Hanover and Citizens lease offices throughout the country for branch sales, underwriting and claims processing functions.
(2) In 2003, long-term debt includes the mandatorily redeemable preferred securities of a subsidiary trust (Minority interest) in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement No. 150”). Preferred dividends associated with these instruments have been reflected in interest expense, which is included in other operating expenses, in 2003. Reclassification of prior year amounts is not permitted under Statement No. 150.
Our results of operations include the accounts of The Hanover Insurance Company (“Hanover”) and Citizens Insurance Company of America (“Citizens”), our principal property and casualty companies. Our results of operations also include the accounts of Allmerica Financial Life Insurance and Annuity Company (“AFLIAC”) and First Allmerica Financial Life Insurance Company (“FAFLIC”), our principal life insurance and annuity companies, and certain other insurance and non-insurance subsidiaries. Hanover and Citizens are domiciled in the states of New Hampshire and Michigan, respectively, while AFLIAC and FAFLIC are both domiciled in Massachusetts.
Despite our ratings downgrades, we were able to essentially maintain existing levels of our property and casualty in-force business and we obtained rate increases in a number of our lines of business. During the second half of 2003, we completed a strategic review of our business and concluded that our efforts should be concentrated on the property and casualty segment. As such, returning our property and casualty A.M. Best ratings to the “A-” level continued to be a key focus, since we believe these ratings are important to achieve profitable growth in the future. In January 2004, A.M. Best upgraded our ratings in our property and casualty business to “A-” and also upgraded our life insurance businesses.
Our earnings in the property and casualty business decreased primarily due to an adverse arbitration decision related to a reinsurance pool in which we formerly participated, as well as increased catastrophe losses. We also strengthened our reserves related to our Workers’ Compensation line. We experienced a modest profit in our life business in 2003 as compared to the large loss experienced in the prior year. The loss in the prior year reflects the significant DAC and related writeoffs resulting from our cessation of sales of our proprietary life and annuity products.
Our Property and Casualty segment manages property and casualty operations through two lines of business based upon product and identified as Personal Lines and Commercial Lines. Personal Lines includes property and casualty coverages such as personal automobile, homeowners and other personal policies, while Commercial Lines includes property and casualty coverages such as workers’ compensation, commercial automobile, commercial multiple peril and other commercial policies.
Our AFS segment manages a block of existing variable annuity, variable universal life and traditional life insurance products, as well as certain group retirement products. During 2003, we also operated an independent broker/dealer business, which was conducted through VeraVest Investments, Inc. (“VeraVest”). VeraVest distributed third party investment and insurance products to retail customers until the fourth quarter of 2003 when such sales were terminated. In addition, this segment actively manufactured and sold variable annuities, variable universal life and traditional life insurance products until the fourth quarter of 2002.
The Asset Management segment provides investment advisory services, primarily to affiliates and to third parties, such as insurance companies’ retirement plans and other fixed income clients, through its subsidiary, Opus Investment Management, Inc., a registered investment advisor. This segment also includes AMGRO, Inc. (“AMGRO”), our property and casualty insurance premium financing business. Prior to the fourth quarter of 2002, FAFLIC offered Guaranteed Investment Contracts (“GICs”). GICs, also referred to as funding agreements, are investment contracts with either short-term or long-term maturities and are issued to institutional buyers or to various business or charitable trusts. Subsequently, we ceased selling GICs, short-term funding agreements were terminated and we retired certain long-term funding agreements, at discounts.
In addition, as a result of adopting Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement No. 150”), we have reclassified dividends on our Capital Securities to interest expense in the Corporate segment (see Corporate Segment). In accordance with Statement of Financial Accounting Standards No. 131, Disclosure about Segments of an Enterprise and Related Information (“Statement No. 131”), we have restated prior periods to reflect current presentation.
AFS segment income in 2003 includes charges of $11.5 million relating to the impairment of assets resulting from our decision to discontinue the retail operations of VeraVest. The 2002 loss in the AFS segment reflects net charges of $698.3 million resulting from the cumulative effect of the significant, persistent decline in equity market values, ratings downgrades (see Rating Agency Actions), and our decision to cease sales of proprietary life insurance and annuity products (see Segment Results-Allmerica Financial Services). 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, we recognized impairments of capitalized technology costs associated with variable products totaling $29.8 million.
The decrease in the AFS segment reflects the charges described above. The increase in Property and Casualty 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.
In 2003, we recognized a gain on the retirement of trust instruments supported by funding obligations of $3.7 million, net of taxes, compared with a gain of $66.7 million in 2002. These gains resulted from the retirement of certain long-term funding obligations at discounts (see Significant Transactions - Gain on Retirement of Funding Obligations).
we recognized a loss of $20.3 million, net of taxes, related to this transaction.
During 2001, we 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 we evaluated our approximately 2,500 agencies in the Property and Casualty segment and identified 691 agencies that did not meet certain profitability standards or were not strategically aligned with us. For these agents, we either terminated the relationship or restricted the agent’s ability to offer commercial lines policies. Certain groups and specialty programs were also discontinued (see Property and Casualty - Selected Property & Casualty Exited Agencies, Policies, Groups & Programs).
The following is our discussion and analysis of the 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 our core operations including realized gains and losses.
Property and Casualty segment income decreased $40.7 million, or 22.1%, to $143.6 million for the year ended December 31, 2003, compared to $184.3 million in 2002. The decrease in segment income is primarily attributable to an increase in adverse development on prior years’ reserves of $34.0 million, to $40.4 million of adverse development for the year ended December 31, 2003, from $6.4 million of adverse development for the year ended December 31, 2002. This increase was primarily due to a charge of $21.9 million from an adverse arbitration decision related to a single large property claim within a voluntary insurance pool. We exited this pool in 1996. In addition, prior years’ workers’ compensation reserves developed adversely, partially offset by favorable development in commercial multiple peril reserves. Catastrophe losses increased $28.1 million, to $59.4 million for the year ended December 31, 2003, compared to $31.3 million for the same period in 2002. Catastrophe losses in 2002 were unusually low. Additionally, segment income for the year ended December 31, 2003 was negatively affected by a $25.6 million increase in policy acquisition and other operating expenses, primarily due to an increase in commissions and expenses. Commissions and expenses increased due to special commission and financial guarantee programs designed to minimize the impact to our commercial lines business from the ratings downgrades in 2002. Policy acquisition and other operating expenses also increased due to higher employee benefits and technology costs. Net investment income decreased $18.5 million for the year ended December 31, 2003 compared to the same period in 2002. Partially offsetting these negative items was a benefit from an estimated $91 million of net premium rate increases. Net premium rate increases reflect rate actions, discretionary pricing adjustments, inflation and changes in exposure, net of the estimated impact of loss inflation and policy acquisition costs. In addition, a 4.3% decrease of policies in force since December 31, 2002 contributed to declines in premiums and losses, as well as segment income.
Property and Casualty segment income increased $90.8 million, or 97.1%, to $184.3 million for the year ended December 31, 2002, compared to $93.5 million in 2001. The increase in segment income is primarily attributable to an estimated $80 million of net premium rate increases. In addition, development on prior years’ reserves improved $27.2 million, to $6.4 million of adverse development for the year ended December 31, 2002 from $33.6 million of adverse development for the year ended December 31, 2001. The favorable change in reserve development in 2002 is primarily the result of improving commercial lines claim frequency, partially offset by adverse development in the personal automobile line. Net catastrophe losses decreased $19.7 million, to $31.3 million for the year ended December 31, 2002. In addition, losses and LAE decreased during 2002 due to approximately $17 million of decreased current accident year claims frequency primarily in the workers’ compensation, commercial automobile, commercial multi peril and homeowners lines. Partially offsetting these items is a decrease in net investment income of $14.0 million. Policy acquisition expenses increased as a result of the variable expenses related to the aforementioned premium rate increases, primarily commissions and premium taxes. In addition, policy acquisition expenses increased $10.7 million as a result of higher premium tax and commission rates during 2002. Other income decreased $8.4 million for the year ended December 31, 2002, primarily due to the decline in finance charge income as a result of the transfer of AMGRO from the Property and Casualty segment to the Asset Management segment.
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. We review the operations of this business based upon statutory results.
In 2002, we reorganized our Property and Casualty segment. Under the new structure, the Property and Casualty 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.
(1) Statutory loss ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio reflects incurred claims compared to premiums earned. The 2001 ratios exclude the effect of agency actions discussed in “Selected Property & Casualty Exited Agencies, Policies, Groups & Programs” and the voluntary pool losses discussed in “Asbestos and Environmental Reserves”.
Personal lines’ net premiums written increased $32.1 million, or 2.2%, to $1.5 billion for the year ended December 31, 2003. This is primarily the result of an increase of $35.0 million, or 9.9% in the homeowners line. Partially offsetting this increase is a decrease of $1.6 million in the personal automobile line. The increase in the homeowners line is primarily the result of an average net premium rate increase of 11.7% since December 31, 2002. The decrease in the personal automobile line resulted primarily from a decrease of 5.1% in policies in force, partially offset by an average net premium rate increase of 5.7% since December 31, 2002.
Personal lines’ statutory underwriting results declined $3.6 million to an underwriting loss of $89.3 million for the year ended December 31, 2003. The increase in underwriting loss is primarily due to an increase in claim frequency and severity due to the harsher winter weather during the first quarter, especially in the Northeast. In addition, catastrophe losses increased $9.9 million, to $35.6 million for the year ended December 31, 2003, compared to $25.7 million for the same period in 2002. Also, we experienced an increase in severity of personal automobile medical costs related to personal injury protection coverage in Michigan. Underwriting results were also unfavorably affected by an $8.7 million increase in adverse development during 2003 in the personal automobile line. Personal lines’ expenses increased due to the aforementioned increase in commissions, employee benefits and technology costs. Partially offsetting these items is an estimated $39 million of net premium rate increases.
Commercial lines’ net premiums written decreased $65.3 million, or 8.3%, to $717.8 million for the year ended December 31, 2003. This decrease is primarily the result of the agency management actions we took in 2001 and our continuing re-underwriting efforts (see Selected Property & Casualty Exited Agencies, Policies, Groups & Programs). As a result of these actions, policies in force decreased 9.1%, 3.6% and 2.8% in the commercial automobile, workers’ compensation, and commercial multiple peril lines, respectively, since December 31, 2002. We do not expect these actions to have a material impact in 2004. This decrease is also partially due to lower retention rates in certain lines as a result of the ratings downgrades and a reduction in average policy premium, as we wrote a smaller proportion of large to medium sized accounts compared to medium to small policies. We think of small commercial policies as having premiums less than $25,000, medium policies as having premiums greater than $25,000 but less than $100,000, and large policies as having premiums greater than $100,000. Partially offsetting these items were net premium rate increases in all of the commercial lines since December 31, 2002.
