(2) In 2004 and 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 2004 and 2003. Reclassification of prior year amounts is not permitted under Statement No. 150.
The following analysis of the consolidated results of operations and financial condition of Allmerica Financial Corporation (“the holding company”) and subsidiaries (“AFC”) should be read in conjunction with the Consolidated Financial Statements included elsewhere herein.
In 2004, we continued to execute our strategies for improving the profitability of our personal lines business and for retaining our profitability in, and growing, our commercial lines business. During the first quarter, our A.M. Best ratings were restored to the A- level for our property and casualty companies, which we believe is important for achieving profitable commercial lines growth. In addition, we completed the process of exiting our broker/dealer operations and have focused on managing and reducing our expenses across our life insurance operations. Our statutory capital levels in both our life and property and casualty insurance businesses also improved. The Massachusetts Division of Insurance approved a $75.0 million dividend from AFLIAC to the holding company, effective December 31, 2004.
During 2004, our segment earnings in the property and casualty business improved compared to the prior year, even though we experienced unusually high catastrophe losses, net of reinsurance. We benefited from net premium rate increases across our principal product lines in both our personal lines and commercial lines segments. Additionally, we experienced lower non-catastrophe loss frequency and favorable development of prior years’ loss reserves in personal lines, partially offset by a decline in commercial lines earnings. The decline in commercial lines earnings was primarily attributable to significant catastrophe losses incurred during the third quarter due to several hurricanes, but higher expenses were also a factor. Our 2003 results also reflected a significant charge in our Other Property and Casualty segment from an adverse arbitration decision related to a single large property claim within a voluntary insurance pool that we exited in 1996. There were no similar charges in 2004. Segment earnings in our life insurance business were favorably impacted by lower operating expenses as a result of the shut down of our broker/dealer operation in 2003, partially offset by higher guaranteed minimum death benefit (“GMDB”) expense and market related amortization of deferred policy acquisition costs.
The Life Companies segment consists of the former Allmerica Financial Services segment (“AFS”), our guaranteed investment contract (“GIC”) business (formerly a part of the Asset Management segment), and our discontinued group life and health business, including group life and health voluntary pools (the former Corporate Risk Management Services segment). Our Life Companies segment manages a block of existing variable annuity, variable universal life and traditional life insurance products, GICs and certain group retirement products. During 2003, we managed this existing life insurance business and also operated an independent broker/dealer business, which distributed third party investment and insurance products. In the fourth quarter of 2003, we announced the cessation of the retail services of our independent broker/dealer, VeraVest Investments, Inc. (“VeraVest”). In addition, this segment actively manufactured and sold variable annuities, variable universal life and traditional life insurance products, as well as our GIC products, until the fourth quarter of 2002.
and our senior debentures. In addition, during 2004, we allocated corporate overhead costs that were previously reported in our former Corporate segment to the four operating segments. All prior periods presented have been restated to reflect the current organization.
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”) in 2003, we reclassified dividends related to the mandatorily redeemable preferred securities of a subsidiary trust holding solely our junior subordinated debentures, to interest expense on corporate debt. In accordance with Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information (“Statement No. 131”), we restated prior periods to reflect this presentation.
Our consolidated net income was $125.3 million in 2004, compared to $86.9 million in 2003. The increase in 2004 of $38.4 million resulted primarily from an $83.1 million improvement in segment income, partially offset by a $34.7 million increase in the corresponding federal income tax expense. Also contributing to the increase in net income was a $30.4 million favorable federal income tax settlement and a $13.2 million reduction in restructuring costs. These favorable items were partially offset by an after-tax charge of $57.2 million related to the implementation of Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (“SOP 03-1”).
Our consolidated net income was $86.9 million in 2003, compared to a net loss of $306.1 million in 2002. Results in 2002 were adversely affected by a loss in the Life Companies segment of $634.7 million, primarily as a result of amortization of deferred acquisition costs following the cessation, in the fourth quarter of 2002, of sales of our proprietary annuity and life insurance products. The increase in 2003 over 2002 of $393.0 million, therefore, resulted primarily from a $590.7 million net improvement in segment income, principally related to our Life Companies segment, partially offset by a $222.9 million reduction in the corresponding federal income tax benefit. Also contributing to the increase in net income in 2003 was a $99.8 million change in net realized investment gains (losses) to a net gain of $10.4 million from a net loss of $89.4 million for 2002. Partially offsetting these increases in net income was a decrease in gains from the retirement of funding agreements and trust instruments supported by funding obligations of $63.0 million and a change of $30.7 million in (losses) gains on derivative instruments to a net loss of $4.5 million in 2003 from a net gain of $26.2 million in 2002.
Life Companies segment income in 2003 includes charges of $11.5 million relating to the impairment of assets resulting from our discontinuing the retail operations of VeraVest. The 2002 loss in our Life Companies segment reflects net charges of $698.3 million resulting from the cumulative effect of the decline in equity market values, ratings downgrades and our cessation of proprietary life insurance and annuity product sales (see Segment Results - Life Companies). These charges include $629.4 million of additional amortization of the DAC asset and $39.1 million due to a change in the assumptions related to the long-term cost of 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 $52.7 million decrease in Property and Casualty segment income for 2003 is primarily attributable to an increase in adverse development of prior years’ loss and loss adjustment expense reserves of $34.0 million, including charges of $21.9 million resulting from the aforementioned adverse arbitration decision. Catastrophe losses increased $28.1 million in 2003. In addition, segment income in 2003 decreased due to a $33.1 million increase in policy acquisition and other operating expenses, as well as a $21.6 million decrease in net investment income. These were partially offset by an estimated $56 million improvement in current accident year loss performance primarily due to net premium rate increases.
During 2004, we recorded income of $30.4 million relating to a federal income tax settlement for prior years (see Income Taxes).
Net realized investment gains, net of taxes and deferred acquisition cost amortization, were $16.1 million in 2004, primarily due to $26.0 million of after-tax gains from the sale of $854.7 million of fixed maturities. Partially offsetting these gains were after-tax losses of $5.7 million related to the termination of certain derivative instruments and $4.4 million of after-tax impairments of fixed maturities. During 2003, net realized investment gains, net of taxes and deferred acquisition cost amortization, were $10.4 million primarily resulting from
In 2004, we ceased certain sponsored businesses and restructured certain commercial lines operations in our Property and Casualty group. In 2003, we ceased our retail operations related to our broker/dealer in our Life Companies segment. During 2002, we began restructuring efforts in our Life Companies segment after terminating all new sales of our proprietary life insurance and annuity products. In 2004, 2003 and 2002, we recognized $5.5 million, $18.7 million and $9.6 million, respectively, net of taxes, primarily as a result of these restructuring efforts. These restructuring costs consisted of severance and other employee-related expenses, as well as the cancellation of certain lease agreements and contracted services. In addition, we recognized, during 2002, other reorganization costs of $4.5 million, net of taxes, primarily related to the forgiveness of interest on certain loans to former Life Companies agents.
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.
Segment income from our Property and Casualty group decreased $52.7 million, or 31.0%, to $117.5 million for the year ended December 31, 2003, compared to $170.2 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 $33.1 million increase in policy acquisition and other operating expenses, primarily due to an increase in special commission and expenses associated with 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 $21.6 million for the year ended December 31, 2003 compared to 2002. Partially offsetting these negative items was a benefit from an estimated $56 million of improved current accident year loss performance, primarily due to net premium rate increases across all principal product lines and a decrease in non-catastrophe claims activity.
