Consolidated net (loss) income includes the results of each segment of the Company, which management evaluates on a pre-tax and pre-minority interest basis. In addition, net (loss) income is adjusted for certain items which management believes are not indicative of the Company's core operations. Adjusted net (loss) income excludes items such as net realized investment gains and losses, including certain gains or losses on derivative instruments, because fluctuations in these gains and losses are determined by interest rates, financial markets and the timing of sales. Also, adjusted net (loss) income excludes net gains and losses on disposals of businesses, discontinued operations, restructuring and reorganization costs, extraordinary items, the cumulative effect of accounting changes and certain other items, which in each case, are neither normal nor recurring. Although the items excluded from adjusted net (loss) income may be significant components in understanding and assessing the Company's financial performance, management believes adjusted net (loss) income enhances an investor's understanding of the Company's results of operations by highlighting net (loss) income attributable to the normal, recurring operations of the business, consistent with industry practice. However, adjusted net (loss) income should not be construed as a substitute for net (loss) income determined in accordance with generally accepted accounting principles ("GAAP"). The Company's consolidated net loss increased $303.0 million, to $306.1 million in 2002, compared to $3.1 million in 2001. The increase in net loss resulted primarily from a decrease in adjusted net income of $439.9 million, principally the result of a significant segment loss in AFS. Also contributing to this decline was a $20.3 million loss from the sale of the universal life business and a $12.3 million increase in restructuring and reorganization costs, net of taxes. Partially offsetting these items were a $66.7 million gain from the retirement of trust instruments supported by funding obligations and a $49.1 million increase in gains on derivative instruments, net of taxes. In 2001, the Company's consolidated net income decreased $203.0 million, or 101.6%, to a net loss of $3.1 million, compared to net income of $199.9 million in 2000. The reduction in net income in 2001 primarily resulted from a decrease in adjusted net income of $136.7 million and a loss from selected property and casualty exited agencies, policies, groups, and programs of $44.4 million, net of taxes. In addition, the reduction in net income in 2001 also resulted from derivative and voluntary pool losses of $22.9 million and $21.5 million, respectively, net of taxes. These decreases in 2001 were partially offset by lower after-tax restructuring costs. The following table reflects adjusted net (loss) income and a reconciliation to consolidated net (loss) income. Adjusted net (loss) income consists of segment (loss) income, federal income tax benefit (expense) on segment (loss) income and minority interest on Capital Securities.
Risk Management's segment income increased $90.8 million, or 97.1%, to $184.3 million for the year ended December 31, 2002, compared to $93.5 million in 2001. The increase in segment income is primarily attributable to an estimate of approximately $80 million of net premium rate increases. Net premium rate increases reflect rate actions, discretionary pricing adjustments, inflation and changes in exposure, net of the estimated impact of loss inflation and policy acquisition costs. In addition, development on prior years' reserves improved $27.2 million, to $6.4 million of adverse development, for the year ended December 31, 2002 from $33.6 million of adverse development for the year ended December 31, 2001. The favorable change in reserve development in 2002 is primarily the result of improving commercial lines claim frequency, partially offset by adverse development in the personal automobile line. Net catastrophe losses decreased $19.7 million, to $31.3 million for the year ended December 31, 2002. In addition, losses and LAE decreased during 2002 due to approximately $17 million of decreased current accident year claims frequency primarily in the workers compensation, commercial automobile, commercial multi peril and homeowners lines. Partially offsetting these items is a decrease in net investment income of $14.0 million and a 2.7% decrease of policies in force since December 31, 2001, resulting in decreased segment income of approximately $14 million. Policy acquisition expenses increased as a result of the variable expenses related to the aforementioned premium rate increases, primarily commissions and premium taxes. In addition, policy acquisition expenses increased $10.7 million as a result of higher premium tax and commission rates during 2002. Other income decreased $8.4 million for the year ended December 31, 2002, primarily due to the decline in finance charge income as a result of the transfer of AMGRO from the Risk Management segment to the AAM segment.
Risk Management's segment income decreased $96.5 million, or 50.8%, to $93.5 million for the year ended December 31, 2001, compared to $190.0 million in 2000. The decline in segment income is primarily attributable to increased losses and LAE resulting from a $121.0 million decrease in favorable development on prior years' reserves. The unfavorable change in reserve development is primarily the result of an increase in personal automobile loss frequency and severity, and the Company having captured, in 1999 and 2000, the accumulated benefits of its claims redesign efforts. Other operating expenses increased during 2001 primarily due to increased technology costs and premium charge-offs. Partially offsetting these items are an estimate of approximately $32 million of net rate increases, primarily in commercial lines. In addition, net catastrophe losses decreased $19.2 million, to $51.0 million for the year ended December 31, 2001. Net catastrophe losses include $10.5 million of incurred losses related to the events of September 11, 2001. A net loss of $0.9 million and a net benefit of $9.8 million are included in segment income in 2001 and 2000, respectively, as a result of a whole account aggregate excess of loss reinsurance agreement ("aggregate excess of loss reinsurance treaty"), which provides coverage for the 1999 accident year.
The following table summarizes the results of operations for the Risk Management segment:
(1) Statutory loss ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio reflects incurred claims compared to premiums earned. The 2001 ratios exclude the effect of agency actions discussed in "Selected Property & Casualty Exited Agencies, Policies, Groups & Programs" and the voluntary pool losses discussed in "Asbestos and Environmental Reserves".
(2) Statutory combined ratio is a common industry measurement of the results of property and casualty insurance underwriting. This ratio is the sum of the ratio of incurred claims and claim expenses to premiums earned and the ratio of underwriting expenses incurred to premiums written. Federal income taxes, net investment income and other non-underwriting expenses are not reflected in the statutory combined ratio.
Personal lines' net premiums written increased $98.9 million, or 7.1%, to $1,485.3 million for the year ended December 31, 2002. This is primarily the result of increases of $59.1 million, or 5.7%, and $40.4 million, or 13.0%, in the personal automobile and homeowners lines, respectively. The increase in the personal automobile line is primarily the result of 6.1%, 5.9% and 4.4% net premium rate increases in Michigan, New York and New Jersey, respectively, since December 31, 2001. The increase in the homeowners line resulted primarily from net premium rate increases of 25.5% and 9.7% in Michigan and New York, respectively. Policies in force for all personal lines decreased 1.4% since December 31, 2001. Personal lines' underwriting results declined $30.5 million to an underwriting loss of $85.7 million for the year ended December 31, 2002. The decline in underwriting results is primarily attributable to increased underwriting expenses, principally related to the increased expenses for mandatory assigned risk personal automobile business in New York. In addition, underwriting expenses increased due to higher premium tax expenses and increases in agents' contingent commissions. Underwriting results were also unfavorably affected by increased current year claims frequency in the personal automobile line for the year ended December 31, 2002 and by an $8.3 million increase in adverse development during 2002 in the personal automobile line. Partially offsetting these items is an estimate of approximately $35 million of net rate increases. In addition, catastrophe losses decreased $6.6 million, to $25.7 million for the year ended December 31, 2002, compared to $32.3 million for the same period in 2001.
Commercial lines' net premiums written decreased $113.7 million, or 12.7%, to $783.1 million for the year ended December 31, 2002. This decrease is primarily the result of the Company's termination of 377 agencies and the withdrawal of commercial lines' underwriting capacity from an additional 314 agencies during the fourth quarter of 2001. As a group, these agencies historically produced unsatisfactory loss ratios. In addition, the Company has seen a reduction in premium levels from active agents as re-underwriting efforts to target specific classes of business and strengthen underwriting guidelines continue (see Selected Property & Casualty Exited Agencies, Policies, Groups & Programs). As a result of these actions, policies in force decreased 22.5%, 15.9% and 8.4% in the commercial automobile, workers' compensation, and commercial multiple peril lines, respectively, since December 31, 2001. Management believes the impact of the agency actions will have a diminishing effect on policies in force, since the agency actions are substantially complete. Partially offsetting these decreases in policies in force were rate increases in all of the commercial lines since December 31, 2001. Commercial lines' underwriting results improved $114.3 million to an underwriting gain of $15.1 million for the year ended December 31, 2002. The improvement in underwriting results is primarily attributable to approximately $45 million of net premium rate increases during the year ended December 31, 2002. Development on prior years' reserves improved $32.4 million to $14.3 million of favorable development for the year ended December 31, 2002 from $18.1 million of adverse development for the same period in 2001. In addition, catastrophe losses decreased $13.1 million, to $5.6 million for the year ended December 31, 2002, compared to $18.7 million for the same period in 2001. In 2002, underwriting results also included a net benefit, when compared to 2001, as the result of exiting historically unprofitable business under the aforementioned agency management actions.
Personal lines' net premiums written increased $92.8 million, or 7.2%, to $1,386.4 million for the year ended December 31, 2001. This is primarily the result of increases of $55.2 million, or 5.7%, and $35.6 million, or 12.9%, in the personal automobile and homeowners lines, respectively. The increase in the personal automobile line is primarily the result of 3.8% and 2.9% net premium rate increases in New York and Michigan, respectively, and an overall increase of 4.0% in policies in force since December 31, 2000. Partially offsetting these favorable items in the personal automobile line is a 5.4% Massachusetts net rate reduction in 2001. The increase in the homeowners line resulted primarily from rate increases of 16.8% in Michigan and an overall 2.1% increase in policies in force in 2001. Net premiums written reflected ceded premiums of $3.0 million and $10.3 million under the aforementioned aggregate excess of loss reinsurance treaty for 2001 and 2000, respectively. Personal lines' underwriting results decreased $61.7 million to an underwriting loss of $55.2 million for the year ended December 31, 2001. The decline in underwriting results is primarily the result of a decrease in favorable development on prior years' reserves of $74.2 million, to $13.6 million of adverse development for the year ended December
31, 2001, from $60.6 million of favorable development for the same period in 2000. The unfavorable trend in reserve development is primarily the result of an increase in personal automobile loss frequency and severity. Partially offsetting the unfavorable effect of prior years' reserve development was a decrease in catastrophe losses of $16.7 million, to $32.3 million for the year ended December 31, 2001, compared to $49 million for the same period in 2000. Net benefits of $1.6 million and $5.7 million are included in underwriting results relating to the aforementioned aggregate excess of loss reinsurance treaty in 2001 and 2000, respectively.
Commercial lines' net premiums written increased $41.0 million, or 4.8%, to $896.8 million for the year ended December 31, 2001. This is primarily the result of increases of $40.7 million, or 13.1% and $15.1 million, or 6.5%, in the commercial multiple peril and the commercial automobile lines, respectively. The increase in the commercial multiple peril line is primarily the result of rate increases of 12.3% and 8.8% in Michigan and New York, respectively. In addition, the commercial automobile line experienced rate increases of 6.4%, 7.6% and 16.5% in Michigan, Massachusetts, and New York, respectively, since December 31, 2000. Net premiums written reflected ceded premiums of $4.4 million and $14.7 million under the aforementioned aggregate excess of loss reinsurance treaty in 2001 and 2000. Commercial lines' underwriting results deteriorated $29.4 million to an underwriting loss of $99.2 million for the year ended December 31, 2001. The decrease in underwriting results is primarily attributable to a deterioration of development on prior years' reserves of $44.9 million, to $18.1 million of adverse development for the year ended December 31, 2001, from $26.8 million of favorable development for the same period in 2000. The decline in underwriting results is also attributable to an increase in policy acquisition and other underwriting expenses since December 31, 2000 primarily related to an absence of ceding commission income from specialty market business that has not been renewed. Partially offsetting these items was a decrease in catastrophe losses of $2.5 million, to $18.7 million for the year ended December 31, 2001, compared to $21.2 million for the same period in 2000. Also, net premium rates increased by approximately $20 million during the year ended December 31, 2001. Net benefits of $2.2 million and $8.2 million are included in underwriting results relating to the aforementioned aggregate excess of loss reinsurance treaty in 2001 and 2000, respectively.
