-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, CI7+uEVzXPHLGmyjC4wC1Fs8D5A8OMlQ5wq971Ky4F5rImj7eveaNfWgoIzk0ufK rAuCclT7LZ3TNWKUmZicXg== 0000927016-99-001189.txt : 19990331 0000927016-99-001189.hdr.sgml : 19990331 ACCESSION NUMBER: 0000927016-99-001189 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 13 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990329 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALLMERICA FINANCIAL CORP CENTRAL INDEX KEY: 0000944695 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 043263626 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-13754 FILM NUMBER: 99576878 BUSINESS ADDRESS: STREET 1: 440 LINCOLN ST CITY: WORCESTER STATE: MA ZIP: 01653 BUSINESS PHONE: 5088551000 MAIL ADDRESS: STREET 1: 440 LINCOLN ST CITY: WORCESTER STATE: MA ZIP: 01653 10-K 1 FORM 10-K - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended: December 31, 1998 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from: to Commission file number: 1-13754 ALLMERICA FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Delaware 04-3263626 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 440 Lincoln Street, Worcester, 01653 Massachusetts (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (508) 855-1000 Securities registered pursuant to Section 12(b) of the Act:
Title of each class of securities Name of Exchange on which Registered --------------------------------- ------------------------------------ Common Stock, $.01 par value, together with Stock Purchase Rights New York Stock Exchange 7 5/8% Senior Debentures due 2025 New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] Based on the closing sales price of March 15, 1999 the aggregate market value of the voting and non-voting stock held by nonaffiliates of the registrant was $2,983,288,029. The number of shares outstanding of the registrant's common stock, $.01 par value, was 56,729,421 shares outstanding as of March 15, 1999. DOCUMENTS INCORPORATED BY REFERENCE Portions of Allmerica Financial Corporation's Annual Report to Shareholders for 1998 are incorporated by reference in Parts I, II, and IV. Portions of Allmerica Financial Corporation's Proxy Statement of Annual Meeting of Shareholders to be held May 11, 1999 are incorporated by reference in Part III. Total number of pages, including cover page: 51 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PART I ITEM I BUSINESS Organization Allmerica Financial Corporation ("AFC" or the "Company") is a non-insurance holding company organized as a Delaware corporation in 1995. The consolidated financial statements of AFC include the accounts of AFC, First Allmerica Financial Life Insurance Company ("FAFLIC") its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance holding company), The Hanover Insurance Company ("Hanover", a wholly-owned subsidiary of Allmerica P&C), Citizens Corporation (formerly an 82.5% owned subsidiary of Hanover), Citizens Insurance Company of America ("Citizens", a wholly-owned subsidiary of Citizens Corporation) and certain other insurance and non-insurance subsidiaries. On December 3, 1998, a wholly owned subsidiary of the Company completed a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock that AFC or its subsidiaries did not already own at a price of $33.25 per share. Approximately 99.8% of publicly held shares of Citizens Corporation common stock were tendered. On December 14, 1998, the Company completed a short-form merger, acquiring all shares of common stock of Citizens Corporation not purchased in the tender offer, through the merger of its wholly-owned subsidiary with Citizens Corporation. Financial Information About Operating Segments The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company conducts business principally in four operating segments. These segments are Property and Casualty; Corporate Risk Management Services; Allmerica Financial Services; and Allmerica Asset Management. In addition to the four operating segments, the Company also has a Corporate segment, which consists primarily of cash, investments, Corporate debt and Capital Securities. Information with respect to each of the Company's segments is included in "Segment Results" on pages 26-39 in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Note 15 on pages 77 and 78 of the Notes to the Consolidated Financial Statements included in the 1998 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Description of Business by Segment Following is a discussion of each of the Company's operating segments. Risk Management Property and Casualty General The Company's Property and Casualty segment is composed of its wholly-owned subsidiary, Allmerica P&C, which consists of The Hanover Insurance Company and its wholly-owned subsidiary, Citizens Corporation. For the year ended December 31, 1998, the Property and Casualty segment accounted for approximately $2,204.8 million, or 65.4%, of consolidated segment revenues and approximately $151.4 million, or 50.7%, of consolidated segment income before taxes and minority interest. The Company primarily underwrites personal and commercial property and casualty insurance through this segment, with Hanover's principal operations located in the Northeast and Citizens' in Michigan. Both Hanover and Citizens have a historically strong regional focus and both place heavy emphasis on underwriting profitability and loss reserve 2 adequacy. As of December 31, 1997, according to A.M. Best, the Property and Casualty segment ranks as the 24th largest property and casualty insurance group in the United States based on net premiums written. The Company strives to maintain a clear focus on the core disciplines of underwriting, pricing, claims adjusting, marketing and sales. In particular, the Property and Casualty segment seeks to achieve and maintain underwriting profitability in each of its major product lines. The Company's overall strategy is to improve profitability through operating efficiencies and to pursue measured growth in profitable markets. The industry's profitability can be affected significantly by price competition, volatile and unpredictable developments such as extreme weather conditions and natural disasters, legal developments affecting insurer liability and the size of jury awards, fluctuations in interest rates and other factors that may affect investment returns and other general economic conditions and trends, such as inflationary pressures that may affect the adequacy of reserves. In 1998, the Company, in the Property and Casualty segment, began efforts to consolidate processing centers from 14 regional branches to 3 regional business centers. The three regional business centers are located in Atlanta, Georgia; Howell, Michigan; and Worcester, Massachusetts. The Company will continue to maintain its local market presence through branch/sales underwriting offices located throughout the country. In addition to the consolidation of offices, the Property and Casualty segment began deploying imaging and workflow technology in the centers which are expected to provide greater efficiencies and enable expense reductions. This technology allows the field agents direct access to underwriting documentation, which management believes will result in increased service levels and reduced cycle time. In 1998, the Company initiated a multi-functional team concept in servicing its personal lines of business. This arrangement provides for Company resources to focus on more than one area of the business including underwriting, policy processing and customer service when interacting with agents. The Company believes this approach will allow for closer alignment and enhanced service to our agents along with increased efficiencies. Lines of Business Hanover and Citizens both underwrite personal and commercial property and casualty insurance coverage. The personal segment principally includes personal automobile and homeowners' coverage. The commercial segment principally includes workers' compensation, commercial automobile and commercial multiple peril coverage. Personal automobile coverage insures individuals against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured's vehicle, and property damage to other vehicles and other property. Homeowners coverage insures individuals for losses to their residences and personal property, such as those caused by fire, wind, hail, water damage (except for flooding), theft and vandalism, and against third party liability claims. Commercial automobile coverage insures businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured's vehicle, and property damage to other vehicles and other property. Workers' compensation coverage insures employers against employee medical and indemnity claims resulting from injuries related to work. Workers' compensation policies are often written in conjunction with other commercial policies. Commercial multiple peril coverage insures businesses against third party liability from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold. It also insures 3 business property for damage, such as that caused by fire, wind, hail, water damage (except for flooding), theft and vandalism. Customers, Marketing and Distribution Through its property and casualty insurance subsidiaries, the Company is licensed to sell property and casualty insurance in all fifty states in the United States, as well as the District of Columbia. Hanover's business is concentrated in the Northeast, primarily Massachusetts, New York, New Jersey and Maine. Citizens' business is predominantly in Michigan and continues to expand into Indiana and Ohio. The Company markets property and casualty insurance products through approximately 2,500 independent insurance agencies and seeks to establish long-term relationships with larger, well-established agencies. In selecting agencies for new appointments, the Company considers the following criteria: a record of profitability and financial stability, an experienced and professional staff, a marketing plan for future growth and a succession plan for management. Once appointed, each agency's performance is carefully monitored. Since the Company offers property and casualty insurance products predominately through independent agents, fostering a close, supportive relationship with each agency is critical to the continued growth of the business. The Company, in the Property and Casualty segment, compensates agents based on profitability, in addition to regular commission. This practice motivates its agents to write policies for customers with above- average profit characteristics. By offering its independent agents a consistent source of products demanded by the agents' customers, the Company believes that an increasing number of its agents will rely on it as their principal supplier of insurance products. The Property and Casualty segment has implemented a number of programs designed to strengthen its relationship with its agencies. These initiatives include the formation of a National Agency Advisory Council at Hanover, and a Regional Agents Advisory Council at Citizens, consisting of agent representatives. These councils seek to coordinate marketing efforts, support implementation of the Company's strategies and enhance local market presence. Citizens' position as a principal provider with many of its agencies is evidenced by its high average premiums written per agency of approximately $1.6 million in 1998 in Michigan. Over the past few years, the Company has begun to exploit the benefits of worksite marketing as a distribution channel for personal property and casualty lines. This worksite distribution channel offers discounted insurance products that are individually written to employees and members of organizations which have established a marketing agreement with the Company. Management believes that advantages of competitive pricing, effective consumer awareness campaigns at sponsoring organizations, the convenience of payroll deducted premiums and word of mouth advertising will contribute to the effectiveness of the worksite distribution channel. Also, the Company, through the Property and Casualty segment, is exploring sales through banks and electronic commerce. Additionally, the Company expects to be well positioned to integrate other insurance products offered by its other subsidiaries in order to maximize corporate worksite marketing relationships. Citizens develops and markets franchise programs that are tailored for members of associations and organizations, including its Citizens Best program for senior citizens. The Company, in the Property and Casualty segment, is not dependent upon a single customer or a few customers, for which the loss of any one or more would have an adverse effect upon the segment's insurance operations. Hanover Hanover accounted for approximately $1,083.7 million, or 55.1%, of the Property and Casualty segment's consolidated net premium earned in 1998. Hanover's products are marketed predominantly through independent agencies which provide specialized knowledge of property and casualty products, local market conditions and targeted customer characteristics. 4 Hanover seeks to pursue measured growth in existing markets through local management operations that apply extensive knowledge of markets to offer competitive products and services. Hanover also seeks to increase operating efficiencies through centralized strategic planning, marketing and administrative support functions and increased use of sophisticated risk selection and operational technologies. Hanover is also expanding its use of agency-company interface ("ACI") technology, which enables agents to electronically submit personal lines policies for review and rating. The Company believes that these investments in technology will, over time, create technological efficiencies and provide capacity for enhanced service to customers. Although Hanover's strategic planning and certain of its administrative functions are centralized in the home office, the Company is committed to maintaining the local market presence afforded by Hanover's twelve branch/sales underwriting offices. These offices provide knowledge of local regulatory and competitive conditions, and have developed close relationships with Hanover's independent agents, who provide specialized knowledge of property and casualty products, local market conditions and target market characteristics. Hanover believes that the selection of attractive markets in which to pursue profitable growth depends upon maintaining its local market presence to enhance underwriting results and identify favorable markets. Citizens Citizens accounted for approximately $882.6 million, or 44.9%, of the Property and Casualty segment's consolidated net premium earned in 1998. Citizens' products are also marketed through independent agencies which provide specialized knowledge of property and casualty products, local market conditions and targeted customer characteristics. Citizens seeks to pursue profitable growth in existing markets by establishing long-term relationships with larger, well-established agencies. To solidify its relationship with higher quality agents, Citizens offers enhanced profit sharing agreements, recognition awards and maintains local presence through five branch/sales underwriting offices, three claims offices in Michigan and one claim office in Indiana. In addition, Citizens continues to maintain long-term pricing and underwriting integrity to remain a stable market for the independent agents. Citizens has been successful in developing and marketing groups in both personal and commercial segments that are tailored for members of associations, financial institutions and employers in Michigan, Indiana and Ohio. The organizations may choose to make Citizens' programs available to their members or employees based on an evaluation of Citizens' rates, service and regulation, but each risk is individually underwritten and each customer is issued a separate policy. Associations and organizations receive no payment for making Citizens' franchise programs available to their members or employees. As of December 31, 1998, Citizens had 144 group programs in-force, 116 of which were in personal lines and 28 of which were in commercial lines. Revenue from personal and commercial lines groups accounts for nearly 50 percent of Citizens' total premium volume. Citizens continues to expand its use of the Company's ACI technology, which enables agents to electronically submit personal lines policies for review and rating. In addition, agents are authorized to bind Citizens on risks. The agents are guided by Citizens' written underwriting rules and practices. These rules and practices set forth eligibility rules for various policies and coverages, unacceptable risks, and maximum and minimum limits of liability. Violation of these rules and practices is grounds for termination of the agency's contract to represent Citizens. Residual Markets and Pooling Arrangements As a condition of its license to do business in various states, the Company is required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements which provide various 5 insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. For example, since most states compel the purchase of a minimal level of automobile liability insurance, states have developed shared market mechanisms to provide the required coverages and in many cases, optional coverages, to those drivers who, because of their driving records or other factors, cannot find insurers who will write them voluntarily. The Company's participation in such shared markets or pooling mechanisms is generally proportional to the Property and Casualty segment's direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. The Company incurred an underwriting loss from participation in such mechanisms, mandatory pools and underwriting associations of $11.6 million, $12.9 million and $5.3 million in 1998, 1997 and 1996, respectively, relating primarily to coverages for personal and commercial automobile, personal and commercial property, and workers' compensation. The increase in the underwriting loss since 1996 is primarily related to Hanover's participation in the Massachusetts Commonwealth Automobile Reinsurers ("CAR") pool which is consistent with the rate decrease and higher actual loss activity experienced in the overall Massachusetts automobile market. Assigned Risk Plans Assigned risk plans are the most common type of shared market mechanism. Many states, including Massachusetts, Illinois, New Jersey and New York operate assigned risk plans. The plan assigns applications from drivers who are unable to obtain insurance in the voluntary market to insurers licensed in the applicant's state. Each insurer is required to accept a specific percentage of applications based on its market share of voluntary business in the state. Once an application has been assigned to an insurer, the insurer issues a policy under its own name and retains premiums and pays losses as if the policy was voluntarily written. Reinsurance Facilities and Pools Reinsurance facilities are currently in operation in various states that require an insurer to write all applications submitted by an agent. As a result, an insurer could be writing policies for applicants with a higher risk of loss than it would normally accept. The reinsurance facility allows the insurer to cede this high risk business to the reinsurance facility, thus sharing the underwriting experience with all other insurers in the state. If a claim is paid on a policy issued in this market, the facility will reimburse the insurer. Typically, reinsurance facilities operate at a deficit, which is then recouped by levying assessments against the same insurers. A type of reinsurance mechanism that exists in New Jersey, The New Jersey Unsatisfied Claim and Judgment Fund ("NJUCJF"), covers no-fault first party medical losses in excess of $0.08 million. All automobile insurers in this state are required to participate in the reinsurance mechanism. Insurers are reimbursed for their covered losses in excess of the threshold. Funding for this fund comes from assessments against automobile insurers based upon their proportionate market share of the state's automobile liability insurance market. The NJUCJF currently has an unfunded liability for future payment years. It calculates assessments against insurers on the basis of a two-year cash flow analysis. At December 31, 1998, CAR was the only reinsurer which represented 10% or more of the Property and Casualty segment's reinsurance business. 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 ("LAE") ceded to CAR for the years ended December 31, 1998, 1997 and 1996 were $34.3 million and $38.1 million, $32.3 million and $28.2 million, and $38.0 million and $21.8 million, respectively. The Company ceded to the Michigan Catastrophic Claims Association ("MCCA") premiums earned of $3.7 million, $9.8 million and $50.5 million in 1998, 1997 and 1996, respectively. Losses and loss adjustment expenses ceded in 1998, 1997 and 1996 were $18.0 million, $(0.8) million and $(52.9) million, respectively. The decrease in earned premiums ceded to MCCA reflects a reduction in premiums charged per policyholder by MCCA. Additionally, on March 18, 1998, MCCA announced plans to refund $1.2 billion of its surplus to its member insurance companies. The action occurred because the associations' surplus increased beyond a level 6 necessary to cover its expected losses and expenses. Because policyholders are the ultimate payers of the MCCA premium, this extraordinary return of MCCA surplus was passed through to policyholders. On June 2, 1998, the Company recorded a $124.2 million one-time reduction of direct and ceded written premiums as a result of a return of excess surplus from the MCCA. This transaction had no impact on the total net premiums recorded by the Company in 1998. At December 31, 1998 and 1997, the Company, in the Property and Casualty segment, had reinsurance recoverable on paid and unpaid losses from CAR of $41.0 million and $45.7 million, respectively, and from MCCA of $250.4 million and $280.2 million, respectively. Management believes that in the current regulatory climate, the Company, in the Property and Casualty segment, is unlikely to incur any material loss or become unable to pay claims as a result of nonpayment of amounts owed to it by CAR, because CAR is a mandated pool supported by all insurance companies licensed to write automobile insurance in the Commonwealth of Massachusetts. In addition, the MCCA (i) is currently in a surplus position, (ii) the payment obligations of the MCCA are extended over many years, resulting in relatively small current payment obligations in terms of MCCA total assets, (iii) all amounts owed to the Company by the MCCA have been paid when due, and (iv) the MCCA is supported by assessments permitted by statute. Reference is made to Note 17 on pages 78 and 79 and Note 21 on pages 81 and 82 of the Notes to Consolidated Financial Statements of the 1998 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Joint Underwriting Associations A joint underwriting association ("JUA") is similar to a reinsurance pool. Generally, a JUA allows an insurer to share with other insurers the underwriting experience of drivers that reflect a higher risk of loss than the insurer would normally accept. Under a JUA, a limited number of insurers are designated as "servicing carriers." The servicing carrier is responsible for collecting premiums and paying claims for the policies issued in the JUA, and such insurers receive a fee for these administrative services. The underwriting results of the servicing carrier are then shared with all insurers in the state. Like reinsurance facilities, JUA's typically operate at a deficit, and fund that deficit by levying assessments on insurers. Other Mechanisms The principal shared market mechanisms for property insurance are the Fair Access to Insurance Requirements Plans ("FAIR Plans"), the formation of which was required by the federal government as a condition to an insurer's ability to obtain federal riot reinsurance coverage following the riots and civil disorder that occurred during the 1960's. These plans, created as mechanisms similar to automobile assigned risk plans, were designed to increase the availability of property insurance in urban areas. The federal government reinsures those insurers participating in FAIR Plans against excess losses sustained from riots and civil disorders. The individual state FAIR Plans are created pursuant to statute or regulation. The property shared market mechanisms provide basic fire insurance and extended coverage protection for dwellings and certain commercial properties that could not be insured in the voluntary market. A few states also include a basic homeowners form of coverage in their shared market mechanism. With respect to commercial automobile coverage, another pooling mechanism, a Commercial Auto Insurance Plan ("CAIP"), uses a limited number of servicing carriers to handle assignments from other insurers. The CAIP servicing carrier is paid a fee by the insurer who otherwise would be assigned the responsibility of handling the commercial automobile policy and paying claims. Approximately 40 states have CAIP mechanisms, including Connecticut, Illinois, New Hampshire, Maine, New Jersey and Rhode Island. Competition The property and casualty industry is highly competitive among national agency companies, direct writers, and regional and local insurers on the basis of both price and service. National agency companies sell insurance 7 through independent agents and usually concentrate on commercial lines of property and casualty insurance. Direct writers, including those with exclusive agent representation, dominate the personal lines of property and casualty insurance and operate on a national, regional or single state basis. Regional and local companies sell through independent agents in one or several states in the same region and usually compete in both personal and commercial lines. Hanover and Citizens market through independent agents and therefore compete with other independent agency companies for business in each of the agencies representing them. Hanover faces competition in personal lines primarily from direct writers and regional and local companies. In its commercial lines, Hanover faces competition primarily from national agency companies and regional and local companies. Due to the number of companies in Hanover's principal property and casualty insurance marketplace, there is no single dominant competitor in any of Hanover's markets. Management believes that its emphasis on maintaining a local presence in its markets, coupled