Five Year Summary of Selected Financial Highlights
For the Years Ended December 31
(In millions) 1997 1996 1995 1994 1993
================================================================================================================================
Statement of Income
................................................................................................................................
Revenues
Premiums $ 2,311.1 $ 2,236.3 $ 2,222.8 $ 2,181.8 $ 2,079.3
Universal life and investment product policy fees 237.3 197.2 172.4 156.8 143.7
Net investment income 653.4 672.6 710.5 743.1 782.8
Net realized gains 76.2 65.9 39.8 1.1 159.6
Other income 117.6 105.6 109.3 124.7 82.8
................................................................................................................................
Total revenues 3,395.6 3,277.6 3,254.8 3,207.5 3,248.2
................................................................................................................................
Benefits, Losses and Expenses
Policy benefits, claims, losses and loss adjustment expenses 2,004.7 1,957.0 2,010.3 2,047.0 1,987.2
Policy acquisition expenses 425.1 470.1 470.9 475.7 435.8
Loss from cession of disability income business 53.9 -- -- -- --
Other operating expenses 546.4 518.8 471.8 531.3 430.3
................................................................................................................................
Total benefits, losses and expenses 3,030.1 2,945.9 2,953.0 3,054.0 2,853.3
................................................................................................................................
Income before federal income taxes 365.5 331.7 301.8 153.5 394.9
Federal income tax expense 93.6 75.2 82.7 53.4 74.7
................................................................................................................................
Income before minority interest, extraordinary item
and cumulative effect of accounting changes 271.9 256.5 219.1 100.1 320.2
Minority interest (62.7) (74.6) (73.1) (51.0) (122.8)
................................................................................................................................
Income before extraordinary item and cumulative
effect of accounting changes 209.2 181.9 146.0 49.1 197.4
Extraordinary item - demutualization expenses -- -- (12.1) (9.2) (4.6)
Cumulative effect of accounting changes -- -- -- (1.9) (35.4)
................................................................................................................................
Net income $ 209.2 $ 181.9 $ 133.9 $ 38.0 $ 157.4
================================================================================================================================
Adjusted Net Income (1) $ 181.0 $ 137.9 $ 116.4 $ 90.4 $ 119.1
================================================================================================================================
Balance Sheet (at December 31)
................................................................................................................................
Total assets $ 22,549.0 $ 18,970.3 $ 17,757.7 $ 15,921.5 $ 15,378.4
Long-term debt 202.1 202.2 202.3 2.7 --
Total liabilities 19,714.8 16,461.6 15,425.0 14,299.4 13,711.7
Minority interest 452.9 784.0 758.5 629.7 615.8
Shareholders' equity 2,381.3 1,724.7 1,574.2 992.4 1,050.9
(1) Represents net income adjusted for certain items which management believes
are not indicative of overall operating trends, including net realized
investment gains (losses), net gains and losses on disposals of businesses,
extraordinary items, the cumulative effect of accounting changes and
differential earnings tax adjustments. While these items may be significant
components in understanding and assessing the Company's financial performance,
management believes adjusted net income enhances an investor's 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.
25
Management's Discussion and Analysis of Financial
Condition and Results of Operations
The following analysis of the consolidated results of operations and financial
condition of the Company should be read in conjunction with the Consolidated
Financial Statements and related consolidated footnotes included elsewhere
herein.
Introduction
................................................................................
The results of operations for Allmerica Financial Corporation and subsidiaries
("AFC" or "the Company") include the accounts of AFC, First Allmerica Financial
Life Insurance Company ("FAFLIC"), its wholly-owned life insurance subsidiary,
Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), Allmerica
Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned
non-insurance holding company), The Hanover Insurance Company ("Hanover", a
wholly-owned subsidiary of Allmerica P&C), Citizens Corporation ("Citizens", an
82.5%-owned subsidiary of Hanover), Citizens Insurance Company of America (a
wholly-owned subsidiary of Citizens) and certain other insurance and
non-insurance subsidiaries.
The results of operations reflect minority interest in Allmerica P&C and its
subsidiary, Hanover, of approximately 40.5% prior to the merger on July 16,
1997. The results of operations also reflect minority interest in Citizens.
Closed Block
................................................................................
On completion of its demutualization, FAFLIC established a Closed Block for the
payment of future benefits, policyholders' dividends and certain expenses and
taxes relating to certain classes of policies. FAFLIC allocated to the Closed
Block an amount of assets expected to produce cash flows which, together with
anticipated revenues from the Closed Block business, are reasonably expected to
be sufficient to support the Closed Block business. The Closed Block includes
only those revenues, benefit payments, dividends and premium taxes considered in
funding the Closed Block and excludes many costs and expenses associated with
operating the Closed Block and administering the policies included therein.
Since many expenses related to the Closed Block were excluded from the
calculation of the Closed Block contribution, the contribution from the Closed
Block does not represent the actual profitability of the Closed Block. As a
result of such exclusion, operating costs and expenses outside the Closed Block
are disproportionate to the business outside of the Closed Block.
The contribution from the Closed Block is included in `Other income' in the
Consolidated Financial Statements. The pre-tax contribution from the Closed
Block was $9.1 million and $8.6 million for the years ended December 31, 1997
and 1996, respectively, and $2.9 million for the period October 1, 1995 (date
used to estimate financial information for the date of establishment of October
16, 1995) through December 31, 1995.
FAFLIC's conversion to a stock life insurance company, which was completed on
October 16, 1995, and the establishment of the Closed Block have affected the
presentation of the Company's Consolidated Financial Statements. For
comparability with prior periods, the following table presents the results of
operations of the Closed Block for the years ended December 31, 1997 and 1996
and the period October 1, 1995 through December 31, 1995 combined with the
results of operations outside the Closed Block for the years then ended.
Management's discussion and analysis addresses the results of operations as
combined unless otherwise noted.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Revenues
Premiums $ 2,369.2 $ 2,298.0 $ 2,234.3
Universal life and investment
product policy fees 237.3 197.2 172.4
Net investment income 706.8 725.2 723.3
Net realized investment gains 77.5 65.2 19.1
Realized gain on sale of mutual
fund processing business -- -- 20.7
Other income 108.7 97.0 106.4
................................................................................
Total revenues 3,499.5 3,382.6 3,276.2
................................................................................
Benefits, Losses and Expenses
Policy benefits, claims, losses
and loss adjustment expenses 2,105.2 2,058.2 2,030.9
Policy acquisition expenses 428.1 473.3 471.7
Loss from cession of disability
income business 53.9 -- --
Other operating expenses 546.8 519.4 471.8
................................................................................
Total benefits, losses
and expenses 3,134.0 3,050.9 2,974.4
................................................................................
Income before federal income taxes 365.5 331.7 301.8
................................................................................
Federal income tax expense (benefit)
Current 79.7 90.9 119.7
Deferred 13.9 (15.7) (37.0)
................................................................................
Total federal income
tax expense 93.6 75.2 82.7
................................................................................
Income before minority interest
and extraordinary item 271.9 256.5 219.1
Minority interest (62.7) (74.6) (73.1)
................................................................................
Income before extraordinary item 209.2 181.9 146.0
Extraordinary item -
demutualization expenses -- -- (12.1)
................................................................................
Net income $ 209.2 $ 181.9 $ 133.9
- --------------------------------------------------------------------------------
26
Results Of Operations
Consolidated Overview
................................................................................
The Company's consolidated net income increased $27.3 million to $209.2 million
in 1997 and $48.0 million to $181.9 million in 1996. Net income includes certain
items which management believes are not indicative of overall operating trends.
The following table reflects consolidated net income adjusted for these items,
all net of taxes and minority interest as applicable.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Net income $ 209.2 $ 181.9 $ 133.9
Adjustments:
Net realized investment gains (37.5) (31.0) (8.5)
Net gain on sale of mutual fund
processing business -- -- (13.5)
Extraordinary item-
demutualization expense -- -- 12.1
Contingency payment from sale of
mutual fund processing business -- (3.1) --
Restructuring costs 4.4 0.3 --
Loss from cession of disability
income business 35.0 -- --
Gain from change in mortality
assumptions (30.5) -- --
Differential earnings tax adjustment -- (10.2) (7.6)
Other non-operating items 0.4 -- --
................................................................................
Adjusted net income $ 181.0 $ 137.9 $ 116.4
================================================================================
1997 Compared to 1996
The increase in adjusted net income of $43.1 million, or 31.3% is primarily
attributable to pre-tax increases of $20.6 million in the Allmerica Financial
Services segment, $13.3 million in the Institutional Services segment, $7.4
million in the Regional Property and Casualty segment, and $24.7 million of
reduced minority interest due to the recent merger with Allmerica P&C. These
increases were partially offset by additional losses of $17.6 million in the
Corporate segment. The increase in the Allmerica Financial Services segment was
primarily attributable to growth in variable product lines, partially offset by
lower net investment income due to a reduction in general account assets. The
increase in the Institutional Services segment was primarily due to improved
interest margins on Guaranteed Investment Contracts ("GICs"). Additionally, the
Regional Property &Casualty segment's contribution increased primarily due to a
$20.3 million growth of net investment income, partially offset by a $10.8
million increase in underwriting losses. These increases were partially offset
by losses in the Corporate segment principally from distributions on the
mandatorily redeemable preferred securities of a subsidiary trust holding solely
junior subordinated debentures of the Company ("Capital Securities") issued
February 3, 1997.
Premium revenue increased $71.2 million, or 3.1%, to $2,369.2 in 1997. Net
premiums earned in the Regional Property and Casualty segment increased $54.8
million, or 2.9%, to $1,953.1 million, reflecting an increase in policies in
force in the personal and commercial automobile lines at Hanover of 6.7% and
7.0%, respectively, as well as an increase in assumed commercial premiums in
Hanover's reinsurance division. The growth in Citizens' personal lines is
primarily due to rate increases in the personal automobile and homeowners lines
and a 2.8% increase in policies in force in the homeowners line. These increases
were partially offset by rate decreases in the workers' compensation lines at
both Hanover and Citizens. Premiums in the Corporate Risk Management Services
segment increased $30.1 million, or 9.9%, to $333.0 million, primarily due to
growth in reinsurance, fully insured group dental and stop loss product lines.
These increases were partially offset by decreases in the risk sharing product
line, reflecting the Company's emphasis on stop loss coverage and administrative
service only ("ASO") arrangements. Premiums in the Allmerica Financial Services
segment decreased $13.6 million, or 14.2%, to $82.1 million, primarily due to
the cession in the fourth quarter of 1997 of the Company's individual disability
income line of business and the Company's continued shift in focus from
traditional life insurance products to variable life insurance and annuity
products.
Universal life and investment product policy fees increased $40.1 million, or
20.3%, to $237.3 million in 1997. This was primarily the result of additional
deposits and appreciation on variable products' account balances.
Net investment income before taxes decreased $18.4 million, or 2.5%, to $706.8
million during 1997. This decrease primarily reflects a reduction in invested
assets due to continued withdrawals of GIC deposits, the effect of the cession
of the disability income line, the continued shift in focus from traditional
life insurance products to variable life and annuity products and reduced
partnership income. These decreases were partially offset by income earned from
the temporary investment of the proceeds from the Company's February 1997
issuance of Capital Securities and an increase in average invested fixed
maturities in the Regional Property and Casualty segment. The Company's average
gross yields for the investment portfolio increased from 7.2% in 1996 to 7.3% in
1997.
Net realized gains on investments were $77.5 million and $65.2 million, before
taxes, and $50.4 million and $42.4 million, after taxes, in 1997 and 1996,
respectively. Through the first quarter of 1997, the Regional Property and
Casualty segment continued its investment strategy to shift its portfolio from
equity investments to tax-exempt and higher-yielding debt securities. This
resulted in the sale of a portion of its equity portfolio and consequently, the
Regional Property and Casualty segment realized additional gains of $3.8 million
on an after-tax basis in 1997. Realized gains, on an after-tax basis, in the
Allmerica Financial Services and Institutional Services segments increased $2.1
million and $1.8 million, respectively.
27
Other income increased $11.7 million, or 12.1%, to $108.7 million in 1997.
Other income from the Allmerica Financial Services segment increased $8.8
million, or 30.1%, to $38.0 million due to increased investment management fee
income resulting from growth in assets under management. Additionally, other
income increased $3.8 million, or 10.4%, to $40.4 million in the Corporate Risk
Management Services segment due to growth in ASO and contract fees.
Policy benefits, claims, losses and loss adjustment expenses ("LAE") increased
$47.0 million, or 2.3%, to $2,105.2 million during 1997. This increase is
primarily due to a $62.1 million, or 4.5%, increase in losses and LAE in the
Company's Regional Property and Casualty segment primarily attributable to a
decrease in favorable development on prior year reserves in Hanover's personal
automobile, homeowners and commercial multiple peril lines, an increase in
claims activity in Citizens' commercial multiple peril and homeowners lines, as
well as increased current year's claim severity in Hanover's personal automobile
and commercial automobile lines. These factors were partially offset by a $36.4
million decrease in catastrophe losses. Additionally, policy benefits increased
$27.6 million, or 13.1% in the Corporate Risk Management Services segment due to
the assumption of a block of affinity group life and health business, growth in
the fully insured group dental product line and unfavorable mortality experience
in the group life product line. These increases were partially offset by a
decrease of $35.0 million, or 21.9% to $125.1 million in the Institutional
Services segment primarily resulting from the continuing decline of traditional
GIC deposits during 1997, and a decline in defined contribution and defined
benefit policy benefits as a result of transfers to the separate accounts. The
Allmerica Financial Services segment also had a decrease in policy benefits,
claims, losses and LAE of $7.7 million, or 2.5%, due primarily to the cession in
1997 of the Company's individual disability income line of business.
Policy acquisition expenses consist principally of commissions, premium taxes
and other policy issuance costs which are deferred and amortized to expense over
the term of the respective policies. Policy acquisition expenses decreased $45.2
million, or 9.5%, to $428.1 million during 1997. This was primarily due to the
change in mortality assumptions used in the amortization of deferred acquisition
costs for the universal life and variable universal life products in the
Allmerica Financial Services segment.
Other operating expenses increased $27.4 million, or 5.3%, to $546.8
million in 1997. Other operating expenses in the Allmerica Financial Services
segment increased $10.6 million, or 9.0%, to $128.8 million in 1997 primarily
from increased premium taxes and administrative expenses related to the growth
in variable product lines. Other operating expenses in the Corporate Risk
Management Services segment increased $8.4 million, or 6.6%, to $134.8 million
in 1997 as a result of increased commissions and premium taxes resulting from
the growth in premiums and ASO fees, as well as the expenses related to a block
of affinity group life and health business assumed in 1997, partially offset by
decreases in employee and administrative costs. Additionally, the Regional
Property and Casualty segment's other operating expenses increased during 1997
primarily as a result of increased premiums.
Federal income tax expense increased $18.4 million in 1997, while the
effective tax rate increased from 22.7% to 25.6% in the same period. For the
life insurance subsidiaries, the effective rate increased from 28.9% to 37.4%,
primarily resulting from the absence, in 1997, of a $10.2 million differential
earnings benefit recognized in 1996, as well as an increase in reserves for
prior year tax liabilities. For the property and casualty subsidiaries, a
decrease in the effective rate from 18.4% to 16.5% resulted from a higher
underwriting loss and greater proportion of pre-tax income from tax-exempt bonds
in 1997.
1996 Compared to 1995
The increase in adjusted net income of $21.5 million is primarily attributable
to pre-tax increases of $39.6 million and $11.1 million in the Allmerica
Financial Services and Institutional Services segments, respectively, partially
offset by pre-tax decreases of $12.8 million and $40.9 million in the Corporate
and Regional Property and Casualty segments, respectively. The increase in the
Allmerica Financial Services segment resulted primarily from increased fees from
strong variable product growth, decreased losses in the disability income line
and income earned on proceeds from the Company's October 1995 initial public
offerings. The increase in the Institutional Services segment related
principally to exiting certain unprofitable businesses in 1995. These increases
were partially offset by losses in the Corporate segment primarily due to
interest expense on the Company's 7-5/8% Senior Debentures issued in October
1995. Additionally, the Regional Property and Casualty segment's adjusted net
income decreased primarily due to severe weather-related claims during 1996,
partially offset by an increase in net investment income of $25.8 million, as
well as a $5.7 million arbitrated settlement from a voluntary pool.
Premium revenue increased $63.7 million, or 2.9%, to $2,298.0 million during
1996. Property and casualty premiums earned increased $35.1 million, or 1.9%, to
$1,898.3 million, reflecting the accounting effects of restructuring a
reinsurance contract at Hanover, increasing net premiums earned by approximately
$19.0 million. In addition, a 2.0% increase in policies in force in the
homeowners line as well as moderate price increases in this line contributed to
the increase in net premiums earned. The growth in Citizens' personal lines is
due to increases in net premiums earned in Ohio and Indiana resulting from
expansion in these states as well as price increases in the personal automobile
and homeowners lines. These increases were partially offset by decreases in the
commercial line due to rate decreases in workers' compensation, Hanover's
withdrawal from a large voluntary pool and continued competitive market
conditions. Premiums in the Corporate Risk Management Services segment increased
$30.2 million, or 11.1%, to $302.9 million due to increases in reinsurance,
fully insured group dental, group life, and stop loss product lines totaling
$33.1 million. These increases were
28
partially offset by a $4.0 million decrease in fully insured group medical
premiums. Premiums in the Allmerica Financial Services segment decreased $2.4
million, or 2.4%, to $95.7 million, primarily reflecting the Company's continued
shift in focus from traditional life insurance products to variable life
insurance and annuity products.
Universal life and investment product policy fees increased $24.8 million, or
14.4%, to $197.2 million in 1996. This reflected additional deposits and
appreciation on variable products' account balances.
Net investment income before taxes was relatively flat, increasing 0.3% to
$725.2 million during 1996. This increase primarily reflects approximately $20.0
million of incremental income in 1996 on proceeds from the Company's initial
public offerings and from the issuance of Senior Debentures in October 1995, as
well as approximately $17.2 million in income from increases in short-term debt
used to finance additions to the investment portfolio. In addition, the Regional
Property and Casualty segment had $10.0 million of income from limited
partnerships in 1996. These increases were substantially offset by a reduction
in invested assets due to declining GIC deposits resulting in a decline in
investment income of $54.4 million. The Company's average gross yield for the
investment portfolio was 7.2% in 1996 and 1995.
Net realized gains on investments were $65.2 million and $19.1 million, before
taxes, and $42.4 million and $12.4 million, after taxes, in 1996 and 1995,
respectively. In 1996, the Regional Property and Casualty segment revised its
investment strategy, resulting in the sale of a portion of its equity portfolio
and the purchase of tax-exempt securities. Consequently, Regional Property and
Casualty segment realized gains increased $22.5 million, to $31.3 million on an
after-tax basis in 1996. Additionally, Institutional Services segment realized
investment gains increased $8.9 million on an after-tax basis in 1996, primarily
reflecting additional real estate sales in favorable market conditions.
Results in 1995 included a $20.7 million pre-tax gain from the March 1995 sale
of the Company's mutual fund processing business.
Other income decreased $9.4 million, or 8.8%, to $97.0 million in 1996. Other
income from the Institutional Services segment decreased $11.5 million, or 47.5%
resulting primarily from the sale of the mutual fund processing business in
March of 1995, which had contributed revenues of approximately $13.7 million in
that year. Also, 1996 results included a non-recurring $4.8 million pre-tax
contingent payment related to the aforementioned sale. Other income in the
Property and Casualty segment decreased $6.8 million due primarily to a
reduction in premium finance and service charges. These decreases were partially
offset by additional income of $6.8 million in the Allmerica Financial Services
segment, primarily attributable to increased investment management income.
Additionally, other income in the Allmerica Asset Management and Corporate Risk
Management segments increased $4.4 million and $2.1 million, respectively.
Policy benefits, claims, losses and LAE increased $27.3 million, or 1.3%, to
$2,058.2 million during 1996. This increase is primarily attributable to an
$83.1 million, or 6.4%, increase in losses and LAE in the Company's Regional
Property and Casualty segment as a result of catastrophe losses and severe
weather in 1996. Additionally, policy benefits, claims, losses and LAE increased
$14.1 million, or 7.2%, in the Corporate Risk Management Services segment
resulting primarily from product growth. These increases were partially offset
by decreased policy benefits of $57.7 million, or 26.5%, in the Institutional
Services segment primarily resulting from the continuing decline of GICs during
1996 and decreases in the Allmerica Financial Services segment of $12.2 million,
or 3.9%, due primarily to reserve strengthening in the disability income line in
1995.
Policy acquisition expenses remained relatively consistent, increasing $1.6
million, or 0.3% to $473.3 million in 1996.
Other operating expenses increased $47.6 million, or 10.1%, to $519.4 million
in 1996 across all major segments, except the Institutional Services segment.
Other operating expenses in the Allmerica Financial Services segment increased
$17.0 million, or 16.8%, to $118.2 million in 1996, primarily from an $8.3
million increase in short-term borrowing costs used to finance additions to the
investment portfolio. Other operating expenses in the Corporate Risk Management
Services segment increased $16.1 million, or 14.6%, to $126.4 million in 1996 as
a result of increased commissions, claims processing expenses and field office
expenses, resulting from the increased volume of both premiums and claims. The
Corporate segment's other operating expenses increased $15.1 million in 1996,
principally related to interest expense on the Company's Senior Debentures for a
full year in 1996 versus one quarter in 1995. Additionally, the Regional
Property and Casualty segment's other operating expenses increased $13.6 million
due primarily to technology and other administrative expenses. These increases
were partially offset by a decrease of $19.8 million in the Institutional
Services segment related to the sale of the mutual fund processing business in
March 1995.
Federal income tax expense decreased $7.5 million in 1996, while the effective
tax rate decreased from 27.4% to 22.7% in the same period. For the life
insurance subsidiaries, the effective rate decreased slightly from 32.0% to
28.9%, primarily due to additional reserves provided for revisions of estimated
prior year tax liabilities in 1995, as well as an increase of $2.6 million in
the differential earnings benefit from 1995 to 1996. For the property and
casualty subsidiaries, a decrease in the effective rate from 25.3% to 18.4%
resulted from a higher underwriting loss and a greater proportion of pre-tax
income from tax-exempt bonds in 1996, and to reserves provided for revisions of
estimated prior year tax liabilities in 1995.
29
Segment Results
................................................................................
The following is management's discussion and analysis of the Company's results
of operations by business segment. The Company offers financial products and
services in two major areas: Risk Management and Retirement and Asset
Accumulation. Within these broad areas, the Company conducts business
principally in five operating segments. These segments are Regional Property and
Casualty; Corporate Risk Management Services; Allmerica Financial Services;
Institutional Services; and Allmerica Asset Management. The segment results are
presented before taxes and minority interest.
In addition to the five operating segments, the Company also has a Corporate
segment, which consists primarily of cash, investments, corporate debt and
Capital Securities.
Risk Management
................................................................................
Regional Property and Casualty
The following table summarizes the results of operations for the Regional
Property and Casualty segment:
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Revenues
Net premiums earned $ 1,953.1 $ 1,898.3 $ 1,863.2
Net investment income 255.7 235.4 209.6
Net realized gains 53.9 48.1 14.6
Other income 12.6 14.8 21.6
................................................................................
Total revenues 2,275.3 2,196.6 2,109.0
Losses and LAE (1) 1,445.5 1,383.4 1,300.3
Policy acquisition expenses 413.2 409.2 409.7
Other operating expenses 210.2 206.3 192.7
................................................................................
Income before taxes $ 206.4 $ 197.7 $ 206.3
================================================================================
(1) Includes policyholders' dividends of $9.3 million, $11.5 million and $10.6
million in 1997, 1996 and 1995, respectively.
Statutory Combined Ratio
97 104.0
96 104.5
95 101.0
Income Before Taxes
................................................................................
1997 Compared to 1996
Income before taxes increased $8.7 million, or 4.4%, to $206.4 million in 1997.
Net realized gains were $53.9 million during 1997, versus $48.1 million during
1996, reflecting increased sales of equity securities at Citizens. Excluding
realized gains and losses and restructuring charges, income before taxes
increased $7.4 million to $158.2 million in 1997 versus $150.8 million in 1996.
This increase is attributable to a $20.3 million increase in net investment
income, partially offset by a $10.8 million increase in the underwriting loss.
The growth in net investment income resulted primarily from an increase in
average invested assets and the Company's portfolio shift from equity securities
to higher yielding debt securities, begun in 1996 and substantially completed in
the first quarter of 1997. This was partially offset by a $3.8 million decrease
in partnership income in 1997. The decline in underwriting results is primarily
attributable to a decrease in favorable development on prior year reserves in
Hanover's personal automobile, homeowners and commercial multiple peril lines,
as well as increased current year claims severity in Hanover's personal
automobile and commercial automobile lines. These factors were partially offset
by a $38.9 million decrease in catastrophe losses at Hanover. Citizens'
underwriting results primarily reflect an increase in claims activity in the
commercial multiple peril and homeowners lines and an increase in catastrophes,
partially offset by favorable claims experience on current and prior accident
years in the personal automobile and workers' compensation lines. Net income
during 1996 was favorably impacted by a $5.7 million arbitrated settlement from
a voluntary pool at Hanover, of which $2.9 million was included in losses and
LAE and $2.8 million was included in other income.
1996 Compared to 1995
Income before taxes decreased $8.6 million, or 4.2%, to $197.7 million in 1996.