The Risk Management segment maintains reserves for its property and casualty products to provide for the Company's ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. These reserves are estimates, involving actuarial projections at a given point in time, of what management expects the ultimate settlement and administration of claims will cost based on facts and circumstances then known, estimates of future trends in claim severity and frequency, judicial theories of liability and policy coverage, and other factors.
The inherent uncertainty of estimating insurance reserves is greater for certain types of property and casualty insurance lines, particularly workers' compensation and other liability lines, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and where the technological, judicial and political climates involving these types of claims are changing. The Company has maintained a historical practice to significantly limit the issuance of certain long-tailed other liability policies, including directors and officers ("D&O") liability, errors and omissions ("E&O") liability and medical malpractice liability, in which the industry has experienced recent adverse loss trends. The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Reserve adjustments are reflected in results of operations as adjustments to losses and LAE. Often these adjustments are recognized in periods subsequent to the period in which the underlying loss event occurred. These types of subsequent adjustments are described as "prior year reserve development". Such development can be either favorable or unfavorable on the financial results of the Company. Inflation generally increases the cost of losses covered by insurance contracts. The effect of inflation on the Company varies by product. Property and casualty insurance premiums are established before the amount of losses and LAE, and the extent to which inflation may affect such expenses are known. Consequently, the Company attempts, in establishing rates and reserves, to anticipate the potential impact of inflation in the projection of ultimate costs. Recently, the Company has experienced increasing medical costs associated with personal automobile personal injury protection claims. This increase is reflected in the Company's reserve estimates, but continued increases could contribute to increased losses and LAE in the future. The Company regularly reviews its reserving techniques, its overall reserving position and its reinsurance. Based on (i) review of historical data, legislative enactments, judicial decisions, legal developments in impositions of damages and policy coverage, political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Company and the industry, (iv) the relatively short-term nature of most policies and (v) internal estimates of required reserves, management believes that adequate provision has been made for loss reserves. However, establishment of appropriate reserves is an inherently uncertain process and there can be no certainty that current established reserves will prove adequate in light of subsequent actual experience. A significant change to the estimated reserves could have a material impact on the results of operations.
The Company performs actuarial reviews on certain detailed line of business coverages. These individual estimates are summarized into six broader lines of business, personal automobile, homeowners, workers' compensation, commercial automobile, commercial multiple peril, and other lines.
(1) The increase in provision for insured events of prior years in 2001 includes $40.8 million of losses related to selected property and casualty exited agencies, policies, groups and programs and $33.0 million of losses related to voluntary pool claims.
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were increased by $6.4 million and $107.4 million in 2002 and 2001, respectively, and decreased by $87.4 million in 2000. The table below summarizes the reserve for losses and LAE by line of business.
During the year ended December 31, 2002 and 2001, estimated loss reserves for claims occurring in prior years developed unfavorably by $36.9 million and $146.6 million, respectively. During the year ended December 31, 2000, estimated loss reserves for claims occurring in prior years developed favorably by $25.9 million. The adverse development in both 2002 and 2001, is primarily the result of increased claim severity related to personal automobile medical settlements for Citizens. Since these settlements have risen beyond previous estimates, reserve increases have been recognized in the period in which the information is obtained. The increase in the prior year reserve estimates for other commercial lines during 2002 is primarily due to the recognition of approximately $5 million in additional reserves for asbestos claims in the Excess and Casualty Reinsurance Association ("ECRA") voluntary pool.
In addition, the Company experienced adverse development in 2001 as a result of the $40.8 million reserve increase on prior years resulting from the agency management actions discussed in "Selected Property & Casualty Exited Agencies, Policies, Groups & Programs". This reserve increase affected primarily the commercial multiple peril, personal automobile, commercial automobile and workers' compensation lines. Additionally, other commercial lines' prior year reserves developed adversely due to a $33.0 million reserve increase in the ECRA voluntary pool. Personal automobile prior year reserves developed adversely due to the aforementioned increased claim severity related to medical settlements for Citizens. In addition to the effect from the agency management actions, the commercial automobile and commercial multiple peril lines experienced adverse development. The increased reserves in these lines is primarily attributable to increased claim payments in the 2000 and 1999 accident years. As these payments have increased above historical amounts, actuarial projections of future settlements have increased the estimated ultimate reserves on prior years. During 2000, the favorable loss development is primarily the result of a decrease in prior year reserves in the personal automobile line. The Company began to experience an improvement in the Northeast in the personal automobile line as claim payment severity began to decrease in accident years 1999 and 1998. As the certainty of the improvement in claim payment severity for accident years 1999 and 1998 increased, ultimate losses for those accident years were reduced and favorable development was recorded during calendar year 2000. During the years ended December 31, 2002, 2001 and 2000, estimated LAE reserves for claims occurring in prior years developed favorably by $30.5 million, $39.2 million and $61.5 million, respectively. The favorable development in all the periods is primarily attributable to claims process improvement initiatives taken by the Company during the 1997 to 2001 calendar year period. Since 1997, the Company has lowered claim settlement costs through increased utilization of in-house attorneys and consolidation of claim offices. As actual experience begins to establish certain trends inherent within the claim settlement process, the actuarial process recognizes these trends within the reserving methodology impacting future claim settlement assumptions. As these measures improved average settlement costs, the actuarial estimate of future settlement costs are reduced and favorable development is recorded. These measures are complete. Reserves established for current year losses and LAE in 2002 and 2001 consider the factors that resulted in the favorable development of prior years' loss and LAE reserves during 2000 and earlier years. Accordingly, current year reserves are modestly lower, relative to those initially established for similar exposures in years prior to 2001.
The Risk Management segment maintains a reinsurance program designed to protect against large or unusual losses and allocated LAE activity. This includes excess of loss reinsurance and catastrophe reinsurance. The Company determines the appropriate amount of reinsurance based on the Company's evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions including the availability and pricing of reinsurance. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company. The Company believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. Catastrophe reinsurance serves to protect the ceding insurer from significant losses arising from a single event such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. Under the Company's catastrophe reinsurance agreements, the Company ceded $1.1 million of losses in 2002 as the result of deterioration in the 2001 accident year and $20.3 million of losses in 2001. The Company, in 1999, entered into a whole account aggregate excess of loss reinsurance agreement, which provides coverage for accident year 1999 for the Company's 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. The coverage limit for losses and allocated LAE is $150.0 million. The effect of this agreement on results of operations in each reporting period is based on losses and allocated LAE ceded, reduced by a sliding scale premium of 50-67.5% depending on the size of the loss, and increased by a ceding commission of 20% of ceded premium. In addition, net investment income is reduced for amounts credited to the reinsurer. As a result of this agreement, the Company recognized a net expense of $3.9 million for the year ended December 31, 2002 and net benefits of $0.2 million and $9.8 million for the years ended December 31, 2001 and 2000, respectively, based on estimates of losses and allocated LAE for accident year 1999. The 2001 impact from this treaty includes a $1.1 million net benefit related to the aforementioned exit of selected property and casualty agencies, policies, groups and programs. 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. The Company, in the Risk Management segment, 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 coverage to individuals or other entities that are otherwise unable to purchase such coverage. These market mechanisms and pooling arrangements include the Massachusetts Commonwealth Automobile Reinsurers and the Michigan Catastrophic Claims Association.
(1) Brokerage and investment management income primarily reflects fees earned from the distribution and management of non-proprietary insurance and investment products. Variable expenses related to this business primarily consist of commissions.
Additional DAC Amortization: Revision of surrender rate assumptions $ 171.1 Equity market depreciation 202.8 Revision of market-related appreciation assumptions 43.3 Revision of GMDB long-term cost assumptions 61.7 Revision of future fees assumption (8.5) Impairment of DAC asset 159.0 - ------------------------------------------------------------------- 629.4 - ------------------------------------------------------------------- GMDB: Revision of long-term cost assumptions 106.7 Reduction of DAC amortization (67.6) - ------------------------------------------------------------------- 39.1 - ------------------------------------------------------------------- Impairment of capitalized technology costs 29.8 - ------------------------------------------------------------------- Total $ 698.3 ===================================================================
from those assumed. This required the Company to substantially increase the level of DAC amortization and GMDB expense under existing assumptions and to reassess the appropriate long-term assumptions on account appreciation and GMDB cost. As a result, the Company revised downward its assumptions regarding future account appreciation and increased its expectations regarding the long-term cost of the GMDB feature. Finally, the Company's evaluation of the compounding effects of the market decline and AFS business model changes on the anticipated profitability of its distribution channels caused the Company to determine that there had been a permanent impairment of the remaining DAC asset related to its former Partners distribution channel (see Statutory Premiums and Deposits for a description of the former distribution channels). Each of these increased costs and changed assumptions are discussed further below. The aforementioned $629.4 million of additional DAC amortization consists of six separate items. First, the Company anticipates that the ratings downgrades (see Rating Agency Actions) and the Company's decision to cease new sales of proprietary life insurance and annuity products will unfavorably affect the persistency of the existing customer accounts, as customers seek to transfer their accounts to companies who are active in the marketplace and have higher ratings. This reduces expected future profits, resulting in $171.1 million of additional DAC amortization. Second, significant declines in equity market values resulted in additional amortization of $202.8 million in 2002. This resulted from application of the Company's reversion-to-the-mean accounting methodology. The Company considers the recent declines to be suggestive of a permanent, partial reduction in future profitability. Third, as of September 30, 2002, the Company reviewed and reset its assumptions regarding future market-related appreciation of separate account assets and its application of the reversion-to-the-mean accounting methodology. In view of the additional market declines in the third quarter, as well as the reduced time horizon resulting from the revised persistency expectations, the Company reduced its expected rate of annual appreciation to 8% (2% per quarter), starting with September 30, 2002 asset levels. This reduces expected future profits, resulting in $43.3 million of additional DAC amortization. Fourth, the Company increased its assumptions related to the long-term cost of GMDB for variable annuity products as of September 30, 2002 (see the discussion of the GMDB reserve below). The increased cost estimates affected the Company's expectation of future gross profits, resulting in additional DAC amortization of $61.7 million in 2002. Fifth, the Company changed its estimate of future fees from certain annuity products in the second quarter of 2002. This decreased DAC amortization by $8.5 million in that quarter. Finally, the Company recognized additional amortization of $159.0 million related to its Partners distribution channel (see Statutory Premiums and Deposits for a description of the former distribution channels). After reviewing all assumptions affecting future profits assumed in its DAC methodology, including the effect of the aforementioned adjustments, the Company determined that the remaining DAC asset related to Partners exceeded the present value of total expected gross profits by $159.0 million as of September 30, 2002. Accordingly, the Company recognized a permanent impairment to its DAC asset of this amount. It should be noted that a permanent impairment is not required for the other distribution channels because of their higher expected profitability. Relative to the other distribution channels, Partners has the highest GMDB costs and the lowest fees from its underlying mutual funds. After September 30, 2002, the Company expects that DAC amortization will be, in general, higher than historical levels as a percentage of gross profits. This is due to lower future gross profits, because of poorer persistency, lower expected market-related appreciation and higher expected GMDB costs. In the fourth quarter of 2002, the Company experienced higher DAC amortization than in prior periods. The Company expects a similar level of amortization as a percentage of gross profits in 2003. However, as a result of resetting the long-term assumption for market-related appreciation and applying the reversion-to-the-mean accounting methodology, the Company believes that DAC amortization will be less sensitive to short-term market movements than in the first nine months of 2002. The Company is exposed to further impairments to the DAC asset if actual experience is worse than the current assumptions. In particular, the Select DAC asset would be subject to impairment should actual gross profits be moderately less than anticipated. Impairments would increase DAC amortization in the period that they are recognized.