with investments in operating and client technologies, will enable Hanover to compete effectively. During the past few years, the competitive environment in Massachusetts has increased substantially. Approximately 36% of Hanover's personal automobile business is currently written in this state. Effective January 1, 1999 Massachusetts's personal automobile rates increased 0.7% as mandated by the Massachusetts Division of Insurance. Effective January 1, 1998 and January 1, 1997 Massachusetts's personal automobile rates decreased 4.0% and 6.2%, respectively, as mandated by the Massachusetts Division of Insurance. The Massachusetts Division of Insurance allows for sponsoring organizations to receive discounts on their auto insurance premiums. Currently, Hanover offers more than 100 group programs throughout the state, including a large group plan in the state with approximately 347,000 eligible members. In 1998, Hanover offered a 10% discount on automobile insurance for its safest drivers. In 1999, the discount for safe drivers will be between 3% and 7%. As a result, policyholders have the ability to reduce their insurance premiums by as much as 17% by combining "safe driver" and "group" discounts. Management has implemented these discounts in an effort to retain the Property and Casualty segment's market share in Massachusetts. These discounts, together with any future mandated rate decreases, may unfavorably impact premium growth in Massachusetts. In Michigan, Citizens competes in personal lines with a number of direct writers and regional and local companies. Citizens is the largest writer of property and casualty insurance in Michigan through independent agents. Citizens' principal competition in the Michigan homeowners line is from direct writers, including State Farm Group. Citizens also faces competition from the two largest direct writers in Michigan, Auto Club Michigan Group and State Farm Group, in the personal automobile line. In February 1996, an amendment to the Essential Insurance Act became effective in Michigan. This amendment eliminates personal automobile and homeowners insurance territorial rating restrictions and limits merit ratings for automobile policies. This legislation has removed barriers to entrance into the market for national agency companies, which has resulted in increased competition in Michigan in the personal lines of property and casualty insurance. This was, in part, due to Michigan's prior insurance regulatory environment which required such companies to develop and implement special incentive programs designed to encourage agents to identify and sell insurance to individuals with lower risk profiles consistent with the constraints of Michigan law. Citizens faces commercial lines competition principally from national agency companies, and regional and local companies. Citizens is the second leading writer in Michigan in its three primary commercial lines combined: commercial automobile, workers' compensation, and commercial multiple peril. The commercial industry has been in a downturn over the past several years due primarily to price competition. Premium rate levels are related to the availability of insurance coverage, which varies according to the level of excess capacity in the industry. The current commercial lines market is extremely competitive due to a continuing soft market in which capacity is high and prices are low. Because of the commitment at both Hanover and Citizens to focus on underwriting profitability and a refusal to write business at inadequate prices, this highly competitive commercial lines market has impacted the Property and Casualty segment's growth in commercial lines. In Michigan, Citizens workers' compensation line is the largest commercial line in terms of premiums written. Over the past 8 few years, competition has caused Citizens to reduce workers' compensation insurance rates five times; 8.5%, 7.0%, 6.4%, 8.7% and 1.9% effective May 1, 1995, December 1, 1995, June 1, 1996, March 1, 1997, and January 1, 1998, respectively. Since there is no one dominant competitor in any of the markets in which the Property and Casualty segment competes, management believes there is opportunity for future growth. Underwriting Pricing The manner in which the Company prices products takes into consideration the expected frequency and severity of losses, the costs of providing the necessary coverage (including the cost of administering policy benefits, sales and other administrative and overhead costs) and a margin for profit. The Company, in the Property and Casualty segment, seeks to achieve a target combined ratio in each of its product lines regardless of market conditions. This strategy seeks to achieve measured growth and consistent profitability on a continuing basis. The Company concentrates on its established major product lines, and accordingly, does not typically pursue the development of products with relatively unpredictable risk profiles. In addition, the Company utilizes its extensive knowledge of local markets, including knowledge of regulatory requirements, to achieve superior underwriting results. Hanover and Citizens rely on information provided by their local agents and both also rely on the knowledge of its staff in the local branch offices. As regional companies with significant market share in a number of states, Hanover and Citizens can apply its extensive knowledge and experience in making underwriting and rate setting decisions. Claims The Company employs experienced claims adjusters, appraisers, medical specialists, managers and attorneys in order to manage its claims. The Company, in the Property and Casualty segment, has field claims adjusters strategically located throughout its operating territories. All claims staff members work closely with the agents to settle claims rapidly and cost- effectively. Claims office adjusting staff are supported by general adjusters on large property losses, automobile and heavy equipment damage appraisers on automobile material damage losses and medical specialists whose principal concentration is in workers' compensation and no-fault automobile injury cases. In addition, the claims offices are supported by staff attorneys who specialize in litigation defense and claim settlements. The Property and Casualty segment also has special units which investigate suspected insurance fraud and abuse. The Company, in the Property and Casualty segment, utilizes claims processing technology which allows smaller and more routine claims to be processed at centralized locations. The Company expects that approximately 70% of its personal lines claims will be processed at these locations, thereby increasing efficiency and reducing operating costs. Citizens has a program under which participating agents have settlement authority for many property loss claims. Based upon the program experience, the Property and Casualty segment believes that this program contributes to lower LAE experience and to its higher customer satisfaction ratings by permitting the early and direct settlement of such small claims. Approximately 30.0% of the number of total paid claims reported to Citizens during 1998, 1997 and 1996 were settled under this program. Hanover and Citizens have increased usage of the managed care expertise of the Allmerica Financial's Corporate Risk Management Services segment in the analysis of medical services and pricing in the management of workers' compensation and medical claims on its automobile policies. The Company believes that this capability has reduced costs and provided more efficient service to customers. 9 Property and casualty insurers are subject to claims arising out of catastrophes which may have a significant impact on their results of operations and financial condition. The Property and Casualty segment may experience catastrophe losses in the future which could have a material adverse impact on the Company. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires and explosions, and the incidence and severity of catastrophes are inherently unpredictable. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and business property insurance have in the past generated the vast majority of catastrophe-related claims. Reserve for Unpaid Losses and Loss Adjustment Expenses Reference is made to "Reserve for Losses and Loss Adjustment Expenses" on pages 33, 34 and 35 of Management's Discussion and Analysis of Financial Condition and Results of Operations of the 1998 Annual Report to Shareholders, which is incorporated herein by reference. The Company's actuaries, in the Property and Casualty segment, review the reserves each quarter and certify the reserves annually as required for statutory filings. The Property and Casualty segment 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, changes in political attitudes and trends in general economic conditions, (ii) review of per claim information, (iii) historical loss experience of the Property and Casualty segment 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. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company's payment of that loss. To recognize liabilities for unpaid losses, the Company establishes reserves as balance sheet liabilities representing estimates of amounts needed to pay reported and unreported losses and LAE. The Company, in the Property and Casualty segment, does not use discounting techniques in establishing reserves for losses and LAE, nor has it participated in any loss portfolio transfers or other similar transactions. The following table reconciles reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance statutory authorities ("Statutory Reserve") to reserves determined in accordance with generally accepted accounting principles ("GAAP Reserve") at December 31, as follows:
1998 1997 1996 -------- -------- -------- (In millions) Statutory reserve for losses and LAE........... $2,011.7 $2,047.2 $2,113.2 GAAP adjustments: Reinsurance recoverable on unpaid losses..... 591.7 576.7 626.9 Other(*)..................................... (6.1) (8.5) 4.0 -------- -------- -------- GAAP reserve for losses and LAE................ $2,597.3 $2,615.4 $2,744.1 ======== ======== ========
- -------- (*) Primarily represents other statutory liabilities reclassified as loss adjustment expense reserves for GAAP reporting and purchase accounting adjustments. 10 Analysis of Losses and Loss Adjustment Expenses Reserve Development The following table sets forth the development of net reserves for unpaid losses and LAE from 1988 through 1998 for the Company.
Year ended December 31, ---------------------------------------------------------------------------------------------------- 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (In millions) Net reserve for losses and LAE(1)......... $2,005.5 $2,038.7 $2,117.2 $2,132.5 $2,109.3 $2,019.6 $1,936.9 $1,772.4 $1,550.6 $1,326.3 $1,150.9 Cumulative amount paid as of(2): One year later.. -- 643.0 732.1 627.6 614.3 566.9 564.3 569.0 561.5 521.1 465.3 Two years later.......... -- -- 1,054.3 1,008.3 940.7 884.4 862.7 888.0 874.5 820.2 725.3 Three years later.......... -- -- -- 1,217.8 1,172.8 1,078.1 1,068.4 1,077.1 1,074.3 1,009.3 901.5 Four years later.......... -- -- -- -- 1,300.4 1,210.9 1,184.1 1,207.1 1,186.4 1,130.1 1,009.7 Five years later.......... -- -- -- -- -- 1,289.5 1,267.5 1,279.4 1,265.4 1,192.7 1,078.8 Six years later.......... -- -- -- -- -- -- 1,323.1 1,337.2 1,314.2 1,240.9 1,116.2 Seven years later.......... -- -- -- -- -- -- -- 1,377.3 1,355.3 1,271.4 1,147.4 Eight years later.......... -- -- -- -- -- -- -- -- 1,385.9 1,301.6 1,170.4 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,324.0 1,192.5 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 1,209.8 Net reserve re- estimated as of(3): End of year..... 2,005.5 2,038.7 2,117.2 2,132.5 2,109.3 2,019.6 1,936.9 1,772.4 1,550.6 1,326.3 1,150.9 One year later.. -- 1,911.5 1,989.3 1,991.1 1,971.7 1,891.5 1,868.1 1,755.0 1,601.5 1,412.4 1,220.4 Two years later.......... -- -- 1,902.8 1,874.3 1,859.4 1,767.4 1,762.8 1,717.7 1,601.9 1,449.0 1,262.0 Three years later.......... -- -- -- 1,826.8 1,780.3 1,691.5 1,703.3 1,670.8 1,614.3 1,471.7 1,290.2 Four years later.......... -- -- -- -- 1,766.2 1,676.3 1,658.9 1,654.1 1,597.6 1,484.7 1,312.3 Five years later.......... -- -- -- -- -- 1,653.7 1,637.3 1,634.6 1,594.3 1,482.3 1,322.1 Six years later.......... -- -- -- -- -- -- 1,650.5 1,630.6 1,588.7 1,486.9 1,328.6 Seven years later.......... -- -- -- -- -- -- -- 1,644.2 1,593.1 1,488.4 1,340.7 Eight years later.......... -- -- -- -- -- -- -- -- 1,621.9 1,552.1 1,403.7 Nine years later.......... -- -- -- -- -- -- -- -- -- 1,524.7 1,412.8 Ten years later.......... -- -- -- -- -- -- -- -- -- -- 1,380.8 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (Deficiency) Redundancy, net(4,5)....... $ -- $ 127.2 $ 214.4 $ 305.7 $ 343.1 $ 365.9 $ 286.4 $ 128.2 $ (71.3) $ (198.4) $ (229.9) ======== ======== ======== ======== ======== ======== ======== ======== ======== ======== ========
- -------- (1) Sets forth the estimated net liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years; represents the estimated amount of net losses and LAE for claims arising in the current and all prior years that are unpaid at the balance sheet date, including incurred but not reported ("IBNR") reserves. (2) Cumulative loss and LAE payments made in succeeding years for losses incurred prior to the balance sheet date. (3) Re-estimated amount of the previously recorded liability based on experience for each succeeding year; increased or decreased as payments are made and more information becomes known about the severity of remaining unpaid claims. (4) Cumulative deficiency or redundancy at December 31, 1998 of the net reserve amounts shown on the top line of the corresponding column. A redundancy in reserves means the reserves established in prior years exceeded actual losses and LAE or were reevaluated at less than the original reserved amount. A deficiency in reserves means the reserves established in prior years were less than actual losses and LAE or were reevaluated at more than the original reserved amount. (5) The following table sets forth the development of gross reserve for unpaid losses and LAE from 1992 through 1998 for the Company: 11
Year Ended December 31, -------------------------------------------------------------- 1998 1997 1996 1995 1994 1993 1992 -------- -------- -------- -------- -------- -------- -------- (In millions) Reserve for losses and LAE: Gross liability........ $2,597.2 $2,615.4 $2,744.1 $2,896.0 $2,821.7 $2,717.3 $2,598.9 Reinsurance recoverable........... 591.7 576.7 626.9 763.5 712.4 697.7 662.0 -------- -------- -------- -------- -------- -------- -------- Net liability.......... $2,005.5 $2,038.7 $2,117.2 $2,132.5 $2,109.3 $2,019.6 $1,936.9 ======== ======== ======== ======== ======== ======== ======== One year later: Gross re-estimated liability............. $2,472.6 $2,541.9 $2,587.8 $2,593.5 $2,500.5 $2,460.5 Re-estimated recoverable........... 561.1 552.6 596.7 621.8 609.0 592.4 -------- -------- -------- -------- -------- -------- Net re-estimated liability............. $1,911.5 $1,989.3 $1,991.1 $1,971.7 $1,891.5 $1,868.1 ======== ======== ======== ======== ======== ======== Two years later: Gross re-estimated liability............. $2,424.5 $2,427.7 $2,339.2 $2,333.3 $2,341.9 Re-estimated recoverable........... 521.7 553.4 479.8 565.9 579.1 -------- -------- -------- -------- -------- Net re-estimated liability............. $1,902.8 $1,874.3 $1,859.4 $1,767.4 $1,762.8 ======== ======== ======== ======== ======== Three years later: Gross re-estimated liability............. $2,358.6 $2,227.0 $2,145.5 $2,257.3 Re-estimated recoverable........... 531.8 446.7 454.0 554.0 -------- -------- -------- -------- Net re-estimated liability............. $1,826.8 $1,780.3 $1,691.5 $1,703.3 ======== ======== ======== ======== Four years later: Gross re-estimated liability............. $2,220.9 $2,102.0 $2,168.2 Re-estimated recoverable........... 454.7 425.7 509.3 -------- -------- -------- Net re-estimated liability............. $1,766.2 $1,676.3 $1,658.9 ======== ======== ======== Five years later: Gross re-estimated liability............. $2,091.7 $2,027.3 Re-estimated recoverable........... 438.0 390.0 -------- -------- Net re-estimated liability............. $1,653.7 $1,637.3 ======== ======== Six years later: Gross re-estimated liability............. $2,022.6 Re-estimated recoverable........... 372.1 -------- Net re-estimated liability............. $1,650.5 ========
Reinsurance The Company, in the Property and Casualty segment, maintains a reinsurance program designed to protect against large or unusual losses and LAE activity. This includes both excess of loss reinsurance and catastrophe reinsurance. Catastrophe reinsurance serves to protect the ceding insurer from significant aggregate losses arising from a single event such as windstorm, hail, hurricane, tornado, riot or other extraordinary events. 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. The Company, in the Property and Casualty segment, has reinsurance for casualty business. Under the 1998 casualty reinsurance program, the reinsurers are responsible for 100% of the amount of each loss in excess of $0.5 million per occurrence up to $30.5 million for general liability and workers' compensation. Additionally, this reinsurance covers workers' compensation losses in excess of $30.5 million to $60.5 million per occurrence. Amounts in excess of $60.5 million in the workers' compensation line are retained 100% by the Company while amounts in excess of $30.5 million in the general liability line are retained by the Company. Effective July 1, 1998, the Company maintained a property reinsurance program in which the reinsurers are responsible for 100% of each loss in excess of $0.5 million per occurrence up to $19.5 million for inland marine and commercial auto physical damage. All other property business is 100% covered by reinsurers for each loss in excess of $1.0 million per occurrence up to $19.0 million. Effective January 1, 1998, the Company, in the Property and Casualty segment, modified its catastrophe reinsurance program to include a higher retention. Under the 1998 catastrophe reinsurance program, the Company 12 retains $45.0 million of loss per occurrence, 10% of all aggregate loss amounts in excess of $45.0 million up to $230.0 million and all amounts in excess of $230.0 million. In 1998 and 1997, the Company, in the Property and Casualty segment, recovered $3.0 million and $1.2 million on its catastrophe coverage, respectively. Effective January 1, 1999, the Company entered into a Whole Account Aggregate Excess of Loss reinsurance agreement with a highly rated reinsurer. The reinsurance agreement provides accident year coverage for the three years 1999 to 2001 for Allmerica P&C operations. The annual and aggregate limits on this agreement are $150.0 million and $300.0 million, respectively. The program covers losses and allocated LAE, including those incurred but not yet reported, in excess of an agreed upon whole account loss and allocated LAE ratio. The Company, in the Property and Casualty segment, cedes to reinsurers a portion of its risk and pays a fee based upon premiums received on all policies subject to such 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. The Company, in the Property and Casualty 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 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 CAR and MCCA. Reference is made to "Reinsurance" in Note 17 on pages 78 and 79 of the Notes to Consolidated Financial Statements of the 1998 Annual Report to Shareholders, which is incorporated herein by reference. Reference is also made to "Reinsurance Facilities and Pools" on pages 6 and 7 of this Form 10-K which is incorporated herein by reference. Corporate Risk Management Services General The Corporate Risk Management Services segment provides managed care medical group insurance products and administrative services as well as other group insurance coverages, such as group life, dental and disability products, to corporate employers. As of December 31, 1998, this segment insured and/or provided administrative services to the employee benefit plans of over 2,600 employers covering 615,199 employee lives. For the year ended December 31, 1998, this segment accounted for approximately $414.1 million, or 12.3%, of consolidated segment revenues and income of $7.6 million, or 2.5%, of consolidated segment income before taxes and minority interest. The Company's strategy emphasizes risk sharing arrangements rather than traditional indemnity medical insurance products. The Company's risk sharing arrangements consist of providing stop-loss indemnity insurance coverage for self-insured employers with 100 to 5,000 employees together with managed care and administrative services for coverage provided by the employer and the Company. This risk sharing approach enables the Company to provide more managed care, administrative and other services with less exposure to losses than traditional indemnity medical insurance. The Company also continues to emphasize the sale of multiple product benefits packages, which include CRMS' group life, dental and disability products, to these same employers. The Company believes a multiple product benefits package provides greater profitability for the Company due to increased price pressure relating to the sale of single products. Additionally, due to the Company's strategy to emphasize risk sharing arrangements rather than traditional indemnity medical insurance products, the Company increased certain fully insured medical rates during 1998. 13 In addition, the Company entered into an agreement with a highly rated reinsurer to cede the underwriting losses of its accident and health assumed reinsurance pool business, effective July 1, 1998. This reinsurance agreement is consistent with the Company's restructuring initiative in its Corporate Risk Management Services segment, whereby it announced its exit from the accident and health assumed reinsurance pool business. Additionally, in 1998, the Company decided to exit its administrative service only business as part of its restructuring plan. The Company continues to leverage the CRMS segment's managed care and claims management expertise to capitalize on opportunities with its Property and Casualty segment affiliates. Legislation in many states permits the cost containment approaches that have been used to manage employee medical and disability costs to be applied to control workers' compensation and the medical component of automobile insurance. In response, the Company has utilized CRMS' expertise in medical management and claims processing for its Property and Casualty segment's workers' compensation business and the medical component of its automobile insurance business. Health care and other claims professionals ensure that appropriate medical care is provided to insureds and that bills from health care providers are reasonable. This integrated managed care and claims adjudication system now manages medical claims covered by workers' compensation, automobile insurance and health benefit plans. The Company believes that its capability of providing 24-hour managed care to effectively manage claims for both casualty and health benefit products can result in reduced costs and serve its customers more efficiently. In addition, the Company is focused on the continued development of its integrated benefits products MedCompONE and Integrated DisabilityONE. MedCompONE integrates workers' compensation coverage with group medical coverage. Group disability coverage, both short term and long term, can also be included. Integrated DisabilityONE integrates workers' compensation coverage with group disability coverage. The integrated services that are provided to employers include claims management and processing, account management, administrative services, and underwriting. The Company believes these products provide customers ease of administration, as well as cost savings due to their interaction with only one carrier. Integrated claims management, including return to work management of all disability claims, helps employers contain the cost of claims, claims handling and claims management services provided to employers through its MedCompONE product. Both MedCompONE and Integrated DisabilityONE are totally integrated claim management and plan administration programs designed to minimize the overall costs of occupational and non-occupational illness and injury. Health Care Regulation and Reform There continue to be a number of legislative and regulatory proposals introduced at the federal and state level to reform the current health care system. At the federal level, recent proposals have focused on managed care reform, and patient protection and advocacy. State and federal legislation adopted over the past few years generally limits the flexibility of insurers with respect to underwriting practices for small employer plans that contain less than 50 employees, provides for crediting previous coverage for the purposes of determining pre-existing conditions, and limits the ability to medically underwrite individual risks in the group market. In addition, several states have enacted managed care reform legislation which may change managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that utilize managed care programs or market health insurance to small employers will continue. However, the Company's rating, underwriting practices, and managed care programs are consistent with the objectives of current reform initiatives. For example, the Company does not experience rate small cases, nor does it refuse coverage to eligible individuals because of medical histories. Also, its managed care programs provide for coverage outside of the preferred network and allow for open communication between a doctor and his/her patient. Because of its emphasis on managed care and risk sharing partnerships, management believes that it will continue to be able to operate effectively in the event of further reform, even if specific states expand the existing limitations. The Company believes that the proposed federal and state health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurer's flexibility and restrict the profitability of health insurers and managed care providers. The Company 14 cannot predict whether any of the current proposals will be enacted or assess the particular impact such proposals may have on the Company's Corporate Risk Management Services' business. Products The following table summarizes premiums by product line for the CRMS segment for the years ended December 31.