This decrease resulted from catastrophes and other severe weather related losses
which contributed to an $83.1 million increase in losses and LAE to $1,383.4
million. Catastrophe losses increased $27.3 million, to $62.9 million in 1996
from $35.6 million during the previous year. The increase in losses and LAE was
partially offset by an increase in net investment income of $25.8 million, or
12.3%, to $235.4 million, attributable to an increase in higher-yielding debt
securities in the portfolio and earnings from a limited partnership. The
decrease in income before tax was also offset by a $33.5 million increase in
realized gains, primarily related to the sale of equity securities, reflecting
the Regional Property and Casualty segment's decision during the first quarter
of 1996 to increase the proportion of debt securities in the portfolio. Income
during 1996 was favorably impacted by the aforementioned $5.7 million arbitrated
settlement. In addition, premium finance and service charges decreased by $3.9
million in 1996.
30
Lines Of Business Results
................................................................................
Personal Lines of Business
The personal lines represented 61.9%, 61.2% and 59.8% of total net premiums
earned in 1997, 1996 and 1995, respectively.
For the Years Ended December 31
(In millions) 1997 1996 1995 1997 1996 1995 1997 1996 1995
====================================================================================================================================
Hanover Citizens Total Regional Property and Casualty
------- ------- ---------
Net premiums earned $ 625.7 $ 607.3 $ 577.1 $ 583.3 $ 554.6 $ 536.2 $ 1,209.0 $ 1,161.9 $ 1,113.3
Losses and loss adjustment
expenses incurred 488.2 452.0 368.6 440.1 404.1 413.6 928.3 856.1 782.2
Policy acquisition expenses 144.3 144.0 135.5 112.1 112.5 108.1 256.4 256.5 243.6
Other underwriting expenses 60.3 58.5 49.4 40.2 39.3 41.1 100.5 97.8 90.5
....................................................................................................................................
Underwriting (loss) profit $ (67.1) $ (47.2) $ 23.6 $ (9.1) $ (1.3) $ (26.6) $ (76.2) $ (48.5) $ (3.0)
- ------------------------------------------------------------------------------------------------------------------------------------
1997 Compared to 1996
Revenues
Personal lines' net premiums earned increased $47.1 million, or 4.1%, to
$1,209.0 million in 1997, compared to $1,161.9 million in 1996. Hanover's
personal lines net premiums earned increased $18.4 million, or 3.0%, to $625.7
million during 1997. This increase is primarily attributable to a 6.7% increase
in policies in force in the personal automobile line as well as a 1.5% increase
in policies in force in the homeowners line, since December 31, 1996. These
increases were partially offset by the effect of a mandated 6.2% decrease in
Massachusetts personal automobile rates on January 1, 1997. Effective January 1,
1998, Massachusetts personal automobile rates were decreased an additional 4.0%
as mandated by the Massachusetts Insurance Commissioner. In 1997, Hanover began
offering a safe driver's discount of 10% on automobile insurance premiums.
Management believes that rate changes and discounts may unfavorably impact
premium growth in Massachusetts. At December 31, 1997, approximately 34% of
Hanover's personal automobile business was written in Massachusetts.
Citizens' personal lines' net premiums earned increased $28.7 million, or
5.2%, to $583.3 million in 1997. This growth is attributable to rate increases
in the personal automobile and homeowners lines and a 2.8% increase in policies
in force in the homeowners line. The growth is partially offset by a 0.6%
decrease in policies in force in the personal automobile line, attributable to
the segment's selective reduction of writings in Michigan when rates were viewed
as inadequate, and to continued strong competition in Michigan. While management
has taken steps to increase penetration in affinity groups and has initiated
other marketing programs, heightened competition may continue to result in
reduced growth in the personal lines.
Underwriting results
The personal lines' underwriting loss in 1997 increased $27.7 million, to a loss
of $76.2 million. Hanover's underwriting results deteriorated $19.9 million to a
loss of $67.1 million, while Citizens' underwriting loss deteriorated $7.8
million to a loss of $9.1 million.
The decline in Hanover's underwriting results is primarily attributable to an
increase in current year claims severity and a $25.0 million reduction in
favorable development on prior year reserves in the personal automobile line.
These factors were partially offset by a $25.8 million decrease in catastrophes,
primarily in the homeowners line.
The decline in Citizens' underwriting results reflects a decrease in prior
year favorable development in the personal automobile line of $10.5 million and
an increase in catastrophe losses of $0.9 million, to $14.3 million, primarily
in the homeowners line.
Policy acquisition expenses in the personal lines remained consistent between
years while other underwriting expenses increased $2.7 million, or 2.8%, to
$100.5 million in 1997. Hanover's policy acquisition expenses increased $0.3
million, or 0.2%, to $144.3 million in 1997. This increase resulted from
increased net premiums earned, significantly offset by decreased commission
rates in the personal automobile and homeowners lines and lower employee related
expenses. The $1.8 million increase in Hanover's other underwriting expenses
resulted from an increase in net premiums earned, partially offset by decreased
employee related expenses, as well as reductions in contingent commissions.
Policy acquisition expenses in the personal lines at Citizens decreased $0.4
million, or 0.4%, to $112.1 million in 1997, primarily reflecting lower
commission rates for 1997, partially offset by higher earned premiums. Citizens'
other underwriting expenses increased $0.9 million, or 2.3%, to $40.2 million
due to an increase in net premiums earned offset by reductions in employee
related expenses.
1996 Compared to 1995
Revenues
Net premiums earned in the personal lines increased $48.6 million, or 4.4%, to
$1,161.9 million in 1996, compared to $1,113.3 million in 1995. Hanover's
personal lines net premiums earned increased $30.2 million, or 5.2%, to $607.3
million during 1996. This increase is primarily attributable to an increase in
the personal automobile line associated with the accounting effects of
restructuring a reinsurance contract,
31
increasing net premiums earned by $19.0 million. A 2.0% increase in policies in
force in Hanover's homeowners line as well as moderate price increases in this
line also contributed to the increase in net premiums earned. These increases
were partially offset by a mandated 4.5% decrease in Massachusetts personal
automobile rates which became effective January 1, 1996. At December 31, 1996,
approximately 39% of Hanover's personal automobile business was written in
Massachusetts.
Citizens' personal lines' net premiums earned increased $18.4 million, or
3.4%, to $554.6 million in 1996. This growth is attributable to rate increases
in the personal automobile and homeowners lines. The growth is partially offset
by a 3.0% decrease in policies in force in the personal automobile line,
attributable to the aforementioned competitive rates in Michigan.
Underwriting results
The personal lines' underwriting loss in 1996 increased $45.5 million, to a loss
of $48.5 million. Hanover's underwriting results deteriorated $70.8 million to a
loss of $47.2 million, while Citizens' underwriting loss improved $25.3 million
to a loss of $1.3 million.
Hanover's personal lines' losses and LAE increased $83.4 million, or 22.6%, to
$452.0 million in 1996. This increase is partially attributable to a $28.8
million increase in losses and LAE in the homeowners line, resulting from
increased catastrophes and severe weather. Catastrophe losses in Hanover's
personal lines increased $17.2 million, to $30.6 million in 1996 from $13.4
million in 1995. Losses and LAE in the personal automobile line increased $49.6
million, or 17.8%, to $328.0 million, primarily reflecting the accounting
effects of restructuring a reinsurance contract, increasing losses by $19.0
million, in addition to a moderate increase in claims frequency and a $4.7
million reduction in favorable reserve development.
The improvement in Citizens' underwriting results reflects favorable claims
activity in both current and prior accident years in the personal automobile
line attributable to improvements in severity. This was partially offset by an
increase in catastrophe losses of $6.2 million, to $13.4 million, primarily in
the homeowners line.
Policy acquisition expenses in the personal lines increased $12.9 million, or
5.3%, to $256.5 million and other underwriting expenses increased $7.3 million
to $97.8 million in 1996. The increase in policy acquisition expenses is
primarily attributable to an increase of $8.5 million, or 6.3%, to $144.0
million at Hanover, resulting from an increase in net premiums earned, as well
as a reapportionment of certain acquisition expenses to the personal lines from
the commercial lines, partially offset by a decrease in assessment expenses
associated with the reapportionment of an involuntary pool. The $9.1 million
increase in Hanover's other underwriting expenses resulted from an increase in
net premiums earned, an increase in start-up expenses associated with group
business and expenses associated with a policy administration technology
project. Policy acquisition expenses in the personal lines at Citizens increased
$4.4 million, or 4.1%, to $112.5 million in 1996, reflecting growth in net
premiums earned. The $1.8 million decline in Citizens' other underwriting
expenses is primarily attributable to reductions in employee related expenses
and commissions, partially offset by expenses associated with a policy
administration technology project.
Commercial Lines of Business
The commercial lines represented 38.1%, 38.8% and 40.2% of net premiums earned
in 1997, 1996 and 1995, respectively.
For the Years Ended December 31
(In millions) 1997 1996 1995 1997 1996 1995 1997 1996 1995
===============================================================================================================================
Hanover Citizens Total Regional Property and Casualty
-------- -------- --------
Net premiums earned $ 472.1 $ 455.5 $ 468.3 $ 272.0 $ 280.9 $ 281.6 $ 744.1 $ 736.4 $ 749.9
Losses and loss adjustment
expenses incurred 307.3 315.5 342.8 197.0 200.3 164.7 504.3 515.8 507.5
Policy acquisition expenses 104.0 101.1 114.6 52.8 51.6 51.5 156.8 152.7 166.1
Other underwriting expenses(1) 80.9 80.6 73.5 24.9 27.0 25.4 105.8 107.6 98.9
...............................................................................................................................
Underwriting (loss) profit $ (20.1) $ (41.7) $ (62.6) $ (2.7) $ 2.0 $ 40.0 $ (22.8) $ (39.7) $ (22.6)
- -------------------------------------------------------------------------------------------------------------------------------
(1) Includes policyholders' dividends.
32
1997 Compared to 1996
Revenues
Commercial lines' net premiums earned in 1997 increased $7.7 million, or 1.0%,
to $744.1 million in 1997, compared to $736.4 million in 1996. Hanover's
commercial lines' net premiums earned increased $16.6 million, or 3.6%, to
$472.1 million. This increase is primarily attributable to a $9.4 million
increase in assumed premiums in Hanover's reinsurance division, as well as a
7.0% increase in policies in force in Hanover's commercial automobile line,
since December 31, 1996. These increases were partially offset by the effect of
an average rate decrease of 12.6%, since January 1, 1997, in Hanover's workers'
compensation line.
Effective July 1, 1997, the Company exited the assumed reinsurance business by
entering into an agreement with USF RE Insurance Company ("USF RE") in which USF
RE acquired the operations of Allmerica Re from Hanover. During 1997, assumed
reinsurance business contributed $34.7 million in net premiums earned.
Citizens' commercial lines' net premiums earned decreased $8.9 million, or
3.2%, to $272.0 million in 1997. This decrease primarily reflects rate
reductions in the workers' compensation line. Rates in the workers' compensation
line at Citizens were decreased 8.5%, 7.0%, 6.4% and 8.7% effective May 1, 1995,
December 1, 1995, June 1, 1996 and March 1, 1997, respectively. This decrease is
partially offset by an increase in policies in force in the commercial multiple
peril and commercial automobile lines of 16.6% and 2.7%, respectively.
Management believes competitive conditions in Michigan in the workers'
compensation line may impact future growth in net premiums earned.
Underwriting results
The commercial lines' underwriting loss decreased $16.9 million, or 42.6% to a
loss of $22.8 million in 1997. Hanover's underwriting results improved $21.6
million, or 51.8%, to a loss of $20.1 million and Citizens' underwriting results
declined $4.7 million, to a loss of $2.7 million in 1997.
The improvement in Hanover's underwriting results reflects an increase in
favorable development on prior accident years in the workers' compensation and
commercial automobile lines as well as a decrease in catastrophe losses of $13.1
million, primarily in the commercial multiple peril line. These factors were
partially offset by a decrease in favorable development on prior accident years
in the commercial multiple peril line as well as increased current year claim
severity in the commercial automobile line.
Citizens' underwriting results declined primarily due to lower net premiums
earned in the workers' compensation line, an increase in current year severity
and frequency in the commercial multiple peril line, less favorable development
of prior year reserves in the commercial automobile line, and an increase in
catastrophe losses of $1.6 million. These decreases were partially offset by a
$13.9 million increase in favorable development of prior year claims in the
workers' compensation line.
Policy acquisition expenses in the commercial lines increased $4.1 million, or
2.7%, to $156.8 million in 1997 and other underwriting expenses decreased $1.8
million, or 1.7%, to $105.8 million. Hanover's policy acquisition expenses
increased $2.9 million, or 2.9%, to $104.0 million, primarily attributable to
growth in net premiums earned. Other underwriting expenses at Hanover increased
$0.3 million, to $80.9 million as a result of higher net premiums earned and
increased re-engineering costs associated with the underwriting and policy
processing in the commercial underwriting segment, partially offset by decreased
contingent commissions and employee related expenses. Citizens' policy
acquisition expenses increased $1.2 million, or 2.3%, primarily as a result of
higher commission rates, offset by a decrease in net premiums earned. Other
underwriting expenses decreased $2.1 million, or 7.8%, to $24.9 million due to
reductions in employee related expenses.
1996 Compared to 1995
Revenues
Commercial lines' net premiums earned in 1996 decreased $13.5 million, or 1.8%,
to $736.4 million. Hanover's commercial lines' net premiums earned decreased
$12.8 million, or 2.7%, to $455.5 million. This decrease is primarily
attributable to Hanover's withdrawal from a large voluntary pool on December 1,
1995, and to aggregate rate decreases of 14.6% since January 1, 1995, in the
workers' compensation line. Citizens' commercial lines' net premiums earned
decreased $0.7 million, or 0.2%, to $280.9 million in 1996. This decrease
primarily reflects the aforementioned rate reductions and a 1.4% decrease in
policies in force in the workers' compensation line due to continuing
competition in this line in Michigan. This decrease is partially offset by an
increase in policies in force in the commercial multiple peril and commercial
automobile lines of 13.2% and 3.7%, respectively.
Underwriting results
The commercial lines' underwriting loss for 1996 increased $17.1 million, or
75.7% to a loss of $39.7 million. Hanover's underwriting loss improved $20.9
million, or 33.4%, to a loss of $41.7 million and Citizens' underwriting profit
decreased $38.0 million, to a profit of $2.0 million in 1996.
Hanover's commercial lines' losses and LAE decreased $27.3 million, or 8.0%,
to $315.5 million in 1996. This improvement is primarily attributable to a $41.5
million decrease in losses and LAE resulting from the withdrawal from a large
voluntary pool. However, this decrease was partially offset by increased losses
in the workers' compensation line of $17.9 million, primarily due to a $19.8
million decrease in favorable reserve development during 1996.
Citizens' underwriting profit decreased primarily due to an increase in loss
severity and frequency in the commercial multiple peril line, lower net premiums
earned in the workers' compensation line, less favorable development of prior
year reserves in the workers' compensation line, an increase in cat-
33
astrophe losses of $0.8 million, partially offset by an increase in net
premiums earned in the commercial multiple peril line.
Policy acquisition expenses in the commercial lines decreased $13.4 million,
or 8.1%, to $152.7 million in 1996 and other underwriting expenses increased
$8.7 million, or 8.8%, to $107.6 million. Hanover's policy acquisition expenses
decreased $13.5 million, or 11.8%, to $101.1 million, primarily attributable to
a reapportionment of certain acquisition expenses from the commercial lines to
the personal lines, a net decrease in assessment expenses associated with
voluntary and involuntary pools, as well as to the decrease in net earned
premium. Other underwriting expenses at Hanover increased $7.1 million, to $80.6
million as a result of an increase in employee related expenses and an increase
in expenses associated with the policy administration technology project.
Citizens' policy acquisition expenses in the commercial lines remained
consistent between years, primarily as a result of flat net earned premiums.
Other underwriting expenses increased $1.6 million, or 6.3%, to $27.0 million in
1996, due to investments in technology and increased policyholders' dividends,
partially offset by reductions in employee related expenses and commissions.
Investment Results
................................................................................
Net investment income before tax was $255.7 million, $235.4 million and $209.6
million in 1997, 1996 and 1995, respectively. The increase from 1996 to 1997
represents an increase in average invested assets and the Company's portfolio
shift, in this segment, to higher yielding debt securities, including longer
duration and non-investment grade securities. Refer to the discussion in the
Investment Portfolio section on page 41 for additional information about
investment and non-investment grade debt securities. Net investment income in
1996 includes $10.0 million of income from partnerships compared to $6.2 million
in 1997. Also, the average pre-tax yield on debt securities increased from 6.4%
in 1996 to 6.8% in 1997. Average invested assets increased $174.2 million, or
4.5%, to $4,027.8 million in 1997 compared to $3,853.6 million in 1996.
The increase from 1995 to 1996 represents an increase in average invested
assets, $10.0 million of income from limited partnerships, and the Company's
aforementioned portfolio shift, in this segment. Also, the average pre-tax yield
on debt securities increased from 6.1% in 1995 to 6.4% in 1996.
Net realized gains on investments before taxes were $53.9 million, $48.1
million and $14.6 million in 1997, 1996 and 1995, respectively. The increase in
net realized gains in 1997 reflects increased sales of equity securities by
Citizens. In both years, net realized investment gains resulted primarily from
the sale of appreciated equity securities due to the Company's strategy of
shifting to a higher proportion of debt securities.
Reserve for Losses and Loss
Adjustment Expenses
................................................................................
The Regional Property and Casualty segment maintains reserves to provide for its
estimated ultimate liability for losses and loss adjustment expenses with
respect to reported and unreported claims incurred as of the end of each
accounting period. These reserves are estimates, involving actuarial projections
at a given point in time, of what management expects the ultimate settlement and
administration of claims will cost based on facts and circumstances then known,
predictions of future events, estimates of future trends in claim severity and
judicial theories of liability and other factors. The inherent uncertainty of
estimating insurance reserves is greater for certain types of property and
casualty insurance lines, particularly workers' compensation and other liability
lines, where a longer period of time may elapse before a definitive
determination of ultimate liability may be made, and where the technological,
judicial and political climates involving these types of claims are changing.
The Regional Property and Casualty segment regularly updates its reserve
estimates as new information becomes available and further events occur which
may impact the resolution of unsettled claims. Changes in prior reserve
estimates are reflected in results of operations in the year such changes are
determined to be needed and recorded.
The table below provides a reconciliation of the beginning and ending reserve
for unpaid losses and LAE as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
==========================================================================================
Reserve for losses and LAE,
beginning of year $ 2,744.1 $ 2,896.0 $ 2,821.7
Incurred losses and LAE, net of reinsurance recoverable:
Provision for insured events
of current year 1,564.1 1,513.3 1,427.3
Decrease in provision for
insured events of prior years (127.9) (141.4) (137.6)
..........................................................................................
Total incurred losses and LAE 1,436.2 1,371.9 1,289.7
..........................................................................................
Payments, net of reinsurance
recoverable:
Losses and LAE attributable to
insured events of current year 775.1 759.6 652.2
Losses and LAE attributable to
insured events of prior years 732.1 627.6 614.3
..........................................................................................
Total payments 1,507.2 1,387.2 1,266.5
..........................................................................................
Change in reinsurance recoverable
on unpaid losses (50.2) (136.6) 51.1
Other (1) (7.5) -- --
..........................................................................................
Reserve for losses and LAE,
end of year $ 2,615.4 $ 2,744.1 $ 2,896.0
- ------------------------------------------------------------------------------------------
(1) Includes purchase accounting adjustments.
34
As part of an ongoing process, the reserves have been re-estimated for all
prior accident years and were decreased by $127.9 million, $141.4 million and
$137.6 million in 1997, 1996 and 1995, respectively.
The decrease in favorable development on prior years' reserves of $13.5
million in 1997 results primarily from a $24.6 million decrease in favorable
development at Hanover to $58.4 million, partially offset by an $11.1 million
increase in favorable development at Citizens to $69.5 million. The decrease in
Hanover's favorable development of $24.6 million in 1997 reflects a decrease in
favorable development of $25.0 million, to $17.4 million in the personal
automobile line as well as a decrease in favorable development of $8.5 million
to unfavorable development of $2.8 million in the commercial multiple peril
line. These decreases were partially offset by an increase in favorable
development in the workers' compensation line of $11.5 million, to $28.8
million. The increase in favorable development at Citizens in 1997 reflects
improved severity in the workers' compensation line where favorable development
increased $13.9 million, to $35.7 million and in the commercial multiple peril
line where favorable development increased $7.0 million to $4.3 million,
partially offset by less favorable development in the personal automobile line,
where favorable development decreased $10.5 million to $22.5 million in 1997.
The increase in favorable development on prior years' reserves of $3.8 million
in 1996 results primarily from an $11.4 million increase in favorable
development at Citizens. The increase in Citizens' favorable development of
$11.4 million in 1996 reflects improved severity in the personal automobile
line, where favorable development increased $28.6 million to $33.0 million in
1996, partially offset by less favorable development in the workers'
compensation line of $10.9 million. Hanover's favorable development, including
voluntary and involuntary pools, decreased $7.7 million in 1996 to $82.9
million, primarily attributable to a decrease in favorable development in the
workers' compensation line of $19.8 million. Favorable development in the
personal automobile line also decreased $4.7 million, to $42.4 million in 1996.
These decreases were offset by increases in favorable development of $1.9
million and $5.6 million, to $12.6 million and $5.7 million, in the commercial
automobile and commercial multiple peril lines, respectively. Favorable
development in other lines increased by $8.8 million, primarily as a result of
environmental reserve strengthening in 1995. Favorable development in Hanover's
voluntary and involuntary pools increased $3.7 million to $4.1 million during
1996.
Citizens' favorable development in 1997 primarily reflects a modest shift over
the past few years of the workers' compensation business to Western and Northern
Michigan, which have demonstrated more favorable loss experience than Eastern
Michigan.
Citizens' favorable development in 1996 and 1995 primarily reflects the
initiatives taken by the Company to manage medical costs in both the automobile
and workers' compensation lines, as well as the impact of the Michigan Supreme
Court ruling on workers' compensation indemnity payments in 1995, which
decreases the maximum amount to be paid for indemnity cases on all existing and
future claims.
Hanover's favorable development from 1995 to 1997 primarily reflects favorable
legislation related to workers' compensation, improved safety features in
automobiles and a moderation of medical costs and inflation.
In 1995, Hanover's favorable development was primarily attributable to a
re-estimate of reserves with respect to certain types of workers' compensation
policies including large deductibles and excess of loss policies. In addition,
during 1995 Hanover refined its estimation of unallocated loss adjustment
expenses which increased favorable development in that year.
This favorable development reflects the Regional Property and Casualty
segment's reserving philosophy consistently applied over these periods.
Conditions and trends that have affected development of the loss and LAE
reserves in the past may not necessarily occur in the future.
Due to the nature of the business written by the Regional Property and
Casualty 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 $53.1 million
and $50.8 million, net of reinsurance of $15.7 million and $20.2 million in 1997
and 1996, 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. Due to their unusual nature and absence of historical claims
data, reserves for these claims are not determined using historical experience
to project future losses. 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
claims are not material, their existence gives rise to uncertainty and is
discussed because of the possibility, however remote, that they may become
material. The Company believes that, notwithstanding the evolution of case law
expanding liability in environmental claims, recorded reserves related to these
claims are adequate. In addition, the Company is not aware of any litigation or
pending claims that may result in additional material liabilities in excess of
recorded reserves. The environmental liability could be revised in the near term
if the estimates used in determining the liability are revised.
Inflation generally increases the cost of losses covered by insurance
contracts. The effect of inflation on the Company varies by product. Property
and casualty insurance premiums are established before the amount of losses and
LAE, and the extent to which inflation may affect such expenses, are known.
Consequently, the Company attempts, in establishing rates, to anticipate the
potential impact of inflation in the projection of ultimate costs. The impact of
inflation has been relatively insignificant in recent years. However, inflation
could contribute to increased losses and LAE in the future.
35
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.
Corporate Risk Management Services
The following table summarizes the results of operations for the Corporate Risk
Management Services segment.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Premiums and premium equivalents
Premiums $ 333.0 $ 302.9 $ 272.7
Premium equivalents 603.6 581.4 513.4
................................................................................
Total premiums and
premium equivalents $ 936.6 $ 884.3 $ 786.1
- --------------------------------------------------------------------------------
Revenues
Premiums $ 333.0 $ 302.9 $ 272.7
Net investment income 22.7 21.7 17.6
Net realized gains (losses) 0.2 0.3 (0.5)
Other income 40.4 36.6 38.7
................................................................................
Total revenues 396.3 361.5 328.5
Policy benefits, claims and losses 238.9 211.3 197.2
Policy acquisition expenses 3.3 3.1 2.7
Other operating expenses 134.8 126.4 110.3
................................................................................
Income before taxes $ 19.3 $ 20.7 $ 18.3
- --------------------------------------------------------------------------------
1997 Compared to 1996
Income before taxes decreased $1.4 million, or 6.8%, to $19.3 million in 1997.
This decrease was primarily due to unfavorable mortality in the group life
product line of $8.4 million, partially offset by a reduction in employee and
administrative costs of $4.8 million, a $1.0 million contribution from the
assumption of a block of affinity group life and health business in January
1997, and improved experience in the long-term disability, stop loss and risk
sharing product lines.
Premiums increased $30.1 million, or 9.9%, to $333.0 million in 1997 primarily
due to increases in reinsurance, fully insured group dental and stop loss
product lines totaling $30.2 million, including $18.9 million resulting from the
aforementioned assumption of a block of affinity group life and health business.