a cost. As of December 31, 2002, the difference between the GMDB and the current account value (the "net amount at risk") for all existing contracts was approximately $4.6 billion. For each one percent change, either increase or decrease from December 31, 2002 levels in the S&P 500 Index, the net amount at risk is estimated to increase or decrease by approximately $50 million to $70 million. This amount will gradually decline as surrenders also reduce the net amount at risk. To estimate the cost of the GMDB feature with respect to the profitability of the related insurance contract, the Company establishes and applies certain assumptions relating to the appreciation of related account assets, mortality and contract persistency, among other matters. The Company regularly evaluates these assumptions to determine whether recent experience or anticipated trends merit adjustments to such assumptions. The compounding effects of the significant third quarter market decline, the ratings downgrades, increased annuity surrenders and related AFS strategic business changes resulted in significantly decreased account values and persistency assumptions which required the Company to reassess, and increase, its assumptions related to the long-term cost of GMDB. The Company has had a consistent policy of providing reserves for GMDB based on its best estimate of the long-term cost of GMDB. As of September 30, 2002, the Company reassessed its expectation of the long-term cost of GMDB in view of the current net amount at risk and the revised persistency expectations, as well as the absence of additional deposits at current market levels. This resulted in revised expectations for the long-term cost of GMDB. The Company calculated a reserve at September 30, 2002 of $106.7 million, and recognized this amount in policy benefits. This was partially offset by a reduction in DAC amortization of $67.6 million. It should be noted that in addition to the reserve increase, policy benefits during 2002 include $77.1 million of additional GMDB expense, versus $22.0 million in the prior year. These amounts were partially offset by reduced DAC amortization of $38.2 million and $10.0 million, respectively. Based on account values as of December 31, 2002, the estimated annual GMDB expense would be approximately $45 million. In the near term, cash costs will likely exceed the annual expense, thereby reducing the reserve. Expected appreciation in asset levels would gradually reduce, and eventually reverse, this difference over time. There can be no assurance that the existing reserve will be sufficient, or that the Company's estimate of long-term GMDB costs is accurate or sufficient. Future changes in market levels, persistency of existing accounts, mortality and other factors may result in material changes to GMDB costs and related expenses.
During 2002, fees from surrenders increased $30.3 million, or 95.9%, to $61.9 million as a result of increased annuity surrenders, primarily in the fourth quarter as a result of the ratings downgrades. This increase was partially offset by a $12.1 million decline in all other fees related to the proprietary products,primarily resulting from lower average invested assets.
Segment income decreased $79.8 million, or 35.8%, to $143.0 million in 2001. This decrease primarily reflects lower asset-based fees and other income, as well as an increase in policy benefits and other operating expenses, net of lower deferred acquisition costs. The decline in asset-based fees and other income is principally attributable to a decrease in the market value of assets under management in the variable product lines, and to lower brokerage income. Segment revenues decreased $40.7 million, or 4.7%, in 2001, primarily due to lower asset-based fees and other income. Fee income decreased $29.5 million, or 7.0%, to $391.6 million, primarily due to variable annuity fees which decreased $21.3 million, or 9.0%. This was primarily due to a decline in the market value of average variable annuity assets under management. In addition, group annuity and non-variable universal life policy fees decreased $9.3 million and $8.4 million, respectively, during 2001. These declines were primarily due to lower average invested assets resulting from the Company's decision to exit its defined contribution group retirement business and from the continued shift in
focus to variable life insurance and annuity products. Additionally, the decline in non-variable universal life fees included approximately $4 million due to changes in certain actuarial assumptions in 2000. These decreases in fees were partially offset by a $9.5 million increase in variable universal life fees principally due to additional deposits. Other income decreased $13.4 million, or 12.1%, to $97.0 million. This decline was primarily due to lower investment management fees of $8.3 million resulting from depreciation and reduced deposits in variable product assets under management as well as to lower brokerage income of $6.1 million resulting from a decrease in mutual fund and general securities transaction volumes. Net investment income increased $5.3 million primarily due to additional income from the investment of higher general account deposits, partially offset by the impact of defaulted bonds, lower average mortgage investments and yields, and to the aforementioned decision to exit the defined contribution group retirement business. Policy benefits, claims and losses increased $31.7 million, or 10.1%, to $346.8 million in 2001, primarily due to increased interest credited of approximately $22 million related to an increase in general account deposits. Additionally, during 2001, the GMDB expense increased $10.5 million, primarily due to the sustained decline in the financial markets in the second half of 2001. Policy acquisition and other operating expenses increased $7.4 million, or 2.2%, to $336.7 million in 2001. Other operating expenses increased approximately $18.3 million, primarily due to increases in technology and distribution costs, partially offset by lower brokerage commissions and administrative expenses due to the aforementioned decrease in trading volumes for mutual fund and general securities transactions. In addition, other operating expenses in 2000 included a $4.7 million net reduction in premium tax and guaranty fund reserves. Policy acquisition expenses decreased $10.9 million, or 12.3%, to $77.8 million. In 2001, policy acquisition expense reflects a refinement in the methodology used by the Company's deferred policy acquisition cost valuation system which decreased amortization expense by approximately $6 million. Included in policy acquisition expenses in 2000 were several unusual items, particularly approximately $36.3 million of reduced expenses related to a change in certain life products actuarial assumptions and an increase in policy acquisition expenses of approximately $25.0 million in the annuity line of business, resulting from an increase in assumed lapse rates. Excluding the effects of the aforementioned unusual items, policy acquisition costs declined approximately $15.2 million, primarily due to lower variable annuity profits. Since variable products' deferred policy acquisition costs are amortized in proportion to gross profits, the lower annuity gross profits in 2001 resulted in less amortization expense.
Quarter Ended December 31, 2002 Compared to Quarter Ended December 31, 2001
Segment revenues Premiums $ 8.9 $ 8.5 Fees: Fees from surrenders 34.5 8.9 Other fees from proprietary products 83.4 88.1 Net investment income 63.9 69.4 Brokerage and investment management income(1) 28.1 16.2 Other income 11.9 5.4 - --------------------------------------------------------------------------- Total segment revenues 230.7 196.5 - --------------------------------------------------------------------------- Policy benefits, claims and losses 87.5 88.5 Policy acquisition costs 64.9 19.2 Brokerage and investment management variable expenses(1) 19.2 10.3 Other operating expenses 59.8 56.8 - --------------------------------------------------------------------------- Segment (loss) income $ (0.7) $ 21.7 ===========================================================================
million in the fourth quarter of the prior year. The increased surrenders resulted in additional surrender fees of $25.6 million in 2002, representing all of the increase in fees during the quarter. However, the additional fees were substantially offset by additional related DAC amortization of approximately $23 million, reflecting the Company's current DAC assumptions mandating a higher amortization level as a percentage of gross annuity profits. The remainder of the increase in DAC amortization of approximately $23 million, to $64.9 million, during the quarter results from applying this higher amortization percentage to current profits generated by existing annuity accounts (see Deferred Acquisition Costs above). During the fourth quarter of 2002, AFS increased its sales of non-proprietary products, consistent with its new strategy. Such sales are made through VeraVest. An increase to $413.5 million, versus $215.1 million in the prior year, resulted in additional brokerage and investment management income of $11.9 million in the quarter, reflected in brokerage and investment management income. These fees were substantially offset by additional commissions paid to the segment's registered representatives of $8.9 million, reflected in other brokerage and investment management variable operating expenses. The increase in other operating expenses reflects primarily acquisition costs that had been deferred in 2001, as they related to proprietary annuity and insurance sales that are no longer offered by the Company. Since distribution efforts have shifted to the development of non-proprietary sales, these costs are no longer eligible for deferral under GAAP. Policy benefits in the fourth quarter of 2002 were relatively consistent with the prior year. Expenses related to GMDB declined modestly, from $13.3 million to $12.2 million in the quarter ended December 31, 2002. Finally, net investment income declined $5.5 million in the fourth quarter of 2002, to $63.9 million. This resulted from lower average general account assets and the effect of defaults and non-income producing investments in the Company's portfolio of fixed income securities. Given the changes in the AFS business, the Company believes the factors affecting profitability in the past are not indicative of how the future earnings of this segment will be generated. The future profitability of the AFS segment, including that of VeraVest, is dependent upon, among other things, the ability to generate profitable non-proprietary sales, the ability to rationalize its expense structure for the non-proprietary business and existing insurance business consistent with its new business strategy, equity market levels and the persistency of existing insurance customer accounts. The Company does not expect this segment to be a significant source of earnings in the near term. Effective December 31, 2002, the Company sold its universal life insurance business (see Significant Transactions - Sale of Universal Life Insurance Business). During the fourth quarter of 2002, the universal life business contributed incremental income of $4.9 million.
The following table sets forth statutory premiums and deposits by product for the Allmerica Financial Services segment.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000 - --------------------------------------------------------------------------- (In millions)
The following table sets forth statutory premiums and deposits by product for the AFS segment for the quarter ended December 31, 2002 compared to the quarter ended December 31, 2001.
Insurance Traditional life $ 7.4 $ 8.1 Universal life 2.0 3.2 Variable universal life 24.2 55.0 Individual health 0.1 0.1 Group variable universal life (3.2) (2.6) - -------------------------------------------------------------- Total insurance 30.5 63.8 - -------------------------------------------------------------- Annuities Separate account annuities 73.2 508.5 General account annuities 63.0 189.6 Retirement investment accounts 1.1 0.8 - -------------------------------------------------------------- Total individual annuities 137.3 698.9 Group annuities 23.1 12.7 - -------------------------------------------------------------- Total annuities 160.4 711.6 - -------------------------------------------------------------- Total premiums and deposits $ 190.9 $ 775.4 ==============================================================
Account Account Values/(1)/ Surrenders/(2)/ Values/(1)/ Surrenders/(2)/ - -------------------------------------------------------------------------------- Agency $ 5,993.8 $ 791.3 $ 6,728.4 $ 516.9 Select 3,406.0 799.8 3,074.6 326.5 Scudder 2,840.5 558.4 2,611.7 244.7 Pioneer 1,038.5 177.0 1,073.6 109.7 Delaware 1,134.0 191.0 1,405.4 169.7 Other 110.3 20.7 36.7 30.0 - -------------------------------------------------------------------------------- Total $ 14,523.1 $ 2,538.2 $ 14,930.4 $ 1,397.5 ================================================================================
The following table summarizes annuity surrender activity for the AFS segment for the quarter ended December 31, 2002 compared to the quarter ended December 31, 2001.
Segment income decreased $1.8 million, or 8.0%, to $20.7 million in 2001 primarily due to decreased earnings on GICs and to lower earnings related to external clients. Earnings on GICs decreased $1.3 million primarily due to a shift from short-term funding agreements to lower margin long-term funding agreements in 2001 and to lower investment income due to defaults on certain bonds supporting GIC obligations. These declines were partially offset by increased earnings from higher net GIC deposits during the year. The decrease in earnings related to external clients resulted from a decrease in management fees from a securitized investment portfolio, partially offset by an increase in new external assets under management. In the fourth quarter of 2001, the Company was notified of short-term funding agreement withdrawals of approximately $380 million which resulted from uncertainty regarding the rating agency actions when Moody's Investors Service placed the Company's "A2" senior debt rating, "a2" Capital Securities rating, and "P1" short-term debt rating on review for possible downgrade and revised the outlook for the life insurance companies' ratings to negative from stable. These withdrawals precipitated losses from related interest rate swap contracts as described in "Derivative Instruments". As noted above, the Company uses derivative instruments to hedge interest rate and currency exchange rate risks related to its GIC portfolio. These hedges resulted in a $48.0 million and a $5.6 million reduction in net investment income during 2001 and 2000, respectively, offset by similar reductions in GIC interest credited during the respective periods. The increased effect of derivative instruments in 2001 was due to an increase in average outstanding GIC deposits and the associated hedges.
The following table summarizes the results of operations for the Corporate segment for the periods indicated.