1998 1997 1996 -------- ------ ------ (In millions) Health Medical Fully insured.................................... $ 35.2 $ 41.9 $ 40.6 Risk sharing..................................... 82.9 81.1 83.2 Dental Fully insured.................................... 24.6 30.0 21.3 Risk sharing..................................... 2.6 2.4 2.7 Short-term disability Fully insured.................................... 6.8 6.8 6.5 Risk sharing..................................... 0.3 0.3 0.5 Long-term disability Fully insured.................................... 9.3 9.2 8.5 Reinsurance assumed (1).............................. 71.7 69.3 57.5 Stop loss (2)........................................ 38.8 31.0 26.4 -------- ------ ------ Total health......................................... 272.2 272.0 247.2 Accidental death & dismemberment..................... 5.5 5.3 5.0 Other reinsurance assumed............................ 4.2 5.5 0.4 Life................................................. 54.1 50.2 50.3 -------- ------ ------ Total CRMS premiums.................................. $ 336.0 $333.0 $302.9 ======== ====== ====== ASO (3).............................................. $ 33.7 $ 27.6 $ 23.8 ======== ====== ====== Total premiums and premium equivalents............... $1,020.0 $936.6 $884.3 ======== ====== ======
- -------- (1) Represents special risk arrangements whereby the Company assumes a limited amount of risk by participating in a pool administered by a third party. Such arrangements provide insurance coverage to companies for certain high limit and excess loss risks. In 1998, the Company has exited substantially all of these special risk arrangements by reinsuring the underwriting losses from this business. (2) Represents premiums primarily related to customized products sold to customers providing for stop loss coverage only or in conjunction with administrative services. (3) Administrative services only ("ASO") fees are included in other income in the financial information contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Annual Report to Shareholders, which is incorporated herein by reference. In 1998, the Company decided to exit its administrative service only business as part of its restructuring plan. Risk Sharing Arrangements The Company participates in risk sharing arrangements primarily for medical, dental and short-term disability coverage. In accordance with its strategy to emphasize risk sharing arrangements with its customers, the Company offers several funding options that allow employers to share in the risk of their plan. Partially self funded plans provide employers with a self-insured arrangement in which the Company provides claims administration and other services selected by the employer. In addition, the Company provides specific and aggregate stop-loss insurance coverage for these plans. The Company also provides minimum premium arrangements for its insured plans. 15 Other Group Coverage The Company's group life, accidental death and dismemberment ("AD&D"), disability and dental products are offered in conjunction with medical insurance coverages or as stand alone products. The Company offers features in its group life insurance which include fixed or variable pricing, or traditional and supplemental contributory group term life insurance. AD&D insurance may be included with group term life insurance to pay additional amounts for losses due to an accident. The Company offers weekly disability income insurance to cover employees for loss of wages during a short period of disability, long term disability insurance either with weekly coverage or on a stand-alone basis and dental insurance for preventive and diagnostic services, routine restorative services and major restorative services. Special Risk Arrangements The Company has decided to exit the special risk market through a reinsurance agreement which cedes the underwriting losses related to this business. Special risk arrangements provided for a limited share of the risk to be taken through reinsurance pools. These programs provided a variety of insurance coverages, including high limit AD&D, high limit disability income, excess loss medical reinsurance for self-funded plans, organ transplant, occupational accident and travel accident. Traditional Products The Company offers full indemnity products for medical, surgical and hospital expense coverage resulting from illness or injury. Many options are available for deductible amounts and coinsurance levels. Marketing The Company sells its CRMS segment's products and services primarily through approximately 30 sales representatives employed by the Company. These representatives assist independent producers (for example, agents, brokers and consultants who represent the purchasers of the Company's products) in the marketing of these products, and provide assistance with plan design issues and ongoing service. Reinsurance The Company purchases reinsurance for the CRMS segment's group life insurance, AD&D, group health, stop-loss and occupational accident coverages. The Company retains a maximum exposure of $500,000 on life policies and $250,000 on AD&D policies. The Company also has reinsurance arrangements to further limit the Company's liability with respect to policies for certain employers and groups. Although reinsurance does not legally discharge the ceding insurer from its primary liability for the full amount of policies reinsured, it does make the assuming insurer liable to the ceding insurer to the extent of the reinsurance ceded. The Company maintains a gross reserve for reinsured liabilities. The Company participates in a catastrophic reinsurance pool for this segment for coverage against catastrophic life losses from the same event. Under the pool arrangement, the Company shares in approximately 3.2% of the pool's losses. The Company purchases reinsurance which limits the Company's share of annual pool claim losses to $500,000. With respect to this segment's group health policies, the Company purchases specific stop-loss coverage for individual major medical claims over $350,000 once such excess claims exceed a minimum aggregate limit of $3.7 million. The Company also purchases catastrophic coverage for three or more claims arising from the same event. Under this coverage the Company is reimbursed for medical and long term disability claims paid in excess of $500,000 in total as a result of the event. The Company purchases reinsurance protection for substantially all of its long term disability payments, covering a specific percent, which generally approximates 50%, of each long term disability policy. Effective October 1, 1998, the Company purchased reinsurance on the 16 MedCompONE block of business. Under this coverage, the Company is reimbursed 50% for all combined claims up to $500,000 with additional excess coverage for claims over $500,000. The Company writes a specific and aggregate stop loss product on business underwritten and administered by certain third parties. The risk associated with these plans is ceded to a group of reinsurers, including FAFLIC, who share in the risk assumed. The Company also assumes risk from a number of other pools that cover stop loss, occupational accident, long term care, and long term disability insurance. As part of the strategy of exiting the accident and health assumed reinsurance pool business, the Company entered into an agreement that cedes the underwriting loss from this business from July 1, 1998 to December 31, 2000 up to an aggregate of $40.0 million. Due to the nature of this business, the run-off related to this block could continue beyond the termination of this reinsurance agreement. For the year ended December 31, 1998, the Company ceded approximately $91.9 million of premiums associated with its aggregate stop loss policies and approximately $11.1 million of premiums for the remaining direct insurance coverages. As of December 31, 1998, the Company had $29.6 million due from reinsurers. Competition The Company competes with many insurance companies and other entities in selling its CRMS products. Competition exists for employer groups, for the employees who are the ultimate consumers of the Company's products sold through the CRMS segment and for the independent producers who represent purchasers of the Company's products. Additionally, most currently insured employer groups receive annual rate adjustments, and employers may seek competitive quotations from several sources prior to renewal. The Company competes primarily with national and regional health insurance companies and other managed care providers. Many of the Company's competitors have greater capital resources, local market presence and greater name recognition than the Company. The Company also competes with Blue Cross and Blue Shield plans, which in some markets have dominant market share. Most Blue Cross and Blue Shield plans are non-profit enterprises that do not necessarily pursue profitability to the same extent as for-profit competitors do. The Company also competes with HMOs, some of which are non-profit enterprises. In addition, in its risk sharing and administrative service businesses, the Company also competes with TPAs. The Company is taking advantage of its capabilities as a multi-line insurer to offer employers in the middle market (200 employees to 5,000 employees) an integrated solution to their workers' compensation, group medical and group disability programs. The majority of other carriers and TPAs in the integrated marketplace are offering only group disability with workers' compensation. The Company believes it is well-positioned to deliver workers' compensation, group disability and group medical on an integrated basis, which provides the Company with a competitive advantage. The Company believes, based upon its knowledge of the market, that in the current environment, the principal competitive factors in the sale of managed care medical products are price, breadth of managed care network arrangements, name recognition, technology and management information systems, distribution systems, quality of customer service, product line flexibility and variety, and financial stability. As a result, the Company believes that its managed care expertise, access to managed care networks, commitment to claims management and customer service, and its advanced claims management and information systems enable it to compete effectively in these markets. Although the Company cannot predict the effect of current federal and state health care reform proposals, the Company believes that such reform measures may increase competition in the sale of health care products by limiting the ability of the Company's customers to purchase health care coverage from a wide variety of health care providers and insurers, by mandating participation by insurers in regional health care alliances or pools and by limiting rating and underwriting practices. 17 Retirement and Asset Accumulation Allmerica Financial Services General The Allmerica Financial Services segment includes the individual financial products and the group retirement products and services businesses of FAFLIC and its wholly-owned subsidiary, AFLIAC, as well as the Company's registered investment advisor and broker-dealer affiliates. Through this segment, the Company is a leading provider of investment-oriented life insurance and annuities to upper income individuals and small businesses throughout the United States. These products are marketed through the Company's career agency force of 603 agents, to mutual fund providers for their variable annuity customers, and on a wholesale basis to financial planners and broker-dealers. For the year ended December 31, 1998, the Allmerica Financial Services segment accounted for $625.6 million, or 18.6%, of consolidated segment revenues and $166.7 million, or 55.8%, of consolidated segment income before taxes and minority interest. The Company offers a diverse line of products tailored to its customer market, including variable annuities, variable universal life, group retirement plan products, retirement plan funding products and universal life. The main components of the Company's current strategy in this segment are to: (i) emphasize investment-oriented insurance products, particularly variable annuities and variable universal life insurance, (ii) continue to develop alternative distribution channels, (iii) leverage the Company's technological resources to support marketing and client service initiatives, (iv) improve the productivity of the career agency distribution system and (v) implement a targeted marketing approach emphasizing value-added service. Prior to 1998, the group retirement plan products were offered through the Company's Institutional Services segment. Throughout 1998, a significant distribution system in this segment is the career agent sales force. Virtually all of the Company's career agents are registered broker-dealer representatives, licensed to sell all of Allmerica Financial Services investment products, as well as its insurance products. The Company has implemented a performance-based compensation system which rewards agents and agencies based upon sales of products which provide greater profits for the Company. The Company has also instituted higher performance standards for agency retention, and requires that such standards be achieved earlier, in order to elevate the productivity of its agent sales force. In addition to its agency distribution system, the Company has established several other distribution channels, which have made significant contributions to the overall growth of variable product sales in this segment. Products sold through these channels include Allmerica Select life and annuity products, which are distributed through independent broker-dealers and financial planners, as well as annuity products sold through alliances with mutual fund partners such as Delaware Group ("Delaware"), Pioneer Group ("Pioneer"), Zurich Kemper Investments ("Kemper") and Fulcrum Trust ("Fulcrum"). New deposits from additional distribution channels have grown from 46.5% of statutory annuity premiums and deposits in 1996 to 72.3% in 1998. The Company's strategy is to pursue additional distribution channels and to seek to increase sales under its existing distribution channels. The Company has developed a number of new marketing and client service initiatives in order to encourage sales of its products and improve customer satisfaction. As part of its focus on the sale of investment-oriented insurance products, the Company has emphasized a financial planning approach utilizing face-to-face presentations and seminar programs to address different client needs. In order to identify a favorable prospective client base, the Company has developed a system utilizing advanced demographic screening and telemarketing techniques. The Company also regularly delivers seminars focused on retirement planning to these prospective clients. During 1998, the Company delivered approximately 600 seminars nationally with an average of more than 50 attendees. The Company has also utilized its technological resources to support its marketing and client service initiatives in this segment. The Company has developed automated portfolio re-balancing capabilities and 18 graphical quarterly report statements, which are used to establish and monitor the desired mix of investments by individual contract and policyholders. According to 1998 A.M. Best's Policy Reports, the Company is among the ten largest writers of individual variable annuity contracts and individual variable universal life insurance policies in the United States in 1997, based on statutory premiums and deposits. Sales of variable products represented approximately 98.0%, 95.7% and 91.8% of this segment's statutory premiums and deposits in 1998, 1997 and 1996, respectively. Statutory premiums and deposits, a common industry benchmark for sales achievement, totaled $4,101.9 million, $3,188.8 million and $2,036.5 million in 1998, 1997 and 1996, respectively. Currently, under the Internal Revenue Code, holders of certain life insurance and annuity products are entitled to tax-favored treatment on these products. For example, income tax payable by policyholders on investment earnings under certain life insurance and annuity products is deferred during the product's accumulation period and is payable, if at all, only when the insurance or annuity benefits are actually paid or to be paid. Also, for example, interest on loans up to $50,000 secured by the cash value of certain insurance policies owned by businesses is eligible for deduction even though investment earnings during the accumulation period are tax-deferred. In the past, legislation has been proposed that would have curtailed the tax-favored treatment of the life insurance and annuity products offered by the Company. These proposals were not enacted; however, such proposals or similar proposals are currently under consideration by Congress. If these or similar proposals directed at limiting the tax-favored treatment of life insurance policies and annuity contracts were enacted, market demand for such products offered by the Company would be adversely affected. The Company cannot predict the impact of such effects. Products The following table reflects premiums and deposits on a statutory accounting practices ("SAP") basis, including universal life and investment-oriented contract deposits, for the segment's major product lines, including the Closed Block, for the years ended December 31, 1998, 1997 and 1996. Receipts from various products are treated differently under GAAP and SAP. Under GAAP, universal life, variable universal life and annuity deposits are not included in revenues but are recorded directly to policyholder account balances.
1998 1997 1996 -------- -------- -------- (In millions) Statutory Premiums and Deposits Variable universal life........................ $ 158.7 $ 148.8 $ 117.2 Group variable universal life.................. 73.3 68.3 7.4 Separate account annuities..................... 2,585.9 2,186.1 1,160.9 General account annuities (1).................. 622.2 234.7 147.9 Retirement investment account annuities........ 20.1 21.8 24.5 Group annuities................................ 561.6 387.2 412.2 Universal life................................. 23.6 60.7 71.6 Traditional life............................... 55.9 58.4 61.9 Individual health.............................. 0.6 22.8 32.9 -------- -------- -------- Total statutory premiums and deposits........ $4,101.9 $3,188.8 $2,036.5 ======== ======== ========
- -------- (1) The general account includes approximately $373.0 million of deposits made in conjunction with the introduction of a new annuity program which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account. Under this program, the funds are then transferred ratably, over a limited period of time, into the Company's separate account investments. 19 While the Company continues to offer certain traditional insurance products, its current focus for new business in this segment is on the sale of variable products. Variable Products The Company's variable products offered through this segment include variable universal life insurance and variable annuities. The Company's variable universal life insurance products combine the flexible terms of the Company's universal life insurance policy with separate account investment opportunities. The Company also offers a variable joint life product through this segment. The Company's variable annuities offer the investment opportunities of the Company's separate accounts and provide a vehicle for tax-deferred savings. These products are sold pursuant to registration statements under the Securities Act or exemptions from registration thereunder. The Company seeks to achieve product distinction with respect to its variable products on the basis of quality and diversity of the separate account investment options underlying these products. The Company's variable universal life and annuity products offer a variety of account investment options with choices ranging from money market funds to international equity funds. The number of these investment options has increased from 60 in 1996 to 98 in 1998, including those underlying the products sold through alternative distribution channels. For management of these separate accounts, the Company supplements its in-house expertise in managing fixed income assets with the equity management expertise of well-known mutual fund advisors, such as Fidelity Investments, as well as other independent management firms who specialize in the management of institutional assets. Additionally, the Company utilizes the services of an experienced investment consultant to the pension industry to assist it in the selection of these institutional managers and in the ongoing monitoring of their performance. Retirement Products In addition to the above, the Company provides consulting and investment services to defined benefit and defined contribution retirement plans of corporate employers, as well as the sale of group annuities to corporate pension plans. The Company also offers participant recordkeeping and administrative services to defined benefit and defined contribution retirement plans. Participants in defined contribution plans serviced by the Company have the option to invest their contributions to the plan in the Company's general account or choose from one of the Company's separate account investment options. Currently, the Company provides administration and recordkeeping for approximately 530 qualified pension and profit sharing plans, which have assets totaling $1.8 billion, and cover approximately 77,000 participants. To address the decrease in the market for defined benefit plans sponsored by employers, the Company has focused on increasing sales of defined contribution plans, targeting plans with less than 500 participants. Based on internal studies, management believes the size of this market provides the greatest opportunity in this line of business. Traditional Products The Company's primary insurance products contained in this segment are traditional life insurance products, including whole life and universal life, as well as fixed annuities and retirement plan funding products. The Company's universal life insurance product is an interest-sensitive product which offers flexibility in arranging the amount of insurance coverage, the premium level and the premium payment period. The Company also offers joint life products through this segment designed to meet estate planning needs. These products offer flexible premiums and benefits and cover two lives, with benefits paid at the first or second death, depending on the policy. In addition, the Company offers a funding vehicle for pension plans of small to medium-sized employers which provides both general account and separate account investment options. 20 Distribution A significant distribution channel for this segment is its national career agency sales force of 603 agents, housed in 19 general agencies located in or adjacent to most of the major metropolitan centers in the United States. Virtually all of these agents are licensed both as insurance agents and securities broker-dealers by the National Association of Securities Dealers ("NASD"), qualifying them to sell the full range of the Company's products. The Company has focused on improving the productivity and reducing the cost of its career agency system through performance-based compensation, higher performance standards for agency retention and agency training programs. The Company also regularly conducts comprehensive financial planning seminars and face-to-face presentations to address different investment objectives of clients. During 1998, total statutory premiums and deposits from sales of variable annuities through the agency sales force totaled $871.3 million, compared to $782.2 million in 1997. The Company has established several distribution channels for this segment's products utilizing independent broker-dealers and financial planners. Through these distribution channels, the Company has obtained access to over 400 distribution firms employing over 55,000 sales personnel. In addition, establishment of these channels has enabled the Company to offer a broader range of investment options through alliances with Delaware, Pioneer, Kemper and Fulcrum mutual funds. During 1998, total statutory premiums and deposits from sales of variable annuities through additional distribution channels totaled $2,334.5 million, compared to $1,621.6 million in 1997. Additionally, the Company offers its group retirement products for sale directly at the worksite through trained and licensed sales representatives. In addition to the Home Office, the Company maintains seven regional sales and service offices located in strategic financial markets. By using education and personalized consulting to increase employee purchases, the Company seeks to lower acquisition costs and increase employee participation levels. Underwriting Life insurance underwriting involves a determination of the type and amount of risk which an insurer is willing to accept and the price charged to do so. The Company's insurance underwriting standards for this segment attempt to produce mortality results consistent with the assumptions used in product pricing. Underwriting also determines the amount and type of reinsurance levels appropriate for a particular risk profile and thereby allows competitive risk selection. Underwriting rules and guidelines are based on the mortality experience of the Company, as well as of the insurance industry and the general population. The Company also uses a variety of medical tests to evaluate certain policy applications, based on the size of the policy, the age of the applicant and other factors. The Company's product specifications are designed to prevent anti-selection. Mortality assumptions are thoroughly communicated and monitored. The underwriting department tracks the profitability indicators of business by each general agent, including the mix of business, percentage of substandard and declined cases and placement ratio. Ongoing internal underwriting audits, conducted at multiple levels, monitor consistency of underwriting requirements and philosophy. Routine independent underwriting audits conducted by its reinsurers have supported the Company's underwriting policies and procedures. Insurance Reserves The Company has established liabilities for policyholders' account balances and future policy benefits in the consolidated balance sheets included in the 1998 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference, to meet obligations on various policies and contracts. Policyholders' account balances for universal life and investment- type policies are equal to cumulative account balances: deposits plus credited interest, less expense and mortality charges and withdrawals. Future policy benefits for traditional products are computed on the basis of assumed investment yields, mortality, persistency, morbidity 21 and expenses (including a margin for adverse deviation), which are established at the time of issuance of a policy and generally vary by product, year of issue and policy duration. Reinsurance Consistent with the general practice in the life insurance industry, the Company has reinsured portions of the coverage provided by this segment's insurance products with other insurance companies. Insurance is ceded principally to reduce net liability on individual risks, to provide protection against large losses and to obtain a greater diversification of risk. Although reinsurance does not legally discharge the ceding insurer from its primary liability for the full amount of policies reinsured, it does make the reinsurers liable to the insurer to the extent of the reinsurance ceded. The Company maintains a gross reserve for reinsurance liabilities. The Company ceded approximately 3.1% of this segment's total statutory life insurance premiums in 1998. With respect to life policies of the Allmerica Financial Services segment, the Company has reinsurance agreements