Personal lines’ net premiums written decreased $50.5 million, or 3.3%, to $1.5 billion for the year ended December 31, 2004. This was primarily the result of a decrease of $65.0 million, or 5.9%, in the personal automobile line, partially offset by an increase of $16.9 million, or 4.3% in the homeowners line. The decrease in the personal automobile line is primarily due to the decline of 11.9% in policies in force since December 31, 2003. Partially offsetting this decrease of policies in force was a 4.6% rate increase in the personal automobile line. The increase in the homeowners line resulted primarily from an overall 12.7% rate increase, partially offset by a decrease in overall policies in force of 8.7% since December 31, 2003. Approximately one-half of the decline in policies in force in both lines was the result of our strategies to enhance margins, and in some cases, reduce exposures in certain states where the regulatory structure is challenging, particularly Massachusetts and New Jersey, where we conduct a significant amount of business. Part of this reduction reflects our exit of certain sponsored market accounts (employer and affinity groups) that were unprofitable and not well aligned with our strategy. However, policies in force also declined in many other markets, most significantly in Michigan where policies in force decreased 8.0% since December 31, 2003. We attribute this decline to the introduction of a new product that enhances our ability to segment risks, certain service issues, which management is currently addressing, and rate increases on specific classes of business. There can be no assurance that we will not experience further declines in our policies in force.
Personal lines’ segment income increased $100.3 million to $134.6 million for the year ended December 31, 2004. The increase in segment income is primarily attributable to an estimated $98 million of improved current accident year loss performance. The improved loss performance is attributable to the favorable effect of net premium rate increases. Also, a decrease in non-catastrophe claims activity due to lower frequency in both the personal automobile and homeowners lines favorably impacted segment income. We believe our improved non-catastrophe claims frequency experience is consistent with recent industry trends although we do not know whether these trends are sustainable. In addition, development on prior years’ loss and loss adjustment expense reserves improved $35.7 million, to $10.4 million of favorable development for the year ended December 31, 2004, compared to $25.3 million of adverse development in 2003. These favorable items were partially offset by an increase in policy acquisition and other operating expenses of $26.7 million for the year ended December 31, 2004 as compared to 2003, due to higher contingent commissions, employee-related expenses and technology costs. Additionally, catastrophe losses increased $14.2 million, to $49.8 million for the year ended December 31, 2004, compared to $35.6 million in 2003, due to four hurricanes in the Southeast.
Commercial lines’ segment income decreased $40.7 million to $58.0 million for the year ended December 31, 2004. The decrease in segment income is primarily attributable to an increase in catastrophe losses of $25.7 million, to $49.5 million for the year ended December 31, 2004, compared to $23.8 million for the same period in 2003. Catastrophe losses were unusually high in 2004 due to four significant hurricanes in the Southeast. Also contributing to the decline in segment income is the increase of $19.4 million in policy acquisition and other operating expenses for the year ended December 31, 2004 compared to the same period in 2003. Policy acquisition and other operating expenses increased due to higher contingent commissions, employee-related expenses and technology costs. Loss adjustment expenses increased approximately $15 million primarily due to higher employee-related expenses, to increased catastrophe activity, and higher litigation activity. Additionally, favorable development on prior years’ loss and LAE reserves decreased $2.9 million, to $4.1 million of favorable development for the year ended December 31, 2004, compared to $7.0 million of favorable development for the same period in 2003. Partially offsetting these unfavorable items was an estimated $14 million in improved current accident year loss performance.
Commercial lines’ net premiums written decreased $66.9 million, or 8.8%, to $697.1 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. 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. This decrease is
also partially due to lower retention rates in certain lines as a result of the ratings downgrades, including attrition with larger accounts. Partially offsetting these items were rate increases in all of the commercial lines since December 31, 2002.
Commercial lines’ segment income decreased $25.5 million to $98.7 million for the year ended December 31, 2003. The decrease in segment income is primarily attributable to an increase in catastrophe losses of $18.3 million, to $23.8 million for the year ended December 31, 2003, compared to $5.5 million 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 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’ policy acquisition and other operating expenses increased due to higher commissions and the prior year’s expenses related to our financial guarantee program, as well as employee benefits and technology costs. Partially offsetting these items is an estimated $47 million of net premium rate increases.
Segment results of the Other Property and Casualty segment decreased $21.3 million to a loss of $15.5 million for the year ended December 31, 2003 from a profit of $5.8 million in 2002. Segment results for 2003 included a charge of $21.9 million resulting from an adverse arbitration decision related to a single large property claim within a voluntary insurance pool. We exited this pool in 1996.
We maintain reserves for our property and casualty products to provide for our ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given point in time, of what we expect the ultimate settlement and administration of claims will cost based on facts and circumstances then known, estimates of future trends in claim severity and frequency, judicial theories of liability and policy coverage, and other factors.
We determine the amount of loss and loss adjustment expense reserves (the “loss reserves”) based on an estimation process that is very complex and uses information obtained from both company specific and industry data, as well as general economic information. The estimation process is judgmental, and requires us to continuously monitor and evaluate the life cycle of claims on type-of-business and nature-of-claim bases. Using data obtained from this monitoring and assumptions about emerging trends, we develop information about the size of ultimate claims based on historical experience and other available market information. The most significant assumptions used in the estimation process, which vary by line of business, include determining the trend in loss costs, the expected consistency in the frequency and severity of claims incurred but not yet reported to prior year claims, changes in the timing of the reporting of losses from the loss date to the notification date, and expected costs to settle unpaid claims. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There are no precise methods, however, for subsequently evaluating the impact of any specific factor on the adequacy of reserves, because the eventual development of reserves is affected by many factors, as noted above. Because the amounts of the loss reserves are sensitive to our assumptions, we do not completely rely on only one estimate to determine our loss reserves. We develop several estimates using generally accepted actuarial projection methodologies that result in various reasonably possible loss reserve outcomes and we adopt an estimate that considers all of the actuarial projection methodologies plus other factors not captured by these methodologies. Regarding voluntary and involuntary pools, we are provided loss estimates by managers of each pool. We adopt an estimate that considers this information and other factors. We exercise judgment
based upon our knowledge of the property and casualty business, review of the outcome of actuarial studies, historical experience and other factors to record an estimate which reflects our expected ultimate loss and loss adjustment expenses. When trends emerge that we believe affect the future settlement of claims, we adjust our reserves accordingly.
We perform actuarial reviews on certain detailed line of business coverages. These individual reviews are summarized into six broader lines of business: personal automobile, homeowners, workers’ compensation, commercial automobile, commercial multiple peril, and other lines.
We may be required to defend claims related to policies that include environmental damage and toxic tort liability. The table below summarizes our business asbestos and environmental reserves (net of reinsurance and excluding pools):
We estimate our ultimate liability for asbestos and environmental claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. We believe that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. In addition, we are not aware of any litigation or pending claims that are expected to result in additional material liabilities in excess of recorded reserves. The environmental liability could be revised in the near term if the estimates used in determining the liability are revised.
Catastrophe reinsurance serves to protect the ceding insurer from significant losses arising from a single event or aggregate events such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. Under our catastrophe reinsurance agreements, we ceded $41.5 million of losses in 2004 primarily as a result of four large catastrophes that occurred in 2004.
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 $4.2 million, $5.3 million and $4.0 million for the years ended December 31, 2004, 2003 and 2002, respectively, 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.
Prior to September 30, 2002, the Life Companies primary business was variable annuities, variable universal life and traditional life insurance products, as well as certain group retirement products and GICs. In the fourth quarter of 2002 and as a result of ratings downgrades, we ceased the sale of proprietary products and GICs, and all remaining short-term funding agreements were terminated.
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. As a result, other income associated with the brokerage operations and the related other operating expenses are significantly lower than in the past. In addition, this was followed by reduced persistency in 2004 for the policies that were sold through our former agency distribution channel.
The following table summarizes the results of operations for the Life Companies segment for the periods indicated:
(2) Other expenses include subadvisory fees of $9.9 million, $11.2 million and $15.1 million for the years ended December 31, 2004, 2003 and 2002 respectively. Other expenses for the years ended December 31, 2004, 2003 and 2002 also include brokerage related commissions of $1.5 million, $57.4 million, and $40.8 million, respectively. The Company no longer sells proprietary or non-proprietary products.