These increases were partially offset by decreases in the risk sharing product
line of $2.6 million. The decline in risk sharing premiums primarily reflects
the Company's emphasis on stop loss coverage and ASO arrangements.
Other income increased $3.8 million, or 10.4%, to $40.4 million in 1997 due to
growth in ASO and contract fees.
Policy benefits, claims and losses increased $27.6 million, or 13.1%, to
$238.9 million in 1997. This increase is primarily due to growth in reinsurance
products, including the aforementioned assumption of a block of affinity group
life and health business, which contributed $12.0 million in policy benefits
during the year. Additionally, group life benefits increased $8.2 million due to
unfavorable mortality experience in 1997. Fully insured group dental increased
by $7.3 million due to growth in the product line. These increases were
partially offset by decreased benefits in the fully insured medical product line
and improved experience in the long-term disability, stop loss and risk sharing
product lines.
Other operating expenses increased $8.4 million, or 6.6%, to $134.8 in 1997
primarily due to increases of $6.2 million in premium taxes and commissions
resulting from the growth in premiums and ASO fees. In addition, 1997 expenses
included $5.9 million related to the aforementioned affinity group life and
health business. These items were partially offset by decreases in employee and
administrative costs of $4.8 million.
1996 Compared to 1995
Income before taxes increased $2.4 million, or 13.1%, to $20.7 million in 1996.
In 1995, the Corporate Risk Management Services segment received a one time
litigation settlement of $11.1 million. Excluding this item, income before taxes
increased $13.5 million, or 187.5%. This increase is primarily attributable to
premium growth in the Company's reinsurance, fully insured group dental and
group life product lines, and to improved overall loss trends.
Premiums increased $30.2 million, or 11.1%, to $302.9 million in 1996,
primarily due to increases in reinsurance, fully insured group dental, group
life and stop loss product lines totaling $33.1 million. These increases were
partially offset by a decrease of $4.0 million in fully insured medical
premiums.
36
Net investment income increased $4.1 million, or 23.3%, to $21.7 million in
1996, due primarily to a $1.6 million increase in income earned on proceeds from
the Company's October 1995 initial public offerings and approximately $1.4
million from increases in short-term debt used to finance additions to the
investment portfolio. In addition, net investment income increased approximately
$1.2 million from growth in invested assets.
Other income decreased $2.1 million, or 5.4%, to $36.6 million in 1996, due
primarily to the absence in 1996 of the aforementioned $11.1 million litigation
settlement. This decrease was partially offset by growth in ASO and contract
fees of $7.9 million in 1996.
Policy benefits, claims and losses increased $14.1 million, or 7.2%, to $211.3
million in 1996. This increase is principally related to the growth in premiums,
partially offset by favorable claims experience overall.
Other operating expenses increased $16.1 million, or 14.6%, to $126.4 million
in 1996, due primarily to increases in commissions, claims processing expenses
and field office expenses, resulting from the increased volume of both premiums
and claims. In addition, other operating expenses includes approximately $1.0
million of short-term borrowing costs related to the short-term debt used to
finance additions to the investment portfolio.
Retirement and Asset Accumulation
................................................................................
Allmerica Financial Services
The following table summarizes the results of operations for the Allmerica
Financial Services segment.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Revenues
Premiums $ 82.1 $ 95.7 $ 98.1
Fees 215.7 181.2 157.9
Net investment income 236.9 251.3 229.1
Net realized gains (losses) 1.8 (1.5) 0.6
Other income 38.0 29.2 22.4
................................................................................
Total revenues 574.5 555.9 508.1
Policy benefits, claims and losses 295.7 303.4 315.6
Policy acquisition expenses 8.7 58.1 56.1
Loss from cession of disability
income business 53.9 -- --
Other operating expenses 128.8 118.2 101.2
................................................................................
Income before taxes $ 87.4 $ 76.2 $ 35.2
================================================================================
1997 Compared to 1996
Income before taxes increased $11.2 million, or 14.7%, to $87.4 million in 1997.
During 1997, the Allmerica Financial Services segment results were affected by
two significant items. Effective October 1, 1997, the Company ceded
substantially all of its individual disability income line of business, which
had generated $1.8 million and $0.8 million in losses during 1997 and 1996,
respectively. The Company recognized a $53.9 million loss during the first
quarter of 1997 upon entering into an agreement in principal to transfer this
business. Additionally, effective October 1, 1997, the Company revised the
mortality assumptions used to determine the amortization of policy acquisition
costs and recognition of certain fees for this segment's universal life and
variable universal life lines of business. As a result of this change in
assumptions, the Company recorded a benefit of $47.0 million. Effective January
1, 1998, the Company entered into an agreement with a highly rated reinsurer to
reinsure the mortality risk on the universal life and variable universal life
lines of business. The terms and provisions of this reinsurance contract are
consistent with the aforementioned change in mortality assumptions. Management
believes that this agreement will not have a material effect on the results of
operations or financial position of the Company.
Financial Services Separate Account Assets
in millions
[BAR GRAPH APPEARS HERE]
97 $7,924
96 $4,804
95 $3,159
Excluding these significant items, income before taxes increased by $18.1
million, or 23.8% to $94.3 million. This increase is primarily attributable to
growth in variable product lines, partially offset by lower net investment
income due to a reduction in average fixed maturities invested.
The decrease in premiums of $13.6 million, or 14.2%, to $82.1 million in 1997
is primarily due to the aforementioned cession of the Company's individual
disability income line of business, which contributed premiums of $22.8 million
in 1997 compared to $32.9 million in 1996. The remaining decrease reflects the
Company's continued shift in focus from traditional life insurance products to
variable life insurance and annuity products.
The increase in fee revenue of $34.5 million, or 19.0%, to $215.7 million in
1997 is due to additional deposits and appreciation in variable products'
account balances. Fees from variable annuities increased $32.9 million, or
57.7%, to $89.9 million in 1997. New distribution arrangements with several
third party mutual fund advisors contributed to the increase in annuity sales in
1997. Fees from variable universal life policies increased $10.2 million, or
23.6%, to $53.5 million in 1997. These increases were partially offset by a
decrease in fees from non-variable universal life of $4.8 million. The Company
expects fees from this product to continue to decline as policies in force and
related contract values decline. Additionally, the Company reduced certain other
fees by $3.8 million due to the aforementioned change in mortality assumptions.
37
Net investment income decreased $14.4 million, or 5.7%, to $236.9 million in
1997. This decrease is primarily due to a reduction in average fixed maturities
invested, partially offset by increased portfolio yields. The reduction in
average fixed maturities invested was primarily a result of the aforementioned
cession of the individual disability income line of business, as well as the
shift in focus from traditional insurance products to variable life insurance
and annuity products.
Other income increased $8.8 million, or 30.1%, to $38.0 million in 1997. This
increase was primarily attributable to increased investment management fee
income resulting from growth in assets under management.
Policy benefits, claims and losses decreased $7.7 million, or 2.5%, to $295.7
million in 1997. This decrease is due primarily to the aforementioned cession of
the Company's individual disability income line of business, which incurred
policy benefits of $32.3 million in 1997 compared to $38.5 million in 1996.
The decrease in policy acquisition expenses of $49.4 million, or 85.0%, to
$8.7 million in 1997 is primarily due to the aforementioned revision of
mortality assumptions. This change resulted in a $50.8 million reduction in
policy acquisition expenses at October 1, 1997, and reduced fourth quarter
amortization by $2.2 million from that based on the Company's mortality
assumptions prior to the revision.
The increase in other operating expenses of $10.6 million, or 9.0%, to $128.8
million in 1997 was primarily attributable to the increased premium taxes and
administrative expenses related to the significant growth in the variable
product lines during 1997.
1996 Compared to 1995
Income before taxes increased $41.0 million, or 116.5%, to $76.2 million in 1996
compared to 1995. This increase was primarily attributable to growth in variable
products' fee revenue, decreased losses in the disability income line and income
earned on the proceeds from the October 1995 initial public offerings.
The decrease in premiums of $2.4 million, or 2.4%, to $95.7 million in 1996
is primarily due to the Company's shift in focus from traditional life insurance
products to variable life insurance and annuity products. Premiums from
traditional life products decreased $3.4 million, or 5.1%, to $62.8 million in
1996.
The increase in fee revenue of $23.3 million, or 14.8%, to $181.2 million in
1996 is due to additional deposits and appreciation on variable products'
account balances. Fees from annuities increased $20.1 million, or 54.5%, to
$57.0 million in 1996. Fees from variable universal life policies increased $8.0
million, or 22.7%, to $43.3 million in 1996. These increases were partially
offset by a continued decline in fees from non-variable universal life of $4.8
million, to $80.9 million, in 1996.
Net investment income increased $22.2 million, or 9.7%, to $251.3 million in
1996 primarily from $15.4 million in additional income on proceeds from the
October 1995 initial public offerings. Also, increases in short-term debt used
to finance additions to the investment portfolio resulted in approximately $10.9
million in additional investment income. Partially offsetting these increases
was a slightly lower portfolio yield in 1996.
Other income increased $6.8 million, or 30.4%, to $29.2 million in 1996. This
increase was primarily attributable to increased investment management income.
Policy benefits, claims and losses decreased $12.2 million, or 3.9%, to
$303.4 million in 1996. Losses in the disability income line decreased $16.3
million due primarily to reserve strengthening of $14.5 million in 1995.
Additionally, non-variable universal life benefits decreased $2.5 million
principally due to improved mortality experience in 1996. These decreases were
partially offset by an increase in variable products' policy benefits of $6.2
million, which related primarily to growth in these product lines.
The increase in other operating expenses of $17.0 million, or 16.8%, to
$118.2 million in 1996 was primarily attributable to $8.3 million of additional
interest expense in 1996 relating to the short-term debt used to finance
additions to the investment portfolio. Additionally, other operating expenses in
1995 included a $7.5 million decrease due to the cession of substantially all
term life insurance business.
Interest Margins
The results of the Allmerica Financial Services segment depend, in part, on the
maintenance of profitable margins between investment results from investment
assets supporting universal life and general account annuity products and the
interest credited on those products.
The following table sets forth interest earned, interest credited and the
related interest margin.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Net investment income $ 141.2 $ 145.9 $ 152.7
Less: Interest credited 99.2 101.3 107.7
................................................................................
Interest margins (1) $ 42.0 $ 44.6 $ 45.0
- --------------------------------------------------------------------------------
(1) Interest margins represent the difference between income earned on
investment assets and interest credited to customers' universal life and general
account annuity policies. Earnings on surplus assets are excluded from net
investment income in the calculation of the above interest margins.
Interest margins decreased slightly in 1997 as a result of a decline in
investment income and related policies in force in the universal life and
general account annuity product lines. Interest margins were relatively
consistent in 1996 as compared to 1995.
38
Institutional Services
The following table summarizes the results of operations for the Institutional
Services segment.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Revenues
Fees, premiums and
non-insurance income (1) $ 40.6 $ 36.6 $ 39.9
Net investment income
GICs 82.3 98.5 152.9
Other 98.6 116.4 114.5
Net realized gains 21.9 19.2 5.5
Gain on sale of mutual fund
processing business -- -- 20.7
................................................................................
Total revenues 243.4 270.7 333.5
................................................................................
Policy benefits, claims and losses
Interest credited to GICs 64.1 89.2 137.2
Other 61.0 70.9 80.6
................................................................................
Total policy benefits, claims
and losses 125.1 160.1 217.8
Policy acquisition expenses 2.9 2.9 3.2
Other operating expenses 53.0 54.9 69.7
................................................................................
Income before taxes $ 62.4 $ 52.8 $ 42.8
================================================================================
(1) Fees, premiums and non-insurance income includes fees from retirement
services, mutual fund services, institutional 401(k) recordkeeping services and
other miscellaneous non-insurance related fees. In March 1995, the Company sold
its mutual fund processing business.
1997 Compared to 1996
Income before taxes increased $9.6 million, or 18.2%, to $62.4 million in 1997.
During 1996, Institutional Services recognized a contingency payment for the
sale of the mutual fund processing business of $4.8 million. Excluding this
item, income before taxes increased $14.4 million, or 30.0%. This increase was
primarily attributable to an increase in the interest margins on GICs of $4.1
million, increased realized gains of $2.7 million and additional contribution
from the defined benefit and defined contribution plan, group variable life and
telemarketing product lines of $1.6 million, $1.4 million and $1.3 million,
respectively.
Fees, premiums and non-insurance income increased $4.0 million, or 10.9%, to
$40.6 million in 1997. Excluding the aforementioned contingency payment, fees,
premiums and non-insurance income increased $8.8 million or 27.7%. This increase
was primarily due to growth in fees from the Company's group variable life and
defined contribution separate account product lines of $4.4 million and $1.2
million, respectively. In addition, recordkeeping fees increased $2.3 million.
Net investment income related to GICs and interest credited to GIC
contractholders have declined as a result of declining traditional GIC deposits.
During 1997, the interest margin on GICs increased $8.9 million due to a
reallocation of general account assets to this line, and to the combination of
slightly higher investment yields and lower average crediting rates on the
remaining contracts. Effective January 1, 1997, capital and investment assets
were reallocated between the defined benefit plan, defined contribution plan and
GIC product lines. This reallocation resulted in an increase in GIC capital and
investment assets of approximately $61.0 million. Had this reallocation occurred
in 1996 and 1995, interest earned in the GIC product line for the years ended
December 31, 1996 and 1995, would have been $103.3 million and $158.7 million,
respectively. Management expects GIC margins to decline as the existing
contracts continue to mature.
Other net investment income decreased $17.8 million, or 15.3%, to $98.6
million in 1997. This decrease resulted from a decline in average invested
assets due to cancellations of defined benefit plans, as well as transfers of
certain plan assets to the separate accounts.
Net realized gains increased $2.7 million, to $21.9 million in 1997. This
change was due primarily to increased gains from the sale of fixed maturity
investments.
Other policy benefits, claims and losses consist primarily of interest
credited to and benefits provided by the Company's defined contribution and
defined benefit plan products, and group variable life product lines including
annuity benefits for certain defined benefit plan participants electing that
option. Other policy benefits, claims and losses declined from $70.9 million in
1996 to $61.0 million in 1997. This was primarily due to reductions in the
interest credited to participants resulting from the aforementioned
cancellations and transfers to the separate accounts.
Other operating expenses decreased $1.9 million, or 3.5%, to $53.0 million in
1997. This decrease was primarily attributable to reductions in employee related
costs.
1996 Compared to 1995
Income before taxes increased $10.0 million, or 23.4%, to $52.8 million in 1996.
This change was primarily attributable to increased realized gains of $13.7
million and to decreased other policy benefits, claims and losses of $9.7
million resulting from defined benefit and defined contribution plan
cancellations. These items were partially offset by a net decline of $9.8
million related to the sale of the mutual fund processing business in 1995 and a
decline in the interest margins on GICs of $6.4 million.
Fees, premiums and non-insurance income decreased $3.3 million, or 28.3%, to
$36.6 million in 1996. This decrease was primarily attributable to a $13.7
million decrease in revenues due to the absence of the mutual fund processing
business in 1996, partially offset by the 1996 receipt of a non-recurring $4.8
million contingent payment related to the aforementioned sale and $3.0 million
from growth in retail telemarketing revenues. Additionally, fee income increased
$1.5 million from the appreciation of separate account balances in related
defined benefit and defined contribution plans.
39
Net investment income related to GICs and interest credited to GIC
contractholders have declined in 1996 as a result of lower traditional GIC
deposits as compared to 1995.
Net realized gains increased $13.7 million, to $19.2 million in 1996. This
change resulted primarily from increased gains from sales of real estate
properties totaling $12.2 million.
Other policy benefits, claims and losses for defined benefit plans, defined
contribution plans, and the group variable life product declined from $80.6
million in 1995 to $70.9 million in 1996. This was primarily due to reductions
in the interest credited to participants resulting from the aforementioned
cancellations in defined benefit and defined contribution plans.
Other operating expenses decreased $14.8 million, or 21.2%, to $54.9 million
in 1996. This decrease was primarily attributable to the sale of the mutual fund
processing business, which incurred $19.8 million of operating expenses in 1995.
Allmerica Asset Management
The following table summarizes the results of operations for the Allmerica Asset
Management segment.
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Fees and other income:
External $ 1.6 $ 1.1 $ 1.0
Internal 7.1 7.7 3.4
................................................................................
Total revenues 8.7 8.8 4.4
Other operating expenses 7.3 7.7 2.1
................................................................................
Income before taxes $ 1.4 $ 1.1 $ 2.3
================================================================================
The Company provides investment advisory and sub-advisory services, primarily
to affiliates, through its registered investment advisor, Allmerica Asset
Management ("AAM"). In the second quarter of 1996, AAM finalized contracts with
two related parties, FAFLIC and AFLIAC, to provide investment advisory services
at cost. The internal fees and corresponding operating expenses related to these
contracts totaled $3.4 million and $4.3 million for the years ended December 31,
1997 and 1996, respectively.
Corporate
The following table summarizes the results of operations for the Corporate
segment.
Period from
October 1
through
December 31 December 31 December 31
(In millions) 1997 1996 1995
===============================================================================
Revenues
Investment and other income $ 11.5 $ 2.7 $ 0.4
Realized losses (0.3) (0.9) --
................................................................................
Total revenues 11.2 1.8 0.4
Other operating expenses 22.6 18.6 3.5
................................................................................
Loss before taxes and
minority interest (11.4) (16.8) (3.1)
Minority interest:
Distributions on mandatorily
redeemable preferred securities
of a subsidiary trust holding
solely junior subordinated
debentures of the Company (22.4) -- --
................................................................................
Loss before taxes $ (33.8) $ (16.8) $ (3.1)
================================================================================
This segment consists primarily of $55.2 million of cash and investments,
$202.1 million of Senior Debentures and $300.0 million of Capital Securities.
Investment and other income increased $8.8 million in 1997 compared to 1996,
primarily due to the investment of the net proceeds from the February 3, 1997
issuance of Capital Securities. These proceeds were invested in the short-term
investment portfolio, and were used to finance the July 16 merger with Allmerica
P&C. Other operating expenses in 1997 and 1996 principally reflect interest
expense on the Company's 7-5/8% Senior Debentures. In 1997, other operating
expenses also reflects $2.8 million of interest expense on the Company's
short-term revolving credit loan which commenced August 15, 1997 and was repaid
and matured on December 15, 1997. Additionally, minority interest represents
distributions on the Capital Securities, which pay cumulative distributions at a
rate of 8.207% semiannually, commencing August 15, 1997.
40
Investment Portfolio
The Company had investment assets diversified across several asset classes, as
follows:
December 31
(Dollars in millions) 1997(1) 1996(1)
================================================================================
% of Total % of Total
Carrying Carrying Carrying Carrying
Value Value Value Value
Fixed maturities (2) $ 7,726.6 79.8% $ 7,891.7 79.4%
Equity securities (2) 479.0 4.9 473.6 4.8
Mortgages 679.5 7.0 764.6 7.7
Policy loans 360.7 3.7 362.6 3.6
Real estate 50.3 0.5 120.7 1.2
Cash and cash equivalents 240.1 2.5 202.6 2.0
Other invested assets 148.3 1.6 128.8 1.3
................................................................................
Total $ 9,684.5 100.0% $ 9,944.6 100.0%
- --------------------------------------------------------------------------------
(1) Includes Closed Block invested assets with a carrying value of $768.7
million and $772.7 million at December 31, 1997 and 1996, respectively.
(2) The Company carries the fixed maturities and equity securities in its
investment portfolio at market value.
[PIE CHART APPEARS HERE]
Bond Portfolio Credit Quality
Aaa/Aa/A 52%
Baa 30%
Ba 9%
B & Below 9%
Total investment assets decreased $260.1 million, or 2.6%, to $9.7 billion
during 1997. This decrease is primarily attributable to the sales of fixed
maturities and loan repayments on outstanding mortgages. Fixed maturities
decreased $165.1 million, or 2.1%, due primarily to the settlement of GIC
contracts and to decreased assets resulting from the cession of the disability
income line. This decrease was partially offset by market value appreciation in
the fixed maturities portfolio of $134.3 million. Mortgage loans also decreased
$85.1 million, or 11.1%, to $679.5 million caused primarily by loan repayments.
Additionally, equity securities increased $5.4 million, or 1.1%, to $479.0
million, as a result of market value appreciation that more than offset the
shift in the Regional Property and Casualty segment's portfolio holdings from
equity securities to fixed maturity securities. The real estate portfolio
decreased $70.4 million, or 58.3%, to $50.3 million during 1997 due to sales of
investment properties. The Company intends to sell its remaining holdings in
this portfolio. The increase in other invested assets of $19.5 million, or
15.1%, to $148.3 million primarily relates to purchases of limited partnerships.
Cash and cash equivalents increased $37.5 million, or 18.5%, to $240.1 million.
The Company's fixed maturity portfolio is comprised of primarily investment
grade corporate securities, tax-exempt issues of state and local governments,
U.S. government and agency securities and other issues. Based on ratings by the
National Association of Insurance Commissioners, investment grade securities
comprised 82.5% and 84.8% of the Company's total fixed maturity portfolio at
December 31, 1997 and 1996, respectively. In 1996 and 1997, there were modest
shifts to higher yielding debt securities, including longer duration and
non-investment grade securities. The average yield on debt securities was 7.6%
and 7.3% for 1997 and 1996, respectively. 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.
The following table illustrates asset valuation allowances and additions to or
deductions from such allowances for the periods indicated.
For the Years Ended December 31
(Dollars in millions)
================================================================================
Other
Real Invested
1996 Mortgages Estate Assets Total
................................................................................
Beginning balance $ 33.8 $ 19.6 $ 3.7 $ 57.1
Provision 5.5 -- -- 5.5
Write-offs (1) (19.7) (4.7) (3.7) (28.1)
................................................................................
Ending balance $ 19.6 $ 14.9 $ -- $ 34.5
Valuation allowance as a
percentage of carrying
value before reserves 2.5% 11.0% --% 3.8%
1997
................................................................................
Provision 2.5 6.0 -- 8.5
Write-offs (1) (1.4) (20.9) -- (22.3)
................................................................................
Ending balance $ 20.7 $ -- $ -- $ 20.7
Valuation allowance as a
percentage of carrying
value before reserves 3.0% --% --% 3.0%
(1) Write-offs reflect asset sales, foreclosures, forgiveness of debt upon
restructuring and reserve releases due to permanent impairments.
41
Write-offs of mortgages during 1996 reflect an increase in the disposal of
modified loans which were previously impaired. The increase in write-offs of
real estate reserves during 1997 reflects the permanent write down of all real
estate assets to the estimated fair value less costs of disposal. During 1997,
the Company adopted a definitive plan to sell its real estate holdings.
Income Taxes
AFC and its domestic subsidiaries (including certain non-insurance operations)
file a consolidated United States federal income tax return. Entities included
within the consolidated group are segregated into either a life insurance or a
non-life insurance company subgroup. The consolidation of these subgroups is
subject to certain statutory restrictions on the percentage of eligible non-life
tax losses that can be applied to offset life company taxable income. Prior to
the merger, Allmerica P&C and its subsidiaries filed a separate United States
federal income tax return.
FAFLIC, as a mutual insurance company until October 1995, was required to
adjust its deduction for policyholder dividends by the differential earnings
amount under Section 809 of the Internal Revenue Code. This amount was computed,
for each tax year, by multiplying the average equity base of the FAFLIC/AFLIAC
consolidated group, as determined for tax purposes, by the estimate of an excess
of an imputed earnings rate over the average mutual life insurance companies'
earnings rate. The differential earnings amount for each tax year was
subsequently recomputed when actual earnings rates were published by the
Internal Revenue Service ("IRS"). As a stock company, FAFLIC is no longer
required to reduce its policyholder dividend deduction by the differential
earnings amount. The differential earnings amount in 1996 related to an
adjustment for the 1994 tax year based on the actual average mutual life
insurance companies' earnings rate issued by the IRS in 1996.
Provision for federal income taxes before minority interest was $93.6 million
during 1997 compared to $75.2 million during 1996. These provisions resulted in
consolidated effective federal tax rates of 25.6% and 22.7%, respectively. The
effective tax rates for AFLIAC and FAFLIC and its non-insurance subsidiaries
were 37.4% and 28.9% during 1997 and 1996, respectively. The increase in the
rate for FAFLIC in 1997 resulted primarily from the absence, in 1997, of a $10.2
million differential earnings benefit recognized in 1996, and from an increase
in reserves for prior year tax liabilities. The effective tax rates for
Allmerica P&C and its subsidiaries were 16.5% and 18.4% during 1997 and 1996,
respectively. The decrease in the rate for Allmerica P&C and its subsidiaries
reflects a higher underwriting loss and greater proportion of pre-tax income
from tax-exempt bonds in 1997.
Provision for federal income taxes before minority interest was $75.2
million during 1996 compared to $82.7 million during 1995. These provisions
resulted in consolidated effective federal tax rates of 22.7% and 27.4% in 1996
and 1995, respectively. The effective tax rates for AFLIAC and FAFLIC and its
non-insurance subsidiaries were 28.9% and 32.0% during 1996 and 1995,
respectively. The reduction in the rate for FAFLIC in 1996 resulted primarily
from additional reserves provided for revisions of estimated prior year tax
liabilities in 1995, as well as an increase of $2.6 million in the differential
earnings benefit from 1995 to 1996. The effective tax rates for Allmerica P&C
and its subsidiaries were 18.4% and 25.3% during 1996 and 1995, respectively.