in place, established on an annual term, for both automatic and facultative reinsurance. Under automatic reinsurance, the reinsurer is automatically bound for up to three times the Company's retention, which currently is $2.0 million per life, with certain restrictions that determine the binding authority with the various reinsurers. For life policies greater than $8.0 million, the Company obtains facultative reinsurance. Prior to issuing facultative reinsurance, the facultative reinsurer reviews all of the underwriting information relating to the policies and reinsures on a policy by policy basis. Depending on the nature of the risk and the size of the policy, the facultative reinsurance could be provided by one company or several. The Company sometimes facultatively reinsures certain policies under $2.0 million which do not satisfy the Company's underwriting guidelines. The Company seeks to enter into reinsurance treaties with highly rated reinsurers. All of the reinsurers utilized by this segment have received an A.M. Best rating of "A- (Excellent)" or better (Best's Insurance Reports, 1998 edition). The Company believes that it has established appropriate reinsurance coverage for this segment based upon its net retained insured liabilities compared to its surplus. Based on its review of its reinsurers' financial positions and reputations in the reinsurance marketplace, the Company believes that its reinsurers are financially sound. The Company also obtains catastrophe reinsurance for life insurance in this segment through a catastrophe accident pool. The maximum pool reinsurance available per company is $50.0 million and the maximum pool reinsurance available for a single event is $125.0 million. Any amounts in excess of these limits are the responsibility of the company suffering the loss. Each participant in the pool pays a premium based on the share of claims paid by the pool. The Company's share of pool losses is approximately 2.5%. There have been three claims for which the Company's share was approximately $80,000 since the Company entered the pool on January 1, 1989. Approximately 125 companies currently participate in this pool. Effective January 1, 1998, the Company entered into an agreement with a highly rated reinsurer to reinsure the mortality risk on the universal life and variable universal life lines of business. Management believes that this agreement will continue to have an immaterial effect on the results of operations and financial position of the Company. In addition, during 1997, the Company entered into a 100% coinsurance agreement to reinsure substantially all of its individual disability income business. Competition There is strong competition among insurance companies seeking clients for the types of insurance, annuities and investment products sold by the Company in this segment. As of December 31, 1998, there were approximately 1,500 companies that offer life insurance in the United States, most of which offer one or more products similar to those offered by the Company. In some cases these products are offered through similar marketing techniques. In addition, the Company may face additional competition from banks and other financial 22 institutions should current regulatory restrictions on the sale of insurance and securities by these institutions be repealed. The Company believes that, based upon its extensive experience in the market, the principal competitive factors affecting the sale of its life insurance and related investment products are price, financial strength and claims-paying ratings, size and strength of agency force, range of product lines, product quality, reputation and name recognition, value-added service and, with respect to variable insurance and annuity products, investment management performance of the underlying separate accounts. Accordingly, management believes that the Company's strong financial strength and claims- paying ratings, the quality and diversity of the separate accounts underlying its investment-based products, the NASD licensing of substantially all of its agents and its reputation in the insurance industry enable it to compete effectively in the markets in which it operates. Allmerica Asset Management General Through the Allmerica Asset Management segment, the Company offers Stable Value Products, such as Guaranteed Interest Contracts (GICs), to ERISA- qualified retirement plans as well as other non-ERISA institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs. In addition, this segment contains a Registered Investment Advisor, which provides investment advisory services to affiliates and to other institutions, such as insurance companies, retirement plans and mutual funds. Prior to 1998, the Company offered GICs through its Institutional Services segment in FAFLIC, primarily to ERISA-qualified defined contribution and defined benefit retirement plans. In 1998, management of these products was transferred to Allmerica Asset Management, though the issuance of GICs continues to be through FAFLIC. In 1997, the Company began offering floating rate GICs, a specific type of GIC designed for non-ERISA institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs. For the year ended December 31, 1998, this segment accounted for approximately $121.7 million, or 3.6%, of consolidated segment revenues, and income of $23.7 million, or 7.9%, of consolidated segment income before taxes and minority interest. Products and Services Stable Value Products Three types of Stable Value Products are offered: the traditional GIC, the synthetic GIC, and the non-qualified GIC, often referred to as "Funding Agreements" or "floating rate GICs". The traditional GIC is issued to ERISA- qualified retirement plans, and provides a fixed guaranteed interest rate and fixed maturity for each contract. Some of the traditional GICs provide for a specific lump sum deposit and no withdrawals prior to maturity. Other traditional GICs allow for window deposits and/or benefit-sensitive withdrawals prior to maturity, for which the Company builds an additional risk charge into the guaranteed interest rate. The synthetic GIC is similar to the traditional GIC, except that the underlying investments are generally held and managed by a third party, in accordance with specific investment guidelines, and the Company periodically resets the guaranteed interest rate for in-force funds, based on the actual investment experience of the funds. The floating rate GIC is similar to the traditional GIC, except that it is issued to non- ERISA institutional buyers, such as money market funds, corporate cash management programs and securities lending collateral programs. This market tends to prefer short duration instruments, so it is typical for the floating rate GIC to have short maturities and periodic interest rate resets, based on an index such as LIBOR. 23 During 1998, total traditional GIC sales were less than $10.0 million and floating rate GIC sales were approximately $1.1 billion, up from $250.0 million in 1997. There were no sales of synthetic GICs. The continued low volume of traditional and synthetic GIC sales reflects the Company's decision to sell these products only when the profit margins meet the Company's standards. The Company expects to continue its sales of floating rate GICs in 1999. Investment Advisory Services Through its registered investment advisor, Allmerica Asset Management, Inc., the Company provides investment advisory services to affiliates and to other institutions, including unaffiliated insurance companies, retirement plans, foundations and mutual funds. At December 31, 1998, Allmerica Asset Management had assets under management of approximately $13.2 billion, of which approximately $1.4 billion represented assets managed for third party clients (i.e. entities unaffiliated with the Company). Assets under management for third party clients grew by over $1.0 billion during 1998. Distribution The Company distributes Stable Value Products through brokers, GIC investment managers and directly from the Home Office. Investment advisory services are marketed directly. Competition Prior to 1995, all GIC sales consisted of traditional GICs. Around that time, increased sensitivity to claims-paying ratings of GIC issuers, a reduction in the amount of new funds allocated to the purchase of GICs in general, and an increase in availability of non-traditional GIC alternatives, resulted in an increasingly difficult market in which to sell traditional GICs. At that time, the Company introduced its synthetic GIC, selling about $110.0 million of this product in the first year. Since then, increased competition in the synthetic GIC market has driven margins on new business down to extremely low levels. The Company introduced its floating rate GIC product in the latter part of 1997. There are approximately two dozen insurance companies that compete in the floating rate GIC market. Floating rate GICs are one of a variety of instruments being purchased by the buyers in this market, and the Company views these other instruments as comprising the primary competition. Short- term commercial paper issued by corporations is the most common of these competing instruments. The primary factors affecting the ability to sell are the yields offered, short term ratings (and to a lesser extent, claims paying ratings) and product structure. With its expertise in asset/liability management, the Company is able to offer yields that are very competitive with comparably rated instruments, and a variety of product structures, while earning an attractive return on capital, with low volatility. Investment Portfolio General At December 31, 1998, the Company held $10.4 billion of investment assets, including $770.5 million of investment assets in the Closed Block. These investments are generally of high quality and broadly diversified across asset classes and individual investment risks. The major categories of investment assets are: fixed maturities, which includes both investment grade and below investment grade public and private debt securities; equity securities; mortgage loans, principally on commercial properties; real estate, which consists primarily of investments in commercial properties; policy loans and other long-term investments. The remainder of the investment assets is comprised of cash and cash equivalents. Management has an integrated approach to developing an investment strategy for the Company that maximizes income, while incorporating overall asset allocation, business segment objectives, and asset/liability 24 management tailored to specific insurance or investment product requirements. The Company's integrated approach and the execution of the investment strategy are founded upon a value orientation. The Company's investment professionals seek to identify undervalued securities in the markets through extensive fundamental research and credit analysis. Management believes this research- driven, value orientation is a key to achieving the overall investment objectives of producing superior rates of return, preserving capital and meeting the financial goals of the Company's business segments. The appropriate asset allocation for the Company (the selection of broad investment categories such as fixed maturities, equity securities, mortgages and real estate) is determined by management initially through a process that focuses overall on the types of businesses in each segment that the Company engages in and the level of surplus (net worth) required to support these businesses. At the segment level, the Company has developed an asset/liability management approach tailored to specific insurance, investment product and income objectives. The investment assets of the Company are then 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. Specific investments frequently meet the requirements of, and are acquired by, more than one investment portfolio (or investment segment of the general account of FAFLIC or AFLIAC, with each investment segment holding a pro rata interest in such investments and the cash flows therefrom). 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 borrowers, industries, sectors and, in the case of mortgages and real estate, property types and geographic locations. In 1998, management continued its strategy of shifting portfolio holdings from equity securities to higher quality fixed maturity securities, as well as decreasing overall investment exposure in certain limited partnership investments, to meet income objectives. All investments held by the Company's insurance subsidiaries are subject to diversification requirements under insurance laws. Consistent with this management approach, portfolio managers maintain close working relationships with the managers of related product lines within the Property and Casualty, Corporate Risk Management Services, Allmerica Financial Services and Allmerica Asset Management segments. Changes in the outlook for investment markets or the returns generated by portfolio holdings are reflected as appropriate on a timely basis in the pricing of the Company's products and services. Rating Agencies Insurance companies are rated by rating agencies to provide both industry and participants and insurance consumers meaningful information on specific insurance companies. Higher ratings generally indicate financial stability and a stronger ability to pay claims. FAFLIC, AFLIAC, Hanover and Citizens all received an A.M. Best financial condition rating of A (Excellent) in 1998. FAFLIC and AFLIAC were given Duff & Phelps claims-paying ability ratings of AA (Very High) in May 1998. FAFLIC, AFLIAC and Hanover were given Moody's financial strength ratings of A1 (Good) in December 1998. FAFLIC, AFLIAC and Hanover, together with its subsidiaries, including Citizens Insurance, were given S&P claims-paying ability rating of AA- (Excellent) as of March 10, 1999. 25 Management believes that its strong ratings are important factors in marketing the products of its insurance companies to its agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company ratings are assigned to an insurer based upon factors relevant to policyholders and are not directed toward protection of investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. Employees The Company has approximately 6,300 employees located throughout the country. Management believes relations with employees and agents are good. ITEM 2 PROPERTIES The Company's headquarters are located at 440 Lincoln Street, Worcester, Massachusetts, and consist primarily of approximately 758,000 rentable square feet of office and conference space owned in fee and include the headquarters of Hanover. Citizens owns its home office, located at 645 W. Grand River, Howell, Michigan, which is approximately 127,000 rentable square feet. Citizens also owns a three-building complex located at 808 North Highlander Way, Howell, Michigan, with approximately 209,000 rentable square feet, where various business operations are conducted. The Company leases office space for its sales force throughout the United States. The leased property houses agency offices and group insurance sales offices. Hanover also leases offices throughout the country for its field employees. The Company believes that its facilities are adequate for its present needs in all material respects. ITEM 3 LEGAL PROCEEDINGS Reference is made to Note 21 on page 81 of the Notes to Consolidated Financial Statements of the 1998 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. Sales Practices In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998, and has scheduled a hearing in March 1999 to consider final approval. Accordingly, AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on an amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. 26 Other The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the opinion of management, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this Annual Report on Form 10-K. 27 PART II ITEM 5 MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Common Stock and Shareholder Ownership The common stock of Allmerica Financial Corporation is traded on the New York Stock Exchange under the symbol "AFC". On March 15, 1999, the Company had 50,432 shareholders of record and 56,729,421 million shares outstanding. On the same date, the trading price of the Company's common stock was $52 7/8 per share. Common Stock Prices and Dividends
High Low Dividends ------- -------- --------- 1998 First Quarter...................................... $66 3/8 $42 5/16 $0.05 Second Quarter..................................... $72 1/8 $61 5/16 $0.05 Third Quarter...................................... $72 1/8 $57 5/16 $0.05 Fourth Quarter..................................... $57 7/8 $39 1/4 -- 1997 First Quarter...................................... $40 1/4 $32 5/8 $0.05 Second Quarter..................................... $40 3/8 $33 1/2 $0.05 Third Quarter...................................... $45 1/4 $39 1/4 $0.05 Fourth Quarter..................................... $51 $42 7/8 $0.05
1998 Dividend Schedule Allmerica Financial Corporation declared no cash dividend during the fourth quarter of 1998. The Company has announced its intention to change its common stock dividend schedule from a quarterly basis to an annual basis. In addition, the Company anticipates an annual dividend of $0.25 per share as compared to prior years' quarterly dividends of $0.05 per share. The payment of future dividends, if any, on the Company's Common Stock will be a business decision made by the Board of Directors from time to time based upon the results of operations and financial condition of the Company and such other factors as the Board of Directors considers relevant. Dividends paid by the Company may be funded from dividends paid to the Company from its subsidiaries. Dividends from insurance subsidiaries are subject to restrictions imposed by state insurance laws and regulations. Reference is made to "Liquidity and Capital Resources" on pages 44-45 of Management's Discussion and Analysis of Financial Condition and Results of Operations and to Note 14 on page 76 of the Notes to Consolidated Financial Statements of the 1998 Annual Report to Shareholders, the applicable portions of which are incorporated herein by reference. ITEM 6 SELECTED FINANCIAL DATA Reference is made to the "Five Year Summary of Selected Financial Highlights" on page 25 of the 1998 Annual Report to Shareholders, which is incorporated herein by reference. 28 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 26-47 of the 1998 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 7A QUANTATATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 40-43 of the 1998 Annual Report to Shareholders, which is incorporated herein by reference. ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Consolidated Financial Statements on pages 49-53 and the accompanying Notes to Consolidated Financial Statements on pages 54-83 of the 1998 Annual Report to Shareholders which meet the requirements of Regulation S-X, and which include a summary of quarterly results of consolidated operations (see Note 23 of Notes to Consolidated Financial Statements--page 83), which is incorporated herein by reference. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 29 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE REGISTRANT Information regarding Directors of the Company is incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 11, 1999, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. EXECUTIVE OFFICERS OF THE REGISTRANT Set forth below is biographical information concerning the executive officers of the Company. John F. O'Brien, 55 Director, Chief Executive Officer and President of the Company since February 1995 See biography under "Directors of the Registrant" above. Bruce C. Anderson, 54 Vice President of the Company since February 1995 Mr. Anderson has been Vice President of AFC since February 1995 and Vice President of Allmerica P&C and Citizens since March 1997. Mr. Anderson has been employed by FAFLIC since 1967 and has been Vice President and Director of FAFLIC since October 1984 and April 1996, respectively. In addition, Mr. Anderson is a director and/or executive officer at various other non-public affiliates. Robert E. Bruce, 48 Vice President of the Company since July 1997 Mr. Bruce has been Vice President of AFC and Citizens since July 1997 and Vice President and Director of Citizens and Hanover since August 1997. In addition, Mr. Bruce has served as Vice President and Director of FAFLIC since May 1995 and August 1997, respectively, and Chief Information Officer of FAFLIC since February 1997. Mr. Bruce is also a director and/or executive officer at various other non-public affiliates. Prior to joining FAFLIC in May 1995, Mr. Bruce was Corporate Manager at Digital Equipment Corporation, a computer manufacturer, from May 1979 to March 1995. John P. Kavanaugh, 44 Vice President and Chief Investment Officer of the Company since 1996 Mr. Kavanaugh has been Vice President and Chief Investment Officer of AFC since September 1996, has been employed by FAFLIC since 1983, and has been Vice President of FAFLIC since December 1991 and Vice President of AFLIAC since January 1992. Mr. Kavanaugh has also served as Director and Chief Investment Officer of FAFLIC, Hanover, Citizens Insurance and AFLIAC since August 1996, and Vice President and Chief Investment Officer of Allmerica P&C and Citizens since September 1996. Mr. Kavanaugh is also a director and/or executive officer at various other non-public affiliates. John F. Kelly, 60 Vice President and General Counsel of the Company since February 1995 Mr. Kelly has been Vice President, General Counsel and Assistant Secretary of AFC since February 1995, has been employed by FAFLIC since July 1968, and has been Senior Vice President and General Counsel of 30 FAFLIC since February 1986 and Director of FAFLIC since April 1996. In addition to his positions with AFC and FAFLIC, Mr. Kelly has been Vice President and General Counsel of Allmerica P&C since August 1992, Assistant Secretary of Allmerica P&C since May 1995, Assistant Secretary of Citizens since December 1992, and Vice President, General Counsel and Assistant Secretary of Citizens since September 1993. Mr. Kelly was Secretary of Allmerica P&C from August 1992 to May 1995. Mr. Kelly has been a Director of AFLIAC since October 1982 and is a director and/or executive officer at various other non-public affiliates. J. Barry May, 51 Vice President of the Company since February 1997 Mr. May has been Vice President of AFC since February 1997, Vice President of Allmerica P&C and President of Hanover since September 1996 and Director and Vice President of Citizens since March 1997. He has been a Director of Hanover and Citizens Insurance since September 1996. Mr. May served as Vice President of Hanover from May 1995 to September 1996, as Regional Vice President from February 1993 to May 1995 and as a General Manager of Hanover from June 1989 to May 1995. Mr. May has been employed by Hanover since 1985. In addition, Mr. May is a director and/or executive officer at various other non-public affiliates. James R. McAuliffe, 54 Vice President of the Company since February 1995 Mr. McAuliffe has been Vice President of AFC from February 1995 through December 1995 and since February 1997, Vice President of Allmerica P&C since August 1992, a Director of Allmerica P&C from August 1992 through December 1994, a Director and Vice President of Citizens since December 1992, and a Director of AFLIAC from April 1987 through May 1995 and since May 1996. Mr. McAuliffe has been President of Citizens Insurance since December 1994. Mr. McAuliffe has been employed by FAFLIC since 1968, and served as Vice President and Chief Investment Officer of FAFLIC from November 1986 through December 1994. Mr. McAuliffe also served as Vice President and Chief Investment Officer of Allmerica P&C from August 1992 through December 1994, and Vice President and Chief Investment Officer of AFLIAC from December 1986 through May 1995. Additionally, Mr. McAuliffe is a director and/or executive officer at various other non-public affiliates. Edward J. Parry, III, 39 Vice President and Treasurer of the Company since February 1995 Chief Financial Officer of the Company since December 1996 Mr. Parry has been Chief Financial Officer of AFC since December 1996. He has also been Vice President and Treasurer of AFC since February 1995. He has served as Chief Financial Officer of FAFLIC, AFLIAC, Allmerica P&C, Hanover, Citizens and Citizens Insurance since December 1996 and as Vice President and Treasurer of FAFLIC, AFLIAC, Allmerica P&C and Hanover since February 1993 and of Citizens since September 1993 and December 1992, respectively. Mr. Parry is also a director and/or executive officer at various other non-public affiliates. Richard M. Reilly, 60 Vice President of the Company since February 1997 Mr. Reilly has been Vice President of AFC and FAFLIC since February 1997 and November 1990, respectively, and Vice President of Allmerica P&C and Citizens since March 1997. He has also been a Director and Vice President of AFLIAC since November 1990 and President and Chief Executive Officer of AFLIAC since August 1995. Mr. Reilly was Vice President of AFC from February 1995 through December 1995. Additionally, Mr. Reilly has been the President of Allmerica Investment Trust, Allmerica Funds, and Allmerica Securities Trust, each a registered investment company, since February 1991, April 1991 and February 1991, respectively. Mr. Reilly is also a director and/or holds an executive office at various other non-public affiliates. 31 Robert P. Restrepo, 48 Vice President of the Company since May 1998 Mr. Restrepo has been Vice President of AFC and President, Chief Executive Officer and Director of Allmerica P&C since May 1998. Prior to joining AFC, Mr. Restrepo was Chief Executive Officer, Personal Lines at Travelers Property and Casualty, a member of the Travelers Group from January 1996 to May 1998. Additionally, Mr. Restrepo was the Senior Vice President, Personal Lines at Aetna Life & Casualty Company from March 1991 to January 1996. Mr. Restrepo is also a director and/or executive officer at various other non-public affiliates of AFC. Eric A. Simonsen, 53 Vice President of the Company since February 1995 Mr. Simonsen has been Vice President of AFC since February 1995. He has been a Vice President of APY since August 1992, of Citizens since December 1992 and of AFLIAC since September 1990. He also served as a director of APY from August of 1992 to July 1997. In addition, he has served as Vice President and as a Director of FAFLIC since September 1990 and April 1996, respectively. Mr. Simonsen has been President of Allmerica Services Corporation since December 1996. Mr. Simonsen was Chief Financial Officer of AFC from February 1995 to December 1996, of FAFLIC and AFLIAC from September 1990 to December 1996, of Allmerica P&C from August 1992 to December 1996 and of Citizens from December 1992 to December 1996. Mr. Simonsen is also a director and/or executive officer at various other non-public affiliates. Phillip E. Soule, 49 Vice President of the Company since February 1997 Mr. Soule has been Vice President of AFC, Citizens, and FAFLIC since February 1997, March 1997 and February 1987, respectively, and of Allmerica P&C since September 1996. He was Vice President of AFC from February 1995 through December 1995. Mr. Soule has been employed by FAFLIC since 1972 in various capacities. ITEM 11 EXECUTIVE COMPENSATION Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 11, 1999, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 11, 1999, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Proxy Statement for the Annual Meeting of Shareholders to be held May 11, 1999, to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934. 32 PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements The consolidated financial statements and accompanying notes thereto on pages 49 through 83 of the 1998 Annual Report to Shareholders have been incorporated herein by reference in their entirety.