Life Companies segment income was $11.3 million for 2004 compared to $8.7 million for 2003. While certain transactions may impact several income statement line items, the following items contribute to the overall change in segment income. This increase of $2.6 million was primarily the result of $47.7 million net savings resulting from the cessation of the retail sales operations of our broker/dealer, VeraVest, and ongoing expense management efforts. Also, $11.5 million of VeraVest asset impairments were recorded in 2003, which were absent in 2004. These were partially offset by an increase in DAC amortization of $24.8 million primarily resulting from the effect of equity market returns being consistent with our assumptions as compared to the effect of equity market returns exceeding our assumptions in 2003. Segment results also deteriorated $10.6 million due to lower interest margins on GICs, primarily from higher expenses associated with interest rate swaps. Also, net investment income declined $9.6 million primarily from the replacement of high-yield investments with lower yielding, higher quality fixed income securities and lower partnership income. (See also Net Investment Income below). Additionally, the combined effect of derivatives losses associated with the GMDB hedging program and increased GMDB reserve expenses required under SOP 03-1, net of DAC, also reduced Life Companies segment income by $8.5 million in 2004. (See also Guaranteed Minimum Death Benefits below).
Net investment income declined $53.4 million to $217.4 million for the year ended 2004 compared to the same period a year ago. The decline in net investment income reflects a decrease in average general account assets, principally resulting from annuity redemptions and reductions in outstanding GIC balances, and a decrease in pre-tax yields on fixed maturity securities. Average pre-tax yields on fixed maturities decreased to 5.9% in 2004 compared to 6.0% in 2003 due to lower prevailing fixed maturity investment rates and a shift to higher credit quality fixed maturity investments.
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. For additional information regarding our accounting policy related to DAC, see “Critical Accounting Policies” on pages 50 to 52 of this Form 10-K.
The aforementioned $629.4 million of DAC adjustments in 2002 consisted of six separate items. First, we anticipated that ratings downgrades and our decision to cease new sales of proprietary life insurance and annuity products unfavorably affected 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 Guaranteed Minimum Death Benefits below). The increased cost estimates affected our expectation of future gross profits, resulting in additional DAC amortization of $61.7 million in 2002.
Other operating expenses declined $121.8 million, to $231.8 million in 2004. The decrease reflects lower commissions, distribution and insurance operation expenses related to the decision to discontinue the retail sales operations of VeraVest.
Other operating expenses decreased $36.2 million, to $353.6 million in 2003. The decrease was 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. In 2003, we recognized the aforementioned $11.5 million charge related to asset impairments resulting from the discontinuing of retail operations of VeraVest. Excluding the asset impairments in 2003 and 2002, other operating expenses would have decreased $17.9 million. This decrease reflected 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.
We use derivative instruments to hedge our GIC portfolio (see Derivative Instruments on page 44 of this Form 10-K). For floating rate GIC liabilities that are matched with fixed rate securities, we manage the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. In addition, some funding agreements are denominated in foreign currencies. To mitigate the effect of changes in currency exchange rates, we hedge this risk by entering into foreign exchange swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts to hedge our net foreign currency exposure. These hedges resulted in a $21.3 million reduction in net investment income during 2004, as compared to a $5.9 million reduction in net investment income during 2003. These reductions were offset by similar reductions in GIC interest credited during these periods.
The increased effect of derivative instruments in 2004 was primarily due to new swap contracts entered into to replace futures contracts. The futures contracts did not qualify for hedge accounting in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivatives and Hedging Activities (“Statement No. 133”), and were therefore deemed “ineffective” for accounting purposes. The new foreign currency swaps are “effective” hedges for accounting purposes; thus, they had no impact on other income during 2004. The “ineffective” futures contracts resulted in a $9.0 million decrease in other income during 2003. While we do not currently expect fluctuations to other income to recur, there can be no assurances that we will not experience losses from ineffective hedges in the future.
As the block of annuity contractholders ages, or if the average age of annuitants increases as a result of antiselection, our mortality costs, as a percentage of the net amount at risk, will increase due to premium increases related to the GMDB mortality reinsurance program. The mortality reinsurance program, which extends until 2012, provides protection against adverse mortality experience but not against the increasing age of annuitants. The hedge program also does not protect against the reduction in proprietary product fees and cash flow, which would result from the reduction in net account balances following a decline in the equity market.
Prior to discontinuing sales of our proprietary products in the fourth quarter of 2002, we distributed our annuity products primarily through three distribution channels: (1) “Agency”, which consisted of our former career agency force; (2) “Select”, which consisted of a network of third party broker/dealers; and (3) “Partners”, which included distributors of the mutual funds advised by Scudder Investments, Pioneer Investment Management, Inc. and Delaware Management Company.
In addition to our review of segment income, beginning in 2003, we also began utilizing an alternative non-GAAP method of viewing our Life Companies business. We adjust the segment income for the Life Companies 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 or amounts available to dividend from the life insurance companies. In addition, all dividends from our life insurance companies are subject to regulatory approval.
Total investment assets decreased $211.5 million, or 2.4%, to $8.8 billion during 2004, primarily as a result of decreases in cash and cash equivalents of $291.6 million, mortgages of $60.3 million and other long-term investments of $25.4 million, partially offset by an increase in fixed maturities of $175.7 million. Cash and cash equivalents decreased primarily as a result of a decrease in collateral held related to our securities lending program, group annuity contract redemptions, as well as the retirement of certain long-term funding agreements in our Life Companies segment. Fixed maturities increased primarily due to improved underwriting results in the Property and Casualty group. This increase was partially offset by the maturity of certain long-term funding agreements in the Life Companies segment and unfavorable market value depreciation. Mortgage loans decreased principally due to loan payoffs, while other long-term investments decreased primarily due to capital distributions from limited partnerships and the sale of real estate, all occurring in the Life Companies segment.
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 94.2% at December 31, 2004 and 94.0% at December 31, 2003 of our total fixed maturity portfolio.
We had $28.2 million of gross unrealized losses on fixed maturities and equity securities at December 31, 2004, as compared to $47.9 million at December 31, 2003. Approximately $5.5 million of the gross unrealized losses at December 31, 2004 relate to investment grade fixed maturity obligations of the U.S. Treasury, U.S. government and agency securities, states and political subdivisions, compared to $9.9 million at December 31, 2003. At both December 31, 2004 and 2003, 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, 2004, 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 enter into foreign currency swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts, to hedge foreign currency and interest rate exposure on specific funding agreement liabilities. We also entered into various types of interest rate swap contracts to hedge exposure to interest rate fluctuations on floating rate funding agreement liabilities that were matched with fixed rate securities.
Our operations are subject to risk resulting from interest rate fluctuations to the extent that there is a difference between the amount of our interest-earning assets and the amount of interest-bearing liabilities that are paid, withdrawn, mature or re-price in specified periods. We have developed an asset/liability management approach tailored to specific insurance or investment product objectives. The principal objective of our approach is to provide maximum levels of net investment income, while maintaining acceptable levels of interest rate and liquidity risk and facilitating our funding needs. We manage our investment assets in over 20 portfolio segments consistent with specific products or groups of products having similar liability characteristics. As part of this approach, we develop investment guidelines for each portfolio consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. We have a general policy of diversifying investments both within and across all portfolios. We monitor the credit quality of our investments and our exposure to individual markets, borrowers, industries, sectors, and in the case of mortgages, property types and geographic locations. In addition, we currently carry long-term debt.
We file a consolidated United States federal income tax return that includes AFC and its domestic subsidiaries (including non-insurance operations). We segregate the entities included within the consolidated group into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income.
The provision for federal income taxes before the effect of a change in accounting principle was an expense of $4.2 million during 2004, compared to benefits of $7.4 million during 2003 and $234.8 million during 2002. These provisions resulted in consolidated effective federal tax rates of 2.2% of pre-tax income for 2004, 9.3% of pre-tax income for 2003 and 45.0% of pre-tax loss for 2002. The current year effective tax rate reflects a $30.4 million benefit resulting from the settlement of disputed items in our federal tax returns filed for 1979 to 1991. The largest of the disputed items relates to deductions taken for increased death benefits pertaining to certain life insurance contracts existing in 1982 and 1983. The settlement entitled us to receive a refund of taxes paid for these years, as well as various tax credits that can be applied to offset federal tax liabilities in other years.
