-----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, HFKiM5eiIrJSoR3J+cJOiQ2lBBRMYN390Irs++INT05sGrDSfCFyQnXNn0lqhUdh jDzc5XwmhI7kXNGSS1Ug0Q== 0000927016-01-503801.txt : 20020410 0000927016-01-503801.hdr.sgml : 20020410 ACCESSION NUMBER: 0000927016-01-503801 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20010930 FILED AS OF DATE: 20011114 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13754 FILM NUMBER: 1789630 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-Q 1 d10q.txt FORM 10-Q FOR 09/30/2001 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2001 ---------------------------- 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, Massachusetts 01653 - -------------------------------------------- ------------- (Address of principal executive offices) (Zip Code) (508) 855-1000 ---------------------------------------------------- (Registrant's telephone number, including area code) - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes [ ] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the registrant's classes of common stock as of the latest practicable date: 52,887,233 shares of common stock outstanding, as of November 1, 2001. Total Number of Pages 37 Included in This Document Exhibit Index is on Page 38 TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Income.................................................... 3 Consolidated Balance Sheets.......................................................... 4 Consolidated Statements of Shareholders' Equity...................................... 5 Consolidated Statements of Comprehensive Income...................................... 6 Consolidated Statements of Cash Flows................................................ 7 Notes to Interim Consolidated Financial Statements................................... 8 - 17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................................................ 18 - 34 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................... 35 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K..................................................... 36 SIGNATURES.................................................................................... 37
PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ------------------ -------------------- (In millions, except per share data) 2001 2000 2001 2000 ====================================================================================================================== Revenues Premiums....................................................... $ 559.9 $ 535.1 $ 1,685.4 $ 1,587.0 Universal life and investment product policy fees.............. 95.0 110.9 294.6 316.1 Net investment income.......................................... 169.6 165.4 501.1 481.3 Net realized investment losses................................. (4.9) (31.8) (89.6) (102.6) Other income................................................... 32.8 36.2 104.9 106.9 ------- ------- --------- --------- Total revenues............................................ 852.4 815.8 2,496.4 2,388.7 ------- ------- --------- --------- Benefits, losses and expenses Policy benefits, claims, losses and loss adjustment expenses... 558.6 500.9 1,636.7 1,470.2 Policy acquisition expenses.................................... 125.4 108.3 355.8 341.4 Other operating expenses....................................... 144.6 127.0 427.8 375.5 Restructuring costs............................................ - - - 20.3 ------- ------- --------- --------- Total benefits, losses and expenses....................... 828.6 736.2 2,420.3 2,207.4 ------- ------- --------- --------- Income before federal income taxes............................. 23.8 79.6 76.1 181.3 ------- ------- --------- --------- Federal income tax (benefit) expense: Current................................................... (71.4) 6.7 (99.6) 1.5 Deferred.................................................. 60.0 6.4 92.9 27.5 ------- ------- --------- --------- Total federal income tax (benefit) expense................ (11.4) 13.1 (6.7) 29.0 ------- ------- --------- --------- Income before minority interest and cumulative effect of change in accounting principle............................... 35.2 66.5 82.8 152.3 Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company................................... (4.0) (4.0) (12.0) (12.0) ------- ------- --------- --------- Income before cumulative effect of change in accounting principle................................................... 31.2 62.5 70.8 140.3 ------- ------- --------- --------- Cumulative effect of change in accounting principle (less applicable income tax benefit of $1.7 for the nine months ended September 30, 2001)................................... - - (3.2) - ------- ------- --------- --------- Net income.................................................... $ 31.2 $ 62.5 $ 67.6 $ 140.3 ======= ======= ========= ========= PER SHARE DATA Basic ----- Income before cumulative effect of change in accounting principle................................................ $ 0.59 $ 1.18 $ 1.34 $ 2.62 Cumulative effect of change in accounting principle (less applicable income tax benefit of $0.03 for the nine months ended September 30, 2001)......................... - - (0.06) - ------- ------- --------- --------- Net income................................................. $ 0.59 $ 1.18 $ 1.28 $ 2.62 ======= ======= ========= ========= Weighted average shares outstanding........................ 52.7 53.1 52.6 53.5 ------- ------- --------- --------- Diluted ------- Income before cumulative effect of change in accounting principle................................................ $ 0.59 $ 1.16 $ 1.33 $ 2.59 Cumulative effect of change in accounting principle (less applicable income tax benefit of $0.03 for the nine months ended September 30, 2001)......................... - - (0.06) - ------- ------- --------- --------- Net income................................................. $ 0.59 $ 1.16 $ 1.27 $ 2.59 ======= ======= ========= ========= Weighted average shares outstanding........................ 53.1 53.9 53.1 54.1 ------- ------- --------- --------- Dividends declared to shareholders......................... $ - $ 0.25 $ - $ 0.25 ======= ======= ========= =========
The accompanying notes are an integral part of these consolidated financial statements. 3 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
(Unaudited) September 30, December 31, (In millions, except per share data) 2001 2000 ======================================================================================================================== Assets Investments: Fixed maturities-at fair value (amortized cost of $9,004.4 and $8,153.7)........... $ 9,221.1 $ 8,118.0 Equity securities-at fair value (cost of $61.0 and $60.0).......................... 56.2 85.5 Mortgage loans..................................................................... 548.5 617.6 Policy loans....................................................................... 382.0 381.3 Other long-term investments........................................................ 159.4 193.2 ---------- ---------- Total investments.............................................................. 10,367.2 9,395.6 ---------- ---------- Cash and cash equivalents.............................................................. 600.9 281.1 Accrued investment income.............................................................. 150.2 155.4 Premiums, accounts and notes receivable, net........................................... 628.7 618.1 Reinsurance receivable on paid and unpaid losses, benefits and unearned premiums.................................................. 1,387.5 1,423.8 Deferred policy acquisition costs...................................................... 1,724.8 1,608.2 Deferred federal income taxes.......................................................... - 103.8 Other assets........................................................................... 687.5 564.6 Separate account assets................................................................ 13,367.0 17,437.4 ---------- ---------- Total assets....................................................................... $ 28,913.8 $ 31,588.0 ========== ========== Liabilities Policy liabilities and accruals: Future policy benefits............................................................. $ 4,051.3 $ 3,617.4 Outstanding claims, losses and loss adjustment expenses............................ 2,899.2 2,880.9 Unearned premiums.................................................................. 1,056.4 981.6 Contractholder deposit funds and other policy liabilities.......................... 1,880.8 2,193.1 ---------- ---------- Total policy liabilities and accruals.......................................... 9,887.7 9,673.0 ---------- ---------- Expenses and taxes payable............................................................. 787.4 768.6 Reinsurance premiums payable........................................................... 112.8 122.3 Trust instruments supported by funding obligations..................................... 1,644.4 621.5 Short-term debt........................................................................ 71.0 56.6 Long-term debt......................................................................... 199.5 199.5 Deferred federal income taxes.......................................................... 14.2 - Separate account liabilities........................................................... 13,367.0 17,437.4 ---------- ---------- Total liabilities.................................................................. 26,084.0 28,878.9 ---------- ---------- Minority interest: Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company............................ 300.0 300.0 ---------- ---------- Commitments and contingencies (Note 12) 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............................................................. 1,756.0 1,765.3 Accumulated other comprehensive income (loss).......................................... 44.7 (5.2) Retained earnings...................................................................... 1,136.3 1,068.7 Treasury stock at cost (7.5 million and 7.7 million shares)............................ (407.8) (420.3) ---------- ---------- Total shareholders' equity......................................................... 2,529.8 2,409.1 ---------- ---------- Total liabilities and shareholders' equity...................................... $ 28,913.8 $ 31,588.0 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 4 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited) Nine Months Ended September 30, ---------------------- (In millions) 2001 2000 ================================================================================================================ Preferred Stock Balance at beginning and end of period.............................................. $ - $ - --------- --------- Common Stock Balance at beginning and end of period.............................................. 0.6 0.6 --------- --------- Additional paid-in capital Balance at beginning of period...................................................... 1,765.3 1,770.5 Unearned compensation related to restricted stock and other...................... (9.3) (6.4) --------- --------- Balance at end of period............................................................ 1,756.0 1,764.1 --------- --------- Accumulated Other Comprehensive Income (Loss) Net unrealized appreciation (depreciation) on investments Balance at beginning of period...................................................... (5.2) (75.3) Net appreciation on available-for-sale securities and derivative instruments..... 76.8 59.9 Provision for deferred federal income taxes...................................... (26.9) (20.9) --------- --------- Other comprehensive income............................................. 49.9 39.0 --------- --------- Balance at end of period............................................................ 44.7 (36.3) --------- --------- Retained earnings Balance at beginning of period...................................................... 1,068.7 882.2 Net income....................................................................... 67.6 140.3 Dividends to shareholders........................................................ - (13.4) --------- --------- Balance at end of period............................................................ 1,136.3 1,009.1 --------- --------- Treasury Stock Balance at beginning of period...................................................... (420.3) (337.8) Shares purchased at cost......................................................... - (61.3) Shares reissued at cost.......................................................... 12.5 18.9 --------- --------- Balance at end of period............................................................ (407.8) (380.2) --------- --------- Total shareholders' equity..................................................... $ 2,529.8 $ 2,357.3 ========= =========
The accompanying notes are an integral part of these consolidated financial statements. 5 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------------- ---------------------- (In millions) 2001 2000 2001 2000 ======================================================================================================== Net income............................................ $ 31.2 $ 62.5 $ 67.6 $ 140.3 Other comprehensive (loss) income: Available-for-sale securities: Net appreciation during the period.............. 78.8 42.3 151.4 59.9 Provision for deferred federal income taxes..... (27.6) (14.9) (53.0) (20.9) ------- ------- ------- ------- Total available-for-sale securities................ 51.2 27.4 98.4 39.0 ------- ------- ------- ------- Derivative instruments: Net depreciation during the period.............. (80.1) - (74.6) - Benefit for deferred federal income taxes....... 28.0 - 26.1 - ------- ------- ------- ------- Total derivative instruments....................... (52.1) - (48.5) - ------- ------- ------- ------- Other comprehensive (loss) income..................... (0.9) 27.4 49.9 39.0 ------- ------- ------- ------- Comprehensive income.................................. $ 30.3 $ 89.9 $ 117.5 $ 179.3 ======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. 6 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) Nine Months Ended September 30, ------------------------ (In millions) 2001 2000 ======================================================================================================================= Cash flows from operating activities Net income.............................................................................. $ 67.6 $ 140.3 Adjustments to reconcile net income to net cash provided by operating activities: Net realized losses................................................................. 89.6 102.6 Net amortization and depreciation................................................... 14.5 18.4 Deferred federal income taxes....................................................... 92.9 29.8 Change in deferred acquisition costs................................................ (133.0) (179.2) Change in premiums and notes receivable, net of reinsurance payable................. (20.1) (32.5) Change in accrued investment income................................................. 5.2 (0.2) Change in policy liabilities and accruals, net...................................... 504.3 150.4 Change in reinsurance receivable.................................................... 36.3 (26.5) Change in expenses and taxes payable................................................ (201.1) 2.8 Separate account activity, net...................................................... - (0.2) Other, net.......................................................................... (34.0) (8.2) ---------- ---------- Net cash provided by operating activities....................................... 422.2 197.5 ---------- ---------- Cash flows from investing activities Proceeds from disposals and maturities of available-for-sale fixed maturities......... 1,836.9 2,321.2 Proceeds from disposals of equity securities.......................................... 41.7 11.8 Proceeds from disposals of other investments.......................................... 42.2 31.5 Proceeds from mortgages matured or collected.......................................... 68.6 83.0 Purchase of available-for-sale fixed maturities....................................... (2,740.4) (3,056.7) Purchase of equity securities......................................................... (10.4) (16.1) Purchase of other investments......................................................... (19.5) (118.2) Purchase of company owned life insurance.............................................. - (64.9) Capital expenditures.................................................................. (22.7) (8.4) Other, net............................................................................ 1.5 (0.1) ---------- ---------- Net cash used in investing activities........................................... (802.1) (816.9) ---------- ---------- Cash flows from financing activities Deposits and interest credited to contractholder deposit funds........................ 148.4 588.1 Withdrawals from contractholder deposit funds......................................... (490.4) (561.1) Deposits to trust instruments supported by funding obligations........................ 1,109.2 496.2 Withdrawals from trust instruments supported by funding obligations................... (86.3) - Change in short-term debt............................................................. 14.4 8.9 Proceeds from issuance of common stock................................................ - 0.6 Treasury stock purchased at cost...................................................... - (58.9) Treasury stock reissued at cost....................................................... 4.4 18.9 Other, net............................................................................ - (1.1) ---------- ---------- Net cash provided by financing activities....................................... 699.7 491.6 ---------- ---------- Net change in cash and cash equivalents................................................... 319.8 (127.8) Cash and cash equivalents, beginning of period............................................ 281.1 464.8 ---------- ---------- Cash and cash equivalents, end of period.................................................. $ 600.9 $ 337.0 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 7 ALLMERICA FINANCIAL CORPORATION NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation and Principles of Consolidation The accompanying unaudited consolidated financial statements of Allmerica Financial Corporation ("AFC" or the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the requirements of Form 10-Q. The interim consolidated financial statements of AFC include the accounts of First Allmerica Financial Life Insurance Company ("FAFLIC"); Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"); The Hanover Insurance Company ("Hanover"); Citizens Insurance Company of America ("Citizens"), and other insurance and non-insurance subsidiaries. All significant intercompany accounts and transactions have been eliminated. The accompanying interim consolidated financial statements reflect, in the opinion of the Company's management, all adjustments necessary for a fair presentation of the financial position and results of operations. The results of operations for the nine months ended September 30, 2001, are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the Company's 2000 Annual Report to Shareholders, as filed on Form 10-K with the Securities and Exchange Commission. 