 Proceeds from disposals of equity securities 162.7 228.7 120.0 Proceeds from disposals of other investments 116.3 99.3 40.5 Proceeds from mortgages matured or collected 204.7 176.9 230.3 Purchase of available-for-sale fixed maturities (2,727.6) (3,830.7) (3,273.3) Purchase of equity securities (67.0) (91.6) (254.0) Purchase of other investments (175.0) (168.0) (24.8) Proceeds from sale of mutual fund processing business -- -- 32.9 Capital expenditures (15.3) (12.8) (14.1) Purchase of minority interest in Allmerica P&C (425.6) -- -- Other investing activities, net 1.3 4.3 4.7 ............................................................................................................................... Net cash provided by (used in) investing activities 120.5 424.6 (128.1) ............................................................................................................................... Cash Flows From Financing Activities ............................................................................................................................... Deposits and interest credited to contractholder deposit funds 457.6 268.7 445.8 Withdrawals from contractholder deposit funds (647.2) (905.0) (1,069.9) Change in short-term debt (5.4) 7.2 (1.6) Change in long-term debt (0.1) (0.1) 0.2 Proceeds from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 296.3 -- -- Dividends paid to shareholders (13.7) (13.9) (6.6) Net proceeds from issuance of common stock 2.8 -- 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 provided by (used in) financing activities 90.3 (685.1) (235.7) ............................................................................................................................... Net change in cash and cash equivalents 37.6 (104.5) (232.6) Net change in cash held in the Closed Block (1.0) (6.5) (17.6) Cash and cash equivalents, beginning of year 178.5 289.5 539.7 ............................................................................................................................... Cash and cash equivalents, end of year $ 215.1 $ 178.5 $ 289.5 =============================================================================================================================== Supplemental Cash Flow Information ............................................................................................................................... Interest paid $ 20.1 $ 33.8 $ 4.1 Income taxes paid $ 66.3 $ 68.1 $ 90.6
The accompanying notes are an integral part of these consolidated financial statements. 50 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 wholly-owned non-insurance holding company). The Closed Block assets and liabilities at December 31, 1997 and 1996 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 7). Unless specifically stated, all disclosures contained herein supporting the consolidated financial statements at December 31, 1997 and 1996 and the years then ended exclude the Closed Block related amounts. All significant intercompany accounts and transactions have been eliminated. Allmerica P&C and a wholly-owned subsidiary of the Company merged on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash and stock (see Note 2). The merger has been accounted for as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million, representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The financial statements reflect minority interest in Allmerica P&C and its subsidiary, The Hanover Insurance Company ("Hanover") of approximately 40.5% prior to the merger on July 16, 1997, and minority interest in Citizens Corporation (an 82.5%-owned non-insurance subsidiary of Hanover) and its wholly-owned subsidiary, Citizens Insurance Company of America ("Citizens") through the end of the year. Minority interest also includes distributions on mandatorily redeemable preferred stock of a subsidiary trust holding solely junior subordinated debentures of the Company. The preparation of financial statements in conformity with generally accepted accounting principles requires the Company 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 are 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. 51 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 dividend scales are inadequate to 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 In accordance with the provisions of Statement of Financial Accounting Standards No. 115 ("Statement No. 115"), "Accounting for Certain Investments in Debt and Equity Securities", the Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. The Company determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. In November 1995, the Financial Accounting Standards Board ("FASB") 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. Marketable equity securities and debt securities are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. 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 the Company 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 the Company believes may not be collectible in full. In establishing reserves, the Company 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. During 1997, the Company adopted a plan to dispose of all real estate assets by the end of 1998. As a result of this decision, real estate held by the Company and real estate joint ventures were written down to the estimated fair value less costs to sell. Depreciation is not recorded on these assets while they are held for disposal. 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 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. Derivative financial instruments are accounted for under three different methods: fair value accounting, deferral accounting and accrual accounting. Interest rate swap contracts used to hedge interest rate risk are accounted for using a combination of the fair value method and accrual method, with changes in fair value reported in unrealized gains and losses in equity consistent with the underlying hedged security, and the net payment or receipt on the swaps reported in net investment income. Foreign currency swap contracts used to hedge foreign currency exchange risk are accounted for using a combination of the fair value method and accrual method, with changes in fair value reported in unrealized gains and losses in equity consistent with the underlying hedged security, and the net payment or receipt on the swaps reported in net investment income. Futures contracts used to hedge interest rate risk are accounted for using the deferral method, with gains and losses deferred in unrealized gains and losses in equity and recognized in earnings in conjunction with the earnings recognition of the underlying hedged item. Other swap contracts entered into for investment purposes are accounted for using the fair value method, with changes in fair value reported in realized investment gains and losses in earnings. 52 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, variable annuities and contractholder deposit funds are deferred and amortized in proportion to total estimated gross profits from investment yields, mortality, surrender charges and expense margins over the expected life of the contracts. This amortization is reviewed annually and adjusted retrospectively when the Company revises its estimate of current or future gross profits to be realized from this group of products, including realized and unrealized gains and losses from investments. Acquisition costs related to fixed annuities and other life insurance products are deferred and amortized, 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 life product and property and casualty line of business 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, the Company 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 ("LAE") are estimates of payments to be made on property and casualty and health insurance for reported losses and LAE and estimates of losses and LAE 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. 53 All policy liabilities and accruals are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, the Company 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, with 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. Certain policy charges that represent compensation for services to be provided in future periods are deferred and amortized over the period benefited using the same assumptions used to amortize capitalized acquisition costs. 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. L. Federal Income Taxes AFC and its domestic subsidiaries file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or 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. Prior to the merger, Allmerica P&C and its subsidiaries filed 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 No. 109, "Accounting for Income Taxes". These differences result primarily from loss and LAE reserves, policy reserves, policy acquisition expenses and unrealized appreciation or depreciation on investments. M. New Accounting Pronouncements In December 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("Statement No. 97-3"). Statement No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and on how to measure the liability. This statement allows for the discounting of the liability if the amount and timing of the cash payments are fixed and determinable. In addition, it provides criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges. This statement is effective for fiscal years beginning after December 15, 1998. The Company believes that the adoption of this statement will not have a material effect on the results of operations or financial position. In June 1997, the FASB issued Statement No. 131, "Disclosures About Segments of an Enterprise and Related Information". This statement establishes standards for the way that public enterprises report information about operating segments in annual financial statements and requires that selected information about those operating segments be reported in interim financial statements. This statement supersedes Statement No. 14, Financial Reporting for Segments of a Business Enterprise. Statement No. 131 requires that all public enterprises report financial and descriptive information about their reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. This statement is effective for fiscal years beginning after December 15, 1997. The Company is currently determining the impact of the adoption of Statement No. 131. 54 In June 1997, the FASB also issued Statement No. 130, "Reporting Comprehensive Income", which established standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. All items that are required to be recognized under accounting standards as components of comprehensive income are to be reported in a financial statement that is displayed with the same prominence as other financial statements. This statement stipulates that comprehensive income reflect the change in equity of an enterprise during a period from transactions and other events and circumstances from non-owner sources. This statement is effective for fiscal years beginning after December 15, 1997. The Company anticipates that the adoption of Statement No. 130 will result primarily in reporting the changes in unrealized gains and losses on investments in debt and equity securities in comprehensive income. In February 1997, the FASB issued Statement No. 128, "Earnings Per Share", which supersedes Accounting Principles Board Opinion No. 15, Earnings Per Share. This standard replaces the primary and fully diluted earnings per share ("EPS") requirements with a basic and diluted EPS computation, and requires a dual presentation of basic and diluted EPS for those companies with complex capital structures. All earnings per share amounts for all periods have been presented to conform to the Statement No. 128 requirements. The adoption of the aforementioned statement had no effect on the Company's previously reported earnings per share. N. Earnings Per Share Earnings per share for the years ended December 31, 1997 and 1996 are based on a weighted average of the number of shares outstanding during 1997 and 1996, respectively. 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 Company's EPS in 1997 is based on net income of $209.2 million for both basic and diluted earnings per share. The weighted average shares outstanding which were utilized in the calculation of basic earnings per share were 54.7 million shares. This differs from the weighted average shares outstanding used in the calculation of diluted earnings per share due to the 0.1 million share effect of dilutive employee stock options. This difference causes a $0.01 per share difference between basic and diluted EPS. There are no differences between basic and diluted earnings per share for 1996 and 1995. Options to purchase 7,742 shares of common stock at $50.00 per share were outstanding during 1997 but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares and, therefore, the effect would be antidilutive. 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 gives 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. Merger with Allmerica Property & Casualty Companies, Inc. ................................................................................ The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was consummated on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash of $425.6 million and approximately 9.7 million shares of AFC stock valued at $372.5 million. The merger has been accounted for as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The Company's consolidated results of operations include minority interest in Allmerica P&C prior to July 16, 1997. The unaudited pro forma information below presents consolidated results of operations as if the merger and issuance of Capital Securities had occurred at the beginning of 1996 and reflects adjustments which include interest expense related to 55 the assumed financing of a portion of the cash consideration paid and amortization of goodwill. The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the merger and issuance of Capital Securities occurred at the beginning of 1996, nor is it necessarily indicative of future results.