The decrease in the rate for Allmerica P&C and its subsidiaries reflects a
higher underwriting loss and greater proportion of pre-tax income from
tax-exempt bonds in 1996, and to reserves provided for revisions in estimated
prior year tax liabilities in 1995.
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.
Sources of cash for the Company's insurance subsidiaries are from premiums and
fees collected, investment income and maturing investments. Primary cash
outflows are paid benefits, claims, losses and loss adjustment expenses, policy
acquisition expenses, other underwriting expenses and investment purchases. Cash
outflows related to benefits, claims, losses and loss adjustment expenses can be
variable because of uncertainties surrounding settlement dates for liabilities
for unpaid losses and because of the potential for large losses either
individually or in the aggregate. The Company periodically adjusts its
investment policy to respond to changes in short-term and long-term cash
requirements.
Net cash used in operating activities was $173.2 million in 1997, while net
cash provided by operating activities was $156.0 million and $131.2 million in
1996 and 1995, respectively. The decrease in 1997 resulted primarily from a
$207.0 million payment for the cession of the disability income line of
business, a significant acceleration of claims payments in the Regional Property
and Casualty segment and increased commissions and other deferrable expenses
related to the growth in the annuity and variable universal life product lines.
The increase in 1996 was primarily attributable to an increase in cash provided
by the operations of the life insurance subsidiaries. This increase was
partially offset by increased underwriting losses in the property and casualty
insurance subsidiaries which resulted from an increase in claims payments.
42
Net cash provided by investing activities was $120.5 million in 1997 and
$424.6 million in 1996. Net cash used in investing activities was $128.1 million
in 1995. The decrease from 1996 to 1997 primarily reflects the purchase of the
minority interest of Allmerica P&C on July 16, 1997 for $425.6 million and fewer
sales of investments used to finance net GIC withdrawals. The decrease was
partially offset by increased sales of investments. The proceeds from these
increased sales were used to finance the cession of the disability income line
of business, $140.0 million of the aforementioned purchase price of the merger,
and the acceleration of claims payments in the Regional Property and Casualty
segment. In 1996, purchases of fixed maturities were unusually high due to the
investment of the remaining net proceeds of the Company's initial public
offerings of stock and debt. The increase from 1995 to 1996 was primarily
attributable to increased sales of investments used to finance net withdrawals
from GICs partially offset by additional purchases of fixed maturities and other
long-term investments financed through an increase in investable cash generated
by operations.
Net cash provided by financing activities was $90.3 million in 1997. Net cash
used for financing activities was $685.1 million, and $235.7 million in 1996 and
1995, respectively. In 1997, the primary source of cash provided by financing
activities was the Company's receipt of proceeds of $296.3 million from the
issuance of Capital Securities. In addition, the Company made cash payments on
withdrawals from GICs that exceeded cash received from deposits on these
contracts by $189.6 million, $636.3 million and $624.1 million in 1997, 1996 and
1995, respectively. In 1997, the Company received approximately $225.0 million
of new deposits on floating rate GICs. In 1995, the cash used for financing
activities was positively affected by the Company's receipt of proceeds of
$248.0 million and $197.2 million from its initial public offerings of stock and
debt, respectively.
In June 1997, the Company entered into a credit agreement providing for a
$225.0 million revolving line of credit which expired on December 15, 1997.
Borrowings under that line of credit were unsecured and incurred interest at a
rate per annum equal to, at the Company's option, a designated base rate or the
eurodollar rate plus applicable margin. The Company borrowed and repaid
approximately $140.0 million during the year and paid approximately $2.8 million
in interest.
On February 3, 1997, AFC Capital Trust (the "Trust"), a wholly-owned
subsidiary business trust of AFC, issued $300.0 million Series A Capital
Securities, which pay cumulative dividends at a rate of 8.207% semiannually
commencing August 15, 1997. The Trust exists for the sole purpose of issuing the
Capital Securities and investing the proceeds thereof in an equivalent amount of
8.207% Junior Subordinated Deferrable Interest Debentures due 2027 of AFC (the
"Subordinated Debentures"). Through certain guarantees, the Subordinated
Debentures and the terms of related agreements, AFC has irrevocably and
unconditionally guaranteed the obligations of the Trust under the Capital
Securities. Net proceeds from the offering of approximately $296.3 million
funded a portion of the July 16, 1997 acquisition of the 24.2 million publicly
held shares of Allmerica P&C. On August 7, 1997, AFC and the Trust exchanged the
Series A Capital Securities for a like amount of Series B Capital Securities and
related guarantees which are registered under the Securities Act of 1933 as
required under the terms of the initial transaction. The Company pays
approximately $24.6 million per year in interest payments on the Capital
Securities, which are reflected in minority interest on an after-tax basis.
On October 16, 1995, FAFLIC converted from a policyholder owned to stockholder
owned insurance company and AFC became the holding company for FAFLIC. AFC also
raised net proceeds of $248.0 million from the sale of Common Stock and issued
$200.0 million principal amount 7-5/8% Senior Debentures due 2025 with net
proceeds to the Company of $197.2 million. The Company pays approximately $15.3
million per year in interest payments on the Senior Debentures.
AFC has sufficient funds at the holding company or available through dividends
from FAFLIC and Allmerica P&C to meet its obligations to pay interest on the
Senior Debentures, Subordinated Debentures and dividends, when and if declared
by the Board of Directors, on the common stock(see Note 14 of the Consolidated
Financial Statements). Whether the Company will pay dividends in the future
depends upon the costs of administering a dividend program as compared to the
benefits conferred, and upon the earnings and financial condition of AFC.
Based on current trends, the Company expects to continue to generate
sufficient positive operating cash to meet all short-term and long-term cash
requirements. The Company maintains a high degree of liquidity within the
investment portfolio in fixed maturity investments, common stock and short-term
investments. FAFLIC and Allmerica P&C have $100.0 million and $40.0 million
respectively, under various committed short-term lines of credit. At December
31, 1997, no amounts were outstanding and $100.0 million and $7.4 million were
available for borrowing by FAFLIC and Allmerica P&C, respectively. FAFLIC had no
commercial paper borrowings outstanding and Allmerica P&C had $32.9 million of
commercial paper borrowings outstanding at December 31, 1997.
43
Recent Developments
On October 23, 1997, Standard & Poor's upgraded its claims-paying ability rating
for FAFLIC and AFLIAC to AA- (Excellent) from A+ (Good).
In July 1997, a lawsuit was instituted in Louisiana against AFC and certain of
its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive
acts, breach of contract, misrepresentation and related claims in the sale of
life insurance policies. In October 1997, plaintiffs voluntarily dismissed the
Louisiana suit and refiled the action in Federal District Court in Worcester,
Massachusetts. The plaintiffs seek to be certified as a class. The case is in
early stages of discovery and the Company is evaluating the claims. Although the
Company believes it has meritorious defenses to plaintiffs' claims, there can be
no assurance that the claims will be resolved on a basis which is satisfactory
to the Company.
The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was
consummated on July 16, 1997. Through the merger, the Company acquired all of
the outstanding common stock of Allmerica P&C that it did not already own in
exchange for cash of $425.6 million and approximately 9.7 million shares of AFC
stock.
The merger has been accounted for as a purchase. Total consideration of
approximately $798.1 million has been allocated to the minority interest in the
assets and liabilities based on estimates of their fair values. The minority
interest acquired totaled $703.5 million. A total of $90.6 million, representing
the excess of the purchase price over the fair values of the net assets
acquired, net of deferred taxes, has been allocated to goodwill and is being
amortized over a 40-year period.
On April 14, 1997, the Company entered into an agreement in principle to cede
substantially all of the Company's individual disability income line of business
under a 100% coinsurance agreement to Metropolitan Life Insurance Company. The
coinsurance agreement became effective October 1, 1997. The transaction has
resulted in the recognition of a $53.9 million pre-tax loss in the first quarter
of 1997.
Year 2000
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities.
Based on a recent assessment, the Company determined that it will be
required to modify or replace significant portions of its software so that its
computer systems will properly utilize dates beyond December 31, 1999. The
Company presently believes that with modifications to existing software and
conversions to new software, the Year 2000 issue will be resolved. However, if
such modifications and conversions are not made, or are not completed timely,
the Year 2000 issue could have a material impact on the operations of the
Company.
The Company has initiated formal communications with all of its significant
suppliers and large customers to determine the extent to which the Company is
vulnerable to those third parties' failure to remediate their own Year 2000
issue. The Company's total Year 2000 project cost and estimates to complete the
project include the estimated costs and time associated with the impact of a
third party's Year 2000 issue, and are based on presently available information.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have material adverse effect on the Company. The
Company does not believe that it has material exposure to contingencies related
to the Year 2000 issue for the products it has sold. Although the Company does
not believe that there is a material contingency associated with the Year 2000
project, there can be no assurance that exposure for material contingencies will
not arise.
The Company will utilize both internal and external resources to reprogram, or
replace, and test the software for Year 2000 modifications. The Company plans to
complete the mission critical elements of the Year 2000 project by December 31,
1998. The cost of the Year 2000 project will be expensed as incurred over the
next two years and is being funded through a reallocation of resources from
discretionary projects. Therefore, the Year 2000 project is not expected to
result in significant incremental technology costs, or to have a material effect
on the results of operations. Through December 31, 1997, the Company has
incurred and expensed approximately $20 million related to the assessment of,
and preliminary efforts in connection with, the project and the development of a
remediation plan. The total remaining cost of the project is estimated at
between $50-$70 million.
The costs of the project and the date on which the Company plans to complete
the Year 2000 modifications are
44
based on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors. However, there can
be no guarantee that these estimates will be achieved and actual results could
differ materially from those plans. Specific factors that might cause such
material differences include, but are not limited to, the availability and cost
of personnel trained in this area, the ability to locate and correct all
relevant computer codes and similar uncertainties.
Forward-Looking Statements
The Company wishes to caution readers that the following important factors,
among others, in some cases have affected and in the future could affect, the
Company's actual results and could cause the Company's actual results for 1997
and beyond to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Company. When used in the MD&A
discussion, the words "believes," "anticipated," "expects" and similar
expressions are intended to identify forward looking statements. See "Important
Factors Regarding Forward-Looking Statements" incorporated herein by reference
and filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the
period ended December 31, 1997.
Factors that may cause actual results to differ materially from those
contemplated or projected, forecast, estimated or budgeted in such forward
looking statements include among others, the following possibilities: (i)
adverse catastrophe experience and severe weather; (ii) adverse loss development
for events the Company insured in prior years or adverse trends in mortality and
morbidity; (iii) heightened competition, including the intensification of price
competition, the entry of new competitors, and the introduction of new products
by new and existing competitors; (iv) adverse state and federal legislation or
regulation, including decreases in rates, limitations on premium levels,
increases in minimum capital and reserve requirements, benefit mandates,
limitations on the ability to manage care and utilization, and tax treatment of
insurance and annuity products; (v) changes in interest rates causing a
reduction of investment income or in the market value of interest rate sensitive
investments; (vi) failure to obtain new customers, retain existing customers or
reductions in policies in force by existing customers; (vii) higher service,
administrative, or general expense due to the need for additional advertising,
marketing, administrative or management information systems expenditures; (viii)
loss or retirement of key executives; (ix) increases in medical costs, including
increases in utilization, costs of medical services, pharmaceuticals, durable
medical equipment and other covered items; (x) termination of provider contracts
or renegotiation at less cost-effective rates or terms of payment; (xi) changes
in the Company's liquidity due to changes in asset and liability matching; (xii)
restrictions on insurance underwriting, based on genetic testing and other
criteria; (xiii) adverse changes in the ratings obtained from independent rating
agencies, such as Moody's, Standard & Poor's, A.M. Best, and Duff & Phelps;
(xiv) lower appreciation on and decline in value of managed investments,
resulting in reduced variable products, assets and related fees; (xv) possible
claims relating to sales practices for insurance products; and (xvi) uncertainty
related to the Year 2000 issue.
45
Report of Independent Accountants
To the Board of Directors and Shareholders of
Allmerica Financial Corporation
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of shareholders' equity, and of cash flows
present fairly, in all material respects, the financial position of Allmerica
Financial Corporation and its subsidiaries at December 31, 1997 and 1996, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1997, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ Price Waterhouse LLP
Boston, Massachusetts
February 3, 1998
Management Report on Responsibility
for Financial Reporting
The management of Allmerica Financial Corporation has the responsibility for
preparing the accompanying consolidated financial statements and for their
integrity and objectivity. The statements were prepared in conformity with
generally accepted accounting principles and include amounts based on
management's informed estimates and judgments. We believe that these statements
present fairly the Company's financial position and results of operations and
that the other information contained in the annual report is accurate and
consistent with the financial statements.
Allmerica Financial Corporation's Board of Directors annually appoints
independent accountants to perform an audit of its consolidated financial
statements. The financial statements have been audited by Price Waterhouse LLP,
independent accountants, in accordance with generally accepted auditing
standards. Their audit included consideration of the Company's system of
internal control in order to determine the audit procedures required to express
their opinion on the consolidated financial statements.
Management of Allmerica Financial Corporation has established and maintains a
system of internal control that provides reasonable assurance that assets are
safeguarded and that transactions are properly authorized and recorded. The
system of internal control provides for appropriate division of responsibility
and is documented by written policies and procedures that are communicated to
employees with significant roles in the financial reporting process and updated
as necessary. Management continually monitors the system of internal control for
compliance. Allmerica Financial Corporation and its subsidiaries maintain a
strong internal audit program that independently assesses the effectiveness of
the internal controls and recommends possible improvements thereto. Management
recognizes the inherent limitations in all internal control systems and believes
that our system of internal control provides an appropriate balance between the
costs and benefits desired. Management believes that the Company's system of
internal control provides reasonable assurance that errors or irregularities
that would be material to the financial statements are prevented or detected in
the normal course of business.
The Audit Committee of the Board of Directors, composed solely of outside
directors, oversees management's discharge of its financial reporting
responsibilities. The committee meets periodically with management, our internal
auditors and our independent accountants, Price Waterhouse LLP. Both our
internal auditors and Price Waterhouse LLP have direct access to the Audit
Committee.
Management recognizes its responsibility for fostering a strong ethical
climate. This responsibility is reflected in the Company's policies which
address, among other things, potential conflicts of interest; compliance with
all domestic and foreign laws including those relating to financial disclosure
and the confidentiality of proprietary information. Allmerica Financial
Corporation maintains a systematic program to assess compliance with these
policies.
/s/ John F. O'Brien /s/ Edward J. Parry, III
John F. O'Brien Edward J. Parry, III
President and Chief Vice President,
Executive Officer Chief Financial Officer and
Principal Accounting Officer
46
Consolidated Statements of Income
For the Years Ended December 31
(In millions, except per share data) 1997 1996 1995
====================================================================================================================
Revenues
....................................................................................................................
Premiums $ 2,311.1 $ 2,236.3 $ 2,222.8
Universal life and investment product policy fees 237.3 197.2 172.4
Net investment income 653.4 672.6 710.5
Net realized investment gains 76.2 65.9 19.1
Realized gain on sale of mutual fund processing business -- -- 20.7
Other income 117.6 105.6 109.3
....................................................................................................................
Total revenues 3,395.6 3,277.6 3,254.8
....................................................................................................................
Benefits, Losses and Expenses
....................................................................................................................
Policy benefits, claims, losses and loss adjustment expenses 2,004.7 1,957.0 2,010.3
Policy acquisition expenses 425.1 470.1 470.9
Loss from cession of disability income business 53.9 -- --
Other operating expenses 546.4 518.8 471.8
....................................................................................................................
Total benefits, losses and expenses 3,030.1 2,945.9 2,953.0
....................................................................................................................
Income before federal income taxes 365.5 331.7 301.8
....................................................................................................................
Federal income tax expense (benefit)
....................................................................................................................
Current 79.7 90.9 119.7
Deferred 13.9 (15.7) (37.0)
....................................................................................................................
Total federal income tax expense 93.6 75.2 82.7
....................................................................................................................
Income before minority interest and extraordinary item 271.9 256.5 219.1
Minority interest:
Distributions on mandatorily redeemable preferred stock of a subsidiary trust
holding solely junior subordinated debentures of the Company (14.5) -- --
Equity in earnings (48.2) (74.6) (73.1)
....................................................................................................................
Total minority interest (62.7) (74.6) (73.1)
....................................................................................................................
Income before extraordinary item 209.2 181.9 146.0
Extraordinary item - demutualization expenses -- -- (12.1)
....................................................................................................................
Net income $ 209.2 $ 181.9 $ 133.9
====================================================================================================================
For the Period Year Ended
October 1 December 31,
Year Ended Year Ended through 1995
December 31, December 31, December 31, Pro Forma*
1997 1996 1995 (Unaudited)
=============================================================================================================
Net income after demutualization $ 209.2 $ 181.9 $ 40.7 $ 130.6
- -------------------------------------------------------------------------------------------------------------
Earnings per common share:
- --------------------------
Basic:
- ------
Net income after demutualization per share $ 3.83 $ 3.63 $ 0.82 $ 2.61
Weighted average shares outstanding 54.7 50.1 49.4 50.1
Diluted:
- --------
Net income after demutualization per share $ 3.82 $ 3.63 $ 0.82 $ 2.61
Weighted average shares outstanding 54.8 50.1 49.4 50.1
- -------------------------------------------------------------------------------------------------------------
* The pro forma information gives effect to the transactions referred to in Note
1N.
The accompanying notes are an integral part of these consolidated financial
statements.
47
Consolidated Balance Sheets
December 31
(In millions, except per share data) 1997 1996
============================================================================================================
Assets
............................................................................................................
Investments:
Fixed maturities-at fair value (amortized cost of $7,052.9 and $7,305.5) $ 7,313.7 $ 7,487.8
Equity securities-at fair value (cost of $341.1 and $328.2) 479.0 473.6
Mortgage loans 567.5 650.1
Real estate 50.3 120.7
Policy loans 141.9 132.4
Other long-term investments 148.3 128.8
............................................................................................................
Total investments 8,700.7 8,993.4
............................................................................................................
Cash and cash equivalents 215.1 178.5
Accrued investment income 142.3 149.0
Deferred policy acquisition costs 965.5 822.7
Reinsurance receivable on unpaid losses, benefits and unearned premiums 1,040.3 875.6
Deferred federal income taxes -- 66.8
Premiums, accounts and notes receivable 554.4 533.0
Other assets 368.6 307.5
Closed Block assets 806.7 810.8
Separate account assets 9,755.4 6,233.0
............................................................................................................
Total assets $ 22,549.0 $ 18,970.3
============================================================================================================
Liabilities
............................................................................................................
Policy liabilities and accruals:
Future policy benefits $ 2,598.6 $ 2,613.7
Outstanding claims, losses and loss adjustment expenses 2,825.1 2,944.1
Unearned premiums 846.8 822.5
Contractholder deposit funds and other policy liabilities 1,852.7 2,060.4
............................................................................................................
Total policy liabilities and accruals 8,123.2 8,440.7
............................................................................................................
Expenses and taxes payable 670.7 622.3
Reinsurance premiums payable 37.7 31.4
Short-term debt 33.0 38.4
Deferred federal income taxes 12.9 --
Long-term debt 202.1 202.2
Closed Block liabilities 885.5 899.4
Separate account liabilities 9,749.7 6,227.2
............................................................................................................
Total liabilities 19,714.8 16,461.6
............................................................................................................
Mandatorily redeemable preferred securities of a subsidiary trust holding solely
junior subordinated debentures of the Company 300.0 --
Common stock 152.9 784.0
............................................................................................................
Minority interest 452.9 784.0
............................................................................................................
Commitments and contingencies (Notes 15 and 20)
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, 60.0 million
and 50.1 million shares issued and outstanding, respectively 0.6 0.5
Additional paid-in capital 1,755.0 1,382.5
Unrealized appreciation on investments, net 217.9 131.6
Retained earnings 407.8 210.1
............................................................................................................
Total shareholders' equity 2,381.3 1,724.7
............................................................................................................
Total liabilities and shareholders' equity $ 22,549.0 $ 18,970.3
============================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
48
Consolidated Statements of Shareholders' Equity
For the Years Ended December 31
(In millions) 1997 1996 1995
====================================================================================================================
Preferred Stock $ -- $ -- $ --
....................................................................................................................
Common Stock
....................................................................................................................
Balance at beginning of year 0.5 0.5 --
Issuance of common stock 0.1 -- --
Demutualization transaction -- -- 0.4
Initial public offering -- -- 0.1
....................................................................................................................
Balance at end of year 0.6 0.5 0.5
....................................................................................................................
Additional Paid-In Capital
....................................................................................................................
Balance at beginning of year 1,382.5 1,382.5 --
Issuance of common stock related to the merger with Allmerica P&C 372.5 -- --
Issuance of common stock 3.7 -- --
Issuance costs of mandatorily redeemable preferred securities of a subsidiary
trust holding solely junior subordinated debentures of the Company (3.7) -- --
Demutualization transaction -- -- 1,134.6
Initial public offering -- -- 247.9
....................................................................................................................
Balance at end of year 1,755.0 1,382.5 1,382.5
....................................................................................................................
Unrealized Appreciation on Investments, Net
....................................................................................................................
Balance at beginning of year 131.6 153.0 (79.0)
....................................................................................................................
Effect of transfer of securities from held-to-maturity to available-for-sale:
Net appreciation on available-for-sale debt securities -- -- 22.4
Provision for deferred federal income taxes and minority interest -- -- (9.6)
....................................................................................................................
-- -- 12.8
....................................................................................................................
Appreciation (depreciation) during the period:
Net appreciation (depreciation) on available-for-sale securities 171.3 (35.1) 466.0
(Provision) Benefit for deferred federal income taxes (59.9) 12.3 (163.1)
Minority interest (25.1) 1.4 (83.7)
....................................................................................................................
86.3 (21.4) 219.2
....................................................................................................................
Balance at end of year 217.9 131.6 153.0
....................................................................................................................
Retained Earnings
....................................................................................................................
Balance at beginning of year 210.1 38.2 1,071.4
Net income prior to demutualization -- -- 93.2
....................................................................................................................
210.1 38.2 1,164.6
Demutualization transaction -- -- (1,164.6)
Net income subsequent to demutualization 209.2 181.9 40.7
Dividends to shareholders (11.5) (10.0) (2.5)
....................................................................................................................
Balance at end of year 407.8 210.1 38.2
....................................................................................................................
Total shareholders' equity $ 2,381.3 $ 1,724.7 $ 1,574.2
====================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
49
Consolidated Statements of Cash Flows
For the Years Ended December 31
(In millions) 1997 1996 1995
===============================================================================================================================
Cash Flows From Operating Activities
...............................................................................................................................
Net income $ 209.2 $ 181.9 $ 133.9
Adjustments to reconcile net income to net cash provided by operating activities:
Minority interest 48.2 74.6 73.1
Net realized gains (77.5) (65.2) (39.8)
Net amortization and depreciation 31.6 44.7 57.7
Loss from cession of disability income business 53.9 -- --
Deferred federal income taxes 13.9 (15.7) (37.0)
Payment related to cession of disability income business (207.0) -- --
Change in deferred acquisition costs (189.7) (73.9) (38.4)
Change in premiums and notes receivable, net of reinsurance payable (15.1) (16.7) (42.0)
Change in accrued investment income 7.0 16.5 6.8
Change in policy liabilities and accruals, net (134.7) (184.3) 116.2
Change in reinsurance receivable 27.1 123.7 (75.6)
Change in expenses and taxes payable 52.5 27.1 7.7
Separate account activity, net -- 5.2 (0.1)
Other, net 7.4 38.1 (31.3)
...............................................................................................................................
Net cash (used in) provided by operating activities (173.2) 156.0 131.2
...............................................................................................................................
Cash Flows From Investing Activities
...............................................................................................................................
Proceeds from disposals and maturities of available-for-sale fixed maturities 3,046.0 4,018.5 2,738.4
Proceeds from disposals of held-to-maturity fixed maturities -- -- 271.3
Proceeds from disposals of equity securities 162.7 228.7 120.0
Proceeds from disposals of other investments 116.3 99.3 40.5
Proceeds from mortgages matured or collected 204.7 176.9 230.3
Purchase of available-for-sale fixed maturities (2,727.6) (3,830.7) (3,273.3)
Purchase of equity securities (67.0) (91.6) (254.0)
Purchase of other investments (175.0) (168.0) (24.8)
Proceeds from sale of mutual fund processing business -- -- 32.9
Capital expenditures (15.3) (12.8) (14.1)
Purchase of minority interest in Allmerica P&C (425.6) -- --
Other investing activities, net 1.3 4.3 4.7
...............................................................................................................................
Net cash provided by (used in) investing activities 120.5 424.6 (128.1)
...............................................................................................................................
Cash Flows From Financing Activities
...............................................................................................................................
Deposits and interest credited to contractholder deposit funds 457.6 268.7 445.8
Withdrawals from contractholder deposit funds (647.2) (905.0) (1,069.9)
Change in short-term debt (5.4) 7.2 (1.6)
Change in long-term debt (0.1) (0.1) 0.2
Proceeds from the issuance of mandatorily redeemable preferred securities of a
subsidiary trust holding solely junior subordinated debentures of the
Company 296.3 -- --
Dividends paid to shareholders (13.7) (13.9) (6.6)
Net proceeds from issuance of common stock 2.8 -- 248.0
Payments for policyholders' membership interests -- -- (27.9)
Net proceeds from issuance of long-term debt -- -- 197.2
Subsidiary treasury stock purchased, at cost -- (42.0) (20.9)
...............................................................................................................................