Annual Report Page(s) ------- Report of Independent Accountants.................................. 48 Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996.......................................................... 49 Consolidated Balance Sheets as of December 31, 1998 and 1997....... 50 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996.................................. 51 Consolidated Statements of Comprehensive Income for the years ended December 31, 1998, 1997 and 1996.................................. 52 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996.......................................................... 53 Notes to Consolidated Financial Statements......................... 54-83
(a)(2) Financial Statement Schedules
Page No. in Schedule this Report -------- ----------- Report of Independent Accountants on Financial Statement Schedules.................................... 39 I Summary of Investments--Other than Investments in Related Parties........................................ 40 II Condensed Financial Information of Registrant.......... 41-43 III Supplementary Insurance Information.................... 44-46 IV Reinsurance............................................ 47 V Valuation and Qualifying Accounts...................... 48 VI Supplemental Information concerning Property/Casualty Insurance Operations................................... 49
(a)(3) Exhibit Index Exhibits filed as part of this Form 10-K are as follows: 2.1 Plan of Reorganization.+ 2.2 Stock and Asset Purchase Agreement by an among State Mutual Life Assurance Company of America, 440 Financial Group of Worcester, Inc., and The Shareholder Services Group, Inc. dated as of March 9, 1995.+ 3.1 Certificate of Incorporation of AFC.+ 3.2 By-Laws of AFC.+ 4 Specimen Certificate of Common Stock.+ 4.1 Form of Indenture relating to the Debentures between the Registrant and State Street Bank & Trust Company, as trustee.++ 4.2 Form of Global Debenture.++ 4.3 Amended and Restated Declaration of Trust of AFC Capital Trust I dated February 3, 1997.+++++ 4.4 Indenture dated February 3, 1997 relating to the Junior Subordinated Debentures of AFC.+++++ 4.5 Series A Capital Securities Guarantee Agreement dated February 3, 1997.+++++ 4.6 Common Securities Guarantee Agreement dated February 3, 1997.+++++
33 4.8 Rights Agreement dated as of December 16, 1997, between the Registrant and First Chicago Trust Company of New York as Rights Agent, filed as Exhibit 1 to the Company's Form 8-A dated December 17, 1997 is incorporated herein by reference. 10.3 Administrative Services Agreement between State Mutual Life Assurance Company of America and The Hanover Insurance Company, dated July 19, 1989.+ 10.4 First Allmerica Financial Life Insurance Company Employees' 401(k) Matched Savings Plan incorporated by reference to Exhibit 10.1 to the Allmerica Financial Corporation Registration Statement on Form 8-K (No. 333-576) and incorporated herein by reference originally filed with the Commission on January 24, 1996. 10.5 State Mutual Life Assurance Company of America Excess Benefit Retirement Plan.+ 10.6 State Mutual Life Assurance Company of America Supplemental Executive Retirement Plan.+ 10.7 State Mutual Incentive Compensation Plan.+ 10.8 State Mutual Companies Long-Term Performance Unit Plan.+ 10.9 Indenture of Lease between State Mutual Life Assurance Company of America and the Hanover Insurance Company dated July 3, 1984 and corrected First Amendment to Indenture of Lease dated December 20, 1993.+ 10.12 Lease dated March 23, 1993 by and between Aetna Life Insurance Company and State Mutual Life Assurance Company of America, including amendments thereto, relating to property in Atlanta, Georgia.+ 10.13 Stockholder Services Agreement dated as of January 1, 1992 between Private Healthcare Systems, Inc. and State Mutual Life Assurance Company of America, the successor to its wholly-owned subsidiary, Group Healthcare Network, Inc.+ 10.14 Lease dated January 26, 1995 by and between Citizens Insurance and Upper Peninsula Commission for Area Progress, Inc., including amendments thereto, relating to property in Escanaba, Michigan.+ 10.16 Trust Indenture for the State Mutual Life Assurance Company of America Employees' 401(k) Matched Savings Plan between State Mutual Life Assurance Company of America and Bank of Boston/Worcester.+ 10.17 State Mutual Life Assurance Company of America Non-Qualified Executive Retirement Plan.+ 10.18 State Mutual Life Assurance Company of America Non-Qualified Executive Deferred Compensation Plan.+ 10.19 The Allmerica Financial Cash Balance Pension Plan incorporated by reference to Exhibit 10.19 to the Allmerica Financial Corporation September 30, 1995 report on Form 10-Q and incorporated herein by reference. 10.20 The Allmerica Financial Corporation Employment Continuity Plan.++++++ 10.21 Amended and Restated Form of Non-Solicitation Agreement executed by substantially all of the executive officers of AFC incorporated by reference to Exhibit 10.21 to the Allmerica Financial Corporation June 30, 1997 report on Form 10-Q and incorporated herein by reference. 10.23 Amended Allmerica Financial Corporation Long-Term Stock Incentive Plan.+++++++ 10.24 The Allmerica Financial Corporation Director Stock Ownership Plan incorporated by reference to Exhibit 10.21 to the Allmerica Financial Corporation June 30, 1996 report on Form 10-Q and incorporated herein by reference. 10.25 Reinsurance Agreement dated September 29, 1997 between First Allmerica Financial Life Insurance Company and Metropolitan Life Insurance Company.+++++++ 10.26 Consolidated Service Agreement between Allmerica Financial Corporation and its subsidiaries, dated January 1, 1998.+++++++ 10.27 Deferral Agreement, dated April 4, 1997, between Allmerica Financial Corporation and John F. O'Brien.+++++++ 10.28 Severance Agreement, dated September 25, 1997, between First Allmerica Financial Life Insurance Company and Larry C. Renfro.+++++++
34 10.29 Credit agreement dated as of June 17, 1998 between the Registrant and the Chase Manhattan Bank incorporated by reference to Exhibit 10.29 to the Allmerica Financial Corporation June 30, 1998 report on Form 10-Q and incorporated herein by reference. 10.30 Form of Deferral Agreement executed by substantially all of the executive officers of AFC dated January 30, 1998. 10.31 Form of Restricted Stock Agreement, dated January 30, 1998 and executed by substantially all of the executive officers of AFC. 10.32 Form of Converted Stock Agreement, dated January 30, 1998 and executed by substantially all of the executive officers of AFC. 10.33 Employment Agreement, dated May 13, 1998 between First Allmerica Financial Life Insurance Company and Robert P. Restrepo, Jr. 10.34 Restricted Stock Agreement, dated May 26, 1998, between Allmerica Financial Corporation and Robert P. Restrepo, Jr. 10.35 Credit agreement dated as of December 1, 1998 between the Registrant and the Chase Manhattan Bank. 13 The following sections of the Annual Report to Shareholders for 1998 ("1998 Annual Report") which are expressly incorporated by reference into this Annual Report on Form 10-K: . Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 26 through 47 of the 1998 Annual Report. . Consolidated Financial Statements and Notes thereto at pages 49 through 83 of the 1998 Annual Report. . Independent Auditors' Report at page 48 of the 1998 Annual Report. . The information appearing under the caption "Five Year Summary of Selected Financial Highlights" at page 25 of the 1998 Annual Report. . The information appearing under the caption "Shareholder Information" at page 85 of the 1998 Annual Report. 21 Subsidiaries of AFC. 23 Consent of PricewaterhouseCoopers LLP. 24 Power of Attorney. 27 Financial Data Schedule. 99.1 Internal Revenue Service Ruling dated April 15, 1995.+ 99.2 Important Factors Regarding Forward Looking Statements.
- -------- + Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's Registration Statement on Form S-1 (No. 33-91766) originally filed with the Commission on May 1, 1995. ++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's Registration Statement on Form S-1 (No. 33-96764) originally filed with the Commission on September 11, 1995. +++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1995 Annual Report on Form 10-K originally filed with the Commission on March 28, 1996. ++++ Incorporated by herein by reference to Exhibit I of the Current Report of the Registrant (Commission File No. 1-13754) filed February 20, 1997. +++++ Incorporated herein by reference to Exhibits 2, 3, 4, 5 and 6, respectively, contained in the Registrant's Current Report on Form 8-K filed on February 5, 1997. ++++++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1996 Annual Report on Form 10-K originally filed with the Commission on March 24, 1997. +++++++ Incorporated herein by reference to the correspondingly numbered exhibit contained in the Registrant's 1997 Annual Report on Form 10-K originally filed with the Commission on March 27, 1998 35 (b) Reports on Form 8-K On October 15, 1998, Allmerica Financial Corporation announced that third quarter operating earnings will be impacted by an estimated $0.25 to $0.30 per share as a result of losses relating to increased frequency of catastrophes and lower investment income. On October 27, 1998, Allmerica Financial Corporation announced that it, or a subsidiary, would commence a cash tender offer to acquire all of the outstanding shares of Citizens Corporation that it did not already own. On October 29, 1998, Allmerica Financial Corporation announced its financial results for the three months ended September 30, 1998. On November 16, 1998, Allmerica Financial Corporation and Citizens Corporation announced that pursuant to an agreement between the Special Committee of the Board of Directors of Citizens Corporation and Allmerica Financial Corporation, the offer price in the outstanding Offer to Purchase by Allmerica was increased and amended to $33.25 per share in cash. The Citizens Special Committee agreed to recommend that Citizens stockholders accept the revised offer price and tender their shares. On November 24, 1998, Allmerica Financial Corporation announced that fourth quarter results will be negatively impacted by an estimated $11 million in pre-tax catastrophe losses as a result of a sustained wind storm that struck Michigan during early November 1998. On December 4, 1998, Allmerica Financial Corporation announced that it reached a settlement agreement in a class action lawsuit in connection with the sale of life insurance policies issued by the Company from 1978 to May 31, 1998. The settlement agreement is subject to a court determination that it is fair and reasonable, and to court approval. The fairness hearing is expected to be held during the spring of 1999. On December 14, 1998, Allmerica Financial Corporation issued a press release relating to the consummation of the merger of Citizens Acquisition Corporation with and into Citizens Corporation. As a result of such merger, Citizens Corporation became a wholly-owned subsidiary of Allmerica Financial Corporation. 36 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Allmerica Financial Corporation Registrant Date: March 24, 1999 /s/ John F. O'Brien By: _________________________________ John F. O'Brien, Chairman of the Board, Chief Executive Officer and President Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 24, 1999 /s/ John F. O'Brien By: _________________________________ John F. O'Brien, Chairman of the Board, Chief Executive Officer and President Date: March 24, 1999 /s/ Edward J. Parry, III By: _________________________________ Edward J. Parry III, Vice President, Chief Financial Officer, Treasurer and Principal Accounting Officer Date: March 24, 1999 * By: _________________________________ Michael P. Angelini, Director Date: March 24, 1999 * By: _________________________________ Gail L. Harrison, Director Date: March 24, 1999 By: _________________________________ Robert P. Henderson, Director Date: March 24, 1999 * By: _________________________________ M. Howard Jacobson, Director Date: March 24, 1999 * By: _________________________________ J. Terrence Murray, Director Date: March 24, 1999 * By: _________________________________ Robert J. Murray, Director 37 Date: March 24, 1999 * By: _________________________________ John L. Sprague, Director Date: March 24, 1999 * By: _________________________________ Robert G. Stachler, Director Date: March 24, 1999 * By: _________________________________ Herbert M. Varnum, Director Date: March 24, 1999 * By: _________________________________ Richard M. Wall, Director /s/ Edward J. Parry *By: ________________________________ Edward J. Parry, Attorney-in-fact 38 Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Allmerica Financial Corporation Our audits of the consolidated financial statements referred to in our report dated February 2, 1999, appearing in the Allmerica Financial Corporation 1998 Annual Report to Shareholders (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PricewaterhouseCoopers LLP _____________________________________ PricewaterhouseCoopers LLP Boston, Massachusetts February 2, 1999 39 Schedule I ALLMERICA FINANCIAL CORPORATION Summary of Investments--Other than Investments in Related Parties December 31, 1998
Amount at which shown in the balance Type of Investment Cost (1) Value sheet - ------------------ -------- ------- -------------- (In millions) Fixed maturities: Bonds: United States Government and government agencies and authorities.................. $ 213.1 $ 201.4 $ 201.4 States, municipalities and political subdivisions.............................. 2,408.9 2,486.7 2,486.7 Foreign governments........................ 107.9 111.1 111.1 Public utilities........................... 431.3 434.6 434.6 All other corporate bonds.................. 4,161.6 4,244.0 4,244.0 Redeemable preferred stocks.................. 295.4 303.0 303.0 -------- ------- -------- Total fixed maturities..................... 7,618.2 7,780.8 7,780.8 -------- ------- -------- Equity securities: Common stocks: Public utilities........................... 3.7 4.6 4.6 Banks, trust and insurance companies....... 9.1 16.7 16.7 Industrial, miscellaneous and all other.... 215.6 353.9 353.9 Nonredeemable preferred stocks............... 24.7 21.9 21.9 -------- ------- -------- Total equity securities.................... 253.1 397.1 397.1 -------- ------- -------- Mortgage loans on real estate.................. 562.3 XXXXXX 562.3 Real estate (2)................................ 20.4 XXXXXX 20.4 Policy loans................................... 154.3 XXXXXX 154.3 Other long-term investments.................... 142.7 XXXXXX 142.7 -------- -------- Total investments.......................... $8,751.0 XXXXXX $9,057.6 ======== ========
- -------- (1) Original cost of equity securities and, as to fixed maturities, original cost reduced by repayments and adjusted for amortization of premiums and accretion of discounts. (2) Includes $14.5 million of real estate acquired through foreclosure. 40 Schedule II ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Statements of Income for the Years Ended December 31,
1998 1997 1996 ------ ------ ------ (In millions) Revenues Net investment income............................... $ 7.1 $ 11.4 $ 2.7 Net realized investment gains (losses).............. 1.7 (0.2) (0.9) ------ ------ ------ Total revenues.................................... 8.8 11.2 1.8 ------ ------ ------ Expenses Interest expense.................................... 40.5 41.1 15.3 Operating expenses.................................. 2.5 5.0 3.3 ------ ------ ------ Total expenses.................................... 43.0 46.1 18.6 ------ ------ ------ Net income before federal income taxes and equity in net income of unconsolidated subsidiaries............ (34.2) (34.9) (16.8) Income tax benefit: Federal............................................. 12.4 11.8 5.9 State............................................... 0.5 0.5 -- Equity in net income of unconsolidated subsidiaries... 222.5 231.8 192.8 ------ ------ ------ Net income............................................ $201.2 $209.2 $181.9 ====== ====== ======
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 41 Schedule II (continued) ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Balance Sheets
December 31, ------------------ 1998 1997 -------- -------- (In millions, except share and per share data) Assets Fixed maturities-at fair value (amortized cost of $0.8 and $3.4).................................................... $ 0.9 $ 3.5 Cash and cash equivalents................................. 2.9 0.9 Investment in unconsolidated subsidiaries................. 3,008.0 2,898.7 Receivable from subsidiaries.............................. 43.9 -- Other assets.............................................. 0.5 12.8 -------- -------- Total assets............................................ $3,056.2 $2,915.9 ======== ======== Liabilities Expenses and taxes payable................................ $ 34.7 $ 10.0 Interest and dividends payable............................ 13.0 15.8 Short-term debt........................................... 41.1 -- Long-term debt............................................ 508.8 508.8 -------- -------- Total liabilities....................................... 597.6 534.6 -------- -------- Shareholders' Equity Preferred stock, par value $0.01 per share, 20.0 million shares authorized, none issued........................... -- -- Common stock, par value $0.01 per share, 300.0 million shares authorized, 60.4 million and 60.0 million shares issued at December 31, 1998 and December 31, 1997, respectively............................................. 0.6 0.6 Additional paid-in capital................................ 1,768.8 1,755.1 Accumulated other comprehensive income.................... 180.5 217.3 Retained earnings......................................... 599.9 408.3 Treasury stock at cost (1.8 million shares)............... (91.2) -- -------- -------- Total shareholders' equity.............................. 2,458.6 2,381.3 -------- -------- Total liabilities and shareholders' equity.............. $3,056.2 $2,915.9 ======== ========
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 42 Schedule II (continued) ALLMERICA FINANCIAL CORPORATION Condensed Financial Information of Registrant Parent Company Only Statement of Cash Flows for the Years Ended December 31,
1998 1997 1996 ------- ------- ------- (In millions) Cash flows from operating activities Net income......................................... $ 201.2 $ 209.2 $ 181.9 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed income of subsidiaries.... (222.5) (231.8) (192.8) Net realized investment (gains) losses............ (1.7) 0.2 0.9 Change in expenses and taxes payable.............. 24.7 0.9 0.9 Change in interest and dividends payable.......... (2.8) 10.0 0.1 Change in receivable from subsidiaries............ (43.9) -- -- Other, net........................................ 8.0 (0.3) (3.8) ------- ------- ------- Net cash used in operating activities............... (37.0) (11.8) (12.8) ------- ------- ------- Cash flows from investing activities Capital contributed to unconsolidated subsidiaries...................................... (95.7) (79.9) -- Proceeds from disposals and maturities of available-for-sale fixed maturities............... 123.9 98.7 32.7 Purchase of available-for-sale fixed maturities.... -- (74.9) (59.6) Purchase of minority interest in Allmerica P&C..... -- (425.6) -- Proceeds from sale of common stock of subsidiary... -- 195.0 -- Purchase of equity securities...................... -- -- (0.7) ------- ------- ------- Net cash provided by (used in) investing activities......................................... 28.2 (286.7) (27.6) ------- ------- ------- Cash flow from financing activities Increase in long-term debt......................... -- 9.3 -- Dividend received from FAFLIC...................... 50.0 -- -- Net proceeds from issuance of commercial paper..... 41.1 -- -- Net proceeds from issuance of common stock......... 11.4 2.8 -- Proceeds from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company......................... -- 296.3 -- Treasury stock purchase............................ (82.7) -- -- Dividends paid to shareholders..................... (9.0) (11.5) (10.0) ------- ------- ------- Net cash provided by (used in) financing activities......................................... 10.8 296.9 (10.0) ------- ------- ------- Net change in cash and cash equivalents............. 2.0 (1.6) (50.4) Cash and cash equivalents at beginning of the period............................................. 0.9 2.5 52.9 ------- ------- ------- Cash and cash equivalents at end of the period...... $ 2.9 $ 0.9 $ 2.5 ======= ======= =======
The condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto. 43 Schedule III ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1998
Future policy Amortiza- benefits, Other Benefits, tion of Deferred losses, policy claims, deferred policy claims and claims and Net invest- losses and policy Other Prem- acquisi- loss Unearned benefits Premium ment settlement acquisi- operating iums tion costs expenses premiums payable revenue income expenses tion costs expenses written ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (In millions) Risk Management Property and Ca- sualty.......... $ 164.9 $2,597.3 $834.9 $ 10.5 $1,966.3 $228.9 $1,493.7 $379.7 $187.1 $1,955.1 Corporate Risk Management Services........ 2.6 358.1 5.2 10.9 336.0 20.7 248.9 3.2 185.6 -- Retirement and Asset Accumulation Allmerica Finan- cial Services... 993.1 2,663.1 3.1 823.8 2.7 253.1 219.3 69.6 211.6 -- Allmerica Asset Management...... 0.6 -- -- 1,791.8 -- 111.4 89.3 0.3 8.4 -- Corporate........ -- -- -- -- -- 11.9 -- -- 63.8 -- Eliminations..... -- -- -- -- -- (1.8) -- -- (7.6) -- -------- -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $1,161.2 $5,618.5 $843.2 $2,637.0 $2,305.0 $624.2 $2,051.2 $452.8 $648.9 $1,955.1 ======== ======== ====== ======== ======== ====== ======== ====== ====== ========
44 Schedule III (continued) ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1997
Future policy Amortiza- benefits, Other Benefits, tion of Deferred losses, policy claims, deferred policy claims and claims and Net invest- losses and policy Other Prem- acquisi- loss Unearned benefits Premium ment settlement acquisi- operating iums tion costs expenses premiums payable revenue income expenses tion costs expenses written ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (In millions) Risk Management Property and Ca- sualty.......... $167.2 $2,615.4 $838.3 $ 10.8 $1,953.1 $253.3 $1,445.5 $399.9 $198.4 $1,991.8 Corporate Risk Management Services........ 2.9 331.4 6.3 9.2 333.0 23.1 238.9 3.3 136.8 -- Retirement and Asset Accumulation Allmerica Finan- cial Services... 794.5 2,476.9 2.2 847.5 24.9 281.6 256.1 8.1 217.8 -- Allmerica Asset Management...... 0.9 -- -- 985.2 0.1 82.5 64.2 0.5 8.0 -- Corporate........ -- -- -- -- -- 14.0 -- -- 64.1 -- Eliminations..... -- -- -- -- -- (1.1) -- -- (11.5) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $965.5 $5,423.7 $846.8 $1,852.7 $2,311.1 $653.4 $2,004.7 $411.8 $613.6 $1,991.8 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
45 Schedule III (continued) ALLMERICA FINANCIAL CORPORATION Supplementary Insurance Information December 31, 1996
Future policy Amortiza- benefits, Other Benefits, tion of Deferred losses, policy claims, deferred policy claims and claims and Net invest- losses and policy Other Prem- acquisi- loss Unearned benefits Premium ment settlement acquisi- operating iums tion costs expenses premiums payable revenue income expenses tion costs expenses written ---------- ---------- -------- ---------- -------- ----------- ---------- ---------- --------- -------- (In millions) Risk Management Property and Ca- sualty.......... $164.2 $2,744.1 $815.1 $ 12.8 $1,898.3 $233.2 $1,383.4 $396.6 $195.1 $1,914.4 Corporate Risk Management Services........ 2.9 299.0 4.7 11.1 302.9 22.1 211.3 3.1 128.0 -- Retirement and Asset Accumulation Allmerica Finan- cial Services... 654.7 2,514.7 2.7 935.2 35.1 311.2 273.1 57.3 154.3 -- Allmerica Asset Management...... 0.9 -- -- 1,101.3 -- 101.5 89.2 0.5 9.3 -- Corporate........ -- -- -- -- -- 5.5 -- -- 64.9 -- Eliminations..... -- -- -- -- -- (0.9) -- -- (12.7) -- ------ -------- ------ -------- -------- ------ -------- ------ ------ -------- Total........... $822.7 $5,557.8 $822.5 $2,060.4 $2,236.3 $672.6 $1,957.0 $457.5 $538.9 $1,914.4 ====== ======== ====== ======== ======== ====== ======== ====== ====== ========
46 Schedule IV ALLMERICA FINANCIAL CORPORATION Reinsurance December 31,
