-----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, Ei0YPrMjPkI5jvIykQy8ICeFhAkl04Nm9zOsdngyu7xOi1GMBgkXkB25qFSkFMLS T1FxQ2X9znQoBikn84bRFA== 0000927016-00-001078.txt : 20000331 0000927016-00-001078.hdr.sgml : 20000331 ACCESSION NUMBER: 0000927016-00-001078 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000330 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: 587290 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, 1999 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 22, 2000 the aggregate market value of the voting and non-voting stock held by nonaffiliates of the registrant was $2,477,327,537. The number of shares outstanding of the registrant's common stock, $.01 par value, was 53,545,299 shares outstanding as of March 22, 2000. DOCUMENTS INCORPORATED BY REFERENCE Portions of Allmerica Financial Corporation's Annual Report to Shareholders for 1999 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 16, 2000 are incorporated by reference in Part III. Total number of pages, including cover page: 45 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- 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 AFC; First Allmerica Financial Life Insurance Company ("FAFLIC"); its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"); Allmerica Asset Management, Inc. ("AAM", a wholly-owned non-insurance subsidiary of AFC); Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance subsidiary of AAM); The Hanover Insurance Company ("Hanover", a wholly-owned subsidiary of Allmerica P&C); Citizens Corporation (a wholly-owned non-insurance subsidiary of Hanover); and Citizens Insurance Company of America ("Citizens", a wholly-owned subsidiary of Citizens Corporation). During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its Employee Benefit Services business, its Affinity Group Underwriters business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." Information with respect to the Company's discontinued operations is included in "Discontinued Operations" on pages 35-36 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 2 on page 58 of the Notes to the Consolidated Financial Statements included in the 1999 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Financial Information About Operating Segments The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services, and Allmerica Asset Management. In addition to the three 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 "Results of Operations" on pages 22-35 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 16 on pages 73-75 of the Notes to the Consolidated Financial Statements included in the 1999 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 operating segments. Risk Management General The Company's Risk Management segment consists primarily of its property and casualty operations, which are generated through The Hanover Insurance Company and Citizens Insurance Company of America. For the 2 year ended December 31, 1999, the Risk Management segment accounted for approximately $2,189.4 million, or 71.7%, of consolidated segment revenues and approximately $199.6 million, or 54.0%, of consolidated segment income before taxes and minority interest. The Company primarily underwrites personal and commercial property and casualty insurance through regional specialized distribution channels utilizing the Company's independent agent network primarily in the Northeast, Midwest and Southeast United States. The Allmerica Voluntary Benefits distribution channel focuses on worksite distribution, offering discounted property and casualty products through employer sponsored programs, and affinity group property and casualty business. Special niche property and casualty products in selected markets are offered through the Allmerica Specialty distribution channel. The Company, in its Risk Management segment, continues to have a strong regional focus and places heavy emphasis on underwriting profitability and loss reserve adequacy. As of December 31, 1998, according to A.M. Best, the Risk Management segment of AFC ranks as the 25th largest property and casualty insurance group 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 Risk Management segment seeks to achieve and maintain underwriting profitability in each of its 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 1999, the Risk Management segment completed efforts to consolidate processing centers from 14 regional branches to 3 regional business centers. These regional business centers are located in Atlanta, Georgia; Howell, Michigan; and Worcester, Massachusetts. The Company will continue to maintain its local market presence through branch sales and underwriting offices located throughout the country. In addition to the consolidation of offices, the Risk Management segment began deploying imaging and workflow technology in the business centers which are expected to provide greater efficiencies and enable expense reductions. This technology allows the field agents direct access to underwriting documentation and policy information, which management believes will result in increased service levels and reduced policy quote-to- issue cycle time. In addition, the Company continues to expand its use of agency-Company interface technology, which enables agents to electronically submit personal lines policies for review and rating by the Company. The Company believes that these investments in technology will result in capacity for enhanced customer service by reducing the time required to approve and make policies effective. Lines of Business The Company underwrites personal and commercial property and casualty insurance coverage. The personal lines principally include personal automobile and homeowners' coverage. The commercial lines principally include 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. Customers, Marketing and Distribution 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. As of December 31, 1999, approximately 39% of AFC's property and casualty written premium is generated in the state of Michigan. The Company's other primary markets include Massachusetts, New York, New Jersey, Maine and Indiana. The Company markets property and casualty products through its regional distribution channels: Hanover North, Hanover South, and Citizens Midwest. The Company also markets employer and group sponsored property and casualty products through the Allmerica Voluntary Benefits distribution channel. Additionally, the Company sells special niche property and casualty products through the Allmerica Specialty distribution channel. The regional distribution channels predominantly market property and casualty insurance products through more than 2,500 independent insurance agencies and seek 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. Independent agents provide specialized knowledge of property and casualty products, local market conditions and targeted customer characteristics. 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 Risk Management 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 Risk Management segment sponsors an Agents Advisory Council as a forum to enhance relationships between AFC and its agents. The Council seeks to work together with the Company to provide products and services that help clients better manage the risks they face and to coordinate marketing efforts, support implementation of the Company's strategies, and enhance local market presence. In Michigan, the Company's position as a principal provider with many of its agencies is evidenced by its high average premiums written per agency of approximately $1.4 million in 1999. Over the past few years, the Company has begun to exploit the benefits of worksite marketing as a distribution channel for personal property and casualty lines through its Allmerica Voluntary Benefits channel. This 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, as well as franchise programs that are tailored for members of associations and organizations, including programs for senior citizens. For instance, the Company has developed and marketed groups in both the 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 the programs available to their members or employees based on an evaluation of 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 franchise programs available to their members or employees. As of December 31, 1999, approximately $413.0 million of written premiums in 4 the Voluntary Benefits distribution channel related to the Midwest, accounting for over 40% of the Company's total property and casualty premium volume in the region. Management believes that advantages of competitive pricing, effective consumer awareness campaigns targeted at sponsoring organizations, the convenience of payroll deducted premiums and word of mouth advertising will contribute to the effectiveness of worksite and affinity sales through this channel, as well as provide for lower distribution expenses. The Company, through the Risk Management segment, is also exploring sales through banks and electronic commerce. Additionally, the Company expects to be well positioned to integrate other insurance products offered by its other subsidiaries in order to maximize corporate worksite marketing relationships. AFC pursues measured growth in existing markets through local management operations that apply extensive knowledge of markets to offer competitive products and services as well as through the establishment of long-term relationships with larger, well-established agencies. The Company believes that the selection of markets in which to pursue profitable growth is dependent upon maintaining its local market presence to enhance underwriting results and identify favorable markets. Although its administrative functions are centralized in its headquarters, the Company is committed to maintaining the local market presence afforded by its seventeen branch sales and underwriting offices. These offices provide knowledge of local regulatory and competitive conditions, and have developed close relationships with the independent agents. During 1999, AFC introduced a new businessowner policy ("BOP") product called the Dimension 2000+ Businessowner Policy, which is designed to replace the traditional BOP product for certain classes of customers. This new product is targeted toward small business, providing broadened coverage and enabling ease of conducting business. Dimension 2000+ utilizes a point-of-sale system providing full quote-to-issue capabilities, which create efficiencies in processing. The product is scheduled for full deployment in 2000. The Company, in the Risk Management 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. 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 Risk Management 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 $13.7 million, $11.6 million and $12.9 million in 1999, 1998 and 1997, respectively, relating primarily to coverages for personal and commercial automobile, personal and commercial property, and workers' compensation. The increase in the underwriting loss since 1998 is primarily related to Hanover's participation in the Massachusetts Commonwealth Automobile Reinsurers ("CAR") pool which is consistent with an increase in the participation ratio 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 was voluntarily written. 5 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. 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 of retentions in excess of $75,000 up to $175,000. 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. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to the Massachusetts Commonwealth Automobile Reinsurers ("CAR"). Net premiums earned and losses and loss adjustment expenses ("LAE") ceded to CAR were $42.8 million and $42.6 million in 1999, $34.3 million and $38.1 million in 1998, and $32.3 million and $28.2 million in 1997. At December 31, 1999, CAR represented 10% or more of the Company's reinsurance business. The Company ceded to the Michigan Catastrophic Claims Association ("MCCA") premiums earned and losses and loss adjustment expenses of $3.7 million and $75.3 million in 1999, $3.7 million and $18.0 million in 1998, and $9.8 million and $(0.8) million in 1997. At December 31, 1999, the MCCA represented 10% or more of the Company's reinsurance business. On June 2, 1998, the Company recorded a $124.2 million one-time reduction of direct and ceded written premiums as a result of a return of excess surplus from the MCCA. This transaction is not reflected in the ceded premium and loss amounts above and had no impact on the total net premiums recorded by the Company in 1998. At December 31, 1999 and 1998, the Company, in the Risk Management segment, had reinsurance recoverable on paid and unpaid losses from CAR of $44.6 million and $41.0 million, respectively, and from MCCA of $285.6 million and $250.4 million, respectively. Management believes that in the current regulatory climate, the Company, in the Risk Management 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, with respect to MCCA (i) it 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 18 on pages 75 and 76 and Note 22 on page 78 of the Notes to Consolidated Financial Statements of the 1999 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 6 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, 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. Approximately 30 states have FAIR Plans including Massachusetts, New York and New Jersey. 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. 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. The Company, through its regional distribution channels, markets through independent agents and, therefore, competes with other independent agency companies for business in each of the agencies representing them. In Massachusetts, the Company faces competition in personal lines primarily from direct writers and regional and local companies. In its commercial lines, the Company faces competition primarily from national agency companies and regional and local companies. Due to the number of companies in AFC's principal property and casualty insurance marketplace, management believes that its emphasis on maintaining a local presence in its markets, through the use of the regional distribution channels, coupled with investments in operating and client technologies, will enable it to compete effectively. During the past few years, the competitive environment in Massachusetts has increased substantially. Approximately 22% of AFC's personal automobile business is written in this state. Effective for both January 1, 2000 and January 1, 1999, Massachusetts's personal automobile rates increased 0.7% as mandated by the Massachusetts Division of Insurance. Effective January 1, 1998, Massachusetts's personal automobile rates decreased 4.0% as mandated by the Massachusetts Division of Insurance. The Massachusetts Division of Insurance allows for sponsoring organizations to receive discounts on their auto insurance premiums. Currently, the Company offers more than 150 group programs throughout the state, including a large group plan in the state with approximately 425,000 eligible members. In 1999, the Company offered a 7% discount on automobile insurance for its safest drivers. In 2000, the discount for safe drivers will be 6%. As a result, policyholders have the ability to reduce their insurance premiums by approximately 10% by combining "safe driver" and "group" 7 discounts. Management has implemented these discounts in an effort to retain the Risk Management segment's market share in Massachusetts. These discounts, together with any future mandated rate decreases, may unfavorably impact premium growth in Massachusetts. In Michigan, the Company competes in personal lines with a number of national direct writers and regional and local companies. According to A.M. Best, as of December 31, 1998, the Company is the largest writer of property and casualty insurance in Michigan through independent agents based upon direct written premiums. Almost half of the Company's Michigan business is in the personal automobile line. In Michigan personal lines, AFC ranked fourth with 8% of the market. AFC's principal personal lines competition is from Auto Club of Michigan and State Farm Group. The personal lines market has seen intense competition in recent years, with many of the Company's competitors committing to market share growth resulting in pricing competition in the automobile and homeowners lines. During 1999, the Company's reduced auto rates by approximately 11% as a result of this competitive environment. In Michigan, AFC's commercial lines competition is principally from national agency companies, and regional and local companies. AFC is the largest commercial lines writer in Michigan with 7% of the market share. The commercial industry has been in a profitability downturn over the past several years primarily due to price competition. Premium rate levels are related to the availability of insurance coverage, which varies according to the level of capacity in the industry. The current commercial lines market is extremely competitive due to the increasing number of competitors, which continues to cause lower prices. This highly competitive commercial lines market has constrained the Risk Management segment's growth in commercial lines premium as a result of AFC's commitment to and focus on underwriting profitability, and a refusal to write business at prices the Company views as inadequate. In Michigan, the Company's workers' compensation line is the largest commercial line in terms of premiums written. Over the past few years, competition has caused the Company to reduce workers' compensation rates five times; 6.4%, 8.7%, 1.9%, 3.3%, and 3.3% effective June 1, 1996, March 1, 1997, January 1, 1998, July 1, 1998, and February 1, 1999, respectively. Because there is no one dominant competitor in any of the markets in which the Risk Management 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 Risk Management segment, seeks to achieve a target combined ratio in each of its product lines regardless of market conditions. This strategy will better enable the Company 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. AFC relies on information provided by its local agents and on the knowledge of its staff in the local branch offices. Since the Risk Management segment maintains a strong regional focus and a significant market share in a number of states, the Company 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 Risk Management segment, has field claims 8 adjusters strategically located throughout its operating territories. All claims staff members work closely with the agents to settle claims rapidly and cost-effectively. Claims office adjusting staff are supported by general adjusters on large property losses, automobile and heavy equipment damage appraisers on automobile material damage losses and medical specialists whose principal concentration is in workers' compensation and no-fault automobile injury cases. In addition, the claims offices are supported by staff attorneys who specialize in litigation defense and claim settlements. The Risk Management segment also has special units which investigate suspected insurance fraud and abuse. The Company, in the Risk Management segment, utilizes claims processing technology which allows smaller and more routine claims to be processed at centralized locations. Approximately 70% of the Company's personal lines claims are currently being processed at these locations, which has helped to increase efficiency and reduce operating costs. The Risk Management segment has a program under which participating agents have settlement authority for many property loss claims. Based upon the program's experience, the Company believes that this program contributes to lower LAE experience and to higher customer satisfaction ratings by permitting the early and direct settlement of these small claims. Approximately 30.0% of the number of total paid claims reported to the Midwest distribution channel during 1999, 1998 and 1997, were settled under this program. 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 Risk Management 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 30 and 31 of Management's Discussion and Analysis of Financial Condition and Results of Operations of the 1999 Annual Report to Shareholders, which is incorporated herein by reference. The Company's actuaries, in the Risk Management segment, review the reserves each quarter and certify the reserves annually as required for statutory filings. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company's payment of that loss. To recognize liabilities for unpaid losses, the Company establishes reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. The Risk Management 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 Risk Management 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. The Company, in the Risk Management 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. 9 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:
1999 1998 1997 -------- -------- -------- (In millions) Statutory reserve for losses and LAE.......... $1,926.6 $2,011.7 $2,047.2 GAAP adjustments: Reinsurance recoverable on unpaid losses.... 694.2 591.7 576.7 Other(*).................................... (2.1) (6.1) (8.5) -------- -------- -------- GAAP reserve for losses and LAE............... $2,618.7 $2,597.3 $2,615.4 ======== ======== ========
- -------- (*) Primarily represents other statutory liabilities reclassified as loss adjustment expense reserves for GAAP reporting and purchase accounting adjustments. 10 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 1989 through 1999 for the Company.
Year ended December 31, --------------------------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (In, millions) Net reserve for losses and LAE(1)......... $1,924.5 $2,005.5 $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 Cumulative amount paid as of(2): One year later.. -- 638.0 643.0 732.1 627.6 614.3 566.9 564.3 569.0 561.5 521.1 Two years later.......... -- -- 967.4 1,054.3 1,008.3 940.7 884.4 862.7 888.0 874.5 820.2 Three years later.......... -- -- -- 1,235.0 1,217.8 1,172.8 1,078.1 1,068.4 1,077.1 1,074.3 1,009.3 Four years later.......... -- -- -- -- 1,325.9 1,300.4 1,210.9 1,184.1 1,207.1 1,186.4 1,130.1 Five years later.......... -- -- -- -- -- 1,369.9 1,289.5 1,267.5 1,279.4 1,265.4 1,192.7 Six years later.......... -- -- -- -- -- -- 1,353.3 1,323.1 1,337.2 1,314.2 1,240.9 Seven years later.......... -- -- -- -- -- -- -- 1,355.8 1,377.3 1,355.3 1,271.4 Eight years later.......... -- -- -- -- -- -- -- -- 1,404.1 1,385.9 1,301.6 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,409.2 1,324.0 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 1,343.4 Net reserve re- estimated as of(3): End of year..... 1,924.5 2,005.5 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 One year later.. -- 1,822.1 1,911.5 1,989.3 1,991.1 1,971.7 1,891.5 1,868.1 1,755.0 1,601.5 1,412.4 Two years later.......... -- -- 1,796.8 1,902.8 1,874.3 1,859.4 1,767.4 1,762.8 1,717.7 1,601.9 1,449.0 Three years later.......... -- -- -- 1,832.5 1,826.8 1,780.3 1,691.5 1,703.3 1,670.8 1,614.3 1,471.7 Four years later.......... -- -- -- -- 1,780.7 1,766.2 1,676.3 1,658.9 1,654.1 1,597.6 1,484.7 Five years later.......... -- -- -- -- -- 1,735.6 1,653.7 1,637.3 1,634.6 1,594.3 1,482.3 Six years later.......... -- -- -- -- -- -- 1,630.3 1,650.5 1,630.6 1,588.7 1,486.9 Seven years later.......... -- -- -- -- -- -- -- 1,627.2 1,644.2 1,593.1 1,488.4 Eight years later.......... -- -- -- -- -- -- -- -- 1,626.1 1,621.9 1,552.1 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,593.4 1,524.7 Ten years later.......... -- -- -- -- -- -- -- -- -- 1,499.1 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (Deficiency) Redundancy, net (4,5).......... $ -- $ 183.4 $ 241.9 $ 284.7 $ 351.8 $ 373.7 $ 389.3 $ 309.7 $ 146.3 $ (42.8) $ (172.8) ======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
- -------- (1) Sets forth the estimated net liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years; represents the estimated amount of net losses and LAE for claims arising in the current and all prior years that are unpaid at the balance sheet date, including incurred but not reported ("IBNR") reserves. (2) Cumulative loss and LAE payments made in succeeding years for losses incurred prior to the balance sheet date. (3) Re-estimated amount of the previously recorded liability based on experience for each succeeding year; increased or decreased as payments are made and more information becomes known about the severity of remaining unpaid claims. (4) Cumulative deficiency or redundancy at December 31, 1999 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. (5) The following table sets forth the development of gross reserve for unpaid losses and LAE from 1992 through 1999 for the Company: 11
Year Ended December 31, ----------------------------------------------------------------------- 1999 1998 1997 1996 1995 1994 1993 1992 -------- -------- -------- -------- -------- -------- -------- -------- (In millions) Reserve for losses and LAE: Gross liability........ $2,618.7 $2,597.2 $2,615.4 $2,744.1 $2,896.0 $2,821.7 $2,717.3 $2,598.9 Reinsurance recoverable........... 694.2 591.7 576.7 626.9 763.5 712.4 697.7 662.0 -------- -------- -------- -------- -------- -------- -------- -------- Net liability.......... $1,924.5 $2,005.5 $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............. $2,432.9 $2,472.6 $2,541.9 $2,587.8 $2,593.5 $2,500.5 $2,460.5 Re-estimated recoverable........... 610.8 561.1 552.6 596.7 621.8 609.0 592.4 -------- -------- -------- -------- -------- -------- -------- Net re-estimated liability............. $1,822.1 $1,911.5 $1,989.3 $1,991.1 $1,971.7 $1,891.5 $1,868.1 ======== ======== ======== ======== ======== ======== ======== Two years later: Gross re-estimated liability............. $2,379.3 $2,424.5 $2,427.7 $2,339.2 $2,333.3 $2,341.9 Re-estimated recoverable........... 582.5 521.7 553.4 479.8 565.9 579.1 -------- -------- -------- -------- -------- -------- Net re-estimated liability............. $1,796.8 $1,902.8 $1,874.3 $1,859.4 $1,767.4 $1,762.8 ======== ======== ======== ======== ======== ======== Three years later: Gross re-estimated liability............. $2,395.3 $2,358.6 $2,227.0 $2,145.5 $2,257.3 Re-estimated recoverable........... 562.8 531.8 446.7 454.0 554.0 -------- -------- -------- -------- -------- Net re-estimated liability............. $1,832.5 $1,826.8 $1,780.3 $1,691.5 $1,703.3 ======== ======== ======== ======== ======== Four years later: Gross re-estimated liability............. $2,359.5 $2,220.9 $2,102.0 $2,168.2 Re-estimated recoverable........... 578.8 454.7 425.7 509.3 -------- -------- -------- -------- Net re-estimated liability............. $1,780.7 $1,766.2 $1,676.3 $1,658.9 ======== ======== ======== ======== Five years later: Gross re-estimated liability............. $2,215.2 $2,091.7 $2,027.3 Re-estimated recoverable........... 479.6 438.0 390.0 -------- -------- -------- Net re-estimated liability............. $1,735.6 $1,653.7 $1,637.3 ======== ======== ======== Six years later: Gross re-estimated liability............. $2,096.6 $2,022.6 Re-estimated recoverable........... 466.3 372.1 -------- -------- Net re-estimated liability............. $1,630.3 $1,650.5 ======== ======== Seven years later: Gross re-estimated liability............. $2,050.1 Re-estimated recoverable........... 422.9 -------- Net re-estimated liability............. $1,627.2 ========
Reinsurance The Company, in the Risk Management 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. In addition the Company, in the Risk Management segment, has reinsurance for casualty business. 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. Under the 1999 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 in the workers' compensation line are retained 100% by the Company while amounts in excess of $30.5 million in the general liability line are retained by the Company. 12 Effective July 1, 1999, the Company maintains a property reinsurance program in which the reinsurers are responsible for 100% of each loss in excess of $0.5 million per occurrence up to $19.5 million for inland marine and commercial auto physical damage. All other property business is 100% covered by reinsurers for each loss in excess of $1.5 million per occurrence up to $18.5 million. Amounts in excess of $19.5 million for inland marine and commercial auto physical damage are 100% retained by the Company while amounts in excess of $18.5 million in all other property lines are retained by the Company. Under the Company's 1999 and 1998 catastrophe reinsurance program, AFC retains $45.0 million of loss per occurrence, 10% of all aggregate loss amounts in excess of $45.0 million up to $230.0 million and all amounts in excess of $230.0 million. In 1998 and 1997, the Company, in the Risk Management segment, recovered $3.0 million and $1.2 million, on its catastrophe coverage, respectively. The Company did not have any catastrophe coverage recoveries in 1999. Effective January 1, 2000, the Company modified its catastrophe reinsurance program. Under this new program, AFC retains $45.0 million of loss per hurricane occurrence and $25.0 million of loss per occurrence for all other exposures, 10% of all aggregate loss amounts in excess of $45.0 million, or $25.0 million for non-hurricane losses, up to $65.0 million, 20% of all aggregate loss amounts in excess of $65.0 million up to $230.0 million and all amounts in excess of $230.0 million. Additionally, effective January 1, 2000, the Company purchased a property catastrophe aggregate treaty which provides for annual aggregate coverage totaling 80% of $50.0 million in excess of $60.0 million for catastrophe losses as defined by the Company. The Company's retention will be calculated cumulatively, in the aggregate, on a quarterly basis with the aggregate losses comprised of all catastrophe losses that exceed $0.5 million in each loss occurrence. The maximum contribution from the Company for any one-loss occurrence for the purposes of calculating the aggregate retention will be $25.0 million. Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for the Company's property and casualty business. The program covers losses and allocated LAE, including those incurred but not yet reported in excess of a specified whole account loss and allocated LAE ratio. The annual and aggregate limits for losses and allocated LAE are $150.0 million and $300.0 million, respectively. In accordance with the provisions of this contract, the Company has exercised its option to cancel this contract effective January 1, 2000. The Company, in the Risk Management 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 Risk Management 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. Reference is made to "Reinsurance" in Note 18 on pages 75 and 76 of the Notes to Consolidated Financial Statements of the 1999 Annual Report to Shareholders, which is incorporated herein by reference. Reference is also made to "Reinsurance Facilities and Pools" on page 6 of this Form 10-K which is incorporated herein by reference. 13 Asset Accumulation Allmerica Financial Services General The Allmerica Financial Services segment includes the individual financial products and the group retirement products and services 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 690 agents, to mutual fund providers for their variable annuity customers, and on a wholesale basis to financial planners and broker-dealers. For the year ended December 31, 1999, the Allmerica Financial Services segment accounted for $714.8 million, or 23.4%, of consolidated segment operating revenues and $205.5 million, or 55.6%, of consolidated segment income before taxes and minority interest. The Company offers a diverse line of products tailored to its customer market, including variable annuities, variable universal life, group retirement plan products, retirement plan funding products and universal life. 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) continue to develop additional distribution channels, (iii) leverage the Company's technological resources to support marketing and client service initiatives, (iv) improve the productivity of the career agency distribution system and (v) implement a targeted marketing approach emphasizing value-added service. A significant distribution system in this segment is the 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 other distribution channels, which have made significant contributions to the overall growth of variable product sales in this segment. Products sold through these additional 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 Zurich Kemper Investments ("Kemper"), Pioneer Group ("Pioneer"), Delaware Group ("Delaware"), and Fulcrum Trust ("Fulcrum"). The Company's strategy is to continue to pursue additional distribution channels and to seek to increase sales under its existing distribution channels. The Company has developed a number of new marketing and client service initiatives in order to encourage sales of its products and improve customer satisfaction. As part of its focus on the sale of investment-oriented insurance products, the Company has emphasized a financial planning approach utilizing face-to-face presentations and seminar programs to address different client needs. In order to identify a favorable prospective 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 1999, the Company delivered approximately 675 seminars nationally with a total of more than 20,000 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. 14 According to 1999 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 1998, based on statutory premiums and deposits. Sales of variable products represented approximately 95.9%, 98.0% and 95.7% of this segment's statutory premiums and deposits in 1999, 1998 and 1997, respectively. Statutory premiums and deposits, a common industry benchmark for sales achievement, totaled $3,609.5 million, $4,101.9 million and $3,188.8 million in 1999, 1998 and 1997, 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, including the Closed Block, for the years ended December 31, 1999, 1998 and 1997. 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.