Commercial lines’ underwriting results decreased $12.7 million to an underwriting gain of $2.4 million for the year ended December 31, 2003. The decrease in underwriting results is primarily attributable to the aforementioned charge of $21.9 million from the voluntary pool arbitration decision. In addition, catastrophe losses increased $18.2 million, to $23.8 million for the year ended December 31, 2003, compared to $5.6 million for the same period in 2002. Development on prior years’ reserves declined $16.6 million to $6.7 million of favorable development for the year ended December 31, 2003, compared to $23.3 of favorable development for the same period in 2002. This decline in commercial lines’ favorable development is primarily due to adverse development in the workers’ compensation line, partially offset by favorable development in the commercial multiple peril line. Commercial lines’ expenses increased due to the aforementioned commissions and financial guarantee expenses, as well as employee benefits and technology costs. Partially offsetting these items is an estimated $47 million of net premium rate increases.
Personal lines’ net premiums written increased $98.9 million, or 7.1%, to $1.5 billion for the year ended December 31, 2002. This is primarily the result of increases of $59.1 million, or 5.7%, and $40.4 million, or 13.0%, in the personal automobile and homeowners lines, respectively. The increase in the personal automobile line is primarily the result of 6.1%, 5.9% and 4.4% net premium rate increases in Michigan, New York and New Jersey, respectively, since December 31, 2001. The increase in the homeowners line resulted primarily from net premium rate increases of 25.5% and 9.7% in Michigan and New York, respectively. Policies in force for all personal lines decreased 1.4% since December 31, 2001.
There is greater inherent uncertainty in estimating insurance reserves for certain types of property and casualty insurance lines, particularly workers’ compensation and other liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability and losses may be made. In addition, the technological, judicial, regulatory and political climates involving these types of claims change regularly. We maintain a practice of significantly limiting the issuance of long-tailed other liability policies, including directors and officers (“D&O”) liability, errors and omissions (“E&O”) liability and medical malpractice liability. The industry has experienced recent adverse loss trends in these lines of business.
We regularly update our reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and loss event occurred. These types of subsequent adjustments are described as “prior year reserve development”. Such development can be either favorable or unfavorable to our financial results and may vary by line of business.
Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation varies by product. Our property and casualty insurance premiums are established before the amount of losses and LAE and the extent to which inflation may affect such expenses are known. Consequently, we attempt, in establishing rates and reserves, to anticipate the potential impact of inflation in the projection of ultimate costs. Recently, we have experienced increasing medical costs associated with personal automobile personal injury protection claims, particularly in Michigan. This increase is reflected in our reserve estimates, but continued increases could contribute to increased losses and LAE in the future.
We regularly review our reserving techniques, our overall reserving position and our reinsurance. Based on (i) our review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) our review of per claim information, (iii) our historical loss experience and that of the industry, (iv) the relatively short-term nature of most policies written by us and (v) our internal estimates of required reserves, we believe that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on our results of operations and financial position.
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were increased by $40.4 million, $6.4 million and $107.4 million in 2003 and 2002 and 2001, respectively.
The table below summarizes the reserve for losses and LAE by line of business.
During the years ended December 31, 2003, 2002, and 2001, estimated loss reserves for claims occurring in prior years developed unfavorably by $74.5 million, $36.9 million and $146.6 million, respectively. The unfavorable loss reserve development in 2003 is primarily the result of the $21.9 million charge in the other commercial line resulting from the aforementioned voluntary pool arbitration decision. Additionally, loss reserves for the workers’ compensation line were increased by $15.7 million in the fourth quarter of 2003, primarily as a result of increasing medical costs. Loss reserve development was also affected by an increase in personal automobile claim severity related to medical settlements in Michigan. Because these settlements have risen beyond previous estimates, reserve increases have been recognized in the period in which the information was obtained. Partially offsetting these items was favorable development in the commercial multiple peril line due to improved claim frequency in the 2002 accident year resulting from our re-underwriting efforts.
The adverse development in both 2002 and 2001 is primarily the result of increased claim severity related to personal automobile medical settlements in Michigan. The increase in the prior year reserve estimates for other commercial lines during 2002 is primarily due to the recognition of approximately $5 million in additional reserves for asbestos claims in the Excess and Casualty Reinsurance Association (“ECRA”) voluntary pool.
of loss reinsurance treaty, which provides coverage for accident year 1999 (see Reinsurance section below). Under the aggregate excess of loss reinsurance treaty, we 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, we recorded an impairment to the DAC asset of $3.4 million. This resulted in an increase in policy acquisition expenses and a decrease in our 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 segment income due to our belief that this item is not indicative of our core operations. Actual future losses from the exited business may vary from our estimate.
Catastrophe reinsurance serves to protect the ceding insurer from significant losses arising from a single event such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. Under our catastrophe reinsurance agreements, we ceded $0.4 million of losses in 2003 and $1.1 million of losses in 2002, as a result of deterioration in the 2001 accident year, and $20.3 million of losses in 2001.
In 1999, we entered into a whole account aggregate excess of loss reinsurance agreement, which provides coverage for accident year 1999 for our property and casualty business. The program covered losses and allocated LAE, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. As a result of this agreement, we recognized net expenses of $5.9 million and $3.9 million for the years ended December 31, 2003 and 2002 and a net benefit of $0.2 million for the year ended December 31, 2001, based on estimates of losses and allocated LAE for accident year 1999. The effect of this agreement on the results of operations in future periods is not currently determinable, as it will be based both on future losses and allocated LAE for accident year 1999.
In addition, in the fourth quarter of 2003, we discontinued the retail sales operations of our broker/dealer, VeraVest, which sold non-proprietary products through our former life insurance and annuity agency channel. During the year ended December 31, 2003, we recognized $11.5 million of asset impairments as a result of this action. Of this amount, $8.1 million relates to receivables and fixed assets and $3.4 million relates to capitalized technology costs. We also incurred a pre-tax charge of $21.9 million for severance and other expenses related to exiting our broker/dealer business and expect to incur an additional pre-tax charge of approximately $3 million to $5 million, primarily in the first quarter of 2004. We expect that brokerage and investment management income and brokerage and investment management variable expenses will be significantly lower than in the past. Operating expenses associated with this business will also be lower primarily due to lower employee related costs. In addition, this decision may have a negative impact on persistency and financial results in the policies that were sold through our former agency distribution channel. Although we believe that our current, overall
DAC assumptions remain reasonable, we cannot provide assurance that persistency in this channel will not differ from our assumptions, and therefore DAC amortization may be affected in future periods.
(1) Brokerage and investment management income primarily reflects fees earned from the distribution of non-proprietary insurance and investment products as well as the management of assets for proprietary products through VeraVest. Variable expenses related to this business primarily consist of commissions and subadvisory fees.
Our decision to cease sales of proprietary products and ratings downgrades during 2002 resulted in a substantial increase in redemptions of variable annuities, beginning in the fourth quarter of 2002. Annuity redemptions in 2003 were $2.5 billion compared to $2.8 billion in 2002, of which $1.2 billion occurred during the fourth quarter of 2002. Additional surrender fees received in 2003 were largely offset by additional DAC amortization, reflecting our current DAC assumptions, which mandate a higher amortization level as a percentage of gross profits.
Other proprietary fees decreased $95.5 million, to $252.4 million in 2003, primarily due to the sale of our universal life insurance business (see Significant Transactions - Sale of Universal Life Insurance Business) and to lower average variable annuity asset levels. Average variable annuity asset levels declined primarily as a result of the cumulative redemptions during the prior twelve months. Net investment income declined $84.9 million, to $199.0 million in 2003, primarily due to lower average invested general account assets. This resulted primarily from increased redemptions and the transfer of assets related to the sale of the universal life insurance business. In addition, net investment income decreased due to the replacement of high-yield investments with lower yielding, higher quality fixed income securities (see Investment Portfolio).
Brokerage and investment management income increased $24.5 million, to $107.0 million in 2003. Prior to our discontinuance in the fourth quarter of 2003 of the retail sales operations of our broker/dealer, increased sales of non-proprietary products resulted in additional brokerage income of $35.3 million. The fees generated from these sales were
Policy benefits in 2003 decreased $242.6 million, to $259.0 million. During 2002, based on our revised expectations for the long-term cost of GMDB, we recorded a reserve increase of $106.7 million. Excluding the effect of the reserve adjustments in 2002, policy benefits would have decreased $135.9 million. This decline is primarily the result of the sale of our universal life insurance business and lower expenses related to GMDB. Additionally, policy benefits decreased due to a decline in interest credited on general account assets resulting from lower average general account assets. Expenses related to GMDB, excluding the aforementioned $106.7 million reserve adjustment, declined $31.1 million, from $77.1 million in 2002 to $46.0 million in 2003. See also “Guaranteed Minimum Death Benefits” below.
Policy acquisition expenses decreased $533.3 million, to $140.8 million in 2003. As discussed in detail in the “Deferred Acquisition Costs” section below, during 2002, we recorded adjustments to DAC amortization totaling $629.4 million. In addition, as a result of the $106.7 million GMDB reserve adjustment mentioned above, DAC amortization was reduced by $67.6 million in 2002. These adjustments during 2002 represent more than the entire difference from the current year. In fact, absent these adjustments, policy acquisition expenses would have increased $28.5 million in 2003 versus 2002. The primary reason for this $28.5 million adjusted increase in DAC amortization is that we now apply a higher amortization percentage, as mandated by our current DAC assumptions, to current gross profits generated by existing annuity accounts. Higher amortization percentages have been used since the fourth quarter of 2002. Additionally, we had incremental DAC amortization expenses related to redemptions, as described above. These increases in DAC amortization were partially offset by additional items resulting in a $12.9 million net decrease in DAC amortization in 2003. See “Deferred Acquisition Costs” below for a detailed discussion of these adjustments to the DAC asset in 2003.
