The Company's headquarters are located at 440 Lincoln Street, Worcester, Massachusetts, and consist primarily of approximately 758,387 rentable square feet of office and conference space owned in fee and includes the headquarters of Hanover. Citizens owns its home office, located at 645 W. Grand River, Howell, Michigan, which is approximately 103,652 rentable square feet. Citizens also owns a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 157,354 rentable square feet, where various business operations are conducted. The Company leases office space for its registered representatives throughout the United States. The leased property houses agency offices. Hanover and Citizens also lease offices throughout the country for its field employees. The Company believes that its facilities are adequate for its present needs in all material respects. Certain of the Company's properties may be available for lease.
The results of operations for Allmerica Financial Corporation and subsidiaries ("AFC" or "the Company") include the accounts of Allmerica Financial Life Insurance and Annuity Company ("AFLIAC") and First Allmerica Financial Life Insurance Company ("FAFLIC"), AFC's principal life insurance and annuity companies; The Hanover Insurance Company ("Hanover") and Citizens Insurance Company of America ("Citizens"), AFC's principal property and casualty companies; and certain other insurance and non-insurance subsidiaries. AFLIAC and FAFLIC are both domiciled in the Commonwealth of Massachusetts, while Hanover and Citizens are domiciled in the states of New Hampshire and Michigan, respectively. Prior to December 30, 2002, AFLIAC was domiciled in the state of Delaware.
The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services ("AFS"), and Allmerica Asset Management ("AAM"). The separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision makers in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. The Risk Management Segment manages property and casualty operations through two lines of business based upon product and identified as Personal Lines and Commercial Lines. Personal Lines include property and casualty coverages such as personal automobile, homeowners and other personal policies, while Commercial Lines include property and casualty coverages such as workers' compensation, commercial automobile, commercial multiple peril and other commercial policies. Prior to 2002, the Risk Management segment managed its business through three distribution channels identified as Standard Markets, Sponsored Markets and Specialty Markets. The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. Prior to September 30, 2002, the AFS segment manufactured and sold variable annuities, variable universal life and traditional life insurance products, as well as certain group retirement products. On September 27, 2002, the Company announced plans to consider strategic alternatives, including a significant reduction of sales of proprietary variable annuities and life insurance products. This resulted from the cumulative effect of the significant, persistent decline in the equity market, culminating in the third quarter of 2002, that followed the decline in the second quarter, as well as the ratings downgrades (see Rating Agency Actions). Subsequently, the Company ceased all new sales of proprietary variable annuities and life insurance products. In the future, the AFS business will consist of two components. First, the Company plans to transform its former Agency distribution channel (see Allmerica Financial Services - Statutory Premiums and Deposits for a description of its former distribution channels) into an independent broker/dealer, VeraVest Investments, Inc., formerly "Allmerica Investments, Inc." ("VeraVest"), to distribute non-proprietary investment and insurance products. The Company has entered into agreements with leading investment product and insurance providers and is seeking additional alliances whereby these providers would compensate the Company for non-proprietary product sales by VeraVest's registered representatives. Second, the Company plans to retain and service existing customer accounts. These include variable annuity and variable universal life accounts, as well as certain remaining traditional life and group retirement accounts, which were issued by its life insurance subsidiaries, AFLIAC and FAFLIC. However, the Company expects that the persistency of its existing customer policies and contracts will be substantially less than its historical experience. Through its Allmerica Asset Management segment, prior to September 2002, FAFLIC offered Guaranteed Investment Contracts ("GICs"). GICs, also referred to as funding agreements, are investment contracts, which can contain either short-term or long-term maturities and are issued to institutional buyers or to various business or charitable trusts. Declining financial strength ratings from various rating agencies during 2002 resulted in GIC contractholders terminating all remaining short-term funding agreements and made it impractical to continue selling new long-term funding agreements. Furthermore, the Company retired certain long-term funding agreements, at discounts, during the fourth quarter of 2002. This segment continues to provide investment advisory services, primarily to affiliates and to third parties, such as money market and other fixed income clients through its subsidiary, Opus Investment Management, Inc. (formerly "Allmerica Asset Management, Inc."). Additionally, during 2002, the Company transferred management of AMGRO, Inc. ("AMGRO"), the Company's property and casualty insurance premium financing business, to this segment. AMGRO was previously part of the Risk Management segment.
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.
The Company's segment (loss) income before federal income taxes and minority interest was a $479.8 million loss in 2002, compared to income of $193.4 million in 2001. This decline is attributable to a decrease of $768.0 million from the AFS segment, partially offset by an increase from the Risk Management segment of $90.8 million. The decrease in the AFS segment reflects net charges of $698.3 million resulting from additional declines in equity market values during 2002, ratings downgrades (see Rating Agency Actions), and the Company's decision to cease sales of proprietary life insurance and annuity products (see Description of Operating Segments). These charges include $629.4 million of additional amortization of the deferred policy acquisition cost ("DAC") asset and $39.1 million due to a change in the assumptions related to the long-term cost of guaranteed minimum death benefits ("GMDB") for variable annuity products, net of the related DAC amortization. In addition, the Company recognized impairments of capitalized technology costs associated with variable products totaling $29.8 million. The increase in Risk Management segment income is primarily attributable to an estimated benefit of approximately $80 million related to net premium rate increases, a $27.2 million decrease in the adverse development of prior years' reserves and a $19.7 million decrease in catastrophe losses. Additionally, segment income increased due to approximately $17 million of decreased current accident year non-catastrophe claims. Partially offsetting these items were increased policy acquisition expenses of $22.8 million and lower net investment income of $14.0 million. The federal income tax benefit was $220.4 million for 2002, compared to an expense of $12.9 million in 2001. This tax benefit is primarily the result of the significant loss recognized by the AFS segment in 2002. Net realized investment losses, after taxes and amortization, were $89.4 million during 2002, 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 income securities. 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 income securities. Gains (losses) on derivative instruments, net of taxes, increased $49.1 million to a net gain of $26.2 million in 2002 as a result of the termination of certain derivative instruments which previously were recognized as ineffective hedges. During 2001, the Company recognized losses on derivatives, net of taxes, of $22.9 million. These losses primarily represent an accounting charge for hedge ineffectiveness on certain derivatives in accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement No. 133") (see Derivative Instruments). In the fourth quarter of 2002, the Company recognized a gain on the retirement of trust instruments supported by funding obligations of $66.7 million, net of taxes. This gain resulted from the retirement of certain long-term funding obligations at discounts (see Significant Transactions - Gain on Retirement of Funding Obligations). During the third quarter of 2002, the Company received additional consideration of $2.3 million, net of taxes, from the sale of the defined contribution business in 2001. The Company sold, through a 100% coinsurance agreement, the fixed universal life insurance block of business effective December 31, 2002, which resulted in the recognition of a $20.3 million after-tax loss (see Significant Transactions - - Sale of Universal Life Business). The Company recognized a benefit of $1.6 million and $5.0 million, net of taxes, in 2002 and 2001, respectively, as a result of refining cost estimates related to the sales practice class action lawsuit that was settled in 1998. In the fourth quarter of 2002, the Company recognized an after-tax charge of $9.6 million related to the restructuring of its AFS segment. This restructuring cost consisted of severance and other employee-benefit related expenses, as well as the cancellation of certain lease agreements and contracted services. In addition, the Company recognized 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, the Company recognized an after-tax charge of $1.8 million for severance and other employee related costs resulting from the reorganization of its technology support group. During the fourth quarter of 2001, the Company recognized an after-tax loss of $44.4 million related to the exit of selected property and casualty agencies, policies, groups, and programs. This loss primarily reflects an increase in loss reserves for both the current and prior accident years. This resulted from a process whereby the Company evaluated its approximately 2,500 agencies in the Risk Management segment and identified 691 agencies that did not meet certain profitability standards or were not strategically aligned with the Company. For these agents, the Company either terminated the relationship or restricted the agent's ability to offer commercial lines policies. Certain groups and specialty programs were also discontinued (see Risk Management - Selected Property & Casualty Exited Agencies, Policies, Groups & Programs). Voluntary pool losses reflect the Company's participation in a reserve deficiency of a voluntary excess and casualty rein-
surance pool. From 1950 to 1982, the Company 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, the Company recognized losses, net of taxes, of $21.5 million, based on the Company's participation in the reserve deficiency. During 2002, the Company 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, the Company recognized a $3.2 million loss, net of taxes, upon adoption of Statement No. 133.
The Company's segment income before federal taxes and minority interest decreased $181.1 million, or 48.4%, to $193.4 million during 2001. This decrease is primarily attributable to a decrease in income from the Risk Management and AFS segments of $96.5 million and $79.8 million, respectively. The decrease in Risk Management's segment income was primarily attributable to decreased favorable loss and loss adjustment expenses ("LAE") reserve development related to prior years of $121.0 million and to an increase of approximately $62 million in current accident year losses and LAE, primarily in the personal automobile, commercial multiple peril and homeowners lines. These decreases were partially offset by net premium rate increases of approximately $101 million. AFS' segment income decreased $79.8 million principally due to lower asset-based fees, primarily resulting from a decrease in the market value of assets under management in the variable product lines, and to lower investment management fees and brokerage income. The decrease in AFS' segment income is also attributable to higher policy benefits and other operating expenses, partially offset by lower deferred policy acquisition costs. The effective tax rate for segment income was 6.7% for 2001, as compared to 15.3% in 2000. The decrease in the tax rate was primarily due to lower underwriting income resulting in an increase in the proportion of tax-exempt investment income and low income housing credits to pre-tax income. Net realized losses on investments, after taxes and amortization, were $78.8 million during 2001, 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 income securities. During 2000, net realized losses on investments, after taxes and amortization, were $87.8 million, primarily attributable to after-tax realized losses of $54.7 million resulting from the sale of approximately $2.2 billion of fixed income securities. In addition, the Company recognized $43.0 million in after-tax realized losses, due to impairments of fixed maturities. The Company recognized losses on derivatives, net of taxes, of $22.9 million during the fourth quarter of 2001. These losses primarily represent the aforementioned accounting charge for hedge ineffectiveness on certain derivatives in accordance with Statement No. 133. During the fourth quarter of 2001, the Company recognized an after-tax loss of $44.4 million related to the aforementioned exit of selected property and casualty agencies, policies, groups and programs. The Company recognized a charge, net of taxes, in the fourth quarter of 2001, of $21.5 million related to the aforementioned voluntary pool losses. The Company recognized a benefit of $5.0 million, net of taxes, in 2001, as a result of refining cost estimates related to the aforementioned class action lawsuit that was settled in 1998. In the fourth quarter of 2001, the Company recognized an after-tax charge of $1.8 million related to severance and other employee related costs resulting from the reorganization of its technology support group. During 2000, the Company recognized an after-tax restructuring charge of $13.5 million. This charge is the result of a formal company-wide restructuring plan, intended to reduce expenses and enhance revenues. This plan consisted of various initiatives, including a series of internal reorganizations, consolidations in home office operations, consolidations in field offices, changes in distribution channels and product changes. During 2001, the Company recognized a $3.2 million loss, net of taxes, upon adoption of Statement No. 133. This loss resulted from recognizing derivative instruments held by the Company on January 1, 2001, at their fair values. This adjustment represents net losses that were previously deferred in other comprehensive income on derivative instruments that do not qualify for hedge accounting. The Company recorded an offsetting gain in other comprehensive income of $3.3 million, net of taxes, to recognize these derivative instruments.