1999 1998 1997 -------- -------- -------- (In millions) Statutory Premiums and Deposits Variable universal life........................ $ 187.0 $ 158.7 $ 148.8 Group variable universal life.................. 94.9 73.3 68.3 Separate account annuities..................... 1,922.2 2,583.6 2,169.1 General account annuities (1).................. 830.2 622.2 234.7 Retirement investment account annuities........ 16.4 20.1 21.8 Group annuities................................ 409.3 563.9 404.2 Universal life................................. 71.8 23.6 60.7 Traditional life............................... 77.4 55.9 58.4 Individual health.............................. 0.3 0.6 22.8 -------- -------- -------- Total statutory premiums and deposits............ $3,609.5 $4,101.9 $3,188.8 ======== ======== ========
- -------- (1) The general account includes approximately $590.5 million in 1999 and $373.0 million in 1998 of deposits made in association with an annuity program which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account and transferred ratably, over a period of time, into the Company's separate accounts. 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. 15 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 69 in 1997 to 133 in 1999, 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. Retirement Products In addition to the above, 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. 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. Currently, the Company provides administration and recordkeeping for approximately 580 qualified pension and profit sharing plans, which have assets totaling $1.8 billion, and cover approximately 62,000 participants. To address the decrease in the market for defined benefit plans sponsored by employers, the Company has focused on increasing sales of defined contribution plans, targeting plans with less than 500 participants. Based on internal studies, management believes the size of this market provides the greatest opportunity in this line of business. Traditional Products The Company's primary insurance products contained in this segment are traditional life insurance products, including whole life and universal life, as well as fixed annuities and retirement plan funding products. 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 A significant distribution channel for this segment is its national career agency sales force of 690 agents, housed in 19 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 16 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. During 1999, total statutory premiums and deposits from sales of variable annuities through the agency sales force totaled $930.1 million, compared to $871.3 million and $782.2 million in 1998 and 1997, respectively. The Company has established several distribution channels for this segment's products utilizing independent broker-dealers and financial planners and continues to pursue additional relationships in this marketplace. Through these distribution channels, the Company has obtained access to over 470 distribution firms employing over 70,000 sales personnel. In addition, establishment of these channels has enabled the Company to offer a broader range of investment options through alliances with Kemper, Pioneer, Delaware, and Fulcrum mutual funds. During 1999, total statutory premiums and deposits from sales of variable annuities through additional distribution channels totaled $1,822.3 million, compared to $2,334.5 million and $1,621.6 million in 1998 and 1997, respectively. Additionally, the Company offers its group retirement products for sale directly at the worksite through trained and licensed sales representatives. In addition to the Home Office, the Company maintains seven regional sales and service offices located in strategic financial markets. By using education and personalized consulting to increase employee purchases, the Company seeks to lower acquisition costs and increase employee participation levels. 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 1999 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. 17 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 3.8% of this segment's total statutory life insurance premiums in 1999. 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 Company's retention is currently $2.0 million per life. The reinsurer is automatically bound for up to three times the Company's retention, or $6.0 million, 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. Under facultative reinsurance, the facultative reinsurer reviews all of the underwriting information relating to the policies prior to issuing the reinsurance 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. All of the reinsurers utilized by this segment have received an A.M. Best rating of "A- (Excellent)" or better (Best's Insurance Reports, 1998 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. Approximately 125 companies currently participate in this pool. 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. Management believes that this agreement will continue to have an immaterial effect on the results of operations and financial position of the Company. In addition, during 1997, the Company entered into a 100% coinsurance agreement to reinsure substantially all of its individual disability income business. 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, 1999, there were approximately 1,600 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. 18 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. Allmerica Asset Management General Through the Allmerica Asset Management segment, the Company offers Stable Value Products, such as Guaranteed Investment Contracts ("GICs"), to ERISA- qualified retirement plans as well as other non-ERISA institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral reinvestment programs. The Company primarily offers funding agreements, also referred to as floating rate GICs, a specific type of GIC, to these non-ERISA institutional buyers. In 1999, the Company established a European Medium Term Note program, also referred to as Euro-GICs, for the purpose of providing an additional market for the issuance of funding agreements. In addition, this segment contains a Registered Investment Advisor, which provides investment advisory services to affiliates and to other institutions, such as insurance companies, retirement plans and mutual funds. For the year ended December 31, 1999, this segment accounted for approximately $150.5 million, or 4.9%, of consolidated segment revenues, and income of $23.5 million, or 6.4%, of consolidated segment income before taxes and minority interest. Products and Services Stable Value Products Three types of Stable Value Products are offered: the traditional GIC, the synthetic GIC and the non-qualified GIC, often referred to as funding agreements. The traditional GIC is issued to ERISA-qualified retirement plans, and 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. The funding agreement is similar to the traditional GIC, except that it is issued to non-ERISA institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral reinvestment programs. This market tends to prefer short duration instruments, so it is typical for the funding agreements sold in this market to have short maturities and periodic interest rate resets, based on an index such as LIBOR. Periodically, buyers prefer to invest in instruments with longer maturities and either fixed or floating rate characteristics. The Company is able to structure its funding agreements to accommodate these buyers. Funding agreements sold through the Euro-GIC program tend to have longer maturities, from 3-10 years, and may utilize either fixed or floating interest rates, and be denominated in either United States or foreign currencies. During 1999, funding agreement sales were approximately $1.0 billion, as compared to $1.1 billion and $250.0 million in 1998 and 1997, respectively. During 1999 deposits of approximately $880.0 million were short maturity floating rate products, while $153.0 million were longer maturity products, including Euro-GIC sales of approximately $53.0 million. In addition, traditional GIC sales totaled approximately $3.0 million, $0.3 million, 19 and $1.1 million in 1999, 1998, and 1997, respectively. There were no sales of synthetic GICs in 1999, 1998, or 1997, and the notional amount of this portfolio decreased to less than $4.0 million during 1999. 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. The Company expects to continue its sales of funding agreements in 2000. Investment Advisory Services Through its registered investment advisor, Allmerica Asset Management, Inc., the Company provides investment advisory services to affiliates and to other institutions, including unaffiliated insurance companies, retirement plans, foundations and mutual funds. At December 31, 1999, Allmerica Asset Management had assets under management of approximately $13.3 billion, of which approximately $2.1 billion represented assets managed for third party clients (i.e. entities unaffiliated with the Company). Assets under management for third party clients grew by approximately $700.0 million during 1999. Distribution The Company distributes Stable Value Products through brokers, investment bankers, GIC investment managers and directly from the Home Office. Investment advisory services are marketed directly. Competition Prior to 1995, all GIC sales consisted of traditional GICs. Around that time, increased sensitivity to claims-paying ratings of GIC issuers, a reduction in the amount of new funds allocated to the purchase of GICs in general, and an increase in availability of non-traditional GIC alternatives, resulted in an increasingly difficult market in which to sell traditional GICs. At that time, the Company introduced its synthetic GIC, selling about $110.0 million of this product in the first year. Since then, increased competition in the synthetic GIC market has driven margins on new business down to extremely low levels. The Company introduced its funding agreement product in the latter part of 1997. There are approximately two dozen insurance companies that compete in the funding agreement market. Funding agreements are one of a variety of instruments being purchased by the buyers in this market, and the Company views these other instruments as comprising the primary competition. Short- term commercial paper issued by corporations is the most common of these competing instruments. The primary factors affecting the ability to sell are the yields offered, short term ratings (and to a lesser extent, claims paying ratings) and product structure. With its expertise in asset/liability management, the Company is able to offer yields that are very competitive with comparably rated instruments, and a variety of product structures, while earning an attractive return on capital, with low volatility. During the third quarter of 1999, uncertainties in the short maturity floating rate funding agreement market prompted a number of investors to terminate their funding agreements with the Company and request the return of their funds. All termination requests received by the Company were paid in a timely manner, and no such requests have been received since the third quarter. The Company introduced its Euro-GIC product in the latter part of 1999. Currently, there are less than twelve insurance companies that compete in this market. Euro-GICs are one of a variety of instruments being purchased by institutional investors in a competitive European market. The Company considers these other instruments as comprising the primary competition, of which medium term notes issued by corporations are the most common form of these competing instruments. The primary factors affecting the ability to sell Euro-GICs are the yields offered, the credit ratings assigned to the program, and the familiarity of the Company name among investors in Europe. As such, the Company periodically sends representatives to Europe to meet with potential investors and has established new relationships with several investment banking firms who manage the distribution of this product. 20 Investment Portfolio General At December 31, 1999, the Company held $9.1 billion of investment assets, including $732.9 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 are founded upon a value orientation. The Company's investment professionals seek to identify undervalued securities in the markets through extensive fundamental research and credit analysis. Management believes this research- driven, value orientation is a key to achieving the overall investment objectives of producing superior rates of return, preserving capital and meeting the financial goals of the Company's business segments. The appropriate asset allocation for the Company (the selection of broad investment categories such as fixed maturities, equity securities, mortgages and real estate) is determined by management initially through a process that focuses overall on the types of businesses in each segment that the Company engages in and the level of surplus (net worth) required to support these businesses. 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 1999, management continued its strategy of shifting portfolio holdings from equity securities to higher quality fixed maturity securities. 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 Risk Management, Allmerica Financial 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 February 2000. 21 FAFLIC and AFLIAC received Duff & Phelps claims-paying ability ratings of AA (Very High) in March 2000. FAFLIC, AFLIAC and Hanover received Moody's financial strength ratings of A1 (Good) in February 2000. FAFLIC, AFLIAC and Hanover, together with its subsidiaries, including Citizens Insurance, received S&P claims-paying ability rating of AA- (Excellent) as of February 3, 2000. 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. 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 137,000 rentable square feet. Citizens also owns a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 207,000 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 22 on page 78 of the Notes to Consolidated Financial Statements of the 1999 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Sales Practices In July 1997, a lawsuit on behalf of a putative class 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, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement 22 agreement. The court granted preliminary approval of the settlement on December 4, 1998. On May 19, 1999, the court issued an order certifying the class for settlement purposes and granting final approval of the settlement agreement. AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. Other The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the opinion of management, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K. 23 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 22, 2000, the Company had 47,919 shareholders of record and 53.5 million shares outstanding. On the same date, the trading price of the Company's common stock was $46.50 per share. Common Stock Prices and Dividends
High Low Dividends --------- -------- --------- 1999 First Quarter.................................... $57 7/8 $50 3/16 -- Second Quarter................................... $62 1/4 $54 1/2 -- Third Quarter.................................... $64 7/16 $47 9/16 $0.25 Fourth Quarter................................... $59 11/16 $46 1/2 -- 1998 First Quarter.................................... $66 3/8 $42 5/16 $0.05 Second Quarter................................... $72 1/8 $61 5/16 $0.05 Third Quarter.................................... $72 1/8 $57 5/16 $0.05 Fourth Quarter................................... $57 7/8 $39 1/4 --
1999 Dividend Schedule Allmerica Financial Corporation declared an annual cash dividend of $0.25 per share on July 27, 1999, which was paid on November 15, 1999. The record date for such dividend was November 1, 1999. 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. 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 44 and 45 of Management's Discussion and Analysis of Financial Condition and Results of Operations and to Note 15 on page 73 of the Notes to Consolidated Financial Statements of the 1999 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. ITEM 6 SELECTED FINANCIAL DATA Reference is made to the "Five Year Summary of Selected Financial Highlights" on page 21 of the 1999 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 22-47 of the 1999 Annual Report to Shareholders, which is incorporated herein by reference. 24 ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Reference is made to "Market Risk and Risk Management Policies" on pages 37- 43 of Management's Discussion and Analysis of Financial Condition and Results of Operations of the 1999 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 49-53 and the accompanying Notes to Consolidated Financial Statements on pages 54-79 of the 1999 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 24 of Notes to Consolidated Financial Statements--page 79), which is incorporated herein by reference. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 25 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 16, 2000, 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, 56 Director, Chief Executive Officer and President of the Company since February 1995 See biography under "Directors of the Registrant" above. Bruce C. Anderson, 55 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. Mark R. Colborn, 51 Vice President of the Company since 2000 Mr. Colborn has been Vice President of AFC since March 2000. In addition, Mr. Colborn has served as Vice President of AFLIAC since July 1992 and FAFLIC since June 1992. He is also an executive officer at various other non-public affiliates of AFC. John P. Kavanaugh, 45 Vice President and Chief Investment Officer of the Company since 1996 Mr. Kavanaugh has been Vice President and Chief Investment Officer of AFC since September 1996, has been employed by FAFLIC since 1983, and has been Vice President of FAFLIC since December 1991 and Vice President of AFLIAC since January 1992. Mr. Kavanaugh has also served as Director and Chief Investment Officer of FAFLIC, Hanover, Citizens Insurance and AFLIAC since August 1996, and Vice President and Chief Investment Officer of Allmerica P&C and Citizens since September 1996. Mr. Kavanaugh is also a director and/or executive officer at various other non-public affiliates. J. Kendall Huber, 45 Vice President and General Counsel of the Company since March 2000 Mr. Huber has been Vice President, General Counsel and Assistant Secretary of AFC since March 2000. Prior to joining AFC, Mr. Huber was Executive Vice President, General Counsel, and Secretary of Promus Hotel Corporation from February 1999 to January 2000. Previously, Mr. Huber was Vice President and Deputy General Counsel of Legg Mason, Inc., from November 1998 to January 1999. He has also served as Vice President and Deputy General Counsel of USF&G Corporation, where he was employed from March 1990 to August 1998. 26 Edward J. Parry, III, 40 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, 61 Vice President of the Company since February 1997 Mr. Reilly has been Vice President of AFC and FAFLIC since February 1997 and November 1990, respectively, and Vice President of Allmerica P&C and Citizens since March 1997. He has also been a Director and Vice President of AFLIAC since November 1990 and President and Chief Executive Officer of AFLIAC since August 1995. Mr. Reilly was Vice President of AFC from February 1995 through December 1995. 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. Robert P. Restrepo, 49 Vice President of the Company since May 1998 Mr. Restrepo has been Vice President of AFC and President, Chief Executive Officer and Director of Allmerica P&C since May 1998. Prior to joining AFC, Mr. Restrepo was Chief Executive Officer, Personal Lines at Travelers Property and Casualty, a member of the Travelers Group from January 1996 to May 1998. Additionally, Mr. Restrepo was the Senior Vice President, Personal Lines at Aetna Life & Casualty Company from March 1991 to January 1996. Mr. Restrepo is also a director and/or executive officer at various other non-public affiliates of AFC. Eric A. Simonsen, 54 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. ITEM 11 EXECUTIVE COMPENSATION Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 16, 2000, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. 27 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 16, 2000, 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 16, 2000, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. 28 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 49 through 79 of the 1999 Annual Report to Shareholders have been incorporated herein by reference in their entirety.
Annual Report Page(s) ------- Report of Independent Accountants..................................... 48 Consolidated Statements of Income for the years ended December 31, 1999, 1998 and 1997.................................................. 49 Consolidated Balance Sheets as of December 31, 1999 and 1998.......... 50 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1999, 1998 and 1997..................................... 51 Consolidated Statements of Comprehensive Income for the years ended December 31, 1999, 1998 and 1997..................................... 52 Consolidated Statements of Cash Flows for the years ended December 31, 1999, 1998 and 1997.................................................. 53 Notes to Consolidated Financial Statements............................ 54-79
(a)(2) Financial Statement Schedules
Page No. in Schedule this Report -------- ----------- Report of Independent Accountants on Financial Statement Schedules.................................... 35 I Summary of Investments--Other than Investments in Related Parties........................................ 36 II Condensed Financial Information of Registrant.......... 37-39 III Supplementary Insurance Information.................... 40-42 IV Reinsurance............................................ 43 V Valuation and Qualifying Accounts...................... 44 VI Supplemental Information concerning Property/Casualty Insurance Operations................................... 45
(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 and 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.+ 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.+++++
29 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. 10.3 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.+ 10.12 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 State Mutual Life Assurance Company of America, the successor to its wholly-owned subsidiary, Group Healthcare Network, Inc.+ 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.+ 10.16 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. 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.+++++++ 10.29 Credit agreement dated as of June 17, 1998 between the Registrant and the Chase Manhattan Bank.++++++++
30 10.30 Form of Deferral Agreement executed by substantially all of the executive officers of AFC dated January 30, 1998.++++++++ 10.31 Form of Restricted Stock Agreement, dated January 30, 1998 and executed by substantially all of the executive officers of AFC.++++++++ 10.32 Form of Converted Stock Agreement, dated January 30, 1998 and executed by substantially all of the executive officers of AFC.++++++++ 10.33 Employment Agreement, dated May 13, 1998 between First Allmerica Financial Life Insurance Company and Robert P. Restrepo, Jr.++++++++ 10.34 Restricted Stock Agreement, dated May 26, 1998, between Allmerica Financial Corporation and Robert P. Restrepo, Jr.++++++++ 10.35 Credit agreement dated as of December 1, 1998 between the Registrant and the Chase Manhattan Bank.++++++++ 10.36 Amendment to the Credit Agreement dated as of June 17, 1998 between the Registrant and the Chase Manhattan Bank incorporated by reference to Exhibit 10.36 to the Allmerica Financial Corporation June 30, 1999 report on Form 10-Q and incorporated herein by reference. 10.37 Allmerica Financial Corporation Short-Term Incentive Compensation Plan incorporated herein by reference to Exhibit A contained in the Registrant's Proxy Statement (Commission File No. 001-13754) originally filed with the Commission on March 31, 1999. 13 The following sections of the Annual Report to Shareholders for 1999 ("1999 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 22 through 47 of the 1999 Annual Report. . Consolidated Financial Statements and Notes thereto at pages 49 through 79 of the 1999 Annual Report. . Report of Independent Accountants at page 48 of the 1999 Annual Report. . The information appearing under the caption "Five Year Summary of Selected Financial Highlights" at page 21 of the 1999 Annual Report. . The information appearing under the caption "Shareholder Information" at page 81 of the 1999 Annual Report. 21 Subsidiaries of AFC. 23 Consent of Independent Accountants. 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. 31 +++++++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1997 Annual Report on Form 10-K originally filed with the Commission on March 27, 1998 ++++++++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1998 Annual Report Form 10-K originally filed with the Commission on March 29, 1999. (b) Reports on Form 8-K On October 7, 1999, Allmerica Financial Corporation announced that it has reached an agreement to sell its group life and health insurance business to Great-West Life & Annuity Insurance Company of Denver. On October 28, 1999, Allmerica Financial Corporation announced its financial results for the three months ended September 30, 1999. 32 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 23,2000 /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 23, 2000 /s/ John F. O'Brien By: _________________________________ John F. O'Brien, Chairman of the Board, Chief Executive Officer and President Date: March 23, 2000 /s/ Edward J. Parry, III By: _________________________________ Edward J. Parry III, Vice President, Chief Financial Officer, Treasurer and Principal Accounting Officer Date: March 23, 2000 * By: _________________________________ Michael P. Angelini, Director Date: March 23, 2000 * By: _________________________________ E. Gordon Gee, Director Date: March 23, 2000 * By: _________________________________ Samuel J. Gerson, Director Date: March 23, 2000 * By: _________________________________ Gail L. Harrison, Director Date: March 23, 2000 * By: _________________________________ Robert P. Henderson, Director 33 Date: March 23, 2000 * By: _________________________________ M Howard Jacobson, Director Date: March 23, 2000 * By: _________________________________ Wendell J. Knox, Director Date: March 23, 2000 By: _________________________________ Terrence Murray, Director Date: March 23, 2000 * By: _________________________________ Robert J. Murray, Director Date: March 23, 2000 * By: _________________________________ John L. Sprague, Director Date: March 23, 2000 * By: _________________________________ Robert G. Stachler, Director Date: March 23, 2000 * By: _________________________________ Herbert M. Varnum, Director /s/ Edward J. Parry *By: ________________________________ Edward J. Parry, Attorney-in-fact 34 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 1, 2000, appearing in the Allmerica Financial Corporation 1999 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)(2) 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/ PricewaterhouseCoopers LLP _____________________________________ PricewaterhouseCoopers LLP Boston, Massachusetts February 1, 2000 35 Schedule I ALLMERICA FINANCIAL CORPORATION Summary of Investments--Other than Investments in Related Parties December 31, 1999
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.................. $ 188.8 $ 189.4 $ 189.4 States, municipalities and political subdivisions.............................. 2,189.8 2,137.6 2,137.6 Foreign governments........................ 89.0 91.9 91.9 Public utilities........................... 359.9 349.0 349.0 All other corporate bonds.................. 3,976.1 3,886.0 3,886.0 Redeemable preferred stocks.................. 291.4 279.9 279.9 -------- ------- -------- Total fixed maturities..................... 7,095.0 6,933.8 6,933.8 -------- ------- -------- Equity securities: Common stocks: Public utilities........................... -- 1.3 1.3 Banks, trust and insurance companies....... 0.1 3.0 3.0 Industrial, miscellaneous and all other.... 28.4 57.8 57.8 Nonredeemable preferred stocks............... 21.0 21.1 21.1 -------- ------- -------- Total equity securities.................... 49.5 83.2 83.2 -------- ------- -------- Mortgage loans on real estate.................. 521.2 XXXXXX 521.2 Real estate(2)................................. 12.6 XXXXXX 12.6 Policy loans................................... 170.5 XXXXXX 170.5 Other long-term investments.................... 177.0 XXXXXX 167.4 -------- ------- -------- Total investments.......................... $8,025.8 XXXXXX $7,888.7 ======== ======= ========
- -------- (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 $10.9 million of real estate acquired through foreclosure. 36 Schedule II ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Statements of Income for the Years Ended December 31,
1999 1998 1997 ------ ------ ------ Revenues Net investment income............................... $ 5.3 $ 7.1 $ 11.4 Net realized investment (losses) gains.............. (0.4) 1.7 (0.2) ------ ------ ------ Total revenues.................................... 4.9 8.8 11.2 ------ ------ ------ Expenses Interest expense.................................... 40.6 40.5 41.1 Operating expenses.................................. 2.3 2.5 5.0 ------ ------ ------ Total expenses.................................... 42.9 43.0 46.1 ------ ------ ------ Net loss before federal income taxes and equity in net income of unconsolidated subsidiaries................ (38.0) (34.2) (34.9) Income tax benefit: Federal............................................. 14.2 12.4 11.8 State............................................... 0.3 0.5 0.5 Equity in net income of unconsolidated subsidiaries... 319.3 222.5 231.8 ------ ------ ------ Net income............................................ $295.8 $201.2 $209.2 ====== ====== ======
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 37 Schedule II (continued) ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Balance Sheets
December 31, ------------------ 1999 1998 -------- -------- (In millions, except share and per share data) Assets Fixed maturities-at fair value (amortized cost of $0.8 in 1998)................................................... $ -- $ 0.9 Cash and cash equivalents................................ 5.6 2.9 Investment in unconsolidated subsidiaries................ 2,761.5 3,008.0 Receivable from subsidiaries............................. 47.2 43.9 Other assets............................................. 7.4 0.5 -------- -------- Total assets........................................... $2,821.7 $3,056.2 ======== ======== Liabilities Expenses and taxes payable............................... $ 14.8 $ 34.7 Interest and dividends payable........................... 13.3 13.0 Short-term debt.......................................... 44.6 41.1 Long-term debt........................................... 508.8 508.8 -------- -------- Total liabilities...................................... 581.5 597.6 -------- -------- 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, 60.4 million shares issued at both December 31, 1999 and December 31, 1998................. 0.6 0.6 Additional paid-in capital............................... 1,770.5 1,768.8 Accumulated other comprehensive income................... (75.3) 180.5 Retained earnings........................................ 882.2 599.9 Treasury stock at cost (6.2 and 1.8 million shares)...... (337.8) (91.2) -------- -------- Total shareholders' equity............................. 2,240.2 2,458.6 -------- -------- Total liabilities and shareholders' equity............. $2,821.7 $3,056.2 ======== ========
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 38 Schedule II (continued) ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Statement of Cash Flows for the Years Ended December 31,
1999 1998 1997 ------- ------- ------- (In millions) Cash flows from operating activities Net income......................................... $ 295.8 $ 201.2 $ 209.2 Adjustments to reconcile net income to net cash used in operating activities: Equity in undistributed income of subsidiaries.... (319.3) (222.5) (231.8) Net realized investment (gains) losses............ 0.4 (1.7) 0.2 Change in expenses and taxes payable.............. (2.8) 24.7 0.9 Change in interest and dividends payable.......... 0.3 (2.8) 10.0 Change in receivable from subsidiaries............ 3.3 (43.9) -- Other, net........................................ 1.7 8.0 (0.3) ------- ------- ------- Net cash used in operating activities............... (20.6) (37.0) (11.8) ------- ------- ------- Cash flows from investing activities Capital contributed to unconsolidated subsidiaries...................................... (54.1) (95.7) (79.9) Proceeds from disposals and maturities of available-for-sale fixed maturities............... 84.6 123.9 98.7 Purchase of available-for-sale fixed maturities.... (41.4) -- (74.9) Purchase of minority interest in Allmerica P&C..... -- -- (425.6) Proceeds from sale of common stock of subsidiary... 247.6 -- 195.0 ------- ------- ------- Net cash provided by (used in) investing activities......................................... 236.7 28.2 (286.7) ------- ------- ------- Cash flow from financing activities Increase in long-term debt......................... -- -- 9.3 Dividend received from unconsolidated subsidiaries...................................... 39.5 50.0 -- Net proceeds from issuance of commercial paper..... 3.5 41.1 -- Net proceeds from issuance of common stock......... 1.1 11.4 2.8 Proceeds from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company......................... -- -- 296.3 Treasury stock purchased at cost................... (250.2) (82.7) -- Treasury stock reissued at cost.................... 6.2 -- -- Dividends paid to shareholders..................... (13.5) (9.0) (11.5) ------- ------- ------- Net cash (used in) provided by financing activities......................................... (213.4) 10.8 296.9 ------- ------- ------- Net change in cash and cash equivalents............. 2.7 2.0 (1.6) Cash and cash equivalents at beginning of the period............................................. 2.9 0.9 2.5 ------- ------- ------- Cash and cash equivalents at end of the period...... $ 5.6 $ 2.9 $ 0.9 ======= ======= =======
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 39 Schedule III ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1999
Future policy Amortization benefits, Other Benefits, of Deferred losses, policy claims, deferred policy claims and claims and Net losses and policy Other acquisition loss Unearned benefits Premium investment settlement acquisition operating Premiums costs expenses premiums payable revenue income expenses costs expenses written ----------- ---------- -------- ---------- -------- ---------- ---------- ------------ --------- -------- (In millions) Risk Management.. $ 173.3 $3,003.8 $887.2 $ 24.8 $1,948.2 $221.4 $1,420.3 $370.6 $197.0 $1,977.0 Asset Accumulation Allmerica Financial Services........ 1,213.1 2,659.8 3.0 700.2 2.3 251.1 232.1 59.1 211.7 -- Allmerica Asset Management...... 0.4 -- -- 1,316.0 -- 138.2 118.3 0.2 8.5 -- Corporate........ -- -- -- -- -- 6.0 -- -- 65.3 -- Eliminations..... -- -- -- -- -- (1.0) -- -- (5.9) -- -------- -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $1,386.8 $5,663.6 $890.2 $2,041.0 $1,950.5 $615.7 $1,770.7 $429.9 $476.6 $1,977.0 ======== ======== ====== ======== ======== ====== ======== ====== ====== ========
40 Schedule III (continued) ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1998
Future policy Amortization benefits, Other Benefits, of Deferred losses, policy claims, deferred policy claims and claims and Net losses and policy Other acquisition loss Unearned benefits Premium investment settlement acquisition operating Premiums costs expenses premiums payable revenue income expenses costs expenses written ----------- ---------- -------- ---------- -------- ---------- ---------- ------------ --------- -------- (In millions) Risk Management.. $ 167.5 $2,955.4 $840.1 $ 21.4 $1,967.9 $229.8 $1,495.4 $379.7 $206.4 $1,956.7 Asset Accumulation Allmerica Financial Services........ 993.1 2,663.1 3.1 823.8 2.7 253.1 219.3 69.6 209.3 -- Allmerica Asset Management...... 0.6 -- -- 1,791.8 -- 111.4 89.3 0.3 8.4 -- Corporate........ -- -- -- -- -- 11.9 -- -- 63.8 -- Eliminations..... -- -- -- -- -- (1.8) -- -- (7.6) -- -------- -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $1,161.2 $5,618.5 $843.2 $2,637.0 $1,970.6 $604.4 $1,804.0 $449.6 $480.3 $1,956.7 ======== ======== ====== ======== ======== ====== ======== ====== ====== ========
