UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-K

For the fiscal year ended: December 31, 20032004

OR

For the transition period from:                    to                    

Commission file number: 1-13754

ALLMERICA FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (508) 855-1000

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: NONE

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesx No¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.x¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yesx No¨

Based on the closing sales price of June 30, 20032004 the aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant was $933,661,967.$1,766,318,609.

The number of shares outstanding of the registrant’s common stock, $.01 par value, was 53,134,14453,370,496 shares outstanding as of February 16, 2004.15, 2005.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Allmerica Financial Corporation’s Proxy Statement of Annual Meeting of Shareholders to be held May 4, 200417, 2005 are incorporated by reference in Part III.

PART I

ItemITEM 1 — BUSINESS

ORGANIZATION

Allmerica Financial Corporation (“AFC”) is a non-insurance holding company organized as a Delaware corporation in 1995. Our consolidated financial statements include the accounts of AFC; The Hanover Insurance Company (“Hanover”) and Citizens Insurance Company of America (“Citizens”), our property and casualty subsidiaries; Allmerica Financial Life Insurance and Annuity Company (“AFLIAC”) and First Allmerica Financial Life Insurance Company (“FAFLIC”), our life insurance and annuity subsidiaries; and certain other insurance and non-insurance subsidiaries.

FINANCIAL INFORMATION ABOUT OPERATING SEGMENTS

We offerOur business includes financial products and services in two major areas: Property and Casualty and Life Companies. Within these broad areas, we conduct business principally in threefour operating segments. These segments are Personal Lines, Commercial Lines, Other Property and Casualty, Allmerica Financial Services (“AFS”) and Asset Management. In additionLife Companies. We report interest expense related to the three operating segments, we have a Corporate segment, which consists primarily of cash, investments,our corporate debt Capital Securities (mandatorily redeemable preferred securitiesseparately from the earnings of a subsidiary trust holding solelyour operating segments. Corporate debt consists of our junior subordinated debentures of AFC) and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those related to certain officers and directors, technology, finance, human resources and legal.our senior debentures.

Information with respect to each of our segments is included in “Segment Results”Results ” on pages 2627 to 4142 in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Note 1615 on pages 9798 to 99100 of the Notes to the Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.

DESCRIPTION OF BUSINESS BY SEGMENT

Following is a discussion of each of our operating segments.

PROPERTY AND CASUALTY

General

Our Property and Casualty segmentgroup accounted for $2.5 billion, or 75.8%81.1%, of consolidated segment revenues and provided $143.6$198.0 million of segment income before federal income taxes for the year ended December 31, 2003.2004. This group manages its operations principally through three segments, identified as Personal Lines, Commercial Lines and Other Property and Casualty. We underwrite personal and commercial property and casualty insurance through Hanover and Citizens, primarily through an independent agent network concentrated in the Midwest, Northeast, Midwest and Southeast United States. Additionally, our Other Property and Casualty segment consists of: voluntary pools business, in which we have not actively participated since 1995; our premium financing business; and our investment management services business.

Our strategy focuses on the fundamentals of the business, namely disciplined underwriting, pricing, quality claim handling, active agency management, effective expense management and customer service. We have a strong regional focus and emphasize underwriting profitability and loss reserve adequacy in each major product line.focus. Our Property and Casualty segmentgroup constituted the 28th30th largest property and casualty insurance group in the United States based on 20022003 direct premiums written, according to A.M. Best.

Risks

The industry’s profitability and cash flow can be significantly affected by: price; competition; volatile and unpredictable developments such as extreme weather conditions and natural disasters, including catastrophes; legal developments affecting insurer and insureds’ liability; extracontractualextra-contractual liability; size of jury awards; acts of terrorism; fluctuations in interest rates and other factors that may affect investment returns; and other general economic conditions and trends, such as inflationary pressures, that may affect the adequacy of reserves. Additionally, the economic conditions in geographic locations where we conduct business, especially those locations where our business is concentrated, may affect the profitability of our business. The regulatory environments in those locations where we conduct business, including any pricing, underwriting or product controls, shared market mechanisms or mandatory pooling arrangements, and other conditions, such as our agency relationships, may also affect the profitability of our business. In addition, our loss and loss adjustment expense reserves are based on our estimates, involving actuarial projections, at a given time, of what we 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 frequency and severity and judicial theories of liability, costs of repairs and replacement, legislative activity and other factors. Changes to these estimates may affect our profitability.

Lines of Business

We underwrite personal and commercial property and casualty insurance coverage.

Personal Lines

Personal linesLines comprised 67.9%two-thirds of the Property and Casualty segment’sgroup’s net written premium in 2003.2004. Personal automobile accounted for 71.7%69.5% and homeowners accounted for 25.5%27.8% of total personal lines’lines net written premium in 2003.2004.

Personal automobilecoverage insures individuals against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured’s vehicle, and property damage to other vehicles and other property.

Homeownerscoverage insures individuals for losses to their residences and personal property, such as those caused by fire, wind, hail, water damage (except for flooding), theft and vandalism, and against third party liability claims.

Other personal linesis comprised of miscellaneous policies including: inland marine, umbrella, fire and earthquake.

Personal lines’ net written premium in Michigan represented approximately 43%Our largest personal lines markets and Massachusetts’the percent of our 2004 personal lines net written premium represented approximately 19% of our total personal lines’ net written premium in 2003.by these markets are: Michigan 44.5%, Massachusetts 18.6%, New Jersey 9.2%, and New York 6.6%.

In Michigan, according to A.M. Best, based upon direct written premium as of December 31, 2002,for 2003, we ranked fourth in the industry for personal lines business, with approximately 9% of the state’s total market. Approximately 69%67% of the Michigan personal lines business is in the personal automobile line, which represents approximately 41%line. Approximately 43% of our total personal automobile net written premium.premium is in Michigan. In addition, approximately 29%31% of the Michigan personal lines business is in the homeowners line, which represents approximately 49%line. Approximately 50% of our total homeowners net written premium.premium is in Michigan. In Michigan, we are a principal provider with many of our agencies, averaging more than $1over $1.5 million of total written premiumspremium per agent in 2003.

In addition, in 2003, approximately 22% of our personal automobile business was written in Massachusetts. The Massachusetts Division of Insurance sets the rates for personal automobile business in the state. Effective January 1, 2004 rates increased by 2.5% (subject to an appeal by the Massachusetts Attorney General) and on January 1, 2003, rates increased 2.7%; rates were not changed in 2002. The Massachusetts Division of Insurance allows companies to offer discounts for sponsoring organizations and safe drivers. Although we eliminated most of the offered discounts during 2003, we continue to review these discounts annually and adjust as appropriate.2004.

Commercial Lines

Commercial linesLines comprised 32.1%one-third of the Property and Casualty segment’sgroup’s net written premium in 2003.2004. Commercial multiple peril net written premium accounted for 45.9%44.3%, commercial automobile 24.0%24.9% and workers’ compensation 17.8%16.7% of total commercial lines’lines net written premium in 2003.2004.

Commercial multiple perilcoverage insures businesses against third party liability from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold. It also insures business property for damage, such as that caused by fire, wind, hail, water damage (except for flooding), theft and vandalism.