Assumed Percentage Ceded to From of Amount Gross Other Other Net Assumed Amount Companies Companies Amount to Net --------- --------- --------- --------- ---------- (In millions) 1998 Life insurance in force..... $44,790.9 $23,886.9 $555.4 $21,459.4 2.59% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 73.8 $ 13.9 $ 3.8 $ 63.7 5.97% Accident and health insurance................ 342.8 175.9 108.1 275.0 39.31% Property and casualty insurance................ 1,967.9 66.1 64.5 1,966.3 3.28% --------- --------- ------ --------- Total premiums.............. $ 2,384.5 $ 255.9 $176.4 $ 2,305.0 7.65% ========= ========= ====== ========= ===== 1997 Life insurance in force..... $44,902.9 $ 7,237.1 $308.9 $37,974.7 0.81% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 70.0 $ 15.6 $ 8.7 $ 63.1 13.79% Accident and health insurance................ 347.4 154.5 102.0 294.9 34.59% Property and casualty insurance................ 2,046.2 195.1 102.0 1,953.1 5.22% --------- --------- ------ --------- Total premiums.............. $ 2,463.6 $ 365.2 $212.7 $ 2,311.1 9.20% ========= ========= ====== ========= ===== 1996 Life insurance in force..... $41,943.1 $ 7,135.8 $559.2 $35,366.5 1.58% ========= ========= ====== ========= ===== Premiums: Life insurance............ $ 72.0 $ 18.1 $ 5.9 $ 59.8 9.87% Accident and health insurance................ 317.1 120.8 81.9 278.2 29.44% Property and casualty insurance................ 2,018.5 232.6 112.4 1,898.3 5.92% --------- --------- ------ --------- Total premiums.............. $ 2,407.6 $ 371.5 $200.2 $ 2,236.3 8.95% ========= ========= ====== ========= =====
47 Schedule V ALLMERICA FINANCIAL CORPORATION Valuation and Qualifying Accounts December 31,
Additions --------------------- Deductions Balance at Charged to Charged to from Balance at Beginning of Costs and Other Allowance End of Period Expense Accounts Account Period ------------ ---------- ---------- ---------- ---------- (In millions) 1998 Mortgage loans.......... $20.7 $(6.8) $-- $ 2.4 $11.5 Allowance for doubtful accounts............... 6.1 4.4 -- 5.1 5.4 ----- ----- ---- ----- ----- $26.8 $(2.4) $-- $ 7.5 $16.9 ===== ===== ==== ===== ===== 1997 Mortgage loans.......... $19.6 $ 2.5 $-- $ 1.4 $20.7 Real estate............. 14.9 6.0 -- 20.9 -- Allowance for doubtful accounts............... 4.5 5.7 -- 4.1 6.1 ----- ----- ---- ----- ----- $39.0 $14.2 $ -- $26.4 $26.8 ===== ===== ==== ===== ===== 1996 Mortgage loans.......... $33.8 $ 5.5 $-- $19.7 $19.6 Real estate............. 19.6 -- -- 4.7 14.9 Allowance for doubtful accounts............... 4.6 6.8 -- 6.9 4.5 ----- ----- ---- ----- ----- $58.0 $12.3 $ -- $31.3 $39.0 ===== ===== ==== ===== =====
48 Schedule VI ALLMERICA FINANCIAL CORPORATION Supplemental Information Concerning Property and Casualty Insurance Operations For the Years Ended December 31,
Discount, if Reserves for any, Deferred Losses and Deducted Policy Loss from Net Net Acquisition Adjustment Previous Unearned Premiums Investment Affiliation with Registrant Costs Expenses(2) Column(1) Premiums(2) Earned Income - --------------------------- ----------- ------------ ------------ ----------- -------- ---------- (In millions) Consolidated Property and Casualty Subsidiaries 1998.................... $164.9 $2,597.3 $-- $834.9 $1,966.3 $228.9 ====== ======== ==== ====== ======== ====== 1997.................... $167.2 $2,615.4 $-- $838.3 $1,953.1 $253.3 ====== ======== ==== ====== ======== ====== 1996.................... $164.2 $2,744.1 $-- $815.1 $1,898.3 $233.2 ====== ======== ==== ====== ======== ======
Amortization Losses and Loss of Deferred Paid Losses Adjustment Expenses Policy and Loss Net ------------------------ Acquisition Adjustment Premiums Current Year Prior Years Expenses Expenses Written ------------ ----------- ------------ ----------- -------- 1998.............. $1,609.0 $(127.2) $379.7 $1,514.9 $1,955.1 ======== ======= ====== ======== ======== 1997.............. $1,564.1 $(127.9) $399.9 $1,507.2 $1,991.8 ======== ======= ====== ======== ======== 1996.............. $1,513.3 $(141.4) $396.6 $1,387.2 $1,914.4 ======== ======= ====== ======== ========
- -------- (1) The Company does not employ any discounting techniques. (2) Reserves for losses and loss adjustment expenses are shown gross of $591.7 million, $576.7 million and $626.9 million of reinsurance recoverable on unpaid losses in 1998, 1997 and 1996, respectively. Unearned premiums are shown gross of prepaid premiums of $37.9 million, $30.0 million and $45.5 million in 1998, 1997 and 1996, respectively. 49 EX-10.30 2 DEFERRAL AGREEMENT EXHIBIT 10.30 DEFERRAL AGREEMENT ------------------ This Deferral Agreement is entered into this as of the 30th day of January, 1998, and is between _____________ (hereinafter referred to as "XX") and ALLMERICA FINANCIAL CORPORATION, Worcester, Massachusetts (hereinafter referred to as the "Company"). This Agreement is entered into before XX has any right, title or interest in the shares of the Company (the "Shares") which are the subject matter of this Deferral Agreement. The Shares will, for a period of three years, be restricted in accordance with the terms and conditions of a certain Restricted Stock Agreement between the Company and XX dated as of January 30, 1998 (the "Restricted Stock Agreement") and a certain Converted Stock Agreement between the Company and XX dated as of January 30, 1998 (the "Converted Stock Agreement"). XX and the Company wish to defer XX's receipt of some or all of the Shares if at the time the restrictions under the Restricted Stock Agreement and the Converted Stock Agreement lapse XX is or in the sole opinion of the Company may be a "covered employee" as that term is currently or as it may be defined in Internal Revenue Code Section 162(m) (a "Covered Employee"). The Shares (or some of the Shares) will only be distributed to XX if distributing the Shares to XX will not violate the provisions of IRC Section 162(m)(1). The Shares (or some of the Shares) will be distributed to XX as soon as the Shares can be distributed to XX without a violation of Section 162(m)(1). ARTICLE I --------- Definitions ----------- 1.01 "Beneficiary" shall mean any person, corporation or trust, or combination of these, last designated by XX in writing and filed with the Company by XX during his lifetime. Any such designation or designations shall be revocable at any time or times, without the consent of any beneficiary, by a written instrument or nomination of beneficiary made by XX and similarly filed with the Company by him during his lifetime. In the absence of living designated beneficiaries, the corpus due hereunder shall be distributed to XX's estate pursuant to the terms hereof in one single distribution. 1.02 "Interest Rate" shall mean the percentage used in determining the amount of Interest each year. The Interest Rate shall be the annual rate the Company is crediting on January 1 of each year for the Fixed Interest Account under the First Allmerica Financial Life Insurance Company 401(k) Plan. "Interest" shall mean the amount credited to any Dividends, accrued interest or other cash sums payable in connection with the Shares and deferred pursuant to the terms of this Deferral Agreement. 1.03 "Account" shall mean a special memorandum account created by the Company on its books. 1.04 "Dividends" shall mean any dividends declared in connection with the Shares. 1.05 "Deferred Corpus" shall mean the Shares XX is entitled to receive under the Restricted Stock Agreement, the Converted Stock Agreement, the Deferred Amount and any other cash payments and interest thereon made in connection with the Shares. The Company, in its sole discretion, may convert the Shares and/or the Deferred Amount to cash and defer cash in lieu of the Shares and/or the Deferred Amount. 1.06 "Deferred Amount" shall mean the Dividends deferred hereunder plus interest accrued on such Dividends compounded annually. In the event the Company, at its sole discretion, purchases additional Shares of the Company's stock with the then existing Deferred Amount and/or any future Dividends, such Shares shall be considered part of the Deferred Amount and as such be subject to the terms and conditions of this Agreement. 1.07 "Internal Revenue Code" shall mean the Internal Revenue Code of 1986 (as amended). 1.08 The singular as used herein shall include the plural, the plural shall refer to the singular, and any pronoun shall refer to any gender when the context so permits. ARTICLE II ---------- Deferred Corpus and Deferred Amount ----------------------------------- 2.01 XX hereby elects to defer in accordance with the terms of this Deferral Agreement the receipt of some or all of the Shares that may be delivered to him in accordance with the terms of the Restricted Stock Agreement and the Converted Stock Agreement. The amount and duration of such deferral shall be as set forth in Article III. XX also agrees that the Company may in its sole discretion convert some or all of the Deferred Amount into additional Shares of Company stock and that such Shares shall be subject to the terms and conditions of this Agreement. 2.02 In addition, XX hereby elects to defer in accordance with the terms of this Deferral Agreement the receipt of any Dividends that may be due him at any time on the Shares. The Company annually, on December 31st of each year, shall credit to the Account an amount of Interest determined by applying the then-prevailing Interest Rate to the Deferred Amount. However, Dividends paid during the then current calendar year shall be credited with Interest only for the amount of time during the then current calendar year that such Dividends were credited to the Account. The Company may at its sole discretion purchase additional Shares of the Company's stock with the Deferred Amount and any future Dividends and construe any such Shares purchased as additional Deferred Corpus subject to the terms and conditions of this Agreement. 2.03 If XX shall die prior to the date this Agreement is terminated, Interest to the extent it may be due shall be credited to the Account until the Deferral Agreement is paid over to the Beneficiary. ARTICLE III ----------- Manner of Payment ----------------- 3.01 If at the time the restrictions under the Restricted Stock Agreement and the Converted Stock Agreement lapse, if XX is a Covered Employee or the Company in its sole discretion believes that XX will be a Covered Employee, the Company and XX hereby agree to defer an amount of Shares that would result in XX not being a Covered Employee or to defer all of the Shares to reduce the impact of Section 162(m) to the Company. The deferral of the Shares will continue until the time when the Company could distribute some or all of the Shares to XX without any negative impact to the Company due to IRC 162(m). If less than all of the Shares are distributed to XX, the -2- Company will distribute to XX the maximum number of Shares that it may distribute to XX without any impact from IRC 162(m). This distribution will occur each year until all deferred Shares and the Deferred Amount have been completely distributed to XX. 3.02 If XX dies while this Agreement is in effect, the Company shall deliver/pay to the Beneficiary the Deferred Corpus on the first day of the year immediately following XX's death. 3.03 In the event XX ceases to be an employee of the Company, or any subsidiary of the Company, for any reason other than death, the Company shall, on the first day of the year following such event, deliver/pay to XX the Deferred Corpus with Interest credited on the Deferred Amount provided the restrictions under the Restricted Stock Agreement and the Converted Stock Agreement have lapsed. In the event XX ceases to be an employee for any reason other than death and the Shares have not or do not vest pursuant to the terms of the Restricted Stock Agreement or the Converted Stock Agreement, the Deferred Amount plus any Interest due will be paid to XX on the first business day in the calendar year following the termination of his employment. ARTICLE IV ---------- Further Provisions ------------------ 4.01 The Shares shall receive the benefit of any stock, securities and/or cash received by shareholders of the Company pursuant to a plan of merger, consolidation, recapitalization or reorganization of the Company. The Shares shall also include any security received as a result of a stock split or stock dividend received by shareholders of the Company. If any cash is received in addition to Dividends, such cash shall also be deferred and be credited with Interest in the same manner as Dividends are credited with Interest. Any stock, securities and/or cash received, in connection with the Shares due to a plan of merger, consolidation, recapitalization, reorganization of the Company and/or as a result of a stock split or stock dividend shall be added to the Deferred Corpus and deferred pursuant to the terms of this Deferral Agreement. Any stock, securities and/or cash received pursuant to this Section shall be considered part of the Shares and shall not vest unless XX becomes vested in the Shares pursuant to the Restricted Stock Agreement and/or the Converted Stock Agreement. 4.02 It is agreed that neither XX nor any other payee hereunder shall have any right to commute, sell, assign, transfer or otherwise convey the right to receive any payments hereunder, which payments and the right thereto are expressly declared to be non-assignable and non-transferrable, and in the event of any attempted assignment or transfer, the Company shall have no liability for failure to recognize any such assignment. 4.03 This Agreement shall be binding upon the parties hereto, their beneficiaries, heirs, executors, administrators or successors. 4.04 This Agreement shall be executed in duplicate counterparts, and each copy shall serve as an original for all purposes, but both counterpart copies shall constitute one and the same agreement. -3- 4.05 All headings set forth in this Agreement are intended for convenience only, and shall not control or affect the meaning, constructions, or effect of this Agreement or of any of the provisions hereof. 4.06 It is understood and agreed that the Deferred Corpus, Deferred Amount and the Account are and shall be owned by the Company and not by XX or by any other payee who shall be entitled to any payments under this Agreement. The Deferred Corpus and the Deferred Amount hereunder shall belong to the Company as part of its funds and for its own use and benefit. A trust is not created by this Agreement, nor shall a constructive trust be imposed. All payments payable and Shares to be distributed under this Agreement to XX or to any other payee shall be made by the Company, and both XX and any other payee always shall be general, unsecured creditors of the Company. All reference in this Agreement to the Account, to the Deferred Corpus and to the Deferred Amount are made herein solely as a means of measuring and determining the amount that the Company is to pay and the number of Shares that the Company is to deliver under this Deferral Agreement. Attest: ALLMERICA FINANCIAL CORPORATION By: - -------------------------- ----------------------------- William J. Cahill, Jr. Name: John F. O'Brien Assistant Secretary --------------------------- Title: President and CEO -------------------------- -------------------------------- XX -4- EX-10.31 3 RESTRICTED STOCK AGREEMENT Exhibit 10.31 ALLMERICA FINANCIAL CORPORATION RESTRICTED STOCK AGREEMENT This Restricted Stock Agreement (the "Agreement") is made as of this 30th day of January, 1998, by and between ALLMERICA FINANCIAL CORPORATION, a Delaware corporation (the "Company"), and __________________ ("the Participant"). P R E A M B L E WHEREAS, pursuant to the terms of the Allmerica Financial Corporation Long Term Stock Incentive Plan (the "Plan"), the Committee (as defined in the Plan) has agreed to give to the Participant subject to the terms and conditions of the Plan and this Agreement, one share of the Company's common stock (the "Match Shares") for each share of common stock that the Participant purchases on the open market between February 11 and March 13, 1998 (the "Open Market Shares"), receives through the conversion of some or all of his future Long Term Incentive Compensation Payments (the "Converted Shares"), and/or purchases on the terms and conditions set forth below from the Plan on or before March 13, 1998 at a price of $52.625 per share (the "Plan Shares") up to an aggregate maximum of ______ shares (the Open Market Shares, the Converted Shares and the Plan Shares hereinafter in the aggregate referred to as the "Acquired Shares"); WHEREAS, notwithstanding the acquisition of Open Market Shares and/or Converted Shares, the Participant may acquire, on the terms and conditions set forth below, up to ______ Plan Shares at a price of $52.625; and, WHEREAS, the Match Shares will be subject to certain restrictions on sale and transfer and other terms and conditions as set forth in this Agreement. NOW, THEREFORE, for and in consideration of the foregoing and the mutual covenants and promises hereinafter set forth, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto agree as follows: 1. Transfer of Match Shares. The Company will transfer to Participant ------------------------ a certificate representing the Match Shares in an amount equal to the Acquired Shares, provided the Participant has delivered to the Company the following: a) a fully executed copy of this Agreement; b) a check in the amount of $_________ which check represents the sum of $52.625 times the number of shares the Participant will purchase from the Plan. The Participant has elected to purchase ______ shares from the Plan. All Plan Shares will be considered Acquired Shares and be subject to the provisions of paragraph 3. Thus, even if Participant has acquired Converted Shares and/or Open Market Shares, Plan Shares will be considered Acquired Shares before Converted Shares or Open Market Shares are considered Acquired Shares. To the extent Plan Shares do not equal the maximum Match Share award, Participant may allocate Converted Shares and/or Open Market Shares as Acquired Shares; c) if Converted Shares are to be counted as Acquired Shares, a fully executed copy of a certain Allmerica Financial Corporation Converted Stock Agreement dated January 30, 1998 signed by the Participant in connection with the Converted Shares; and/or d) if Open Market Shares are to be counted as Acquired Shares, evidence acceptable to the Company that the Participant has acquired Open Market Shares and the amount of the Open Market Shares acquired. Based upon the foregoing, the Participant shall receive a certificate representing _______ Match Shares. 2. Vesting and Company's Right to a Return of the Match Shares. ----------------------------------------------------------- (a) Vesting. The Match Shares shall be one hundred (100%) ------- percent vested on the date the Participant has completed three (3) additional years of active service with the Company or one of its subsidiaries or affiliates (the Company and its subsidiaries and affiliates hereinafter referred to as "Allmerica"). The three (3) years of additional active service will commence on the date of this Agreement and be determined pursuant to the terms of this Agreement. (b) Termination. Upon the termination of Participant's ----------- employment with Allmerica for whatever reason, whether with or without cause, for good reason or otherwise, any non-vested Match Shares shall be returned to the Company for no consideration. (c) Retirement. In the event that the Participant retires prior to ---------- the Match Shares becoming vested, the Match Shares shall be returned to the Company for no consideration. Retirement for purposes of this Agreement shall have the same meaning as it does in the Plan. However, the pro rata vesting provision in the event of retirement or early retirement as set forth in Section 7(d) of the Plan is not applicable to the Match Shares. (d) Disability. In the event Participant is placed in a long ---------- term disability status (as such term is defined in the Plan) then any time during which Participant is in such status shall not be counted in determining whether Participant has provided the required amount of active service for purpose of vesting of the Match Shares. Notwithstanding any provision in the Plan to the contrary, if the Participant's employment with Allmerica is terminated due to disability before the Match Shares are fully vested, the Participant shall return to the Company, for no consideration, the Match Shares. (e) Death. In the event Participant dies prior to the Match Shares ----- becoming fully vested, the Company's right to have the Match Shares returned to the Company for no consideration shall lapse. Thus, notwithstanding any provisions to the contrary in this Agreement, in the event of Participant's death, the Match Shares shall become fully vested. -2- (f) The sale of any portion of the Match Shares. In the event ------------------------------------------- Participant sells, transfers or encumbers all or any portion of the Match Shares before such shares are fully vested, the Match Shares shall be returned to the Company for no consideration. The Participant agrees to inform the Company in the event the Match Shares, or any portion thereof, are sold, transferred or encumbered prior to such shares becoming fully vested. (g) Change of Control. As stated in the Plan, in the event of a ----------------- Change of Control (as defined in the Plan), the Match Shares shall be fully vested. 3. Proof of Ownership. Annually the Participant shall deliver to the ------------------ Company proof that the Participant has not sold, transferred or encumbered at the end of each anniversary of the date Participant received the Match Shares from the Company evidence that Participant owns directly and without any liens or encumbrances the Match Shares and the Acquired Shares. This requirement to deliver proof of ownership of the Match Shares and the Acquired Shares shall continue until the Match Shares are fully vested. If Participant fails to deliver proof that he still owns in his own account the Match Shares and the Acquired Shares, then the Company shall, at its option, be entitled to have the Match Shares returned to the Company for no consideration. The Company shall have this right in the event Participant fails to deliver within thirty (30) days of the respective anniversary evidence that Participant still owns the Match Shares and the Acquired Shares. Evidence of ownership of the Match Shares and the Acquired Shares shall be fulfilled by delivering to the Company a certification in the form of Exhibit A attached hereto. Notwithstanding the foregoing, the Participant may encumber the Open Market Shares and the Plan Shares by giving a security interest in such shares to a lender who finances in whole or in part the Participant's acquisition of the Open Market Shares and/or the Plan Shares. Such purchase money financing will not be a violation of the terms and conditions of this Agreement. Participant shall, at the request of the Company, deliver copies of such financing to the Company. The Company and the Participant hereby acknowledged that the Participant and the Company have entered into one or more Deferral Agreements deferring, or under certain circumstances, deferring the Participant's receipt of the Match Shares (the "Deferral Agreement"). As long as the Deferral Agreement is in effect, the Participant does not need to deliver Exhibit A to one Company but shall deliver Exhibit B. 4. Shares Received in Certain Corporate Transactions. The terms of ------------------------------------------------- this Agreement shall apply to any stock or securities received by Participant in exchange for the Match Shares pursuant to a plan of merger, consolidation, recapitalization or reorganization of the Company. The terms of this Agreement shall also apply to any security received as a result of a stock split or stock dividend with respect to the Match Shares and such securities shall become Match Shares pursuant to the terms of this Agreement. -3- 5. Stock Legend. The Company and Participant agree that all ------------ certificates representing the Match Shares that at any time are subject to the provisions of this Agreement will have endorsed upon them in bold-faced type a legend in substantially the following form: RESTRICTIONS ON THE OWNERSHIP RIGHTS OF THE STOCK REPRESENTED BY THIS CERTIFICATE HAVE BEEN IMPOSED PURSUANT TO A RESTRICTED STOCK AGREEMENT DATED JANUARY 30, 1998. A COPY OF THE RESTRICTED STOCK AGREEMENT IS ON FILE AT THE PRINCIPAL OFFICE OF THE COMPANY AND WILL BE FURNISHED WITHOUT CHARGE TO THE HOLDER OF THIS CERTIFICATE UPON RECEIPT BY THE COMPANY AT ITS PRINCIPAL PLACE OF BUSINESS OF A WRITTEN REQUEST FROM THE HOLDER REQUESTING SUCH COPY. The Company and the Participant agree that as long as the Deferral Agreement is in effect, the Participant will not receive a certificate representing the Match Shares. 