41 Schedule III (continued) ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1997
Future policy Amortization benefits, Other Benefits, of Deferred losses, policy claims, deferred policy claims and claims and Net losses and policy Other acquisition loss Unearned benefits Premium investment settlement acquisition operating Premiums costs expenses premiums payable revenue income expenses costs expenses written ----------- ---------- -------- ---------- -------- ---------- ---------- ------------ --------- -------- (In millions) Risk Management.. $170.1 $2,946.8 $844.6 $ 20.0 $1,955.5 $254.1 $1,443.7 $399.9 $215.5 $1,659.6 Asset Accumulation Allmerica Financial Services........ 794.5 2,476.9 2.2 847.5 24.9 281.6 256.1 8.1 217.8 -- Allmerica Asset Management...... 0.9 -- -- 985.2 0.1 82.5 64.2 0.5 8.0 -- Corporate........ -- -- -- -- -- 14.0 -- -- 64.1 -- Eliminations..... -- -- -- -- -- (1.1) -- -- (11.5) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $965.5 $5,423.7 $846.8 $1,852.7 $1,980.5 $631.1 $1,764.0 $408.5 $493.9 $1,659.6 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
42 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) 1999 Life insurance in force..... $41,393.1 $21,251.5 $374.2 $20,515.8 1.82% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 21.3 $ 18.6 $ 0.7 $ 3.4 20.59% Accident and health insurance................ 32.2 31.4 -- 0.8 -- Property and casualty insurance................ 2,135.0 261.7 73.0 1,946.3 3.75% --------- --------- ------ --------- Total premiums.............. $ 2,188.5 $ 311.7 $ 73.7 $ 1,950.5 3.78% ========= ========= ====== ========= ===== 1998 Life insurance in force..... $44,790.9 $23,886.9 $555.4 $21,459.4 2.59% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 15.8 $ 13.3 $ 0.7 $ 3.2 21.88% Accident and health insurance................ 35.6 34.5 -- 1.1 -- Property and casualty insurance................ 1,967.9 66.1 64.5 1,966.3 3.28% --------- --------- ------ --------- Total premiums.............. $ 2,019.3 $ 113.9 $ 65.2 $ 1,970.6 3.31% ========= ========= ====== ========= ===== 1997 Life insurance in force..... $44,902.9 $ 7,237.1 $308.9 $37,974.7 0.81% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 16.7 $ 14.9 $ 0.6 $ 2.4 25.00% Accident and health insurance................ 39.2 14.2 -- 25.0 -- Property and casualty insurance................ 2,046.2 195.1 102.0 1,953.1 5.22% --------- --------- ------ --------- Total premiums.............. $ 2,102.1 $ 224.2 $102.6 $ 1,980.5 5.18% ========= ========= ====== ========= =====
43 Schedule V ALLMERICA FINANCIAL CORPORATION Valuation and Qualifying Accounts December 31,
Additions ------------------- Deductions Balance at Charged to Charged from Balance beginning costs and to other allowance at end of period expense accounts account of period ---------- ---------- -------- ---------- --------- (In millions) 1999 Mortgage loans............ $11.5 $(2.4) $-- $ 3.3 $ 5.8 Allowance for doubtful accounts................. 5.4 5.6 -- 5.2 5.8 ----- ----- ---- ----- ----- $16.9 $ 3.2 $-- $ 8.5 $11.6 ===== ===== ==== ===== ===== 1998 Mortgage loans............ $20.7 $(6.8) $-- $ 2.4 $11.5 Allowance for doubtful accounts................. 6.1 4.4 -- 5.1 5.4 ----- ----- ---- ----- ----- $26.8 $(2.4) $-- $ 7.5 $16.9 ===== ===== ==== ===== ===== 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 ===== ===== ==== ===== =====
44 Schedule VI ALLMERICA FINANCIAL CORPORATION Supplemental Information Concerning Property and Casualty Insurance Operations For the Years Ended December 31,
Reserves Discount, for if any, Deferred losses and deducted policy loss from Net Net Affiliation with acquisition adjustment previous Unearned premiums investment Registrant costs expenses(2) column(1) premiums(2) earned income ---------------- ----------- ----------- --------- ----------- -------- ---------- (In millions) Consolidated Property and Casualty Subsidiaries 1999.................. $167.3 $2,618.7 $-- $883.3 $1,946.3 $220.5 ====== ======== ==== ====== ======== ====== 1998.................. $164.9 $2,597.3 $-- $834.9 $1,966.3 $228.9 ====== ======== ==== ====== ======== ====== 1997.................. $167.2 $2,615.4 $-- $838.3 $1,953.1 $253.3 ====== ======== ==== ====== ======== ======
Amortization Paid Losses and loss of deferred losses adjustment expenses policy and loss Net ------------------------ acquisition adjustment premiums Current Year Prior Years expenses expenses written ------------ ----------- ------------ ---------- -------- 1999............... $1,601.4 $(183.4) $370.6 $1,499.1 $1,975.4 ======== ======= ====== ======== ======== 1998............... $1,609.0 $(127.2) $379.7 $1,514.9 $1,955.1 ======== ======= ====== ======== ======== 1997............... $1,564.1 $(127.9) $399.9 $1,507.2 $1,991.8 ======== ======= ====== ======== ========
- -------- (1) The Company does not employ any discounting techniques. (2) Reserves for losses and loss adjustment expenses are shown gross of $694.2 million, $591.7 million and $576.7 million of reinsurance recoverable on unpaid losses in 1999, 1998 and 1997, respectively. Unearned premiums are shown gross of prepaid premiums of $57.4 million, $37.9 million and $30.0 million in 1999, 1998 and 1997, respectively. 45 EX-13 2 SECTIONS OF THE ANNUAL REPORT TO SHAREHOLDERS Exhibit 13.1 Five Year Summary of Selected Financial Highlights
For the Years Ended December 31 1999 1998 1997 1996 1995 ================================================================================================================================ (In millions, except per share data) STATEMENT OF INCOME Revenues Premiums $ 1,950.5 $ 1,970.6 $ 1,980.5 $ 1,937.1 $ 1,952.2 Universal life and investment product policy fees 359.3 296.6 237.3 197.2 172.4 Net investment income 615.7 604.4 631.1 651.2 692.0 Net realized investment gains 91.0 59.2 76.0 65.6 40.3 Other income 128.7 103.2 81.5 77.7 80.0 - -------------------------------------------------------------------------------------------------------------------------------- Total revenues 3,145.2 3,034.0 3,006.4 2,928.8 2,936.9 ================================================================================================================================ Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 1,770.7 1,804.0 1,764.0 1,747.8 1,815.2 Policy acquisition expenses 429.9 449.6 408.5 454.4 452.7 Sales practice litigation expense -- 31.0 -- -- -- Loss from cession of disability income business -- -- 53.9 -- -- Restructuring costs (1.9) 9.0 -- -- -- Other operating expenses 478.5 440.3 440.0 421.4 392.3 - -------------------------------------------------------------------------------------------------------------------------------- Total benefits, losses and expenses 2,677.2 2,733.9 2,666.4 2,623.6 2,660.2 ================================================================================================================================ Income before federal income taxes 468.0 300.1 340.0 305.2 276.7 Federal income tax expense 106.9 56.1 84.7 66.2 73.6 - -------------------------------------------------------------------------------------------------------------------------------- Income before minority interest, extraordinary item and discontinued operations 361.1 244.0 255.3 239.0 203.1 Minority interest (16.0) (29.3) (62.7) (74.6) (73.1) - -------------------------------------------------------------------------------------------------------------------------------- Income from continuing operations 345.1 214.7 192.6 164.4 130.0 Discontinued operations: (Loss) income from operations of discontinued group life and health business, net of taxes (18.8) (13.5) 16.6 17.5 16.0 Loss from disposal of group life and health business, net of taxes (30.5) -- -- -- -- - -------------------------------------------------------------------------------------------------------------------------------- Income before extraordinary item 295.8 201.2 209.2 181.9 146.0 Extraordinary item - demutualization expenses -- -- -- -- (12.1) - -------------------------------------------------------------------------------------------------------------------------------- Net income $ 295.8 $ 201.2 $ 209.2 $ 181.9 $ 133.9 ================================================================================================================================ Earnings per common share (diluted)(1) $ 5.33 $ 3.33 $ 3.82 $ 3.63 $ 0.82 Dividends declared per common share (diluted) $ 0.25 $ 0.15 $ 0.20 $ 0.20 $ 0.05 ================================================================================================================================ Adjusted net income(2) $ 280.9 $ 212.5 $ 164.3 $ 121.1 $ 99.8 ================================================================================================================================ BALANCE SHEET (AT DECEMBER 31) Total assets $ 30,769.6 $ 27,653.1 $ 22,549.0 $ 18,970.3 $ 17,757.7 Long-term debt 199.5 199.5 202.1 202.2 202.3 Total liabilities 28,229.4 24,894.5 19,714.8 16,461.6 15,425.0 Minority interest 300.0 300.0 452.9 784.0 758.5 Shareholders' equity 2,240.2 2,458.6 2,381.3 1,724.7 1,574.2
(1) Represents earnings per common share for the period October 1, 1995 through December 31, 1995. Pro forma earnings per common share (unaudited) for the year ended December 31, 1995 was $2.61. The pro forma information 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 on January 1, 1995. This 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 transaction been consummated at the beginning of 1995 and does not represent a projection or forecast of the Company's consolidated results of operations for any future period. (2) 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, restructuring costs, differential earnings tax adjustments, and certain other items. 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. 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 Asset Management, Inc. ("AAM," a wholly-owned non-insurance subsidiary of AFC); Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C," a wholly-owned non-insurance subsidiary of AAM); The Hanover Insurance Company ("Hanover," a wholly-owned subsidiary of Allmerica P&C); Citizens Corporation (a wholly-owned non-insurance subsidiary of Hanover); Citizens Insurance Company of America ("Citizens," a wholly-owned subsidiary of Citizens Corporation) 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 acquisition of minority interest on July 16, 1997. The results of operations also reflect minority interest in Citizens Corporation, prior to the acquisition of minority interest on or about December 3, 1998, of approximately 16.8% and 17.5% in 1998 and 1997, respectively. DESCRIPTION OF OPERATING SEGMENTS ================================================================================ The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management; Allmerica Financial Services; and Allmerica Asset Management. The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. In 1999, the Company reorganized its Property and Casualty and Corporate Risk Management Services operations within the Risk Management segment. Under the new structure, the Risk Management segment manages its business through five distribution channels identified as Hanover North, Hanover South, Citizens Midwest, Allmerica Voluntary Benefits, and Allmerica Specialty. During the second quarter of 1999, the Company approved a plan to exit its group life and health business, consisting of its Employee Benefit Services ("EBS") business, its Affinity Group Underwriters ("AGU") business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). Results of operations from this business, relating to both the current and the prior periods, have been segregated and reported as a component of discontinued operations in the Consolidated Statements of Income. Operating results from this business were previously reported in the Allmerica Voluntary Benefits and Allmerica Specialty distribution channels. Prior to 1999, results of the group life and health business were included in the Corporate Risk Management Services segment, while all other Risk Management business was reflected in the Property and Casualty segment. The Risk Management segment's property and casualty business is offered primarily through the Hanover North, Hanover South and Citizens Midwest distribution channels utilizing the Company's independent agent network primarily in the Northeast, Midwest and Southeast United States, maintaining a strong regional focus. Allmerica Voluntary Benefits focuses on worksite distribution, which offers discounted property and casualty products through employer sponsored programs, and affinity group property and casualty business. Allmerica Specialty offers special niche property and casualty products in selected markets. The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in Guaranteed Investment Contracts ("GICs") such as the traditional GIC, the synthetic GIC and other funding agreements. Funding agreements are investment contracts issued to institu- 2 tional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs, which typically have short maturities and periodic interest rate resets based on an index such as LIBOR. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates and to other institutions, such as insurance companies and pension plans. In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Series A Capital Securities ("Capital Securities") and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. RESULTS OF OPERATIONS CONSOLIDATED OVERVIEW ================================================================================ The Company's consolidated net income increased $94.6 million to $295.8 million in 1999. In 1998, the Company's consolidated net income decreased $8.0 million to $201.2 million. Net income includes certain items which management believes are not indicative of overall operating trends, such as net realized investment gains and losses, net gains and losses on disposals of businesses, discontinued operations, extraordinary items, the cumulative effect of accounting changes and certain other items. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of adjusted net income enhances 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. For purposes of assessing each segment's contribution to adjusted net income, management evaluates the results of these segments on a pre-tax and minority interest basis. The following table reflects each segment's contribution to adjusted net income and a reconciliation to consolidated net income as adjusted for these items. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Segment income (loss) before federal income taxes and minority interest: Risk Management $ 199.6 $ 149.6 $ 174.2 Asset Accumulation Allmerica Financial Services 205.5 169.0 134.6 Allmerica Asset Management 23.5 23.7 18.4 - ------------------------------------------------------------------------------- Subtotal 229.0 192.7 153.0 Corporate (59.3) (50.9) (48.0) - ------------------------------------------------------------------------------- Segment income before federal income taxes and minority interest 369.3 291.4 279.2 - ------------------------------------------------------------------------------- Federal income taxes on segment income (72.4) (53.1) (63.4) Minority interest on preferred dividends (16.0) (16.0) (14.5) Minority interest on segment income -- (9.8) (37.0) - ------------------------------------------------------------------------------- Adjusted net income 280.9 212.5 164.3 Adjustments (net of taxes, minority interest and amortization, as applicable): Net realized investment gains 63.0 28.8 37.3 Sales practice litigation expense -- (20.2) -- Gain from change in mortality assumptions -- -- 30.5 Loss from cession of disability income business -- -- (35.0) Restructuring costs 1.2 (5.8) -- Other items -- (0.6) (4.5) - ------------------------------------------------------------------------------- Income from continuing operations 345.1 214.7 192.6 Discontinued operations: (Loss) income from operations of discontinued group life and health business (net of applicable taxes) (18.8) (13.5) 16.6 Loss on disposal of group life and health business (net of applicable taxes) (30.5) -- -- - ------------------------------------------------------------------------------- Net income $ 295.8 $ 201.2 $ 209.2 ================================================================================ 1999 Compared to 1998 The Company's segment income before taxes and minority interest increased $77.9 million, or 26.7%, to $369.3 million during 1999. This increase is primarily attributable to increased income of $50.0 million from the Risk Management segment and an increase of $36.5 million from the Allmerica Financial Services segment. The increase in Risk Management segment income is primarily attributable to a $56.2 million increase in favorable development on prior years reserves, a 3 $15.9 million favorable impact from a whole account aggregate excess of loss reinsurance agreement ("aggregate excess of loss reinsurance treaty"), and decreased catastrophes of $13.4 million. Partially offsetting these favorable items are a $14.3 million increase in involuntary pool underwriting losses and a $13.9 million increase in current year claims activity, primarily in the commercial lines. The increase in the Allmerica Financial Services segment is primarily attributable to higher asset-based fee income resulting from market appreciation and additional desposits in the variable annuity and variable universal life product lines. These increased fees were partially offset by higher policy acquisition and other operating expenses. Partially offsetting these increases were increased losses from the Corporate segment of $8.4 million, due to lower investment and other income and to higher corporate overhead costs. The effective tax rate for segment income was 19.6% for 1999 as compared to 18.2% in 1998. The increase in the tax rate was primarily due to improved underwriting results in the Risk Management segment, partially offset by changes in reserves for prior years tax liabilities. Net realized gains on investments, after taxes, minority interest and amortization, were $63.0 million during 1999, primarily due to after-tax net realized gains from sales of appreciated equity securities of $92.2 million, partially offset by $31.3 million of after-tax realized losses from impairments recognized on fixed maturities. During 1998, net realized gains on investments, after taxes, minority interest and amortization were $28.8 million, primarily due to after-tax net realized gains from sales of appreciated equity securities of $41.4 million and after-tax gains on real estate of $9.0 million. These were partially offset by $20.1 million of after-tax realized losses from impairments recognized on fixed maturities and $11.4 million of after-tax realized losses on partnership investments. Minority interest on segment income decreased in the current period primarily due to the Company's acquisition of the outstanding common stock of Citizens Corporation on or about December 3, 1998. Prior to the acquisition, minority interest reflected approximately 16.8% of the results of operations from Citizens Corporation. In July 1997, a lawsuit on behalf of a putative class 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, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998. On May 19, 1999, the court issued an order certifying the class for settlement purposes and granting final approval of the settlement agreement. AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. On October 28, 1998, the Company announced that it was restructuring its Risk Management segment. As part of the initiative, the segment consolidated its property and casualty field support activities from fourteen regional branches into three hub locations. As a result of this restructuring initiative, the Company recognized a loss of $5.8 million, net of taxes, in the fourth quarter of 1998. This loss was reduced by $1.2 million, net of taxes, in the fourth quarter of 1999. During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its EBS business, its AGU business and its reinsurance pool business. During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations -Reporting the Effects of Disposal of a Segment of a Business, and Extra ordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB Opinion No. 30"). In the third quarter of 1999, the operating results from the discontinued segment were adjusted to reflect the recording of additional reserves related to accident claims from prior years. On October 6, 1999, the Company entered into an agreement with Great-West Life and Annuity Insurance Company of Denver, which provides for the sale of the Company's EBS business effective March 1, 2000. The Company has recorded a $30.5 million loss, net of taxes, on the disposal of its group life and health business. 4 1998 Compared to 1997 The Company's segment income before taxes and minority interest increased $12.2 million, or 4.4%, to $291.4 million during 1998. This increase is primarily attributable to increased income of $39.7 million from the Asset Accumulation group. This increase was partially offset by reduced income of $24.6 million from the Risk Management segment and increased losses of $2.9 million from the Corporate segment. The increase of $34.4 million in the Allmerica Financial Services segment was primarily attributable to growth from additional deposits and market appreciation in the variable annuity and variable universal life assets resulting in increased fee revenue, partially offset by an increase in related policy acquisition and other operating expenses. Segment income before taxes and minority interest increased $5.3 million in the Allmerica Asset Management segment, primarily due to increased sales of floating rate GICs. Risk Management segment income declined primarily due to increased catastrophe losses of $63.8 million and decreased net investment income of $24.4 million resulting from lower average invested assets in the segment. These decreases were partially offset by lower loss adjustment expenses ("LAE"), lower policy acquisition and other operating expenses and increased fee revenue. The effective tax rate for segment income was 18.2% in 1998 as compared to 22.7% in 1997. The decrease in the tax rate resulted from the reduction in underwriting income from the Risk Management segment and a greater proportion of pre-tax income from tax-exempt bonds in 1998. Net realized gains on investments, after taxes, minority interest and amortization, were $28.8 million during 1998, primarily due to after-tax net realized gains from sales of appreciated equity securities of $41.4 million and after-tax gains on real estate of $9.0 million. These were partially offset by $20.1 million of after-tax realized losses from impairments recognized on fixed maturities and $11.4 million of after-tax realized losses on partnership investments. During 1997, net realized gains on investments, after taxes, minority interest and amortization, of $37.3 million, resulted primarily from the sale of appreciated equity securities, due to the Company's strategy of shifting to a higher level of debt securities, as well as sales of real estate investment properties. Minority interest on segment income decreased in the current period as compared to the prior year primarily due to the Company's merger with Allmerica P&C on July 16, 1997. Prior to the acquisition, minority interest reflected 40.5% of the results of operations from this subsidiary. In addition, on or about December 3, 1998, the Company acquired all of the outstanding common stock of Citizens Corporation that it did not already own in exchange for cash of $195.9 million. The Citizens acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 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. Prior to the acquisition, minority interest reflected approximately 16.8% and 17.5% of the results of operations from Citizens Corporation in 1998 and 1997, respectively. Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of business. The Company recognized a $35.0 million loss, net of taxes, during the first quarter of 1997 upon entering into an agreement in principal to transfer the 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 its universal life and variable universal life lines of business. As a result of this change in assumptions, the Company recognized a benefit of $30.5 million, net of taxes, during 1997. SEGMENT RESULTS ================================================================================ The following is management's discussion and analysis of the Company's results of operations by business segment. The segment results are presented before taxes and minority interest and other items which management believes are not indicative of overall operating trends, including realized gains and losses. RISK MANAGEMENT ================================================================================ The following table summarizes the results of operations for the Risk Management segment: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Segment revenues Net premiums written $1,977.0 $1,956.7 $1,994.1 - -------------------------------------------------------------------------------- Net premiums earned $1,948.2 $1,967.9 $1,955.5 Net investment income 221.4 229.8 254.1 Other income 19.8 24.4 18.0 - -------------------------------------------------------------------------------- Total segment revenues 2,189.4 2,222.1 2,227.6 Losses and LAE(1) 1,420.3 1,495.4 1,443.7 Policy acquisition expenses 370.6 379.7 399.9 Other operating expenses 198.9 197.4 209.8 - -------------------------------------------------------------------------------- Segment income $ 199.6 $ 149.6 $ 174.2 ================================================================================ (1) Includes policyholders' dividends of $12.3 million, $11.9 million and $9.3 million in 1999, 1998 and 1997, respectively. 5 1999 Compared to 1998 Risk Management's segment income increased $50.0 million, or 33.4%, to $199.6 million in 1999, compared to $149.6 million in 1998. The increase in segment income is primarily attributable to a $56.2 million increase in favorable development on prior year reserves and a $15.9 million favorable impact resulting from the aggregate excess of loss reinsurance treaty. Also, catastrophe losses decreased $13.4 million, to $76.9 million in 1999, compared to $90.3 in 1998. Partially offsetting these items are a $14.3 million increase in involuntary pool underwriting losses and a $13.9 million increase in current year claims activity, primarily in the commercial lines. In addition, net investment income before taxes decreased $8.4 million, or 3.7%, to $221.4 million in 1999, compared to $229.8 million in 1998. The decrease in net investment income is primarily the result of a reduction in average invested assets. Other income decreased $4.6 million to $19.8 million in 1999, primarily as a result of management's decision to exit certain workers' compensation servicing carrier business. The decline in net premiums earned is primarily attributable to the aforementioned aggregate excess of loss reinsurance treaty. During 1999, the Risk Management segment results were affected by the aforementioned aggregate excess of loss reinsurance treaty with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for the Company's property and casualty business, and is subject to cancellation or commutation annually at the Company's option. The program covers losses and allocated loss adjustment expenses, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. As a result of this agreement, the Company recognized a net benefit of $15.9 million for the year ended December 31, 1999. Premiums, and losses and LAE ceded under this treaty were $21.9 million and $35.0 million, respectively. The Company realized an additional $4.3 million benefit from commissions ceded under this contract, partially offset by $1.5 million of interest costs. In accordance with the provisions of this contract, the Company has exercised its option to cancel this contract effective January 1, 2000. The effect of this agreement on the results of operations in future periods is not currently determinable, as it will be based on future losses and allocated LAE. The agreement may decrease or increase income in future periods. 1998 Compared to 1997 Risk Management's segment income decreased $24.6 million, or 14.1%, to $149.6 million in 1998, compared to $174.2 million in 1997. The decrease in segment income is primarily the result of an increase in losses due to increased catastrophes of $63.8 million, to $90.3 million in 1998, partially offset by lower loss adjustment expenses. Also contributing to the decrease in the segment's results was a decrease in pre-tax net investment income of $24.3 million, or 9.6%, to $229.8 million in 1998, compared to $254.1 million in 1997. This decrease is primarily the result of a reduction in average invested assets and a $7.0 million decrease in limited partnership income. These were partially offset by lower policy acquisition and other operating expenses of $20.2 million and $12.4 million, respectively. In addition, other income increased $6.4 million, to $24.4 million in 1998, primarily as a result of an increase in finance charges on installment premiums. 6 Distribution channel results The following table summarizes the results of operations for the distribution channels of the Risk Management segment:
For the Year Ended December 31, 1999 ====================================================================================================================== (In millions, except ratios) Hanover Hanover Citizens Voluntary Allmerica North South Midwest Benefits Specialty Other(2) Total Net premiums written $668.1 $198.4 $521.3 $545.6 $ 40.2 $ 3.4 $1,977.0 Underwriting profit (loss) $ 4.4 $ (8.7) $ 1.8 $ (1.8) $(13.4) $(10.3) $ (28.0) Statutory combined ratio(1) 102.1 105.8 102.9 103.6 127.7 N/M 101.2 For the Year Ended December 31, 1998 ====================================================================================================================== (In millions, except ratios) Hanover Hanover Citizens Voluntary Allmerica North South Midwest Benefits Specialty Other(2) Total Net premiums written $616.1 $208.1 $547.5 $527.5 $ 48.1 $ 9.4 $1,956.7 Underwriting (loss) profit $(36.6) $ (7.4) $(39.1) $ 15.3 $ (6.5) $(9.6) $ (83.9) Statutory combined ratio(1) 106.4 104.5 106.8 99.2 104.8 N/M 104.6
(1) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non-underwriting expenses are not reflected in the statutory combined ratio. (2) Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments. 1999 Compared to 1998 Hanover North Hanover North's net premiums written increased $52.0 million, or 8.4%, to $668.1 million for the year ended December 31, 1999, compared to $616.1 million for 1998. Net premiums written related to commercial lines increased $32.1 million, or 13.8%, primarily due to an increase in policies in force of 6.7% since December 31, 1998. Personal automobile net premiums written increased $14.0 million to $270.5 million, primarily resulting from the Company's decision to reduce safe driver discounts and to an increase in policies in force of 5.2%. A 0.7% increase in the Massachusetts personal automobile rate during 1999 is also contributing to this increase. Hanover North's underwriting results improved $41.0 million to an underwriting profit of $4.4 million for the year ended December 31, 1999, compared to an underwriting loss of $36.6 million in 1998. The improvement in underwriting results is primarily attributable to improved current year claims severity in the personal lines, as well as to an increase in favorable development on prior years' loss reserves in the personal automobile line. In addition, catastrophe losses decreased $5.7 million to $13.3 million for the year ended December 31, 1999, from $19.0 million in 1998. Hanover South Hanover South's net premiums written decreased $9.7 million, or 4.7%, to $198.4 million for the year ended December 31, 1999, compared to $208.1 million in 1998. The decrease is primarily due to an $11.1 million, or 20.5%, decrease in the personal automobile line's net premiums written, resulting from an 18.1% decrease in policies in force during 1999. This decline is attributable to the Company having exited certain markets in the South. The Company believes this exit plan to be substantially complete. Underwriting results deteriorated $1.3 million to a loss of $8.7 million for the year ended December 31, 1999, from an underwriting loss of $7.4 million in 1998. The decrease in underwriting results is primarily attributable to a $4.4 million increase in losses in the workers' compensation line attributed to an increase in both frequency and severity in current year claims activity. This deterioration is partially offset by a decrease in severity in the commercial multiple peril line. Citizens Midwest Citizens Midwest's net premiums written decreased $26.2 million, or 4.8%, to $521.3 million for the year ended December 31, 1999, compared to $547.5 million for 1998. This decrease is primarily attributable to a $22.5 million decrease in the personal automobile line's net premiums written to $154.0 million, compared to $176.5 million for 1998. This decline is primarily 7 due to rate decreases in the Michigan personal automobile line of 3.6% and 3.7% in the first and third quarters of 1999, respectively, resulting from continued competitive conditions in Michigan. In addition, Citizens Midwest's net premiums written decreased $9.9 million as a result of additional premiums ceded under the aggregate excess of loss reinsurance treaty. These decreases are partially offset by an increase of $6.8 million in the commercial multiple peril line resulting from increases in both rate and policies in force of 5.9% and 4.9%, respectively, during 1999. Citizens Midwest's underwriting results improved $40.9 million to an underwriting profit of $1.8 million for the year ended December 31, 1999, from an underwriting loss of $39.1 million in 1998. This improvement is primarily attributable to a $13.8 million decrease in policy acquisition and other underwriting expenses resulting from continued efficiencies gained through consolidation of underwriting processes, and a reduction in homeowners' non-catastrophe claims activity totaling $9.5 million. In addition, a $9.0 million decrease in catastrophe losses to $19.7 million in 1999, compared to $28.7 million in 1998, contributed to this improvement. Results were also favorably impacted by $7.9 million due to the aforementioned aggregate excess of loss reinsurance treaty. Voluntary Benefits Voluntary Benefits' net premiums written increased $18.1 million, or 3.4%, to $545.6 million for the year ended December 31, 1999, compared to $527.5 million in 1998. This increase is primarily attributed to an increase in policies in force of 4.3%, partially offset by a $12.0 million increase in ceded premiums written under the aggregate excess of loss reinsurance treaty. Underwriting results deteriorated $17.1 million to a loss of $1.8 million for the year ended December 31, 1999, from an underwriting gain of $15.3 million in 1998. The deterioration in underwriting results is primarily attributable to an increase in non-catastrophe claims activity in the personal automobile and homeowners lines. Also contributing to this deterioration is a $6.5 million increase in policy acquisition and other underwriting expenses resulting from increased marketing initiatives. Partially offsetting these factors is a $9.5 million benefit from the aggregate excess of loss reinsurance treaty. Specialty Markets Specialty Markets' net premiums written decreased to $40.2 million for the year ended December 31, 1999, compared to $48.1 million for the same period in 1998. This decrease was primarily due to a decrease in the commercial multiple peril line of $6.1 million, to $9.5 million, as a result of increased ceded premiums written under the aggregate excess of loss reinsurance treaty, and to a 3.2% reduction of policies in force. Underwriting results deteriorated $6.9 million, to a loss of $13.4 million for the year ended December 31, 1999, compared to a loss of $6.5 million in 1998. The deterioration in underwriting results is primarily attributable to an increase in non-catastrophe claims activity in the commercial multiple peril line.
