-----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, ViEX4Gc+EIexn3D0eEkQlBbj5BaLDLCaJ/iLuwwhnfmR7egx6jKbAFlUw/6DXjZa Bo6gVnUi9yY2aJYArz5dwg== 0000944695-98-000019.txt : 19981116 0000944695-98-000019.hdr.sgml : 19981116 ACCESSION NUMBER: 0000944695-98-000019 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980930 FILED AS OF DATE: 19981113 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: SEC FILE NUMBER: 001-13754 FILM NUMBER: 98749289 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 10-Q 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, 1998 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: 60,353,982 shares of common stock outstanding, as of November 1, 1998. Page 1 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 8-14 Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations 15-38 PART II. OTHER INFORMATION Item 6.Exhibits and Reports on Form 8-K 39 SIGNATURES 40 Page 2 PART I - FINANCIAL INFORMATION ITEM I - 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) 1998 1997 1998 1997 REVENUES Premiums $ 570.4 $ 585.6 $ 1,730.0 $1,726.7 Universal life and investment product policy fees 75.0 61.4 217.2 174.8 Net investment income 153.0 164.5 462.5 498.5 Net realized investment gains 9.5 14.7 50.5 56.7 Other income 35.7 29.5 104.0 86.4 ------ ------ ------- ------ Total revenues 843.6 855.7 2,564.2 2,543.1 ------ ------ ------- ------ BENEFITS, LOSSES AND EXPENSES Policy benefits, claims,losses and loss adjustment Expenses 524.1 515.1 1,549.5 1,516.1 Policy acquisition expenses 111.6 114.2 344.0 344.7 Sales practice litigation expense 31.0 0.0 31.0 0.0 Loss from exiting reinsurance pools 25.3 0.0 25.3 0.0 Loss from cession of disability income business 0.0 0.0 0.0 53.9 Other operating expenses 143.1 136.3 422.1 408.1 Total benefits, losses and ------ ------ -------- ------- expenses 835.1 765.6 2,371.9 2,322.8 ------ ------ -------- ------- Income before federal income taxes 8.5 90.1 192.3 220.3 ------ ------- -------- ------- Federal income tax expense (benefit) Current 13.1 33.8 57.0 66.2 Deferred (22.0) (9.8) (23.3) (13.2) ------- ------- -------- ------- Total federal income tax expense (8.9) 24.0 33.7 53.0 ------- ------- -------- ------- Income before minority interest 17.4 66.1 158.6 167.3 Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (4.0) (4.1) (12.0) (10.5) Equity in earnings (5.2) (1.3) (11.1) (42.5) ------- ------- -------- -------- (9.2) (5.4) (23.3) (53.0) ------- ------- -------- -------- Net income $ 8.2 $ 60.7 $ 135.3 $ 114.3 ======= ======= ======== ======== PER SHARE DATA Basic Net income $ 0.14 $ 1.04 $ 2.26 $ 2.16 Weighted average shares ======= ======= ======== ======== outstanding 60.0 58.2 60.0 52.9 ======= ======= ======== ======== Diluted Net income $ 0.13 $ 1.04 $ 2.24 $ 2.16 Weighted average shares ======= ======= ======== ======== outstanding 60.6 58.4 60.5 53.0 ======= ======= ======== ======== Dividends declared to shareholders $ 0.05 $ 0.05 $ 0.15 $ 0.15 ======= ======= ======== ========
The accompanying notes are an integral part of these consolidated financial statements. Page 3 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
(Unaudited) September 30, December 31, (In millions, except per share data) 1998 1997 ASSETS Investments: Debt securities-at fair value (amortized cost of $7,679.2 and $7,052.9) $ 7,917.9 $ 7,313.7 Equity securities-at fair value (cost of $290.5 and $341.1) 371.9 479.0 Mortgage loans 561.5 567.5 Real estate 25.1 50.3 Policy loans 153.4 141.9 Other long-term investments 139.2 148.3 --------- --------- Total investments 9,169.0 8,700.7 --------- --------- Cash and cash equivalents 410.3 215.1 Accrued investment income 140.4 142.3 Deferred policy acquisition costs 1,108.3 965.5 Deferred federal income taxes 39.4 0.0 Reinsurance receivable on paid and unpaid losses, benefits and unearned premiums 1,155.2 1,040.3 Premiums, accounts and notes receivable, net 551.8 554.4 Other assets 441.5 368.6 Closed Block assets 803.8 806.7 Separate account assets 11,424.9 9,755.4 --------- --------- Total assets $25,244.6 $22,549.0 ========= ========= LIABILITIES Policy liabilities and accruals: Future policy benefits $ 2,748.5 $ 2,598.6 Outstanding claims, losses and loss adjustment expenses 2,856.3 2,825.1 Unearned premiums 883.4 846.8 Contractholder deposit funds and other policy liabilities 2,567.1 1,852.7 --------- --------- Total policy liabilities and accruals 9,055.3 8,123.2 --------- --------- Expenses and taxes payable 621.0 670.7 Reinsurance premiums payable 77.5 37.7 Short-term debt 58.5 33.0 Deferred federal income taxes 0.0 12.9 Long-term debt 199.5 202.1 Closed Block liabilities 878.4 885.5 Separate account liabilities 11,420.4 9,749.7 --------- --------- Total liabilities 22,310.6 19,714.8 --------- --------- Minority interest: Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 300.0 Common stock 153.7 152.9 --------- --------- Total minority interest 453.7 452.9 --------- --------- Commitments and contingencies (Note 9) SHAREHOLDERS' EQUITY Preferred stock, $0.01 par value, 20.0 million shares authorized, none issued 0.0 0.0 Common stock, $0.01 par value, 300.0 million shares authorized, 60.4 million and 60.0 million shares issued and outstanding, respectively 0.6 0.6 Additional paid-in capital 1,767.6 1,755.0 Accumulated other comprehensive income 178.1 217.9 Retained earnings 534.0 407.8 --------- --------- Total shareholders' equity 2,480.3 2,381.3 --------- --------- Total liabilities and shareholders' equity $25,244.6 $22,549.0 ========= =========
The accompanying notes are an integral part of these consolidated financial statements. Page 4 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited) Nine Months Ended September 30 (In millions) 1998 1997 PREFERRED STOCK Balance at beginning and end of period $ 0.0 $ 0.0 -------- -------- COMMON STOCK Balance at beginning of period 0.6 0.5 Issuance of common stock 0.0 0.1 -------- -------- Balance at end of period 0.6 0.6 -------- -------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period 1,755.0 1,382.5 Issuance of common stock 12.6 375.9 Issuance costs of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 0.0 (3.7) -------- -------- Balance at end of period 1,767.3 1,754.7 -------- -------- ACCUMULATED OTHER COMPREHENSIVE INCOME NET UNREALIZED APPRECIATION ON INVESTMENTS Balance at beginning of period 217.9 131.6 Net (depreciation)appreciation on available-for-sale securities (64.4) 130.6 Benefit (provision) for deferred federal income taxes 22.3 (46.4) Minority interest 2.3 (24.0) -------- -------- Other comprehensive income (39.8) 60.2 -------- -------- Balance at end of period 178.1 191.8 -------- -------- RETAINED EARNINGS Balance at beginning of period 407.8 210.1 Net income 135.3 114.3 Dividends to shareholders (9.1) (8.1) -------- -------- Balance at end of period 534.0 316.3 -------- -------- Total shareholders' equity $2,480.3 $2,263.4 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. Page 5 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Net income $ 8.2 $ 60.7 $135.3 $114.3 Other comprehensive income Net (depreciation)appreciation on available-for sale securities (108.5) 105.8 (64.4) 130.6 Benefit(provision)for deferred federal income taxes 38.0 (37.7) 22.3 (46.4) Minority interest 5.0 (17.8) 2.3 (24.0) ------ ------- ------- ------- Other comprehensive income (65.5) 50.3 (39.8) 60.2 ------ ------- ------- ------- Comprehensive income $(57.3) $111.0 $ 95.5 $174.5 ====== ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. Page 6 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) Nine Months Ended September 30 (In millions) 1998 1997 CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 135.3 $ 114.3 Adjustments to reconcile net income to net cash(used in)provided by operating activities: Minority interest 11.3 42.5 Net realized gains (50.2) (57.8) Net amortization and depreciation 24.3 20.5 Loss from exiting reinsurance pools 25.3 0.0 Sales practice litigation expense 31.0 0.0 Loss from cession of disability income business 0.0 53.9 Deferred federal income taxes (23.3) (13.3) Change in deferred acquisition costs (143.2) (70.2) Change in premiums and notes receivable, net of reinsurance payable 42.9 (0.9) Change in accrued investment income 1.2 7.2 Change in policy liabilities and accruals, net 177.9 (86.1) Change in reinsurance receivable (84.9) 46.8 Change in expenses and taxes payable (108.3) 8.8 Separate account activity, net 1.3 0.2 Other, net (46.5) (12.0) Net cash (used in) provided by -------- -------- operating activities (5.9) 53.9 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from disposals and maturities of available-for-sale fixed maturities 1,552.5 2,068.3 Proceeds from disposals of equity securities 228.3 126.6 Proceeds from disposals of other investments 79.4 96.0 Proceeds from mortgages matured or collected 147.5 157.4 Purchase of available-for-sale fixed maturities (2,209.6) (2,064.4) Purchase of equity securities (111.3) (45.8) Purchase of other investments (221.3) (94.3) Capital expenditures (4.3) (5.4) Purchase of minority interest in Allmerica P & C 0.0 (425.6) Other investing activities, net (7.9) 1.2 Net cash used in investing -------- -------- activities (546.7) (186.0) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Deposits and interest credited to contractholder deposit funds 1,167.0 173.8 Withdrawals from contractholder deposit funds (456.5) (501.2) Change in short-term debt 25.5 150.8 Change in long-term debt (2.6) 0.0 Net proceeds from issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 0.0 296.3 Net proceeds from issuance of common stock 11.2 2.6 Dividends paid to shareholders (9.9) (8.1) Treasury stock purchased at cost (8.0) 0.0 Net cash provided by financing -------- -------- activities 726.7 114.2 -------- -------- Net change in cash and cash equivalents 174.1 (17.9) Net change in cash held in the Closed Block 21.1 2.7 Cash and cash equivalents, beginning of period 215.1 178.5 -------- -------- Cash and cash equivalents, end of period $ 410.3 $ 163.3 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. Page 7 ALLMERICA FINANCIAL CORPORATION NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation 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 AFC, First Allmerica Financial Life Insurance Company ("FAFLIC"), its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries (principally brokerage and investment advisory subsidiaries), and Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance holding company). The Closed Block assets and liabilities at September 30, 1998 and December 31, 1997 are presented in the consolidated financial statements as single line items. Results of operations for the Closed Block for the quarter ended and nine months ended September 30, 1998 and 1997 are included in other income in the consolidated financial statements. All significant intercompany accounts and transactions have been eliminated. The financial statements reflect minority interest in Allmerica P&C and its subsidiary, the Hanover Insurance Company ("Hanover") of approximately 40.5% prior to the merger on July 16, 1997. The financial statements also reflect minority interest in Citizens Corporation (an 83.2%-owned non-insurance holding company subsidiary of Hanover) and its wholly-owned subsidiary, Citizens Insurance Company of America ("Citizens"). The accompanying interim consolidated financial statements reflect, in the opinion of the Company's management, all adjustments, consisting of only normal and recurring adjustments, necessary for a fair presentation of the financial position and results of operations. Certain reclassifications have been made to the 1997 consolidated statements of income in order to conform to the 1998 presentation. The results of operations for the quarter and nine months ended September 30, 1998 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 1997 Annual Report to Shareholders, as filed on Form 10-K with the Securities and Exchange Commission. 2. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement No. 133), which establishes accounting and reporting standards for derivative instruments. Statement No. 133 requires that an entity recognize all derivatives as either assets or liabilities at fair value in the statement of financial position, and establishes special accounting for the following three types of hedges: fair value hedges, cash flow hedges, and hedges of foreign currency exposures of net investments in foreign operations. This statement is effective for fiscal years beginning after June 15, 1999. The Company believes that the adoption of this statement will not have a material effect on the results of operations or financial position. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use" ("SoP No. 98-1"). SoP No. 98-1 requires that certain costs incurred in developing internal-use computer software be capitalized and provides guidance for determining whether computer software is to be considered for internal use. This statement is effective for fiscal years beginning after December 15, 1998. In the second quarter, the Company adopted SoP No. 98-1 effective January 1, 1998, resulting in an increase in pre-tax income of $6.2 million. The adoption of SoP No. 98-1 did not have a material effect on the results of operations or financial position for the three months ended March 31, 1998. Through the nine months ended September 30, 1998, the adoption of this SoP resulted in a $7.5 million increase to pre-tax income. In December 1997, the AICPA issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SoP No. 97-3"). SoP No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and how to measure the liability. This statement allows for the discounting of the liability if the amount and timing of the cash payments are fixed and determinable. In addition, it provides criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges. This statement is effective for fiscal years beginning after December 15, 1998. The Company believes that the adoption of this statement will not have a material effect on the results of operations or financial position. Page 8 In June 1997, the FASB issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (Statement No. 130). Statement No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. All items that are required to be recognized under accounting standards as components of comprehensive income are to be reported in a financial statement that is displayed with the same prominence as other financial statements. This statement stipulates that comprehensive income reflect the change in equity of an enterprise during a period from transactions and other events and circumstances from non-owner sources. This statement is effective for fiscal years beginning after December 15, 1997. The Company adopted Statement No. 130 for the first quarter of 1998, which resulted primarily in reporting unrealized gains and losses on investments in debt and equity securities in comprehensive income. In June 1997, the FASB also issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" (Statement No. 131). This statement establishes standards for the way that public enterprises report information about operating segments in annual financial statements and requires that selected information about those operating segments be reported in interim financial statements. This statement supersedes Statement No. 14, "Financial Reporting for Segments of a Business Enterprise". Statement No. 131 requires that all public enterprises report financial and descriptive information about their reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. This statement is effective for fiscal years beginning after December 15, 1997. The Company adopted Statement No. 131 for the first quarter of 1998, which resulted in certain segment re-definitions which have no impact on the consolidated results of operations. (See Note 7.) 3. Merger with Allmerica Property & Casualty Companies, Inc. The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was consummated on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash of $425.6 million and approximately 9.7 million shares of AFC stock valued at $372.5 million. On February 3, 1997, the Company issued $300.0 million of Series A Capital Securities ("Capital Securities"). Net proceeds from the offering of approximately $296.3 million funded a portion of the July 16, 1997 acquisition. The merger has been accounted for as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The Company's consolidated results of operations include minority interest in Allmerica P&C prior to July 16, 1997. The unaudited pro forma information below presents consolidated results of operations as if the merger and issuance of Capital Securities had occurred at the beginning of 1997 and reflects adjustments which include interest expense related to the assumed financing of a portion of the cash consideration paid and amortization of goodwill. Page 9 The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the merger and issuance of Capital Securities occurred at the beginning of 1997, nor is it necessarily indicative of future results.
