The following analysis of the consolidated results of operations and financial condition of Allmerica Financial Corporation and subsidiaries (“AFC”) should be read in conjunction with the Consolidated Financial Statements included elsewhere herein.
This year was a year of transition for us. We were focused on improving our property and casualty ratings, specifically returning our A.M. Best ratings to the “A-” level, as well as completing the restructuring of our Allmerica Financial Services business and conversion of our former agency sales force to that of an independent broker/dealer. In addition, we continued to monitor and improve our statutory capital levels in both our life and property and casualty insurance businesses. Additionally, in the property and casualty insurance business, we were focused on maintaining our profitability and retaining our policyholders in our commercial lines business, which is more sensitive to ratings downgrades. We also executed strategies to improve the profitability of our personal lines business.
During 2003, we also completed the cessation of sales of our proprietary life and annuity products, which began in the fourth quarter of 2002. We concluded the final transfer of assets related to our 2002 sale of our universal life business, and consolidated our infrastructure to manage the in-force business and to reduce expenses. In addition, we were focused on transforming our former agency distribution channel to a broker/dealer operation, which generated brokerage and management income and related variable expenses. We formed strategic alliances with other insurance companies to distribute their products through this operation. After completing the review of our business strategy discussed above, we decided to cease the retail operations of the broker/dealer in the fourth quarter of 2003, which resulted in additional restructuring charges.
We offer financial products and services and conduct business principally in three operating segments. These segments are Property and Casualty, Allmerica Financial Services (“AFS”), and Asset Management. We present the separate financial information of each segment consistent with the manner in which our chief operating decision maker evaluates results in deciding how to allocate resources and in assessing performance. A summary of our reportable segments is included below.
In addition to the three operating segments, we have a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities (mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the holding company) and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those related to certain officers and directors, technology, finance, human resources and legal.
In 2002, our consolidated net loss increased $303.0 million, to $306.1 million, compared to $3.1 million in 2001. The increase in net loss resulted primarily from a change in segment income of $673.2 million to a segment loss of $504.4 million in 2002, from segment income of $168.8 million in 2001, principally the result of a significant segment loss in AFS. This was partially offset by a $233.3 million change in the corresponding federal income taxes from a tax expense of $4.3 million in 2001 to a tax benefit of $229.0 million in 2002. Also contributing to this decline was a $20.3 million loss from the sale of the universal life business and a $12.3 million increase in restructuring and reorganization costs. Partially offsetting these items were a $66.7 million gain from the retirement of trust instruments supported by funding obligations and a $49.1 million change in (losses) gains on derivative instruments, from a net loss of $22.9 million in 2001, to a net gain of $26.2 million in 2002.
The following table reflects segment income (loss) and a reconciliation to consolidated net income (loss).
The decrease in Property and Casualty segment income is primarily attributable to an increase in adverse development of prior years’ loss and loss adjustment expense (“LAE”) reserves of $34.0 million, including charges of $21.9 million resulting from an adverse arbitration decision within a voluntary insurance pool that we exited in 1996. Catastrophe losses increased $28.1 million in 2003. In addition, segment income decreased due to a $25.6 million increase in policy acquisition and other operating expenses, as well as an $18.5 million decrease in net investment income. These were partially offset by an estimated $91 million of net premium rate increases. Additionally, a decrease in policies in force resulted in declines in premiums and losses, as well as segment income.
The federal income tax benefit was $229.0 million for 2002, compared to an expense of $4.3 million in 2001. This tax benefit is primarily the result of the significant loss recognized by the AFS segment in 2002.
The change in net realized investment gains (losses), net of taxes and deferred acquisition cost amortization, in 2003 primarily resulted from $54.0 million of after-tax gains from the sale of approximately $1.5 billion of fixed maturities. These gains were partially offset by impairments of $40.0 million, net of taxes, primarily related to fixed maturities. During 2002, net realized investment losses, after taxes and amortization, were $89.4 million, primarily due to $145.3 million of fixed maturity impairments, net of taxes, and $35.9 million of after-tax losses related to the termination of certain derivative instruments. These losses were partially offset by $73.4 million of after-tax net realized gains from the sale of approximately $3.1 billion of fixed maturities. During 2001, net realized losses on investments, after taxes and amortization, were $78.8 million, primarily due to after-tax realized losses from impairments of fixed maturities of $116.4 million. These losses were partially offset by $37.5 million of after-tax net realized gains from the sale of approximately $2.2 billion of fixed maturities.
During 2003, we recognized income of $3.6 million, net of taxes, from the settlement of post-closing items related to the December 2002 sale of our universal life insurance business through a 100% coinsurance agreement (see Significant Transactions - Sale of Universal Life Business). In 2002,
In 2003, we recognized an after-tax charge of $18.7 million related to the restructuring of our AFS segment, including VeraVest. In 2002, we recognized an after-tax charge of $9.6 million related to the restructuring of our AFS segment. These restructuring costs consisted of severance and other employee-benefit related expenses, as well as the cancellation of certain lease agreements and contracted services. In addition, we recognized, in 2002, other reorganization costs of $4.5 million, net of taxes, primarily related to the forgiveness of interest on certain loans to AFS agents. During the fourth quarter of 2001, we recognized an after-tax charge of $1.8 million for severance and other employee related costs resulting from the reorganization of our technology support group.
Voluntary pool losses reflect our participation in a reserve deficiency of a voluntary excess and casualty reinsurance pool. From 1950 to 1982, we voluntarily participated in this reinsurance pool along with several other property and casualty carriers. The pool was dissolved in 1982 and since that time has been in run-off. During the fourth quarter of 2001, the pool obtained results from an independent actuarial review of its current reserve position, which noted a range of reserve deficiency, primarily as a result of adverse development of asbestos claims. As a result of this study, we recognized losses, net of taxes, of $21.5 million, based on our participation in the reserve deficiency.
During 2002, we recognized a $3.7 million loss, net of taxes, upon adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. During 2001, we recognized a $3.2 million loss, net of taxes, upon adoption of Statement of Financial Accounting Standards No. 133.
The following table summarizes the results of operations for the Property and Casualty segment:
(3) Statutory underwriting results include certain overhead expenses, which on a GAAP basis are reflected in the Corporate Segment.
Personal lines’ underwriting results declined $30.5 million to an underwriting loss of $85.7 million for the year ended December 31, 2002. The decline in underwriting results is primarily attributable to increased underwriting expenses, principally related to the increased expenses for mandatory assigned risk personal automobile business in New York. In addition, underwriting expenses increased due to higher premium tax expenses and increases in agents’ contingent commissions. Underwriting results were also unfavorably affected by increased current year claims frequency in the personal automobile line for the year ended December 31, 2002 and by an $8.3 million increase in adverse development during 2002 in the personal automobile line. Partially offsetting these items is an estimated $35 million of net premium rate increases. In addition, catastrophe losses decreased $6.6 million, to $25.7 million for the year ended December 31, 2002, compared to $32.3 million for the same period in 2001.
Commercial lines’ net premiums written decreased $113.7 million, or 12.7%, to $783.1 million for the year ended December 31, 2002. This decrease is primarily the result of the agency management actions we took in 2001. As a result of these actions, policies in force decreased 22.5%, 15.9% and 8.4% in the commercial automobile, workers’ compensation, and commercial multiple peril lines, respectively, since December 31, 2001. Partially offsetting these decreases in policies in force were rate increases in all of the commercial lines since December 31, 2001.
Commercial lines’ underwriting results improved $114.3 million to an underwriting gain of $15.1 million for the year ended December 31, 2002. The improvement in underwriting results is primarily attributable to approximately $45 million of net premium rate increases during the year ended December 31, 2002. Development on prior years’ reserves improved $32.4 million to $14.3 million of favorable development for the year ended December 31, 2002 from $18.1 million of adverse development for the same period in 2001. In addition, catastrophe losses decreased $13.1 million, to $5.6 million for the year ended December 31, 2002, compared to $18.7 million for the same period in 2001. In 2002, underwriting results also included a net benefit, when compared to 2001, as the result of exiting historically unprofitable business under the aforementioned agency management actions.
Net investment income before taxes was $183.5 million, $202.0 million and $216.0 million for the years ended December 31, 2003, 2002 and 2001, respectively. The decrease in net investment income in 2003, compared to 2002, primarily reflects a reduction in average pre-tax yields on fixed maturities and an increased emphasis on higher credit quality fixed maturities. Average pre-tax yields on fixed maturities decreased to 6.0% in 2003 compared to 6.4% in 2002 due to the lower prevailing fixed maturity investment rates and the aforementioned shift to higher credit quality fixed maturities. The decrease in net investment income also reflects a reduction in average invested assets as a result of a $92.1 million dividend from the property and casualty companies to the holding company in July 2002 and a transfer of $73.7 million in January 2003 to fund the property and casualty companies’ portion of the additional minimum pension liability we recognized at December 31, 2002. We expect our investment results will continue to be negatively affected by lower prevailing fixed maturity investment rates.
The decrease in net investment income in 2002, compared to 2001, primarily reflects a reduction in average pre-tax yields on fixed maturities, as well as a reduction in average invested assets. This reduction in assets resulted from the $92.1 million dividend referenced above and the transfer of $55.5 million to fund the property and casualty companies’ portion of the additional minimum pension liability we recognized at December 31, 2001. In addition, net investment income decreased due to the impact of defaults on certain high yield fixed maturities. Average pre-tax yields on fixed maturities decreased to 6.4% in 2002, compared to 6.9% in 2001, due to the lower prevailing fixed maturity investment rates.