For the Year Ended December 31, 1998 ======================================================================================================================== (In millions, except ratios) Hanover Hanover Citizens Voluntary Allmerica North South Midwest Benefits Specialty Other(2) Total Net premiums written $616.1 $208.1 $547.5 $527.5 $ 48.1 $ 9.4 $1,956.7 Underwriting (loss) profit $(36.6) $ (7.4) $(39.1) $ 15.3 $ (6.5) $(9.6) $ (83.9) Statutory combined ratio(1) 106.4 104.5 106.8 99.2 104.8 N/M 104.6 For the Year Ended December 31, 1997 ======================================================================================================================== (In millions, except ratios) Hanover Hanover Citizens Voluntary Allmerica North South Midwest Benefits Specialty Other(2) Total Net premiums written $612.7 $231.7 $538.9 $491.1 $ 27.4 $92.3 $1,994.1 Underwriting loss $(30.5) $ (1.1) $(31.8) $ (6.8) $(22.9) $(5.3) $ (98.4) Statutory combined ratio(1) 105.0 103.1 106.2 128.4 100.4 N/M 104.0
(1) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non-underwriting expenses are not reflected in the statutory combined ratio. (2) Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments. 8 1998 Compared to 1997 Hanover North Hanover North's net premiums written increased $3.4 million, or 0.6%, to $616.1 million for the year ended December 31, 1998, compared to $612.7 million in 1997. Net premiums written in the homeowners, commercial multiple peril and commercial automobile lines increased $5.1 million, $4.5 million, and $4.1 million, respectively. The improvement in the homeowners line related to both an increase in policies in force of 5.3% and a rate increase of 3.8% over prior year. Commercial multiple peril and commercial automobile line increases resulted from increases in policies in force of 7.0% and 14.3%, respectively. Personal automobile net premiums written decreased $11.3 million, to $256.5 million, primarily resulting from a mandated 4.0% decrease in Massachusetts personal automobile rates, which became effective January 1, 1998. Increased safe driver discounts on automobile insurance premiums also contributed to the decrease in premiums written. Hanover North's underwriting results deteriorated $6.1 million to an underwriting loss of $36.6 million for the year ended December 31, 1998, compared to an underwriting loss of $30.5 million in 1997. The deterioration in underwriting results is primarily attributable to a decrease in favorable development on prior accident years' reserves in the workers' compensation and commercial automobile lines, partially offset by a $12.7 million improvement in current year claims activity in the personal automobile line. In addition, catastrophe losses increased $14.6 million, primarily in the homeowners line, as a result of an ice storm in the first quarter of 1998. Improved loss adjustment expenses and policy acquisition and other underwriting expenses of $15.8 million and $16.5 million, respectively, partially offset this deterioration. Hanover South Hanover South's net premiums written decreased $23.6 million, or 10.2%, to $208.1 million for the year ended December 31, 1998, compared to $231.7 million for the same period in 1997. The decrease is primarily due to a $16.0 million, or 22.8%, decrease in the personal automobile line's net premiums written and a $6.7 million, or 16.9%, decrease in the homeowners line, resulting from the Company having exited certain markets in the South. Underwriting results deteriorated $6.3 million from an underwriting loss of $1.1 million for the year ended December 31, 1997, to a loss of $7.4 million for the same period in 1998. The unfavorable change is primarily attributable to a $9.0 million increase in losses in the commercial multiple peril line due to increased non-catastrophe claims frequency. In addition, catastrophe losses increased $7.3 million as a result of severe storms. Partially offsetting these factors are a $6.3 million improvement in loss activity in the personal automobile line and a decrease of $5.0 million in policy acquisition and other underwriting expenses. Citizens Midwest Citizens Midwest's net premiums written increased $8.6 million, or 1.6%, to $547.5 million for the year ended December 31, 1998. This increase is primarily attributable to a $10.7 million increase in the commercial multiple peril line, to $101.4 million, compared to $90.7 million in the prior year. This increase is primarily the result of a 7.0% aggregate rate increase in 1998. Citizens Midwest's underwriting results deteriorated $7.3 million to an underwriting loss of $39.1 million for the year ended December 31, 1998, from an underwriting loss of $31.8 million for 1997. This deterioration is attributable to a $22.1 million decrease in favorable development on prior accident years' reserves in the workers' compensation line and to a $19.1 million increase in catastrophe losses, to $28.7 million in 1998, resulting from severe storms. Partially offsetting these items are improvements in non-catastrophe claims activity in both the commercial multiple peril and personal automobile lines of $10.9 million and $8.0 million, respectively. Reductions in both loss adjustment expenses and policy acquisition and other underwriting expenses of $9.8 million and $4.3 million, respectively, also offset deteriorating results. The decreases in expenses primarily resulted from efficiencies gained through consolidation and re-engineering of both the claims and underwriting processes. Cost savings were also achieved through reductions in employee-related expenses and decreased rent expense resulting from the consolidation of processing centers. Voluntary Benefits Voluntary Benefits' net premiums written increased $36.4 million, or 7.4%, to $527.5 million for the year ended December 31, 1998, compared to $491.1 million for the same period in 1997. This increase is primarily attributed to an increase in the personal automobile line of $30.2 million, or 7.8%, over prior year resulting from an increase in affinity group business policies in force. Underwriting results improved $22.1 million to a profit of $15.3 million for the year ended December 31, 1998, from an underwriting loss of $6.8 million for 1997. The improvement in underwriting results is primarily attributable to improved non-catastrophe claims activity in the personal automobile and homeowners lines. 9 Specialty Markets Specialty Markets' net premiums written increased to $48.1 million for the year ended December 31, 1998, compared to $27.4 million for 1997. Net premiums earned increased $17.5 million to $39.4 million for the year ended December 31, 1998, from $21.9 million for 1997. These increases are primarily attributable to growth in the commercial multiple peril line. Underwriting results improved $16.4 million to a loss of $6.5 million for the year ended December 31, 1998, compared to a loss of $22.9 million for 1997. The improvement is primarily attributable to improved claims activity in the workers compensation line of $6.8 million. In addition, reductions in both loss adjustment expenses and policy acquisition and other underwriting expenses of $4.6 million and $4.4 million, respectively, contributed to the improvement in underwriting results. INVESTMENT RESULTS ================================================================================ Net investment income before taxes was $221.4 million, $229.8 million and $254.1 million for the years ended December 31, 1999, 1998 and 1997, respectively. The decrease in net investment income in 1999, compared to 1998, primarily reflects a reduction in average fixed maturity assets of $122.1 million, or 3.3%, to $3,560.1 million in 1999 compared to $3,682.2 million in 1998. The reduction is due to the transfer of $350.0 million in cash and securities to the Corporate segment during the second quarter of 1999. Average pre-tax yields on debt securities remained stable at 6.7% for 1999 and 1998. Average invested assets decreased $385.9 million, or 9.2%, to $3,805.5 million in 1999 compared to $4,191.4 million in 1998. The decrease in net investment income in 1998, compared to 1997, primarily reflects a reduction in invested assets as a result of a $117.1 million and a $53.9 million transfer of assets to the Corporate Segment in April 1998 and December 1997, respectively. In addition, net investment income in 1998 includes a $0.8 million loss from partnerships, compared to $6.2 million of income from partnerships in 1997. Average pre-tax yields on debt securities remained relatively stable at 6.7% in 1998, compared to 6.8% for 1997. Average invested assets decreased $80.6 million, or 1.9%, to $4,191.4 million in 1998 compared to $4,272.0 million in 1997. RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES ================================================================================ The Risk Management segment maintains reserves for its property and casualty products to provide for the Company's 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 Company 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 1999 1998 1997 ================================================================================ (In millions) Reserve for losses and LAE, beginning of year $2,597.3 $2,615.4 $2,744.1 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,601.4 1,609.0 1,564.1 Decrease in provision for insured events of prior years (183.4) (127.2) (127.9) - ------------------------------------------------------------------------------- Total incurred losses and LAE 1,418.0 1,481.8 1,436.2 - ------------------------------------------------------------------------------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 861.1 871.9 775.1 Losses and LAE attributable to insured events of prior years 638.0 643.0 732.1 - ------------------------------------------------------------------------------- Total payments 1,499.1 1,514.9 1,507.2 - ------------------------------------------------------------------------------- Change in reinsurance recoverable on unpaid losses 102.5 15.0 (50.2) Other(1) -- -- (7.5) - ------------------------------------------------------------------------------- Reserve for losses and LAE, end of year $2,618.7 $2,597.3 $2,615.4 ================================================================================ (1) Includes purchase accounting adjustments. 10 As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $183.4 million, $127.2 million and $127.9 million in 1999, 1998 and 1997, respectively, reflecting increased favorable development on reserves for both losses and loss adjustment expenses. Favorable development on prior years' loss reserves was $93.1 million, $58.9 million, and $87.2 million for the years ended December 31, 1999, 1998, and 1997, respectively. The increase of $34.2 million in 1999 is primarily due to improved personal automobile results in the Northeast and increased reinsurance recoverables in the commercial multiple peril line. Favorable development on prior years' loss adjustment expense reserves was $90.3 million, $68.3 million, and $40.7 million for the years ended December 31, 1999, 1998, and 1997, respectively. The increase in favorable development in both 1999 and 1998 is primarily attributable to claims process improvement initiatives taken by the Company over the past two years. The Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. This favorable development reflects the Company'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. Management believes the favorable development on prior accident years experienced in 1999 may not be sustainable in future periods. Due to the nature of the business written by the Risk Management 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 $47.3 million, $49.9 million and $53.1 million, net of reinsurance of $11.2 million, $14.2 million and $15.7 million in 1999, 1998 and 1997, 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. 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 significant, their existence gives rise to uncertainty and are discussed because of the possibility, however remote, that they may become significant. 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. 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. 11 ASSET ACCUMULATION ================================================================================ Allmerica Financial Services The following table summarizes the results of operations, including the Closed Block, for the Allmerica Financial Services segment. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Segment revenues Premiums $ 54.5 $ 58.1 $ 83.0 Fees 359.3 296.6 241.5 Investment and other income 392.5 369.3 389.4 - -------------------------------------------------------------------------------- Total segment revenues 806.3 724.0 713.9 - -------------------------------------------------------------------------------- Policy benefits, claims and losses 321.0 314.3 356.6 Policy acquisition and other operating expenses 279.8 240.7 222.7 - -------------------------------------------------------------------------------- Segment income $ 205.5 $ 169.0 $ 134.6 ================================================================================ 1999 Compared to 1998 Segment income increased $36.5 million, or 21.6%, to $205.5 million in 1999. This increase is primarily attributable to higher asset-based fee income resulting from market appreciation and additional deposits in the variable annuity and variable universal life product lines, partially offset by higher policy acquisition and other operating expenses. In addition, segment income in 1998 was negatively impacted by losses incurred on hedge fund partnership investments. Segment revenues increased $82.3 million, or 11.4% in 1999 primarily due to increased fees and other income. Fee income from variable annuities and individual variable universal life policies increased $66.1 million, or 32.8%, in 1999 due to market appreciation and additional deposits. In addition, investment and other income increased $23.2 million primarily due to higher investment management fees and brokerage income resulting from growth and appreciation in variable product assets under management. Financial Profiles, a financial software company acquired during the third quarter of 1998, contributed $6.5 million of this $23.2 million increase. Net investment income decreased $1.6 million in 1999 principally due to a reduction in average fixed maturities invested resulting from asset transfers to the separate accounts in the annuity and group retirement product lines, as well as cancellations of certain accounts in the group retirement business. These decreases were partially offset by the absence of losses incurred on hedge fund partnership investments in 1998. Premiums and fees from traditional and non-variable universal life insurance products declined $6.7 million primarily from the Company's continued shift in focus to variable life insurance and annuity products. Policy benefits, claims and losses increased $6.7 million, or 2.1%, to $321.0 million in 1999. This increase is primarily due to the Company's establishment of a $7.4 million mortality reserve in the first quarter of 1999 related to the variable annuity line of business, subsequent increases in this reserve of $5.8 million, and additional growth in this line. In addition, annuity reserves increased $5.5 million related to an annuity program which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account. Under this program, general account deposits are transferred ratably over a period of time into the Company's separate accounts. These increases were partially offset by more favorable mortality experience in the traditional life line of business, lower policy benefits due to a reduction of policies in force in the universal life product line, as well as decreased interest credited due to the aforementioned cancellations in the group retirement business. Policy acquisition and other operating expenses increased $39.1 million, or 16.2%, to $279.8 million in 1999. This increase reflects growth in the individual variable annuity and variable universal life product lines. In addition, other operating expenses relating to trail commissions in the annuity line of business and to Financial Profiles increased $9.2 million and $8.1 million, respectively. Partially offsetting these increases is a $3.5 million decline in policy acquisition expenses resulting from the implementation of an enhanced valuation system for the annuity line of business in 1999. This decline consists of a one-time increase in the deferred acquisition cost asset of $13.5 million, partially offset by increased ongoing deferred acquisition expenses of approximately $10.0 million. The Company expects the increase in deferred acquisition expenses to continue. 1998 Compared to 1997 Segment income increased $34.4 million, or 25.6%, to $169.0 million in 1998. This increase is primarily attributable to higher asset-based fee income resulting from additional deposits and market appreciation in the variable annuity and variable universal life product lines, partially offset by an increase in policy acquisition and other operating expenses. Additionally, in 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, which resulted in decreased policy acquisition costs in 1998 of approximately $8.4 million in these product lines. In addition, as a result of a January 1, 1998 agreement with a highly rated reinsurer to reinsure the mortality risk on the universal life and variable universal life lines of business, policy benefits, claims and 12 losses decreased approximately $3.1 million. The terms and provisions of the reinsurance contract are consistent with the aforementioned change in mortality assumptions. These increases were partially offset by lower net investment income, which included losses incurred on hedge fund partnership investments during 1998. Segment revenues increased $10.1 million, or 1.4% to $724.0 million in 1998 primarily due to increased fees and other income, partially offset by lower premiums and net investment income. Fees from individual annuities increased $47.1 million, or 52.4%, to $137.0 million in 1998. Distribution arrangements with several third party mutual fund advisors contributed to the increase in annuity sales in 1998. Fees from individual variable universal life policies increased $10.8 million, or 20.0%, to $64.7 million in 1998. In addition, other income increased $8.5 million primarily due to higher investment management fees resulting from growth and appreciation in variable product assets under management. Net investment income decreased $28.6 million primarily due to a reduction in average fixed maturities invested resulting from the aforementioned cession of the Company's individual disability income line of business, asset transfers to the separate accounts in the annuity and group retirement product lines and from losses incurred on hedge fund partnership investments in 1998. In addition, premiums decreased $24.9 million, or 30.0%, to $58.1 million in 1998. This decrease is primarily due to the cession, in 1997, of substantially all of the Company's individual disability income line of business, which contributed premiums of $0.6 million in 1998 compared to $22.8 million during 1997. Policy benefits, claims and losses decreased $42.3 million, or 11.9%, to $314.3 million in 1998. This decrease is primarily due to the aforementioned cession of substantially all of the individual disability income line of business, which incurred policy benefits of $3.4 million in 1998, compared to $32.3 million in 1997. Also contributing to the overall decrease was a reduction in interest credited on group retirement products of $3.8 million due to the aforementioned shift to the separate accounts and to $3.1 million of improved mortality experience in the universal life and variable universal life lines of business. Policy acquisition and other operating expenses increased $18.0 million, or 8.1%, to $240.7 million in 1998. This increase was primarily attributable to continued growth in the variable product lines, to increased technology costs, and to increased interest expense related to commercial paper used to manage short-term cash flows. These increases were partially offset by reductions in employee related costs resulting from the restructuring of the group retirement business during the fourth quarter of 1997. Statutory Premiums and Deposits The following table sets forth statutory premiums and deposits by product for the Allmerica Financial Services segment. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Insurance: Traditional life $ 77.4 $ 55.9 $ 58.4 Universal life 71.8 23.6 60.7 Variable universal life 187.0 158.7 148.8 Individual health 0.3 0.6 22.8 Group variable universal life 94.9 73.3 68.3 - -------------------------------------------------------------------------------- Total insurance 431.4 312.1 359.0 - -------------------------------------------------------------------------------- Annuities: Separate account annuities 1,922.2 2,583.6 2,169.1 General account annuities 830.2 622.2 234.7 Retirement investment accounts 16.4 20.1 21.8 - -------------------------------------------------------------------------------- Total individual annuities 2,768.8 3,225.9 2,425.6 Group annuities 409.3 563.9 404.2 - -------------------------------------------------------------------------------- Total annuities 3,178.1 3,789.8 2,829.8 - -------------------------------------------------------------------------------- Total premiums and deposits $3,609.5 $4,101.9 $3,188.8 ================================================================================ 1999 Compared to 1998 For the year ended December 31, 1999, total premiums and deposits decreased $492.4 million, or 12.0%, to $3,609.5 million. This decrease is primarily due to lower individual and group annuity deposits, partially offset by increased universal and variable universal life insurance premiums. The decrease in individual annuity deposits was caused by a sharp decline in sales among third party mutual fund advisors, slightly offset by growth in the career agency and broker-dealer distribution channels. Decreases in sales at three specific mutual fund advisors aggregating $538.0 million are responsible for the $457.1 million overall contraction within this line. Two of these mutual fund advisors remain committed to distributing the Company's annuities, while one advisor has shifted to emphasize its proprietary products. While these reduced sales levels could negatively impact future earnings, the Company continues to pursue additional relationships in the marketplace. The increase in general account annuities reflects the Company's aforementioned annuity program introduced in 1998, which provides, for a limited time, enhanced crediting rates. In addition, group annuity deposits declined $154.6 million in 1999 primarily due to cancellations of certain accounts within the group retirement business. These decreases were partially offset by higher variable universal life insurance premiums due to increased sales and renewals in the current year. 13 1998 Compared to 1997 For the year ended December 31, 1998, total premiums and deposits increased $913.1 million, or 28.6 %, to $4,101.9 million. This increase is primarily due to growth in individual and group annuity deposits across all distribution channels, particularly the aforementioned third party mutual fund advisors. Deposits from this distribution channel increased $602.0 million, or 53.6%, in 1998. In addition, deposits from the Company's individual annuity products, sold through the career agency and broker-dealer distribution channels, increased $200.0 million, or 15.6%. Group annuity deposits grew $159.7 million as a result of new sales and additional deposits to existing group retirement plans. Allmerica Asset Management The following table summarizes the results of operations for the Allmerica Asset Management segment. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Interest margins on GICs: Net investment income $ 137.9 $ 111.3 $ 82.3 Interest credited 118.6 89.3 64.2 - -------------------------------------------------------------------------------- Net interest margin 19.3 22.0 18.1 Fees and other income: External 6.2 4.0 2.2 Internal 6.4 6.4 6.6 Other operating expenses 8.4 8.7 8.5 - -------------------------------------------------------------------------------- Segment income $ 23.5 $ 23.7 $ 18.4 ================================================================================ 1999 Compared to 1998 Income in the Allmerica Asset Management segment is generated by interest margins earned on the Company's GICs and funding agreements, as well as investment advisory fees earned on assets under management. Investment advisory services are provided to affiliates and third parties, such as money market and other fixed income clients. Related fees are based upon asset balances under the Company's management. Segment income decreased $0.2 million, or 0.8%, to $23.5 million in 1999. This decrease is primarily attributable to the absence of a one-time $2.6 million mortgage loan equity participation interest received in 1998 and lower mortgage prepayment fees in 1999. Excluding the effect of these items, interest margins on GICs increased $3.8 million. This increase reflects continued sales of funding agreements during the first six months of 1999, partially offset by withdrawals during the fourth quarter of 1999. These withdrawals reflected uncertainties in the market resulting in greater redemptions for the industry overall. Management expects income from the GIC product line to be unfavorably impacted in future periods due to funding agreement withdrawals experienced in the fourth quarter of 1999 and a diminished market for these products. Income from assets under management grew $1.6 million in 1999 as a result of increased business from new and existing money market and other external fixed income fund clients. 1998 Compared to 1997 Segment income increased $5.3 million, or 28.8%, to $23.7 million in 1998, primarily due to an increase in GIC interest margins of $3.9 million and additional asset management fees of $1.6 million. Interest margins on new floating rate GICs increased $9.8 million in 1998, to $10.2 million, as compared to $0.4 million in 1997. This increase more than offset a decrease in the traditional GIC interest margins of $5.9 million, from $17.7 million in 1997, which resulted from the continued run-off of the traditional GIC product. Included in the traditional GIC interest margin in 1998 is the receipt of the aforementioned $2.6 million mortgage loan equity participation payment, while 1997 reflects approximately $1.5 million of one-time benefits. Additionally, fee revenue increased $1.6 million in 1998 due to growth in assets under management. Corporate The following table summarizes the results of operations for the Corporate segment for the periods indicated. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Segment revenues Investment and other income $ 6.0 $ 12.9 $ 16.1 Interest expense 15.4 16.0 18.1 Other operating expenses 49.9 47.8 46.0 - ------------------------------------------------------------------------------- Segment loss $ (59.3) $ (50.9) $ (48.0) ================================================================================ 1999 Compared to 1998 Segment loss increased $8.4 million, or 16.5%, to $59.3 million in 1999, primarily due to lower investment and other income and higher corporate overhead costs. Investment and other income decreased $6.9 million in 1999 due to lower average invested assets. This decline primarily reflects the sale of investments which were used to fund the Company's stock repurchase program and the transfer of $125.0 million of assets 14 from AFC to FAFLIC as part of a 1999 capital contribution. These decreases were partially offset by assets transferred from the Risk Management segment of $125.0 million and $225.0 million in April and May of 1999, respectively. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. In addition, interest expense in 1998 includes $0.7 million related to the Company's short term revolving credit loan associated with the acquisition of Citizens Corporation's minority interest. Other operating expenses increased $2.1 million, or 4.4%, to $49.9 million in 1999. This expense category consists primarily of corporate overhead expenses, which reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. The increase in other operating expenses is primarily due to higher corporate overhead costs, partially offset by a reduction in other corporate expenses. 1998 Compared to 1997 Segment loss increased $2.9 million, or 6.0%, to $50.9 million in 1998, primarily due to lower investment and other income and higher corporate overhead costs, partially offset by reduced interest and other corporate expenses. Investment and other income decreased $3.2 million in 1998 primarily from the absence of $9.1 million of short-term income generated by the temporary investment of the net proceeds from the issuance of Capital Securities in 1997. This was partially offset by additional income due to higher average invested assets resulting from transfers of $117.1 million and $53.9 million from the Risk Management segment in April 1998 and December 1997, respectively. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. In addition, interest expense in 1998 includes $0.7 million related to the Company's short term revolving credit loan which commenced on December 4, 1998 to affect the acquisition of Citizens Corporation's minority interest, while interest expense in 1997 includes $2.8 million of Allmerica P&C merger-related interest expense. Other operating expenses increased $1.8 million, or 3.9%, to $47.8 million in 1998, primarily due to $5.8 million of higher corporate overhead costs, partially offset by a reduction in other corporate expenses. DISCONTINUED OPERATIONS ================================================================================ During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its EBS business, its AGU business and its reinsurance pool business. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. The operating results of the discontinued segment have been reported in the Consolidated Statements of Income as discontinued operations in accordance with APB Opinion No. 30 with a June 30, 1999 measurement date. Reinsurance Pools The reinsurance pool business consists primarily of assumed medical stop loss business, the medical and disability portions of workers' compensation risks, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. During the third quarter of 1998, the Company announced that it ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Concurrent with the decision to exit the reinsurance pool business, the Company entered into a reinsurance agreement that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the reinsurance pool business. As a result of this transaction, the Company recognized a $25.3 million pre-tax loss in the third quarter of 1998. For the year ended December 31, 1999, the Company recognized estimated future pre-tax losses of $40.6 million. EBS The EBS business provides managed care products and offers group life, medical, dental, and disability insurance to the middle market. On October 6, 1999, the Company entered into an agreement with Great-West Life and Annuity Insurance Company of Denver, which provides for the sale of the Company's EBS business effective March 1, 2000. The sales transaction effectively transfers the business upon renewal subjecting the Company to losses on its existing book during the runoff period. As required by APB Opinion No. 30, the loss from disposal of the discontinued segment includes estimated pre-tax net proceeds from the aforementioned sale of the Company's EBS business of $25.3 million, as well as estimated pre-tax future losses of $15.7 million, expected from the runoff of EBS after the June 30, 1999 measurement date. Accordingly, 15 the Company recognized a pre-tax net gain from disposal of discontinued EBS business of $9.6 million. Net proceeds for the sale are comprised of the sales price, which is a function of persistency levels at March 1, 2000 and 2001, less estimated costs of sale, including severance, legal and retirement. Additionally, in the fourth quarter of 1998, the Company closed nearly half of its nationwide Corporate Risk Management Services' sales offices, eliminated certain staff, and discontinued certain automation initiatives that resulted in a $4.0 million pre-tax loss from restructuring. AGU AGU operates as a Managing Group Underwriting unit offering members of affinity groups medical, life and disability insurance. Estimated pre-tax future losses expected from runoff are $15.9 million. The following table summarizes the loss from operations and disposal for the discontinued group life and health insurance business for the periods indicated. For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) (Loss) income from operations of discontinued group life and health business before federal income taxes $ (28.9) $ (20.5) $ 25.5 Federal income tax benefit (expense) 10.1 7.0 (8.9) - ------------------------------------------------------------------------------- (Loss) income from operations of discontinued group life and health business, net of taxes (18.8) (13.5) 16.6 - ------------------------------------------------------------------------------- Loss from disposal of discontinued group life and health business before federal income taxes (46.9) -- -- Federal income tax benefit 16.4 -- -- - ------------------------------------------------------------------------------- Loss from disposal of discontinued group life and health business, net of taxes (30.5) -- -- - ------------------------------------------------------------------------------- Net (loss) income from discontinued segment $ (49.3) $ (13.5) $ 16.6 ================================================================================ 1999 Compared to 1998 The $28.9 million loss from operations before federal income taxes for the year ended December 31, 1999 results primarily from additional reserves provided for accident claims related to prior years. The loss from operations before federal income taxes for the year ended December 31, 1998 of $20.5 million, reflects primarily the $25.3 million loss recognized from the aforementioned reinsurance agreement. As required by APB Opinion No. 30, the loss from disposal of the discontinued segment includes estimated proceeds from the aforementioned sale of the Company's EBS business, as well as an estimate of future losses expected from the runoff of the discontinued operations after the June 30, 1999 measurement date. Accordingly, the Company recognized a pre-tax loss from disposal of its group life and health business of $46.9 million, which is comprised of the following (in millions): Proceeds from sale $ 25.3 Losses expected from runoff: EBS (15.7) Reinsurance pools (40.6) AGU (15.9) - ------------------------------------------------------------------------------ $(46.9) ================================================================================ The provision for anticipated future losses on the runoff of discontinued operations was established based on estimates of cash flows from the assets supporting the discontinued products offset by estimates of cash flows expected to meet the obligations of outstanding contracts and estimates of cash flows expected to meet operational funding requirements. These estimates are continually reviewed and adjusted as necessary. To the extent that actual future losses differ from these estimates, the Company's reported results from the disposal of the discontinued segment would be affected. The Company believes the provision established appropriately reflects expected future results. However, due to the inherent volatility in this segment, and to its history of increased losses, there can be no assurance that current reserves are adequate and future losses will not arise. 1998 Compared to 1997 The loss from operations before federal income taxes for the year ended December 31, 1998 of $20.5 million, reflects primarily the $25.3 million loss recognized from the aforementioned reinsurance agreement. Income from operations before federal income taxes of $25.5 million for the year ended December 31, 1997 reflects the growth in the reinsurance, fully insured group dental and stop loss products, as well as the assumption of a block of affinity group life and health business in January 1997. In addition, the segment benefitted from improved experience in the long-term disability, stop loss and risk sharing product lines of business. 16 INVESTMENT PORTFOLIO ================================================================================ The Company had investment assets diversified across several asset classes, as follows: December 31 1999(1) 1998(1) ================================================================================ (In millions) % of Total % of Total Carrying Carrying Carrying Carrying Value Value Value Value Fixed maturities(2) $ 7,306.7 80.6% $ 8,195.0 79.0% Equity securities(2) 83.2 0.9 397.1 3.8 Mortgages 657.5 7.3 698.3 6.7 Policy loans 371.6 4.1 365.2 3.5 Cash and cash equivalents 464.8 5.1 559.7 5.4 Real estate and other invested assets 180.0 2.0 163.1 1.6 - -------------------------------------------------------------------------------- Total $ 9,063.8 100.0% $10,378.4 100.0% ================================================================================ (1) Includes Closed Block invested assets with a carrying value of $732.9 million and $770.5 million at December 31, 1999 and 1998, respectively. (2) The Company carries the fixed maturities and equity securities in its investment portfolio at market value. Total investment assets decreased $1,314.6 million, or 12.7%, to $9.1 billion during 1999. This decrease resulted primarily from decreased fixed maturities of $888.3 million, equity securities of $313.9 million and cash and cash equivalents of $94.9 million. The decrease in fixed maturities is due to sales of assets for the redemption of funding agreements, the purchase of AFC common stock under the stock repurchase program, and the shift in assets from the general to the separate accounts. In January 1999, sales of equity securities resulted in proceeds of $310.0 million and realized gains of $116.0 million. Proceeds from the equity securities were used, in part, to repay the loan used to fund the acquisition of minority interest of Citizens Corporation. In addition, the decrease in cash and cash equivalents is due to the transfer of funds into the separate accounts in association with an annuity program, which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account and transferred ratably over a period of time into the Company's separate accounts. The Company's fixed maturity portfolio is comprised of primarily investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners, investment grade securities comprised 84.4% and 84.7% of the Company's total fixed maturity portfolio at December 31, 1999 and 1998, respectively. The average yield on debt securities was 7.2% and 7.3% for 1999 and 1998, 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. MARKET RISK AND RISK MANAGEMENT POLICIES ================================================================================ Interest Rate Sensitivity The operations of the Company are subject to risk resulting from interest rate fluctuations to the extent that there is a difference between the amount of the Company's interest-earning assets and the amount of interest-bearing liabilities that are paid, withdrawn, mature or re-price in specified periods. The principal objective of the Company's asset/liability management activities is to provide maximum levels of net investment income while maintaining acceptable levels of interest rate and liquidity risk and facilitating the funding needs of the Company. The Company has developed an asset/liability management approach tailored to specific insurance or investment product objectives. The investment assets of the Company are 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. 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 markets, borrowers, industries, sectors, and in the case of mortgages and real estate, property types and geographic locations. In addition, the Company carries long and short-term debt, as well as mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. The Company uses derivative financial instruments, primarily interest rate swaps, with indices that correlate to on-balance sheet instruments to modify its indicated net interest sensitivity to levels deemed to be appropriate. Specifically, for floating rate GIC liabilities that are matched with fixed rate securities, the Company manages the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. Additionally, the Company uses exchange 17 traded financial futures contracts to hedge against interest rate risk on anticipated GIC sales. The following tables for the years ended December 31, 1999 and 1998 provide information about the Company's financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The tables present principal cash flows and related weighted-average interest rates by expected maturities. Expected 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 and asset backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated bonds, but exclude interest rate swap contracts and foreign currency swap contracts, which are disclosed in separate tables. Foreign-denominated bonds are also shown separately in the tables of financial instruments subject to foreign currency risk. For liabilities that have no contractual maturity, the tables present principal cash flows and related weighted-average interest rates based on the Company's historical experience, management's judgment, and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. Additionally, the Company has assumed its available for sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available for sale securities and mortgage loans comprise an immaterial portion of the portfolio and do not have a significant impact on weighted average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the tables at their current interest rate.