(Unaudited) Nine Months Ended September 30, (In millions) 1997 Revenue $ 2,521.6 ========= Net realized capital gains included in revenue $ 43.2 ========= Income before taxes and minority interest $ 196.4 Income taxes (45.1) Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (12.0) Equity in earnings (10.9) --------- Net income $ 128.4 ========= Net income per common share (basic and diluted) $ 2.14 ========= Weighted average shares outstanding( diluted) 60.0 ========= Weighted average shares outstanding(basic) 59.9 =========
4. Significant Transactions On October 27, 1998, the Company announced that it, or one of its subsidiaries, shortly will commence a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock that AFC or its subsidiaries do not already own at a price of $29.00 per share. On November 2, 1998, AFC commenced the tender offer which, unless extended, will expire on December 2, 1998. Based on the number of shares of Citizens Corporation common stock held by unaffiliated stockholders, the transaction is valued at $171.0 million. Citizens Corporation has established a special committee of the Board of Directors, consisting of directors unaffiliated with AFC, to study the offer and make a recommendation to Citizens Corporation stockholders. On October 27, 1998, the Board of Directors of AFC authorized the repurchase of up to $200.0 million of its issued common stock. Effective July 1, 1998, the Company entered into a reinsurance agreement with a highly rated reinsurer that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the Company's accident and health assumed reinsurance pool business. These pools consist primarily of the Corporate Risk Management segment's assumed stop loss business, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. The agreement is consistent with management's decision to exit this line of business, which the Company expects to run-off over the next three years. As a result of this transaction, the Company recognized a $25.3 million pre-tax loss in the third quarter of 1998. On January 1, 1998, substantially all of the Company's defined benefit, defined contribution 401(K) and post retirement plans were merged with the existing benefit plans of FAFLIC. The transfer of benefit plans did not have a material impact on the results of operations or financial position of the Company. 5. Federal Income Taxes Federal income tax expense for the periods ended September 30, 1998 and 1997, 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. Significant items, such as the loss from exiting reinsurance pools, sales practice litigation expenses and the loss from the cession of disability income business, are reflected in Federal income tax expense as discreet items, based on the statutory tax rate. Page 10 6. Closed Block Included in other income in the Consolidated Statements of Income is a net pre-tax contribution from the Closed Block of $0.1 million and $6.1 million for the third quarter and nine months ended September 30, 1998, respectively, compared to $2.3 million and $8.3 million, for the third quarter and nine months ended September 30, 1997, respectively. Summarized financial information of the Closed Block is as follows:
(Unaudited) September 30, December 31, (In millions) 1998 1997 ASSETS Fixed maturities-at fair value (amortized cost of $396.7 and $400.1) $417.4 $412.9 Mortgage loans 137.1 112.0 Policy loans 212.5 218.8 Cash and cash equivalents 4.0 25.1 Accrued investment income 14.8 14.1 Deferred policy acquisition costs 15.9 18.2 Other assets 2.1 5.6 ------- ------- Total assets $803.8 $806.7 ======= ======= LIABILITIES Policy liabilities and accruals $865.6 $875.1 Other liabilities 12.8 10.4 ------- ------- Total liabilities $878.4 $885.5 ======= =======
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 REVENUES Premiums $ 9.1 $ 9.3 $46.3 $48.3 Net investment income 13.5 13.1 39.9 39.8 Net realized investment gains(losses) (2.0) 0.1 (0.4) 1.1 ------ ------ ------ ------ Total revenues 20.6 22.5 85.8 89.2 ------ ------ ------ ------ BENEFITS AND EXPENSES Policy benefits 19.5 19.3 76.9 78.4 Policy acquisition expenses 0.9 0.7 2.2 2.1 Other operating expenses 0.1 0.2 0.6 0.4 ------ ------ ------ ------ Total benefits and expenses 20.5 20.2 79.7 80.9 ------ ------ ------ ------ Contribution from the Closed Block $ 0.1 $ 2.3 $ 6.1 $ 8.3 ====== ====== ====== ======
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. Page 11 7. Segment Information The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company conducts business principally in four operating segments. Effective January 1, 1998, the Company adopted Statement No. 131. Upon adoption, the separate financial information of each segment was re-defined 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 significant changes in reportable segments is included below. The Risk Management group includes two segments: Property and Casualty and Corporate Risk Management Services. The Property and Casualty segment includes property and casualty insurance products, such as automobile insurance, homeowners insurance, commercial multiple peril insurance, and workers' compensation insurance. These products are offered by Allmerica P&C through its operating subsidiaries, Hanover and Citizens. Substantially all of the Property and Casualty segment's earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The Corporate Risk Management Services segment includes group life and health insurance products and services which assist employers in administering employee benefit programs and in managing the related risks. The Retirement and Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(K) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in three types of Guaranteed Investment Contracts (GICs); the traditional GIC, the synthetic GIC and the "floating rate" GIC. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the four operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. Significant changes to the Company's segmentation include a reclassification of corporate overhead expenses from each operating segment into the Corporate segment. Additionally, certain products (group retirement products, such as 401(K) plans and tax-sheltered annuities, group variable universal life) and certain other non-insurance operations (telemarketing and trust services) previously reported in the Allmerica Financial Institutional Services segment were combined with the Allmerica Financial Services segment. Also, the Company reclassified the GIC product line previously reported in the Allmerica Financial Institutional Services segment into the Allmerica Asset Management segment. Management evaluates the results of the aforementioned segments based on pre- tax segment income. Pre-tax segment income is determined by adjusting net income for net realized investment gains and losses, net gains and losses on disposals of businesses, 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 pre-tax segment income enhances its understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, pre-tax segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. Page 12 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) 1998 1997 1998 1997 Segment revenues: Risk Management Property and Casualty $545.0 $556.6 $1,654.4 $1,645.6 Corporate Risk Management Services 102.3 103.2 310.7 301.9 ------- ------- --------- --------- Subtotal 647.3 659.8 1,965.1 1,947.5 Retirement and Asset Accumulation Allmerica Financial Services 174.4 177.1 538.0 543.3 Allmerica Asset Management 32.8 22.3 86.6 69.8 ------- ------- --------- --------- Subtotal 207.2 199.4 624.6 613.1 Corporate 3.8 4.5 9.9 14.3 Intersegment revenues (1.5) (2.6) (5.8) (8.7) ------- ------- --------- --------- Total segment revenues including Closed Block 856.8 861.1 2,593.8 2,566.2 Adjustment for Closed Block (22.7) (20.1) (80.1) (79.8) Net realized gains (losses) 9.5 14.7 50.5 56.7 ------- ------- --------- --------- Total revenues $843.6 $855.7 $2,564.2 $2,543.1 ======= ======= ========= ========= Segment income (loss) beforeincome taxes and minority interest: Risk Management Property and Casualty $23.5 $35.9 $98.0 $119.0 Corporate Risk Management Services 0.3 9.0 6.8 18.9 ------- ------- --------- --------- Subtotal 23.8 44.9 104.8 137.9 Retirement and Asset Accumulation Allmerica Financial Services 38.6 37.8 123.9 99.6 Allmerica Asset Management 6.9 5.2 17.0 13.8 ------- ------- --------- --------- Subtotal 45.5 43.0 140.9 113.4 Corporate (9.3) (11.8) (35.6) (30.8) ------- ------- --------- --------- Segment income before income taxes and minority interest 60.0 76.1 210.1 220.5 Adjustments to segment income: Net realized investment gains, net of amortization 4.8 17.1 39.4 59.3 Loss on exiting reinsurance pools (25.3) 0.0 (25.3) 0.0 Sales practice litigation expense (31.0) 0.0 (31.0) 0.0 Loss on cession of disability income business 0.0 0.0 0.0 (53.9) Other items 0.0 (3.1) (0.9) (5.6) ------- ------- --------- --------- Income before taxes and minority interest $ 8.5 $90.1 $192.3 $220.3 ======= ======= ========= =========
Identifiable Assets Deferred Acquisition Costs (Unaudited) (Unaudited) September 30, December 31, September 30, December 31, (In millions) 1998 1997 1998 1997 Risk Management Property and Casualty $ 5,591.5 $ 5,650.4 $ 167.7 $ 167.2 Corporate Risk Management Services 667.1 621.9 2.7 2.9 --------- --------- ------- ------- Subtotal 6,258.6 6,272.3 170.4 170.1 Retirement and Asset Accumulation Allmerica Financial Services 16,979.6 15,159.2 937.2 794.5 Allmerica Asset Management 1,764.4 1,035.1 0.7 0.9 ---------- ---------- -------- ------- Subtotal 18,744.0 16,194.3 937.9 795.4 Corporate 230.9 82.4 0.0 0.0 ---------- ---------- -------- ------- Total $25,233.5 $22,549.0 $1,108.3 $965.5 ========== ========== ======== =======
Page 13 8. Earnings Per Share In 1997, the FASB issued Statement of Financial Accounting Standards No. 128, "Earnings Per Share", (Statement No. 128) which supersedes Accounting Principle Board Opinion No. 15, "Earnings Per Share". This standard replaces the primary earnings per share with a basic and diluted earnings per share computation and requires a dual presentation of basic and diluted earnings per share for those companies with complex capital structures. All earnings per share amounts for all periods have been presented to conform to the Statement No. 128 requirements. The adoption of the aforementioned standard had no effect on the company's previously reported earnings per share. The weighted average number of shares of common stock and equivalents which were utilized in the calculation of basic earnings per share were 60.0 million and 52.9 million for the nine months ended September 30, 1998 and 1997, respectively and 60.0 million and 58.2 million for the quarters ended September 30, 1998 and 1997, respectively. The weighted average shares outstanding used in the calculation of diluted earnings per share include the 0.5 million and 0.1 million share effect of dilutive employee stock options and grants for the nine months ended September 30, 1998 and 1997, respectively, and a 0.6 million and 0.2 million share effect of dilutive employee stock options and grants for the quarter ended September 30, 1998 and 1997, respectively. This difference causes a $0.02 per share difference between basic and diluted earnings per share for the quarter and nine months ended September 30, 1998. 9. Commitments and Contingencies Litigation In July 1997, a lawsuit on behalf of a punitive class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. The Company and the plaintiffs have entered into a settlement agreement which they will present to the court for approval. Although the Company believes it has meritorious defenses to plaintiffs' claims, it concluded that this settlement was best for the Company. Accordingly, AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes it has established an appropriate reserve, this reserve may be revised based on changes in the Company's estimate of the ultimate cost of the settlement. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. Page 14 PART I 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. INTRODUCTION The results of operations for Allmerica Financial Corporation and subsidiaries ("AFC" or "the Company") include the accounts of AFC, First Allmerica Financial Life Insurance Company ("FAFLIC") its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance holding company), The Hanover Insurance Company ("Hanover", a wholly-owned subsidiary of Allmerica P&C), Citizens Corporation ("Citizens", an 83.2%-owned subsidiary of Hanover), Citizens Insurance Company of America (a wholly-owned subsidiary of Citizens) and certain other insurance and non-insurance subsidiaries. The results of operations reflect minority interest in Allmerica P&C and its subsidiary, the Hanover Insurance Company ("Hanover") of approximately 40.5% prior to the merger on July 16, 1997. The results of operations also reflect minority interest in Citizens Corporation. CLOSED BLOCK On completion of its demutualization, FAFLIC established a Closed Block for the payment of future benefits, policyholders' dividends and certain expenses and taxes relating to certain classes of policies. FAFLIC allocated to the Closed Block an amount of assets expected to produce cash flows which, together with anticipated revenues from the Closed Block business, are reasonably expected to be sufficient to support the Closed Block business. The Closed Block includes only those revenues, benefit payments, dividends and premium taxes considered in funding the Closed Block and excludes many costs and expenses associated with operating the Closed Block and administering the policies included therein. Since many expenses related to the Closed Block were excluded from the calculation of the Closed Block contribution, the contribution from the Closed Block does not represent the actual profitability of the Closed Block. As a result of such exclusion, operating costs and expenses outside the Closed Block are disproportionate to the business outside the Closed Block. The contribution from the Closed Block is included in `Other income' in the interim Consolidated Financial Statements. The pre-tax contribution from the Closed Block was $0.1 million and $6.1 million for the third quarter and nine months ended September 30, 1998, respectively, compared to $2.3 million and $8.3 million for the third quarter and nine months ended September 30, 1997, respectively. Page 15 The following table presents the results of operations of the Closed Block combined with the results of operations outside the Closed Block for all periods presented. Management's discussion and analysis addresses the results of operations as combined unless otherwise noted.