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 70 to 77 of the Notes to Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K.
DAC consist of commissions, underwriting costs and other costs, which vary with, and are primarily related to, the production of insurance deposits. Our variable annuity product offerings included contracts that offered enhanced crediting rates or bonus payments, also referred to as sales inducements. Prior to the adoption of SOP 03-1, sales inducements were included with our deferred policy acquisition costs. Acquisition costs and sales inducements 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. Our estimated gross profits are based on assumptions including mortality, contract persistency, asset growth rates, expenses associated with policy maintenance and contract costs (such as those relating to any GMDB feature and fees payable to distributors). The principal source of earnings for these policies is from asset-based fees, which can vary in relation to changes in the equity market.
Decreased persistency and equity market value declines are factors which would lower our estimated gross profits. Decreased persistency not only lowers net fees due to lower average invested assets, it also will increase the cost of the GMDB feature of variable annuity contracts, further reducing profitability. This results in future revenues being insufficient to offset GMDB claims in the near term.
We review the DAC asset quarterly 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.
The Regulatory Action Level, which equals 150% of the Authorized Control Level, requires the insurer to submit to the commissioner of the state of domicile a RBC plan, or if applicable, a revised RBC plan. After examination or analysis, the commissioner will issue an order specifying corrective actions to be taken.
Life and health companies whose Total Adjusted Capital is between 200% and 250% of the Authorized Control Level are subject to a trend test. The trend test calculates the greater of the decrease in the margin between the current year and the prior year and the average of the past three years. It assumes that the decrease could occur again in the coming year. Any company that trends below 190% of the Authorized Control Level (i.e. demonstrates a negative
The improvement of our life companies’ RBC ratios reflect lower required risk-based capital primarily as a result of lower deposit fund reserves and group annuity contracts. Additionally, lower required statutory GMDB reserves as a result of improvements in the equity market and surrender activity contributed to the improvement in our RBC ratios. The NAIC is contemplating changes to the RBC Formula for life companies. Among these changes are proposed revisions to capital standards for certain products with equity related risks. Although it is yet to be determined when and exactly how these changes will be implemented, they are expected to cause RBC levels to be lower for our company and others with products that have equity related risks.
On December 3, 2003, we implemented a hedging program for our in-force variable annuity policies with GMDB features. The program’s primary purpose is to provide us with an economic hedge against increased GMDB claims which could arise from declines in the equity market below levels at December 3, 2003. Also, the program is expected to reduce the volatility in statutory capital and risk-based capital levels from the effects of future equity market movements and allows us to retain most of the benefits of reduced GMDB costs in a rising equity market. The hedge program does not provide protection from the GMDB cost associated with the net amount at risk of $2.7 billion in existence on December 3, 2003. Over time, the actual amount of the unhedged economic cost will vary depending on equity market levels, redemption rates, and certain GMDB product features, such as roll-up (net deposits accumulated at a specified rate) or ratchet (highest historical account value on a contract anniversary).
AFLIAC declared a dividend of $75.0 million to the holding company in December 2004, which was paid in January 2005. In December 2003, AFLIAC declared and paid a $25.0 million dividend to the holding company. Both dividends were approved by the Massachusetts Commissioner of Insurance.
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 degree of liquidity within their respective investment portfolios in fixed maturity investments, common stock and short-term investments. In addition, we had no commercial paper borrowings as of December 31, 2004 and we do not anticipate utilizing commercial paper in 2005. Debt ratings downgrades resulted in the non-renewal of our credit line in 2003 and continue to preclude or adversely affect the cost and availability of credit lines, commercial paper, other additional debt and equity financing.
(5) Qualified pension plan funding obligations represent the amounts necessary to be contributed to the plan to satisfy minimum funding obligations in accordance with the Employee Retirement Income Security Act of 1974. Beginning in 2006, substantial contributions may be required based on the current level of pension assets and liabilities. It is not currently possible to reliably estimate these obligations.
We intend to vigorously defend this matter, and regard plaintiffs claims for lost trading profits as being speculative and, in any case, subject to an obligation to mitigate damages. Further, in our view, these purported lost profits would not have been earned because of various actions taken by us, the investment management industry and regulators, to defer or eliminate market timing, including the implementation of “fair value” pricing.
The monetary damages sought by plaintiffs, if awarded, could have a material adverse effect on our financial position. However, in our judgment, 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. The date for the damage phase of the litigation has been postponed and a new date has not yet been set.
We have been named a defendant in various other legal proceedings arising in the normal course of business and are involved, from time to time, in investigations and proceedings by governmental and self-regulatory agencies, including inquiries relating to “market timing” in sub-accounts of variable annuity and life products, “revenue sharing” and other matters, and regulatory inquiries into compensation arrangements with brokers and agents. Additional information on other litigation and claims may be found in Note 20, “Contingencies” on pages 104 and 105 of the Notes to the Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K. In our opinion, based on the advice of legal counsel, the ultimate resolutions of such proceedings will not have a material effect on our financial position, although they could have a material effect on the results of operations for a particular quarter or annual period.
We believe that strong ratings are important factors in marketing our products to our agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company financial strength ratings are assigned to an insurer based upon factors deemed by the rating agencies to be relevant to policyholders and are not directed toward protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security.
The following tables provide information about our ratings at December 31, 2002, 2003 and 2004.
Additionally, as a result of the ratings downgrades in 2002 of our life insurance companies, we are no longer able to generate new sales of proprietary insurance and GIC products in our Life Companies segment. Although we do not expect downgrades in our ratings, there can be no assurance that current ratings or downgrades that could occur would not have a material adverse affect on our results of operations and financial position.
Our holding company’s current debt ratings, which are below investment grade, are expected to adversely affect the ability to obtain, or the cost and availability of credit lines, commercial paper, other debt and equity financing, and resulted in our non-renewal of our credit line in 2003.
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 2005 and beyond to differ materially from historical results and from those expressed in any of our forward-looking statements. 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, 2004.
We generate a significant portion of our total revenues and earnings through our property and casualty insurance subsidiaries. The results of companies in the property and casualty insurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability could be affected significantly by (i) adverse catastrophe experience, severe weather or other unanticipated significant losses; (ii) adverse loss development or loss adjustment expense for events we have insured in either the current or in prior years, including risks indirectly insured through discontinued pools which are included in the Other Property and Casualty segment; (iii) an inability to retain profitable policies in force and attract profitable policies in our Personal Lines segment; (iv) increases in costs, particularly those occurring after the time our products are priced and including construction, automobile, and medical and rehabilitation costs; (v) restrictions on insurance underwriting; (vi) industry-wide change resulting from current investigations and inquiries relating to compensation arrangements with insurance brokers and agents; and (vii) disruptions caused by the introduction of new personal lines products and related technology changes and new personal and commerical lines operating models.
Our businesses may be affected by (i) lower appreciation or decline in value of our managed investments or the investment markets in general, resulting in reduced variable product assets and related variable product management fees, lapses and increased surrenders, increased DAC amortization, as well as increased cost of guaranteed minimum death benefits; (ii) adverse trends in mortality and morbidity; (iii) possible claims relating to sales practices for insurance and investment products; (iv) earlier than expected withdrawals and changes in redemption patterns from our general account annuities and other insurance products, particularly with respect to younger-aged annuities sold in the former Agency channel which was affected by the shutdown of VeraVest; (v) losses due to foreign currency fluctuations; (vi) the extent to which the performance of the various hedging instruments utilized in our GMDB hedging program do not correlate with the investment performance and underlying annuity sub-accounts; (vii) the continued availability of equity index futures; and (viii) adverse actions related to legal and regulatory actions described under “Contingencies”.
