-----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, HW3iXD7djqThB21aBw2NKwj/b3n5yaLDmgr8IVbQLqnNGMdtUnKmATUB/9Eh7jSK xx8Y5wYdZJrZrhKXHjXS5g== 0000944695-99-000021.txt : 19990816 0000944695-99-000021.hdr.sgml : 19990816 ACCESSION NUMBER: 0000944695-99-000021 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19990630 FILED AS OF DATE: 19990813 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: 99689435 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 [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: June 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from: _________to __________ Commission file number: 1-13754 ALLMERICA FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Delaware 04-3263626 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 440 Lincoln Street, Worcester, 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: 54,202,576 shares of common stock outstanding, as of August 1, 1999. 39 Total Number of Pages Included in This Document Exhibit Index is on Page 40 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 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 PART II. OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders 37 Item 6. Exhibits and Reports on Form 8-K 38 SIGNATURES 39 Page 2 PART I - FINANCIAL INFORMATION ITEM I - FINANCIAL STATEMENTS ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions, except per share data) 1999 1998 1999 1998 REVENUES Premiums $ 494.7 $ 499.0 $ 953.0 $ 991.1 Universal life and investment product policy fees 88.6 72.7 171.5 142.2 Net investment income 158.2 149.3 312.5 298.7 Net realized investment (losses) gains (5.5) 11.3 126.3 40.2 Other income 28.8 25.1 57.7 47.9 ------- ------- ------- ------- Total revenues 764.8 757.4 1,621.0 1,520.1 ------- ------- ------- ------- BENEFITS, LOSSES AND EXPENSES Policy benefits, claims, losses and loss adjustment expenses 440.2 456.0 883.4 900.7 Policy acquisition expenses 111.9 114.0 204.6 230.4 Other operating expenses 119.9 104.8 237.7 212.0 ------- ------- ------- ------- Total benefits, losses and expenses 672.0 674.8 1,325.7 1,343.1 ------- ------- ------- ------- Income from continuing operations before federal income taxes 92.8 82.6 295.3 177.0 ------- ------- ------- ------- Federal income tax expense (benefit) Current 19.0 14.2 73.2 42.3 Deferred 3.0 3.4 (3.5) (2.1) ------- ------- ------- ------- Total federal income tax expense 22.0 17.6 69.7 40.2 ------- ------- ------- ------- Income from continuing operations before minority interest 70.8 65.0 225.6 136.8 ------- ------- ------- ------- Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (4.0) (4.0) (8.0) (8.0) Equity in earnings 0.0 (1.8) 0.0 (6.1) ------- ------- ------- ------- (4.0) (5.8) (8.0) (14.1) Income from continuing operations 66.8 59.2 217.6 122.7 (Loss) income from operations of discontinued business (less applicable income taxes (benefit) of $(3.5) and $0.7 for the quarters ended June 30, 1999 and 1998 and $(1.8) and $2.4 for the six months ended June 30, 1999 and 1998 (6.6) 1.1 (3.3) 4.4 ------- ------- ------- ------- Net income $ 60.2 $ 60.3 $ 214.3 $ 127.1 ======= ======= ======= ======= PER SHARE DATA Basic Income from continuing operations $ 1.22 $ 0.98 $ 3.89 $ 2.05 (Loss) income from discontinued operations (0.12) 0.02 (0.06) 0.07 ------- ------- ------- ------- $ 1.10 $ 1.00 $ 3.83 $ 2.12 ======= ======= ======= ======= Weighted average shares outstanding 54.5 60.0 55.9 59.9 ======= ======= ======= ======= Diluted Income from continuing operations $ 1.21 $ 0.98 $ 3.86 $ 2.03 (Loss) income from discontinued operations (0.12) 0.02 (0.06) 0.07 ------- ------- ------- ------- Net income $ 1.09 $ 1.00 $ 3.80 $ 2.10 ======= ======= ======= ======= Weighted average shares outstanding 55.1 60.5 56.4 60.4 ======= ======= ======= ======= Dividends declared to shareholders $ 0.0 $ 0.05 $ 0.0 $ 0.10 ======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. Page 3 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED BALANCE SHEETS
(Unaudited) June 30, December 31, (In millions, except per share data) 1999 1998 ASSETS Investments: Fixed maturities-at fair value (amortized cost of $8,056.2 and $7,618.2) $ 8,044.3 $ 7,780.8 Equity securities-at fair value (cost of $87.4 and $253.1) 106.4 397.1 Mortgage loans 555.7 562.3 Policy loans 160.5 154.3 Real estate and other long-term investments 176.8 163.1 ---------- ---------- Total investments 9,043.7 9,057.6 ---------- ---------- Cash and cash equivalents 578.0 550.3 Accrued investment income 140.8 142.3 Deferred policy acquisition costs 1,284.5 1,161.2 Reinsurance receivable on paid and unpaid losses, benefits and unearned premiums 1,152.6 1,136.0 Deferred federal income taxes 112.8 19.8 Premiums, accounts and notes receivable, net 611.6 510.5 Other assets 483.5 529.4 Closed Block assets 783.0 803.1 Separate account assets 15,635.9 13,697.7 ---------- ---------- Total assets $ 29,826.4 $ 27,607.9 ========== ========== LIABILITIES Policy liabilities and accruals: Future policy benefits $ 2,870.0 $ 2,802.2 Outstanding claims, losses and loss adjustment expenses 2,793.0 2,816.3 Unearned premiums 871.2 843.2 Contractholder deposit funds and other policy liabilities 3,200.7 2,637.0 ---------- ---------- Total policy liabilities and accruals 9,734.9 9,098.7 ---------- ---------- Expenses and taxes payable 707.6 716.1 Reinsurance premiums payable 95.1 50.2 Short-term debt 50.2 221.3 Long-term debt 199.5 199.5 Closed Block liabilities 855.2 872.0 Separate account liabilities 15,635.2 13,691.5 ---------- ---------- Total liabilities 27,277.7 24,849.3 ---------- ---------- Minority interest: Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 300.0 ---------- ---------- Commitments and contingencies (Note 11) 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 shares issued 0.6 0.6 Additional paid-in capital 1,771.1 1,768.8 Accumulated other comprehensive income 2.3 180.5 Retained earnings 814.2 599.9 Treasury stock at cost (6.2 million and 1.8 million shares) (339.5) (91.2) ---------- ---------- Total shareholders' equity 2,248.7 2,458.6 ---------- ---------- Total liabilities and shareholders' equity $ 29,826.4 $ 27,607.9 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. Page 4 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited) Six Months Ended June 30, (In millions) 1999 1998 PREFERRED STOCK Balance at beginning and end of period $ 0.0 $ 0.0 ---------- ---------- COMMON STOCK Balance at beginning and end of period 0.6 0.6 ---------- ---------- ADDITIONAL PAID-IN CAPITAL Balance at beginning of period 1,768.8 1,755.0 Issuance of common stock 2.3 11.3 ---------- ---------- Balance at end of period 1,771.1 1,766.3 ---------- ---------- ACCUMULATED OTHER COMPREHENSIVE INCOME NET UNREALIZED APPRECIATION ON INVESTMENTS Balance at beginning of period 180.5 217.9 Net (depreciation) appreciation on available-for-sale securities (274.0) 44.1 Benefit (provision) for deferred federal income taxes 95.8 (15.7) Minority interest 0.0 (2.7) ---------- ---------- Other comprehensive (loss) income (178.2) 25.7 ---------- ---------- Balance at end of period 2.3 243.6 ---------- ---------- RETAINED EARNINGS Balance at beginning of period 599.9 407.8 Net income 214.3 127.1 Dividends to shareholders 0.0 (6.0) ---------- ---------- Balance at end of period 814.2 528.9 ---------- ---------- TREASURY STOCK Balance at beginning of period (91.2) 0.0 Shares purchased at cost (250.2) 0.0 Shares reissued at cost 1.9 0.0 ---------- ---------- Balance at end of period (339.5) 0.0 ---------- ---------- Total shareholders' equity $ 2,248.7 $ 2,539.4 ========== ==========
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 Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Net income $ 60.2 $ 60.3 $ 214.3 $ 127.1 Other comprehensive income: Net (depreciation) appreciation on available-for-sale securities (112.4) 19.0 (274.0) 44.1 Benefit (provision) for deferred federal income taxes 39.4 (6.7) 95.8 (15.7) Minority interest 0.0 (2.0) 0.0 (2.7) ------- ------- ------- ------- Other comprehensive (loss) income (73.0) 10.3 (178.2) 25.7 ------- ------- ------- ------- Comprehensive (loss) income $ (12.8) $ 70.6 $ 36.1 $ 152.8 ======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. Page 6 ALLMERICA FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) Six Months Ended June 30, (In millions) 1999 1998 CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 214.3 $ 127.1 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Minority interest 0.0 6.1 Net realized gains (126.9) (42.6) Net amortization and depreciation 17.8 16.1 Deferred federal income taxes (0.3) (1.4) Change in deferred acquisition costs (97.4) (86.8) Change in premiums and notes receivable, net of reinsurance payable (55.9) (4.0) Change in accrued investment income 1.3 (3.5) Change in policy liabilities and accruals, net 63.8 23.9 Change in reinsurance receivable (16.6) (63.3) Change in expenses and taxes payable (10.9) (54.9) Separate account activity, net 53.5 1.1 Other, net (10.2) (8.3) --------- --------- Net cash provided by (used in) operating activities 32.5 (90.5) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from disposals and maturities of available-for-sale fixed maturities 1,390.5 1,263.5 Proceeds from disposals of equity securities 371.4 61.1 Proceeds from disposals of other investments 20.6 49.9 Proceeds from mortgages matured or collected 49.3 92.2 Purchase of available-for-sale fixed maturities (1,854.7) (1,770.3) Purchase of equity securities (67.1) (90.6) Purchase of other investments (71.8) (110.6) Capital expenditures (15.9) (11.7) Other investing activities, net 0.0 11.4 --------- --------- Net cash used in investing activities (177.7) (505.1) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Deposits and interest credited to contractholder deposit funds 1,246.6 844.8 Withdrawals from contractholder deposit funds (668.5) (259.4) Change in short-term debt (171.1) 13.6 Change in long-term debt 0.0 (2.6) Proceeds from issuance of common stock 0.2 9.8 Purchase of treasury shares (250.2) 0.0 Reissuance of treasury shares 1.9 0.0 Dividends paid to shareholders 0.0 (6.6) -------- ------- Net cash provided by financing activities 158.9 599.6 -------- ------- Net change in cash and cash equivalents 13.7 4.0 Net change in cash held in the Closed Block 14.0 16.9 Cash and cash equivalents, beginning of period 550.3 215.1 -------- ------- Cash and cash equivalents, end of period $ 578.0 $ 236.0 ======== =======
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 and Principles of Consolidation The accompanying unaudited consolidated financial statements of Allmerica Financial Corporation ("AFC" or the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the requirements of Form 10-Q. The interim consolidated financial statements of AFC include the accounts of First Allmerica Financial Life Insurance Company ("FAFLIC"), its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries (principally brokerage and investment advisory subsidiaries), 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 (a wholly-owned subsidiary of Hanover), and Citizens Insurance Company of America ("Citizens", a wholly-owned subsidiary of Citizens Corporation). The Closed Block assets and liabilities and its results of operations are presented in the consolidated financial statements as single line items. Unless specifically stated, all disclosures contained herein supporting the consolidated financial statements exclude the Closed Block related amounts. All significant intercompany accounts and transactions have been eliminated. In December 1998, the Company acquired all of the outstanding common stock of Citizens Corporation that it did not already own. Prior to this acquisition, the financial statements reflect minority interest in Citizens Corporation and its wholly-owned subsidiary, Citizens, of 17.5% (see Note 4). 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. The results of operations for the six months ended June 30, 1999, 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 1998 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 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. This statement is effective for fiscal years beginning after June 15, 2000. The Company is currently assessing the impact of the adoption of Statement No. 133. In December 1997, the AICPA issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SoP No. 97-3"). SoP No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and how to measure the liability. This statement allows for the discounting of the liability if the amount and timing of the cash payments are fixed and determinable. In addition, it provides criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges. This statement is effective for fiscal years beginning after December 15, 1998. The adoption of SoP No. 97-3 had no effect on the results of operations or financial position of the Company. Page 8 3. Discontinued Operations During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its Employee Benefit Services ("EBS") business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). The Company is pursuing a sale of its EBS business during the second half of 1999. During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the Company's group life and health insurance business, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB No. 30").As permitted by APB No. 30, the Consolidated Balance Sheet has not been segregated between continuing and discontinued operations. At June 30, 1999, the businesses had assets of approximately $469.3 million consisting primarily of invested assets, premiums and fees receivable, and reinsurance recoverables, and liabilities of approximately $445.2 million consisting primarily of policy liabilities. Revenues for the discontinued operations were $89.7 million and $99.3 million for the quarters ended June 30, 1999 and 1998, respectively, and $187.1 million and $200.5 million for the six months ended June 30, 1999 and 1998, respectively. 4. Acquisition of Minority Interest of Citizens Corporation On December 3, 1998, Citizens Acquisition Corporation, a wholly-owned subsidiary of the Company, completed a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock that AFC or its subsidiaries did not already own at a price of $33.25 per share. Approximately 99.8% of publicly held shares of Citizens Corporation common stock were tendered. On December 14, 1998, the Company completed a short-form merger, acquiring all shares of common stock of Citizens Corporation not purchased in its tender offer, through the merger of its wholly-owned subsidiary, Citizens Acquisition Corporation, with Citizens Corporation at a price of $33.25 per share. Total consideration for the transactions amounted to $195.9 million. The acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The Company's consolidated results of operations include minority interest in Citizens Corporation prior to December 3, 1998. The unaudited proforma information below presents consolidated results of operations as if the acquisition had occurred at the beginning of 1998. Page 9 The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the acquisition occurred at the beginning of 1998, nor is it necessarily indicative of future results.