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 REVENUES Premiums $579.5 $594.9 $1,776.3 $1,775.0 Universal life and investment product policy fees 75.0 1.4 217.2 174.8 Net investment income 166.5 177.6 502.4 538.3 Net realized investment gains 7.5 14.8 50.1 57.8 Other income 35.6 27.2 97.9 78.1 ------- ------- --------- --------- Total revenues 864.1 875.9 2,643.9 2,624.0 ------- ------- --------- --------- BENEFITS, LOSSES AND EXPENSES Policy benefits, claims, losses and loss adjustment expenses 543.6 534.4 1,626.4 1,594.5 Policy acquisition expenses 112.5 114.9 346.2 346.8 Loss from exiting reinsurance pools 31.0 0.0 31.0 0.0 Sales practice litigation expenses 25.3 0.0 25.3 0.0 Loss from cession of disability income business 0.0 0.0 0.0 53.9 Other operating expenses 143.2 136.5 422.7 408.5 ------- ------- --------- --------- Total benefits, losses and expenses 855.6 785.8 2,451.6 2,403.7 ------- ------- --------- --------- Income before federal income taxes 8.5 90.1 192.3 220.3 ------- ------- --------- --------- Federal income tax expense (benefit): Current 13.1 33.8 57.0 66.2 Deferred (22.0) (9.8) (23.3) (13.2) ------- ------- --------- --------- Total federal income tax expense (8.9) 24.0 33.7 53.0 ------- ------- --------- --------- Income before minority interest 17.4 66.1 158.6 167.3 Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (4.0) (4.1) (12.0) (10.5) Equity in earnings (5.2) (1.3) (11.3) (42.5) ------- ------- --------- --------- (9.2) (5.4) (23.3) (53.0) ------- ------- --------- --------- Net income $ 8.2 $ 60.7 $ 135.3 $ 114.3 ======= ======= ========= =========
Page 16 Description of Operating Segments The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company conducts business principally in four operating segments. These segments are Property and Casualty; Corporate Risk Management Services; Allmerica Financial Services; and Allmerica Asset Management. Effective January 1, 1998, the Company adopted Statement No. 131. Consistent with the Company's adoption of this statement, the separate financial information of each segment was re-defined 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 significant changes in reportable segments is included below. The Risk Management group includes two segments: Property and Casualty and Corporate Risk Management Services. The Property and Casualty segment includes property and casualty insurance products, such as automobile insurance, homeowners insurance, commercial multiple peril insurance, and workers' compensation insurance. These products are offered by Allmerica P&C through its operating subsidiaries, Hanover and Citizens. Substantially all of the Property and Casualty segment's earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). Prior to 1998, certain corporate overhead expenses were allocated to the Property and Casualty business and were reflected in the results of this segment. In addition, results of operations from the property and casualty holding companies and certain non- insurance subsidiaries of Allmerica P&C were reflected in the results of this segment. These overhead expenses and the activity from the holding companies are now reported in the Corporate segment. Results from certain non-insurance subsidiaries are no longer being reflected in the results of the Property and Casualty segment. The Corporate Risk Management Services segment includes group life and health insurance products and services which assist employers in administering employee benefit programs and in managing the related risks. Prior to 1998, certain corporate overhead expenses were allocated to the Corporate Risk Management Services business and were reflected in the results of this segment. These overhead expenses are now reported in the Corporate segment. In addition, results from certain non-insurance subsidiaries, which were previously reported in the Property and Casualty segment, are now being reported in the Corporate Risk Management Services segment. The Retirement and Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(K) plans and tax-sheltered annuities distributed to institutions. Prior to 1998, certain corporate overhead expenses were allocated to the Allmerica Financial Services business and were reflected in the results of this segment. These overhead expenses are now reported in the Corporate segment. Certain products (including defined benefit and defined contribution plans, group variable universal life) and certain other non-insurance operations (telemarketing and trust services) previously reported in the Allmerica Financial Institutional Services segment have been combined with the Allmerica Financial Services segment. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in three types of Guaranteed Investment Contracts (GICs); the traditional GIC, the synthetic GIC and the "floating rate" GIC. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. Prior to 1998, certain corporate overhead expenses were allocated to the Allmerica Asset Management business and were reflected in the results of this segment. These overhead expenses are now reported in the Corporate segment. Additionally, the GIC products, now offered through Allmerica Asset Management, were previously reported in the results of the Allmerica Financial Institutional Services segment. In addition to the four operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Series A Capital Securities ("Capital Securities") and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. Through implementation of Statement No. 131, the definition of the Corporate segment was redefined to include all holding companies, as well as the parent company and the corporate debt. Corporate overhead expenses, which were previously allocated to the operating segments, are now included in the Corporate segment. Page 17 Results of Operations Consolidated Overview The Company's consolidated net income decreased $52.5 million, or 86.5%, to $8.2 million, and increased $21.0 million, or 18.4%, to $135.3 million, for the third quarter and nine months ended September 30, 1998, respectively, compared to the same periods in 1997. Net income includes certain items which management believes are not indicative of overall operating trends, such as net realized investment gains and losses, net gains and losses on disposals of businesses, extraordinary items, the cumulative effect of accounting changes, and certain other items. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of adjusted net income enhances its understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, adjusted net income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. For purposes of assessing each segment's contribution to adjusted net income, management evaluates the results of these segments on a pre-tax basis. The following table reflects each segment's contribution to adjusted net income and a reconciliation to consolidated net income as adjusted for these items.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Segment income (loss) before income taxes and minority interest: Risk Management Property and Casualty $23.5 $35.9 $98.0 $119.0 Corporate Risk Management Services 0.3 9.0 6.8 18.9 ------ ------ ------- ------- Subtotal 23.8 44.9 104.8 137.9 Retirement and Asset Accumulation Allmerica Financial Services 38.6 37.8 123.9 99.6 Allmerica Asset Management 6.9 5.2 17.0 13.8 ------ ------ ------- ------- Subtotal 45.5 43.0 140.9 113.4 Corporate (9.3) (11.8) (35.6) (30.8) ------ ------ ------- ------- Segment income before income taxes and minority interest 60.0 76.1 210.1 220.5 ------ ------ ------- ------- Federal income taxes on segment income (10.7) (19.1) (41.4) (53.1) Minority interest: Distributions on Capital Securities (4.0) (4.1) (12.0) (10.5) Equity in earnings (1.9) (0.5) (7.4) (31.6) ------ ------ ------- ------- Adjusted net income 43.4 52.4 149.3 125.3 Adjustments (net of taxes, minority interest and amortization,as applicable): Net realized investment gains 1.4 10.1 23.2 26.8 Sales practice litigation expense (20.2) 0.0 (20.2) 0.0 Loss from exiting reinsurance pools (16.4) 0.0 (16.4) 0.0 Loss on cession of disability income business 0.0 0.0 0.0 (35.0) Other items 0.0 (1.8) (0.6) (2.8) ------ ------ ------- ------- Net income $ 8.2 $60.7 $135.3 $114.3 ====== ====== ======= =======
Page 18 Quarter Ended September 30, 1998 Compared to Quarter Ended September 30, 1997 The Company's segment income before taxes and minority interest declined $16.1 million, or 21.2%, to $60.0 million in the third quarter of 1998, compared to the same period in 1997. This decrease is primarily attributable to reduced income of $21.1 million from the Risk Management segment, partially offset by increased income of $2.5 million from the Retirement and Asset Accumulation segment and decreased losses of $2.5 million in the Corporate segment. Property and Casualty segment income decreased $12.4 million primarily attributable to a $19.3 million increase in catastrophe losses, as well as a decrease in net premiums earned and net investment income. These decreases were partially offset by a $9.4 million increase in favorable development on prior year reserves and a decrease in policy acquisition and other operating expenses. The decrease in Corporate Risk Management segment income of $8.7 million is due to unfavorable loss experience in the risk sharing and long- term disability product lines totaling approximately $7.3 million, as well as increased expenses related to claims processing costs of approximately $3.2 million. Allmerica Asset Management segment income increased $1.7 million for the third quarter of 1998 primarily due to the receipt of a $2.6 million equity participation payment from a mortgage loan, partially offset by a decline in interest margins on GICs. The increase of $0.8 million in the Allmerica Financial Services segment is primarily attributable to higher asset based fee income driven by growth in the variable annuity and variable universal life product lines. This increase was largely offset by losses on hedge fund partnership investments during the quarter. The Corporate segment's decreased net loss primarily reflects the absence of expenses related to the Company's merger with Allmerica P&C on July 16, 1997, as well as the Company's exit from certain non-insurance business during 1998. The effective tax rate for segment income was 17.8% for the third quarter of 1998 compared to 25.1% for the third quarter of 1997. The decrease in tax rates was principally driven by the reduction in underwriting income from the Property and Casualty segment. Net realized gains on investments were $1.4 million in the third quarter of 1998, resulting primarily from after-tax net realized gains on equity securities of $32.4 million, partially offset by after-tax net realized losses of $16.9 million and $12.0 million on fixed maturities and hedge fund partnerships, respectively. During the third quarter of 1997, net realized gains on investments of $10.1 million resulted primarily from sales of equity securities in the Property and Casualty segment. In July 1997, a lawsuit on behalf of a punitive class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. The Company and the plaintiffs have entered into a settlement agreement which they will present to the court for approval. Although the Company believes it has meritorious defenses to plaintiffs' claims, it concluded that this settlement was best for the Company. Accordingly, AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes it has established an appropriate reserve, this reserve may be revised based on changes in the Company's estimate of the ultimate cost of the settlement. Effective July 1, 1998, the Company entered into a reinsurance agreement with a highly rated reinsurer that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the Company's accident and health assumed reinsurance pool business. These pools consist primarily of the Corporate Risk Management segment's assumed stop loss business, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. The agreement is consistent with management's decision to exit this line of business, which the Company expects to run-off over the next three years. As a result of this transaction, the Company recognized a $16.4 million loss, net of taxes, in the third quarter of 1998. Minority interest on segment income increased in the current period as compared to the prior year due primarily to the aforementioned merger with Allmerica P&C. Prior to the acquisition, minority interest reflected 40.5% of the results