Other operating expenses decreased $39.8 million, to $208.3 million in 2003. The decrease is primarily due to a $29.8 million impairment expense in 2002 related to technology used in our proprietary variable annuity and variable universal life business. Of this amount, $29.1 million related to capitalized software development costs. The remaining $0.7 million related to technology hardware. In 2003, we recognized the aforementioned $11.5 million charge related to asset impairments resulting from our decision to discontinue retail operations of VeraVest. Of the $11.5 million, $8.1 million relates to receivables and fixed assets and $3.4 million relates to software costs. See “Technology Costs” below for a detailed discussion of these items. Excluding the asset impairments in 2003 and 2002, other operating expenses would have decreased $21.5 million. This decrease reflects lower distribution and insurance operation expenses, partially offset by acquisition costs that we had been allowed to defer in 2002, as they related to proprietary annuity and insurance sales. We no longer offer these products, so we are no longer deferring these types of costs.
Segment results deteriorated $768.0 million, to a loss of $625.0 million during 2002. This loss reflects the aforementioned net charges of $698.3 million. During 2002, fees from surrenders increased $30.3 million, to $61.9 million as a result of increased annuity redemptions, primarily in the fourth quarter as a result of the ratings downgrades. This increase was partially offset by a $12.1 million decline in all other fees related to proprietary products, primarily resulting from lower average invested assets.
As discussed further in “Critical Accounting Policies”, DAC for variable life products and variable annuities consists of commissions, underwriting costs and other costs that are amortized in proportion to the estimated total gross profits from such products. We estimate that these costs will be earned over the expected life of the insurance contracts to which such costs relate. To estimate the profitability of our insurance contracts, we establish and apply 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). We regularly evaluate these assumptions to determine whether recent experience or anticipated trends merit adjustments to such assumptions.
The aforementioned $629.4 million of DAC adjustments in 2002 consisted of six separate items. First, we anticipated that ratings downgrades (see Rating Agency Actions) and our decision to cease new sales of proprietary life insurance and annuity products would unfavorably affect the persistency of then existing customer accounts. This resulted in the reduction of our estimate of future gross profits and $171.1 million of additional DAC amortization in 2002.
Fourth, we increased our assumptions related to the long-term cost of GMDB for variable annuity products (see the discussion of GMDB reserves below). The increased cost estimates affected our expectation of future gross profits, resulting in additional DAC amortization of $61.7 million in 2002.
Fifth, we changed our estimates of future fees from certain annuity contracts, which decreased amortization by $8.5 million in 2002.
Fourth, for all three distribution channels, we revised our estimate of persistency of variable annuity contracts. Overall, we now expect better persistency than we had anticipated previously in 2002. This is primarily the result of the significant decline in redemptions throughout 2003. Although we had anticipated that redemptions would moderate throughout the year, the degree of decline in 2003 was greater than expected and caused us to change our persistency expectations. This change resulted in a $20.2 million decrease in DAC amortization in 2003. Changes in persistency, including changes resulting from our decision to cease retail sales through VeraVest as described previously, may continue to affect DAC amortization in future periods.
Fifth, we revised our estimate of policy maintenance costs for both our life insurance contracts and our annuity products. This change resulted in $5.8 million of additional amortization in 2003.
To estimate the cost of the GMDB feature with respect to the profitability of the related insurance contract, we establish and apply various assumptions relating to the appreciation of related account assets, mortality and contract persistency, among other matters. We regularly evaluate these assumptions to determine whether recent experience or anticipated trends merit adjustments to such assumptions. The compounding effects of the significant market decline in 2002, the ratings downgrades, increased annuity surrenders and related AFS strategic business changes resulted in significantly decreased account values and persistency assumptions at September 30, 2002, which required us to reassess and increase our long-term cost of GMDB assumptions.
We have a policy of providing reserves for GMDB based on our best estimate of the long-term cost of GMDB. As of September 30, 2002, we reassessed our expectation of the long-term cost of GMDB in view of the then net amount at risk and revised persistency expectations, as well as the absence of additional deposits at the then current market levels. This resulted in revised expectations of the long-term cost of GMDB. We calculated a reserve of $106.7 million at September 30, 2002, and recognized this amount in policy benefits. This was partially offset by a reduction in DAC amortization of $67.6 million. It should be noted that including the aforementioned $106.7 million reserve increase, the total provision for GMDB recognized in policy benefits during 2002 was $183.8 million. Excluding the $106.7 million reserve, GMDB expenses increased $55.1 million to $77.1 million in 2002, as compared to $22.0 million in 2001. These amounts were partially offset by reduced DAC amortization of $38.2 million and $10.0 million in 2002 and 2001, respectively.
The following table provides a reconciliation of our beginning and ending reserve for GMDB utilizing generally accepted accounting principles. These reserves differ from the statutory GMDB reserves disclosed in the section
“Statutory Capital of Insurance Subsidiaries”, which are calculated using prescribed statutory accounting principles.
(2) We maintain a GMDB mortality reinsurance program covering the incidence of mortality on variable annuity policies. We pay the reinsurers monthly premiums based on variable annuity net amount at risk in exchange for reimbursement of the net amount at risk portion of qualified cash claims. We retain the market risk associated with the net amount at risk on the variable annuity business.
We will adopt in the first quarter of 2004 Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (“SOP 03-1”) effective January 1, 2004. SOP 03-1 provides guidance for, among other items, determining liabilities for GMDB costs. The determination of the GMDB reserve under SOP 03-1 is complex and requires various assumptions including, among other items, estimates of future market returns and expected contract persistency. Based on the equity market level as of December 31, 2003, we currently estimate that the impact of adopting SOP 03-1 will require us to record an additional $85 million to $95 million pre-tax charge to earnings during the first quarter of 2004, reflected in cumulative effect of a change in accounting principle in the Consolidated Statements of Income. This reflects adjustments to both our GMDB reserve and our DAC asset, as well as additional reserves required for our product features. Due to the inherent volatility of the reserve calculation required under SOP 03-1, we are unable to estimate the annual GMDB expense for 2004. Subsequent to the adoption of SOP 03-1, changes in the reserve will continue to be included in segment income.
We expect that the hedge program will partially offset the volatility associated with the GMDB reserve upon adoption of SOP 03-1. If the equity market declines, we believe that gains on the hedge derivatives will partially offset any increases in the GMDB reserve required under SOP 03-1. Alternatively, if the equity market rises, we expect a decrease in the GMDB reserve to be partially offset by losses from the hedge derivatives. However, we are uncertain as to the degree that the hedge program will partially offset the volatility associated with the GMDB reserve upon adoption of SOP 03-1.
In connection with the GMDB hedging program we incurred $8.4 million in pre-tax losses on the hedge contracts in 2003. These losses were partially offset by lower deferred acquisition cost amortization in 2003. These losses are the result of the increased equity market levels between December 3 and December 31, 2003. In 2003, these losses are included in losses (gains) on derivative instruments in the Consolidated Statements of Income and are not included in segment income. Beginning January 1, 2004, the results of the GMDB hedge contracts will be included in segment income.
During 2003, we recognized $3.4 million of asset impairments related to technology used for our distribution of non-proprietary products, reflected in other operating expenses. During 2002, we recognized $29.8 million of asset impairments related to technology used in our variable annuity and variable universal life business, reflected in other operating expenses. In light of the restructuring of our AFS business, we concluded that expected future cash flows do not support continued capitalization of the entire cost of these technology assets. Accordingly, we recognized the aforementioned permanent impairments in other operating expenses.
(1) Account values reflect market values as of January 1 of the year indicated.
Redemptions totaled $1.3 billion in the fourth quarter of 2002 and $1.0 billion in the first quarter of 2003, driven largely by the actions affecting AFS in 2002, and averaged approximately $500 million in the subsequent quarters of 2003. In addition, we could experience an increase in redemptions in our former Agency channel as a result of our decision to cease retail sales through VeraVest and terminate the contracts of the registered representatives who constituted our former Agency channel. Nevertheless, we believe that our current, overall DAC assumptions include reasonable redemption levels. However, we cannot provide assurance that ultimately redemptions will not differ from our assumptions. Therefore, DAC amortization may be adversely affected in future periods.
In addition to our review of segment income, beginning in 2003, we also utilize an alternative non-GAAP method of viewing this business and that of our Asset Management business. We adjust the combined segment income for both AFS and Asset Management for various non-cash items. We believe this measure allows for the review of the performance of this business based on the current cash operations. In addition, this measure provides us with information regarding cash flows of this business that we can use in assessing the funding requirements to support these operations and any excess cash the business may be generating. However, this measure does not reflect statutory earnings or increases in statutory surplus available to dividend from the life insurance companies. In addition, all dividends from our life insurance companies are subject to regulatory approval (see Liquidity and Capital Resources on pages 54 to 56 of this Annual Report on Form 10-K and Note 15-Dividend Restrictions on page 97 of this Annual Report on Form 10-K). The following table provides a reconciliation of segment income to segment income excluding certain non-cash items.
We adjust segment income for DAC because the cash payments related to the acquisition of the remaining business were made in prior years. Since we are no longer selling the products that generated these deferred costs, we do not expect any future cash payments associated with DAC. Additionally, we adjust segment income for the change in our GMDB reserve because this change represents the difference between the cash GMDB payments and the related expense reflected in segment income. The items excluded from segment income, including DAC amortization, the change in our GMDB reserve, depreciation and amortization of certain assets, and asset impairments may be significant in understanding and assessing our financial performance. Segment income excluding certain non-cash items, should not be construed as a substitute for segment income or net income determined in accordance with GAAP.
Segment loss increased $7.4 million, or 8.4%, to $95.5 million in 2003, and decreased $0.3 million, or 0.3%, to $88.1 million in 2002. Corporate overhead costs in 2003 included increased employee compensation and pension costs, while these costs in 2002 reflect lower employee compensation costs due to forfeited stock grants by our previous President as a result of his resignation. The continued decline in net investment income is principally due to lower average invested assets and to lower investment yields.
Interest expense for all periods relates to the interest paid on our Capital Securities and Senior Debentures. Prior to the adoption of Statement No. 150, interest expense on our Capital Securities was reflected as minority interest.
We held general account investment assets diversified across several asset classes, as follows:
Total investment assets decreased $630.5 million, or 6.9%, to $8.6 billion during 2003, primarily as a result of the settlement of payables associated with the sale of our universal life insurance business. Approximately $550 million of investment assets, with an amortized value of $525 million, were used for this settlement (see Significant Transactions - Sale of Universal Life Insurance Business). In addition, investment assets, particularly fixed maturities, declined as a result of annuity redemptions from the general account in the AFS segment and retirement of certain long-term funding agreements in the Asset Management segment. Mortgage loans decreased $84.7 million primarily due to increased prepayments and maturities of these investments, as well as our decision to discontinue investing new funds in these instruments.