2. New Accounting Pronouncements In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("Statement No. 142"), which requires that goodwill and intangible assets that have indefinite useful lives no longer be amortized over their useful lives, but instead be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. In addition, the statement provides specific guidance for testing the impairment of intangible assets. Additional financial statement disclosures about goodwill and other intangible assets, including changes in the carrying amount of goodwill, carrying amounts by classification of amortized and non- amortized assets, and estimated amortization expenses for the next five years, are also required. This statement is effective for fiscal years beginning after December 15, 2001 for all goodwill and other intangible assets held at the date of adoption. Certain provisions of this statement are also applicable for goodwill and other intangible assets acquired after June 30, 2001, but prior to adoption of this statement. The Company is currently assessing the impact of the adoption of Statement No. 142. In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, "Business Combinations" ("Statement No. 141"), which requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method of accounting. It further specifies the criteria that intangible assets must meet in order to be recognized and reported apart from goodwill. The implementation of Statement No. 141 is not expected to have a material effect on the Company's financial statements. In December 2000, the American Institute of Certified Public Accountants issued Statement of Position 00-3, "Accounting by Insurance Enterprises for Demutualization and Formations of Mutual Insurance Holding Companies and For Certain Long-Duration Participating Contracts" ("SoP No. 00-3"). SoP No. 00-3 requires that closed block assets, liabilities, revenues and expenses be displayed together with all other assets, liabilities, revenues and expenses of the insurance enterprise based on the nature of the particular item, with appropriate disclosures relating to the closed block. In addition, the SoP provides guidance on the accounting for participating contracts issued before and after the date of demutualization, recording of closed block earnings and related policyholder dividend liabilities, and the accounting treatment for expenses and equity balances at the date of demutualization. This statement became effective for fiscal years beginning after December 15, 2000. The adoption of SoP No. 00-3 did not have a material impact on the Company's financial position or results of operations. Certain prior year amounts have been reclassified to conform to the required presentation in the current year. In June 1998, the 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 all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on the type of hedge transaction. For fair value hedge transactions in which the Company is hedging changes in an asset's, liability's or firm commitment's fair value, changes in the fair value of the derivative instruments will generally be offset in the income statement by changes in the hedged item's fair value. For cash flow hedge transactions, in which the Company is hedging the variability of cash flows related to a variable rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument will be reported in other comprehensive income. The gains and losses on the 8 derivative instrument that are reported in other comprehensive income will be reclassified into earnings in the periods in which earnings are impacted by the variability of the cash flows of the hedged item. To the extent any hedges are determined to be ineffective, all or a portion of the change in value of the derivative will be recognized currently in earnings. This statement became effective for fiscal years beginning after June 15, 2000. The Company adopted Statement No. 133 on January 1, 2001. In accordance with the transition provisions of the statement, the Company recorded a $3.2 million charge, net-of- taxes, in earnings to recognize all derivative instruments at their fair values. This adjustment represents net losses that were previously deferred in other comprehensive income on derivative instruments that do not qualify for hedge accounting. The Company recorded an offsetting gain in other comprehensive income of $3.3 million, net-of-tax, to recognize these derivative instruments. 3. Summary of New Significant Accounting Policies Accounting for Derivatives and Hedging Activities All derivatives are recognized on the balance sheet at their fair value. On the date the derivative contract is entered into, the Company designates the derivative as (1) a hedge of the fair value of a recognized asset or liability ("fair value" hedge); (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability ("cash flow" hedge); (3) a foreign-currency fair value or cash flow hedge ("foreign currency" hedge); or (4) "held for trading". Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a fair value hedge, along with the gain or loss on the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash flow hedge are recorded in other comprehensive income, until earnings are affected by the variability of cash flows (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings). Changes in the fair value of derivatives that are highly effective and that are designated and qualify as foreign currency hedges are recorded in either current period earnings or other comprehensive income, depending on whether the hedge transaction is a fair value hedge or a cash flow hedge. Lastly, changes in the fair value of derivative trading instruments are reported in current period earnings. The Company may hold financial instruments that contain "embedded" derivative instruments. The Company assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the financial instrument, or host contract, and whether a separate instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract, and (2) a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as a fair-value, cash-flow, or foreign currency hedge, or as a trading derivative instrument. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the balance sheet or to specific forecasted transactions. The Company also formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively, as discussed below. The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item, including forecasted transactions; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is no longer designated as a hedge instrument, because it is unlikely that a forecasted transaction will occur; or (4) management determines that designation of the derivative as a hedge instrument is no longer appropriate. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, the derivative will continue to be carried on the balance sheet at its fair value, and the hedged asset or liability will no longer be adjusted for changes in fair value. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, the derivative will continue to be carried on the balance sheet at its fair value, and gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at its fair value on the balance sheet, with changes in its fair value recognized in current period earnings. 9 4. 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 business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). During the third quarter of 1998, the Company ceased writing new premiums in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB Opinion No. 30"). In 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. The Company also recorded a $30.5 million loss, net of taxes, on the disposal of this segment, consisting of after-tax losses from the run-off of the group life and health business of approximately $46.9 million, partially offset by net proceeds from the sale of the EBS business of approximately $16.4 million. Subsequent to a measurement date of June 30, 1999, approximately $15.1 million of the aforementioned $46.9 million loss has been generated from the operations of the discontinued business. In March of 2000, the Company transferred its EBS business to Great-West Life and Annuity Insurance Company of Denver. As a result of this transaction, the Company has received consideration of approximately $26 million, based on renewal rights for existing policies. The Company retained policy liabilities estimated at $101.7 million at September 30, 2001 related to this business. As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not been segregated between continuing and discontinued operations. At September 30, 2001 and 2000, the discontinued segment had assets of approximately $397.1 million and $505.1 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of approximately $367.6 million and $419.8 million, respectively, consisting primarily of policy liabilities. Revenues for the discontinued operations were $8.1 million and $39.0 million for the quarters ended September 30, 2001 and 2000, respectively, and $27.9 million and $174.7 million for the nine months ended September 30, 2001 and 2000, respectively. 5. Significant Transactions As of September 30, 2001, the Company has repurchased approximately $436.3 million, or approximately 8 million shares, of its common stock under programs authorized by the Board of Directors (the "Board") in 1998, 1999 and 2000. As of September 30, 2001, the Board had authorized total stock repurchases of $500.0 million, leaving approximately $63.7 million available to the Company for future repurchases. There have been no share repurchases to date in 2001. The Company repurchased approximately 1.9 million shares at a cost of approximately $103.4 million in 2000. During the second quarter of 2000, the Company adopted a formal company-wide restructuring plan. This plan is the result of a corporate initiative that began in the fall of 1999, intended to reduce expenses and enhance revenues. This plan consists of various initiatives including a series of internal reorganizations, consolidations in home office operations, consolidations in field offices, changes in distribution channels and product changes. As a result of the Company's restructuring plan, it recognized a pre-tax charge of $21.4 million during 2000. Approximately $5.7 million of this charge relates to severance and other employee related costs resulting from the elimination of approximately 360 positions, of which 240 employees have been terminated as of September 30, 2001 and 120 vacant positions have been eliminated. All levels of employees, from staff to senior management, were affected by the restructuring. In addition, approximately $15.7 million of this charge relates to other restructuring costs, consisting of one-time project costs, lease cancellations and the present value of idle leased space. As of September 30, 2001, the Company has made payments of approximately $20.6 million related to this restructuring plan, of which approximately $5.4 million relates to severance and other employee related costs. This plan has been substantially implemented. 10 6. Investments A. Derivative Instruments The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate or foreign currency volatility. 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, and sectors. The Company uses derivative financial instruments, primarily interest rate swaps and futures contracts, with indices that correlate to balance sheet instruments to modify its indicated net interest sensitivity to levels deemed to be appropriate. Specifically, for floating rate funding agreements that are matched with fixed rate securities, the Company manages the risk of cash flow variability by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. Under interest rate 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. Additionally, the Company uses exchange traded financial futures contracts to hedge against interest rate risk on anticipated guaranteed investment contract ("GIC") sales and other funding agreements, as well as the reinvestment of fixed maturities. 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. Similarly, the Company is exposed to interest rate risk on fixed maturities reinvestments from the time of maturity until the purchase of new fixed maturities. The Company only trades futures contracts with nationally recognized brokers, which the Company believes have adequate capital to ensure that there is minimal risk of default. As a result of the Company's issuance of trust instruments supported by funding obligations denominated in foreign currencies, as well as the Company's investment in securities 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 enters into foreign exchange swap contracts to hedge its net foreign currency exposure. Additionally, the Company enters into compound currency/interest rate swap contracts to hedge foreign currency and interest rate exposure on specific trust instruments supported by funding obligations. Under these swap contracts, the Company agrees to exchange interest and principal related to foreign fixed income securities and trust obligations payable in foreign currencies, at current exchange rates, for the equivalent payment in U.S. dollars translated at a specific currency exchange rate. By using derivative instruments, the Company is exposed to credit risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain (including any accrued receivable) in a derivative. 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. Depending on the nature of the derivative transaction, bilateral collateral arrangements may be required. The Company's derivative activities are monitored by management, who review portfolio activities and risk levels. Management also oversees all derivative transactions to ensure that the types of transactions entered into and the results obtained from those transactions are consistent with the Company's risk management strategy and with Company policies and procedures. Fair Value Hedges The Company enters into compound foreign currency/interest rate swaps to convert its foreign denominated fixed rate trust instruments supported by funding obligations to U.S. dollar floating rate instruments. For the nine months ended September 30, 2001, the Company recognized a net gain of $0.3 million (reported as other income in the Consolidated Statements of Income), which represented the ineffective portion of all fair value hedges. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted. 11 Cash Flow Hedges The Company enters into various types of 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 risk of cash flow variability 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. The Company also purchases long futures contracts and sells short futures contracts on margin to hedge against interest rate fluctuations associated with the sale of GICs and other funding agreements, as well as the reinvestment of fixed maturities. 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. Similarly, the Company is exposed to interest rate risk on reinvestments of fixed maturities from the time of maturity until the purchase of new fixed maturities. The Company uses U.S. Treasury Note Futures to hedge this risk. The Company also enters into foreign currency swap contracts to hedge foreign currency exposure on specific fixed income securities, as well as compound foreign currency/interest rate swap contracts to hedge foreign currency and interest rate exposure on specific trust instruments supported by funding obligations. Under these swap contracts, the Company agrees to exchange interest and principal related to foreign fixed maturities and trust obligations payable in foreign currencies, at current exchange rates, for the equivalent payment in U.S. dollars translated at a specific currency exchange rate. For the nine months ended September 30, 2001, the Company recognized a net gain of $2.0 million, reported as other income in the Consolidated Statements of Income, which represented the total ineffectiveness of all cash flow hedges. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted. Gains and losses on derivative contracts that are reclassified from accumulated other comprehensive income to current period earnings are included in the line item in which the hedged item is recorded. As of September 30, 2001, $73.1 million of the deferred net losses on derivative instruments accumulated in other comprehensive income could be recognized in earnings during the next twelve months depending on the forward interest rate and currency rate environment. Transactions and events that (1) are expected to occur over the next twelve months and (2) will necessitate reclassifying to earnings these derivatives gains (losses) include (a) the re-pricing of variable rate trust instruments supported by funding obligations, (b) the interest payments (receipts) on foreign denominated trust instruments supported by funding obligations and foreign securities, (c) the anticipated sale of GICs and other funding agreements, and (d) the anticipated reinvestment of fixed maturities. The maximum term over which the Company is hedging its exposure to the variability of future cash flows (for all forecasted transactions, excluding interest payments on variable-rate debt) is 12 months. Trading Activities 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 stated annual premium. In the case of default, the Company will pay the counterparty par value for a pre-determined security of the issuer. As of September 30, 2001, the Company no longer held credit default swap contracts. 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 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 September 30, 2001, was $5.1 million. The Company does not require collateral or other security to support financial instruments with credit risk. These products are not linked to specific assets and liabilities on the balance sheet or to a forecasted transaction, and therefore do not qualify for hedge accounting. The swap contracts are marked to market with any gain or loss recognized currently. The net amount receivable or payable under insurance portfolio- linked swap contracts is recognized when the contracts are marked to market. The net decrease in realized investment gains related to these contracts was $4.3 million, $0.7 million and $0.2 million for the nine months ended September 30, 2001 and the years ended December 31, 2000 and 1999, respectively. The fair values of swap contracts outstanding were immaterial at September 30, 2001 and December 31, 2000. 12 The stated annual premium under credit default swap contracts is recognized currently in net investment income. There was no net increase to investment income related to credit default swap contracts for the nine months ended September 30, 2001; however, there was a net increase of $0.2 million for the nine months ended September 30, 2000. B. Impact of Defaults on Net Investment Income The Company had fixed maturity securities with a carrying value of $15.3 million, $7.5 million and $4.1 million on non-accrual status at September 30, 2001, December 31, 2000 and September 30, 2000, respectively. 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 investment income of $9.2 million and $2.6 million for the nine months ended September 30, 2001 and 2000, respectively. 7. Federal Income Taxes Federal income tax expense for the nine months ended September 30, 2001 and 2000, has been computed using estimated effective tax rates. These rates are revised, if necessary, at the end of each successive interim period to reflect the current estimates of the annual effective tax rates. 8. Other Comprehensive (Loss) Income The following table provides a reconciliation of gross unrealized gains (losses) to the net balance shown in the Statements of Comprehensive Income:
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------------------------------- (In millions) 2001 2000 2001 2000 ==================================================================================================================== Unrealized gains (losses) on available-for-sale securities: Unrealized holding gains (losses) arising during period (net of income taxes (benefit) of $30.4 million and $4.4 million for the quarters ended September 30, 2001 and 2000 and $38.5 million and $(12.5) million for the nine months ended September 30, 2001 and 2000)................................. $ 61.3 $ 10.9 $ 46.8 $ (36.0) Less: reclassification adjustment for gains (losses) included in net income (net of income taxes (benefit) of $2.8 million and $(10.5) million for the quarters ended September 30, 2001 and 2000 and $(14.5) million and $(33.4) million for the nine months ended September 30, 2001 and 2000)................. 10.1 (16.5) (51.6) (75.0) ------- ------- ------- ------- Total available-for-sale securities..................................... 51.2 27.4 98.4 39.0 ------- ------- ------- ------- Unrealized losses on derivative instruments: Unrealized holding losses arising during period (net of income tax benefit of $33.6 million and $32.7 million for the quarter and nine months ended September 30, 2001).......................... (62.2) - (60.6) - Less: reclassification adjustment for losses included in net income (net of income tax benefit of $5.6 million and $6.6 million for the quarter and nine months ended September 30, 2001)................................................ (10.1) - (12.1) - ------- ------- ------- ------- Total derivative instruments............................................ (52.1) - (48.5) - ------- ------- ------- ------- Other comprehensive (loss) income....................................... $ (0.9) $ 27.4 $ 49.9 $ 39.0 ======= ======= ======= =======
13 9. Closed Block Included in the Consolidated Statements of Income is a net pre-tax contribution (loss) from the Closed Block of $2.0 million and $12.9 million for the quarter and nine months ended September 30, 2001, respectively, compared to $(1.1) million and $3.7 million for the quarter and nine months ended September 30, 2000, respectively. Summarized financial information of the Closed Block is as follows:
(Unaudited) September 30, December 31, (In millions) 2001 2000 - --------------------------------------------------------------------------------------------------------- Assets Fixed maturities-at fair value (amortized cost of $417.2 and $400.3).... $ 430.9 $ 397.5 Mortgage loans.......................................................... 141.8 144.9 Policy loans............................................................ 186.5 191.7 Cash and cash equivalents............................................... - 1.9 Accrued investment income............................................... 15.1 14.6 Deferred policy acquisition costs....................................... 10.6 11.0 Other assets............................................................ 7.6 6.4 ------- ------- Total assets.......................................................... $ 792.5 $ 768.0 ======= ======= Liabilities Policy liabilities and accruals......................................... $ 804.4 $ 808.9 Policyholder dividends.................................................. 38.0 20.0 Other liabilities....................................................... 1.6 0.8 ------- ------- Total liabilities..................................................... $ 844.0 $ 829.7 ======= ======= Excess of Closed Block liabilities over assets designated to the Closed Block............................................................ $ 51.5 $ 61.7 Amounts included in accumulated other comprehensive income: Net unrealized investment losses, net of deferred federal income tax benefit of $2.9 million and $1.3 million.............................. (5.3) (2.5) ------- ------- Maximum future earnings to be recognized from Closed Block assets and liabilities.................................................. $ 46.2 $ 59.2 ======= =======
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------- ----------------- (In millions) 2001 2000 2001 2000 - -------------------------------------------------------------------------------------------------------------------- Revenues Premiums................................................................ $ 7.2 $ 7.7 $ 39.6 $ 42.0 Net investment income................................................... 14.1 13.1 41.7 40.1 Net realized investment gains (losses).................................. 0.3 (1.1) (0.9) (4.7) ------ ------ ------ ------ Total revenues........................................................ 21.6 19.7 80.4 77.4 ------ ------ ------ ------ Benefits and expenses Policy benefits......................................................... 19.4 20.2 66.9 71.9 Policy acquisition expenses............................................. 0.2 0.5 0.3 1.5 Other operating expenses................................................ - 0.1 0.3 0.3 ------ ------ ------ ------ Total benefits and expenses........................................... 19.6 20.8 67.5 73.7 ------ ------ ------ ------ Contribution from the Closed Block.................................. $ 2.0 $ (1.1) $ 12.9 $ 3.7 ====== ====== ====== ======
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. 14 10. 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. The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. The Risk Management Segment manages its products through three distribution channels identified as Standard Markets, Sponsored Markets, and Specialty Markets. Standard Markets sells property and casualty insurance products through independent agents and brokers primarily in the Northeast, Midwest and Southeast United States. Sponsored Markets offers property and casualty products to members of affinity groups and other organizations. This distribution channel also focuses on worksite distribution, which offers discounted property and casualty (automobile and homeowners) insurance through employer sponsored programs. Specialty Markets offers specialty or program property and casualty business nationwide. This channel focuses on niche classes of risks and leverages specific underwriting processes. 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 and to a lesser extent, certain group retirement products. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in GICs, such as short-term and long-term funding agreements. Short-term 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. Long-term funding agreements are investment contracts issued to various businesses or charitable trusts, which are used to support debt issued by the trust to foreign and domestic institutional buyers, such as banks, insurance companies, and pension plans. These funding agreements have long maturities and may be issued with a fixed or variable interest rate based on an index such as LIBOR. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates and to third parties, such as money market and other fixed income clients. 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, technology, finance, human resources and legal. Management evaluates the results of the aforementioned segments based on a pre- tax and pre-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. 15 Summarized below is financial information with respect to business segments for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------------------------------------- (In millions) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------ Segment revenues: Risk Management............................................. $ 615.0 $ 588.4 $ 1,833.3 $ 1,725.3 ------- ------- --------- --------- Asset Accumulation: Allmerica Financial Services............................. 202.5 217.2 630.0 659.7 Allmerica Asset Management............................... 40.1 41.0 121.4 105.2 ------- ------- --------- --------- Subtotal................................................ 242.6 258.2 751.4 764.9 ------- ------- --------- --------- Corporate................................................... 2.1 2.2 4.6 4.9 Intersegment revenues................................... (1.8) (1.2) (5.6) (3.8) ------- ------- --------- --------- Total segment revenues................................... 857.9 847.6 2,583.7 2,491.3 Adjustments to segment revenues: Net realized losses......................................... (4.9) (31.8) (89.6) (102.6) (Losses) gains on derivatives............................... (0.6) - 2.3 - ------- ------- --------- --------- Total revenues........................................... $ 852.4 $ 815.8 $ 2,496.4 $ 2,388.7 ======= ======= ========= ========= Segment income (loss) before federal income taxes, minority interest and cumulative effect of change in accounting principle: Risk Management.......................................... $ 6.8 $ 59.4 $ 64.5 $ 156.4 ------- ------- --------- --------- Asset Accumulation: Allmerica Financial Services.......................... 34.4 56.7 121.3 166.6 Allmerica Asset Management............................ 6.1 5.8 16.5 15.5 ------- ------- --------- --------- Subtotal........................................... 40.5 62.5 137.8 182.1 ------- ------- --------- --------- Corporate................................................... (15.7) (13.7) (47.5) (40.4) ------- ------- --------- --------- Segment income before federal income taxes and minority interest.................................... 31.6 108.2 154.8 298.1 Adjustments to segment income: Net realized investment losses, net of amortization......... (7.2) (28.6) (88.7) (96.5) (Losses) gains on derivatives............................... (0.6) - 2.3 - Sales practice litigation................................... - - 7.7 - Restructuring costs......................................... - - - (20.3) ------- ------- --------- --------- Income before federal income taxes, minority interest and cumulative effect of change in accounting principle............................................ $ 23.8 $ 79.6 $ 76.1 $ 181.3 ======= ======= ========= =========
Identifiable Assets Deferred Acquisition Costs - ------------------------------------------------------------------------------------------------------------ (Unaudited) (Unaudited) September 30, December 31, September 30, December 31, (In millions) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------ Risk Management............................... $ 6,041.6 $ 6,186.6 $ 206.5 $ 187.2 ---------- ---------- ---------- ---------- Asset Accumulation Allmerica Financial Services................ 19,664.0 23,082.5 1,518.2 1,420.8 Allmerica Asset Management.................. 3,034.8 2,238.4 0.1 0.2 ---------- ---------- ---------- ---------- Subtotal.................................. 22,698.8 25,320.9 1,518.3 1,421.0 Corporate..................................... 173.4 80.5 - - ---------- ---------- ---------- ---------- Total....................................... $ 28,913.8 $ 31,588.0 $ 1,724.8 $ 1,608.2 ========== ========== ========== ==========
16 11. Earnings Per Share The following table provides share information used in the calculation of the Company's basic and diluted earnings per share:
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ------------------------------------------------------ (In millions, except per share data) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------ Basic shares used in the calculation of earnings per share..................................... 52.7 53.1 52.6 53.5 Dilutive effect of securities: Employee stock options.......................... 0.2 0.5 0.3 0.3 Non-vested stock grants......................... 0.2 0.3 0.2 0.3 ------ ------ ------ ------ Diluted shares used in the calculation of earnings per share..................................... 53.1 53.9 53.1 54.1 ------ ------ ------ ------ Per share effect of dilutive securities on income from continuing operations before cumulative effect of change in accounting principle and net income............................... $ - $ 0.02 $ 0.01 $ 0.03 ====== ====== ====== ======
12. Commitments and Contingencies Litigation In 1997, a lawsuit on behalf of a putative class was instituted against the Company alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In November 1998, the Company and the plaintiffs entered into a settlement agreement and in May 1999, the Federal District Court in Worcester, Massachusetts approved the settlement agreement and certified the class for this purpose. AFC recognized a $31.0 million pre-tax expense in 1998 related to this litigation. In the second quarter of 2001, the Company recognized a pre-tax benefit of $7.7 million resulting from the refinement of cost estimates. Although the Company believes that the remaining expense reflects appropriate recognition of its obligation under the settlement, this 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 if estimates of the ultimate resolution of these proceedings are revised. 17 PART I - FINANCIAL INFORMATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following analysis of the interim consolidated results of operations and financial condition of the Company should be read in conjunction with the interim Consolidated Financial Statements and related footnotes included elsewhere herein and the Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the 2000 Annual Report to Shareholders, as filed on Form 10-K with the Securities and Exchange Commission. INTRODUCTION The results of operations for Allmerica Financial Corporation and subsidiaries ("AFC" or "the Company") include the accounts of First Allmerica Financial Life Insurance Company ("FAFLIC") and Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), AFC's principal life insurance and annuity companies; The Hanover Insurance Company ("Hanover") and Citizens Insurance Company of America ("Citizens"), AFC's principal property and casualty companies; and certain other insurance and non-insurance subsidiaries. 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. Results of Operations - --------------------- Consolidated Overview Consolidated net income includes the results of each segment of the Company, which management evaluates on a pre-tax and pre-minority interest basis. In addition, net income also 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", which excludes these items, 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. The Company's consolidated net income for the third quarter of 2001 decreased $31.3 million, or 50.1%, to $31.2 million, compared to the same period in 2000. The reduction in net income in the third quarter resulted primarily from a decrease in adjusted net income of $45.5 million, partially offset by a decrease in net realized investment losses of $14.6 million. Consolidated net income for the first nine months of 2001 decreased $72.7 million, or 51.8%, to $67.6 million, compared to the first nine months of 2000. The reduction in net income resulted primarily from a decrease in adjusted net income of $90.3 million. Net income in 2000 also included a restructuring charge of $13.2 million. The following table reflects adjusted net income and a reconciliation to consolidated net income. Adjusted net income consists of segment income (loss), federal income taxes on segment income and minority interest on Capital Securities (mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company). 18
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ------------------ ------------------- (In millions) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------- Segment income (loss) before federal income taxes and minority interest: Risk Management............................................. $ 6.8 $ 59.4 $ 64.5 $ 156.4 Asset Accumulation: Allmerica Financial Services.......................... 34.4 56.7 121.3 166.6 Allmerica Asset Management............................ 6.1 5.8 16.5 15.5 ------- ------- ------- ------- Subtotal.............................................. 40.5 62.5 137.8 182.1 Corporate................................................... (15.7) (13.7) (47.5) (40.4) ------- ------- ------- ------- Segment income before federal income taxes and minority interest......................................... 31.6 108.2 154.8 298.1 Federal income tax benefit (expense) on segment income..... 6.8 (24.3) (12.3) (65.3) Minority interest on Capital Securities.................... (4.0) (4.0) (12.0) (12.0) ------- ------- ------- ------- Adjusted net income............................................. 34.4 79.9 130.5 220.8 Adjustments (net of taxes and amortization, as applicable): Net realized investment losses.............................. (2.8) (17.4) (66.2) (67.3) (Losses) gains on derivatives............................... (0.4) - 1.5 - Sales practice litigation................................... - - 5.0 - Restructuring costs......................................... - - - (13.2) ------- ------- ------- ------- Income before cumulative effect of change in accounting principle.......................................... 31.2 62.5 70.8 140.3 Cumulative effect of change in accounting principle, net of applicable taxes.................................. - - (3.2) - ------- ------- ------- ------- Net income...................................................... $ 31.2 $ 62.5 $ 67.6 $ 140.3 ======= ======= ======= =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 The Company's segment income before federal income taxes and minority interest decreased $76.6 million, or 70.8%, to $31.6 million in the third quarter of 2001. This decrease is primarily attributable to a decrease in income from the Risk Management and the Allmerica Financial Services segments of $52.6 million and $22.3 million, respectively. The decrease in Risk Management's segment income was primarily attributable to a reduction in favorable loss and loss adjustment expenses ("LAE") reserve development of $33.7 million and to an increase of approximately $32 million in current accident year losses and LAE. These decreases were partially offset by premium rate increases of approximately $24 million. Allmerica Financial Services' segment income decreased $22.3 million primarily due to declines in asset-based fees, primarily resulting from a decrease in the market value of assets under management in the variable product lines, and to lower brokerage income and investment management fees. The decrease is also attributable to an increase in policy benefits and policy acquisition costs, partially offset by higher net investment income. The effective tax rate for segment income was (21.5%) for the third quarter of 2001 compared to 22.5% for the third quarter of 2000. The decrease in the tax rate is primarily due to lower underwriting income resulting in an increase in the proportion of tax-exempt investment income to pre-tax income, as well as to an increase in the dividends received deduction associated with the Company's variable products. Net realized losses on investments, after taxes, were $2.8 million in the third quarter of 2001, resulting primarily from impairments of fixed maturities and decreases in the market values of certain derivative instruments. These losses were partially offset by gains from sales of fixed maturities. Most of these impairments occurred in the Company's portfolio of high-yield bonds. During the third quarter of 2000, the Company recognized net realized losses on investments, after taxes, of $17.4 million, primarily due to losses from the sale of securities pursuant to the Company's tax strategy to increase portfolio yields and to impairments of fixed maturities. 