Commercial automobilecoverage insures businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured’s vehicle, and property damage to other vehicles and other property.

Workers’ compensationcoverage insures employers against employee medical and indemnity claims resulting from injuries related to work. Workers’ compensation policies are often written in conjunction with other commercial policies.

Other commercial linesis comprised of miscellaneous policies including:including umbrella, ocean marine, inland marine, fidelity and surety bonds, general liability and fire.

We manage our commercial lines portfolio with a focus on growth from the most profitable industry segments, which varies by line of business and geography. In 2003,2004, approximately 26%24%, 13%12% and 11%12% of our commercial lines’lines net premiums written premium was generated in the states of Michigan, Massachusetts and New York, respectively. Approximately 68% of commercial lines net premiums written premium is comprised of small policies having less than $25,000 in premium. Policies with premium between $25,000 and $100,000, for which we have historically experienced better loss ratios than those policies with greater than $100,000 in premium, account for an additional 22%23% of the total. CommercialThe commercial lines segment maintains an underwriting discipline which emphasizes quality control as a means to writingsecuring and retaining thea large proportion of our agents’ best business for our best agents.business. This is monitored through a formalized monthly review in each branchan ongoing quality assurance program, accountability for each underwriter, as well as by an annual audit conducted in each branch. Accountability for quality underwritingwhich is shared at the local, regional and corporate levels.

Other Property and Casualty

The Other Property and Casualty segment consists of voluntary pools business, which we have not actively participated in since 1995, AMGRO, Inc. (“AMGRO”), our premium financing business, and Opus Investment Management, Inc. (“Opus”), which markets investment management services to institutions, pension funds and other organizations. Prior to 2004, the operating results of AMGRO and Opus were included in our former Asset Management segment. In addition, the Other Property and Casualty segment includes earnings on holding company assets.

Premium Financing Services

Through AMGRO, we engage in the business of financing property and casualty insurance premiums to commercial customers, primarily those of unaffiliated carriers. Generally, these installment finance receivables are secured by the related unearned insurance premiums on such polices. The customers of AMGRO are those persons or firms that borrow from AMGRO to finance insurance premiums.

Investment Advisory Services

Through our registered investment advisor, Opus, we provide investment advisory services to affiliates and to other institutions, including unaffiliated insurance companies, retirement plans, foundations and mutual funds. At December 31, 2004, Opus had assets under management of approximately $11 billion, of which approximately $875 million represented assets managed for entities unaffiliated with us.

Marketing and Distribution

We are licensed to sell property and casualty insurance in all fifty states in the United States, as well as the District of Columbia. In 2003,2004, approximately 38% of our net written premium iswas generated in Michigan and 17% iswas generated in Massachusetts. Our other primary markets include New Jersey, New York, Louisiana, Maine and Illinois.Indiana.

Our Property and Casualty segmentgroup maintains eighteensixteen local branch sales and underwriting offices in fourteen states. Additional processing support is provided in Atlanta, Georgia, Worcester, Massachusetts, and Howell, Michigan. Administrative functions are centralized in our headquarters in Worcester, Massachusetts. This regional strategy allows us to maintain a strong focus on local markets and the flexibility to respond to specific market conditions. It also is a predominant factor in the establishment and maintenance of long-term relationships with larger, well-established independent agencies.

One major step taken in 2004 to improve our service and ease of doing business with agents was the launch of our new web-based agency portal. The Agency Place, (“TAP”) provides a full menu of services and enhancements to agents. It is an internet-based agent portal, which allows our agents to access real-time policy, claims and billing information for their customers related to most of our products, as well as to access the Point of Sale system and the forms that they need to write new business with us. The rollout of TAP, which was completed in August 2004, is widely used and available to all agents.

Independent agents provide specialized knowledge of property and casualty products, local market conditions and customer demographics. Independent agents account for a significant amountmost of the sales of our property and casualty product.products. Our growth strategy is closely aligned to our relationship with the independent agency force;force. We compensate agents are compensated bothprimarily through regular commissions and through contingent commissionsa profit sharing plan that areis tied to growth and profitability. This

encourages agents to select customers whose risk characteristics are aligned with our underwriting philosophy.

During 2003, as a result of the A.M. Best downgrade of our property and casualty companies to B++, we initiated a bonus program to recognize and reward those agents who maintained or grew their existing book of business with us. We recognized a $5 million expense during 2003 related to this bonus program and anticipate an additional $3 million in 2004. After A.M. Best upgraded our property and casualty companies ratings to A- in January of 2004, we discontinued this program.

Agencies are appointed based on profitability record, financial stability, staff experience and professionalism, and demonstrated business strategy. Once appointed, we carefully monitor each agency’s performance and, in accordance with applicable legal and regulatory requirements, we take actions as necessary to change these business relationships, such as by discontinuing the authority of the agent to underwrite certain products or revising commissions or profit sharing opportunities.

We sponsor local and national agent advisory councils as forums to enhance relationships with our agents. These councils work with us to provide products and services that help insureds better manage the risks they face and to coordinate marketing efforts, support implementation of our strategies and enhance local market presence.

During 2001, we completed an extensive review of our agency relationships, which resulted in the termination of 377 agencies and the withdrawal of commercial lines’ underwriting authority from an additional 314 agencies. These actions affected approximately 27% of approximately 2,500 active agencies representing us in 2001. These agencies had consistently produced unsatisfactory loss ratios. In addition, we terminated virtually all of our specialty commercial programs, which accounted for $54.4 million of net premiums written in 2001, and discontinued a number of special marketing arrangements. The total earned premium associated with the exited business was $74.9 million, $164.6 million and $252.9 million in 2003, 2002 and 2001, respectively. As noted in “Property and Casualty, Product Line Results – Commercial Lines”, discussed on pages 28 to 29 in Management’s Discussion and Analysis of this Form 10-K, these actions have resulted in improved underwriting results, primarily in commercial lines. In connection with these actions, we performed an actuarial review of outstanding reserves with segregated loss history on the exited business. Based on this review, losses and expenses totaling $68.3 million were recorded in 2001. Actual future losses from the exited business may vary from our estimate.

We utilize independent agents and brokers to offer discounted personal lines insurance products to employer and affinity groups, which include credit unions, clubs and associations (“Sponsored Markets”). These programs, which are generally considered a voluntary employee or member benefit, are provided to those groups that we believe provide a higher potential for better underwriting results. Sponsored Markets’ voluntary net written premiums grewdecreased approximately 6%4% to $783.0$753.9 million in 2003.2004. The most significant of these programs that we offer is the Citizens Best program. This program is offered to any resident in Michigan who is a member of a qualified retirement or senior citizens organization. The Citizens Best program accounted for $326.4$312.4 million in direct written premium in 2003,2004, or approximately 39%41% of all Sponsored Markets’ direct written premium. A significant portion of the segment’s discounted group business, including the Citizens Best program, is open to any agent who has a policyholder that meets the required criteria of the group.

In 2003, we conducted a thorough analysis of certain Sponsored Markets business accounts. After completing our review, we concluded that a portion of this business was unprofitable and not well aligned with our strategy for the future. As a result, we have made the decision to discontinue this portion of our sponsored business, which representsrepresented approximately $70 million of direct written premium in 2003. We are obligated to renew certain policies associated with this business through 2005 and policies written in New Jerseya few states indefinitely. The total earned premium associated with this exited business was $59.3 million in 2004.