of operations from this subsidiary. Page 19 Nine Months Ended September 30, 1998 Compared to Nine Months Ended September 30, 1997 The Company's segment income before taxes and minority interest decreased $10.4 million, or 4.7%, to $210.1 million during the first nine months of 1998. This decrease is primarily attributable to reduced income of $33.1 million and increased losses of $4.8 million from the Risk Management and Corporate segments, respectively, partially offset by increased income of $27.5 million from the Retirement and Asset Accumulation segment. Property and Casualty segment income declined $21.0 million for the first nine months of 1998 primarily attributable to an increase in catastrophe losses of $56.5 million, partially offset by a $16.5 million increase in favorable development on prior year reserves and lower policy acquisition and other underwriting expenses. The $12.1 million decrease in Corporate Risk Management segment income was primarily due to unfavorable loss experience in the risk-sharing and long-term disability lines of business and increased operating expenses. The increase of $24.3 million in the Allmerica Financial Services segment was primarily attributable to growth from new deposits and market appreciation in the variable annuity and variable universal life assets resulting in increased fee revenue. The increase in segment income of $3.2 million in the Allmerica Asset Management segment resulted primarily from the aforementioned $2.6 million equity participation payment from a mortgage loan. The operating loss in the Corporate segment increased $4.8 million, primarily due to the absence of $8.1 million of net investment income earned on the proceeds from the prior year issuance of Capital Securities, and to increased overhead costs. This was partially offset by additional net investment income generated by transfers of investments from the Property and Casualty segment. The effective tax rate for segment income was 19.7% for the first nine months of 1998 compared to 24.1% for the same time period in 1997. The decrease in tax rates was principally driven by the reduction in underwriting income from the Property and Casualty segment. Net realized gains on investments were $23.2 million during the first nine months of 1998, primarily due to after-tax net realized gains from sales of appreciated equity securities of $45.4 million, partially offset by $8.6 million of after-tax realized losses from sales of fixed maturities. During the nine months of 1997, net realized gains on investments of $26.8 million resulted primarily from the sale of appreciated equity securities, due to the Company's strategy of shifting to a higher level of debt securities, as well as sales of real estate investment properties. Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of business. The Company recognized a $35.0 million loss, net of taxes, during the first quarter of 1997 upon entering into an agreement in principal to transfer the business. Minority interest on segment income decreased in the current period as compared to the prior year due primarily to the Company's merger with Allmerica P&C on July 16, 1997. Prior to the acquisition, minority interest reflected 40.5% of the results of operations from this subsidiary. Page 20 Risk Management Property and Casualty The following table summarizes the results of operations for the Property and Casualty segment.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Segment revenues Net premiums earned $487.2 $493.4 $1,476.5 $1,454.4 Net investment income 56.1 62.1 170.8 187.8 Other income 1.7 1.1 7.1 3.4 ------ ------ -------- -------- Total segment revenues 545.0 556.6 1,654.4 1,645.6 Losses and loss adjustment expenses 385.5 373.7 1,135.5 1,084.1 Policy acquisition and other operating expenses 136.0 147.0 420.9 442.5 ------ ------ -------- -------- Segment income before taxes and minority interest $ 23.5 $ 35.9 $ 98.0 $ 119.0 ====== ====== ======== ======== Includes policyholders' dividends of $2.5 million, $2.8 million, $8.1 million and $6.9 million for the quarters ended September 30, 1998 and 1997 and the nine months ended September 30, 1998 and 1997, respectively.
Quarter Ended September 30, 1998 Compared to Quarter Ended September 30, 1997 Property and Casualty segment's income before taxes and minority interest decreased $12.4 million, to $23.5 million, in the third quarter of 1998, compared to $35.9 million, for the same period in 1997. This decrease is primarily attributable to a $19.3 million increase in catastrophe losses, to $28.5 million for the third quarter of 1998, compared to $9.2 million for the comparable quarter of 1997, as well as decreases in net premiums earned and net investment income. These decreases were partially offset by a $9.4 million increase in favorable development on prior year reserves and a decrease in policy acquisition and other operating expenses. Net investment income before taxes decreased $6.0 million, or 9.7%, to $56.1 million during the third quarter of 1998, compared to $62.1 million in the comparable quarter of 1997.The decrease is primarily the result of a decrease in average invested assets at Hanover and a $2.1 million decrease in limited partnership income at both Hanover and Citizens. The average pre-tax yield on debt securities was 6.6% and 6.7% for the third quarter of 1998, and 1997, respectively. LINE OF BUSINESS RESULTS Personal Lines of Business The personal lines of business represented 62.2% and 61.7% of total net premiums earned in the third quarter of 1998 and 1997, respectively.
Total (Unaudited) Property Quarter Ended September 30, Hanover Citizens & Casualty (In millions) 1998 1997 1998 1997 1998 1997 Net premiums earned $152.9 $158.8 $150.2 $145.7 $303.1 $304.5 Losses and loss adjustment expenses 114.8 128.6 124.3 114.1 239.1 242.7 Policy acquisition and other underwriting expenses 46.5 52.8 35.9 37.0 82.4 89.8 ------- ------- ------- ------- ------- ------- Underwriting loss $ (8.4) $(22.6) $(10.0) $ (5.4) $(18.4) $(28.0) ======= ======= ======= ======= ======= =======
Page 21 Revenues Personal lines' net premiums earned decreased $1.4 million, or 0.5%, to $303.1 million during the third quarter of 1998, compared to $304.5 million in the third quarter of 1997. Hanover's personal lines' net premiums earned decreased $5.9 million, or 3.7%, to $152.9 million during the third quarter of 1998. This decrease is primarily due to decreases in policies in force, since September 30, 1997, of 4.5% and 3.9%, in the personal automobile and homeowner's lines, respectively. This decline is associated with the Company's decision last year to exit certain Western and Southern states. A mandated 4.0% decrease in Massachusetts' personal automobile rates which became effective January 1, 1998, also contributed to the decrease in net premiums earned. Citizens' personal lines' net premiums earned increased $4.5 million, or 3.1%, to $150.2 million for the quarter ended September 30, 1998, from $145.7 million for the quarter ended September 30, 1997. This increase is primarily attributable to a twelve month average rate increase of 15.9% in the homeowner's line. This is partially offset by a decrease in policies in force since September 30, 1997, of 2.5% and 1.8% in the personal automobile and homeowner's lines, respectively. While management has taken steps to increase penetration in the affinity groups and has initiated other marketing programs, the Company believes that heightened competition may continue to impact premium growth in the personal segment. Underwriting results The personal lines' underwriting results in the third quarter of 1998 improved $9.6 million, to a loss of $18.4 million, compared to a loss of $28.0 million for the same period in 1997. Hanover's underwriting results improved $14.2 million, to a loss of $8.4 million. Citizens' underwriting results deteriorated $4.6 million, to a loss of $10.0 million. The improvement in Hanover's underwriting results is primarily attributable to favorable non-catastrophe current year claims activity in the personal automobile line and an aggregate $2.0 million increase in favorable development on prior year reserves in the personal automobile and homeowner's lines. This was partially offset by a $6.1 million increase in catastrophe losses, primarily in the homeowner's line. The deterioration in Citizens' underwriting results is attributed to an increase in losses and loss adjustment expense (LAE) of $10.2 million, or 8.9%, to $124.3 million. This increase is primarily the result of a $7.4 million increase in catastrophe losses, to $14.3 million for the quarter ended September 30, 1998, from $6.9 million for the same period ended 1997, primarily in the homeowner's line. Policy acquisition and other underwriting expenses in the personal lines decreased $7.4 million, or 8.2%, to $82.4 million in the third quarter of 1998, primarily reflecting reductions in employee related expenses at both Hanover and Citizens. Commercial Lines of Business The commercial lines of business represented 37.8% and 38.3% of total net premiums earned in the third quarter of 1998 and 1997, respectively.
Total (Unaudited) Property Quarter Ended September 30, Hanover Citizens & Casualty (In millions) 1998 1997 1998 1997 1998 1997 Net premiums earned $ 113.5 $120.0 $70.6 $68.9 $184.1 $188.9 Losses and loss adjustment expenses 87.2 70.7 56.7 57.5 143.9 128.2 Policy acquisition and other underwriting expenses 37.5 39.4 16.6 17.7 54.1 57.1 Policyholders' dividends 1.6 1.5 0.9 1.3 2.5 2.8 ------ ----- ----- ----- ----- ----- Underwriting (loss) profit $ (12.8) $ 8.4 $(3.6) $(7.6)$(16.4) $ 0.8 ====== ===== ===== ===== ===== =====
Page 22 Revenues Commercial lines' net premiums earned decreased $4.8 million, or 2.5%, to $184.1 million for the quarter ended September 30, 1998, from $188.9 for the quarter ended September 30, 1997. Hanover's commercial lines' net premiums earned decreased $6.5 million, or 5.4%, to $113.5 million. This decrease is primarily related to the Company's disposal of the majority of its assumed reinsurance business, which contributed $0.9 million in net premiums earned for the quarter ended September 30, 1998, compared to $9.1 million for the same period of 1997. Also contributing to this decrease is a twelve month average rate decrease of 12.0% in the workers' compensation line. These decreases were partially offset by increases in policies in force since September 30,1997, in the workers' compensation and commercial automobile lines of 10.9% and 9.4%, respectively. Citizens' commercial lines' net premiums earned increased $1.7 million, or 2.5%, to $70.6 million, in the third quarter of 1998. This increase primarily reflects growth in policies in force of 11.9% in the commercial multiple peril line since September 30, 1997, and twelve month average rate increases of 8.0% and 6.2% in the commercial multiple peril and commercial automobile lines, respectively. These increases are partially offset by a 13.6% decrease in policies in force and a twelve month average rate decrease of 6.6% in the workers' compensation line. Management believes competitive conditions in the workers' compensation line may impact future growth in net premiums earned. Underwriting results The commercial lines' underwriting results in the third quarter of 1998 deteriorated $17.2 million, to a loss of $16.4 million compared to a gain of $0.8 million for the same period in 1997. Hanover's underwriting results declined $21.2 million, to a loss of $12.8 million. Citizens' underwriting results improved $4.0 million, to a loss of $3.6 million. The deterioration in Hanover's underwriting results reflects a $16.5 million increase in losses and LAE, attributed to unfavorable current year claims activity in the workers' compensation and commercial multiple peril lines, as well as a $3.7 million increase in catastrophe losses. The improvement in Citizens' underwriting results reflects an aggregate $6.1 million increase in favorable development on prior year reserves, partially offset by a $2.1 million increase in catastrophe losses, primarily in the commercial multiple peril line. Policy acquisition and other underwriting expenses in the commercial lines decreased $3.0 million, or 5.3%, to $54.1 million in the third quarter of 1998, primarily reflecting reductions in employee related expenses at both Hanover and Citizens. Nine Months Ended September 30, 1998 Compared to Nine Months Ended September 30, 1997 Property and Casualty's segment income before taxes and minority interest decreased $21.0 million, or 17.6%, to $98.0 million for the nine months ended September 30 1998, compared to $119.0 million, for the same period in 1997. This decrease is primarily attributable to an increase in catastrophe losses of $56.5 million, partially offset by a $16.5 million increase in favorable development on prior year reserves and lower policy acquisition and other underwriting expenses. Net investment income before taxes decreased $17.0 million, or 9.1%, to $170.8 million during the first nine months of 1998, compared to $187.8 million in the comparable period of 1997. The decrease is primarily the result of a decrease in Hanover's average invested assets and a $6.2 decrease in limited partnership income at both Hanover and Citizens. The average pre-tax yield on debt securities was 6.7% and 6.8% for the nine months ended September 30,1998 and 1997, respectively. Page 23 LINE OF BUSINESS RESULTS Personal Lines of Business The personal lines of business represented 62.0% and 61.8% of total net premiums earned in the nine months ended September 30, 1998 and 1997, respectively.