19 Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 The Company's segment income before federal income taxes and minority interest decreased $143.3 million, or 48.1%, to $154.8 million in the first nine months of 2001. This decrease is primarily attributable to a decrease in income from the Risk Management and Allmerica Financial Services segments of $91.9 million and $45.3 million, respectively. The decrease in Risk Management's segment income was primarily attributable to decreased favorable loss and LAE reserve development of $118.9 million and to an increase of approximately $54 million in current accident year losses and LAE. These decreases in segment income were partially offset by premium rate increases of approximately $78 million and decreased catastrophe losses of $11.3 million. Allmerica Financial Services' segment income decreased $45.3 million principally due to lower asset-based fees, primarily resulting from a decrease in the market value of assets under management in the variable product lines, and to lower brokerage income and investment management fees. The decrease is also attributable to higher policy benefits and other operating expenses, partially offset by lower deferred policy acquisition costs. The effective tax rate for segment income was 7.9% for the first nine months of 2001 compared to 21.9% for the first nine months of 2000. The decrease in the tax rate is primarily due to lower underwriting income resulting in an increase in the proportion of tax-exempt investment income to pre-tax income, as well as to an increase in the dividends received deduction associated with the Company's variable products. Net realized losses on investments after taxes were $66.2 million in the first nine months of 2001 resulting primarily from impairments of fixed maturities. During the first nine months of 2000, net realized losses on investments after taxes of $67.3 million resulted primarily from after tax realized losses of $57.6 million due to the sale of $1.7 billion of fixed income securities in order to reinvest the proceeds in higher yielding securities. In addition, the Company recognized $21.0 million in after tax realized losses from impairments of fixed maturities in 2000. The Company recognized a benefit of $5.0 million, net of taxes, in the second quarter of 2001, as a result of refining cost estimates related to settlement of a class action lawsuit. During the first quarter of 2001, the Company recognized a $3.2 million loss, net of taxes, upon adoption of Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." In the second quarter of 2000, the Company recognized a one-time after-tax restructuring charge of $13.2 million. This charge is the result of a formal company-wide restructuring plan, intended to reduce expenses and enhance revenues. 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. 20 Risk Management - --------------- The following table summarizes the results of operations for the Risk Management segment for the periods indicated:
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------- --------------------- (In millions) 2001 2000 2001 2000 - ----------------------------------------------------------------------------------------------------------- Segment revenues Net premiums written...................................... $ 586.7 $ 561.8 $ 1,734.8 $ 1,651.6 ======= ======= ========= ========= Net premiums earned....................................... $ 552.5 $ 527.2 $ 1,644.9 $ 1,543.8 Net investment income..................................... 54.2 55.2 164.0 164.8 Other income.............................................. 8.3 6.0 24.4 16.7 ------- ------- --------- --------- Total segment revenues............................... 615.0 588.4 1,833.3 1,725.3 Losses and operating expenses Losses and LAE (1)........................................ 457.0 390.9 1,321.0 1,150.2 Policy acquisition expenses............................... 101.7 93.4 297.2 279.4 Other operating expenses.................................. 49.5 44.7 150.6 139.3 ------- ------- --------- --------- Total losses and operating expenses.................. 608.2 529.0 1,768.8 1,568.9 ------- ------- --------- --------- Segment income................................................. $ 6.8 $ 59.4 $ 64.5 $ 156.4 ======= ======= ========= =========
(1) Includes policyholders' dividends of $2.3 million and $4.9 million for the quarters ended September 30, 2001 and 2000, respectively, and $6.2 million and $11.3 million for the nine months ended September 30, 2001 and 2000, respectively. Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 Risk Management's segment income declined $52.6 million, or 88.6%, to $6.8 million for the quarter ended September 30, 2001. The decrease in segment income is primarily attributable to a $66.1 million increase in losses and LAE. This is primarily the result of a $33.7 million decrease in favorable development on prior years' reserves, to $15.8 million of adverse development in the third quarter of 2001. The unfavorable trend in reserve development is related to adverse claims frequency trends in the personal automobile and homeowners lines, increased commercial automobile loss severity, and to the Company having captured, in prior periods, the accumulated benefits of its claim processing redesign efforts. In addition, losses and LAE increased as a result of approximately a $32 million increase in current accident year losses in the third quarter, primarily in the personal automobile, commercial multiple peril and homeowners lines. The increase in personal automobile and homeowners lines current accident year losses is primarily the result of increased claims frequency, while current accident year losses in the commercial multiple peril line increased as a result of increased claims severity. Policy acquisition and other operating expenses have increased $13.1 million to $151.2 million in the third quarter of 2001 as the result of earned premium growth. Partially offsetting these items are approximately $24 million of rate increases, primarily in the commercial lines. Catastrophe losses decreased $0.4 million to $15.6 million, including $15.0 million related to the events of September 11, 2001, in the third quarter of 2001. A net benefit of $2.7 million in the third quarter of 2000 is included in segment income as a result of a whole account aggregate excess of loss reinsurance treaty, which provides coverage for the 1999 accident year. As a result of the events of September 11, 2001, the reinsurance industry has incurred significant losses. The Company believes that this may result in increased reinsurance costs, as well as changes in the terms of its reinsurance coverage. The Company is not able to estimate the impact of these possible changes. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 Risk Management's segment income decreased $91.9 million, or 58.8%, to $64.5 million for the nine months ended September 30, 2001. The decrease in segment income is primarily attributable to increased losses and LAE resulting from a $118.9 million decrease in favorable development on prior years' reserves, to $31.4 million of adverse development for the nine months ended September 30, 2001 from $87.5 million of favorable development for the same period in 2000. The unfavorable trend in reserve development is related to an increase in commercial multiple peril lines loss severity, adverse claims frequency trends in the personal automobile and homeowners lines, and to the Company's having captured, in prior periods, the accumulated benefits of its claim processing redesign efforts. Approximately $38 million of increased current 21 year claims severity in the commercial multiple peril line also contributed to the decline in results. In addition, approximately $23 million and $10 million of increased current year claims frequency in the personal automobile and homeowners lines, respectively, unfavorably impacted results. Partially offsetting these items are approximately $78 million of rate increases, primarily in commercial lines. In addition, catastrophe losses decreased $11.3 million, to $37.7 million, including $15.0 million related to the events of September 11, 2001, for the nine months ended September 30, 2001, compared to $49.0 million for the same period in 2000. A net benefit of $2.7 million in 2000 is included in segment income as a result of the aforementioned aggregate excess of loss reinsurance treaty. Distribution Channel Results Distribution channel results are reported using statutory accounting principles, which are prescribed by state insurance regulators. The primary difference between statutory and generally accepted accounting principles ("GAAP") is the deferral of certain underwriting costs under GAAP that are amortized over the life of the policy. Under statutory accounting principles, these costs are recognized when incurred or paid. Management reviews the operations of this business based upon statutory results. Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 The following table summarizes the results of operations for the distribution channels of the Risk Management segment:
(Unaudited) Quarter Ended September 30, 2001 --------------------------------------------------------------- Standard Sponsored Specialty (In millions, except ratios) Markets Markets Markets Other (2) Total - ------------------------------------------------------------------------------------------------------------ Statutory net premiums written............ $ 396.7 $ 177.6 $ 13.2 $ 0.2 $ 587.7 ------- ------- ------- ----- ------- Statutory combined ratio (1).............. 110.3 97.5 265.4 N/M 108.6 ------- ------- ------- ----- ------- Statutory underwriting (loss) profit...... $ (42.7) $ (0.1) $ (14.9) $ 0.4 $ (57.3) ------- ------- ------- ----- Reconciliation to segment income: Net investment income................... 54.2 Other income and expenses, net.......... 5.3 Other Statutory to GAAP adjustments..... 4.6 ------- Segment income $ 6.8 ======= - ------------------------------------------------------------------------------------------------------------
(Unaudited) Quarter Ended September 30, 2000 --------------------------------------------------------------- Standard Sponsored Specialty (In millions, except ratios) Markets Markets Markets Other (2) Total - ------------------------------------------------------------------------------------------------------------ Statutory net premiums written............ $ 388.0 $ 161.8 $ 10.6 $ 1.1 $ 561.5 ------- ------- ------- ----- ------- Statutory combined ratio (1).............. 98.6 93.6 149.2 N/M 98.8 ------- ------- ------- ----- ------- Statutory underwriting profit (loss)...... $ - $ 6.3 $ (4.9) $(3.6) $ (2.2) ------- ------- ------- ----- Reconciliation to segment income: Net investment income................... 55.2 Other income and expenses, net.......... 3.3 Other Statutory to GAAP adjustments..... 3.1 ------- Segment income............................ $ 59.4 ======= - ------------------------------------------------------------------------------------------------------------
(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. N/M - Not meaningful 22 Standard Markets - ---------------- Standard Markets' net premiums written increased $8.7 million, or 2.2%, to $396.7 million for the quarter ended September 30, 2001. This improvement is primarily attributable to increases of $6.6 million, or 5.0%, $5.6 million, or 7.2%, and $3.0 million, or 6.4%, in the personal automobile, commercial multiple peril, and homeowners lines, respectively. The increase in the personal automobile line is primarily the result of a 3.6% increase in policies in force since September 30, 2000 and a 2.9% net rate increase in Michigan. This is partially offset by a 5.4% personal automobile net rate decrease in Massachusetts. Commercial multiple peril net premiums written increased primarily as the result of a 5.5% increase in policies in force since September 30, 2000 and 8.7% and 6.0% rate increases in Michigan and New York, respectively. In addition, homeowners' net premiums written increased primarily as a result of a 10.7% rate increase in Michigan, partially offset by a 0.7% decrease in policies in force since September 30, 2000. Partially offsetting these favorable items is a $8.8 million, or 16.8%, decrease in worker's compensation net premiums written due to the non-renewal of several large unprofitable commercial accounts in 2001. Third quarter 2000 results reflected a $3.6 million decrease in net premiums written, resulting from the aforementioned aggregate excess of loss agreement. Standard Markets' underwriting results declined $42.7 million to an underwriting loss of $42.7 million for the quarter ended September 30, 2001. This is primarily attributable to the aforementioned decrease in favorable development on prior years' loss reserves. An increase in current year claims frequency in the personal lines also contributed to the decline in underwriting results. In addition, increased current year claims severity in the commercial multiple peril and workers compensation lines unfavorably impacted results. Catastrophe losses increased $4.2 million to $13.4 million for the third quarter of 2001, compared to $9.2 million for the same period in 2000. Partially offsetting these items are approximately $17 million of rate increases, primarily in the commercial lines. A decrease in current year claims activity in the commercial automobile line also favorably impacted results in the third quarter of 2001. A net benefit of $2.6 million in the third quarter of 2000 is included in segment income as a result of the aforementioned aggregate excess of loss reinsurance treaty. Sponsored Markets - ----------------- Sponsored Markets' net premiums written increased $15.8 million, or 9.8%, to $177.6 million for the quarter ended September 30, 2001. This increase is primarily due to increases of $8.3 million, or 6.8%, and $5.6 million, or 14.8%, in the personal automobile and homeowners lines, respectively. Personal automobile's net premiums written increased as a result of a 5.0% growth in policies in force since September 30, 2000 and the aforementioned Michigan net rate increase, partially offset by the aforementioned Massachusetts net rate reduction. Homeowners' net premiums written increased primarily due to a 5.3% growth in policies in force and a 10.7% Michigan rate increase compared to the same period in 2000. Third quarter 2000 results reflected a $1.7 million decrease in net premiums written, resulting from the aforementioned aggregate excess of loss agreement. Sponsored Markets' underwriting results declined $6.4 million to an underwriting loss of $0.1 million for the quarter ended September 30, 2001. The decrease in underwriting results is primarily attributable to approximately a $6 million decrease in favorable development on prior years' reserves. Increased current year claim frequency in the personal automobile line unfavorably impacted third quarter 2001 results. Partially offsetting these items are approximately $7 million of rate increases and an improvement in current year claims severity in the homeowners line. In addition, catastrophe losses decreased $4.7 million to $2.1 million in the third quarter of 2001. A net benefit of $1.0 million in the third quarter of 2000 is included in segment income as a result of the aforementioned aggregate excess of loss reinsurance treaty. Specialty Markets - ----------------- Specialty Markets' net premiums written increased $2.6 million, or 24.5%, to $13.2 million for the quarter ended September 30, 2001. This increase is primarily attributable to increases of $0.9 million and $0.6 million in the commercial multiple peril and commercial automobile lines, respectively. Commercial multiple peril's net premiums written increased primarily as a result of a 5.4% growth in policies in force since September 30, 2000 and a decrease in the utilization of reinsurance. Commercial automobile's net premiums written increased primarily as a result of significant growth in policies in force since September 30, 2000 and a decrease in the utilization of reinsurance. Specialty Markets' underwriting results declined $10.0 million to an underwriting loss of $14.9 million for the quarter ended September 30, 2001. The decline in underwriting results is primarily the result of an increase in current accident year claims severity in the commercial automobile line. In addition, an absence of ceding commission income from business that has not been renewed unfavorably impacted results. 23 Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 The following table summarizes the results of operations for the distribution channels of the Risk Management segment:
(Unaudited) Nine Months Ended September 30, 2001 ----------------------------------------------------------------- Standard Sponsored Specialty (In millions, except ratios) Markets Markets Markets Other (2) Total - -------------------------------------------------------------------------------------------------------------- Statutory net premiums written............. $1,184.2 $500.5 $ 47.4 $ 0.8 $1,732.9 -------- ------ ------ ----- -------- Statutory combined ratio (1)............... 106.9 101.9 145.9 N/M 106.5 -------- ------ ------ ----- -------- Statutory underwriting loss................ $ (89.9) $(16.0) $(20.8) $(5.8) $ (132.5) -------- ------ ------ ----- -------- Reconciliation to segment income: Net investment income.................... 164.0 Other income and expenses, net........... 15.0 Other Statutory to GAAP adjustments...... 18.0 -------- Segment income............................. $ 64.5 ======== - --------------------------------------------------------------------------------------------------------------
(Unaudited) Nine Months Ended September 30, 2000 --------------------------------------------------------------- Standard Sponsored Specialty (In millions, except ratios) Markets Markets Markets Other (2) Total - ------------------------------------------------------------------------------------------------------------- Statutory net premiums written............ $1,150.2 $464.5 $ 28.9 $ 3.8 $1,647.4 -------- ------ ------ ----- -------- Statutory combined ratio (1).............. 101.3 96.4 114.8 N/M 100.5 -------- ------ ------ ----- -------- Statutory underwriting (loss) profit...... $ (32.8) $ 8.7 $ (4.7) $(6.8) $ (35.6) -------- ------ ------ ----- -------- Reconciliation to segment income: Net investment income................... 164.8 Other income and expenses, net.......... 8.7 Other Statutory to GAAP adjustments..... 18.5 -------- Segment income............................ $ 156.4 ======== - -------------------------------------------------------------------------------------------------------------