Segment revenues Investment and other income $ 5.0 $ 6.7 $ 6.3 Interest expense 15.3 15.3 15.3 Other operating expenses 53.2 55.2 51.8 - ---------------------------------------------------------------------------- Segment loss $ (63.5) $ (63.8) $ (60.8) ============================================================================
Segment loss decreased $0.3 million, or 0.5%, to $63.5 million in 2002, primarily as a result of decreased corporate overhead costs of $2.1 million, including lower costs due to forfeited stock grants by the Company's President as a result of his resignation, partially offset by a $1.7 million decrease in net investment income. The decrease in net investment income is principally due to lower average invested assets and to lower investment yields. Interest expense for both periods relates to the interest paid on the Senior Debentures of the Company.
Segment loss increased $3.0 million, or 4.9%, to $63.8 million in 2001, primarily as a result of increased corporate overhead costs, including technology costs and certain corporate overhead expenses previously allocated to other operating segments, partially offset by state tax credits recognized by the holding company.
The Company held general account investment assets diversified across several asset classes, as follows:
Total investment assets decreased $1.5 billion, or 13.9%, to $9.2 billion during 2002, primarily as a result of a decrease in fixed maturities of $1.4 billion. Fixed maturities decreased primarily due to short-term funding agreement withdrawals and the retirement of certain long-term funding agreements in the AAM segment. In addition, fixed maturities decreased in the AFS segment due to annuity surrenders from the general account, as well as transfers to the separate accounts from the general account, which together more than offset $856.7 million of new deposits in the general account in 2002. During 2003, approximately $550 million of investment assets will be used for the settlement of the net payable associated with the sale of the Company's universal life insurance business (see Significant Transactions - Sale of Universal Life Insurance Business).
Of the $106.7 million and $152.5 million of gross unrealized losses on fixed maturities and equity securities, approximately $1.8 million and $17.4 million relates to investment grade fixed maturity obligations of the U.S. Treasury, U.S. government and agency securities, states and political subdivisions, as of December 31, 2002 and 2001, respectively. An additional $30.1 million and $66.2 million of gross unrealized losses relates to holdings of investment grade fixed maturities in a variety of industries and sectors, while approximately $74.8 million and $68.9 million relates to holdings of below investment grade fixed maturities and equity securities in a variety of industries and sectors as of December 31, 2002 and 2001, respectively. Substantially all below investment grade securities with an unrealized loss have been rated by the NAIC, Standard & Poor's or Moody's as of December 31, 2002 and 2001. The Company had fixed maturity securities with a carrying value of $39.9 million and $10.7 million on non-accrual status at December 31, 2002 and 2001, respectively. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the fixed maturities, was a reduction in net investment income of $19.5 million and $11.3 million for the years ended December 31, 2002 and 2001, respectively. Management expects that defaults in the fixed maturities portfolio may continue to negatively impact investment income.
The Company manages the risk of cash flow variability on floating rate funding agreements that are matched with fixed rate securities, by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. With the adoption of Statement No. 133 on January 1, 2001, the swap contracts were considered cash flow hedges of the interest rate risk associated with the floating rate funding agreements, including funding agreements with put features allowing the policyholder to cancel the contract prior to maturity. During the fourth quarter of 2001, the Company reviewed the trend in put activity since inception of the funding agreement business in order to determine the ongoing effectiveness of the hedging relationship. Based upon the historical trend in put activity, as well as management's uncertainty about possible future events, the Company had determined that it was probable that some of the future variable cash flows of the puttable funding agreements would not occur, and therefore the hedges were ineffective. During the fourth quarter of 2001, the Company reclassified losses of $35.8 million to (gains) losses on derivative instruments in the Consolidated Statements of Income from other comprehensive income related to the payments that were probable of not occurring on ineffective interest rate swap contracts. During 2002, the Company reclassified these losses of $35.8 million to realized investment losses from (gains) losses on derivative instruments in the Consolidated Statements of Income upon termination of the ineffective interest rate swap contracts. As of December 31, 2002, the Company no longer has outstanding floating rate funding agreements with put features. In addition, the Company no longer offers long-term or short-term funding agreements.
A portion of the Company's investments consists of securities denominated in foreign currencies. A portion of the Company's liabilities consists of trust instruments supported by funding obligations denominated in foreign currencies. The Company's operating results are exposed to changes in exchange rates between the U.S. dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From time to time, the Company may also have exposure to other foreign currencies. To mitigate the short-term effect of changes in currency exchange rates, the Company regularly hedges by entering into foreign exchange swap, futures and options contracts, as well as compound foreign currency/interest rate swap contracts to hedge its net foreign currency exposure. The following tables for the years ended December 31, 2002 and 2001 provide information about the Company's derivative financial instruments and other financial instruments, used for purposes other than trading, by functional currency and presents fair value information in U.S. dollar equivalents. The tables summarize information on instruments that are sensitive to foreign currency exchange rates, including securities denominated in foreign currencies, compound foreign currency/ interest rate swap contracts, foreign currency forward exchange agreements, foreign currency futures contracts, and foreign currency options contracts. For foreign currency denominated securities and liabilities, the tables present principal cash flows and applicable current forward foreign currency exchange rates by contractual maturity. For foreign currency derivative instruments, the tables present the notional amounts and weighted-average exchange rates by expected (contractual) maturity dates. These notional amounts are used to calculate the contractual payments to be exchanged under the contracts. The significant decrease in the notional amount of swaps outstanding at December 31, 2002 compared to December 31, 2001 is primarily due to short-term funding agreement withdrawals, as well as the retirement of certain long-term funding agreements at discounts. As these funding agreements were extinguished, the swap contracts hedging them were terminated.
The provision for federal income taxes before minority interest and the effect of a change in accounting principle was a benefit of $234.8 million during 2002, compared to a benefit of $75.5 million during 2001. These benefits resulted in consolidated effective federal tax rates of 45.0% and 127.1% of pre-tax losses for 2002 and 2001, respectively. The large benefit in the current period is primarily due to the significant loss recognized by the AFS segment. The benefit also reflects an $11.6 million favorable settlement of certain prior years' federal income tax returns.
The provision for federal income taxes before minority interest and the effect of a change in accounting principle was a $75.5 million benefit during 2001. This benefit resulted in a consolidated effective federal tax rate of 127.1% of pre-tax losses. During 2000, the provision for federal income taxes before minority interest was a $2.7 million expense and resulted in a consolidated effective federal tax rate of 1.3%. The change in the rate is primarily due to lower underwriting income in 2001 resulting in an increase in the proportion of tax-exempt investment income, the dividends received deduction associated with the Company's variable products and low income housing credits to pre-tax income.
Included in the Company's deferred tax net asset as of December 31, 2002 is an approximately $78 million asset related to federal income tax net operating loss carryforwards ("NOL"). This NOL may be utilized in future years to offset taxable income of approximately $222 million, subject to certain limitations. In addition, there is an asset of approximately $150 million related to alternative minimum and other tax credit carryforwards at December 31, 2002. These credits may be utilized to offset regular federal income taxes due from future income. Although the Company believes that these assets are fully recoverable, there can be no certainty that future events will not affect their recoverability.
Historically, AFS offered fixed universal life insurance products through its Agency distribution channel (see Allmerica Financial Services - Statutory Premiums and Deposits for a description of its former distribution channels). The Company sold substantially all of this business through a 100% coinsurance agreement which was effective December 31, 2002. Under the agreement, the Company ceded approximately $660 million of universal life insurance reserves in exchange for the transfer of approximately $550 million of investment assets with an amortized cost of approximately $525 million. At December 31, 2002, the Company recorded a loss from this transaction of $20.3 million, net of taxes. This loss consisted primarily of the aforementioned ceded reserves, asset transfers, a permanent impairment of the universal life deferred acquisition cost asset of $155.9 million and administrative expenses of approximately $10 million. On a statutory accounting basis, this transaction produced an increase in statutory surplus of approximately $109 million (see Statutory Capital of Insurance Subsidiaries).
The Company shares a significant amount of insurance risk of the primary underlying contracts with various insurance entities through the use of reinsurance contracts (see Segment Results - Risk Management, Reinsurance). As a result, when the Company experiences loss events that are subject to the reinsurance contract, reinsurance recoveries are recorded. The amount of the reinsurance recoverable can vary based on the size of the individual loss or the aggregate amount of all losses in a particular line, book of business or an aggregate amount associated with a particular accident year. The valuation of losses recoverable depends on whether the underlying loss is a reported loss, or an incurred but not reported loss. For reported losses, the Company values reinsurance recoverables at the time the underlying loss is recognized, in accordance with contract terms. For incurred but not reported losses, the Company estimates the amount of reinsurance recoverable based on the terms of the reinsurance contracts and historical reinsurance recovery information and applies that information to the gross loss reserve estimates. The most significant assumption the Company uses is the average size of the individual losses for those claims that have occurred but have not yet been recorded by the Company. The reinsurance recoverable is based on what the Company believes are reasonable estimates and is disclosed separately on the financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses are settled.
At each balance sheet date, the Company evaluates the historical and expected future gross profits. Any adjustment in estimated profit requires that the amortization rate be revised retroactively to the date of policy/annuity issuance. The cumulative difference related to prior periods is recognized as a component of the current periods' amortization, along with amortization associated with the actual gross profits of the period. Lower actual gross profits would typically result in less amortization expense. The converse would also be true. However, if lower gross profits were to continue into the future, a partial permanent impairment of the existing DAC asset may occur.
The Company periodically reviews the DAC asset to determine if it is recoverable from future income. If DAC is determined to be unrecoverable, such costs are expensed at the time of determination. The amount of DAC considered recoverable would be reduced in the near term if the estimate of ultimate or future gross profits is reduced. The amount of DAC amortization would be revised if any of the estimates discussed above are revised. In addition, the disposition of a line of business can result in the permanent impairment of the related DAC asset.
.. The Company Action Level, which equals 200% of the Authorized Control Level, requires the Company to prepare and submit a RBC plan to the commissioner of the state of domicile. A RBC plan proposes actions which a company may take in order to bring statutory capital above the Company Action Level. After review, the commissioner will notify the Company if the plan is satisfactory.
.. The Authorized Control Level authorizes the commissioner of the state of domicile to take whatever regulatory actions considered necessary to protect the best interest of the policyholders and creditors of the insurer.
.. 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 millions, except ratios) Total Company Authorized RBC Ratio RBC Ratio Adjusted Action Control Industry Regulatory Capital Level Level Scale Scale - -------------------------------------------------------------------------------- AFLIAC/(1)/ $ 481.9 $ 197.2 $ 98.6 244% 489% FAFLIC 200.0 96.2 48.2 207% 415% Hanover/(2)/ 830.3 388.0 194.0 214% 428%
/(1)/ AFLIAC's Total Adjusted Capital includes $200.0 million related to its subsidiary, FAFLIC. /(2)/ Hanover's Total Adjusted Capital includes $484.9 million related to its subsidiary, Citizens.
AFC has entered into an agreement with the Massachusetts Commissioner of Insurance, (the "Massachusetts Commissioner"), in consideration of the decision not to write new business, whereby it will indefinitely maintain the RBC ratio of AFLIAC at a minimum of 100% of the Company Action Level (on the Industry Scale). This agreement, which was previously with FAFLIC, replaced an earlier commitment that FAFLIC maintain a 225% RBC ratio (on the Industry Scale).
During 2002, AFC made capital contributions to its then subsidiary FAFLIC, which in turn contributed capital to its then subsidiary, AFLIAC. Such contributions were necessary due to the negative impact on statutory surplus of increased sales commissions, the effect of declines in the equity market on GMDB reserves and an increased level of realized investment losses. Such contributions were also made in consideration of the ratings of the life companies and the 225% RBC agreement described above, which has since been superseded. For each contribution made, the amount was accrued as of the end of the prior quarter and was; therefore, reflected in the previous quarter's surplus balance in the corresponding Company's statutory quarterly or annual statement. Hanover also paid an ordinary dividend to AFC in July, 2002.