Total (Unaudited) Property Nine Months Ended September 30, Hanover Citizens & Casualty (In millions) 1998 1997 1998 1997 1998 1997 Net premiums earned $ 466.3 $466.7 $448.6 $432.7 $914.9 $899.4 Losses and loss adjustment expenses 359.2 362.1 349.0 336.0 708.2 698.1 Policy acquisition and other underwriting expenses 136.4 147.9 112.2 112.6 248.6 260.5 ------ ----- ------ ----- ------ ------ Underwriting loss $ (29.3) $(43.3) $(12.6) $(15.9) $(41.9) $(59.2) ====== ===== ====== ===== ====== ======
Revenues Personal lines' net premiums earned increased $15.5 million, or 1.7%, to $914.9 million during the nine months ended September 30, 1998, compared to $899.4 million in the same period of 1997. Hanover's personal lines' net premiums earned decreased $0.4 million, or 0.1%, to $466.3 million during the nine months ended September 30, 1998. This decrease is primarily due to decreases in policies in force, since September 30, 1997, of 4.5% and 3.9%, in the personal automobile and homeowner's lines, respectively. This decline is associated with the Company's decision last year to exit certain Western and Southern states. A mandated 4.0% decrease in Massachusetts' personal automobile rates which became effective January 1, 1998, also contributed to the decrease in net premiums earned. Citizens' personal lines' net premiums earned increased $15.9 million, or 3.7%, to $448.6 million for the nine months ended September 30, 1998, from $432.7 million for the nine months ended September 30, 1997. This increase is primarily attributable to a twelve month average rate increase of 15.9% in the homeowner's line, partially offset by decreases in policies in force since September 30, 1997, of 2.5% and 1.8% in the personal automobile and homeowner's lines, respectively. Underwriting results The personal lines' underwriting results for the nine months ended September 30, 1998, improved $17.3 million, to a loss of $41.9 million, compared to a loss of $59.2 million for the same period in 1997. Hanover's underwriting results improved $14.0 million, to a loss of $29.3 million. Citizens' underwriting results improved $3.3 million, to a loss of $12.6 million. The improvement in Hanover's underwriting results is primarily attributable to an $11.1 million total increase in favorable development on prior year reserves in the personal automobile and homeowner's lines, as well as favorable current year claims activity in the personal automobile line. This was partially offset by a $16.4 million increase in catastrophe losses, primarily in the homeowner's line. The improvement in Citizens' underwriting results is attributable to improved current year claims activity in both the personal automobile and homeowner's lines, and a $3.2 million increase in favorable development on prior year reserves. This is significantly offset by an increase in catastrophe losses of $18.1 million over the prior year, primarily in the homeowner's line. Policy acquisition and other underwriting expenses in the personal lines decreased $11.9 million, or 4.6%, to $248.6 million in the first nine months of 1998, primarily reflecting reductions in employee related expenses at both Hanover and Citizens. Page 24 Commercial Lines of Business The commercial lines of business represented 38.0% and 38.2% of total net premiums earned in the nine months ended September 30, 1998 and 1997, respectively.
Total (Unaudited) Property Nine Months Ended September 30, Hanover Citizens & Casualty (In millions) 1998 1997 1998 1997 1998 1997 Net premiums earned $ 351.0 $353.1 $210.6 $201.9 $561.6 $555.0 Losses and loss adjustment expenses 250.1 227.3 169.1 151.8 419.2 379.1 Policy acquisition and other underwriting expenses 120.5 129.9 52.0 52.5 172.5 182.4 Policyholders' dividends 4.4 2.2 3.7 4.7 8.1 6.9 ------ ----- ------ ----- ------ ------ Underwriting loss $ (24.0) $ (6.3) $(14.2) $ (7.1) $(38.2) $(13.4) ====== ====== ====== ====== ====== ======
Revenues Commercial lines' net premiums earned increased $6.6 million, or 1.2%, to $561.6 million in the nine months ended September 30, 1998, from $555.0 million in the same period of 1997. Hanover's commercial lines' net premiums earned decreased $2.1 million, or 0.6%, to $351.0 million. This decrease is attributable to the effect of the Company's disposal of the majority of its assumed reinsurance business, which contributed $7.8 million and $24.9 million in net premium earned during the nine months ended September 30, 1998, and 1997, respectively. This is partially offset by increases in policies in force in the workers' compensation and commercial automobile lines of 10.9% and 9.4%, respectively since September 30, 1997. Citizens' commercial lines' net premiums earned increased $8.7 million, or 4.3%, to $210.6 million, for the nine months ended September 30, 1998, from $201.9 million, for the nine months ended September 30, 1997. The increase in net premiums earned primarily reflects growth in policies in force of 11.9% in the commercial multiple peril line since September 30, 1997, and twelve month average rate increases of 8.0% and 6.2% in the commercial multiple peril and commercial automobile lines, respectively. These increases are partially offset by a 13.6% decrease in policies in force and a twelve month average rate decrease of 6.6% in the workers' compensation line. Underwriting results The commercial lines' underwriting loss for the nine months ended September 30, 1998, increased $24.8 million, to a loss of $38.2 million, compared to a loss of $13.4 million for the same period in 1997. Hanover's underwriting results declined $17.7 million, to a loss of $24.0 million. Citizens' underwriting results deteriorated $7.1 million, to an underwriting loss of $14.2 million. The deterioration in Hanover's underwriting results is attributable to an increase in catastrophe losses of $10.5 million, primarily in the commercial multiple peril line, as well as unfavorable current year claims activity in the workers' compensation and commercial multiple peril lines. This is partially offset by a $4.9 million increase in favorable development on prior year reserves. The deterioration in Citizens' underwriting results is primarily attributable to an $11.5 million increase in catastrophe losses, primarily in the commercial multiple peril line, and unfavorable current year claims activity in the workers' compensation line. These increases are partially offset by favorable current year claims activity in the commercial multiple peril and commercial automobile lines. Policy acquisition and other underwriting expenses in the commercial lines decreased $9.9 million, or 5.4%, to $172.5 million in the nine months ended September 30, 1998, primarily reflecting reductions in employee related expenses. Page 25 RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES The Property and Casualty segment maintains reserves to provide for its estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given point in time, of what management expects the ultimate settlement and administration of claims will cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claim severity and judicial theories of liability and other factors. The inherent uncertainty of estimating insurance reserves is greater for certain types of property and casualty insurance lines, particularly workers' compensation and other liability lines, where a longer period of time may elapse before definitive determination of ultimate liability may be made, where the technological, judicial, and political climates involving these types of claims are changing. The Property & Casualty segment regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Changes in prior reserve estimates are reflected in results of operations in the year such changes are determined to be needed and recorded. The table below provides a reconciliation of the beginning and ending reserve for unpaid losses and LAE as follows:
(Unaudited) Nine Months Ended September 30, (In millions) 1998 1997 Reserve for losses and LAE, beginning of period $2,615.4 $2,744.1 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of the current year 1,220.3 1,156.5 Decrease in provision for insured events of prior years (92.9) (76.4) -------- -------- Total incurred losses and LAE 1,127.4 1,080.1 Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 551.7 536.9 Losses and LAE attributable to insured events of prior years 587.9 592.8 ------- -------- Total payments 1,139.7 1,129.7 Change in reinsurance recoverable on unpaid losses (16.8) (54.1) Other 0.0 (7.4) -------- -------- Reserve for losses and LAE, end of period $2,586.4 $2,663.0 ======== ========
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $92.9 million and $76.4 million for the nine months ended September 30, 1998, and 1997, respectively. Hanover's favorable development increased $16.4 million to $55.0 million during 1998, from $38.6 million in 1997. This increase is primarily attributable to a reduction in LAE, in most major lines, due to claims process improvement initiatives. Favorable reserve development at Citizens increased $.1 million, to $37.9 million, from $37.8 million, for the nine months ended September 30, 1998 and September 30, 1997, respectively. The overall favorable reserve development in both years primarily reflects the initiatives taken by the Company to manage claims adjusting costs and a modest shift over the past few years of the workers' compensation business to Western and Northern Michigan which have demonstrated more favorable loss experience than Eastern Michigan. This favorable development reflects the Company's reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the losses and LAE reserves in the past may not necessarily occur in the future. Page 26 Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation on the Property and Casualty segment varies by product. Property and casualty insurance premiums are established before the amount of losses and LAE, and the extent to which inflation may affect such expenses, are known. Consequently, the Property and Casualty segment attempts, in establishing rates, to anticipate the potential impact of inflation in the projection of ultimate costs. The impact of inflation has been relatively insignificant in recent years. However, inflation could contribute to increased losses and LAE in the future. The 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. The Company believes that a significant change to the estimated reserves could have a material impact on the results of operations. REINSURANCE The Property and Casualty segment maintains a reinsurance program designed to protect against large or unusual losses and allocated LAE activity, which includes pro-rata, excess of loss reinsurance and catastrophe reinsurance. Catastrophe reinsurance serves to protect the ceding insurer from significant aggregate losses arising from a single event such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. The Property and Casualty segment determines the appropriate amount of reinsurance based on the evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. The Property and Casualty segment also has reinsurance for casualty business. Effective January 1, 1998, the Property and Casualty segment modified its catastrophe reinsurance program to include a higher retention. Under the 1998 catastrophe reinsurance program, the Company retains the first $45.0 million. For losses in excess of $45.0 million and up to $180.0 million, the Company retains 10% of the loss. Effective June 1, 1998, the Company purchased an additional treaty for losses in excess of $180.0 million and up to $230.0 million, of which the Company retains 10% of the loss. Amounts in excess of $230.0 million are retained 100% by the Company. Under the 1997 catastrophe reinsurance program, Hanover retained the first $25.0 million of loss per occurrence and all amounts in excess of $180.0 million, 55% of all aggregate loss amounts in excess of $25.0 million up to $45.0 million, and 10% of all aggregate loss amounts in excess of $45.0 million up to $180.0 million. Also, under the 1997 catastrophic reinsurance program, Citizens retained 5% of losses in excess of $10.0 million, up to $25.0 million, and 10% of losses in excess of $25.0 million up to $180.0 million. Amounts in excess of $180.0 million were retained 100% by the Company. Under the Property and Casualty segment's casualty reinsurance program, the reinsurers are responsible for 100% of the amount of each loss in excess of $0.5 million per occurrence up to $30.5 million for general liability and workers' compensation. Additionally, this reinsurance covers workers' compensation losses in excess of $30.5 million to $60.5 million per occurrence. Amounts in excess of $60.5 million are retained 100% by the Company. The Property and Casualty segment cedes to reinsurers a portion of its risk and pays a fee based upon premiums received on all policies subject to such reinsurance. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company in the Property and Casualty segment. The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. Page 27 INVESTMENT RESULTS Net investment income before taxes decreased $6.0 million, or 9.7%, to $56.1 million during the third quarter of 1998, compared to $62.1 million in the comparable quarter of 1997. The decrease is primarily the result of a decrease in Hanover's average invested assets as a result of asset transfers of $117.1 million and $53.9 million to the Corporate Segment in April 1998 and December 1997, respectively. Also contributing to this decrease is a $2.1 million decrease in limited partnership income to a loss of $0.9 million in 1998, from income of $1.2 million in 1997. The limited partnerships pursue investment opportunities primarily through global fixed-income trading strategies. The average pre-tax yield on debt securities was 6.6% and 6.7% for the third quarter of 1998 and 1997, respectively. Net investment income before taxes decreased $17.0 million, or 9.1%, to $170.8 million during the nine months ended September 30, 1998, compared to $187.8 million in the comparable period of 1997. The decrease is primarily the result of the aforementioned decrease in Hanover's average invested assets and a $6.2 million decrease in limited partnership income to a loss of $0.9 million in 1997, from income of $5.3 million in 1997. The average pre-tax yield on debt securities was 6.7% and 6.8% for the nine months ended September 30, 1998 and 1997, respectively. Corporate Risk Management Services The following table summarizes the results of operations for the Corporate Risk Management Services segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Premiums and premium equivalents Premiums $ 82.8 $ 84.9 $252.1 $247.9 Premium equivalents 173.1 150.3 504.9 448.5 ------ ------ ------ ------ Total premiums and premium equivalents $255.9 $235.2 $757.0 $696.4 ====== ====== ====== ====== Segment revenues Premiums $ 82.8 $ 84.9 $252.1 $247.9 Net investment income 4.4 6.0 15.8 17.5 Other income 15.1 12.3 42.8 36.5 ------ ------ ------ ------ Total segment revenues 102.3 103.2 310.7 301.9 Policy benefits, claims and losses 60.7 59.3 186.2 178.1 Policy acquisition expenses 0.4 0.8 2.4 2.5 Other operating expenses 40.9 34.1 115.3 102.4 ------ ------ ------ ------ Segment income before taxes $ 0.3 $ 9.0 $ 6.8 $ 18.9 ====== ====== ====== ======