For the Year Ended December 31, 1999 2000 2001 2002 2003 2004 ====================================================================================================== (Dollars in millions) Rate Sensitive Assets: Available for sale securities $466.3 $553.5 $533.8 $587.0 $522.7 Average interest rate 7.73% 7.46% 7.26% 6.89% 7.37% Mortgage loans $119.4 $ 61.1 $ 32.3 $ 41.7 $ 77.5 Average interest rate 9.08% 8.27% 8.17% 7.33% 7.68% Policy loans $ -- $ -- $ -- $ -- $ -- Average interest rate -- -- -- -- -- Rate Sensitive Liabilities: Fixed interest rate GICs $ 70.0 $ 27.6 $ 46.4 $ -- $ -- Average interest rate 7.60% 7.10% 7.29% -- -- Variable interest rate GICs $107.8 $ 43.2 $ 50.1 $ 402.5 $463.4 Average interest rate 6.26% 6.24% 6.24% 6.28% 6.17% Supplemental contracts without life contingencies $ 21.9 $ 11.2 $ 6.9 $ 4.7 $ 0.4 Average interest rate 4.03% 4.04% 4.05% 4.08% 4.13% Other individual contract deposit funds $ 11.2 $ 9.3 $ 7.6 $ 6.0 $ 4.2 Average interest rate 5.77% 5.87% 6.12% 5.75% 5.89% Other group contract deposit funds $107.9 $ 85.7 $ 49.8 $ 43.0 $ 35.8 Average interest rate 5.84% 5.17% 5.51% 5.45% 5.65% Individual fixed annuity contracts $ 96.3 $106.9 $115.7 $124.3 $134.0 Average interest rate 5.37% 5.18% 5.09% 5.01% 4.84% Trust instruments supported by funding obligations $ -- $ 50.6 $ -- $ -- $ -- Average interest rate -- 4.33% -- -- -- Long term debt $ -- $ -- $ -- $ -- $ -- Average interest rate -- -- -- -- -- Mandatorily redeemable preferred securities of a subsidiary trust holding soley junior subordinated debentures of the Company $ -- $ -- $ -- $ -- $ -- Average interest rate -- -- -- -- -- Fair Value For the Year Ended December 31, 1999 Thereafter Total 12/31/99 ============================================================================================= (Dollars in millions) Rate Sensitive Assets: Available for sale securities $4,563.9 $7,227.2 $7,260.5 Average interest rate 7.30% 7.31% Mortgage loans $ 331.4 $ 663.4 $ 656.5 Average interest rate 7.65% 7.98% Policy loans $ 371.6 $ 371.6 $ 371.6 Average interest rate 6.81% 6.81% Rate Sensitive Liabilities: Fixed interest rate GICs $ 105.0 $ 249.0 $ 253.8 Average interest rate 6.86% 7.17% Variable interest rate GICs $ -- $1,067.0 $1,087.6 Average interest rate -- 6.23% Supplemental contracts without life contingencies $ 3.7 $ 48.8 $ 48.8 Average interest rate 4.10% 4.04% Other individual contract deposit funds $ 10.1 $ 48.4 $ 48.2 Average interest rate 5.55% 5.85% Other group contract deposit funds $ 280.7 $ 602.9 $ 583.5 Average interest rate 5.65% 5.59% Individual fixed annuity contracts $ 515.3 $1,092.5 $1,057.1 Average interest rate 3.86% 4.99% Trust instruments supported by funding obligations $ -- $ 50.6 $ 49.6 Average interest rate -- 4.33% Long term debt $ 199.5 $ 199.5 $ 187.4 Average interest rate 7.63% 7.63% Mandatorily redeemable preferred securities of a subsidiary trust holding soley junior subordinated debentures of the Company $ 300.0 $ 300.0 $ 292.5 Average interest rate 8.21% 8.21%
18
Fair Value For the Year Ended December 31, 1998 1999 2000 2001 2002 2003 Thereafter Total 12/31/98 ================================================================================================================================= (Dollars in millions) Rate Sensitive Assets: Available for sale securities $527.4 $558.8 $574.8 $783.8 $811.7 $4,466.9 $7,723.4 $8,223.5 Average interest rate 8.22% 8.00% 7.71% 7.38% 6.90% 7.17% 7.33% Mortgage loans $ 91.9 $143.8 $ 64.8 $ 33.5 $ 44.5 $ 331.3 $ 709.8 $ 729.5 Average interest rate 8.31% 9.24% 7.89% 8.30% 7.42% 7.79% 8.16% Policy loans $ -- $ -- $ -- $ -- $ -- $ 365.2 $ 365.2 $ 365.2 Average interest rate -- -- -- -- -- 6.73% 6.73% Rate Sensitive Liabilities: Fixed interest rate GICs $337.1 $ 83.7 $ 25.8 $ 32.3 $ -- $ -- $ 478.9 $ 489.3 Average interest rate 6.51% 7.28% 6.87% 7.22% -- -- 6.71% Variable interest rate GICs $151.0 $ 57.2 $ -- $301.6 $803.1 $ -- $1,312.9 $1,341.5 Average interest rate 5.14% 5.32% -- 5.31% 5.41% -- 5.35% Supplemental contracts without life contingencies $ 16.0 $ 4.1 $ 3.7 $ 3.3 $ 2.9 $ 7.3 $ 37.3 $ 37.3 Average interest rate 4.25% 4.56% 4.57% 4.58% 4.60% 4.61% 4.44% Other individual contract deposit funds $ 16.1 $ 12.7 $ 9.7 $ 7.2 $ 4.8 $ 11.1 $ 61.6 $ 61.1 Average interest rate 4.08% 4.06% 4.04% 4.02% 4.00% 3.80% 4.01% Other group contract deposit funds $243.8 $274.0 $ 77.3 $ 43.0 $ 28.2 $ 34.1 $ 700.4 $ 704.0 Average interest rate 6.23% 5.96% 5.77% 5.66% 5.18% 5.93% 5.97% Individual fixed annuity contracts $108.7 $107.6 $103.6 $ 97.3 $ 90.9 $ 602.5 $1,110.6 $1,073.6 Average interest rate 4.49% 4.44% 4.40% 4.27% 4.20% 3.50% 3.90% Long term debt $ -- $ -- $ -- $ -- $ -- $ 199.5 $ 199.5 $ 213.4 Average interest rate -- -- -- -- -- 7.63% 7.63% Mandatorily redeemable preferred securities of a subsidiary trust holding soley junior subordinated debentures of the Company $ -- $ -- $ -- $ -- $ -- $ 300.0 $ 300.0 $ 334.7 Average interest rate -- -- -- -- -- 8.21% 8.21%
The following tables for the years ended December 31, 1999 and 1998 provide information about the Company's derivative financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The tables present notional amounts and, as applicable, weighted-average interest rates by contractual maturity date. Notional amounts are used to calculate the contractual payments to be exchanged under the contracts. Weighted-average variable rates are indicated by the applicable floating rate index. 19
For the Year Ended December 31, 1999 2000 2001 2002 2003 ======================================================================================================== (Dollars in millions) Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ 44.0 $ 43.1 $ 83.5 $ 191.0 Average pay rate 6.16% 5.63% 6.33% 5.85% Average receive rate 3 Mo. LIBOR 3 Mo. LIBOR 3 Mo. LIBOR 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ -- $ -- $ -- $ 195.0 Average pay rate -- -- -- 5.58% Average receive rate -- -- -- 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ -- $ -- $ -- $ 100.0 Average pay rate -- -- -- 5.89% Average receive rate -- -- -- Fed Funds Pay Fed Funds/receive 1 month LIBOR swaps $ -- $ -- $ -- $ 50.0 Average pay rate -- -- -- Fed Funds Average receive rate -- -- -- 1 Mo. LIBOR Futures contracts (long) $ 33.2 $ -- $ -- $ -- Number of contracts (5 year T notes) 334,000 -- -- -- Weighted average opening price 99.258 -- -- -- Fair Value For the Year Ended December 31, 1999 2004 Thereafter Total 12/31/99 ========================================================================================================= (Dollars in millions) Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ 197.3 $ 23.6 $ 582.5 $ 18.1 Average pay rate 5.59% 7.34% 5.90% Average receive rate 3 Mo. LIBOR 3 Mo. LIBOR 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ -- $ -- $ 195.0 $ 8.2 Average pay rate -- -- 5.58% Average receive rate -- -- 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ 122.0 $ -- $ 222.0 $ 7.0 Average pay rate 5.63% -- 5.75% Average receive rate Fed Funds -- Fed Funds Pay Fed Funds/receive 1 month LIBOR swaps $ -- $ -- $ 50.0 $ (0.1) Average pay rate -- -- Fed Funds Average receive rate -- -- 1 Mo. LIBOR Futures contracts (long) $ -- $ -- $ 33.2 $ 32.7 Number of contracts (5 year T notes) -- -- 334,000 Weighted average opening price -- -- 99.258
20
For the Year Ended December 31, 1998 1999 2000 2001 2002 ========================================================================================================= (Dollars in millions) Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ -- $ 44.0 $ -- $ 102.5 Average pay rate -- 6.16% -- 6.23% Average receive rate -- 3 Mo. LIBOR -- 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ -- $ -- $ -- $ 44.0 Average pay rate -- -- -- 6.22% Average receive rate -- -- -- 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ -- $ -- $ -- $ 88.0 Average pay rate -- -- -- 5.81% Average receive rate -- -- -- FED FUNDS Futures contracts (long) $ 86.5 $ -- $ -- $ -- Number of contracts (5 year T notes) 758,000 -- -- -- Weighted average opening price 114.098 -- -- -- Fair Value For the Year Ended December 31, 1998 2003 Thereafter Total 12/31/98 ========================================================================================================= (Dollars in millions) Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ 273.0 $ 23.6 $ 443.1 $ (13.6) Average pay rate 5.71% 7.34% 5.96% Average receive rate 3 Mo. LIBOR 3 Mo. LIBOR 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ 337.5 $ -- $ 381.5 $ (6.1) Average pay rate 5.75% -- 5.80% Average receive rate 1 Mo. LIBOR -- 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ 200.0 $ -- $ 288.0 $ (8.6) Average pay rate 5.80% -- 5.80% Average receive rate FED FUNDS -- FED FUNDS Futures contracts (long) $ -- $ -- $ 86.5 $ 85.9 Number of contracts (5 year T notes) -- -- 758,000 Weighted average opening price -- -- 114.098
Foreign Currency Sensitivity A portion of the Company's investments consists of fixed interest securities denominated in foreign currencies. A portion of the Company's liabilities consists of fixed interest trust obligations backed by funding agreements denominated in foreign currencies. The Company's operating results are exposed to changes in exchange rates between the U.S. dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From time to time, the Company may also have exposure to other foreign currencies. To mitigate the short-term effect of changes in currency exchange rates, the Company regularly hedges by entering into foreign exchange swap contracts to hedge its net foreign currency exposure. The following tables for the years ended December 31, 1999 and 1998 provide information about the Company's derivative financial instruments and other financial instruments, used for purposes other than trading, by functional currency and presents fair value information in U.S. dollar equivalents. The tables summarize information on instruments that are sensitive to foreign currency exchange rates, including fixed interest securities denominated in foreign currencies, and foreign currency forward exchange agreements. For foreign currency denominated securities with contractual maturities, the tables present principal cash flows, related weighted-average interest rates by contractual maturities, and applicable current forward foreign currency exchange rates. For foreign currency forward exchange agreements, the tables present the notional amounts and weighted-average exchange rates by expected (contractual) maturity dates. These notional amounts are used to calculate the contractual payments to be exchanged under the contracts. 21
For the Year Ended December 31, 1999 2000 2001 2002 2003 ============================================================================================== (Currencies in millions) Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs 10.0 -- -- -- Current forward foreign exchange rate 0.6281 -- -- -- Fixed interest rate securities denominated in Japanese Yen 620.0 -- -- -- Current forward foreign exchange rate 0.0098 -- -- -- Fixed interest rate securities denominated in British Pounds -- -- -- -- Current forward foreign exchange rate -- -- -- Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency 10.0 -- -- -- Average contract rate 0.665 -- -- -- Current forward foreign exchange rate 0.6281 -- -- -- Pay Japanese Yen Notional amount in foreign currency 620.0 -- -- -- Average contract rate 0.008 -- -- -- Current forward foreign exchange rate 0.0098 -- -- -- Pay British Pounds Notional amount in foreign currency -- -- -- -- Average contract rate -- -- -- -- Current forward foreign exchange rate -- -- -- -- Fixed Interest Liabilities Denominated in Foreign Currencies: Trust instruments supported by funding obligations denominated in Euros -- 50.0 -- -- Current forward foreign exchange rate -- 1.0062 -- -- Currency Swap Agreements Related to Fixed Interest Trust Obligations: Pay Euros Notional amount in foreign currency -- 50.0 -- -- Average contract rate -- 1.006 -- -- Current forward foreign exchange rate -- 1.0062 -- -- Fair Value For the Year Ended December 31, 1999 2004 Thereafter Total 12/31/99 ========================================================================================= (Currencies in millions) Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs -- -- 10.0 $ 6.8 Current forward foreign exchange rate -- -- 0.6281 Fixed interest rate securities denominated in Japanese Yen -- -- 620.0 $ 6.1 Current forward foreign exchange rate -- -- 0.0098 Fixed interest rate securities denominated in British Pounds -- 9.5 9.5 $ 20.6 Current forward foreign exchange rate -- 1.6153 1.6153 Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency -- -- 10.0 $ 0.2 Average contract rate -- -- 0.665 Current forward foreign exchange rate -- -- 0.6281 Pay Japanese Yen Notional amount in foreign currency -- -- 620.0 $ (1.2) Average contract rate -- -- 0.008 Current forward foreign exchange rate -- -- 0.0098 Pay British Pounds Notional amount in foreign currency -- 9.5 9.5 $ (1.8) Average contract rate -- 1.980 1.980 Current forward foreign exchange rate -- 1.6153 1.6153 Fixed Interest Liabilities Denominated in Foreign Currencies: Trust instruments supported by funding obligations denominated in Euros -- -- 50.0 $ 49.6 Current forward foreign exchange rate -- -- 1.0062 Currency Swap Agreements Related to Fixed Interest Trust Obligations: Pay Euros Notional amount in foreign currency -- -- 50.0 $ (2.7) Average contract rate -- -- 1.006 Current forward foreign exchange rate -- -- 1.0062
22
For the Year Ended December 31, 1998 1999 2000 2001 2002 ============================================================================================= (Currencies in millions) Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs -- 10.0 -- -- Current forward foreign exchange rate -- 0.7077 -- -- Fixed interest rate securities denominated in Canadian Dollars 20.0 -- -- -- Current forward foreign exchange rate 0.6535 -- -- -- Fixed interest rate securities denominated in Japanese Yen -- 620.0 -- -- Current forward foreign exchange rate -- 0.0088 -- -- Fixed interest rate securities denominated in British Pounds -- -- -- -- Current forward foreign exchange rate -- -- -- -- Fixed interest rate securities denominated in Finnish Markkas 47.3 -- -- -- Current forward foreign exchange rate 0.1962 -- -- -- Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency -- 10.0 -- -- Average contract rate -- 0.664 -- -- Current forward foreign exchange rate -- 0.7077 -- -- Pay Canadian Dollars Notional amount in foreign currency 20.0 -- -- -- Average contract rate 0.750 -- -- -- Current forward foreign exchange rate 0.6535 -- -- -- Pay Japanese Yen Notional amount in foreign currency -- 620.0 -- -- Average contract rate -- 0.008 -- -- Current forward foreign exchange -- 0.0088 -- -- Pay British Pounds Notional amount in foreign currency -- -- -- -- Average contract rate -- -- -- -- Current forward foreign exchange rate -- -- -- -- Pay Finnish Markkas Notional amount in foreign currency 47.3 -- -- -- Average contract rate 0.211 -- -- -- Current forward foreign exchange rate 0.1962 -- -- -- Fair Value For the Year Ended December 31, 1998 2003 Thereafter Total 12/31/98 ============================================================================================ (Currencies in millions) Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs -- -- 10.0 $ 7.0 Current forward foreign exchange rate -- -- 0.7077 Fixed interest rate securities denominated in Canadian Dollars -- -- 20.0 $ 15.3 Current forward foreign exchange rate -- -- 0.6535 Fixed interest rate securities denominated in Japanese Yen -- -- 620.0 $ 5.5 Current forward foreign exchange rate -- -- 0.0088 Fixed interest rate securities denominated in British Pounds -- 9.5 9.5 $ 25.0 Current forward foreign exchange rate -- 1.6595 1.6595 Fixed interest rate securities denominated in Finnish Markkas -- -- 47.3 $ 10.1 Current forward foreign exchange rate -- -- 0.1962 Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency -- -- 10.0 $ (0.9) Average contract rate -- -- 0.664 Current forward foreign exchange rate -- -- 0.7077 Pay Canadian Dollars Notional amount in foreign currency -- -- 20.0 $ 1.9 Average contract rate -- -- 0.750 Current forward foreign exchange rate -- -- 0.6535 Pay Japanese Yen Notional amount in foreign currency -- -- 620.0 $ (0.1) Average contract rate -- -- 0.008 Current forward foreign exchange -- -- 0.0088 Pay British Pounds Notional amount in foreign currency -- 9.5 9.5 $ (2.3) Average contract rate -- 1.980 1.980 Current forward foreign exchange rate -- 1.6595 1.6595 Pay Finnish Markkas Notional amount in foreign currency -- -- 47.3 $ 1.2 Average contract rate -- -- 0.211 Current forward foreign exchange rate -- -- 0.1962
23 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 July 16, 1997 merger, Allmerica P&C and its subsidiaries filed a separate United States federal income tax return. The provision for federal income taxes before minority interest and discontinued operations was $106.9 million during 1999 compared to $56.1 million during 1998. These provisions resulted in consolidated effective federal tax rates of 22.8% and 18.7%, respectively. The effective tax rates for FAFLIC and AFLIAC and their non-insurance affiliates were 26.1% and 28.6% during 1999 and 1998, respectively. The decrease in the rate for AFLIAC and FAFLIC and their non-insurance affiliates primarily reflects changes in reserves for prior years tax liabilities. The effective tax rates for Allmerica P&C and its subsidiaries were 20.6% and 10.7% during 1999 and 1998, respectively. The increase in the rate for Allmerica P&C and its subsidiaries is primarily the result of a larger proportion of pre-tax income from realized capital gains in 1999, as well as improved underwriting results. The provision for federal income taxes before minority interest and discontinued operations was $56.1 million during 1998 compared to $84.7 million during 1997. These provisions resulted in consolidated effective federal tax rates of 18.7% and 24.9%, respectively. The effective tax rates for FAFLIC and AFLIAC and their non-insurance subsidiaries were 28.6% and 37.8% during 1998 and 1997, respectively. The decrease in the rate for AFLIAC and FAFLIC and their non-insurance subsidiaries resulted primarily from an increase in available tax credits, as well as the reduction, in 1998, of any net increases in reserves for prior years tax liabilities. The effective tax rates for Allmerica P&C and its subsidiaries were 10.7% and 16.5% during 1998 and 1997, respectively. The decrease in the rate for Allmerica P&C and its subsidiaries reflects higher underwriting losses and a greater proportion of pre-tax income from tax-exempt bonds in 1998. 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. During 1999, AFC received $350.0 million in extraordinary dividends from its property and casualty businesses. These funds were principally used to repurchase $250.2 million of AFC common stock and pay $39.9 million of interest expense on the Senior Debentures and Capital Securities. Any additional dividends from the property and casualty insurance companies to AFC prior to April 2000 would require regulatory approval. During the third quarter of 1999, the Company used the remaining funds from the aforementioned dividends, as well as proceeds from sales of AFC holding company investments, to fund a $125.0 million capital contribution from AFC to FAFLIC. As of July 1, 1999, FAFLIC's ownership of Allmerica P&C, as well as several non-insurance subsidiaries, were transferred from FAFLIC to AFC. Under an agreement with the Commonwealth of Massachusetts Insurance Commissioner ("the Commissioner"), AFC contributed the aforementioned $125.0 million and agreed to maintain FAFLIC's statutory surplus at specified levels during the following six years. Future capital contributions from AFC to FAFLIC may be required. In addition, any dividend from FAFLIC to AFC during the years 2000 and 2001 would require the prior approval of the Commissioner. During 1998, FAFLIC's Board of Directors declared and paid a common stock dividend to AFC of $50.0 million. Additionally, Hanover's Board of Directors declared and paid a $125.0 million dividend to Allmerica P&C, of which $117.1 million was transferred to AFC in exchange for shares of Allmerica P&C capital stock. These funds were used for the acquisition of the minority interest of Citizens Corporation. In addition, AFC paid $39.9 of interest expense during 1998 on Senior Debentures and Capital Securities. 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 24 adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash provided by operating activities was $15.2 million and $37.9 million in 1999 and 1998, respectively, compared to net cash used in operating activities of $173.2 million in 1997. The decrease in 1999 resulted primarily from a decrease in premiums received due to the timing of certain agent billings in the Risk Management segment. In addition, a decrease in cash resulted from net payments made related to the 1998 reinsurance agreement to cede the mortality risk of the Company's universal and variable universal life business. These decreases in cash were partially offset by cash receipts from the Company's separate accounts, as well as the absence of the 1998 payment of $30.3 million related to the Company's exit of its reinsurance pool business. The increase in 1998 resulted primarily from the absence of a $207.0 million payment made during 1997 for the cession of the disability income line of business, partially offset by a 1998 payment of $30.3 million related to exiting reinsurance pools. Also, cash was used in 1998 operations to fund increased commissions and other deferred expenses related to continued growth in the variable annuity product lines of the Allmerica Financial Services segment, and to pay the federal taxes resulting from audits of prior return years. Net cash provided by investing activities was $794.9 million and $120.5 million in 1999 and 1997, respectively, while net cash used in investing activities was $617.1 million in 1998. The $1.4 billion increase from 1998 to 1999 primarily results from $469.2 million in net proceeds from fixed maturities in 1999 principally used to fund net withdrawals and maturities of funding agreements, as compared to net purchases of fixed maturities totaling $595.6 million during 1998. Proceeds from net sales of equity securities increased approximately $180.0 million in 1999 as compared to 1998. Additionally, the increase in cash provided by investing activities in 1999 over the prior year reflects the absence in 1999, of $195.9 million of cash used to fund the purchase of the minority interest of Citizens Corporation during 1998. The change in 1998 primarily reflects the absence of proceeds from sales of fixed maturities in 1997 used to fund the aforementioned cession of the disability income line of business, the aforementioned purchase of the minority interest of Citizens Corporation during 1998 for $195.9 million, and the greater net purchases of fixed maturities resulting from an increase in funds available from floating rate GIC deposits. These were partially offset by increased net sales of equity securities in 1998. Net cash used in financing activities was $905.0 million in 1999, as compared to net cash provided by financing activities of $898.7 million and $90.3 million in 1998 and 1997, respectively. During 1999, the Company had net withdrawals of funding agreements of $522.9 million as compared to net deposits in 1998 of $794.2 million. Also, the Company repurchased an additional $250.2 million of AFC common stock as compared to the initial repurchase of $82.7 million in 1998. In addition, during 1999 cash was used to repay $180.0 million in short term debt used to finance the aforementioned acquisition of the minority interest of Citizens Corporation. In 1998, cash provided by financing activities was positively impacted by net deposits for funding agreements of $794.2 million compared to net withdrawals of $189.6 million in 1997. In addition, short term borrowings increased by $188.3 million primarily related to the Citizens acquisition in 1998. These increases were partially offset by the absence in 1998, of the 1997 receipt of net proceeds of $296.3 million from the issuance of Capital Securities and $82.7 million of common stock repurchases in 1998. AFC has sufficient funds at the holding company or available through dividends from FAFLIC and Allmerica P&C, or through available credit facilities to meet its obligations to pay interest on the Senior Debentures, Capital Securities and dividends, when and if declared by the Board of Directors, on the common stock. Whether the Company will pay dividends in the future depends upon the costs of administering a dividend program as compared to the benefits conferred, and upon the earnings and financial condition of AFC. Based on current trends, the Company expects to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. The Company maintains a high degree of liquidity within the investment portfolio in fixed maturity investments, common stock and short-term investments. AFC has $150.0 million available under a committed syndicated credit agreement which expires on May 28, 2000. Borrowings under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. At December 31, 1999, no amounts were outstanding under this agreement. The Company had $45.0 million of commercial paper borrowings outstanding at December 31, 1999. 25 CONTINGENCIES ================================================================================ The Company has been named a defendant in various legal proceedings arising in the normal course of business. In the Company's opinion, 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. RECENT DEVELOPMENTS ================================================================================ In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement No. 133"), which establishes accounting and reporting standards for derivative instruments. Statement No. 133 requires that an entity recognize all derivatives as either assets or liabilities at fair value in the statement of financial position, and establishes special accounting for the following three types of hedges: fair value hedges, cash flow hedges, and hedges of foreign currency exposures of net investments in foreign operations. This statement is effective for fiscal years beginning after June 15, 2000. The Company is currently assessing the impact of the adoption of Statement No. 133. YEAR 2000 ================================================================================ The Year 2000 issue resulted from computer programs being written using two digits rather than four to define the applicable year. 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. Any of these specific events, depending on duration, could have a material adverse impact on the results of operations and the financial position of the Company. The Company met the objectives of its Year 2000 remediation plan, which had three mission critical elements: internal systems, desktop systems, and external partners. All of its inventoried systems have been corrected, tested for year 2000 dates and are in production; its desktop computers are capable of correctly processing year 2000 dates, and third party software installed on the Company's desktop machines has been confirmed capable of processing year 2000 dates properly. Through an aggressive communications process, the Company obtained verification of Year 2000 readiness from its suppliers. During the fourth quarter and throughout the millennium rollover period, the Company's systems functioned without any apparent Year 2000-related disruptions. As such, the Company does not believe that there is a material contingency associated with the Year 2000 issue, however, there can be no assurance that exposure for material contingencies will not arise. The cost of the Year 2000 project was expensed as incurred and has been funded primarily through a reallocation of resources from discretionary projects and a reduction in systems maintenance and support costs. Therefore, the Year 2000 project did not result in any significant incremental technology costs, and thus did not have a material effect on the results of operations. The Company incurred and expensed approximately $64 million related to the assessment, plan development and completion of the Year 2000 project through December 31, 1999. An additional $4 million is estimated for residual fixed costs which may be incurred in 2000. 26 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 1999 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", "anticipates", "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 1999. 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; as well as continued compliance with state and federal regulations; (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 renegotiations at less cost-effective rates or terms of payment; (xi) changes in the Company's liquidity due to changes in asset and liability matching; (xii) restrictions on insurance underwriting, based on genetic testing and other criteria; (xiii) adverse changes in the ratings obtained from independent rating agencies, such as Moody's, Standard and 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; (xvi) uncertainty related to the Year 2000 issue; (xvii) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance contracts; (xviii) earlier than expected withdrawals from the Company's general account annuities, GICs (including funding agreements), and other insurance products; (xix) changes in the mix of assets comprising the Company's investment portfolio and the fluctuation of the market value of such assets; (xx) losses resulting from the Company's participation in certain reinsurance pools; and (xxi) adverse results of regulatory audits related to the Company's prior years' federal income tax filings. 27 Report of Independent Accountants [LOGO] PriceWaterhouseCoopers 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, comprehensive income, shareholders' equity, and cash flows present fairly, in all material respects, the financial position of Allmerica Financial Corporation and its subsidiaries (the "Company") at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. 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 auditing standards generally accepted in the United States 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/ PriceWaterhouseCoopers LLP Boston, Massachusetts February 1, 2000 Management's 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 PricewaterhouseCoopers 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, PricewaterhouseCoopers LLP. Both our internal auditors and PricewaterhouseCoopers 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 28 Consolidated Statements of Income
For the Years Ended December 31 1999 1998 1997 ==================================================================================================================== (In millions, except per share data) Revenues Premiums $ 1,950.5 $ 1,970.6 $ 1,980.5 Universal life and investment product policy fees 359.3 296.6 237.3 Net investment income 615.7 604.4 631.1 Net realized investment gains 91.0 59.2 76.0 Other income 128.7 103.2 81.5 - -------------------------------------------------------------------------------------------------------------------- Total revenues 3,145.2 3,034.0 3,006.4 - -------------------------------------------------------------------------------------------------------------------- Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 1,770.7 1,804.0 1,764.0 Policy acquisition expenses 429.9 449.6 408.5 Sales practice litigation -- 31.0 -- Loss from cession of disability income business -- -- 53.9 Restructuring costs (1.9) 9.0 -- Other operating expenses 478.5 440.3 440.0 - -------------------------------------------------------------------------------------------------------------------- Total benefits, losses and expenses 2,677.2 2,733.9 2,666.4 - -------------------------------------------------------------------------------------------------------------------- Income before federal income taxes 468.0 300.1 340.0 - -------------------------------------------------------------------------------------------------------------------- Federal income tax expense (benefit) Current 88.1 72.5 70.8 Deferred 18.8 (16.4) 13.9 - -------------------------------------------------------------------------------------------------------------------- Total federal income tax expense 106.9 56.1 84.7 - -------------------------------------------------------------------------------------------------------------------- Income before minority interest 361.1 244.0 255.3 Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (16.0) (14.5) Equity in earnings -- (13.3) (48.2) - -------------------------------------------------------------------------------------------------------------------- Total minority interest (16.0) (29.3) (62.7) - -------------------------------------------------------------------------------------------------------------------- Income from continuing operations 345.1 214.7 192.6 - -------------------------------------------------------------------------------------------------------------------- (Loss) income from operations of discontinued business (less applicable income taxes (benefit) of $(10.1), $(7.0) and $8.9 for the years ended December 31, 1999, 1998 and 1997, respectively) (18.8) (13.5) 16.6 Loss on disposal of group life and health business, including provision of $72.2 for operating losses during phase-out period for the year ended December 31, 1999 (less applicable income tax benefit of $16.4) (30.5) -- -- - -------------------------------------------------------------------------------------------------------------------- Net income $ 295.8 $ 201.2 $ 209.2 ==================================================================================================================== Earnings per common share: Basic: Income from continuing operations $ 6.27 $ 3.59 $ 3.53 (Loss) income from operations of discontinued business (less applicable income taxes (benefit) of $(0.19), $(0.12) and $0.17 for the years ended December 31, 1999, 1998 and 1997, respectively) (0.34) (0.23) 0.30 Loss on disposal of group life and health business, including provision of $1.31 for operating losses during phase-out period for the year ended December 31, 1999 (less applicable income tax benefit of $0.30) (0.55) -- -- - -------------------------------------------------------------------------------------------------------------------- Net income per share $ 5.38 $ 3.36 $ 3.83 Weighted average shares outstanding 55.0 59.9 54.7 ==================================================================================================================== Diluted: Income from continuing operations $ 6.21 $ 3.56 $ 3.52 (Loss) income from operation of discontinued business (less applicable income taxes (benefit) of $(0.19), $(0.12) and $0.17 for the years ended December 31, 1999, 1998 and 1997, respectively) (0.33) (0.23) 0.30 Loss on disposal of group life and health business, including provision of $1.30 for operating losses during phase-out period for the year ended December 31, 1999 (less applicable income tax benefit of $0.29) (0.55) -- -- - -------------------------------------------------------------------------------------------------------------------- Net income per share $ 5.33 $ 3.33 $ 3.82 Weighted average shares outstanding 55.5 60.3 54.8 ====================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements. 29 Consolidated Balance Sheets