- -------------------------------------------------------------------------------- Date of Path of Amount Effective Contribution Contribution (in millions) Date/(1)/ - -------------------------------------------------------------------------------- February, 2002 AFC to FAFLIC $ 30 December 31, 2001 FAFLIC to AFLIAC 30
August, 2002 AFC to FAFLIC 158 June 30, 2002 FAFLIC to AFLIAC 35
The Company does not expect the life insurance subsidiaries to require levels of capital contributions from AFC as in prior years, due to the expectation of sufficient statutory capital and earnings; therefore, the Company does not expect that it will be necessary to dividend significant funds from its property and casualty companies to AFC during 2003 (see Liquidity and Capital Resources).
The above mentioned agreement was superseded by the implementation of a new GMDB mortality reinsurance program. Effective December 1, 2002, AFLIAC and FAFLIC entered into a new mortality reinsurance program with unaffiliated reinsurers covering the incidence of mortality on variable annuity policies. This transaction reduced required statutory net GMDB reserves and resulted in an increase in statutory capital and surplus of approximately $20 million for the life companies at December 31, 2002.
Net cash provided by operating activities was $43.8 million, $658.4 million and $318.0 million in 2002, 2001 and 2000, respectively. The decrease in cash during 2002 primarily reflects net payments from the general account as a result of increased annuity contract withdrawals in the AFS segment as a result of ratings downgrades and the Company's decision to cease new sales, compared to net deposits in 2001 which included funds received from the aforementioned promotional annuity program. Additionally, premium collections in the property and casualty business decreased as compared to 2001, principally due to timing of cash receipts. The Company also made approximately $60 million of payments related to funds held for the aggregate excess of loss reinsurance contract as a result of the ratings downgrades (see Rating Agency Actions). These net cash outflows were partially offset by decreased loss and LAE payments in the property and casualty business, as well as increased federal income tax refunds. The increase in 2001 is primarily the result of higher general account deposits, including funds received from the aforementioned promotional annuity program with enhanced crediting rates and to an increase in premiums received from the property and casualty business. These increases in cash were partially offset by increased loss and LAE payments in the property and casualty business.
Net cash provided by investing activities was $1.5 billion in 2002, while net cash used in investing activities was $1.0 billion and $899.5 million in 2001 and 2000, respectively. The $2.5 billion increase in cash provided in 2002 from 2001 resulted primarily from net sales of fixed maturities in 2002, compared to net purchases of fixed maturities in 2001. The increase in net sales of fixed maturities in 2002 was primarily a result of short-term funding agreement withdrawals, the retirement of certain long-term funding agreements, and payments made related to annuity surrenders in the AFS segment. The $107.7 million increase in cash used in 2001 is primarily the result of higher net purchases of fixed maturities,
Net cash used in financing activities was $1.5 billion in 2002, while net cash provided by financing activities was $417.9 million and $397.8 million in 2001 and 2000, respectively. The decrease in cash provided by financing activities is primarily due to net funding agreement withdrawals, including the retirement of the trust instruments supported by funding obligations, of $1.4 billion versus net deposits of $399.2 million in 2001 and to the re-payment of the Company's short-term debt obligation of $83.3 million in 2002. The decrease in cash provided in 2001 compared to 2000 is primarily due to lower net funding agreement deposits, including trust instruments supported by funding obligations, partially offset by the absence of common stock repurchases in 2001.
The following tables provide information about the Company's ratings at December 31, 2000, 2001 and 2002, and rating agency actions that occurred in 2002 and, where applicable, 2003:
Rating downgrades have also adversely affected the cost and availability of any additional debt or equity financing and will continue to do so in the future should ratings remain at current levels or decrease further.
/s/ Edward J. Parry, III Executive Officer of the Chairman, Chief Financial Officer and Principal Accounting Officer
ment of mortgage loans and on mortgage loans which the Company believes may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral. Fixed maturities and mortgage loans that are delinquent are placed on non-accrual status, and thereafter interest income is recognized only when cash payments are received. Policy loans are carried principally at unpaid principal balances. Realized investment gains and losses, other than those related to separate accounts for which the Company does not bear the investment risk, are reported as a component of revenues based upon specific identification of the investment assets sold. When an other-than-temporary decline in value of a specific investment is deemed to have occurred, the Company reduces the cost basis of the investment to fair value. This reduction is permanent and is recognized as a realized investment loss. Changes in the reserves for mortgage loans are included in realized investment gains or losses.
Separate account assets and liabilities represent segregated funds administered and invested by the Company for the benefit of variable annuity and variable life insurance contractholders and certain pension funds. Assets consist principally of mutual funds, bonds, common stocks, and short-term obligations at market value. The investment income and gains and losses of these accounts generally accrue to the contractholders and, therefore, are not included in the Company's net income. Appreciation and depreciation of the Company's interest in the separate accounts, including undistributed net investment income, is reflected in shareholders' equity or net investment income.
Future policy benefits are liabilities for life, health and annuity products. Such liabilities are established in amounts adequate to meet the estimated future obligations of policies in force. The liabilities associated with traditional life insurance products are computed using the net level premium method for individual life and annuity policies, and are based upon estimates as to future investment yield, mortality and withdrawals that include provisions for adverse deviation. Future policy benefits for individual life insurance and annuity policies are computed using interest rates ranging from 2 1/2% to 6.0% for life insurance and 2% to 9 1/2% for annuities. Mortality, morbidity and withdrawal assumptions for all policies are based on the Company's own experience and industry standards. Liabilities for universal life, variable universal life and variable annuities include deposits received from customers and investment earnings on their fund balances, less administrative charges. Universal life fund balances are also assessed mortality and surrender charges. Liabilities for variable annuities include a reserve for guaranteed minimum fund values in excess of contract values. 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. Premiums for property and casualty insurance are reported as earned on a pro-rata basis over the contract period. The unexpired portion of these premiums is recorded as unearned premiums. Contractholder deposit funds and other policy liabilities include investment-related products such as guaranteed investment contracts, deposit administration funds and immediate participation guarantee funds and consist of deposits received from customers and investment earnings on their fund balances. 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. All policy liabilities and accruals are based on the various estimates discussed above. Although the adequacy of these amounts cannot be assured, the Company believes that it is more likely than not that policy liabilities and accruals will be sufficient to meet future obligations of policies in force. The amount of liabilities and accruals, however, could be revised in the near term if the estimates discussed above are revised.
Premiums for individual life insurance and individual and group annuity products, excluding universal life and investment-related products, are considered revenue when due. Property and casualty insurance premiums are recognized as revenue over the related contract periods. Benefits, losses
In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46, "Consolidation of Variable Interest Entities - an interpretation of ARB No. 51" ("FIN 46"). FIN 46 provides guidance regarding the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, specifically as it relates to the identification of entities for which control is achieved through a means other than voting rights ("variable interest entities") and the determination of which party is responsible for consolidating the variable interest entities (the "primary beneficiary"). In addition to mandating that the primary beneficiary consolidate the variable interest entity, FIN 46 also requires disclosures by companies that hold a significant variable interest, even if they are not the primary beneficiary. Certain financial statement disclosures are applicable immediately for those entities for which it is reasonably possible that the enterprise will consolidate any variable interest entities. This interpretation also applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. For those variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003, the provisions of this interpretation shall be applied no later than the first reporting period after June 15, 2003. The Company is currently assessing the effect that adoption of FIN 46 will have on it's financial position and results of operations. In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("Statement No. 148"). This statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("Statement No. 123"), to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement No. 123 to require more prominent disclosures, in both annual and interim financial statements, regarding the proforma effects of using the fair value method of accounting for stock-based compensation. The provisions of this statement are effective for fiscal years ending after December 15, 2002. As of December 31, 2002, the Company has elected to continue applying the provisions of Accounting Principles Board Opinion No. 25 for stock-based employee compensation. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others - an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34" ("FIN 45"). FIN 45 provides guidance regarding financial statement disclosure requirements for guarantors related to obligations under guarantees. FIN 45 also clarifies the requirements related to the recognition of a liability by the guarantor, at the inception of a guarantee, for these obligations under guarantees. This interpretation also incorporates, without change, the guidance in FASB Interpretation No. 34, "Disclosure of Indirect Guarantees of Indebtedness of Others," which is being superseded. The initial recognition and measurement provisions of this interpretation are required to be applied only on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of reporting periods ending after December 15, 2002. The adoption of FIN 45 did not have a material effect on the Company's financial position or results of operations.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("Statement No. 146"). This statement requires that a liability for costs associated with an exit or disposal activity is recognized and measured initially at its fair value in the period the liability is incurred. This statement supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". 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. The adoption of Statement No. 146 is not expected to have a material effect on the Company's financial statements. In August 2001, the FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("Statement No. 144"). This statement addresses significant issues relating to the implementation of Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("Statement No. 121"), by developing a single accounting model, based on the framework established in Statement No. 121, for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. In addition, Statement No. 144 supersedes the accounting and reporting provisions of Accounting Principles Board Opinion No. 30 ("APB No. 30"), "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for the disposal of a segment of a business and amends Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The provisions of this statement are effective for fiscal years beginning after December 15, 2001. The adoption of Statement No. 144 did not have a material effect on the Company's financial statements. In June 2001, the FASB issued Statement of Financial Accounting Standards No. 142, which requires that goodwill and intangible assets that have indefinite useful lives no longer be amortized over their useful lives, but instead be tested at least annually for impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. In addition, the statement provides specific guidance for testing the impairment of intangible assets. Additional financial statement disclosures about goodwill and other intangible assets, including changes in the carrying amount of goodwill, carrying amounts by classification of amortized and non-amortized assets, and estimated amortization expenses for the next five years, are also required. This statement became effective for fiscal years beginning after December 15, 2001 for all goodwill and other intangible assets held at the date of adoption. The Company adopted Statement No. 142 on January 1, 2002. In accordance with the transition provisions of this statement, the Company recorded a $3.7 million charge, net-of-taxes, in earnings, to recognize the impairment of goodwill related to two of its non-insurance subsidiaries. The Company utilized a discounted cash flow model to value these subsidiaries. In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, "Business Combinations" ("Statement No. 141"), which requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method of accounting. It further specifies the criteria that intangible assets must meet in order to be recognized and reported apart from goodwill. The implementation of Statement No. 141 is not expected to have a material effect on the Company's financial statements. In March 2000, the FASB issued Interpretation No. 44, "Accounting for Certain Transactions Involving Stock Compensation - an interpretation of APB Opinion No. 25" ("FIN 44"). FIN 44 clarifies the application of APB Opinion No. 25 regarding the definition of an employee, the criteria for determining a noncompensatory plan, the accounting for changes to the terms of a previously fixed stock option or award, the accounting for an exchange of stock compensation awards in a business combination, and other stock compensation related issues. FIN 44 became effective July 1, 2000 with respect to new awards, modifications to outstanding awards, and changes in grantee status that occur on or after that date. In addition, FIN 44 covers certain events occurring between December 16, 1998 and the July effective date, as well as certain other events occurring between January 13, 2000 and the July effective date. To the extent that applicable events occurred in those periods, the effects of applying FIN 44 are recognized on a prospective basis beginning July 1, 2000. The adoption of FIN 44 did not have a material impact on the Company's financial position or results of operations. In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement No. 133"), which establishes accounting and reporting standards for derivative instruments. Statement No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on the type of hedge transaction. For fair value hedge transactions in which the Company is hedging changes in an asset's, liability's or firm commitment's fair value, changes in the fair value of the derivative instruments will generally be offset in the income statement by
Earnings per share ("EPS") for the years ended December 31, 2002, 2001, and 2000 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. Options to purchase shares of common stock whose exercise prices are greater than the average market price of the common shares are not included in the computation of diluted earnings per share because the effect would be antidilutive.