For our Other Property and Casualty segment business, investment advisory services are marketed directly through Opus, while premium financing services are generally marketed through independent insurance agents.

Pricing and Competition

We seek to achieve a targeted statutory combined ratio (the sum of the ratio of incurred claims and claim expense to premiums earned and the ratio of underwriting expenses incurred to premiums written) in each of our product lines regardless of market conditions. The targeted combined ratios reflect current investment yield expectations, our loss payout patterns, and target returns on equity. This strategy is intended to better enable us to achieve measured growth and consistent profitability. We concentrate on our established major product lines, and accordingly, do not typically pursue the development of products with relatively unpredictable risk profiles. In addition, we seek to utilize our extensive knowledge of local markets, including knowledge of regulatory requirements, to achieve superior underwriting results. We rely on market information provided by our local agents and on the knowledge of our staff in the local branch offices. Since we maintain a strong regional focus and a significant market share in a number of states, we can apply our extensive knowledge and experience in making underwriting and rate setting decisions.

The property and casualty industry is a competitive market with national agency companies, direct writers, and regional and local insurers competing for business on the basis of both price and service. Many national agency, regional and local companies sell insurance through independent agents and concentrate on both commercial and personal lines. We market through independent agents and, therefore, compete with both direct writers and other independent agency companies for business in each of the agencies representing them. Such competition is based upon, among other things, pricing and availability of products, product design, agency and customer service, and ratings.

Our four most significant states in 2003 and 2004 based on net written premium were Michigan, Massachusetts, New Jersey and New York. They represented, in total, approximately 71% of our total net written premium in both 2004 and 2003.

In Michigan, we compete in personal lines with a number of national direct writers and regional and local companies. Principal personal lines competitors are Auto Club of Michigan, State Farm Group and Auto Owners. We believe our agency relationships, Citizens Insurance brand recognition and the Citizens Best program enable us to distribute our products competitively in Michigan.

Based on net written premium, approximately 22% of our 2004 personal automobile business was written in Massachusetts. The Massachusetts Commissioner of Insurance (“the Commissioner”) sets the rates for personal automobile business in the state. Effective January 1, 2005, the Commissioner decreased rates by 1.7%, whereas on January 1, 2004, rates were increased by 2.5% and on January 1, 2003, rates increased 2.7%.

In 2004, we strengthened our management of our Massachusetts personal automobile business. This included the termination of 26 agencies, the reduction or elimination of group business, and an enhanced cession strategy relating to the Massachusetts residual market. We placed additional focus on claims handling practices for Massachusetts business. The effect of these actions significantly improved our Massachusetts underwriting performance compared to prior years.

In an Order dated November 23, 2004, that was clarified and confirmed on December 31, 2004, the Massachusetts Commissioner of Insurance directed the implementation of changes to the residual market for personal automobile insurance. The Order provided for a three year transition from the current residual market system to an assigned risk system similar to those found in most other states. The transition period was to begin on January 1, 2005, with full implementation of the assigned risk system to be accomplished by January 1, 2008; however, on February 1, 2005, the Superior Court for Suffolk County granted a request to stay the implementation of the Commissioner’s Order pending the resolution of a declaratory judgment action that had been filed challenging the Commissioner’s authority to implement the residual market changes.

In commercial lines, we face competition primarily from national agency companies and regional and local companies. We believe that our emphasis on maintaining a local presence in our markets, coupled with investments in operating efficiency and technology, will enable us to compete effectively. Our Property and Casualty group is not dependent on a single customer or even a few customers, for which the loss of any one or more would have an adverse effect upon the group’s insurance operation.

In our Other Property and Casualty segment, we face strong competition among providers of investment advisory services. In general, competition is based on a number of factors, including investment performance, pricing and client service. There are few barriers to entry by new investment advisory firms. Opus derives a significant portion of its revenue from investment advisory fees received from Allmerica Investment Trust Funds (i.e., funds in which the separate accounts of our life insurance subsidiaries invest premiums received from variable life insurance and annuity deposits) and other separately managed accounts. As a result, we are dependent upon the relationships we maintain with these funds and separately managed accounts. In the event that any of these relationships are discontinued, the segment’s financial results may be adversely affected.

Claims

We utilize experienced claims adjusters, appraisers, medical specialists, managers and attorneys in order to manage our claims. Our Property and Casualty group has field claims adjusters strategically located throughout our operating territories. All claims staff members work closely with the agents and seek to settle claims rapidly and in a cost-effective manner.

Claims office adjusting staff is supported by general adjusters for large property and large casualty losses, by automobile and heavy equipment damage appraisers for automobile material damage losses, and by medical specialists whose principal concentration is on workers’ compensation and no-fault automobile injury cases. In addition, the claims offices are supported by staff attorneys who specialize in litigation defense and claim settlements. We also maintain a special investigative unit that investigates suspected insurance fraud and abuse.

We utilize claims processing technology which allows most of the smaller and more routine personal lines claims to be processed at centralized locations. The centralization helps to increase efficiency and minimize operating costs.

Terrorism

As a result of the Federal Terrorism Risk Insurance Act of 2002 (“TRIA”), prior terrorism exclusions are void for certified terrorist events (as defined by TRIA). As required, we have notified policyholders of their option to elect the terrorism coverage and the cost of this coverage. We are actively managing our exposures on an individual line of business basis and in the aggregate by zip code and, as available, street address. At this time, we have purchased no additional specific terrorism-only reinsurance coverage. However, we are reinsured for certain terrorism coverage within existing Catastrophe, Property per Risk and Casualty Excess of Loss corporate treaties. (See Reinsurance-Terrorism Coverage on page 12 of this Form 10-K). Our retention limit under TRIA in 2004 was $82.9 million, representing 8.2% of year-end 2003 statutory policyholder surplus, and is estimated to be $119.6 million in 2005, representing 10.8% of 2004 year-end statutory policyholder surplus.

Catastrophes

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. We may experience catastrophe losses in the future which could have a material adverse impact on us. Catastrophes can be caused by various events, including snow, ice storms, hurricanes, earthquakes, tornadoes, wind, hail, terrorism, fires and explosions. The incidence and severity of catastrophes are inherently unpredictable. We manage our catastrophe risks through underwriting procedures, including the use of specific exclusions for floods, terrorism, as allowed, and other factors, through geographic exposure management and through reinsurance programs. The catastrophe reinsurance program is structured to protect us on a per-occurrence basis, as well as to limit losses in the event of multiple catastrophic events. We have focused efforts on evaluating aggregation of exposures and high concentrations of insured property values and number of covered employees in order to determine exposure to loss from terrorist events. We will continue to actively monitor geographic location and coverage concentrations in order to manage corporate exposure to all catastrophic events. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and commercial multiple peril insurance have, in the past, generated the majority of catastrophe-related claims.