Quarter Ended September 30, 1998 Compared to Quarter Ended September 30, 1997 Segment income before taxes decreased $8.7 million, or 96.7%, to $0.3 million in the third quarter of 1998. This decrease was primarily due to unfavorable loss experience in the risk-sharing and long-term disability product lines totaling approximately $7.3 million, as well as increased expenses related to claims processing costs of approximately $3.2 million. These decreases were partially offset by favorable loss experience in the fully insured medical and dental product lines of approximately $1.7 million. In addition, segment results reflect the Company's entrance into an agreement with a highly rated reinsurer to cede the excess underwriting losses of the accident and health assumed reinsurance pool business, effective July 1, 1998. As a result of this transaction, segment income before taxes for the accident and health assumed reinsurance pool business improved $0.7 million, primarily attributable to a decrease in losses. Premiums decreased $2.1 million, or 2.5%, to $82.8 million. This decrease was primarily due to total decreases of $5.6 million in the fully insured medical and dental and the accident and health assumed reinsurance pool business. The decline in fully insured medical and dental product lines primarily reflects the Company's cancellation of several large unprofitable accounts. Decreases were partially offset by growth in the group life, risk sharing, and affinity group life and health reinsurance product lines totaling approximately $3.5 million. Page 28 Other income increased $2.8 million, or 22.8%, to $15.1 million due to an increase in administrative service fees. Policy benefits, claims and losses increased $1.4 million, or 2.4%, to $60.7 million. This increase is principally attributable to increases of $6.3 million and $2.0 million from the risk-sharing and group life business, respectively, due to growth in these product lines as well as less favorable loss experience. In addition, long-term disability policy benefits increased $1.7 million due to less favorable loss experience. These increases were partially offset by lower policy benefits of $5.1 million due to more favorable loss experience in the remaining policies of the fully insured medical and dental product lines. This favorable loss experience is primarily related to the aforementioned cancellation of several large unprofitable accounts. Lower benefits on the Company's accident and health assumed reinsurance pool business resulted from the aforementioned reinsurance transaction. Operating expenses increased $6.8 million, or 19.9%, to $40.9 million, primarily due to increased claims processing, customer service, and technology expenses, as well as increased commissions, expense allowances, and premium taxes. Nine Months Ended September 30, 1998 Compared to Nine Months Ended September 30, 1997 Segment income before taxes decreased $12.1 million, or 64.0%, to $6.8 million in the nine months ended September 30, 1998. This decrease was primarily due to unfavorable loss experience in the risk-sharing and long-term disability lines of approximately $7.5 million, and to increased operating expenses of $12.9 million, primarily from higher claims processing and customer service costs. These decreases were partially offset by a $6.3 million increase in administrative fees, and to favorable loss experience in the fully insured medical and dental product lines of $1.2 million. In addition, segment results reflect the Company's entrance into an agreement with a highly rated reinsurer to cede the excess underwriting losses of the accident and health assumed reinsurance pool business, effective July 1, 1998. After consideration of this transaction, segment income before taxes declined $0.7 million in the accident and health assumed reinsurance pool business, primarily due to unfavorable experience in the first half of 1998, which more than offset the effect of a breakeven combined ratio for the third quarter. Premiums increased $4.2 million, or 1.7%, to $252.1 million, primarily due to growth in the risk sharing product line of $5.1 million, accident and health assumed reinsurance pool business of $3.8 million, and the group life product line of $2.8 million. These increases were partially offset by decreases in fully insured medical and dental products of $7.9 million, which reflect the cancellation of several large unprofitable accounts. Other income increased $6.3 million, or 17.3%, to $42.8 million during the nine months ended September 30, 1998, due to an increase in administrative service fees. Policy benefits, claims and losses increased $8.1 million, or 4.5%, to $186.2 million. This increase is primarily attributable to increases of $10.5 million in the risk sharing product line due to growth and unfavorable experience. Increased policy benefits totaling $2.2 million in the group life and $2.2 million in the long-term disability product line were primarily due to growth and unfavorable loss experience, respectively. In addition, benefits increased $4.9 million in the accident and health reinsurance pool business primarily due to growth and unfavorable loss experience through the second quarter of 1998. This increase was partially offset by the effects of the aforementioned reinsurance transaction in the third quarter of 1998 which resulted in a decrease in losses during this time period. These increases were partially offset by reduced losses in the fully insured medical and dental product lines totaling $9.1 million, primarily due to improved loss experience. Operating expenses increased $12.9 million, or 12.6%, to $115.3 million primarily due to increased claims processing, customer service, and technology expenses, as well as growth related increases in commissions, expense allowances, and premium taxes. Page 29 Retirement and Asset Accumulation Allmerica Financial Services The following table summarizes the results of operations, including the Closed Block, for the Allmerica Financial Services segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Segment revenues Premiums $ 9.5 $ 16.6 $ 47.7 $ 72.7 Fees 75.0 61.4 217.2 174.8 Net investment income 72.6 85.6 229.0 257.5 Other income 17.3 13.5 44.1 38.3 ------ ------ ------ ------ Total segment revenues 174.4 177.1 538.0 543.3 Policy benefits, claims and losses 73.6 85.7 241.5 280.2 Policy acquisition expenses 15.0 15.7 45.1 46.2 Other operating expenses 47.2 37.9 127.5 117.3 ------ ------ ------ ------ Segment income before taxes $ 38.6 $ 37.8 $123.9 $ 99.6 ====== ====== ====== ======
Quarter Ended September 30, 1998 Compared to Quarter Ended September 30, 1997 Segment income before taxes increased $0.8 million, or 2.1%, to $38.6 million. This increase is primarily attributable to higher asset based fee income driven by growth in the variable annuity and variable universal life product lines, as well as a reduction in employee related costs resulting from the restructuring of defined benefit plan and defined contribution plan business during the fourth quarter of 1997. These items were partially offset by losses incurred on hedge fund partnership investments during the third quarter of 1998. Premiums decreased $7.1 million, or 42.8%, to $9.5 million. This decrease is due primarily to the cession in 1997 of substantially all of the Company's individual disability income block of business, which contributed premiums of $7.0 million in the third quarter of 1997 compared to $0.1 million in the same period of 1998. The increase in fee revenue of $13.6 million, or 22.1%, to $75.0 million is due to additional deposits and appreciation on variable products' account balances. Fees from individual annuities increased $10.5 million, or 43.0%, to $34.9 million in the third quarter of 1998. Distribution arrangements with several third party mutual fund advisors continue to contribute to the increase in annuity sales. Fees from individual variable universal life policies increased $3.0 million, or 22.6%, to $16.3 million in the third quarter of 1998. These increases were partially offset by a continued decline in fees from non-variable universal life of $1.0 million. The Company expects fees from this product to continue decreasing as policies in force and related contract values decline. Net investment income decreased $13.0 million, or 15.2%, to $72.6 million. This decrease is primarily due to losses incurred on hedge fund partnership investments of $9.3 million, a reduction in average fixed maturities invested resulting from the aforementioned cession of the individual disability income line of business, and to transfers to the separate accounts in the annuity and retirement product lines. Other income increased $3.8 million, or 28.1%, to $17.3 million, primarily as a result of higher distribution and investment management fee income attributable to growth in variable product assets under management. Policy benefits, claims and losses decreased $12.1 million, or 14.1%, to $73.6 million. This decrease is primarily due to the aforementioned cession of substantially all of the individual disability income line of business, which incurred policy benefits of $10.9 million in the third quarter of 1997, compared to $0.7 million in the third quarter of 1998. Also contributing to the overall decrease was improved mortality experience in the universal life product lines as a result of the January 1, 1998 reinsurance of a significant portion of the mortality risk in these product lines. Page 30 Policy acquisition expenses decreased $0.7 million, or 4.5%, to $15.0 million. This decrease is due primarily to lower policy acquisition expenses in the individual universal life and variable universal life lines of business, which is due to a change in mortality assumptions in 1997. This change was consistent with the January 1, 1998 reinsurance of a significant portion of the related mortality risk on these lines. This decrease was partially offset by higher policy acquisition expenses in the individual variable annuity product line, due to growth. Other operating expenses increased $9.3 million, or 24.5%, to $47.2 million. This increase was primarily attributable to continued growth in the variable product lines, and to increased interest expense due to an increase in commercial paper used to manage short-term cash flows. These increases were partially offset by reductions in employee related costs resulting from the restructuring of defined benefit plan and defined contribution plan business during the fourth quarter of 1997. Nine Months Ended September 30, 1998 Compared to Nine Months Ended September 30, 1997 Segment income before taxes increased $24.3 million, or 24.4%, to $123.9 million. This increase is primarily attributable to continued growth from new deposits and market appreciation in the variable annuity and variable universal life assets resulting in increased fee revenue, and a reduction in employee related costs resulting from the restructuring of defined benefit plan and defined contribution plan business during the fourth quarter of 1997, partially offset by losses incurred on hedge fund partnership investments during the third quarter of 1998.Premiums decreased $25.0 million, or 34.4%, to $47.7 million during the nine months ended September 30, 1998. This decrease is due primarily to the cession in 1997 of substantially all of the Company's individual disability income line of business, which contributed premiums of $23.4 million in the nine months ended September 30, 1997, compared to $0.5 million for the same period in 1998. The remaining decrease in premiums is a result of the Company's continued shift in focus from traditional life insurance products to variable life insurance and annuity products. The increase in fee revenue of $42.4 million, or 24.3%, to $217.2 million is due to additional deposits and appreciation on variable products' account balances. Fees from individual annuities increased $35.7 million, or 57.2%, to $98.1 million in the first nine months of 1998. Distribution arrangements with several third party mutual fund advisors continue to contribute to the increase in annuity sales in 1998. Fees from individual variable universal life policies increased $8.7 million, or 22.4%, to $47.5 million in the first nine months of 1998. These increases were partially offset by a continued decline in fees from non-variable universal life of $3.8 million. Net investment income decreased $28.5 million, or 11.1%, to $229.0 primarily due to a reduction in average fixed maturities invested resulting from the aforementioned cession of the individual disability income line of business, losses incurred on hedge fund investments in the current year, and transfers to the separate accounts in the annuity and retirement product lines. Other income increased $5.8 million, or 15.1%, to $44.1 million. This increase is primarily attributable to higher investment management fee income resulting from growth in variable product assets under management. Policy benefits, claims and losses decreased $38.7 million, or 13.8%, to $241.5 million. This decrease is primarily due to the cession of substantially all of the individual disability income line of business, which incurred policy benefits of $30.8 million in the first nine months of 1997, compared to $1.8 million for the same period in 1998. Also contributing to the overall decrease was a reduction in interest credited on group retirement products of $5.2 million due to the aforementioned shift to the separate accounts, and to improved mortality experience in the traditional life line of business of $1.5 million. Policy acquisition expenses decreased $1.1 million, or 2.4%, to $45.1 million. This decrease is due, in part, to the aforementioned cession in 1997 of the individual disability income line of business. In addition, a decrease in amortization in the individual universal life and variable universal life lines of business resulted from the change in mortality assumptions in 1997, which are consistent with the aforementioned reinsurance transaction. These decreases were substantially offset by higher policy acquisition expenses in the individual variable annuity lines, due to growth. Other operating expenses increased $10.2 million, or 8.7%, to $127.5 million. This increase was primarily attributable to continued growth in the variable product lines, and to increased interest expense due to an increase in commercial paper used to manage short-term cash flows. These increases were partially offset by reductions in employee related costs resulting from the restructuring of defined benefit plan and defined contribution plan business during the fourth quarter of 1997. Page 31 Interest Margins The results of the Allmerica Financial Services segment depend, in part, on the maintenance of profitable margins between investment results from investment assets supporting universal life and general account annuity products and the interest credited on those products. The following table sets forth interest earned, interest credited and the related interest margin.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Net investment income $33.2 $34.4 $100.7 $105.0 Less: Interest credited 23.8 24.6 67.6 73.8 ----- ----- ------ ------ Interest margins $ 9.4 $ 9.8 $ 33.1 $ 31.2 ===== ===== ====== ====== Interest margins represent the difference between income earned on investment assets and interest credited to customers' universal life and general account annuity policies. Earnings on surplus assets are excluded from net investment income in the calculation of the above interest margins.