(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. N/M - Not meaningful Standard Markets - ---------------- Standard Markets' net premiums written increased $34.0 million, or 3.0%, to $1,184.2 million for the nine months ended September 30, 2001. This improvement is primarily attributable to increases of $20.2 million, or 8.7%, $10.0 million, or 2.6%, and $7.6 million, or 4.6%, in the commercial multiple peril, personal automobile lines, and commercial automobile lines, respectively. The increase in the commercial multiple peril line is primarily the result of a 5.5% increase in policies in force since September 30, 2000 and 8.7% and 6.0% rate increases in Michigan and New York, respectively. Personal automobile's net premiums written increased as a result of a 6.7% growth in policies in force in the Northeast since September 30, 2000 and a 2.9% Michigan net rate increase. Partially offsetting these items are a personal automobile net rate decrease of 5.4% in Massachusetts and a 7.0% decrease in policies in force in the Midwest since September 30, 2000. Commercial automobile net premiums written increased primarily as a result of 5.9% and 4.9% rate increases in Michigan and Massachusetts, respectively, partially offset by a 7.2% decrease in policies in force since September 30, 2000. Partially offsetting these favorable items is a $9.9 million, or 6.2%, decrease in workers' compensation's net premiums written due to the non-renewal of several unprofitable large commercial accounts in 2001. Nine months ended September 30, 2000 results 24 reflected a $3.6 million decrease in net premiums written, resulting from the aforementioned aggregate excess of loss agreement. Standard Markets' underwriting losses increased $57.1 million to an underwriting loss of $89.9 million for the nine months ended September 30, 2001. This is primarily attributable to the aforementioned decrease in favorable development on prior years' reserves. An increase in current year claims severity in the commercial multiple peril line also contributed to the decline in underwriting results. In addition, increased current accident year claims frequency in personal lines unfavorably impacted results. Partially offsetting these unfavorable items are approximately $57 million of rate increases, primarily in the commercial lines. Catastrophe losses decreased $7.0 million to $25.0 million for the nine months ended September 30, 2001, compared to $32.0 million for the same period in 2000. Sponsored Markets - ----------------- Sponsored Markets' net premiums written increased $36.0 million, or 7.8%, to $500.5 million for the nine months ended September 30, 2001. This improvement is primarily due to increases of $19.6 million, or 5.4%, and 14.9 million, or 16.2%, in the personal automobile and homeowners lines, respectively. Personal automobile's net premiums written increased as a result of a 5.0% growth in policies in force since September 30, 2000 and the aforementioned Michigan net rate increase, partially offset by a 5.4% Massachusetts net rate reduction. Homeowners' net premiums written increased primarily due to a 5.3% growth in policies in force and a 10.7% Michigan rate increase compared to the same period in 2000. Sponsored Markets' underwriting results declined $24.7 million, to an underwriting loss of $16.0 million, for the nine months ended September 30, 2001. The decline in underwriting results is primarily attributable to approximately a $31 million decrease in favorable development on prior years' reserves. In addition, increased claims frequency in the personal automobile line unfavorably impacted results for the nine months ended September 30, 2001. This is partially offset by approximately $21 million of rate increases and improvement in current year claims severity in the homeowners line. Specialty Markets - ----------------- Specialty Markets' net premiums written increased $18.5 million, or 64.0%, to $47.4 million for the nine months ended September 30, 2001. This improvement is primarily attributable to increases of $10.8 million and $5.9 million in the commercial automobile and commercial multiple peril lines, respectively. Commercial automobile's net premiums written increased primarily as a result of a significant growth in policies in force since September 30, 2000 and a decrease in the utilization of reinsurance. The increase in commercial multiple peril's net premiums written is primarily the result of a decrease in the utilization of reinsurance and a 5.4% growth in policies in force over the prior year. Specialty Markets' underwriting results declined $16.1 million, to an underwriting loss of $20.8 million, for the nine months ended September 30, 2001. The decline in underwriting results is primarily the result of an increase in current accident year claims severity in the commercial automobile and commercial multiple peril lines as a result of large losses. In addition, an absence of ceding commission income from business that has not been renewed also unfavorably impacted results. Investment Results Net investment income before tax was $54.2 million and $55.2 million for the quarters ended September 30, 2001 and 2000, respectively. The decline of $1.0 million, or 1.8%, is primarily due to the impact of defaulted bonds. Net investment income before tax was $164.0 million and $164.8 million for the nine months ended September 30, 2001 and 2000, respectively. The decrease in net investment income in 2001, compared to 2000, primarily reflects a reduction in average invested assets and the impact of defaulted bonds, partially offset by higher yields. This reduction in average invested assets is due to transfers of cash and securities of $100.0 million to the Corporate segment during the second quarter of 2001. Average pre-tax yields on debt securities increased to 6.9% in 2001 compared to 6.8% in 2000, due to the shift in investment strategy providing for investments in taxable securities instead of tax exempt securities, to maximize after-tax investment yields. 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 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 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. 25 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 period 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:
(Unaudited) Nine Months Ended September 30, --------------------------- (In millions) 2001 2000 - ---------------------------------------------------------------------------------------- Reserve for losses and LAE, beginning of period........... $2,719.1 $2,615.9 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year.......... 1,283.4 1,224.8 Increase (decrease) in provision for insured events of prior years.................................... 31.4 (87.5) -------- -------- Total incurred losses and LAE......................... 1,314.8 1,137.3 -------- -------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year.................................... 599.3 589.1 Losses and LAE attributable to insured events of prior years..................................... 643.2 561.7 -------- -------- Total payments........................................ 1,242.5 1,150.8 -------- -------- Change in reinsurance recoverable on unpaid losses.... (10.4) 44.5 -------- -------- Reserve for losses and LAE, end of period................. $2,781.0 $2,646.9 ======== ========
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were increased by $31.4 million and decreased $87.5 million for the nine months ended September 30, 2001 and 2000, respectively. During the first nine months of 2001, estimated loss reserves for claims occurring in prior years increased $62.8 million. During the first nine months of 2000, favorable development on prior years' loss reserves was $39.6 million. This $102.4 million change is primarily the result of an increase in commercial lines loss severity, and the Company having captured, in 1999 and 2000, the accumulated benefits of its claims redesign efforts. These efforts resulted in reduced reserves related to prior accident years, primarily in the personal automobile line in the Northeast. The adverse development in 2001 also reflects additional losses related to fourth quarter 2000 non-catastrophe weather related claims in Michigan. These claims primarily impacted the personal automobile, workers' compensation, and commercial multiple peril lines. Favorable development on prior year's LAE reserves was $31.4 million and $47.9 million for the nine months ended September 30, 2001 and 2000, respectively. The favorable development in both periods is primarily attributable to claims process improvement initiatives taken by the Company over the past three years. Since 1997, the Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claims offices. These measures are substantially complete. Reserves established for current year losses and LAE consider the factors that resulted in the favorable development of prior years' loss and LAE reserves during 2000 and earlier years. Accordingly, current year reserves are modestly lower, relative to those initially established for similar exposures in years prior to 2000. 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 $36.6 million and $43.4 million, net of reinsurance of $12.1 million and $5.1 million in the first nine months of 2001 and 2000, 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 outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company currently believes that recorded reserves related to these claims are adequate. The environmental liability could be revised if the estimates used in determining the liability are revised. 26 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 and reserves, 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. Asset Accumulation - ------------------ Allmerica Financial Services The following table summarizes the results of operations for the Allmerica Financial Services segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ----------------- ----------------- (In millions) 2001 2000 2001 2000 - -------------------------------------------------------------------------------------------------- Segment revenues Premiums............................................ $ 7.4 $ 7.9 $ 40.5 $ 43.2 Fees................................................ 95.0 110.9 294.6 316.1 Net investment income............................... 76.3 70.0 219.5 215.4 Other income........................................ 23.8 28.4 75.4 85.0 ------- ------- -------- ------- Total segment revenues.................................. 202.5 217.2 630.0 659.7 Policy benefits, claims and losses...................... 86.1 81.6 258.3 244.3 Policy acquisition and other operating expenses......... 82.0 78.9 250.4 248.8 ------- ------- -------- ------- Segment income.......................................... $ 34.4 $ 56.7 $ 121.3 $ 166.6 ======= ======= ======== =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 Segment income decreased $22.3 million, or 39.3%, to $34.4 million during the third quarter of 2001. This decrease reflects lower asset-based fees and other income, as well as an increase in policy benefits and policy acquisition costs, partially offset by higher net investment income. The decline in asset-based fees and other income is principally attributable to a decrease in the market value of assets under management in the variable product lines, and to lower brokerage income and investment management fees. Segment revenues decreased $14.7 million, or 6.8%, in the third quarter of 2001, primarily due to lower asset-based fees and other income. Fee income decreased $15.9 million, or 14.3%, to $95.0 million primarily as a result of variable annuity fees which decreased $9.3 million, or 15.1%. This was primarily due to a decline in the market value of average variable annuity assets under management. Other income decreased $4.6 million, or 16.2%, to $23.8 million. This decline was primarily due to lower brokerage income resulting from a decrease in mutual fund and general securities transaction volumes as well as decreased investment management fees due to a decline in variable product assets under management. An increase in net investment income of $6.3 million primarily resulted from the investment of higher general account deposits, including approximately $300 million of deposits from the introduction of a promotional annuity program, partially offset by the impact of defaulted bonds. This promotional program offered an enhanced crediting rate of 7% for new general account deposits, for up to one year. The Company completed this program in the second quarter of 2001. (See "Investment Portfolio"). 27 Policy benefits, claims and losses increased $4.5 million, or 5.5%, to $86.1 million, primarily due to an increase in general account deposits, including the introduction of the aforementioned promotional annuity program. Additionally, policy benefits increased $2.9 million as a result of the events of September 11, 2001. These increases were partially offset by the absence in 2001 of approximately $5.5 million of reserve strengthening in the universal life and traditional life lines of business. Certain annuity policy benefits include guaranteed minimum death benefits ("GMDB"). The Company has established reserves for GMDB based on its best estimate of the long-term cost of GMDB. In recent quarters, the expenses for this benefit have been approximately $2 million to $3 million per quarter, net of adjustment for deferred policy acquisition cost amortization. Due to the recent, sustained decline in the financial markets, this expense is expected to increase by approximately $6 million to $8 million per quarter, net of adjustment for deferred policy acquisition cost amortization. Additional declines in the financial markets would further increase these costs. Policy acquisition and other operating expenses increased $3.1 million, or 3.9%, to $82.0 million in the third quarter of 2001 primarily due to higher policy acquisition costs of $3.7 million. Included in policy acquisition expenses in 2000 were several unusual items, particularly approximately $33.8 million of reduced expenses related to a change in certain life products actuarial assumptions and an increase in policy acquisition expenses of approximately $25.0 million in the annuity line of business, resulting from an increase in assumed lapse rates. Excluding the effect of the aforementioned unusual items, policy acquisition costs declined due to lower annuity profits. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 Segment income decreased $45.3 million, or 27.2%, to $121.3 million during the first nine months of 2001. This decrease primarily reflects lower asset- based fees and other income, as well as an increase in policy benefits and other operating expenses, net of lower deferred acquisition costs. The decline in asset-based fees and other income is principally attributable to a decrease in the market value of assets under management in the variable product lines, and to lower brokerage income and investment management fees. Segment revenues decreased $29.7 million, or 4.5%, in the first nine months of 2001, primarily due to lower asset-based fees and other income. Fee income decreased $21.5 million, or 6.8%, to $294.6 million, primarily due to variable annuity fees which decreased $16.2 million, or 9.1%, primarily due to a decline in the market value of average variable annuity assets under management. In addition, non-variable universal life policy fees decreased $8.1 million in the first nine months of 2001, primarily due to a decline in average invested assets resulting from the continued shift in focus to variable life insurance and annuity products. Other income decreased $9.6 million, or 11.3%, to $75.4 million. This decline was primarily due to lower brokerage income resulting from a decrease in mutual fund and general securities transaction volumes, as well as decreased investment management fees resulting from depreciation in variable product assets under management. Net investment income increased $4.1 million primarily due to additional income from the investment of higher general account deposits, including deposits from the aforementioned promotional annuity program. This increase was partially offset by the impact of defaulted bonds and by lower average mortgage investments and yields. Policy benefits, claims and losses increased $14.0 million, or 5.7%, to $258.3 million in the first nine months of 2001, primarily due to an increase in general account deposits, including the introduction of the aforementioned promotional annuity program, and to less favorable mortality experience in the individual variable universal life product line. Additionally, policy benefits increased by $2.9 million as a result of the events of September 11, 2001. These increases were partially offset by the absence in 2001 of the aforementioned reserve strengthening in the universal life and traditional life lines of business of approximately $5.5 million and more favorable mortality experience in the traditional life line of business in the current year. Policy acquisition and other operating expenses increased $1.6 million, or 0.6%, to $250.4 million in the first nine months of 2001. Other operating expenses increased approximately $10.9 million, primarily as a result of increased distribution and technology costs. This increase was partially offset by a $9.3 million decrease in policy acquisition expenses, primarily due to lower annuity profits. 28 Statutory Premiums and Deposits The following table sets forth statutory premiums and deposits by product for the Allmerica Financial Services segment.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ------------------------ ----------------------- (In millions) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------- Insurance: Traditional life.................................... $ 7.5 $ 8.0 $ 31.5 $ 33.6 Universal life...................................... 2.8 3.2 12.2 13.7 Variable universal life............................. 47.8 51.0 149.1 153.7 Individual health................................... - 0.1 0.2 0.2 Group variable universal life....................... 8.1 13.7 67.4 43.8 ------ ------ -------- -------- Total insurance............................... 66.2 76.0 260.4 245.0 ------ ------ -------- -------- Annuities: Separate account annuities.......................... 435.3 617.7 1,414.6 1,973.1 General account annuities........................... 180.8 123.5 737.2 387.6 Retirement investment accounts...................... 1.3 2.1 5.2 8.2 ------ ------ -------- -------- Total individual annuities.................... 617.4 743.3 2,157.0 2,368.9 Group annuities..................................... 19.8 119.2 185.0 378.5 ------ ------ -------- -------- Total annuities............................... 637.2 862.5 2,342.0 2,747.4 ------ ------ -------- -------- Total premiums and deposits.............................. $703.4 $938.5 $2,602.4 $2,992.4 ====== ====== ======== ========