(Unaudited) Six Months Ended (In millions, except per share data) June 30, 1998 Revenue $1,513.2 ========= Net realized capital gains included in revenue $ 39.4 ========= Income before taxes and minority interest $ 169.6 Income taxes (37.8) Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (8.0) --------- Income from continuing operations 123.8 Income from operations of discontinued business 4.4 --------- Net income $ 128.2 ========= PER SHARE DATA Basic Income from continuing operations $ 2.07 ========= Weighted average shares outstanding 59.9 ========= Diluted Income form continuing operations $ 2.05 ========= Weighted average shares outstanding 60.4 =========
5. Significant Transactions Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for the Company's property and casualty business, and is subject to cancellation or commutation annually at the Company's option. The program covers losses and allocated loss adjustment expenses ("LAE"), including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. The annual and aggregate coverage limits for losses and allocated LAE are $150.0 million and $300.0 million, respectively. The effect of this agreement on results of operations in each reporting period is based on losses and allocated LAE ceded, reduced by a sliding scale premium of 50.0-67.0% depending on the size of the loss, and increased by a ceding commission of 20.0% of ceded premium. In addition, net investment income is reduced for amounts credited to the reinsurer. As a result of this agreement, the Company recognized a net (expense) benefit of $(3.0) million and $16.9 million, for the quarter and six months ended June 30, 1999, based on year-to-date and annual estimates of losses and allocated loss adjustment expenses for accident year 1999. During March 1999, the Company completed the repurchase of $200.0 million of its common stock under its October, 1998 repurchase program authorized by the Board of Directors of AFC. On March 23, 1999, the Board of Directors of AFC authorized the repurchase of up to an additional $200.0 million of its issued common stock. As of June 30, 1999, under this additional program, the Company had repurchased an additional $132.6 million of its issued common stock. 6. Federal Income Taxes Federal income tax expense for the six months ended June 30, 1999 and 1998, 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. Page 10 7. Other Comprehensive Income The following table provides a reconciliation of gross unrealized (losses) gains to the net balance shown in the Statement of Comprehensive Income:
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Unrealized (losses) gains on securities: Unrealized holding (losses) gains arising during period (net of taxes and minority interest of $(34.8) million and $13.1 million for the quarters ended June 30, 1999 and 1998 and $(61.0) million and $29.2 million for the six months ended June 30, 1999 and 1998) $ (77.7) $ 13.3 $ (89.0) $ 44.1 Less: reclassification adjustment for gains included in net income (net of taxes and minority interest of $(4.6) million and $4.4 million for the quarters ended June 30, 1999 and 1998 and $34.8 million and $10.8 million for the six months ended June 30, 1999 and 1998) (4.7) 3.0 89.2 18.4 ------ ------ ------- ------ Other comprehensive (loss) income $ (73.0) $ 10.3 $(178.2) $ 25.7 ====== ====== ======= ======
8. Closed Block Included in other income in the Consolidated Statements of Income is a net pre-tax contribution from the Closed Block of $2.5 million and $7.1 million for the second quarter and six months ended June 30, 1999, respectively, compared to $3.6 million and $6.0 million for the second quarter and six months ended June 30, 1998, respectively. Summarized financial information of the Closed Block is as follows:
(Unaudited) June 30, December 31, (In millions) 1999 1998 ASSETS Fixed maturities-at fair value (amortized cost of $415.0 and $399.1) $410.7 $414.2 Mortgage loans 133.0 136.0 Policy loans 205.0 210.9 Cash and cash equivalents 0.0 9.4 Accrued investment income 14.2 14.1 Deferred policy acquisition costs 14.1 15.6 Other assets 6.0 2.9 ------ ------ Total assets $783.0 $803.1 ====== ====== LIABILITIES Policy liabilities and accruals $843.6 $862.9 Other liabilities 11.6 9.1 ------ ------ Total liabilities $855.2 $872.0 ====== ======
Page 11
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 REVENUES Premiums $ 8.4 $ 9.0 $35.6 $37.2 Net investment income 13.5 13.2 26.6 26.4 Net realized investment (losses) gains (0.3) 1.6 0.5 1.6 ------ ------ ------ ------ Total revenues 21.6 23.8 62.7 65.2 ------ ------ ------ ------ BENEFITS AND EXPENSES Policy benefits 18.9 19.7 54.4 57.4 Policy acquisition expenses 0.6 0.6 1.1 1.3 Other operating expenses (0.4) (0.1) 0.1 0.5 ------ ------ ------ ------ Total benefits and expenses 19.1 20.2 55.6 59.2 ------ ------ ------ ------ Contribution from the Closed Block $ 2.5 $ 3.6 $ 7.1 $ 6.0 ====== ====== ====== ======
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. 9. Segment Information The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services, and Allmerica Asset Management. The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. In 1999, the Company reorganized its Property and Casualty and Corporate Risk Management Services operations within the Risk Management segment. Under the new structure, the Risk Management segment manages its business through five distribution channels identified as Hanover North, Hanover South, Citizens Midwest, Allmerica Voluntary Benefits, and Allmerica Specialty. During the second quarter of 1999, the Company approved a plan to exit its group life and health business, consisting of its EBS business and its reinsurance pool business. Results of operations from this business, relating to both the current and the prior periods, have been segregated and reported as a component of discontinued operations in the Consolidated Statements of Income. Operating results from this business were previously reported in the Allmerica Voluntary Benefits and Allmerica Specialty distribution channels. Prior to 1999, results of the group life and health business were included in the Corporate Risk Management Services segment, while all other Risk Management business was reflected in the Property and Casualty segment. The Risk Management segment's property and casualty business is offered primarily through the Hanover North, Hanover South and Citizens Midwest distribution channels utilizing the Company's independent agent network primarily in the Northeast, Midwest and Southeast United States, maintaining a strong regional focus. Allmerica Voluntary Benefits focuses on worksite distribution, which offers discounted property and casualty products through employer sponsored programs. In addition, the affinity group property and casualty business, which was included in Citizens Midwest, Hanover North and Hanover South in the first quarter of 1999, is now included in the Allmerica Voluntary Benefits distribution channel. This change is consistent with the resegmentation which was presented in the first quarter of 1999 and with the way results are regularly evaluated by the chief operating decision maker. Accordingly, results for all periods presented have been restated to reflect this change. Allmerica Specialty offers special niche property and casualty products in selected markets. Page 12 The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in Guaranteed Investment Contracts ("GICs") such as traditional GIC, synthetic GIC and other funding agreements. Funding agreements are investment contracts issued to institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs, which typically have short maturities and periodic interest rate resets based on an index such as LIBOR. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. Management evaluates the results of the aforementioned segments based on a pre-tax and minority interest basis. Segment income is determined by adjusting net income for net realized investment gains and losses, net gains and losses on disposals of businesses, dicontinued operations, extraordinary items, the cumulative effect of accounting changes and certain other items which management believes are not indicative of overall operating trends. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of segment income enhances its understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. Summarized below is financial information with respect to business segments for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Segment revenues: Risk Management $554.5 $560.4 $1,075.8 $1,118.1 ------- ------- -------- -------- Asset Accumulation Allmerica Financial Services 193.9 172.4 398.6 363.6 Allmerica Asset Management 40.5 29.9 74.8 53.8 ------- ------- -------- -------- Subtotal 234.4 202.3 473.4 417.4 ------- ------- -------- -------- Corporate 2.4 4.1 3.6 6.1 Intersegment revenues (1.9) (0.5) (2.5) (2.5) ------- ------- -------- -------- Total segment revenues including Closed Block 789.4 766.3 1,550.3 1,539.1 Adjustments to segment revenues: Adjustment for Closed Block (19.1) (20.2) (55.6) (59.2) Net realized (losses) gains (5.5) 11.3 126.3 40.2 ------- ------- -------- -------- Total revenues $764.8 $757.4 $1,621.0 $1,520.1 ======= ======= ======== ======== Segment income (loss) before income taxes and minority interest: Risk Management $ 55.3 $ 34.9 $ 85.1 $ 72.6 ------- ------- -------- -------- Asset Accumulation Allmerica Financial Services 47.7 44.2 96.6 86.4 Allmerica Asset Management 6.8 6.2 12.5 10.1 ------- ------- -------- -------- Subtotal 54.5 50.4 109.1 96.5 ------- ------- -------- -------- Corporate (13.5) (12.7) (29.5) (25.0) ------- ------- -------- -------- Segment income before income taxes and minority interest 96.3 72.6 164.7 144.1 Adjustments to segment income: Net realized investment (losses) gains, net of amortization (3.5) 10.1 130.6 33.7 Other items 0.0 (0.1) 0.0 (0.8) ------- ------- -------- -------- Income from continuing operations before taxes and minority interest $ 92.8 $ 82.6 $ 295.3 $177.0 ======= ======= ======== ========
Page 13
Identifiable Assets Deferred Acquisition Costs (Unaudited) (Unaudited) June 30, December 31, June 30, December 31 (In millions) 1999 1998 1999 1998 Risk Management $ 5,810.6 $ 6,219.0 $ 169.2 $ 167.5 --------- --------- -------- -------- Asset Accumulation Allmerica Financial Services 21,306.0 19,416.6 1,114.8 993.1 Allmerica Asset Management 2,482.9 1,810.9 0.5 0.6 --------- --------- -------- -------- Subtotal 23,788.9 21,227.5 1,115.3 993.7 Corporate 226.9 161.4 0.0 0.0 --------- --------- -------- -------- Total $29,826.4 $27,607.9 $1,284.5 $1,161.2 ========= ========= ======== ========
10. Earnings Per Share
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions, except per share data) 1999 1998 1999 1998 Basic shares used in the calculation of earnings per share 54.5 60.0 55.9 59.9 Dilutive effect of securities: Employee stock options 0.4 0.4 0.3 0.4 Non-vested stock grants 0.2 0.1 0.2 0.1 ---- ---- ---- ---- Diluted shares used in the calculation of earnings per share 55.1 60.5 56.4 60.4 ==== ==== ==== ==== Per share effect of dilutive securities on net income and income from continuing operations $0.01 $ 0.0 $0.03 $0.02 ==== ==== ==== ====
11. Commitments and Contingencies Litigation In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998. On May 19, 1999, the court issued an order certifying the class for settlement purposes and granting final approval of the settlement agreement. AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. 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 (a wholly-owned non-insurance subsidiary of Hanover), Citizens Insurance Company of America ("Citizens," a wholly-owned subsidiary of Citizens Corporation) and certain other insurance and non-insurance subsidiaries. In December 1998, the Company acquired all of the outstanding common stock of Citizens Corporation that it did not already own. Prior to this acquisition, the results of operations reflect minority interest in Citizens Corporation and its wholly owned subsidiary, Citizens, of 17.5%. Description of Operating Segments The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services, and Allmerica Asset Management. The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. In 1999, the Company reorganized its Property and Casualty and Corporate Risk Management Services operations within the Risk Management segment. Under the new structure, the Risk Management segment manages its business through five distribution channels identified as Hanover North, Hanover South, Citizens Midwest, Allmerica Voluntary Benefits, and Allmerica Specialty. During the second quarter of 1999, the Company approved a plan to exit its group life and health business, consisting of its Employee Benefit Services ("EBS") business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). Results of operations from this business, relating to both the current and the prior periods, have been segregated and reported as a component of discontinued operations in the Consolidated Statements of Income. Operating results from this business were previously reported in the Allmerica Voluntary Benefits and Allmerica Specialty distribution channels. Prior to 1999, results of the group life and health business were included in the Corporate Risk Management Services segment, while all other Risk Management business was reflected in the Property and Casualty segment. The Risk Management segment's property and casualty business is offered primarily through the Hanover North, Hanover South and Citizens Midwest distribution channels utilizing the Company's independent agent network primarily in the Northeast, Midwest and Southeast United States, maintaining a strong regional focus. Allmerica Voluntary Benefits focuses on worksite distribution, which offers discounted property and casualty products through employer sponsored programs. In addition, the affinity group property and casualty business, which was included in Citizens Midwest, Hanover North and Hanover South in the first quarter of 1999, is also included in the Allmerica Voluntary Benefits distribution channel. This change is consistent with the resegmentation which was presented in the first quarter of 1999 and with the way results are regularly evaluated by the chief operating decision maker. Accordingly, results for all periods presented have been restated to reflect this change. Allmerica Specialty offers special niche property and casualty products in selected markets. Page 15 The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in Guaranteed Investment Contracts ("GICs") such as traditional GIC, synthetic GIC and other funding agreements. Funding agreements are investment contracts issued to institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs, which typically have short maturities and periodic interest rate resets based on an index such as LIBOR. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. Results of Operations Consolidated Overview The Company's consolidated net income for the second quarter decreased $0.1 million, or 0.2%, to $60.2 million, compared to $60.3 million for the same period in 1998. Consolidated net income for the first six months increased $87.2 million, or 68.6%, to $214.3 million, compared to $127.1 million for the first six months of 1998. Net income includes certain items which management believes are not indicative of overall operating trends, such as net realized investment gains and losses, net gains and losses on disposals of businesses, discontinued operations, extraordinary items, the cumulative effect of accounting changes and certain other items. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of adjusted net income enhances 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 and minority interest basis. The following table reflects each segment's contribution to adjusted net income and reconciliation to consolidated net income as adjusted for these items. Page 16
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Segment income (loss) before income taxes and minority interest: Risk Management $ 55.3 $ 34.9 $ 85.1 $ 72.6 ------ ------ ------ ------ Asset Accumulation Allmerica Financial Services 47.7 44.2 96.6 86.4 Allmerica Asset Management 6.8 6.2 12.5 10.1 ------ ------ ------ ------ Subtotal 54.5 50.4 109.1 96.5 Corporate (13.5) (12.7) (29.5) (25.0) ------ ------ ------ ------ Segment income before income taxes and minority interest 96.3 72.6 164.7 144.1 Federal income taxes on segment income (19.3) (12.2) (32.4) (28.6) Minority interest on preferred dividends (4.0) (4.0) (8.0) (8.0) Minority interest on segment income 0.0 (1.7) 0.0 (5.5) ------ ------ ------ ------ Adjusted net income 73.0 54.7 124.3 102.0 Adjustments (net of taxes, minority interest and amortization, as applicable): Net realized investment (losses) gains (6.2) 4.5 93.3 21.3 Other items 0.0 0.0 0.0 (0.6) ------ ------ ------ ------ Net income from continuing operations 66.8 59.2 217.6 122.7 Discontinued operations: (Loss) income from operations of discontinued group life and health business (net of applicable taxes) (6.6) 1.1 (3.3) 4.4 ------ ------ ------ ------ Net income $ 60.2 $ 60.3 $214.3 $127.1 ====== ====== ====== ======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 The Company's segment income before taxes and minority interest increased $23.7 million, or 32.6%, to $96.3 million in the second quarter of 1999. This increase is attributable to increased income of $20.4 million from the Risk Management segment and $4.1 million from the Asset Accumulation group. The increase in the Risk Management segment was primarily attributable to a $34.6 million decrease in catastrophe losses, partially offset by unfavorable current year claims activity in both the commercial multiple peril and homeowners' lines. The increase in the Allmerica Financial Services segment is primarily attributable to higher asset-based fee income driven by growth and market appreciation in the variable annuity and variable universal life product lines, net of related expenses. Additionally, Allmerica Asset Management segment income increased $0.6 million primarily due to growth in income from assets under management. The effective tax rate for segment income was 20.2% for the second quarter of 1999 compared to 16.8% for the second quarter of 1998. The increase in the tax rate was principally driven by the decrease in the proportion of tax-exempt income to pre-tax operating income. Net realized losses on investments after taxes were $6.2 million in the second quarter of 1999, resulting primarily from net realized losses on fixed maturities of $7.4 million. During the second quarter of 1998, net realized gains on investments after taxes and minority interest of $4.5 million resulted primarily from net realized gains on fixed maturities and equity securities of $3.5 million and $1.4 million, respectively. Page 17 During the second quarter of 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its EBS business and its reinsurance pool business . The Company is pursuing a sale of its EBS business during the second half of 1999. During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the Company's group life and health insurance business, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB No. 30"). Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 The Company's segment income before taxes and minority interest increased $20.6 million, or 14.3%, to $164.7 million in the first six months of 1999. This increase is attributable to increased income of $12.6 million from the Asset Accumulation group and $12.5 million from the Risk Management segment, partially offset by additional losses of $4.5 million in the Corporate segment. The increase in the Allmerica Financial Services segment of $10.2 million was primarily attributable to higher asset-based fee income resulting from growth and market appreciation in the variable annuity and variable universal life product lines, net of related expenses. The increase in the Allmerica Asset Management segment of $2.4 million is principally due to growth in income from assets under management and increased interest margins on GICs. Risk Management segment income for the first six months of 1999 resulted primarily from a $16.9 million favorable impact related to the whole account aggregate excess of loss reinsurance treaty ("aggregate excess of loss reinsurance treaty") entered into during the first quarter of 1999. The operating loss in the Corporate segment increased primarily due to a reduction in net investment income as well as higher technology costs. The effective tax rate for segment income was 19.7% for the first six months of 1999 compared to 19.8% for the first six months of 1998. The decrease in the tax rate was principally driven by a change in reserves for prior year tax liability, partially offset by a decrease in the proportion of tax-exempt income to pre-tax operating income. Net realized gains on investments after taxes were $93.3 million in the first six months of 1999, resulting primarily from net realized gains on equity securities and partnership investments of $99.1 million and $4.1 million, respectively, partially offset by $16.4 million of after-tax realized losses from impairments recognized on fixed maturities. The increase in net realized gains on equity securities relates principally to the sale of $310.0 million of appreciated equities in the property and casualty investment portfolio. During the first six months of 1998, net realized gains on investments after taxes and minority interest of $21.3 million resulted primarily from net realized gains on equity securities and fixed maturities of $12.3 million and $9.6 million, respectively. Segment Results The following is management's discussion and analysis of the Company's results of operations by business segment. The segment results are presented before taxes and minority interest and other items which management believes are not indicative of overall operating trends, including realized gains and losses. Page 18 Risk Management The following table summarizes the results of operations for the Risk Management segment:
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Net premiums written $505.2 $501.8 $982.4 $991.0 ------ ------ ------ ------ Net premiums earned $494.6 $498.7 $952.2 $990.1 ------ ------ ------ ------ Underwriting loss $ (1.2) $(20.7) $(31.7) $(45.1) Net investment and other income 56.5 55.6 116.8 117.7 ------ ------ ------ ------ Segment income before taxes and minority interest $ 55.3 $ 34.9 $ 85.1 $ 72.6 ====== ====== ====== ======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Premium Risk Management's net premiums written increased $3.4 million, or 0.7%, to $505.2 million for the quarter ended June 30, 1999, compared to $501.8 million for the same period in 1998. This is primarily attributable to an increase in net premiums written in the workers' compensation line of $6.8 million, or 15.5%, primarily due to an increase in policies in force of 7.2% since June 30, 1998, and to a decrease of $3.7 million in ceded premium under the aggregate excess of loss reinsurance treaty. These increases in net premiums written are partially offset by a $5.2 million decrease in personal automobile net premiums written primarily attributed to an average rate decrease of 3.6% and a 1.8% decline of policies in force since June 30, 1998. Risk Management's net premiums earned decreased $4.1 million, or 0.8%, to $494.6 million for the quarter ended June 30, 1999, compared to $498.7 million for the same period in 1998. This decrease is primarily attributable to an $8.4 million decrease in the personal automobile line, to $224.3 million for the quarter ended June 30, 1999, from $232.7 million for the same quarter in 1998. The decrease in the personal automobile line's net premiums earned is primarily attributable to an average rate decrease of 3.6% since June 30, 1998, as well as to a decrease in policies in force of 1.8% since June 30, 1998. This was partially offset by increased net premiums earned of $3.7 million from the aforementioned aggregate excess of loss reinsurance treaty. Management believes that competitive conditions in the personal automobile line may continue to impact future growth in net premiums earned. Underwriting results Risk Management's underwriting loss decreased $19.5 million to $1.2 million for the quarter ended June 30, 1999, compared to $20.7 million for the same period in 1998. The decrease is primarily attributable to a $34.6 million decrease in catastrophe losses, to $9.2 million for the quarter ended June 30, 1999, from $43.8 million for the same period in 1998. In addition, there was improved severity of $16.0 million in the personal automobile line, partially offset by unfavorable current year claims activity in both the commercial multiple peril and homeowners lines. Policy acquisition and other underwriting expenses increased $4.0 million to $144.0 million for the quarter ended June 30, 1999, compared to $140.0 million for the same period in 1998. Underwriting results were also unfavorably impacted by a $3.0 million reduction in net recoverability on the aforementioned aggregate excess of loss reinsurance treaty. Page 19 Distribution channel results The following table summarizes the results of operations for the distribution channels of the Risk Management segment:
(Unaudited) Quarter Ended June 30,1999 (In millions, Hanover Hanover Citizens Voluntary Allmerica except ratios) North South Midwest Benefits Specialty Other Total Net premiums written $168.0 $ 49.9 $138.9 $138.5 $ 10.0 $(0.1) $505.2 Underwriting profit (loss) $ 7.0 $ (2.6) $ (0.8) $ 1.0 $ (3.5) $(2.3) $ (1.2) Statutory combined ratio 97.3 103.4 100.9 98.2 140.8 N/M 100.1 Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non- underwriting expenses are not reflected in the statutory combined ratio. Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments.
(Unaudited) Quarter Ended June 30,1998 (In millions, Hanover Hanover Citizens Voluntary Allmerica except ratios) North South Midwest Benefits Specialty Other Total Net premiums written $159.4 $ 52.4 $140.2 $134.0 $ 14.8 $ 1.0 $501.8 Underwriting (loss) profit $ (1.9) $(2.4) $(14.9) $ (1.3) $ 0.9 $(1.1) $(20.7) Statutory combined ratio 102.3 105.4 110.0 103.8 91.4 N/M 105.0 Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non- underwriting expenses are not reflected in the statutory combined ratio. Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments.