We determine the amount of loss and LAE reserves based on an estimation process that is very complex and uses information obtained from both company specific and industry data, as well as general economic information. The estimation process is highly judgmental, and requires us to continuously monitor and evaluate the life cycle of claims on type-of-business and nature-of-claim bases. Using data obtained from this monitoring and assumptions about emerging trends, we develop information about the size of ultimate claims based on our historical experience and other available market information. The most significant assumptions that we use in the estimation process, which vary by line of business, include determining the trend in loss costs, the expected consistency in the frequency and severity of claims incurred but not yet reported to prior year claims, changes in the timing of the reporting of losses from the loss date to the notification date and the expected costs to settle unpaid claims. Because the amount of the loss and LAE reserves are sensitive to our assumptions, we do not completely rely on only one estimate to determine our loss and LAE reserves. Rather, we develop several estimates using generally recognized actuarial projection methodologies that result in various loss and LAE reserve outcomes and we adopt the best estimate. We may determine that the low or high end estimate calculated by the method does not represent a reasonable estimate, because certain projection methodologies may not result in a reasonable reserve estimate for a particular line of business due to certain underlying data or assumptions. When trends emerge that we believe affect the future settlement of claims, we adjust our reserves accordingly.
The table below summarizes the change in provision for insured events of prior years by line of business.
In addition, in 2001 a reserve increase of $40.8 million on prior years resulted from the agency management actions discussed in “Selected Property & Casualty Exited Agencies, Policies, Groups & Programs”. This reserve increase affected primarily the commercial multiple peril, personal automobile, commercial automobile and workers’ compensation lines. Additionally, other commercial lines’ prior year reserves developed adversely due to a $33.0 million reserve increase in the ECRA voluntary pool. Personal automobile prior year reserves developed adversely due to the aforementioned increased claim severity related to medical settlements in Michigan. In addition to the effect from the agency management actions, the commercial automobile and commercial multiple peril lines experienced adverse development. The increased reserves in these lines is primarily attributable to increased claim payments in the 2000 and 1999 accident years. As these payments have increased above historical amounts, actuarial projections of future settlements have increased the estimated ultimate reserves on prior years.
During the years ended December 31, 2003, 2002 and 2001, estimated LAE reserves for claims occurring in prior years developed favorably by $34.1 million, $30.5 million and $39.2 million, respectively. The favorable development in all periods is primarily attributable to claims process improvement initiatives taken by us during the 1997 to 2001 calendar year period. Since 1997, we have lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. As actual experience begins to establish certain trends inherent within the claim settlement process, the actuarial process recognizes these trends within the reserving methodology impacting future claim settlement assumptions. As these measures improved average settlement costs, the actuarial estimate of future settlement costs are reduced and favorable development is recorded. These measures are complete.
Although we do not specifically underwrite policies that include asbestos, environmental damage and toxic tort liability, we may be required to defend such claims. The table below summarizes direct business asbestos and environmental reserves (net of reinsurance and excluding pools):
Ending loss and LAE reserves for all direct business written by our property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $24.9 million, $25.6 million and $26.7 million, net of reinsurance of $15.0 million, $16.0 million and $13.0 million in 2003, 2002 and 2001, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the three-year period ended December 31, 2003. As a result of our historical direct underwriting mix of commercial lines policies toward smaller and middle market risks, past asbestos, environmental damage and toxic tort liability loss experience has remained minimal in relation to the our total loss and LAE incurred experience. We estimate our ultimate liability for these claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. We believe that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. In addition, we are not aware of any litigation or pending claims that are expected to 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.
In addition, and not included in the table above, we have established loss and LAE reserves for assumed reinsurance pool business with asbestos, environmental damage and toxic tort liability of $45.6 million, $45.2 million, and $39.3 million in 2003, 2002 and 2001, respectively. These reserves relate to pools in which we have terminated our participation; however, we continue to be subject to claims related to years in which we were a participant. We participated in the ECRA voluntary pool during 1950 to 1982, until it was dissolved and put in runoff in 1982. Our percentage of the total pool liabilities varied from 1.15% to 6.00% during these years. Our participation in this pool has resulted in average paid losses of $2.4 million annually over the past ten years. During 2001, the pool commissioned an independent actuarial review of its then current reserve position, which noted a range of reserve deficiency primarily as a result of adverse development of asbestos claims. As a result of this study, we recorded an additional $33.0 million of losses in the fourth quarter of 2001, which is included in the reported outstanding loss and LAE reserves. Because of the inherent uncertainty regarding the types of claims in these pools, we cannot provide assurance that these reserves will be sufficient.
During the fourth quarter of 2001, we completed an extensive review of our agency relationships which resulted in the termination of 377 agencies and the withdrawal of commercial lines’ underwriting authority from an additional 314 agencies. These actions affected approximately 27% of approximately 2,500 active agencies representing us in 2001. These agencies had consistently produced unsatisfactory loss ratios. In addition, we terminated virtually all of our specialty commercial programs and discontinued a number of special marketing arrangements. The total earned premium associated with the exited business was $74.9 million, $164.6 million and $252.9 million in 2003, 2002 and 2001, respectively. The estimated future premium deficiency on these policies is $7.2 million and this loss was recorded during 2001. In connection with these actions, we performed an actuarial review of outstanding reserves with segregated loss history on the exited business. Based on this review, an increase to reserves of $52.9 million was recorded in 2001. This increase includes $12.1 million of adverse development in 2001 and $40.8 million of adverse development on prior year reserves, which is net of a $5.9 million benefit from our whole account aggregate excess
Our Property and Casualty segment maintains a reinsurance program designed to protect against large or unusual losses and allocated LAE activity. This includes excess of loss reinsurance and catastrophe reinsurance. We determine the appropriate amount of reinsurance based on our evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to us. We believe that the terms of our 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 a review of our reinsurers’ financial statements and reputations in the reinsurance marketplace, we believe that our reinsurers are financially sound.
Prior to September 30, 2002, the Allmerica Financial Services segment manufactured and sold variable annuities, variable universal life and traditional life insurance products, as well as certain group retirement products. In the fourth quarter of 2002 and as a result of ratings downgrades (see Rating Agency Actions), we ceased the sale of proprietary products. As a result, the factors that affect our results of operations after the cessation of sales of proprietary products are substantially different from those in effect prior to that date.
The following table summarizes the results of operations for the Allmerica Financial Services segment for the periods indicated.
Allmerica Financial Services segment income was $26.9 million in 2003 compared to a loss of $625.0 million in 2002. Income in 2003 includes a charge of $11.5 million relating to the impairment of assets resulting from our decision to discontinue the retail operations of VeraVest. The loss in 2002 reflects the net charges of $698.3 million relating to the shutdown of proprietary life insurance and annuity product sales.
The following table summarizes the aforementioned charges and benefits for 2002. These items are discussed in further detail in the “Deferred Acquisition Costs”, “Guaranteed Minimum Death Benefits” and “Technology Costs” sections of this discussion.
Other income increased $6.1 million in 2003, to $36.5 million primarily due to increased revenues generated by higher asset-based distribution fees and a termination fee related to one large group variable universal life insurance client.
Brokerage and investment management variable expenses increased $12.8 million, to $68.7 million in 2003. The increase primarily reflects the aforementioned $16.6 million increase in commissions, partially offset by lower investment management expenses due to lower average assets under management.
The substantial and sustained decline in the equity market, culminating in the third quarter of 2002, precipitated a number of significant events which caused us to incur large increases in DAC amortization. These included, in large part, substantial ratings downgrades, which contributed to our decision to cease new sales of proprietary variable annuity and life products. We believe that this business decision will adversely affect the profitability of our existing policies and contracts by significantly decreasing the persistency of customer accounts. Decreased persistency also will increase the cost of the GMDB feature of variable annuity contracts, further reducing profitability. This results from a reduction of revenues in future periods due to a decline in average invested assets, whereby the revenues will not be sufficient to offset GMDB claims in the near term. In addition, the 2002 market decline resulted in significant differences in actual account value investment returns from those assumed. This required us to substantially increase the level of DAC amortization and GMDB expense under existing assumptions and to reassess the appropriate long-term assumptions on account appreciation and GMDB cost. As a result, we revised downward our assumptions regarding future account appreciation and increased expectations regarding the long-term cost of the GMDB feature. Finally, our evaluation of the compounding effects of the market decline and AFS business model changes on the anticipated profitability of our distribution channels caused us to determine that there had been a permanent impairment of the remaining DAC asset related to the former Partners distribution channel (see Annuity Account Values and Redemptions for a description of the former distribution channels). Each of these increased costs and changed assumptions are discussed further below.
Finally, we recognized additional amortization of $159.0 million in 2002 related to our former Partners distribution channel. After reviewing all assumptions affecting future profits assumed in our DAC methodology, including the effect of the aforementioned adjustments, we determined that the remaining DAC asset related to Partners exceeded the present value of total expected gross profits by $159.0 million. Accordingly, we recognized a permanent impairment to our DAC asset of this amount. A permanent impairment in 2002 was not required for the other distribution channels because of their higher expected profitability.
During 2003, we had six additional items reducing DAC amortization by a total of $12.9 million. First, because the equity market returns in 2003 exceeded the assumptions in our DAC estimation process, we recognized reduced DAC amortization of $17.8 million. Our level of DAC amortization continues to be sensitive to equity market returns, since equity market returns affect our estimate of future gross profits from variable products. To the extent that the return in any quarter is greater than the approximately 2 percent assumed in our model, amortization is reduced, and vice versa. Excluding the effect, if any, from the GMDB hedging program and SOP 03-1, (see Guaranteed Minimum Death Benefits), we believe each 1 percent variation from expected market appreciation will affect DAC amortization and segment income by approximately $1 million.
Second, we recognized additional amortization of $4.5 million, related to our former Select and Partners distribution channels. We determined that the remaining DAC asset related to our former Select and Partners channels exceeded the present value of total expected gross profits by $3.4 million and $1.1 million, respectively in 2003. Accordingly, we recognized permanent impairments to our DAC asset for these amounts.
Third, to facilitate our ongoing recoverability testing for the former Partners and Select distribution channels, we refined our methodology concerning the aggregation of annuity contracts for the purposes of estimating future gross profits and current amortization. This refinement resulted in $19.2 million of additional amortization in 2003.
Finally, we revised our estimate related to certain fees from annuity products based on the current mix of business. This change resulted in a $4.4 million decrease in DAC amortization in 2003.