The following is management's discussion and analysis of the Company's results of operations by business segment. The segment results are presented before taxes and minority interest and other items which management believes are not indicative of overall operating trends, including realized gains and losses.
Underwriting results are reported using statutory accounting principles, which are prescribed by state insurance regulators. The primary difference between statutory accounting principles and GAAP is the deferral of certain underwriting costs under GAAP that are amortized over the life of the policy. Under statutory accounting principles, these costs are recognized when incurred or paid. Management reviews the operations of this business based upon statutory results. In 2002, the Company reorganized its Risk Management segment. Under the new structure, the Risk Management segment manages its operations through two lines of business based upon product offerings and identified as Personal Lines and Commercial Lines. Personal Lines include personal automobile, homeowners and other personal policies, while Commercial Lines include workers' compensation, commercial automobile, commercial multiple peril and other commercial policies.
Net investment income before tax was $202.0 million, $216.0 million and $218.4 million for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in net investment income in 2002, compared to 2001, primarily reflects a reduction in average pre-tax yields on fixed securities. 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 and the transfer of $55.5 million to fund the property and casualty companies' portion of the additional minimum pension liability recorded by AFC at December 31, 2001 pursuant to the cost allocation policy under the Company's Consolidated Service Agreement. 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 since first quarter of 2001. Management expects its investment results to be negatively affected by lower prevailing fixed maturity investment rates in 2003, defaults in the fixed maturities portfolio and by the transfer of $76.0 million to fund the property and casualty companies' portion of the additional minimum pension liability recorded by AFC at December 31, 2002. The decrease in net investment income in 2001, compared to 2000, primarily reflects the impact of fixed maturities that defaulted and a reduction in average invested assets, partially offset by an increase in average pre-tax yields on fixed maturities. Average invested assets decreased $23.7 million, or 0.7%, to $3,378.1 million in 2001, compared to $3,401.8 million in 2000. Average pre-tax yields on fixed maturities increased to 6.9% in 2001, compared to 6.8% in 2000, due to the shift in investment strategy providing for investments in taxable securities instead of tax exempt securities, to maximize after-tax investment yields.
The amount of loss and LAE reserves is determined 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 the Company 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, the Company develops information about the size of ultimate claims based on its 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 and LAE reserves are sensitive to the Company's assumptions, the Company does not completely rely on only one estimate to determine its loss and LAE reserves. Rather, the Company develops several estimates using generally recognized actuarial projection methodologies that result in a range of possible loss and LAE reserve outcomes; the Company's best estimate is within that range. Because certain projection methodologies may not result in a reasonable reserve estimate for a particular line of business due to certain underlying data assumptions, the Company may determine that the low or high end range estimate calculated by the method does not represent a reasonable estimate. When trends emerge that the Company believes affect the future settlement of claims, the Company will adjust its reserves accordingly.
When trends emerge that the Company believes affect the future settlement of claims, the Company will adjust its reserves accordingly. Reserve adjustments are reflected in the Consolidated Statements of Income as adjustments to losses and loss adjustment expenses. Often, these adjustments are recognized in periods subsequent to the period in which the underlying loss event occurred. These types of subsequent adjustments are disclosed and discussed separately as "prior year reserve development". Such development can be either favorable or unfavorable to the financial results of the Company. The table below summarizes the change in provision for insured events of prior years by line of business.
Although the Company does not specifically underwrite policies that include asbestos, environmental damage and toxic tort liability, the Company 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 its property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $25.6 million, $26.7 million and $25.4 million, net of reinsurance of $16.0 million, $13.0 million and $15.9 million in 2002, 2001 and 2000, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the three-year period ended December 31, 2002. As a result of the Company's 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 Company's 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. In addition, the Company has established loss and LAE reserves for assumed reinsurance and pool business with asbestos, environmental damage and toxic tort liability of $45.2 million, $39.3 million, and $10.6 million in 2002, 2001 and 2000, respectively. These reserves relate to pools in which the Company has terminated its participation; however, the Company continues to be subject to claims related to years in which it was a participant. The Company was a participant in ECRA from 1950 to 1982. In 1982, the pool was dissolved and since that time the business has been in runoff. The Company's participation in this pool has resulted in average paid losses of $2.3 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, the Company recorded an additional $33.0 million of losses in the fourth quarter of 2001. This reserving action has been presented as a separate line item in the Consolidated Statements of Income and has been excluded from adjusted net income due to management's belief that this item is not indicative of overall operating trends. Because of the inherent uncertainty regarding the types of claims in these pools, there can be no assurance that these reserves will be sufficient. During 2002, the Company recorded an additional $5.0 million of loss reserves related to ECRA.
During the fourth quarter of 2001, the Company completed an extensive review of its 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 the Company in 2001. These agencies had consistently produced unsatisfactory loss ratios. In addition, the Company terminated virtually all of its specialty commercial programs and discontinued a number of special marketing arrangements. The total earned premium associated with the exited business was $164.6 million and $252.9 million in 2002 and 2001, respectively, and is estimated to be approximately $82 million in 2003. The Company is contractually or under statutory regulations obligated to renew policies with certain agents that will continue to be in runoff in 2003. The estimated future premium deficiency on these policies is $7.2 million and this loss was recorded during 2001. In connection with these actions, the Company 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 the fourth quarter of 2001. This increase includes $12.1 million of adverse development in the current year and $40.8 million of adverse development on prior year reserves, which is net of a $5.9 million benefit from the aforementioned aggregate excess of loss reinsurance treaty. Under the aggregate excess of loss reinsurance treaty, the Company recognized a net benefit of $1.1 million, including the aforementioned $5.9 million benefit related to prior year reserves. In addition, as a result of projected future losses on the exited business, the Company recorded an impairment to the DAC asset of $3.4 million. This resulted in an increase in policy acquisition expenses and a decrease in the Company's DAC asset balance as of December 31, 2001. The total charge of $68.3 million has been presented as a separate line item in the Consolidated Statements of Income and has been excluded from adjusted net income due to management's belief that this item is not indicative of overall operating trends. Actual future losses from the exited business may vary from the Company's estimate.
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. On September 27, 2002, the Company announced plans to consider strategic alternatives, including a significant reduction of sales of proprietary variable annuities and variable life insurance products. This resulted from the effect of the significant, persistent decline in the equity market, culminating in the third quarter of 2002, that followed the decline in the second quarter, as well as the ratings downgrades (see Rating Agency Actions). Subsequently, the Company ceased all new sales of proprietary variable annuities and life insurance products (see Description of Operating Segments). As a result of the changes with AFS, the factors that affect this segment's results of operations after September 27, 2002 are substantially different from those in effect prior to that date. The substantial changes in DAC and other assumptions resulting from the segment's change in operations are reflected in the results for the year, discussed in subsequent paragraphs. In addition, the fourth quarter 2002 results of operations are substantially different from results achieved by this segment in the past, and, in fact, the Company believes these results are more indicative of results of operations to be expected in the near term; therefore, a separate discussion of the last three months of the year is included immediately following the year over year discussion below.
The following table summarizes the results of operations for the Allmerica Financial Services segment.
Segment revenues Premiums $ 48.1 $ 49.0 $ 52.1 Fees: Fees from surrenders 61.9 31.6 35.3 Other proprietary product fees 347.9 360.0 385.8 Net investment income 283.9 288.9 283.6 Brokerage and investment management income/(1)/ 79.8 73.8 88.2 Other income 33.1 23.2 22.2 - -------------------------------------------------------------------------------- Total segment revenues 854.7 826.5 867.2 - -------------------------------------------------------------------------------- Policy benefits, claims and losses 501.6 346.8 315.1 Policy acquisition costs 674.1 77.8 88.7 Brokerage and investment management variable expenses/(1)/ 49.8 41.8 47.7 Other operating expenses 254.2 217.1 192.9 - -------------------------------------------------------------------------------- Segment (loss) income $ (625.0) $ 143.0 $ 222.8 ================================================================================
Segment results deteriorated $768.0 million, to a loss of $625.0 million during 2002. This loss reflects net charges of $698.3 million resulting from the effect of the significant, persistent decline in equity market values during the most recent three years, culminating in the third quarter, as well as ratings downgrades (see Rating Agency Actions), and the Company's decision to cease new sales of proprietary life insurance and annuity products. These charges include $629.4 million of additional amortization of the DAC asset, a change in the assumptions related to the long-term cost of GMDB for variable annuity products resulting in a reserve increase of $106.7 million, partially offset by a reduction in DAC amortization of $67.6 million, and the recognition of impairments of capitalized technology costs associated with variable products totaling $29.8 million. The following table summarizes the aforementioned charges and benefits for 2002. Each is explained in subsequent paragraphs.