Hanover North Hanover North's net premiums written increased $8.6 million, or 5.4%, to $168.0 million for the quarter ended June 30, 1999, compared to $159.4 million for the same period in 1998. This increase is primarily attributable to a $6.9 million increase in net premiums written in the commercial lines. In addition, there was a $1.7 million increase in the personal lines. Hanover North's underwriting results improved $8.9 million to an underwriting profit of $7.0 million for the quarter ended June 30, 1999, compared to an underwriting loss of $1.9 million for the same period in 1998. This improvement in underwriting results is primarily attributable to an increase in net premiums earned of $13.8 million, or 8.9%, to $169.5 million for the quarter ended June 30, 1999, compared to $155.7 million for the same period in 1998, reflecting growth in all of the major lines. Also contributing to the improvement in underwriting results is a $5.1 million decrease in catastrophes, which is partially offset by unfavorable claims activity, primarily in the workers' compensation and commercial multiple peril lines. Hanover South Hanover South's net premiums written decreased $2.5 million, or 4.8%, to $49.9 million for the quarter ended June 30, 1999, compared to $52.4 million for the same period in 1998. The decrease is primarily due to a $2.2 million, or 16.8%, decrease in personal automobile net premiums written due to the exit of certain states in the South. Underwriting results deteriorated $0.2 million to an underwriting loss of $2.6 million for the quarter ended June 30, 1999, compared to $2.4 million for the same period in 1998. The decrease in underwriting results is primarily attributable to a $2.7 million and a $0.5 million deterioration in the commercial multiple peril and workers' compensation lines, respectively, offset by a $3.2 million decrease in catastrophe losses. Citizens Midwest Citizens Midwest's net premiums written decreased $1.3 million, or 0.9%, to $138.9 million for the quarter ended June 30, 1999, compared to $140.2 million for the same period in 1998. This decrease is primarily attributable to a decrease in the personal automobile line of $4.8 million, to $37.8 million, for the quarter ended June 30, 1999, compared to $42.6 million for the same period in 1998. This decrease is attributable to rate decreases in the Michigan personal automobile line of 2.0% and 3.6% in the third quarter of 1998 and first quarter of 1999, respectively. This is significantly offset by increases of $2.5 million and $2.0 million in the workers' compensation and homeowners lines, respectively, for the quarter ended June 30, 1999. Page 20 Citizens Midwest's underwriting results improved $14.1 million to an underwriting loss of $0.8 million for the quarter ended June 30, 1999, compared to an underwriting loss of $14.9 million for the same period in 1998. The improvement in underwriting results is primarily attributable to an $18.5 million decrease in catastrophe losses to $0.7 million for the quarter ended June 30, 1999, compared to $19.2 million for the same period in 1998. The decrease in catastrophes is partially offset by unfavorable claims activity in the commercial lines. Voluntary Benefits Voluntary Benefits' net premiums written increased $4.5 million, or 3.4%, to $138.5 million for the quarter ended June 30, 1999, compared to $134.0 million for the same period in 1998. The increase is primarily due to increases in policies in force in the homeowners line and a decrease in group discounts in the personal automobile line. Net premiums earned were $129.4 million and $131.5 million for the quarters ended June 30, 1999 and 1998, respectively. Underwriting results improved $2.3 million to an underwriting profit of $1.0 million for the quarter ended June 30, 1999, compared to an underwriting loss of $1.3 million for the same period in 1998. The improvement in underwriting results is attributable to a $7.8 million decrease in catastrophe losses, and to improved severity in the personal automobile line. This is partially offset by a $2.4 million increase in policy acquisition and other underwriting expenses and to a $2.1 million decrease in net premiums earned. Specialty Markets Specialty Markets' net premiums written decreased $4.8 million, or 32.4%, to $10.0 million for the second quarter ended June 30, 1999, compared to $14.8 million for the same period in 1998. Net premiums earned were $12.3 million and $9.5 million for the quarters ended June 30, 1999 and 1998, respectively. Underwriting results deteriorated $4.4 million to a loss of $3.5 million for the quarter ended June 30, 1999, compared to an underwriting gain of $0.9 million for same period in 1998. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 Premium Risk Management's net premiums written decreased $8.6 million, or 0.9%, to $982.4 million during the six months ended June 30, 1999, compared to $991.0 million in 1998. This decrease is primarily attributable to an aggregate excess of loss reinsurance treaty entered into during the first quarter of 1999, resulting in additional ceded premiums written of $21.9 million. Excluding the impact of the reinsurance treaty, net premiums written increased $13.3 million, or 1.3%, primarily due to increases of $9.2 million and $5.9 million in the workers' compensation and commercial multiple peril lines, respectively, during 1999. The increase in the workers' compensation line is primarily attributable to an increase in policies in force of 7.2% since June 30, 1998. The increase in the commercial multiple peril line is principally due to a 1.3% rate increase and an increase in policies in force of 1.2% since June 30, 1998. Risk Management's net premiums earned decreased $37.9 million primarily attributable to a $21.9 million decrease due to the aforementioned aggregate excess of loss reinsurance treaty. In addition, net premiums earned decreased $12.6 million in the personal automobile line due to a 3.6% rate decrease and to a 1.8% decrease in policies in force since June 30, 1998. Underwriting results Risk Management's underwriting loss decreased $13.4 million, to $31.7 million, for the six months ended June 30, 1999, compared to an underwriting loss of $45.1 million for the same period in 1998. The improvement in underwriting results is primarily attributable to a $16.9 million favorable impact from the aggregate excess of loss reinsurance treaty. Excluding the impact of the aggregate excess of loss reinsurance treaty, underwriting results decreased $3.5 million. This decrease is due to a deterioration in current year commercial lines' claim activity, partially offset by a decrease in policy acquisition and other underwriting expenses. This decline in policy acquisition and other underwriting expenses primarily reflects a decrease in net premiums earned and declining information systems costs, relating to the year 2000 issue Page 21 Distribution channel results The following table summarizes the results of operations for the distribution channels of the Risk Management segment:
(Unaudited) Six Months Ended June 30,1999 (In millions, Hanover Hanover Citizens Voluntary Allmerica except ratios) North South Midwest Benefits Specialty Other Total Net premiums written $331.7 $100.5 $262.4 $266.2 $ 21.4 $ 0.2 $982.4 Underwriting profit (loss) $ (1.7) $ (5.7) $(12.7) $ (2.5) $ (3.9) $(5.2) $(31.7) Statutory combined ratio 100.1 103.8 105.2 99.5 123.5 N/M 102.5 Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non- underwriting expenses are not reflected in the statutory combined ratio. Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments.
(Unaudited) Six Months Ended June 30,1998 (In millions, Hanover Hanover Citizens Voluntary Allmerica except ratios) North South Midwest Benefits Specialty Other Total Net premiums written $307.0 $105.8 $280.9 $268.0 $ 22.4 $ 6.9 $991.0 Underwriting profit (loss) $(27.7) $ (1.4) $(21.0) $ 6.3 $ (1.8) $ 0.5 $(45.1) Statutory combined ratio 109.6 102.5 107.0 99.4 104.3 N/M 104.8 Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non- underwriting expenses are not reflected in the statutory combined ratio. Includes results from certain property and casualty business which the Company has exited, as well as purchase accounting adjustments.
Hanover North Hanover North's net premiums written increased $24.7 million, or 8.0%, to $331.7 million for the six months ended June 30, 1999, compared to $307.0 million for the same period in 1998. Net premiums written in the commercial lines increased $16.5 million, or 12.2%, to $151.6 million for the six months ended June 30, 1999, primarily due to an increase in policies in force. Personal lines' net premiums written increased $8.2 million to $180.1 million, primarily driven by a 5.8% rate increase in the Massachusetts personal automobile line resulting from the Company's decision to reduce safe driver discounts. Hanover North's underwriting results improved $26.0 million to a loss of $1.7 million for the six months ended June 30, 1999, compared to an underwriting loss of $27.7 million for the same period in 1998. The improvement in underwriting results is primarily attributable to improved current year severity in the personal lines, as well as additional favorable development on prior year's loss reserves in the personal automobile line. In addition, catastrophe losses decreased $7.1 million for the six months ended June 30, 1999, compared to the same period in 1998. Hanover South Hanover South's net premiums written decreased $5.3 million, or 5.0%, to $100.5 million for the six months ended June 30, 1999, compared to $105.8 million for the same period in 1998. The decrease is primarily due to a $5.6 million, or 19.9%, decrease in the personal automobile line's net premiums written driven by a 24.1% decrease in policies in force. This decline is attributable to the Company's decision to exit certain markets in the South. Underwriting results deteriorated $4.3 million from an underwriting loss of $1.4 million for the six months ended June 30, 1998, to a loss of $5.7 million for the same period in 1999. The decrease in underwriting results is primarily attributable to a $5.9 million deterioration in commercial lines' claim activity. In addition, loss activity in the homeowners line increased $1.2 million for the six months ended June 30, 1999, compared to the same period in 1998. Partially offsetting these unfavorable factors is a $3.5 million increase in underwriting results as a result of the aggregate excess of loss reinsurance treaty. Page 22 Citizens Midwest Citizens Midwest's net premiums written decreased $18.5 million, or 6.6%, to $262.4 million for the six months ended June 30, 1999. This decrease is primarily attributable to a $10.3 million decrease in the personal automobile line's net premiums written to $81.3 million for the period ended June 30, 1999, compared to $91.6 million in the same period in 1998. This decline is due to rate decreases in the Michigan personal automobile line of 2.0% and 3.6% in the third quarter of 1998 and first quarter of 1999, respectively. In addition, Citizens Midwest's net premiums written decreased $4.9 million as a result of additional premiums ceded under the aggregate excess of loss reinsurance treaty. Citizens Midwest's underwriting results improved $8.3 million to an underwriting loss of $12.7 million for the six months ended June 30, 1999, from an underwriting loss of $21.0 million for the same period in 1998. The improvement in the underwriting results is attributable to a $5.5 million decrease in catastrophe losses to $13.2 million in 1999, compared to $18.7 million in 1998. In addition, underwriting results were favorably impacted $3.9 million due to the aforementioned aggregate excess of loss reinsurance treaty. Voluntary Benefits Voluntary Benefits' net premiums written decreased $1.8 million, or 0.7%, to $266.2 million for the six months ended June 30, 1999, compared to $268.0 million for the same period in 1998. This decrease is primarily due to a $12.6 million decrease in net premiums written from the aggregate excess of loss reinsurance treaty. Excluding the impact of this reinsurance treaty, net premiums written increased $10.8 million, or 4.0%, attributable to the Company's decision to reduce group and safe driver discounts offered in Massachusetts. Underwriting results deteriorated $8.8 million to a loss of $2.5 million for the six months ended June 30, 1999, from an underwriting gain of $6.3 million for the for the same period in 1998. The deterioration in underwriting results is primarily attributable to an $11.2 million increase in catastrophe losses to $23.9 million in 1999, compared to $12.7 million in 1998. In addition, underwriting results are adversely impacted by increased loss activity in the personal automobile line. Partially offsetting these unfavorable factors is a $10.1 million increase in underwriting results due to the aggregate excess of loss reinsurance treaty. Specialty Markets Specialty Markets' net premiums written decreased slightly to $21.4 million for the six months ended June 30, 1999, compared to $22.4 million for the same period in 1998. Net premiums earned increased $11.5 million to $26.1 million for the six months ended June 30, 1999, from $14.6 million for the same period in 1998. Underwriting results deteriorated $2.1 million to an underwriting loss of $3.9 million for the six months ended June 30, 1999, compared to an underwriting loss of $1.8 million for the period ended June 30, 1998. The deterioration in underwriting results is primarily attributable to case reserve strengthening and an increase in underwriting expenses. Investment Results Net investment income before tax was $113.5 million and $115.3 million in the first six months of 1999 and 1998, respectively. This primarily reflects a reduction in average invested assets of $317.5 million, or 7.5%, to $3,900.5 million in 1999, compared to $4,218.0 million in 1998. This reduction in average invested assets is due to transfers of cash and securities of $350.0 million to the Corporate segment during the second quarter of 1999. Average pre-tax yields on debt securities were 6.7% in 1999 and 1998. Reserve for Losses and Loss Adjustment Expenses The Risk Management segment maintains reserves for its property & casualty products to provide for the Company's ultimate liability for losses and loss adjustment expenses ("LAE") with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given point in time, of what management expects the ultimate settlement and administration of claims will cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claim severity and judicial theories of liability and other factors. The inherent uncertainty of estimating insurance reserves is greater for certain types of property and casualty insurance lines, particularly workers' compensation and other liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and where the technological, judicial and political climates involving these types of claims are changing. The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Changes in prior reserve estimates are reflected in results of operations in the year such changes are determined to be needed and recorded. Page 23 The table below provides a reconciliation of the beginning and ending reserve for unpaid losses and LAE as follows:
(Unaudited) Six Months Ended June 30, (In millions) 1999 1998 Reserve for losses and LAE, beginning of year $2,597.3 $2,615.4 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 795.6 812.5 Decrease in provision for insured events of prior years (96.1) (68.1) --------- --------- Total incurred losses and LAE $ 699.5 $ 744.4 --------- --------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 342.1 335.2 Losses and LAE attributable to insured events of prior years 424.2 433.6 --------- --------- Total payments $ 766.3 $ 768.8 --------- --------- Change in reinsurance recoverable on unpaid losses 44.3 (11.3) --------- --------- Reserve for losses and LAE, end of year $2,574.8 $2,579.7 ========= =========
