FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 2001
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OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from: to
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Commission file number: 1-13754
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ALLMERICA FINANCIAL CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 04-3263626
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(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
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(Registrant's telephone number, including area code)
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [ ] No [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the registrant's classes of
common stock as of the latest practicable date: 52,887,233 shares of common
stock outstanding, as of November 1, 2001.
Total Number of Pages 37 Included in This Document
Exhibit Index is on Page 38
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Income.................................................... 3
Consolidated Balance Sheets.......................................................... 4
Consolidated Statements of Shareholders' Equity...................................... 5
Consolidated Statements of Comprehensive Income...................................... 6
Consolidated Statements of Cash Flows................................................ 7
Notes to Interim Consolidated Financial Statements................................... 8 - 17
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations................................................................ 18 - 34
Item 3. Quantitative and Qualitative Disclosures About Market Risk........................... 35
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K..................................................... 36
SIGNATURES.................................................................................... 37
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------ --------------------
(In millions, except per share data) 2001 2000 2001 2000
======================================================================================================================
Revenues
Premiums....................................................... $ 559.9 $ 535.1 $ 1,685.4 $ 1,587.0
Universal life and investment product policy fees.............. 95.0 110.9 294.6 316.1
Net investment income.......................................... 169.6 165.4 501.1 481.3
Net realized investment losses................................. (4.9) (31.8) (89.6) (102.6)
Other income................................................... 32.8 36.2 104.9 106.9
------- ------- --------- ---------
Total revenues............................................ 852.4 815.8 2,496.4 2,388.7
------- ------- --------- ---------
Benefits, losses and expenses
Policy benefits, claims, losses and loss adjustment expenses... 558.6 500.9 1,636.7 1,470.2
Policy acquisition expenses.................................... 125.4 108.3 355.8 341.4
Other operating expenses....................................... 144.6 127.0 427.8 375.5
Restructuring costs............................................ - - - 20.3
------- ------- --------- ---------
Total benefits, losses and expenses....................... 828.6 736.2 2,420.3 2,207.4
------- ------- --------- ---------
Income before federal income taxes............................. 23.8 79.6 76.1 181.3
------- ------- --------- ---------
Federal income tax (benefit) expense:
Current................................................... (71.4) 6.7 (99.6) 1.5
Deferred.................................................. 60.0 6.4 92.9 27.5
------- ------- --------- ---------
Total federal income tax (benefit) expense................ (11.4) 13.1 (6.7) 29.0
------- ------- --------- ---------
Income before minority interest and cumulative effect of
change in accounting principle............................... 35.2 66.5 82.8 152.3
Minority interest:
Distributions on mandatorily redeemable preferred securities
of a subsidiary trust holding solely junior subordinated
debentures of the Company................................... (4.0) (4.0) (12.0) (12.0)
------- ------- --------- ---------
Income before cumulative effect of change in accounting
principle................................................... 31.2 62.5 70.8 140.3
------- ------- --------- ---------
Cumulative effect of change in accounting principle (less
applicable income tax benefit of $1.7 for the nine months
ended September 30, 2001)................................... - - (3.2) -
------- ------- --------- ---------
Net income.................................................... $ 31.2 $ 62.5 $ 67.6 $ 140.3
======= ======= ========= =========
PER SHARE DATA
Basic
-----
Income before cumulative effect of change in accounting
principle................................................ $ 0.59 $ 1.18 $ 1.34 $ 2.62
Cumulative effect of change in accounting principle (less
applicable income tax benefit of $0.03 for the nine
months ended September 30, 2001)......................... - - (0.06) -
------- ------- --------- ---------
Net income................................................. $ 0.59 $ 1.18 $ 1.28 $ 2.62
======= ======= ========= =========
Weighted average shares outstanding........................ 52.7 53.1 52.6 53.5
------- ------- --------- ---------
Diluted
-------
Income before cumulative effect of change in accounting
principle................................................ $ 0.59 $ 1.16 $ 1.33 $ 2.59
Cumulative effect of change in accounting principle (less
applicable income tax benefit of $0.03 for the nine
months ended September 30, 2001)......................... - - (0.06) -
------- ------- --------- ---------
Net income................................................. $ 0.59 $ 1.16 $ 1.27 $ 2.59
======= ======= ========= =========
Weighted average shares outstanding........................ 53.1 53.9 53.1 54.1
------- ------- --------- ---------
Dividends declared to shareholders......................... $ - $ 0.25 $ - $ 0.25
======= ======= ========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
3
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
September 30, December 31,
(In millions, except per share data) 2001 2000
========================================================================================================================
Assets
Investments:
Fixed maturities-at fair value (amortized cost of $9,004.4 and $8,153.7)........... $ 9,221.1 $ 8,118.0
Equity securities-at fair value (cost of $61.0 and $60.0).......................... 56.2 85.5
Mortgage loans..................................................................... 548.5 617.6
Policy loans....................................................................... 382.0 381.3
Other long-term investments........................................................ 159.4 193.2
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Total investments.............................................................. 10,367.2 9,395.6
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Cash and cash equivalents.............................................................. 600.9 281.1
Accrued investment income.............................................................. 150.2 155.4
Premiums, accounts and notes receivable, net........................................... 628.7 618.1
Reinsurance receivable on paid and unpaid losses,
benefits and unearned premiums.................................................. 1,387.5 1,423.8
Deferred policy acquisition costs...................................................... 1,724.8 1,608.2
Deferred federal income taxes.......................................................... - 103.8
Other assets........................................................................... 687.5 564.6
Separate account assets................................................................ 13,367.0 17,437.4
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Total assets....................................................................... $ 28,913.8 $ 31,588.0
========== ==========
Liabilities
Policy liabilities and accruals:
Future policy benefits............................................................. $ 4,051.3 $ 3,617.4
Outstanding claims, losses and loss adjustment expenses............................ 2,899.2 2,880.9
Unearned premiums.................................................................. 1,056.4 981.6
Contractholder deposit funds and other policy liabilities.......................... 1,880.8 2,193.1
---------- ----------
Total policy liabilities and accruals.......................................... 9,887.7 9,673.0
---------- ----------
Expenses and taxes payable............................................................. 787.4 768.6
Reinsurance premiums payable........................................................... 112.8 122.3
Trust instruments supported by funding obligations..................................... 1,644.4 621.5
Short-term debt........................................................................ 71.0 56.6
Long-term debt......................................................................... 199.5 199.5
Deferred federal income taxes.......................................................... 14.2 -
Separate account liabilities........................................................... 13,367.0 17,437.4
---------- ----------
Total liabilities.................................................................. 26,084.0 28,878.9
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Minority interest:
Mandatorily redeemable preferred securities of a subsidiary trust holding
solely junior subordinated debentures of the Company............................ 300.0 300.0
---------- ----------
Commitments and contingencies (Note 12)
Shareholders' equity
Preferred stock, $0.01 par value, 20.0 million shares authorized, none issued.......... - -
Common stock, $0.01 par value, 300.0 million shares authorized, 60.4 million
shares issued...................................................................... 0.6 0.6
Additional paid-in capital............................................................. 1,756.0 1,765.3
Accumulated other comprehensive income (loss).......................................... 44.7 (5.2)
Retained earnings...................................................................... 1,136.3 1,068.7
Treasury stock at cost (7.5 million and 7.7 million shares)............................ (407.8) (420.3)
---------- ----------
Total shareholders' equity......................................................... 2,529.8 2,409.1
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Total liabilities and shareholders' equity...................................... $ 28,913.8 $ 31,588.0
========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
4
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Unaudited)
Nine Months Ended
September 30,
----------------------
(In millions) 2001 2000
================================================================================================================
Preferred Stock
Balance at beginning and end of period.............................................. $ - $ -
--------- ---------
Common Stock
Balance at beginning and end of period.............................................. 0.6 0.6
--------- ---------
Additional paid-in capital
Balance at beginning of period...................................................... 1,765.3 1,770.5
Unearned compensation related to restricted stock and other...................... (9.3) (6.4)
--------- ---------
Balance at end of period............................................................ 1,756.0 1,764.1
--------- ---------
Accumulated Other Comprehensive Income (Loss)
Net unrealized appreciation (depreciation) on investments
Balance at beginning of period...................................................... (5.2) (75.3)
Net appreciation on available-for-sale securities and derivative instruments..... 76.8 59.9
Provision for deferred federal income taxes...................................... (26.9) (20.9)
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Other comprehensive income............................................. 49.9 39.0
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Balance at end of period............................................................ 44.7 (36.3)
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Retained earnings
Balance at beginning of period...................................................... 1,068.7 882.2
Net income....................................................................... 67.6 140.3
Dividends to shareholders........................................................ - (13.4)
--------- ---------
Balance at end of period............................................................ 1,136.3 1,009.1
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Treasury Stock
Balance at beginning of period...................................................... (420.3) (337.8)
Shares purchased at cost......................................................... - (61.3)
Shares reissued at cost.......................................................... 12.5 18.9
--------- ---------
Balance at end of period............................................................ (407.8) (380.2)
--------- ---------
Total shareholders' equity..................................................... $ 2,529.8 $ 2,357.3
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
5
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------------- ----------------------
(In millions) 2001 2000 2001 2000
========================================================================================================
Net income............................................ $ 31.2 $ 62.5 $ 67.6 $ 140.3
Other comprehensive (loss) income:
Available-for-sale securities:
Net appreciation during the period.............. 78.8 42.3 151.4 59.9
Provision for deferred federal income taxes..... (27.6) (14.9) (53.0) (20.9)
------- ------- ------- -------
Total available-for-sale securities................ 51.2 27.4 98.4 39.0
------- ------- ------- -------
Derivative instruments:
Net depreciation during the period.............. (80.1) - (74.6) -
Benefit for deferred federal income taxes....... 28.0 - 26.1 -
------- ------- ------- -------
Total derivative instruments....................... (52.1) - (48.5) -
------- ------- ------- -------
Other comprehensive (loss) income..................... (0.9) 27.4 49.9 39.0
------- ------- ------- -------
Comprehensive income.................................. $ 30.3 $ 89.9 $ 117.5 $ 179.3
======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial
statements.
6
ALLMERICA FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30,
------------------------
(In millions) 2001 2000
=======================================================================================================================
Cash flows from operating activities
Net income.............................................................................. $ 67.6 $ 140.3
Adjustments to reconcile net income to net cash provided by operating activities:
Net realized losses................................................................. 89.6 102.6
Net amortization and depreciation................................................... 14.5 18.4
Deferred federal income taxes....................................................... 92.9 29.8
Change in deferred acquisition costs................................................ (133.0) (179.2)
Change in premiums and notes receivable, net of reinsurance payable................. (20.1) (32.5)
Change in accrued investment income................................................. 5.2 (0.2)
Change in policy liabilities and accruals, net...................................... 504.3 150.4
Change in reinsurance receivable.................................................... 36.3 (26.5)
Change in expenses and taxes payable................................................ (201.1) 2.8
Separate account activity, net...................................................... - (0.2)
Other, net.......................................................................... (34.0) (8.2)
---------- ----------
Net cash provided by operating activities....................................... 422.2 197.5
---------- ----------
Cash flows from investing activities
Proceeds from disposals and maturities of available-for-sale fixed maturities......... 1,836.9 2,321.2
Proceeds from disposals of equity securities.......................................... 41.7 11.8
Proceeds from disposals of other investments.......................................... 42.2 31.5
Proceeds from mortgages matured or collected.......................................... 68.6 83.0
Purchase of available-for-sale fixed maturities....................................... (2,740.4) (3,056.7)
Purchase of equity securities......................................................... (10.4) (16.1)
Purchase of other investments......................................................... (19.5) (118.2)
Purchase of company owned life insurance.............................................. - (64.9)
Capital expenditures.................................................................. (22.7) (8.4)
Other, net............................................................................ 1.5 (0.1)
---------- ----------
Net cash used in investing activities........................................... (802.1) (816.9)
---------- ----------
Cash flows from financing activities
Deposits and interest credited to contractholder deposit funds........................ 148.4 588.1
Withdrawals from contractholder deposit funds......................................... (490.4) (561.1)
Deposits to trust instruments supported by funding obligations........................ 1,109.2 496.2
Withdrawals from trust instruments supported by funding obligations................... (86.3) -
Change in short-term debt............................................................. 14.4 8.9
Proceeds from issuance of common stock................................................ - 0.6
Treasury stock purchased at cost...................................................... - (58.9)
Treasury stock reissued at cost....................................................... 4.4 18.9
Other, net............................................................................ - (1.1)
---------- ----------
Net cash provided by financing activities....................................... 699.7 491.6
---------- ----------
Net change in cash and cash equivalents................................................... 319.8 (127.8)
Cash and cash equivalents, beginning of period............................................ 281.1 464.8
---------- ----------
Cash and cash equivalents, end of period.................................................. $ 600.9 $ 337.0
========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
7
ALLMERICA FINANCIAL CORPORATION
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation and Principles of Consolidation
The accompanying unaudited consolidated financial statements of Allmerica
Financial Corporation ("AFC" or the "Company") have been prepared in accordance
with generally accepted accounting principles for interim financial information
and with the requirements of Form 10-Q.
The interim consolidated financial statements of AFC include the accounts of
First Allmerica Financial Life Insurance Company ("FAFLIC"); Allmerica Financial
Life Insurance and Annuity Company ("AFLIAC"); The Hanover Insurance Company
("Hanover"); Citizens Insurance Company of America ("Citizens"), and other
insurance and non-insurance subsidiaries. All significant intercompany accounts
and transactions have been eliminated.