During 1999, the Company approved a plan to exit its group life and health insurance business, consisting of its Employee Benefit Services ("EBS") business, its Affinity Group Underwriters ("AGU") business and its accident and health assumed reinsurance pool business ("reinsurance pool business"). During 1998, the Company ceased writing new premiums in the reinsurance pool business, subject to certain contractual obligations. Prior to 1999, these businesses comprised substantially all of the former Corporate Risk Management Services segment. Accordingly, the operating results of the discontinued segment, including its reinsurance pool business, have been reported in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB Opinion No. 30"). In 1999, the Company recorded a $30.5 million loss, net of taxes, on the disposal of this segment, consisting of after-tax losses from the run-off of the group life and health business of approximately $46.9 million, partially offset by net proceeds from the sale of the EBS business of approximately $16.4 million. Subsequent to the measurement date of June 30, 1999, approximately $7.4 million of the aforementioned $46.9 million loss has been generated from the operations of the discontinued business. In March of 2000, the Company transferred its EBS business to Great-West Life and Annuity Insurance Company of Denver. As a result of this transaction, the Company has received consideration of approximately $27 million, based on renewal rights for existing policies. The Company retained policy liabilities estimated at $69.6 million at December 31, 2002 related to this business. As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have not been segregated between continuing and discontinued operations. At December 31, 2002 and 2001, the discontinued segment had assets of approximately $290.4 million and $397.6 million, respectively, consisting primarily of invested assets and reinsurance recoverables, and liabilities of approximately $347.5 million and $369.3 million, respectively, consisting primarily of policy liabilities. Revenues for the discontinued operations were $23.3 million, $34.4 million and $207.7 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Gross Gross Amortized Unrealized Unrealized Fair Cost /(1)/ Gains Losses Value - ----------------------------------------------------------------------------- U.S. Treasury securities and U.S. government and agency securities $ 280.5 $ 4.9 $ 3.1 $ 282.3 States and political subdivisions 1,830.5 16.4 17.1 1,829.8 Foreign governments 34.3 2.4 0.2 36.5 Corporate fixed maturities 6,145.0 195.4 119.2 6,221.2 Mortgage-backed securities 1,003.7 32.0 3.8 1,031.9 - ----------------------------------------------------------------------------- Total fixed maturities $ 9,294.0 $ 251.1 $ 143.4 $ 9,401.7 ============================================================================= Equity securities $ 61.2 $ 10.0 $ 9.1 $ 62.1 =============================================================================
/(1)/ Amortized cost for fixed maturities and cost for equity securities.
Property type: Office building $ 142.0 $ 177.0 Industrial / warehouse 62.2 68.3 Retail 51.0 67.9 Residential 6.9 11.5 Other 0.5 0.7 Valuation allowances (2.8) (3.8) - ------------------------------------------------------------------- Total $ 259.8 $ 321.6 =================================================================== Geographic region: Pacific $ 72.3 $ 78.2 South Atlantic 63.3 91.8 New England 45.1 50.5 East North Central 38.3 40.0 West South Central 18.6 33.3 Middle Atlantic 11.1 16.8 Other 13.9 14.8 Valuation allowances (2.8) (3.8) - ------------------------------------------------------------------- Total $ 259.8 $ 321.6 ===================================================================
At December 31, 2002, scheduled mortgage loan maturities were as follows: 2003 - $25.7 million; 2004 - $64.9 million; 2005 - $14.6 million; 2006 - $29.2 million; 2007 - $16.9 million and $108.5 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 2002, the Company did not refinance any mortgage loans based on terms which differed from current market rates. Mortgage loans investment valuation allowances of $2.8 million and $3.8 million at December 31, 2002 and 2001, respectively, have been deducted in arriving at investment carrying values as presented in the Consolidated Balance Sheets. There were no impaired loans or related reserves as of December 31, 2002 and 2001. Those mortgage loans that were impaired during a portion of 2001 had an average carrying value of $2.2 million as of December 31, 2001. Related interest income while such loans were impaired was $1.4 million in 2000. There was no interest income received in 2002 and 2001 related to impaired loans.
The Company maintains an overall risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate or foreign currency volatility. The operations of the Company are subject to risk resulting from interest rate fluctuations to the extent that there is a difference between the amount of the Company's interest-earning assets and the amount of interest-bearing liabilities that are paid, withdrawn, mature or re-price in specified periods. The principal objective of the Company's asset/liability management activities is to provide maximum levels of net investment income while maintaining acceptable levels of interest rate and liquidity risk and facilitating the funding needs of the Company. The Company has developed an asset/liability management approach tailored to specific insurance or investment product objectives. The investment assets of the Company are managed in over 20 portfolio segments consistent with specific products or groups of products having similar liability characteristics. As part of this approach, management develops investment guidelines for each portfolio consistent with the return objectives, risk tolerance, liquidity, time horizon, tax and regulatory requirements of the related product or business segment. Management has a general policy of diversifying investments both within and across all portfolios. The Company monitors the credit quality of its investments and its exposure to individual markets, borrowers, industries, and sectors. The Company uses derivative financial instruments, primarily interest rate swaps and futures contracts, with indices that correlate to balance sheet instruments to modify its indicated net interest sensitivity to levels deemed to be appropriate. Specifically, for floating rate funding agreements that are matched with fixed rate securities, the Company manages the risk of cash flow variability by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. Under interest rate swap contracts, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount. Additionally, the Company uses exchange traded financial futures contracts to hedge against interest rate risk on the reinvestment of fixed maturities. The Company is exposed to interest rate risk on fixed maturity reinvestments from the time of maturity until the purchase of new fixed maturities. Prior to September 2002, the Company used exchange traded futures contracts to hedge against interest rate risk on anticipated sales of guaranteed investment contracts ("GIC") and other funding agreements. The Company was exposed to interest rate risk from the time of sale of the GIC until the receipt of the deposit and purchase of the underlying asset to back the liability. The Company only trades derivative instruments with nationally recognized brokers, which the Company believes have adequate capital to ensure that there is minimal risk of default. As a result of the Company's issuance of trust instruments supported by funding obligations denominated in foreign currencies, as well as the Company's investment in securities denominated in foreign currencies, the Company's operating results are exposed to changes in exchange rates between the U.S. dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From time to time, the Company may also have exposure to other foreign currencies. To mitigate the short-term effect of changes in currency exchange rates, the Company regularly enters into foreign exchange swap, futures and options contracts to hedge its net foreign currency exposure. Additionally, the Company enters into compound currency/interest rate swap contracts to hedge foreign currency and interest rate exposure on specific trust instruments supported by funding obligations. By using derivative instruments, the Company is exposed to credit risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain (including any accrued receivable) in a derivative. The Company regularly assesses the financial strength of its counterparties and generally enters into derivative instruments with counterparties rated "A" or better by nationally recognized rating agencies. Depending on the nature of the derivative transaction, the Company maintains bilateral Collateral Standardized Arrangements ("CSA") with each counterparty. In general, the CSA sets a minimum threshold of exposure that must be collateralized, although thresholds may vary by CSA. At December 31, 2002 and 2001, respectively, collateral of $23.7 million and $69.7 million, in the form of cash, bonds and US Treasury notes were held by our counterparties related to these agreements. The Company's derivative activities are monitored by management, who review portfolio activities and risk levels. Management also oversees all derivative transactions to ensure that the types of transactions entered into and the results obtained from those transactions are consistent with the Company's risk management strategy and with Company policies and procedures.
The Company enters into compound foreign currency/interest rate swaps to convert its foreign denominated fixed rate trust instruments supported by funding obligations to U.S. dollar floating rate instruments. For the years ended December 31, 2002 and 2001, the Company recognized net gains of $0.3 million, reported in (gains) losses on derivative instruments in the Consolidated Statements of Income, which represented the ineffective portion of all fair value hedges. All components of each derivative's gain or loss are included in the assessment of hedge effectiveness, unless otherwise noted.
Floating Rate Secured Notes $ 241.6 $ 249.4 Second Priority Senior Notes 65.3 60.7 Senior Subordinated Notes 32.9 32.9 Junior Subordinated Notes 21.9 21.9 - ------------------------------------------------------------------ Total Allmerica CBO Capital $ 361.7 $ 364.9 ==================================================================
Unrealized gains and losses on available-for-sale, other securities, and derivative instruments are summarized as follows:
- ----------------------------------------------------------------------------- Net (depreciation) appreciation, beginning of year $ (97.0) $ 21.7 $ (75.3) Net appreciation (depreciation) on available-for-sale securities 144.6 (0.6) 144.0 Net depreciation from the effect on deferred policy acquisition costs and on policy liabilities (36.1) -- (36.1) (Provision) benefit for deferred federal income taxes (38.0) 0.2 (37.8) - ----------------------------------------------------------------------------- 70.5 (0.4) 70.1 - ----------------------------------------------------------------------------- Net (depreciation) appreciation, end of year $ (26.5) $ 21.3 $ (5.2) =============================================================================
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000 - ----------------------------------------------------------------- (In millions)
Fixed maturities $ 567.9 $ 614.0 $ 564.6 Mortgage loans 23.9 42.7 52.1 Equity securities 1.6 2.3 2.0 Policy loans 24.8 27.1 26.1 Derivative instruments (37.7) (48.0) (5.6) Other long-term investments 14.0 16.5 7.2 Short-term investments 9.5 17.3 14.5 - ----------------------------------------------------------------- Gross investment income 604.0 671.9 660.9 Less investment expenses (13.8) (16.7) (15.4) - ----------------------------------------------------------------- Net investment income $ 590.2 $ 655.2 $ 645.5 =================================================================
The Company had fixed maturities with a carrying value of $39.9 million and $10.7 million on non-accrual status at December 31, 2002 and 2001, respectively. The Company had mortgage loans with a carrying value of $7.4 million on non-accrual status at December 31, 2002. There were no mortgage loans on non-accrual status at December 31, 2001. 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 $19.9 million, $11.3 million, and $3.6 million in 2002, 2001, and 2000, 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, 2002 and 2001. Interest income on restructured mortgage loans that would have been recorded in accordance with the original terms of such loans amounted to $1.7 million in 2000. Actual interest income on these loans included in net investment income aggregated $1.4 million in 2000. There were no mortgage loans which were non-income producing at December 31, 2002 and 2001. There were, however, fixed maturities with a carrying value of $7.2 million and $2.9 million at December 31, 2002 and 2001, respectively, which were non-income producing during 2002 and 2001. Included in other long-term investments is income from limited partnerships of $5.3 million, $9.4 million, and $7.8 million in 2002, 2001, and 2000, respectively.
The Company recognized losses of $238.5 million, $185.3 million and $66.1 million in 2002, 2001 and 2000, respectively, related to other-than-temporary impairments of fixed maturities and other securities.
Unrealized appreciation (depreciation) on available-for sale securities: Unrealized holding gains (losses) arising during period, (net of taxes (benefit) of $11.4 million, $(18.3) million and $(12.9) million in 2002, 2001 and 2000) $ 21.1 $ (34.0) $ (24.1) Less: reclassification adjustment for losses included in net income (net of tax benefits of $38.7 million, $35.9 million and $50.7 million in 2002, 2001 and 2000) (71.9) (66.7) (94.2) - ----------------------------------------------------------------------------- Total available-for-sale securities 93.0 32.7 70.1 - ----------------------------------------------------------------------------- Unrealized depreciation on derivative instruments: Unrealized holding gains (losses) arising during period, (net of taxes (benefit) of $4.7 and $(63.4) million in 2002 and 2001) 8.9 (117.7) -- Less: reclassification adjustment for gains (losses) included in net income (net of taxes (benefit) of $25.2 million and $(63.9) million in 2002 and 2001) 46.9 (118.6) -- - ----------------------------------------------------------------------------- Total derivative instruments (38.0) 0.9 -- - ----------------------------------------------------------------------------- Net unrealized appreciation on investments $ 55.0 $ 33.6 $ 70.1 =============================================================================
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about certain financial instruments (insurance contracts, real estate, goodwill and taxes are excluded) for which it is practicable to estimate such values, whether or not these instruments are included in the balance sheet. The fair values presented for certain financial instruments are estimates which, in many cases, may differ significantly from the amounts which could be realized upon immediate liquidation. In cases where market prices are not available, estimates of fair value are based on discounted cash flow analyses which utilize current interest rates for similar financial instruments which have comparable terms and credit quality. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
Fair values are based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using independent pricing sources or internally developed pricing models using discounted cash flow analyses.