6. Notices. Any notice required to be given hereunder will be deemed ------- to be duly given on the date of delivery if delivered in person or on the date of mailing if mailed by registered or certified mail, postage prepaid, return receipt requested, to the party or parties that are to receive such notice at the addresses indicated on the signature page of this Agreement. The address of Participant or the Company may be changed only by giving written notice to the other party of such change of address. 7. Taxes. To the extent the lapse of restrictions results in the ----- receipt of compensation by Participant for tax purposes, the Company shall withhold from any cash compensation then or thereafter payable to Participant any tax required to be withheld by reason thereof. To the extent the Company determines that such cash compensation is or may be insufficient to fully satisfy such withholding requirement, Participant shall deliver to the Company cash in an amount determined by the Company to be sufficient to satisfy any such withholding requirement. The Company will not deliver to the Participant an unrestricted certificate for any Shares until the Participant delivers to the Company cash sufficient to satisfy all withholding requirements imposed on the Company or a subsidiary of the Company. Notwithstanding the foregoing with the consent of the Company, the Participant may sell fully vested Match Shares in an amount necessary to satisfy the Participant's withholding requirement provided the proceeds from such sale are delivered directly to the Company to satisfy Participant's withholding requirements. 8. Stock Power and Retention of Certificates. The Company may require ----------------------------------------- Participant to execute and deliver to the Company a stock power in blank with respect to non-vested Match Shares and may, in its sole discretion, determine to retain possession of or escrow the certificate for the non-vested Match Shares. The Company shall have the right, in its sole discretion, to exercise such stock power in the event that the Company becomes entitled to the non-vested Match Shares pursuant to the terms of this Agreement. Notwithstanding retention of such certificate by the Company, Participant shall have all rights (including dividend and voting rights) with respect to the non-vested Match Shares represented by such certificate. -4- The Company and the Participant agree that as long as the Deferral Agreement is in effect, the provisions of this paragraph are not applicable. 9. Entire Agreement; Counterparts. This Agreement contains the entire ------------------------------ understanding between the parties concerning the subject contained in this Agreement. Except for the Agreement, there are no representations, agreements, arrangements, or understandings, oral or written, between or among the parties hereto, relating to the subject matter of this Agreement, that are not fully expressed herein. This Agreement may be signed in one or more counterparts, all of which shall be considered one and the same agreement. 10. Further Assurances. Each party to this Agreement agrees to perform ------------------ all further acts and to execute and deliver all further documents as may be reasonably necessary to carry out the intent of this Agreement. 11. Severability. In the event that any of the provisions, or portions ------------ thereof, of this Agreement are held to be unenforceable or invalid by any court of competent jurisdiction, the validity and enforceability of the remaining provisions, or portions thereof, will not be affected, and such unenforceable provisions shall be automatically replaced by a provision as similar in terms as may be valid and enforceable. 12. Construction. Whenever used in this Agreement, the singular number ------------ will include the plural, and the plural number will include the singular, and the masculine or neuter gender shall include the masculine, feminine, or neuter gender. The headings of the Sections of this Agreement have been inserted for purposes of convenience and shall not be used for interpretive purposes. 13. Governing Law. This Agreement shall be governed by and construed in ------------- accordance with the laws of the State of Delaware. 14. Successors. The provisions of this Agreement will benefit and will ---------- be binding upon the assigns, successors in interest, personal representatives, estates, heirs and legatees of each of the parties hereto. 15. Specific Performance. Each of the parties hereto acknowledges and -------------------- agrees that in the event of any breach of this Agreement, the nonbreaching parties would be irreparably harmed and could not be made whole by monetary damages. Each of the parties hereto accordingly agrees to waive the defense in any action for injunction or specific performance that a remedy at law would be adequate and that the parties hereto, in addition to any other remedy to which they may be entitled at law or in equity, shall be entitled to an injunction or to compel specific performance of this Agreement. 16. Amendment. This Agreement may only be amended by the written --------- consent of all of the parties to this Agreement at the time of such amendment. -5- 17. Facsimile Signature. The Company may execute this Agreement by ------------------- means of a facsimile signature. IN WITNESS WHEREOF, the parties hereto have entered into this Agreement as of the date first above written. ADDRESS: ALLMERICA FINANCIAL CORPORATION 440 Lincoln Street By: Worcester, MA 01653 ---------------------------------------- Name: Bruce C. Anderson ---------------------------------- Title: Vice President -------------------------------- ADDRESS: Participant --------------------------- -6- Exhibit A MATCH SHARE AND ACQUIRED SHARE CERTIFICATION I, ______________________________, hereby certify to Allmerica Financial Corporation (the "Company") that the Match Shares and the Acquired Shares (as such terms are defined in the certain Restricted Stock Agreement between the Company and the undersigned dated January 30, 1998) are still owned directly by me and that during the period following my acquisition of such Shares I have not transferred or encumbered in any manner the Match Shares or any Converted Shares which are considered Acquired Shares (as defined in the Agreement). I also hereby certify that the Open Market Shares, if any, that I have and the Plan Shares are still owned directly by me and such shares are not encumbered, except to the extent I pledged such shares as security for a loan that was used to acquire the Open Market Shares and/or the Plan Shares. This Certification is given under the penalties of perjury. ------------------------------------ Participant Date: ------------------------------- Exhibit B PLAN SHARE CERTIFICATION I, ______________________________, hereby certify to Allmerica Financial Corporation (the "Company") that the Plan Shares (as such term is defined in the certain Restricted Stock Agreement between the Company and the undersigned dated January 30, 1998) are still owned directly by me and that during the period following my acquisition of such Shares I have not transferred or encumbered the Plan Shares except to the extent I pledged such shares as security for a loan that was used to acquire the Plan Shares. This Certification is given under the penalties of perjury. ------------------------------- Participant Date: -------------------------- EX-10.32 4 CONVERTED STOCK AGREEMENT Exhibit 10.32 ALLMERICA FINANCIAL CORPORATION CONVERTED STOCK AGREEMENT This Converted Stock Agreement (the "Agreement") is made as of this 30th day of January, 1998, by and between ALLMERICA FINANCIAL CORPORATION, a Delaware corporation (the "Company"), and _______________ ("the Participant"). P R E A M B L E WHEREAS, pursuant to the terms of the Allmerica Financial Corporation Long Term Stock Incentive Plan (the "Plan"), the Committee (as defined in the Plan) has agreed to give to the Participant subject to the terms and conditions of the Plan and this Agreement, one share of the Company's common stock for each $39.47 of the second and/or third installment of the 1997 Allmerica Financial Long-Term Performance Unit Plan (the "1997 Awards") and/or the third installment of the 1996 Allmerica Financial Long-Term Performance Unit Plan (the "1996 Award") that the Participant elects to convert into Allmerica Financial Corporation stock (the "Restricted Stock") up to a maximum of _______ shares. WHEREAS, the Restricted Stock will be subject to certain restrictions on sale and transfer and other terms and conditions as set forth in this Agreement. NOW, THEREFORE, for and in consideration of the foregoing and the mutual covenants and promises hereinafter set forth, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto agree as follows: 1. Transfer of Restricted Stock. The Company will transfer to Participant ---------------------------- a certificate representing _______ shares of Restricted Stock which certificate reflects the amount of his 1997 Award and 1996 Award that the Participant elected to be converted, provided the Participant has delivered to the Company the following: a) a completed election form in the form attached hereto as Exhibit A; and, b) a fully executed copy of this Agreement. 2. Waiver of Claim. The Participant acknowledges and agrees that to the --------------- extent he converts the 1997 Awards or any portion thereof and/or converts the 1996 Award or any portion thereof, he has irrevocably waived any claim for payment under the 1996 and/or 1997 Allmerica Financial Long-Term Performance Unit Plan to the extent of such election and agrees to look solely to the terms of this Agreement to determine his rights to the Restricted Stock issue in lieu of the 1997 Awards or any portion thereof and/or in lieu of the 1996 Award or any portion thereof. In the event the Participant elects to convert the second and/or third installment of the 1997 Awards in full and/or elects to convert the 1996 Award in full and such conversion(s) result in the award of partial share(s), such conversion(s) will be rounded up to the next full share. To the -1- extent the Participant elects to convert any installment in part, such conversion(s) shall be rounded downward to the next whole share amount. 3. Vesting and Company's Right to a Return of the Restricted Stock. --------------------------------------------------------------- (a) Vesting. The Restricted Stock shall be one hundred (100%) percent ------- vested on the date the Participant has completed three (3) additional years of active service with the Company or one of its subsidiaries or affiliates (the Company and its subsidiaries and affiliates hereinafter referred to as "Allmerica"). The three (3) years of additional active service will commence on the date of this Agreement and be determined pursuant to the terms of this Agreement. (b) Termination. Upon the termination of Participant's employment ----------- with Allmerica for whatever reason, whether with or without cause, for good reason or otherwise, any non-vested Restricted Stock shall be returned to the Company for no consideration. (c) Retirement. In the event that the Participant retires prior to ---------- the Restricted Stock becoming vested, the Restricted Stock shall be returned to the Company for no consideration. Retirement for purposes of this Agreement shall have the same meaning as it does in the Plan. However, the pro rata vesting provision in the event of retirement or early retirement as set forth in Section 7(d) of the Plan is not applicable to the Restricted Stock. (d) Disability. In the event Participant is placed in a long term ---------- disability status (as such term is defined in the Plan) then any time during which Participant is in such status shall not be counted in determining whether Participant has provided the required amount of active service for purpose of vesting of the Restricted Stock. Notwithstanding any provision in the Plan to the contrary, if the Participant's employment with Allmerica is terminated due to disability before the Restricted Stock is fully vested, the Participant shall return to the Company, for no consideration, the Restricted Stock. (e) Death. In the event Participant dies prior to the Restricted ----- Stock becoming fully vested, the Company's right to have the Restricted Stock returned to the Company for no consideration shall lapse. Thus, notwithstanding any provisions to the contrary in this Agreement, in the event of Participant's death, the Restricted Stock shall become fully vested. (f) The sale of any portion of the Restricted Stock. In the event ----------------------------------------------- Participant sells, transfers or encumbers all or any portion of the Restricted Stock before such shares are fully vested, the Restricted Stock shall be returned to the Company for no consideration. The Participant agrees to inform the Company in the event the Restricted Stock, or any portion thereof, is sold, transferred or encumbered prior to such stock becoming fully vested. 4. Proof of Ownership. Annually the Participant shall deliver to the ------------------ Company proof that the Participant has not sold, transferred or encumbered at the end of each anniversary of the date Participant received the Restricted Stock from the Company evidence that Participant owns directly and without any liens or encumbrances the Restricted Stock. This requirement to deliver proof of ownership of the Restricted Stock shall continue until the Restricted Stock is fully vested. If -2- Participant fails to deliver proof that he still owns in his own account the Restricted Stock, then the Company shall, at its option, be entitled to have the Restricted Stock returned to the Company for no consideration. The Company shall have this right in the event Participant fails to deliver within thirty (30) days of the respective anniversary evidence that Participant still owns the Restricted Stock. Evidence of ownership of the Restricted Stock shall be fulfilled by delivering to the Company a certification in the form of Exhibit B attached hereto. Notwithstanding the foregoing, as long as the Restricted Stock is subject to the terms and conditions of a certain Deferral Agreement between the Participant and the Company (the "January 30 Deferral Agreement") the provision of this section shall not be applicable. 5. Shares Received in Certain Corporate Transactions. The terms of this ------------------------------------------------- Agreement shall apply to any stock or securities received by Participant in exchange for the Restricted Stock pursuant to a plan of merger, consolidation, recapitalization or reorganization of the Company. The terms of this Agreement shall also apply to any security received as a result of a stock split or stock dividend with respect to the Restricted Stock and such securities shall become Restricted Stock pursuant to the terms of this Agreement. 6. Stock Legend. The Company and Participant agree that all certificates ------------ representing the Restricted Stock that at any time are subject to the provisions of this Agreement will have endorsed upon them in bold-faced type a legend in substantially the following form: RESTRICTIONS ON THE OWNERSHIP RIGHTS OF THE STOCK REPRESENTED BY THIS CERTIFICATE HAVE BEEN IMPOSED PURSUANT TO A RESTRICTED STOCK AGREEMENT DATED JANUARY 30, 1998. A COPY OF THE RESTRICTED STOCK AGREEMENT IS ON FILE AT THE PRINCIPAL OFFICE OF THE COMPANY AND WILL BE FURNISHED WITHOUT CHARGE TO THE HOLDER OF THIS CERTIFICATE UPON RECEIPT BY THE COMPANY AT ITS PRINCIPAL PLACE OF BUSINESS OF A WRITTEN REQUEST FROM THE HOLDER REQUESTING SUCH COPY. Notwithstanding the foregoing, the Company and the Participant agree that as long as the January 30, 1998 Deferral Agreement is in effect, the Participant shall not receive a certificate for the Restricted Stock. 7. Notices. Any notice required to be given hereunder will be deemed to ------- be duly given on the date of delivery if delivered in person or on the date of mailing if mailed by registered or certified mail, postage prepaid, return receipt requested, to the party or parties that are to receive such notice at the addresses indicated on the signature page of this Agreement. The address of Participant or the Company may be changed only by giving written notice to the other party of such change of address. 8. Taxes. To the extent the lapse of restrictions results in the receipt ----- of compensation by Participant for tax purposes, the Company shall withhold from any cash compensation then or thereafter payable to Participant any tax required to be withheld by reason thereof. To the extent the Company determines that such cash compensation is or may be insufficient to fully satisfy such withholding requirement, Participant shall deliver to the Company cash in an amount determined -3- by the Company to be sufficient to satisfy any such withholding requirement. The Company will not deliver to the Participant an unrestricted certificate for any shares until the Participant delivers to the Company cash sufficient to satisfy all withholding requirements imposed on the Company or a subsidiary of the Company. Notwithstanding the foregoing with the consent of the Company, the Participant may sell fully vested shares in an amount necessary to satisfy the Participant's withholding requirement provided the proceeds from such sale are delivered directly to the Company to satisfy Participant's withholding requirements. 9. Stock Power and Retention of Certificates. The Company may require ----------------------------------------- Participant to execute and deliver to the Company a stock power in blank with respect to the Restricted Stock and may, in its sole discretion, determine to retain possession of or escrow the certificate for the Restricted Stock. The Company shall have the right, in its sole discretion, to exercise such stock power in the event that the Company becomes entitled to the non-vested Restricted Stock pursuant to the terms of this Agreement. Notwithstanding retention of such certificate by the Company, Participant shall have all rights (including dividend and voting rights) with respect to the Restricted Stock represented by such certificate. Notwithstanding the foregoing, as long as the January 30, 1998 Deferral Agreement is in effect, this provision shall not be applicable. 10. January 30, 1998 Deferral. The Participant and the Company ------------------------- acknowledge that they have entered into a Deferral Agreement dated January 30, 1998, deferring the Participant's receipt of the Restricted Stock in certain circumstances (the "January 30, 1998 Deferral Agreement"). 11. Entire Agreement; Counterparts. This Agreement contains the entire ------------------------------ understanding between the parties concerning the subject contained in this Agreement. Except for the Agreement, there are no representations, agreements, arrangements, or understandings, oral or written, between or among the parties hereto, relating to the subject matter of this Agreement, that are not fully expressed herein. This Agreement may be signed in one or more counterparts, all of which shall be considered one and the same agreement. 12. Further Assurances. Each party to this Agreement agrees to perform ------------------ all further acts and to execute and deliver all further documents as may be reasonably necessary to carry out the intent of this Agreement. 13. Severability. In the event that any of the provisions, or portions ------------ thereof, of this Agreement are held to be unenforceable or invalid by any court of competent jurisdiction, the validity and enforceability of the remaining provisions, or portions thereof, will not be affected, and such unenforceable provisions shall be automatically replaced by a provision as similar in terms as may be valid and enforceable. 14. Construction. Whenever used in this Agreement, the singular number ------------ will include the plural, and the plural number will include the singular, and the masculine or neuter gender shall include the masculine, feminine, or neuter gender. The headings of the Sections of this Agreement have been inserted for purposes of convenience and shall not be used for interpretive purposes. 15. Governing Law. This Agreement shall be governed by and construed in ------------- accordance with the laws of the State of Delaware. -4- 16. Successors. The provisions of this Agreement will benefit and will be ---------- binding upon the assigns, successors in interest, personal representatives, estates, heirs and legatees of each of the parties hereto. 17. Specific Performance. Each of the parties hereto acknowledges and -------------------- agrees that in the event of any breach of this Agreement, the nonbreaching parties would be irreparably harmed and could not be made whole by monetary damages. Each of the parties hereto accordingly agrees to waive the defense in any action for injunction or specific performance that a remedy at law would be adequate and that the parties hereto, in addition to any other remedy to which they may be entitled at law or in equity, shall be entitled to an injunction or to compel specific performance of this Agreement. 18. Amendment. This Agreement may only be amended by the written consent --------- of all of the parties to this Agreement at the time of such amendment. 19. Facsimile Signature. The Company may execute this Agreement by means ------------------- of a facsimile signature. IN WITNESS WHEREOF, the parties hereto have entered into this Agreement as of the date first above written. ADDRESS: ALLMERICA FINANCIAL CORPORATION 440 Lincoln Street By: Worcester, MA 01653 --------------------------------- Name: John F. O'Brien ------------------------------- Title: President and CEO ------------------------------ ADDRESS: ------------------------------------ Exhibit B RESTRICTED STOCK CERTIFICATION I, ________________________________________________________________, hereby certify to Allmerica Financial Corporation (the "Company") that the Restricted Stock (as that term is defined in the certain Restricted Stock Agreement between the Company and the undersigned dated January 30, 1998) are still owned directly by me and that during the period following my acquisition of the Restricted Stock I have not transferred or encumbered in any manner the Restricted Stock, and that such Shares as of the date of this Certification are owned directly by me without any encumbrances of any kind. This Certification is given under the penalties of perjury. -------------------------------- Participant Date: --------------------------- EX-10.33 5 EMPLOYMENT AGREEMENT (RESTREPO) EXHIBIT 10.33 May 13, 1998 Mr. Robert P. Restrepo, Jr. 6 Kenmore Road Bloomfield, CT 06002 Dear Bob: I am pleased to amend our earlier offer of employment to join Allmerica Financial as President of Allmerica Property and Casualty Companies, Inc. The terms of your employment are as follows: 1. Your annual salary, payable bi-weekly, will be $425,000. Your first performance review date will be 1/1/99 at which time you will be considered for a further salary increase and grant of stock within our Long Term Stock Program. You will also receive an allowance for ground transportation of up to $25,000 per year. 2. You will receive a one time sign-on bonus of $250,000 concurrent with your date of hire. 3. You will be a participant in the 1998 Annual Incentive Compensation Program, with an award target of 75% and 150% as a maximum award of your annualized base salary. You will be guaranteed a 50% award for the 1998 program which amounts to $212,500, with potential for more as generated by the corporate formula applying your target and maximum award potential. We anticipate utilizing the same basic formula for 1999 utilizing our 1999 financial objectives as criteria to measure our accomplishments. Mr. Robert P. Restrepo, Jr. May 13, 1998 Page 2 4. You will be a participant in the Long Term Stock Incentive Plan as indicated below, which includes consideration of the economic value you would relinquish concurrent with your joining Allmerica Financial and your participation as an executive in the 1998 AFC stock programs: a. Receive a 6,000 share grant of restricted stock, concurrent with your employment, with a three year "cliff" vesting requirement, b. Receive a 10,000 grant of restricted stock, concurrent with your employment, with a three year "cliff" vesting requirement, with the understanding that you would purchase an equal number of shares in the open market and hold them for the same three year period. We have made arrangements for the Operating Committee members to secure a personal loan to help meet this requirement if requested, and c. Receive a grant of 50,000 stock options, concurrent with your employment. These options would include the maximum limitation of incentive stock options with the balance being non-qualified stock options, each to utilize a five year, 20%, graded, vesting schedule, with ten years from date of grant to exercise once vested. All options are subject to the provisions of the Stock Option Plan. 5. In the event that Jack O'Brien ceases to be President and CEO, for whatever reason, within three years of your commencing employment with the Company, it is agreed that you have, for any reason, the option within 90 days of his leaving, to terminate your employment, and you would be eligible to receive the following payments: a. You would receive a payment equal to your annualized base salary, projected average annualized incentive compensation and the premium cost of your medical benefits for a period of 12 months, Mr. Robert P. Restrepo, Jr. May 13, 1998 Page 3 b. You would be entitled to have your 6,000 grant of restricted shares and your 10,000 matched restricted stock converted into a cash payment determined in the following manner: Your 16,000 shares of restricted stock would vest on a monthly basis, 1/36 per month, ("Your Vested Amount"). Your Vested Amount would be multiplied at a rate of $65.00 per share. For example at the end of 13 months, you would be vested in 5,778 shares (13/36 of 16,000). That sum would be multiplied by $65.00 resulting in a cash payment of $375,570, c. Your 50,000 grant of options would be fully vested concurrent with your termination from the Company, d. In the event you receive all payments pursuant to paragraph 5, you agree to execute a mutually acceptable severance agreement with the Company. 