As a result of resetting the long-term assumption for market related appreciation to 8 percent annually and applying the reversion-to-the-mean accounting methodology, we believe that DAC amortization will be less sensitive to short-term market movements. Additionally, we believe that our redemption levels will remain consistent with those experienced in 2003. Therefore, we expect similar levels of DAC amortization in future periods as experienced in 2003.
We will continue to evaluate our process for estimating future gross profits and DAC amortization. These regular evaluations may result in future adjustments to DAC amortization for a number of reasons, including permanent impairments to our DAC asset if our actual experience is worse than our current assumptions. Impairments would increase DAC amortization in the period that they are recognized.
The GMDB feature provides annuity contractholders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on either the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically, the greatest of these values. If the GMDB is higher than the current account value at the time of death, we incur a cost equal to the difference. As of December 31, 2003, the difference between the GMDB and the current account value (the “net amount at risk”) for all existing contracts was approximately $2.6 billion, compared to approximately $4.6 billion at December 31, 2002. The decrease was the result of an increase in equity market values during the year, as well as surrenders, which result in forfeitures of the GMDB benefit. For each one percent increase or decrease in the S&P 500 Index from December 31, 2003 levels, the net amount at risk is estimated to increase or decrease by approximately $50 million to $70 million.
(1) Claims ceded to reinsurers exclude those contracts with a date of death prior to December 1, 2002 and certain other claims.
On December 3, 2003, we implemented a hedging program for our in-force variable annuity policies with GMDB features. The program’s primary purpose is to provide us with an economic hedge against increased GMDB claims which could arise from declines in the equity market below levels at December 3, 2003. Also, the program is expected to reduce the volatility in statutory capital and risk-based capital levels from the effects of future equity market movements and allows us to retain most of the benefits of reduced GMDB costs in a rising equity market. However, it does not hedge or reduce our cost from the net amount at risk existing at December 3, 2003.
The program utilizes a dynamic hedging approach involving exchange traded futures contracts. Under the program, hedge contracts are expected to generate cash to fund increases in GMDB claims resulting from declines in the equity market.
Prior to the fourth quarter of 2002, we distributed our annuity products primarily through three distribution channels: (1) “Agency”, which consisted of our former career agency force; (2) “Select”, which consisted of a network of third party broker/dealers; and (3) “Partners”, which included distributors of the mutual funds advised by Scudder Investments, Pioneer Investment Management, Inc. and Delaware Management Company.
The following table summarizes the results of operations for the Asset Management segment.
Ratings downgrades during 2002 (see Rating Agency Actions) resulted in the termination of all remaining short-term funding agreements, and ultimately, we ceased selling new long-term funding agreements in 2002. Furthermore, we retired some of our funding agreements at discounts during 2003 and in the fourth quarter of 2002. Although these retirements resulted in gains for us (see Consolidated Overview), income from the GIC product line will be unfavorably affected in future periods due to the declining balance of outstanding GIC deposits and lower interest spreads from the remaining GICs resulting from investments in lower yielding securities. Excluding foreign currency fluctuations, we expect that net interest margins from GICs will be modestly negative in 2004. In addition, we expect the lower income from our external client and asset management business to continue.
We use derivative instruments to hedge our GIC portfolio (see Derivative Instruments). For floating rate GIC liabilities that are matched with fixed rate securities, we manage the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. In addition, some funding agreements are denominated in foreign currencies. To mitigate the effect of changes in currency exchange rates, we hedge this risk by entering into foreign exchange swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts to hedge our net foreign currency exposure. These hedges resulted in a $5.9 million reduction in net investment income during 2003, as compared to a $37.7 million reduction in net investment income in 2002, offset by similar reductions in GIC interest credited during both periods. The decreased effect of derivative instruments was due to a decrease in average outstanding GIC deposits and the associated hedges. In addition, these hedges resulted in a $9.0 million decrease in other income during 2003, resulting from exposure to foreign currency fluctuations from futures contracts entered into in the fourth quarter of 2002 which were deemed “ineffective” hedges for accounting purposes. In December 2003, the ineffective futures contracts were replaced with foreign currency swaps, which are expected to be “effective” hedges for accounting purposes, thus we do not expect the fluctuations to recur in the future. However, there can be no assurance that we will not experience losses from ineffective hedges in the future.
Asset Management segment income increased $3.7 million, or 17.9%, to $24.4 million in 2002 primarily due to the inclusion of $3.7 million of earnings related to our premium financing subsidiary, AMGRO, in 2002, which was previously included in the Property and Casualty segment. In addition, segment income increased due to an increase in fees and other income related to external clients, offset by lower earnings on GICs. New external assets under management resulted in an increase in earnings from asset management services provided to external clients. Earnings on GICs decreased $2.3 million primarily due to lower net investment income and to withdrawals of short-term funding agreements. Net investment income declined primarily due to lower prevailing fixed maturity investment rates, and to the effect of defaults on certain fixed maturities supporting GIC obligations.
As noted above, we use derivative instruments to hedge interest rate and currency exchange risks related to our GIC portfolio (see Derivative Instruments). These hedges resulted in a $37.7 million reduction in net investment income during 2002, as compared to a $48.0 million reduction in net investment income during 2001. These reductions in net investment income were offset by similar reductions in GIC interest credited during the respective periods. The decreased effect of derivative instruments was due to a decrease in average outstanding GIC deposits and the associated hedges.
At December 31, 2003, $247.5 million of our fixed maturities were invested in traditional private placement securities, as compared to $423.1 million at December 31, 2002. Fair values of traditional private placement securities are determined by either a third party broker or by internally developed pricing models, including the use of discounted cash flow analyses.
We recognized $55.6 million of realized losses on other-than-temporary impairments of fixed maturities for the year ended December 31, 2003, as compared to $223.6 million for the year ended December 31, 2002, principally resulting from our exposure to below investment grade securities. Other-than-temporary impairments of fixed maturities in 2003 included: $18.8 million related to the airline/transportation sector; $11.6 million related to the industrial sector; $10.4 million related to securitized investments; and $7.1 million related to the finance sector. Other-than-temporary impairments of fixed maturities in 2002 included: $66.1 million related to the communication sector; $49.6 million related to the airline/transportation sector; $25.9 million related to the utility sector; $23.9 million related to securitized investments; and $19.3 million related to the energy sector. In addition, we recognized $6.0 million of realized losses on other-than-temporary impairments of equity securities and other long-term investments during 2003, compared to $14.9 million in 2002.
In our determination of other-than-temporary impairments, we consider several factors and circumstances including the issuer’s overall financial condition; the issuer’s credit and financial strength ratings; the issuer’s financial performance, including earnings trends, dividend payments, and asset quality; a weakening of the general market conditions in the industry or geographic region in which the issuer operates; a prolonged period in which the fair value of an issuer’s securities remains below our cost; and with respect to fixed maturity investments, any factors that might raise doubt about the issuer’s ability to pay all amounts due according to the contractual terms. We apply these factors to all securities. Other-than-temporary impairments are recorded as a realized loss, which serves to reduce net income and earnings per share. Temporary losses are recorded as unrealized losses, which do not affect net income and earnings per share but reduce other comprehensive income. We cannot provide assurance that the other-than-temporary impairments will, in fact, be adequate to cover future losses or that we will not have additional impairments in the future.
The following table provides information about our fixed maturities and equity securities that have been continuously in an unrealized loss position at December 31, 2003 and 2002:
We had fixed maturity securities with a carrying value of $28.6 million on non-accrual status at December 31, 2003, as compared to $39.9 million at December 31, 2002. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, was a reduction in net investment income of $7.6 million for the year ended December 31, 2003, as compared to a reduction of $19.5 million for the year ended December 31, 2002. We expect that defaults in the fixed maturities portfolio may continue to negatively affect investment income.
On December 3, 2003, we implemented an economic hedging program involving exchange traded futures contracts to hedge against increased GMDB claims that could arise from declines in the equity market below levels at December 3, 2003 (See Allmerica Financial Services - Guaranteed Minimum Death Benefits). The program is expected to reduce the volatility in statutory capital and risk-based capital levels from the effects of future equity market movements and allows us to retain most of the benefits of reduced GMDB costs in a rising equity market. During the year ended December 31, 2003, we recognized $8.4 million in losses as losses (gains) on derivative instruments in the Consolidated Statements of Income as a result of this program. The GMDB hedges do not qualify for hedge accounting under Statement No. 133.
We recognized $4.3 million of net realized losses on derivatives for the year ended December 31, 2003, $53.1 million of losses for the year ended December 31, 2002 and $32.9 million of losses for the year ended December 31, 2001. The realized losses during 2003 were primarily due to the termination of derivative instruments used to hedge funding agreements, in response to the retirement of certain long-term funding agreements at discounts. The realized losses during 2002 were primarily due to the termination of derivative instruments used to hedge funding agreements, during a declining interest rate environment, in response to short-term funding agreement withdrawals and the retirement of certain long-term funding agreements at discounts. The realized losses during 2001 were primarily due to the termination of interest rate swap contracts in response to short-term funding agreement withdrawals.
In 2001, we managed the risk of cash flow variability on floating rate funding agreements that were matched with fixed rate securities, by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. In accordance with the provisions of Statement No. 133, which we adopted on January 1, 2001, the swap contracts were considered cash flow hedges of the interest rate risk associated with the floating rate funding agreements, including funding agreements with put features allowing the policyholder to cancel the contract prior to maturity. We no longer have outstanding floating rate funding agreements with put features. In addition, we no longer offer long-term or short-term funding agreements. During 2001, we reclassified losses of $35.8 million to losses (gains) on derivative instruments in the Consolidated Statements of Income from other comprehensive income related to payments that were not probable of occurring on ineffective interest rate swap contracts. During 2002, we reclassified these losses to realized investment gains (losses) from losses (gains) on derivative instruments in the Consolidated Statements of Income. These reclassifications, which occurred during the first and second quarters of 2002, were due to the termination of interest rate swap contracts.