The accompanying interim consolidated financial statements reflect, in the
opinion of the Company's management, all adjustments necessary for a fair
presentation of the financial position and results of operations. The results
of operations for the nine months ended September 30, 2001, are not necessarily
indicative of the results to be expected for the full year. These financial
statements should be read in conjunction with the Company's 2000 Annual Report
to Shareholders, as filed on Form 10-K with the Securities and Exchange
Commission.
2. New Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets" ("Statement No. 142"), which requires that goodwill and intangible
assets that have indefinite useful lives no longer be amortized over their
useful lives, but instead be tested at least annually for impairment. Intangible
assets that have finite useful lives will continue to be amortized over their
useful lives. In addition, the statement provides specific guidance for testing
the impairment of intangible assets. Additional financial statement disclosures
about goodwill and other intangible assets, including changes in the carrying
amount of goodwill, carrying amounts by classification of amortized and non-
amortized assets, and estimated amortization expenses for the next five years,
are also required. This statement is effective for fiscal years beginning after
December 15, 2001 for all goodwill and other intangible assets held at the date
of adoption. Certain provisions of this statement are also applicable for
goodwill and other intangible assets acquired after June 30, 2001, but prior to
adoption of this statement. The Company is currently assessing the impact of the
adoption of Statement No. 142.
In June 2001, the FASB issued Statement of Financial Accounting Standards No.
141, "Business Combinations" ("Statement No. 141"), which requires that all
business combinations initiated after June 30, 2001 be accounted for using the
purchase method of accounting. It further specifies the criteria that
intangible assets must meet in order to be recognized and reported apart from
goodwill. The implementation of Statement No. 141 is not expected to have a
material effect on the Company's financial statements.
In December 2000, the American Institute of Certified Public Accountants issued
Statement of Position 00-3, "Accounting by Insurance Enterprises for
Demutualization and Formations of Mutual Insurance Holding Companies and For
Certain Long-Duration Participating Contracts" ("SoP No. 00-3"). SoP No. 00-3
requires that closed block assets, liabilities, revenues and expenses be
displayed together with all other assets, liabilities, revenues and expenses of
the insurance enterprise based on the nature of the particular item, with
appropriate disclosures relating to the closed block. In addition, the SoP
provides guidance on the accounting for participating contracts issued before
and after the date of demutualization, recording of closed block earnings and
related policyholder dividend liabilities, and the accounting treatment for
expenses and equity balances at the date of demutualization. This statement
became effective for fiscal years beginning after December 15, 2000. The
adoption of SoP No. 00-3 did not have a material impact on the Company's
financial position or results of operations. Certain prior year amounts have
been reclassified to conform to the required presentation in the current year.
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement
No. 133"), which establishes accounting and reporting standards for derivative
instruments. Statement No. 133 requires that all derivative instruments be
recorded on the balance sheet at their fair value. Changes in the fair value of
derivatives are recorded each period in current earnings or other comprehensive
income, depending on the type of hedge transaction. For fair value hedge
transactions in which the Company is hedging changes in an asset's, liability's
or firm commitment's fair value, changes in the fair value of the derivative
instruments will generally be offset in the income statement by changes in the
hedged item's fair value. For cash flow hedge transactions, in which the
Company is hedging the variability of cash flows related to a variable rate
asset, liability, or a forecasted transaction, changes in the fair value of the
derivative instrument will be reported in other comprehensive income. The gains
and losses on the
8
derivative instrument that are reported in other comprehensive income will be
reclassified into earnings in the periods in which earnings are impacted by the
variability of the cash flows of the hedged item. To the extent any hedges are
determined to be ineffective, all or a portion of the change in value of the
derivative will be recognized currently in earnings. This statement became
effective for fiscal years beginning after June 15, 2000. The Company adopted
Statement No. 133 on January 1, 2001. In accordance with the transition
provisions of the statement, the Company recorded a $3.2 million charge, net-of-
taxes, in earnings to recognize all derivative instruments at their fair values.
This adjustment represents net losses that were previously deferred in other
comprehensive income on derivative instruments that do not qualify for hedge
accounting. The Company recorded an offsetting gain in other comprehensive
income of $3.3 million, net-of-tax, to recognize these derivative instruments.
3. Summary of New Significant Accounting Policies
Accounting for Derivatives and Hedging Activities
All derivatives are recognized on the balance sheet at their fair value. On the
date the derivative contract is entered into, the Company designates the
derivative as (1) a hedge of the fair value of a recognized asset or liability
("fair value" hedge); (2) a hedge of a forecasted transaction or of the
variability of cash flows to be received or paid related to a recognized asset
or liability ("cash flow" hedge); (3) a foreign-currency fair value or cash flow
hedge ("foreign currency" hedge); or (4) "held for trading". Changes in the
fair value of a derivative that is highly effective and that is designated and
qualifies as a fair value hedge, along with the gain or loss on the hedged asset
or liability that is attributable to the hedged risk, are recorded in current
period earnings. Changes in the fair value of a derivative that is highly
effective and that is designated and qualifies as a cash flow hedge are recorded
in other comprehensive income, until earnings are affected by the variability of
cash flows (e.g., when periodic settlements on a variable-rate asset or
liability are recorded in earnings). Changes in the fair value of derivatives
that are highly effective and that are designated and qualify as foreign
currency hedges are recorded in either current period earnings or other
comprehensive income, depending on whether the hedge transaction is a fair value
hedge or a cash flow hedge. Lastly, changes in the fair value of derivative
trading instruments are reported in current period earnings.
The Company may hold financial instruments that contain "embedded" derivative
instruments. The Company assesses whether the economic characteristics of the
embedded derivative are clearly and closely related to the economic
characteristics of the remaining component of the financial instrument, or host
contract, and whether a separate instrument with the same terms as the embedded
instrument would meet the definition of a derivative instrument. When it is
determined that (1) the embedded derivative possesses economic characteristics
that are not clearly and closely related to the economic characteristics of the
host contract, and (2) a separate instrument with the same terms would qualify
as a derivative instrument, the embedded derivative is separated from the host
contract, carried at fair value, and designated as a fair-value, cash-flow, or
foreign currency hedge, or as a trading derivative instrument.
The Company formally documents all relationships between hedging instruments and
hedged items, as well as its risk-management objective and strategy for
undertaking various hedge transactions. This process includes linking all
derivatives that are designated as fair value, cash flow, or foreign currency
hedges to specific assets and liabilities on the balance sheet or to specific
forecasted transactions. The Company also formally assesses, both at the
hedge's inception and on an ongoing basis, whether the derivatives that are used
in hedging transactions are highly effective in offsetting changes in fair
values or cash flows of hedged items. When it is determined that a derivative
is not highly effective as a hedge or that it has ceased to be a highly
effective hedge, the Company discontinues hedge accounting prospectively, as
discussed below.
The Company discontinues hedge accounting prospectively when (1) it is
determined that the derivative is no longer effective in offsetting changes in
the fair value or cash flows of a hedged item, including forecasted
transactions; (2) the derivative expires or is sold, terminated, or exercised;
(3) the derivative is no longer designated as a hedge instrument, because it is
unlikely that a forecasted transaction will occur; or (4) management determines
that designation of the derivative as a hedge instrument is no longer
appropriate.
When hedge accounting is discontinued because it is determined that the
derivative no longer qualifies as an effective fair value hedge, the derivative
will continue to be carried on the balance sheet at its fair value, and the
hedged asset or liability will no longer be adjusted for changes in fair value.
When hedge accounting is discontinued because it is probable that a forecasted
transaction will not occur, the derivative will continue to be carried on the
balance sheet at its fair value, and gains and losses that were accumulated in
other comprehensive income will be recognized immediately in earnings. In all
other situations in which hedge accounting is discontinued, the derivative will
be carried at its fair value on the balance sheet, with changes in its fair
value recognized in current period earnings.
9
4. Discontinued Operations
During the second quarter of 1999, the Company approved a plan to exit its group
life and health insurance business, consisting of its Employee Benefit Services
("EBS") business, its Affinity Group Underwriters business and its accident and
health assumed reinsurance pool business ("reinsurance pool business"). During
the third quarter of 1998, the Company ceased writing new premiums in the
reinsurance pool business, subject to certain contractual obligations. Prior to
1999, these businesses comprised substantially all of the former Corporate Risk
Management Services segment. Accordingly, the operating results of the
discontinued segment, including its reinsurance pool business, have been
reported in the Consolidated Statements of Income as discontinued operations in
accordance with Accounting Principles Board Opinion No. 30, "Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" ("APB Opinion No. 30"). In the third quarter of 1999, the
operating results from the discontinued segment were adjusted to reflect the
recording of additional reserves related to accident claims from prior years.
The Company also recorded a $30.5 million loss, net of taxes, on the disposal of
this segment, consisting of after-tax losses from the run-off of the group life
and health business of approximately $46.9 million, partially offset by net
proceeds from the sale of the EBS business of approximately $16.4 million.
Subsequent to a measurement date of June 30, 1999, approximately $15.1 million
of the aforementioned $46.9 million loss has been generated from the operations
of the discontinued business.
In March of 2000, the Company transferred its EBS business to Great-West Life
and Annuity Insurance Company of Denver. As a result of this transaction, the
Company has received consideration of approximately $26 million, based on
renewal rights for existing policies. The Company retained policy liabilities
estimated at $101.7 million at September 30, 2001 related to this business.
As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not
been segregated between continuing and discontinued operations. At September
30, 2001 and 2000, the discontinued segment had assets of approximately $397.1
million and $505.1 million, respectively, consisting primarily of invested
assets and reinsurance recoverables, and liabilities of approximately $367.6
million and $419.8 million, respectively, consisting primarily of policy
liabilities. Revenues for the discontinued operations were $8.1 million and
$39.0 million for the quarters ended September 30, 2001 and 2000, respectively,
and $27.9 million and $174.7 million for the nine months ended September 30,
2001 and 2000, respectively.
5. Significant Transactions
As of September 30, 2001, the Company has repurchased approximately $436.3
million, or approximately 8 million shares, of its common stock under programs
authorized by the Board of Directors (the "Board") in 1998, 1999 and 2000. As
of September 30, 2001, the Board had authorized total stock repurchases of
$500.0 million, leaving approximately $63.7 million available to the Company for
future repurchases. There have been no share repurchases to date in 2001. The
Company repurchased approximately 1.9 million shares at a cost of approximately
$103.4 million in 2000.
During the second quarter of 2000, the Company adopted a formal company-wide
restructuring plan. This plan is the result of a corporate initiative that
began in the fall of 1999, intended to reduce expenses and enhance revenues.
This plan consists of various initiatives including a series of internal
reorganizations, consolidations in home office operations, consolidations in
field offices, changes in distribution channels and product changes. As a
result of the Company's restructuring plan, it recognized a pre-tax charge of
$21.4 million during 2000. Approximately $5.7 million of this charge relates to
severance and other employee related costs resulting from the elimination of
approximately 360 positions, of which 240 employees have been terminated as of
September 30, 2001 and 120 vacant positions have been eliminated. All levels of
employees, from staff to senior management, were affected by the restructuring.
In addition, approximately $15.7 million of this charge relates to other
restructuring costs, consisting of one-time project costs, lease cancellations
and the present value of idle leased space. As of September 30, 2001, the
Company has made payments of approximately $20.6 million related to this
restructuring plan, of which approximately $5.4 million relates to severance and
other employee related costs. This plan has been substantially implemented.
10
6. Investments
A. Derivative Instruments
The Company maintains an overall risk management strategy that incorporates the
use of derivative instruments to minimize significant unplanned fluctuations in
earnings that are caused by interest rate or foreign currency volatility. The
operations of the Company are subject to risk resulting from interest rate
fluctuations to the extent that there is a difference between the amount of the
Company's interest-earning assets and the amount of interest-bearing liabilities
that are paid, withdrawn, mature or re-price in specified periods. The principal
objective of the Company's asset/liability management activities is to provide
maximum levels of net investment income while maintaining acceptable levels of
interest rate and liquidity risk and facilitating the funding needs of the
Company. The Company has developed an asset/liability management approach
tailored to specific insurance or investment product objectives. The investment
assets of the Company are managed in over 20 portfolio segments consistent with
specific products or groups of products having similar liability
characteristics. As part of this approach, management develops investment
guidelines for each portfolio consistent with the return objectives, risk
tolerance, liquidity, time horizon, tax and regulatory requirements of the
related product or business segment. Management has a general policy of
diversifying investments both within and across all portfolios. The Company
monitors the credit quality of its investments and its exposure to individual
markets, borrowers, industries, and sectors.
The Company uses derivative financial instruments, primarily interest rate swaps
and futures contracts, with indices that correlate to balance sheet instruments
to modify its indicated net interest sensitivity to levels deemed to be
appropriate. Specifically, for floating rate funding agreements that are
matched with fixed rate securities, the Company manages the risk of cash flow
variability by hedging with interest rate swap contracts designed to pay fixed
and receive floating interest. Under interest rate swap contracts, the Company
agrees to exchange, at specified intervals, the difference between fixed and
floating interest amounts calculated on an agreed-upon notional principal
amount. Additionally, the Company uses exchange traded financial futures
contracts to hedge against interest rate risk on anticipated guaranteed
investment contract ("GIC") sales and other funding agreements, as well as the
reinvestment of fixed maturities. The Company is exposed to interest rate risk
from the time of sale of the GIC until the receipt of the deposit and purchase
of the underlying asset to back the liability. Similarly, the Company is exposed
to interest rate risk on fixed maturities reinvestments from the time of
maturity until the purchase of new fixed maturities. The Company only trades
futures contracts with nationally recognized brokers, which the Company believes
have adequate capital to ensure that there is minimal risk of default.