As discussed further in "Critical Accounting Policies", DAC for variable life products and variable annuities consists of commissions, underwriting costs and other costs which are amortized in proportion to the total gross profits that the Company estimates will be earned over the expected life of the insurance contracts to which such costs relate. To estimate the profitability of its insurance contracts, the Company establishes and applies certain assumptions relating to, among other matters, appreciation of account assets, contract persistency and contract costs (such as those relating to any GMDB feature and fees payable to distributors). The Company regularly evaluates these assumptions to determine whether recent experience or anticipated trends merit adjustments to such assumptions. The substantial and sustained decline in the equity market, culminating in the third quarter, precipitated a number of significant events which caused the Company to incur large increases in DAC amortization. These included, in large part, substantial ratings downgrades, which contributed to the Company's decision to cease new sales of proprietary variable annuity and life products. The Company believes that this business decision will adversely affect the profitability of its 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
FOR THE QUARTER ENDED DECEMBER 31 2002 2001 - --------------------------------------------------------------------------- (In millions)
Segment results deteriorated $22.4 million, to a loss of $0.7 million in the fourth quarter of 2002. The approximate break-even result in 2002 resulted from substantially higher amortization of DAC, partially offset by increased surrender fees and net fees earned from sales of non-proprietary products. The Company's decision to cease sales of proprietary products and the aforementioned ratings downgrades resulted in an expected substantial increase in surrenders of variable annuities in the fourth quarter. Annuity surrenders in the fourth quarter of 2002 were $1.2 billion versus $391.6
Insurance Traditional life $ 36.4 $ 39.9 $ 50.6 Universal life 11.7 15.4 17.2 Variable universal life 210.8 204.1 209.1 Individual health 0.2 0.3 0.2 Group variable universal life 35.8 64.8 47.7 - --------------------------------------------------------------------------- Total insurance 294.9 324.5 324.8 - --------------------------------------------------------------------------- Annuities Separate account annuities 1,892.4 1,923.1 2,555.1 General account annuities 856.7 926.8 524.7 Retirement investment accounts 5.8 6.0 9.3 - --------------------------------------------------------------------------- Total individual annuities 2,754.9 2,855.9 3,089.1 Group annuities 79.6 197.7 463.1 - --------------------------------------------------------------------------- Total annuities 2,834.5 3,053.6 3,552.2 - --------------------------------------------------------------------------- Total premiums and deposits $ 3,129.4 $ 3,378.1 $ 3,877.0 ===========================================================================
For the year ended December 31, 2002, total premiums and deposits decreased $248.7 million, or 7.4%, to $3.1 billion. These decreases were primarily due to lower group annuity deposits resulting from the Company's decision to cease marketing activities for new group retirement business and to lower individual annuity deposits, entirely in the fourth quarter of 2002, resulting from the aforementioned ratings downgrades and decision to cease all new sales of proprietary products. Group variable universal life deposits decreased due to the cessation of marketing activities for this product. During the fourth quarter of 2002, total premiums and deposits declined significantly compared to the same period in 2001 (see Statutory Premiums and Deposits - Quarter ended December 31, 2002 Compared to Quarter Ended December 31, 2001 below). Effective December 31, 2002, the Company sold substantially all of its fixed universal life insurance business (see Significant Transactions - Sale of Universal Life Insurance Business). Prior to the cessation of sales of the Company's proprietary products, annuity products were distributed primarily through three distribution channels: (1) "Agency", which consisted of the Company's 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 ("Scudder"), Pioneer Investment Management, Inc. and Delaware Management Company ("Delaware"). Agency, Select, and Partners represented, respectively, approximately 22%, 33%, and 45% of individual annuity deposits in 2002, and Scudder represented 39% of all individual annuity deposits. During 2001, Agency, Select, and Partners represented, respectively, approximately 24%, 38%, and 38% of individual annuity deposits, and Scudder represented 28% of all individual annuity deposits.
FOR THE QUARTER ENDED DECEMBER 31 2002 2001 - -------------------------------------------------------------- (In millions)
The substantial decline in statutory premiums and deposits from 2001 to 2002 is due to the aforementioned decision to cease all new sales of proprietary variable annuities and life insurance products. The Company implemented this decision during the month of October 2002; implementation was substantially complete by the end of that month. Accordingly, statutory premiums and deposits during the fourth quarter of 2002 reflect primarily new sales during the month of October. Future statutory premiums and deposits will be substantially less, since they will only include additional premiums and deposits either allowed or required by existing contracts. Effective December 31, 2002, the Company sold substantially all of its fixed universal life insurance business (see Significant Transactions - Sale of Universal Life Insurance Business). The Company plans to retain and service its existing customer accounts, including variable annuity, variable life, and certain traditional life and group retirement accounts. As of December 31, 2002, Agency, Select, Partners and other distribution channels represented, respectively, 44%, 16%, 24% and 16% of the segment's total general and separate account assets.
The following table summarizes annuity account values and surrender activity, including partial surrenders, for the AFS segment.
Surrenders increased $1.1 billion in 2002, primarily during the fourth quarter, due to the aforementioned ratings downgrades and the Company's decision to cease all new sales of proprietary variable annuities and life insurance products. Management expects high surrender levels related to its annuity business in 2003.
Account Account Values/(1)/ Surrenders/(2)/ Values/(1)/ Surrenders/(2)/ - -------------------------------------------------------------------------------- Agency $ 4,762.2 $ 396.9 $ 5,500.7 $ 124.6 Select 3,279.7 414.6 3,002.4 101.7 Scudder 2,951.5 235.5 2,517.6 88.0 Pioneer 847.7 66.5 957.9 29.1 Delaware 819.8 85.6 1,049.8 42.8 Other 102.9 7.4 103.7 5.4 - -------------------------------------------------------------------------------- Total $ 12,763.8 $ 1,206.5 $ 13,132.1 $ 391.6 ================================================================================
(1) Account values reflect market values as of October 1 of the year indicated.
Surrenders increased substantially in the fourth quarter of 2002 due to the aforementioned ratings downgrades and the Company's decision to cease all new sales of proprietary variable annuities and life insurance products. The fourth quarter 2002 level of surrender activity is consistent with management's expectations and with the surrender rate assumptions included in the Company's calculation of its DAC asset and its GMDB reserve at December 31, 2002.
The following table summarizes the results of operations for the Allmerica Asset Management segment.
Interest margins on GICs: Net investment income $ 100.2 $ 144.3 $ 137.8 Interest credited 85.7 127.5 119.7 - ---------------------------------------------------------------------------- Net interest margin 14.5 16.8 18.1 - ---------------------------------------------------------------------------- Premium financing business: Fees 13.5 - - Operating expenses 9.8 - - - ---------------------------------------------------------------------------- Net premium financing income 3.7 - - - ---------------------------------------------------------------------------- Fees and other income: External 8.1 6.5 6.3 Internal 5.9 5.2 5.1 Other operating expenses (7.8) (7.8) (7.0) - ---------------------------------------------------------------------------- Segment income $ 24.4 $ 20.7 $ 22.5 ============================================================================ Average GIC deposits outstanding $ 2,122.7 $ 2,737.9 $ 1,887.9 ============================================================================ Outstanding GIC deposits, end of year $ 1,410.0 $ 2,689.7 $ 2,258.0 ============================================================================
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 the Company's premium financing subsidiary, AMGRO, in 2002, which was previously included in the Risk Management 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. Declining financial strength ratings from various rating agencies during 2002 (see Rating Agency Actions) resulted in the termination of all remaining short-term funding agreements, and ultimately, the Company ceased selling new long-term funding agreements. Furthermore the Company retired certain funding agreements at discounts during the fourth quarter of 2002. Although these retirements resulted in a gain for the Company (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. The Company uses derivative instruments to hedge its GIC portfolio (see Derivative Instruments). For floating rate GIC liabilities that are matched with fixed rate securities, the Company manages the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. In addition, certain funding agreements are denominated in foreign currencies. To mitigate the short-term effect of changes in currency exchange rates, the Company regularly hedges this risk by entering into foreign exchange swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts to hedge its net foreign currency exposure. These hedges resulted in a $37.7 million and a $48.0 million reduction in net investment income during 2002 and 2001, respectively, 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. Although the Company believes its exposure to foreign currency and interest rate fluctuations are currently economically hedged, there can be no assurance that the Company will not experience losses from ineffective hedges in the future.
% OF TOTAL % of Total CARRYING CARRYING Carrying Carrying VALUE VALUE Value Value - ---------------------------------------------------------------------------- Fixed maturities/(1)/ $ 8,003.1 87.1 $ 9,401.7 88.1 Equity securities/(1)/ 52.8 0.6 62.1 0.6 Mortgages 259.8 2.8 321.6 3.0 Policy loans/(1)/ 361.4 3.9 379.6 3.5 Cash and cash equivalents/(1)/ 389.8 4.2 350.2 3.3 Other long-term investments 129.7 1.4 161.2 1.5 - ---------------------------------------------------------------------------- Total $ 9,196.6 100.0 $ 10,676.4 100.0 ============================================================================
The Company's fixed maturity portfolio is comprised primarily of investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners ("NAIC"), investment grade securities comprised 90.5% and 90.7% of the Company's total fixed maturity portfolio at December 31, 2002 and 2001, respectively. Although management expects that new funds will be invested primarily in cash, cash equivalents and investment grade fixed maturities, the Company may invest a portion of new funds in below investment grade fixed maturities or equity securities. The average yield on fixed maturities was 6.7% and 7.3% for December 31, 2002 and 2001, respectively. This decline reflects lower prevailing fixed maturity investment rates since the first quarter of 2001. Due to the current interest rate environment, management expects its investment yield to be negatively affected by lower prevailing fixed maturity investment rates in 2003. As of December 31, 2002 and 2001, $423.1 million and $509.8 million, respectively, of the Company's fixed maturities were invested in non-publicly traded securities. Fair values of non-publicly traded securities are determined by either a third party broker or by internally developed pricing models, including the use of discounted cash flow analyses. Principally as a result of the Company's exposure to below investment grade securities, the Company recognized $223.6 million and $179.0 million of realized losses on other-than-temporary impairments of fixed maturities for the years ended December 31, 2002 and 2001, respectively. 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 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. Other-than-temporary impairments of fixed maturities in 2001 included $50.8 million related to the communication sector, $32.3 million related to securitized investments, $19.4 million related to the industrial sector, $16.9 million related to the metals sector, and $15.9 million related to the energy sector. The losses reflect the continued deterioration of high-yield securities in the Company's portfolio. In addition, the Company recognized $14.9 million and $6.3 million of realized losses on other-than-temporary impairments of equity securities and other long-term investments for the years ended December 31, 2002 and 2001, respectively. In the Company's determination of other-than-temporary impairments, management considers 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 (typically six months or longer) in which the fair value of an issuer's securities remains below the Company's 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. The Company applies 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. No assurance can be given that the other-than-temporary impairments will, in-fact, be adequate to cover future losses or that substantial additional impairments will not be required in the future. The following table for the years ended December 31, 2002 and 2001 provides information about the Company's fixed maturities and equity securities that are in a gross unrealized loss position.
The gross unrealized losses of fixed maturities and equity securities are viewed as being temporary as it is management's assessment that these securities will recover in the near-term. Furthermore, as of December 31, 2002, the Company has the intent and ability to retain such investments for a period of time sufficient to allow for this anticipated recovery in fair value. Of the $85.7 million and $85.3 million of gross unrealized losses of fixed maturities and equity securities at December 31, 2002 and 2001, respectively, that have been in such a position for greater than 6 months, $14.1 million and $16.6 million have been in a significant unrealized loss position (typically those securities with a fair value less than 80% of amortized cost) as of December 31, 2002 and 2001, respectively. The risks inherent in the assessment methodology include the risk that, subsequent to the balance sheet date, market factors may differ from management's expectations; management may decide to subsequently sell a security for unforeseen business needs; or changes in the
credit assessment or equity characteristics from the Company's original assessment may lead the Company to determine that a sale at the current value would maximize recovery on such investments. To the extent that there are such adverse changes, the unrealized loss would then be realized and the Company would record a charge to earnings. The following table sets forth gross unrealized losses for fixed maturities by maturity period, and for equity securities. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage backed securities are included in the category representing their ultimate maturity.