State Regulation

Our property and casualty insurance subsidiaries are subject to extensive regulation in the various states and jurisdictions in which they transact business and are also supervised by the individual state insurance departments. Numerous aspects of our business are subject to regulatory standards, including premium rates, mandatory risks that must be covered, prohibited exclusions, licensing of agents, investments, restrictions on the size of risks that may be insured under a single policy, reserves and provisions for unearned premiums, losses and other obligations, deposits of securities for the benefit of policyholders, policy forms, and other conduct, including the use of credit information in underwriting, as well as other underwriting and claims practices. States also regulate various aspects of the contractual relationships between insurers and independent agents. In addition, as a condition to writing business in certain states, insurers are required to participate in various pools or risk sharing mechanisms or to accept certain classes of risk, regardless of whether such risks meet our underwriting requirements for voluntary business. Some states also limit or impose restrictions on the ability of an insurer to withdraw from certain classes of business. For example, Massachusetts, New Jersey and New York each impose material restrictions on a company’s ability to withdraw from the personal automobile line in their respective states. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of insurance business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance departments can impose significant charges on a carrier in connection with a market withdrawal or refuse to approve these plans on the grounds that they could lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject withdrawal plans to prior approval requirements may significantly restrict an insurer’s ability to exit unprofitable markets.

The insurance laws of many states generally provide that property and casualty insurers doing business in those states belong to statutory property and casualty guaranty funds. The purpose of these guaranty funds is to protect policyholders by requiring that solvent property and casualty insurers pay certain insurance claims of insolvent insurers. These guaranty associations generally pay these claims by assessing solvent insurers proportionately based on the insurer’s share of voluntary written premium in the state. While most guaranty associations provide for recovery of assessments through rate increases, surcharges or premium tax credits, there is no assurance that insurers will ultimately recover these assessments, which could be material – particularly following a large catastrophe affecting us and the industry generally or in markets where we have significant market share.

We are subject to periodic examinations conducted by state insurance departments. We are also required to file annual and other reports relating to the financial condition of our insurance subsidiaries and other matters.

Residual Markets and Pooling Arrangements

As a condition of our license to do business in various states, we 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. Such mechanisms include assigned risk plans, reinsurance facilities and pools, joint underwriting associations, fair access to insurance requirements plans, and commercial automobile insurance plans. For example, since most states compel the purchase of a minimal level of automobile liability insurance, states have developed shared market mechanisms to provide the required coverages and in many cases, optional coverages, to those drivers who, because of their driving records or other factors, cannot find insurers who will write them voluntarily. Our participation in such shared markets or pooling mechanisms is generally proportional to the Property and Casualty segment’sgroup’s direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. We incurred an underwriting loss from participation in these mechanisms, mandatory pools and underwriting associations of $16.7 million and $26.9 million in 2004 and $30.8 million in 2003, and 2002, respectively, relating primarily to coverages for personal and commercial automobile, personal and commercial property,

and workers’ compensation. The decrease in the underwriting loss in 2003,2004, compared to 2002,2003, is primarily the result of a decrease in Hanover’s participationimproved results in the Massachusetts Commonwealth Automobile Reinsurers (“CAR”) pool.

Assigned Risk Plans

Assigned risk plans are the most common type of shared market mechanism. Many states, including Illinois, New Jersey and New York, operate assigned risk plans. Such plans assign applications from drivers who are unable to obtain insurance in the voluntary market to insurers licensed in the applicant’s state. Each insurer is required to accept a specific percentage of applications based on its market share of voluntary business in the state. Once an application has been assigned to an insurer, the insurer issues a policy under its own name and retains premiums and pays losses as if the policy was voluntarily written. With respect to New York’s assigned risk plan, which is called The New York Automobile Insurance Plan (“NYAIP”), we have elected to transfer our assignments to a servicing carrier under a limited assignment distribution (“LAD”) agreement. Under this LAD agreement, the servicing carrier retains the assigned underwriting results of the NYAIP for which it receives a fee from us. ThisWe did not incur material expenses related to this agreement in 2004 while the fee was $9.1 million and $20.0 million in 2003 and 2002, respectively.2003.

Reinsurance Facilities and Pools

Reinsurance facilities are currently in operation in various states that require an insurer to write all applications submitted by an agent. As a result, an insurer could be writing policies for applicants with a higher risk of loss than it would normally accept. The reinsurance facility allows the insurer to cede this high risk business to the reinsurance facility, thus sharing the underwriting experience with all other insurers in the state. If a claim is paid on a policy issued in this market, the facility will reimburse the insurer. Typically, reinsurance facilities operate at a deficit, which is then recouped by levying assessments against the same insurers.

With respect to our Massachusetts business, we cede a portion of our personal and commercial automobile premiums to the CAR pool. Net premiums earned and losses and loss adjustment expenses (“LAE”) ceded to CAR were $46.6 million and $38.1 million in 2004, $46.2 million and $61.0 million in 2003, and $46.8 million and $59.4 million in 2002, and $34.2 million and $38.0 million in 2001, respectively. At December 31, 2003,2004, CAR represented at least 10% of our reinsurance activity.

In addition to CAR, Massachusetts also maintains an Exclusive Representative Producer (“ERP”) program. An ERP is an independent agency which cannot obtain a voluntary insurance market for personal or commercial automobile business from insurance companies in the state of Massachusetts. CAR then assigns an ERP agency to an individual insurance carrier, which is then required to write all personal or commercial automobile business produced by that agency (subject to any cessions to the CAR pool). We are required to maintain a level of ERP’sERPs consistent with other carriers in the state and proportionate to our overall market share of such business. Once an agency is assigned to an insurance carrier, it is difficult to terminate the relationship. ERP’sERPs generally produce underwriting results that are markedly poorer than our voluntary agents, although results vary significantly among ERP’s.ERPs. As of December 31, 2003,2004, we had approximately 25 ERP’s subscribed32 ERPs assigned to the companyus with annual direct voluntaryretained written premium of approximately $75$41.2 million. As described above under “Pricing and Competition”, the Massachusetts Commissioner of Insurance has adopted rules to redistribute the residual market, although such rules are the subject of a stay order issued by a state court.

A reinsurance mechanism that exists in Michigan, the Michigan Catastrophic Claims Association (“MCCA”), covers no-fault first party medical losses of retentions in excess of $325,000.$350,000. All automobile insurers in this state are required to participate in this reinsurance mechanism. Insurers are reimbursed for their covered losses in excess of this threshold. This threshold, which increased from $300,000$325,000 to $325,000$350,000 on July 1, 20032004 and will continue to increase each July 1st in scheduled amounts until it reaches $500,000 in 2011. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. We ceded to the MCCA premiums earned and losses and LAE of $60.9 million and $12.4 million in 2004, $46.8 million and $124.2 million in 2003, and $32.6 million and $49.8 million in 2002, and $7.2 million and $44.5 million in 2001, respectively. At December 31, 2003,2004, the MCCA represented at least 10% of our reinsurance activity.

At December 31, 20032004 and 2002,2003, we had reinsurance recoverables on paid and unpaid losses from CAR of $74.4$52.0 million and $54.8$74.4 million, respectively, and from the MCCA of $436.5$411.9 million and $349.1$436.5 million, respectively. We believe that we are unlikely to incur any material loss as a result of nonpaymentnon-payment of amounts owed to us by CAR, because CAR is a mandated pool supported by all insurance companies licensed to write automobile insurance in the Commonwealth of Massachusetts. In addition, with respect to MCCA, we are unlikely to incur any material loss from this facility as a result of nonpaymentnon-payment of amounts owed to us by MCCA because (i) it is currently in a surplus position, (ii) the payment obligations of the MCCA are extended over many years, resulting in relatively small current payment obligations in terms of MCCA total assets, and (iii) the MCCA is supported by assessments permitted by statute.