As a result of the Company's issuance of trust instruments supported by funding
obligations denominated in foreign currencies, as well as the Company's
investment in securities denominated in foreign currencies, the Company's
operating results are exposed to changes in exchange rates between the U.S.
dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From time to
time, the Company may also have exposure to other foreign currencies. To
mitigate the short-term effect of changes in currency exchange rates, the
Company regularly enters into foreign exchange swap contracts to hedge its net
foreign currency exposure. Additionally, the Company enters into compound
currency/interest rate swap contracts to hedge foreign currency and interest
rate exposure on specific trust instruments supported by funding obligations.
Under these swap contracts, the Company agrees to exchange interest and
principal related to foreign fixed income securities and trust obligations
payable in foreign currencies, at current exchange rates, for the equivalent
payment in U.S. dollars translated at a specific currency exchange rate.
By using derivative instruments, the Company is exposed to credit risk. If the
counterparty fails to perform, credit risk is equal to the extent of the fair
value gain (including any accrued receivable) in a derivative. The Company
regularly assesses the financial strength of its counterparties and generally
enters into forward or swap agreements with counterparties rated "A" or better
by nationally recognized rating agencies. Depending on the nature of the
derivative transaction, bilateral collateral arrangements may be required.
The Company's derivative activities are monitored by management, who review
portfolio activities and risk levels. Management also oversees all derivative
transactions to ensure that the types of transactions entered into and the
results obtained from those transactions are consistent with the Company's risk
management strategy and with Company policies and procedures.
Fair Value Hedges
The Company enters into compound foreign currency/interest rate swaps to convert
its foreign denominated fixed rate trust instruments supported by funding
obligations to U.S. dollar floating rate instruments. For the nine months ended
September 30, 2001, the Company recognized a net gain of $0.3 million (reported
as other income in the Consolidated Statements of Income), which represented the
ineffective portion of all fair value hedges. All components of each
derivative's gain or loss are included in the assessment of hedge effectiveness,
unless otherwise noted.
11
Cash Flow Hedges
The Company enters into various types of interest rate swap contracts to hedge
exposure to interest rate fluctuations. Specifically, for floating rate funding
agreement liabilities that are matched with fixed rate securities, the Company
manages the risk of cash flow variability by hedging with interest rate swap
contracts. Under these swap contracts, the Company agrees to exchange, at
specified intervals, the difference between fixed and floating interest amounts
calculated on an agreed-upon notional principal amount. The Company also
purchases long futures contracts and sells short futures contracts on margin to
hedge against interest rate fluctuations associated with the sale of GICs and
other funding agreements, as well as the reinvestment of fixed maturities. The
Company is exposed to interest rate risk from the time of sale of the GIC until
the receipt of the deposit and purchase of the underlying asset to back the
liability. Similarly, the Company is exposed to interest rate risk on
reinvestments of fixed maturities from the time of maturity until the purchase
of new fixed maturities. The Company uses U.S. Treasury Note Futures to hedge
this risk.
The Company also enters into foreign currency swap contracts to hedge foreign
currency exposure on specific fixed income securities, as well as compound
foreign currency/interest rate swap contracts to hedge foreign currency and
interest rate exposure on specific trust instruments supported by funding
obligations. Under these swap contracts, the Company agrees to exchange
interest and principal related to foreign fixed maturities and trust obligations
payable in foreign currencies, at current exchange rates, for the equivalent
payment in U.S. dollars translated at a specific currency exchange rate.
For the nine months ended September 30, 2001, the Company recognized a net gain
of $2.0 million, reported as other income in the Consolidated Statements of
Income, which represented the total ineffectiveness of all cash flow hedges.
All components of each derivative's gain or loss are included in the assessment
of hedge effectiveness, unless otherwise noted.
Gains and losses on derivative contracts that are reclassified from accumulated
other comprehensive income to current period earnings are included in the line
item in which the hedged item is recorded. As of September 30, 2001, $73.1
million of the deferred net losses on derivative instruments accumulated in
other comprehensive income could be recognized in earnings during the next
twelve months depending on the forward interest rate and currency rate
environment. Transactions and events that (1) are expected to occur over the
next twelve months and (2) will necessitate reclassifying to earnings these
derivatives gains (losses) include (a) the re-pricing of variable rate trust
instruments supported by funding obligations, (b) the interest payments
(receipts) on foreign denominated trust instruments supported by funding
obligations and foreign securities, (c) the anticipated sale of GICs and other
funding agreements, and (d) the anticipated reinvestment of fixed maturities.
The maximum term over which the Company is hedging its exposure to the
variability of future cash flows (for all forecasted transactions, excluding
interest payments on variable-rate debt) is 12 months.
Trading Activities
The Company enters into insurance portfolio-linked and credit default swap
contracts for investment purposes. Under the insurance portfolio-linked swap
contracts, the Company agrees to exchange cash flows according to the
performance of a specified underwriter's portfolio of insurance business. As
with interest rate swap contracts, the primary risk associated with insurance
portfolio-linked swap contracts is the inability of the counterparty to meet its
obligation. Under the terms of the credit default swap contracts, the Company
assumes the default risk of a specific high credit quality issuer in exchange
for a stated annual premium. In the case of default, the Company will pay the
counterparty par value for a pre-determined security of the issuer. As of
September 30, 2001, the Company no longer held credit default swap contracts.
The primary risk associated with these transactions is the default risk of the
underlying companies. The Company regularly assesses the financial strength of
its counterparties and the underlying companies in default swap contracts, and
generally enters into swap agreements with companies rated "A" or better by
nationally recognized rating agencies. Because the underlying principal of swap
contracts is not exchanged, the Company's maximum exposure to counterparty
credit risk is the difference in payments exchanged, which at September 30,
2001, was $5.1 million. The Company does not require collateral or other
security to support financial instruments with credit risk. These products are
not linked to specific assets and liabilities on the balance sheet or to a
forecasted transaction, and therefore do not qualify for hedge accounting.
The swap contracts are marked to market with any gain or loss recognized
currently. The net amount receivable or payable under insurance portfolio-
linked swap contracts is recognized when the contracts are marked to market. The
net decrease in realized investment gains related to these contracts was $4.3
million, $0.7 million and $0.2 million for the nine months ended September 30,
2001 and the years ended December 31, 2000 and 1999, respectively. The fair
values of swap contracts outstanding were immaterial at September 30, 2001 and
December 31, 2000.
12
The stated annual premium under credit default swap contracts is recognized
currently in net investment income. There was no net increase to investment
income related to credit default swap contracts for the nine months ended
September 30, 2001; however, there was a net increase of $0.2 million for the
nine months ended September 30, 2000.
B. Impact of Defaults on Net Investment Income
The Company had fixed maturity securities with a carrying value of $15.3
million, $7.5 million and $4.1 million on non-accrual status at September 30,
2001, December 31, 2000 and September 30, 2000, respectively. The effect of non-
accruals, compared with amounts that would have been recognized in accordance
with the original terms of the investments, was a reduction in net investment
income of $9.2 million and $2.6 million for the nine months ended September 30,
2001 and 2000, respectively.
7. Federal Income Taxes
Federal income tax expense for the nine months ended September 30, 2001 and
2000, has been computed using estimated effective tax rates. These rates are
revised, if necessary, at the end of each successive interim period to reflect
the current estimates of the annual effective tax rates.
8. Other Comprehensive (Loss) Income
The following table provides a reconciliation of gross unrealized gains (losses)
to the net balance shown in the Statements of Comprehensive Income:
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
-----------------------------------------
(In millions) 2001 2000 2001 2000
====================================================================================================================
Unrealized gains (losses) on available-for-sale securities:
Unrealized holding gains (losses) arising during period (net of
income taxes (benefit) of $30.4 million and $4.4 million
for the quarters ended September 30, 2001 and 2000 and
$38.5 million and $(12.5) million for the nine months
ended September 30, 2001 and 2000)................................. $ 61.3 $ 10.9 $ 46.8 $ (36.0)
Less: reclassification adjustment for gains (losses) included in
net income (net of income taxes (benefit) of $2.8 million
and $(10.5) million for the quarters ended September 30,
2001 and 2000 and $(14.5) million and $(33.4) million for
the nine months ended September 30, 2001 and 2000)................. 10.1 (16.5) (51.6) (75.0)
------- ------- ------- -------
Total available-for-sale securities..................................... 51.2 27.4 98.4 39.0
------- ------- ------- -------
Unrealized losses on derivative instruments:
Unrealized holding losses arising during period (net of income
tax benefit of $33.6 million and $32.7 million for the quarter
and nine months ended September 30, 2001).......................... (62.2) - (60.6) -
Less: reclassification adjustment for losses included in net
income (net of income tax benefit of $5.6 million and
$6.6 million for the quarter and nine months ended
September 30, 2001)................................................ (10.1) - (12.1) -
------- ------- ------- -------
Total derivative instruments............................................ (52.1) - (48.5) -
------- ------- ------- -------
Other comprehensive (loss) income....................................... $ (0.9) $ 27.4 $ 49.9 $ 39.0
======= ======= ======= =======
13
9. Closed Block
Included in the Consolidated Statements of Income is a net pre-tax contribution
(loss) from the Closed Block of $2.0 million and $12.9 million for the quarter
and nine months ended September 30, 2001, respectively, compared to $(1.1)
million and $3.7 million for the quarter and nine months ended September 30,
2000, respectively. Summarized financial information of the Closed Block is as
follows:
(Unaudited)
September 30, December 31,
(In millions) 2001 2000
- ---------------------------------------------------------------------------------------------------------
Assets
Fixed maturities-at fair value (amortized cost of $417.2 and $400.3).... $ 430.9 $ 397.5
Mortgage loans.......................................................... 141.8 144.9
Policy loans............................................................ 186.5 191.7
Cash and cash equivalents............................................... - 1.9
Accrued investment income............................................... 15.1 14.6
Deferred policy acquisition costs....................................... 10.6 11.0
Other assets............................................................ 7.6 6.4
------- -------
Total assets.......................................................... $ 792.5 $ 768.0
======= =======
Liabilities
Policy liabilities and accruals......................................... $ 804.4 $ 808.9
Policyholder dividends.................................................. 38.0 20.0
Other liabilities....................................................... 1.6 0.8
------- -------
Total liabilities..................................................... $ 844.0 $ 829.7
======= =======
Excess of Closed Block liabilities over assets designated to the
Closed Block............................................................ $ 51.5 $ 61.7
Amounts included in accumulated other comprehensive income:
Net unrealized investment losses, net of deferred federal income tax
benefit of $2.9 million and $1.3 million.............................. (5.3) (2.5)
------- -------
Maximum future earnings to be recognized from Closed Block
assets and liabilities.................................................. $ 46.2 $ 59.2
======= =======
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------- -----------------
(In millions) 2001 2000 2001 2000
- --------------------------------------------------------------------------------------------------------------------
Revenues
Premiums................................................................ $ 7.2 $ 7.7 $ 39.6 $ 42.0
Net investment income................................................... 14.1 13.1 41.7 40.1
Net realized investment gains (losses).................................. 0.3 (1.1) (0.9) (4.7)
------ ------ ------ ------
Total revenues........................................................ 21.6 19.7 80.4 77.4
------ ------ ------ ------
Benefits and expenses
Policy benefits......................................................... 19.4 20.2 66.9 71.9
Policy acquisition expenses............................................. 0.2 0.5 0.3 1.5
Other operating expenses................................................ - 0.1 0.3 0.3
------ ------ ------ ------
Total benefits and expenses........................................... 19.6 20.8 67.5 73.7
------ ------ ------ ------
Contribution from the Closed Block.................................. $ 2.0 $ (1.1) $ 12.9 $ 3.7
====== ====== ====== ======
Many expenses related to Closed Block operations are charged to operations
outside the Closed Block; accordingly, the contribution from the Closed Block
does not represent the actual profitability of the Closed Block operations.
Operating costs and expenses outside of the Closed Block are, therefore,
disproportionate to the business outside the Closed Block.
14
10. Segment Information
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services and Allmerica Asset Management.
The separate financial information of each segment is presented consistent with
the way results are regularly evaluated by the chief operating decision maker in
deciding how to allocate resources and in assessing performance. A summary of
the Company's reportable segments is included below.
The Risk Management Segment manages its products through three distribution
channels identified as Standard Markets, Sponsored Markets, and Specialty
Markets. Standard Markets sells property and casualty insurance products
through independent agents and brokers primarily in the Northeast, Midwest and
Southeast United States. Sponsored Markets offers property and casualty
products to members of affinity groups and other organizations. This
distribution channel also focuses on worksite distribution, which offers
discounted property and casualty (automobile and homeowners) insurance through
employer sponsored programs. Specialty Markets offers specialty or program
property and casualty business nationwide. This channel focuses on niche
classes of risks and leverages specific underwriting processes.
The Asset Accumulation group includes two segments: Allmerica Financial Services
and Allmerica Asset Management. The Allmerica Financial Services segment
includes variable annuities, variable universal life and traditional life
insurance products and to a lesser extent, certain group retirement products.
Through its Allmerica Asset Management segment, the Company offers its customers
the option of investing in GICs, such as short-term and long-term funding
agreements. Short-term funding agreements are investment contracts issued to
institutional buyers, such as money market funds, corporate cash management
programs and securities lending collateral programs, which typically have short
maturities and periodic interest rate resets based on an index such as LIBOR.