Our operations are subject to risk resulting from interest rate fluctuations to the extent that there is a difference between the amount of our interest-earning assets and the amount of interest-bearing liabilities that are paid, withdrawn, mature or re-price in specified periods. We have developed an asset/liability management approach tailored to specific insurance or investment product objectives. The principal objective of our approach is to provide maximum levels of net investment income, while maintaining acceptable levels of interest rate and liquidity risk and facilitating our funding needs. We manage our investment assets in over 20 portfolio segments consistent with specific products or groups of products having similar liability characteristics. As part of this approach, we develop investment guidelines for each portfolio consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. We have a general policy of diversifying investments both within and across all portfolios. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors, and in the case of mortgages, property types and geographic locations. In addition, we currently carry long-term debt. At December 31, 2002, we held mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of our holding company. In accordance with Statement No. 150, the mandatorily redeemable preferred securities have been reclassified to long-term debt in our Consolidated Balance Sheet for the year ended December 31, 2003. Under this statement, reclassification of these instruments in prior periods was not permitted.
cash flows and related weighted-average interest rates by expected maturities, unless otherwise noted below. Expected 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 we may have the right to put or sell the obligations back to the issuers. Mortgage-backed and asset-backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated fixed maturities, but exclude interest rate swap contracts and foreign currency swap contracts, which are disclosed in separate tables. Foreign-denominated fixed maturities are also shown separately in the table of financial instruments subject to foreign currency risk. For liabilities that have no contractual maturity, the tables present principal cash flows and related weighted-average interest rates based on our historical experience, management’s judgment, and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. Additionally, we have assumed our available-for-sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available-for-sale securities and mortgage loans comprise an immaterial portion of the portfolio and do not have a significant impact on weighted-average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the tables at their current interest rate.
A portion of our investment securities and trust instruments supported by funding obligations are denominated in foreign currencies. Our operating results are exposed to changes in exchange rates between the U.S. dollar and foreign currencies, primarily the Japanese Yen, British Pound and Euro. To mitigate the short-term effect of changes in currency exchange rates, we regularly hedge by entering into foreign exchange swaps, futures, and options contracts, as well as compound foreign currency/interest rate swap contracts to hedge our net foreign currency exposure. The following tables for the years ended December 31, 2003 and 2002 provide information about our derivative financial instruments and other financial instruments, used for purposes other than trading, by functional currency and presents fair value information in U.S. dollar equivalents. The tables summarize information on instruments that are sensitive to foreign currency exchange rates, including securities denominated in foreign currencies, compound foreign currency/interest rate swap contracts, foreign currency forward exchange agreements, foreign currency futures contracts, and foreign currency options contracts. For foreign currency denominated securities and liabilities, the tables present principal cash flows and applicable current foreign currency exchange rates by contractual maturity. For foreign currency derivative instruments, the tables present the notional amounts and weighted-average exchange rates by expected (contractual) maturity dates. The notional amounts are used to calculate the contractual payments to be exchanged under the contracts. During the fourth quarter 2003, we entered into swap contracts denominated in Japanese Yen to replace the Yen futures contracts.
The following table for the year ended December 31, 2003 provides information about our derivative financial instruments used for purposes other than trading that are sensitive to changes in the equity market. The table presents notional amounts, number of contracts, and weighted-average contract price by index and expected maturity.
The provision for federal income taxes before minority interest and the effect of a change in accounting principle was a benefit of $7.4 million during 2003, compared to benefits of $234.8 million during 2002 and $75.5 million during 2001. These benefits resulted in consolidated effective federal tax rates of 9.3% of pre-tax income for 2003, 45.0% of pre-tax loss for 2002 and 127.1% of pre-tax loss for 2001. The benefits in 2003 and 2001 are due to the high proportion of tax-exempt investment income, the dividends received deduction associated with our variable products and low-income housing credits, relative to pre-tax income. The large benefit in 2002 is primarily due to the significant loss recognized by the AFS segment as well as an $11.6 million favorable settlement of federal income tax returns related to 1977 through 1981.
Included in our deferred tax net asset as of December 31, 2003 is an asset of approximately $63 million related to federal income tax net operating loss carryforwards (“NOL”) and an asset of approximately $53 million related to capital loss carryforwards. The NOL may be utilized in future years to offset taxable income of approximately $180 million and will begin expiring in 2016. The capital loss carryforwards may be utilized to offset future capital gains of approximately $151 million and will begin expiring in 2008. In addition, at December 31, 2003, there is an asset of approximately $151 million, of which approximately $98 million relates to alternative minimum tax credit carryforwards and approximately $53 million relates to low income housing tax credit carryforwards and other general business credits. The alternative minimum tax credit carryforwards have no expiration date and the low income housing credit carryforwards will expire beginning in 2018. We may utilize the credits to offset regular federal income taxes due from future income, and although we believe that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability.
We determine the amount of loss and loss adjustment expense reserves (the “loss reserves”), as discussed in “Segment Results - Property and Casualty, Overview of Loss Reserve Estimation Process” based on an estimation process that is very complex and uses information obtained from both company specific and industry data, as well as general economic information. The estimation process is judgmental, and requires us to continuously monitor and evaluate the life cycle of claims on type-of-business and nature-of-claim bases. Using data obtained from this monitoring and assumptions about emerging trends, we develop information about the size of ultimate claims based on historical experience and other available market information. The most significant assumptions, which vary by line of business, used in the estimation process include determining the trend in loss costs, the expected consistency in the frequency and severity of claims incurred but not yet reported to prior year claims, changes in the timing of the reporting of losses from the loss date to the notification date, and expected costs to settle unpaid claims. Because the amount of the loss reserves is sensitive to our assumptions, we do not completely rely on only one estimate to determine our loss reserves. We develop several estimates using generally recognized actuarial projection methodologies that result in various reasonably possible loss reserve outcomes and we adopt the best estimate. When trends emerge that we believe affect the future settlement of claims, we would adjust our reserves accordingly (see Segment Results -Property and Casualty, Management’s Review of Judgments and Key Assumptions for further explanation of factors affecting our reserve estimates, our review process and our process for determining changes to our reserve estimates). Reserve
The NAIC prescribes an annual calculation regarding risk-based capital (“RBC”). RBC is a method of measuring the minimum amount of capital appropriate for an insurance company to support its overall business operations in consideration of its size and risk profile. The RBC ratio for regulatory purposes is calculated as total adjusted capital divided by required risk based capital. Total adjusted capital for life insurance companies is defined as capital and surplus, plus asset valuation reserve, plus 50% of dividends apportioned for payment. Total adjusted capital for property and casualty companies is capital and surplus. The Company Action Level is the first level at which regulatory involvement is specified based upon the level of capital. Regulators may take action for reasons other than triggering various RBC action levels. The various action levels are summarized as follows:
• The Company Action Level, which equals 200% of the Authorized Control Level, requires the Company to prepare and submit a RBC plan to the commissioner of the state of domicile. A RBC plan proposes actions which a company may take in order to bring statutory capital above the Company Action Level. After review, the commissioner will notify the Company if the plan is satisfactory.
• The Authorized Control Level authorizes the commissioner of the state of domicile to take whatever regulatory actions considered necessary to protect the best interest of the policyholders and creditors of the insurer.
• The Mandatory Control Level, which equals 70% of the Authorized Control Level, authorizes the commissioner of the state of domicile to take actions necessary to place the Company under regulatory control (i.e. rehabilitation or liquidation).
• Life and health companies whose Total Adjusted Capital is between 200% and 250% of the Authorized Control Level are subject to a trend test. The trend test calculates the greater of the decrease in the margin between the current year and the prior year and the average of the past three years. It assumes that the decrease could occur again in the coming year. Any company that trends below 190% of the Authorized Control Level (i.e. demonstrates a negative trend) would trigger the Company Action Level. As of December 31, 2003 and December 31, 2002, both AFLIAC and FAFLIC had adjusted capital levels well above 250% of the Authorized Control Level risk based capital and; therefore, were not subject to the trend test.
(3) AFLIAC statutory GMDB reserve balances exclude those reserves held by its subsidiary, FAFLIC.
AFC also entered into several transactions that significantly improved the statutory capital positions of both AFLIAC and FAFLIC as of December 31, 2002. These transactions include selling, through a 100% coinsurance agreement, effective December 31, 2002, the fixed universal life insurance business which produced an increase in statutory surplus of approximately $109 million. In addition, FAFLIC successfully completed a tender offer through which it retired additional long-term funding agreements at amounts less than statutory accounting carrying values. This transaction, together with open market repurchases of long-term funding agreements in the fourth quarter, resulted in the retirement of approximately $550 million of funding agreements at amounts below face value. These actions produced a net increase in FAFLIC’s statutory surplus of approximately $84 million.
During 2002, AFC made capital contributions to its then subsidiary FAFLIC, which in turn contributed capital to its then subsidiary, AFLIAC. Such contributions were necessary due to the negative impact on statutory surplus of increased sales commissions, the effect of declines in the equity market on GMDB reserves and an increased level of realized investment losses. Such contributions were also made in consideration of the ratings of the life companies and the 225% RBC agreement described above, which has since been superseded. For each contribution made, the amount was accrued as of the end of the prior quarter and was, therefore, reflected in the previous quarter’s surplus balance in the corresponding company’s statutory quarterly or annual statement. Hanover also paid an ordinary dividend to AFC in July, 2002.
(1) The effective date represents the date which these transactions were reflected in our statutory surplus balance.
For the year ended December 31, 2002, the life companies incurred GMDB costs of $95.2 million, and ceded $34.5 million of GMDB costs under the aforementioned reinsurance programs. In addition, for the year ended December 31, 2003, the life companies incurred GMDB costs of $92.8 million, and ceded $74.7 million of GMDB costs under the aforementioned 2002 GMDB mortality reinsurance program.