December 31 1999 1998 ==================================================================================================================== (In millions, except per share data) Assets Investments: Fixed maturities-at fair value (amortized cost of $7,095.0 and $7,618.2) $ 6,933.8 $ 7,780.8 Equity securities-at fair value (cost of $49.5 and $253.1) 83.2 397.1 Mortgage loans 521.2 562.3 Policy loans 170.5 154.3 Real estate and other long-term investments 180.0 163.1 - -------------------------------------------------------------------------------------------------------------------- Total investments 7,888.7 9,057.6 - -------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents 442.2 550.3 Accrued investment income 134.7 142.3 Deferred policy acquisition costs 1,386.8 1,161.2 Reinsurance receivable on unpaid losses, benefits and unearned premiums 1,279.9 1,136.0 Deferred federal income taxes 141.7 19.8 Premiums, accounts and notes receivable 583.5 555.7 Other assets 510.2 529.4 Closed Block assets 772.3 803.1 Separate account assets 17,629.6 13,697.7 - -------------------------------------------------------------------------------------------------------------------- Total assets $30,769.6 $27,653.1 ==================================================================================================================== Liabilities Policy liabilities and accruals: Future policy benefits $ 2,825.0 $ 2,802.2 Outstanding claims, losses and loss adjustment expenses 2,838.6 2,816.3 Unearned premiums 890.2 843.2 Contractholder deposit funds and other policy liabilities 2,041.0 2,637.0 - -------------------------------------------------------------------------------------------------------------------- Total policy liabilities and accruals 8,594.8 9,098.7 - -------------------------------------------------------------------------------------------------------------------- Expenses and taxes payable 795.5 716.1 Reinsurance premiums payable 73.0 95.4 Trust instruments supported by funding obligations 50.6 -- Short-term debt 45.0 221.3 Long-term debt 199.5 199.5 Closed Block liabilities 842.1 872.0 Separate account liabilities 17,628.9 13,691.5 - -------------------------------------------------------------------------------------------------------------------- Total liabilities 28,229.4 24,894.5 - -------------------------------------------------------------------------------------------------------------------- Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 300.0 - -------------------------------------------------------------------------------------------------------------------- Commitments and contingencies (Notes 17 and 22) Shareholders' Equity Preferred stock, $0.01 par value, 20.0 million shares authorized, none issued -- -- Common stock, $0.01 par value, 300.0 million shares authorized, 60.4 million shares issued 0.6 0.6 Additional paid-in capital 1,770.5 1,768.8 Accumulated other comprehensive income (75.3) 180.5 Retained earnings 882.2 599.9 Treasury stock at cost (6.2 and 1.8 million shares) (337.8) (91.2) - -------------------------------------------------------------------------------------------------------------------- Total shareholders' equity 2,240.2 2,458.6 - -------------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $30,769.6 $27,653.1 ====================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements. 30 Consolidated Statements of Shareholders' Equity
For the Years Ended December 31 1999 1998 1997 ==================================================================================================================== (In millions) Preferred Stock $ -- $ -- $ -- Common Stock Balance at beginning of year 0.6 0.6 0.5 Issuance of common stock -- -- 0.1 - -------------------------------------------------------------------------------------------------------------------- Balance at end of year 0.6 0.6 0.6 Additional Paid-In Capital Balance at beginning of year 1,768.8 1,755.0 1,382.5 Issuance of common stock 1.7 13.8 376.2 Issuance costs of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company -- -- (3.7) - -------------------------------------------------------------------------------------------------------------------- Balance at end of year 1,770.5 1,768.8 1,755.0 Accumulated Other Comprehensive Income Net Unrealized (Depreciation) Appreciation on Investments: Balance at beginning of year 180.5 217.9 131.6 (Depreciation) appreciation during the period: Net (depreciation) appreciation on available-for-sale securities (393.8) (82.7) 171.3 Benefit (provision) for deferred federal income taxes 138.0 28.8 (59.9) Minority interest -- 16.5 (25.1) - -------------------------------------------------------------------------------------------------------------------- (255.8) (37.4) 86.3 - -------------------------------------------------------------------------------------------------------------------- Balance at end of year (75.3) 180.5 217.9 Retained Earnings Balance at beginning of year 599.9 407.8 210.1 Net income 295.8 201.2 209.2 Dividends to shareholders (13.5) (9.1) (11.5) - -------------------------------------------------------------------------------------------------------------------- Balance at end of year 882.2 599.9 407.8 - -------------------------------------------------------------------------------------------------------------------- Treasury Stock Balance at beginning of year (91.2) -- -- Shares purchased at cost (252.8) (91.2) -- Shares reissued at cost 6.2 -- -- - -------------------------------------------------------------------------------------------------------------------- Balance at end of year (337.8) (91.2) -- - -------------------------------------------------------------------------------------------------------------------- Total shareholders' equity $2,240.2 $2,458.6 $2,381.3 ====================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 31 Consolidated Statements of Comprehensive Income
For the Years Ended December 31 1999 1998 1997 ==================================================================================================================== (In millions) Net income $ 295.8 $ 201.2 $ 209.2 Other comprehensive (loss) income: Net (depreciation) appreciation on available for sale securities (393.8) (82.7) 171.3 Benefit (provision) for deferred federal income taxes 138.0 28.8 (59.9) Minority interest -- 16.5 (25.1) - -------------------------------------------------------------------------------------------------------------------- Other comprehensive (loss) income (255.8) (37.4) 86.3 - -------------------------------------------------------------------------------------------------------------------- Comprehensive income $ 40.0 $ 163.8 $ 295.5 ====================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements 32 Consolidated Statements of Cash Flows
For the Years Ended December 31 1999 1998 1997 ==================================================================================================================== (In millions) Cash Flows From Operating Activities Net Income $ 295.8 $ 201.2 $ 209.2 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Minority interest -- 13.3 48.2 Net realized investment gains (90.4) (61.0) (77.5) Net amortization and depreciation 34.2 21.9 31.6 Deferred federal income taxes 18.8 (16.4) 13.9 Loss on disposal of group life and health business 30.5 -- -- Loss from exiting reinsurance pools -- 25.3 -- Sales practice litigation expense -- 31.0 -- Loss from cession of disability income business -- -- 53.9 Payment related to exiting reinsurance pools -- (30.3) -- Payment related to cession of disability income business -- -- (207.0) Change in deferred acquisition costs (183.8) (185.8) (189.7) Change in premiums and notes receivable, net of reinsurance payable (50.2) 56.7 (15.1) Change in accrued investment income 7.7 -- 7.0 Change in policy liabilities and accruals, net 28.7 168.1 (134.7) Change in reinsurance receivable (143.8) (115.4) 27.1 Change in expenses and taxes payable 29.6 9.1 46.8 Separate account activity, net 5.3 (48.5) 5.7 Other, net 32.8 (31.3) 7.4 - -------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 15.2 37.9 (173.2) Cash Flows From Investing Activities Proceeds from disposals and maturities of available-for-sale fixed maturities 2,996.5 1,970.6 3,046.0 Proceeds from disposals of equity securities 424.3 285.3 162.7 Proceeds from disposals of other investments 31.4 120.8 116.3 Proceeds from mortgages matured or collected 128.2 171.2 204.7 Purchase of available-for-sale fixed maturities (2,527.3) (2,566.2) (2,727.6) Purchase of equity securities (78.9) (119.9) (67.0) Purchase of other investments (140.7) (274.4) (175.0) Capital expenditures (30.1) (22.3) (15.3) Purchase of minority interest in Citizens Corporation -- (195.9) -- Purchase of Financial Profiles, Inc. -- (13.0) -- Purchase of minority interest in Allmerica P&C -- -- (425.6) Other investing activities, net (8.5) 26.7 1.3 - -------------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 794.9 (617.1) 120.5 Cash Flows From Financing Activities Deposits and interest credited to contractholder deposit funds 1,514.6 1,419.2 457.6 Withdrawals from contractholder deposit funds (2,037.5) (625.0) (647.2) Change in trust instruments supported by funding obligations 50.6 -- -- Change in short-term debt (176.3) 188.3 (5.4) Change in long-term debt -- (2.6) (0.1) 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 (13.5) (9.9) (13.7) Net proceeds from issuance of common stock 1.1 11.4 2.8 Treasury stock purchased at cost (250.2) (82.7) -- Treasury stock reissued at cost 6.2 -- -- - -------------------------------------------------------------------------------------------------------------------- Net cash (used in) provided by financing activities (905.0) 898.7 90.3 - -------------------------------------------------------------------------------------------------------------------- Net change in cash and cash equivalents (94.9) 319.5 37.6 Net change in cash held in the Closed Block (13.2) 15.7 (1.0) Cash and cash equivalents, beginning of year 550.3 215.1 178.5 - -------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 442.2 $ 550.3 $ 215.1 ==================================================================================================================== Supplemental Cash Flow Information Interest paid $ 19.9 $ 21.6 $ 20.1 Income taxes paid $ 77.8 $ 133.5 $ 66.3
The accompanying notes are an integral part of these consolidated financial statements. 33 Notes To Consolidated Financial Statements 1. ================================================================================ Summary of Significant Accounting Policies A. Basis of Presentation and Principles of Consolidation The consolidated financial statements of Allmerica Financial Corporation ("AFC" or the "Company") 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 services); Allmerica Asset Management, Inc. ("AAM", a wholly-owned noninsurance subsidiary of AFC); Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance subsidiary of AAM); The Hanover Insurance Company ("Hanover", a wholly-owned subsidiary of Allmerica P&C); Citizens Corporation (a wholly-owned subsidiary of Hanover); and Citizens Insurance Company of America ("Citizens", a wholly-owned subsidiary of Citizens Corporation). The Closed Block (See Note 1B) assets and liabilities and its results of operations are presented in the consolidated financial statements as single line items. Unless specifically stated, all disclosures contained herein supporting the consolidated financial statements exclude the Closed Block related amounts. All significant intercompany accounts and transactions have been eliminated. On or about December 3, 1998, the Company acquired all of the outstanding common stock of Citizens Corporation (formerly an 82.5% owned non-insurance subsidiary of Hanover) in exchange for cash of $195.9 million (See Note 3). The acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 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, Hanover of approximately 40.5% prior to the merger on July 16, 1997. In addition, prior to the December 3, 1998 acquisition, the financial statements reflect minority interest in Citizens Corporation and its wholly-owned subsidiary, Citizens of approximately 16.8% and 17.5% in 1998 and 1997, respectively. Minority interest also includes distributions on mandatorily redeemable preferred securities 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 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 as of FAFLIC's demutualization 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. 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. 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 as 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 the inception of the Closed Block, 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 at inception. 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, 34 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. Debt securities and marketable equity 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. As of December 31, 1999, there were 4 properties remaining in the Company's real estate portfolio, all of which are being actively marketed. These assets are carried at the estimated fair value less costs of disposal. 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 the foreign currency exchange risk associated with investment securities 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 associated with trust obligations backed by funding agreements are accounted for using the fair value method, with changes in fair value reported in other operating income consistent with the underlying hedged trust obligation. 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. Default swap contracts entered into for investment purposes are accounted for using the fair value method, with changes in fair value, if any, reported in realized investment gains and losses in earnings. Premium paid to the Company on default swap contracts is reported in net investment income in earnings. 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. Any ineffective swaps or futures hedges are recognized currently in realized investment gains and losses in earnings. 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. 35 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 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 6.0% for life insurance and 2 1/2% 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, variable universal life and variable annuities 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 variable annuities include a reserve for benefit claims in excess of a guaranteed minimum fund value. 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 insurance are reported as earned on a pro-rata basis over the contract period. The unexpired portion of these premiums is recorded as unearned premiums. Contractholder deposit funds and other policy liabilities include investment-related products such as guaranteed investment contracts, deposit administration funds and immediate participation guarantee funds and consist of deposits received from customers and investment earnings on their fund balances. All policy liabilities and accruals are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, 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. 36 J. Premium and Fee Revenue and Related Expenses Premiums for individual life insurance and individual and group annuity products, excluding universal life and investment-related products, are considered revenue when due. Property and casualty 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 include annuity benefit claims in excess of a guaranteed minimum fund value, and 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. Federal 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 July 16, 1997 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 of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement No. 109"). These differences result primarily from loss and LAE reserves, policy reserves, policy acquisition expenses and unrealized appreciation or depreciation on investments L. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement No. 133"), which establishes accounting and reporting standards for derivative instruments. Statement No. 133 requires that an entity recognize all derivatives as either assets or liabilities at fair value in the statement of financial position, and establishes special accounting for the following three types of hedges: fair value hedges, cash flow hedges, and hedges of foreign currency exposures of net investments in foreign operations. This statement is effective for fiscal years beginning after June 15, 2000. The Company is currently assessing the impact of the adoption of Statement No. 133. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use" ("SoP No. 98-1"). SoP No. 98-1 requires that certain costs incurred in developing internal-use computer software be capitalized and provides guidance for determining whether computer software is to be considered for internal use. This statement is effective for fiscal years beginning after December 15, 1998. In the second quarter of 1998, the Company adopted SoP No. 98-1 effective January 1, 1998, resulting in an increase in pre-tax income of $12.4 million through December 31, 1998. The adoption of SoP No. 98-1 did not have a material effect on the results of operations or financial position for the three months ended March 31, 1998. In December 1997, the AICPA issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SoP No. 97-3"). SoP No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and 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 adoption of SoP No. 97-3 did not have a material effect on the results of operations or financial position of the Company. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("Statement No. 131"). 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 adopted Statement No. 131 for the first quarter of 1998, which resulted in certain segment re-definitions, and had no impact on the consolidated results of operations (See Note 16). 37 In June 1997, the FASB also issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("Statement No. 130"). Statement No. 130 establishes 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 adopted Statement No. 130 for the first quarter of 1998, which resulted primarily in reporting unrealized gains and losses on investments in debt and equity securities in comprehensive income. M. Earnings Per Share Earnings per share ("EPS") for the years ended December 31, 1999, 1998, and 1997 are based on a weighted average of the number of shares outstanding during each year. The Company's EPS is based on net income for both basic and diluted earnings per share. The weighted average shares outstanding which were utilized in the calculation of basic earnings per share differ from the weighted average shares outstanding used in the calculation of diluted earnings per share due to the effect of dilutive employee stock options and nonvested stock grants. Options to purchase shares of common stock whose exercise prices are greater than the average market price of the common shares are not included in the computation of diluted earnings per share because the effect would be antidilutive. N. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. 2. ================================================================================ Discontinued Operations During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its Employee Benefit Services ("EBS") business, its Affinity Group Underwriters ("AGU") business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB Opinion No. 30"). In the third quarter of 1999, the operating results from the discontinued segment were adjusted to reflect the recording of additional reserves related to accident claims from prior years. On October 6, 1999, the Company entered into an agreement with Great-West Life and Annuity Insurance Company of Denver, which provides for the sale of the Company's EBS business effective March 1, 2000. The Company has recorded a $30.5 million loss, net of taxes, on the disposal of its group life and health business. Subsequent to the June 30, 1999 measurement date, operations from the discontinued business generated losses of approximately $9.7 million, net of taxes. As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not been segregated between continuing and discontinued operations. At December 31, 1999, the discontinued segment had assets of approximately $536.2 million consisting primarily of invested assets, premiums and fees receivable, and reinsurance recoverables, and liabilities of approximately $485.9 million consisting primarily of policy liabilities. Revenues for the discontinued operations were $367.0 million, $398.5 million, and $389.2 million for the years ended December 31, 1999, 1998 and 1997, respectively. 3. ================================================================================ Acquisition of Minority Interest of Citizens Corporation On December 3, 1998 Citizens Acquisition Corporation, a wholly owned subsidiary of the Company, completed a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock at a price of $33.25 per share. Approximately 99.8% of publicly held shares of Citizens Corporation common stock were tendered. On December 14, 1998, the Company completed a short-form merger, acquiring all shares of common stock of Citizens Corporation not purchased in its tender offer, through the merger of its wholly owned subsidiary, Citizens Acquisition Corporation with Citizens Corporation at a price of $33.25 per share. Total consideration for the transactions amounted to $195.9 million. The acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 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 Citizens Corporation prior to December 3, 1998. The unaudited proforma information below presents consolidated results of operation as if the acquisition had occurred at the beginning of 1997. The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the acquisition occurred at the beginning of 1997, nor is it necessarily indicative of future results. 38 (Unaudited) For the Years Ended December 31 1998 1997 ================================================================================ (In millions, except per share data) Revenue $ 3,019.7 $ 2,988.5 - -------------------------------------------------------------------------------- Net realized capital gains included in revenue $ 56.4 $ 71.3 - -------------------------------------------------------------------------------- Income before taxes and minority interest $ 284.9 $ 321.1 Income taxes (51.1) (78.5) Minority Interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (14.5) Equity in earnings -- (31.6) - -------------------------------------------------------------------------------- Income from continuing operations 217.8 196.5 (Loss) income from operations of discontinued business (13.5) 16.6 - -------------------------------------------------------------------------------- Net income $ 204.3 $ 213.1 - -------------------------------------------------------------------------------- PER SHARE DATA Basic Income from continuing operations $ 3.64 $ 3.59 Weighted average shares outstanding 59.9 54.7 Diluted Income from continuing operations $ 3.61 $ 3.59 Weighted average shares outstanding 60.3 54.8 ================================================================================ 4. ================================================================================ Significant Transactions During March 1999, the Company completed the repurchase of $200.0 million of its issued common stock under its October, 1998 repurchase program authorized by the Board of Directors of AFC. On March 23, 1999, the Board of Directors of AFC authorized the repurchase of up to an additional $200.0 million of its issued common stock. As of December 31, 1999, under this additional program, the Company had repurchased 2.2 million shares of its common stock for an aggregate cost of approximately $132.9 million. Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for the Company's property and casualty business, and is subject to cancellation or commutation annually at the Company's option. The program covers losses and allocated loss adjustment expenses, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. The annual and aggregate coverage limits for losses and allocated LAE are $150.0 million and $300.0 million, respectively. The effect of this agreement on results of operations in each reporting period is based on losses and allocated LAE ceded, reduced by a sliding scale premium of 50.0-67.0% depending on the size of the loss, and increased by a ceding commission of 20.0% of ceded premium. In addition, net investment income is reduced for amounts credited to the reinsurer. As a result of this agreement, the Company recognized a net benefit of $15.9 million for the year ended December 31, 1999, based on annual estimates of losses and allocated loss adjustment expenses for accident year 1999. In accordance with the provisions of this contract, the Company has exercised its option to cancel this contract effective January 1, 2000. On October 29, 1998, the Company announced that it had adopted a formal restructuring plan for its Risk Management business. As part of this initiative, the segment consolidated its property and casualty field support activities from fourteen regional branches into three hub locations. As a result of the Company's restructuring initiative, it recognized a pretax loss of $9.0 million in the fourth quarter of 1998. Approximately $4.8 million of this loss relates to severance and other employee related costs resulting from the elimination of 306 positions, of which 207 and 106 employees had been terminated as of December 31, 1999 and 1998, respectively. In addition, lease cancellations and contract terminations resulted in losses of approximately $2.5 million and $1.7 million, respectively. During 1999, this loss was reduced by $1.9 million, relating to severance and other employee related costs, resulting from the reinstatement of 66 positions. The Company made payments of approximately $4.7 million and $0.1 million in 1999 and 1998, respectively, related to this restructuring initiative. Effective July 1, 1998, the Company entered into a reinsurance agreement with a highly rated reinsurer that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the Company's reinsurance pool business. These pools consist primarily of the Company's assumed stop loss business, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. The agreement is consistent with management's decision to exit this line of business, which the Company expects to run-off over the next three years. As a result of this transaction, the Company recognized a $25.3 million pre-tax loss in the third quarter of 1998. This loss is reported in 1999 as part of the discontinued operations of the Company. 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 blocks of business. The agreement did not have a material effect on its results of operations or financial position. 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 recognized 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 39 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 with a highly rated reinsurer. 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 of Series A Capital Securities ("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 July 16, 1997 acquisition. 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. 5. ================================================================================ 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 1999 ================================================================================ (In millions) Gross Gross Amortized Unrealized Unrealized Fair Cost(1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 185.0 $ 2.6 $ 2.0 $ 185.6 States and political subdivisions 2,189.8 26.3 78.5 2,137.6 Foreign governments 89.0 3.1 0.2 91.9 Corporate fixed maturities 4,211.9 73.8 175.1 4,110.6 Mortgage-backed securities 419.3 1.8 13.0 408.1 - -------------------------------------------------------------------------------- Total fixed maturities $7,095.0 $ 107.6 $ 268.8 $6,933.8 ================================================================================ Equity securities $ 49.5 $ 35.1 $ 1.4 $ 83.2 ================================================================================ December 31 1998 ================================================================================ (In millions) Gross Gross Amortized Unrealized Unrealized Fair Cost(1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 194.5 $ 12.1 $ 24.6 $ 182.0 States and political subdivisions 2,408.9 83.0 5.2 2,486.7 Foreign governments 107.9 7.7 4.5 111.1 Corporate fixed maturities 4,340.5 168.4 83.4 4,425.5 Mortgage-backed securities 566.4 11.9 2.8 575.5 - -------------------------------------------------------------------------------- Total fixed maturities $7,618.2 $ 283.1 $ 120.5 $7,780.8 ================================================================================ Equity securities $ 253.1 $ 151.1 $ 7.1 $ 397.1 ================================================================================ (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, 1999, the amortized cost and market value of these assets on deposit in New York were $196.4 million and $193.0 million, respectively. At December 31, 1998, the amortized cost and market value of assets on deposit were $268.5 million and $284.1 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $112.7 million and $105.4 million were on deposit with various state and governmental authorities at December 31, 1999 and 1998, respectively. There were no contractual fixed maturity investment commitments at December 31, 1999. 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 1999 ================================================================================ (In millions) Amortized Fair Cost Value Due in one year or less $ 424.3 $ 423.3 Due after one year through five years 2,238.1 2,213.9 Due after five years through ten years 2,036.5 1,950.4 Due after ten years 2,396.1 2,346.2 - -------------------------------------------------------------------------------- Total $7,095.0 $6,933.8 ================================================================================ 40 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 1999 Maturities and Other(1) Total Net appreciation, beginning of year $ 81.9 $ 98.6 $ 180.5 - -------------------------------------------------------------------------------- Net depreciation on available-for-sale securities (352.7) (119.6) (472.3) Net appreciation from the effect on deferred policy acquisition costs and on policy liabilities 78.5 -- 78.5 Benefits for deferred federal income taxes 95.3 42.7 138.0 - -------------------------------------------------------------------------------- (178.9) (76.9) (255.8) - -------------------------------------------------------------------------------- Net (depreciation) appreciation, end of year $ (97.0) $ 21.7 $ (75.3) ================================================================================ 1998 Net appreciation, beginning of year $ 133.3 $ 84.6 $ 217.9 - -------------------------------------------------------------------------------- Net depreciation on available-for-sale securities (108.8) (1.5) (110.3) Purchased minority interest related to the acquisition of minority interest in Citizens 10.7 10.7 21.4 Net depreciation from the effect on deferred policy acquisition costs and on policy liabilities 6.2 -- 6.2 Benefit for deferred federal income taxes and minority interest 40.5 4.8 45.3 - -------------------------------------------------------------------------------- (51.4) 14.0 (37.4) - -------------------------------------------------------------------------------- Net appreciation, end of year $ 81.9 $ 98.6 $ 180.5 ================================================================================ 1997 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 ================================================================================ (1) Includes net (depreciation) appreciation on other investments of $(5.1) million, $0.8 million, and $1.8 million in 1999, 1998 and 1997, respectively. B. Mortgage Loans and Real Estate AFC's mortgage loans and real estate are diversified by property type and location. Real estate investments have been obtained primarily through foreclosure. Mortgage loans are collateralized by the related properties and generally are no more than 75% of the property's value at the time the original loan is made. The carrying values of mortgage loans and real estate investments net of applicable reserves were $533.8 million and $582.7 million at December 31, 1999 and 1998, respectively. Reserves for mortgage loans were $5.8 million and $11.5 million at December 31, 1999 and 1998, respectively. During 1997, the Company committed to a plan to dispose of all real estate assets. At December 31, 1999 there were 4 properties remaining in the Company's real estate portfolio which are being actively marketed. 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 1999, 1998 and 1997. There were no material contractual commitments to extend credit under commercial mortgage loan agreements at December 31, 1999. Mortgage loans and real estate investments comprised the following property types and geographic regions: December 31 1999 1998 ================================================================================ (In millions) Property type: Office building $ 301.5 $ 304.4 Residential 50.5 52.8 Retail 92.2 108.5 Industrial / warehouse 83.6 110.0 Other 11.8 18.5 Valuation allowances (5.8) (11.5) - -------------------------------------------------------------------------------- Total $ 533.8 $ 582.7 ================================================================================ Geographic region: South Atlantic $ 132.2 $ 136.1 Pacific 133.6 155.1 East North Central 62.7 80.5 Middle Atlantic 50.3 61.2 New England 90.8 60.7 West South Central 40.7 54.7 Other 29.3 45.9 Valuation allowances (5.8) (11.5) - -------------------------------------------------------------------------------- Total $ 533.8 $ 582.7 ================================================================================ 41 At December 31, 1999, scheduled mortgage loan maturities were as follows: 2000 - $108.1 million; 2001 - $33.9 million; 2002 - $27.5 million; 2003 - $40.6 million; 2004 - $76.4 million and $234.7 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 1999, the Company did not refinance any mortgage loans based on terms which differed from those granted to new borrowers. C. Investment Valuation Allowances Investment valuation allowances which have been deducted in arriving at investment carrying values as presented in the Consolidated Balance Sheets and changes thereto are shown below. For the Years Ended December 31 ================================================================================ (In millions) Balance at Balance at January 1 Provisions Write-offs December 31 1999 Mortgage loans $ 11.5 $ (2.4) $ 3.3 $ 5.8 ================================================================================ 1998 Mortgage loans $ 20.7 $ (6.8) $ 2.4 $ 11.5 ================================================================================ 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 ================================================================================ Provisions on mortgages during 1999 and 1998 reflect the release of redundant specific reserves. Write-offs of $20.9 million to the investment valuation allowance related to real estate in 1997 primarily reflect write downs to the estimated fair value less costs to sell pursuant to the aforementioned 1997 plan of disposal. The carrying value of impaired loans was $18.0 million and $22.0 million, with related reserves of $0.8 million and $6.0 million as of December 31, 1999 and 1998, respectively. All impaired loans were reserved for as of December 31, 1999 and 1998. The average carrying value of impaired loans was $21.0 million, $26.1 million and $30.8 million, with related interest income while such loans were impaired, of $2.1 million, $3.2 million and $3.2 million as of December 31, 1999, 1998 and 1997, 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") and other funding agreements. 