Reference is made to Note 1817 on pages 99101 and 100102 and Note 2120 on pages 102 and 103104 to 105 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.

Voluntary Pools

We have terminated our participation in virtually all voluntary pool business; however, we continue to be subject to claims related to years in which we were a participant. The most significant of these pools is a voluntary excess and casualty reinsurance pool known as the Excess and Casualty Reinsurance Association, (“ECRA”), in which we were a participant in from 1950 to 1982. In 1982, the pool was dissolved and since that time the business has been in runoff. Our participation in this pool has resulted in average paid losses of $2.4$2.0 million annually

over the past ten years. During 2001, the pool commissioned an independent actuarial review of the current reserve position, which noted a range of reserve deficiency primarily as a result of adverse development of asbestos claims. As a result of this study, we recorded an additional $33.0 million of losses. We believe that this item is not indicative of overall operating trends of this pool or other voluntary pools in which we participate. Because of the inherent uncertainty regarding the types of claims in this pool, there can be no assurance that these additionalthe reserves will be sufficient. Loss and LAE reserves for our voluntary pools were $71.8$72.0 million and $80.1$71.8 million at December 31, 20032004 and 2002,2003, respectively, including $50.0$50.3 million and $49.9$50.0 million related to ECRA as of December 31, 2004 and 2003, and 2002, respectively. In addition, during 2003, we incurred a $21.9 million charge related to a second voluntary pool (Industrial Risk Insurers, “IRI”), related to an adverse arbitration decision. We participated in this pool from 1982 to 1995. The reinsurance recoverable balance for this pool at December 31, 2003 was not significant and we do not anticipate further significant activity in the future. For all butExcluding the ECRA and IRI pools,pool, the average annual paid losses and reserve balances at December 31, 20032004 were not individually or in the aggregate, significant. Excluding the ECRA and IRI pools, the average annual paid losses and reserve balances at December 31, 2003 were not individually, or in the aggregate, significant.

Other Involuntary PoolsState Regulation

The principal shared market mechanisms forOur property and casualty insurance subsidiaries are subject to extensive regulation in the Fair Access to Insurance Requirements Plans (“FAIR Plans”), the formation ofvarious states and jurisdictions in which was requiredthey transact business and are also supervised by the federal governmentindividual state insurance departments. Numerous aspects of our business are subject to regulatory standards, including premium rates, mandatory risks that must be covered, prohibited exclusions, licensing of agents, investments, restrictions on the size of risks that may be insured under a single policy, reserves and provisions for unearned premiums, losses and other obligations, deposits of securities for the benefit of policyholders, policy forms, and other conduct, including the use of credit information in underwriting, as well as other underwriting and claims practices. States also regulate various aspects of the contractual relationships between insurers and independent agents. In addition, as a condition to an insurer’s abilitywriting business in certain states, insurers are required to obtain federal riot reinsurance coverage following the riots and civil disorder that occurred during the 1960s. These plans, created asparticipate in various pools or risk sharing mechanisms similaror to automobile assignedaccept certain classes of risk, plans, were designed to increase the availabilityregardless of property insurance in urban areas, but now cover other circumstances where homeowners are unable to obtain insurance,whether such as a result of hurricanes or other natural exposures. The federal government reinsures those insurers participating in FAIR Plans against excess losses sustained from riots and civil disorders. The individual state FAIR Plans are created pursuant to statute or regulation. The property shared market mechanisms provide basic fire insurance and extended coverage protectionrisks meet our underwriting requirements for dwellings and certain commercial properties that could not be insured in the voluntary market. A fewbusiness. Some states also include a basic homeowners form of coverage in their shared market mechanism. Approximately 30 states have FAIR Plans, including Massachusetts, North Carolina and New York.

With respect to commercial automobile coverage, another pooling mechanism, a Commercial Auto Insurance Plan (“CAIP”), uses a limited number of servicing carriers to handle assignments from other insurers. The CAIP servicing carrier is paid a fee by the insurer who otherwise would be assigned the responsibility of handling the commercial automobile policy and paying claims. Approximately 40 states have CAIP mechanisms, including New Jersey, New York, California and New Hampshire.

Competition and Pricing

The property and casualty industry is a competitive market with national agency companies, direct writers, and regional and local insurers competing for businesslimit or impose restrictions on the basisability of both price and service. National agency companies sell insurance through independent agents and usually concentrate on commercial lines. Direct writers, including those with exclusive agent representation, dominate the personal linesan insurer to withdraw from certain classes of property and casualty insurance and operate on a national, regional or single state basis. Regional and local companies sell through independent agents in one or several states in the same region and usually compete in both personal and commercial lines. We market through independent agents and, therefore, compete with other independent agency companies for business in each of the agencies representing them. Such competition is based upon, among other things, pricing and availability of products, product design, agency and customer service, and ratings.

We seek to achieve a targeted combined ratio (the sum of the ratio of incurred claims and claim expense to premiums earned and the ratio of underwriting expenses incurred to premiums written) in each of our product lines regardless of market conditions. The targeted combined ratios reflect current investment yield expectations, our loss payout patterns, and target returns on equity. This strategy is intended to better enable us to achieve measured growth and consistent profitability. We concentrate on our established major product lines, and accordingly, do not typically pursue the development of products with relatively unpredictable risk profiles. In addition, we seek to utilize our extensive knowledge of local markets, including knowledge of regulatory requirements, to achieve superior underwriting results. We rely on market information provided by our local agents and on the knowledge of our staff in the local branch offices. Since we maintain a strong regional focus and a significant market share in a number of states, we can apply our extensive knowledge and experience in making underwriting and rate setting decisions.

Net written premium in the states of Michigan,business. For example, Massachusetts, New Jersey and New York represented,each impose material restrictions on a company’s ability to withdraw from the personal automobile line in total, approximately 70%their respective states. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of our total netinsurance business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance departments can impose significant charges on a carrier in connection with a market withdrawal or refuse to approve these plans on the grounds that they could lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject withdrawal plans to prior approval requirements may significantly restrict an insurer’s ability to exit unprofitable markets.

The insurance laws of many states generally provide that property and casualty insurers doing business in those states belong to statutory property and casualty guaranty funds. The purpose of these guaranty funds is to protect policyholders by requiring that solvent property and casualty insurers pay certain insurance claims of insolvent insurers. These guaranty associations generally pay these claims by assessing solvent insurers proportionately based on the insurer’s share of voluntary written premium in both 2003the state. While most guaranty associations provide for recovery of assessments through rate increases, surcharges or premium tax credits, there is no assurance that insurers will ultimately recover these assessments, which could be material – particularly following a large catastrophe affecting us and 2002.the industry generally or in markets where we have significant market share.

In Michigan,We are subject to periodic examinations conducted by state insurance departments. We are also required to file annual and other reports relating to the financial condition of our insurance subsidiaries and other matters.