During 2003, we received no dividends from our property and casualty businesses. Approximately $100 million is currently available to dividend from our property and casualty
Net cash used in operating activities was $174.3 million in 2003, while net cash provided by operating activities was $43.8 million and $658.4 million in 2002 and 2001, respectively. The decrease in cash during 2003 primarily reflects net payments from the general account as a result of continued increased annuity contract withdrawals in the AFS segment as a result of ratings downgrades and our decision to cease new sales. In addition, approximately $100 million of cash was transferred as a result of the sale of our universal life insurance business. Additionally, we contributed $25 million to our qualified pension plan. In 2002, we received approximately $60 million in funds which were held with a third party reinsurer, that in 2003 were disbursed to its successor. This payment related to funds held for the aggregate excess of loss reinsurance contract as a result of the ratings downgrades (see Rating Agency Actions). In 2004, these funds were returned to us due to the improvement in our financial strength ratings. The decrease in cash during 2002 primarily reflects net payments from the general account as a result of increased annuity contract withdrawals in the AFS segment as a result of ratings downgrades and our decision to cease new sales. Additionally, premium collections in the property and casualty business decreased, principally due to timing of cash receipts. These net cash outflows were partially offset by decreased loss and LAE payments in the property and casualty business, as well as increased federal income tax refunds.
Net cash used in financing activities was $189.3 million and $1.5 billion in 2003 and 2002, respectively, while net cash provided by financing activities was $417.9 million in 2001. The $1.3 billion decrease in cash used in 2003 is primarily due to lower net funding agreement withdrawals, including withdrawals from trust instruments supported by funding obligations. The decrease in cash provided in 2002 is primarily due to these net funding agreement withdrawals, as well as the extinguishment of our short-term debt obligation totaling $83.3 million.
degree of liquidity within their respective investment portfolios in fixed maturity investments, common stock and short-term investments. In addition, we had no commercial paper borrowings as of December 31, 2003 and we do not anticipate utilizing commercial paper in 2004. Debt ratings downgrades resulted in the non-renewal of our credit line and continue to preclude or adversely affect the cost and availability of credit lines, commercial paper, other additional debt and equity financing (see Rating Agency Actions).
Our financing obligations generally include debt, repayment of our Capital Securities (also classified as debt), operating lease payments, trust instruments supported by funding obligations and funding agreements. The following table represents our annual payments related to the principal payments of these financing obligations as of December 31, 2003 and operating lease payments reflect expected cash payments based upon lease terms. Actual payments may differ from the contractual payments in the table.
(1) Long-term debt includes our senior debentures due in 2025, which pay annual interest at a rate of 7 5/8%, and our Capital Securities, due in 2027, which pay cumulative dividends at an annual rate of 8.207%.
(5) Qualified pension plan funding obligations represent the amounts necessary to be contributed to the plan to satisfy minimum funding obligations in accordance with the Employee Retirement Income Security Act of 1974.
We have been named a defendant in various other legal proceedings arising in the normal course of business and are involved, from time to time, in investigations and proceedings by governmental and self-regulatory agencies. Additional
information on other litigation and claims may be found in Note 21, “Contingencies” on pages 102 and 103 of the Notes to the Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Report on Form 10-K. In our opinion, based on the advice of legal counsel, the ultimate resolutions of such proceedings will not have a material effect on our financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.
The following tables provide information about our ratings at December 31, 2001, 2002 and 2003, and rating agency actions that occurred in 2002. Additionally, where applicable, we have included rating agency actions occurring in 2004.
Our property and casualty ratings downgrades in 2002, in particular the A.M. Best rating, resulted in lower earnings and growth in this business, primarily in commercial lines. In the fourth quarter of 2002, we secured third party guarantees and established a special commission program, in an effort to minimize the loss of commercial lines business as a result of the downgrades. Expenses incurred as a result of purchasing third party guarantees in 2003 were $4.9 million. In addition, we incurred $5.0 million in additional commission expenses related to the special commission program. These expenses are expected to decrease to $3.5 million combined in 2004 due to our A.M. Best rating upgrade. Additionally, as a result of the ratings downgrades in 2002 of our life insurance companies, we are no longer able to generate new sales of proprietary products in our AFS segment and experienced increased surrender rates in the life insurance and annuity business, particularly in the fourth quarter of 2002 and the first quarter of 2003. In addition, we are no longer able to sell our GIC products. These downgrades also caused counterparties to terminate certain swap agreements, which were replaced with alternative derivative instruments. Although we do not expect downgrades in our ratings, there can be no assurance that current ratings or downgrades that could occur would not have a material adverse affect on our results of operations and financial position.
We generate a significant portion of our total revenues and earnings through our property and casualty insurance subsidiaries. The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability could be affected significantly by (i) adverse catastrophe experience, severe weather or other unanticipated significant losses; (ii) adverse loss development or loss adjustment expense for events we have insured in either the current or in prior years; (iii) increases in costs, particularly those occurring after the time our products are priced and including construction, automobile, and medical and rehabilitation costs; and (iv) restrictions on insurance underwriting.
Our businesses may be affected by (i) lower appreciation or decline in value of our managed investments or the investment markets in general, resulting in reduced variable product assets and related variable product management fees, lapses and increased surrenders, increased DAC amortization, as well as increased cost of guaranteed minimum death benefits; (ii) adverse trends in mortality and morbidity; (iii) possible claims relating to sales practices for insurance and investment products; (iv) earlier than expected withdrawals and changes in redemption patterns from our general account annuities, and other insurance products; (v) losses due to foreign currency fluctuations; (vi) the extent to which the performance of the various hedging instruments utilized in our GMDB hedging program do not correlate with the investment performance and underlying annuity sub-accounts; and (vii) the continued availability of equity index futures.
Other market fluctuations and general economic, market and political conditions also may negatively affect our business and profitability. These conditions include (i) heightened competition, including the intensification of price competition, the entry of new competitors and the introduction of new products by new and existing competitors, or as the result of consolidation within the financial services industry and the entry of additional financial institutions into the insurance industry; (ii) adverse state and federal legislation or
Loss ratio, Statutory - The ratio of losses to premiums earned for a given period.
Net premium rate increase - A measure of the estimated earnings impact of increasing premium rates charged to property and casualty policyholders. This measure includes the estimated increase in revenue associated with higher prices (premiums), including those caused by price inflation and changes in exposure, partially offset by higher volume driven expenses and inflation of loss costs. Volume driven expenses include policy acquisition costs such as commissions paid to property and casualty agents which are typically based on a percentage of premium dollars.
Registered representative - Salesperson of a broker/dealer. Salespeople are registered with the Centralized Registration Depository, a system operated by the National Association of Securities Dealers, that maintains registration information regarding broker/dealers and their registered personnel.
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.
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.
Fixed maturities and equity 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 accumulated other comprehensive income, a separate component of shareholders’ equity. The amortized cost of fixed maturities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income.
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.
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 decline in value of a specific investment is deemed to have occurred, the Company reduces the cost basis of the investment to fair value. This reduction is permanent and is recognized as a realized investment loss. Changes in the reserves for mortgage loans are included in realized investment gains or losses.
When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, the derivative will continue to be carried on the balance sheet at its fair value, and the hedged asset or liability will no longer be adjusted for changes in fair value. When hedge accounting is discontinued because the derivative used in a cash flow hedge expires or is sold, terminated, or exercised, the gain or loss on the derivative will continue to
be deferred in accumulated other comprehensive income and reclassified to earnings when the hedged forecasted transaction affects earnings. When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, the derivative will continue to be carried on the balance sheet at its fair value, and gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at its fair value on the balance sheet, with changes in its fair value recognized in current period earnings.
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 insurance business acquisition costs are deferred and amortized over the terms of the insurance policies. Acquisition costs related to variable annuities and contractholder deposit funds that were deferred in 2002 and prior, are 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 periodically 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 which were deferred in 2002 and prior are 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 recoverability of deferred policy acquisition costs is not assured, the Company believes it is more likely than not that all of these costs will be recovered. The amount of deferred policy acquisition costs considered recoverable, however, could be reduced in the near term if the estimates of gross profits or total revenues discussed above are reduced or permanently impaired as a result of the disposition of a line of business. 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.
In accordance with the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“Statement No. 142”), the Company ceased amortizing its goodwill beginning in 2002 and carries it at the January 1, 2002 amortized cost balance, net of impairments. The Company’s goodwill primarily relates to its property and casualty business. The Company tests for the recoverability of goodwill annually or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The Company recognizes impairment losses only to the extent that the carrying amounts of reporting units with goodwill exceed the fair value. The amount of the impairment loss that is recognized is determined based upon the excess of the carrying value of goodwill compared to the implied fair value of the goodwill, as determined with respect to all assets and liabilities of the reporting unit.
Separate account assets and liabilities represent segregated funds administered and invested by the Company for the benefit of variable annuity and variable life insurance contractholders and certain pension funds. Assets consist principally of mutual funds, bonds, common stocks, and short-term obligations at market value. The investment income and 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.
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 6.0% for life insurance and 2% to 9 1/2% for annuities. Mortality, morbidity and withdrawal assumptions for all policies are based on the Company’s own experience and industry standards. Liabilities for universal life, variable universal life and variable annuities 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 variable annuities include a reserve for guaranteed minimum fund values in excess of contract values, also referred to as guaranteed minimum death benefits (“GMDB”).
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.
M. Mandatorily Redeemable Preferred Securities of a Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company
Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company reflects the issuance, through a subsidiary business trust, of $300.0 million of Series B Capital Securities, which are registered under the Securities Act of 1933, and related Junior Subordinated Deferrable Interest Debentures due 2027. These capital securities pay cumulative dividends at a rate of 8.207% semiannually. Through certain guarantees, these subordinated debentures and the terms of related agreements, AFC has irrevocably and unconditionally guaranteed the obligations of the subsidiary business trust under these capital securities. Effective July 1, 2003, these securities are reflected in long-term debt in the Consolidated Balance Sheets, in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement No. 150”). Prior to 2003, these securities were included in minority interest in the Consolidated Balance Sheets.
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 of Financial Accounting Standards No. 109, Accounting for Income Taxes (“Statement No. 109”). These differences result primarily from policy acquisition expenses, loss and LAE reserves, policy reserves, tax credit carryforwards, employee benefit plans, net operating loss and capital loss carryforwards, and unrealized appreciation or depreciation on investments.