(Unaudited) For the Years Ended December 31 (In millions) 1997 1996 ================================================================================ Revenue $ 3,374.1 $ 3,241.6 - -------------------------------------------------------------------------------- Net realized capital gains included in revenue $ 62.7 $ 45.8 - -------------------------------------------------------------------------------- Income before taxes and minority interest $ 341.6 $ 294.1 Income taxes (85.7) (62.8) Minority Interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (16.0) Equity in earnings (16.6) (14.9) ................................................................................ Net income $ 223.3 $ 200.4 - -------------------------------------------------------------------------------- Net income per common share: Basic $ 3.73 $ 3.35 Diluted $ 3.72 $ 3.35 - -------------------------------------------------------------------------------- Weighted average shares outstanding 60.0 59.8 - --------------------------------------------------------------------------------
3. Significant Transactions ................................................................................ Effective January 1, 1998, the Company entered into an agreement with Reinsurance Group of America, Inc. to reinsure the mortality risk on the universal life and variable universal life blocks of business. The Company believes that this agreement will not have a material effect on its results of operations or financial position. On April 14, 1997, the Company entered into an agreement in principle to cede substantially all of the Company's individual disability income line of business under a 100% coinsurance agreement to Metropolitan Life Insurance Company. The coinsurance agreement became effective October 1, 1997. The transaction has resulted in the recognition of a $53.9 million pre-tax loss in the first quarter of 1997. 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 funded a portion of the acquisition of the 24.2 million publicly held shares of Allmerica P&C pursuant to the merger on July 16, 1997. On August 7, 1997, AFC and the Trust exchanged the Series A Capital Securities for a like amount of Series B Capital Securities and related guarantees which are registered under the Securities Act of 1933 as required under the terms of the initial transaction. During the year ended December 31, 1997, distributions of $14.5 million, net of federal income taxes, were reflected in minority interest. 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. 56 4. 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 Statement No. 115. The amortized cost and fair value of available-for-sale fixed maturities and equity securities were as follows:
December 31 (In millions) 1997 ================================================================================================================================== Gross Gross Amortized Unrealized Unrealized Fair Cost (1) Gains Losses Value ------------------------------------------------------ U.S. Treasury securities and U.S. government and agency securities $ 269.6 $ 9.5 $ 0.9 $ 278.2 States and political subdivisions 2,200.6 78.3 3.1 2,275.8 Foreign governments 111.6 8.6 2.2 118.0 Corporate fixed maturities 4,044.3 175.1 12.3 4,207.1 Mortgage-backed securities 426.8 9.8 2.0 434.6 .................................................................................................................................. Total fixed maturities $ 7,052.9 $ 281.3 $ 20.5 $ 7,313.7 - ---------------------------------------------------------------------------------------------------------------------------------- Equity securities $ 341.1 $ 141.9 $ 4.0 $ 479.0 - ---------------------------------------------------------------------------------------------------------------------------------- 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 - ----------------------------------------------------------------------------------------------------------------------------------
(1) Amortized cost for fixed maturities and cost for equity securities. In connection with AFLIAC's voluntary withdrawal of its license 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 liabilities of AFLIAC for New York policyholders, claimants and creditors. At December 31, 1997, the amortized cost and market value of these assets on deposit in New York were $276.8 million and $291.7 million, respectively. At December 31, 1996, the amortized cost and market value of assets on deposit were $284.9 million and $292.2 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $105.1 million and $98.0 million were on deposit with various state and governmental authorities at December 31, 1997 and 1996, respectively. 57 There were no contractual fixed maturity investment commitments at December 31, 1997 and 1996, 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) 1997 ======================================================================== Amortized Fair Cost Value -------------------------- Due in one year or less $ 464.9 $ 468.1 Due after one year through five years 2,146.9 2,229.7 Due after five years through ten years 2,142.5 2,222.3 Due after ten years 2,298.6 2,393.6 ........................................................................ Total $ 7,052.9 $ 7,313.7 ======================================================================== 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 1997 Voluntary Sales Gains Losses ----------------------------------------------- Fixed maturities $ 1,972.4 $ 27.9 $ 16.2 - ------------------------------------------------------------------------ Equity securities $ 145.5 $ 55.8 $ 1.3 - ------------------------------------------------------------------------ 1996 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 - ------------------------------------------------------------------------ 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 1997 Maturities and Other(1) Total ------------------------------------- Net appreciation, beginning of year $ 71.1 $ 60.5 $ 131.6 ........................................................................... Net appreciation (depreciation) on available-for-sale securities 83.6 (5.8) 77.8 Purchased minority interest related to the merger with Allmerica P&C 50.7 59.6 110.3 Net depreciation from the effect on deferred policy acquisition costs and on policy liabilities (16.8) -- (16.8) Provision for deferred federal income taxes and minority interest (55.3) (29.7) (85.0) ........................................................................... 62.2 24.1 86.3 ........................................................................... Net appreciation, end of year $ 133.3 $ 84.6 $ 217.9 =========================================================================== 1996 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 =========================================================================== 1995 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 =========================================================================== (1) Includes net appreciation on other investments of $1.8 million, $0.6 million, and $2.2 million in 1997, 1996 and 1995, respectively. 58 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) 1997 1996 ================================================================== Mortgage loans $ 567.5 $ 650.1 .................................................................. Real estate: Held for sale 50.3 110.4 Held for production of income -- 10.3 .................................................................. Total real estate 50.3 120.7 .................................................................. Total mortgage loans and real estate $ 617.8 $ 770.8 ================================================================== Reserves for mortgage loans were $20.7 million and $19.6 million at December 31, 1997 and 1996, respectively. During 1997, the Company committed to a plan to dispose of all real estate assets by the end of 1998. As a result, real estate assets with a carrying amount of $54.7 million were written down to the estimated fair value less cost to sell of $50.3 million, and a net realized investment loss of $4.4 million was recognized. Depreciation is not recorded on these assets while they are held for disposal. There were no non-cash investing activities, including real estate acquired through foreclosure of mortgage loans, in 1997. During 1996 and 1995, non-cash investing activities included real estate acquired through foreclosure of mortgage loans, which had a fair value of $0.9 million and $26.1 million, respectively. At December 31, 1997, contractual commitments to extend credit under commercial mortgage loan agreements amounted to approximately $39.4 million, of which $10.0 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) 1997 1996 ====================================================== Property type: Office building $ 265.1 $ 317.1 Residential 66.6 95.4 Retail 132.8 177.0 Industrial / warehouse 107.2 124.8 Other 66.8 91.0 Valuation allowances (20.7) (34.5) ...................................................... Total $ 617.8 $ 770.8 ====================================================== Geographic region: South Atlantic $ 173.4 $ 227.0 Pacific 152.8 154.4 East North Central 102.0 119.2 Middle Atlantic 73.8 112.6 West South Central 34.9 41.6 New England 46.9 50.9 Other 54.7 99.6 Valuation allowances (20.7) (34.5) ...................................................... Total $ 617.8 $ 770.8 ====================================================== At December 31, 1997, scheduled mortgage loan maturities were as follows: 1998 - - $136.4 million; 1999 - $70.8 million; 2000 - $129.2 million; 2001 - $26.4 million; 2002 - $29.9 million; and $174.8 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 1997, the Company did not refinance any mortgage loans based on terms which differed from those granted to new borrowers. 