Residual Markets and Pooling Arrangements

As a condition of our license to do business in various states, we competeare 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. Such mechanisms include assigned risk plans, reinsurance facilities and pools, joint underwriting associations, fair access to insurance requirements plans, and commercial automobile insurance plans. For example, since most states compel the purchase of a minimal level of automobile liability insurance, states have developed shared market mechanisms to provide the required coverages and in many cases, optional coverages, to those drivers who, because of their driving records or other factors, cannot find insurers who will write them voluntarily. Our participation in such shared markets or pooling mechanisms is generally proportional to the Property and Casualty group’s direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. We incurred an underwriting loss from participation in these mechanisms, mandatory pools and underwriting associations of $16.7 million and $26.9 million in 2004 and 2003, respectively, relating primarily to coverages for personal lines with a number of national direct writers and regionalcommercial automobile, personal and local companies. Principal personal lines competitors are Auto Club of Michigan, State Farm Group and Allstate. We believe our agency relationships, Citizens Insurance brand recognition and the Citizens Best program enable us to distribute our products competitively in Michigan.commercial property,

Due to the regulatory environment in Massachusetts, New York and New Jersey, there is less competitionworkers’ compensation. The decrease in the personal lines marketunderwriting loss in these states. The stricter regulatory pricing guidelines within these states have had an adverse effect on profitability2004, compared to 2003, is primarily the result of improved results in personal lines. Inthe Massachusetts a state where, in 2003, approximately 19% of our personal lines’ net premiums were written, the Commissioner of Insurance determines virtually all aspects of personal automobile insurance rates, including agent commissions. Competition is therefore focused in large part on effectively managing voluntary agency and ERP business and on optimizing cession strategy with CAR. Strict pricing, agency commission and product regulations challenge an insurer’s ability to adequately price personal lines products, which may lead to unsatisfactory underwriting results.

In commercial lines, we face competition primarily from national agency companies and regional and local companies. We believe that our emphasis on maintaining a local presence in our markets, coupled with investments in operating and client technologies, will enable us to compete effectively. Our Property and Casualty segment is not dependent on a single customer or even a few customers, for which the loss of any one or more would have an adverse effect upon the segment’s insurance operation.Commonwealth Automobile Reinsurers (“CAR”) pool.

Assigned Risk Plans

Assigned risk plans are the most common type of shared market mechanism. Many states, including Illinois, New Jersey and New York, operate assigned risk plans. Such plans assign applications from drivers who are unable to obtain insurance in the voluntary market to insurers licensed in the applicant’s state. Each insurer is required to accept a specific percentage of applications based on its market share of voluntary business in the state. Once an application has been assigned to an insurer, the insurer issues a policy under its own name and retains premiums and pays losses as if the policy was voluntarily written. With respect to New York’s assigned risk plan, which is called The New York Automobile Insurance Plan (“NYAIP”), we have elected to transfer our assignments to a servicing carrier under a limited assignment distribution (“LAD”) agreement. Under this LAD agreement, the servicing carrier retains the assigned underwriting results of the NYAIP for which it receives a fee from us. We did not incur material expenses related to this agreement in 2004 while the fee was $9.1 million in 2003.

Reinsurance Facilities and Pools

Reinsurance facilities are currently in operation in various states that require an insurer to write all applications submitted by an agent. As a result, an insurer could be writing policies for applicants with a higher risk of loss than it would normally accept. The reinsurance facility allows the insurer to cede this high risk business to the reinsurance facility, thus sharing the underwriting experience with all other insurers in the state. If a claim is paid on a policy issued in this market, the facility will reimburse the insurer. Typically, reinsurance facilities operate at a deficit, which is then recouped by levying assessments against the same insurers.

With respect to our Massachusetts business, we cede a portion of our personal and commercial automobile premiums to the CAR pool. Net premiums earned and losses and loss adjustment expenses (“LAE”) ceded to CAR were $46.6 million and $38.1 million in 2004, $46.2 million and $61.0 million in 2003, and $46.8 million and $59.4 million in 2002, respectively. At December 31, 2004, CAR represented at least 10% of our reinsurance activity.

In addition to CAR, Massachusetts also maintains an Exclusive Representative Producer (“ERP”) program. An ERP is an independent agency which cannot obtain a voluntary insurance market for personal or commercial automobile business from insurance companies in the state of Massachusetts. CAR assigns an ERP agency to an individual insurance carrier, which is then required to write all personal or commercial automobile business produced by that agency (subject to any cessions to the CAR pool). We are required to maintain a level of ERPs consistent with other carriers in the state and proportionate to our overall market share of such business. Once an agency is assigned to an insurance carrier, it is difficult to terminate the relationship. ERPs generally produce underwriting results that are markedly poorer than our voluntary agents, although results vary significantly among ERPs. As of December 31, 2004, we had approximately 32 ERPs assigned to us with annual direct retained written premium of approximately $41.2 million. As described above under “Pricing and Competition”, the Massachusetts Commissioner of Insurance has adopted rules to redistribute the residual market, although such rules are the subject of a stay order issued by a state court.

A reinsurance mechanism that exists in Michigan, the Michigan Catastrophic Claims Association (“MCCA”), covers no-fault first party medical losses of retentions in excess of $350,000. All automobile insurers in this state are required to participate in this reinsurance mechanism. Insurers are reimbursed for their covered losses in excess of this threshold, which increased from $325,000 to $350,000 on July 1, 2004 and will continue to increase each July 1st in scheduled amounts until it reaches $500,000 in 2011. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. We ceded to the MCCA premiums earned and losses and LAE of $60.9 million and $12.4 million in 2004, $46.8 million and $124.2 million in 2003, and $32.6 million and $49.8 million in 2002, respectively. At December 31, 2004, the MCCA represented at least 10% of our reinsurance activity.

At December 31, 2004 and 2003, we had reinsurance recoverables on paid and unpaid losses from CAR of $52.0 million and $74.4 million, respectively, and from the MCCA of $411.9 million and $436.5 million, respectively. We believe that we are unlikely to incur any material loss as a result of non-payment of amounts owed to us by CAR, because CAR is a mandated pool supported by all insurance companies licensed to write automobile insurance in the Commonwealth of Massachusetts. In addition, with respect to MCCA, we are unlikely to incur any material loss from this facility as a result of non-payment of amounts owed to us by MCCA because (i) it is currently in a surplus position, (ii) the payment obligations of the MCCA are extended over many years, resulting in relatively small current payment obligations in terms of MCCA total assets, and (iii) the MCCA is supported by assessments permitted by statute.

Reference is made to Note 17 on pages 101 and 102 and Note 20 on pages 104 to 105 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.

Voluntary Pools

We utilize experiencedhave terminated our participation in virtually all voluntary pool business; however, we continue to be subject to claims adjusters, appraisers, medical specialists, managersrelated to years in which we were a participant. The most significant of these pools is a voluntary excess and attorneys in order to manage our claims. Our Propertycasualty reinsurance pool known as the Excess and Casualty segmentReinsurance Association, (“ECRA”) in which we were a participant from 1950 to 1982. In 1982, the pool was dissolved and since that time the business has fieldbeen in runoff. Our participation in this pool has resulted in average paid losses of $2.0 million annually over the past ten years. Because of the inherent uncertainty regarding the types of claims adjusters strategically located throughoutin this pool, there can be no assurance that the reserves will be sufficient. Loss and LAE reserves for our operating territories. All claims staff members work closely withvoluntary pools were $72.0 million and $71.8 million at December 31, 2004 and 2003, respectively, including $50.3 million and $50.0 million related to ECRA as of December 31, 2004 and 2003, respectively. Excluding the agents and seek to settle claims rapidly and in a cost-effective manner.