In February 2004, the Financial Accounting Standards Board’s Emerging Issues Task Force reached a consensus regarding certain disclosure requirements in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (“EITF No. 03-1”). EITF No. 03-1 describes certain quantitative and qualitative disclosures that are required for marketable equity securities covered by Statement No. 115, including the aggregate amount of unrealized losses and the aggregate related fair value of investments with unrealized losses, by investment type, as well as the nature of the investment(s), cause of impairment, number of positions held, severity and duration of the impairment. The disclosures required by EITF No. 03-1 are effective for fiscal years ending after December 15, 2003. The Emerging Issues Task Force is discussing further the other issues addressed in EITF No. 03-1, including the meaning of other-than-temporary impairment and its application to investments accounted for under the cost method or the equity method, or as either available-for-sale or held-to-maturity under Statement No. 115.
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (“SOP 03-1”). SOP 03-1 is applicable to all insurance enterprises as defined by Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises. This statement provides guidance regarding accounting and disclosures of separate account assets and liabilities and an insurance company’s interest in such separate accounts. It further provides for the accounting and disclosures related to contractholder transfers to separate accounts from a company’s general account and the determination of the balance that accrues to the benefit of the contractholder. In addition, SOP 03-1 provides guidance for determining any additional liabilities for guaranteed minimum death benefits or other insurance benefit features, potential benefits available only on
annuitization and liabilities related to sales inducements, such as immediate bonus payments, persistency bonuses, and enhanced crediting rates or “bonus interest” rates, as well as the required disclosures related to these items. This statement is effective for fiscal years beginning after December 15, 2003. The determination of the GMDB reserve under SOP 03-1 is complex and requires various assumptions, including, among other items, estimates of future market returns and expected contract persistency. Based on the equity market level as of December 31, 2003, the Company estimates an additional $55 million to $62 million charge, net of taxes, in the first quarter of 2004, upon adoption of this statement.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“Statement No. 149”). This statement amends financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“Statement No. 133”) as a result of certain decisions made by the Derivatives Implementation Group. In addition, this statement also clarifies the definition of a derivative. This statement is effective, on a prospective basis, for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003, except for those implementation issues previously cleared by the FASB prior to June 30, 2003. The provisions related to previously cleared implementation issues shall continue to be applied in accordance with their respective effective dates. The adoption of Statement No. 149 did not have a material effect on the Company’s financial position or results of operations.
potential variable interest entities and concluded that as of December 31, 2003, AFC was not the primary beneficiary of any material variable interest entities; and, therefore would not be required to consolidate those entities as a result of implementing FIN 46. However, the Company does hold a significant variable interest in a limited partnership. In 1997, the Company invested in the McDonald Corporate Tax Credit Fund - 1996 Limited Partnership, which was organized to invest in low income housing projects which qualify for tax credits under the Internal Revenue Code. The Company’s investment in this limited partnership, which represents approximately 36% of the partnership, is not a controlling interest; it entitles the Company to tax credits to be applied against its federal income tax liability in addition to tax losses to offset taxable income. The Company’s maximum exposure to loss on this investment is limited to its carrying value, which is $8.8 million at December 31, 2003.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“Statement No. 148”). This statement amends FASB Statement No. 123, Accounting for Stock-Based Compensation (“Statement No. 123”), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement No. 123 to require more prominent disclosures, in both annual and interim financial statements, regarding the pro forma effects of using the fair value method of accounting for stock-based compensation. The provisions of this statement are effective for fiscal years ending after December 15, 2002. The Company has elected to continue applying the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”), and related interpretations for stock-based employee compensation.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“Statement No. 146”). This statement requires that a liability for costs associated with an exit or disposal activity is recognized and measured initially at its fair value in the period the liability is incurred. This statement supersedes Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (“EITF No. 94-3”). Additionally, the statement requires financial statement disclosures about the description of the exit or disposal activity, including for each major type of cost, the total amount expected to be incurred and a reconciliation of the beginning and ending liability balances. The provisions of this statement are effective for all exit and disposal activities initiated after December 31, 2002.
fiscal years beginning after December 15, 2001 for all goodwill and other intangible assets held at the date of adoption. The Company adopted Statement No. 142 on January 1, 2002. In accordance with the transition provisions of this statement, the Company recorded a $3.7 million charge, net of taxes, in earnings, to recognize the impairment of goodwill related to two of its non-insurance subsidiaries. The Company used a discounted cash flow model to value these subsidiaries.
The Company applies the provisions of APB Opinion No. 25, in accounting for its stock-based compensation plans, and thus compensation cost is not generally required to be recognized in the financial statements for the Company’s stock options issued to employees. However, costs associated with the issuance of stock options to certain agents who did not qualify as employees were recognized in 2003, 2002, and 2001.
As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not been segregated between continuing and discontinued operations. At December 31, 2003 and 2002, the discontinued segment had assets of approximately $284.5 million and $290.4 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of approximately $350.5 million and $347.5 million, respectively, consisting primarily of policy liabilities. Revenues for the discontinued operations were $14.5 million, $23.3 million and $34.4 million for the years ended December 31, 2003, 2002 and 2001, respectively.
the Company ceded approximately $660 million of universal life insurance reserves in exchange for the transfer of approximately $550 million of investment assets, with an amortized cost of approximately $525 million, subject to certain post-closing adjustments. At December 31, 2002, the Company recorded a pre-tax loss of $31.3 million. This loss consisted primarily of the aforementioned ceded reserves, asset transfers, a permanent impairment of the universal life DAC asset of $155.9 million and administrative expenses of approximately $10 million. This loss is reflected as a separate line item in the Consolidated Statements of Income. In 2003, the Company transferred cash and other investment assets of approximately $100 million and $450 million, respectively, for the settlement of the net payable associated with this transaction. In addition, the Company recorded incremental pre-tax income of $5.5 million during 2003 related to the settlement of post-closing items.
In the fourth quarter of 2002, the Company recognized a pre-tax charge of $15.0 million related to the restructuring of its AFS segment, which has been accounted for under the guidance of EITF No. 94-3. Approximately $11.7 million of this charge relates to severance and other employee and agent related costs resulting from the elimination of 476 positions, of which 411 employees have been terminated as of December 31, 2003 and 63 vacant positions have been eliminated. All levels of employees, from staff to senior management, were affected by the restructuring. Additionally, the Company terminated all life insurance and annuity agent contracts effective December 31, 2002. In addition, approximately $3.3 million of this charge relates to other restructuring costs, consisting of lease and contract cancellations and the present value of idle leased space. As of December 31, 2003, the Company has made payments of approximately $13.6 million related to this restructuring plan, of which approximately $11.2 million relates to severance and other employee related costs. During 2003, the Company eliminated an additional 158 positions related to this restructuring, of which 151 employees have been terminated as of December 31, 2003. The Company recorded a pre-tax charge of $7.0 million during 2003, in accordance with Statement No. 146, consisting of $6.7 million of employee related costs and $0.3 million related to contract cancellations. As of December 31, 2003, the Company has made payments of approximately $4.5 million related to this restructuring plan, of which approximately $4.2 million relates to severance and other employee related costs. The plan is substantially complete.
In connection with AFLIAC’s voluntary withdrawal of its license in New York, AFLIAC agreed with the New York Department of Insurance in 1994 to maintain, through a custodial account in New York, a security deposit, the market value of which will equal 102% of all outstanding liabilities of AFLIAC for New York policyholders, claimants and creditors. During 2003, the New York Department of Insurance allowed AFLIAC to release assets on deposit due to the decrease in outstanding liabilities relating to the sale of the universal life insurance business in December 2002. At December 31, 2003, the amortized cost and fair value of assets on deposit in New York were $42.6 million and $46.4 million, respectively. At December 31, 2002, the amortized cost and fair value of the assets on deposit were $180.1 million and $189.9 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $132.8 million and $137.4 million were on deposit with various state and governmental authorities at December 31, 2003 and 2002, respectively. Fair values related to these securities were $141.0 million and $148.1 million at December 31, 2003 and 2002, respectively.
The Company enters into various reinsurance, derivative, and other arrangements that may require fixed maturities to be held as collateral. At December 31, 2003 and 2002, fixed maturities held as collateral had a fair value of $282.2 million and $16.2 million, respectively.
The Company’s mortgage loans are diversified by property type and location. Mortgage loans are collateralized by the related properties and generally do not exceed 75% of the property’s value at the time of origination. No mortgage loans were originated during 2003 and 2002. The carrying values of mortgage loans, net of applicable reserves, were $175.1 million and $259.8 million at December 31, 2003 and 2002, respectively. Reserves for mortgage loans were $1.8 million and $2.8 million at December 31, 2003 and 2002, respectively.
At December 31, 2003, the Company held one real estate investment with a carrying value of $4.3 million that was acquired through the foreclosure of a mortgage loan. This foreclosure represents the only non-cash mortgage activity in 2003. No real estate was held at December 31, 2002 in the Company’s investment portfolio. There were no non-cash investing activities, including real estate acquired through foreclosure of mortgage loans in 2002.
The Company enters into compound foreign currency/interest rate swaps to convert its foreign denominated fixed rate trust instruments supported by funding obligations to U.S. dollar floating rate instruments. The Company recognized net losses of $0.2 million for the year ended December 31, 2003 and net gains of $0.3 million for both the years ended December 31, 2002 and 2001, reported in losses (gains) on derivative instruments in the Consolidated Statements of Income. These losses and gains represented the ineffective portion of all fair value hedges. All components of each derivative’s gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted.
The Company may enter into various types of derivatives to hedge exposure to interest rate fluctuations. Specifically, for floating rate funding agreement liabilities that are matched with fixed rate securities, the Company may manage the risk of cash flow variability by hedging with interest rate swap contracts. Under these swap contracts, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount.