59 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 January 1 Additions Deductions December 31 1997 Mortgage loans $ 19.6 $ 2.5 $ 1.4 $ 20.7 Real estate 14.9 6.0 20.9 -- ............................................................................. Total $ 34.5 $ 8.5 $ 22.3 $ 20.7 ============================================================================= 1996 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 ============================================================================= Deductions of $20.9 million to the investment valuation allowance related to real estate in 1997 primarily reflect writedowns to the estimated fair value less costs to sell pursuant to the aforementioned 1997 plan of disposal. The carrying value of impaired loans was $30.5 million and $33.6 million, with related reserves of $13.8 million and $11.9 million as of December 31, 1997 and 1996, respectively. All impaired loans were reserved as of December 31, 1997 and 1996. The average carrying value of impaired loans was $30.8 million, $50.4 million and $117.9 million, with related interest income while such loans were impaired, of $3.2 million, $5.8 million and $9.3 million as of December 31, 1997, 1996 and 1995, respectively. D. Futures Contracts AFC purchases long futures contracts and sells short futures contracts on margin to hedge against interest rate fluctuations associated with the sale of Guaranteed Investment Contracts ("GICs"). The Company is exposed to interest rate risk from the time of sale of the GIC until the receipt of the deposit and purchase of the underlying asset to back the liability. The Company's exposure to credit risk under futures contracts is limited to the margin deposited with the broker. The Company only trades futures contracts with nationally recognized brokers, which the Company believes have adequate capital to ensure that there is minimal danger of default. The Company does not require collateral or other securities to support financial instruments with credit risk. There were no futures contracts outstanding at December 31, 1997 and $(40.0) million notional amount of net short contracts at December 31, 1996. The notional amounts of the contracts represent the extent of the Company's investment but not the future cash requirements, as the Company generally settles open positions prior to maturity. The fair value of futures contracts outstanding were $(39.4) million at December 31, 1996. 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. If instruments being hedged by futures contracts are disposed, any unamortized gains or losses on such contracts are included in the determination of the gain or loss from the disposition. There were no deferred hedging gains or losses in 1997. Deferred hedging gains were $0.6 million and $5.6 million in 1996 and 1995, respectively. Gains and losses on hedge contracts that are deemed ineffective by the Company are realized immediately. A reconciliation of the notional amount of futures contracts is as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 ============================================================================= Contracts outstanding, beginning of year $ (40.0) $ 74.7 $ 126.6 New contracts (6.5) (44.0) 349.2 Contracts terminated 46.5 (70.7) (401.1) ............................................................................. Contracts outstanding, end of year $ -- $ (40.0) $ 74.7 ============================================================================= 60 E. Foreign Currency Swap Contracts The Company enters into foreign currency swap contracts with swap counterparties to hedge foreign currency exposure on specific fixed income securities. Interest and principal related to foreign fixed income securities payable in foreign currencies, at current exchange rates, are exchanged for the equivalent payment in U.S. dollars translated at a specific currency exchange rate. The primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. 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, as indicated by the fair value of the contract. The fair values of the foreign currency swap contracts outstanding were $0.1 million and $(9.2) million at December 31, 1997 and 1996, respectively. Changes in the fair value of contracts are reported as an unrealized gain or loss, consistent with the underlying hedged security. The Company does not require collateral or other security to support financial instruments with credit risk. 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 1997, 1996 and 1995. Any gain or loss on the termination of swap contracts is deferred and recognized with any gain or loss on the hedged transaction. The Company had no deferred gain or loss on foreign currency swap contracts in 1997 or 1996. A reconciliation of the notional amount of foreign currency swap contracts is as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 =============================================================================== Contracts outstanding, beginning of year $ 68.6 $ 104.6 $ 118.7 New contracts 5.0 -- -- Contracts expired (18.2) (36.0) -- Contracts terminated -- -- (14.1) ............................................................................... Contracts outstanding, end of year $ 55.4 $ 68.6 $ 104.6 =============================================================================== Expected maturities of such foreign currency swap contracts outstanding at December 31, 1997 are $25.0 million in 1999, $11.6 million in 2000 and $18.8 million thereafter. There are no expected maturities of such foreign currency swap contracts in 1998, 2001 and 2002. F. Interest Rate 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. As with foreign currency swap contracts, the primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. 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, which at December 31, 1997 was not material to the Company. The Company does not require collateral or other security to support financial instruments with credit risk. The net amount receivable or payable is recognized over the life of the swap contract as an adjustment to net investment income. The (decrease) or increase in net investment income related to interest rate swap contracts was $(0.4) million, $0.6 million and $0.7 million for the years ended December 31, 1997, 1996 and 1995, respectively. The fair value of interest rate swap contracts outstanding was $(2.3) million at December 31, 1997. There were no interest rate swap contracts outstanding at December 31, 1996. Changes in the fair value of contracts are reported as an unrealized gain or loss, consistent with the underlying hedged security. Any gain or loss on the termination of interest rate swap contracts accounted for as hedges are deferred and recognized with any gain or loss on the hedged transaction. The Company had no deferred gain or loss on interest rate swap contracts in 1997 or 1996. A reconciliation of the notional amount of interest rate swap contracts is as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 ============================================================================== Contracts outstanding, beginning of year $ 5.0 $ 17.5 $ 22.8 New contracts 244.7 5.0 -- Contracts expired (5.6) (17.5) (5.3) .............................................................................. Contracts outstanding, end of year $ 244.1 $ 5.0 $ 17.5 ============================================================================== Expected maturities of such interest rate swap contracts outstanding at December 31, 1997 are as follows: $5.0 million in 1998 and $239.1 million in 2000 and thereafter. There are no expected maturities of such interest rate contracts in 1999. 61 G. Other Swap Contracts The Company enters into security return-linked 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. As with interest rate swap contracts, the primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. 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, which at December 31, 1997, was not material to the Company. The Company does not require collateral or other security to support financial instruments with credit risk. The swap contracts are marked to market with any gain or loss recognized currently. The net amount receivable or payable under these contracts is recognized when the contracts are marked to market. The fair values of swap contracts outstanding were $(0.1) million and $0.1 million at December 31, 1997 and 1996, respectively. The net decrease in realized investment gains related to other swap contracts was $(1.6) million for the year ended December 31, 1997. There were no realized investment gains on other swap contracts recognized in 1996 or 1995. A reconciliation of the notional amount of other swap contracts is as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 ============================================================================== Contracts outstanding, beginning of year $ 58.6 $ -- $ -- New contracts 192.1 58.6 -- Contracts expired (211.6) -- -- Contracts terminated (24.1) -- -- .............................................................................. Contracts outstanding, end of year $ 15.0 $ 58.6 $ -- ============================================================================== Expected maturities of such other swap contracts outstanding at December 31, 1997 are as follows: $10.0 million in 1999 and $5.0 million in 2001. There are no expected maturities of such other swap contracts in 1998, 2000 or 2002. H. Other At December 31, 1997, 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 $264.4 million. 5. 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) 1997 1996 1995 ========================================================================= Fixed maturities $ 544.4 $ 555.8 $ 555.1 Mortgage loans 57.5 69.5 97.0 Equity securities 10.6 11.1 13.2 Policy loans 10.9 10.3 20.3 Real estate 20.1 40.8 48.7 Other long-term investments 12.4 19.0 7.1 Short-term investments 21.9 11.3 21.6 ......................................................................... Gross investment income 677.8 717.8 763.0 ......................................................................... Less investment expenses (24.4) (45.2) (52.5) ......................................................................... Net investment income $ 653.4 $ 672.6 $ 710.5 ========================================================================= At December 31, 1997, mortgage loans on non-accrual status were $3.6 million which were all restructured loans. There were no fixed maturities which were on non-accrual status at December 31, 1997. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the investments, had no impact in 1997, and reduced net income by $0.5 million and $0.6 million in 1996 and 1995, 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 $40.3 million, $51.3 million and $98.9 million at December 31, 1997, 1996 and 1995, respectively. Interest income on restructured mortgage loans that would have been recorded in accordance with the original terms of such loans amounted to $3.9 million, $7.7 million and $11.1 million in 1997, 1996 and 1995, respectively. Actual interest income on these loans included in net investment income aggregated $4.2 million, $4.5 million and $7.1 million in 1997, 1996 and 1995, respectively. There were no fixed maturities or mortgage loans which were non-income producing for the twelve months ended December 31, 1997. Included in other long-term investments is income from limited partnerships of $7.8 million, $13.7 million and $0.1 million in 1997, 1996 and 1995 respectively. 62 B. Net Realized Investment Gains and Losses Realized gains (losses) on investments were as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 ======================================================================== Fixed maturities $ 14.0 $ (10.1) $ (7.0) Mortgage loans (1.2) (2.4) 1.4 Equity securities 53.2 55.0 16.2 Real estate 12.8 21.1 5.3 Other (2.6) 2.3 3.2 ........................................................................ Net realized investment gains $ 76.2 $ 65.9 $ 19.1 ======================================================================== 6. Fair Value Disclosures of Financial Instruments .................................................. Statement 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, 1997 or 1996. 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. Mandatorily Redeemable Securities of a Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company 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. 63 The estimated fair values of the financial instruments were as follows:
December 31 (in millions) 1997 1996 ====================================================================================================================== Carrying Fair Carrying Fair Value Value Value Value Financial Assets ...................................................................................................................... Cash and cash equivalents $ 215.1 $ 215.1 $ 178.5 $ 178.5 Fixed maturities 7,313.7 7,313.7 7,487.8 7,487.8 Equity securities 479.0 479.0 473.6 473.6 Mortgage loans 567.5 597.0 650.1 675.7 Policy loans 141.9 141.9 132.4 132.4 ...................................................................................................................... $ 8,717.2 $ 8,746.7 $ 8,922.4 $ 8,948.0 ====================================================================================================================== Financial Liabilities ...................................................................................................................... Guaranteed investment contracts $ 985.2 $ 1,004.7 $ 1,101.3 $ 1,119.2 Supplemental contracts without life contingencies 22.4 22.4 23.1 23.1 Dividend accumulations 87.8 87.8 87.3 87.3 Other individual contract deposit funds 57.9 55.7 76.9 74.3 Other group contract deposit funds 714.8 715.5 789.1 788.3 Individual fixed annuity contracts 907.4 882.2 935.6 911.7 Short-term debt 33.0 33.0 38.4 38.4 Long-term debt 202.1 216.6 202.2 199.1 Mandatorily redeemable preferred securities of a subsidiary trust holding soley junior subordinated debentures of the Company 300.0 326.8 -- -- ...................................................................................................................... $ 3,310.6 $ 3,344.7 $ 3,253.9 $ 3,241.4 ======================================================================================================================
7. Closed Block ................................................................................ Included in other income in the Consolidated Statements of Income in 1997, 1996 and 1995 is a net pre-tax contribution from the Closed Block of $9.1 million, $8.6 million and $2.9 million, respectively. Summarized financial information of the Closed Block as of December 31, 1997 and 1996 and for the period ended December 31, 1997 and 1996 and the period from October 1, 1995 through December 31, 1995 is as follows: December 31 (In millions) 1997 1996 ========================================================================= Assets Fixed maturities, at fair value (amortized cost of $400.1 and $397.2, respectively) $ 412.9 $ 403.9 Mortgage loans 112.0 114.5 Policy loans 218.8 230.2 Cash and cash equivalents 25.1 24.1 Accrued investment income 14.1 14.3 Deferred policy acquisition costs 18.2 21.1 Other assets 5.6 2.7 ......................................................................... Total assets $ 806.7 $ 810.8 ========================================================================= Liabilities Policy liabilities and accruals $ 875.1 $ 883.4 Other liabilities 10.4 16.0 ......................................................................... Total liabilities $ 885.5 $ 899.4 ========================================================================= 64
Period from October 1 For the Years Ended through December 31 December 31 (In millions) 1997 1996 1995 ====================================================================================================== Revenues Premiums and other income $ 58.3 $ 61.7 $ 11.5 Net investment income 53.4 52.6 12.8 Realized investment gain (loss) 1.3 (0.7) -- ...................................................................................................... Total revenues 113.0 113.6 24.3 ...................................................................................................... Benefits and expenses Policy benefits 100.5 101.2 20.6 Policy acquisition expenses 3.0 3.2 0.8 Other operating expenses 0.4 0.6 -- ...................................................................................................... Total benefits and expenses 103.9 105.0 21.4 ...................................................................................................... Contribution from the Closed Block $ 9.1 $ 8.6 $ 2.9 ====================================================================================================== Cash flows Cash flows from operating activities: Contribution from the Closed Block $ 9.1 $ 8.6 $ 2.9 Initial cash transferred to the Closed Block -- -- 139.7 Change in: deferred policy acquisition costs, net 2.9 3.4 0.4 premiums and other receivables -- 0.2 (0.1) policy liabilities and accruals (11.6) (13.9) 2.0 accrued investment income 0.2 2.3 (1.3) deferred taxes (5.1) 1.0 -- other assets (2.9) (1.6) 1.9 expenses and taxes payable (2.0) 1.7 (2.0) Other, net (1.2) 1.4 0.9 ...................................................................................................... Net cash (used in) provided by operating activities (10.6) 3.1 144.4 ...................................................................................................... Cash flows from investing activities: Sales, maturities and repayments of investments 161.6 188.1 29.0 Purchases of investments (161.4) (196.9) (158.8) Other, net 11.4 12.2 3.0 ...................................................................................................... Net cash provided by (used in) investing activities 11.6 3.4 (126.8) ...................................................................................................... Net increase in cash and cash equivalents 1.0 6.5 17.6 Cash and cash equivalents, beginning of year 24.1 17.6 -- ...................................................................................................... Cash and cash equivalents, end of year $ 25.1 $ 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, 1997, 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. 8. Debt ................................................................................ Short and long-term debt consisted of the following: December 31 (In millions) 1997 1996 ============================================================================== Short-term Commercial paper $ 32.6 $ 37.8 Other 0.4 0.6 .............................................................................. Total short-term debt $ 33.0 $ 38.4 ============================================================================== Long-term Senior Debentures (unsecured) $ 199.5 $ 199.5 Other 2.6 2.7 .............................................................................. Total long-term debt $ 202.1 $ 202.2 ============================================================================== 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, 1997, the weighted average interest rate for outstanding commercial paper was approximately 5.8%. In June 1997, the Company entered into a credit agreement providing for a $225.0 million revolving line of credit that expired on December 15, 1997. During 1997, the Company drew $140.0 million on the line of credit. Borrowings under the line of credit were unsecured and bore interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus an applicable margin. These borrowings were repaid in full by December 15, 1997. At December 31, 1997, the Company had approximately $140.0 million in committed lines of credit provided by U.S. banks, of which $107.4 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 limited to 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. These repurchase agreements were settled by the end of 1996. 65 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 7-5/8%, 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. Interest expense was $21.7 million, $32.1 million and $7.3 million in 1997, 1996 and 1995, respectively. Interest expense included $15.3 million, $15.3 million and $3.2 million related to the Company's Senior Debentures for the years ended December 31, 1997, 1996 and 1995 respectively. Interest paid on the credit agreement during 1997 was approximately $2.8 million. Interest expense during 1996 also included $11.0 million related to interest payments of repurchase agreements. All interest expense is recorded in other operating expenses. 9. Federal Income Taxes ................................................................................ Provisions for federal income taxes have been calculated in accordance with the provisions of Statement 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) 1997 1996 1995 ================================================================================ Federal income tax expense (benefit) Current $ 79.7 $ 90.9 $ 119.7 Deferred 13.9 (15.7) (37.0) ............................................................................... Total $ 93.6 $ 75.2 $ 82.7 =============================================================================== 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) 1997 1996 1995 ================================================================================ Expected federal income tax expense $ 127.9 $ 116.1 $ 105.6 Tax-exempt interest (37.9) (35.3) (32.2) Differential earnings amount -- (10.2) (7.6) Dividend received deduction (3.2) (1.6) (4.0) Changes in tax reserve estimates 7.8 4.7 19.3 Other, net (1.0) 1.5 1.6 ............................................................................... Federal income tax expense $ 93.6 $ 75.2 $ 82.7 =============================================================================== 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 liability (asset) represents the tax effects of temporary differences attributable to the Company's consolidated federal tax return group. As a result of the merger discussed in Note 2, the Companies will file a single consolidated federal income tax return for tax years ending on and after December 31, 1997. Deferred tax amounts presented for 1996 reflect the combination of the former FAFLIC/AFLIAC consolidated group with the former Allmerica P&C consolidated group. Its components were as follows: December 31 (In millions) 1997 1996 ================================================================================ Deferred tax (assets) liabilities AMT carryforwards $ (15.6) $ (16.3) Loss reserve discounting (391.6) (355.1) Deferred acquisition costs 291.8 249.4 Employee benefit plans (48.0) (41.4) Investments, net 175.4 128.6 Bad debt reserve (14.3) (26.2) Other, net 15.2 (5.8) ................................................................................ Deferred tax liability (asset), net $ 12.9 $ (66.8) ================================================================================ Gross deferred income tax assets totaled $469.5 million and $444.8 million at December 31, 1997 and 1996, respectively. Gross deferred income tax liabilities totaled $482.4 million and $378.0 million at December 31, 1997 and 1996, respectively. The Company believes, based on its 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, the Company considered the future reversal of its existing temporary differences and available tax planning strategies that could be implemented, if necessary. At December 31, 1997, there are available alternative minimum tax credit carryforwards of $15.6 million. 66 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 former Allmerica P&C consolidated group's federal income tax returns through 1991. The Company has appealed 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 former 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 the Company'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. 10. Pension Plans ................................................................................ AFC provides retirement benefits to substantially all of its employees under three separate defined benefit pension plans. Effective January 1, 1995, the Company adopted a defined benefit cash balance formula, under which the Company annually provides an allocation to each eligible employee based on a percentage of that employee's salary, similar to a defined contribution plan arrangement. The 1997, 1996 and 1995 allocations were based on 7.0% of each eligible employee's salary. In addition to the cash balance allocation, certain transition group employees, who have met specified age and service requirements as of December 31, 1994, are eligible for a grandfathered benefit based primarily on the employees' years of service and compensation during their highest five consecutive plan years of employment. 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) 1997 1996 1995 ============================================================================= Service cost - benefits earned during the year $ 19.9 $ 19.0 $ 19.7 Interest cost on projected benefit obligations 23.5 21.9 21.1 Actual return on assets (64.0) (42.2) (89.3) Net amortization and deferral 29.0 9.3 66.1 ............................................................................. Net pension expense $ 8.4 $ 8.0 $ 17.6 ============================================================================= The following table summarizes the combined status of the three pension plans. At December 31, 1997 and 1996, the plans' assets exceeded their projected benefit obligations. December 31 (In millions) 1997 1996 ============================================================================== Actuarial present value of benefit obligations: Vested benefit obligation $ 332.6 $ 308.9 Unvested benefit obligation 7.5 6.6 .............................................................................. Accumulated benefit obligation $ 340.1 $ 315.5 ============================================================================== Pension liability included in Consolidated Balance Sheets: Projected benefit obligation $ 370.4 $ 344.2 Plan assets at fair value 395.5 347.8 .............................................................................. Plan assets greater than projected benefit obligation 25.1 3.6 Unrecognized net gain from past experience (44.9) (9.1) Unrecognized prior service benefit (13.9) (11.5) Unamortized transition asset (26.2) (24.7) .............................................................................. Net pension liability $ (59.9) $ (41.7) ============================================================================== As a result of the Company's merger with Allmerica P&C, certain pension liabilities were reduced by $11.7 million to reflect their fair value as of the merger date. Determination of the projected benefit obligations was based on a weighted average discount rate of 7.0% in 1997 and 1996 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 5.0% to 5.5%. Plan assets are invested primarily in various separate accounts and the general account of FAFLIC. Plan assets also include 973,262 shares of AFC Common Stock at both December 31, 1997 and 1996, with a market value of $48.6 million and $32.6 million at December 31, 1997 and 1996, respectively. The Company has three separate defined contribution 401(k) plans for its employees. The Company matches employee elective 401(k) contributions, up to a maximum percentage determined annually by the Board of Directors. During 1997, 1996 and 1995, the Company matched 50% of employees' contributions up to 6.0% of eligible compensation. The total expenses related to these plans were $3.3 million, $5.5 million and $5.2 million, in 1997, 1996 and 1995, respectively. In addition to these plans, the Company has a defined contribution plan for substantially all of its agents. The Plan expense in 1997, 1996 and 1995 was $2.8 million, $2.0 million and $3.5 million, respectively. On January 1, 1998, substantially all of the aforementioned defined benefit and defined contribution 401(k) plans were merged with the existing benefit plans of FAFLIC. The transfer of benefit plans will not have a material impact on the results of operations or financial position of the Company. 67 11. 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 nine 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) 1997 1996 =========================================================================== Accumulated postretirement benefit obligation: Retirees $ 40.7 $ 40.4 Fully eligible active plan participants 7.0 7.5 Other active plan participants 24.1 24.4 ........................................................................... 71.8 72.3 Plan assets at fair value -- -- Accumulated postretirement benefit obligation in excess of plan assets 71.8 72.3 Unrecognized prior service benefit 15.3 23.8 Unrecognized loss (0.8) (5.0) ........................................................................... Accrued postretirement benefit costs $ 86.3 $ 91.1 =========================================================================== The components of net periodic postretirement benefit expense were as follows: For the Years Ended December 31 (In millions) 1997 1996 1995 =========================================================================== Service cost $ 3.0 $ 3.2 $ 4.2 Interest cost 4.6 4.6 6.9 Amortization of gain (2.8) (2.8) (0.5) ........................................................................... Net periodic postretirement benefit expense $ 4.8 $ 5.0 $ 10.6 =========================================================================== As a result of the Company's merger with Allmerica P&C, certain postretirement liabilities were reduced by $6.1 million to reflect their fair value as of the merger date. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 1997, health care costs were assumed to increase 8.0% in 1998, 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, 1997 by $4.9 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 1997 by $0.6 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1997 and 1996. As described in Note 10, all of the postretirement benefit plans of the Company were merged with the existing plans of FAFLIC, effective January 1, 1998. 12. Stock-Based Compensation Plans ................................................................................ The Company has elected to apply the provisions of APB No. 25 (Accounting Principles Board Opinion No. 25) in accounting for its stock-based compensation plans, and thus no compensation cost has been recognized for stock options in the financial statements. The pro forma effect of recognizing compensation cost based on an instrument's fair value at the date of grant, consistent with Statement No. 123, "Accounting for Stock-Based Compensation", results in net income and earnings per share of $206.0 million and $3.76 per share-diluted ($3.77 per share-basic) in 1997, and $181.4 million and $3.62 per share (basic and diluted) in 1996. Since options vest over several years and additional awards generally are made each year, the aforementioned pro forma effects are not likely to be representative of the effects on reported net income for future years. 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, the maximum number of shares available for award in any given year is equal to 2.25% of the outstanding common stock of the Company at the beginning of the year, plus any awards authorized but unused from prior years. In addition, the maximum number of shares authorized for grants over the life of the plan is equal to 3,678,733 shares as of December 31, 1997, increasing annually by 1.25% of the Company's outstanding stock. 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. 68 Stock grants may be awarded to eligible employees at a price established by the Committee (which may be zero). Under the Employees' Plan, stock grants may vest based upon performance criteria or continued employment. Stock grants which vest based on performance vest over a minimum one year period. Stock grants which vest based on continued employment vest at the end of a minimum of three consecutive years. Information on the Company's stock option plan is summarized below: (In whole shares and dollars) 1997 1996 ================================================================================ Weighted Weighted Average Average Options Exercise Price Options Exercise Price ................................................................................ Outstanding at beginning of -------------------------- year 209,500 $ 27.50 -- $ -- Granted 849,500 35.64 231,500 27.50 Converted from Allmerica P&C merger 114,509 27.40 -- -- Exercised 16,021 27.23 -- -- Forfeited 82,444 33.74 22,000 27.50 - -------------------------------------------------------------------------------- Outstanding at end of year 1,075,044 $ 33.45 209,500 $ 27.50 - -------------------------------------------------------------------------------- Options exercisable at end of year 57,116 $ 27.38 -- $ -- - -------------------------------------------------------------------------------- No options expired during 1997 and 1996. The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. For options granted during 1997 and 1996, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of options granted in 1997 and 1996 was $15.02 per share and $13.19 per share, respectively. For options converted pursuant to the merger with Allmerica P&C, the exercise price was less than the fair value of the stock on the conversion date. The weighted average fair value of these options was $28.24 per share. The following significant assumptions were used to determine fair value for 1997 options granted and converted: dividend yield of 0.5%, expected volatility of 31.52%, risk free interest rates ranging from 5.66% to 6.19%, and expected lives of 2.5, 4, 5, 6 and 7 years. The following significant assumptions were used to determine fair value for 1996 options granted: dividend yield of 0.6%, expected volatility of 23.5%, risk free interest rates ranging from 5.29% to 6.33%, and expected lives of 2.5, 4, 5, 6 and 7 years. The following table summarizes information about employee options outstanding and exercisable at December 31, 1997.