Long-term funding agreements are investment contracts issued to various
businesses or charitable trusts, which are used to support debt issued by the
trust to foreign and domestic institutional buyers, such as banks, insurance
companies, and pension plans. These funding agreements have long maturities and
may be issued with a fixed or variable interest rate based on an index such as
LIBOR. This segment is also a Registered Investment Advisor providing
investment advisory services, primarily to affiliates and to third parties, such
as money market and other fixed income clients.
In addition to the three operating segments, the Company has a Corporate
segment, which consists primarily of cash, investments, corporate debt, Capital
Securities and corporate overhead expenses. Corporate overhead expenses reflect
costs not attributable to a particular segment, such as those generated by
certain officers and directors, technology, finance, human resources and legal.
Management evaluates the results of the aforementioned segments based on a pre-
tax and pre-minority interest basis. Segment income is determined by adjusting
net income for net realized investment gains and losses, net gains and losses on
disposals of businesses, discontinued operations, extraordinary items, the
cumulative effect of accounting changes and certain other items which management
believes are not indicative of overall operating trends. While these items may
be significant components in understanding and assessing the Company's financial
performance, management believes that the presentation of segment income
enhances understanding of the Company's results of operations by highlighting
net income attributable to the normal, recurring operations of the business.
However, segment income should not be construed as a substitute for net income
determined in accordance with generally accepted accounting principles.
15
Summarized below is financial information with respect to business segments for
the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------
(In millions) 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Segment revenues:
Risk Management............................................. $ 615.0 $ 588.4 $ 1,833.3 $ 1,725.3
------- ------- --------- ---------
Asset Accumulation:
Allmerica Financial Services............................. 202.5 217.2 630.0 659.7
Allmerica Asset Management............................... 40.1 41.0 121.4 105.2
------- ------- --------- ---------
Subtotal................................................ 242.6 258.2 751.4 764.9
------- ------- --------- ---------
Corporate................................................... 2.1 2.2 4.6 4.9
Intersegment revenues................................... (1.8) (1.2) (5.6) (3.8)
------- ------- --------- ---------
Total segment revenues................................... 857.9 847.6 2,583.7 2,491.3
Adjustments to segment revenues:
Net realized losses......................................... (4.9) (31.8) (89.6) (102.6)
(Losses) gains on derivatives............................... (0.6) - 2.3 -
------- ------- --------- ---------
Total revenues........................................... $ 852.4 $ 815.8 $ 2,496.4 $ 2,388.7
======= ======= ========= =========
Segment income (loss) before federal income taxes, minority
interest and cumulative effect of change in accounting
principle:
Risk Management.......................................... $ 6.8 $ 59.4 $ 64.5 $ 156.4
------- ------- --------- ---------
Asset Accumulation:
Allmerica Financial Services.......................... 34.4 56.7 121.3 166.6
Allmerica Asset Management............................ 6.1 5.8 16.5 15.5
------- ------- --------- ---------
Subtotal........................................... 40.5 62.5 137.8 182.1
------- ------- --------- ---------
Corporate................................................... (15.7) (13.7) (47.5) (40.4)
------- ------- --------- ---------
Segment income before federal income taxes and
minority interest.................................... 31.6 108.2 154.8 298.1
Adjustments to segment income:
Net realized investment losses, net of amortization......... (7.2) (28.6) (88.7) (96.5)
(Losses) gains on derivatives............................... (0.6) - 2.3 -
Sales practice litigation................................... - - 7.7 -
Restructuring costs......................................... - - - (20.3)
------- ------- --------- ---------
Income before federal income taxes, minority interest
and cumulative effect of change in accounting
principle............................................ $ 23.8 $ 79.6 $ 76.1 $ 181.3
======= ======= ========= =========
Identifiable Assets Deferred Acquisition Costs
- ------------------------------------------------------------------------------------------------------------
(Unaudited) (Unaudited)
September 30, December 31, September 30, December 31,
(In millions) 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------
Risk Management............................... $ 6,041.6 $ 6,186.6 $ 206.5 $ 187.2
---------- ---------- ---------- ----------
Asset Accumulation
Allmerica Financial Services................ 19,664.0 23,082.5 1,518.2 1,420.8
Allmerica Asset Management.................. 3,034.8 2,238.4 0.1 0.2
---------- ---------- ---------- ----------
Subtotal.................................. 22,698.8 25,320.9 1,518.3 1,421.0
Corporate..................................... 173.4 80.5 - -
---------- ---------- ---------- ----------
Total....................................... $ 28,913.8 $ 31,588.0 $ 1,724.8 $ 1,608.2
========== ========== ========== ==========
16
11. Earnings Per Share
The following table provides share information used in the calculation of the
Company's basic and diluted earnings per share:
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------------------------------------
(In millions, except per share data) 2001 2000 2001 2000
- ------------------------------------------------------------------------------------------------------------------
Basic shares used in the calculation of
earnings per share..................................... 52.7 53.1 52.6 53.5
Dilutive effect of securities:
Employee stock options.......................... 0.2 0.5 0.3 0.3
Non-vested stock grants......................... 0.2 0.3 0.2 0.3
------ ------ ------ ------
Diluted shares used in the calculation of
earnings per share..................................... 53.1 53.9 53.1 54.1
------ ------ ------ ------
Per share effect of dilutive securities on
income from continuing operations before
cumulative effect of change in accounting
principle and net income............................... $ - $ 0.02 $ 0.01 $ 0.03
====== ====== ====== ======
12. Commitments and Contingencies
Litigation
In 1997, a lawsuit on behalf of a putative class was instituted against the
Company alleging fraud, unfair or deceptive acts, breach of contract,
misrepresentation, and related claims in the sale of life insurance policies. In
November 1998, the Company and the plaintiffs entered into a settlement
agreement and in May 1999, the Federal District Court in Worcester,
Massachusetts approved the settlement agreement and certified the class for this
purpose. AFC recognized a $31.0 million pre-tax expense in 1998 related to this
litigation. In the second quarter of 2001, the Company recognized a pre-tax
benefit of $7.7 million resulting from the refinement of cost estimates.
Although the Company believes that the remaining expense reflects appropriate
recognition of its obligation under the settlement, this estimate may be revised
based on the amount of reimbursement actually tendered by AFC's insurance
carriers, and based on changes in the Company's estimate of the ultimate cost of
the benefits to be provided to members of the class.
The Company has been named a defendant in various other legal proceedings
arising in the normal course of business. In the Company's opinion, based on
the advice of legal counsel, the ultimate resolution of these proceedings will
not have a material effect on the Company's consolidated financial statements.
However, liabilities related to these proceedings could be established if
estimates of the ultimate resolution of these proceedings are revised.
17
PART I - FINANCIAL INFORMATION
ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following analysis of the interim consolidated results of operations and
financial condition of the Company should be read in conjunction with the
interim Consolidated Financial Statements and related footnotes included
elsewhere herein and the Management's Discussion and Analysis of Financial
Condition and Results of Operations contained in the 2000 Annual Report to
Shareholders, as filed on Form 10-K with the Securities and Exchange Commission.
INTRODUCTION
The results of operations for Allmerica Financial Corporation and subsidiaries
("AFC" or "the Company") include the accounts of First Allmerica Financial Life
Insurance Company ("FAFLIC") and Allmerica Financial Life Insurance and Annuity
Company ("AFLIAC"), AFC's principal life insurance and annuity companies; The
Hanover Insurance Company ("Hanover") and Citizens Insurance Company of America
("Citizens"), AFC's principal property and casualty companies; and certain other
insurance and non-insurance subsidiaries.
Description of Operating Segments
- ---------------------------------
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services, and Allmerica Asset Management.
The separate financial information of each segment is presented consistent with
the way results are regularly evaluated by the chief operating decision maker in
deciding how to allocate resources and in assessing performance.
Results of Operations
- ---------------------
Consolidated Overview
Consolidated net income includes the results of each segment of the Company,
which management evaluates on a pre-tax and pre-minority interest basis. In
addition, net income also includes certain items which management believes are
not indicative of overall operating trends, such as net realized investment
gains and losses, net gains and losses on disposals of businesses, discontinued
operations, extraordinary items, the cumulative effect of accounting changes and
certain other items. While these items may be significant components in
understanding and assessing the Company's financial performance, management
believes that the presentation of "Adjusted Net Income", which excludes these
items, enhances understanding of the Company's results of operations by
highlighting net income attributable to the normal, recurring operations of the
business. However, adjusted net income should not be construed as a substitute
for net income determined in accordance with generally accepted accounting
principles.
The Company's consolidated net income for the third quarter of 2001 decreased
$31.3 million, or 50.1%, to $31.2 million, compared to the same period in 2000.
The reduction in net income in the third quarter resulted primarily from a
decrease in adjusted net income of $45.5 million, partially offset by a decrease
in net realized investment losses of $14.6 million. Consolidated net income for
the first nine months of 2001 decreased $72.7 million, or 51.8%, to $67.6
million, compared to the first nine months of 2000. The reduction in net income
resulted primarily from a decrease in adjusted net income of $90.3 million. Net
income in 2000 also included a restructuring charge of $13.2 million.
The following table reflects adjusted net income and a reconciliation to
consolidated net income. Adjusted net income consists of segment income (loss),
federal income taxes on segment income and minority interest on Capital
Securities (mandatorily redeemable preferred securities of a subsidiary trust
holding solely junior subordinated debentures of the Company).
18
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------ -------------------
(In millions) 2001 2000 2001 2000
- -------------------------------------------------------------------------------------------------------------
Segment income (loss) before federal income taxes and
minority interest:
Risk Management............................................. $ 6.8 $ 59.4 $ 64.5 $ 156.4
Asset Accumulation:
Allmerica Financial Services.......................... 34.4 56.7 121.3 166.6
Allmerica Asset Management............................ 6.1 5.8 16.5 15.5
------- ------- ------- -------
Subtotal.............................................. 40.5 62.5 137.8 182.1
Corporate................................................... (15.7) (13.7) (47.5) (40.4)
------- ------- ------- -------
Segment income before federal income taxes and
minority interest......................................... 31.6 108.2 154.8 298.1
Federal income tax benefit (expense) on segment income..... 6.8 (24.3) (12.3) (65.3)
Minority interest on Capital Securities.................... (4.0) (4.0) (12.0) (12.0)
------- ------- ------- -------
Adjusted net income............................................. 34.4 79.9 130.5 220.8
Adjustments (net of taxes and amortization, as applicable):
Net realized investment losses.............................. (2.8) (17.4) (66.2) (67.3)
(Losses) gains on derivatives............................... (0.4) - 1.5 -
Sales practice litigation................................... - - 5.0 -
Restructuring costs......................................... - - - (13.2)
------- ------- ------- -------
Income before cumulative effect of change in
accounting principle.......................................... 31.2 62.5 70.8 140.3
Cumulative effect of change in accounting principle,
net of applicable taxes.................................. - - (3.2) -
------- ------- ------- -------
Net income...................................................... $ 31.2 $ 62.5 $ 67.6 $ 140.3
======= ======= ======= =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
The Company's segment income before federal income taxes and minority interest
decreased $76.6 million, or 70.8%, to $31.6 million in the third quarter of
2001. This decrease is primarily attributable to a decrease in income from the
Risk Management and the Allmerica Financial Services segments of $52.6 million
and $22.3 million, respectively. The decrease in Risk Management's segment
income was primarily attributable to a reduction in favorable loss and loss
adjustment expenses ("LAE") reserve development of $33.7 million and to an
increase of approximately $32 million in current accident year losses and LAE.
These decreases were partially offset by premium rate increases of approximately
$24 million. Allmerica Financial Services' segment income decreased $22.3
million primarily due to declines in asset-based fees, primarily resulting from
a decrease in the market value of assets under management in the variable
product lines, and to lower brokerage income and investment management fees.
The decrease is also attributable to an increase in policy benefits and policy
acquisition costs, partially offset by higher net investment income.
The effective tax rate for segment income was (21.5%) for the third quarter of
2001 compared to 22.5% for the third quarter of 2000. The decrease in the tax
rate is primarily due to lower underwriting income resulting in an increase in
the proportion of tax-exempt investment income to pre-tax income, as well as to
an increase in the dividends received deduction associated with the Company's
variable products.
Net realized losses on investments, after taxes, were $2.8 million in the third
quarter of 2001, resulting primarily from impairments of fixed maturities and
decreases in the market values of certain derivative instruments. These losses
were partially offset by gains from sales of fixed maturities. Most of these
impairments occurred in the Company's portfolio of high-yield bonds. During the
third quarter of 2000, the Company recognized net realized losses on
investments, after taxes, of $17.4 million, primarily due to losses from the
sale of securities pursuant to the Company's tax strategy to increase portfolio
yields and to impairments of fixed maturities.
19
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
The Company's segment income before federal income taxes and minority interest
decreased $143.3 million, or 48.1%, to $154.8 million in the first nine months
of 2001. This decrease is primarily attributable to a decrease in income from
the Risk Management and Allmerica Financial Services segments of $91.9 million
and $45.3 million, respectively. The decrease in Risk Management's segment
income was primarily attributable to decreased favorable loss and LAE reserve
development of $118.9 million and to an increase of approximately $54 million in
current accident year losses and LAE. These decreases in segment income were
partially offset by premium rate increases of approximately $78 million and
decreased catastrophe losses of $11.3 million. Allmerica Financial Services'
segment income decreased $45.3 million principally due to lower asset-based
fees, primarily resulting from a decrease in the market value of assets under
management in the variable product lines, and to lower brokerage income and
investment management fees. The decrease is also attributable to higher policy
benefits and other operating expenses, partially offset by lower deferred policy
acquisition costs.