Our 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 94.0% at December 31, 2003 and 90.5% at December 31, 2002 of our total fixed maturity portfolio.
The following table provides information about the credit quality of our fixed maturities at December 31, 2003 and 2002:
Although we expect to invest new funds primarily in cash, cash equivalents and investment grade fixed maturities, we may invest a portion of new funds in below investment grade fixed maturities or equity securities. The average yield on fixed maturities was 6.0% for the year ended December 31, 2003 and 6.7% for the year ended December 31, 2002. This decline reflects lower prevailing fixed maturity investment rates and an increased emphasis on purchasing higher credit quality fixed maturities during 2003, as compared to 2002. We expect that the lower prevailing fixed maturity investment rates reflected in the current interest rate environment will continue to negatively affect our investment yield.
We had $47.9 million of gross unrealized losses on fixed maturities and equity securities at December 31, 2003, as compared to $106.7 million at December 31, 2002. Approximately $9.9 million of the gross unrealized losses at December 31, 2003 relate to investment grade fixed maturity obligations of the U.S. Treasury, U.S. government and agency securities, states and political subdivisions, compared to $1.8 million at December 31, 2002. At both December 31, 2003 and 2002, substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s or Moody’s.
We view the gross unrealized losses of fixed maturities and equity securities as being temporary as it is our assessment that these securities will recover in the near-term. Furthermore, as of December 31, 2003, we had the intent and ability to retain such investments for a period of time sufficient to allow for this anticipated recovery in fair value. The risks inherent in our assessment methodology include the risk that, subsequent to the balance sheet date, market factors may differ from our expectations; we may decide to subsequently sell a security for unforeseen business needs; or changes in the credit assessment or equity characteristics from our original assessment may lead us 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 we would record a charge to earnings. Although unrealized losses are not reflected in the results of financial operations until they are realized or deemed “other than temporary”, the fair value of the underlying investment, which does reflect the unrealized loss, is reflected in our Consolidated Balance Sheets.
We use derivative financial instruments, primarily interest rate swaps, with indices that correlate to balance sheet instruments to modify our indicated net interest sensitivity to levels we deem appropriate. Specifically, for floating rate GIC liabilities that are matched with fixed rate securities, we manage the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. Additionally, we use exchange traded financial futures contracts to hedge against interest rate risk on the reinvestment of fixed maturities. Prior to September 2002, we used exchange traded financial futures contracts to hedge against interest rate risk on anticipated GIC sales and other funding agreements. We no longer offer funding agreements (see Description of Operating Segments).
The following tables for the years ended December 31, 2003 and 2002 provide information about our financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The tables present principal
During 2003, we terminated our interest rate swap contracts, due to the retirement of the remaining floating rate funding agreements at discounts. The following table for the year ended December 31, 2002 provides information about our derivative financial instruments, used for purposes other than trading, that are sensitive to changes in interest rates. The table presents 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.
A portion of our liabilities include a GMDB feature that provides annuity contract holders with a guaranteed minimum death benefit. This minimum death benefit is subject to equity market risk. On December 3, 2003, we implemented a hedging program to economically hedge against increased GMDB claims that could arise from declines in the equity market below levels at December 3, 2003. The program is designed to reduce the volatility in statutory capital levels from the effects of future equity market movements.
In 2003 and 2002, we retired $78.8 million and $548.9 million, respectively, of long-term funding agreement obligations at discounts. This resulted in gains of $5.7 million and $102.6 million in 2003 and 2002, respectively, which are reported as gains 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. In 2003, the net foreign currency transaction gain on the retired foreign-denominated funding agreements of $3.6 million was recorded as other income in the Consolidated Statements of Income. In 2002, 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 included in 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 $6.4 million and $14.1 million in 2003 and 2002, respectively, was included in net realized investment gains (losses) in the Consolidated Statements of Income.
Historically, our AFS segment offered fixed universal life insurance products through our former Agency distribution channel (see Allmerica Financial Services for a description of our former distribution channels). We sold substantially all of this business through a 100% coinsurance agreement which was effective December 31, 2002. Under the agreement, we ceded approximately $660 million of universal life insurance reserves in exchange for the transfer of approximately $550 million of investment assets with an amortized cost of approximately $525 million. At December 31, 2002, we recorded a loss from this transaction of $20.3 million, net of taxes. This loss consisted primarily of the aforementioned ceded reserves, asset transfers, a permanent impairment of the universal life deferred acquisition cost asset of $155.9 million and administrative expenses of approximately $10 million. On a statutory accounting basis, this transaction produced an increase in statutory surplus of approximately $109 million (see Statutory Capital of Insurance Subsidiaries). In 2003, we recorded income of $3.6 million, net of taxes, related to settlement of post-closing items on the transaction and we transferred cash and other investment assets to settle our net payable associated with the transaction.
The discussion and analysis of our financial condition and results of operations are based upon the consolidated financial statements. These statements have been prepared in accordance with GAAP, which requires us 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 we believe, affect the more significant judgments and estimates used in the preparation of our financial statements. Additional information about our significant accounting policies may be found in Note 1, “Summary of Significant Accounting Policies” on pages 69 to 76 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
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 our financial results.
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 our 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). Our 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 (see Segment Results - Allmerica Financial Services, Deferred Acquisition Costs, 2003, for a discussion on DAC sensitivity to the equity market).
At each balance sheet date, we evaluate the historical and expected future gross profits. Any adjustment in estimated profit requires that the amortization rate be revised retroactively to the date of policy/annuity issuance. The cumulative difference related to prior periods is recognized as a component of the current periods’ amortization, along with amortization associated with the actual gross profits of the period. Lower actual gross profits would typically result in less amortization expense. The converse would also be true. However, if lower gross profits were to continue into the future, a partial permanent impairment of the existing DAC asset may occur.
We periodically review the DAC asset to determine if it is recoverable from future income. If DAC is determined to be unrecoverable, such costs are expensed at the time of determination. The amount of DAC considered recoverable would be reduced in the near-term if the estimate of ultimate or future gross profits is reduced. We would revise the amount of DAC amortization if any of the estimates discussed above were revised. In addition, the disposition of a line of business can result in the permanent impairment of the related DAC asset.
We employ a systematic methodology to evaluate declines in fair values below amortized cost for all investments. The methodology utilizes a quantitative and qualitative process ensuring that available evidence concerning the declines in fair value below amortized cost is evaluated in a disciplined manner. In determining whether a decline in fair value below amortized cost is other-than-temporary, we evaluate the length of time 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; the financial condition and prospects of the issuer’s market and industry; and, our ability and intent to hold the investment. We apply 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, we reduce the cost basis of the investment to fair value. This reduction is permanent and is recognized as a realized investment loss (see Investment Portfolio for further discussions regarding other-than-temporary impairments and securities in an unrealized loss position).
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 statutory GMDB reserves, Total Adjusted Capital and RBC ratios for our life insurance subsidiaries and for Hanover, as applicable, as of December 31, 2003 and 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):
(2) Hanover’s Total Adjusted Capital includes $526.5 million related to its subsidiary, Citizens.
(1) AFLIAC’s Total Adjusted Capital includes $200.0 million related to its subsidiary, FAFLIC.
(2) Hanover’s Total Adjusted Capital includes $484.9 million related to its subsidiary, Citizens.
The total adjusted statutory capital position of our life companies showed significant improvement during 2003 increasing from $481.9 million at December 31, 2002 to $553.4 million at December 31, 2003. This increase is after the payment of a $25 million dividend to the holding company, which was approved by the Massachusetts Commissioner of Insurance, (the “Massachusetts Commissioner”), and effected in December 2003. The improvement in our life insurance companies’ RBC reflects lower required risk based capital resulting from lower minimum pension liabilities, sales of high-yield securities and lower required statutory GMDB reserves. In addition, on December 3, 2003, we implemented a hedging program for our in-force variable annuity policies with GMDB features. The program’s purpose is to provide us with an economic hedge against increased GMDB claims that could arise from declines in the equity market below levels at December 3, 2003. The program is expected to reduce the volatility in statutory capital and risk-based capital levels from the effects of future equity market movements and allows us to retain most of the benefits of reduced GMDB costs in a rising equity market. However, it does not hedge or reduce the cost of the GMDB at levels in effect as of December 3, 2003.
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 95% of our annuity products that are most sensitive to changes in the equity market, is no longer consolidated into FAFLIC.
AFC has entered into an agreement with the Massachusetts Commissioner in consideration of the decision not to write new business, whereby it will indefinitely maintain the RBC ratio of AFLIAC at a minimum of 100% of the Company Action Level (on the Industry Scale). This agreement, which was previously with FAFLIC, replaced an earlier commitment that FAFLIC maintain a 225% RBC ratio (on the Industry Scale).
We do not expect the life insurance subsidiaries to require levels of capital contributions from AFC as in prior years due to the expectation of sufficient statutory capital and earnings; therefore, we do not expect that it will be necessary to dividend significant funds from our property and casualty companies to AFC during 2004 (see Liquidity and Capital Resources).
The statutory surplus of the life companies, particularly AFLIAC, which holds approximately 95% of the annuity deposits with the GMDB feature, was highly sensitive to movements in the equity market. This was due, in large part, to the required methodology for calculating GMDB (“Actuarial Guideline 34”) reserves for statutory accounting purposes. As of December 31, 2003, the level of net GMDB reserves in the life companies is approximately $117 million. An increase of these reserves would not result directly in cash losses to us, but it would result in a reduction in statutory surplus. In December 2003, we implemented the aforementioned GMDB hedging program which significantly reduces our sensitivity to movements in the equity market. 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.
The above mentioned agreement was superseded by the implementation of a GMDB mortality reinsurance program. Effective December 1, 2002, the life companies entered into a mortality reinsurance program with unaffiliated reinsurers covering the incidence of mortality on variable annuity policies. This transaction reduced required statutory net GMDB reserves and resulted in an increase in statutory capital and surplus of approximately $20 million for the life companies at December 31, 2002.
Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, our primary source of cash is dividends from our insurance subsidiaries. However, dividend payments to us by our 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), we entered into an agreement with the Massachusetts Commissioner, in consideration of the decision not to write new life insurance and annuity business, whereby we will indefinitely maintain the RBC ratio of AFLIAC at a minimum of 100% of the Company Action Level (on the Industry Scale).
companies without prior approval from the Insurance Commissioners in the states of domicile. With permission from the Massachusetts Commissioner, our holding company, AFC, received a $25 million dividend from AFLIAC in the fourth quarter of 2003. Further dividends from AFLIAC would require consent from the Massachusetts Commissioner.
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. This agreement was terminated on March 31, 2003. In 2003, AFLIAC did not cede any related GMDB costs prior to March 31, 2003, and, likewise, no reimbursements were made by AFC. In 2002, AFLIAC incurred GMDB costs of approximately $92 million. Since 2001, AFLIAC ceded $33.6 million under the agreement, of which AFC reimbursed $33.6 million through December 2002. Due to the aforementioned termination of this agreement, we do not expect any related future reimbursements.
Sources of cash for our 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. We periodically adjust our investment policy to respond to changes in short-term and long-term cash requirements.
At December 31, 2003, our holding company held $68.4 million of cash and investments. Historically, funds provided to the holding company were from its property and casualty insurance subsidiaries. However, a $25 million dividend from our life insurance subsidiaries was paid to the holding company as of December 31, 2003. We believe our holding company has the ability to meet its obligations through the remainder of 2004, consisting primarily of interest on the senior debentures and Capital Securities. Therefore, we currently do not expect that it will be necessary to dividend funds from the property and casualty companies in 2004 in order to fund 2004 holding company obligations. In 2003 and 2002, we did not pay an annual dividend.
We expect to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. Our insurance subsidiaries maintain a high
(3) Funding agreement payments are reflected in the category representing their contractual maturity.
(6) Non-qualified pension plan benefit obligations reflect estimated payments to be made through plan year 2013 for pension, post retirement and past employment benefits. Estimates of these payments and the payment patterns are based upon historical experience.
On July 24, 2002, an action captioned American National Bank and Trust Company of Chicago, as Trustee f/b/o Emerald Investments Limited Partnership, and Emerald Investments Limited Partnership v. Allmerica Financial Life Insurance and Annuity Company was commenced in the United States District Court for the Northern District of Illinois, Eastern Division. In 1999, plaintiffs purchased two variable annuity contracts with initial premiums of $2.5 million each. Plaintiffs, who AFLIAC identified as engaging in frequent transfers of significant sums between sub-accounts that in its opinion constituted “market timing”, were subject to restrictions upon such trading that AFLIAC imposed in 2002. In December 2003, the court granted partial summary judgment to the plaintiffs, holding that at least certain restrictions imposed on their trading activities violated the terms of the annuity contracts. The court ordered limited discovery regarding the plaintiffs’ attempts to trade following dissemination of the trading restrictions. We have filed a motion for reconsideration and clarification of the court’s partial summary judgment opinion. Other than the limited discovery ordered by the court, no discovery in the case has ensued to date, and it is too early in the proceedings for us to assess the amount of potential damages if AFLIAC should ultimately be unsuccessful in defending this lawsuit. Plaintiffs allege that such restrictions constitute a breach of the terms of the annuity contracts and seek unspecified damages, including lost profits and prejudgment interest. The outcome is not expected to be material to our financial position, although it could have a material effect on the results of operations for a particular quarter or annual period.
In December 2003, Edward J. Parry, III was elected a director of AFC. Mr. Parry’s term of office as a director of AFC expires in 2004. In addition, in February 2004, Joseph R. Ramrath was elected a director of AFC. Mr. Ramrath’s term of office as a director of AFC expires in 2006.
We wish to caution readers that the following important factors, among others, in some cases have affected and in the future could affect our actual results and could cause our actual results for 2004 and beyond to differ materially from historical results and from those expressed in any forward-looking statements made by, or on our behalf. 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 our Annual Report on Form 10-K for the period ended December 31, 2003.
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; (iii) changes in interest rates causing a reduction of investment income or in the market value of interest rate sensitive investments; (iv) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (v) higher service, administrative or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (vi) the inability to attract, or the loss or retirement of key executives; (vii) changes in our liquidity due to changes in asset and liability matching, including the effect of defaults of debt securities; (viii) adverse changes in the ratings obtained from independent rating agencies, such as Moody’s, Standard and Poor’s and A.M. Best; (ix) failure of a reinsurer of our policies to pay its liabilities under reinsurance or coinsurance contracts or adverse effects on the cost and availability of reinsurance; (x) changes in the mix of assets comprising our investment portfolios and changes in general market conditions that may cause the market value of our investment portfolio to fluctuate; (xi) losses resulting from our participation in certain reinsurance pools; (xii) defaults or impairments of debt securities held by us; (xiii) higher employee benefit costs due to changes in market values of plan assets, interest rates and employee compensation levels; (xiv) the effects of our restructuring actions, including any resulting from the cessation of retail sales through VeraVest or from our review of operational matters related to our business, including a review of our markets, products, organization, financial capabilities, agency management, regulatory environment, ancillary businesses and service processes; and (xv) interruptions in our ability to conduct business as a result of terrorist actions, catastrophes or other significant events affecting infrastructure, and delays in recovery of our operating capabilities.
In addition, with respect to our Allmerica Financial Services segment, we have provided forward looking information relating to the impact of equity market values on certain financial metrics, including among other things, GMDB expenses and DAC amortization, net amount at risk 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, 2003. 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.
Catastrophe - A single event that causes the property and casualty industry both a significant number of claims (1,000 or more) and $25 million or more in insured property damage losses.
Loss adjustment expenses (LAE) - Expenses incurred in the adjusting, recording, and settlement of claims. These expenses include both internal company expenses and outside services. Examples of LAE include claims adjustment services, adjuster salaries and fringe benefits, legal fees and court costs, investigation fees, and claims processing fees.
Loss adjustment expense ratio, Statutory - The ratio of loss adjustment expenses to earned premiums for a given period.
Underwriting expense ratio, Statutory - This ratio reflects underwriting expenses to written premiums.
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, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 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.
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.
The consolidated financial statements of Allmerica Financial Corporation (“AFC” or the “Company”) include the accounts of The Hanover Insurance Company (“Hanover”); Citizens Insurance Company of America (“Citizens”); Allmerica Financial Life Insurance and Annuity Company (“AFLIAC”); First Allmerica Financial Life Insurance Company (“FAFLIC”), and other insurance and non-insurance subsidiaries. These legal entities conduct their operations through several business segments as discussed in Note 16. All significant intercompany accounts and transactions have been eliminated.
FAFLIC established and began operating a closed block (the “Closed Block”) for the benefit of the participating policies included therein, consisting of certain individual life insurance participating policies, individual deferred annuity contracts and supplementary contracts not involving life contingencies which were in force as of FAFLIC’s demutualization on October 16, 1995; such policies constitute the “Closed Block Business”. The purpose of the Closed Block is to protect the policy dividend expectations of such FAFLIC dividend paying policies and contracts. Unless the Massachusetts Insurance Commissioner consents to an earlier termination, the Closed Block will continue to be in effect until the date none of the Closed Block policies are in force. FAFLIC allocated to the Closed Block assets in an amount that is expected to produce cash flows which, together with future revenues from the Closed Block Business, are reasonably sufficient to support the Closed Block Business, including provision for payment of policy benefits, certain future expenses and taxes and for continuation of policyholder dividend scales payable in 1994 so long as the experience underlying such dividend scales continues. The Company expects that the factors underlying such experience will fluctuate in the future and policyholder dividend scales for Closed Block Business will be set accordingly.
Although the assets and cash flow generated by the Closed Block inure solely to the benefit of the holders of policies included in the Closed Block, the excess of Closed Block liabilities over Closed Block assets as measured on a GAAP basis represent the expected future post-tax income from the Closed Block which may be recognized in income over the period the policies and contracts in the Closed Block remain in force.
If, over the period the policies and contracts in the Closed Block remain in force, the actual income from the Closed Block is less than the expected income from the Closed Block, only such actual income (which could reflect a loss) would be recognized in income. If the actual income from the Closed Block in any given period is less than the expected income for that period and changes in dividend scales are inadequate to offset the negative performance in relation to the expected performance, the income inuring to shareholders of the Company will be reduced. If a policyholder dividend liability had been previously established in the Closed Block because the actual income to the relevant date had exceeded the expected income to such date, such liability would be reduced by this reduction in income (but not below zero) in any periods in which the actual income for that period is less than the expected income for such period.
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
The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item, including forecasted transactions; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is no longer designated as a hedge instrument, because it is unlikely that a forecasted transaction will occur; or (4) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
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.
Premiums for individual life insurance and individual and group annuity products, excluding universal life and investment-related products, are considered revenue when due. Property and casualty insurance premiums are recognized as revenue over the related contract periods. Benefits, losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through the provision for future benefits, estimated and unpaid losses and amortization of deferred policy acquisition costs. Revenues for investment-related products consist of net investment income and contract charges assessed against the fund values. Related benefit expenses 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.
In December 2003, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 132, (revised 2003) Employers’ Disclosures about Pensions and Other Postretirement Benefits - an amendment of FASB Statements No. 87, 88, and 106 (“Statement No. 132 - revised”). This statement revises employers’ disclosures about pension plans and other postretirement benefit plans. Statement No. 132 - revised requires additional disclosures related to plan assets, benefit obligations, contributions, and net periodic benefit cost of defined benefit pension plans and other postretirement benefit plans, including information regarding the Company’s selection of certain assumptions, as well as expected benefit payments. This statement also requires disclosures in interim financial statements related to net periodic pension costs and contributions. Most provisions of this statement are effective for fiscal years ending after December 15, 2003. Disclosures regarding expected benefit payments are effective for fiscal years ending after June 15, 2004. The adoption of Statement No. 132 - revised did not have a material effect on the Company’s financial position or results of operations.