The Company also may use U.S. Treasury Note futures to hedge against interest rate fluctuations associated with the reinvestment of fixed maturities by purchasing long and selling short futures contracts on margin. The Company is exposed to interest rate risk on reinvestments of fixed maturities from the time of maturity until the purchase of new fixed maturities. Additionally, prior to September 2002, the Company used exchange traded futures contracts to hedge against interest rate fluctuations associated with the sale of GICs and other funding agreements. The Company was exposed to interest rate risk from the time of the sale of the GIC until receipt of the deposit and purchase of the underlying asset to back the liability.
Further, the Company also enters into compound foreign currency/interest rate swap contracts to hedge foreign currency and interest rate exposure on specific trust instruments supported by funding obligations. Under the swap contracts, the Company agrees to exchange interest and principal related to trust obligations payable in foreign currencies, at current exchange rates, for the equivalent payment in U.S. dollars translated at a specific currency exchange rate. Additionally, the Company used foreign exchange futures and options contracts to hedge foreign currency exposure on specific trust instruments supported by funding obligations. Finally, the Company also enters into foreign exchange forward contracts to hedge its foreign currency exposure on specific fixed maturity securities. Under the foreign exchange futures, options, and forward contracts, the Company has the right to purchase the hedged currency at a fixed strike price in U.S. dollars.
The net loss in 2001 included a total loss of $35.8 million, related to ineffective hedges of floating rate funding agreements with put features allowing the policyholder to cancel the contract prior to maturity. During the fourth quarter of 2001, the Company reviewed the trend in put activity since inception of the funding agreement business in order to determine the ongoing effectiveness of the hedging relationship. Based upon the historical trend in put activity, as well as the uncertainty about possible future events, the Company determined that it was probable that some of the future variable cash flows of the funding agreements would not occur, and therefore the hedges were ineffective. The Company analyzed the future payments under each outstanding funding agreement, and determined the amount of payments that were probable of occurring versus those that were probable of not occurring. The total accumulated losses deferred in other comprehensive income related to the payments that were probable of not occurring, which totaled $35.8 million, was reclassified to earnings during the fourth quarter of 2001 and reflected in losses (gains) on derivative instruments in the Consolidated Statements of Income. During 2002, all of the Company’s floating rate funding agreements with put features were terminated; therefore, the total accumulated losses of $35.8 million were reclassified from losses (gains) on derivative instruments to net realized investment losses in the Consolidated Statements of Income.
During the years ended December 31, 2003, 2002, and 2001, respectively, the Company recognized net gains of $3.9 million and $10.9 million, and a net loss of $1.4 million on all trading derivatives. The net gain recognized in 2003 included $14.0 million of net gains representing the ineffectiveness on equity-linked swap contracts, which is recorded in other income in the Consolidated Statements of Income. Additionally, the net gain in 2003 included $8.4 million in losses recorded within (gains) losses on derivative instruments in the Consolidated Statements of Income related to the
GMDB hedges. Further, the 2003 net gain also includes a $1.7 million loss related to embedded derivatives on equity-linked trust instruments supported by funding obligations, which is reported in (gains) losses on derivative instruments in the Consolidated Statements of Income. The net gain of $10.9 million in 2002 and the net loss of $1.4 million in 2001 represent the total ineffectiveness on equity-linked swap contracts and the embedded derivative on the equity-linked trust instruments supported by funding obligations. These amounts were reported in (gains) losses on derivative instruments and other income in the Consolidated Statements of Income.
As of December 31, 2002, the Company no longer held any other swap contracts for investment purposes. The net decrease in net investment income related to these contracts was $0.4 million and $0.7 million for the years ended December 31, 2002 and 2001, respectively.
(2) Balances at December 31, 2003, 2002 and 2001 include net (depreciation) appreciation on other assets of $(2.9) million, $0.1 million, and $0.5 million, respectively.
(1) Includes gross unrealized losses for investment grade fixed maturity obligations of the U.S. Treasury, U.S. government and agency securities, states, and political subdivisions of $9.9 million and $1.8 million at December 31, 2003 and 2002, respectively.
Included in other long-term investments is income from limited partnerships of $4.1 million, $5.3 million and $9.4 million in 2003, 2002 and 2001, respectively.
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.
(1) In 2003, long-term debt includes the mandatorily redeemable preferred securities of a subsidiary trust (Minority interest) in accordance with Statement of Financial Accounting Standards No. 150.
Summarized financial information of the Closed Block as of December 31, 2003 and 2002 and for the periods ended December 31, 2003, 2002 and 2001 is as follows:
In accordance with the provisions of Statement No. 142, the Company performed its annual review of its goodwill for impairment in the fourth quarter of 2003. Based on this review, the Company recorded, during the fourth quarter of 2003, a pre-tax charge of $2.1 million, to recognize the impairment of goodwill related to one of its non-insurance subsidiaries. This charge, which relates to the Allmerica Financial Services segment (see Note 16 - Segment Information), was reflected in other operating expenses in the Consolidated Statements of Income. The Company used a discounted cash flow model to value this subsidiary. Subsequent to the Company’s annual impairment review, on December 31, 2003, the Company sold this subsidiary. The remaining $0.9 million of goodwill was expensed as a component of the loss on sale.
(1) In 2003, in accordance with Statement No. 150, these securities were reclassified to long-term debt. Prior to 2003, these securities were classified in the mezzanine level of the balance sheet as minority interest. See “Note 1M. Mandatorily Redeemable Preferred Securities of a Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company”. Reclassification of periods prior to 2003 is not permitted.
Senior Debentures of the Company have a $200.0 million face value, pay interest semi-annually at a rate of 7 5/8%, and mature on October 16, 2025. The Senior Debentures are subject to certain restrictive covenants, including limitations on issuance or disposition of stock of restricted subsidiaries and limitations on liens. The Company is in compliance with all covenants.
AFC issued commercial paper in 2002 and 2001 primarily to manage imbalances between operating cash flows and existing commitments primarily in its premium financing business. Commercial paper borrowing arrangements were supported by a credit agreement. The Company had $150.0 million available under a committed syndicated credit agreement, which expired on May 23, 2003. This agreement was not renewed. In addition, the Company had no commercial paper borrowings as of December 31, 2003 and does not anticipate utilizing commercial paper in 2004.
Interest expense was $39.9 million, $17.1 million and $19.5 million in 2003, 2002 and 2001, respectively. Interest expense included $15.3 million related to the Company’s Senior Debentures for each year. In 2003, interest expense also included $24.6 million related to the preferred dividends on the Company’s mandatorily redeemable preferred securities of a subsidiary trust. As a result of the adoption of Statement No. 150, preferred dividends related to these securities were required to be reflected as a component of interest expense. In 2002 and prior, these costs were reflected as minority interest. These preferred dividends were not permitted to be reclassified for periods prior to 2003. Also, there was no interest expense related to borrowings under the credit agreements in 2003, 2002 and 2001. All interest expense is recorded in other operating expenses.
Provisions for federal income taxes have been calculated in accordance with the provisions of Statement No. 109. A summary of the federal income tax benefit in the Consolidated Statements of Income is shown below:
loss carryforwards of $179.8 million which begin to expire in 2016. The Company also has capital loss carryforwards of $150.5 million which expire in 2008.
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 1997. The IRS has also examined the former Allmerica Property and Casualty Companies, Inc. (“Allmerica P&C”) consolidated group’s federal income tax returns through 1997. Certain adjustments proposed by the IRS with respect to FAFLIC/AFLIAC’s federal income tax returns for 1982 and 1983 remain unresolved. 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.
The Company utilizes a target allocation strategy, focusing on creating a mix of assets to generate growth in equity, as well as manage expenses and contributions. Various factors were taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. The Company has determined that the optimal investment strategy is to have a target mix of
72% of its plan assets in equity securities and 28% in fixed income securities and money market funds. The target allocations and actual invested asset allocations for 2003 and 2002 for the Company’s plan assets are as follows:
The curtailment loss in 2003 of $0.7 million is the result of the AFS VeraVest restructuring effort in the fourth quarter of 2003 (see Note 3 - Significant Transactions). The curtailment loss primarily reflects the elimination of future expected years of service for those home office participants terminated as a result of the AFS VeraVest restructuring. The
The unrecognized net actuarial gains (losses) which exceed 10% of the greater of the projected benefit obligation or the market value of plan assets are amortized as a component of net pension cost over five years.
The Company has elected to defer accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“The Act”). The Act provides for a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the benefit provided under Medicare. Authoritative guidance on the accounting for the federal subsidy is pending and that guidance, when issued, could require the Company to modify previously reported information.
As a result of the Company’s merger with Allmerica P&C in 1997, certain postretirement liabilities were reduced to reflect their fair value as of the merger date. These postretirement liabilities were reduced by $1.7 million and $2.4 million in 2003 and 2002, respectively, which reflects fair value, net of applicable amortization.
Assumed health care cost trend rates have a significant effect on the amounts reported. A one-percentage point change in assumed health care cost trend rates would have the following effects:
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.
stock options to certain former AFS agents who did not qualify as employees, in net income (loss) during 2002 and 2001. The fair value of these options was determined using the Black-Scholes option-pricing model. In 2003, these options were forfeited as a result of the termination of these former agents’ contracts (see Note 3 - Significant Transactions). As such, during 2003, the Company reversed all compensation expense related to unvested options previously issued to these agents.
Options may be granted to eligible employees or agents at a price not less than the market price of the Company’s common stock on the date of grant. Options previously granted to former agents were granted 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 granted in 2003 and 2002 vest over three years with a 25% vesting rate in the first two years and a 50% vesting rate in the final year. For those options granted prior to 2002, all vest at the rate of 20% annually for five consecutive years. Options must be exercised not later than ten years from the date of grant.
Options to purchase 3.4 million shares, 4.6 million shares, and 3.4 million shares of common stock were outstanding during 2003, 2002 and 2001, respectively, but were not included in the computation of diluted earnings per share because the option’s exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive.
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 no dividends to its parent in 2003, and declared dividends to its parent of $92.1 million and $100.0 million in 2002 and 2001, respectively. During 2004, the maximum allowable dividend and other distributions that can be paid to Hanover’s parent without prior approval of the New Hampshire Insurance Commissioner is $100.2 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 declared dividends to its parent totaling $48.4 million, $48.2 million and $50.0 million in 2003, 2002 and 2001, respectively. Prior to July 2004, Citizens cannot declare dividends to its parent without prior approval of the Michigan Insurance Commissioner. The allowable dividend without prior approval will increase to approximately $64.3 million on July 11, 2004.