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 Total premiums and deposits decreased $235.1 million, or 25.1%, to $703.4 million. These decreases are primarily due to lower separate account and group annuity deposits, partially offset by higher general account deposits. The Company believes that the lower separate account and group annuity deposits reflect an industry-wide trend resulting from a general decline in the equity markets. In addition, group annuity deposits decreased due to the Company's decision to exit its defined contribution retirement plan business and to cease marketing activities for new defined benefit retirement business. Partially offsetting these decreases were higher annuity deposits into the Company's general account, resulting in part, from the aforementioned promotional annuity program. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 For the nine months ended September 30, 2001, total premiums and deposits decreased $390.0 million, or 13.0%, to $2,602.4 million. These decreases are primarily due to lower separate account and group annuity deposits resulting from the aforementioned general decline in the equity markets and to the aforementioned activities regarding the Company's defined contribution and defined benefit lines of business. Partially offsetting these decreases were higher annuity deposits into the Company's general account resulting, in part, from the aforementioned promotional annuity program. Annuity products are distributed primarily through three distribution channels: (1) "Agency", which consists of the Company's career agency force; (2) "Select", which consists of a network of third party broker-dealers; and (3) "Partners", which includes distributors of the mutual funds advised by Zurich Scudder Investments ("Zurich-Scudder"), Pioneer Investment Management, Inc. and Delaware Management Company. Select, Partners, and Agency represented, respectively, approximately 38%, 37%, and 25% of individual annuity deposits in the first nine months of 2001, and Zurich-Scudder represented 27% of all individual annuity deposits. During the first nine months of 2000, Select, Partners, and Agency represented, respectively, approximately 25%, 46%, and 29% of individual annuity deposits. The increase in deposits within the Select channel resulted primarily from the aforementioned promotional annuity program which was only available in the Select channel, and to a significant expansion of the number of wholesalers in this channel. 29 Allmerica Asset Management The following table summarizes the results for the Allmerica Asset Management segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ---------------- ------------------ (In millions) 2001 2000 2001 2000 - -------------------------------------------------------------------------------------------------- Interest margins on GICs Net investment income.............................. $ 37.1 $ 38.1 $ 113.5 $ 96.6 Interest credited.................................. 32.2 33.4 99.8 84.3 ------ ------ -------- ------- Net interest margin................................... 4.9 4.7 13.7 12.3 ------ ------ -------- ------- Fees and other income External........................................... 1.7 1.7 4.5 4.8 Internal........................................... 1.3 1.2 4.0 3.8 Other operating expenses.............................. (1.8) (1.8) (5.7) (5.4) ------ ------ -------- ------- Segment income........................................ $ 6.1 $ 5.8 $ 16.5 $ 15.5 ====== ====== ======== =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 Segment income increased $0.3 million, or 5.2%, to $6.1 million during the third quarter of 2001. This increase is primarily due to increased earnings on guaranteed investment contracts ("GICs"). Additional long-term funding agreement deposits were approximately $74.0 million in the third quarter of 2001. The rating agency actions described in "Recent Developments" may negatively impact the GIC line of business in future periods. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 Segment income increased $1.0 million, or 6.5%, to $16.5 million in the first nine months of 2001. This increase is primarily due to increased earnings on GICs, partially offset by a decrease in fees and other income related to external clients. Earnings on GICs increased in 2001 primarily due to additional long-term funding agreement deposits of $1.2 billion, partially offset by lower investment income due to defaults on certain bonds supporting GIC obligations. The decrease in external fees and other income primarily resulted from a decrease in management fees from a securitized investment portfolio, partially offset by an increase in new external assets under management. Corporate The following table summarizes the results of operations for the Corporate segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, ------------------ ------------------ (In millions) 2001 2000 2001 2000 - -------------------------------------------------------------------------------------------------- Segment revenues Net investment income................................ $ 2.1 $ 2.2 $ 4.6 $ 4.9 Interest expense....................................... 3.8 3.8 11.4 11.4 Other operating expenses............................... 14.0 12.1 40.7 33.9 ------- ------- ------- ------- Segment loss........................................... $ (15.7) $ (13.7) $ (47.5) $ (40.4) ======= ======= ======= =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 Segment loss increased $2.0 million, or 14.6%, to $15.7 million in the third quarter of 2001 primarily due to an increase in employee related costs, higher technology expenses and the timing of certain corporate overhead costs. Interest expense for both periods relates to the interest paid on the Senior Debentures of the Company. 30 Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 Segment loss increased $7.1 million, or 17.6%, to $47.5 million in the first nine months of 2001 primarily due to the timing of certain corporate overhead expenses, increased technology costs and certain corporate overhead expenses previously allocated to other operating segments. Interest expense for both periods relates to the interest paid on the Senior Debentures of the Company. Investment Portfolio The Company held general account investment assets diversified across several asset classes, as follows:
(Unaudited) September 30, 2001 December 31, 2000 ------------------------------------------------------------------- Carrying % of Total Carrying % of Total (Dollars in millions) Value Carrying Value Value Carrying Value - ----------------------------------------------------------------------------------------------------------------------- Fixed maturities (1)................................ $ 9,221.1 84.1% $8,118.0 83.9% Equity securities (1)............................... 56.2 0.5 85.5 0.9 Mortgages........................................... 548.5 5.0 617.6 6.4 Policy loans........................................ 382.0 3.5 381.3 3.9 Cash and cash equivalents........................... 600.9 5.5 281.1 2.9 Other long-term investments......................... 159.4 1.4 193.2 2.0 --------- ----- -------- ----- Total.......................................... $10,968.1 100.0% $9,676.7 100.0% ========= ===== ======== =====
(1) The Company carries fixed maturities and equity securities in its investment portfolio at market value. Total investment assets increased $1.3 billion, or 13.3%, to $11.0 billion during the first nine months of 2001. This increase consisted primarily of additional fixed maturities of $1.1 billion and additional cash and cash equivalents of $319.8 million. The increase in fixed maturities and cash and cash equivalents is primarily due to the investment of funds received from the sale of GICs by the Allmerica Asset Management segment, as well as an increase in general account deposits, including those related to the aforementioned promotional annuity program, in the Allmerica Financial Services segment. Also, a shift in assets from the Company's separate accounts to its general accounts and the timing of investment purchases in the Allmerica Financial Services segment contributed to these increases. 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 89.5% and 88.1% of the Company's total fixed maturity portfolio at September 30, 2001 and December 31, 2000, respectively. The average yield on fixed maturities was 7.4% for the nine months ended September 30, 2001 and 2000. 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. As a result of the Company's exposure to below investment grade securities, the Company recognized $118.5 million and $30.0 million of realized losses on other than temporary impairments of fixed maturities during the first nine months of 2001 and 2000, respectively. The losses reflect the continued deterioration of the high-yield market. The recognition of these losses followed the review of recent defaults on interest payments, financial information from issuers, estimated future cash flows and other trends in the high-yield market. In addition, the Company had fixed maturity securities with a carrying value of $15.3 million and $7.5 million on non-accrual status at September 30, 2001 and December 31, 2000, respectively. No assurance can be given that the fixed maturity impairments will, in-fact, be adequate to cover future losses or that substantial additional impairments will not be required in the future. The effect of holding securities for which income is not accrued, compared with amounts that would have been recognized in accordance with the original terms of the investments, was a reduction in net investment income of $9.2 million and $2.6 million for the nine months ended September 30, 2001 and 2000, respectively. This includes the impact of securities held as of the aforementioned financial statement dates, as well as those securities sold during the period. Management expects that defaults in the fixed maturities portfolio may continue to negatively impact investment income. 31 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. Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000 The provision for federal income taxes before minority interest, discontinued operations and the effect of a change in accounting principle was an $11.4 million benefit during the third quarter of 2001 compared to a $13.1 million expense during the same period in 2000. These provisions resulted in consolidated effective federal tax rates of (47.9%) and 16.5% for the quarters ended September 30, 2001 and 2000, respectively. The decrease in the rate is primarily due to lower underwriting income, both for the current quarter and anticipated for the full year. This resulted in an increase in the proportion of tax-exempt investment income to pre-tax income in the current quarter, as well as a reduction in the tax rate expected for the full year. Also, in the current quarter, the Company recognized a benefit related to the dividends received deduction associated with its variable products. The Company did not recognize such benefit in any of the first three quarters of 2000. Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30, 2000 The provision for federal income taxes before minority interest, discontinued operations and the effect of a change in accounting principle was a $6.7 million benefit during the first nine months of 2001 compared to a $29.0 million expense during the same period in 2000. These provisions resulted in consolidated effective federal tax rates of (8.8%) and 16.0% for the nine months ended September 30, 2001 and 2000, respectively. The decrease in the rate is primarily due to lower underwriting income and increased realized losses in the first nine months of 2001 resulting in an increase in the proportion of tax-exempt investment income to pre-tax income, as well as to the recognition of the dividends received deduction associated with the Company's variable products. 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 the first nine months of 2001, AFC received $100.0 million of dividends from its property and casualty businesses. Additional dividends from the Company's insurance subsidiaries in 2001 would be considered "extraordinary" and would require prior approval from the respective state regulators. The Company does not expect dividend payments from its life insurance subsidiaries in 2002. Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claims, losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash provided by operating activities was $422.2 million and $197.5 million during the first nine months of 2001 and 2000, respectively. The increase in 2001 is primarily the result of higher general account deposits, including funds received from the aforementioned promotional annuity program, and to an increase in premiums received from the property and casualty business. These increases in cash were partially offset by increased loss and LAE payments in the property and casualty business. Net cash used in investing activities was $802.1 million and $816.9 million during the first nine months of 2001 and 2000, respectively. The decrease in cash used in 2001 is primarily the result of year over year declines in purchases of mortgages, joint venture investments, and company owned life insurance, partially offset by higher net purchases of fixed maturities. Net purchases of fixed maturities increased primarily due to the timing of investing new funding agreement deposits and from additional deposits into the general account, including those related to the aforementioned promotional annuity program. 32 Net cash provided by financing activities was $699.7 million and $491.6 million during the first nine months of 2001 and 2000, respectively. The increase in 2001 is primarily due to an increase in net funding agreement deposits, including trust instruments supported by funding obligations, of $157.7 million and a $44.4 million year over year reduction in cash used for the Company's share repurchase program. In the opinion of management, AFC has sufficient funds at the holding company or available through dividends from its insurance subsidiaries, 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. On October 23, 2001, the Board of Directors declared an annual dividend of $0.25 per share on the issued and outstanding common stock of the Company, payable November 20, 2001 to shareholders of record at the close of business November 5, 2001. 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 $215.0 million available under a committed syndicated credit agreement, which expires on May 24, 2002. 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 September 30, 2001, no amounts were outstanding under this agreement. The Company had $71.0 million of commercial paper borrowings outstanding at September 30, 2001. These borrowings are used in connection with the Company's premium financing business, which is included in the Risk Management segment. Recent Developments During the third quarter of 2001, the Company was informed of rating decisions made by three rating agencies. A.M. Best re-affirmed the "A" (Excellent) financial strength ratings assigned to the life insurance and property and casualty insurance companies. In addition, Fitch rating service, formerly Duff & Phelps, re-affirmed the "AA" (Very High) claims paying ability ratings of the life insurance companies. Moody's Investors Service also re-affirmed the life and property and casualty insurance companies' financial strength ratings of "A1" (Good), but revised the outlook for the life insurance companies' ratings to negative from stable. Rating downgrades from current levels may adversely impact the Company's product sales and its results of operations. Additionally, during the third quarter of 2001, A.M. Best re-affirmed the "A-" senior debt rating and the "bbb+" Capital Securities rating and Fitch re- affirmed its "A+" senior debt rating assigned to the Company. Moody's placed the Company's "A2" senior debt rating, "a2" Capital Securities rating, and "P1" short-term debt rating on review for possible downgrade. Rating downgrades from current levels may adversely affect the cost of any additional debt financing. For the nine months ended September 30, 2001 and 2000, the Company recognized net expenses (benefits) of $3.9 million and ($9.3) million, respectively, related to its employee pension plans. The expense or benefit related to the pension plans results from several factors, including changes in the market value of plan assets, interest rates and employee compensation levels. The net benefit in 2000 primarily reflected increases in the market value of plan assets in 1999 and prior years, while the net expense in 2001 primarily reflected a decline in the market value of plan assets in 2000. In 2002, management expects a significant increase in employee pension plan costs due to an expected decline in the market value of plan assets and interest rates in 2001. Such increases may negatively affect the Company's results of operations. The Risk Management segment recently enhanced its agency management and review process, evaluating its approximately 2600 existing agencies. The result of this process was the identification of approximately 600 agencies that do not meet certain profitability standards or are not strategically aligned with the Company. For these agents, the Company intends to either terminate the relationship or restrict the agent's access to certain types of policies. Management currently expects this process may result in lower annual written premium of approximately $200 million. However, the Company anticipates improved profitability as a result of expected lower losses incurred. Due to contractual and regulatory requirements, there will be a termination period in which the Company is obligated to renew existing policies, typically 12-18 months. There can be no assurance that the anticipated improvement in profitability will materialize. 33 Contingencies The Company's insurance subsidiaries are routinely engaged in various legal proceedings arising in the normal course of business, including claims for punitive damages. Additional information on other litigation and claims may be found in Note 12 "Commitments and Contingencies - Litigation" to the consolidated financial statements. In the opinion of management, none of such contingencies are expected to have a material effect on the Company's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period would be materially affected by an unfavorable outcome. 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 2001 and beyond to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. When used in the MD&A discussion, the words "believes", "anticipated", "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2. 