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $96.1 million and $68.1 million for the six months ended June 30, 1999 and 1998, respectively, reflecting increased favorable development on reserves for both losses and loss adjustment expenses. Favorable development on prior years' loss reserves was $52.0 million and $29.5 million for the six months ended June 30, 1999 and 1998, respectively. This increase of $22.5 million is primarily due to improved personal automobile results in the Northeast. Favorable development on prior year's loss adjustment expense reserves was $44.1 million and $38.6 million for the six months ended June 30, 1999 and 1998, respectively. This favorable development in both periods is primarily attributable to claims process improvement initiatives taken by the Company over the past two years. This favorable development reflects the Company's reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation on the Company varies by product. Property and casualty insurance premiums are established before the amount of losses and LAE, and the extent to which inflation may affect such expenses, are known. Consequently, the Company attempts, in establishing rates, to anticipate the potential impact of inflation in the projection of ultimate costs. The impact of inflation has been relatively insignificant in recent years. However, inflation could contribute to increased losses and LAE in the future. The Company regularly reviews its reserving techniques, its overall reserving position and its reinsurance. Based on (i) review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages, changes in political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Company and the industry, (iv) the relatively short-term nature of most policies and (v) internal estimates of required reserves, management believes that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on the results of operations. Page 24 Reinsurance The Risk Management segment maintains a reinsurance program designed to protect against large or unusual losses and allocated LAE activity. This includes excess of loss reinsurance and catastrophe reinsurance. The Company determines the appropriate amount of reinsurance based on the Company's evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company 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. 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. Effective January 1, 1999, the Company retains $45.0 million of loss per occurrence, 10% of all aggregate loss amounts in excess of $45.0 million up to $230.0 million and all amounts in excess of $230.0 million under its catastrophe reinsurance program. Under the Company'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, in the workers' compensation line, are retained 100% by the Company, while amounts in excess of $30.5 million, in the general liability line, are retained 100% by the Company. Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for the Company's property and casualty business, and is subject to cancellation or commutation annually at the Company's option. The program covers losses and allocated loss adjustment expenses, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. The annual and aggregate coverage limits for losses and allocated LAE are $150.0 million and $300.0 million, respectively. The effect of this agreement on results of operations in each reporting period is based on losses and allocated LAE ceded, reduced by a sliding scale premium of 50.0-67.0% depending on the size of the loss, and increased by a ceding commission of 20.0% of ceded premium. In addition, net investment income is reduced for amounts credited to the reinsurer. As a result of this agreement, the Company recognized a net (expense) benefit of $(3.0) and $16.9 million for the quarter and six months ended June 30, 1999, based on year-to-date and annual estimates of losses and allocated loss adjustment expenses for accident year 1999. The effect of this agreement on the results of operations in future periods is not currently determinable, as it will be based both on future losses and allocated LAE, and on the possible cancellation or commutation of the agreement. The agreement may increase or decrease income in future periods. The Company, in the Risk Management segment, is subject to concentration of risk with respect to reinsurance ceded to various residual market mechanisms. As a condition to the ability to conduct certain business in various states, the Company is required to participate in various residual market mechanisms and pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage voluntarily provided by private insurers. These market mechanisms and pooling arrangements include the Commonwealth Automobile Reinsurers and the Michigan Catastrophic Claims Association. Page 25 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 Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Segment revenues Premiums $ 8.5 $ 9.3 $ 36.4 $ 38.2 Fees 88.6 72.7 171.5 142.2 Investment and other income 96.8 90.4 190.7 183.2 ------- ------- ------- ------- Total segment revenues 193.9 172.4 398.6 363.6 Policy benefits, claims and losses 75.8 74.4 174.2 167.9 Policy acquisition and other operating expenses 70.4 53.8 127.8 109.3 ------- ------- ------- ------- Segment income before taxes $ 47.7 $ 44.2 $ 96.6 $ 86.4 ======= ======= ======= =======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Segment income before taxes increased $3.5 million, or 7.9%, to $47.7 million during the second quarter of 1999. This increase is primarily attributable to higher asset-based fee income driven by growth and market appreciation in the variable annuity and variable universal life product lines, partially offset by higher policy benefits and other operating expenses. Segment revenues increased $21.5 million, or 12.5%, in 1999 primarily due to increased fees and other income. Fee income from annuities and individual variable universal life policies increased $16.2 million, or 32.5%, in the second quarter of 1999 due to additional deposits and market appreciation. In addition, other income increased $4.6 million due primarily to higher investment management fees resulting from growth and appreciation in variable product assets under management. Financial Profiles, a third quarter 1998 acquisition, contributed $1.9 million of this $4.6 million increase. Policy benefits, claims and losses increased $1.4 million, or 1.9%, to $75.8 million in the second quarter of 1999. This increase was primarily due to a $1.9 million increase in the mortality reserve related to the variable annuity line of business, additional growth in this line, and the introduction in 1998 of a new annuity program which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account. These increases were offset by more favorable mortality experience in the Closed Block and individual variable universal life lines of business, as well as decreased interest credited due to cancellations of certain accounts in the group retirement business. Policy acquisition and other operating expenses increased $16.6 million, or 30.9%, in the second quarter of 1999. This increase primarily results from ongoing growth in the variable product lines. Also, policy acquisition expenses increased $2.5 million related to the implementation of an enhanced valuation system for the annuity line of business earlier in 1999. In addition, other operating expenses relating to Financial Profiles and trail commissions in the annuity line of business increased $2.3 million and $2.2 million, respectively. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 Segment income before taxes increased $10.2 million, or 11.8%, to $96.6 million in the first half of 1999. This increase is primarily attributable to higher asset-based fee income driven by growth and market appreciation in the variable annuity and variable universal life product lines, partially offset by higher policy benefits and operating expenses. Page 26 Segment revenues increased $35.0 million, or 9.6%, in 1999 primarily due to increased fees and other income. Fee income from annuities and individual variable universal life policies increased $31.5 million, or 33.4%, in the first six months of 1999 compared to the same period in 1998 due to additional deposits and market appreciation. In addition, investment and other income increased $7.5 million due primarily to higher investment management fees resulting from growth and appreciation in variable product assets under management and the aforementioned acquisition of Financial Profiles. These increases were partially offset by a decrease in premiums of $1.8 million and a decline in fees of $1.4 million primarily from the Company's continued shift in focus from traditional and non-variable universal life insurance products to variable life insurance and annuity products. Policy benefits, claims and losses increased $6.3 million, or 3.8%, to $174.2 million during the first half of 1999. This increase was primarily due to the Company's establishment of a $7.4 million mortality reserve in the first quarter of 1999 related to the variable annuity line of business, a second quarter increase in this reserve of $1.9 million, and additional growth in this line. In addition, annuity reserves increased $5.4 million due to the introduction of the aforementioned new annuity program, with enhanced crediting rates. These increases were offset by more favorable mortality experience in the universal life, Closed Block and individual variable universal life lines of business, as well as decreased interest credited due to cancellations of certain accounts in the group retirement business. Policy acquisition and other operating expenses increased $18.5 million, or 16.9%, in the six months ended June 30, 1999. This increase was primarily due to growth in the variable product lines. In addition, Financial Profiles, which was acquired in the third quarter of 1998, generated $4.2 million of expenses during the first half of 1999. Partially offsetting these increases is an $8.5 million decline in policy acquisition expenses resulting from the implementation of an enhanced valuation system for the annuity line of business in the first quarter of 1999. This decline consists of a one-time increase in the deferred acquisition asset of $13.5 million, partially offset by increased ongoing deferred acquisition expenses of approximately $5.0 million. 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 Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Net investment income $ 30.9 $ 34.6 $ 59.2 $ 67.5 Less: Interest credited 23.9 20.7 47.4 43.8 ------- ------- ------- ------- Interest margins $ 7.0 $ 13.9 $ 11.8 $ 23.7 ======= ======= ======= ======= Interest margins represent the difference between income earned on investment assets and interest credited to customers' universal life and general account annuity policies. Earnings on surplus assets are excluded from net investment income in the calculation of the above interest margins.
Interest margins decreased in the first six months of 1999 due to reduced income from mortgage loans, a shift in assets to the variable product lines, and to the introduction of the aforementioned annuity program with enhanced crediting rates. Page 27 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 Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Interest margins Net investment income $ 36.9 $ 27.6 $ 68.3 $ 49.2 Interest credited 31.5 21.9 58.1 39.4 ------- ------- ------- ------- Net interest margin 5.4 5.7 10.2 9.8 ------- ------- ------- ------- Other income and expenses External investment advisory fees and other income 1.6 0.6 3.0 1.2 Internal investment advisory fees and other income 2.0 1.7 3.5 3.4 Other operating expenses 2.2 1.8 4.2 4.3 ------- ------- ------- ------- Segment income before taxes $ 6.8 $ 6.2 $ 12.5 $ 10.1 ======= ======= ======= =======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Income in the Allmerica Asset Management segment is generated by interest margins earned on the Company's GICs and funding agreements, as well as investment advisory fees earned on assets under management. Investment advisory services are provided to affiliates and third parties, such as money market and other fixed income clients. Related fees are based upon asset balances under the Company's management. Segment income before taxes increased $0.6 million, or 9.7%, to $6.8 million. This increase is primarily attributable to increased investment advisory fees resulting from increased assets under management from new and existing money market and other external fixed income fund clients. These increases were partially offset by a slight decrease in interest margins due to the absence, in 1999, of approximately $0.4 million of mortgage prepayment fees received in 1998. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 Segment income before taxes increased $2.4 million, or 23.8%, to $12.5 million. This increase is primarily attributable to growth in investment advisory fees on assets under management and improved interest margins. Assets under management grew in the first half of 1999 as a result of increased business from new and existing money market and other external fixed income fund clients. Interest margins on GICs increased slightly since the first half of 1998, due to continued sales of funding agreements, partially offset by withdrawals of traditional GICs and to the absence, in 1999, of approximately $0.8 million of mortgage prepayyment fees received in 1998. Funding agreement deposits in the first six months of 1999 increased approximately $252.2 million. Page 28 Corporate The following table summarizes the results of operations for the Corporate segment for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Segment revenues Investment and other income $ 2.4 $ 4.1 $ 3.6 $ 6.1 Interest expense 3.8 3.8 7.6 7.6 Other operating expenses 12.1 13.0 25.5 23.5 ------- ------- ------- ------- Segment loss before taxes and minority interest $ (13.5) $ (12.7) $ (29.5) $ (25.0) ======= ======= ======= =======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Segment loss before taxes and minority interest increased $0.8 million, or 6.3 %, to $13.5 million in the second quarter of 1999 primarily due to a $1.7 million decrease in investment and other income, partially offset by a $0.9 million decrease in other operating expenses. Investment income declined $1.5 million during the second quarter of 1999 due to lower average invested assets. This decline primarily reflects the sale of investments which were used to fund the Company's stock repurchase program, partially offset by assets transferred from the Risk Management segment of $125.0 million and $225.0 million in April and May of 1999, respectively. Interest expense for both periods relates solely to the interest paid on the Senior Debentures of the Company. Other operating expenses for the quarter ended June 30, 1999 decreased $0.9 million, or 6.9%. This expense category consists primarily of corporate overhead expenses, which reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the Legal department. The decrease in other operating expenses primarily reflects the Company's exit from certain non-insurance businesses during 1998. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 Segment loss before taxes and minority interest increased $4.5 million, or 18.0%, to $29.5 million for the six months ended June 30, 1999. Investment and other income decreased $2.5 million in 1999 primarily from lower average invested assets. This decline primarily resulted from the sale of investments used to fund the Company's stock repurchase program, partially offset by the aforementioned transfers of assets from the Risk Management segment. Interest expense for both periods relates solely to the interest paid on the Senior Debentures of the Company. Other operating expenses increased $2.0 million, or 8.5%, primarily due to $3.2 million of higher corporate technology and overhead costs, partially offset by decreased expenses resulting from the Company's exit from certain non-insurance businesses in 1998. Page 29 Discontinued Operations On June 30, 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its EBS business and its accident and health assumed reinsurance pool business. The Company is pursuing a sale of its EBS business during the second half of 1999. During the third quarter of 1998, the Company ceased writing new premium in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the Company's group life and health insurance business, including its reinsurance pool business, have been reported in the Consolidated Statements of Income as discontinued operations in accordance with APB No. 30. The following table summarizes the results of operations for the discontinued group life and health insurance business for the periods indicated.