Massachusetts’ statute limits the dividends a life insurer may pay in any twelve month period, without the prior permission of the 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. In addition, under Massachusetts law, no domestic insurer may pay a dividend or make any distribution to its shareholders from other than unassigned funds unless the Commissioner has approved such dividend or distribution. Effective December 30, 2002, AFLIAC, previously a Delaware domiciled life insurance company, became a Massachusetts domiciled life insurance company. On December 31, 2002, AFLIAC became a direct subsidiary of AFC as well as the immediate parent of FAFLIC, which remains a Massachusetts domiciled life insurance company. As a result of this transaction, and in consideration of the decision not to write new business, AFC agreed with the Massachusetts Insurance Commissioner to maintain total adjusted capital levels at a minimum of 100% of AFLIAC’s Company Action Level, which was $151.5 million at December 31, 2003. Total adjusted capital for life insurance companies is defined as capital and surplus, plus asset valuation reserve, plus 50% of dividends apportioned for payment and was $553.4 million at December 31, 2003 for AFLIAC. The Company Action Level is the first level in which the Massachusetts Insurance Commissioner would mandate regulatory involvement based solely upon levels of risk based capital. There can be no assurance that AFLIAC would not require additional capital contributions from AFC. In the fourth quarter of 2003, with permission from the Massachusetts Insurance Commissioner, AFLIAC declared and paid a $25 million dividend to its parent, AFC. No dividends were declared by AFLIAC or FAFLIC to their parent during 2002 or 2001, and neither company can pay dividends to their parent without prior approval from the Massachusetts Insurance Commissioner.
The Property and Casualty segment manages its operations through two lines of business based upon product and identified as Personal Lines and Commercial Lines. Personal Lines includes property and casualty coverages such as personal automobile, homeowners and other personal policies, while Commercial Lines includes property and casualty coverages such as workers’ compensation, commercial automobile, commercial multiple peril and other commercial policies.
At December 31, 2003, our AFS segment manages a block of existing variable annuity, variable universal life and traditional life insurance products, as well as certain group retirement products. During 2003, AFS managed this existing life insurance business and also operated our independent broker/dealer business, which was conducted through VeraVest Investment, Inc. (“VeraVest”). VeraVest distributed third party investment and insurance products. In the fourth quarter of 2003, we announced the cessation of retail sales through VeraVest (see Note 3 - Significant Transactions). In addition, prior to September 30, 2002, this segment actively manufactured and sold variable annuities, variable universal life and traditional life insurance products. Subsequent to our
In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities (mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company) and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those related to certain officers and directors, technology, finance, human resources and legal. During 2003, the Company adopted Statement No. 150 (see Note 1 - New Accounting Pronouncements) which resulted in the reclassification of dividends on the Company’s Capital Securities from minority interest to interest expense in the Consolidated Statements of Income. In accordance with Statement No. 131, all periods in the Corporate segment have been restated to reflect current presentation consistent with the way management evaluates results.
Management evaluates the results of the aforementioned segments based on a pre-tax basis. Segment income excludes certain items, which are included in net income, such as federal income taxes and net realized investment gains and losses, including certain gains or losses on derivative instruments, because fluctuations in these gains and losses are determined by interest rates, financial markets and the timing of sales. Also, segment income excludes net gains and losses on disposals of businesses, discontinued operations, restructuring and reorganization costs, extraordinary items, the cumulative effect of accounting changes and certain other items. While these items may be significant components in understanding and assessing the Company’s financial performance, management believes that the presentation of segment income (loss) enhances understanding of the Company’s results of operations by highlighting net income (loss) attributable to the normal operations of the business. However, segment income (loss) should not be construed as a substitute for net income (loss) determined in accordance with generally accepted accounting principles.
(1) Includes assets related to the Company’s discontinued operations of $284.5 million and $290.4 million at December 31, 2003 and 2002, respectively.
Expected rental income to be received under non-cancelable sublease agreements in existence at December 31, 2003 related to building leases is $4.4 million.
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.
Effective December 31, 2002, the Company entered into a 100% coinsurance agreement related to substantially all of its universal life insurance business (see Note 3 - Significant Transactions). Reinsurance recoverables related to this agreement were $625.3 million and $648.4 million at December 31, 2003 and 2002, respectively. This balance represents approximately 29.6% and 31.2% of the Company’s reinsurance recoverables at December 31, 2003 and 2002, respectively.
In addition, 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, among others, the Massachusetts Commonwealth Automobile Reinsurers (“CAR”) and the Michigan Catastrophic Claims Association (“MCCA”). At December 31, 2003, both CAR and MCCA represented 10% or more of the Company’s reinsurance activity. As a servicing carrier in 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 2003, 2002 and 2001 were $46.2 million and $61.0 million, $46.8 million and $59.4 million,
Reinsurance recoverables related to MCCA were $436.5 million and $349.1 million at December 31, 2003 and 2002, respectively, while reinsurance recoverables related to CAR were $74.4 million and $54.8 million at December 31, 2003 and 2002, respectively. Because the MCCA is supported by assessments permitted by statute, and all amounts billed by the Company to CAR and MCCA have been paid when due, the Company believes that it has no significant exposure to uncollectible reinsurance balances from these two entities.
Prior to September 30, 2002, the Company manufactured and sold variable annuities, variable universal life and traditional life insurance products. Subsequently, the Company ceased all new sales of proprietary variable annuities and life insurance products.
The liability for future policy benefits and outstanding claims, losses and loss adjustment expenses, excluding the effect of reinsurance, related to the Company’s accident and health business, consisting of the Company’s exited individual health business and its discontinued group accident and health business, was $437.3 million, $434.8 million and $463.5 million at December 31, 2003, 2002 and 2001, respectively. Reinsurance recoverables related to this business were $322.4 million, $329.3 million and $343.0 million in 2003, 2002 and 2001, respectively. The decreases in 2002 and 2001 were primarily attributable to the continued run-off of the group accident and health business.
The table below provides a reconciliation of the beginning and ending reserve for unpaid losses and LAE as follows:
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were increased by $40.4 million, $ 6.4 million and $107.4 million in 2003, 2002, and 2001, respectively.
During the years ended December 31, 2003, 2002 and 2001, estimated loss reserves for claims occurring in prior years developed unfavorably by $74.5 million, $36.9 million and $146.6 million, respectively. The unfavorable loss reserve development in 2003 is primarily the result of a $21.9 million charge in the other commercial line resulting from an adverse arbitration decision in the second quarter of 2003, related to a voluntary insurance pool that the Company exited in 1996. Additionally, loss reserves for the workers’ compensation line were increased by $15.7 million in the fourth quarter of 2003, primarily as a result of increasing medical costs. Loss reserve development was also affected by an increase in personal automobile claim severity related to medical settlements in Michigan. Because these settlements have risen beyond previous estimates, reserve increases have been recognized in the period in which the information was obtained. Partially offsetting these items was favorable development in the commercial multiple peril line due to improved claim frequency in the 2002 accident year resulting from our re-underwriting efforts. The adverse development in both 2002 and 2001 is primarily the result of increased claim severity related to personal automobile medical settlements in Michigan. The increase in the prior year reserve estimates for other commercial lines during 2002 is primarily due to the recognition of approximately $5 million in additional reserves for asbestos claims in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool.
periods is primarily attributable to claims process improvement initiatives taken by the Company during the 1997 to 2001 calendar year period. Since 1997, the Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. As actual experience begins to establish certain trends inherent within the claim settlement process, the actuarial process recognizes these trends within the reserving methodology impacting future claim settlement assumptions. As these measures improved average settlement costs, the actuarial estimate of future settlement costs are reduced and favorable development is recorded. These measures are complete.
Ending loss and LAE reserves for all direct business written by its property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $24.9 million, $25.6 million and $26.7 million, net of reinsurance of $15.0 million, $16.0 million and $13.0 million in 2003, 2002 and 2001, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the three-year period ended December 31, 2003. As a result of our historical direct underwriting mix of commercial lines policies toward smaller and middle market risks, past asbestos, environmental damage and toxic tort liability loss experience has remained minimal in relation to our total loss and LAE incurred experience. The Company estimates its ultimate liability for these claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company believes that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. In addition, the Company is not aware of any litigation or pending claims that are expected to 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.
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 impact of any such future assessments or voluntary payments.
Effective January 1, 2001, the Company’s insurance subsidiaries adopted the National Association of Insurance Commissioners’ uniform statutory accounting principles, or Codification, in accordance with requirements prescribed by state authorities. A cumulative effect of the change in accounting principle resulted from the adoption of Codification and was reflected as an adjustment to surplus in 2001. This adjustment represents the difference between total capital and surplus as of January 1, 2001 and the amount total capital and surplus would have been had the accounting principles been applied retroactively for all prior periods. As of January 1, 2001, the property and casualty and life and health insurance subsidiaries recorded cumulative effect adjustments of $82.4 million and $45.0 million, respectively. The adjustment reflected by the property and casualty insurance subsidiaries consisted of an increase in surplus of $141.9 million related to the establishment of deferred tax assets and reductions in surplus of $59.5 million related to changes in valuations of other invested assets and non-admitted assets. The adjustment reflected by the life and health insurance subsidiaries included an increase in surplus of $49.7 million related to the establishment of deferred tax assets and the change in valuation of pension liabilities. Reductions in surplus reflected by the life and health insurance subsidiaries totaled $4.7 million and resulted from the change in valuations of post-employment benefits and non-admitted assets.
In the fourth quarter of 2003, the Company recognized charges of $14.9 million, net of taxes, relating primarily to the VeraVest restructuring (see Note 3 - Significant Transactions). In addition, the Company recognized after-tax charges of $5.5 million related to exchange traded futures contracts used to economically hedge any increased GMDB reserves resulting from equity market movements.