Net cash provided by (used in) financing activities 90.3 (685.1) (235.7)
...............................................................................................................................
Net change in cash and cash equivalents 37.6 (104.5) (232.6)
Net change in cash held in the Closed Block (1.0) (6.5) (17.6)
Cash and cash equivalents, beginning of year 178.5 289.5 539.7
...............................................................................................................................
Cash and cash equivalents, end of year $ 215.1 $ 178.5 $ 289.5
===============================================================================================================================
Supplemental Cash Flow Information
...............................................................................................................................
Interest paid $ 20.1 $ 33.8 $ 4.1
Income taxes paid $ 66.3 $ 68.1 $ 90.6
The accompanying notes are an integral part of these consolidated financial
statements.
50
Notes To Consolidated Financial Statements
1. Summary of Significant Accounting Policies
................................................................................
A. Basis of Presentation and Principles of Consolidation
First Allmerica Financial Life Insurance Company ("FAFLIC") was organized as a
mutual life insurance company until October 16, 1995. FAFLIC converted to a
stock life insurance company pursuant to a plan of reorganization effective
October 16, 1995 and became a wholly owned subsidiary of Allmerica Financial
Corporation ("AFC" or the "Company"). The consolidated financial statements have
been prepared as if FAFLIC were organized as a stock life insurance company for
all periods presented. Thus, generally accepted accounting principles for stock
life insurance companies have been applied retroactively for all periods
presented.
The consolidated financial statements of AFC include the accounts of
FAFLIC, its wholly owned life insurance subsidiary, Allmerica Financial Life
Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries
(principally brokerage and investment advisory subsidiaries), and Allmerica
Property and Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned
non-insurance holding company). The Closed Block assets and liabilities at
December 31, 1997 and 1996 and its results of operations subsequent to
demutualization are presented in the consolidated financial statements as single
line items. Prior to demutualization such amounts are presented line by line in
the consolidated financial statements (see Note 7). Unless specifically stated,
all disclosures contained herein supporting the consolidated financial
statements at December 31, 1997 and 1996 and the years then ended exclude the
Closed Block related amounts. All significant intercompany accounts and
transactions have been eliminated.
Allmerica P&C and a wholly-owned subsidiary of the Company merged on July
16, 1997. Through the merger, the Company acquired all of the outstanding common
stock of Allmerica P&C that it did not already own in exchange for cash and
stock (see Note 2). The merger has been accounted for as a purchase. Total
consideration of approximately $798.1 million has been allocated to the minority
interest in the assets and liabilities based on estimates of their fair values.
The minority interest acquired totaled $703.5 million. A total of $90.6 million,
representing the excess of the purchase price over the fair values of the net
assets acquired, net of deferred taxes, has been allocated to goodwill and is
being amortized over a 40-year period.
The financial statements reflect minority interest in Allmerica P&C and its
subsidiary, The Hanover Insurance Company ("Hanover") of approximately 40.5%
prior to the merger on July 16, 1997, and minority interest in Citizens
Corporation (an 82.5%-owned non-insurance subsidiary of Hanover) and its
wholly-owned subsidiary, Citizens Insurance Company of America ("Citizens")
through the end of the year. Minority interest also includes distributions on
mandatorily redeemable preferred stock of a subsidiary trust holding solely
junior subordinated debentures of the Company.
The preparation of financial statements in conformity with generally
accepted accounting principles requires the Company to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
B. Closed Block
As of October 16, 1995, FAFLIC established and began operating a closed block
(the "Closed Block") for the benefit of the participating policies included
therein, consisting of certain individual life insurance participating policies,
individual deferred annuity contracts and supplementary contracts not involving
life contingencies which were in force on October 16, 1995; such policies
constitute the "Closed Block Business". The purpose of the Closed Block is to
protect the policy dividend expectations of such FAFLIC dividend paying policies
and contracts after the demutualization. Unless the Commissioner consents to an
earlier termination, the Closed Block will continue to be in effect until the
date none of the Closed Block policies are in force. On October 16, 1995, FAFLIC
allocated to the Closed Block assets in an amount that is expected to produce
cash flows which, together with future revenues from the Closed Block Business,
are reasonably sufficient to support the Closed Block Business, including
provision for payment of policy benefits, certain future expenses and taxes and
for continuation of policyholder dividend scales payable in 1994 so long as the
experience underlying such dividend scales continues. The Company expects that
the factors underlying such experience will fluctuate in the future and
policyholder dividend scales for Closed Block Business will be set accordingly.
Although the assets and income allocated to the Closed Block inure solely
to the benefit of the holders of policies included in the Closed Block, the
excess of Closed Block liabilities over Closed Block assets at October 16, 1995
measured on a GAAP basis represent the expected future post-tax income from the
Closed Block which may be recognized in income over the period the policies and
contracts in the Closed Block remain in force.
If the actual income from the Closed Block in any given period equals or
exceeds the expected income for such period as determined at October 16, 1995,
the expected income would be recognized in income for that period. Further, any
excess of the actual income over the expected income would also be recognized in
income to the extent that the aggregate expected income for all prior periods
exceeded the aggregate actual income. Any remaining excess of actual income over
expected income would be accrued as a liability for policyholder dividends in
the Closed Block to be paid to the Closed Block policyholders. This accrual for
future dividends effectively limits the actual Closed Block income recognized in
income to the Closed Block income expected to emerge from operation of the
Closed Block as determined as of October 16, 1995.
51
If, over the period the policies and contracts in the Closed Block remain
in force, the actual income from the Closed Block is less than the expected
income from the Closed Block, only such actual income (which could reflect a
loss) would be recognized in income. If the actual income from the Closed Block
in any given period is less than the expected income for that period and changes
in dividend scales are inadequate to offset the negative performance in relation
to the expected performance, the income inuring to shareholders of the Company
will be reduced. If a policyholder dividend liability had been previously
established in the Closed Block because the actual income to the relevant date
had exceeded the expected income to such date, such liability would be reduced
by this reduction in income (but not below zero) in any periods in which the
actual income for that period is less than the expected income for such period.
C. Valuation of Investments
In accordance with the provisions of Statement of Financial Accounting Standards
No. 115 ("Statement No. 115"), "Accounting for Certain Investments in Debt and
Equity Securities", the Company is required to classify its investments into one
of three categories: held-to-maturity, available-for-sale or trading. The
Company determines the appropriate classification of debt securities at the time
of purchase and re-evaluates such designation as of each balance sheet date.
In November 1995, the Financial Accounting Standards Board ("FASB") issued
a Special Report, A Guide to Implementation of Statement 115 on Accounting for
Certain Investments in Debt and Equity Securities, which permitted companies to
reclassify securities, where appropriate, based on the new guidance. As a
result, the Company transferred securities with amortized cost and fair value of
$696.4 million and $725.6 million, respectively, from the held-to-maturity
category to the available-for-sale category, which resulted in a net increase in
shareholders' equity of $12.8 million.
Marketable equity securities and debt securities are classified as
available-for-sale. Available-for-sale securities are carried at fair value,
with the unrealized gains and losses, net of tax, reported in a separate
component of shareholders' equity. The amortized cost of debt securities is
adjusted for amortization of premiums and accretion of discounts to maturity.
Such amortization is included in investment income.
Mortgage loans on real estate are stated at unpaid principal balances, net
of unamortized discounts and reserves. Reserves on mortgage loans are based on
losses expected by the Company to be realized on transfers of mortgage loans to
real estate (upon foreclosure), on the disposition or settlement of mortgage
loans and on mortgage loans which the Company believes may not be collectible in
full. In establishing reserves, the Company considers, among other things, the
estimated fair value of the underlying collateral.
Fixed maturities and mortgage loans that are delinquent are placed on
non-accrual status, and thereafter interest income is recognized only when cash
payments are received.
Policy loans are carried principally at unpaid principal balances.
During 1997, the Company adopted a plan to dispose of all real estate
assets by the end of 1998. As a result of this decision, real estate held by the
Company and real estate joint ventures were written down to the estimated fair
value less costs to sell. Depreciation is not recorded on these assets while
they are held for disposal.
Realized investment gains and losses, other than those related to separate
accounts for which the Company does not bear the investment risk, are reported
as a component of revenues based upon specific identification of the investment
assets sold. When an other than temporary impairment of the value of a specific
investment or a group of investments is determined, a realized investment loss
is recorded. Changes in the valuation allowance for mortgage loans are included
in realized investment gains or losses.
D. Financial Instruments
In the normal course of business, the Company enters into transactions involving
various types of financial instruments, including debt, investments such as
fixed maturities, mortgage loans and equity securities, investment and loan
commitments, swap contracts and interest rate futures contracts. These
instruments involve credit risk and also may be subject to risk of loss due to
interest rate fluctuation. The Company evaluates and monitors each financial
instrument individually and, when appropriate, obtains collateral or other
security to minimize losses.
Derivative financial instruments are accounted for under three different
methods: fair value accounting, deferral accounting and accrual accounting.
Interest rate swap contracts used to hedge interest rate risk are accounted for
using a combination of the fair value method and accrual method, with changes in
fair value reported in unrealized gains and losses in equity consistent with the
underlying hedged security, and the net payment or receipt on the swaps reported
in net investment income. Foreign currency swap contracts used to hedge foreign
currency exchange risk are accounted for using a combination of the fair value
method and accrual method, with changes in fair value reported in unrealized
gains and losses in equity consistent with the underlying hedged security, and
the net payment or receipt on the swaps reported in net investment income.
Futures contracts used to hedge interest rate risk are accounted for using the
deferral method, with gains and losses deferred in unrealized gains and losses
in equity and recognized in earnings in conjunction with the earnings
recognition of the underlying hedged item. Other swap contracts entered into for
investment purposes are accounted for using the fair value method, with changes
in fair value reported in realized investment gains and losses in earnings.
52
E. Cash and Cash Equivalents
Cash and cash equivalents includes cash on hand, amounts due from banks and
highly liquid debt instruments purchased with an original maturity of three
months or less.
F. Deferred Policy Acquisition Costs
Acquisition costs consist of commissions, underwriting costs and other costs,
which vary with, and are primarily related to, the production of revenues.
Property and casualty, group life and group health insurance business
acquisition costs are deferred and amortized over the terms of the insurance
policies. Acquisition costs related to universal life products, variable
annuities and contractholder deposit funds are deferred and amortized in
proportion to total estimated gross profits from investment yields, mortality,
surrender charges and expense margins over the expected life of the contracts.
This amortization is reviewed annually and adjusted retrospectively when the
Company revises its estimate of current or future gross profits to be realized
from this group of products, including realized and unrealized gains and losses
from investments. Acquisition costs related to fixed annuities and other life
insurance products are deferred and amortized, generally in proportion to the
ratio of annual revenue to the estimated total revenues over the contract
periods based upon the same assumptions used in estimating the liability for
future policy benefits.
Deferred acquisition costs for each life product and property and casualty
line of business are reviewed to determine if they are recoverable from future
income, including investment income. If such costs are determined to be
unrecoverable, they are expensed at the time of determination. Although
realization of deferred policy acquisition costs is not assured, the Company
believes it is more likely than not that all of these costs will be realized.
The amount of deferred policy acquisition costs considered realizable, however,
could be reduced in the near term if the estimates of gross profits or total
revenues discussed above are reduced. The amount of amortization of deferred
policy acquisition costs could be revised in the near term if any of the
estimates discussed above are revised.
G. Property and Equipment
Property, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is provided using the
straight-line or accelerated method over the estimated useful lives of the
related assets which generally range from 3 to 30 years. Amortization of
leasehold improvements is provided using the straight-line method over the
lesser of the term of the leases or the estimated useful life of the
improvements.
H. Separate Accounts
Separate account assets and liabilities represent segregated funds administered
and invested by the Company for the benefit of certain pension, variable annuity
and variable life insurance contractholders. Assets consist principally of
bonds, common stocks, mutual funds, and short-term obligations at market value.
The investment income, gains and losses of these accounts generally accrue to
the contractholders and, therefore, are not included in the Company's net
income. Appreciation and depreciation of the Company's interest in the separate
accounts, including undistributed net investment income, is reflected in
shareholders' equity or net investment income.
I. Policy Liabilities and Accruals
Future policy benefits are liabilities for life, health and annuity products.
Such liabilities are established in amounts adequate to meet the estimated
future obligations of policies in force. The liabilities associated with
traditional life insurance products are computed using the net level premium
method for individual life and annuity policies, and are based upon estimates as
to future investment yield, mortality and withdrawals that include provisions
for adverse deviation. Future policy benefits for individual life insurance and
annuity policies are computed using interest rates ranging from 2-1/2% to 6% for
life insurance and 2% to 9-1/2% for annuities. Estimated liabilities are
established for group life and health policies that contain experience rating
provisions. Mortality, morbidity and withdrawal assumptions for all policies are
based on the Company's own experience and industry standards. Liabilities for
universal life include deposits received from customers and investment earnings
on their fund balances, less administrative charges. Universal life fund
balances are also assessed mortality and surrender charges.
Liabilities for outstanding claims, losses and loss adjustment expenses
("LAE") are estimates of payments to be made on property and casualty and health
insurance for reported losses and LAE and estimates of losses and LAE incurred
but not reported. These liabilities are determined using case basis evaluations
and statistical analyses and represent estimates of the ultimate cost of all
losses incurred but not paid. These estimates are continually reviewed and
adjusted as necessary; such adjustments are reflected in current operations.
Estimated amounts of salvage and subrogation on unpaid property and casualty
losses are deducted from the liability for unpaid claims.
Premiums for property and casualty, group life, and accident and health
insurance are reported as earned on a pro-rata basis over the contract period.
The unexpired portion of these premiums is recorded as unearned premiums.
Contractholder deposit funds and other policy liabilities include
investment-related products such as guaranteed investment contracts, deposit
administration funds and immediate participation guarantee funds and consist of
deposits received from customers and investment earnings on their fund balances.
53
All policy liabilities and accruals are based on the various estimates
discussed above. Although the adequacy of these amounts cannot be assured, the
Company believes that it is more likely than not that policy liabilities and
accruals will be sufficient to meet future obligations of policies in force. The
amount of liabilities and accruals, however, could be revised in the near term
if the estimates discussed above are revised.
J. Premium and Fee Revenue and Related Expenses
Premiums for individual life and health insurance and individual and group
annuity products, excluding universal life and investment-related products, are
considered revenue when due. Property and casualty, and group life, accident and
health insurance premiums are recognized as revenue over the related contract
periods. Benefits, losses and related expenses are matched with premiums,
resulting in their recognition over the lives of the contracts. This matching is
accomplished through the provision for future benefits, estimated and unpaid
losses and amortization of deferred policy acquisition costs. Revenues for
investment-related products consist of net investment income and contract
charges assessed against the fund values. Related benefit expenses primarily
consist of net investment income credited to the fund values after deduction for
investment and risk charges. Revenues for universal life products consist of net
investment income, with mortality, administration and surrender charges assessed
against the fund values. Related benefit expenses include universal life benefit
claims in excess of fund values and net investment income credited to universal
life fund values. Certain policy charges that represent compensation for
services to be provided in future periods are deferred and amortized over the
period benefited using the same assumptions used to amortize capitalized
acquisition costs.
K. Policyholder Dividends
Prior to demutualization, certain life, health and annuity insurance policies
contained dividend payment provisions that enabled the policyholder to
participate in the earnings of the Company. The amount of policyholders'
dividends was determined annually by the Board of Directors. The aggregate
amount of policyholders' dividends was related to the actual interest,
mortality, morbidity and expense experience for the year and the Company's
judgment as to the appropriate level of statutory surplus to be retained. Upon
demutualization, certain participating individual life insurance policies and
individual annuity and supplemental contracts were transferred to the Closed
Block. The Closed Block was funded to protect the dividend expectations of such
policies and contracts. Accordingly, these policies no longer participate in the
earnings and surplus of the Open Block. Subsequent to demutualization, the
Company ceased issuance of participating policies.
L. Federal Income Taxes
AFC and its domestic subsidiaries file a consolidated United States federal
income tax return. Entities included within the consolidated group are
segregated into either a life insurance or non-life insurance company subgroup.
The consolidation of these subgroups is subject to certain statutory
restrictions on the percentage of eligible non-life tax losses that can be
applied to offset life company taxable income. Prior to the merger, Allmerica
P&C and its subsidiaries filed a separate United States federal income tax
return.
Deferred income taxes are generally recognized when assets and liabilities
have different values for financial statement and tax reporting purposes, and
for other temporary taxable and deductible differences as defined by Statement
No. 109, "Accounting for Income Taxes". These differences result primarily from
loss and LAE reserves, policy reserves, policy acquisition expenses and
unrealized appreciation or depreciation on investments.
M. New Accounting Pronouncements
In December 1997, the American Institute of Certified Public Accountants issued
Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for
Insurance-Related Assessments" ("Statement No. 97-3"). Statement No. 97-3
provides guidance on when a liability should be recognized for guaranty fund and
other assessments and on how to measure the liability. This statement allows for
the discounting of the liability if the amount and timing of the cash payments
are fixed and determinable. In addition, it provides criteria for when an asset
may be recognized for a portion or all of the assessment liability or paid
assessment that can be recovered through premium tax offsets or policy
surcharges. This statement is effective for fiscal years beginning after
December 15, 1998. The Company believes that the adoption of this statement will
not have a material effect on the results of operations or financial position.
In June 1997, the FASB issued Statement No. 131, "Disclosures About
Segments of an Enterprise and Related Information". This statement establishes
standards for the way that public enterprises report information about operating
segments in annual financial statements and requires that selected information
about those operating segments be reported in interim financial statements. This
statement supersedes Statement No. 14, Financial Reporting for Segments of a
Business Enterprise. Statement No. 131 requires that all public enterprises
report financial and descriptive information about their reportable operating
segments. Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by
the chief operating decision maker in deciding how to allocate resources and in
assessing performance. This statement is effective for fiscal years beginning
after December 15, 1997. The Company is currently determining the impact of the
adoption of Statement No. 131.
54
In June 1997, the FASB also issued Statement No. 130, "Reporting
Comprehensive Income", which established standards for the reporting and display
of comprehensive income and its components in a full set of general-purpose
financial statements. All items that are required to be recognized under
accounting standards as components of comprehensive income are to be reported in
a financial statement that is displayed with the same prominence as other
financial statements. This statement stipulates that comprehensive income
reflect the change in equity of an enterprise during a period from transactions
and other events and circumstances from non-owner sources. This statement is
effective for fiscal years beginning after December 15, 1997. The Company
anticipates that the adoption of Statement No. 130 will result primarily in
reporting the changes in unrealized gains and losses on investments in debt and
equity securities in comprehensive income.
In February 1997, the FASB issued Statement No. 128, "Earnings Per Share",
which supersedes Accounting Principles Board Opinion No. 15, Earnings Per Share.
This standard replaces the primary and fully diluted earnings per share ("EPS")
requirements with a basic and diluted EPS computation, and requires a dual
presentation of basic and diluted EPS for those companies with complex capital
structures. All earnings per share amounts for all periods have been presented
to conform to the Statement No. 128 requirements. The adoption of the
aforementioned statement had no effect on the Company's previously reported
earnings per share.
N. Earnings Per Share
Earnings per share for the years ended December 31, 1997 and 1996 are based on a
weighted average of the number of shares outstanding during 1997 and 1996,
respectively. Earnings per share for the period October 1, 1995 (date used to
estimate financial information for the effective date of the demutualization
transaction of October 16, 1995) through December 31, 1995 is based on a
weighted average of the number of shares outstanding between October 16, 1995
and December 31, 1995.
The Company's EPS in 1997 is based on net income of $209.2 million for both
basic and diluted earnings per share. The weighted average shares outstanding
which were utilized in the calculation of basic earnings per share were 54.7
million shares. This differs from the weighted average shares outstanding used
in the calculation of diluted earnings per share due to the 0.1 million share
effect of dilutive employee stock options. This difference causes a $0.01 per
share difference between basic and diluted EPS. There are no differences between
basic and diluted earnings per share for 1996 and 1995.
Options to purchase 7,742 shares of common stock at $50.00 per share were
outstanding during 1997 but were not included in the computation of diluted
earnings per share because the options' exercise price was greater than the
average market price of the common shares and, therefore, the effect would be
antidilutive.
The unaudited pro forma earnings per share for the year ended December 31,
1995 is based on a weighted average of the number of shares that would have been
outstanding between January 1, 1995 and December 31, 1995 had the
demutualization transaction occurred as of January 1, 1995.
The unaudited pro forma earnings and earnings per share information gives
effect to the demutualization transaction and the Senior Debentures transaction
as if these transactions had occurred as of January 1, 1995. The effect on
earnings is to eliminate demutualization expenses of $12.1 million, to eliminate
a differential earnings adjustment tax credit of $7.6 million and to increase
interest and amortization expense related to the Senior Debentures by $7.8
million, for a net decrease in pro forma earnings of $3.3 million.
The unaudited pro forma information is provided for informational purposes
only and should not be construed to be indicative of the Company's consolidated
results of operations had the transactions been consummated on January 1, 1995,
and does not represent a projection or forecast of the Company's consolidated
results of operations for any future period.
O. Reclassifications
Certain prior year amounts have been reclassified to conform to the current year
presentation.
2. Merger with Allmerica Property & Casualty Companies, Inc.
................................................................................
The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was
consummated on July 16, 1997. Through the merger, the Company acquired all of
the outstanding common stock of Allmerica P&C that it did not already own in
exchange for cash of $425.6 million and approximately 9.7 million shares of AFC
stock valued at $372.5 million.
The merger has been accounted for as a purchase. Total consideration of
approximately $798.1 million has been allocated to the minority interest in the
assets and liabilities based on estimates of their fair values. The minority
interest acquired totaled $703.5 million. A total of $90.6 million representing
the excess of the purchase price over the fair values of the net assets
acquired, net of deferred taxes, has been allocated to goodwill and is being
amortized over a 40-year period.
The Company's consolidated results of operations include minority interest
in Allmerica P&C prior to July 16, 1997. The unaudited pro forma information
below presents consolidated results of operations as if the merger and issuance
of Capital Securities had occurred at the beginning of 1996 and reflects
adjustments which include interest expense related to
55
the assumed financing of a portion of the cash consideration paid and
amortization of goodwill.
The following unaudited pro forma information is not necessarily indicative
of the consolidated results of operations of the combined Company had the merger
and issuance of Capital Securities occurred at the beginning of 1996, nor is it
necessarily indicative of future results.
(Unaudited)
For the Years Ended December 31
(In millions) 1997 1996
================================================================================
Revenue $ 3,374.1 $ 3,241.6
- --------------------------------------------------------------------------------
Net realized capital gains included in revenue $ 62.7 $ 45.8
- --------------------------------------------------------------------------------
Income before taxes and minority interest $ 341.6 $ 294.1
Income taxes (85.7) (62.8)
Minority Interest:
Distributions on mandatorily redeemable
preferred securities of a subsidiary trust
holding solely junior subordinated
debentures of the Company (16.0) (16.0)
Equity in earnings (16.6) (14.9)
................................................................................
Net income $ 223.3 $ 200.4
- --------------------------------------------------------------------------------
Net income per common share:
Basic $ 3.73 $ 3.35
Diluted $ 3.72 $ 3.35
- --------------------------------------------------------------------------------
Weighted average shares outstanding 60.0 59.8
- --------------------------------------------------------------------------------
3. Significant Transactions
................................................................................
Effective January 1, 1998, the Company entered into an agreement with
Reinsurance Group of America, Inc. to reinsure the mortality risk on the
universal life and variable universal life blocks of business. The Company
believes that this agreement will not have a material effect on its results of
operations or financial position.
On April 14, 1997, the Company entered into an agreement in principle to
cede substantially all of the Company's individual disability income line of
business under a 100% coinsurance agreement to Metropolitan Life Insurance
Company. The coinsurance agreement became effective October 1, 1997. The
transaction has resulted in the recognition of a $53.9 million pre-tax loss in
the first quarter of 1997.
On February 3, 1997, AFC Capital Trust (the "Trust"), a subsidiary business
trust of AFC, issued $300.0 million Series A Capital Securities, which pay
cumulative dividends at a rate of 8.207% semiannually commencing August 15,
1997. The Trust exists for the sole purpose of issuing the Capital Securities
and investing the proceeds thereof in an equivalent amount of 8.207% Junior
Subordinated Deferrable Interest Debentures due 2027 of AFC (the "Subordinated
Debentures"). Through certain guarantees, the Subordinated Debentures and the
terms of related agreements, AFC has irrevocably and unconditionally guaranteed
the obligations of the Trust under the Capital Securities. Net proceeds from the
offering of approximately $296.3 million funded a portion of the acquisition of
the 24.2 million publicly held shares of Allmerica P&C pursuant to the merger on
July 16, 1997. On August 7, 1997, AFC and the Trust exchanged the Series A
Capital Securities for a like amount of Series B Capital Securities and related
guarantees which are registered under the Securities Act of 1933 as required
under the terms of the initial transaction. During the year ended December 31,
1997, distributions of $14.5 million, net of federal income taxes, were
reflected in minority interest.
Pursuant to the plan of reorganization effective October 16, 1995, the
Company issued 37.5 million shares of its common stock to eligible
policyholders. The Company also issued 12.6 million shares of its common stock
at a price of $21.00 per share in a public offering, resulting in net proceeds
of $248.0 million, and issued Senior Debentures in the principal amount of
$200.0 million which resulted in net proceeds of $197.2 million.