Fair values are based on the current cash surrender value of the policy. This value is dependent on the fair value of the underlying securities which is based on quoted market prices, if available. If a quoted market price is not available, fair values are estimated using independent pricing sources or internally developed pricing models.
Fair values for the Company's liabilities under guaranteed investment type contracts are estimated using discounted cash flow calculations using current interest rates for similar contracts with maturities consistent with those remaining for the contracts being valued. Liabilities under supplemental contracts without life contingencies are estimated based on current fund balances and other individual contract funds represent the present value of future policy benefits. Other liabilities are based on current surrender values.
Mandatorily Redeemable Preferred Securities of a Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company
There were no reserves on mortgage loans at December 31, 2002 and 2001. 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.
On January 1, 2002, the Company adopted Statement No. 142. Upon implementation, the Company recorded an impairment charge of $3.7 million, net of taxes, and ceased its amortization of goodwill. Amortization expense in 2001 and 2000 was $4.0 million and $3.8 million, respectively, net of taxes. In accordance with Statement No. 142, the following table provides (loss) income before the cumulative effect of a change in accounting principle, net (loss) income, and related per-share amounts as of December 31, 2002, 2001, and 2000 as reported and adjusted as if the Company had ceased amortizing goodwill effective January 1, 2000.
DECEMBER 31, 2002 2001 2000 - ----------------------------------------------------------------------------- (In millions, except per share data)
During 2002 and 2001, AFC issued commercial paper primarily to manage imbalances between operating cash flows and existing commitments primarily in its premium financing business. Commercial paper borrowing arrangements are supported by a credit agreement. At December 31, 2002, the Company had $150.0 million available for borrowing under a committed syndicated credit agreement which expires on May 24, 2003. Borrowings under this agreement are unsecured and incur interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus applicable margin. Senior Debentures of the Company have a $200.0 million face value, pay interest semiannually at a rate of 7 5/8%, and mature on October 16, 2025. The Senior Debentures are subject to certain restrictive covenants, including limitations on issuance of or disposition of stock of restricted subsidiaries and limitations on liens. The Company is in compliance with all covenants. Interest expense was $17.1 million, $19.5 million and $21.4 million in 2002, 2001 and 2000, respectively. Interest expense included $15.3 million related to the Company's Senior Debentures for each year. In 2002 and 2001, there was no interest expense related to borrowings under the credit agreements. Interest expense related to borrowings under the credit agreements was approximately $0.1 million in 2000. All interest expense is recorded in other operating expenses.
Provisions for federal income taxes have been calculated in accordance with the provisions of Statement No. 109. A summary of the federal income tax (benefit) expense in the Consolidated Statements of Income is shown below:
Federal income tax (benefit) expense Current $ (6.8) $ (12.4) $ 1.2 Deferred (228.0) (63.1) 1.5 - -------------------------------------------------------------------------------- Total $ (234.8) $ (75.5) $ 2.7 ================================================================================
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000 - ----------------------------------------------------------------------------- (In millions)
Expected federal income tax (benefit) expense $ (182.4) $ (20.8) $ 76.5 Tax-exempt interest (24.3) (30.3) (33.2) Prior years' federal income tax settlement (11.6) -- -- Tax credits (10.8) (10.8) (10.3) Dividend received deduction (9.8) (12.6) (10.8) Changes in estimates for prior years dividend received deduction -- -- (13.3) Changes in other tax estimates 3.0 (1.4) (7.5) Other, net 1.1 0.4 1.3 - ----------------------------------------------------------------------------- Federal income tax (benefit) expense $ (234.8) $ (75.5) $ 2.7 =============================================================================
The deferred income tax net asset represents the tax effects of temporary differences attributable to the Company's consolidated federal tax return group. Its components were as follows:
Deferred tax (assets) liabilities Insurance reserves $ (421.9) $ (381.6) Deferred acquisition costs 361.2 518.7 Tax credit carryforwards (149.8) (105.3) Employee benefit plans (113.3) (72.7) Loss carryforwards (77.7) (94.4) Discontinued operations (22.4) (20.2) Software capitalization 19.0 23.7 Investments, net 6.9 (32.0) Bad debt reserves (4.9) (3.0) Restructuring reserves (3.9) (1.1) Litigation reserves (0.9) (3.3) Other, net (5.5) 3.1 - --------------------------------------------------------------------- Deferred tax asset, net $ (413.2) $ (168.1) =====================================================================
Gross deferred income tax assets totaled approximately $1.7 billion and $1.9 billion at December 31, 2002 and 2001, respectively. Gross deferred income tax liabilities totaled approximately $1.3 billion and $1.7 billion at December 31, 2002 and 2001, respectively. The Company believes, based on its earnings history and its future expectations, that the Company's taxable income in future years will be sufficient to realize all deferred tax assets. In determining the adequacy of future income, the Company considered the future reversal of its existing temporary differences and available tax planning strategies that could be implemented, if necessary. At December 31, 2002, there are available alternative minimum tax credit carryforwards, low income housing credit carryforwards and certain other tax credit carryforwards of $93.5 million, $49.2 million and $7.1 million, respectively. The alternative minimum tax credit carryforwards have no expiration date and the low income housing credit carryforwards will expire beginning in 2018. The Company also has net operating loss carryforwards of $222.0 million expiring in 2016. 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 1994. The IRS has also examined the former Allmerica Property and Casualty Companies, Inc. ("Allmerica P&C") consolidated group's federal income tax returns through 1994. Certain adjustments proposed by the IRS with respect to FAFLIC/AFLIAC's federal income tax returns for 1982 and 1983 remain unresolved. In the Company's opinion, adequate tax liabilities have been established for all years. However, the amount of these tax liabilities could be revised in the near term if estimates of the Company's ultimate liability are revised.
AFC provides retirement benefits to substantially all of its employees under defined benefit pension plans. These plans are based on a defined benefit cash balance formula, whereby the Company annually provides an allocation to each covered employee based on a percentage of that employee's eligible salary, similar to a defined contribution plan arrangement. The allocation was based on 3.0%, 5.0% and 7.0% of each covered employee's eligible salary for 2002, 2001 and 2000, respectively. In addition to the cash balance allocation, certain transition group employees, who have met specified age and service requirements as of December 31, 1994, are eligible for a grandfathered benefit based primarily on the employees' years of service and compensation during their highest five consecutive plan years of employment. The Company's policy for the plans is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974. In order to measure the expense associated with these plans, management must make various estimates and assumptions, including discount rates used to value liabilities, assumed rates of return on plan assets, compensation increases, employee turnover rates and anticipated mortality rates, for example. The estimates used by management are based on the Company's historical experience, as well as current facts and circumstances. In addition, the Company uses outside actuaries to assist in measuring the expense and liability associated with these plans.
Service cost - benefits earned during the year $ 11.1 $ 14.7 $ 18.5 Interest cost 32.6 30.9 28.6 Expected return on plan assets (33.4) (39.6) (43.1) Recognized net actuarial loss(gain) 11.3 (0.4) (11.2) Amortization of transition asset (2.2) (2.2) (2.2) Amortization of prior service cost (2.6) (3.1) (3.1) Curtailment loss and special termination benefits 5.4 -- -- - ------------------------------------------------------------------------------- Net periodic pension cost (benefit) $ 22.2 $ 0.3 $ (12.5) ===============================================================================
Change in benefit obligations: Projected benefit obligation, beginning of year $ 483.2 $ 450.9 Service cost - benefits earned during the year 11.1 14.7 Interest cost 32.6 30.9 Actuarial losses 28.6 12.4 Benefits paid (30.1) (25.7) - ------------------------------------------------------------------------------- Projected benefit obligation, end of year 525.4 483.2 =============================================================================== Change in plan assets: Fair value of plan assets, beginning of year 364.3 441.5 Actual return on plan assets (65.2) (51.5) Benefits paid (30.1) (25.7) - ------------------------------------------------------------------------------- Fair value of plan assets, end of year 269.0 364.3 =============================================================================== Funded status of the plan (256.4) (118.9) Unrecognized transition obligation (15.0) (17.2) Unamortized prior service cost (3.5) (1.7) Unrecognized net actuarial gains 26.3 27.6 - ------------------------------------------------------------------------------- Net pension liability $ (248.6) $ (110.2) ===============================================================================
As a result of the AFS restructuring in 2002 (see Note 3 - Significant Transactions), the Company recognized a curtailment gain and special termination benefit costs related to its postretirement benefit plans. The curtailment gain resulted from the effect of agent terminations related to those not fully eligible for benefits, while the special termination benefit costs reflect acceleration of retirement criteria for selected terminated employees. As a result of the Company's merger with Allmerica P&C in 1997, certain postretirement liabilities were reduced to reflect their fair value as of the merger date. These postretirement liabilities were reduced by $2.4 million and $3.2 million 2002 and 2001, respectively, which reflects fair value, net of applicable amortization. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2002, health care costs were assumed to increase 9.0% in 2003, declining
thereafter until the ultimate rate of 5.0% is reached in 2010 and remains at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation at December 31, 2002 by $3.5 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2002 by $0.6 million. Conversely, decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation at December 31, 2002 by $3.1 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2002 by $0.5 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 6.25% and 6.88% at December 31, 2002 and 2001, respectively. In addition, the actuarial present value of the accumulated postretirement benefit obligation was determined using an assumed rate of increase in future compensation levels of 4.0% for FAFLIC agents.
Since options vest over several years and additional awards generally are made each year, the aforementioned pro forma effects are not likely to be representative of the effects on reported net income for future years. In March 2000, the FASB issued FIN 44, which clarifies the application of APB Opinion No. 25 regarding the definition of employee, the criteria for determining a noncompensatory plan, the accounting for changes to the terms of a previously fixed stock option or award, the accounting for an exchange of stock compensation awards in a business combination, and other stock compensation related issues. Costs associated with the issuance of stock options to certain agents who did not qualify as an employee as defined in FIN 44 were recognized in 2002, 2001 and 2000 and were not material to the results of operations or financial position of the Company. Effective June 17, 1996, the Company adopted a Long-Term Stock Incentive Plan for employees of the Company (the "Employees' Plan"). Key employees of the Company and its subsidiaries are eligible for awards pursuant to the Plan administered by the Compensation Committee of the Board of Directors (the "Committee") of the Company. Under the terms of the Employees' Plan, the maximum number of shares authorized for grants over the life of the Plan is equal to 7,162,086 shares as of December 31, 2002, 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 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. Stock grants may be awarded to eligible employees at a price established by the Committee (which may be zero). Under the Employees' Plan, stock grants may vest based upon performance criteria or continued employment. Stock grants which vest based on performance vest over a minimum one year period. Stock grants which vest based on continued employment vest at the end of a minimum of three consecutive years.