Claims office adjusting staff is supported by general adjusters for large property and large casualty losses, by automobile and heavy equipment damage appraisers for automobile material damageECRA pool, the average annual paid losses and by medical specialists whose principal concentration is on workers’ compensation and no-fault automobile injury cases. In addition, the claims offices are supported by staff attorneys who specialize in litigation defense and claim settlements. We also maintain a special investigative unit that investigates suspected insurance fraud and abuse.

We utilize claims processing technology which allows most of the smaller and more routine personal lines claims to be processedreserve balances at centralized locations. The centralization helps to increase efficiency and minimize operating costs.December 31, 2004 were not individually significant.

Terrorism

As a result of the Federal Terrorism Risk Insurance Act of 2002 (“TRIA”), prior terrorism exclusions are void for certified terrorist events (as defined by TRIA). As required, we have notified policyholders of their option to elect the terrorism coverage and the cost of this coverage. We are actively managing our exposures on an individual line of business basis and in the aggregate by zip code and, as available, street address. At this time, we have purchased no additional specific terrorism-only reinsurance coverage. However, some terrorism coverage is provided within existing Property per Risk and Casualty Excess of Loss corporate treaties. Our retention limit under TRIA in 2003 was $66.5 million, representing 6.6% of year-end 2003 statutory policyholder surplus, and is estimated to be $82.9 million in 2004, representing 8.3 % of 2003 year-end statutory policyholder surplus.

Catastrophes

Property and casualty insurers are subject to claims arising out of catastrophes, which may have a significant impact on their results and financial condition. We may experience catastrophe losses in the future which could have a material adverse impact on us. Catastrophes can be caused by various events, including snow, ice storms, hurricanes, earthquakes, tornadoes, wind, hail, terrorism, fires and explosions. The incidence and severity of catastrophes are inherently unpredictable. We manage our catastrophe risks through underwriting procedures, including the use of specific exclusions for floods, terrorism, as allowed, and other factors, through geographic exposure management and through reinsurance programs. The catastrophe reinsurance program is structured to protect us on a per-occurrence basis, as well as to limit losses in the event of multiple catastrophic events. We have focused efforts on evaluating aggregation of exposures and high concentrations of insured property values and number of covered employees in order to determine exposure to loss from terrorist events. We will continue to actively monitor geographic location and coverage concentrations in order to manage corporate exposure to all catastrophic events. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and commercial multi peril insurance have in the past generated the majority of catastrophe-related claims.

State Regulation

Our property and casualty insurance subsidiaries are subject to extensive regulation in the various states and jurisdictions in which they transact business and are also supervised by the individual state insurance departments. Numerous aspects of our business are subject to regulatory standards, including premium rates, mandatory risks that must be covered, prohibited exclusions, licensing of agents, investments, restrictions on the size of risks that may be insured under a single policy, reserves and provisions for unearned premiums, losses and other obligations, deposits of securities for the benefit of policyholders, policy forms, and other conduct, including the use of credit information in underwriting, as well as other underwriting and claims practices. States also regulate various aspects of the contractual relationships between insurers and independent agents. In addition, as a condition to writing

business in certain states, insurers are required to participate in various pools or risk sharing mechanisms or to accept certain classes of risk, regardless of whether such risks meet our underwriting requirements for voluntary business. Some states also limit or impose material restrictions on the ability of an insurer to withdraw from certain classes of business. For example, Massachusetts, New Jersey and New York each impose material restrictions on a company’s ability to withdraw from the personal automobile line in their respective states. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of insurance business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance departments can impose significant charges on a carrier in connection with a market withdrawal or refuse to approve these plans on the grounds that they could lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject withdrawal plans to prior approval requirements may significantly restrict an insurer’s ability to exit unprofitable markets.

The insurance laws of many states generally provide that property and casualty insurers doing business in those states belong to statutory property and casualty guaranty funds. The purpose of these guaranty funds is to protect policyholders by requiring that solvent property and casualty insurers pay certain insurance claims of insolvent insurers. These guaranty associations generally pay these claims by assessing solvent insurers proportionately based on the insurer’s share of voluntary written premiumspremium in the state. While most guaranty associations provide for recovery of assessments through rate increases, surcharges or premium tax credits, there is no assurance that insurers will ultimately recover these assessments, which could be material – particularly following a large catastrophe affecting us orand the industry generally or in markets where we have significant market share.

We are subject to periodic examinations conducted by state insurance departments. We are also required to file annual and other reports relating to the financial condition of our insurance subsidiaries and other matters.

Residual Markets and Pooling Arrangements

As a condition of our license to do business in various states, we 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. Such mechanisms include assigned risk plans, reinsurance facilities and pools, joint underwriting associations, fair access to insurance requirements plans, and commercial automobile insurance plans. For example, since most states compel the purchase of a minimal level of automobile liability insurance, states have developed shared market mechanisms to provide the required coverages and in many cases, optional coverages, to those drivers who, because of their driving records or other factors, cannot find insurers who will write them voluntarily. Our participation in such shared markets or pooling mechanisms is generally proportional to the Property and Casualty group’s direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. We incurred an underwriting loss from participation in these mechanisms, mandatory pools and underwriting associations of $16.7 million and $26.9 million in 2004 and 2003, respectively, relating primarily to coverages for personal and commercial automobile, personal and commercial property,

and workers’ compensation. The decrease in the underwriting loss in 2004, compared to 2003, is primarily the result of improved results in the Massachusetts Commonwealth Automobile Reinsurers (“CAR”) pool.

Assigned Risk Plans

Assigned risk plans are the most common type of shared market mechanism. Many states, including Illinois, New Jersey and New York, operate assigned risk plans. Such plans assign applications from drivers who are unable to obtain insurance in the voluntary market to insurers licensed in the applicant’s state. Each insurer is required to accept a specific percentage of applications based on its market share of voluntary business in the state. Once an application has been assigned to an insurer, the insurer issues a policy under its own name and retains premiums and pays losses as if the policy was voluntarily written. With respect to New York’s assigned risk plan, which is called The New York Automobile Insurance Plan (“NYAIP”), we have elected to transfer our assignments to a servicing carrier under a limited assignment distribution (“LAD”) agreement. Under this LAD agreement, the servicing carrier retains the assigned underwriting results of the NYAIP for which it receives a fee from us. We did not incur material expenses related to this agreement in 2004 while the fee was $9.1 million in 2003.

Reinsurance Facilities and Pools

Reinsurance facilities are currently in operation in various states that require an insurer to write all applications submitted by an agent. As a result, an insurer could be writing policies for applicants with a higher risk of loss than it would normally accept. The reinsurance facility allows the insurer to cede this high risk business to the reinsurance facility, thus sharing the underwriting experience with all other insurers in the state. If a claim is paid on a policy issued in this market, the facility will reimburse the insurer. Typically, reinsurance facilities operate at a deficit, which is then recouped by levying assessments against the same insurers.