Effective March 31, 1995, the Company entered into an agreement with TSSG,
a division of First Data Corporation, pursuant to which the Company sold its
mutual fund processing business and agreed not to engage in this business for
four years after that date. In accordance with this agreement, the Company
received proceeds of $32.1 million. A gain of $13.5 million, net of taxes of
$7.2 million, was recorded in March 1995. Additionally, the Company received a
non-recurring $3.1 million contingent payment, net of taxes of $1.7 million, in
1996 related to the aforementioned sale.
56
4. Investments
................................................................................
A. Summary of Investments
The Company accounts for its investments, all of which are classified as
available-for-sale, in accordance with the
provisions of Statement No. 115.
The amortized cost and fair value of available-for-sale fixed maturities
and equity securities were as follows:
December 31
(In millions) 1997
==================================================================================================================================
Gross Gross
Amortized Unrealized Unrealized Fair
Cost (1) Gains Losses Value
------------------------------------------------------
U.S. Treasury securities and U.S. government and agency securities $ 269.6 $ 9.5 $ 0.9 $ 278.2
States and political subdivisions 2,200.6 78.3 3.1 2,275.8
Foreign governments 111.6 8.6 2.2 118.0
Corporate fixed maturities 4,044.3 175.1 12.3 4,207.1
Mortgage-backed securities 426.8 9.8 2.0 434.6
..................................................................................................................................
Total fixed maturities $ 7,052.9 $ 281.3 $ 20.5 $ 7,313.7
- ----------------------------------------------------------------------------------------------------------------------------------
Equity securities $ 341.1 $ 141.9 $ 4.0 $ 479.0
- ----------------------------------------------------------------------------------------------------------------------------------
December 31
(In millions) 1996
==================================================================================================================================
Gross Gross
Amortized Unrealized Unrealized Fair
Cost (1) Gains Losses Value
------------------------------------------------------
U.S. Treasury securities and U.S. government and agency securities $ 279.1 $ 9.3 $ 1.6 $ 286.8
States and political subdivisions 2,236.9 48.5 7.7 2,277.7
Foreign governments 108.8 7.4 -- 116.2
Corporate fixed maturities 4,297.6 140.4 16.0 4,422.0
Mortgage-backed securities 383.1 4.7 2.7 385.1
..................................................................................................................................
Total fixed maturities $ 7,305.5 $ 210.3 $ 28.0 $ 7,487.8
- ----------------------------------------------------------------------------------------------------------------------------------
Equity securities $ 328.2 $ 149.1 $ 3.7 $ 473.6
- ----------------------------------------------------------------------------------------------------------------------------------
(1) Amortized cost for fixed maturities and cost for equity securities.
In connection with AFLIAC's voluntary withdrawal of its license in New
York, AFLIAC agreed with the New York Department of Insurance to maintain,
through a custodial account in New York, a security deposit, the market value of
which will at all times equal 102% of all outstanding liabilities of AFLIAC for
New York policyholders, claimants and creditors. At December 31, 1997, the
amortized cost and market value of these assets on deposit in New York were
$276.8 million and $291.7 million, respectively. At December 31, 1996, the
amortized cost and market value of assets on deposit were $284.9 million and
$292.2 million, respectively. In addition, fixed maturities, excluding those
securities on deposit in New York, with an amortized cost of $105.1 million and
$98.0 million were on deposit with various state and governmental authorities at
December 31, 1997 and 1996, respectively.
57
There were no contractual fixed maturity investment commitments at December
31, 1997 and 1996, respectively.
The amortized cost and fair value by maturity periods for fixed maturities are
shown below. Actual maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties, or the Company may have the right to put or sell the
obligations back to the issuers. Mortgage backed securities are included in the
category representing their ultimate maturity.
December 31
(In millions) 1997
========================================================================
Amortized Fair
Cost Value
--------------------------
Due in one year or less $ 464.9 $ 468.1
Due after one year through five years 2,146.9 2,229.7
Due after five years through ten years 2,142.5 2,222.3
Due after ten years 2,298.6 2,393.6
........................................................................
Total $ 7,052.9 $ 7,313.7
========================================================================
The proceeds from voluntary sales of available-for-sale securities and the
gross realized gains and gross realized losses on those sales were as follows:
For the Years Ended December 31
(In millions)
========================================================================
Proceeds from Gross Gross
1997 Voluntary Sales Gains Losses
-----------------------------------------------
Fixed maturities $ 1,972.4 $ 27.9 $ 16.2
- ------------------------------------------------------------------------
Equity securities $ 145.5 $ 55.8 $ 1.3
- ------------------------------------------------------------------------
1996
Fixed maturities $ 2,463.3 $ 19.3 $ 31.0
- ------------------------------------------------------------------------
Equity securities $ 228.7 $ 56.3 $ 1.3
- ------------------------------------------------------------------------
1995
Fixed maturities $ 1,612.3 $ 23.7 $ 33.0
- ------------------------------------------------------------------------
Equity securities $ 122.2 $ 23.1 $ 6.9
- ------------------------------------------------------------------------
Unrealized gains and losses on available-for-sale and other securities, are
summarized as follows:
For the Years Ended December 31
(In millions)
===========================================================================
Equity
Fixed Securities
1997 Maturities and Other(1) Total
-------------------------------------
Net appreciation, beginning of year $ 71.1 $ 60.5 $ 131.6
...........................................................................
Net appreciation (depreciation) on
available-for-sale securities 83.6 (5.8) 77.8
Purchased minority interest related
to the merger with Allmerica P&C 50.7 59.6 110.3
Net depreciation from the effect on
deferred policy acquisition costs
and on policy liabilities (16.8) -- (16.8)
Provision for deferred federal
income taxes and minority interest (55.3) (29.7) (85.0)
...........................................................................
62.2 24.1 86.3
...........................................................................
Net appreciation, end of year $ 133.3 $ 84.6 $ 217.9
===========================================================================
1996
Net appreciation, beginning of year $ 108.7 $ 44.3 $ 153.0
...........................................................................
Net (depreciation) appreciation
on available-for-sale securities (94.3) 36.1 (58.2)
Net appreciation from the effect on
deferred policy acquisition costs
and on policy liabilities 23.1 -- 23.1
Benefit (provision) for deferred
federal income taxes and
minority interest 33.6 (19.9) 13.7
...........................................................................
(37.6) 16.2 (21.4)
...........................................................................
Net appreciation, end of year $ 71.1 $ 60.5 $ 131.6
===========================================================================
1995
Net (depreciation) appreciation,
beginning of year $ (89.4) $ 10.4 $ (79.0)
...........................................................................
Effect of transfer of securities
between classifications:
Net appreciation on available-
for-sale fixed maturities 29.2 -- 29.2
Effect of transfer on deferred
policy acquisition costs and
on policy liabilities (6.8) -- (6.8)
Provision for deferred federal
income taxes and
minority interest (9.6) -- (9.6)
...........................................................................
12.8 -- 12.8
...........................................................................
Net appreciation on available-
for-sale securities 465.4 87.5 552.9
Net depreciation from the effect on
deferred policy acquisition costs
and on policy liabilities (86.9) -- (86.9)
Provision for deferred federal
income taxes and minority interest (193.2) (53.6) (246.8)
...........................................................................
185.3 33.9 219.2
...........................................................................
Net appreciation, end of year $ 108.7 $ 44.3 $ 153.0
===========================================================================
(1) Includes net appreciation on other investments of $1.8 million, $0.6
million, and $2.2 million in 1997, 1996 and 1995, respectively.
58
B. Mortgage Loans and Real Estate
AFC's mortgage loans and real estate are diversified by property type and
location. Real estate investments have been obtained primarily through
foreclosure. Mortgage loans are collateralized by the related properties and
generally are no more than 75% of the property's value at the time the original
loan is made.
The carrying values of mortgage loans and real estate investments net of
applicable reserves were as follows:
December 31
(In millions) 1997 1996
==================================================================
Mortgage loans $ 567.5 $ 650.1
..................................................................
Real estate:
Held for sale 50.3 110.4
Held for production of income -- 10.3
..................................................................
Total real estate 50.3 120.7
..................................................................
Total mortgage loans and real estate $ 617.8 $ 770.8
==================================================================
Reserves for mortgage loans were $20.7 million and $19.6 million at December
31, 1997 and 1996, respectively.
During 1997, the Company committed to a plan to dispose of all real estate
assets by the end of 1998. As a result, real estate assets with a carrying
amount of $54.7 million were written down to the estimated fair value less cost
to sell of $50.3 million, and a net realized investment loss of $4.4 million was
recognized. Depreciation is not recorded on these assets while they are held for
disposal.
There were no non-cash investing activities, including real estate acquired
through foreclosure of mortgage loans, in 1997. During 1996 and 1995, non-cash
investing activities included real estate acquired through foreclosure of
mortgage loans, which had a fair value of $0.9 million and $26.1 million,
respectively.
At December 31, 1997, contractual commitments to extend credit under
commercial mortgage loan agreements amounted to approximately $39.4 million, of
which $10.0 million related to the Closed Block. These commitments generally
expire within one year.
Mortgage loans and real estate investments comprised the following property
types and geographic regions:
December 31
(In millions) 1997 1996
======================================================
Property type:
Office building $ 265.1 $ 317.1
Residential 66.6 95.4
Retail 132.8 177.0
Industrial / warehouse 107.2 124.8
Other 66.8 91.0
Valuation allowances (20.7) (34.5)
......................................................
Total $ 617.8 $ 770.8
======================================================
Geographic region:
South Atlantic $ 173.4 $ 227.0
Pacific 152.8 154.4
East North Central 102.0 119.2
Middle Atlantic 73.8 112.6
West South Central 34.9 41.6
New England 46.9 50.9
Other 54.7 99.6
Valuation allowances (20.7) (34.5)
......................................................
Total $ 617.8 $ 770.8
======================================================
At December 31, 1997, scheduled mortgage loan maturities were as follows: 1998
- - $136.4 million; 1999 - $70.8 million; 2000 - $129.2 million; 2001 - $26.4
million; 2002 - $29.9 million; and $174.8 million thereafter. Actual maturities
could differ from contractual maturities because borrowers may have the right to
prepay obligations with or without prepayment penalties and loans may be
refinanced. During 1997, the Company did not refinance any mortgage loans based
on terms which differed from those granted to new borrowers.
59
C. Investment Valuation Allowances
Investment valuation allowances which have been deducted in arriving at
investment carrying values as presented in the consolidated balance sheets and
changes thereto are shown below.
For the Years Ended December 31
(In millions)
=============================================================================
Balance at Balance at
January 1 Additions Deductions December 31
1997
Mortgage loans $ 19.6 $ 2.5 $ 1.4 $ 20.7
Real estate 14.9 6.0 20.9 --
.............................................................................
Total $ 34.5 $ 8.5 $ 22.3 $ 20.7
=============================================================================
1996
Mortgage loans $ 33.8 $ 5.5 $ 19.7 $ 19.6
Real estate 19.6 -- 4.7 14.9
.............................................................................
Total $ 53.4 $ 5.5 $ 24.4 $ 34.5
=============================================================================
1995
Mortgage loans $ 47.2 $ 1.5 $ 14.9 $ 33.8
Real estate 22.9 (0.6) 2.7 19.6
.............................................................................
Total $ 70.1 $ 0.9 $ 17.6 $ 53.4
=============================================================================
Deductions of $20.9 million to the investment valuation allowance related to
real estate in 1997 primarily reflect writedowns to the estimated fair value
less costs to sell pursuant to the aforementioned 1997 plan of disposal.
The carrying value of impaired loans was $30.5 million and $33.6 million, with
related reserves of $13.8 million and $11.9 million as of December 31, 1997 and
1996, respectively. All impaired loans were reserved as of December 31, 1997 and
1996.
The average carrying value of impaired loans was $30.8 million, $50.4 million
and $117.9 million, with related interest income while such loans were impaired,
of $3.2 million, $5.8 million and $9.3 million as of December 31, 1997, 1996 and
1995, respectively.
D. Futures Contracts
AFC purchases long futures contracts and sells short futures contracts on margin
to hedge against interest rate fluctuations associated with the sale of
Guaranteed Investment Contracts ("GICs"). 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. The Company's exposure
to credit risk under futures contracts is limited to the margin deposited with
the broker. The Company only trades futures contracts with nationally recognized
brokers, which the Company believes have adequate capital to ensure that there
is minimal danger of default. The Company does not require collateral or other
securities to support financial instruments with credit risk.
There were no futures contracts outstanding at December 31, 1997 and $(40.0)
million notional amount of net short contracts at December 31, 1996. The
notional amounts of the contracts represent the extent of the Company's
investment but not the future cash requirements, as the Company generally
settles open positions prior to maturity. The fair value of futures contracts
outstanding were $(39.4) million at December 31, 1996.
Gains and losses on hedge contracts related to interest rate fluctuations are
deferred and recognized in income over the period being hedged corresponding to
related guaranteed investment contracts. If instruments being hedged by futures
contracts are disposed, any unamortized gains or losses on such contracts are
included in the determination of the gain or loss from the disposition. There
were no deferred hedging gains or losses in 1997. Deferred hedging gains were
$0.6 million and $5.6 million in 1996 and 1995, respectively. Gains and losses
on hedge contracts that are deemed ineffective by the Company are realized
immediately.
A reconciliation of the notional amount of futures contracts is as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
=============================================================================
Contracts outstanding,
beginning of year $ (40.0) $ 74.7 $ 126.6
New contracts (6.5) (44.0) 349.2
Contracts terminated 46.5 (70.7) (401.1)
.............................................................................
Contracts outstanding, end of year $ -- $ (40.0) $ 74.7
=============================================================================
60
E. Foreign Currency Swap Contracts
The Company enters into foreign currency swap contracts with swap counterparties
to hedge foreign currency exposure on specific fixed income securities. Interest
and principal related to foreign fixed income securities payable in foreign
currencies, at current exchange rates, are exchanged for the equivalent payment
in U.S. dollars translated at a specific currency exchange rate. The primary
risk associated with these transactions is the inability of the counterparty to
meet its obligation. 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. The
Company's maximum exposure to counterparty credit risk is the difference between
the foreign currency exchange rate, as agreed upon in the swap contract, and the
foreign currency spot rate on the date of the exchange, as indicated by the fair
value of the contract. The fair values of the foreign currency swap contracts
outstanding were $0.1 million and $(9.2) million at December 31, 1997 and 1996,
respectively. Changes in the fair value of contracts are reported as an
unrealized gain or loss, consistent with the underlying hedged security. The
Company does not require collateral or other security to support financial
instruments with credit risk.
The difference between amounts paid and received on foreign currency swap
contracts is reflected in the net investment income related to the underlying
assets and is not material in 1997, 1996 and 1995. Any gain or loss on the
termination of swap contracts is deferred and recognized with any gain or loss
on the hedged transaction. The Company had no deferred gain or loss on foreign
currency swap contracts in 1997 or 1996.
A reconciliation of the notional amount of foreign currency swap contracts is
as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
===============================================================================
Contracts outstanding,
beginning of year $ 68.6 $ 104.6 $ 118.7
New contracts 5.0 -- --
Contracts expired (18.2) (36.0) --
Contracts terminated -- -- (14.1)
...............................................................................
Contracts outstanding, end of year $ 55.4 $ 68.6 $ 104.6
===============================================================================
Expected maturities of such foreign currency swap contracts outstanding at
December 31, 1997 are $25.0 million in 1999, $11.6 million in 2000 and $18.8
million thereafter. There are no expected maturities of such foreign currency
swap contracts in 1998, 2001 and 2002.
F. Interest Rate Swap Contracts
The Company enters into interest rate swap contracts to hedge exposure to
interest rate fluctuations. 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. As with
foreign currency swap contracts, the primary risk associated with these
transactions is the inability of the counterparty to meet its obligation. 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. 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
December 31, 1997 was not material to the Company. The Company does not require
collateral or other security to support financial instruments with credit risk.
The net amount receivable or payable is recognized over the life of the swap
contract as an adjustment to net investment income. The (decrease) or increase
in net investment income related to interest rate swap contracts was $(0.4)
million, $0.6 million and $0.7 million for the years ended December 31, 1997,
1996 and 1995, respectively. The fair value of interest rate swap contracts
outstanding was $(2.3) million at December 31, 1997. There were no interest rate
swap contracts outstanding at December 31, 1996. Changes in the fair value of
contracts are reported as an unrealized gain or loss, consistent with the
underlying hedged security. Any gain or loss on the termination of interest rate
swap contracts accounted for as hedges are deferred and recognized with any gain
or loss on the hedged transaction. The Company had no deferred gain or loss on
interest rate swap contracts in 1997 or 1996.
A reconciliation of the notional amount of interest rate swap contracts is as
follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
==============================================================================
Contracts outstanding,
beginning of year $ 5.0 $ 17.5 $ 22.8
New contracts 244.7 5.0 --
Contracts expired (5.6) (17.5) (5.3)
..............................................................................
Contracts outstanding, end of year $ 244.1 $ 5.0 $ 17.5
==============================================================================
Expected maturities of such interest rate swap contracts outstanding at
December 31, 1997 are as follows: $5.0 million in 1998 and $239.1 million in
2000 and thereafter. There are no expected maturities of such interest rate
contracts in 1999.
61
G. Other Swap Contracts
The Company enters into security return-linked and insurance portfolio-linked
swap contracts for investment purposes. Under the security return-linked
contracts, the Company agrees to exchange cash flows according to the
performance of a specified security or portfolio of securities. 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 these transactions is the inability of the counterparty to meet
its obligation. 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.
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 December 31, 1997, was not material to the Company.
The Company does not require collateral or other security to support financial
instruments with credit risk.
The swap contracts are marked to market with any gain or loss recognized
currently. The net amount receivable or payable under these contracts is
recognized when the contracts are marked to market. The fair values of swap
contracts outstanding were $(0.1) million and $0.1 million at December 31, 1997
and 1996, respectively. The net decrease in realized investment gains related to
other swap contracts was $(1.6) million for the year ended December 31, 1997.
There were no realized investment gains on other swap contracts recognized in
1996 or 1995.
A reconciliation of the notional amount of other swap contracts is as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
==============================================================================
Contracts outstanding,
beginning of year $ 58.6 $ -- $ --
New contracts 192.1 58.6 --
Contracts expired (211.6) -- --
Contracts terminated (24.1) -- --
..............................................................................
Contracts outstanding, end of year $ 15.0 $ 58.6 $ --
==============================================================================
Expected maturities of such other swap contracts outstanding at December 31,
1997 are as follows: $10.0 million in 1999 and $5.0 million in 2001. There are
no expected maturities of such other swap contracts in 1998, 2000 or 2002.
H. Other
At December 31, 1997, AFC had no concentration of investments in a single
investee exceeding 10% of shareholders' equity, except for investments with the
U.S. Treasury with a carrying value of $264.4 million.
5. Investment Income and Gains and Losses
................................................................................
A. Net Investment Income
The components of net investment income were as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
=========================================================================
Fixed maturities $ 544.4 $ 555.8 $ 555.1
Mortgage loans 57.5 69.5 97.0
Equity securities 10.6 11.1 13.2
Policy loans 10.9 10.3 20.3
Real estate 20.1 40.8 48.7
Other long-term investments 12.4 19.0 7.1
Short-term investments 21.9 11.3 21.6
.........................................................................
Gross investment income 677.8 717.8 763.0
.........................................................................
Less investment expenses (24.4) (45.2) (52.5)
.........................................................................
Net investment income $ 653.4 $ 672.6 $ 710.5
=========================================================================
At December 31, 1997, mortgage loans on non-accrual status were $3.6 million
which were all restructured loans. There were no fixed maturities which were on
non-accrual status at December 31, 1997. The effect of non-accruals, compared
with amounts that would have been recognized in accordance with the original
terms of the investments, had no impact in 1997, and reduced net income by $0.5
million and $0.6 million in 1996 and 1995, respectively.
The payment terms of mortgage loans may from time to time be restructured or
modified. The investment in restructured mortgage loans, based on amortized
cost, amounted to $40.3 million, $51.3 million and $98.9 million at December 31,
1997, 1996 and 1995, respectively. Interest income on restructured mortgage
loans that would have been recorded in accordance with the original terms of
such loans amounted to $3.9 million, $7.7 million and $11.1 million in 1997,
1996 and 1995, respectively. Actual interest income on these loans included in
net investment income aggregated $4.2 million, $4.5 million and $7.1 million in
1997, 1996 and 1995, respectively.
There were no fixed maturities or mortgage loans which were non-income
producing for the twelve months ended December 31, 1997.
Included in other long-term investments is income from limited partnerships of
$7.8 million, $13.7 million and $0.1 million in 1997, 1996 and 1995
respectively.
62
B. Net Realized Investment Gains and Losses Realized gains (losses) on
investments were as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
========================================================================
Fixed maturities $ 14.0 $ (10.1) $ (7.0)
Mortgage loans (1.2) (2.4) 1.4
Equity securities 53.2 55.0 16.2
Real estate 12.8 21.1 5.3
Other (2.6) 2.3 3.2
........................................................................
Net realized investment gains $ 76.2 $ 65.9 $ 19.1
========================================================================
6. Fair Value Disclosures of Financial Instruments
..................................................
Statement No. 107, "Disclosures about Fair Value of Financial Instruments",
requires disclosure of fair value information about certain financial
instruments (insurance contracts, real estate, goodwill and taxes are excluded)
for which it is practicable to estimate such values, whether or not these
instruments are included in the balance sheet. The fair values presented for
certain financial instruments are estimates which, in many cases, may differ
significantly from the amounts which could be realized upon immediate
liquidation. In cases where market prices are not available, estimates of fair
value are based on discounted cash flow analyses which utilize current interest
rates for similar financial instruments which have comparable terms and credit
quality. Fair values of interest rate futures were not material at December 31,
1997 or 1996.
The following methods and assumptions were used to estimate the fair value of
each class of financial instruments:
Cash and Cash Equivalents
For these short-term investments, the carrying amount approximates fair value.
Fixed Maturities
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources or internally developed pricing models using discounted cash flow
analyses.
Equity Securities
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources or internally developed pricing models.
Mortgage Loans
Fair values are estimated by discounting the future contractual cash flows using
the current rates at which similar loans would be made to borrowers with similar
credit ratings. The fair value of below investment grade mortgage loans are
limited to the lesser of the present value of the cash flows or book value.
Reinsurance Receivables
The carrying amount reported in the consolidated balance sheets approximates
fair value.
Policy Loans
The carrying amount reported in the consolidated balance sheets approximates
fair value since policy loans have no defined maturity dates and are inseparable
from the insurance contracts.
Investment Contracts (Without Mortality Features)
Fair values for the Company's liabilities under guaranteed investment type
contracts are estimated using discounted cash flow calculations using current
interest rates for similar contracts with maturities consistent with those
remaining for the contracts being valued. Other liabilities are based on
surrender values.
Debt
The carrying value of short-term debt reported in the balance sheet approximates
fair value. The fair value of long-term debt was estimated using market quotes,
when available, and, when not available, discounted cash flow analyses.
Mandatorily Redeemable Securities of a Subsidiary Trust Holding Solely Junior
Subordinated Debentures of the Company
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources.
63
The estimated fair values of the financial instruments were as follows:
December 31
(in millions) 1997 1996
======================================================================================================================
Carrying Fair Carrying Fair
Value Value Value Value
Financial Assets
......................................................................................................................
Cash and cash equivalents $ 215.1 $ 215.1 $ 178.5 $ 178.5
Fixed maturities 7,313.7 7,313.7 7,487.8 7,487.8
Equity securities 479.0 479.0 473.6 473.6
Mortgage loans 567.5 597.0 650.1 675.7
Policy loans 141.9 141.9 132.4 132.4
......................................................................................................................
$ 8,717.2 $ 8,746.7 $ 8,922.4 $ 8,948.0
======================================================================================================================
Financial Liabilities
......................................................................................................................
Guaranteed investment contracts $ 985.2 $ 1,004.7 $ 1,101.3 $ 1,119.2
Supplemental contracts without life contingencies 22.4 22.4 23.1 23.1
Dividend accumulations 87.8 87.8 87.3 87.3
Other individual contract deposit funds 57.9 55.7 76.9 74.3
Other group contract deposit funds 714.8 715.5 789.1 788.3
Individual fixed annuity contracts 907.4 882.2 935.6 911.7
Short-term debt 33.0 33.0 38.4 38.4
Long-term debt 202.1 216.6 202.2 199.1
Mandatorily redeemable preferred securities of a
subsidiary trust holding soley junior subordinated
debentures of the Company 300.0 326.8 -- --
......................................................................................................................
$ 3,310.6 $ 3,344.7 $ 3,253.9 $ 3,241.4
======================================================================================================================
7. Closed Block
................................................................................
Included in other income in the Consolidated Statements of Income in 1997, 1996
and 1995 is a net pre-tax contribution from the Closed Block of $9.1 million,
$8.6 million and $2.9 million, respectively. Summarized financial information of
the Closed Block as of December 31, 1997 and 1996 and for the period ended
December 31, 1997 and 1996 and the period from October 1, 1995 through December
31, 1995 is as follows:
December 31
(In millions) 1997 1996
=========================================================================
Assets
Fixed maturities, at fair value (amortized
cost of $400.1 and $397.2, respectively) $ 412.9 $ 403.9
Mortgage loans 112.0 114.5
Policy loans 218.8 230.2
Cash and cash equivalents 25.1 24.1
Accrued investment income 14.1 14.3
Deferred policy acquisition costs 18.2 21.1
Other assets 5.6 2.7
.........................................................................
Total assets $ 806.7 $ 810.8
=========================================================================
Liabilities
Policy liabilities and accruals $ 875.1 $ 883.4
Other liabilities 10.4 16.0
.........................................................................