Other market fluctuations and general economic, market and political conditions also may negatively affect our business and profitability. These conditions include (i) heightened competition, including the intensification of price competition, the entry of new competitors and the introduction of new products by new and existing competitors, or as the result of consolidation within the financial services industry and the entry of additional financial institutions into the insurance industry; (ii) adverse state and federal legislation or regulation, including decreases in rates, the inability to obtain further rate increases, 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, limitations on the use of credit scoring, such as the recent proposal to ban the use of credit scores with respect to personal lines in Michigan, recent and future changes affecting the tax treatment of insurance and annuity products, restrictions on the use of certain compensation arrangements with agents and brokers, 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 or other key employees, particularly in the Life Companies segment; (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, except where required or permitted by applicable accounting principles, components of our Consolidated Balance Sheets are not marked to market or otherwise intended to reflect our estimates of the fair market or disposition value of such assets or liabilities or the related businesses. The recorded value of certain assets, such as deferred acquisition costs, deferred federal income taxes and goodwill, and certain liabilities such as guaranteed minimum death benefit reserves, reflect the application of our assumptions to generally accepted accounting principles. (See “Critical Accounting Policies”, on pages 50 to 52 and Note 1-Summary of Significant Accounting Policies on pages 70 to 77 of the Notes to the Consolidated Financial Statements included in Financial Statements and Supplementary Data of this Form 10-K). Accordingly, in the event of a disposition of all or a portion of any such assets, liabilities or related businesses, the value obtainable in such a transaction may differ materially from the value reflected in our consolidated financial statements, which would in turn have a material impact on Shareholders’ Equity and book value per share. From time to time management evaluates strategic options for the Life Companies, which options could include the disposition of all or a portion of such business. In the event of such a disposition, it is management’s expectation that the realizable value would be substantially and materially lower than the value reflected in Shareholders’ Equity in our Consolidated Balance Sheets. Additionally, such transactions may also result in the reallocation of corporate overhead costs to other segments.
Antiselection - The tendency of people who suspect or know they are more likely than average to experience loss to apply for or retain an insurance or an annuity contract to a greater extent than are people who lack such knowledge of probable loss.
Guaranteed Minimum Death Benefit (GMDB) - A contract feature which provides annuity contractholders with a guarantee that the benefit received at death will be no less than a prescribed minimum amount. This minimum amount is based on either the net deposits paid into the contract, the net deposits accumulated at a specified rate, the highest historical account value on a contract anniversary, or more typically, the greatest of these values.
Rates - The pricing factor upon which the policyholder’s premium is based.
Reversion-to-the-mean - Actuarial approach to develop estimates of future returns, which assumes that the market will return to an average gross long-term return estimate, developed with reference to historical long-term equity market performance and subject to assessment of the reasonableness of resulting estimates of future return assumptions. For purposes of making this reasonableness assessment, we have set limitations as to maximum and minimum future rates of return assumptions, as well as the duration of use of these maximum or minimum rates of return.
Surrender or withdrawal - Surrenders of life insurance policies and annuity contracts for their entire net cash surrender values and withdrawals of a portion of such values.
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 15. All significant intercompany accounts and transactions have been eliminated.
If the actual income from the Closed Block in any given period equals or exceeds the expected income for such period as determined at the inception of the Closed Block, the expected income would be recognized in income for that period. Further, cumulative actual Closed Block income in excess of the expected income would not inure to the shareholders and would be recorded as an additional liability for policyholder dividend obligations. This accrual for future dividends effectively limits the actual Closed Block income recognized in income to the Closed Block income expected to emerge from operation of the Closed Block as determined at inception.
believes may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral.
In the normal course of business, the Company enters into transactions involving various types of financial instruments, including debt, investments such as fixed maturities, mortgage loans and equity securities, investment and loan commitments, swap contracts, option contracts and futures contracts. These instruments involve credit risk and are also subject to risk of loss due to interest rate and foreign currency fluctuation. The Company evaluates and monitors each financial instrument individually and, when appropriate, obtains collateral or other security to minimize losses.
The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item, including forecasted transactions; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is no longer designated as a hedge instrument because it is unlikely that a forecasted transaction will occur; or (4) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair value hedge, the derivative will continue to be carried
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.
Liabilities for outstanding claims, losses and loss adjustment expenses (“LAE”) are estimates of payments to be made on property and casualty and health insurance contracts for reported losses and LAE and estimates of losses and LAE incurred but not reported. These liabilities are determined using case basis evaluations and statistical analyses and represent estimates of the ultimate cost of all losses incurred but not paid. These estimates are continually reviewed and adjusted as necessary; such adjustments are reflected in current operations. Estimated amounts of salvage and subrogation on unpaid property and casualty losses are deducted from the liability for unpaid claims.
Trust instruments supported by funding obligations consist of deposits received from customers, investment earnings on their fund balance and the effect of changes in foreign currencies related to these deposits.
Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“Statement No. 109”). These differences result primarily from loss and LAE reserves, policy reserves, policy acquisition expenses, tax credit carryforwards, employee benefit plans, net operating loss carryforwards, and deferred sales inducement.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“Statement No. 123(R)”). This statement requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. Statement No. 123(R) replaces Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“Statement No. 123”), and supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”). The provisions of this statement are effective for interim and annual periods beginning after June 15, 2005. The Company is evaluating the effects of Statement No. 123(R) and will begin expensing stock options in the third quarter of 2005.
In March 2004, the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”) reached several consensuses regarding the application of guidance related to the evaluation of whether an investment is other than temporarily impaired in accordance with EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (“EITF No. 03-1”). However, on September 30, 2004, the FASB delayed indefinitely the effective date for the measurement and recognition guidance of EITF No. 03-1. The disclosure requirements were not deferred. EITF No. 03-1 describes certain quantitative and qualitative disclosures that are required for marketable fixed maturities and equity securities covered by Statement No. 115, including the aggregate amount of unrealized losses and the aggregate related fair value of investments with unrealized losses, by investment type, as well as additional information supporting the conclusion that the impairments are not other-than-temporary, such as the nature of the investment(s), cause of impairment and severity and duration of the impairment. The disclosures required by EITF No. 03-1 were effective for fiscal years ending after December 15, 2003. The additional disclosures for cost method investments were effective for fiscal years ending after June 15, 2004. The Company implemented the disclosure requirements of this EITF for the year ending December 31, 2003.
In July 2003, the American Institute of Certified Public Accountants issued SOP 03-1, which is applicable to all insurance enterprises as defined by Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises. This statement provides guidance regarding accounting and disclosures of separate account assets and liabilities and an insurance company’s interest in such separate accounts. It further provides for the accounting and disclosures related to contractholder transfers to separate accounts from a company’s general account and the determination of the balance that accrues to the benefit of the contractholder. In addition, SOP 03-1 provides guidance for determining any additional liabilities for guaranteed minimum death benefits or other insurance benefit features, potential benefits available only on annuitization and liabilities related to sales inducements, such as immediate bonus payments, persistency bonuses, and enhanced crediting rates or “bonus interest” rates, as well as the required disclosures related to these items. This statement was effective for fiscal years beginning after December 15, 2003. The determination of the GMDB reserve under SOP 03-1 is complex and requires various assumptions, including, among other items, estimates of future market returns and expected contract persistency. Upon adoption of this statement in the first quarter of 2004, the Company recorded a $57.2 million charge, net of taxes. This charge was reported as a cumulative effect of a change in accounting principle in the Consolidated Statements of Income. See also Note 3, Adoption of Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.