With respect to our Massachusetts business, we cede a portion of our personal and commercial automobile premiums to the CAR pool. Net premiums earned and losses and loss adjustment expenses (“LAE”) ceded to CAR were $46.6 million and $38.1 million in 2004, $46.2 million and $61.0 million in 2003, and $46.8 million and $59.4 million in 2002, respectively. At December 31, 2004, CAR represented at least 10% of our reinsurance activity.

In addition to CAR, Massachusetts also maintains an Exclusive Representative Producer (“ERP”) program. An ERP is an independent agency which cannot obtain a voluntary insurance market for personal or commercial automobile business from insurance companies in the state of Massachusetts. CAR assigns an ERP agency to an individual insurance carrier, which is then required to write all personal or commercial automobile business produced by that agency (subject to any cessions to the CAR pool). We are required to maintain a level of ERPs consistent with other carriers in the state and proportionate to our overall market share of such business. Once an agency is assigned to an insurance carrier, it is difficult to terminate the relationship. ERPs generally produce underwriting results that are markedly poorer than our voluntary agents, although results vary significantly among ERPs. As of December 31, 2004, we had approximately 32 ERPs assigned to us with annual direct retained written premium of approximately $41.2 million. As described above under “Pricing and Competition”, the Massachusetts Commissioner of Insurance has adopted rules to redistribute the residual market, although such rules are the subject of a stay order issued by a state court.

A reinsurance mechanism that exists in Michigan, the Michigan Catastrophic Claims Association (“MCCA”), covers no-fault first party medical losses of retentions in excess of $350,000. All automobile insurers in this state are required to participate in this reinsurance mechanism. Insurers are reimbursed for their covered losses in excess of this threshold, which increased from $325,000 to $350,000 on July 1, 2004 and will continue to increase each July 1st in scheduled amounts until it reaches $500,000 in 2011. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. We ceded to the MCCA premiums earned and losses and LAE of $60.9 million and $12.4 million in 2004, $46.8 million and $124.2 million in 2003, and $32.6 million and $49.8 million in 2002, respectively. At December 31, 2004, the MCCA represented at least 10% of our reinsurance activity.

At December 31, 2004 and 2003, we had reinsurance recoverables on paid and unpaid losses from CAR of $52.0 million and $74.4 million, respectively, and from the MCCA of $411.9 million and $436.5 million, respectively. We believe that we are unlikely to incur any material loss as a result of non-payment of amounts owed to us by CAR, because CAR is a mandated pool supported by all insurance companies licensed to write automobile insurance in the Commonwealth of Massachusetts. In addition, with respect to MCCA, we are unlikely to incur any material loss from this facility as a result of non-payment of amounts owed to us by MCCA because (i) it is currently in a surplus position, (ii) the payment obligations of the MCCA are extended over many years, resulting in relatively small current payment obligations in terms of MCCA total assets, and (iii) the MCCA is supported by assessments permitted by statute.

Reference is made to Note 17 on pages 101 and 102 and Note 20 on pages 104 to 105 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.

Voluntary Pools

We have terminated our participation in virtually all voluntary pool business; however, we continue to be subject to claims related to years in which we were a participant. The most significant of these pools is a voluntary excess and casualty reinsurance pool known as the Excess and Casualty Reinsurance Association, (“ECRA”) in which we were a participant from 1950 to 1982. In 1982, the pool was dissolved and since that time the business has been in runoff. Our participation in this pool has resulted in average paid losses of $2.0 million annually over the past ten years. Because of the inherent uncertainty regarding the types of claims in this pool, there can be no assurance that the reserves will be sufficient. Loss and LAE reserves for our voluntary pools were $72.0 million and $71.8 million at December 31, 2004 and 2003, respectively, including $50.3 million and $50.0 million related to ECRA as of December 31, 2004 and 2003, respectively. Excluding the ECRA pool, the average annual paid losses and reserve balances at December 31, 2004 were not individually significant.

Other Involuntary Pools

The principal shared market mechanisms for property insurance are the Fair Access to Insurance Requirements Plans (“FAIR Plans”), the formation of which was required by the federal government as a condition to an insurer’s ability to obtain federal riot reinsurance coverage following the riots and civil disorder that occurred during the 1960s. These plans, created as mechanisms similar to automobile assigned risk plans, were designed to increase the availability of property insurance in urban areas, but now cover other circumstances where homeowners are unable to obtain insurance, such as a result of hurricanes or other natural exposures. The federal government reinsures those insurers participating in FAIR Plans against excess losses sustained from riots and civil disorders. The individual state FAIR Plans are created pursuant to statute or regulation. The property shared market mechanisms provide basic fire insurance and extended coverage protection for dwellings and certain commercial properties that could not be insured in the voluntary market. A few states also include a basic homeowners form of coverage in their shared market mechanism. Approximately 30 states have FAIR Plans, including Massachusetts. We have recently seen significant growth in the Massachusetts FAIR Plan coastal exposures. We also anticipate the FAIR Plan to have significant hurricane exposures for 100 year or more events, which would likely be material to the FAIR Plan, as well as to participating companies. The Massachusetts FAIR Plan does not purchase catastrophe reinsurance and, as such, we are exposed to our proportionate share of this potential liability. It should also be noted that such an event would be subject to our reinsurance programs, as described in the “Reinsurance” section on pages 11 and 12 of this Form 10-K. Although it is difficult to accurately estimate such exposure, it would likely be material to our financial statements. Two other state FAIR Plans, where our participation is larger as compared to other states, are North Carolina and New York.

With respect to commercial automobile coverage, another pooling mechanism, a Commercial Auto Insurance Plan (“CAIP”), uses a limited number of servicing carriers to handle assignments from other insurers. The CAIP servicing carrier is paid a fee by the insurer who otherwise would be assigned the responsibility of handling the commercial automobile policy and paying claims. Approximately 40 states have CAIP mechanisms, including the states of New Jersey, New York, and Louisiana, where our participation is larger as compared to other states.

Reserve for Unpaid Losses and Loss Adjustment Expenses

Reference is made to “Reserve for Losses and Loss Adjustment Expenses” on pages 2931 to 3334 of Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Form 10-K.

Our property and casualty actuaries review the reserves each quarter and certify the reserves annually as required for statutory filings. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to us and our settlement and payment of that loss. To recognize liabilities for unpaid losses, we establish reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE.loss adjustment expenses (“LAE”).

We regularly review our reserving techniques, our overall reserving position and our 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 our property and casualty business and the industry, (iv) the relatively short-term nature of most policies written by us and (v) internal estimates of required reserves, we believe 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 effect on our results of operations or financial position.

We do not use discounting techniques in establishing reserves for losses and LAE, nor have we participated in any loss portfolio transfers or other similar transactions.

The following table reconciles reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance statutory authorities (“Statutory”) to reserves determined in accordance with generally accepted accounting principles (“GAAP”) at December 31.

Analysis of Losses and Loss Adjustment Expenses Reserve Development

The following table sets forth the development of our GAAP reserves (net of reinsurance recoverables) for unpaid losses and LAE from 19931994 through 2003.2004.

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