Total liabilities $ 885.5 $ 899.4
=========================================================================
64
Period from
October 1
For the Years Ended through
December 31 December 31
(In millions) 1997 1996 1995
======================================================================================================
Revenues
Premiums and other income $ 58.3 $ 61.7 $ 11.5
Net investment income 53.4 52.6 12.8
Realized investment gain (loss) 1.3 (0.7) --
......................................................................................................
Total revenues 113.0 113.6 24.3
......................................................................................................
Benefits and expenses
Policy benefits 100.5 101.2 20.6
Policy acquisition expenses 3.0 3.2 0.8
Other operating expenses 0.4 0.6 --
......................................................................................................
Total benefits and expenses 103.9 105.0 21.4
......................................................................................................
Contribution from the Closed Block $ 9.1 $ 8.6 $ 2.9
======================================================================================================
Cash flows
Cash flows from operating activities:
Contribution from the Closed
Block $ 9.1 $ 8.6 $ 2.9
Initial cash transferred to the
Closed Block -- -- 139.7
Change in:
deferred policy acquisition costs, net 2.9 3.4 0.4
premiums and other receivables -- 0.2 (0.1)
policy liabilities and accruals (11.6) (13.9) 2.0
accrued investment income 0.2 2.3 (1.3)
deferred taxes (5.1) 1.0 --
other assets (2.9) (1.6) 1.9
expenses and taxes payable (2.0) 1.7 (2.0)
Other, net (1.2) 1.4 0.9
......................................................................................................
Net cash (used in) provided
by operating activities (10.6) 3.1 144.4
......................................................................................................
Cash flows from investing activities:
Sales, maturities and
repayments of investments 161.6 188.1 29.0
Purchases of investments (161.4) (196.9) (158.8)
Other, net 11.4 12.2 3.0
......................................................................................................
Net cash provided by (used in)
investing activities 11.6 3.4 (126.8)
......................................................................................................
Net increase in cash and cash
equivalents 1.0 6.5 17.6
Cash and cash equivalents,
beginning of year 24.1 17.6 --
......................................................................................................
Cash and cash equivalents,
end of year $ 25.1 $ 24.1 $ 17.6
======================================================================================================
On October 16, 1995, there were no valuation allowances transferred to the
Closed Block on mortgage loans. There were no valuation allowances on mortgage
loans at December 31, 1997, 1996 and 1995, respectively.
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.
8. Debt
................................................................................
Short and long-term debt consisted of the following:
December 31
(In millions) 1997 1996
==============================================================================
Short-term
Commercial paper $ 32.6 $ 37.8
Other 0.4 0.6
..............................................................................
Total short-term debt $ 33.0 $ 38.4
==============================================================================
Long-term
Senior Debentures (unsecured) $ 199.5 $ 199.5
Other 2.6 2.7
..............................................................................
Total long-term debt $ 202.1 $ 202.2
==============================================================================
AFC issues commercial paper primarily to manage imbalances between operating
cash flows and existing commitments. Commercial paper borrowing arrangements are
supported by various lines of credit. At December 31, 1997, the weighted average
interest rate for outstanding commercial paper was approximately 5.8%.
In June 1997, the Company entered into a credit agreement providing for a
$225.0 million revolving line of credit that expired on December 15, 1997.
During 1997, the Company drew $140.0 million on the line of credit. Borrowings
under the line of credit were unsecured and bore interest at a rate per annum
equal to, at the Company's option, a designated base rate or the eurodollar rate
plus an applicable margin. These borrowings were repaid in full by December 15,
1997.
At December 31, 1997, the Company had approximately $140.0 million in
committed lines of credit provided by U.S. banks, of which $107.4 million was
available for borrowing. These lines of credit generally have terms of less than
one year, and require the Company to pay annual commitment fees limited to 0.07%
of the available credit. Interest that would be charged for usage of these lines
of credit is based upon negotiated arrangements.
During 1996, the Company utilized repurchase agreements to finance certain
investments. These repurchase agreements were settled by the end of 1996.
65
In October 1995, AFC issued $200.0 million face amount of Senior Debentures
for proceeds of $197.2 million net of discounts and issuance costs. These
securities have an effective interest rate of 7-5/8%, and mature on October 16,
2025. Interest is payable semiannually on October 15 and April 15 of each year.
The Senior Debentures are subject to certain restrictive covenants, including
limitations on issuance of or disposition of stock of restricted subsidiaries
and limitations on liens. The Company is in compliance with all covenants.
Interest expense was $21.7 million, $32.1 million and $7.3 million in 1997,
1996 and 1995, respectively. Interest expense included $15.3 million, $15.3
million and $3.2 million related to the Company's Senior Debentures for the
years ended December 31, 1997, 1996 and 1995 respectively. Interest paid on the
credit agreement during 1997 was approximately $2.8 million. Interest expense
during 1996 also included $11.0 million related to interest payments of
repurchase agreements. All interest expense is recorded in other operating
expenses.
9. Federal Income Taxes
................................................................................
Provisions for federal income taxes have been calculated in accordance with the
provisions of Statement No. 109. A summary of the federal income tax expense
(benefit) in the consolidated statements of income is shown below:
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Federal income tax expense (benefit)
Current $ 79.7 $ 90.9 $ 119.7
Deferred 13.9 (15.7) (37.0)
...............................................................................
Total $ 93.6 $ 75.2 $ 82.7
===============================================================================
The federal income taxes attributable to the consolidated results of
operations are different from the amounts determined by multiplying income
before federal income taxes by the expected federal income tax rate. The sources
of the difference and the tax effects of each were as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
================================================================================
Expected federal income tax
expense $ 127.9 $ 116.1 $ 105.6
Tax-exempt interest (37.9) (35.3) (32.2)
Differential earnings amount -- (10.2) (7.6)
Dividend received deduction (3.2) (1.6) (4.0)
Changes in tax reserve estimates 7.8 4.7 19.3
Other, net (1.0) 1.5 1.6
...............................................................................
Federal income tax expense $ 93.6 $ 75.2 $ 82.7
===============================================================================
Until conversion to a stock life insurance company, FAFLIC, as a mutual
company, reduced its deduction for policyholder dividends by the differential
earnings amount. This amount was computed, for each tax year, by multiplying the
average equity base of the FAFLIC/AFLIAC consolidated group, as determined for
tax purposes, by the estimate of an excess of an imputed earnings rate over the
average mutual life insurance companies' earnings rate. The differential
earnings amount for each tax year was subsequently recomputed when actual
earnings rates were published by the Internal Revenue Service ("IRS"). The
differential earnings amount included in 1996 related to an adjustment for the
1994 tax year based on the actual average mutual life insurance companies'
earnings rate issued by the IRS in 1996. As a stock life company, FAFLIC is no
longer required to reduce its policyholder dividend deduction by the
differential earnings amount.
The deferred income tax liability (asset) represents the tax effects of
temporary differences attributable to the Company's consolidated federal tax
return group. As a result of the merger discussed in Note 2, the Companies will
file a single consolidated federal income tax return for tax years ending on and
after December 31, 1997. Deferred tax amounts presented for 1996 reflect the
combination of the former FAFLIC/AFLIAC consolidated group with the former
Allmerica P&C consolidated group. Its components were as follows:
December 31
(In millions) 1997 1996
================================================================================
Deferred tax (assets) liabilities
AMT carryforwards $ (15.6) $ (16.3)
Loss reserve discounting (391.6) (355.1)
Deferred acquisition costs 291.8 249.4
Employee benefit plans (48.0) (41.4)
Investments, net 175.4 128.6
Bad debt reserve (14.3) (26.2)
Other, net 15.2 (5.8)
................................................................................
Deferred tax liability (asset), net $ 12.9 $ (66.8)
================================================================================
Gross deferred income tax assets totaled $469.5 million and $444.8 million
at December 31, 1997 and 1996, respectively. Gross deferred income tax
liabilities totaled $482.4 million and $378.0 million at December 31, 1997 and
1996, respectively.
The Company believes, based on its recent earnings history and its future
expectations, that the Company's taxable income in future years will be
sufficient to realize all deferred tax assets. In determining the adequacy of
future income, the Company considered the future reversal of its existing
temporary differences and available tax planning strategies that could be
implemented, if necessary. At December 31, 1997, there are available alternative
minimum tax credit carryforwards of $15.6 million.
66
The Company's federal income tax returns are routinely audited by the IRS,
and provisions are routinely made in the financial statements in anticipation of
the results of these audits. The IRS has examined the FAFLIC/AFLIAC consolidated
group's federal income tax returns through 1991. The IRS has also examined the
former Allmerica P&C consolidated group's federal income tax returns through
1991. The Company has appealed certain adjustments proposed by the IRS with
respect to the federal income tax returns for 1989, 1990 and 1991 for both the
FAFLIC/AFLIAC consolidated group as well as the former Allmerica P&C
consolidated group. Also, certain adjustments proposed by the IRS with respect
to FAFLIC/AFLIAC's federal income tax returns for 1982 and 1983 remain
unresolved. If upheld, these adjustments would result in additional payments;
however, the Company will vigorously defend its position with respect to these
adjustments. In the Company's opinion, adequate tax liabilities have been
established for all years. However, the amount of these tax liabilities could be
revised in the near term if estimates of the Company's ultimate liability are
revised.
10. Pension Plans
................................................................................
AFC provides retirement benefits to substantially all of its employees under
three separate defined benefit pension plans. Effective January 1, 1995, the
Company adopted a defined benefit cash balance formula, under which the Company
annually provides an allocation to each eligible employee based on a percentage
of that employee's salary, similar to a defined contribution plan arrangement.
The 1997, 1996 and 1995 allocations were based on 7.0% of each eligible
employee's salary. In addition to the cash balance allocation, certain
transition group employees, who have met specified age and service requirements
as of December 31, 1994, are eligible for a grandfathered benefit based
primarily on the employees' years of service and compensation during their
highest five consecutive plan years of employment. The Company's policy for the
plans is to fund at least the minimum amount required by the Employee Retirement
Income Security Act of 1974.
Components of net pension expense were as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
=============================================================================
Service cost - benefits earned
during the year $ 19.9 $ 19.0 $ 19.7
Interest cost on projected benefit
obligations 23.5 21.9 21.1
Actual return on assets (64.0) (42.2) (89.3)
Net amortization and deferral 29.0 9.3 66.1
.............................................................................
Net pension expense $ 8.4 $ 8.0 $ 17.6
=============================================================================
The following table summarizes the combined status of the three pension
plans. At December 31, 1997 and 1996, the plans' assets exceeded their projected
benefit obligations.
December 31
(In millions) 1997 1996
==============================================================================
Actuarial present value of benefit obligations:
Vested benefit obligation $ 332.6 $ 308.9
Unvested benefit obligation 7.5 6.6
..............................................................................
Accumulated benefit obligation $ 340.1 $ 315.5
==============================================================================
Pension liability included in Consolidated
Balance Sheets:
Projected benefit obligation $ 370.4 $ 344.2
Plan assets at fair value 395.5 347.8
..............................................................................
Plan assets greater than projected
benefit obligation 25.1 3.6
Unrecognized net gain from past experience (44.9) (9.1)
Unrecognized prior service benefit (13.9) (11.5)
Unamortized transition asset (26.2) (24.7)
..............................................................................
Net pension liability $ (59.9) $ (41.7)
==============================================================================
As a result of the Company's merger with Allmerica P&C, certain pension
liabilities were reduced by $11.7 million to reflect their fair value as of the
merger date.
Determination of the projected benefit obligations was based on a weighted
average discount rate of 7.0% in 1997 and 1996 and the assumed long-term rate of
return on plan assets was 9.0%. The actuarial present value of the projected
benefit obligations was determined using assumed rates of increase in future
compensation levels ranging from 5.0% to 5.5%. Plan assets are invested
primarily in various separate accounts and the general account of FAFLIC. Plan
assets also include 973,262 shares of AFC Common Stock at both December 31, 1997
and 1996, with a market value of $48.6 million and $32.6 million at December 31,
1997 and 1996, respectively.
The Company has three separate defined contribution 401(k) plans for its
employees. The Company matches employee elective 401(k) contributions, up to a
maximum percentage determined annually by the Board of Directors. During 1997,
1996 and 1995, the Company matched 50% of employees' contributions up to 6.0% of
eligible compensation. The total expenses related to these plans were $3.3
million, $5.5 million and $5.2 million, in 1997, 1996 and 1995, respectively. In
addition to these plans, the Company has a defined contribution plan for
substantially all of its agents. The Plan expense in 1997, 1996 and 1995 was
$2.8 million, $2.0 million and $3.5 million, respectively.
On January 1, 1998, substantially all of the aforementioned defined benefit
and defined contribution 401(k) plans were merged with the existing benefit
plans of FAFLIC. The transfer of benefit plans will not have a material impact
on the results of operations or financial position of the Company.
67
11. Other Postretirement Benefit Plans
................................................................................
In addition to the Company's pension plans, the Company currently provides
postretirement medical and death benefits to certain full-time employees and
dependents, under several plans sponsored by FAFLIC, Hanover and Citizens.
Generally, employees become eligible at age 55 with at least 15 years of
service. Spousal coverage is generally provided for up to two years after death
of the retiree. Benefits include hospital, major medical and a payment at death
equal to retirees' final compensation up to certain limits. Effective January 1,
1996, the Company revised these benefits so as to establish limits on future
benefit payments and to restrict eligibility to current employees. The medical
plans have varying copayments and deductibles, depending on the plan. These
plans are unfunded.
The plan changes, effective January 1, 1996, resulted in a negative plan
amendment (change in eligibility and medical benefits) of $26.8 million and
curtailment (no future increases in life insurance) of $5.3 million. The
negative plan amendment will be amortized as prior service cost over the average
number of years to full eligibility (approximately nine years or $3.0 million
per year). Of the $5.3 million curtailment gain, $3.3 million has been deducted
from unrecognized loss and $2.0 million has been recorded as a reduction of the
net periodic postretirement benefit expense.
The plans' funded status reconciled with amounts recognized in the Company's
consolidated balance sheet were as follows:
December 31
(In millions) 1997 1996
===========================================================================
Accumulated postretirement benefit obligation:
Retirees $ 40.7 $ 40.4
Fully eligible active plan participants 7.0 7.5
Other active plan participants 24.1 24.4
...........................................................................
71.8 72.3
Plan assets at fair value -- --
Accumulated postretirement benefit
obligation in excess of plan assets 71.8 72.3
Unrecognized prior service benefit 15.3 23.8
Unrecognized loss (0.8) (5.0)
...........................................................................
Accrued postretirement benefit costs $ 86.3 $ 91.1
===========================================================================
The components of net periodic postretirement benefit expense were as
follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
===========================================================================
Service cost $ 3.0 $ 3.2 $ 4.2
Interest cost 4.6 4.6 6.9
Amortization of gain (2.8) (2.8) (0.5)
...........................................................................
Net periodic postretirement
benefit expense $ 4.8 $ 5.0 $ 10.6
===========================================================================
As a result of the Company's merger with Allmerica P&C, certain
postretirement liabilities were reduced by $6.1 million to reflect their fair
value as of the merger date.
For purposes of measuring the accumulated postretirement benefit obligation
at December 31, 1997, health care costs were assumed to increase 8.0% in 1998,
declining thereafter until the ultimate rate of 5.5% is reached in 2001 and
remains at that level thereafter. The health care cost trend rate assumption has
a significant effect on the amounts reported. For example, increasing the
assumed health care cost trend rates by one percentage point in each year would
increase the accumulated postretirement benefit obligation at December 31, 1997
by $4.9 million, and the aggregate of the service and interest cost components
of net periodic postretirement benefit expense for 1997 by $0.6 million.
The weighted-average discount rate used in determining the accumulated
postretirement benefit obligation was 7.0% at December 31, 1997 and 1996.
As described in Note 10, all of the postretirement benefit plans of the
Company were merged with the existing plans of FAFLIC, effective January 1,
1998.
12. Stock-Based Compensation Plans
................................................................................
The Company has elected to apply the provisions of APB No. 25 (Accounting
Principles Board Opinion No. 25) in accounting for its stock-based compensation
plans, and thus no compensation cost has been recognized for stock options in
the financial statements. The pro forma effect of recognizing compensation cost
based on an instrument's fair value at the date of grant, consistent with
Statement No. 123, "Accounting for Stock-Based Compensation", results in net
income and earnings per share of $206.0 million and $3.76 per share-diluted
($3.77 per share-basic) in 1997, and $181.4 million and $3.62 per share (basic
and diluted) in 1996. Since options vest over several years and additional
awards generally are made each year, the aforementioned pro forma effects are
not likely to be representative of the effects on reported net income for future
years.
Effective June 17, 1996, the Company adopted a Long Term Stock Incentive
Plan for employees of the Company (the "Employees' Plan"). Key employees of the
Company and its subsidiaries are eligible for awards pursuant to the Plan
administered by the Compensation Committee of the Board of Directors (the
"Committee") of the Company. Under the terms of the Employees' Plan, the maximum
number of shares available for award in any given year is equal to 2.25% of the
outstanding common stock of the Company at the beginning of the year, plus any
awards authorized but unused from prior years. In addition, the maximum number
of shares authorized for grants over the life of the plan is equal to 3,678,733
shares as of December 31, 1997, increasing annually by 1.25% of the Company's
outstanding stock.
Options may be granted to eligible employees at a price not less than the
market price of the Company's common stock on the date of grant. Option shares
may be exercised subject to the terms prescribed by the Committee at the time of
grant, otherwise options vest at the rate of 20% annually for five consecutive
years and must be exercised not later than ten years from the date of grant.
68
Stock grants may be awarded to eligible employees at a price established by
the Committee (which may be zero). Under the Employees' Plan, stock grants may
vest based upon performance criteria or continued employment. Stock grants which
vest based on performance vest over a minimum one year period. Stock grants
which vest based on continued employment vest at the end of a minimum of three
consecutive years.
Information on the Company's stock option plan is summarized below:
(In whole shares and dollars) 1997 1996
================================================================================
Weighted Weighted
Average Average
Options Exercise Price Options Exercise Price
................................................................................
Outstanding at
beginning of --------------------------
year 209,500 $ 27.50 -- $ --
Granted 849,500 35.64 231,500 27.50
Converted from
Allmerica P&C
merger 114,509 27.40 -- --
Exercised 16,021 27.23 -- --
Forfeited 82,444 33.74 22,000 27.50
- --------------------------------------------------------------------------------
Outstanding at
end of year 1,075,044 $ 33.45 209,500 $ 27.50
- --------------------------------------------------------------------------------
Options
exercisable at
end of year 57,116 $ 27.38 -- $ --
- --------------------------------------------------------------------------------
No options expired during 1997 and 1996. The fair value of each option is
estimated on the date of grant using the Black-Scholes option-pricing model. For
options granted during 1997 and 1996, the exercise price equaled the market
price of the stock on the grant date. The weighted average fair value of options
granted in 1997 and 1996 was $15.02 per share and $13.19 per share,
respectively. For options converted pursuant to the merger with Allmerica P&C,
the exercise price was less than the fair value of the stock on the conversion
date. The weighted average fair value of these options was $28.24 per share.
The following significant assumptions were used to determine fair value for
1997 options granted and converted: dividend yield of 0.5%, expected volatility
of 31.52%, risk free interest rates ranging from 5.66% to 6.19%, and expected
lives of 2.5, 4, 5, 6 and 7 years. The following significant assumptions were
used to determine fair value for 1996 options granted: dividend yield of 0.6%,
expected volatility of 23.5%, risk free interest rates ranging from 5.29% to
6.33%, and expected lives of 2.5, 4, 5, 6 and 7 years.
The following table summarizes information about employee options outstanding
and exercisable at December 31, 1997.
Options Outstanding Options Currently Exercisable
......................................................................................................................
Weighted
Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Range of Exercise Prices Number Lives Price Number Price
======================================================= ==============================================================
----------- ---------------------------------------------------------------
$24.50 to $29.90 290,044 8.31 $27.45 55,116 $ 27.09
$35.375 to $50.00 785,000 9.41 $35.67 2,000 $ 35.38
During 1997, the Company granted 68,127 shares of nonvested stock to eligible
employees at a zero purchase price, which vest after three years of continuous
employment; 4,395 of these shares were forfeited during the year. The weighted
average fair market value of nonvested shares at the date of grant was $34.13
per share. The Company recognizes compensation expense related to nonvested
shares over the vesting period on a pro rata basis. As a result, the Company
recognized $0.7 million of compensation cost in 1997.
69
13. Dividend Restrictions
................................................................................
Massachusetts, Delaware, New Hampshire and Michigan have enacted laws governing
the payment of dividends to stockholders by insurers. These laws affect the
dividend paying ability of FAFLIC, AFLIAC, Hanover and Citizens, respectively.
Massachusetts' statute limits the dividends an insurer may pay in any twelve
month period, without the prior permission of the Commonwealth of Massachusetts
Insurance Commissioner, to the greater of (i) 10% of its statutory policyholder
surplus as of the preceding December 31 or (ii) the individual company's
statutory net gain from operations for the preceding calendar year (if such
insurer is a life company), or its net income for the preceding calendar year
(if such insurer is not a life company). In addition, under Massachusetts law,
no domestic insurer shall pay a dividend or make any distribution to its
shareholders from other than unassigned funds unless the Commissioner shall have
approved such dividend or distribution. No dividends were declared by FAFLIC to
AFC during 1997, 1996 or 1995. During 1998, FAFLIC could pay dividends of $196.3
million to AFC without prior approval of the Commissioner.
Pursuant to Delaware's statute, the maximum amount of dividends and other
distributions that an insurer may pay in any twelve month period, without the
prior approval of the Delaware Commissioner of Insurance, is limited to the
greater of (i) 10% of its policyholders' surplus as of the preceding December 31
or (ii) the individual company's statutory net gain from operations for the
preceding calendar year (if such insurer is a life company) or its net income
(not including realized capital gains) for the preceding calendar year (if such
insurer is not a life company). Any dividends to be paid by an insurer, whether
or not in excess of the aforementioned threshold, from a source other than
statutory earned surplus would also require the prior approval of the Delaware
Commissioner of Insurance. No dividends were declared by AFLIAC to FAFLIC during
1997, 1996 or 1995. During 1998, AFLIAC could pay dividends of $33.9 million to
FAFLIC without prior approval.
Pursuant to New Hampshire's statute, the maximum dividends and other
distributions that an insurer may pay in any twelve month period, without prior
approval of the New Hampshire Insurance Commissioner, is limited to 10% of such
insurer's statutory policyholder surplus as of the preceding December 31.
Hanover declared dividends to Allmerica P&C totaling $120.0 million, $105.0
million and $40.0 million during 1997, 1996 and 1995, respectively. During 1998,
the maximum dividend and other distributions that could be paid to Allmerica P&C
by Hanover, without prior approval of the Insurance Commissioner, is
approximately $127.6 million.
Pursuant to Michigan's statute, the maximum dividends and other distributions
that an insurer may pay in any twelve month period, without prior approval of
the Michigan Insurance Commissioner, is limited to the greater of 10% of
policyholders' surplus as of December 31 of the immediately preceding year or
the statutory net income less realized gains, for the immediately preceding
calendar year. Citizens Insurance declared dividends to Citizens Corporation
totaling $6.3 million and $3.0 million during 1996 and 1995, respectively. No
dividends were declared by Citizens Insurance during 1997. During 1998, Citizens
Insurance could pay dividends of $86.9 million to Citizens Corporation without
prior approval.
14. Segment Information
................................................................................
The Company offers financial products and services in two major areas: Risk
Management and Retirement and Asset Accumulation. Within these broad areas, the
Company conducts business principally in five operating segments.
The Risk Management group includes two segments: Regional Property and
Casualty and Corporate Risk Management Services.
The Regional Property and Casualty segment includes property and casualty
insurance products, such as automobile insurance, homeowners insurance,
commercial multiple-peril insurance, and workers' compensation insurance. These
products are offered by Allmerica P&C through its operating subsidiaries,
Hanover and Citizens. Substantially all of the Regional Property and Casualty
segment's earnings are generated in Michigan and the Northeast (Connecticut,
Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and
Maine). The Corporate Risk Management Services segment includes group life and
health insurance products and services which assist employers in administering
employee benefit programs and in managing the related risks.
The Retirement and Asset Accumulation group includes three segments: Allmerica
Financial Services, Institutional Services and Allmerica Asset Management. The
Allmerica Financial Services segment includes variable annuities, variable
universal life, traditional and health insurance products distributed via retail
channels to individuals across the country. The Institutional Services segment
includes primarily group retirement products such as 401(k) plans, tax-sheltered
annuities and GIC contracts which are distributed to institutions across the
country via work-site marketing and other arrangements. Allmerica Asset
Management is a Registered Investment Advisor which provides investment advisory
services, primarily to affiliates, and to other institutions, such as insurance
companies and pension plans.
In addition to the five operating segments, the Company also has a Corporate
segment, which consists primarily of cash, investments, corporate debt and
Capital Securities.
70
Summarized below is financial information with respect to business segments
for the years ended and as of December 31.
(In millions) 1997 1996 1995
=========================================================================================
Revenues:
Risk Management -------------
Regional Property and Casualty $ 2,275.3 $ 2,196.6 $ 2,109.0
Corporate Risk Management 396.3 361.5 328.5
.........................................................................................
Subtotal 2,671.6 2,558.1 2,437.5
.........................................................................................
Retirement and Asset Accumulation
Allmerica Financial Services 470.6 450.9 486.7
Institutional Services 243.4 270.7 330.2
Allmerica Asset Management 8.7 8.8 4.4
.........................................................................................