Options Outstanding Options Currently Exercisable ...................................................................................................................... Weighted Average Weighted Weighted Remaining Average Average Contractual Exercise Exercise Range of Exercise Prices Number Lives Price Number Price ======================================================= ============================================================== ----------- --------------------------------------------------------------- $24.50 to $29.90 290,044 8.31 $27.45 55,116 $ 27.09 $35.375 to $50.00 785,000 9.41 $35.67 2,000 $ 35.38
During 1997, the Company granted 68,127 shares of nonvested stock to eligible employees at a zero purchase price, which vest after three years of continuous employment; 4,395 of these shares were forfeited during the year. The weighted average fair market value of nonvested shares at the date of grant was $34.13 per share. The Company recognizes compensation expense related to nonvested shares over the vesting period on a pro rata basis. As a result, the Company recognized $0.7 million of compensation cost in 1997. 69 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. No dividends were declared by FAFLIC to AFC during 1997, 1996 or 1995. During 1998, FAFLIC could pay dividends of $196.3 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. No dividends were declared by AFLIAC to FAFLIC during 1997, 1996 or 1995. During 1998, AFLIAC could pay dividends of $33.9 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 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. Hanover declared dividends to Allmerica P&C totaling $120.0 million, $105.0 million and $40.0 million during 1997, 1996 and 1995, respectively. During 1998, the maximum dividend and other distributions that could be paid to Allmerica P&C by Hanover, without prior approval of the Insurance Commissioner, is approximately $127.6 million. 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. Citizens Insurance declared dividends to Citizens Corporation totaling $6.3 million and $3.0 million during 1996 and 1995, respectively. No dividends were declared by Citizens Insurance during 1997. During 1998, Citizens Insurance could pay dividends of $86.9 million to Citizens Corporation without prior approval. 14. Segment Information ................................................................................ The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. 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 Accumulation group includes three segments: Allmerica Financial Services, Institutional Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life, 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 cash, investments, corporate debt and Capital Securities. 70 Summarized below is financial information with respect to business segments for the years ended and as of December 31.
(In millions) 1997 1996 1995 ========================================================================================= Revenues: Risk Management ------------- Regional Property and Casualty $ 2,275.3 $ 2,196.6 $ 2,109.0 Corporate Risk Management 396.3 361.5 328.5 ......................................................................................... Subtotal 2,671.6 2,558.1 2,437.5 ......................................................................................... Retirement and Asset Accumulation Allmerica Financial Services 470.6 450.9 486.7 Institutional Services 243.4 270.7 330.2 Allmerica Asset Management 8.7 8.8 4.4 ......................................................................................... Subtotal 722.7 730.4 821.3 ......................................................................................... Corporate 11.2 1.8 0.4 Eliminations (9.9) (12.7) (4.4) ......................................................................................... Total $ 3,395.6 $ 3,277.6 $ 3,254.8 - ----------------------------------------------------------------------------------------- Income (loss) from continuing operations before income taxes: Risk Management Regional Property and Casualty $ 206.4 $ 197.7 $ 206.3 Corporate Risk Management 19.3 20.7 18.3 ......................................................................................... Subtotal 225.7 218.4 224.6 ......................................................................................... Retirement and Asset Accumulation Allmerica Financial Services 87.4 76.2 35.2 Institutional Services 62.4 52.8 42.8 Allmerica Asset Management 1.4 1.1 2.3 ......................................................................................... Subtotal 151.2 130.1 80.3 ......................................................................................... Corporate (11.4) (16.8) (3.1) ......................................................................................... Total $ 365.5 $ 331.7 $ 301.8 - ----------------------------------------------------------------------------------------- Identifiable assets: Risk Management Regional Property and Casualty $ 5,710.6 $ 5,703.9 $ 5,741.8 Corporate Risk Management 571.0 522.1 458.9 ......................................................................................... Subtotal 6,281.6 6,226.0 6,200.7 ......................................................................................... Retirement and Asset Accumulation Allmerica Financial Services 12,049.6 8,822.4 7,218.6 Institutional Services 4,158.5 3,886.7 4,280.9 Allmerica Asset Management 4.1 2.4 2.1 ......................................................................................... Subtotal 16,212.2 12,711.5 11,501.6 ......................................................................................... Corporate 55.2 32.8 55.4 ......................................................................................... Total $ 22,549.0 $ 18,970.3 $ 17,757.7 - -----------------------------------------------------------------------------------------
15. Lease Commitments ................................................................................ Rental expenses for operating leases, principally with respect to buildings, amounted to $33.6 million, $34.9 million and $36.4 million in 1997, 1996 and 1995, respectively. At December 31, 1997, future minimum rental payments under non-cancelable operating leases were approximately $72.5 million, payable as follows: 1998 - $24.8 million; 1999 - $19.8 million; 2000 - $13.6 million; 2001 - - $7.9 million; and $6.4 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 1998. 16. Reinsurance ................................................................................ In the normal course of business, the Company seeks to reduce the loss that my 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 Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". 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, 1997, CAR was the only reinsurer which represented 10% or more of the Company's reinsurance business. As a servicing carrier in 71 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 1997, 1996 and 1995 were $32.3 million and $28.2 million, $38.0 million and $21.8 million, and $49.1 million and $33.7 million, respectively. The Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 1997, 1996 and 1995 of $9.8 million and $(0.8) million, $50.5 million and $(52.9) million, and $66.8 million and $62.9 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 effects of reinsurance were as follows:
For the Years Ended December 31 (In millions) 1997 1996 1995 ========================================================================================================== Life and accident and health insurance premiums: ------------ Direct $ 417.4 $ 389.1 $ 438.9 Assumed 110.7 87.8 71.0 Ceded (170.1) (138.9) (150.3) .......................................................................................................... Net premiums $ 358.0 $ 338.0 $ 359.6 - ---------------------------------------------------------------------------------------------------------- Property and casualty premiums written: Direct $ 2,068.5 $ 2,039.7 $ 2,039.4 Assumed 103.1 108.7 125.0 Ceded (179.8) (234.0) (279.1) .......................................................................................................... Net premiums $ 1,991.8 $ 1,914.4 $ 1,885.3 - ---------------------------------------------------------------------------------------------------------- Property and casualty premiums earned: Direct $ 2,046.2 $ 2,018.5 $ 2,021.7 Assumed 102.0 112.4 137.7 Ceded (195.1) (232.6) (296.2) .......................................................................................................... Net premiums $ 1,953.1 $ 1,898.3 $ 1,863.2 - ---------------------------------------------------------------------------------------------------------- Life and accident and health insurance and other individual policy benefits, claims, losses and loss adjustment expenses: Direct $ 656.4 $ 606.5 $ 741.0 Assumed 61.6 44.9 38.5 Ceded (158.8) (77.8) (69.5) .......................................................................................................... Net policy benefits, claims, losses and loss adjustment expenses $ 559.2 $ 573.6 $ 710.0 - ---------------------------------------------------------------------------------------------------------- Property and casualty benefits, claims, losses and loss adjustment expenses: Direct $ 1,464.9 $ 1,299.8 $ 1,383.3 Assumed 101.2 85.8 146.1 Ceded (120.6) (2.2) (229.1) .......................................................................................................... Net policy benefits, claims, losses and loss adjustment expenses $ 1,445.5 $ 1,383.4 $ 1,300.3 - ----------------------------------------------------------------------------------------------------------
17. Deferred Policy Acquisition Costs ................................................................................ The following reflects the changes to the deferred policy acquisition asset:
For the Years Ended December 31 (In millions) 1997 1996 1995 ==================================================================================== ---------- Balance at beginning of year $ 822.7 $ 735.7 $ 802.8 Acquisition expenses deferred 617.7 547.4 505.4 Amortized to expense during the year (476.0) (470.1) (470.9) Adjustment to equity during the year (11.1) 9.7 (50.4) Transferred to the Closed Block -- -- (24.8) Adjustment for cession of term life insurance -- -- (26.4) Adjustment for cession of disability income insurance (38.6) -- -- Adjustment for revision of universal life and variable universal life insurance mortality assumptions 50.8 -- -- .................................................................................... Balance at end of year $ 965.5 $ 822.7 $ 735.7 - ------------------------------------------------------------------------------------