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 has insured in either the current or 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, or as the result of consolidation within the financial services industry and the entry of additional financial institutions into the insurance industry; (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, requirements to write certain classes of business and recent and future changes affecting the tax treatment of insurance and annuity products, as well as continued compliance with state and federal regulations; (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) difficulties in recruiting new or retaining existing career agents, wholesalers, broker-dealers and partnership relations to support the sale of variable products; (viii) higher service, administrative, or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (ix) loss or retirement of key executives; (x) increases in costs, particulary those occurring after the time our products are priced and including construction, automobile, and medical and rehabilitation costs; (xi) changes in the Company's liquidity due to changes in asset and liability matching; (xii) restrictions on insurance underwriting; (xiii) adverse changes in the ratings obtained from independent rating agencies, such as Fitch, Moody's, Standard and Poor's and A.M. Best; (xiv) lower appreciation on or decline in value of the Company's managed investments or the investment markets in general, resulting in reduced variable product sales, assets and related variable product, management and brokerage fees, lapses and increased surrenders, as well as increased cost of guaranteed minimum death benefits/decreased account balances supporting our guaranteed benefits products; (xv) possible claims relating to sales practices for insurance products; (xvi) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance contracts or adverse effects on the cost and availability of reinsurance resulting from the September 11 terrorist attack; (xvii) earlier than expected withdrawals from the Company's general account annuities, GICs (including funding agreements), and other insurance products; (xviii) changes in the mix of assets comprising the Company's investment portfolio and the fluctuation of the market value of such assets; (xix) losses resulting from the Company's participation in certain reinsurance pools; (xx) losses due to foreign currency fluctuations; (xxi) defaults in debt securities held by the Company, and (xxii) higher employee benefit costs due to changes in market values of plan assets, interest rates and employee compensation levels. 34 PART I - FINANCIAL INFORMATION ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our market risks, and the ways we manage them, are summarized in management's discussion and analysis of financial condition and results of operations as of December 31, 2000, included in the Company's Form 10-K for the year ended December 31, 2000. There have been no material changes in the first nine months of 2001 to such risks or our management of such risks. 35 PART II - OTHER INFORMATION ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits EX - 99.2 Important Factors Regarding Forward Looking Statements (b) Reports on Form 8-K None 36 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Allmerica Financial Corporation ------------------------------- Registrant Dated November 13, 2001 ------------------ /s/ John F. O'Brien ------------------------------------------- John F. O'Brien President and Chief Executive Officer Dated November 13, 2001 ------------------ /s/ Edward J. Parry III ------------------------------------------- Edward J. Parry III Vice President, Chief Financial Officer and Principal Accounting Officer 37 EXHIBIT INDEX Exhibit Number Exhibit - -------------- ------- 99.2 Important Factors Regarding Forward Looking Statements 38 EX-99.2 3 dex992.txt IMPORTANT FACTORS REGARDING FORWARD EXHIBIT 99.2 IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS The Company wishes to caution readers that the following important factors, among others, in some cases have affected the Company's results and in the future could cause actual results and needs of the Company to vary materially from forward-looking statements made from time to time by the Company on the basis of management's then-current expectations. The businesses in which the Company is engaged are in rapidly changing and competitive markets and involve a high degree of risk, and accuracy with respect to forward looking projections is difficult. Risks Relating to our Risk Management Business Our results may fluctuate as a result of cyclical changes in the property and casualty insurance industry. We generate a significant portion of our total revenues through our property and casualty insurance subsidiaries. The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability could be affected significantly by: . increases in costs occurring after the time our insurance products are priced; . competitive and regulatory pressures which may affect the prices of our products and the nature of the risks covered; . volatile and unpredictable developments, including severe weather catastrophes; . legal, regulatory and socio-economic developments, such as new theories of insurer liability and related claims, increases in the size of jury awards, and increases in construction, automobile repair and medical and rehabilitation costs; . fluctuations in interest rates, inflationary pressures, default rates and other factors that affect investment returns; and . other general economic conditions and trends that may affect the adequacy of reserves. The demand for property and casualty insurance can also vary significantly based on general economic conditions, rising as the overall level of economic activity increases and falling as such activity decreases. The fluctuations in demand and competition could produce underwriting results that would have a negative impact on our results of operations and financial condition. Actual losses from claims against our property and insurance subsidiaries may exceed their reserves for claims. Our property and casualty insurance subsidiaries maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. Reserves do not represent an exact calculation of liability. Rather, reserves represent estimates, involving actuarial projections at a given time, of what they expect the ultimate settlement and administration of claims will cost based on facts and circumstances then known to them, predictions of future events, estimates of future trends in claims frequency and severity and judicial theories of liability, costs of repair and replacement, legislative activity and other factors. The inherent uncertainties of estimating reserves are greater for certain types of property and casualty insurance lines. These include 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. We regularly review our reserving techniques, reinsurance and the overall adequacy of our reserves based upon: . our review of historical data, legislative enactments, judicial decisions, legal developments in imposition of damages, changes in political attitudes and trends in general economic conditions; . our review of per claim information; . historical loss experience of our property and casualty insurance subsidiaries and the industry as a whole; and . the relative short-term nature of most of our property and casualty insurance policies. Because setting reserves is inherently uncertain, we cannot provide assurance that the existing reserves or future reserves established by our property and casualty insurance subsidiaries will prove adequate in light of subsequent events. Our results of operations and financial condition could therefore be materially affected by adverse loss development for events that we insure. Due to our geographical concentration in our Risk Management business, changes in the economic, regulatory and other conditions in the regions where we operate could have a significant negative impact on our business as a whole. We generate a significant portion of our property and casualty insurance net premiums written and earnings in Michigan, Massachusetts and other states in the Northeast, including Connecticut, Maine, New York, New Jersey, New Hampshire, Rhode Island and Vermont. In the nine months ended September 30, 2001, approximately 36.5% and 16.8% of our net written premium in our Risk Management business was generated in the states of Michigan and Massachusetts, respectively. The revenues and profitability of our property and casualty insurance subsidiaries are therefore subject to prevailing economic, regulatory, demographic and other conditions, including adverse weather, in Michigan and the Northeast. Because of our strong regional focus, our business as a whole could be significantly affected by changes in the economic, regulatory and other conditions in the regions where we transact business. Catastrophe losses could materially reduce our profitability or cash flow. Our property and casualty insurance subsidiaries are subject to claims arising out of catastrophes that may have a significant impact on their results of operations and financial condition. We may experience catastrophe losses which could have a material adverse impact on our business. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires, severe winter weather, sabotage, terrorist actions and explosion. The frequency and severity of catastrophes are inherently unpredictable. The extent of gross 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. The extent of net losses depends on the amount and collectibility of reinsurance. 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 our catastrophe-related claims. Our catastrophe losses have historically been principally weather related, particularly snow and ice damage from winter storms. -2- We purchase catastrophe reinsurance as protection against catastrophe losses. Based upon our review of our reinsurers' financial statements and reputations in the reinsurance marketplace, we believe that the financial condition of our reinsurers is sound. However, reinsurance is subject to credit risks, including those resulting from over-concentration within the industry. The availability, scope of coverage and cost of reinsurance could be adversely affected by the losses incurred from the September 11, 2001 terrorist attacks and the perceived risks associated with possible future terrorist activities. We cannot currently estimate the impact of these events on us. We also cannot provide assurance that our current reinsurance will be adequate to protect us against future catastrophe losses or that reinsurance or with coverage provisions reflective of the risks underwritten in our primary policies will continue to be available to us at commercially reasonable rates or with coverage provisions reflective of the risks underwritten in our primary policies. We may incur financial losses resulting from our participation in shared market mechanisms and mandatory and voluntary pooling arrangements. As a condition to conducting business in several states, our property and casualty insurance subsidiaries are required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements. These arrangements are designed to provide various insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. We cannot predict whether our participation in these shared market mechanisms or pooling arrangements will provide underwriting profits or losses to us. In 2000, 1999 and 1998, we incurred an underwriting loss from participation in these mechanisms and pooling arrangements of $26.1 million, $24.2 million and $14.7 million, respectively. We may face similar losses in the future. In addition, we may be adversely affected by liabilities resulting from our previous participation in certain voluntary assumed reinsurance pools, including accident and health reinsurance pools. We discontinued our participation in such pools in 1998 but remain subject to claims from periods in which we participated as well as for certain continuing obligations in a limited number of accident and health pools that we were prohibited from exiting in full. Although the accident and health assumed reinsurance business has suffered substantial losses during the past several years, we believe that our 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 provide assurance that our current reserves are adequate or that we will not incur losses in the future. Although we have discontinued participation in these reinsurance pools as described above, we may become subject to claims related to prior years or from pools we could not exit in full. Our operating results and financial position may be harmed from liabilities resulting from any such claims. Our profitability could be adversely affected by periodic changes to our relationships with our agencies. Our Risk Management segment reviews our agencies from time to time to identify those that do not meet our profitability standards or are not strategically aligned with our business. Following these periodic reviews, we may restrict such agencies' access to certain types of policies or terminate our relationship with them, subject to applicable contractual and regulatory requirements to renew certain policies for a limited time. For example, we recently identified approximately 600 agencies with whom we plan to either limit or terminate our relationship. Although we currently anticipate a decline of approximately $200 million in our annual written premium as a result of these actions, we expect our overall profitability to improve over time as a result of expected lower losses incurred. However, we cannot be sure that we will achieve the desired results from these measures, and our failure to do so could negatively affect our operating results and financial position. -3- Risks Relating to our Asset Accumulation Business Interest rate fluctuations could negatively affect our profitability. Some of our products, including guaranteed investment contracts, funding agreements, the general account options in our variable products, traditional whole and universal life insurance and fixed annuities expose us to the risk that changes in interest rates will reduce our "spread", or the difference between the amounts that we are required to pay under the contracts and the rate of return we are able to earn on our general account investments intended to support our obligations under the contracts. Declines in our spread from these products or other spread businesses we conduct could have a material adverse effect on our business or results of operations. In periods of increasing interest rates, we may not be able to replace the assets in our general account investment portfolios with higher yielding assets needed to fund the higher crediting rates necessary to keep our interest sensitive products competitive. We therefore may have to accept a lower spread and thus lower profitability or face a decline in sales and greater loss of existing contracts and related assets. In periods of declining interest rates, we may have to reinvest the cash we receive as interest or return of principal on our investments in lower yielding instruments then available. Moreover, borrowers may prepay fixed-income securities, commercial mortgages and mortgage- backed securities in our general account in order to borrow at lower market rates, which increases this risk. Because we are entitled to reset the interest rates on our general account supported life insurance and annuity products and guaranteed investment contracts only at limited, pre-established intervals, and since many of our policies have guaranteed minimum interest or crediting rates, our spreads could decrease and potentially become negative. A decline in market interest rates available on investments could also reduce our return from investments of capital that do not support particular policy obligations, which could have a material adverse effect on our results of operations. Increases in interest rates may cause increased surrenders and withdrawal of insurance products. In periods of increasing interest rates, policy loans and surrenders and withdrawals of life insurance policies and annuity contracts may increase as policyholders seek to buy products with perceived higher returns. This process may lead to a flow of cash out of our businesses. These outflows may require investment assets to be sold at a time when prices for those assets are lower because of the increase in market interest rates, which may result in realized investment losses. The value of fixed income investments, in particular, tends to fluctuate in an inverse relationship to interest rates. A sudden demand among consumers to change product types or withdraw funds could lead us to sell assets at a loss to meet the demand for funds. In addition, unanticipated withdrawals and terminations also may require us to accelerate the amortization of deferred policy acquisition costs. This would increase our current expenses. A continued decline or increase in volatility in the securities markets may negatively affect our business. Our investment-based and asset management products and services expose us to the risk that sales will continue to decline and lapses in variable life and annuity products and withdrawal of assets from other investment products will increase if, as a result of a continued market downturn, increased market volatility or other market conditions, customers become dissatisfied with their investments. A declining market also leads to lower account balances as a result of decreases in market value of assets under management. In many cases, our fees in these businesses are based on a percentage of the assets we manage and, if account values decline, our fee revenue declines. A declining market also results in a decline in the volume of transactions that we execute for our customers in our brokerage business, and therefore a decline in our commission and fee revenue. In addition, the lower account balances that result from a declining securities market particularly affect our variable annuity products that offer guaranteed minimum death benefits, or GMDB. Under certain market conditions, including those we currently face, the assets in an annuitant's account may be insufficient to satisfy our -4- GMDB obligations at the time of the annuitant's death. In this case, we must satisfy the difference from other cash sources. In the event that a significant number of deaths of such annuitants occur at a time that account balances are decreased as a result of a market downturn, our liquidity, level of statutory capital and earnings would be significantly and adversely affected. In recent quarters, our GMDB expense has been approximately $2 million to $3 million per quarter, net of adjustment for deferred policy acquisition cost amortization,and we expect such expense to increase by approximately $6 million to $8 million per quarter, net of adjustment for deferred policy acquisition costs amortization, as a result of the sustained decline in the financial markets we currently face. Additional declines in the financial markets could further increase this expense. Actual losses from claims against our life insurance subsidiaries may exceed their reserves for claims. For our life insurance and annuity products, we calculate reserves based on assumptions and estimates such as estimated premiums we will receive over the assumed life of policy, the timing of the event covered by the insurance policy, the expected life of the insured or annuitant, the anticipated market performance of underlying investments, the amount of benefits or claims to be paid and the investment returns on the assets we purchase with the premiums we receive. We establish reserves based on assumptions and estimates of mortality and morbidity rates, policy and claim termination rates, benefit amounts, investment returns and other factors. Because setting reserves is inherently uncertain, we cannot provide assurance that our existing reserves or