Subtotal 722.7 730.4 821.3
.........................................................................................
Corporate 11.2 1.8 0.4
Eliminations (9.9) (12.7) (4.4)
.........................................................................................
Total $ 3,395.6 $ 3,277.6 $ 3,254.8
- -----------------------------------------------------------------------------------------
Income (loss) from continuing
operations before income taxes:
Risk Management
Regional Property and Casualty $ 206.4 $ 197.7 $ 206.3
Corporate Risk Management 19.3 20.7 18.3
.........................................................................................
Subtotal 225.7 218.4 224.6
.........................................................................................
Retirement and Asset Accumulation
Allmerica Financial Services 87.4 76.2 35.2
Institutional Services 62.4 52.8 42.8
Allmerica Asset Management 1.4 1.1 2.3
.........................................................................................
Subtotal 151.2 130.1 80.3
.........................................................................................
Corporate (11.4) (16.8) (3.1)
.........................................................................................
Total $ 365.5 $ 331.7 $ 301.8
- -----------------------------------------------------------------------------------------
Identifiable assets:
Risk Management
Regional Property and Casualty $ 5,710.6 $ 5,703.9 $ 5,741.8
Corporate Risk Management 571.0 522.1 458.9
.........................................................................................
Subtotal 6,281.6 6,226.0 6,200.7
.........................................................................................
Retirement and Asset Accumulation
Allmerica Financial Services 12,049.6 8,822.4 7,218.6
Institutional Services 4,158.5 3,886.7 4,280.9
Allmerica Asset Management 4.1 2.4 2.1
.........................................................................................
Subtotal 16,212.2 12,711.5 11,501.6
.........................................................................................
Corporate 55.2 32.8 55.4
.........................................................................................
Total $ 22,549.0 $ 18,970.3 $ 17,757.7
- -----------------------------------------------------------------------------------------
15. Lease Commitments
................................................................................
Rental expenses for operating leases, principally with respect to buildings,
amounted to $33.6 million, $34.9 million and $36.4 million in 1997, 1996 and
1995, respectively. At December 31, 1997, future minimum rental payments under
non-cancelable operating leases were approximately $72.5 million, payable as
follows: 1998 - $24.8 million; 1999 - $19.8 million; 2000 - $13.6 million; 2001
- - $7.9 million; and $6.4 million thereafter. It is expected that, in the normal
course of business, leases that expire will be renewed or replaced by leases on
other property and equipment; thus, it is anticipated that future minimum lease
commitments will not be less than the amounts shown for 1998.
16. Reinsurance
................................................................................
In the normal course of business, the Company seeks to reduce the loss that my
arise from catastrophes or other events that cause unfavorable underwriting
results by reinsuring certain levels of risk in various areas of exposure with
other insurance enterprises or reinsurers. Reinsurance transactions are
accounted for in accordance with the provisions of Statement No. 113,
"Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration
Contracts".
Amounts recoverable from reinsurers are estimated in a manner consistent with
the claim liability associated with the reinsured policy. Reinsurance contracts
do not relieve the Company from its obligations to policyholders. Failure of
reinsurers to honor their obligations could result in losses to the Company;
consequently, allowances are established for amounts deemed uncollectible. The
Company determines the appropriate amount of reinsurance based on evaluation of
the risks accepted and analyses prepared by consultants and reinsurers and on
market conditions (including the availability and pricing of reinsurance). The
Company also believes that the terms of its reinsurance contracts are consistent
with industry practice in that they contain standard terms with respect to lines
of business covered, limit and retention, arbitration and occurrence. Based on
its review of its reinsurers' financial statements and reputations in the
reinsurance marketplace, the Company believes that its reinsurers are
financially sound.
The Company is subject to concentration of risk with respect to reinsurance
ceded to various residual market mechanisms. As a condition to the ability to
conduct certain business in various states, the Company is required to
participate in various residual market mechanisms and pooling arrangements which
provide various insurance coverages to individuals or other entities that are
otherwise unable to purchase such coverage voluntarily provided by private
insurers. These market mechanisms and pooling arrangements include the
Massachusetts Commonwealth Automobile Reinsurers ("CAR"), the Maine Workers'
Compensation Residual Market Pool ("MWCRP") and the Michigan Catastrophic Claims
Association ("MCCA"). At December 31, 1997, CAR was the only reinsurer which
represented 10% or more of the Company's reinsurance business. As a servicing
carrier in
71
Massachusetts, the Company cedes a significant portion of its private
passenger and commercial automobile premiums to CAR. Net premiums earned and
losses and loss adjustment expenses ceded to CAR in 1997, 1996 and 1995 were
$32.3 million and $28.2 million, $38.0 million and $21.8 million, and $49.1
million and $33.7 million, respectively.
The Company ceded to MCCA premiums earned and losses and loss adjustment
expenses in 1997, 1996 and 1995 of $9.8 million and $(0.8) million, $50.5
million and $(52.9) million, and $66.8 million and $62.9 million, respectively.
Because the MCCA is supported by assessments permitted by statute, and all
amounts billed by the Company to CAR, MWCRP and MCCA have been paid when due,
the Company believes that it has no significant exposure to uncollectible
reinsurance balances.
The effects of reinsurance were as follows:
For the Years Ended December 31
(In millions) 1997 1996 1995
==========================================================================================================
Life and accident and health insurance premiums: ------------
Direct $ 417.4 $ 389.1 $ 438.9
Assumed 110.7 87.8 71.0
Ceded (170.1) (138.9) (150.3)
..........................................................................................................
Net premiums $ 358.0 $ 338.0 $ 359.6
- ----------------------------------------------------------------------------------------------------------
Property and casualty premiums written:
Direct $ 2,068.5 $ 2,039.7 $ 2,039.4
Assumed 103.1 108.7 125.0
Ceded (179.8) (234.0) (279.1)
..........................................................................................................
Net premiums $ 1,991.8 $ 1,914.4 $ 1,885.3
- ----------------------------------------------------------------------------------------------------------
Property and casualty premiums earned:
Direct $ 2,046.2 $ 2,018.5 $ 2,021.7
Assumed 102.0 112.4 137.7
Ceded (195.1) (232.6) (296.2)
..........................................................................................................
Net premiums $ 1,953.1 $ 1,898.3 $ 1,863.2
- ----------------------------------------------------------------------------------------------------------
Life and accident and health insurance and
other individual policy benefits,
claims, losses and loss adjustment expenses:
Direct $ 656.4 $ 606.5 $ 741.0
Assumed 61.6 44.9 38.5
Ceded (158.8) (77.8) (69.5)
..........................................................................................................
Net policy benefits, claims, losses
and loss adjustment expenses $ 559.2 $ 573.6 $ 710.0
- ----------------------------------------------------------------------------------------------------------
Property and casualty benefits,
claims, losses and loss
adjustment expenses:
Direct $ 1,464.9 $ 1,299.8 $ 1,383.3
Assumed 101.2 85.8 146.1
Ceded (120.6) (2.2) (229.1)
..........................................................................................................
Net policy benefits, claims, losses
and loss adjustment expenses $ 1,445.5 $ 1,383.4 $ 1,300.3
- ----------------------------------------------------------------------------------------------------------
17. Deferred Policy Acquisition Costs
................................................................................
The following reflects the changes to the deferred policy acquisition asset:
For the Years Ended December 31
(In millions) 1997 1996 1995
====================================================================================
----------
Balance at beginning of year $ 822.7 $ 735.7 $ 802.8
Acquisition expenses deferred 617.7 547.4 505.4
Amortized to expense during
the year (476.0) (470.1) (470.9)
Adjustment to equity during
the year (11.1) 9.7 (50.4)
Transferred to the Closed Block -- -- (24.8)
Adjustment for cession of term
life insurance -- -- (26.4)
Adjustment for cession of disability
income insurance (38.6) -- --
Adjustment for revision of universal
life and variable universal life
insurance mortality assumptions 50.8 -- --
....................................................................................
Balance at end of year $ 965.5 $ 822.7 $ 735.7
- ------------------------------------------------------------------------------------
At October 1, 1997, the Company revised the mortality assumptions for
universal life and variable universal life product lines. These revisions
resulted in a $50.8 million recapitalization of deferred policy acquisition
costs.
18. Liabilities for Outstanding Claims,
Losses and Loss Adjustment Expenses
................................................................................
The Company regularly updates its estimates of liabilities for outstanding
claims, losses and loss adjustment expenses as new information becomes available
and further events occur which may impact the resolution of unsettled claims for
its property and casualty and its accident and health lines of business. Changes
in prior estimates are reflected in results of operations in the year such
changes are determined to be needed and recorded.
The liability for future policy benefits and outstanding claims, losses and
loss adjustment expenses related to the Company's accident and health business
was $533.6 million, $471.7 million and $446.9 million at December 31, 1997, 1996
and 1995, respectively. Accident and health claim liabilities were re-estimated
for all prior years and were decreased by $0.2 million and $0.6 million in 1997
and 1996, respectively, and increased by $17.6 million in 1995. Unfavorable
development in the accident and health business during 1995 was primarily due to
reserve strengthening and adverse experience in the Company's individual
disability income line of business. Effective October 1, 1997, the Company ceded
substantially all of its individual disability income line of
72
business, under a 100% coinsurance agreement. At December 31, 1997, the
individual disability income reserves ceded under this agreement were $249.0
million, representing 46.7% of the Company's total accident and health reserves.
The following table provides a reconciliation of the beginning and ending
property and casualty reserve for unpaid losses and loss adjustment expenses:
For the Years Ended December 31
(In millions) 1997 1996 1995
============================================================================================================
Reserve for losses and LAE,
beginning of year $ 2,744.1 $ 2,896.0 $ 2,821.7
Incurred losses and LAE, net of
reinsurance recoverable:
Provision for insured events
of current year 1,564.1 1,513.3 1,427.3
Decrease in provision for
insured events of prior years (127.9) (141.4) (137.6)
............................................................................................................
Total incurred losses and LAE 1,436.2 1,371.9 1,289.7
............................................................................................................
Payments, net of reinsurance
recoverable:
Losses and LAE attributable to
insured events of current year 775.1 759.6 652.2
Losses and LAE attributable to
insured events of prior years 732.1 627.6 614.3
............................................................................................................
Total payments 1,507.2 1,387.2 1,266.5
............................................................................................................
Change in reinsurance recoverable
on unpaid losses (50.2) (136.6) 51.1
Other (1) (7.5) -- --
............................................................................................................
Reserve for losses and LAE,
end of year $ 2,615.4 $ 2,744.1 $ 2,896.0
============================================================================================================
(1) Includes purchase accounting adjustments.
As part of an ongoing process, the property and casualty reserves have been
re-estimated for all prior accident years and were decreased by $127.9 million,
$141.4 million and $137.6 million in 1997, 1996 and 1995, respectively.
The decrease in favorable development on prior years' reserves of $13.5
million in 1997 results primarily from a $24.6 million decrease in favorable
development at Hanover to $58.4 million, partially offset by an $11.1 million
increase in favorable development at Citizens to $69.5 million. The decrease in
Hanover's favorable development of $24.6 million in 1997 reflects a decrease in
favorable development of $25.0 million, to $17.4 million in the personal
automobile line, as well as a decrease in favorable development of $8.5 million,
to unfavorable development of $2.8 million in the commercial multiple peril
line. These decreases were partially offset by an increase in favorable
development in the workers' compensation line of $11.5 million, to $28.8
million. The increase in favorable development at Citizens in 1997 reflects
improved severity in the workers' compensation line where favorable development
increased $13.9 million, to $35.7 million and in the commercial multiple peril
line where favorable development increased $7.0 million to $4.3 million,
partially offset by less favorable development in the personal automobile line,
where favorable development decreased $10.5 million, to $22.5 million in 1997.
The increase in favorable development on prior years' reserves of $3.8
million in 1996 results primarily from an $11.4 million increase in favorable
development at Citizens. The increase in Citizens' favorable development of
$11.4 million in 1996 reflects improved severity in the personal automobile
line, where favorable development increased $28.6 million to $33.0 million in
1996, partially offset by less favorable development in the workers'
compensation line of $10.9 million. Hanover's favorable development, including
voluntary and involuntary pools, decreased $7.7 million in 1996 to $82.9
million, primarily attributable to a decrease in favorable development in the
workers' compensation line of $19.8 million. Favorable development in the
personal automobile line also decreased $4.7 million, to $42.4 million in 1996.
These decreases were offset by increases in favorable development of $1.9
million and $5.6 million, to $12.6 million and $5.7 million, in the commercial
automobile and commercial multiple peril lines, respectively. Favorable
development in other lines increased by $8.8 million, primarily as a result of
environmental reserve strengthening in 1995. Favorable development in Hanover's
voluntary and involuntary pools increased $3.7 million to $4.1 million during
1996.
Citizens' favorable development in 1997 primarily reflects a modest shift
over the past few years of the workers' compensation business to Western and
Northern Michigan, which have demonstrated more favorable loss experience than
Eastern Michigan.
Citizens' favorable development in 1996 and 1995 primarily reflects the
initiatives taken by the Company to manage medical costs in both the automobile
and workers' compensation lines, as well as the impact of the Michigan Supreme
Court ruling on workers' compensation indemnity payments in 1995, which
decreases the maximum amount to be paid for indemnity cases on all existing and
future claims.
Hanover's favorable development from 1995 to 1997 primarily reflects
favorable legislation related to workers' compensation, improved safety features
in automobiles and a moderation of medical costs and inflation.
In 1995, Hanover's favorable development was primarily attributable to a re-
estimate of reserves with respect to certain types of workers' compensation
policies including large deductibles and excess of loss policies. In addition,
during 1995 Hanover refined its estimation of unallocated loss adjustment
expenses which increased favorable development in that year.
73
This favorable development reflects the Regional Property and Casualty
subsidiaries' reserving philosophy consistently applied over these periods.
Conditions and trends that have affected development of the loss and LAE
reserves in the past may not necessarily occur in the future.
Due to the nature of the business written by the Regional Property and
Casualty subsidiaries, the exposure to environmental liabilities is relatively
small and therefore their 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 total reserve for losses and LAE were $53.1
million and $50.8 million, net of reinsurance of $15.7 million and $20.2 million
at the end of 1997 and 1996, respectively. The Regional Property and Casualty
subsidiaries do not specifically underwrite policies that include this coverage,
but as case law expands policy provisions and insurers' liability beyond the
intended coverage, the Regional Property and Casualty subsidiaries may be
required to defend such claims. Due to their unusual nature and absence of
historical claims data, reserves for these claims are not determined using
historical experience to project future losses. 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 claims are not material, their existence
gives rise to uncertainty and is discussed because of the possibility, however
remote, that they may become material. The Company believes that,
notwithstanding the evolution of case law expanding liability in environmental
claims, recorded reserves related to these claims are adequate. In addition, the
Company is not aware of any litigation or pending claims that may result in
additional material liabilities in excess of recorded reserves. The
environmental liability could be revised in the near term if the estimates used
in determining the liability are revised.
19. Minority Interest
................................................................................
The Company's interest in Allmerica P&C, through its wholly-owned subsidiary
FAFLIC, is represented by ownership of 59.5% and 58.3% of the outstanding shares
of common stock at December 31, 1996 and 1995, respectively. Allmerica P&C was a
wholly-owned subsidiary of AFC at December 31, 1997. Allmerica P&C's interest in
Citizens was approximately 82.5% at December 31, 1997 and 1996, and 81.1% at
December 31, 1995.
Minority interest at December 31, 1997 also reflects the Company's issuance of
Capital Securities (See Note 3).
20. Contingencies
................................................................................
Regulatory and Industry Developments
Unfavorable economic conditions may contribute to an increase in the number of
insurance companies that are under regulatory supervision. This may result in an
increase in mandatory assessments by state guaranty funds, or voluntary payments
by, solvent insurance companies to cover losses to policyholders of insolvent or
rehabilitated companies. Mandatory assessments, which are subject to statutory
limits, can be partially recovered through a reduction in future premium taxes
in some states. The Company is not able to reasonably estimate the potential
effect on it of any such future assessments or voluntary payments.
Litigation
In July 1997, a lawsuit was instituted in Louisiana against AFC and certain of
its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive
acts, breach of contract, misrepresentation and related claims in the sale of
life insurance policies. In October 1997, plaintiffs voluntarily dismissed the
Louisiana suit and refiled the action in Federal District Court in Worcester,
Massachusetts. The plaintiffs seek to be certified as a class. The case is in
early stages of discovery and the Company is evaluating the claims. Although the
Company believes it has meritorious defenses to plaintiffs' claims, there can be
no assurance that the claims will be resolved on a basis which is satisfactory
to the Company.
On June 23, 1995, the governor of Maine approved a legislative settlement for
the Maine Workers' Compensation Residual Market Pool deficit for the years 1988
through 1992. The settlement provides for an initial funding of $220.0 million
toward the deficit. The insurance carriers were liable for $65.0 million and
employers would contribute $110.0 million payable through surcharges on premiums
over the course of the next ten years. The major insurers are responsible for
90% of the $65.0 million. Hanover's allocated share of the settlement was
approximately $4.2 million, which was paid in December 1995. The remainder of
the deficit of $45.0 million will be paid by the Maine Guaranty Fund, payable in
quarterly contributions over ten years. A group of smaller carriers filed
litigation to appeal the settlement. Although the Company believes that adequate
reserves have been established for any additional liability, there can be no
assurance that the appeal will be resolved on a basis which is satisfactory to
the Company.
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 in the
near term if estimates of the ultimate resolution of these proceedings are
revised.
74
Residual Markets
The Company is required to participate in residual markets in various states.
The results of the residual markets are not subject to the predictability
associated with the Company's own managed business, and are significant to the
workers' compensation line of business and both the private passenger and
commercial automobile lines of business.
Year 2000
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities.
Although the Company does not believe that there is a material contingency
associated with the Year 2000 project, there can be no assurance that exposure
for material contingencies will not arise.
21. Statutory Financial Information
................................................................................
The insurance subsidiaries are required to file annual statements with state
regulatory authorities prepared on an accounting basis prescribed or permitted
by such authorities (statutory basis). Statutory surplus differs from
shareholders' equity reported in accordance with generally accepted accounting
principles primarily because policy acquisition costs are expensed when
incurred, investment reserves are based on different assumptions, postretirement
benefit costs are based on different assumptions and reflect a different method
of adoption, life insurance reserves are based on different assumptions and
income tax expense reflects only taxes paid or currently payable.
Statutory net income and surplus are as follows:
(In millions) 1997 1996 1995
================================================================================
Statutory Net Income (Combined)
................................................................................
Property and Casualty Companies $ 190.3 $ 155.3 $ 155.3
Life and Health Companies 191.2 133.3 134.3
................................................................................
Statutory Shareholders'
Surplus (Combined)
................................................................................
Property and Casualty Companies $ 1,279.8 $ 1,201.6 $ 1,128.4
Life and Health Companies 1,221.3 1,120.1 965.6
................................................................................
22. Quarterly Results of Operations (Unaudited)
................................................................................
The quarterly results of operations for 1997 and 1996 are summarized below:
For the Three Months Ended
(In millions)
============================================== =======================================================
1997 March 31 June 30 Sept. 30 Dec. 31
======================================================
Total revenues $ 854.9 $ 832.5 $ 855.7 $ 852.5
============================================== =======================================================
Net income $ 15.9 $ 37.7 $ 60.7 $ 94.9
============================================== =======================================================
Net income per share (basic and diluted) $ 0.32 $ 0.75 $ 1.04 $ 1.58
============================================== =======================================================
Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05
============================================== =======================================================
1996
Total revenues $ 831.4 $ 798.9 $ 806.9 $ 840.4
============================================== =======================================================
Net income $ 47.3 $ 42.6 $ 46.7 $ 45.3
============================================== =======================================================
Net income per share (basic and diluted) $ 0.94 $ 0.85 $ 0.93 $ 0.91
============================================== =======================================================
Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05
============================================== =======================================================
Note: Due to the use of weighted average shares outstanding when calculating
earnings per common share, the sum of the quarterly per common share data may
not equal the per common share data for the year.
75
Allmerica Financial Corporation
BOARD OF DIRECTORS
Michael P. Angelini (A)
Partner, Bowditch & Dewey, LLP
Gail L. Harrison (D)
Founding Principal, The Wexler Group
Robert P. Henderson (C)
General Partner, Greylock Management
Corporation
M Howard Jacobson (A)
Senior Advisor and Consultant,
Bankers Trust Company
J. Terrence Murray (D)
Chairman and Chief Executive Officer,
Fleet Financial Group, Inc.
Robert J. Murray (D)
Chairman, President and Chief Executive Officer,
New England Business Service, Inc.
John F. O'Brien
President and Chief Executive Officer,
Allmerica Financial Corporation
John L. Sprague (A)
President, John L. Sprague Associates, Inc.
Robert G. Stachler (C)
Partner, Taft, Stettinius & Hollister
Herbert M. Varnum (C)
Former Chairman and Chief Executive Officer,
Quabaug Corporation
Richard Manning Wall (C)
General Counsel and Assistant to the Chairman
and CEO, FLEXcon Company, Inc.
(A) Audit Committee
(C) Compensation Committee
(D) Directors Committee
OPERATING COMMITTEE
Bruce C. Anderson
Vice President, Corporate Services
Robert E. Bruce
Vice President, Corporate Technology Services
John P. Kavanaugh
Vice President and Chief Investment Officer
John F. Kelly
Vice President, General Counsel and
Assistant Secretary
J. Barry May
President, The Hanover Insurance Company
James R. McAuliffe
President, Citizens Insurance Company
of America
John F. O'Brien
President and Chief Executive Officer
Edward J. Parry III
Vice President, Chief Financial Officer
and Treasurer
Richard M. Reilly
Vice President, Allmerica Financial Services
Eric A. Simonsen
President, Allmerica Services Corporation
Phillip E. Soule
Vice President, Corporate Risk Management
Services
76
Shareholder Information
ANNUAL MEETING OF SHAREHOLDERS
The management and Board of Directors of Allmerica Financial Corporation invite
you to attend the Company's Annual Meeting of Shareholders. The meeting will be
held on May 12, 1998, at 9:00 a.m. at Allmerica Financial, 440 Lincoln Street,
Worcester, MA.
COMMON STOCK AND SHAREHOLDER OWNERSHIP PROFILE
The common stock of Allmerica Financial Corporation is traded on the New York
Stock Exchange under the symbol "AFC." On March 6, 1998, the Company had 62,369
shareholders of record. On the same date, the trading price of the Company's
common stock closed at $62 1/2 per share.
COMMON STOCK PRICES AND DIVIDENDS
1997 HIGH LOW DIVIDENDS
- --------------------------------------------------------------------------------
First Quarter $40 1/4 $32 5/8 $0.05
................................................................................
Second Quarter $40 3/8 $33 1/2 $0.05
................................................................................
Third Quarter $45 1/4 $39 1/4 $0.05
................................................................................
Fourth Quarter $51 $42 7/8 $0.05
................................................................................
1996 HIGH LOW DIVIDENDS
- --------------------------------------------------------------------------------
First Quarter $28 $24 3/4 $0.05
................................................................................
Second Quarter $30 1/8 $25 1/4 $0.05
................................................................................
Third Quarter $32 7/8 $27 1/2 $0.05
................................................................................
Fourth Quarter $33 3/4 $30 1/8 $0.05
................................................................................
DIVIDENDS
Allmerica Financial Corporation currently pays a quarterly cash dividend of
$0.05 per share.
REGISTRAR AND STOCK TRANSFER AGENT
First Chicago Trust Company of New York
525 Washington Boulevard
Jersey City, NJ 07303-2512
(800) 317-4454
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
160 Federal Street
Boston, MA 02110
INDUSTRY RATINGS
A.M. STANDARD DUFF &
CLAIMS PAYING ABILITY BEST &POORS MOODY'S PHELPS
- --------------------------------------------------------------------------------
First Allmerica Financial
Life Insurance Company A AA- A1 AA
................................................................................
Allmerica Financial
Life Insurance and
Annuity Company A AA- A1 AA
................................................................................
The Hanover Insurance
Company A AA- A1 --
................................................................................
Citizens Insurance
Company of America A -- -- --
................................................................................
STANDARD DUFF &
DEBT RATINGS & POORS MOODY'S PHELPS
- --------------------------------------------------------------------------------
Allmerica Financial
Corporation Senior Debt A- A2 A+
................................................................................
Allmerica Financial
Corporation Capital
Securities BBB+ A2 --
................................................................................
TOLL-FREE INVESTOR INFORMATION LINE
Call our toll-free investor information line, (800) 407-5222, to receive
additional printed information, including Form 10-K's or quarterly reports on
Form 10-Q filed with the Securities and Exchange Commission, fax-on-demand
services, access to shareholder services, pre-recorded messages and other
services. Alternatively, investors may address questions to:
Jean Peters, Vice President-Investor Relations
Allmerica Financial Corporation
440 Lincoln Street, Worcester, MA 01653
tel. (508) 855-1000 fax (508) 852-7588
MacArthur Starks, Jr., Director-Investor Relations
tel (508) 855-1000 fax (508) 855-3675
CORPORATE OFFICES AND PRINCIPAL SUBSIDIARIES
Allmerica Financial Corporation
440 Lincoln Street
Worcester, MA 01653
The Hanover Insurance Company
100 North Parkway
Worcester, MA 01605
Citizens Insurance Company of America
645 West Grand River
Howell, MI 48843
Printed entirely on recycled paper
Design: The Graphic Expression Inc., New York