At October 1, 1997, the Company revised the mortality assumptions for universal life and variable universal life product lines. These revisions resulted in a $50.8 million recapitalization of deferred policy acquisition costs. 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 $533.6 million, $471.7 million and $446.9 million at December 31, 1997, 1996 and 1995, respectively. Accident and health claim liabilities were re-estimated for all prior years and were decreased by $0.2 million and $0.6 million in 1997 and 1996, 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 income line of business. Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of 72 business, under a 100% coinsurance agreement. At December 31, 1997, the individual disability income reserves ceded under this agreement were $249.0 million, representing 46.7% of the Company's total accident and health reserves. The following table provides a reconciliation of the beginning and ending property and casualty reserve for unpaid losses and loss adjustment expenses:
For the Years Ended December 31 (In millions) 1997 1996 1995 ============================================================================================================ Reserve for losses and LAE, beginning of year $ 2,744.1 $ 2,896.0 $ 2,821.7 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,564.1 1,513.3 1,427.3 Decrease in provision for insured events of prior years (127.9) (141.4) (137.6) ............................................................................................................ Total incurred losses and LAE 1,436.2 1,371.9 1,289.7 ............................................................................................................ Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 775.1 759.6 652.2 Losses and LAE attributable to insured events of prior years 732.1 627.6 614.3 ............................................................................................................ Total payments 1,507.2 1,387.2 1,266.5 ............................................................................................................ Change in reinsurance recoverable on unpaid losses (50.2) (136.6) 51.1 Other (1) (7.5) -- -- ............................................................................................................ Reserve for losses and LAE, end of year $ 2,615.4 $ 2,744.1 $ 2,896.0 ============================================================================================================
(1) Includes purchase accounting adjustments. As part of an ongoing process, the property and casualty reserves have been re-estimated for all prior accident years and were decreased by $127.9 million, $141.4 million and $137.6 million in 1997, 1996 and 1995, respectively. The decrease in favorable development on prior years' reserves of $13.5 million in 1997 results primarily from a $24.6 million decrease in favorable development at Hanover to $58.4 million, partially offset by an $11.1 million increase in favorable development at Citizens to $69.5 million. The decrease in Hanover's favorable development of $24.6 million in 1997 reflects a decrease in favorable development of $25.0 million, to $17.4 million in the personal automobile line, as well as a decrease in favorable development of $8.5 million, to unfavorable development of $2.8 million in the commercial multiple peril line. These decreases were partially offset by an increase in favorable development in the workers' compensation line of $11.5 million, to $28.8 million. The increase in favorable development at Citizens in 1997 reflects improved severity in the workers' compensation line where favorable development increased $13.9 million, to $35.7 million and in the commercial multiple peril line where favorable development increased $7.0 million to $4.3 million, partially offset by less favorable development in the personal automobile line, where favorable development decreased $10.5 million, to $22.5 million in 1997. 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 of $10.9 million. 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. 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. Citizens' favorable development in 1997 primarily reflects a modest shift over the past few years of the workers' compensation business to Western and Northern Michigan, which have demonstrated more favorable loss experience than Eastern Michigan. Citizens' favorable development in 1996 and 1995 primarily reflects the initiatives taken by the Company to manage medical costs in both the automobile and workers' compensation lines, as well as the impact of the Michigan Supreme Court ruling on workers' compensation indemnity payments in 1995, which decreases the maximum amount to be paid for indemnity cases on all existing and future claims. Hanover's favorable development from 1995 to 1997 primarily reflects favorable legislation related to workers' compensation, improved safety features in automobiles and a moderation of medical costs and inflation. In 1995, Hanover's favorable development was 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 Hanover refined its estimation of unallocated loss adjustment expenses which increased favorable development in that year. 73 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 the 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 liabilities. Loss and LAE reserves related to environmental damage and toxic tort liability, included in the total reserve for losses and LAE were $53.1 million and $50.8 million, net of reinsurance of $15.7 million and $20.2 million at the end of 1997 and 1996, respectively. 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. Due to their unusual nature and absence of historical claims data, reserves for these claims are not determined using historical experience to project future losses. The Company estimated its ultimate liability for these claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these 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 Company believes that, notwithstanding the evolution of case law expanding liability in environmental claims, recorded reserves related to these claims are adequate. In addition, the Company 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% and 58.3% of the outstanding shares of common stock at December 31, 1996 and 1995, respectively. Allmerica P&C was a wholly-owned subsidiary of AFC at December 31, 1997. Allmerica P&C's interest in Citizens was approximately 82.5% at December 31, 1997 and 1996, and 81.1% at December 31, 1995. Minority interest at December 31, 1997 also reflects the Company's issuance of Capital Securities (See Note 3). 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 In July 1997, a lawsuit was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and refiled the action in Federal District Court in Worcester, Massachusetts. The plaintiffs seek to be certified as a class. The case is in early stages of discovery and the Company is evaluating the claims. Although the Company believes it has meritorious defenses to plaintiffs' claims, there can be no assurance that the claims will be resolved on a basis which is satisfactory to the Company. 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 was 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. Although the Company believes that adequate reserves have been established for any additional liability, there can be no assurance that the appeal will be resolved on a basis which is satisfactory to the Company. The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the Company's opinion, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. However, liabilities related to these proceedings could be established in the near term if estimates of the ultimate resolution of these proceedings are revised. 74 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. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. 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 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) 1997 1996 1995 ================================================================================ Statutory Net Income (Combined) ................................................................................ Property and Casualty Companies $ 190.3 $ 155.3 $ 155.3 Life and Health Companies 191.2 133.3 134.3 ................................................................................ Statutory Shareholders' Surplus (Combined) ................................................................................ Property and Casualty Companies $ 1,279.8 $ 1,201.6 $ 1,128.4 Life and Health Companies 1,221.3 1,120.1 965.6 ................................................................................ 22. Quarterly Results of Operations (Unaudited) ................................................................................ The quarterly results of operations for 1997 and 1996 are summarized below:
For the Three Months Ended (In millions) ============================================== ======================================================= 1997 March 31 June 30 Sept. 30 Dec. 31 ====================================================== Total revenues $ 854.9 $ 832.5 $ 855.7 $ 852.5 ============================================== ======================================================= Net income $ 15.9 $ 37.7 $ 60.7 $ 94.9 ============================================== ======================================================= Net income per share (basic and diluted) $ 0.32 $ 0.75 $ 1.04 $ 1.58 ============================================== ======================================================= Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05 ============================================== ======================================================= 1996 Total revenues $ 831.4 $ 798.9 $ 806.9 $ 840.4 ============================================== ======================================================= Net income $ 47.3 $ 42.6 $ 46.7 $ 45.3 ============================================== ======================================================= Net income per share (basic and diluted) $ 0.94 $ 0.85 $ 0.93 $ 0.91 ============================================== ======================================================= Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05 ============================================== =======================================================