The effective tax rate for segment income was 7.9% for the first nine months of
2001 compared to 21.9% for the first nine months of 2000. The decrease in the
tax rate is primarily due to lower underwriting income resulting in an increase
in the proportion of tax-exempt investment income to pre-tax income, as well as
to an increase in the dividends received deduction associated with the Company's
variable products.
Net realized losses on investments after taxes were $66.2 million in the first
nine months of 2001 resulting primarily from impairments of fixed maturities.
During the first nine months of 2000, net realized losses on investments after
taxes of $67.3 million resulted primarily from after tax realized losses of
$57.6 million due to the sale of $1.7 billion of fixed income securities in
order to reinvest the proceeds in higher yielding securities. In addition, the
Company recognized $21.0 million in after tax realized losses from impairments
of fixed maturities in 2000.
The Company recognized a benefit of $5.0 million, net of taxes, in the second
quarter of 2001, as a result of refining cost estimates related to settlement of
a class action lawsuit.
During the first quarter of 2001, the Company recognized a $3.2 million loss,
net of taxes, upon adoption of Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities."
In the second quarter of 2000, the Company recognized a one-time after-tax
restructuring charge of $13.2 million. This charge is the result of a formal
company-wide restructuring plan, intended to reduce expenses and enhance
revenues.
Segment Results
The following is management's discussion and analysis of the Company's results
of operations by business segment. The segment results are presented before
taxes and minority interest and other items which management believes are not
indicative of overall operating trends, including realized gains and losses.
20
Risk Management
- ---------------
The following table summarizes the results of operations for the Risk Management
segment for the periods indicated:
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------- ---------------------
(In millions) 2001 2000 2001 2000
- -----------------------------------------------------------------------------------------------------------
Segment revenues
Net premiums written...................................... $ 586.7 $ 561.8 $ 1,734.8 $ 1,651.6
======= ======= ========= =========
Net premiums earned....................................... $ 552.5 $ 527.2 $ 1,644.9 $ 1,543.8
Net investment income..................................... 54.2 55.2 164.0 164.8
Other income.............................................. 8.3 6.0 24.4 16.7
------- ------- --------- ---------
Total segment revenues............................... 615.0 588.4 1,833.3 1,725.3
Losses and operating expenses
Losses and LAE (1)........................................ 457.0 390.9 1,321.0 1,150.2
Policy acquisition expenses............................... 101.7 93.4 297.2 279.4
Other operating expenses.................................. 49.5 44.7 150.6 139.3
------- ------- --------- ---------
Total losses and operating expenses.................. 608.2 529.0 1,768.8 1,568.9
------- ------- --------- ---------
Segment income................................................. $ 6.8 $ 59.4 $ 64.5 $ 156.4
======= ======= ========= =========
(1) Includes policyholders' dividends of $2.3 million and $4.9 million for the
quarters ended September 30, 2001 and 2000, respectively, and $6.2 million
and $11.3 million for the nine months ended September 30, 2001 and 2000,
respectively.
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
Risk Management's segment income declined $52.6 million, or 88.6%, to $6.8
million for the quarter ended September 30, 2001. The decrease in segment income
is primarily attributable to a $66.1 million increase in losses and LAE. This
is primarily the result of a $33.7 million decrease in favorable development on
prior years' reserves, to $15.8 million of adverse development in the third
quarter of 2001. The unfavorable trend in reserve development is related to
adverse claims frequency trends in the personal automobile and homeowners lines,
increased commercial automobile loss severity, and to the Company having
captured, in prior periods, the accumulated benefits of its claim processing
redesign efforts. In addition, losses and LAE increased as a result of
approximately a $32 million increase in current accident year losses in the
third quarter, primarily in the personal automobile, commercial multiple peril
and homeowners lines. The increase in personal automobile and homeowners lines
current accident year losses is primarily the result of increased claims
frequency, while current accident year losses in the commercial multiple peril
line increased as a result of increased claims severity. Policy acquisition and
other operating expenses have increased $13.1 million to $151.2 million in the
third quarter of 2001 as the result of earned premium growth. Partially
offsetting these items are approximately $24 million of rate increases,
primarily in the commercial lines. Catastrophe losses decreased $0.4 million to
$15.6 million, including $15.0 million related to the events of September 11,
2001, in the third quarter of 2001. A net benefit of $2.7 million in the third
quarter of 2000 is included in segment income as a result of a whole account
aggregate excess of loss reinsurance treaty, which provides coverage for the
1999 accident year.
As a result of the events of September 11, 2001, the reinsurance industry has
incurred significant losses. The Company believes that this may result in
increased reinsurance costs, as well as changes in the terms of its reinsurance
coverage. The Company is not able to estimate the impact of these possible
changes.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
Risk Management's segment income decreased $91.9 million, or 58.8%, to $64.5
million for the nine months ended September 30, 2001. The decrease in segment
income is primarily attributable to increased losses and LAE resulting from a
$118.9 million decrease in favorable development on prior years' reserves, to
$31.4 million of adverse development for the nine months ended September 30,
2001 from $87.5 million of favorable development for the same period in 2000.
The unfavorable trend in reserve development is related to an increase in
commercial multiple peril lines loss severity, adverse claims frequency trends
in the personal automobile and homeowners lines, and to the Company's having
captured, in prior periods, the accumulated benefits of its claim processing
redesign efforts. Approximately $38 million of increased current
21
year claims severity in the commercial multiple peril line also contributed to
the decline in results. In addition, approximately $23 million and $10 million
of increased current year claims frequency in the personal automobile and
homeowners lines, respectively, unfavorably impacted results. Partially
offsetting these items are approximately $78 million of rate increases,
primarily in commercial lines. In addition, catastrophe losses decreased $11.3
million, to $37.7 million, including $15.0 million related to the events of
September 11, 2001, for the nine months ended September 30, 2001, compared to
$49.0 million for the same period in 2000. A net benefit of $2.7 million in 2000
is included in segment income as a result of the aforementioned aggregate excess
of loss reinsurance treaty.
Distribution Channel Results
Distribution channel results are reported using statutory accounting principles,
which are prescribed by state insurance regulators. The primary difference
between statutory and generally accepted accounting principles ("GAAP") is the
deferral of certain underwriting costs under GAAP that are amortized over the
life of the policy. Under statutory accounting principles, these costs are
recognized when incurred or paid. Management reviews the operations of this
business based upon statutory results.
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
The following table summarizes the results of operations for the distribution
channels of the Risk Management segment:
(Unaudited)
Quarter Ended September 30, 2001
---------------------------------------------------------------
Standard Sponsored Specialty
(In millions, except ratios) Markets Markets Markets Other (2) Total
- ------------------------------------------------------------------------------------------------------------
Statutory net premiums written............ $ 396.7 $ 177.6 $ 13.2 $ 0.2 $ 587.7
------- ------- ------- ----- -------
Statutory combined ratio (1).............. 110.3 97.5 265.4 N/M 108.6
------- ------- ------- ----- -------
Statutory underwriting (loss) profit...... $ (42.7) $ (0.1) $ (14.9) $ 0.4 $ (57.3)
------- ------- ------- -----
Reconciliation to segment income:
Net investment income................... 54.2
Other income and expenses, net.......... 5.3
Other Statutory to GAAP adjustments..... 4.6
-------
Segment income $ 6.8
=======
- ------------------------------------------------------------------------------------------------------------
(Unaudited)
Quarter Ended September 30, 2000
---------------------------------------------------------------
Standard Sponsored Specialty
(In millions, except ratios) Markets Markets Markets Other (2) Total
- ------------------------------------------------------------------------------------------------------------
Statutory net premiums written............ $ 388.0 $ 161.8 $ 10.6 $ 1.1 $ 561.5
------- ------- ------- ----- -------
Statutory combined ratio (1).............. 98.6 93.6 149.2 N/M 98.8
------- ------- ------- ----- -------
Statutory underwriting profit (loss)...... $ - $ 6.3 $ (4.9) $(3.6) $ (2.2)
------- ------- ------- -----
Reconciliation to segment income:
Net investment income................... 55.2
Other income and expenses, net.......... 3.3
Other Statutory to GAAP adjustments..... 3.1
-------
Segment income............................ $ 59.4
=======
- ------------------------------------------------------------------------------------------------------------
(1) Statutory combined ratio is a common industry measurement of the results of
property and casualty insurance underwriting. This ratio is the sum of the
ratio of incurred claims and claim expenses to premiums earned and the ratio
of underwriting expenses incurred to premiums written. Federal income taxes,
net investment income and other non-underwriting expenses are not reflected
in the statutory combined ratio.
(2) Includes results from certain property and casualty business which the
Company has exited.
N/M - Not meaningful
22
Standard Markets
- ----------------
Standard Markets' net premiums written increased $8.7 million, or 2.2%, to
$396.7 million for the quarter ended September 30, 2001. This improvement is
primarily attributable to increases of $6.6 million, or 5.0%, $5.6 million, or
7.2%, and $3.0 million, or 6.4%, in the personal automobile, commercial multiple
peril, and homeowners lines, respectively. The increase in the personal
automobile line is primarily the result of a 3.6% increase in policies in force
since September 30, 2000 and a 2.9% net rate increase in Michigan. This is
partially offset by a 5.4% personal automobile net rate decrease in
Massachusetts. Commercial multiple peril net premiums written increased
primarily as the result of a 5.5% increase in policies in force since September
30, 2000 and 8.7% and 6.0% rate increases in Michigan and New York,
respectively. In addition, homeowners' net premiums written increased primarily
as a result of a 10.7% rate increase in Michigan, partially offset by a 0.7%
decrease in policies in force since September 30, 2000. Partially offsetting
these favorable items is a $8.8 million, or 16.8%, decrease in worker's
compensation net premiums written due to the non-renewal of several large
unprofitable commercial accounts in 2001. Third quarter 2000 results reflected a
$3.6 million decrease in net premiums written, resulting from the aforementioned
aggregate excess of loss agreement.
Standard Markets' underwriting results declined $42.7 million to an
underwriting loss of $42.7 million for the quarter ended September 30, 2001.
This is primarily attributable to the aforementioned decrease in favorable
development on prior years' loss reserves. An increase in current year claims
frequency in the personal lines also contributed to the decline in underwriting
results. In addition, increased current year claims severity in the commercial
multiple peril and workers compensation lines unfavorably impacted results.
Catastrophe losses increased $4.2 million to $13.4 million for the third quarter
of 2001, compared to $9.2 million for the same period in 2000. Partially
offsetting these items are approximately $17 million of rate increases,
primarily in the commercial lines. A decrease in current year claims activity
in the commercial automobile line also favorably impacted results in the third
quarter of 2001. A net benefit of $2.6 million in the third quarter of 2000 is
included in segment income as a result of the aforementioned aggregate excess of
loss reinsurance treaty.
Sponsored Markets
- -----------------
Sponsored Markets' net premiums written increased $15.8 million, or 9.8%, to
$177.6 million for the quarter ended September 30, 2001. This increase is
primarily due to increases of $8.3 million, or 6.8%, and $5.6 million, or 14.8%,
in the personal automobile and homeowners lines, respectively. Personal
automobile's net premiums written increased as a result of a 5.0% growth in
policies in force since September 30, 2000 and the aforementioned Michigan net
rate increase, partially offset by the aforementioned Massachusetts net rate
reduction. Homeowners' net premiums written increased primarily due to a 5.3%
growth in policies in force and a 10.7% Michigan rate increase compared to the
same period in 2000. Third quarter 2000 results reflected a $1.7 million
decrease in net premiums written, resulting from the aforementioned aggregate
excess of loss agreement.
Sponsored Markets' underwriting results declined $6.4 million to an underwriting
loss of $0.1 million for the quarter ended September 30, 2001. The decrease in
underwriting results is primarily attributable to approximately a $6 million
decrease in favorable development on prior years' reserves. Increased current
year claim frequency in the personal automobile line unfavorably impacted third
quarter 2001 results. Partially offsetting these items are approximately $7
million of rate increases and an improvement in current year claims severity in
the homeowners line. In addition, catastrophe losses decreased $4.7 million to
$2.1 million in the third quarter of 2001. A net benefit of $1.0 million in the
third quarter of 2000 is included in segment income as a result of the
aforementioned aggregate excess of loss reinsurance treaty.
Specialty Markets
- -----------------
Specialty Markets' net premiums written increased $2.6 million, or 24.5%, to
$13.2 million for the quarter ended September 30, 2001. This increase is
primarily attributable to increases of $0.9 million and $0.6 million in the
commercial multiple peril and commercial automobile lines, respectively.
Commercial multiple peril's net premiums written increased primarily as a result
of a 5.4% growth in policies in force since September 30, 2000 and a decrease in
the utilization of reinsurance. Commercial automobile's net premiums written
increased primarily as a result of significant growth in policies in force since
September 30, 2000 and a decrease in the utilization of reinsurance.
Specialty Markets' underwriting results declined $10.0 million to an
underwriting loss of $14.9 million for the quarter ended September 30, 2001. The
decline in underwriting results is primarily the result of an increase in
current accident year claims severity in the commercial automobile line. In
addition, an absence of ceding commission income from business that has not been
renewed unfavorably impacted results.