Due in one year or less $ 3.2 $ 0.9 Due after one year through five years 39.8 38.6 Due after five years through ten years 36.7 51.8 Due after ten years 26.6 52.1 - -------------------------------------------------------------------- Total fixed maturities 106.3 143.4 Equity securities 0.4 9.1 - -------------------------------------------------------------------- Total fixed maturities and equity securities $ 106.7 $ 152.5 ====================================================================
The Company enters into various types of interest rate swap contracts to hedge exposure to interest rate fluctuations on floating rate funding agreement liabilities that are matched with fixed rate securities. The Company also enters into foreign currency swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts, to hedge foreign currency and interest rate exposure on specific funding agreement liabilities. Finally, from time to time the Company has entered into other swap contracts for investment purposes. The Company recognized $53.1 million and $32.9 million of net realized losses on derivatives for the years ended December 31, 2002 and 2001, respectively. The realized losses during the year ended December 31, 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 the year ended December 31, 2001 were due primarily to the termination of swap contracts used to hedge short-term funding agreements, during a declining interest rate environment, in response to withdrawals.
The following tables for the years ended December 31, 2002 and 2001 provide information about the Company's derivative financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The tables present notional amounts and, as applicable, weighted-average interest rates by expected maturity date. Notional amounts are used to calculate the contractual payments to be exchanged under the contracts. Weighted-average variable rates are indicated by the applicable floating rate index. The significant decrease in notional amount of swaps outstanding at December 31, 2002 compared to December 31, 2001 is primarily due to short-term funding agreement withdrawals, as well as the retirement of certain long-term funding agreements at discounts. As these funding agreements were extinguished, the swap contracts hedging them were terminated.
AFC and its domestic subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income.
In the fourth quarter of 2002, the Company retired $548.9 million of its long-term funding agreement obligations at discounts. This resulted in a gain of $102.6 million, which is reported as gain from retirement of trust instruments supported by funding obligations in the Consolidated Statements of Income. Certain amounts related to the termination of derivative instruments used to hedge the retired funding agreements were reported in separate line items in the Consolidated Statements of Income. The net foreign currency transaction loss on the retired foreign-denominated funding agreements, which was partially offset by foreign exchange gains on derivative instruments used to hedge the retired funding agreements, of $12.2 million was recorded as other income in the Consolidated Statements of Income. The net market value loss on the early termination of derivative instruments used to hedge the retired funding agreements of $14.1 million was recorded as net realized investment losses in the Consolidated Statements of Income.
The discussion and analysis of the Company's financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with GAAP which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The following critical accounting policies, among others, are those which management believes affect the more significant judgments and estimates used in the preparation of the Company's financial statements. Additional information about the Company's significant accounting policies may be found in Note 1, "Summary of Significant Accounting Policies" on pages 68 to 74 of the Notes to Consolidated Financial Statements included in this Form 10-K.
The amount of loss and loss adjustment expense reserves (the "loss reserves"), as discussed in "Segment Results - Risk Management, Reserve for Losses and Loss Adjustment Expenses" is determined 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 the Company 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, the Company develops information about the size of ultimate claims based on its 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 the Company's assumptions, the Company does not completely rely on only one estimate to determine its loss reserves. Rather, the Company develops several estimates using generally recognized actuarial projection methodologies that result in a range of reasonably possible loss reserve outcomes; the Company's best estimate is within that range. When trends emerge that the Company believes affect the future settlement of claims, the Company will adjust its reserves accordingly. Reserve adjustments are reflected in the Consolidated Statements of Income as adjustments to losses and loss adjustment expenses. Often, these adjustments are recognized in periods subsequent to the period in which the underlying loss event occurred. These types of subsequent adjustments are disclosed and discussed separately as "prior year reserve development". Such development can be either favorable or unfavorable to the financial results of the Company.
Deferred policy acquisition costs consist of commissions, underwriting costs and other costs, which vary with, and are primarily related to, the production of insurance deposits. Acquisition costs related to the Company's variable products (variable universal life and variable annuities) are recorded on the balance sheet and amortized through the income statement in proportion to total estimated gross profits over the expected life of the contracts (see Segment Results - Allmerica Financial Services, Deferred Acquisition Costs). The Company's estimated gross profits are based on assumptions including mortality, persistency, asset growth rates and expenses associated with policy maintenance. The principal source of earnings for these policies is from asset-based fees, which can vary in relation to changes in the equity market.
The Company employs a systematic methodology to evaluate declines in fair values below amortized cost for all investments. This methodology ensures that available evidence concerning the declines is evaluated in a disciplined manner. In determining whether a decline in fair value below amortized cost is other-than-temporary, the Company evaluates the length of time (typically six months or longer) and the extent to which the fair value has been less than amortized cost; the financial condition and near-term prospects of the issuer; the issuer's credit and financial strength ratings; the issuer's financial performance, including earnings trends, dividend payments, and asset quality; any specific events which may influence the operations of the issuer; general market conditions; and, the financial condition and prospects of the issuer's market and industry. The Company applies judgment in assessing whether the aforementioned factors have caused an other-than-temporary decline in value. When an other-than-temporary decline in value 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 (see Investment Portfolio).
.. The Regulatory Action Level, which equals 150% of the Authorized Control Level, requires the insurer to submit to the commissioner of the state of domicile a RBC plan, or if applicable, a revised RBC plan. After examination or analysis, the commissioner will issue an order specifying corrective actions ("Corrective Order") to be taken.
.. 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).
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, 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.
RBC ratios for regulatory purposes, as described above, are expressed as a percentage of the capital required to be above the Authorized Control Level (the "Regulatory Scale"); however, in the insurance industry RBC ratios are widely expressed as a percentage of the Company Action Level (without regard to the application of the negative trend test). Set forth below are RBC ratios for the Companies' life insurance subsidiaries and for Hanover as of December 31, 2002, expressed both on the Industry Scale (Total Adjusted Capital divided by the Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by Authorized Control Level):
On 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. Under the previous internal ownership structure, FAFLIC was the immediate parent of AFLIAC and a direct subsidiary of AFC. As a result of this internal reorganization, the statutory surplus of AFLIAC substantially increased since it includes FAFLIC's capital. This allows for a greater tolerance of equity market volatility. In turn, the statutory surplus of FAFLIC substantially decreased since it no longer includes AFLIAC's capital. However, FAFLIC's statutory surplus is no longer as susceptible to equity market volatility since AFLIAC, which holds approximately 90% of the Company's annuity products that are most sensitive to changes in the equity market, is no longer consolidated into FAFLIC.
AFC has 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 block of 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.
January, 2003 AFC to FAFLIC 20 December 31, 2002 FAFLIC to AFLIAC 20
/(1)/ The effective date represents the date which these transactions were reflected in the Company's statutory surplus balance.
The statutory surplus of the life companies, particularly AFLIAC, which holds approximately 90% of the annuity deposits with the GMDB feature, is highly sensitive to movements in the equity market. This is due, in large part, to the required methodology for calculating GMDB ("Actuarial Guideline 34") reserves for statutory accounting purposes. As of December 31, 2002, the level of net GMDB reserves in the life companies was approximately $203 million. An increase of these reserves does not result directly in cash losses to the Company, but it does result in a reduction in statutory surplus. For each one percent decline in the S&P 500 Index, the expected increase in required statutory GMDB reserves is approximately $3 million to $4 million. Any increase in required reserves would result in an equal decrease in the statutory surplus. Any increase in the S&P 500 Index would result in a decrease in required statutory GMDB reserves, as well as an increase in surplus due to the impact of the GMDB reinsurance. The DAC amortization adjustments described earlier do not have an impact on statutory surplus, as DAC is not a concept recognized under statutory accounting principles.
AFLIAC entered into a reinsurance agreement, in 2001, with an independent reinsurer, to cede up to $40 million of its GMDB costs annually based upon contract date, in excess of $40 million, for a three year period. As described under "Liquidity and Capital Resources" below, AFC entered into a related agreement to reimburse costs incurred by this independent reinsurer.
For the year ended December 31, 2002, AFLIAC and FAFLIC incurred GMDB costs of $92.3 million and $2.9 million, respectively, and ceded $34.4 million and $0.1 million, respectively, of GMDB costs under the aforementioned reinsurance programs.
The actuarial profession is currently examining issues surrounding the development of a reserve methodology for variable annuity products. Although no specific recommendations have been made at this time, such changes could potentially have a material negative effect on the Company's statutory surplus and RBC ratio.
Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, AFC's primary source of cash is dividends from its insurance subsidiaries. However, dividend payments to AFC by its insurance subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus and restrictions on the payment of "extraordinary" dividends, as defined. As mentioned above (see Statutory Capital of Insurance Subsidiaries), AFC has entered into an agreement with the Massachusetts Insurance Commissioner, in consideration of the decision not to write new life insurance and annuity business, whereby it partially offset by cash provided by sales of mortgage loans, and year over year declines in purchases of mortgages and will indefinitely maintain the RBC ratio of AFLIAC at a minimum of 100% of the Company Action Level (on the Industry Scale).
During 2002, AFC received $92 million of dividends from its property and casualty businesses. Additional dividends from the Company's property and casualty insurance subsidiaries prior to July, 2003 would be considered "extraordinary" and would require prior approval from the respective state regulators. The Company does not expect dividend payments from its life insurance subsidiaries in 2003.
During 2002, AFC contributed $188 million to its life insurance subsidiaries. Such capital contributions were made due to the negative impact on statutory surplus of increased sales commissions, GMDB reserves, an increased level of realized investment losses, the level of premiums and deposits and in consideration of the ratings of the life companies and the 225% RBC agreement, as described above, which has since been superseded. The Company does not expect that its life insurance subsidiaries will require the levels of capital contributions as in prior years due to the expectation of sufficient statutory capital and earnings; therefore, the Company does not expect it will be necessary to dividend funds from the property and casualty companies in 2003. However, there can be no guarantee that future dividends will not be necessary in order to maintain these surplus levels.
In 2001, AFLIAC entered into an agreement to cede a portion of its GMDB obligations to an independent reinsurer (see Statutory Capital of Insurance Subsidiaries). Under a related agreement, AFC agreed to reimburse these costs to the reinsurer. In 2002, AFLIAC incurred GMDB costs of approximately $92 million. Since 2001, AFLIAC ceded $33.6 million under the agreement, of which AFC has reimbursed $33.6 million through December 2002. Management expects that reimbursements related to this agreement will not be significant in the future due to the aforementioned additional GMDB reinsurance program.
Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claims, losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. Management expects that, due to the decision to cease new sales of life and annuity products, the expectation of high policy surrenders in AFS products and the retirement of funding obligations in AAM, additional cash outflows will occur in 2003. These outflows will be funded with existing cash and with proceeds from sales of cash equivalents and fixed maturities. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements.
partially offset by cash provided by sales of mortgage loans, and year over year declines in purchases of mortgages and company owned life insurance. Net purchases of fixed maturities in 2001 increased principally due to additional deposits into the general account, including those related to the aforementioned promotional annuity program.
At December 31, 2002, AFC, as a holding company, held $64.6 million of cash and investments. Historically, funds provided to the holding company were from its property and casualty insurance subsidiaries. Management believes the holding company of AFC has the ability to meet its obligations through 2003, including annual interest on Senior Debentures and Capital Securities of $39.9 million and the $20 million capital contribution paid in January 2003 to its life insurance subsidiaries (see Statutory Capital of Insurance Subsidiaries). Therefore, the Company currently does not expect it will be necessary to dividend funds from the property and casualty companies in 2003 in order to fund 2003 holding company obligations as discussed above. However, the Company believes the holding company will require additional funding in 2004 in order to meet its obligations, which will include obligations consistent with those expected for 2003 and may include certain federal income tax liabilities. The Company decided, in 2002, to suspend payment of its annual common stock dividend. Whether the Company will pay dividends in the future depends upon the earnings and financial condition of AFC, although the Company does not expect to pay a dividend in 2003.
The Company expects to continue to generate sufficient positive cash to meet all short-term and long-term cash requirements. The Company's insurance subsidiaries maintain a high degree of liquidity within their respective investment portfolios in fixed maturity investments, common stock and short-term investments. AFC has $150 million available under a committed syndicated credit agreement which expires May 2003. Borrowings under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. The agreement provides covenants, including, but not limited to, requirements that the Company maintain adjusted statutory surplus in certain of its insurance subsidiaries totaling in excess of $1 billion. At December 31, 2002, the Company was in compliance with all debt covenants. At December 31, 2002, no amounts were outstanding under this agreement. In addition, the Company had no commercial paper borrowing as of December 31, 2002. Ratings downgrades have adversely affected the cost and availability of additional debt and equity financing and will continue to do so in the future should ratings remain at current levels or decrease further (see Rating Agency Actions). The Company does not expect to renew this credit agreement.
The Company's insurance subsidiaries are routinely engaged in various legal proceedings arising in the normal course of business, including claims for extracontractual or punitive damages. Additional information on other litigation and claims may be found in Note 21, "Contingencies - Litigation," on pages 98 and 99 the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. In the opinion of management, none of such contingencies are expected to have a material effect on the Company's consolidated financial position, although it is possible that the results of operations in a particular quarter or annual period could be materially affected by an unfavorable outcome.
Insurance companies are rated by rating agencies to provide both industry participants and insurance consumers information on specific insurance companies. Higher ratings generally indicate the rating agencies' opinion regarding financial stability and a stronger ability to pay claims.
The decrease in the property and casualty ratings, in particular the A.M. Best rating, could continue to negatively impact earnings and growth in this business, primarily in the Company's commercial lines. In the fourth quarter, the Company secured third party guarantees, which expire in August 2003, in an effort to minimize the loss of commercial lines business as a result of the downgrades. These measures are primarily intended to reduce the risk of cancellation or non-renewal of these commercial policies in the near term. The Company believes that the longer the ratings remain at the current level, the greater the adverse effect of the lower ratings on the operating results of the Risk Management segment. There can be no assurance that these downgrades, or any further downgrades that may occur, will not have a material adverse effect on the results of operations and financial position of the Company.
The Company recognized net periodic pension expenses from its employee pension plans of $16.8 million and $0.3 million in 2002 and 2001, respectively. In 2000, the Company recognized a net periodic pension benefit of $12.5 million related to these plans. The expense or benefit related to the pension plans results from several factors, including changes in the market value of plan assets, interest rates and employee compensation levels. The net expense in 2002 and 2001 primarily reflects decreased market values of plan assets as compared to prior years, while the net benefit in 2000 primarily reflects increases in the market value of plan assets. In addition, during 2002, the Company recognized $5.4 million of additional pension expenses associated with the restructuring of the AFS segment. In 2003, management expects an increase of approximately $27 million in net periodic pension expenses due to declines in the market value of plan assets and interest rates in 2002.
The Company wishes to caution readers that the following important factors, among others, in some cases have affected and in the future could affect, the Company's actual results and could cause the Company's actual results for 2003 and beyond to differ materially from historical results and from those expressed in any forward-looking statements made by, or on behalf of, the Company. When used in Management's Discussion and Analysis, the words "believes", "anticipates", "expects" and similar expressions are intended to identify forward looking statements. See "Important Factors Regarding Forward-Looking Statements" filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 2002. Such factors could also cause future results to differ from historical results.
Factors that may cause actual results to differ materially from historical results and from those contemplated or projected, forecast, estimated or budgeted in such forward looking statements include among others, the following possibilities: (i) lower appreciation on or decline in value of the Company's managed investments or the investment markets in general, resulting in reduced variable product assets and related variable product management and brokerage fees, lapses and increased surrenders, increased DAC amortization, as well as increased cost of guaranteed minimum death benefits/decreased account balances supporting our guaranteed benefits products; (ii) adverse catastrophe experience and severe weather; (iii) adverse loss development for events the Company has insured in either the current or in prior years or adverse trends in mortality and morbidity; (iv) 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; (v) adverse state and federal legislation or regulation, including decreases in rates, limitations on premium levels, increases in minimum capital and reserve requirements, benefit mandates, limitations on the ability to manage care and utilization, requirements to write certain classes of business and recent and future changes affecting the tax treatment of insurance and annuity products, as well as continued compliance with state and federal regulations; (vi) changes in interest rates causing a reduction of investment
income or in the market value of interest rate sensitive investments; (vii) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (viii) difficulties in recruiting new or retaining existing registered representatives and wholesalers to support the sale of non-proprietary investment and insurance products; (ix) higher service, administrative, or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (x) loss or retirement of key executives; (xi) our success in hiring a new President and Chief Executive Officer (xii) increases in costs, particularly those occurring after the time our products are priced and including construction, automobile, and medical and rehabilitation costs; (xiii) changes in the Company's liquidity due to changes in asset and liability matching, including the effect of defaults of debt securities; (xiv) restrictions on insurance underwriting; (xv) adverse changes in the ratings obtained from independent rating agencies, such as Moody's, Standard and Poor's and A.M. Best, or the inability to restore the property and casualty subsidiaries' A.M.Best rating to the "A-" level or higher; (xvi) possible claims relating to sales practices for insurance and investment products; (xvii) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance or coinsurance contracts or adverse effects on the cost and availability of reinsurance; (xviii) earlier than expected withdrawals from the Company's general account annuities, GICs (including funding agreements), and other insurance products; (xix) changes in the mix of assets comprising the Company's investment portfolio and the fluctuation of the market value of such assets; (xx) losses resulting from the Company's participation in certain reinsurance pools; (xxi) losses due to foreign currency fluctuations; (xxii) defaults of debt securities held by the Company; (xxiii) higher employee benefit costs due to changes in market values of plan assets, interest rates and employee compensation levels, and (xxiv) the effect of the Company's restructuring actions. In addition, with respect to the Allmerica Financial Services segment, the Company has provided forward looking information relating to the impact of equity market values on certain financial metrics, including among other things, GMDB expenses, net amount at risk, DAC amortization and Actuarial Guideline 34 reserves for statutory accounting purposes. This information is an estimation only and is based upon matters as in effect on December 31, 2002. Actual amounts of these certain financial metrics would vary based upon numerous other factors, including but not limited to, variable product account values, allocation between separate and general accounts, mortality experience, surrender and withdrawal rates and patterns, investment experience and performance of equity and financial markets throughout the period, as well as from period to period.
To the Board of Directors and Shareholders of Allmerica Financial Corporation:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows present fairly, in all material respects, the financial position of Allmerica Financial Corporation and its subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002 and derivative instruments in 2001.
The management of Allmerica Financial Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in conformity with generally accepted accounting principles and include amounts based on management's informed estimates and judgments. We believe that these statements present fairly the Company's financial position and results of operations and that the other information contained in the annual report is accurate and consistent with the financial statements. Allmerica Financial Corporation's Board of Directors annually appoints independent accountants to perform an audit of its consolidated financial statements. The financial statements have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Their audit included consideration of the Company's system of internal control in order to determine the audit procedures required to express their opinion on the consolidated financial statements. Management of Allmerica Financial Corporation has established and maintains a system of internal control that provides reasonable assurance that assets are safeguarded and that transactions are properly authorized and recorded. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. Management continually monitors the system of internal control for compliance. Allmerica Financial Corporation and its subsidiaries maintain a strong internal audit program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. Management recognizes the inherent limitations in all internal control systems and believes that our system of internal control provides an appropriate balance between the costs and benefits desired. Management believes that the Company's system of internal control provides reasonable assurance that errors or irregularities that would be material to the financial statements are prevented or detected in the normal course of business. The Audit Committee of the Board of Directors, composed solely of outside directors, oversees management's discharge of its financial reporting responsibilities. The committee meets periodically with management, our internal auditors and our independent accountants, PricewaterhouseCoopers LLP. Both our internal auditors and PricewaterhouseCoopers LLP have direct access to the Audit Committee. Management recognizes its responsibility for fostering a strong ethical climate. This responsibility is reflected in the Company's policies which address, among other things, potential conflicts of interest; compliance with all domestic and foreign laws including those relating to financial disclosure and the confidentiality of proprietary information. Allmerica Financial Corporation maintains a systematic program to assess compliance with these policies.
In accordance with the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", ("Statement No. 115"), the Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. The Company determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. 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 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. Mortgage loans on real estate are stated at unpaid principal balances, net of unamortized discounts and reserves. Reserves on mortgage loans are based on losses expected by the Company to be realized on transfers of mortgage loans to real estate (upon foreclosure), on the disposition or settle-
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.
The Company shares certain insurance risks it has underwritten through the use of reinsurance contracts with various insurance entities. Reinsurance accounting is followed for ceded transactions when the risk transfer provisions of Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", have been met. As a result, when the Company experiences loss or claims events, or unfavorable mortality or morbidity experience that are subject to a reinsurance contract, reinsurance recoveries are recorded. The amount of the reinsurance recoverable can vary based on the terms of the reinsurance contract, the size of the individual loss or claim, or the aggregate amount of all losses or claims in a particular line, book of business or an aggregate amount associated with a particular accident year. The valuation of losses or claims recoverable depends on whether the underlying loss or claim is a reported loss or claim, an incurred but not reported loss or a future policy benefit. For reported losses and claims, the Company values reinsurance recoverables at the time the underlying loss or claim is recognized, in accordance with contract terms. For incurred but not reported losses and future policy benefits, the Company estimates the amount of reinsurance recoverable based on the terms of the reinsurance contracts and historical reinsurance recovery information and applies that information to the gross loss reserve and future policy benefit estimates. The reinsurance recoverables are based on what the Company believes are reasonable estimates and the balance is disclosed separately in the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses and claims are settled.