Note: Due to the use of weighted average shares outstanding when calculating earnings per common share, the sum of the quarterly per common share data may not equal the per common share data for the year. 75 Allmerica Financial Corporation BOARD OF DIRECTORS Michael P. Angelini (A) Partner, Bowditch & Dewey, LLP Gail L. Harrison (D) Founding Principal, The Wexler Group Robert P. Henderson (C) General Partner, Greylock Management Corporation M Howard Jacobson (A) Senior Advisor and Consultant, Bankers Trust Company J. Terrence Murray (D) Chairman and Chief Executive Officer, Fleet Financial Group, Inc. Robert J. Murray (D) Chairman, President and Chief Executive Officer, New England Business Service, 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 (C) Former Chairman and Chief Executive Officer, Quabaug Corporation Richard Manning Wall (C) General Counsel and Assistant to the Chairman and CEO, FLEXcon Company, Inc. (A) Audit Committee (C) Compensation Committee (D) Directors Committee OPERATING COMMITTEE Bruce C. Anderson Vice President, Corporate Services Robert E. Bruce Vice President, Corporate Technology 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, Allmerica Financial Services Eric A. Simonsen President, Allmerica Services Corporation Phillip E. Soule Vice President, Corporate Risk Management Services 76 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 12, 1998, 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 March 6, 1998, the Company had 62,369 shareholders of record. On the same date, the trading price of the Company's common stock closed at $62 1/2 per share. COMMON STOCK PRICES AND DIVIDENDS 1997 HIGH LOW DIVIDENDS - -------------------------------------------------------------------------------- First Quarter $40 1/4 $32 5/8 $0.05 ................................................................................ Second Quarter $40 3/8 $33 1/2 $0.05 ................................................................................ Third Quarter $45 1/4 $39 1/4 $0.05 ................................................................................ Fourth Quarter $51 $42 7/8 $0.05 ................................................................................ 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 ................................................................................ DIVIDENDS Allmerica Financial Corporation currently pays a quarterly cash dividend of $0.05 per share. REGISTRAR AND STOCK TRANSFER AGENT First Chicago Trust Company of New York 525 Washington Boulevard Jersey City, NJ 07303-2512 (800) 317-4454 INDEPENDENT ACCOUNTANTS Price Waterhouse LLP 160 Federal Street Boston, MA 02110 INDUSTRY RATINGS A.M. STANDARD DUFF & CLAIMS PAYING ABILITY BEST &POORS MOODY'S PHELPS - -------------------------------------------------------------------------------- First Allmerica Financial Life Insurance Company A AA- A1 AA ................................................................................ Allmerica Financial Life Insurance and Annuity Company A AA- A1 AA ................................................................................ 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+ ................................................................................ Allmerica Financial Corporation Capital Securities BBB+ A2 -- ................................................................................ TOLL-FREE INVESTOR INFORMATION LINE Call our toll-free investor information line, (800) 407-5222, to receive additional printed information, including Form 10-K's 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 Printed entirely on recycled paper Design: The Graphic Expression Inc., New York EX-21 9 SUBSIDIARIES OF THE AFC Exhibit 21 Direct and Indirect Subsidiaries of the Registrant I. Allmerica Financial Corporation (Delaware) A. Allmerica, Inc. (Massachusetts) B. Allmerica Funding Corp. (Massachusetts) C. 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) (65.8% owned) i. APC Funding Corp. (Massachusetts) ii. Allmerica Financial Insurance Brokers, Inc. (Massachusetts) iii. Citizens Insurance Company of Illinois, Inc. (Illinois) iv. The Hanover Insurance Company (New Hampshire) 1. Allmerica Financial Benefit Insurance Company (Pennsylvania) 2. Allmerica Plus 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. Allmerica Financial Life Insurance and Annuity Company (Delaware) i. Somerset Square, Inc. (Massachusetts) e. Allmerica Institutional Services, Inc. (Massachusetts) f. Allmerica Investments, Inc. (Massachusetts) g. Allmerica Investment Management Company, Inc. (Massachusetts) h. Allmerica Asset Management, Inc. (Massachusetts) i. Allmerica Financial Services Insurance Agency, Inc. (Massachusetts) j. Allmerica Asset Management, Limited (Bermuda) k. Allmerica Benefits, Inc. (Florida) D. Allmerica Property & Casualty Companies, Inc. (Delaware) (34.2% owned) E. AFC Capital Trust I (Delaware) F. Allmerica Services Corporation (Massachusetts) G. First Sterling Reinsurance Company Limited (Bermuda) 62 EX-23 10 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, No. 333-582, No. 333-24929 and No. 333-31397) of Allmerica Financial Corporation of our report dated February 3, 1998, appearing in the Allmerica Financial Corporation 1997 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 appear in this Form 10-K. /s/ Price Waterhouse LLP Price Waterhouse LLP Boston, Massachusetts March 24, 1998 63 EX-24 11 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 - --------------------------------------- John F. O'Brien Director, President and CEO 1/29/98 /s/ Edward J. Parry III - --------------------------------------- Edward J. Parry III Vice President, CFO, Treasurer 1/29/98 and Principal Accounting Officer /s/ Michael P. Angelini - --------------------------------------- Michael P. Angelini Director 1/29/98 /s/ Gail L. Harrison - --------------------------------------- Gail L. Harrison Director 1/29/98 /s/ Robert P. Henderson - --------------------------------------- Robert P. Henderson Director 1/29/98 /s/ M Howard Jacobson - --------------------------------------- M Howard Jacobson Director 1/29/98 - --------------------------------------- J. Terrence Murray Director 1/29/98 /s/ Robert J. Murray - --------------------------------------- Robert J. Murray Director 1/29/98 /s/ John L. Sprague - --------------------------------------- John L. Sprague Director 1/29/98 /s/ Robert G. Stachler - --------------------------------------- Robert G. Stachler Director 1/29/98
64 /s/ Herbert M. Varnum - --------------------------------------- Herbert M. Varnum Director 1/29/98 /s/ Richard Manning Wall - --------------------------------------- Richard Manning Wall Director 1/29/98
65 EX-27 12 FINANCIAL DATA SCHEDULE
7 This Schedule contains summary financial information extracted from the Consolidated Financial Statements of Allmerica Financial Corporation as of December 31, 1997 and for the period then ended, and is qualified in its entirety by reference to such financial statements. 1,000,000 12-MOS DEC-31-1997 DEC-31-1997 7,314 0 0 479 568 50 8,701 215 1,040 966 22,549 2,599 847 2,825 1,853 235 300 0 1 2,380 22,549 2,311 653 76 355 2,005 425 600 366 94 272 0 0 0 209 3.83 3.82 2,744 1,559 (123) 775 732 2,615 (123)
EX-99.2 13 IMPORTANT FACTORS RE FORWARD LOOKING STATEMENTS EXHIBIT 99.2 ALLMERICA FINANCIAL CORPORATION 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 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, 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 decision, 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 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. In addition, in 1997, A.M. Best decided to no longer rate Citizens independently from its majority parent, The Hanover Insurance Company, but instead rated the two separate companies as a group. Consequently, Citizens was assigned Best's "A (Excellent)" rating, despite its "A+ (Superior)" qualifications. 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 protections 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, Allmerica 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 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, however; such proposals or similar proposals are currently under consideration by Congress. 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, 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 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 managed care reform, and patient protection and advocacy. State and federal legislation adopted over the past few years generally limits the flexibility of insurers with respect to underwriting practices for small employer plans that contain less than 50 employees, provides for crediting previous coverage for the purposes of determining pre-existing conditions, and limits the ability to medically underwrite individual risks in the group market. In addition, several states have enacted managed care reform legislation which may change managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that utilize managed care programs or market health insurance to small employers will continue. However, the Company's rating, underwriting practices, and managed care programs are consistent with the objective of current reform initiatives. For example, the Company does not experience rate small cases, nor does it refuse coverage to eligible individuals because of medical histories. Also, its managed care programs provide for coverage outside of the preferred network and allow for open communication between a doctor and his/her patient. Because of its emphasis on managed care and risk sharing partnerships, management believes that it will continue to be able to operate effectively in the event of further reform, even if specific states expand the existing limitations. The Company believes that the proposed federal and state health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurer's flexibility and restrict the profitability of health insurers and managed care providers. The Company cannot predict whether any of the current proposals will be enacted or access the particular impact such proposals may have on the Company's Corporate Risk Management Services' business. IMPACT OF THE YEAR 2000 ISSUE The Year 2000 Issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities. Based on a recent assessment, the Company determined that it will be required to modify or replace significant portions of its software so that its computer systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 Issue can be resolved. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 Issue could have a material impact on the operations of the Company. The Company has initiated formal communications with all of its significant suppliers and large customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 Issue. The Company's total Year 2000 project cost and estimates to complete the project include the estimated costs and time associated with the impact of a third party's Year 2000 Issue, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have material adverse effect on the Company. The Company does not believe that it has material exposure to contingencies related to the Year 2000 Issue for the products it has sold. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. The Company will utilize both internal and external resources to reprogram, or replace, and test the software for Year 2000 modifications. The Company plans to complete the mission critical elements of the Year 2000 project by December 31, 1998. The cost of the Year 2000 project will be expensed as incurred over the next two years, and is being funded through a reallocation of resources from discretionary projects. Therefore, the Year 2000 project is not expected to result in significant incremental technology costs or to have material effect on the results of operations. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. -----END PRIVACY-ENHANCED MESSAGE-----