23
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
The following table summarizes the results of operations for the distribution
channels of the Risk Management segment:
(Unaudited)
Nine Months Ended September 30, 2001
-----------------------------------------------------------------
Standard Sponsored Specialty
(In millions, except ratios) Markets Markets Markets Other (2) Total
- --------------------------------------------------------------------------------------------------------------
Statutory net premiums written............. $1,184.2 $500.5 $ 47.4 $ 0.8 $1,732.9
-------- ------ ------ ----- --------
Statutory combined ratio (1)............... 106.9 101.9 145.9 N/M 106.5
-------- ------ ------ ----- --------
Statutory underwriting loss................ $ (89.9) $(16.0) $(20.8) $(5.8) $ (132.5)
-------- ------ ------ ----- --------
Reconciliation to segment income:
Net investment income.................... 164.0
Other income and expenses, net........... 15.0
Other Statutory to GAAP adjustments...... 18.0
--------
Segment income............................. $ 64.5
========
- --------------------------------------------------------------------------------------------------------------
(Unaudited)
Nine Months Ended September 30, 2000
---------------------------------------------------------------
Standard Sponsored Specialty
(In millions, except ratios) Markets Markets Markets Other (2) Total
- -------------------------------------------------------------------------------------------------------------
Statutory net premiums written............ $1,150.2 $464.5 $ 28.9 $ 3.8 $1,647.4
-------- ------ ------ ----- --------
Statutory combined ratio (1).............. 101.3 96.4 114.8 N/M 100.5
-------- ------ ------ ----- --------
Statutory underwriting (loss) profit...... $ (32.8) $ 8.7 $ (4.7) $(6.8) $ (35.6)
-------- ------ ------ ----- --------
Reconciliation to segment income:
Net investment income................... 164.8
Other income and expenses, net.......... 8.7
Other Statutory to GAAP adjustments..... 18.5
--------
Segment income............................ $ 156.4
========
- -------------------------------------------------------------------------------------------------------------
(1) Statutory combined ratio is a common industry measurement of the results of
property and casualty insurance underwriting. This ratio is the sum of the
ratio of incurred claims and claim expenses to premiums earned and the
ratio of underwriting expenses incurred to premiums written. Federal income
taxes, net investment income and other non-underwriting expenses are not
reflected in the statutory combined ratio.
(2) Includes results from certain property and casualty business which the
Company has exited.
N/M - Not meaningful
Standard Markets
- ----------------
Standard Markets' net premiums written increased $34.0 million, or 3.0%, to
$1,184.2 million for the nine months ended September 30, 2001. This improvement
is primarily attributable to increases of $20.2 million, or 8.7%, $10.0 million,
or 2.6%, and $7.6 million, or 4.6%, in the commercial multiple peril, personal
automobile lines, and commercial automobile lines, respectively. The increase in
the commercial multiple peril line is primarily the result of a 5.5% increase in
policies in force since September 30, 2000 and 8.7% and 6.0% rate increases in
Michigan and New York, respectively. Personal automobile's net premiums written
increased as a result of a 6.7% growth in policies in force in the Northeast
since September 30, 2000 and a 2.9% Michigan net rate increase. Partially
offsetting these items are a personal automobile net rate decrease of 5.4% in
Massachusetts and a 7.0% decrease in policies in force in the Midwest since
September 30, 2000. Commercial automobile net premiums written increased
primarily as a result of 5.9% and 4.9% rate increases in Michigan and
Massachusetts, respectively, partially offset by a 7.2% decrease in policies in
force since September 30, 2000. Partially offsetting these favorable items is a
$9.9 million, or 6.2%, decrease in workers' compensation's net premiums written
due to the non-renewal of several unprofitable large commercial accounts in
2001. Nine months ended September 30, 2000 results
24
reflected a $3.6 million decrease in net premiums written, resulting from the
aforementioned aggregate excess of loss agreement.
Standard Markets' underwriting losses increased $57.1 million to an underwriting
loss of $89.9 million for the nine months ended September 30, 2001. This is
primarily attributable to the aforementioned decrease in favorable development
on prior years' reserves. An increase in current year claims severity in the
commercial multiple peril line also contributed to the decline in underwriting
results. In addition, increased current accident year claims frequency in
personal lines unfavorably impacted results. Partially offsetting these
unfavorable items are approximately $57 million of rate increases, primarily in
the commercial lines. Catastrophe losses decreased $7.0 million to $25.0
million for the nine months ended September 30, 2001, compared to $32.0 million
for the same period in 2000.
Sponsored Markets
- -----------------
Sponsored Markets' net premiums written increased $36.0 million, or 7.8%, to
$500.5 million for the nine months ended September 30, 2001. This improvement is
primarily due to increases of $19.6 million, or 5.4%, and 14.9 million, or
16.2%, in the personal automobile and homeowners lines, respectively. Personal
automobile's net premiums written increased as a result of a 5.0% growth in
policies in force since September 30, 2000 and the aforementioned Michigan net
rate increase, partially offset by a 5.4% Massachusetts net rate reduction.
Homeowners' net premiums written increased primarily due to a 5.3% growth in
policies in force and a 10.7% Michigan rate increase compared to the same period
in 2000.
Sponsored Markets' underwriting results declined $24.7 million, to an
underwriting loss of $16.0 million, for the nine months ended September 30,
2001. The decline in underwriting results is primarily attributable to
approximately a $31 million decrease in favorable development on prior years'
reserves. In addition, increased claims frequency in the personal automobile
line unfavorably impacted results for the nine months ended September 30, 2001.
This is partially offset by approximately $21 million of rate increases and
improvement in current year claims severity in the homeowners line.
Specialty Markets
- -----------------
Specialty Markets' net premiums written increased $18.5 million, or 64.0%, to
$47.4 million for the nine months ended September 30, 2001. This improvement is
primarily attributable to increases of $10.8 million and $5.9 million in the
commercial automobile and commercial multiple peril lines, respectively.
Commercial automobile's net premiums written increased primarily as a result of
a significant growth in policies in force since September 30, 2000 and a
decrease in the utilization of reinsurance. The increase in commercial multiple
peril's net premiums written is primarily the result of a decrease in the
utilization of reinsurance and a 5.4% growth in policies in force over the prior
year.
Specialty Markets' underwriting results declined $16.1 million, to an
underwriting loss of $20.8 million, for the nine months ended September 30,
2001. The decline in underwriting results is primarily the result of an increase
in current accident year claims severity in the commercial automobile and
commercial multiple peril lines as a result of large losses. In addition, an
absence of ceding commission income from business that has not been renewed also
unfavorably impacted results.
Investment Results
Net investment income before tax was $54.2 million and $55.2 million for the
quarters ended September 30, 2001 and 2000, respectively. The decline of $1.0
million, or 1.8%, is primarily due to the impact of defaulted bonds.
Net investment income before tax was $164.0 million and $164.8 million for the
nine months ended September 30, 2001 and 2000, respectively. The decrease in net
investment income in 2001, compared to 2000, primarily reflects a reduction in
average invested assets and the impact of defaulted bonds, partially offset by
higher yields. This reduction in average invested assets is due to transfers of
cash and securities of $100.0 million to the Corporate segment during the
second quarter of 2001. Average pre-tax yields on debt securities increased to
6.9% in 2001 compared to 6.8% in 2000, due to the shift in investment strategy
providing for investments in taxable securities instead of tax exempt
securities, to maximize after-tax investment yields.
Reserve for Losses and Loss Adjustment Expenses
The Risk Management segment maintains reserves for its property and casualty
products to provide for the Company's ultimate liability for losses and LAE with
respect to reported and unreported claims incurred as of the end of each
accounting period. These reserves are estimates, involving actuarial
projections at a given point in time, of what management expects the ultimate
settlement and administration of claims will cost based on facts and
circumstances then known, predictions of future events, estimates of future
trends in claim severity and judicial theories of liability and other factors.
The inherent uncertainty of estimating insurance reserves is greater for certain
types of property and casualty insurance lines, particularly workers'
compensation and other liability lines, where a longer period of time may elapse
before a definitive determination of ultimate liability may be made, and where
the technological, judicial and political climates involving these types of
claims are changing.
25
The Company regularly updates its reserve estimates as new information becomes
available and further events occur which may impact the resolution of unsettled
claims. Changes in prior reserve estimates are reflected in results of
operations in the period such changes are determined to be needed and recorded.
The table below provides a reconciliation of the beginning and ending reserve
for unpaid losses and LAE as follows:
(Unaudited)
Nine Months Ended
September 30,
---------------------------
(In millions) 2001 2000
- ----------------------------------------------------------------------------------------
Reserve for losses and LAE, beginning of period........... $2,719.1 $2,615.9
Incurred losses and LAE, net of reinsurance recoverable:
Provision for insured events of current year.......... 1,283.4 1,224.8
Increase (decrease) in provision for insured events
of prior years.................................... 31.4 (87.5)
-------- --------
Total incurred losses and LAE......................... 1,314.8 1,137.3
-------- --------
Payments, net of reinsurance recoverable:
Losses and LAE attributable to insured events of
current year.................................... 599.3 589.1
Losses and LAE attributable to insured events of
prior years..................................... 643.2 561.7
-------- --------
Total payments........................................ 1,242.5 1,150.8
-------- --------
Change in reinsurance recoverable on unpaid losses.... (10.4) 44.5
-------- --------
Reserve for losses and LAE, end of period................. $2,781.0 $2,646.9
======== ========
As part of an ongoing process, the reserves have been re-estimated for all prior
accident years and were increased by $31.4 million and decreased $87.5 million
for the nine months ended September 30, 2001 and 2000, respectively.
During the first nine months of 2001, estimated loss reserves for claims
occurring in prior years increased $62.8 million. During the first nine months
of 2000, favorable development on prior years' loss reserves was $39.6 million.
This $102.4 million change is primarily the result of an increase in commercial
lines loss severity, and the Company having captured, in 1999 and 2000, the
accumulated benefits of its claims redesign efforts. These efforts resulted in
reduced reserves related to prior accident years, primarily in the personal
automobile line in the Northeast. The adverse development in 2001 also reflects
additional losses related to fourth quarter 2000 non-catastrophe weather related
claims in Michigan. These claims primarily impacted the personal automobile,
workers' compensation, and commercial multiple peril lines. Favorable
development on prior year's LAE reserves was $31.4 million and $47.9 million for
the nine months ended September 30, 2001 and 2000, respectively. The favorable
development in both periods is primarily attributable to claims process
improvement initiatives taken by the Company over the past three years. Since
1997, the Company has lowered claim settlement costs through increased
utilization of in-house attorneys and consolidation of claims offices. These
measures are substantially complete.
Reserves established for current year losses and LAE consider the factors that
resulted in the favorable development of prior years' loss and LAE reserves
during 2000 and earlier years. Accordingly, current year reserves are modestly
lower, relative to those initially established for similar exposures in years
prior to 2000.
Due to the nature of the business written by the Risk Management segment, the
exposure to environmental liabilities is relatively small and therefore its
reserves are relatively small compared to other types of liabilities. Loss and
LAE reserves related to environmental damage and toxic tort liability, included
in the reserve for losses and LAE, were $36.6 million and $43.4 million, net of
reinsurance of $12.1 million and $5.1 million in the first nine months of 2001
and 2000, respectively. The Company does not specifically underwrite policies
that include this coverage, but as case law expands policy provisions and
insurers' liability beyond the intended coverage, the Company may be required to
defend such claims. The Company estimated its ultimate liability for these
claims based upon currently known facts, reasonable assumptions where the facts
are not known, current law and methodologies currently available. Although these
outstanding claims are not significant, their existence gives rise to
uncertainty and are discussed because of the possibility that they may become
significant. The Company currently believes that recorded reserves related to
these claims are adequate. The environmental liability could be revised if the
estimates used in determining the liability are revised.
26
Inflation generally increases the cost of losses covered by insurance contracts.
The effect of inflation on the Company varies by product. Property and casualty
insurance premiums are established before the amount of losses and LAE, and the
extent to which inflation may affect such expenses are known. Consequently, the
Company attempts, in establishing rates and reserves, to anticipate the
potential impact of inflation in the projection of ultimate costs. The impact
of inflation has been relatively insignificant in recent years. However,
inflation could contribute to increased losses and LAE in the future.
The Company regularly reviews its reserving techniques, its overall reserving
position and its reinsurance. Based on (i) review of historical data,
legislative enactments, judicial decisions, legal developments in impositions of
damages, changes in political attitudes and trends in general economic
conditions, (ii) review of per claim information, (iii) historical loss
experience of the Company and the industry, (iv) the relatively short-term
nature of most policies and (v) internal estimates of required reserves,
management believes that adequate provision has been made for loss reserves.
However, establishment of appropriate reserves is an inherently uncertain
process and there can be no certainty that current established reserves will
prove adequate in light of subsequent actual experience. A significant change to
the estimated reserves could have a material impact on the results of
operations.
Asset Accumulation
- ------------------
Allmerica Financial Services
The following table summarizes the results of operations for the Allmerica
Financial Services segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
----------------- -----------------
(In millions) 2001 2000 2001 2000
- --------------------------------------------------------------------------------------------------
Segment revenues
Premiums............................................ $ 7.4 $ 7.9 $ 40.5 $ 43.2
Fees................................................ 95.0 110.9 294.6 316.1
Net investment income............................... 76.3 70.0 219.5 215.4
Other income........................................ 23.8 28.4 75.4 85.0
------- ------- -------- -------
Total segment revenues.................................. 202.5 217.2 630.0 659.7
Policy benefits, claims and losses...................... 86.1 81.6 258.3 244.3
Policy acquisition and other operating expenses......... 82.0 78.9 250.4 248.8
------- ------- -------- -------
Segment income.......................................... $ 34.4 $ 56.7 $ 121.3 $ 166.6
======= ======= ======== =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
Segment income decreased $22.3 million, or 39.3%, to $34.4 million during the
third quarter of 2001. This decrease reflects lower asset-based fees and other
income, as well as an increase in policy benefits and policy acquisition costs,
partially offset by higher net investment income. The decline in asset-based
fees and other income is principally attributable to a decrease in the market
value of assets under management in the variable product lines, and to lower
brokerage income and investment management fees.