Property, equipment, leasehold improvements and capitalized software are stated at cost, less accumulated depreciation and amortization. Depreciation is provided using the straight-line or accelerated method over the estimated useful lives of the related assets which generally range from 3 to 30 years. The estimated useful life for capitalized software is generally 5 years. Amortization of leasehold improvements is provided using the straight-line method over the lesser of the term of the leases or the estimated useful life of the improvements. The Company tests for the recoverability of long-lived assets 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 long-lived assets exceed the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the assets. When an impairment loss has been deemed to have occurred, the Company reduces the carrying value of the asset to fair value. Fair values are estimated using discounted cash flow analysis.
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 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.
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.
and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through the provision for future benefits, estimated and unpaid losses and amortization of deferred policy acquisition costs. Revenues for investment-related products consist of net investment income and contract charges assessed against the fund values. Related benefit expenses include annuity benefit claims for guaranteed minimum fund values in excess of contract values, and net investment income credited to the fund values after deduction for investment and risk charges. Revenues for universal life products consist of net investment income, with mortality, administration and surrender charges assessed against the fund values. Related benefit expenses include universal life benefit claims in excess of fund values and net investment income credited to universal life fund values. Certain policy charges that represent compensation for services to be provided in future periods are deferred and amortized over the period benefited using the same assumptions used to amortize deferred acquisition costs.
AFC and its domestic subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. 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, net operating loss carryforwards, employee benefit plans and unrealized appreciation or depreciation on investments.
changes in the hedged item's fair value. For cash flow hedge transactions, in which the Company is hedging the variability of cash flows related to a variable rate asset, liability, or a forecasted transaction, changes in the fair value of the derivative instrument will be reported in other comprehensive income. The gains and losses on the derivative instrument that are reported in other comprehensive income will be reclassified into earnings in the periods in which earnings are impacted by the variability of the cash flows of the hedged item. To the extent any hedges are determined to be ineffective, all or a portion of the change in value of the derivative will be recognized currently in earnings. This statement was effective for fiscal years beginning after June 15, 2000. The Company adopted Statement No. 133 on January 1, 2001. In accordance with the transition provisions of the statement, the Company recorded a $3.2 million charge, net of taxes, in earnings to recognize all derivative instruments at their fair values. This adjustment represents net losses that were previously deferred in other comprehensive income on derivative instruments that do not qualify for hedge accounting. The Company recorded an offsetting gain in other comprehensive income of $3.3 million, net of taxes, to recognize these derivative instruments.
The Company accounts for its investments in fixed maturities and equity securities, all of which are classified as available-for-sale, in accordance with the provisions of Statement No. 115. The amortized cost and fair value of available-for-sale fixed maturities and equity securities were as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost /(1)/ Gains Losses Value - ----------------------------------------------------------------------------- U.S. Treasury securities and U.S. government and agency securities $ 570.5 $ 22.8 $ 0.8 $ 592.5 States and political subdivisions 1,448.3 53.7 2.3 1,499.7 Foreign governments 14.1 0.8 0.1 14.8 Corporate fixed maturities 4,424.5 251.1 102.9 4,572.7 Mortgage-backed securities 1,258.5 65.1 0.2 1,323.4 - ----------------------------------------------------------------------------- Total fixed maturities $ 7,715.9 $ 393.5 $ 106.3 $ 8,003.1 ============================================================================= Equity securities $ 49.1 $ 4.1 $ 0.4 $ 52.8 =============================================================================
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. At December 31, 2002, the amortized cost and market value of these assets on deposit in New York were $180.1 million and $189.9 million, respectively. At December 31, 2001, the amortized cost and market value of these assets on deposit were $180.0 million and $182.9 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $137.4 million and $140.5 million were on deposit with various state and governmental authorities at December 31, 2002 and 2001, respectively. Market values related to these securities were $148.1 million and $145.2 million at December 31, 2002 and 2001, respectively. At December 31, 2002, there were contractual investment commitments of $12.3 million. The amortized cost and fair value by maturity periods for fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage backed securities are included in the category representing their ultimate maturity.
Amortized Fair Cost Value - ------------------------------------------------------------------ Due in one year or less $ 299.6 $ 298.7 Due after one year through five years 2,497.6 2,580.4 Due after five years through ten years 2,235.1 2,332.6 Due after ten years 2,683.6 2,791.4 - ------------------------------------------------------------------ Total $ 7,715.9 $ 8,003.1 ==================================================================
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 2002 and 2001. The carrying values of mortgage loans, net of applicable reserves, were $259.8 million and $321.6 million at December 31, 2002 and 2001, respectively. Reserves for mortgage loans were $2.8 million and $3.8 million at December 31, 2002 and 2001, respectively. During 2001, the Company received proceeds of $194.3 million as a result of the sale of $182.2 million of its mortgage loan portfolio. There was no real estate held at December 31, 2002 in the Company's investment portfolio. At December 31, 2001, the Company held one real estate investment with a carrying value of $1.9 million which was acquired through the foreclosure of a mortgage loan. This investment represented the one non-cash investing activity in 2001. There were no non-cash investing activities, including real estate acquired through foreclosure of mortgage loans in 2002 and 2000. There were no contractual commitments to extend credit under commercial mortgage loan agreements at December 31, 2002. Mortgage loan investments comprised the following property types and geographic regions:
The Company enters into various types of interest rate swap contracts to hedge exposure to interest rate fluctuations. Specifically, for floating rate funding agreement liabilities that are matched with fixed rate securities, the Company manages the risk of cash flow variability by hedging with interest rate swap contracts. Under these swap contracts, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount. The Company also purchases long futures contracts and sells short futures contracts on margin to hedge against interest rate fluctuations associated with the reinvestment of fixed maturities. The Company is exposed to interest rate risk on reinvestments of fixed maturities from the time of maturity until the purchase of new fixed maturities. The Company uses U.S. Treasury Note futures to hedge this risk. 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 sale of the GIC until receipt of the deposit and purchase of the underlying asset to back the liability. The Company also enters into foreign currency forward contracts to hedge foreign currency exposure on specific fixed income securities. Additionally, the Company enters into compound foreign currency/interest rate swap contracts to hedge foreign currency and interest rate exposure, and foreign exchange futures and options contracts to hedge foreign currency 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. Under the foreign exchange forward, futures and options contracts, the Company has the right to purchase the hedged currency at a fixed strike price in U.S. dollars. For the years ended December 31, 2002 and 2001, respectively, the Company recognized a net gain of $65.1 million and a net loss of $35.5 million, representing the total ineffectiveness of all cash flow hedges. The net gain reflects total ineffectiveness in 2002, of which $40.0 million related to ineffective swap contracts and was reported in (gains) losses on derivative instruments in the Consolidated Statements of Income, and $25.1 million related to ineffective futures and options contracts, which was reported in other income in the Consolidated Statements of Income. The 2001 net loss of $35.5 million, representing total ineffectiveness on all cash flow hedges, was reported in (gains) losses on derivative instruments in the Consolidated Statements of Income. The Company did not hold any ineffective futures or options contracts during 2001. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted. 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 management's 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 (gains) losses 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 (gains) losses on derivative instruments to net realized investment losses in the Consolidated Statements of Income. As of December 31, 2002, $5.9 million of the deferred net gains on derivative instruments accumulated in other comprehensive income could be recognized in earnings during the next twelve months depending on the forward interest rate and currency rate environment. Transactions and events that (1) are expected to occur over the next twelve months and (2) will necessitate reclassifying to earnings these derivatives gains (losses) include (a) the re-pricing of variable rate trust instruments supported by funding obligations, (b) the interest payments (receipts) on foreign denominated trust instruments supported by funding obligations and foreign securities, (c) the possible repurchase of other funding agreements, and (d) the anticipated reinvestment of fixed maturities. The maximum term over which the Company is hedging its exposure to the variability of future cash flows, for all forecasted transactions, excluding interest payments on variable-rate funding agreements, is 12 months.
The Company entered into insurance portfolio-linked, credit default, and other swap contracts for investment purposes. These products were not linked to specific assets and liabilities on the balance sheet or to a forecasted transaction, and therefore did not qualify for hedge accounting. Under the insurance portfolio-linked swap contracts, the Company agreed to exchange cash flows according to the performance of a specified underwriter's portfolio of insurance business.
Under the terms of the credit default swap contracts, the Company assumed the default risk of a specific high credit quality issuer in exchange for a stated annual premium. In the case of default, the Company would have paid the counterparty par value for a pre-determined security of the issuer. The primary risk associated with these transactions was the default risk of the underlying companies. Under the other swap contract entered into for investment purposes, the Company agreed to exchange the difference between fixed and floating interest amounts calculated on an agreed upon notional principal amount. As of December 31, 2001, the Company no longer held insurance or credit default swap contracts, although final payment related to the insurance portfolio-linked swap contract was recorded in 2002, in accordance with contract terms. Net realized investment gains related to insurance portfolio-linked contracts were $2.1 million in 2002, while net realized investment losses related to these contracts were $4.3 million and $0.7 million for the years ended December 31, 2001 and 2000, respectively. The stated annual premium under credit default swap contracts was recognized in net investment income. There were no net increases to investment income related to credit default swap contracts for the years ended December 31, 2002 and 2001; however, there was a net increase of $0.2 million for the year ended December 31, 2000. As of December 31, 2002 the Company no longer held any other swap contracts for investment purposes. The fair value of the other swap contract held for investment purposes was $(2.1) million at December 31, 2001. The net decrease in net investment income related to this contract was $0.4 million, $0.7 million and $0.1 million for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company holds an investment in the Allmerica CBO I, Ltd., which was formed in 1998 as a collateralized bond obligation, to issue secured notes to various investors and use the proceeds to purchase high yield fixed income securities. The note holders own beneficial interests in the cash flows of the high yield securities. The interests are classified based upon priority of payments, and consist of the following par values as of December 31:
At both December 31, 2002 and 2001, the Company owned a $36.9 million par value investment in the Allmerica CBO I, Ltd., consisting of $30.9 million of Senior Subordinated Notes and $6.0 million of Junior Subordinated Notes. The Company's investment in Allmerica CBO I, Ltd. was considered to be other-than-temporarily impaired and therefore completely written off during 2001. Through the Company's ownership of the Junior Subordinated Notes, it is entitled to 27.4% of the residual value, if any, of the CBO. The Company has no remaining exposure to loss because its investment in the non-recourse notes has already been completely written off.