No options expired during 2002, 2001, or 2000. 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 2002, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of all options granted in 2002, 2001, and 2000 was $14.48 per share, $19.49 per share, and $17.11 per share, respectively. The following significant assumptions were used to determine fair value for 2002 options granted and converted:
STOCK AWARDS 2002 2001 2000 - --------------------------------------------------------------------------- Common stock granted 70,982 269,690 190,141 Weighted average fair value per share at the date of grant $ 39.22 $ 52.08 $ 38.01
DECEMBER 31 2002 2001 2000 - ------------------------------------------------------------------------------- (In millions, except per share data)
Basic shares used in the calculation of earnings per share 52.9 52.7 53.3 Dilutive effect of securities/(1)/: Employee stock options -- 0.2 0.4 Non-vested stock grants -- 0.2 0.3 - ------------------------------------------------------------------------------- Diluted shares used in the calculation of earnings per share 52.9 53.1 54.0 - ------------------------------------------------------------------------------- Per share effect of dilutive securities on income before cumulative effect of change in accounting principle and net income $ -- $ -- $ 0.05 =============================================================================== Per share effect of dilutive securities on net (loss) income $ -- $ -- $ 0.05 ===============================================================================
(1) Excludes 0.2 million shares due to antidilution for the year ended December 31, 2002.
Options to purchase 4.6 million shares and 3.4 million shares of common stock were outstanding during 2002 and 2001, respectively, but were not included in the computation of diluted earnings per share because the option's exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. In 2000, all options to purchase shares of common stock were included in the computation of diluted earnings per share.
reinsurers to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts deemed uncollectible. The Company determines the appropriate amount of reinsurance based on evaluation of the risks accepted and analyses prepared by consultants and reinsurers and on market conditions (including the availability and pricing of reinsurance). The Company also believes that the terms of its reinsurance contracts are consistent with industry practice in that they contain standard terms with respect to lines of business covered, limit and retention, arbitration and occurrence. Based on its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. Effective December 31, 2002, the Company entered into a 100% coinsurance agreement related to substantially all of the Company's universal life business (see Note 3 - Significant Transactions). Reinsurance recoverables related to this agreement were $648.4 million at December 31, 2002. This balance represents approximately 31.2% of the Company's reinsurance recoverables at December 31, 2002. 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 2002, 2001 and 2000 for accident year 1999 were $3.2 million, $12.1 million and $25.0 million, respectively, while net losses and LAE ceded during 2002, 2001 and 2000 were $3.9 million, $15.8 million and $34.1 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 the Massachusetts Commonwealth Automobile Reinsurers ("CAR"), and the Michigan Catastrophic Claims Association ("MCCA"). At December 31, 2002, CAR represented 10% or more of the Company's reinsurance activity. As a servicing carrier in Massachusetts, the Company cedes a significant portion of its private passenger and commercial automobile premiums to CAR. Net premiums earned and losses and loss adjustment expenses ceded to CAR in 2002, 2001 and 2000 were $46.8 million and $59.4 million, $34.2 million and $38.0 million, and $37.3 million and $44.5 million, respectively. Additionally, the Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 2002, 2001 and 2000 of $32.6 million and $49.8 million, $7.2 million and $44.5 million, and $3.7 million and $31.1 million, respectively. Because the MCCA is supported by assessments permitted by statute, and all amounts billed by the Company to CAR and MCCA have been paid when due, the Company believes that it has no significant exposure to uncollectible reinsurance balances from these two entities. The effects of reinsurance were as follows:
The following reflects the changes to the deferred policy acquisition asset:
Balance at beginning of year $ 1,784.2 $ 1,608.2 $ 1,399.9 Acquisition expenses deferred 710.0 688.8 684.1 Amortized to expense during the year (921.4) (479.2) (456.6) Impairment of DAC asset related to annuity business (159.0) -- -- Impairment of DAC asset related to sale of universal life insurance business (155.9) -- -- Adjustment to equity during the year (15.7) (2.0) (19.2) Adjustment for commission buyout program -- (31.6) -- - ---------------------------------------------------------------------------- Balance at end of year $ 1,242.2 $ 1,784.2 $ 1,608.2 ============================================================================
The Company regularly updates its estimates of liabilities for outstanding claims, losses and loss adjustment expenses as new information becomes available and further events occur which may impact the resolution of unsettled claims for its property and casualty and its accident and health lines of business. Changes in prior estimates are recorded in results of operations as adjustments to losses and LAE in the year such changes are determined to be needed. Often these adjustments are recognized in periods subsequent to the period in which the underlying loss event occurred. These types of subsequent adjustments are described as "prior year reserve development". Such development can be either favorable or unfavorable on the financial results of the Company. The liability for future policy benefits and outstanding claims, losses and loss adjustment expenses, excluding the effect of reinsurance, related to the Company's accident and health business, consisting of the Company's exited individual health business and its discontinued group accident and health business, was $434.8 million, $463.5 million and $519.3 million at December 31, 2002, 2001 and 2000, respectively. Reinsurance recoverables related to this business were $329.3 million, $343.0 million and $335.9 million in 2002, 2001 and 2000, respectively. The decreases in 2002 and 2001 were primarily attributable to the continued run-off of the group accident and health business. Also, the decrease in 2000 was impacted by the Company's entrance into a reinsurance agreement which provided for the cession of the Company's long-term group disability reserves, partially offset by reserve strengthening in the reinsurance pool business.
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were increased by $6.4 million and $107.4 million in 2002 and 2001, respectively, and decreased by $87.4 million in 2000. During the year ended December 31, 2002 and 2001, estimated loss reserves for claims occurring in prior years developed unfavorably by $36.9 million and $146.6 million, respectively. During the year ended December 31, 2000 estimated loss reserves for claims occurring in prior years developed favorably by $25.9 million. The adverse development in both 2002 and 2001 is primarily the result of increased claim severity for personal automobile medical settlements for Citizens. As these settlements have risen beyond previous estimates, reserve increases have been recognized in the period in which the information is obtained. The increase in the prior year reserve estimates for other commercial lines during 2002 is primarily due to the recognition of approximately $5 million in additional reserves for asbestos claims in the Excess and Casualty Reinsurance Association ("ECRA") voluntary pool. In addition, the Company experienced adverse development in 2001 as a result of the $40.8 million reserve increase on prior years resulting from the agency management actions discussed in Note 3 - "Significant Transactions". This reserve increase affected primarily the commercial multiple peril, personal automobile, commercial automobile and workers' compensation lines. Additionally, other commercial lines' prior year reserves developed adversely due to a $33.0 million reserve increase in the ECRA voluntary pool. Personal automobile prior year reserves developed adversely due to the aforementioned increased claim severity related to medical settlements for Citizens. In addition to the effect from the agency management actions, the commercial automobile and commercial multiple peril lines experienced adverse development. The increased reserves in these lines is primarily attributable to increased claim payments in the 2000 and 1999 accident years. As these payments have increased above historical amounts, actuarial projections of future settlements have increased the estimated ultimate reserves on prior years. During 2000, the favorable loss development is primarily the result of a decrease in prior year reserves in the personal automobile line. The Company began to experience an improvement in the Northeast in the personal automobile line as claim payment severity began to decrease in accident years 1999 and 1998. As the certainty of the improvement in claim payment severity for accident years 1999 and 1998 increased, ultimate losses for those accident years were reduced and favorable development was recorded during calendar year 2000. During the years ended December 31, 2002, 2001 and 2000, estimated loss adjustment expense reserves for claims occurring in prior years developed favorably by $30.5 million, $39.2 million and $61.5 million, respectively. The favorable development in all the periods is primarily attributable to claims process improvement initiatives taken by the Company during the 1997 to 2001 calendar year period. Since 1997, the Company has lowered claim settlement costs
Ending losses and LAE reserves for all direct business written by its property and casualty companies related to asbestos, environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $25.6 million, $26.7 million and $25.4 million, net of reinsurance of $16.0 million, $13.0 million and $15.9 million in 2002, 2001 and 2000, respectively. The outstanding reserves for direct business asbestos and environmental damage have remained relatively consistent for the three-year period ended December 31, 2002. The Company estimates its ultimate liability for these claims based upon currently known facts, reasonable assumptions where the facts are not known, current law and methodologies currently available. Although these outstanding claims are not significant, their existence gives rise to uncertainty and are discussed because of the possibility that they may become significant. The Company believes that, notwithstanding the evolution of case law expanding liability in environmental claims, recorded reserves related to these claims are adequate. In addition, the Company is not aware of any litigation or pending claims that may result in additional material liabilities in excess of recorded reserves. The environmental liability could be revised in the near term if the estimates used in determining the liability are revised. In addition, the Company has established loss and LAE reserves for assumed reinsurance and pool business with asbestos, environmental damage and toxic tort liability of $45.2 million, $39.3 million and $10.6 million in 2002, 2001 and 2000, respectively. These reserves relate to pools that the Company has terminated its participation; however, the Company continues to be subject to claims related to years in which it was a participant. The Company was a participant in ECRA from 1950 to 1982. In 1982, the pool was dissolved and since that time the business has been in runoff. The Company's participation in this pool has resulted in average paid losses of $2.3 million annually over the past ten years. During 2001, the pool commissioned an independent actuarial review of the current reserve position, which noted a range of reserve deficiency primarily as a result of adverse development of asbestos claims. As a result of this study, the Company recorded an additional $33.0 million of losses in the fourth quarter of 2001. This reserving action has been presented as a separate line item in the Consolidated Statements of Income. Because of the inherent uncertainty regarding the types of claims in these pools, there can be no assurance that these reserves will be sufficient. During 2002, the Company recorded an additional $5.0 million of loss reserves related to ECRA.
Unfavorable economic conditions may contribute to an increase in the number of insurance companies that are under regulatory supervision. This may result in an increase in mandatory assessments by state guaranty funds, or voluntary payments by solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through a reduction in future pre-
mium taxes in some states. The Company is not able to reasonably estimate the potential impact of any such future assessments or voluntary payments.
The Company is required to participate in residual markets in various states. The results of the residual markets are not subject to the predictability associated with the Company's own managed business, and are significant to the workers' compensation line of business and both the personal and commercial automobile lines of business.
The Company's insurance subsidiaries are required to file annual statements with state regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Statutory surplus differs from shareholders' equity reported in accordance with generally accepted accounting principles primarily because policy acquisition costs are expensed when incurred, statutory accounting principles require asset valuation and interest maintenance reserves, postretirement benefit costs are based on different assumptions and reflect a different method of adoption, life insurance reserves are based on different assumptions and the recognition of deferred tax assets is based on different recoverability assumptions. Effective January 1, 2001, the Company's insurance subsidiaries adopted the National Association of Insurance Commissioners' uniform statutory accounting principles, or Codification, in accordance with requirements prescribed by state authorities. A cumulative effect of the change in accounting principle resulted from the adoption of Codification and was reflected as an adjustment to surplus in 2001. This adjustment represents the difference between total capital and surplus as of January 1, 2001 and the amount total capital and surplus would have been had the accounting principles been applied retroactively for all prior periods. As of January 1, 2001, the property and casualty and life and health insurance subsidiaries recorded cumulative effect adjustments of $82.4 million and $45.0 million, respectively. The adjustment reflected by the property and casualty insurance subsidiaries consisted of an increase in surplus of $141.9 million related to the establishment of deferred tax assets and reductions in surplus of $59.5 million related to changes in valuations of other invested assets and non-admitted assets. The adjustment reflected by the life and health insurance subsidiaries included an increase in surplus of $49.7 million related to the establishment of deferred tax assets and the change in valuation of pension liabilities. Reductions in surplus reflected by the life and health insurance subsidiaries totaled $4.7 million and resulted from the change in valuations of post-employment benefits and non-admitted assets.
Statutory Net Income (Loss) - Combined Property and Casualty Companies $ 11.8 $ (7.9) $ 111.8 Life and Health Companies (296.0) (44.9) (43.6) - -------------------------------------------------------------------------- Statutory Shareholders' Surplus - Combined Property and Casualty Companies $ 834.0 $ 926.1 $ 1,036.2 Life and Health Companies 427.1 377.9 528.5 ==========================================================================
Note: Due to the use of weighted average shares outstanding when calculating earnings per common share, the sum of the quarterly per common share data may not equal the per common share data for the year. Diluted net loss per share for the three months ended June 30 and September 30, 2002 and for December 31, 2001 represents basic loss per share due to antidilution.