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“Statement No. 150”). This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify mandatorily redeemable financial instruments and other financial instruments that embody an obligation of the issuer as liabilities. At inception, these liabilities shall initially be measured at fair value. Mandatorily redeemable financial instruments and certain forward contracts in which both the amount to be paid and the settlement date are fixed shall be subsequently measured at the present value of the amount to be paid at settlement, accruing interest cost using the rate implicit at inception. Other financial instruments shall be subsequently measured at fair value. Additionally, mandatorily redeemable financial instruments and certain forward contracts shall, on a prospective basis, reflect any amounts paid or to be paid to holders of these instruments in excess of the initial measurement amount as interest cost. For financial instruments created before the issuance date of Statement No. 150 and still existing at the beginning of the interim period of adoption, any changes between carrying value and fair value or other measurement attribute provided for by this statement, upon adoption of this statement, shall be reflected as a cumulative effect of a change in accounting principle. This statement is effective for interim periods beginning after June 15, 2003. On November 7, 2003, the FASB deferred the aforementioned measurement provisions of Statement No. 150 for securities issued before November 5, 2003. The Company has $300 million of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. These securities embody an unconditional obligation that requires the Company to redeem the securities on a stated maturity date. As such, the securities have been reclassified from the mezzanine level of the balance sheet to debt, at face value. Dividends on the securities are classified as interest expense in the current year. In addition, these instruments contain a settlement alternative that occurs as a result of a “special event.” A special event could occur if a change in laws and/or regulations or the application or interpretation of these laws and/or regulations causes the interest from these debentures to become taxable income (or non-deductible expense), or for the subsidiary trust to become deemed an “investment company” and subject to the filing requirements of Registered Investment Companies.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities - an interpretation of ARB No. 51, which was subsequently revised by the December 2003 issuance of Interpretation No. 46, (collectively referred to as “FIN 46 or the “Interpretation”). FIN 46 provides guidance regarding the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, specifically as it relates to the identification of entities for which control is achieved through a means other than voting rights (“variable interest entities”) and the determination of which party is responsible for consolidating the variable interest entities (the “primary beneficiary”). In addition to mandating that the primary beneficiary consolidate the variable interest entity, FIN 46 also requires disclosures by companies that hold a significant variable interest, even if they are not the primary beneficiary. Certain financial statement disclosures were applicable immediately for those entities for which it was reasonably possible that the enterprise would, upon adoption of FIN 46, consolidate or be required to disclose information about any variable interest entities. Additionally, an enterprise with an interest in an entity to which FIN 46 had not been applied as of December 24, 2003, is required to apply this Interpretation no later than the end of the first reporting period that ends after March 15, 2004. Application of FIN 46 for special purpose entities was required no later than as of the end of the first reporting period that ends after December 15, 2003. The Company performed a review of
In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others - an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34 (“FIN 45”). FIN 45 provides guidance regarding financial statement disclosure requirements for guarantors related to obligations under guarantees. FIN 45 also clarifies the requirements related to the recognition of a liability by the guarantor, at the inception of a guarantee, for these obligations under guarantees. This interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The initial recognition and measurement provisions of this interpretation are required to be applied only on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of reporting periods ending after December 15, 2002. The adoption of FIN 45 did not have a material effect on the Company’s financial position or results of operations.
In June 2001, the FASB issued Statement No. 142, which requires that goodwill and intangible assets that have indefinite useful lives no longer be amortized over their useful lives, but instead be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. In addition, the statement provides specific guidance for testing the impairment of intangible assets. Additional financial statement disclosures about goodwill and other intangible assets, including changes in the carrying amount of goodwill, carrying amounts by classification of amortized and non-amortized assets, and estimated amortization expenses for the next five years, are also required. This statement became effective for
Earnings per share (“EPS”) for the years ended December 31, 2003, 2002, and 2001 are based on a weighted average of the number of shares outstanding during each year. The Company’s EPS is based on net income for both basic and diluted earnings per share. The weighted average shares outstanding which were utilized in the calculation of basic earnings per share differ from the weighted average shares outstanding used in the calculation of diluted earnings per share due to the effect of dilutive employee stock options and nonvested stock grants. If the effect of such stock options and grants are antidilutive, the weighted average shares outstanding utilized in the calculation of diluted earnings per share equal those utilized in the calculation of basic earnings per share.
During 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its Employee Benefit Services (“EBS”) business, its Affinity Group Underwriters (“AGU”) business and its accident and health assumed reinsurance pool business (“reinsurance pool business”). During 1998, the Company ceased writing new premiums in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business, have been reported in accordance with Accounting Principles Board Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB Opinion No. 30”). In 1999, the Company recorded a $30.5 million loss, net of taxes, on the disposal of this segment, consisting of after-tax losses from the run-off of the group life and health business of approximately $46.9 million, partially offset by net proceeds from the sale of the EBS business of approximately $16.4 million. Subsequent to the measurement date of June 30, 1999, approximately $17.5 million of the aforementioned $46.9 million loss has been generated from the operations of the discontinued business.
In March of 2000, the Company transferred its EBS business to Great-West Life and Annuity Insurance Company of Denver. As a result of this transaction, the Company has received consideration of $27.6 million, based on renewal rights for existing policies. The Company retained policy liabilities estimated at $86.7 million at December 31, 2003 related to this business.
In 2003 and 2002, the Company retired $78.8 million and $548.9 million, respectively, of long-term funding agreement obligations at discounts. This resulted in pre-tax gains of $5.7 million and $102.6 million in 2003 and 2002, respectively, which are reported as gains 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 market value loss on the early termination of derivative instruments used to hedge the retired funding agreements of $6.4 million and $14.1 million, were recorded as net realized investment losses in the Consolidated Statements of Income in 2003 and 2002, respectively. The net foreign currency transaction gains (losses) in 2003 and 2002, related to the retired foreign-denominated funding agreements of $3.6 million and $(12.2) million, respectively, were recorded as other income in the Consolidated Statements of Income.
Effective December 31, 2002, the Company effectively sold, through a 100% coinsurance agreement, substantially all of its fixed universal life insurance business. Under the agreement,
In 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 in an additional 314 agencies. These actions affected approximately 27% of the estimated 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. As a result of these actions, the Company recorded a total charge of $68.3 million which has been presented as a separate line item in the Consolidated Statements of Income. The total charge consists of a $52.9 million increase in reserves, a $7.2 million estimated future premium deficiency, $4.8 million of cost associated with ceding certain losses, and a $3.4 million impairment to the deferred acquisition cost asset. 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. The Company was contractually or under statutory regulations obligated to renew policies with certain agents that were in runoff through 2003. The estimated future premium deficiency on these policies of $7.2 million was recorded during 2001. Under the aggregate excess of loss reinsurance treaty, the Company ceded $5.9 million of additional losses included in the aforementioned $52.9 million reserve increase; the cost of ceding these losses into the treaty of $4.8 million was recorded in 2001. 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. Actual future losses from the exited business may vary from the Company’s estimate.
The Company participates in a security lending program for the purpose of enhancing income. Securities on loan to various counterparties were fully collateralized by cash and had a fair value of $384.7 million and $46.9 million, at December 31, 2003 and 2002, respectively. The fair value of the loaned securities is monitored on a daily basis, and the collateral is maintained at a level of at least 102% of the fair value of the loaned securities.
At December 31, 2003, there were contractual investment commitments of $1.9 million.
There were no contractual commitments to extend credit under commercial mortgage loan agreements at December 31, 2003.
At December 31, 2003, scheduled mortgage loan maturities were as follows: 2004 - $42.4 million; 2005 - $13.5 million; 2006 - $16.0 million; 2007 - $10.0 million; 2008 - $7.6 million and $85.6 million thereafter. Actual maturities could differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties and loans may be refinanced. During 2003, the Company did not refinance any mortgage loans based on terms which differed from current market rates.
Mortgage loans investment valuation allowances of $1.8 million and $2.8 million at December 31, 2003 and 2002, respectively, have been deducted in arriving at investment carrying values as presented in the Consolidated Balance Sheets. There were no impaired loans or related reserves as of December 31, 2003 and 2002. There was no interest income received in 2003 and 2002 related to impaired loans.
The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by foreign currency, equity market and interest rate volatility. As a result of the Company’s issuance of trust instruments supported by funding obligations denominated in foreign currencies, as well as its investment in securities denominated in foreign currencies, the Company’s operating results are exposed to changes in exchange rates between the U.S. dollar, the Japanese Yen, the British Pound, and the Euro. The Company uses foreign currency exchange swaps, futures, and options to mitigate the short-term effect of changes in currency exchange rates and to manage the risk of cash flow variability. Additionally, in prior years, the Company had floating rate funding agreements that were matched with fixed rate securities, which exposed the Company’s cash flows to changes in interest rates. The Company used derivative financial instruments, primarily foreign currency exchange swaps, interest rate swaps, and futures contracts, with indices that correlated to balance sheet instruments, to modify its indicated net interest sensitivity to levels deemed to be appropriate. Prior to September 2002, the Company used exchange traded futures contracts to hedge against interest rate risk on anticipated sales of guaranteed investment contracts (“GIC”) and other funding agreements. The Company was exposed to interest rate risk from the time of sale of the GIC until the receipt of deposit and purchase of the underlying asset to back the liability. Finally, the Company is exposed to changes in the equity market due to increases in GMDB reserves that result from declines in the equity market. The Company uses exchange traded equity market futures contracts to reduce the volatility in statutory capital reserves from the effects of the equity market movements.
The operations of the Company are subject to risks resulting from interest rate fluctuations to the extent that there is a difference between the amount of the Company’s interest-earning assets and the amount of interest-bearing liabilities that are paid, withdrawn, mature or re-price in specified periods. The principal objective of the Company’s
asset/liability management activities is to provide maximum levels of net investment income, while maintaining acceptable levels of interest rate and liquidity risk and facilitating the funding needs of the Company. The Company’s investment assets are managed in over 20 portfolio segments consistent with specific products or groups of products having similar liability characteristics. As part of this approach, the Company has developed investment guidelines for each portfolio consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. Management has a general policy of diversifying investments both within and across all portfolios. The Company monitors the credit quality of its investments and the exposure to individual markets, borrowers, industries, and sectors.
By using derivative instruments, the Company is exposed to credit risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain (including any accrued receivable) in a derivative. The Company regularly assesses the financial strength of the counterparties and generally enters into derivative instruments with counterparties rated “A” or better by nationally recognized rating agencies. Depending on the nature of the derivative transaction, the Company maintains bilateral Collateral Standardized Arrangements (“CSA”) with each counterparty. In general, the CSA sets a minimum threshold of exposure that must be collateralized, although thresholds may vary by CSA. The Company’s counterparties held collateral, in the form of cash, bonds and U.S. Treasury notes, of $71.6 million and $23.7 million at December 31, 2003 and 2002, respectively.
related to ineffectiveness of futures and options contracts and were reported in other income in the Consolidated Statements of Income. Additionally, for the year ended December 31, 2001, the Company recognized a net loss of $37.6 million, representing the total ineffectiveness on all cash flow hedges, which were 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.