In May 2003, the FASB issued Statement No. 150. This statement established 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. This statement was effective for interim periods beginning after June 15, 2003. The Company, through AFC Capital Trust I, has $300.0 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 2004 and 2003, and as minority interest in 2002. 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. FIN 46(R) 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(R) also requires disclosures by companies that hold a significant variable interest, even if they are not the primary beneficiary. The Company performed a review of potential variable interest entities and concluded that as of December 31, 2004, AFC was not the primary beneficiary of any material variable interest entities; and, therefore would not be required to consolidate any variable interest entities as a result of FIN 46(R). However, the Company does hold a significant variable interest in a limited partnership. In 1997, the Company invested in the McDonald Corporate Tax Credit Fund-1996 Limited Partnership, which was organized to invest in low income housing projects which qualify for tax credits under the Internal Revenue Code. The Company’s investment in this limited partnership, which represents approximately 36% of the partnership, is not a controlling interest; it entitles the Company to tax credits to be applied against its federal income tax liability in addition to tax losses to offset taxable income. The Company’s maximum exposure to loss on this investment is limited to its carrying value, which is $7.2 million at December 31, 2004. In addition, the Company had $300.0 million of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. Prior to July 1, 2003, these securities were classified as a separate line item in the mezzanine level of the balance sheet. Upon adoption of Statement No. 150, these securities were reclassified to debt. These securities were issued by a trust that was established for the sole purpose of issuing the securities to investors and are fully guaranteed by the Company. In the first quarter of 2004, the Company adopted the provisions of FIN 46(R), which required that the Company deconsolidate the trust for financial reporting purposes. The net effect of deconsolidating the trust was to increase the Company’s consolidated assets and liabilities by $9.3 million, which represents the Company’s equity interest in the trust.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“Statement No. 146”). This statement requires that a liability for costs associated with an exit or disposal activity is recognized and measured initially at its fair value in the period the liability is incurred. This statement supersedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring) (“EITF No. 94-3”). Additionally, the statement requires financial statement disclosures about the description of the exit or disposal activity, including for each major type of cost, the total amount expected to be incurred and a reconciliation of the beginning and ending liability balances. The provisions of this statement are effective for all exit and disposal activities initiated after December 31, 2002.
Earnings per share (“EPS”) for the years ended December 31, 2004, 2003, and 2002 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.
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 2004, 2003, and 2002.
The table below presents the account value, net amount at risk and average attained age of underlying contractholders for guarantees in the event of death as of December 31, 2004 and 2003. The net amount at risk is the death benefit coverage in force or the amount that the Company would have to pay if all contractholders had died as of the specified date, and represents the excess of the guaranteed benefit over the fair value of the underlying investments.
The Company’s variable annuity product offerings included contracts that offered enhanced crediting rates or bonus payments. These enhanced rates are considered sales inducements under SOP 03-1. As such, the balance of sales inducement assets was required to be reclassified from DAC to other assets upon adoption of SOP 03-1, and amortization of these sales inducements over the life of the contract is required to be reflected as a policy benefit. Amortization of these contracts is required to be computed using the same methodology and assumptions used in amortizing DAC.
Upon adoption of SOP 03-1, assets related to the MVA product, primarily fixed maturities, which are carried at fair value, were reclassified to the general account as available-for-sale securities. Reserves related to contract account values included in separate account liabilities were also reclassified to the Company’s general account. Changes in the fair value of these assets continue to be reflected in other comprehensive income in the Consolidated Balance Sheets. Additionally, amounts assessed against the contractholders for mortality, administrative, and other services continue to be included in universal life and investment product policy fees and changes in liabilities for minimum guarantees continue to be included in policy benefits, claims, losses and loss adjustment expenses in the Consolidated Statements of Income. Components of the interest spreads related to this product continue to be recorded in net investment income and policy benefits, claims losses and loss adjustment expenses in the Consolidated Statements of Income. Realized investment gains and losses are recognized as incurred, consistent with prior years.
The amortized cost and fair value by maturity periods for fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage-backed securities are included in the category representing their ultimate maturity.
The Company’s mortgage loans are diversified by property type and location. Mortgage loans are collateralized by the related properties and generally do not exceed 75% of the property’s value at the time of origination. No mortgage loans were originated during 2004 and 2003. The carrying values of mortgage loans, net of applicable reserves, were $114.8 million and $175.1 million at December 31, 2004 and 2003, respectively. Reserves for mortgage loans were $1.5 million and $1.8 million at December 31, 2004 and 2003, respectively.
At December 31, 2004, scheduled mortgage loan maturities were as follows: 2005 - $8.9 million; 2006 - $15.2 million; 2007 - $3.5 million; 2008 - $7.1 million; 2009 - $10.7 million and $69.4 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 2004, the Company did not refinance any mortgage loans based on terms that differed from current market rates.
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 GICs 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
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 of Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (“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.
During 2004, the Company recognized a net loss of $18.3 million on all trading derivatives. In 2003 and 2002, the Company recognized net gains of $3.9 million and $10.9 million, respectively on all trading derivatives. The net loss recognized in 2004 included $25.1 million in losses recorded within other operating expenses in the Consolidated Statements of Income related to the GMDB hedges. Additionally, the net loss in 2004 included $7.4 million of net gains representing the ineffectiveness on equity-linked swap contracts, which were recorded in other income in the Consolidated Statements of Income. Further, the 2004 net loss also included a $0.6 million loss related to embedded derivatives on equity-linked trust instruments supported by funding obligations, which was reported in losses (gains) on derivative instruments in the Consolidated Statements of Income. The net gain recognized in 2003 included $14.0 million of net gains representing the ineffectiveness on equity-linked swap contracts, which was recorded in other income in the Consolidated Statements of Income. Additionally, the net gain in 2003 included $8.4 million in losses recorded within losses (gains) on derivative instruments in the Consolidated Statements of Income related to the GMDB hedges. Further, the 2003 net gain also included a $1.7 million loss related to embedded derivatives on equity-linked trust instruments supported by funding obligations, which is reported in losses (gains) on derivative instruments in the Consolidated Statements of Income. The net gain of $10.9 million in 2002 represents the total ineffectiveness on equity-linked swap contracts and the embedded derivative on the equity-linked trust instruments supported by funding obligations. These amounts were reported in losses (gains) on derivative instruments and other income in the Consolidated Statements of Income.
(1) Fixed maturities include after-tax net appreciation (depreciation) on derivative instruments of $20.0 million, $(4.7) million and $(38.0) million in 2004, 2003 and 2002, respectively. Balances at December 31, 2004, 2003 and 2002 include after-tax net depreciation from derivative instruments of $50.5 million, $70.5 million and $65.8 million, respectively.
(2) At December 31, 2004 and 2003, 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.
The Company had fixed maturities with a carrying value of $29.8 million and $28.6 million on non-accrual status at December 31, 2004 and 2003, respectively. The Company had no mortgage loans on non-accrual status at December 31, 2004 or 2003. 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 $6.0 million, $7.6 million, and $19.9 million in 2004, 2003, and 2002, respectively.
The payment terms of mortgage loans may from time to time be restructured or modified. There were no restructured mortgage loans at December 31, 2004 and 2003.
There were no mortgage loans which were non-income producing at December 31, 2004 and 2003. However, the Company had non-income producing fixed maturities with a carrying value of $13.9 million and $15.1 million at December 31, 2004 and 2003, respectively.
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 that could be realized upon immediate liquidation.
The carrying amount reported in the Consolidated Balance Sheets approximates fair value since policy loans have no defined maturity dates and are inseparable from the insurance contracts.
Fair values are estimated using discounted cash flow calculations using current interest rates for similar contracts with maturities consistent with those remaining for the contracts being valued.
Summarized financial information of the Closed Block as of December 31, 2004 and 2003 and for the periods ended December 31, 2004, 2003 and 2002 is as follows:
Many expenses related to Closed Block operations are charged to operations outside the Closed Block; accordingly, the contribution from the Closed Block does not represent the actual profitability of the Closed Block operations. Operating costs and expenses outside of the Closed Block are, therefore, disproportionate to the business outside the Closed Block.
Interest expense was $40.6 million, $39.9 million and $17.1 million in 2004, 2003 and 2002, respectively. Interest expense included $15.3 million related to the Company’s senior debentures for each year. In 2004, interest expense also included $25.3 million related to the junior subordinated debentures, while the interest expense in 2003 of $24.6 million reflects expense associated with the mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. As a result of the adoption of Statement No. 150 in 2003, preferred dividends related to these securities were required to be reflected as a component of interest expense. In 2002, these costs were reflected as minority interest. These preferred dividends were not permitted to be reclassified for periods prior to 2003. There was no interest expense related to borrowings under the credit agreements in 2003 and 2002. All interest expense is recorded in other operating expenses.