Interest margins were relatively consistent in 1998 as compared to 1997. Allmerica Asset Management The following table summarizes the results of operations for the Allmerica Asset Management segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Nine Months Ended September 30, September 30, (In millions) 1998 1997 1998 1997 Segment revenues: Net investment income $30.2 $20.2 $79.4 $63.2 Fees and other income: External 1.1 0.2 2.3 1.6 Internal 1.5 1.9 4.9 5.0 ----- ----- ----- ----- Total segment revenues 32.8 22.3 86.6 69.8 Policy benefits, claims and losses 23.8 15.0 63.2 49.2 Other operating expenses 2.1 2.1 6.4 6.8 ----- ----- ----- ----- Segment income before taxes $ 6.9 $ 5.2 $17.0 $13.8 ===== ===== ===== ===== For all periods presented, net investment income and policy benefits, claims and losses primarily reflect the income earned and interest credited, respectively, on GICs. Interest margins on GICs reflect the difference between income earned on deposits from policyholder contracts and interest credited to these policies.
Quarter Ended September 30, 1998 compared to Quarter Ended September 30, 1997 Segment income before taxes increased $1.7 million, or 32.7%, to $6.9 million primarily as a result of a 1998 payment of $2.6 million from a mortgage loan equity participation interest. Excluding this item, segment income before taxes decreased $0.9 million, or 17.3%, to $4.3 million. This decrease primarily reflects a decline in interest margins on traditional GICs, partially offset by growth in income from assets under management. Interest margins on traditional GICs declined $4.3 million, which more than offset a $2.9 million increase in interest margins from floating rate GICs. Interest margins on traditional GICs decreased as a result of a decline in investment portfolio yields and from the continuing runoff of the traditional GIC portfolio. This decline was partially offset by increased deposits generated by floating rate GICs. Page 32 Nine Months Ended September 30, 1998 compared to Nine Months Ended September 30, 1997 Segment income before taxes increased $3.2 million, or 23.2% to $17.0 million. The increase is primarily attributable to the 1998 receipt of the aforementioned $2.6 million equity participation payment from a mortgage loan. Excluding this item, segment income before taxes increased $0.6 million, or 4.3%, to $14.4 million. This increase reflects growth in assets under management, partially offset by lower interest margins on traditional GICs. Interest margins on traditional GICs declined $7.0 million, which more than offset a $6.6 million increase in interest margins from floating rate GICs. Interest margins on traditional GICs decreased as a result of a decline in investment portfolio yields and from the continuing runoff of the traditional GIC portfolio. This decline was partially offset by increased deposits generated by floating rate GICs. 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) 1998 1997 1998 1997 Segment revenues Investment and other income $ 3.8 $ 4.5 $ 9.9 $ 14.3 Interest expense 3.8 4.9 11.4 12.5 Other operating expenses 9.3 11.4 34.1 32.6 ------ ------ ------- ------- Segment loss before taxes and minority interest $(9.3) $(11.8) $(35.6) $(30.8) ====== ====== ======= =======
Quarter Ended September 30, 1998 compared to Quarter Ended September 30, 1997 Segment loss before taxes and minority interest decreased $2.5 million, or 21.2%, to $9.3 million in the third quarter of 1998 primarily due to reduced interest and other expenses. Net investment and other income decreased $0.7 million in 1998, primarily from the absence of $2.3 million of short-term income generated by the temporary investment of the net proceeds from the issuance of Capital Securities in 1997. This was partially offset by increased income from fixed maturities, due to higher average invested assets resulting from transfers of $125 million and $195 million from the Property and Casualty segment in April 1998 and December 1997, respectively. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. Interest expense in 1997 also reflects $1.1 million of Allmerica P&C merger-related interest expense. Other operating expenses for the quarter ended September 30, 1998 decreased $2.1 million, or 18.4%. This expense category consists primarily of certain non-insurance subsidiary expenses and corporate overhead expenses, which reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. The decrease in other operating expenses primarily reflects the Company's exit from certain non-insurance businesses during 1998, partially offset by higher corporate overhead costs. Nine Months Ended September 30, 1998 compared to Nine Months Ended September 30, 1997 Segment loss before taxes and minority interest increased $4.8 million, or 15.6%, to $35.6 million for the nine months ended September 30, 1998 primarily due to lower net investment income. Net investment and other income decreased $4.4 million in 1998 primarily from the absence of $8.1 million of short-term income generated by the temporary investment of the net proceeds from the issuance of Capital Securities in 1997. This was partially offset by additional income due to higher average invested assets from the aforementioned transfers of assets from the Property and Casualty segment. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. Interest expense in 1997 also reflects $1.1 million of merger-related interest expense. Other operating expenses increased $1.5 million, or 4.6%, primarily due to $3.6 million of higher corporate overhead costs, partially offset by the absence of certain non-insurance subsidiary expenses. Page 33 Investment Portfolio The Company had investment assets diversified across several asset classes, as follows:
September 30, 1998 December 31, 1997 Carrying % of Total Carrying % of Total (Dollars in millions) Value Carrying Value Value Carrying Value Fixed Maturities $ 8,335.3 80.5% $7,726.6 79.8% Equity securities 371.9 3.6 479.0 4.9 Mortgages 698.6 6.8 679.5 7.0 Policy loans 365.9 3.5 360.7 3.7 Real estate 25.1 0.2 50.3 0.5 Cash and cash equivalents 414.3 4.0 240.1 2.5 Other invested assets 139.2 1.4 148.3 1.6 --------- ----- -------- ----- Total $10,350.3 100.0% $9,684.5 100.0% ========= ===== ======== ===== Includes Closed Block invested assets with a carrying value of $771.0 million and $768.8 million at September 30, 1998 and December 31, 1997, respectively. The Company carries the fixed maturities and equity securities in its investment portfolio at market value.
Total investment assets increased $665.8 million, or 6.9%, to $10.4 billion during 1998. Fixed maturities increased $608.7 million, or 7.9%. The increase in fixed maturities was primarily due to an increase in funds available for investment generated from the sale of "floating rate" GICs. Equity securities decreased $107.1 million, or 22.4% to $371.9 million during 1998 primarily due to the sale of equity securities during the third quarter of 1998. Real estate decreased $25.2 million, or 50.1%, to $25.1 million during the nine months of 1998 due to continued sales of investment properties. The Company intends to sell its remaining holdings in the real estate portfolio. The Company's fixed maturity portfolio is comprised of primarily investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners, investment grade securities comprised 82.9% and 82.5% of the Company's total fixed maturity portfolio at September 30, 1998 and December 31, 1997, respectively. In 1997, there was a modest shift to higher yielding debt securities, including longer duration and non-investment grade securities. The average yield on debt securities was 7.3% and 7.6% for the nine months ended September 30, 1998 and 1997, respectively. Although management expects that a substantial portion of new funds will be invested in investment grade fixed maturities, the Company may invest a portion of new funds in below investment grade fixed maturities or equity interests. The following table illustrates asset valuation allowances and additions to or deductions from such allowances for the periods indicated.
(Dollars in millions) Mortgages Real Estate Total Year Ended December 31, 1997 Beginning balance $19.6 $ 14.9 $34.5 Provision 2.5 6.0 8.5 Write-offs (1.4) (20.9) (22.3) ------ ------ ------ Ending balance $20.7 $ 0.0 $20.7 Valuation allowance as a percentage of carrying value before reserves 3.0% 0.0% 3.0% Nine months ended September 30, 1998 Provision (benefits) (7.1) 0.0 (7.1) Write-offs (2.3) 0.0 (2.3) ------ ------ ------ Ending balance $11.3 $ 0.0 $11.3 ====== ====== ====== Valuation allowance as a percentage of carrying value before reserves 1.6% 0.0% 1.6% Write-offs reflect asset sales, foreclosures and forgiveness of debt upon restructurings.