As of December 31, 2003, $40.1 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 are expected to occur over the next twelve months and will necessitate reclassifying to earnings these derivatives gains (losses) include: the interest payments (receipts) on foreign denominated trust instruments supported by funding obligations and foreign securities; the possible repurchase of other funding agreements; and 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.
During the fourth quarter of 2003, the Company began using exchange traded equity futures contracts to economically hedge increased GMDB reserves which could arise from declines in the equity market. The hedge is expected to reduce the volatility in statutory capital and risk-based capital levels from the effects of future equity market movements. The GMDB hedges do not qualify for hedge accounting under Statement No. 133. Additionally, the Company entered into equity-linked swap contracts which are economic hedges but do not qualify for hedge accounting under Statement No. 133. These products are linked to specific equity-linked liabilities on the balance sheet. Under the equity-linked swap contracts, the Company agrees to exchange, at specific intervals, the difference between fixed and floating rate interest amounts calculated on an agreed upon notional amount. The final payment at maturity will include the appreciation, if any, of a basket of specific equity indices. Finally, the Company also entered into insurance portfolio-linked 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 other swap contracts entered into for investment purposes, the Company agreed to exchange the differences 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 portfolio-linked swap contracts, although final payment related to this contract was recorded in 2002, in accordance with contract terms. Net realized investment gains related to insurance portfolio-linked contracts were $2.1 million for the year ended December 31, 2002, while net realized investment losses related to these contracts were $4.3 million for the year ended December 31, 2001.
At December 31, 2002, the Company held a $36.9 million par value 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 Company sold its investment in Allmerica CBO I during the second quarter of 2003.
(1) Includes net (depreciation) appreciation on derivative instruments of $(7.2) million, $(58.5) million and $1.4 million in 2003, 2002 and 2001, respectively. Balances at December 31,2003, 2002 and 2001 include net depreciation from derivative instruments of $108.4 million, $101.2 million and $42.7 million, respectively.
The following table provides information about the Company’s fixed maturities and equity securities that have been continuously in an unrealized loss position at December 31, 2003 and 2002:
(2) At December 31, 2003 and 2002, substantially all below investment grade securities with an unrealized loss had been rated by the NAIC, Standard & Poor’s, or Moody’s.
The Company employs a systematic methodology to evaluate declines in fair values below amortized cost for all investments. The methodology utilizes a quantitative and qualitative process ensuring that available evidence concerning the declines in fair value below amortized cost 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 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; the financial condition and prospects of the issuer’s market and industry; and, the Company’s ability and intent to hold the investment. As a result of this review, the Company has concluded that the gross unrealized losses of fixed maturities and equity securities are temporary.
At December 31, 2003, the Company had no concentration of investments in a single investee exceeding 10% of shareholders’ equity except for investments with Federal National Mortgage Association with a fair value of $504.9 million and Federal Home Loan Mortgage Corporation with a fair value of $360.4 million. At December 31, 2002, the Company had no concentration of investments in a single investee exceeding 10% of shareholders’ equity except for investments with Federal National Mortgage Association with a fair value of $440.0 million and Federal Home Loan Mortgage Corporation with a fair value of $259.7 million.
The Company had fixed maturities with a carrying value of $28.6 million and $39.9 million on non-accrual status at December 31, 2003 and 2002, respectively. The Company had no mortgage loans on non-accrual status at December 31, 2003, however the Company had mortgage loans with a carrying value of $7.4 million on non-accrual status at December 31, 2002. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the investments, was a reduction in net investment income of $7.6 million, $19.9 million, and $11.3 million in 2003, 2002, and 2001, respectively.
There were no mortgage loans which were non-income producing at December 31, 2003 and 2002. However, the Company had non-income producing fixed maturities with a carrying value of $15.1 million and $7.2 million at December 31, 2003 and 2002, respectively.
The Company recognized losses of $61.6 million, $238.5 million and $185.3 million in 2003, 2002 and 2001, respectively, related to other-than-temporary impairments of fixed maturities and other securities. In addition, the Company transferred approximately $550 million of investment assets, with an amortized cost of $525 million, to settle net payables related to the sale of the Company’s universal life insurance business (see Note 3 - Significant Transactions). Of this amount, approximately $100 million was cash; the remaining balance was settled through the transfer of fixed maturities and policy loans.
Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet. The fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts which could be realized upon immediate liquidation.
There were no reserves on mortgage loans at December 31, 2003 and 2002.
On January 1, 2002, the Company adopted Statement No. 142. Upon implementation, the Company recorded an impairment charge of $3.7 million, net of taxes, and ceased its amortization of goodwill. Amortization expense in 2001 was $4.0 million, net of taxes. In accordance with Statement No. 142, the following table provides income (loss) before the cumulative effect of a change in accounting principle, net income (loss), and related per share amounts as of December 31, 2003, 2002 and 2001 as reported and adjusted as if the Company had ceased amortizing goodwill effective January 1, 2001.
Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company have a face value of $300.0 million, pay cumulative dividends semi-annually at 8.207% and mature February 3, 2027. Through certain guarantees, the Company has irrevocably and unconditionally guaranteed the obligations of the subsidiary business trust under these capital securities. The securities are subject to certain restrictive covenants, with which the Company is in compliance.
The federal income tax benefit attributable to the consolidated results of operations is different from the amount 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:
Gross deferred income tax assets totaled approximately $1.4 billion and $1.7 billion at December 31, 2003 and 2002, respectively. Gross deferred income tax liabilities totaled approximately $1.0 billion and $1.3 billion at December 31, 2003 and 2002, respectively.
The Company believes, based on objective evidence, the deferred tax assets will be realized. At December 31, 2003, there are available alternative minimum tax credit carryforwards, low income housing credit carryforwards and certain other tax credit carryforwards of $97.8 million, $48.7 million and $4.1 million, respectively. The alternative minimum tax credit carryforwards have no expiration date and the low income housing credit carryforwards will expire beginning in 2018. At December 31, 2003, the Company has net operating
AFC provides retirement benefits to substantially all of its employees under defined benefit pension plans. These plans are based on a defined benefit cash balance formula, whereby the Company annually provides an allocation to each covered employee based on a percentage of that employee’s eligible salary, similar to a defined contribution plan arrangement. In addition to the cash balance allocation, certain transition group employees, who have met specified age and service requirements as of December 31, 1994, are eligible for a grandfathered benefit based primarily on the employees’ years of service and compensation during their highest five consecutive plan years of employment. The Company’s policy for the plans is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974 (“ERISA”).
In order to measure the expense associated with these plans, management must make various estimates and assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, compensation increases, employee turnover rates and anticipated mortality rates, for example. The estimates used by management are based on the Company’s historical experience, as well as current facts and circumstances. In addition, the Company uses outside actuaries to assist in measuring the expense and liability associated with these plans.
The expected rate of return was determined by using historical mean returns, adjusted for certain factors believed to have an impact on future returns. Specifically, the Company expects the equity market returns will be in the high single digit range and has adjusted the historical mean returns downward to reflect this expectation. Also, the Company decreased its fixed income mean return from historical levels based on its expectation of modest increases in interest rates, slightly offsetting the coupon return. The adjusted mean returns were weighted to the plan’s actual asset allocation at December 31, 2002, resulting in an expected rate of return on plan assets for 2003 of 8.50%.
The following table is a reconciliation of the beginning and ending balances of the benefit obligation and the fair value of plan assets. At December 31, 2003 and 2002, the projected benefit obligations exceeded the plans’ assets. Changes in the minimum pension liability are reflected as an adjustment to accumulated other comprehensive income and are primarily comprised of the difference between the present value of accumulated benefit obligations and the market value of assets funding the plan. At December 31, 2003 and 2002, the Company had $112.8 million and $185.9 million in accumulated other comprehensive income related to its minimum pension liability. As such, during 2003, the Company recorded a decrease in the minimum pension liability of $73.1 million, while in 2002, the Company recorded an increase of $121.1 million. These changes in the liability are primarily the result of fluctuations in the market value of assets held by the plan due to general shifts in the equity market, as well as the $25.0 million Company contribution to the qualified plan in 2003.
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 $3.3 million and $4.7 million in 2003 and 2002, respectively, which reflects fair value, net of applicable amortization. In addition to the net pension liability, the Company has also recorded intangible assets related to its non-qualified plans of $0.6 million and $3.8 million as of December 31, 2003 and 2002, respectively.
curtailment loss and special termination benefits in 2002 of $4.3 million and $1.1 million, respectively, relate to the 2002 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 2002 AFS restructuring, while special termination benefit costs reflect acceleration of retirement criteria under the plan for transition group participants terminated due to the restructuring.
In addition to the defined benefit plans, AFC provides a defined contribution 401(k) plan for its employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum percentage determined annually by the Board of Directors. During 2003, 2002 and 2001, the Company matched 50% of employees’ contributions up to 6.0% of eligible compensation. The total expense related to this plan was $5.4 million, $5.0 million, and $5.7 million in 2003, 2002 and 2001, respectively. In addition to this plan, the Company also has a defined contribution plan for substantially all of its former AFS agents. The Company recognized expenses in 2003, 2002 and 2001 of $1.1 million, $3.1 million, and $3.3 million, respectively, related to this plan. The decrease in expense in 2003 is due to the termination of all agent contracts as of December 31, 2002 pursuant to the AFS restructuring (see Note 3 - Significant Transactions). As a result, there will be no future agent or employer contributions to this plan.
In addition to the Company’s pension plans, the Company currently provides postretirement medical and death benefits to certain full-time employees, former agents, retirees and their dependents, under welfare benefit plans sponsored by FAFLIC. Generally, active employees become eligible with at least 15 years of service after the age of 40. Former agents of the Company became eligible at age 55 with at least 15 years of service. The Company ceased its distribution of proprietary life and annuity products in 2002 (see Note16 - Segment Information) and terminated all life insurance and annuity agent contracts as of December 31, 2002. The population of agents receiving postretirement benefits was frozen as of this date. 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.
As a result of the AFS restructuring in 2002 (see Note 3 -Significant Transactions), the Company recognized a curtailment gain and special termination benefit costs related to its postretirement benefit plans. The curtailment gain resulted from the effect of agent terminations related to those not fully eligible for benefits, while the special termination benefit costs reflect acceleration of retirement criteria for selected terminated employees.