/(1)/ Includes net depreciation on derivative instruments of $58.5 million and net appreciation on derivative instruments of $1.4 million in 2002 and 2001, respectively. Balances at December 31, 2002 and 2001 include net depreciation from derivative instruments of $101.2 million and $42.7 million, respectively.
/(2)/ Includes net appreciation on other investments of $0.1 million, $0.5 million, and $1.8 million in 2002, 2001 and 2000, respectively.
For the Years Ended December 31 2002 2001 2000 - ----------------------------------------------------------------- (In millions)
Fixed maturities $ (110.8) $ (121.1) $ (151.7) Mortgage loans 1.0 10.7 1.3 Equity securities 1.3 28.4 3.8 Derivative instruments (53.1) (32.9) 3.1 Other long-term investments (0.7) (9.0) 2.8 - ----------------------------------------------------------------- Net realized investment losses $ (162.3) $ (123.9) $ (140.7) =================================================================
- ---------------------------------------------------------------------------- Fixed maturities $ 2,165.7 $ 114.3 $ 57.5 Equity securities $ 40.1 $ 30.0 $ -- ============================================================================
- ---------------------------------------------------------------------------- Fixed maturities $ 1,997.0 $ 11.0 $ 99.5 Equity securities $ 13.1 $ 4.0 $ 0.2 ============================================================================
The carrying value of short-term debt reported in the Consolidated Balance Sheets approximates fair value. The fair value of long-term debt was estimated using market quotes, when available, and when not available, discounted cash flow analyses.
Summarized financial information of the Closed Block as of December 31, 2002 and 2001 and for the periods ended December 31, 2002, 2001 and 2000 is as follows:
Reported (loss) income before cumulative effect of change in accounting principle $ (302.4) $ 0.1 $ 199.9 Goodwill amortization -- 4.0 3.8 - ----------------------------------------------------------------------------- Adjusted (loss) income before cumulative effect of change in accounting principle $ (302.4) $ 4.1 $ 203.7 ============================================================================= Reported net (loss) income $ (306.1) $ (3.1) $ 199.9 Goodwill amortization -- 4.0 3.8 - ----------------------------------------------------------------------------- Adjusted net (loss) income $ (306.1) $ 0.9 $ 203.7 ============================================================================= Per Share Information: Basic Reported (loss) income before cumulative effect of change in accounting principle $ (5.72) $ -- $ 3.75 Goodwill amortization -- 0.08 0.07 - ----------------------------------------------------------------------------- Adjusted (loss) income before cumulative effect of change in accounting principle $ (5.72) $ 0.08 $ 3.82 - ----------------------------------------------------------------------------- Reported net (loss) income $ (5.79) $ (0.06) $ 3.75 Goodwill amortization -- 0.08 0.07 - ----------------------------------------------------------------------------- Adjusted net (loss) income $ (5.79) $ 0.02 $ 3.82 ============================================================================= Diluted Reported (loss) income before cumulative effect of change in accounting principle $ (5.72) $ -- $ 3.70 Goodwill amortization -- 0.08 0.07 - ----------------------------------------------------------------------------- Adjusted (loss) income before cumulative effect of change in accounting principle $ (5.72) $ 0.08 $ 3.77 ============================================================================= Reported net (loss) income $ (5.79) $ (0.06) $ 3.70 Goodwill amortization -- 0.08 0.07 - ----------------------------------------------------------------------------- Adjusted net (loss) income $ (5.79) $ 0.02 $ 3.77 =============================================================================
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 2002 and determined that no further impairments were required.
Short-term Commercial paper $ - $ 83.3 Long-term Senior Debentures (unsecured) $ 199.5 $ 199.5 ==========================================================
The federal income taxes attributable to the consolidated results of operations are different from the amounts determined by multiplying income before federal income taxes by the statutory federal income tax rate. The sources of the difference and the tax effects of each were as follows:
The curtailment loss and special termination benefits in 2002 of $4.3 million and $1.1 million, respectively, relate to the AFS restructuring (see Note 3 - Significant Transactions). The curtailment loss primarily reflects the elimination of future expected years of service for agents terminated pursuant to the aforementioned AFS restructuring, while special termination benefit costs reflect acceleration of retirement criteria under the plan for transition group participants terminated due to the restructuring. The following table summarizes the status of the plans. At December 31, 2002 and 2001, the projected benefit obligations exceeded the plans' assets. During 2002 and 2001, the Company recorded increases in its minimum pension liability related to its pension plans of $121.1 million and $64.8 million, respectively. This is reflected as an adjustment to accumulated other comprehensive income and is primarily comprised of the difference between the present value of accumulated benefit obligations and the market value of assets funding the plan. This liability resulted primarily from a decrease in the market value of assets held by the plan due to a general decline in the equity markets.
As a result of the Company's merger with Allmerica P&C in 1997, certain pension liabilities were reduced to reflect their fair value as of the merger date. These pension liabilities were reduced by $4.7 million and $6.1 million in 2002 and 2001 respectively, which reflects fair value, net of applicable amortization. Determination of the projected benefit obligations was based on weighted average discount rates of 6.25% and 6.88% in 2002 and 2001, respectively, and the assumed long-term rate of return on plan assets was 9.5% in 2002 and
In addition to the Company's pension plans, the Company currently provides postretirement medical and death benefits to certain full-time employees, agents, retirees and their dependents, under welfare benefit plans sponsored by FAFLIC. Generally, active employees and agents become eligible at age 55 with at least 15 years of service. Spousal coverage is generally provided for up to two years after death of the retiree. Benefits include hospital, major medical and a payment at death equal to retirees' final compensation up to certain limits. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments to beneficiaries of retired employees and to restrict eligibility to then current employees. The medical plans have varying copayments and deductibles, depending on the plan. These plans are unfunded. The plans' funded status reconciled with amounts recognized in the Company's Consolidated Balance Sheets were as follows:
Change in benefit obligations: Accumulated postretirement benefit obligation, beginning of year $ 77.2 $ 75.5 Service cost 2.2 2.3 Interest cost 5.0 4.9 Actuarial losses (gains) 4.7 (1.2) Benefits paid (4.2) (4.3) Curtailment gain and special termination benefits (9.0) -- - --------------------------------------------------------------- Accumulated postretirement benefit obligation, end of year 75.9 77.2 - --------------------------------------------------------------- Fair value of plan assets, end of year -- -- =============================================================== Funded status of the plan (75.9) (77.2) Unamortized prior service cost (2.8) (5.4) Unrecognized net actuarial gains (6.0) (8.4) - --------------------------------------------------------------- Accumulated postretirement benefit costs $ (84.7) $ (91.0) ===============================================================
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000 - ---------------------------------------------------------------------------- (In millions)
Service cost $ 2.2 $ 2.3 $ 1.9 Interest cost 5.0 4.9 4.9 Recognized net actuarial gain (0.3) (0.4) (0.5) Amortization of prior service cost (2.2) (2.2) (2.2) Curtailment gain and special termination benefits (6.8) -- -- - ---------------------------------------------------------------------------- Net periodic postretirement (benefit) cost $ (2.1) $ 4.6 $ 4.1 ============================================================================
The Company has elected to apply the provisions of APB No. 25 (Accounting Principles Board Opinion No. 25) in accounting for its stock-based compensation plans, and thus compensation cost is not generally required to be recognized for the Company's stock options in the financial statements. Net loss and loss per share after the pro forma effect of recognizing compensation cost based on an instrument's fair value at the date of grant, consistent with Statement No. 123, were as follows:
2002 2001 2000 - ------------------------------------------------------------------------------ Net (loss) income after effect of Statement No. 123 $ (318.5) $ (13.2) $ 190.8 (Loss) income per share - diluted $ (6.03) $ (0.25) $ 3.54 (Loss) income per share - basic $ (6.03) $ (0.25) $ 3.58
WEIGHTED AVERAGE ASSUMPTIONS FOR OPTIONS AWARDED DURING 2002 2001 2000 - ------------------------------------------------------------------------ Dividend yield -- 0.4% 0.5% Expected volatility/(1)/ 24.38% to 61.09% 40.16% 37.60% Risk-free interest rate/(1)/ 1.65% to 1.81% 1.74% 5.03% Expected lives range (in years) 2.5 to 5 2.5 to 7 2.5 to 7
(1) During 2002, due to increased variations in the monthly expected volatility and risk-free interest rates, the Company utilized averages as of the date of each grant in 2002 for the expected volatility and risk-free interest rate assumptions. This change resulted in a range of assumptions. Prior to 2002, the Company utilized an annual estimate for these assumptions.
The following table summarizes information about employee options outstanding and exercisable at December 31, 2002.
During 2002, 2001 and 2000, the Company granted shares of nonvested stock to eligible employees, which vest after three years of continuous employment. During 2002, 2001 and 2000, the Company also granted shares of nonvested stock to certain agents, which vest 60% after three years, and 20% per year thereafter or after three years of continuous service. The following table summarizes information about employee and agent nonvested stock.
The Company recognizes compensation expense related to nonvested shares over the vesting period on a pro rata basis. As a result, the Company recognized $0.9 million, $7.2 million and $5.3 million of compensation cost in 2002, 2001 and 2000 respectively. The expense in 2002 reflects net benefits of $6.0 million resulting from the termination of nonvested stock grants which were previously granted to the President of the Company and other employees whose positions were eliminated in 2002 (see Note 3 - Significant Transactions). In October 2000, the Company granted 500,250 stock appreciation rights to certain employees, payable after December 31, 2001. These rights provided for stock or cash awards to participants based upon the appreciation, if any, of the Company's stock from October 2, 2000 through December 31, 2001, the vesting period. Compensation costs associated with these rights were recorded over the vesting period and were $(0.7) million and $0.7 million in 2001 and 2000, respectively.