The Company believes, based on objective evidence, the deferred tax assets will be realized. At December 31, 2004, there were available alternative minimum tax credit carryforwards, low income housing credit carryforwards and foreign tax credit carryforwards of $124.5 million, $56.2 million and $4.2 million, respectively. The alternative minimum tax credit carryforwards have no expiration date, the low income housing credit carryforwards will expire beginning in 2018 and the foreign tax credit carryforward will expire beginning in 2013. At December 31, 2004, the Company has net operating loss carryforwards of $98.9 million which begin to expire in 2016. The Company also has capital loss carryforwards of $13.7 million which expire in 2008.
The Company’s federal income tax returns are routinely audited by the IRS, and provisions are routinely made in the financial statements in anticipation of the results of these audits. The IRS has examined the FAFLIC/AFLIAC consolidated group’s federal income tax returns through 1997. The IRS has also examined the former Allmerica Property and Casualty Companies, Inc. (“Allmerica P&C”) consolidated group’s federal income tax returns through 1997. In the Company’s opinion, adequate tax liabilities have been established for all years. However, the amount of these tax liabilities could be revised in the near term if estimates of the Company’s ultimate liability are revised.
As of January 1, 2005, the defined benefit pension plans were frozen and the Company enhanced its defined contribution 401(k) plan. No further cash balance allocations will be credited for plan years beginning on or after January 1, 2005. In addition, grandfathered benefits are frozen at January 1, 2005 levels with an annual transition pension adjustment calculated at an interest rate equal to 5% per year, up to 35 years of completed service, and 3% thereafter. As a result of these actions, the Company recognized a curtailment gain of $1.0 million in 2004. The changes to the 401(k) plan are discussed in detail below.
The Company utilizes a measurement date of January 1st to determine its periodic pension costs. Weighted-average assumptions used to determine net periodic pension costs are as follows:
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, 2003, resulting in an expected rate of return on plan assets for 2004 of 8.50%.
The Company utilizes a target allocation strategy, focusing on creating a mix of assets to generate growth in equity, as well as managing expenses and contributions. Various factors were taken into consideration in determining the appropriate asset mix, such as census data, actuarial valuation information and capital market assumptions. The Company has determined that the optimal investment strategy is to have a target mix of 72% of its plan assets in equity securities and 28% in fixed income securities and money market funds. The target allocations and actual invested asset allocations for 2004 and 2003 for the Company’s plan assets are as follows:
During the fourth quarter of 2003, a portion of the plan assets were transferred from separate investment accounts of FAFLIC to non-affiliated commingled pools. At December 31, 2004 and 2003, approximately 67% and 66% respectively, of plan assets were invested in these commingled pools. Prior to 2003, plan assets were invested primarily in various separate accounts and the general account of FAFLIC. Equity securities include 796,462 shares of AFC common stock at December 31, 2004 and 2003 with a market value of $26.1 million and $24.5 million, respectively.
The unrecognized net actuarial gains (losses) which exceed 10% of the greater of the projected benefit obligation or the market value of plan assets are amortized as a component of net periodic pension cost over five years.
The Company is required to contribute $0.9 million to its qualified pension plan in 2005 in order to fund its minimum obligation in accordance with ERISA. In addition, the Company expects to contribute $1.9 million to its non-qualified pension plans to fund 2005 benefit payments. At this time, no discretionary contributions are expected to be made to the plans in 2005.
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 2004, 2003 and 2002, the Company matched 50% of employees’ contributions up to 6.0% of eligible compensation. The total expense related to this plan was $5.2 million, $5.4 million, and $5.0 million in 2004, 2003 and 2002, respectively.
Effective January 1, 2005, coincident with the aforementioned decision to freeze the defined benefit plans, the Company enhanced its 401(k) plan to match 100% of employees’ 401(k) plan contributions up to 5% of eligible compensation. Additionally, the Company will make an annual contribution to employees’ accounts which is equal to 3% of the employee’s compensation. This annual contribution will be made regardless of whether the employee contributes to the plan, as long as the employee is employed on the last day of the year.
In addition, the Company also has a defined contribution plan for substantially all of its former Life Companies agents. The Company recognized expenses in 2003 and 2002 of $1.1 million and $3.1 million, respectively, related to this plan. There was no expense recognized in 2004 related to this plan. The termination of all agent contracts as of December 31, 2002 pursuant to the Life Companies restructuring (see Note 2 - Significant Transactions) resulted in a decrease in the expense in 2003. 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 Note 15 - 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.
Plan amendments in 2004 and 2003 resulted in a benefit of $12.3 million and $9.6 million, respectively. The amendments reflect net increases in certain home office and agent retiree contributions, deductibles and co-payments, thereby lowering plan costs. In addition, the 2004 plan amendments include the implementation of a cap on future medical and drug claims for plan participants under the age of 65.
Assumed health care cost trend rates have a significant effect on the amounts reported. A one-percentage point change in assumed health care cost trend rates in each year would have the following effects:
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 8,487,127 shares as of December 31, 2004, 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.
Options may be granted to eligible employees or agents at a price not less than the market price of the Company’s common stock on the date of grant. Option shares may be exercised subject to the terms prescribed by the Committee at the time of grant, otherwise options granted in 2004, 2003 and 2002 vest over three years with a 25% vesting rate in the first two years and a 50% vesting rate in the final year. For those options granted prior to 2002, all vest at the rate of 20% annually for five consecutive years. Options must be exercised not later than ten years from the date of grant.
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 2004, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of all options granted in 2004, 2003 and 2002 was $9.88 per share, $10.57 per share and $14.48 per share, respectively. No options expired during 2004, 2003 or 2002.
The following table summarizes information about employee options outstanding and exercisable at December 31, 2004:
During 2004, the Company granted shares of nonvested stock to eligible employees, which vest after three years of continuous employment of service. No shares of nonvested stock were granted to property and casualty agents. During 2003, the Company did not grant any shares of nonvested stock to employees or property and casualty agents. During 2002, 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 and 2002, the Company also granted shares of nonvested stock to certain former Life Companies 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 Life Companies agents were forfeited as a result of the Company’s decision to cease operations of its broker/dealer operations (see Note 2 - Significant Transactions). The following table summarizes information about employee and agent nonvested stock.
Pursuant to New Hampshire’s statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer’s statutory policyholder surplus as of the preceding December 31. Hanover declared no dividends to its parent in 2004 or 2003, and declared dividends to its parent of $92.1 million in 2002. During 2005, the maximum allowable dividend and other distributions that can be paid to Hanover’s parent without prior approval of the New Hampshire Insurance Commissioner is $109.9 million.
Massachusetts’ statute limits the dividends a life insurer may pay in any twelve month period, without the prior permission of the Massachusetts Commissioner of Insurance, to the greater of (i) 10% of its statutory policyholder surplus as of the preceding December 31 or (ii) the individual company’s statutory net gain from operations for the preceding calendar year. In addition, under Massachusetts law, no domestic insurer may pay a dividend or make any distribution to its shareholders from other than unassigned funds unless the Commissioner has approved such dividend or distribution. Effective December 30, 2002, AFLIAC, previously a Delaware domiciled life insurance company, became a Massachusetts domiciled life insurance company. On December 31, 2002, AFLIAC became a direct subsidiary of AFC as well as the immediate parent of FAFLIC, which remains a Massachusetts domiciled life insurance company. As a result of this transaction, and in consideration of the decision not to write new business, AFC agreed with the Massachusetts Commissioner of Insurance to maintain total adjusted capital levels at a minimum of 100% of AFLIAC’s Company Action Level, which was $123.2 million at December 31, 2004. Total adjusted capital for life insurance companies is defined as capital and surplus, plus asset valuation reserve, plus 50% of dividends apportioned for payment and was $581.9 million at December 31, 2004 for AFLIAC. The Company Action Level is the first level in which the Massachusetts Commissioner of Insurance would mandate regulatory involvement based solely upon levels of risk based capital. There can be no assurance that AFLIAC would not require additional capital contributions from AFC. In the fourth quarters of 2004 and 2003, with permission from the Massachusetts Commissioner of Insurance, AFLIAC declared dividends of $75.0 million and $25.0 million, respectively, to its parent, AFC. No dividends were declared by AFLIAC or FAFLIC to their parent in 2002, and neither company can pay dividends to their parent without prior approval from the Massachusetts Commissioner of Insurance.