(Unaudited) (Unaudited) Quarter Ended Six Months Ended June 30, June 30, (In millions) 1999 1998 1999 1998 Revenues Premiums $ 74.3 $ 83.1 $ 155.3 $ 168.5 Net investment and other income 15.4 16.2 31.8 32.0 ------- ------- ------- ------- Total revenues 89.7 99.3 187.1 200.5 Policy benefits, claims and losses 69.0 62.6 127.8 124.7 Policy acquisition and other operating expenses 30.8 34.7 64.4 69.0 ------- ------- ------- ------- (Loss) income from operations of discontinued group life and health business before federal income taxes (10.1) 1.8 (5.1) 6.8 Federal income tax (benefit) expense (3.5) 0.7 (1.8) 2.4 ------- ------- ------- ------- (Loss) income from operations of discontinued group life and health business, net of taxes $ (6.6) $ 1.1 $ (3.3) $ 4.4 ======= ======= ======= =======
Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Income from operations before federal income taxes decreased $11.9 million to a loss of $10.1 million during the second quarter of 1999. Losses in the assumed reinsurance pool business totaled $13.0 million in the current quarter as compared to income of $0.9 million in the prior year. This was partially offset by a $2.0 million increase in income from the EBS business to $3.3 million in 1999. Premiums declined $8.8 million, or 10.6%, in 1999, primarily resulting from a $10.8 million charge related to unrecoverable receivables in the accident and health assumed reinsurance pool business. In addition, premiums declined $1.6 million in the fully insured medical product line, due to the Company's decision, in 1998, to cancel several large, unprofitable accounts. These decreases were partially offset by an increase in assumed premiums of $4.0 million in the accident and health assumed reinsurance pool business, as well as $1.7 million of growth in the affinity group life and health business. Policy benefits, claims and losses increased $6.4 million, or 10.2% in 1999, primarily due to $8.6 million in reserve increases in the accident and health assumed reinsurance pool business, net of applicable reinsurance. In addition, losses increased $1.9 million and $1.7 million in the risk sharing and affinity group life and health lines of business, respectively, due to growth and unfavorable loss experience. Partially offsetting these increases was favorable loss experience in the fully insured medical, dental and disability product lines totaling $5.9 million. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 Income from operations before federal income taxes decreased $11.9 million to a loss of $5.1 million during the first six months of 1999. Losses in the assumed reinsurance pool business totaled $11.8 million in the period ended June 30, 1999 as compared to income of $2.0 million in the prior year. This was partially offset by a $3.5 million increase in income from the EBS business to $8.2 million in 1999. Page 30 Premiums declined $13.2 million, or 7.8%, in 1999, primarily resulting from the aforementioned charge related to unrecoverable receivables in the accident and health assumed reinsurance business. In addition, premiums declined $6.3 million in the fully insured medical and dental product lines due to the Company's decision, in 1998, to cancel several large, unprofitable accounts. These decreases were partially offset by an increase of $3.6 million in the risk sharing line of business due to growth. Policy benefits, claims and losses increased $3.1 million, or 2.5%, in 1999, primarily due to the aforementioned reserve increases in the accident and health assumed reinsurance business. In addition, losses increased $5.1 million due to growth and unfavorable experience in the risk sharing lines of business. Partially offsetting these increases were decreased losses in the fully insured medical, dental and disability product lines totaling $10.0 million resulting from favorable experience through the first six months of 1999. The Company believes that its current reserves for the accident and health assumed reinsurance pool business appropriately reflect both current claims and unreported losses. However, due to the inherent volatility in this business, possible issues related to the enforceability of reinsurance treaties in the industry, and to its recent history of increased losses, there can be no assurance that either current reserves are adequate or that future losses will not arise. Although the Company has discontinued its participation in these reinsurance pools, claims related to prior years may occur and/or develop unfavorably. Investment Portfolio The Company had investment assets diversified across several asset classes, as follows:
June 30, 1999 December 31, 1998 % of Total % of Total Carrying Carrying Carrying Carrying (Dollars in millions) Value Value Value Value Fixed maturities $ 8,455.0 81.6% $ 8,195.0 79.0% Equity securities 106.4 1.0 397.1 3.8 Mortgages 688.7 6.7 698.3 6.7 Policy loans 365.5 3.5 365.2 3.5 Cash and cash equivalents 573.3 5.5 559.7 5.4 Real estate and other invested assets 176.8 1.7 163.1 1.6 ----------------- ----------------- Total $10,365.7 100.0% $10,378.4 100.0% ================= ================= Includes Closed Block invested assets with a carrying value of $744.0 million and $770.5 million at June 30, 1999 and December 31, 1998, respectively. The Company carries the fixed maturities and equity securities in its investment portfolio at market value.
Total investment assets decreased $12.7 million, or 0.1%, to $10.4 billion during the first six months of 1999. This decrease resulted primarily from decreased equity securities of $290.7 million, partially offset by an increase of $260.0 million of fixed maturities. In January 1999, sales of equity securities resulted in proceeds of $310.0 million and realized gains of $116.0 million. Proceeds from the equity securities were used, in part, to repay the loan used to fund the acquisition of minority interest of Citizens Corporation. The increase in fixed maturities is principally due to new funding agreement deposits, partially offset by sales used for the repurchase of AFC common stock under the stock repurchase program. In addition, real estate and other long-term investments increased $13.7 million, primarily due to the investment in new partnerships. 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 85.4% and 84.7% of the Company's total fixed maturity portfolio at June 30, 1999 and December 31, 1998, respectively. The average yield on debt securities was 7.1% and 7.3% for the six months ended June 30, 1999 and 1998, 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. Page 31 The following table illustrates the asset valuation allowance and additions to or deductions from such allowance for the periods indicated.
(Dollars in millions) Mortgages Year Ended December 31, 1998 Beginning balance $ 20.7 Benefit (6.8) Write-offs (1) (2.4) -------- Ending balance $ 11.5 Valuation allowance as a percentage of carrying value before reserves 1.6 % Six months ended June 30, 1999 Provision 0.0 Write-offs (0.1) -------- Ending balance $ 11.4 ======== Valuation allowance as a percentage of carrying value before reserves 1.6 % Write-offs reflect asset sales, foreclosures and forgiveness of debt upon restructurings.
Income Taxes AFC and its domestic subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Quarter Ended June 30, 1999 Compared to Quarter Ended June 30, 1998 Provision for federal income taxes before minority interest and discontinued operations was $22.0 million during the second quarter of 1999 compared to $17.6 million during the same period in 1998. These provisions resulted in consolidated effective federal tax rates of 23.9% and 21.4%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were 22.1% and 32.7% during the second quarter of 1999 and 1998, respectively. The effective tax rates for Allmerica P&C and its subsidiaries were 25.6% and 9.1% during the second quarter of 1999 and 1998, respectively. The decrease in the rate for AFLIAC and FAFLIC and its subsidiaries is primarily the result of a smaller proportion of pre-tax income from realized capital gains in 1999. The increase in the rate for the Allmerica P&C subsidiaries is primarily the result of a decrease in the proportion of tax exempt income to pre-tax income. Six Months Ended June 30, 1999 Compared to Six Months Ended June 30, 1998 The provision for federal income taxes before minority interest and discontinued operations was $69.7 million during the first six months of 1999 compared to $40.2 million during the same period in 1998. These provisions resulted in consolidated effective federal tax rates of 23.6% and 22.7%, respectively. The effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries were 26.4% and 31.8% during the first six months of 1999 and 1998, respectively. The effective tax rates for Allmerica P&C and its subsidiaries were 22.0% and 11.4% during the first six months of 1999 and 1998, respectively. The decrease in the rate for AFLIAC and FAFLIC and its subsidiaries is primarily the result of a smaller proportion of pre-tax income from realized capital gains in 1999. The increase in the rate for the Allmerica P&C subsidiaries is primarily the result of a decrease in the proportion of tax exempt income to pre-tax income, as well as a larger proportion of pre-tax income from realized capital gains in 1999. Page 32 Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, AFC's primary source of cash is dividends from its insurance subsidiaries. However, dividend payments to AFC by its insurance subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus and restrictions on the payment of "extraordinary" dividends, as defined. During 1999, AFC received $350.0 million in extraordinary dividends from its property and casualty businesses. These funds were principally used to repurchase $250.2 million of AFC common stock and pay $20.3 million of interest expense on the Senior Debentures and Capital Securities. During the third quarter of 1999, the Company expects to use the remaining funds from the aforementioned dividends, as well as anticipated proceeds from sales of AFC holding company investments, to fund a $125.0 million capital contribution from AFC to FAFLIC. As of July 1, 1999, FAFLIC's ownership of Allmerica P&C, as well as several non-insurance subsidiaries, were transferred from FAFLIC to AFC. Under an agreement with the Commonwealth of Massachusetts Insurance Commissioner ("the Commissioner"), AFC will contribute the aforementioned $125.0 million and maintain FAFLIC's statutory surplus at specified levels during the following six years. Future capital contributions from AFC to FAFLIC may be required. In addition, any dividend from FAFLIC to AFC during the years 2000 and 2001 would require the prior approval of the Commissioner. During the first six months of 1998, Hanover and FAFLIC declared dividends to AFC of $125.0 million and $50.0 million, respectively. These funds were transferred to the holding company in anticipation of the fourth quarter 1998 acquisition of the minority interest of Citizens and were temporarily invested in short-term securities. In addition, AFC paid $20.3 million of interest expense during the first half of 1998 on the Senior Debentures and Capital Securities. Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claims, losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash provided by operating activities was $32.5 million during the first six months of 1999, compared to cash used in operating activities of $90.5 million for the same period of 1998. The change in 1999 was primarily due to the timing of settlements related to receivable balances with the Company's Separate Accounts. This receipt of cash was partially offset by cash used to fund increased commissions and other deferrable expenses related to continued growth in the variable annuity product lines of the Allmerica Financial Services segment. Net cash used in investing activities declined $327.4 million, to $177.7 million, during the first six months of 1999. This change is primarily due to $310.0 million of sales of equity securities in January 1999. Net cash provided by financing activities decreased $440.7 million to $158.9 million during the first six months of 1999, as compared to $599.6 million during the same period in 1998. In 1999, the Company repurchased AFC common stock with an aggregate cost of $250.2 million. In addition, cash was used to repay $150.0 million in short term debt used to finance the acquisition of the minority interest of Citizens Corporation. 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. 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. On July 27, 1999, the Board of Directors declared an annual dividend of $0.25 per share on the issued and outstanding common stock of the Company, payable November 15, 1999 to shareholders of record at the close of business November 1, 1999. Page 33 Based on current trends, the Company expects to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. The Company maintains a high degree of liquidity within the investment portfolio in fixed maturity investments, common stock and short- term investments. AFC has $150.0 million available under a committed syndicated credit agreement which expires on May 28, 2000. Borrowings under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. At June 30, 1999, no amounts were outstanding under this agreement. The Company had $50.2 million of commercial paper borrowings outstanding at June 30, 1999. Contingencies In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998. On May 19, 1999, the court issued an order certifying the class for settlement purposes and granting final approval of the settlement agreement. AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the Company's opinion, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. However, liabilities related to these proceedings could be established in the near term if estimates of the ultimate resolution of these proceedings are revised. 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 require modification or replacement to enable its computer systems to process dates beyond December 31, 1999. The Company is presently completing the process of modifying or replacing existing software and believes that 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 suppliers 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 Company's involvement on a third party's Year 2000 program, 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 issue, there can be no assurance that exposure for material contingencies will not arise. Page 34 The cost of the Year 2000 project will be expensed as incurred and is being funded primarily through a reallocation of resources from discretionary projects and a reduction in systems maintenance and support costs. Therefore, the Year 2000 project is not expected to result in any significant incremental technology cost, except as described above, and is not expected to have a material effect on the results of operations. The Company has incurred and expensed approximately $59 million related to the assessment plan development and substantial completion of the Year 2000 project, through June 30, 1999. The total remaining cost of the project is estimated at between $10-20 million. Approximately 10% of the Company's Year 2000 resources to be utilized in 1999 have been allocated to the Company's remediation plan, which has three mission critical elements: internal systems, desktop systems, and external partners. Internal Systems All of the 613 AFC systems inventoried have been corrected, tested for year 2000 dates, and returned to production. Desktop Systems The Company has verified that all desktop computers are capable of correctly processing year 2000 dates. Additionally, over 99% of the third party software installed on the Company's desktop machines has been confirmed capable of processing year 2000 dates properly. Any remaining desktop systems will be upgraded, eliminated, or replaced prior to year end. External Partners The Company has tested and verified that 97% of its electronic interfaces will process year 2000 dates correctly. Ninety-two percent of the property and casualty agents have confirmed that they are capable of properly processing year 2000 dates. In addition, the Company has verified, through a process that included, where appropriate, testing, written disclosure and personal contact, that 86% of its non-electronic partners are capable of properly processing year 2000 dates. Most external partners have informed the Company that they expect to be compliant. The Company hopes for full compliance of external partners in the third quarter of 1999, however, external partner compliance is not under the Company's control. As such, the Company has initiated a proactive program to track these remaining external partners. Action plans are being developed to mitigate the risk of interruption of essential business processes should it be determined that the Company's year 2000 readiness criteria for external partners will not be met by September 30, 1999. In partnership with an outside consulting firm, the Company has completed an enterprise-wide Year 2000 business risk identification and assessment. The Continuity of Operations Plan (COOP) requirements have been identified for all business units of the Company and applicable plans are currently being developed. These plans will contain immediate steps needed 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 business unit operations functioning in the event of a failure or delay due to year 2000 record format and date calculation changes. All plans, including individual plans by business segment, are scheduled to be completed by September 30, 1999. Contingency planning will utilize approximately 15% of the Company's Year 2000 resources in 1999. The remaining 75% of the Company's Year 2000 resources will be utilized to address on-going compliance issues. These include periodic reviews of applications, installation and testing of new hardware and software packages, testing new software maintenance and testing internally developed software. 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 responsiveness and 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, the Year 2000 readiness of suppliers and business partners, and similar uncertainties. Page 35 Forward-Looking Statements The Company wishes to caution readers that the following important factors, among others, in some cases have affected and in the future could affect, the Company's actual results and could cause the Company's actual results for 1999 and beyond to differ materially from those expressed in any forward- looking statements made by, or on behalf of, the Company. When used in the MD&A discussion, the words "believes", "anticipates", "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2. 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 relating to sales practices for insurance products; (xvi) uncertainty related to the Year 2000 issue; (xvii) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance contracts; (xviii) earlier than expected withdrawals from the Company's general account annuities, GICs (including funding agreements), and other insurance products; (xix) changes in the mix of assets comprising the Company's investment portfolio and the fluctuation of the market value of such assets; and (xx) losses resulting from the Company's participation in certain reinsurance pools. Page 36 PART II - OTHER INFORMATION ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS This registrant's annual shareholder's meeting was held on May 11, 1999. All four directors nominated for reelection by the Board of Directors were named in proxies for the meeting, which proxies were solicited pursuant to Regulations 14A of the Securities and Exchange Act of 1934. Messrs. Gerson and Murray were elected to serve a three-year term. Mr. Henderson was elected to serve a two-year term. Mr. Sprague was elected to serve a one-year term. The following votes were cast:
VOTES FOR WITHHELD Samuel J. Gerson 41,356,558 474,962 Robert P. Henderson 41,534,971 476,549 Robert J. Murray 41,542,064 469,456 John L. Sprague 41,537,674 473,846
The other directors whose terms were continued after the Annual Meeting are Mr. Michael P. Angelini, Mr. E. Gordon Gee, Ms. Gail L. Harrison, Mr. M Howard Jacobson, Mr. J. Terrence Murray, Mr. John F. O'Brien, Mr. Robert G. Stachler and Mr. Herbert M. Varnum. Shareholders ratified the appointment of PricewaterhouseCoopers LLP as the Independent Public Accountants of the Company for 1999: for 41,733,083; against 75,568; abstain 202,869. Shareholders approved a Short-Term Incentive Compensation Plan: for 39,893,835; against 1,561,335; abstain 556,350. Page 37 PART II - OTHER INFORMATION ITEM 6 - EXHIBITS AND REPORTS ON FORM 8K (a) Exhibits EX - 10.36 Amendment to the Credit Agreement dated as of June 17, 1998 between the Registrant and the Chase Manhattan Bank. EX - 10.37 Allmerica Financial Corporation Short-Term Incentive Compensation Plan. + EX - 27 Financial Data Schedule EX - 99.2 Important Factors Regarding Forward Looking Statements + Incorporated herein by reference to Exhibit A contained in the Registrants current Proxy Statement (Commission File No. 001-13754) filed March 31, 1999. (b) Reports on Form 8K On April 29, 1999, Allmerica Financial Corporation announced its financial results for the three months ended March 31, 1999. On May 25, 1999, Allmerica Financial Corporation announced that a settlement agreement in a class action lawsuit against the Company and three of its subsidiaries received final approval in U.S. District Court in Worcester. The class action lawsuit related to the sale of approximately 400,000 policies from 1978 to May 31, 1998. Page 38 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 August 12, 1999 /s/ John F. O'Brien John F. O'Brien President and Chief Executive Officer Dated August 12, 1999 /s/ Edward J. Parry III Edward J. Parry III Vice President, Chief Financial Officer, and Treasurer Page 39 EXHIBIT INDEX Exhibit Number Exhibit 10.36 Amendment to the Credit Agreement dated as of June 17, 1998 between the Registrant and the Chase Manhattan Bank. 10.37 Allmerica Financial Corporation Short-term Incentive Compensation Plan. + 27 Financial Data Schedule 99.2 Important Factors Regarding Forward Looking Statements + Incorporated herein by reference to Exhibit A contained in the Registrants current Proxy Statement (Commission File No. 001- 13754) filed March 31, 1999. Page 40 EX-10 2 AMENDMENT AND RESTATEMENT dated as of May 28, 1999 of 364-DAY CREDIT AGREEMENT dated as of May 29, 1998 among ALLMERICA FINANCIAL CORPORATION The LENDERS Party Hereto and THE CHASE MANHATTAN BANK, as Administrative Agent ------------------------------------- $150,000,000 ------------------------------------- CHASE SECURITIES INC., as Arranger and Book Manager AMENDMENT AND RESTATEMENT dated as of May 28, 1999 (this "Amendment and Restatement") of the 364-DAY CREDIT AGREEMENT referred to below, among: ALLMERICA FINANCIAL CORPORATION, a Delaware corporation (the "Company"); the LENDERS party hereto; and THE CHASE MANHATTAN BANK, as administrative agent to the Lenders (in such capacity, with any successors in such capacity, the "Administrative Agent"). W I T N E S S E T H: WHEREAS, the Borrower, the Lenders and the Administrative Agent are parties to a 364-Day Credit Agreement dated as of May 29, 1998 immediately prior to the effectiveness of this Amendment and Restatement pursuant to Section 4 hereof, the "Existing Credit Agreement") and desire to amend and restate the Existing Credit Agreement to make certain amendments and other modifications thereto; and NOW, THEREFORE, in consideration of the foregoing premises and the mutual agreements contained herein, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree to amend the Existing Credit Agreement as set forth herein and to restate the Existing Credit Agreement to read in its entirety as set forth in the Existing Credit Agreement, which is hereby incorporated herein by reference, with the amendments thereto specified in Section 2 of this Amendment and Restatement (the Existing Credit Agreement, as amended and restated hereby, being herein called the "Amended and Restated Credit Agreement"): Section 1. Definitions. Terms defined in the Existing Credit Agreement but not herein have the meanings given them in the Existing Credit Agreement. Section 2. Amendments. Effective on the date provided in Section 4 of this Amendment and Restatement, subject to satisfaction of the conditions to effectiveness set forth therein, the Existing Credit Agreement is hereby amended as follows: 2.01. General. References in the Existing Credit Agreement to "this Agreement" or words of similar import (including indirect references to the Existing Credit Agreement) shall be deemed to be references to the Amended and Restated Credit Agreement. 2.02. Certain Definitions. Each of the following definitions in Section 1.01 of the Credit Agreement shall be amended in its entirety to read as follows: "Applicable Loan Fee Percentage" shall mean 0.08% per annum. "Applicable Margin" shall mean, with respect to Eurodollar Loans, 0.22% per annum. "Commitment Termination Date" shall mean May 27, 2000, as such date may be extended pursuant to Section 2.09 hereof. Amendment and Restatement ------------------------- Page 1 of 6 2.03. Clause (f) of Section 8.04 of the Credit Agreement shall be amended by inserting the following parenthetical immediately after the word "thereto" in the ninth line thereof: "(unless the aggregate purchase price for such acquisition is less than $20,000,000 and such approval is not required by applicable law, in which case such approval shall not be required hereunder)". 2.04. Clause (l) of Section 8.05 of the Credit Agreement shall be amended in its entirety to read as follows: "(l) additional Liens upon real and/or personal Property created after the date hereof, provided that the aggregate Indebtedness secured thereby and incurred on and after the date hereof shall not exceed $30,000,000 in the aggregate at any one time outstanding; and". 2.05. Clause (f) of Section 8.06 of the Credit Agreement shall be amended in its entirety to read as follows: "(f) additional Indebtedness of the Company and its Subsidiaries (including, without limitation, Capital Lease Obligations and other Indebtedness secured by Liens permitted under Sections 8.05(j) or 8.05(l) hereof) if on the date of the incurrence of such Indebtedness (after giving pro forma effect to such Indebtedness and the application of the net proceeds therefrom) the (A) the sum of (i) Total Debt plus (ii) the aggregate liquidation preference of all Special Preferred Securities but only that portion of such aggregate liquidation preference that is at such time equal to, or in excess of, 15% of Total Capitalization on such date would not exceed (B) 25% of Total Capitalization. 2.06. Section 8.08 of the Credit Agreement shall be amended by (i) replacing the word "and" immediately prior to clause (y) thereof with a comma and (ii) amending said clause (y) in its entirety, and inserting a new clause (z) immediately following said clause (y), to read as follows: "(y) the Company and its Subsidiaries may enter into transactions in the ordinary course of business and upon terms no less favorable to the Company or such Subsidiary than the Company or such Subsidiary would obtain in a comparable arm's-length transaction with a Person not an Affiliate and (z) the Company and its Subsidiaries may make investment in Affiliates in an aggregate amount not exceeding 10% of the Total Shareholders' Equity." Amendment and Restatement ------------------------- Page 2 of 6 Section 3. Representations and Warranties. The Borrower hereby represents and warrants to the Lenders and the Administrative Agent that (a) the representations and warranties set forth in Article III of the Existing Credit Agreement as amended and restated hereby are true and correct as of the Effective Date (as defined in Section 4 hereof) with the same force and effect as if made on and as of such date (or, if any such representation or warranty is expressly stated to have been made as of a specific date, as of such specific date) and (b) no Default shall have occurred and be continuing on the Effective Date both immediately before and after giving effect to the amendments set forth in Section 2 of this Amendment and Restatement. Section 4. Conditions Precedent. The amendment and restatement of the Existing Credit Agreement contemplated hereby shall be effective as of May 28, 1999 (the "Effective Date") upon the satisfaction of each of the following conditions precedent: (a) Amended and Restated Credit Agreement. This Amendment and Restatement, duly executed and delivered by the Borrower, the Lenders and the Administrative Agent. (b) Payments. Evidence satisfactory to the Administrative Agent of payment (or arrangements for payment) in full of all unpaid loan fees under Section 2.04 of the Existing Credit Agreement, which shall have accrued to but not including the Commitment Termination Date as in effect immediately prior to the effectiveness of this Amendment and Restatement. (c) Other Documents. Receipt by the Administrative Agent of such other documents as any Administrative Agent or any Lender or special New York counsel to Chase may reasonably request. Section 5. Miscellaneous. Except as herein provided, the Existing Credit Agreement shall remain unchanged and in full force and effect. This Amendment and Restatement may be executed in any number of counterparts, all of which taken together shall constitute one and the same amendatory instrument and any of the parties hereto may execute this Amendment and Restatement by signing any such counterpart and sending the same by telecopier, mail messenger or courier to the Administrative Agent or special New York counsel to Chase. This Amendment and Restatement shall be governed by, and construed in accordance with, the law of the State of New York. Amendment and Restatement ------------------------- Page 3 of 6 IN WITNESS WHEREOF, the parties hereto have caused this Amendment and Restatement to be duly executed as of the day and year first above written. BORROWER -------- ALLMERICA FINANCIAL CORPORATION By: /s/ Edward J. Parry III ------------------------- Name: Edward J. Parry III Title: Vice President, Chief Financial Officer, and Treasurer Amendment and Restatement ------------------------- Page 4 of 6 LENDERS ------- Commitments - ----------- (as of May 28, 1999) $30,000,000 THE CHASE MANHATTAN BANK, individually and as Administrative Agent By: /s/ Lawrence M. Karp ------------------------- Name: Lawrence M. Karp Title: Vice President $30,000,000 BANKBOSTON, N.A. By: /s/Stewart P. Neff ------------------------- Name: Stewart P. Neff Title: Managing Director $30,000,000 THE FIRST NATIONAL BANK OF CHICAGO By: /s/ Samuel W. Bridges ------------------------ Name: Samuel W. Bridges Title: First Vice President $45,000,000 FLEET NATIONAL BANK. By: /s/ David A. Bosselait ------------------------ Name: David A. Bosselait Title: Vice President Page 5 of 6 $15,000,000 THE BANK OF NEW YORK By: /s/ Robert V. Masi -------------------------- Name: Robert V. Masi Title: Vice President Amended and Restated Credit Agreement NY3:#7208600v3 [EXECUTION COPY] NY3:#7208600v3 Amendment and Restatement NY3:#7208600v3 NY3:#7208600v3 Amendment and Restatement ------------------------- Page 6 of 6 EX-27 3
7 This Schedule contains summary financial information extracted from the Consolidated Financial Statements of Allmerica Financial Corporation as of June 30, 1999 and for the period then ended, and is qualified in its entirety reference to such financial statements. 1,000,000 6-MOS DEC-31-1999 JUN-30-1999 8044 0 0 106 556 18 9044 578 1153 1285 29826 2870 871 2793 3201 250 300 0 1 2248 29826 953 313 126 58 883 204 238 295 70 218 (3) 0 0 214 3.83 3.80 2597 796 (96) 342 424 2575 0
EX-99 4 EXHIBIT 99.2 ALLMERICA FINANCIAL CORPORATION IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS The Company wishes to caution readers that the following important factors, among others, in some cases have affected the Company's results and in the future could cause actual results and needs of the Company to vary materially from forward-looking statements made from time to time by the Company on the basis of management's then-current expectations, The businesses in which the Company is engaged are in rapidly changing and competitive markets and involve a high degree of risk, and accuracy with respect to forward looking projections is difficult. Geographic Concentration in the Property and Casualty Insurance Business Substantially all of the Company's property and casualty insurance subsidiaries net premiums written and earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The revenues and profitability of the Company's property and casualty insurance subsidiaries are therefore subject to prevailing economic, regulatory, demographic and other conditions, including adverse weather, in Michigan and the Northeast. Cyclicality in the Property and Casualty Insurance Industry Historically, the property and casualty insurance industry has been highly cyclical. The property and casualty industry's profitability can be affected significantly by price competition, volatile and unpredictable developments such as extreme weather conditions and natural disasters, legal developments affecting insurer liability and the size of jury awards, fluctuations in interest rates and other factors that affect investment returns and other general economic conditions and trends that may affect the adequacy of reserves. Over the past several years, the property and casualty insurance industry as a whole has been in a soft market. Competition for premiums in the property and casualty insurance markets may continue to have an adverse impact on the Company's rates and profitability. Catastrophe Losses in the Property and Casualty Insurance Industry Property and casualty insurers are subject to claims arising out of catastrophes, which may have a significant impact on their results of operations and financial condition. The Company may experience catastrophe losses in the future which could have a material adverse impact on the Company. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires, severe winter weather and explosions, and the frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of two factors: the total amount of insured exposure in the area affected by the event and the severity of the event. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and commercial property insurance have in the past generated the vast majority of the Company's catastrophe-related claims. The Company purchases catastrophe reinsurance as protection against catastrophe losses. The Company believes, based upon its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, that the financial condition of its reinsurers is sound. However, there can be no assurance that reinsurance will be adequate to protect the Company against such losses or that such reinsurance will continue to be available to the Company in the future at commercially reasonable rates. Page 1 of 7 Uncertainty Regarding Adequacy of Property and Casualty Loss Reserves The Company's property and casualty insurance subsidiaries maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses ("LAE") with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given time, of what the Company's property and casualty insurance subsidiaries expect the ultimate settlement and administration of claims will cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claims severity and judicial theories of liability, legislative activity and other factors. The inherent uncertainties of estimating reserves are greater for certain types of property and casualty insurance lines, particularly workers' compensation, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and environmental liability, where the technological, judicial and political climates involving these types of claims are changing. The Company's property and casualty insurance subsidiaries regularly review reserving techniques, reinsurance and overall reserve adequacy. Based upon (I) review of historical data, legislative enactments, judicial decision, legal developments in imposition of damages, changes in political attitudes and trends in general economic conditions; (ii) review of per claim information; (iii) historical loss experience of the property and casualty insurance subsidiaries and the industry; and (iv) the relatively short-term nature of most of its property and casualty insurance policies, management believes that adequate provision has been made for reserves. However, establishment of appropriate reserves is an inherently uncertain process involving estimates of future losses and there can be no certainty that currently established reserves will prove adequate in light of subsequent actual experience. The Company's property and casualty insurance subsidiaries' reserves are annually certified as required by insurance regulatory authorities. Sensitivity to Interest Rates Relative to Life Insurance Subsidiaries The Company's life insurance subsidiaries are exposed to risk of disintermediation and reduction in interest spread or profit margins when interest rates fluctuate. Bond calls, mortgage prepayments, contract surrenders and withdrawals of life insurance policies, annuities and guaranteed investment contracts are influenced by the interest rate environment. Since the Company's life insurance subsidiaries' investment portfolios consist primarily of fixed income assets, the investment portfolio market value and the yields on newly invested and reinvested assets vary depending on interest rates. Management attempts to mitigate any negative impact of interest rate changes through asset/liability management, product design (including an increased focus on variable insurance products), management of crediting rates, use of hedging techniques, relatively high surrender charges and management of mortality charges and dividend scales with respect to its in force life insurance policies. Uncertainty Regarding Accident and Health Assumed Reinsurance Pool Business The Company believes that notwithstanding the recent losses incurred by the accident and health assumed reinsurance pool business, the Company's current reserves appropriately reflect both current claims and unreported losses. However, due to the inherent volatility in this business, possible issues related to the enforceability of reinsurance treaties in the industry and to its recent history of increased losses, we cannot assure you that our current reserves are adequate or that we will not have losses in the future. Although we have discontinued our participation in these reinsurance pools, we may become subject to claims related to prior years. We may be harmed from liabilities resulting from any such claims. Page 2 of 7 Regulatory, Surplus, Capital, Rating Agency and Related Matters Insurance companies are subject to supervision and regulation by the state insurance authority in each state in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company's business and financial condition, including limitations on the authorization of lines of business, underwriting limitations, the setting of premium rates, the establishment of standards of solvency, the licensing of insurers and agents, concentration of investments, levels of reserves, the payment of dividends, transactions with affiliates, changes of control and the approval of policy forms. Such regulation is concerned primarily with the protection of policyholders. State regulatory oversight and various proposals at the federal level (including the proposed adoption of a federal regulatory framework for insurance companies) may in the future adversely affect the Company's ability to sustain adequate returns in certain lines of business. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and certain state legislatures have considered or enacted laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioners ("NAIC") and state insurance regulators are reexamining existing laws and regulations, and as a condition to accreditation have required the adoption of certain model laws which specifically focus on insurance company investments, issues relating to the solvency of insurance companies, risk-based capital ("RBC") guidelines, interpretations of existing laws, the development of new laws, and the definition of extraordinary dividends. The capacity for an insurance company's growth in premiums is in part a function of its statutory surplus. Maintaining appropriate levels of statutory surplus, as measured by state insurance regulators, is considered important by state insurance regulatory authorities and the private agencies that rate insurers' claims-paying abilities and financial strength. Failure to maintain certain levels of statutory surplus could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by the private rating agencies. The NAIC has created a new system for assessing the adequacy of statutory capital for life and health insurers and property and casualty insurers. The new system, known as risk-based capital, is in addition to the states' fixed dollar minimum capital and other requirements. The new system is based on risk-based formulas (separately defined for life and health insurers and property and casualty insurers) that apply prescribed factors to the various risk elements in an insurer's business to report a minimum capital requirement proportional to the amount of risk assumed by the insurer. Because the investment of First Allmerica Financial Life Insurance Company ("FAFLIC"), a life insurance subsidiary of the Company, in Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C") represents a significant percentage of FAFLIC's surplus, the trading In addition, in 1997, A.M. Best decided to no longer rate Citizens independently from its majority parent, The Hanover Insurance Company, but instead rated the two separate companies as a group. Consequently, Citizens was assigned Best's "A (Excellent)" rating, despite its "A+ (Superior)" qualifications. Management believes that its strong ratings are important factors in marketing the products of its insurance companies to its agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company ratings are assigned to an insurer based upon factors relevant to policyholders and are not directed toward protections of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. Further downgrades may have a material adverse effect on the Company's business and prospects. Page 3 of 7 State Guaranty Funds, Shared Markets Mechanisms and Pooling Arrangements All fifty states of the United Sates have insurance guaranty fund laws requiring all life and health and property and casualty insurance companies doing business within the state to participate in guaranty associations, which are organized to pay contractual obligations under insurance policies issued by impaired or insolvent insurance companies. These associations levy assessments (up to prescribed limits) on all member insurers in a particular state on the basis of the proportionate share of the premiums written by member insurers in the lines of business in which the impaired or insolvent insurer is engaged. Mandatory assessments by state guaranty funds are used to cover losses to policyholders of insolvent or rehabilitated companies and can be partially recovered through a reduction in future premium taxes in many states. These assessments may increase in the future depending upon the rate of insolvencies of insurance companies. In addition, as a condition to the ability to conduct business in various states, the Company's property and casualty insurance subsidiaries are required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. The Company cannot predict whether its participation in these shared market mechanisms or pooling arrangements will provide underwriting profits or losses to the Company. Competition The Company's business is composed of four principal segments: Property and Casualty Insurance, Corporate Risk Management Services, Allmerica Financial Services, and Allmerica Asset Management. Each of these industry segments, in general, is highly competitive. The Company's products and services compete not only with those offered by insurance companies, but also with products offered by other financial institutions and health maintenance organizations. In all of its segments, many of the Company's competitors are larger and have greater financial, technical, and operating resources than those of the Company. In addition, the Company may face additional competition from banks and other financial institutions should current regulatory restrictions on the sale of insurance and securities by these institutions be repealed. Retention of Key Executives The future success of the Company will be affected by its continued ability to attract and retain qualified executives. The Company's success is dependent in large part on John F. O'Brien, the loss of whom could adversely affect the Company's business. The Company does not have an employment agreement with Mr. O'Brien. FEDERAL INCOME TAX LEGISLATION Currently, under the Code, holders of certain life insurance and annuity products are entitled to tax-favored treatment on these products. For example, income tax payable by policyholders on investment earnings under certain life insurance and annuity products is deferred during the product's accumulation period and is payable, if at all, only when the insurance or annuity benefits are actually paid or to be paid. Also, for example, interest on loans up to $50,000 secured by the cash value of certain insurance policies owned by businesses is eligible for deduction even though investment earnings during the accumulation period are tax-deferred. Page 4 of 7 In the past, legislation has been proposed that would have curtailed the tax-favored treatment of the life insurance and annuity products offered by the Company. These proposals were not enacted, however; such proposals or similar proposals are currently under consideration by Congress. If these or similar proposals directed at limiting the tax-favored treatment of life insurance policies and annuity contracts were enacted, market demand for such products offered by the Company would be adversely affected. SALES PRACTICES A number of civil jury verdicts have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgements against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. The Company and its subsidiaries, from time to time are involved in such litigation. Although the outcome of any litigation cannot be predicted with certainty, to date, no such lawsuit has resulted in the award of any material amount of damages against the Company. In December 1996, the Company received notice from the Securities and Exchange Commission (the "Commission") that it would be conducting a limited inspection concerning the Company's marketing and sales practices associated with variable insurance products. The Commission requested that certain information be provided to it by the Company, which the Company promptly complied with. No litigation has been instituted, nor has the Commission initiated any further action with respect to this matter. HEALTH CARE REFORM LEGISLATION There continue to be a number of legislative and regulatory proposals introduced at the federal and state level to reform the current health care system. At the federal level, recent proposals have focused on managed care reform, and patient protection and advocacy. State and federal legislation adopted over the past few years generally limits the flexibility of insurers with respect to underwriting practices for small employer plans that contain less than 50 employees, provides for crediting previous coverage for the purposes of determining pre-existing conditions, and limits the ability to medically underwrite individual risks in the group market. In addition, several states have enacted managed care reform legislation which may change managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that utilize managed care programs or market health insurance to small employers will continue. However, the Company's rating, underwriting practices, and managed care programs are consistent with the experience rate small cases, nor does it refuse coverage to eligible individuals because of medical histories. Also, its managed care programs provide for coverage outside of the preferred network and allow for open communication between a doctor and his/her patient. Because of its emphasis on managed care and risk sharing partnerships, management believes that it will continue to be able to operate effectively in the event of further reform, even if specified states expand the existing limitations. The Company believes that the proposed federal and state health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurer's flexibility and Page 5 of 7 Impact of the Year 2000 Issue The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on a 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 completing the process of modifying or replacing existing software and believes that 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 suppliers 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 Company's involvement on a third party's Year 2000 program, 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 issue, there can be no assurance that exposure for material contingencies will not arise. The cost of the Year 2000 project will be expensed as incurred and is being funded primarily through a reallocation of resources from discretionary projects and a reduction in systems maintenance and support costs. 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. Approximately 10% of the Company's Year 2000 resources to be utilized in 1999 have been allocated to the Company's remediation plan, which has three mission critical elements: internal systems, desktop systems, and external partners. Internal Systems Over 98% of the Company's internal systems have been corrected, tested for year 2000 dates, and returned to production. The remaining systems, which include relatively small systems waiting for vendor upgrade or scheduled for elimination or replacement, are targeted to be complete by June 30, 1999. Desktop Systems The Company has verified that all desktop computers are capable of correctly processing year 2000 dates. Additionally, over 98% of the third party software installed on the Company's desktop machines has been confirmed capable of processing year 2000 dates properly. The remaining desktop systems are expected to be upgraded, eliminated, or replaced by June 30, 1999. Page 6 of 7 External Partners The Company has verified that 50% of its electronic interfaces will process year 2000 dates correctly. Eighty percent of the Property and Casualty agents have confirmed that they are capable of properly processing year 2000 dates. Sixty percent of the Company's non-electronic partners have responded that they are capable of properly processing year 2000 dates. Most external partners have informed the Company that they expect to be compliant. The Company hopes for full compliance of external partners by July 1, 1999. In partnership with an outside consulting firm, the Company has completed an enterprise-wide year 2000 business risk identification and assessment. The Continuity of Operations Plan (COOP) requirements have been identified for all business units of the Company and applicable plans are currently being developed. These plans will contain immediate steps needed 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 business unit operations functioning in the event of a failure or delay due to Year 2000 record format and date calculation changes. All plans, including individual plans by business segment, are scheduled to be completed by September 30, 1999. Contingency planning will utilize approximately 15% of the Company's Year 2000 resources in 1999. The remaining 75% of the Company's Year 2000 resources will be utilized to address on-going compliance issues. These include periodic reviews of applications, installation and testing of new hardware and software packages, testing new software maintenance and testing internally developed software. 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 responsiveness and 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, the Year 2000 readiness of suppliers and business partners, and similar uncertainties. Page 7 of 7 -----END PRIVACY-ENHANCED MESSAGE-----