Segment revenues decreased $14.7 million, or 6.8%, in the third quarter of 2001,
primarily due to lower asset-based fees and other income. Fee income decreased
$15.9 million, or 14.3%, to $95.0 million primarily as a result of variable
annuity fees which decreased $9.3 million, or 15.1%. This was primarily due to
a decline in the market value of average variable annuity assets under
management. Other income decreased $4.6 million, or 16.2%, to $23.8 million.
This decline was primarily due to lower brokerage income resulting from a
decrease in mutual fund and general securities transaction volumes as well as
decreased investment management fees due to a decline in variable product assets
under management. An increase in net investment income of $6.3 million
primarily resulted from the investment of higher general account deposits,
including approximately $300 million of deposits from the introduction of a
promotional annuity program, partially offset by the impact of defaulted bonds.
This promotional program offered an enhanced crediting rate of 7% for new
general account deposits, for up to one year. The Company completed this
program in the second quarter of 2001. (See "Investment Portfolio").
27
Policy benefits, claims and losses increased $4.5 million, or 5.5%, to $86.1
million, primarily due to an increase in general account deposits, including the
introduction of the aforementioned promotional annuity program. Additionally,
policy benefits increased $2.9 million as a result of the events of September
11, 2001. These increases were partially offset by the absence in 2001 of
approximately $5.5 million of reserve strengthening in the universal life and
traditional life lines of business. Certain annuity policy benefits include
guaranteed minimum death benefits ("GMDB"). The Company has established reserves
for GMDB based on its best estimate of the long-term cost of GMDB. In recent
quarters, the expenses for this benefit have been approximately $2 million to $3
million per quarter, net of adjustment for deferred policy acquisition cost
amortization. Due to the recent, sustained decline in the financial markets,
this expense is expected to increase by approximately $6 million to $8 million
per quarter, net of adjustment for deferred policy acquisition cost
amortization. Additional declines in the financial markets would further
increase these costs.
Policy acquisition and other operating expenses increased $3.1 million, or 3.9%,
to $82.0 million in the third quarter of 2001 primarily due to higher policy
acquisition costs of $3.7 million. Included in policy acquisition expenses in
2000 were several unusual items, particularly approximately $33.8 million of
reduced expenses related to a change in certain life products actuarial
assumptions and an increase in policy acquisition expenses of approximately
$25.0 million in the annuity line of business, resulting from an increase in
assumed lapse rates. Excluding the effect of the aforementioned unusual items,
policy acquisition costs declined due to lower annuity profits.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000 Segment income decreased $45.3 million, or 27.2%, to $121.3 million during
the first nine months of 2001. This decrease primarily reflects lower asset-
based fees and other income, as well as an increase in policy benefits and other
operating expenses, net of lower deferred acquisition costs. The decline in
asset-based fees and other income is principally attributable to a decrease in
the market value of assets under management in the variable product lines, and
to lower brokerage income and investment management fees.
Segment revenues decreased $29.7 million, or 4.5%, in the first nine months of
2001, primarily due to lower asset-based fees and other income. Fee income
decreased $21.5 million, or 6.8%, to $294.6 million, primarily due to variable
annuity fees which decreased $16.2 million, or 9.1%, primarily due to a decline
in the market value of average variable annuity assets under management. In
addition, non-variable universal life policy fees decreased $8.1 million in the
first nine months of 2001, primarily due to a decline in average invested assets
resulting from the continued shift in focus to variable life insurance and
annuity products. Other income decreased $9.6 million, or 11.3%, to $75.4
million. This decline was primarily due to lower brokerage income resulting
from a decrease in mutual fund and general securities transaction volumes, as
well as decreased investment management fees resulting from depreciation in
variable product assets under management. Net investment income increased $4.1
million primarily due to additional income from the investment of higher general
account deposits, including deposits from the aforementioned promotional annuity
program. This increase was partially offset by the impact of defaulted bonds and
by lower average mortgage investments and yields.
Policy benefits, claims and losses increased $14.0 million, or 5.7%, to $258.3
million in the first nine months of 2001, primarily due to an increase in
general account deposits, including the introduction of the aforementioned
promotional annuity program, and to less favorable mortality experience in the
individual variable universal life product line. Additionally, policy benefits
increased by $2.9 million as a result of the events of September 11, 2001. These
increases were partially offset by the absence in 2001 of the aforementioned
reserve strengthening in the universal life and traditional life lines of
business of approximately $5.5 million and more favorable mortality experience
in the traditional life line of business in the current year.
Policy acquisition and other operating expenses increased $1.6 million, or 0.6%,
to $250.4 million in the first nine months of 2001. Other operating expenses
increased approximately $10.9 million, primarily as a result of increased
distribution and technology costs. This increase was partially offset by a $9.3
million decrease in policy acquisition expenses, primarily due to lower annuity
profits.
28
Statutory Premiums and Deposits
The following table sets forth statutory premiums and deposits by product for
the Allmerica Financial Services segment.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------------ -----------------------
(In millions) 2001 2000 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------
Insurance:
Traditional life.................................... $ 7.5 $ 8.0 $ 31.5 $ 33.6
Universal life...................................... 2.8 3.2 12.2 13.7
Variable universal life............................. 47.8 51.0 149.1 153.7
Individual health................................... - 0.1 0.2 0.2
Group variable universal life....................... 8.1 13.7 67.4 43.8
------ ------ -------- --------
Total insurance............................... 66.2 76.0 260.4 245.0
------ ------ -------- --------
Annuities:
Separate account annuities.......................... 435.3 617.7 1,414.6 1,973.1
General account annuities........................... 180.8 123.5 737.2 387.6
Retirement investment accounts...................... 1.3 2.1 5.2 8.2
------ ------ -------- --------
Total individual annuities.................... 617.4 743.3 2,157.0 2,368.9
Group annuities..................................... 19.8 119.2 185.0 378.5
------ ------ -------- --------
Total annuities............................... 637.2 862.5 2,342.0 2,747.4
------ ------ -------- --------
Total premiums and deposits.............................. $703.4 $938.5 $2,602.4 $2,992.4
====== ====== ======== ========
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
Total premiums and deposits decreased $235.1 million, or 25.1%, to $703.4
million. These decreases are primarily due to lower separate account and group
annuity deposits, partially offset by higher general account deposits. The
Company believes that the lower separate account and group annuity deposits
reflect an industry-wide trend resulting from a general decline in the equity
markets. In addition, group annuity deposits decreased due to the Company's
decision to exit its defined contribution retirement plan business and to cease
marketing activities for new defined benefit retirement business. Partially
offsetting these decreases were higher annuity deposits into the Company's
general account, resulting in part, from the aforementioned promotional annuity
program.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
For the nine months ended September 30, 2001, total premiums and deposits
decreased $390.0 million, or 13.0%, to $2,602.4 million. These decreases are
primarily due to lower separate account and group annuity deposits resulting
from the aforementioned general decline in the equity markets and to the
aforementioned activities regarding the Company's defined contribution and
defined benefit lines of business. Partially offsetting these decreases were
higher annuity deposits into the Company's general account resulting, in part,
from the aforementioned promotional annuity program.
Annuity products are distributed primarily through three distribution channels:
(1) "Agency", which consists of the Company's career agency force; (2) "Select",
which consists of a network of third party broker-dealers; and (3) "Partners",
which includes distributors of the mutual funds advised by Zurich Scudder
Investments ("Zurich-Scudder"), Pioneer Investment Management, Inc. and Delaware
Management Company. Select, Partners, and Agency represented, respectively,
approximately 38%, 37%, and 25% of individual annuity deposits in the first nine
months of 2001, and Zurich-Scudder represented 27% of all individual annuity
deposits. During the first nine months of 2000, Select, Partners, and Agency
represented, respectively, approximately 25%, 46%, and 29% of individual annuity
deposits. The increase in deposits within the Select channel resulted primarily
from the aforementioned promotional annuity program which was only available in
the Select channel, and to a significant expansion of the number of wholesalers
in this channel.
29
Allmerica Asset Management
The following table summarizes the results for the Allmerica Asset Management
segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
---------------- ------------------
(In millions) 2001 2000 2001 2000
- --------------------------------------------------------------------------------------------------
Interest margins on GICs
Net investment income.............................. $ 37.1 $ 38.1 $ 113.5 $ 96.6
Interest credited.................................. 32.2 33.4 99.8 84.3
------ ------ -------- -------
Net interest margin................................... 4.9 4.7 13.7 12.3
------ ------ -------- -------
Fees and other income
External........................................... 1.7 1.7 4.5 4.8
Internal........................................... 1.3 1.2 4.0 3.8
Other operating expenses.............................. (1.8) (1.8) (5.7) (5.4)
------ ------ -------- -------
Segment income........................................ $ 6.1 $ 5.8 $ 16.5 $ 15.5
====== ====== ======== =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
Segment income increased $0.3 million, or 5.2%, to $6.1 million during the third
quarter of 2001. This increase is primarily due to increased earnings on
guaranteed investment contracts ("GICs"). Additional long-term funding
agreement deposits were approximately $74.0 million in the third quarter of
2001. The rating agency actions described in "Recent Developments" may
negatively impact the GIC line of business in future periods.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
Segment income increased $1.0 million, or 6.5%, to $16.5 million in the first
nine months of 2001. This increase is primarily due to increased earnings on
GICs, partially offset by a decrease in fees and other income related to
external clients. Earnings on GICs increased in 2001 primarily due to
additional long-term funding agreement deposits of $1.2 billion, partially
offset by lower investment income due to defaults on certain bonds supporting
GIC obligations. The decrease in external fees and other income primarily
resulted from a decrease in management fees from a securitized investment
portfolio, partially offset by an increase in new external assets under
management.
Corporate
The following table summarizes the results of operations for the Corporate
segment for the periods indicated.
(Unaudited) (Unaudited)
Quarter Ended Nine Months Ended
September 30, September 30,
------------------ ------------------
(In millions) 2001 2000 2001 2000
- --------------------------------------------------------------------------------------------------
Segment revenues
Net investment income................................ $ 2.1 $ 2.2 $ 4.6 $ 4.9
Interest expense....................................... 3.8 3.8 11.4 11.4
Other operating expenses............................... 14.0 12.1 40.7 33.9
------- ------- ------- -------
Segment loss........................................... $ (15.7) $ (13.7) $ (47.5) $ (40.4)
======= ======= ======= =======
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
Segment loss increased $2.0 million, or 14.6%, to $15.7 million in the third
quarter of 2001 primarily due to an increase in employee related costs, higher
technology expenses and the timing of certain corporate overhead costs.
Interest expense for both periods relates to the interest paid on the Senior
Debentures of the Company.
30
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
Segment loss increased $7.1 million, or 17.6%, to $47.5 million in the
first nine months of 2001 primarily due to the timing of certain corporate
overhead expenses, increased technology costs and certain corporate overhead
expenses previously allocated to other operating segments.
Interest expense for both periods relates to the interest paid on the Senior
Debentures of the Company.
Investment Portfolio
The Company held general account investment assets diversified across several
asset classes, as follows:
(Unaudited)
September 30, 2001 December 31, 2000
-------------------------------------------------------------------
Carrying % of Total Carrying % of Total
(Dollars in millions) Value Carrying Value Value Carrying Value
- -----------------------------------------------------------------------------------------------------------------------
Fixed maturities (1)................................ $ 9,221.1 84.1% $8,118.0 83.9%
Equity securities (1)............................... 56.2 0.5 85.5 0.9
Mortgages........................................... 548.5 5.0 617.6 6.4
Policy loans........................................ 382.0 3.5 381.3 3.9
Cash and cash equivalents........................... 600.9 5.5 281.1 2.9
Other long-term investments......................... 159.4 1.4 193.2 2.0
--------- ----- -------- -----
Total.......................................... $10,968.1 100.0% $9,676.7 100.0%
========= ===== ======== =====
(1) The Company carries fixed maturities and equity securities in its investment
portfolio at market value.
Total investment assets increased $1.3 billion, or 13.3%, to $11.0 billion
during the first nine months of 2001. This increase consisted primarily of
additional fixed maturities of $1.1 billion and additional cash and cash
equivalents of $319.8 million. The increase in fixed maturities and cash and
cash equivalents is primarily due to the investment of funds received from the
sale of GICs by the Allmerica Asset Management segment, as well as an increase
in general account deposits, including those related to the aforementioned
promotional annuity program, in the Allmerica Financial Services segment. Also,
a shift in assets from the Company's separate accounts to its general accounts
and the timing of investment purchases in the Allmerica Financial Services
segment contributed to these increases.
The Company's fixed maturity portfolio is comprised of primarily investment
grade corporate securities, tax-exempt issues of state and local governments,
U.S. government and agency securities and other issues. Based on ratings by the
National Association of Insurance Commissioners, investment grade securities
comprised 89.5% and 88.1% of the Company's total fixed maturity portfolio at
September 30, 2001 and December 31, 2000, respectively. The average yield on
fixed maturities was 7.4% for the nine months ended September 30, 2001 and 2000.
Although management expects that new funds will be invested primarily in
investment grade fixed maturities, the Company may invest a portion of new funds
in below investment grade fixed maturities or equity interests.