The Company applies the provisions of APB Opinion No. 25 in accounting for its stock-based compensation plans, and thus compensation cost is not generally required to be recognized in the financial statements for the Company’s stock options issued to employees. However, costs associated with the issuance of stock options to certain agents who did not qualify as employees were recognized in 2003, 2002 and 2001.
In accordance with FASB Interpretation No. 44, the Company recognized costs associated with the issuance of
Effective June 17, 1996, the Company adopted a Long-Term Stock Incentive Plan for employees of the Company (the “Employees’ Plan”). Key employees of the Company and its subsidiaries are eligible for awards pursuant to the Plan administered by the Compensation Committee of the Board of Directors (the “Committee”) of the Company. Under the terms of the Employees’ Plan, the maximum number of shares authorized for grants over the life of the Plan is equal to 7,824,678 shares as of December 31, 2003, increasing annually by 1.25% of the Company’s outstanding stock. Additionally, the maximum number of shares available for award in any given year is equal to 3.25% of the outstanding common stock of the Company at the beginning of the year, plus any awards authorized but unused from prior years.
The fair value of each option is estimated on the date of grant or date of conversion using the Black-Scholes option-pricing model. For options granted through 2003, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of all options granted in 2003, 2002 and 2001 was $10.57 per share, $14.48 per share and $19.49 per share, respectively. No options expired during 2003, 2002 or 2001.
(1) During 2003 and 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 for the expected volatility and risk-free interest rate assumptions. This resulted in a range of assumptions. The Company’s expected volatility rate during the second half of 2003 reflected levels more consistent with the Company’s experience prior to 2002. 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, 2003.
During 2003, the Company did not grant any shares of nonvested stock to employees or property and casualty agents. During 2002 and 2001, the Company granted shares of nonvested stock to eligible employees and certain property and casualty agents, which vest after three years of continuous employment or service. During 2003, 2002 and 2001, the Company also granted shares of nonvested stock to certain former AFS agents, which vest 60% after three years and 20% per year thereafter. All of these shares granted in 2003 and all unvested grants issued prior to 2003 to former AFS agents were forfeited as a result of the Company’s decision to cease operations of its broker/dealer operations (see Note 3 - Significant Transactions). 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 $2.3 million, $0.9 million and $7.2 million of compensation cost in 2003, 2002 and 2001, respectively. The expense in 2003 and 2002 reflects net benefits of $1.8 million and $6.0 million, respectively, resulting from the termination of nonvested stock grants which were previously granted to agents and other employees whose positions were eliminated in those years (see Note 3 - Significant Transactions), as well as those shares previously granted to the former President of the Company after his resignation in 2002.
New Hampshire, Michigan and Massachusetts have enacted laws governing the payment of dividends to stockholders by insurers. New Hampshire and Michigan laws affect the dividend paying ability of Hanover and Citizens, respectively, while Massachusetts laws affect the dividend paying ability of AFLIAC and FAFLIC.
The Company offers financial products and services and conducts business principally in three operating segments. These segments are Property and Casualty (formerly “Risk Management”), AFS, and Asset Management (formerly “Allmerica Asset Management”). Prior to 2003, AFS and Asset Management comprised the Asset Accumulation group. 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 maker in deciding how to allocate resources and in assessing performance. A summary of the Company’s reportable segments is included below.
announcement on September 27, 2002 that we planned to consider strategic alternatives, including a significant reduction of sales of proprietary variable annuities and life insurance products, we ceased all new sales of these products.
Through its 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. The Company’s 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 for FAFLIC to continue selling new long-term funding agreements. Furthermore, the Company retired certain long-term funding agreements, at discounts, during 2003 and the fourth quarter of 2002 (see Note 3 - Significant Transactions). 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., a Registered Investment Advisor. Additionally, this segment includes AMGRO, Inc., the Company’s property and casualty insurance premium financing business.
Rental expenses for operating leases amounted to $27.3 million, $30.8 million and $32.7 million in 2003, 2002 and 2001, respectively. These expenses relate primarily to building leases of the Company. At December 31, 2003, future minimum rental payments under non-cancelable operating leases were approximately $42.3 million, payable as follows: 2004-$18.1 million; 2005-$11.8 million; 2006-$6.9 million; 2007-$3.6 million; and $1.9 million thereafter. It is expected that, in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment; thus, it is anticipated that future minimum lease commitments may not be less than the amounts shown for 2004.
Effective January 1, 1999, the Company entered into a whole account aggregate excess of loss reinsurance agreement, which provides coverage for the 1999 accident year for the Company’s property and casualty business. The program covered losses and allocated LAE expenses, including those incurred but not yet reported, in excess of a specified whole account loss and allocated LAE ratio. The annual coverage limit for losses and allocated LAE is $150.0 million. The Company is subject to concentration of risk with respect to this reinsurance agreement. Net premiums earned under this agreement during 2003, 2002 and 2001 for accident year 1999 were $9.6 million, $3.2 million and $12.1 million, respectively, while net losses and LAE ceded during 2003, 2002 and 2001 were $11.8 million, $3.9 million and $15.8 million, respectively. The effect of this agreement on the results of operations in future periods is not currently determinable, as it will be based on future losses and allocated LAE for accident year 1999.
and $34.2 million and $38.0 million, respectively. Additionally, the Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 2003, 2002 and 2001 of $46.8 million and $124.2 million, $32.6 million and $49.8 million, and $7.2 million and $44.5 million, respectively.
During 2003 and 2002, we determined that the DAC asset related to certain distribution channels for our annuity business exceeded the present value of total expected gross profits. Therefore, we recognized permanent impairments of the DAC asset of $4.5 million and $159.0 million, respectively, related to these items. Additionally, in 2002, we recognized approximately $203 million of additional amortization related to the impact of the equity market on future gross profits of our life insurance and annuity products and approximately $200 million of additional amortization related to the changes in several actuarial estimates related to our life insurance and annuity products. Also, in 2002, we recognized a permanent impairment related to the universal life DAC asset of $155.9 million due to the sale of that business.
During 2001, we 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.
The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying policy was written and loss event occurred. These types of subsequent adjustments are described as “prior year reserve development”. Such development can be either favorable or unfavorable to the Company’s financial results and may vary by line of business.
In addition, in 2001, a reserve increase of $40.8 million on prior years resulted from the agency management actions discussed in Note 3 - “Significant Transactions”. This reserve increase affected primarily the commercial multiple peril, personal automobile, commercial automobile and workers’ compensation lines. Additionally, other commercial lines’ prior year reserves developed adversely due to a $33.0 million reserve increase in the ECRA voluntary pool. Personal automobile prior year reserves developed adversely due to the aforementioned increased claim severity related to medical settlements in Michigan. In addition to the effect from the agency management actions, the commercial automobile and commercial multiple peril lines experienced adverse development. The increased reserves in these lines are primarily attributable to increased claim payments in the 2000 and 1999 accident years. As these payments have increased above historical amounts, actuarial projections of future settlements have increased the estimated ultimate reserves on prior years.
In addition, and not included in the table above, the Company has established loss and LAE reserves for assumed reinsurance pool business with asbestos, environmental damage and toxic tort liability of $45.6 million, $45.2 million and $39.3 million in 2003, 2002 and 2001, respectively. These reserves relate to pools in which 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 participated in the ECRA voluntary pool during 1950 to 1982, until it was dissolved and put in runoff in 1982. The Company’s percentage of the total pool liabilities varied from 1.15% to 6.00% during these years. The Company’s participation in this pool has resulted in average paid losses of $2.4 million annually over the past ten years. During 2001, the pool commissioned an independent actuarial review of its then current reserve position, which noted a range of reserve deficiency primarily as a result of adverse development of asbestos claims. As a result of this study, the Company recorded an additional $33.0 million of losses in the fourth quarter of 2001, which is included in the reported outstanding loss and LAE reserves. This reserving action has been presented as a separate line item in the Consolidated Statements of Income. 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.
United States District Court for the Northern District of Illinois, Eastern Division. In 1999, plaintiffs purchased two variable annuity contracts with initial premiums of $2.5 million each. Plaintiffs, who AFLIAC identified as engaging in frequent transfers of significant sums between sub-accounts that in its opinion constituted “market timing”, were subject to restrictions upon such trading that AFLIAC imposed in 2002. Plaintiffs allege that such restrictions constitute a breach of the terms of the annuity contracts and seek unspecified damages, including lost profits and prejudgment interest. In December 2003, the court granted partial summary judgment to the plaintiffs, holding that at least certain restrictions imposed on their trading activities violated the terms of the annuity contracts. The court ordered limited discovery regarding the plaintiffs’ attempts to trade following dissemination of the trading restrictions. The Company has filed a motion for reconsideration and clarification of the court’s partial summary judgment opinion. Other than the limited discovery ordered by the court, no discovery in the case has ensued to date, and it is too early in the proceedings for the Company to assess the amount of potential damages if AFLIAC should ultimately be unsuccessful in defending this lawsuit. The outcome is not expected to be material to the Company’s financial position, although it could have a material effect on the results of operations for a particular quarter or annual period.
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. Subsequently, the Company has 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 $2.4 million in reserves at December 31, 2003 related to this lawsuit.
The Company has been named a defendant in various other legal proceedings arising in the normal course of business and is involved, from time to time, in investigations and proceedings by governmental and self-regulatory agencies. In the Company’s opinion, based on the advice of legal counsel, the ultimate resolutions of such proceedings will not have a material effect on the Company’s consolidated financial statements, although they could have a material effect on the results of operations for a particular quarter or annual period.
The Company’s insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Statutory surplus differs from shareholders’ equity reported in accordance with generally accepted accounting principles primarily because policy acquisition costs are expensed when incurred, statutory accounting principles require asset valuation and interest maintenance reserves, postretirement benefit costs are based on different assumptions and reflect a different method of adoption, life insurance reserves are based on different assumptions and the recognition of deferred tax assets is based on different recoverability assumptions.
The quarterly results of operations for 2003 and 2002 are summarized below:
Due to the use of weighted average shares outstanding when calculating earnings per common share, the sum of the quarterly per common share data may not equal the per common share data for the year. Diluted net loss per share for the three months ended June 30 and September 30, 2002 represents basic loss per share due to antidilution.
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).