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 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. The notional amount of futures contracts outstanding was $37.1 million and $92.7 million, at December 31, 1999 and 1998, respectively. The notional amounts of the contracts represent the extent of the Company's investment but not future cash requirements, as the Company generally settles open positions prior to maturity. The maturity of all futures contracts outstanding are less than one year. The fair value of futures contracts outstanding was $36.8 million and $92.5 million at December 31, 1999 and 1998, respectively. Gains and losses on hedge contracts related to interest rate fluctuations are deferred and recognized in income over the period being hedged corresponding to related guaranteed investment contracts. 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. Deferred hedging losses were $0.9 million and $1.8 million in 1999 and 1998, respectively. Gains and losses on hedge contracts that are deemed ineffective by the Company are realized immediately. There was $0.1 million of gains realized on ineffective hedges in 1998. There were no gains or losses in 1999 and 1997. A reconciliation of the notional amount of futures contracts is as follows: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Contracts outstanding, beginning of year $ 92.7 $ -- $ (40.0) New contracts 947.0 1,117.5 (6.5) Contracts expired (1,002.6) (1,024.8) 46.5 - -------------------------------------------------------------------------------- Contracts outstanding, end of year $ 37.1 $ 92.7 $ -- ================================================================================ 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. Additionally, in 1999, the Company entered into a foreign currency swap contract to hedge foreign currency exposure on specific fixed rate trust obligations backed by funding agreements. Interest and principal related to foreign fixed income securities and trust obligations 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 42 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 $(4.7) million and $1.2 million at December 31, 1999 and 1998, respectively. Changes in the fair value of contracts hedging fixed income securities are reported as an unrealized gain or loss, consistent with the underlying hedged security. Changes in fair value of contracts hedging fixed rate trust obligations backed by funding agreements are reported as other operating income, consistent with the underlying hedged liability. The net decrease in other operating income related to these contracts was $2.6 million in 1999. 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 1999, 1998 and 1997. 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 1999 or 1998. A reconciliation of the notional amount of foreign currency swap contracts is as follows: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Contracts outstanding, beginning of year $ 42.6 $ 42.6 $ 47.6 New contracts 52.9 -- 5.0 Contracts expired (24.0) -- (10.0) - -------------------------------------------------------------------------------- Contracts outstanding, end of year $ 71.5 $ 42.6 $ 42.6 ================================================================================ Expected maturities of such foreign currency swap contracts outstanding at December 31, 1999 are $8.3 million in 2000, $52.9 million in 2001, and $10.3 million thereafter. There are no expected maturities of such foreign currency swap contracts in 2002, 2003 and 2004. F. Interest Rate Swap Contracts The Company enters into interest rate swap contracts to hedge exposure to interest rate fluctuations. Specifically, for floating rate funding agreement liabilities that are matched with fixed rate securities, the Company manages the interest rate risk by hedging with interest rate swap contracts. 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, 1999 and 1998 were net payables of $4.2 million, and $3.9 million, respectively. 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 in net investment income related to interest rate swap contracts was $7.2 million, $2.8 million and $0.4 million for the years ended December 31, 1999, 1998 and 1997, respectively. The fair value of interest rate swap contracts outstanding was $33.2 million and $(28.3) million at December 31, 1999 and 1998, respectively. 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 1999 or 1998. A reconciliation of the notional amount of interest rate swap contracts is as follows: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Contracts outstanding, beginning of year $1,112.6 $ 244.1 $ 5.0 New contracts 905.4 873.5 244.7 Contracts terminated (888.5) -- -- Contracts expired (80.0) (5.0) (5.6) - -------------------------------------------------------------------------------- Contracts outstanding, end of year $1,049.5 $1,112.6 $ 244.1 ================================================================================ Expected maturities of such interest rate swap contracts outstanding at December 31, 1999 are $44.0 million in 2000, $43.1 million in 2001, $83.5 million in 2002, $536.0 million in 2003, $319.3 million in 2004 and $23.6 million thereafter. G. Other Swap Contracts The Company enters into insurance portfolio-linked and credit default swap contracts for investment purposes. 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 insurance portfolio-linked swap contracts is the inability of the counterparty to meet its obligation. Under the terms of the credit default swap contracts, the Company assumes the default risk of a specific high credit quality issuer in exchange for a 43 stated annual premium. In the case of default, the Company will pay the counterparty par value for a pre-determined security of the issuer. The primary risk associated with these transactions is the default risk of the underlying companies. The Company regularly assesses the financial strength of its counterparties and the underlying companies in default swap contracts, and generally enters into forward or swap agreements with companies 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, 1999, 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 fair values of swap contracts outstanding were $(0.3) million and $(0.1) million at December 31, 1999 and 1998, respectively. The net amount receivable or payable under insurance portfolio-linked swap contracts is recognized when the contracts are marked to market. The net (decrease) increase in realized investment gains related to these contracts was $(0.2) million, $1.0 million, and $(1.4) million for the years ended December 31, 1999, 1998 and 1997, respectively. The stated annual premium under credit default swap contracts is recognized currently in net investment income. The net increase to investment income related to credit default swap contracts was $0.4 million and $0.2 million for the years ended December 31, 1999 and 1998, respectively. There was no net investment income recognized in 1997. A reconciliation of the notional amount of other swap contracts is as follows: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Contracts outstanding, beginning of year $ 255.0 $ 15.0 $ 58.6 New contracts 50.0 266.3 192.1 Contracts expired (115.0) (26.3) (211.6) Contracts terminated -- -- (24.1) - -------------------------------------------------------------------------------- Contracts outstanding, end of year $ 190.0 $ 255.0 $ 15.0 ================================================================================ Expected maturities of such other swap contracts outstanding at December 31, 1999 are as follows: $140.0 million in 2000 and $50.0 million in 2001. There are no expected maturities of other swap contracts in 2002, 2003, 2004 and thereafter. H. Other At December 31, 1999 and 1998, AFC had no concentration of investments in a single investee exceeding 10% of shareholders' equity. 6. ================================================================================ 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 1999 1998 1997 ================================================================================ (In millions) Fixed maturities $ 524.8 $ 517.9 $ 525.8 Mortgage loans 45.5 57.6 57.1 Equity securities 2.4 7.2 10.5 Policy loans 12.7 11.9 10.9 Real estate and other long-term investments 12.9 7.1 31.5 Short-term investments 33.1 17.7 19.0 - -------------------------------------------------------------------------------- Gross investment income 631.4 619.4 654.8 Less investment expenses (15.7) (15.0) (23.7) - -------------------------------------------------------------------------------- Net investment income $ 615.7 $ 604.4 $ 631.1 ================================================================================ At December 31, 1999, the Company had fixed maturities with a carrying value of $1.4 million on non-accrual status. There were no mortgage loans on non-accrual status at December 31, 1999. At December 31, 1998, there was one mortgage loan on non-accrual status which had an outstanding principal balance of $4.3 million. This loan was restructured and fully impaired. There were no fixed maturities on non-accrual status at December 31, 1998. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the investments, was a reduction in net income of $2.0 million in 1999, and had no impact in 1998 and 1997. 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 $18.8 million, $28.7 million and $40.3 million at December 31, 1999, 1998 and 1997, respectively. Interest income on restructured mortgage loans that would have been recorded in accordance with the original terms of such loans amounted to $2.5 million, $3.3 million and $3.9 million and in 1999, 1998 and 1997, respectively. Actual interest income on these loans included in net investment income aggregated $1.8 million, $3.3 million and $4.2 million in 1999, 1998 and 1997, respectively. There were no mortgage loans which were non-income producing for the year ended December 31, 1999. There were, however, fixed maturities with a carrying value of $2.0 million which were non-income producing for the year ended December 31, 1999. Included in other long-term investments is income from limited partnerships of $7.2 million in 1999, losses of $6.3 million in 1998, and income of $7.6 million in 1997. 44 B. Net Realized Investment Gains and Losses Realized gains (losses) on investments were as follows: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Fixed maturities $ (62.6) $ (13.3) $ 13.5 Mortgage loans 2.5 8.8 (1.2) Equity securities 141.8 63.7 53.1 Real estate 2.3 13.9 13.0 Other 7.0 (13.9) (2.4) - -------------------------------------------------------------------------------- Net realized investment gains $ 91.0 $ 59.2 $ 76.0 ================================================================================ 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 1999 Voluntary Sales Gains Losses Fixed maturities $1,884.3 $ 20.4 $37.5 Equity securities $ 420.1 $149.4 $ 7.6 ================================================================================ 1998 Fixed maturities $ 899.5 $ 13.5 $11.1 Equity securities $ 258.7 $ 72.8 $ 9.0 ================================================================================ 1997 Fixed maturities $1,948.3 $ 27.3 $15.9 Equity securities $ 144.9 $ 55.5 $ 1.2 ================================================================================ C. Other Comprehensive Income Reconciliation The following table provides a reconciliation of gross unrealized gains to the net balance shown in the Consolidated Statements of Comprehensive Income: For the Years Ended December 31 1999 1998 1997 ================================================================================ (In millions) Unrealized gains (losses) on securities: Unrealized holding (losses) gains arising during period, (net of taxes (benefit) and minority interest of $(108.0) million, $(20.7) million and $122.0 million in 1999, 1998 and 1997, respectively) $(200.0) $ (1.1) $125.5 Less: reclassification adjustment for gains included in net income (net of taxes and minority interest of $30.0 million, $24.6 million and $37.0 million in 1999, 1998 and 1997, respectively) 55.8 36.3 39.2 - -------------------------------------------------------------------------------- Other comprehensive (loss) income $(255.8) $(37.4) $ 86.3 ================================================================================ 7. ================================================================================ 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. Included in the fair value of fixed maturities are swap contracts used to hedge fixed maturities with a fair value of $31.1 million and $(27.1) million at December 31, 1999 and 1998, respectively. In addition, the Company held futures contracts with a carrying value of $(0.9) million and $(1.8) million at December 31, 1999 and 1998, respectively. The fair value of these contracts was $36.8 million and $92.5 million at December 31, 1999 and 1998, respectively. 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. 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. 45 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. Trust Instruments Supported by Funding Obligations Fair values 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. 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 Preferred 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. The estimated fair values of the financial instruments were as follows:
December 31 1999 1998 ======================================================================================================================= (In millions) Carrying Fair Carrying Fair Value Value Value Value Financial Assets Cash and cash equivalents $ 442.2 $ 442.2 $ 550.3 $ 550.3 Fixed maturities 6,933.8 6,933.8 7,780.8 7,780.8 Equity securities 83.2 83.2 397.1 397.1 Mortgage loans 521.2 521.9 562.3 587.1 Policy loans 170.5 170.5 154.3 154.3 - ----------------------------------------------------------------------------------------------------------------------- $8,150.9 $8,151.6 $9,444.8 $9,469.6 ======================================================================================================================= Financial Liabilities Guaranteed investment contracts $1,316.0 $1,341.4 $1,791.8 $1,830.8 Supplemental contracts without life contingencies 48.8 48.8 37.3 37.3 Dividend accumulations 88.1 88.1 88.4 88.4 Other individual contract deposit funds 48.4 48.2 61.6 61.1 Other group contract deposit funds 602.9 583.5 700.4 704.0 Individual fixed annuity contracts 1,092.5 1,057.1 1,110.6 1,073.6 Trust instruments supported by funding obligations 50.6 49.6 -- -- Short-term debt 45.0 45.0 221.3 221.3 Long-term debt 199.5 187.4 199.5 213.4 Mandatorily redeemable preferred securities of a subsidiary trust holding soley junior subordinated debentures of the Company 300.0 292.5 300.0 334.7 - ----------------------------------------------------------------------------------------------------------------------- $3,791.8 $3,741.6 $4,510.9 $4,564.6 =======================================================================================================================
46 8. ================================================================================ Closed Block Included in other income in the Consolidated Statements of Income in 1999, 1998 and 1997 is a net pre-tax contribution from the Closed Block of $13.8 million, $10.4 million and $9.1 million, respectively. Summarized financial information of the Closed Block as of December 31, 1999 and 1998 and for the periods ended December 31, 1999, 1998 and 1997 is as follows: December 31 1999 1998 ================================================================================ (In millions) Assets Fixed maturities, at fair value (amortized cost of $387.4 and $399.1, respectively) $ 372.9 $ 414.2 Mortgage loans 136.3 136.0 Policy loans 201.1 210.9 Cash and cash equivalents 22.6 9.4 Accrued investment income 14.0 14.1 Deferred policy acquisition costs 13.1 15.6 Other assets 12.3 2.9 - -------------------------------------------------------------------------------- Total assets $ 772.3 $ 803.1 ================================================================================ Liabilities Policy liabilities and accruals $ 835.2 $ 862.9 Other liabilities 6.9 9.1 - -------------------------------------------------------------------------------- Total liabilities $ 842.1 $ 872.0 ================================================================================ For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Revenues Premiums and other income $ 52.1 $ 55.4 $ 58.3 Net investment income 53.8 53.3 53.4 Realized investment (loss) gain (0.6) 0.1 1.3 - ------------------------------------------------------------------------------- Total revenues 105.3 108.8 113.0 =============================================================================== Benefits and expenses Policy benefits 88.9 95.0 100.5 Policy acquisition expenses 2.5 2.7 3.0 Other operating expenses 0.1 0.7 0.4 - ------------------------------------------------------------------------------- Total benefits and expenses 91.5 98.4 103.9 - ------------------------------------------------------------------------------- Contribution from the Closed Block $ 13.8 $ 10.4 $ 9.1 =============================================================================== Cash flows Cash flows from operating activities: Contribution from the Closed Block $ 13.8 $ 10.4 $ 9.1 Change in: Deferred policy acquisition costs, net 2.5 2.6 2.9 Premiums and other receivables -- 0.3 -- Policy liabilities and accruals (13.1) (13.5) (11.6) Accrued investment income 0.1 -- 0.2 Deferred taxes -- 0.1 (5.1) Other assets (8.3) 2.4 (2.9) Expenses and taxes payable (2.9) (2.9) (2.0) Other, net 0.8 (0.1) (1.2) - ------------------------------------------------------------------------------- Net cash used in operating activities (7.1) (0.7) (10.6) - ------------------------------------------------------------------------------- Cash flows from investing activities: Sales, maturities and repayments of investments 139.0 83.6 161.6 Purchases of investments (128.5) (106.5) (161.4) Other, net 9.8 7.9 11.4 - ------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 20.3 (15.0) 11.6 - ------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 13.2 (15.7) 1.0 Cash and cash equivalents, beginning of year 9.4 25.1 24.1 - ------------------------------------------------------------------------------- Cash and cash equivalents, end of year $ 22.6 $ 9.4 $ 25.1 =============================================================================== There were no valuation allowances on mortgage loans at December 31, 1999, 1998 and 1997, 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. 47 9. ================================================================================ Debt Short and long-term debt consisted of the following: December 31 1999 1998 ================================================================================ (In millions) Short-term Commercial paper $ 45.0 $ 41.3 Borrowings under bank credit facility -- 150.0 Repurchase agreements -- 30.0 - -------------------------------------------------------------------------------- Total short-term debt $ 45.0 $ 221.3 ================================================================================ Long-term Senior Debentures (unsecured) $ 199.5 $ 199.5 ================================================================================ AFC issues commercial paper primarily to manage imbalances between operating cash flows and existing commitments. Commercial paper borrowing arrangements are supported by a credit agreement. At December 31, 1999, the weighted average interest rate for outstanding commercial paper was approximately 5.27%. Effective May 28, 1999, the Company renewed a credit agreement entered into on May 28, 1998, which replaces lines of credit previously held by FAFLIC and Allmerica P&C, and provides for a $150.0 million credit facility, which expires on May 28, 2000. Borrowings under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. At December 31, 1999, the Company had approximately $150.0 million in committed lines of credit, all of which 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 0.08% of the available credit. Effective December 4, 1998, AFC entered into a credit agreement that expired on February 5, 1999. Borrowings under this agreement were unsecured and incurred interest at a rate per annum equal to the eurodollar rate plus applicable margin. Borrowings outstanding under this credit facility at December 31, 1998 were $150.0 million. These borrowings were repaid in February 1999. The Company utilizes repurchase agreements to finance certain transactions and had approximately $30.0 million in such agreements outstanding at December 31, 1998. There were no repurchase agreements outstanding at December 31, 1999. Senior Debentures of the Company have a $200.0 million face value, pay interest semiannually at a rate of 7 5/8%, and mature on October 16, 2025. 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 $22.0 million, $23.4 million and $21.7 million in 1999, 1998 and 1997, respectively. Interest expense included $15.3 million related to the Company's Senior Debentures for each year. Interest expense related to borrowings under the credit agreements were approximately $1.0 million, $0.7 million and $2.8 million in 1999, 1998, and 1997, respectively. All interest expense is recorded in other operating expenses. 10. ================================================================================ 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 1999 1998 1997 ================================================================================ (In millions) Federal income tax expense (benefit) Current $ 88.1 $ 72.5 $ 70.8 Deferred 18.8 (16.4) 13.9 - -------------------------------------------------------------------------------- Total $ 106.9 $ 56.1 $ 84.7 ================================================================================ 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 statutory federal income tax rate. The sources of the difference and the tax effects of each were as follows: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Expected federal income tax expense $ 163.8 $ 104.9 $ 119.0 Tax-exempt interest (37.4) (38.9) (37.9) Dividend received deduction (3.8) (5.1) (3.2) Changes in tax reserve estimates (8.7) 2.3 7.8 Tax credits (8.5) (8.5) (2.7) Other, net 1.5 1.4 1.7 - ------------------------------------------------------------------------------- Federal income tax expense $ 106.9 $ 56.1 $ 84.7 =============================================================================== 48 The deferred income tax (asset) liability represents the tax effects of temporary differences attributable to the Company's consolidated federal tax return group. Its components were as follows: December 31 1999 1998 =============================================================================== (In millions) Deferred tax (assets) liabilities AMT carryforwards $ (17.1) $ (16.8) Loss reserve discounting (439.9) (406.6) Deferred acquisition costs 414.2 345.8 Employee benefit plans (47.4) (45.3) Investments, net (30.1) 121.6 Discontinued operations (11.7) -- Bad debt reserve (2.1) (1.8) Litigation reserves (6.0) (10.9) Other, net (1.6) (5.8) - ------------------------------------------------------------------------------- Deferred tax asset, net $(141.7) $ (19.8) =============================================================================== Gross deferred income tax assets totaled $716.6 million and $538.2 million at December 31, 1999 and 1998, respectively. Gross deferred income tax liabilities totaled $574.9 million and $518.4 million at December 31, 1999 and 1998, 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, 1999, there are available alternative minimum tax credit carryforwards of $17.1 million. The Company's federal income tax returns are routinely audited by the IRS, and provisions are routinely made in the financial statements in anticipation of the results of these audits. The IRS has examined the FAFLIC/AFLIAC consolidated group's federal income tax returns through 1994. The IRS has also examined the former Allmerica P&C consolidated group's federal income tax returns through 1994. The Company has appealed certain adjustments proposed by the IRS with respect to the federal income tax returns for 1992, 1993 and 1994 for the FAFLIC/AFLIAC 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. 11. ================================================================================ Pension Plans AFC provides retirement benefits to substantially all of its employees under a defined benefit pension plan. This plan is based on a defined benefit cash balance formula, whereby 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 1999, 1998 and 1997 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 periodic pension cost were as follows: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Service cost - benefits earned during the year $ 19.3 $ 19.0 $ 19.9 Interest cost 26.5 25.5 23.5 Expected return on plan assets (38.9) (34.9) (31.2) Recognized net actuarial loss 0.4 0.4 0.1 Amortization of transition asset (1.4) (1.8) (1.9) Amortization of prior service cost (2.2) (1.7) (2.0) - ------------------------------------------------------------------------------- Net periodic pension cost $ 3.7 $ 6.5 $ 8.4 =============================================================================== The following table summarizes the status of the plan. At December 31, 1999 and 1998, the plans' assets exceeded their projected benefit obligations. December 31 1999 1998 =============================================================================== (In millions) Change in benefit obligations: Projected benefit obligation at beginning of year $ 414.2 $ 370.4 Service cost - benefits earned during the year 19.3 19.0 Interest cost 26.5 25.5 Actuarial (gains) losses (44.4) 20.4 Benefits paid (22.9) (21.1) - ------------------------------------------------------------------------------- Projected benefit obligation at end of year 392.7 414.2 - ------------------------------------------------------------------------------- Change in plan assets: Fair value of plan assets at beginning of year 441.6 395.5 Actual return on plan assets 51.9 67.2 Benefits paid (22.9) (21.1) - ------------------------------------------------------------------------------- Fair value of plan assets at end of year 470.6 441.6 - ------------------------------------------------------------------------------- Funded status of the plan 77.9 27.4 Unrecognized transition obligation (21.6) (23.9) Unamortized prior service cost (12.0) (11.0) Unrecognized net actuarial gains (101.6) (54.9) - ------------------------------------------------------------------------------- Net pension liability $ (57.3) $ (62.4) =============================================================================== 49 As a result of the Company's merger with Allmerica P&C, certain pension liabilities were reduced to reflect their fair value as of the merger date. These pension liabilities were reduced by $8.9 million and $10.3 million in 1999 and 1998, respectively, which reflects fair value, net of applicable amortization. Determination of the projected benefit obligations was based on a weighted average discount rate of 7.75% and 6.5% in 1999 and 1998, respectively, and the assumed long-term rate of return on plan assets was 9.0% in both 1999 and 1998. 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 796,462 shares and 973,262 shares of AFC Common Stock at December 31, 1999 and 1998, respectively, with a market value of $44.3 million and $56.3 million at December 31, 1999 and 1998, respectively. The Company has a defined contribution 401(k) plan for its employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum percentage determined annually by the Board of Directors. During 1999, 1998 and 1997, the Company matched 50% of employees' contributions up to 6.0% of eligible compensation. The total expense related to this plan was $5.9 million, $5.6 million and $3.3 million in 1999, 1998 and 1997, respectively. In addition to this plan, the Company has a defined contribution plan for substantially all of its agents. The Plan expense in 1999, 1998 and 1997 was $3.1 million, $3.0 million and $2.8 million, respectively. 12. ================================================================================ 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 a plan sponsored by FAFLIC. 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 plans' funded status reconciled with amounts recognized in the Company's Consolidated Balance Sheets were as follows: December 31 1999 1998 =============================================================================== (In millions) Change in benefit obligations: Accumulated postretirement benefit obligation at beginning of year $ 84.0 $ 71.8 Service cost 2.9 3.1 Interest cost 4.6 5.1 Actuarial (gains) losses (21.2) 7.6 Benefits paid (3.5) (3.6) - ------------------------------------------------------------------------------- Accumulated postretirement benefit obligation at end of year 66.8 84.0 - ------------------------------------------------------------------------------- Fair value of plan assets at end of year -- -- =============================================================================== Funded status of the plan (66.8) (84.0) Unamortized prior service cost (9.8) (12.9) Unrecognized net actuarial (gains) losses (13.8) 7.5 - ------------------------------------------------------------------------------- Accumulated postretirement benefit costs $ (90.4) $ (89.4) =============================================================================== The components of net periodic postretirement benefit cost were as follows: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Service cost $ 2.9 $ 3.1 $ 3.0 Interest cost 4.6 5.1 4.6 Recognized net actuarial loss (gain) 0.1 0.1 (0.1) Amortization of prior service cost (2.3) (2.4) (2.7) - ------------------------------------------------------------------------------- Net periodic postretirement benefit cost $ 5.3 $ 5.9 $ 4.8 =============================================================================== As a result of the Company's merger with Allmerica P&C, certain postretirement liabilities were reduced to reflect their fair value as of the merger date. These postretirement liabilities were reduced by $4.6 million and $5.4 million in 1999 and 1998, respectively, which reflects fair value, net of applicable amortization. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 1999, health care costs were assumed to increase 6.0% in 2000, 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, 1999 by $4.1 million, and the aggregate of the service and interest cost com- 50 ponents of net periodic postretirement benefit expense for 1999 by $0.6 million. Conversely, decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation at December 31, 1999 by $3.6 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 1999 by $0.5 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.75% and 6.5% at December 31, 1999 and 1998, respectively. In addition, the actuarial present value of the accumulated postretirement benefit obligation was determined using an assumed rate of increase in future compensation levels of 5.5% for FAFLIC agents. 13. ================================================================================ 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 $286.5 million and $5.17 per share-diluted ($5.21 per share-basic) in 1999, $194.4 million and $3.23 per share-diluted ($3.25 per share-basic) in 1998, and $206.0 million and $3.76 per share ($3.77 per share-basic) in 1997. 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 5,166,597 shares as of December 31, 1999, 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. 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:
1999 1998 1997 ========================================================================================================================== (In whole shares and dollars) Weighted Weighted Weighted Average Average Average Options Exercise Price Options Exercise Price Options Exercise Price Outstanding at beginning of year 1,746,239 $42.39 1,075,044 $33.45 209,500 $27.50 Granted 1,286,917 52.39 807,511 54.06 849,500 35.64 Converted from Allmerica P&C merger -- -- -- -- 114,509 27.40 Converted from Citizens acquisition -- -- 38,976 28.27 -- -- Exercised 63,150 37.09 61,693 31.34 16,021 27.23 Forfeited 176,227 29.03 113,599 41.85 82,444 33.74 - -------------------------------------------------------------------------------------------------------------------------- Outstanding at end of year 2,793,779 $46.76 1,746,239 $42.39 1,075,044 $33.45 ========================================================================================================================== Options exercisable at end of year 546,521 $38.41 240,384 $32.61 57,116 $27.38 ==========================================================================================================================
51 No options expired during 1999, 1998, or 1997. The fair value of each option is estimated on the date of grant or date of conversion using the Black-Scholes option-pricing model. For options granted through 1999, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of options granted in 1999, 1998 and 1997 was $20.97 per share, $23.68 per share, and $15.02 per share, respectively. For options converted pursuant to the acquisition of the minority interest in Citizens Corporation and Allmerica P&C, the exercise price was less than the fair value of the stock on the conversion date. The weighted average fair values of these options were $27.87 and $28.24 per share, respectively. The following significant assumptions were used to determine fair value for 1999 options granted and converted: Weighted Average Assumptions for Options Awarded during 1999 1998 1997 ================================================================================ Dividend yield 0.6% 0.4% 0.5% Expected volatility 40.69% 47.49% 31.52% Risk-free interest rate 5.70% 4.84% 5.66% to 6.19% Expected lives range (in years) 2.5 to 7 2.5 to 7 2.5 to 7 The following table summarizes information about employee options outstanding and exercisable at December 31, 1999.