As a result of the Company's exposure to below investment grade securities, the
Company recognized $118.5 million and $30.0 million of realized losses on other
than temporary impairments of fixed maturities during the first nine months of
2001 and 2000, respectively. The losses reflect the continued deterioration of
the high-yield market. The recognition of these losses followed the review of
recent defaults on interest payments, financial information from issuers,
estimated future cash flows and other trends in the high-yield market. In
addition, the Company had fixed maturity securities with a carrying value of
$15.3 million and $7.5 million on non-accrual status at September 30, 2001 and
December 31, 2000, respectively. No assurance can be given that the fixed
maturity impairments will, in-fact, be adequate to cover future losses or that
substantial additional impairments will not be required in the future.
The effect of holding securities for which income is not accrued, compared with
amounts that would have been recognized in accordance with the original terms of
the investments, was a reduction in net investment income of $9.2 million and
$2.6 million for the nine months ended September 30, 2001 and 2000,
respectively. This includes the impact of securities held as of the
aforementioned financial statement dates, as well as those securities sold
during the period. Management expects that defaults in the fixed maturities
portfolio may continue to negatively impact investment income.
31
Income Taxes
AFC and its domestic subsidiaries (including certain non-insurance operations)
file a consolidated United States federal income tax return. Entities included
within the consolidated group are segregated into either a life insurance or a
non-life insurance company subgroup. The consolidation of these subgroups is
subject to certain statutory restrictions on the percentage of eligible non-life
tax losses that can be applied to offset life company taxable income.
Quarter Ended September 30, 2001 Compared to Quarter Ended September 30, 2000
The provision for federal income taxes before minority interest, discontinued
operations and the effect of a change in accounting principle was an $11.4
million benefit during the third quarter of 2001 compared to a $13.1 million
expense during the same period in 2000. These provisions resulted in
consolidated effective federal tax rates of (47.9%) and 16.5% for the quarters
ended September 30, 2001 and 2000, respectively. The decrease in the rate is
primarily due to lower underwriting income, both for the current quarter and
anticipated for the full year. This resulted in an increase in the proportion
of tax-exempt investment income to pre-tax income in the current quarter, as
well as a reduction in the tax rate expected for the full year. Also, in the
current quarter, the Company recognized a benefit related to the dividends
received deduction associated with its variable products. The Company did not
recognize such benefit in any of the first three quarters of 2000.
Nine Months Ended September 30, 2001 Compared to Nine Months Ended September 30,
2000
The provision for federal income taxes before minority interest, discontinued
operations and the effect of a change in accounting principle was a $6.7 million
benefit during the first nine months of 2001 compared to a $29.0 million expense
during the same period in 2000. These provisions resulted in consolidated
effective federal tax rates of (8.8%) and 16.0% for the nine months ended
September 30, 2001 and 2000, respectively. The decrease in the rate is primarily
due to lower underwriting income and increased realized losses in the first nine
months of 2001 resulting in an increase in the proportion of tax-exempt
investment income to pre-tax income, as well as to the recognition of the
dividends received deduction associated with the Company's variable products.
Liquidity and Capital Resources
Liquidity describes the ability of a company to generate sufficient cash flows
to meet the cash requirements of business operations. As a holding company,
AFC's primary source of cash is dividends from its insurance subsidiaries.
However, dividend payments to AFC by its insurance subsidiaries are subject to
limitations imposed by state regulators, such as the requirement that cash
dividends be paid out of unreserved and unrestricted earned surplus and
restrictions on the payment of "extraordinary" dividends, as defined. During
the first nine months of 2001, AFC received $100.0 million of dividends from its
property and casualty businesses. Additional dividends from the Company's
insurance subsidiaries in 2001 would be considered "extraordinary" and would
require prior approval from the respective state regulators. The Company does
not expect dividend payments from its life insurance subsidiaries in 2002.
Sources of cash for the Company's insurance subsidiaries are from premiums and
fees collected, investment income and maturing investments. Primary cash
outflows are paid benefits, claims, losses and loss adjustment expenses, policy
acquisition expenses, other underwriting expenses and investment purchases.
Cash outflows related to benefits, claims, losses and loss adjustment expenses
can be variable because of uncertainties surrounding settlement dates for
liabilities for unpaid losses and because of the potential for large losses
either individually or in the aggregate. The Company periodically adjusts its
investment policy to respond to changes in short-term and long-term cash
requirements.
Net cash provided by operating activities was $422.2 million and $197.5 million
during the first nine months of 2001 and 2000, respectively. The increase in
2001 is primarily the result of higher general account deposits, including funds
received from the aforementioned promotional annuity program, and to an increase
in premiums received from the property and casualty business. These increases
in cash were partially offset by increased loss and LAE payments in the property
and casualty business.
Net cash used in investing activities was $802.1 million and $816.9 million
during the first nine months of 2001 and 2000, respectively. The decrease in
cash used in 2001 is primarily the result of year over year declines in
purchases of mortgages, joint venture investments, and company owned life
insurance, partially offset by higher net purchases of fixed maturities. Net
purchases of fixed maturities increased primarily due to the timing of investing
new funding agreement deposits and from additional deposits into the general
account, including those related to the aforementioned promotional annuity
program.
32
Net cash provided by financing activities was $699.7 million and $491.6 million
during the first nine months of 2001 and 2000, respectively. The increase in
2001 is primarily due to an increase in net funding agreement deposits,
including trust instruments supported by funding obligations, of $157.7 million
and a $44.4 million year over year reduction in cash used for the Company's
share repurchase program.
In the opinion of management, AFC has sufficient funds at the holding company or
available through dividends from its insurance subsidiaries, or through
available credit facilities to meet its obligations to pay interest on the
Senior Debentures, Capital Securities and dividends, when and if declared by the
Board of Directors, on the common stock. On October 23, 2001, the Board of
Directors declared an annual dividend of $0.25 per share on the issued and
outstanding common stock of the Company, payable November 20, 2001 to
shareholders of record at the close of business November 5, 2001.
Based on current trends, the Company expects to continue to generate sufficient
positive operating cash to meet all short-term and long-term cash requirements.
The Company maintains a high degree of liquidity within the investment portfolio
in fixed maturity investments, common stock and short-term investments. AFC has
$215.0 million available under a committed syndicated credit agreement, which
expires on May 24, 2002. Borrowings under this agreement are unsecured and incur
interest at a rate per annum equal to, at the Company's option, a designated
base rate or the eurodollar rate plus applicable margin. At September 30, 2001,
no amounts were outstanding under this agreement. The Company had $71.0 million
of commercial paper borrowings outstanding at September 30, 2001. These
borrowings are used in connection with the Company's premium financing business,
which is included in the Risk Management segment.
Recent Developments
During the third quarter of 2001, the Company was informed of rating decisions
made by three rating agencies. A.M. Best re-affirmed the "A" (Excellent)
financial strength ratings assigned to the life insurance and property and
casualty insurance companies. In addition, Fitch rating service, formerly Duff
& Phelps, re-affirmed the "AA" (Very High) claims paying ability ratings of the
life insurance companies. Moody's Investors Service also re-affirmed the life
and property and casualty insurance companies' financial strength ratings of
"A1" (Good), but revised the outlook for the life insurance companies' ratings
to negative from stable. Rating downgrades from current levels may adversely
impact the Company's product sales and its results of operations.
Additionally, during the third quarter of 2001, A.M. Best re-affirmed the "A-"
senior debt rating and the "bbb+" Capital Securities rating and Fitch re-
affirmed its "A+" senior debt rating assigned to the Company. Moody's placed
the Company's "A2" senior debt rating, "a2" Capital Securities rating, and "P1"
short-term debt rating on review for possible downgrade. Rating downgrades from
current levels may adversely affect the cost of any additional debt financing.
For the nine months ended September 30, 2001 and 2000, the Company recognized
net expenses (benefits) of $3.9 million and ($9.3) million, respectively,
related to its employee pension plans. The expense or benefit related to the
pension plans results from several factors, including changes in the market
value of plan assets, interest rates and employee compensation levels. The net
benefit in 2000 primarily reflected increases in the market value of plan assets
in 1999 and prior years, while the net expense in 2001 primarily reflected a
decline in the market value of plan assets in 2000. In 2002, management expects
a significant increase in employee pension plan costs due to an expected decline
in the market value of plan assets and interest rates in 2001. Such increases
may negatively affect the Company's results of operations.
The Risk Management segment recently enhanced its agency management and review
process, evaluating its approximately 2600 existing agencies. The result of this
process was the identification of approximately 600 agencies that do not meet
certain profitability standards or are not strategically aligned with the
Company. For these agents, the Company intends to either terminate the
relationship or restrict the agent's access to certain types of policies.
Management currently expects this process may result in lower annual written
premium of approximately $200 million. However, the Company anticipates improved
profitability as a result of expected lower losses incurred. Due to contractual
and regulatory requirements, there will be a termination period in which the
Company is obligated to renew existing policies, typically 12-18 months. There
can be no assurance that the anticipated improvement in profitability will
materialize.
33
Contingencies
The Company's insurance subsidiaries are routinely engaged in various legal
proceedings arising in the normal course of business, including claims for
punitive damages. Additional information on other litigation and claims may be
found in Note 12 "Commitments and Contingencies - Litigation" to the
consolidated financial statements. In the opinion of management, none of such
contingencies are expected to have a material effect on the Company's
consolidated financial position, although it is possible that the results of
operations in a particular quarter or annual period would be materially affected
by an unfavorable outcome.
Forward-Looking Statements
The Company wishes to caution readers that the following important factors,
among others, in some cases have affected and in the future could affect, the
Company's actual results and could cause the Company's actual results for 2001
and beyond to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Company. When used in the MD&A
discussion, the words "believes", "anticipated", "expects" and similar
expressions are intended to identify forward looking statements. See "Important
Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2.
Factors that may cause actual results to differ materially from those
contemplated or projected, forecast, estimated or budgeted in such forward
looking statements include among others, the following possibilities: (i)
adverse catastrophe experience and severe weather; (ii) adverse loss development
for events the Company has insured in either the current or in prior years or
adverse trends in mortality and morbidity; (iii) heightened competition,
including the intensification of price competition, the entry of new
competitors, and the introduction of new products by new and existing
competitors, or as the result of consolidation within the financial services
industry and the entry of additional financial institutions into the insurance
industry; (iv) adverse state and federal legislation or regulation, including
decreases in rates, limitations on premium levels, increases in minimum capital
and reserve requirements, benefit mandates, limitations on the ability to manage
care and utilization, requirements to write certain classes of business and
recent and future changes affecting the tax treatment of insurance and annuity
products, as well as continued compliance with state and federal regulations;
(v) changes in interest rates causing a reduction of investment income or in the
market value of interest rate sensitive investments; (vi) failure to obtain new
customers, retain existing customers or reductions in policies in force by
existing customers; (vii) difficulties in recruiting new or retaining existing
career agents, wholesalers, broker-dealers and partnership relations to support
the sale of variable products; (viii) higher service, administrative, or general
expense due to the need for additional advertising, marketing, administrative or
management information systems expenditures; (ix) loss or retirement of key
executives; (x) increases in costs, particulary those occurring after the time
our products are priced and including construction, automobile, and medical and
rehabilitation costs; (xi) changes in the Company's liquidity due to changes in
asset and liability matching; (xii) restrictions on insurance underwriting;
(xiii) adverse changes in the ratings obtained from independent rating agencies,
such as Fitch, Moody's, Standard and Poor's and A.M. Best; (xiv) lower
appreciation on or decline in value of the Company's managed investments or the
investment markets in general, resulting in reduced variable product sales,
assets and related variable product, management and brokerage fees, lapses and
increased surrenders, as well as increased cost of guaranteed minimum death
benefits/decreased account balances supporting our guaranteed benefits products;
(xv) possible claims relating to sales practices for insurance products; (xvi)
failure of a reinsurer of the Company's policies to pay its liabilities under
reinsurance contracts or adverse effects on the cost and availability of
reinsurance resulting from the September 11 terrorist attack; (xvii) earlier
than expected withdrawals from the Company's general account annuities, GICs
(including funding agreements), and other insurance products; (xviii) changes in
the mix of assets comprising the Company's investment portfolio and the
fluctuation of the market value of such assets; (xix) losses resulting from the
Company's participation in certain reinsurance pools; (xx) losses due to foreign
currency fluctuations; (xxi) defaults in debt securities held by the Company,
and (xxii) higher employee benefit costs due to changes in market values of plan
assets, interest rates and employee compensation levels.
34
PART I - FINANCIAL INFORMATION
ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Our market risks, and the ways we manage them, are summarized in management's
discussion and analysis of financial condition and results of operations as of
December 31, 2000, included in the Company's Form 10-K for the year ended
December 31, 2000. There have been no material changes in the first nine months
of 2001 to such risks or our management of such risks.
35
PART II - OTHER INFORMATION
ITEM 6
EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EX - 99.2 Important Factors Regarding Forward Looking Statements
(b) Reports on Form 8-K
None
36
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Allmerica Financial Corporation
-------------------------------
Registrant
Dated November 13, 2001
------------------
/s/ John F. O'Brien
-------------------------------------------
John F. O'Brien
President and Chief Executive Officer
Dated November 13, 2001
------------------
/s/ Edward J. Parry III
-------------------------------------------
Edward J. Parry III
Vice President, Chief Financial Officer and
Principal Accounting Officer
37
EXHIBIT INDEX
Exhibit Number Exhibit
- -------------- -------
99.2 Important Factors Regarding Forward Looking Statements
38