future reserves to support our obligations under our life and insurance annuity products will prove adequate in light of subsequent events. Our results of operations and financial condition could therefore be materially affected by adverse loss development for events that we insure. We rely heavily on key relationships to market our variable products, and we could lose sales if we are unable to maintain these relationships. The future sale of our variable products will depend on our ability to recruit new or retain existing career agents, wholesalers, broker-dealers, partnership and other distribution relationships. For example, our relationship with Zurich-Kemper is important for marketing our annuity products. In the nine months ended September 30, 2001, Zurich-Kemper generated approximately 27% of our annuity product sales, based on statutory premiums and deposits. Competition for such relationships is intense. Our success in marketing of our variable products is highly dependent on these relationships and deterioration in them could adversely affect future sales and surrender activities. We could be adversely affected by litigation regarding insurers' sales practices. A number of civil jury verdicts have been returned against life and health insurers in the jurisdictions in which we do business. These cases involved the insurers' sales practices or disclosures, 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 are given substantial discretion in awarding punitive damages in these circumstances. We, from time to time, are subject to litigation of this type. Risks Relating to our Business Generally Other market fluctuations and general economic, market and political conditions may also negatively affect our business and profitability. At September 30, 2001, we held approximately $11.0 billion of investment assets in categories such as fixed maturities, equity securities, mortgage loans and other long-term investments. Our investment returns, and thus our profitability, may be adversely affected from time to time by conditions affecting our specific investments and, more generally, by stock, bonds, real estate and other market fluctuations and general economic, market and political conditions. Our ability to make a profit on insurance products, fixed annuities and guaranteed investment -5- products depends in part on the returns on investments supporting our obligations under these products and the value of specific investments may fluctuate substantially depending on the foregoing conditions. We use a variety of strategies to hedge our exposure to interest rate and other market risk. However, hedging strategies are not always available and carry certain credit risks, and our hedging could be ineffective. The current uncertainties in the U.S. and international economic and investment climates have adversely affected our businesses and profitability in 2001, and can be expected to continue to do so, unless conditions improve. General uncertainties in our business illustrate this risk. The incomes from our Risk Management and Allmerica Financial Services segments in the first nine months of 2001 decreased by 58.8% and 27.2%, respectively, compared to the same period in 2000. As we announced in our press release dated October 29, 2001, our forecasts for net operating earnings for the three months and year ended December 31, 2001 are materially lower than ranges we had previously announced for such periods. Market conditions also affect the value of assets under our employee pension plans. The expense or benefit related to our employee pension plans results from several factors, including changes in the market value of plan assets, interest rates and employee compensation levels. We recognized net expenses of $3.9 million related to our employee pension plans during the nine months ended September 30, 2001. In 2002, we expect a significant increase in such costs due to a decline in the market value of plan assets and interest rates in 2001. Such increased costs could negatively affect our results of operations. In addition, debt securities comprise a material portion of our investment portfolio. The issuers of those securities, as well as borrowers under the loans we make, customers, trading counterparties, counterparties under swaps and other derivative contracts and reinsurers, may be affected by the declining market. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, downturns in the economy or real estate values, operational failure or other reasons. The current uncertain trend in the U.S. and other economies has resulted in rising investment impairments. Our ability to fulfill our debt and other obligations could be adversely affected by the default of third parties on their obligations owed to us. We are a holding company and rely on our insurance company subsidiaries for cash flow; we may not be able to receive dividends from our subsidiaries in needed amounts. We are a holding company for a diversified group of insurance and financial services companies and our principal assets are the shares of capital stock of our subsidiaries. Our ability to make required debt service payments as well as our ability to pay operating expenses and pay dividends to shareholders, depends upon the receipt of sufficient funds from our subsidiaries. The payment of dividends by our insurance company subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as the regulatory restrictions. For example, during the nine months ended September 30, 2001, we received $100.0 million of dividends from our property and casualty businesses. Additional dividends from our insurance subsidiaries prior to April 2002 would be considered "extraordinary" and would require approval from state regulators. In addition, we have agreed with the Commonwealth of Massachusetts Insurance Commissioner not to receive any dividends from FAFLIC in 2001 without the commissioner's prior approval. The ability of FAFLIC to make dividends may also be affected by our commitment with the Commonwealth of Massachusetts Insurance Commissioner to maintain a minimum risk-based capital ratio for FAFLIC of 225% until after December 31, 2004. In the event that FAFLIC's risk-based capital falls below 225%, the Commissioner has the authority to require FAFLIC to increase the ratio to at least 225% pursuant to a reasonable plan approved by the Commissioner. This ratio is higher than that which we would otherwise be required to maintain under state law and could impede our ability to receive dividends from FAFLIC. We have not received, and cannot depend on receiving, dividends from our life insurance subsidiaries. Because of the regulatory limitations on the payment of dividends from our insurance company subsidiaries, we may not always be able to receive dividends from these subsidiaries at times and in amounts necessary to meet our debt and other obligations. The inability of our subsidiaries to pay dividends to us in an -6- amount sufficient to meet our debt service and funding obligations would have a material adverse effect on us. These regulatory dividend restrictions also impede our ability to transfer cash and other capital resources among our subsidiaries. Our dependence on our insurance subsidiaries for cash flow exposes us to the risk of changes in their ability to generate sufficient cash inflows from new or existing customers or from increased cash outflows. Cash outflows may result from claims activity, surrenders, lapses or investment losses. In addition, a shortage of available cash could limit our life and annuity companies' ability to generate product sales (deposits), as most life and annuity sales require immediate cash payments to agents, brokers or other producers upon the sale of the product. Reductions in cash flow from our subsidiaries would have a material adverse effect on our business and results of operations. Fluctuations in currency exchange rates may adversely affect our financial condition. We have investments in securities denominated in foreign currencies. As of September 30, 2001, our investments in foreign currency denominated securities amounted to approximately $22.3 million, based on the exchange ratio prevailing on that date between the U.S. dollar and the relevant foreign currency . We also hold trust obligations backed by funding obligations denominated in foreign currencies. As a result, we are exposed to changes in exchange rates between the U.S. dollar and various foreign currencies, including the Swiss Franc, Japanese Yen, British Pound and the Euro. To the extent these exchange rates fluctuate in the future, our financial condition could be adversely affected. We enter into foreign exchange swap contracts and compound foreign currency or interest rate swap contracts from time to time to mitigate risks from foreign currency fluctuations. However, we cannot provide assurance that these measures will be adequate, or that these risks will not adversely affect our business. Furthermore, swap contracts and similar transactions also expose us to credit risk with the counter-party to the transaction. Our businesses are heavily regulated and changes in regulation may reduce our profitability. Our insurance businesses are subject to supervision and regulation by the state insurance authority in each state in which we transact business. This system of supervision and regulation relates to numerous aspects of an insurance company's business and financial condition, including limitations on the authorization of lines of business, underwriting limitations, the ability to terminate agents, supervisory and liability responsibilities for agents and registered representatives, the setting of premium rates, the requirement to write certain classes of business which we might otherwise avoid or charge different 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. Most insurance regulations are designed to protect the interests of policyholders rather than stockholders and other investors. State regulatory oversight and various proposals at the federal level may in the future adversely affect our 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. Products that are also "securities", such as variable life insurance and variable annuities, are also subject to federal and state securities laws and such products and their distribution are regulated and supervised by the Securities and Exchange Commission, the National Association of Securities Dealers, or NASD, and state securities commissions. Our business could be negatively impacted by adverse state and federal legislation or regulation, including those resulting in: . decreases in rates; . limitations on premium levels; -7- . increases in minimum capital and reserve requirements; . benefit mandates; . limitations on the ability to manage care and utilization; . requirements to write certain classes of business; . tax treatment of insurance and annuity products; and . restrictions on underwriting. We are rated by several rating agencies, and a decline in our ratings could adversely affect our operations. Ratings have become increasingly important in establishing the competitive position of insurance companies. Our ratings are important in marketing the products of our insurance companies to our agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Our insurance company subsidiaries are rated by A.M. Best and Moody's, and certain of our insurance company subsidiaries are rated for their claims-paying ability by Standard & Poor's and Fitch. These ratings reflect a rating agency's opinion of our insurance subsidiaries' financial strength, operating performance, strategic position and ability to meet their obligations to policyholders. These ratings are not evaluations directed to investors, and are not recommendations to buy, sell or hold our securities. Our ratings are subject to periodic review by the rating agencies and we cannot guarantee the continued retention of our ratings. Negative changes in our level of statutory surplus could adversely affect our rates and profitability. 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. Regulators may require that additional capital be contributed to increase the level of statutory surplus. Failure to maintain certain levels of statutory surplus could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by private rating agencies. The National Association of Insurance Commissioners, or 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 and investments to report a minimum capital requirement proportional to the amount of risk assumed by the insurer. We believe that any failure to maintain appropriate levels of statutory surplus would have an adverse impact on our rates and profitability. We are subject to mandatory assessments by state guaranty funds; an increase in these assessments could adversely affect our results of operations and financial condition. All fifty states of the United States have insurance guaranty fund laws requiring life and property and casualty insurance companies doing business within the state to participate in guaranty associations. These associations are organized to pay contractual obligations under insurance policies issued by impaired or insolvent insurance companies. The 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 -8- 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. During 2001, we had a total assessment of approximately $2.4 million levied against us. These assessments may increase in the future depending upon the rate of insolvencies of insurance companies. An increase in assessments could adversely affect our results of operations and financial condition. Intense competition could negatively affect our ability to maintain or increase our profitability. We compete with a large number of other companies in each of our three principal segments: risk management, financial services and asset management. We compete, and will continue to compete, with national and regional insurers, mutual companies, specialty insurance companies, underwriting agencies and financial services institutions. In recent years, there has been substantial consolidation and convergence among companies in the financial services industry, particularly as the laws separating banking, insurance and securities have been relaxed, resulting in increased competition from large, well- capitalized financial services firms. Many of our competitors have greater financial, technical and operating resources than we do. In addition, competition in the property and casualty insurance markets has intensified over the past several years. This competition may have an adverse impact on our revenues and profitability. A number of new, proposed or potential legislative or industry developments could further increase competition in our industry. These developments include: . the enactment of the Gramm-Leach-Bliley Act of 1999, which could result in increased competition from new entrants to our markets; . the implementation of commercial lines deregulation in several states; . programs in which state-sponsored entities provide property insurance in catastrophe prone areas or other alternative markets types of coverage; and . changing practices caused by the Internet, which have led to greater competition in the insurance business in general. In addition, we could face heightened competition resulting from the entry of new competitors and the introduction of new products by new and existing competitors. Increased competition could make it difficult for us to obtain new customers, retain existing customers or maintain policies in force by existing customers. It could also result in increasing our service, administrative, policy acquisition or general expense due to the need for additional advertising and marketing of our products. We cannot provide assurance that we will be able to maintain our current competitive position in the markets in which we operate, or that we will be able to expand our operations into new markets. If we fail to do so, our business could be materially adversely affected. If we are unable to attract and retain qualified personnel, we may not be able to compete effectively and our operations could be impacted significantly. Our future success will be affected by our continued ability to attract and retain qualified executives. Our success depends in large part on our President and Chief Executive Officer, John F. O'Brien, the loss of whom could adversely affect our business. We do not currently have an employment agreement with Mr. O'Brien or any of our key executives. We cannot guarantee that our reinsurers will pay in a timely fashion, if at all. -9- We purchase reinsurance by transferring part of the risk that we have assumed (known as ceding) to a reinsurance company in exchange for part of the premium we receive in connection with the risk. As of September 30, 2001, our reinsurance receivable amounted to approximately $1.4 billion. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us (the reinsured) of our liability to our policyholders or, in cases where we are a reinsurer, to our reinsureds. Accordingly, we bear credit risk with respect to our reinsurers. We cannot be sure that our reinsurers will pay the reinsurance recoverables owed to us currently or in the future or that they will pay such recoverables on a timely basis. Additionally, as discussed above, the availability, scope of coverage, cost, and creditworthiness of reinsurance could also be adversely affected as a result of the September 11, 2001 terrorist attacks and the perceived risks associated with future terrorist activies. We cannot currently estimate the impact of these events on us. Changes in federal income tax law could make some of our products less attractive to customers and increase our tax costs. In June 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted. The 2001 Act contains provisions that will, over time, significantly lower individual tax rates. This will have the effect of reducing the benefits of deferral on the build-up value of annuities and life insurance products. The 2001 Act also includes provisions that will eliminate, over time, the estate, gift and generation-skipping taxes and partially eliminate the step- up in basis rule applicable to property held in a decedent's estate. Some of these changes might hinder our life and annuity product sales and result in increased surrender of insurance products. We cannot predict the overall effect on the sales of our products of the tax law changes included in the 2001 Act. Congress has, from time to time, also considered other tax legislation that could make our products less attractive to consumers, including legislation that would reduce or eliminate the benefit of the current federal income tax rule under which tax on the build-up value of annuities and life insurance products can generally be deferred until payments are made to our policyholder or other beneficiary and excluded when paid as a death benefit under a life insurance contract. Congress, as well as foreign, state and local governments, also consider from time to time legislation that could increase our tax costs. If such legislation is adopted, our consolidated net income could decline. We cannot predict whether such legislation will be enacted, what the specific terms of any such legislation will be or how, if at all, it might affect sales of our products. -10- -----END PRIVACY-ENHANCED MESSAGE-----