Options Outstanding Options Currently Exercisable Weighted Average Weighted Weighted Remaining Average Average Number Contractual Lives Exercise Price Number Exercise Price ============================================================================================================= Range of Exercise Prices $24.50 to $30.66 252,929 6.23 $27.56 152,127 $27.39 $35.375 to $50.00 656,786 7.43 $35.98 245,806 $35.74 $51.00 to $52.50 1,157,585 9.09 $52.07 250 $52.06 $52.625 to $68.25 726,479 8.28 $54.73 148,338 $54.12
During 1999, 1998 and 1997 the Company granted shares of nonvested stock to eligible employees, which vest after three years of continuous employment. During 1999, the Company also granted shares of nonvested stock to certain agents, which vest 60% after three years, and 20% per year thereafter. The following table summarizes information about employee and agent nonvested stock. Stock Awards 1999 1998 1997 ================================================================================ Common stock granted 66,710 237,394 68,127 Weighted average fair value per share at the date of grant $ 52.06 $ 37.21 $ 34.13 The Company recognizes compensation expense related to nonvested shares over the vesting period on a pro rata basis. As a result, the Company recognized $4.3 million, $3.3 million and $0.7 million of compensation cost in 1999, 1998 and 1997 respectively. 14. ================================================================================ Earnings Per Share The following table provides share information used in the calculation of the Company's basic and diluted earnings per share: December 31 1999 1998 1997 ================================================================================ (In millions, except per share data) Basic shares used in the calculation of earnings per share 55.0 59.9 54.7 Dilutive effect of securities: Employee stock options 0.3 0.3 0.1 Non-vested stock grants 0.2 0.1 -- - -------------------------------------------------------------------------------- Diluted shares used in the calculation of earnings per share 55.5 60.3 54.8 ================================================================================ Per share effect of dilutive securities on income from continuing operations $0.06 $0.03 $0.01 ================================================================================ Per share effect of dilutive securities on net income $0.05 $0.03 $0.01 ================================================================================ Options to purchase 729,363 shares, 97,500 shares and 7,742 shares of common stock were outstanding during 1999, 1998 and 1997, respectively, but were not included in the computation of diluted earnings because the option's exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. 52 15. ================================================================================ 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. During 1999 and 1997, no dividends were declared by FAFLIC to AFC. During 1998, FAFLIC paid dividends of $50.0 million to AFC. As of July 1, 1999, FAFLIC's ownership of Allmerica P&C, as well as several non-insurance subsidiaries, was transferred from FAFLIC to AFC. Under an agreement with the Commonwealth of Massachusetts Insurance Commissioner any dividend from FAFLIC to AFC for years 2000 and 2001 would require the prior approval of the Commissioner and may require AFC to make additional capital contributions to FAFLIC. 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 1999, 1998 or 1997. During 2000, AFLIAC could pay dividends of $34.3 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 $350.0 million, $125.0 million and $120.0 million during 1999, 1998 and 1997, respectively. Included in these amounts were extraordinary dividends totaling $225.0 million and $125.0 million in 1999 and 1998, respectively, which were approved by the Commissioner. Prior to April 2000, Hanover can declare no dividends to Allmerica P&C without prior approval of the New Hampshire Insurance Commissioner. The allowable dividend without prior approval will increase to approximately $108.6 million on April 1, 2000. 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 declared dividends to Citizens Corporation totaling $200.0 million during both 1999 and 1998. Included in these amounts were extraordinary dividends totaling $200.0 million and $180.0 million in 1999 and 1998, respectively, which were approved by the Commissioner. No dividends were declared by Citizens in 1997. Prior to April 2000, Citizens can declare no dividends to Citizens Corporation without prior approval of the Michigan Insurance Commissioner. The allowable dividend without prior approval will increase to approximately $120.8 million on April 1, 2000. 16. ================================================================================ Segment Information The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services, and Allmerica Asset Management. In accordance with Statement No. 131, the separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. In 1999, the Company reorganized its Property and Casualty business and Corporate Risk Management Services operations within the Risk Management segment. Under the new structure, the Risk Management segment manages its business through five distribution channels identified as Hanover North, Hanover South, Citizens Midwest, Allmerica Voluntary Benefits and Allmerica Specialty. During the second quarter of 1999, the Company approved a plan to exit its group life and health business, consisting of its EBS business, its AGU business and its reinsurance pool business. Results of operations from this business, relating to both the current and the prior periods, have been segregated and reported as a component of discontinued operations in the Consolidated Statements of Income. Operating results from this business were previously reported in the 53 Allmerica Voluntary Benefits and Allmerica Specialty distribution channels. Prior to 1999, results of the group life and health business were included in the Corporate Risk Management Services segment, while all other Risk Management business was reflected in the Property and Casualty segment. The Risk Management segment's property and casualty business is offered primarily through the Hanover North, Hanover South and Citizens Midwest distribution channels utilizing the Company's independent agent network primarily in the Northeast, Midwest and Southeast United States, maintaining a strong regional focus. Allmerica Voluntary Benefits focuses on worksite distribution, which offers discounted property and casualty products through employer sponsored programs, and affinity group property and casualty business. Allmerica Specialty offers special niche property and casualty products in selected markets. The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in GICs such as the traditional GIC, synthetic GIC and other funding agreements. Funding agreements are investment contracts issued to institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs, which typically have short maturities and periodic interest rate resets based on an index such as LIBOR. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. Management evaluates the results of the aforementioned segments based on a pre-tax and minority interest basis. Segment income is determined by adjusting net income for net realized investment gains and losses, net gains and losses on disposals of businesses, discontinued operations, extraordinary items, the cumulative effect of accounting changes and certain other items which management believes are not indicative of overall operating trends. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of segment income enhances understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. Summarized below is financial information with respect to business segments: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Segment revenues: Risk Management $2,189.4 $2,222.1 $2,227.6 Asset Accumulation Allmerica Financial Services 806.3 724.0 713.9 Allmerica Asset Management 150.5 121.7 91.1 - ------------------------------------------------------------------------------- Subtotal 956.8 845.7 805.0 - ------------------------------------------------------------------------------- Corporate 6.0 12.9 16.1 Intersegment revenues (5.9) (7.6) (11.5) - ------------------------------------------------------------------------------- Total segment revenues including Closed Block 3,146.3 3,073.1 3,037.2 - ------------------------------------------------------------------------------- Adjustments to segment revenues: Adjustment for Closed Block (92.1) (98.3) (102.6) Change in mortality assumptions -- -- (4.2) Net realized gains 91.0 59.2 76.0 - ------------------------------------------------------------------------------- Total revenues $3,145.2 $3,034.0 $3,006.4 =============================================================================== Segment income (loss) before income taxes and minority interest: Risk Management $ 199.6 $ 149.6 $ 174.2 Asset Accumulation Allmerica Financial Services 205.5 169.0 134.6 Allmerica Asset Management 23.5 23.7 18.4 - ------------------------------------------------------------------------------- Subtotal 229.0 192.7 153.0 - ------------------------------------------------------------------------------- Corporate (59.3) (50.9) (48.0) - ------------------------------------------------------------------------------- Segment income before income taxes and minority interest 369.3 291.4 279.2 - ------------------------------------------------------------------------------- Adjustments to segment income: Net realized investment gains, net of amortization 96.8 49.5 75.9 Sales practice litigation expense -- (31.0) -- Gain from change in mortality assumptions -- -- 47.0 Loss on cession of disability income business -- -- (53.9) Restructuring costs 1.9 (9.0) -- Other items -- (0.8) (8.2) - ------------------------------------------------------------------------------- Income from continuing operations before federal income taxes and minority interest $ 468.0 $ 300.1 $ 340.0 =============================================================================== 54 December 31 1999 1998 1999 1998 ================================================================================ (In millions) Identifiable Assets Deferred Acquisition Costs Risk Management $ 5,869.0 $ 6,219.0 $ 173.3 $ 167.5 Asset Accumulation Allmerica Financial Services 23,435.7 19,461.8 1,213.1 993.1 Allmerica Asset Management 1,387.6 1,810.9 0.4 0.6 - -------------------------------------------------------------------------------- Subtotal 24,823.3 21,272.7 1,213.5 993.7 Corporate 77.3 161.4 -- -- - -------------------------------------------------------------------------------- Total $30,769.6 $27,653.1 $ 1,386.8 $ 1,161.2 ================================================================================ 17. ================================================================================ Lease Commitments Rental expenses for operating leases, including those related to the discontinued operations of the Company, amounted to $33.2 million, $34.9 million and $33.6 million in 1999, 1998 and 1997, respectively. These expenses relate primarily to building leases of the Company. At December 31, 1999, future minimum rental payments under non-cancelable operating leases were approximately $70.1 million, payable as follows: 2000 - $27.0 million; 2001 - $20.7 million; 2002 - $12.9 million; 2003 - $6.5 million; and $3.0 million thereafter. It is expected that, in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment; thus, it is anticipated that future minimum lease commitments may not be less than the amounts shown for 2000. 18. ================================================================================ Reinsurance In the normal course of business, the Company seeks to reduce the losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance transactions are accounted for in accordance with the provisions of 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. Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement with a highly rated insurer (See Note 4). The Company is subject to concentration of risk with respect to this reinsurance agreement, which represented 10% or more of the Company's reinsurance business at December 31, 1999. Net premiums earned and losses and loss adjustment expenses ceded under this agreement in 1999 were $21.9 million and $35.0 million, respectively. In addition, 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, 1999, CAR and MCCA represented 10% or more of the Company's reinsurance business. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to CAR. Net premiums earned and losses and loss adjustment expenses ceded to CAR in 1999, 1998 and 1997 were $42.8 million and $42.6 million, $34.3 million and $38.1 million, and $32.3 million and $28.2 million, respectively. The Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 1999, 1998 and 1997 of $3.7 million and $75.3 million, $3.7 million and $18.0 million, and $9.8 million and $(0.8) million, respectively. On June 2, 1998, the Company recorded a $124.2 million one-time reduction of its direct and ceded written premiums as a result of a return of excess surplus from MCCA. This transaction had no impact on the total net premiums recorded by the Company in 1998. 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. 55 The effects of reinsurance were as follows: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Life and accident and health insurance premiums: Direct $ 53.5 $ 51.4 $ 55.9 Assumed 0.7 0.7 0.6 Ceded (50.0) (47.8) (29.1) - ------------------------------------------------------------------------------- Net premiums $ 4.2 $ 4.3 $ 27.4 =============================================================================== Property and casualty premiums written: Direct $2,179.0 $1,970.4 $2,068.5 Assumed 67.3 58.8 103.1 Ceded (270.9) (74.1) (179.8) - ------------------------------------------------------------------------------- Net premiums $1,975.4 $1,955.1 $1,991.8 =============================================================================== Property and casualty premiums earned: Direct $2,135.0 $1,967.9 $2,046.2 Assumed 73.0 64.5 102.0 Ceded (261.7) (66.1) (195.1) - ------------------------------------------------------------------------------- Net premiums $1,946.3 $1,966.3 $1,953.1 =============================================================================== Life and accident and health insurance and other individual policy benefits, claims, losses and loss adjustment expenses: Direct $ 391.9 $ 359.5 $ 401.1 Assumed 0.1 0.3 0.4 Ceded (39.2) (49.5) (79.4) - ------------------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $ 352.8 $ 310.3 $ 322.1 =============================================================================== Property and casualty benefits, claims, losses and loss adjustment expenses: Direct $1,603.8 $1,589.2 $1,464.9 Assumed 61.7 62.7 101.2 Ceded (247.6) (158.2) (120.6) - ------------------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $1,417.9 $1,493.7 $1,445.5 =============================================================================== 19. ================================================================================ Deferred Policy Acquisition Costs The following reflects the changes to the deferred policy acquisition asset: For the Years Ended December 31 1999 1998 1997 =============================================================================== (In millions) Balance at beginning of year $1,161.2 $ 965.5 $ 822.7 Acquisition expenses deferred 612.8 638.2 601.0 Amortized to expense during the year (429.9) (449.6) (459.3) Adjustment for discontinued operations 3.4 (0.2) -- Adjustment to equity during the year 39.3 7.3 (11.1) 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 $1,386.8 $1,161.2 $ 965.5 =============================================================================== 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. 20. ================================================================================ 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 recorded in results of operations in the year such changes are determined to be needed. The liability for future policy benefits and outstanding claims, losses and loss adjustment expenses related to the Company's accident and health business was $601.3 million and $568.0 million at December 31, 1999 and 1998, respectively. Accident and health claim liabilities were re-estimated for all prior years and were increased by $51.2 million and $14.6 million in 1999 and 1998, respectively. The increase in 1999 resulted from the Company's reserve strengthening primarily in the EBS and reinsurance pool business. The 1998 increase also resulted from the Company's reserve strengthening primarily in the assumed reinsurance and stop loss only business. 56 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 1999 1998 1997 =============================================================================== (In millions) Reserve for losses and LAE, beginning of year $2,597.3 $2,615.4 $2,744.1 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,601.4 1,609.0 1,564.1 Decrease in provision for insured events of prior years (183.4) (127.2) (127.9) - ------------------------------------------------------------------------------- Total incurred losses and LAE 1,418.0 1,481.8 1,436.2 =============================================================================== Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 861.1 871.9 775.1 Losses and LAE attributable to insured events of prior years 638.0 643.0 732.1 - ------------------------------------------------------------------------------- Total payments 1,499.1 1,514.9 1,507.2 =============================================================================== Change in reinsurance recoverable on unpaid losses 102.5 15.0 (50.2) Other(1) -- -- (7.5) - ------------------------------------------------------------------------------- Reserve for losses and LAE, end of year $2,618.7 $2,597.3 $2,615.4 =============================================================================== (1) Includes purchase accounting adjustments. As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $183.4 million, $127.2 million and $127.9 million in 1999, 1998 and 1997, respectively, reflecting increased favorable development on reserves for both losses and loss adjustment expenses. Favorable development on prior years' loss reserves was $93.1 million, $58.9 million, and $87.2 million for the years ended December 31, 1999, 1998, and 1997, respectively. The increase of $34.2 million in 1999 is primarily due to improved personal automobile results in the Northeast and increased reinsurance recoverables in the commercial multiple peril line. Favorable development on prior year's loss adjustment expense reserves was $90.3 million, $68.3 million, and $40.7 million for the years ended December 31, 1999, 1998, and 1997, respectively. The increase in favorable development in both 1999 and 1998 is primarily attributable to claims process improvement initiatives taken by the Company over the past two years. The Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. This favorable development reflects the Company'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 Risk Management 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 $47.3 million, $49.9 million and $53.1 million, net of reinsurance of $11.2 million, $14.2 million and $15.7 million in 1999, 1998 and 1997, 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. 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 significant, their existence gives rise to uncertainty and is discussed because of the possibility, however remote, that they may become significant. 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. 21. ================================================================================ Minority Interest The Company's interest in Allmerica P&C is represented by ownership of 59.5% of the outstanding common stock prior to its merger with AFC on July 16, 1997. Allmerica P&C's interest in Citizens Corporation prior to the acquisition of minority interest completed on or about December 3, 1998, whereby Citizens Corporation became a wholly-owned subsidiary, and at December 31, 1997 was 83.2% and 82.5%, respectively. Minority interest at December 31, 1999 and 1998 also reflects the Company's issuance of Capital Securities (See Note 4). 57 22. ================================================================================ 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 on behalf of a putative class 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, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998. On May 19, 1999, the court issued an order certifying the class for settlement purposes and granting final approval of the settlement agreement. AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. 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. 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 resulted from computer programs being written using two digits rather than four to define the applicable year. 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 issue, there can be no assurance that exposure for material contingencies will not arise. 58 23. ================================================================================ Statutory Financial Information The Company's 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. In 1999, 49 out of 50 states have adopted the National Association of Insurance Commissioners proposed Codification, which provides for uniform statutory accounting principles. These principles are effective January 1, 2001. The Company is currently assessing the impact that the adoption of Codification will have on its insurance subsidiaries. Statutory net income and surplus are as follows: 1999 1998 1997 ================================================================================ (In millions) Statutory Net Income (Combined) Property and Casualty Companies $ 511.6 $ 180.7 $ 190.3 Life and Health Companies 239.0 86.4 191.2 - -------------------------------------------------------------------------------- Statutory Shareholders' Surplus (Combined) Property and Casualty Companies $1,089.1 $1,269.3 $1,279.6 Life and Health Companies 590.1 1,164.1 1,221.3 ================================================================================ As of July 1, 1999, FAFLIC transferred its remaining ownership in Allmerica P&C to AFC. At December 31, 1998 and 1997, the life and health companies' statutory surplus reflected interest in Allmerica P&C of approximately 70.0% and 66.0%, respectively. 24. ================================================================================ Quarterly Results of Operations (Unaudited) The quarterly results of operations for 1999 and 1998 are summarized below: For the Three Months Ended March 31 June 30 Sept. 30 Dec. 31 ================================================================================ (In millions, except per share data)) 1999 Total revenues $856.2 $764.8 $761.7 $762.5 Net income $154.1 $ 60.2 $ 13.1 $ 68.4 Net income per share: Basic $ 2.69 $ 1.10 $ 0.24 $ 1.26 Diluted $ 2.67 $ 1.09 $ 0.24 $ 1.25 Dividends declared per share $ -- $ -- $ 0.25 $ -- ================================================================================ 1998 Total revenues $762.7 $757.4 $745.0 $768.9 Net income $ 66.8 $ 60.3 $ 8.2 $ 65.9 Net income per share: Basic $ 1.11 $ 1.00 $ 0.14 $ 1.11 Diluted $ 1.11 $ 1.00 $ 0.13 $ 1.10 Dividends declared per share $ 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. 59 Allmerica Financial Corporation BOARD OF DIRECTORS Michael P. Angelini (a) Chairman and Partner, Bowditch & Dewey, LLP E. Gordon Gee (d) Chancellor-elect, Vanderbilt University Samuel J. Gerson (d) Chairman and Chief Executive Officer, Filene's Basement, Inc. Gail L. Harrison (a) Founding Principal, The Wexler Group Robert P. Henderson (c) General Partner, Greylock Management Corporation M Howard Jacobson (c) Senior Advisor and Consultant, Bankers Trust Private Bank Wendell J. Knox (a) President and Chief Executive Officer, Abt Associates Robert J. Murray (a) Chairman, President and Chief Executive Officer, New England Business Service, Inc. J. Terrence Murray (d) Chairman and Chief Executive Officer, FleetBoston Financial Corporation 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, LLP Herbert M. Varnum (c) Former Chairman and Chief Executive Officer, Quabaug Corporation (a) Audit Committee (c) Compensation Committee (d) Directors Committee OPERATING COMMITTEE Bruce C. Anderson Vice President, Corporate Services Mark R. Colborn Vice President, Operations Services J. Kendall Huber Vice President, General Counsel and Assistant Secretary John P. Kavanaugh Vice President, Chief Investment Officer John F. O'Brien President and Chief Executive Officer Edward J. Parry, III Vice President, Chief Financial Officer and Treasurer Richard M. Reilly President and Chief Executive Officer, Allmerica Financial Life Insurance and Annuity Company Robert P. Restrepo, Jr. President and Chief Executive Officer, Allmerica Property and Casualty Companies, Inc. Eric A. Simonsen President, Allmerica Services Corporation 60 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 16, 2000, at 9:00 a.m. at Allmerica Financial, 440 Lincoln Street, Worcester, Massachusetts. 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." As of the end of business on February 29, 2000, the Company had 48,075 shareholders of record. On the same date, the trading price of the Company's common stock closed at $41.75 per share. COMMON STOCK PRICES AND DIVIDENDS
1999 High Low Dividends - --------------------------------------------------------------------- First Quarter $57.88 $50.19 -- Second Quarter $62.25 $54.50 -- Third Quarter $64.44 $47.56 $0.25 Fourth Quarter $59.69 $46.50 -- 1998 High Low Dividends - --------------------------------------------------------------------- First Quarter $66.38 $42.31 $0.05 Second Quarter $72.13 $61.31 $0.05 Third Quarter $72.13 $57.31 $0.05 Fourth Quarter $57.88 $39.25 --
DIVIDENDS Allmerica Financial Corporation currently pays an annual cash dividend of $0.25 per share. IMSA Allmerica Financial is proud to be a charter member of the Insurance Marketplace Standards Association. The Association promotes high standards of conduct in the sale and servicing of individual life insurance and annuity products. Our membership demonstrates Allmerica's commitment to the high ethical standards and practices set forth in IMSA's Principles of Ethical Conduct and accompanying Code of Life Insurance Ethical Market Conduct. Membership in the association requires the successful completion of rigorous internal and independent, third party assessments, designed to determine whether Allmerica's policies and procedures satisfy IMSA's principles and codes. REGISTRAR AND STOCK TRANSFER AGENT First Chicago Trust Company of New York, A division of Equiserve, LP 525 Washington Boulevard Jersey City, NJ 07303-2512 (800) 317-4454 INDEPENDENT ACCOUNTANTS PricewaterhouseCoopers 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 -- Allmerica Financial Corporation Short Term Debt A1+ P1 -- First Allmerica Financial Life Insurance Company Short Term Debt A1+ P1 -- First Allmerica Financial Life Insurance Company Short Term Insurance Financial Strength Rating -- P1 --
TOLL-FREE INVESTOR INFORMATION LINE Call our toll-free investor information line, (800) 407-5222, to receive additional printed information, including Form 10-Ks or quarterly reports on Form 10-Q filed with the Securities and Exchange Commission, fax-on-demand services, access to shareholder services, prerecorded messages, and other services. Alternatively, investors may address questions to: Henry P. St. Cyr, CFA, Vice President, Investor Relations Allmerica Financial Corporation 440 Lincoln Street, Worcester, MA 01653 tel: (508) 855-2959 fax: (508) 853-4481 William J. Steglitz, CPA, Manager, Investor Relations tel: (508) 855-3883 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 WEB SITE Please visit our Internet site at http://www.allmerica.com EX-21 3 DIRECT AND INDIRECT SUBSIDIARIES Exhibit 21 - Direct and Indirect Subsidiaries of the Registrant I. Allmerica Financial Corporation (Delaware) A. Allmerica Asset Management, Inc. (Massachusetts) a. Allmerica Property & Casualty Companies, Inc. (Delaware) 1. Allmerica Financial Insurance Brokers, Inc. (Massachusetts) 2. Citizens Insurance Company of Illinois, Inc. (Illinois) 3. The Hanover Insurance Company (New Hampshire) a. Allmerica Financial Benefit Insurance Company (Pennsylvania) b. Allmerica Plus Insurance Agency, Inc. (Massachusetts) c. The Hanover American Insurance Company (New Hampshire) d. Hanover Texas Insurance Management Company, Inc. (Texas) e. Citizens Corporation (Delaware) 1. Citizens Insurance Company of Ohio (Ohio) 2. Citizens Insurance Company of America (Michigan) i. Citizens Management Inc. (Michigan) 3. Citizens Insurance Company of the Midwest (Indiana) f. AMGRO, Inc. (Massachusetts) 1. Lloyds Credit Corporation (Massachusetts) g. Massachusetts Bay Insurance Company (New Hampshire) h. Allmerica Financial Alliance Insurance Company (New Hampshire) b. Sterling Risk Management Services, Inc. (Delaware) c. Allmerica Benefits, Inc. (Florida) d. Allmerica Asset Management, Limited (Bermuda) B. Financial Profiles, Inc. (California) C. Allmerica, Inc. (Massachusetts) D. Allmerica Funding Corp. (Massachusetts) E. First Allmerica Financial Life Insurance Company (Massachusetts) a. Allmerica Trust Company, N.A. (Federally Chartered) (99.2% owned) b. Advantage Insurance Network, Inc. (Delaware) c. Allmerica Financial Life Insurance and Annuity Company (Delaware) 1. Allmerica Investments, Inc. (Massachusetts) 2. Allmerica Investment Management Company, Inc. (Massachusetts) 3. Allmerica Financial Investment Management Services, Inc. (Massachusetts) 4. Allmerica Financial Services Insurance Agency, Inc. (Massachusetts) 5. Allmerica Investments Insurance Agency, Inc. of Alabama (Alabama) 6. Allmerica Investments Insurance Agency of Florida, Inc. (Florida) 7. Allmerica Investment Insurance Agency, Inc. of Georgia (Georgia) 8. Allmerica Investment Insurance Agency, Inc. of Kentucky (Kentucky) 9. Allmerica Investments Insurance Agency, Inc. of Mississippi (Mississippi) F. AFC Capital Trust I (Delaware) G. Allmerica Services Corporation (Massachusetts) H. First Sterling Limited (Bermuda) a. First Sterling Reinsurance Company Limited (Bermuda) EX-23 4 CONSENT OF INDEPENDENT ACCOUNTANTS Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-72491, No. 333-576, No. 333-578, No. 333-580, No. 333-582, No. 333-24929 and No. 333-31397) of our report dated February 1, 2000 relating to the financial statements, which appears in the Allmerica Financial Corporation 1999 Annual Report to Shareholders, which is incorporated by reference in this Annual Report on Form 10-K for the year ended December 31, 1999. We also consent to the incorporation by reference of our report dated February 1, 2000 relating to the financial statement schedules, which also appears in this Form 10-K. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Boston, Massachusetts March 28, 2000 EX-24 5 POWER OF ATTORNEY EXHIBIT 24 POWER OF ATTORNEY We, the undersigned, hereby severally constitute and appoint John F. O'Brien, John F. Kelly and Edward J. Parry III, and each of them singly, our true and lawful attorneys, with full power in each of them, sign for and in each of our names and in any and all capacities, Form 10-K of Allmerica Financial Corporation (the "Company") and any other filings made on behalf of said Company pursuant to the requirements of the Securities Exchange Act of 1934, and to file the same with all exhibits and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue hereof. Witness our hands and common seal on the date set forth below.
Signature Title Date - ---------------------------------- ---------------------------------- -------------------------- /s/ John F. O'Brien Director, President and CEO 2/21/00 - ---------------------------------- John F. O'Brien /s/ Edward J. Parry III Vice President, CFO, Treasurer 2/21/00 - ---------------------------------- and Principal Accounting Officer Edward J. Parry III /s/ Michael P. Angelini Director 2/21/00 - ---------------------------------- Michael P. Angelini /s/ E. Gordon Gee Director 2/21/00 - ---------------------------------- E. Gordon Gee /s/ Samuel J. Gerson Director 2/21/00 - ---------------------------------- Samuel J. Gerson /s/ Gail L. Harrison Director 2/21/00 - ---------------------------------- Gail L. Harrison /s/ Robert P. Henderson Director 2/21/00 - ---------------------------------- Robert P. Henderson /s/ M Howard Jacobson Director 2/21/00 - ---------------------------------- M Howard Jacobson /s/ Wendell J. Knox Director 2/21/00 - ---------------------------------- Wendell J. Knox
EX-27 6 FINANCIAL DATA SCHEDULE
7 This Schedule contains summary financial information extracted from the Consolidated Financial Statements of Allmerica Financial Corporation as of December 31, 1999 and for the period then ended, and is qualified in its entirety by reference to such financial statements. 1,000,000 12-MOS DEC-31-1999 DEC-31-1999 6934 0 0 83 521 13 7889 442 1280 1387 30770 2825 890 2839 2041 245 300 0 1 2239 30770 1951 616 91 129 1771 430 477 468 107 361 (49) 0 0 296 5.38 5.33 2597 1601 (183) 861 638 2619 0
EX-99.2 7 IMPORTANT FACTORS REGARDING 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, Maine, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island and Vermont). 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. Uncertainty Regarding Accident and Health Assumed Reinsurance Pool Business The Company believes that notwithstanding the recent losses incurred by the accident and health assumed reinsurance business, the Company's reserves appropriately reflect both current claims and unreported losses. However, due to the inherent volatility in this business, possible issues related to the enforceability of reinsurance treaties in the industry and to its recent history of increased losses, we cannot assure you that our current reserves are adequate or that we will not have losses in the future. Although we have discontinued our participation in these reinsurance pools, we may become subject to claims related to prior years. We may be harmed from liabilities resulting from any such claims. 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 Commissioners ("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 uses a system for assessing the adequacy of statutory capital for life and health insurers and property and casualty insurers. The system, known as risk-based capital, is in addition to the states' fixed dollar minimum capital and other requirements. The 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. 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 three principal segments: Risk Management, Allmerica Financial Services, and Allmerica Asset Management. 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. 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 since prior regulatory restrictions on the sale of insurance and securities by these institutions have been 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 only when the insurance or annuity benefits are actually paid or to be paid. 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 judgements 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 for which the Company has not established appropriate reserves. 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 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 specified 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 an insurer's flexibility in this market. -----END PRIVACY-ENHANCED MESSAGE-----