The Company offers financial products and services in two major areas: Risk Management and Asset Accumulation. Within these broad areas, the Company conducts business principally in three operating segments. These segments are Risk Management, Allmerica Financial Services, and Allmerica Asset Management. In accordance with Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information," the separate financial information of each segment is presented consistent with the way results are regularly evaluated by the chief operating decision makers in deciding how to allocate resources and in assessing performance. A summary of the Company's reportable segments is included below. The Risk Management Segment manages property and casualty operations through two lines of business based upon product and identified as Personal Lines and Commercial Lines. Personal Lines include property and casualty coverages such as personal automobile, homeowners and other
personal policies, while Commercial Lines include property and casualty coverages such as workers' compensation, commercial automobile, commercial multiple peril and other commercial policies. Prior to 2002, the Risk Management segment managed its business through three distribution channels identified as Standard Markets, Sponsored Markets and Specialty Markets. The Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. 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. On September 27, 2002, the Company announced plans to consider strategic alternatives, including a significant reduction of sales of proprietary variable annuities and life insurance products. Subsequently, the Company ceased all new sales of proprietary variable annuities and life insurance products. After September 30, 2002, the AFS business consists of two components. First, the segment includes its independent broker dealer, VeraVest Investments, Inc., formerly "Allmerica Investments, Inc." ("VeraVest"), which distributes third-party investment and insurance products. The Company has entered into agreements with leading investment product and insurance providers and is seeking additional alliances whereby these providers would compensate the Company for non-proprietary product sales by VeraVest's registered representatives. Second, this segment will retain and service existing variable annuity and variable universal life accounts, as well as its remaining traditional life and group retirement accounts, which were issued by its life insurance subsidiaries, AFLIAC and FAFLIC. Through its Allmerica Asset Management segment, prior to September 2002, FAFLIC offered GICs. GICs, also referred to as funding agreements, are investment contracts with either short-term or long-term maturities, which are issued to institutional buyers or to various business or charitable trusts. Declining financial strength ratings from various rating agencies during 2002 resulted in GIC contractholders terminating all remaining short-term funding agreements and made it impractical to continue selling new long-term funding agreements. Furthermore, the Company retired certain long-term funding agreements, at discounts, during the fourth quarter of 2002 (see Note 3 - Significant Transactions). This segment continues to be a Registered Investment Advisor providing investment advisory services, primarily to affiliates and to third parties, such as money market and other fixed income clients through its subsidiary, Opus Investments, Inc. (formerly "Allmerica Asset Management, Inc."). Additionally, during 2002, the Company transferred management of AMGRO, Inc., the Company's property and casualty insurance premium financing business, to this segment, which was previously part of the Risk Management segment. In addition to the three operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those related to certain officers and directors, technology, finance, human resources and legal. Management evaluates the results of the aforementioned segments based on a pre-tax and pre-minority interest basis. Segment (loss) income is determined by adjusting net income for 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 (loss) 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, which in each case, are neither normal nor recurring. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of segment (loss) income enhances understanding of the Company's results of operations by highlighting net (loss) income attributable to the normal, recurring operations of the business. However, segment (loss) income should not be construed as a substitute for net (loss) income determined in accordance with generally accepted accounting principles.
Segment revenues: Risk Management $ 2,498.7 $ 2,454.8 $ 2,307.7 Asset Accumulation Allmerica Financial Services 854.7 826.5 867.2 Allmerica Asset Management 127.2 155.2 149.2 - ------------------------------------------------------------------------------- Subtotal 981.9 981.7 1,016.4 - ------------------------------------------------------------------------------- Corporate 5.0 6.7 6.3 Intersegment revenues (10.3) (7.5) (7.0) - ------------------------------------------------------------------------------- Total segment revenues 3,475.3 3,435.7 3,323.4 - ------------------------------------------------------------------------------- Adjustments to segment revenues: Net realized losses (162.3) (123.9) (140.7) Other item 3.6 -- -- - ------------------------------------------------------------------------------- Total revenues $ 3,316.6 $ 3,311.8 $ 3,182.7 =============================================================================== Segment income (loss) before federal income taxes and minority interest: Risk Management $ 184.3 $ 93.5 $ 190.0 Asset Accumulation Allmerica Financial Services (625.0) 143.0 222.8 Allmerica Asset Management 24.4 20.7 22.5 - ------------------------------------------------------------------------------- Subtotal (600.6) 163.7 245.3 - ------------------------------------------------------------------------------- Corporate (63.5) (63.8) (60.8) - ------------------------------------------------------------------------------- Segment (loss) income before federal income taxes and minority interest (479.8) 193.4 374.5 - ------------------------------------------------------------------------------- Adjustments to segment income: Net realized investment losses, net of amortization (137.4) (121.3) (135.2) Gain from retirement of trust instruments supported by funding obligations 102.6 -- -- Loss from sale of universal life business (31.3) -- -- Losses from selected property and casualty exited agencies, policies, groups, and programs -- (68.3) -- Gains (losses) on derivative instruments 40.3 (35.2) -- Voluntary pool losses -- (33.0) -- Restructuring costs (14.8) (2.7) (20.7) Other items (0.8) 7.7 -- - ------------------------------------------------------------------------------- (Loss) income from continuing operations before federal income taxes and minority interest $ (521.2) $ (59.4) $ 218.6 ===============================================================================
Risk Management/(1)/ $ 6,056.1 $ 6,239.8 $ 215.1 $ 199.0 Asset Accumulation Allmerica Financial Services 18,910.7 21,113.0 1,027.1 1,585.2 Allmerica Asset Management 1,559.8 2,829.3 -- -- - -------------------------------------------------------------------------------- Subtotal 20,470.5 23,942.3 1,027.1 1,585.2 Corporate and intersegment eliminations (8.6) 154.0 -- -- - -------------------------------------------------------------------------------- Total $ 26,518.0 $ 30,336.1 $ 1,242.2 $ 1,784.2 ================================================================================
(1) Includes assets related to the Company's discontinued operations of $290.4 million and $397.6 million at December 31, 2002 and 2001, respectively.
In the normal course of business, the Company seeks to reduce the losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance transactions are accounted for in accordance with the provisions of Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of
Life and accident and health insurance premiums: Direct $ 85.7 $ 89.1 $ 94.3 Assumed 0.6 0.7 0.7 Ceded (36.7) (38.2) (41.0) - ------------------------------------------------------------------------------- Net premiums $ 49.6 $ 51.6 $ 54.0 =============================================================================== Property and casualty premiums written: Direct $ 2,478.8 $ 2,510.6 $ 2,391.7 Assumed 66.6 52.7 63.5 Ceded (279.6) (285.6) (303.6) - ------------------------------------------------------------------------------- Net premiums $ 2,265.8 $ 2,277.7 $ 2,151.6 =============================================================================== Property and casualty premiums earned: Direct $ 2,487.4 $ 2,438.6 $ 2,297.8 Assumed 61.7 53.5 66.8 Ceded (278.6) (293.7) (299.8) - ------------------------------------------------------------------------------- Net premiums $ 2,270.5 $ 2,198.4 $ 2,064.8 =============================================================================== Life and accident and health insurance and other individual policy benefits, claims, losses and loss adjustment expenses: Direct $ 542.0 $ 463.0 $ 455.3 Assumed 6.1 0.3 0.3 Ceded (31.8) (46.1) (35.1) - ------------------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $ 516.3 $ 417.2 $ 420.5 =============================================================================== Property and casualty benefits, claims, losses and loss adjustment expenses: Direct $ 1,817.2 $ 2,026.4 $ 1,819.5 Assumed 79.2 91.4 68.1 Ceded (210.7) (281.9) (326.3) - ------------------------------------------------------------------------------- Net policy benefits, claims, losses and loss adjustment expenses $ 1,685.7 $ 1,835.9 $ 1,561.3 ===============================================================================
For the Years Ended December 31 2002 2001 2000 - ---------------------------------------------------------------------------- (In millions)
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. As a result, the Company determined that the DAC asset related to one distribution channel for its annuity business exceeded the present value of its total expected gross profits. Therefore, the Company recognized a permanent impairment of its DAC asset of $159.0 million related to this item. Additionally, the Company recognized approximately $203 million of additional amortization related to the impact of the equity market on future gross profits of the Company's life insurance and annuity products and approximately $200 million of additional amortization related to the changes in several actuarial estimates related to the Company's life insurance and annuity products. Also, in 2002, the Company recognized a permanent impairment related to its universal life DAC asset of $155.9 million due to the sale of that business. During 2001, the Company implemented an in-force trail commission program on certain annuity business previously written by qualifying agents. This program provided for the election of a trail commission on in-force business in exchange for the buyout of deferred commissions.
Reserve for losses and LAE, beginning of year $ 2,921.5 $ 2,719.1 $ 2,618.7 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,682.1 1,708.3 1,634.9 Increase (decrease) in provision for insured events of prior years/(1)/ 6.4 107.4 (87.4) Losses related to selected property & casualty exited agencies, policies, groups & programs, for current year -- 12.1 -- - ---------------------------------------------------------------------------- Total incurred losses and LAE 1,688.5 1,827.8 1,547.5 - ---------------------------------------------------------------------------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 898.0 892.8 870.2 Losses and LAE attributable to insured events of prior years 763.6 780.3 703.8 - ---------------------------------------------------------------------------- Total payments 1,661.6 1,673.1 1,574.0 - ---------------------------------------------------------------------------- Change in reinsurance recoverable on unpaid losses 13.3 47.7 126.9 - ---------------------------------------------------------------------------- Reserve for losses and LAE, end of year $ 2,961.7 $ 2,921.5 $ 2,719.1 ============================================================================
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. Reserves established for current year losses and LAE in 2002 and 2001 consider the factors that resulted in the favorable development of prior years' loss and LAE reserves during 2000 and earlier years. Accordingly, current year reserves are modestly lower, relative to those initially established for similar exposures in years prior to 2001. Although the Company does not specifically underwrite policies that include asbestos, environmental damage and toxic tort liability, the Company may be required to defend such claims. The table below summarizes direct business asbestos and environmental reserves (net of reinsurance and excluding pools):
In 1997, a lawsuit on behalf of a putative class was instituted against the Company alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In November 1998, the Company and the plaintiffs entered into a settlement agreement and in May 1999, the Federal District Court in Worcester, Massachusetts approved the settlement agreement and certified the class for this purpose. AFC recognized a $31.0 million pre-tax expense in 1998 related to this litigation. The Company recognized pre-tax benefits of $2.5 million and $7.7 million in 2002 and 2001, respectively, resulting from the refinement of cost estimates. Although the Company believes that it has appropriately recognized its obligation under the settlement, this estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers. The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the Company's opinion, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements.
The quarterly results of operations for 2002 and 2001 are summarized below:
During the fourth quarter of 2002, the Company recognized a gain from the retirement of trust instruments supported by funding obligations of $66.7 million, net of taxes (see Note 3 - Significant Transactions). In addition, the Company recognized after-tax charges of $20.3 million and $9.6 million related to the loss from the sale of its universal life insurance business and the restructuring of its AFS segment, respectively (see Note 3 - Significant Transactions). During the fourth quarter of 2001, the Company recognized after-tax charges of $44.4 million and $21.5 million related to the exit of selected property and casualty agencies, policies, groups and programs, and to voluntary pool environmental losses, respectively. (see Note 20 - Liabilities for Outstanding Claims, Losses and Loss Adjustment Expenses). In addition, the Company recognized losses on derivative instruments of $24.4 million, net of taxes, in the fourth quarter of 2001, primarily as a result of hedge ineffectiveness (see Note 4 - Investments, Cash Flow Hedges).