The Property and Casualty group manages its operations principally through three segments: Personal Lines, Commercial Lines and Other Property and Casualty. Personal Lines include such property and casualty coverages as personal automobile, homeowners and other personal policies, while Commercial Lines include such property and casualty coverages as workers’ compensation, commercial automobile, commercial multiple peril and other commercial policies. In addition, the Other Property and Casualty segment consists of: voluntary pools in which the Company has not actively participated since 1995; AMGRO, Inc. (“AMGRO”), the Company’s premium financing business; Opus Investment
The Life Companies segment consists of the former Allmerica Financial Services segment, the Company’s GIC business (formerly part of the Asset Management segment) and the discontinued group life and health business, including group life and health voluntary pools (the former Corporate Risk Management Services segment). The Life Companies segment manages a block of existing variable annuity, variable universal life and traditional life insurance products, GICs, and certain group retirement products. During 2003, the Company managed this existing life insurance business and also operated an independent broker/dealer business, which distributed third party investment and insurance products. In the fourth quarter of 2003, the Company announced the cessation of the retail business of its independent broker/dealer. In addition, prior to September 30, 2002, this segment actively manufactured and sold variable annuities, variable universal life and traditional life insurance products, as well as the Company’s GIC products. GICs 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 assets and liabilities of the Company’s discontinued group life and health business were previously reported in the Property and Casualty segment.
The Company reports interest expense related to its corporate debt separately from the earnings of its operating segments. Corporate debt consists of the Company’s junior subordinated debentures and its senior debentures. During 2003, the Company adopted Statement No. 150 (see Note 1P - New Accounting Pronouncements) which resulted in the reclassification of dividends on the Company’s mandatorily redeemable preferred securities of a subsidiary trust from minority interest to interest expense in the Consolidated Statements of Income. In accordance with Statement No. 131, all periods have been restated to reflect current presentation consistent with the way management evaluates results.
Rental expenses for operating leases amounted to $16.4 million, $27.3 million and $30.8 million in 2004, 2003 and 2002, respectively. These expenses relate primarily to building leases of the Company.
At December 31, 2004, future minimum rental payments under non-cancelable operating leases, including those related to the Company’s restructuring activities, were approximately $38.3 million, payable as follows: 2005 - $15.2 million; 2006 - $10.8 million; 2007 - $7.0 million; 2008 - $4.1; and $1.2 million thereafter. Additionally, as a result of the Company’s 2003 restructuring activities, the Company is subleasing certain properties. The rental income expected under the non-cancelable sublease agreements in existence at December 31, 2004 is $3.3 million. 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.
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 2004, 2003 and 2002 for accident year 1999 were $3.2 million, $9.6 million and $3.2 million, respectively, while net losses and LAE ceded during 2004, 2003 and 2002 were $3.9 million, $11.8 million and $3.9 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.
In addition, the Company is subject to concentration of risk with respect to reinsurance ceded to various residual market mechanisms. As a condition to the ability to conduct certain business in various states, the Company is required to participate in various residual market mechanisms and pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage voluntarily provided by private insurers. These market mechanisms and pooling arrangements include, among others, the Massachusetts Commonwealth Automobile Reinsurers (“CAR”) and the Michigan Catastrophic Claims Association (“MCCA”). At December 31, 2004, both CAR and MCCA represented 10% or more of the Company’s reinsurance activity. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its personal and commercial automobile premiums to CAR. Net premiums earned and losses and LAE ceded to CAR in 2004, 2003 and 2002 were $46.6 million and $38.1 million, $46.2 million and $61.0 million, and $46.8 million and $59.4 million, respectively. Additionally, the Company ceded to MCCA premiums earned and losses and LAE in 2004, 2003 and 2002 of $60.9 million and $12.4 million, $46.8 million and $124.2 million, and $32.6 million and $49.8 million, respectively.
During 2004, 2003 and 2002, the Company determined that the DAC asset related to certain distribution channels for the annuity business exceeded the present value of total expected gross profits. Therefore, the Company recognized permanent impairments of the DAC asset of $7.1 million, $4.5 million and $159.0 million, respectively, related to these items. Additionally, in 2002, the Company recognized approximately $203 million of additional amortization related to the impact of the equity market on future gross profits of life insurance and annuity products and approximately $200 million of additional amortization related to the changes in several actuarial estimates related to life insurance and annuity products. Also, in 2002, the Company recognized a permanent impairment related to the universal life DAC asset of $155.9 million due to the sale of that business.
During the years ended December 31, 2004, 2003 and 2002, estimated loss reserves for claims occurring in prior years developed unfavorably by $1.3 million, $74.5 million and $36.9 million, respectively. The unfavorable loss development during the year ended December 31, 2004 was primarily the result of continued adverse development in the workers’ compensation line of business related to increased medical costs and long term attendant care. Additionally, adverse loss development was experienced in other commercial lines, primarily umbrella and general liability, which was primarily the result of increases in estimated ultimate losses for these long-tail lines. Partially offsetting these items was favorable loss development in the commercial multiple peril, commercial automobile, homeowners and personal automobile lines of business. The improvement in loss development on these lines of business is primarily the result of improved claim frequency trends.
Ending loss and LAE reserves for all direct business written by its property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $24.7 million, $24.9 million and $25.6 million, net of reinsurance of $16.3 million, $15.0 million and $16.0 million in 2004, 2003 and 2002, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the three-year period ended December 31, 2004. As a result of the Company’s historical direct underwriting mix of commercial lines policies of smaller and middle market risks, past asbestos, environmental damage and toxic tort liability loss experience has remained minimal in relation to the total loss and LAE incurred experience.
The Company estimates its ultimate liability for asbestos and environmental claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company believes that, notwithstanding the evolution of case law expanding liability in asbestos and environmental claims, recorded reserves related to these claims are adequate. In addition, the Company is not aware of any litigation or pending claims that are expected to result in additional material liabilities in excess of recorded reserves. The environmental liability could be revised in the near term if the estimates used in determining the liability are revised.
such restrictions constituted a breach of the terms of the annuity contracts. 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 Company filed a motion for reconsideration and clarification of the court’s partial summary judgment opinion, which was denied on April 8, 2004.
On May 19, 2004, plaintiffs filed a Brief Statement of Damages in which, without quantifying their damage claim, they outlined a claim for (i) amounts totaling $150,000 for surrender charges imposed on the partial surrender by plaintiffs of the annuity contracts, (ii) loss of trading profits they expected over the remaining term of each annuity contract, and (iii) lost trading profits resulting from AFLIAC’s alleged refusal to process five specific transfers in 2002 because of trading restrictions imposed on market timers. With respect to the lost profits, plaintiffs claim that pursuant to their trading strategy of transferring money from money market accounts to inter- national equity accounts and back again to money market accounts, they have been able to consistently obtain relatively risk free returns of between 35% to 40% annually. Plaintiffs claim that they would have been able to continue to maintain such returns on the account values of their annuity contracts over the remaining terms of the annuity contracts (which are based in part on the lives of the named annuitants). The aggregate account value of plaintiffs’ annuities was approximately $12.8 million in December 2001.
The monetary damages sought by plaintiffs, if awarded, could have a material adverse effect on the Company’s financial position. However, in the Company’s judgment, 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. The date for the damage phase of the litigation has been postponed and a new date has not yet been set.
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, which currently include inquiries relating to “market timing” in sub-accounts of variable annuity and life products, “revenue sharing” and other matters, and regulatory inquiries into compensation arrangements with brokers and agents. 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 position, although they could have a material effect on the results of operations for a particular quarter or annual period.
In the fourth quarter of 2003, the Company recognized charges of $14.9 million, net of taxes, relating primarily to the VeraVest restructuring (see Note 2 - Significant Transactions). In addition, the Company recognized after-tax charges of $5.5 million related to exchange-traded futures contracts used to economically hedge any increased GMDB reserves resulting from equity market movements.