Write-offs of real estate reserves during 1997 reflect the permanent write down of all real estate assets to the estimated fair value less costs of disposal. During 1997, the Company adopted a definitive plan to sell its real estate holdings. Page 34 Income Taxes AFC and its domestic subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Prior to the merger in July 1997, Allmerica P&C and its subsidiaries filed a separate United States federal income tax return. The benefit from federal income taxes before minority interest was $8.9 million during the third quarter of 1998 compared to a provision of $24.0 million during the same period in 1997. The benefit and provision resulted in consolidated effective federal tax rates of (104.0%) and 26.6%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were (36.7%) and 36.8% during the third quarter of 1998 and 1997, respectively. The decrease in the rate for AFLIAC and FAFLIC and its non-insurance subsidiaries resulted primarily from a $10.8 million tax benefit and an $8.9 million tax benefit related to the Company's 1998 sales practice litigation expense and loss from exiting the Company's accident and health reinsurance pool business, respectively. The effective tax rates for Allmerica P&C and its subsidiaries were 12.3% and 14.5% during the third quarter of 1998 and 1997, respectively. The decrease in the rate for the Allmerica P&C and its subsidiaries primarily reflects lower underwriting income in 1998. The provision for federal income taxes before minority interest was $33.7 million during the first nine months of 1998 compared to $53.0 million during the same period in 1997. These provisions resulted in consolidated effective federal tax rates of 17.5% and 24.1%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were 29.1% and 39.2% during the first nine months of 1998 and 1997, respectively. The decrease in the rate for AFLIAC and FAFLIC and its non-insurance subsidiaries resulted primarily from a $10.8 million tax benefit and an $8.9 million tax benefit related to the Company's 1998 sales practice litigation expense and loss from exiting the Company's accident and health reinsurance pool business, respectively, partially offset by prior year's tax benefit related to a loss from cession of disability income business. The effective tax rates for Allmerica P&C and its subsidiaries were 11.8% and 17.1% during the first nine months of 1998 and 1997, respectively. The decrease in the rate for the Allmerica P&C subsidiaries primarily reflects higher underwriting losses in 1998. Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, AFC's primary source of cash is dividends from its insurance subsidiaries. However, dividend payments to AFC by its insurance s subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus and restrictions on the payment of "extraordinary" dividends, as defined. Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claims, losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash used in operating activities was $5.9 million for the first nine months of 1998, compared to $53.9 million provided by operating activities during the same period in 1997. The change in 1998 resulted primarily from the timing of recoveries of reinsurance related to the universal life and variable universal life reinsurance agreement, which was effective January 1, 1998. Also, cash was used in 1998 operations to fund increased commissions and other deferrable expenses related to continued growth in the variable annuity product lines of the Allmerica Financial Services segment, and to pay the Internal Revenue Service for current audits of prior tax years. These cash uses were partially offset by a change in the timing of reinsurance payments relating to the Property and Casualty segment. Net cash used in investing activities was $546.7 million during the first nine months of 1998, as compared to $186.0 million during the same period in 1997. This change is primarily due to greater net purchases of fixed maturities resulting from an increase in funds available from floating rate GIC deposits, partially offset by increased net sales of equity securities during the nine months ended September 30, 1998. Page 35 Net cash provided by financing activities was $726.7 million during the first nine months of 1998, as compared to $114.2 million during the comparable prior year period. In 1998, cash provided by financing activities was positively impacted by net GIC deposits of $710.6 million compared to net GIC withdrawals of $327.4 million in the prior year. This increase was partially offset by the 1997 receipt of net proceeds of $296.3 million from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior debentures of the Company. AFC has sufficient funds at the holding company or available through dividends from FAFLIC and Allmerica P&C to meet its obligations to pay interest on the Senior Debentures, Capital Securities and dividends, when and if declared by the Board of Directors, on the common stock. On January 12, 1998, FAFLIC's Board of Directors declared a common stock dividend to AFC of $50.0 million, to be paid in installments upon the Company's request. As of September 30, 1998, approximately $35.0 million has been paid, with the remaining balance to be paid during the fourth quarter of 1998. Whether the Company will pay dividends in the future depends upon the costs of administering a dividend program as compared to the benefits conferred, and upon the earnings and financial condition of AFC. Based on current trends, the Company expects to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. The Company maintains a high degree of liquidity within the investment portfolio in fixed maturity investments, common stock and short-term investments. Effective May 29, 1998, AFC entered into a committed syndicated credit agreement with Chase Manhattan Bank as the administrative agent. This agreement, which replaces lines of credit previously held by FAFLIC and Allmerica P&C, provides for a $150.0 million credit facility, which expires on May 28, 1999. 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. There were no amounts outstanding under this credit facility agreement during the period. Additionally, the Company had commercial paper borrowings outstanding at September 30, 1998 of $59.0 million. Contingencies In July 1997, a lawsuit on behalf of a punitive class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. The Company and the plaintiffs have entered into a settlement agreement which they will present to the court for approval. Although the Company believes it has meritorious defenses to plaintiffs' claims, it concluded that this settlement was best for the Company. Accordingly, AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes it has established an appropriate reserve, this reserve may be revised based on changes in the Company's estimate of the ultimate cost of this settlement. Recent Developments On October 27, 1998, Allmerica Financial Corporation announced that it, or one of its wholly-owned subsidiaries, shortly will commence a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock that it or its subsidiaries do not already own at a price of $29.00 per share. On November 2, 1998, the Allmerica Financial Corporation commenced the tender offer which, unless extended, will expire on December 2, 1998. Based on the number of shares of Citizens Corporation common stock held by unaffiliated stockholders, the transaction is valued at approximately $171 million. Citizens Corporation has established a special committee of the Board of Directors, consisting of directors unaffiliated with AFC, to study the offer and make a recommendation to Citizens Corporation stockholders. Page 36 Since the announcement by AFC of its intention to commence a tender offer to acquire all of the outstanding shares of Citizens Corporation Common Stock that it or its subsidiaries do not own, five lawsuits have been commenced by Citizens stockholders in Delaware Court of Chancery: Susser v. O'Brien, et. al., Civil Action No. 16745; Specht v. O'Brien, et. al., Civil Action No. 16746; Steiner v. O'Brien, et. al., Civil Action No. 16747; Finkelstein v. O'Brien, et. al., Civil Action No. 16748; McKinnie v. O'Brien, et. al., Civil Action No. 16749. Each of the actions purports to be a class action brought on behalf of the Citizens stockholders unaffiliated with AFC and asserts claims against AFC, Citizens Corporation and the members of the Citizens Corporation Board of Directors. The actions each allege that, through the conduct of the defendants, AFC has proposed to acquire the shares owned by unaffiliated Citizens stockholders at an unfair and inadequate price, in violation of fiduciary duties allegedly owed by the defendant to the unaffiliated Citizens stockholders. The various complaints purport by their terms to seek injunctive relief preventing consummation of the tender offer and related merger, or rescission if they are successfully consummated, and compensatory damages. No motion for the injunctive relief has been filed. The complaints have been formally served upon the defendants with regard to Susser v. O'Brien, et. al., Civil Action No. 16745, and the time within which the defendants have to respond to the complaints has not expired. For the four remaining lawsuits, the complaints have not yet been formally served upon the defendants and the time within which the defendants have to respond to the complaints accordingly has not expired. The defendants anticipate that the complaints will be consolidated into a single action. Allmerica Financial believes the actions to be without merit, and it intends to defend the action vigorously. On October 27, 1998, the Board of Directors of Allmerica Financial Corporation authorized the repurchase of up to $200.0 million of its issued common stock. On October 29, 1998, the Company announced that, in restructuring its Risk Management business, it will incur a loss of approximately $10 million to $12 million in the fourth quarter of 1998. In addition to exiting the Company's accident and health assumed reinsurance pool business, the Corporate Risk Management segment will exit its administrative services only business, close nearly half of its nationwide sales offices, and take additional expense reductions in the home office. Further expense improvements in the Property and Casualty segment are anticipated from the consolidation of field support activities from fourteen regional branches into three hub locations. The Company has also commenced the implementation of additional technology enhancements, which enable agents to issue small commercial and personal lines policies on a largely automated basis. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on a third party assessment, the Company determined that significant portions of its software required modification or replacement to enable its computer systems to properly process dates beyond December 31, 1999. The Company is presently modifying or replacing and believes this action will resolve the Year 2000 issue. However, if such modifications and conversions are not made, or are not completed timely, or should there be serious unanticipated interruptions from unknown sources, the Year 2000 issue could have a material adverse impact on the operations of the Company. Specifically, the Company could experience, among other things, an interruption in its ability to collect and process premiums, process claim payments, safeguard and manage its invested assets, accurately maintain policyholder information, accurately maintain accounting records, and perform customer service. Any of these specific events, depending on duration, could have a material adverse impact on the results of operations and the financial position of the Company. The Company has initiated formal communications with all of its significant suppliers and large customers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 issue. The Company's total Year 2000 project cost and estimates to complete the project include the estimated costs and time associated with the impact of a third party's Year 2000 issue, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have material adverse effect on the Company. The Company does not believe that it has material exposure to contingencies related to the Year 2000 Issue for the products it has sold. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. Page 37 The Company will utilize both internal and external resources to reprogram or replace, and test both information technology and embedded technology systems for Year 2000 modifications. The Company plans to complete the mission critical elements of the Year 2000 by December 31, 1998. The cost of the Year 2000 project will be expensed as incurred over the next two years and is being funded primarily through a reallocation of resources from discretionary projects. Therefore, the Year 2000 project is not expected to result in any significant incremental technology cost and is not expected to have a material effect on the results of operations. Through September 30, 1998, the Company has incurred and expensed approximately $47 million related to the assessment of, and preliminary efforts in connection with, the project and the development of a remediation plan. The total remaining cost of the project is estimated at between $30-40 million. The Company's contingency plans related to the Year 2000 issue are addressed in a plan developed jointly with an outside vendor. The plan contains immediate steps to keep business functions operating while unforeseen Year 2000 issues are being addressed. It outlines responses to situations that may affect critical business functions and also provides triage guidance, a documented order of actions to respond to problems. During the triage process, business priorities are established and "Critical Points of Failure" are identified as having a significant impact on the business. The Company's contingency plans are designed to keep a business unit's operation functioning in the event of a failure or delay due to Year 2000 record format and date calculation changes. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. Forward-Looking Statements The Company wishes to caution readers that the following important factors, among others, in some cases have affected and in the future could affect, the Company's actual results and could cause the Company's actual results for 1997 and beyond to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. When used in the MD&A discussion, the words "believes", "anticipated", "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 1997. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward looking statements include among others, the following possibilities: (i) adverse catastrophe experience and severe weather; (ii) adverse loss development for events the Company insured in prior years or adverse trends in mortality and morbidity; (iii) heightened competition, including the intensification of price competition, the entry of new competitors, and the introduction of new products by new and existing competitors; (iv) adverse state and federal legislation or regulation, including decreases in rates, limitations on premium levels, increases in minimum capital and reserve requirements, benefit mandates, limitations on the ability to manage care and utilization, and tax treatment of insurance and annuity products; (v) changes in interest rates causing a reduction of investment income or in the market value of interest rate sensitive investments; (vi) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (vii) higher service, administrative, or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (viii) loss or retirement of key executives; (ix) increases in medical costs, including increases in utilization, costs of medical services, pharmaceuticals, durable medical equipment and other covered items; (x) termination of provider contracts or renegotiations at less cost-effective rates or terms of payment; (xi) changes in the Company's liquidity due to changes in asset and liability matching; (xii) restrictions on insurance underwriting, based on genetic testing and other criteria; (xiii) adverse changes in the ratings obtained from independent rating agencies, such as Moody's, Standard and Poor's, A.M. Best, and Duff & Phelps; (xiv) lower appreciation on and decline in value of managed investments, resulting in reduced variable products' assets and related fees; (xv) possible claims and liabilities relating to sales practices for insurance products; (xvi) uncertainty related to the Year 2000 issue; (xvii) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance contracts; and (xviii) potential liabilities associated with the Company's tender offer for shares of Citizens Corporation common stock held by unaffiliated stockholders. Page 38 PART II - OTHER INFORMATION ITEM 6 - EXHIBITS AND REPORTS ON FORM 8K (a) Exhibits EX - 27 Financial Data Schedule (b) Reports on Form 8K On October 15, 1998, a report on Form 8-K was filed reporting under item 5, Other Events, that third quarter results will be negatively impacted by an estimated $0.25 to $0.30 per share as a result of losses relating to increased frequency of catastrophes and lower investment income. On October 27, 1998, a report on Form 8-K was filed reporting under item 5, Other Events, that Allmerica Financial Corporation announced that it, or a subsidiary, will shortly commence a cash tender offer to acquire all of the outstanding shares of Citizens Corporation common stock that it does not already own at a price of $29.00 per share On November 3, 1998, a report on Form 8-K was filed reporting under item 5, other Events, that Allmerica Financial Corporation announced its financial results for the three months ended September 30, 1998. The Company also announced that the Board of Directors of AFC authorized the repurchase of up to $200.0 million of its issued common stock. Page 39 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, 1998 ----------------- /s/ John F. O'Brien ------------------- John F. O'Brien President and Chief Executive Officer Dated November 13, 1998 ----------------- /s/ Edward J. Parry III ----------------------- Edward J. Parry III. Vice President, Chief Financial Officer And Treasurer Page 40 EXHIBIT INDEX Exhibit Number Exhibit - -------------- ------- 27 Financial Data Schedule Page 41 EX-27 2 WARNING: THE EDGAR SYSTEM ENCOUNTERED ERROR(S) WHILE PROCESSING THIS SCHEDULE. This schedule contains summary financial extracted from the interim consolidated balance sheet and income statement of Allmerica Financial Corporation as of September 30, 1998 and for the period then ended, and is qualified in its entirety by reference to such financial statements. 1,000,000 9-MOS DEC-31-1998 SEP-30-1998 7918 0 0 372 562 25 9169 410 1155 1108 25245 2749 883 2856 2567 258 300 0 1 2479 25245 1730 463 51 321 1550 344 478 192 34 159 0 0 0 135 2.26 2.24 2615 1220 (93) 552 588 2586 0
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