6. You would become a category 2 participant in the Company's Change of Control program. If you receive benefits under this plan, you would not be entitled to receive the benefits set forth in paragraph 5 above. 7. While we understand that you do not plan to move your residence at this time, you will be eligible for our executive relocation package, should you ultimately find it appropriate to move closer to the company. In the event you decide to move to the greater Worcester area within the first five years of employment, in addition to the executive relocation program, the Company would reimburse you for any losses that you incur equal to one half of your out of pocket losses you incur on the sale of your home. Your original purchase price plus the recent renovation of $200,000, less the then current market value shall determine the amount of your loss, if any. Mr. Robert P. Restrepo, Jr. May 13, 1998 Page 4 8. You will be eligible to participate in Allmerica Financial's benefit programs (including but not limited to Group Medical, Life, Dental, Short and Long Term Disability, 401(k) Match Plan and Cash Balance Plan), in accordance with the eligibility and entrance date requirements for each plan. 9. You will be eligible to earn four (4) weeks vacation annually. 10. You would be eligible to join a country club or other club of your choosing at the expense of Allmerica Financial, such expense to be imputed to you as income. As we discussed this morning, Brooks is proceeding to conduct the normal referencing with individuals provided by you which we hope to have completed by Wednesday, May 13, 1998. We remain very excited about your joining the Allmerica team and look forward to your formal acceptance of our offer. Please do not hesitate to call me at (508) 855-2524 if you have any questions. Sincerely, Bruce C. Anderson EX-10.34 6 RESTRICTED STOCK AGREEMENT (W/ RESTREPO) EXHIBIT 10.34 ALLMERICA FINANCIAL CORPORATION RESTRICTED STOCK AGREEMENT This Restricted Stock Agreement (the "Agreement") is made as of this 26th day of May, 1998, by and between ALLMERICA FINANCIAL CORPORATION, a Delaware corporation (the "Company"), and Robert P. Restrepo, Jr. ("the Participant"). P R E A M B L E WHEREAS, pursuant to the terms of the Allmerica Financial Corporation Long Term Stock Incentive Plan (the "Plan"), the Committee (as defined in the Plan) has agreed to give to the Participant subject to the terms and conditions of the Plan and this Agreement, 6,000 shares of the Company's common stock (the "Shares"); WHEREAS, the Shares will be subject to certain restrictions on sale and transfer and other terms and conditions as set forth in this Agreement; and WHEREAS, the Shares are subject to the terms of a certain Deferral Agreement between the Company and the Participant dated May 26, 1998 (the "Deferral Agreement"). NOW, THEREFORE, for and in consideration of the foregoing and the mutual covenants and promises hereinafter set forth, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto agree as follows: 1. Transfer of Stock. Subject to and in accordance with the terms of the ----------------- Deferral Agreement, the Company will transfer to Participant a certificate representing the Shares. 2. Vesting and Company's Right to a Return of the Shares. ----------------------------------------------------- (a) Vesting. The Shares shall be one hundred (100%) percent vested on ------- the date the Participant has completed three (3) additional years of active service with the Company or one of its subsidiaries or affiliates (the Company and its subsidiaries and affiliates hereinafter referred to as "Allmerica"). The three (3) years of additional active service will commence on the date of this Agreement and be determined pursuant to the terms of this Agreement. (b) Termination. Upon the termination of Participant's employment ----------- with Allmerica for whatever reason, whether with or without cause, for good reason or otherwise, any non-vested Shares shall be returned to the Company for no consideration. (c) Retirement. In the event that the Participant retires prior to ---------- the Shares becoming vested, the Company shall be entitled to have the non-vested Shares shall be returned to the Company for no consideration. Retirement for purposes of this Agreement shall have the same meaning as it does in the Plan. However, the pro rata vesting provision in the event of retirement or early retirement as set forth in Section 7(d) of the Plan shall not be applicable. -1- (d) Disability. In the event Participant is placed in a long term ---------- disability status (as such term is defined in the Plan) then any time during which Participant is in such status shall not be counted in determining whether Participant has provided the required amount of active service for purpose of vesting of the Shares. In addition, if the Participant's employment relationship with Allmerica is terminated due to disability, the Participant shall return to the Company, for no consideration, any non-vested Shares. (e) Death. In the event Participant dies prior to the Shares becoming ----- Fully Vested, the Company's right to have the Shares returned to the Company for no consideration shall lapse. Thus, notwithstanding any provisions to the contrary in this Agreement, in the event of Participant's death, the Shares shall become Fully Vested. (f) The sale of any portion of the Shares. In the event Participant ------------------------------------- sells, transfers or encumbers all or any portion of the non-vested Shares, the non-vested Shares shall be returned to the Company for no consideration. The Participant agrees to inform the Company in the event the non-vested Shares, or any portion thereof, are sold, transferred or encumbered. 3. Proof of Ownership. Annually the Participant shall deliver to the ------------------ Company proof that the Participant has not sold, transferred or encumbered at the end of each anniversary of the date Participant received the Shares from the Company evidence that Participant owns directly and without any liens or encumbrances the non-vested Shares. This requirement to deliver proof of ownership of the non-vested Shares shall continue until the Shares are Fully Vested. If Participant fails to deliver proof that he still owns in his own account the non-vested Shares, then the Company shall, at its option, be entitled to have the non-vested Shares returned to the Company for no consideration. The Company shall have this right in the event Participant fails to deliver within thirty (30) days of the respective anniversary evidence that Participant still owns the non-vested Shares. Evidence of ownership of the non- vested Shares shall be fulfilled by delivering to the Company a certification in the form of Exhibit A attached hereto. As long as the Deferral Agreement is in effect, the Participant does not need to deliver Exhibit A to the Company. 4. Shares Received in Certain Corporate Transactions. The terms of this ------------------------------------------------- Agreement shall apply to any stock or securities received by Participant in exchange for the Shares pursuant to a plan of merger, consolidation, recapitalization or reorganization of the Company. The terms of this Agreement shall also apply to any security received as a result of a stock split or stock dividend with respect to the Shares and such securities shall become Shares pursuant to the terms of this Agreement. -2- 5. Stock Legend. The Company and Participant agree that all certificates ------------ delivered to the Participant representing the Shares that at any time are subject to the provisions of this Agreement will have endorsed upon them in bold-faced type a legend in substantially the following form: RESTRICTIONS ON THE OWNERSHIP RIGHTS OF THE STOCK REPRESENTED BY THIS CERTIFICATE HAVE BEEN IMPOSED PURSUANT TO A RESTRICTED STOCK AGREEMENT DATED MAY 26, 1998. A COPY OF THE RESTRICTED STOCK AGREEMENT IS ON FILE AT THE PRINCIPAL OFFICE OF THE COMPANY AND WILL BE FURNISHED WITHOUT CHARGE TO THE HOLDER OF THIS CERTIFICATE UPON RECEIPT BY THE COMPANY AT ITS PRINCIPAL PLACE OF BUSINESS OF A WRITTEN REQUEST FROM THE HOLDER REQUESTING SUCH COPY. The Company and the Participant agree that as long as the Deferral Agreement is in effect, the Participant will not receive a certificate representing the Shares. 6. Notices. Any notice required to be given hereunder will be deemed to ------- be duly given on the date of delivery if delivered in person or on the date of mailing if mailed by registered or certified mail, postage prepaid, return receipt requested, to the party or parties that are to receive such notice at the addresses indicated on the signature page of this Agreement. The address of Participant or the Company may be changed only by giving written notice to the other party of such change of address. 7. Taxes. To the extent the lapse of restrictions results in the receipt ----- of compensation by Participant for tax purposes, the Company shall withhold from any cash compensation then or thereafter payable to Participant any tax required to be withheld by reason thereof. To the extent the Company determines that such cash compensation is or may be insufficient to fully satisfy such withholding requirement, Participant shall deliver to the Company cash in an amount determined by the Company to be sufficient to satisfy any such withholding requirement. The Company will not deliver to the Participant an unrestricted certificate for any Shares until the Participant delivers to the Company cash sufficient to satisfy all withholding requirements imposed on the Company or a subsidiary of the Company. Notwithstanding the foregoing with the consent of the Company, the Participant may sell fully vested Shares in an amount necessary to satisfy the Participant's withholding requirement provided the proceeds from such sale are delivered directly to the Company to satisfy Participant's withholding requirements. If Participant makes the election authorized by (S)83(b) of the Internal Revenue Code of 1986, as amended, Participant shall submit to the Company a copy of the statement filed by Participant to make such election and, if necessary, deliver to the Company cash in an amount determined by the Company to be due to satisfy any withholding requirements as a result of the (S)83(b) election. 8. Stock Power and Retention of Certificates. The Company may require ----------------------------------------- Participant to execute and deliver to the Company a stock power in blank with respect to the non-vested Shares and may, in its sole discretion, determine to retain possession of or escrow the certificate for the non-vested Shares. The Company shall have the right, in its sole discretion, to exercise such stock power -3- in the event that the Company becomes entitled to the non-vested Shares pursuant to the terms of this Agreement. Notwithstanding retention of such certificates by the Company, Participant shall have all rights (including dividend and voting rights) with respect to the non-vested Shares represented by such certificates. 9. Entire Agreement; Counterparts. This Agreement contains the entire ------------------------------ understanding between the parties concerning the subject contained in this Agreement. Except for the Agreement, there are no representations, agreements, arrangements, or understandings, oral or written, between or among the parties hereto, relating to the subject matter of this Agreement, that are not fully expressed herein. This Agreement may be signed in one or more counterparts, all of which shall be considered one and the same agreement. 10. Further Assurances. Each party to this Agreement agrees to perform ------------------ all further acts and to execute and deliver all further documents as may be reasonably necessary to carry out the intent of this Agreement. The Participant must deliver to the Company a letter certifying the source of Participant's income (the "Side Letter") prior to receipt of the Shares. Failure to adhere to the terms of the Side Letter may affect Participant's right to freely sell fully vested Shares. 11. Severability. In the event that any of the provisions, or portions ------------ thereof, of this Agreement are held to be unenforceable or invalid by any court of competent jurisdiction, the validity and enforceability of the remaining provisions, or portions thereof, will not be affected, and such unenforceable provisions shall be automatically replaced by a provision as similar in terms as may be valid and enforceable. 12. Construction. Whenever used in this Agreement, the singular number ------------ will include the plural, and the plural number will include the singular, and the masculine or neuter gender shall include the masculine, feminine, or neuter gender. The headings of the Sections of this Agreement have been inserted for purposes of convenience and shall not be used for interpretive purposes. 13. Governing Law. This Agreement shall be governed by and construed in ------------- accordance with the laws of the State of Delaware. 14. Successors. The provisions of this Agreement will benefit and will be ---------- binding upon the assigns, successors in interest, personal representatives, estates, heirs and legatees of each of the parties hereto. 15. Specific Performance. Each of the parties hereto acknowledges and -------------------- agrees that in the event of any breach of this Agreement, the nonbreaching parties would be irreparably harmed and could not be made whole by monetary damages. Each of the parties hereto accordingly agrees to waive the defense in any action for injunction or specific performance that a remedy at law would be adequate and that the parties hereto, in addition to any other remedy to which they may be entitled at law or in equity, shall be entitled to an injunction or to compel specific performance of this Agreement. 16. Amendment. This Agreement may only be amended by the written consent --------- of all of -4- the parties to this Agreement at the time of such amendment. 17. Facsimile Signature. The Company may execute this Agreement by means ------------------- of a facsimile signature. IN WITNESS WHEREOF, the parties hereto have entered into this Agreement as of the date first above written. ADDRESS: ALLMERICA FINANCIAL CORPORATION 440 Lincoln Street By: ---------------------------------- Worcester, MA 01653 Name: Bruce C. Anderson -------------------------------- Title: Vice President ------------------------------- ADDRESS: 6 Kenmore Road - ------------------------------ --------------------------------------- Bloomfield CT 06002 Participant Robert P. Restrepo, Jr. - ------------------------------ --------------------------- - ------------------------------ -5- Exhibit A CERTIFICATION I, Robert P. Restrepo, Jr., hereby certify to Allmerica Financial Corporation ------------------------ (the "Company") that the non-vested Shares (as that term is defined in the certain Restricted Stock Agreement between the Company and the undersigned dated May 26, 1998) are still owned directly by me and that during the period following my acquisition of the Shares I have not transferred or encumbered in any manner the non-vested Shares, and that such Shares as of the date of this Certification are owned directly by me without any encumbrances of any kind. This Certification is given under the penalties of perjury. -------------------------------------------- Participant: Robert P. Restrepo, Jr. Date: --------------------------------------- EX-10.35 7 CREDIT AGREEMENT DATED 12/1/98 Exhibit 10.35 [Chase Logo Appears Here] December 1, 1998 Allmerica Financial Corporation 440 Lincoln Street Worcester, Massachusetts 01653 and Citizens Acquisition Corporation c/o Allmerica Financial Corporation Attention: Mr. Edward J. Parry, III Chief Financial Officer Ladies and Gentlemen: The Chase Manhattan Bank ("Lender") is pleased to confirm that it is ------ prepared to make funds available to Allmerica Financial Corporation ("Allmerica") and Citizens Acquisition Corporation ("Citizens Acquisition;" each --------- -------------------- of Allmerica and Citizens Acquisition shall hereinafter be referred to as individually as "Borrower" and collectively as "Borrowers"), subject to the -------- --------- terms and conditions outlined below. Unless otherwise defined herein, capitalized terms used herein shall have the meanings assigned to them in the Note (as defined below). Commitment Lender agrees to make loans in an aggregate principal amount not to exceed at any one time $200,000,000, as such amount may be reduced in part or in whole (the "Commitment"), which loans may ---------- be Eurodollar Loans or Base Rate Loans (collectively, "Committed --------- Loans"). Borrowers may borrow, repay, prepay and reborrow at any ----- time from the date hereof to but excluding June 1, 1999 (the "Availability Period"), subject to the limitations set forth -------------------- herein and in a promissory note (the "Note") substantially in the ---- form of Exhibit B hereto. In addition, the Bank may, in its sole discretion, but shall have no obligation to, make Offered Rate Loans to the Borrower; provided that at no time shall the sum of -------- outstanding Committed Loans and outstanding Offered Rate Loans exceed $200,000,000. Committed Loans and any Offered Rate Loans which the Bank may make (collectively, the "Loans") shall be ----- evidenced by the Note. Purpose proceeds of the Loans will be used to acquire the publicly- - ------- held shares of Citizens Corporation; provided that no part of the proceeds of the Loans will be used in violation of Regulation U of the Board of Governors of the Federal Reserve System of the United States of America. Termination/ Borrowers may upon at least three Banking Days' notice to Reduction of Lender terminate at any time or reduce from time to time, the Commitment unused amount of the Commitment. - ---------- Commitment Fee Borrowers jointly and severally agree to pay a commitment fee, - -------------- which shall accrue on the daily average unused Commitment during the Availability Period at a rate per annum equal to 0.10%, calculated on the basis of a 365/366 day year, for the actual number of days elapsed, and payable quarterly in arrears on the last Banking Day of each calendar quarter and on the effective date of any reduction or termination of the Commitment. Interest Rate; Each Loan shall bear interest as selected by Borrowers and Interest Periods; provided in the Note. Eurodollar Loans shall be available for Maturity interest periods of, at Borrowers' selection, one, two, three - -------- or six months. Offered Rate Loans shall be available for interest periods offered by Lender in its sole discretion and accepted by Borrowers. No interest period may extend beyond June 1, 1999, the date on which all Loans shall finally mature. Drawdowns Borrowers may request a Loan by giving Lender notice by - --------- 11:00 a.m. New York City time (i) on the same Banking Day of a Base Rate Loan or an Offered Rate Loan and (ii) at least three Banking Days' prior to a Eurodollar Loan. Break Funding Borrowers jointly and severally agree to pay Lender on demand - ------------- an amount determined by Lender in good faith to be sufficient (in the reasonable opinion of Lender) to compensate Lender for any loss, cost or expense that Lender determines is attributable to the failure by Borrowers to borrow a Eurodollar Loan or Offered Rate Loan on the date specified in the notice to borrow such Loan. Without limiting the effect of the preceding sentence, such compensation shall include an amount equal to the excess, if any, of (i) the amount of interest which would have accrued on the principal amount of such Loan had Borrowers not failed to borrow such Loan for the period from the date of such failure to borrow to the last day of the interest period that would have been the Interest Period for such Loan) over (ii) the amount of interest which would accrue on such principal amount for such period at the interest rate which Lender would bid were it to bid, at the commencement of such period, for dollar deposits of a comparable amount and period from other banks in the London interbank market (as reasonably determined by Lender), or if Lender shall cease to make such bids, the equivalent bid rate, as reasonably determined by Lender, derived from display page 3750 (British Bankers Association - LIBOR) of the Dow Jones Markets (Telerate) Screen (or any successor or substitute therefor). Conditions The obligation of Lender to make Committed Loans to Borrowers of Lending is subject to the conditions precedent that: (a) in the case - ---------- of the initial Committed Loan, Lender shall have received (i) the Note duly executed and delivered by Borrowers as joint 2 and several obligors, (ii) a corporate borrowing resolution certified by each Borrower's Secretary or Assistant Secretary, (iii) an incumbency certificate of each Borrower's Secretary or Assistant Secretary setting forth the names, titles and true signatures of such Borrower's officers authorized to sign this Agreement and the Note, (iv) an opinion of counsel to Borrowers substantially in the form of Exhibit A hereto, (v) in the case of the initial Committed Loan, a certificate signed by a duly authorized officer of Allmerica, dated the date of such Loan, certifying that since December 31, 1997, there has been no material adverse change in the condition (financial or otherwise), business or operations of Allmerica and its subsidiaries on a consolidated basis or the ability of Allmerica to pay its obligations hereunder or under the Note, and (b) in the case of any Committed Loan, no default or Event of Default under this Agreement or the Note has occurred and is continuing, or would result from the making of such Loan and (c) in the case of any Committed Loan which increases the aggregate principal amount of Committed Loans outstanding immediately prior to the making of such Committed Loan, the fact that the statement referred to in clause (a)(v) above is true on the date of such Committed Loan. Borrowers' request for a Committed Loan and acceptance of the proceeds thereof shall each constitute a representation and warranty that the statements in clauses (b) and (c) above are true and correct both as of the date of such request and as of the date of such Committed Loan. Representations Each Borrower hereby represents and warrants as to itself and Warranties that: (a) this Agreement and the Note when delivered will be - -------------- the legal, valid and binding obligations of such Borrower enforceable against such Borrower in accordance with their terms, except to the extent that such enforcement may be limited by applicable bankruptcy, insolvency and other similar laws affecting creditors' rights generally, and (b) the execution, delivery and performance by such Borrower of this Agreement and the Note have been authorized by all necessary corporate action and do not and will not contravene such Borrower's charter or by-laws or any applicable law or any contractual provision binding on or affecting such Borrower. In addition, Allmerica hereby makes the representations and warranties contained in Section 7 of that certain Credit Agreement dated as of May 29, 1998 among Allmerica, the Lenders signatory thereto, the Bank, as Administrative Agent, and Fleet National Bank, as Co-Agent (the "Existing Credit -------- ------ Agreement"), which provisions, together with the related --------- definitions, as in effect on the date hereof are hereby incorporated herein by reference (mutatis mutandis) for the ------- -------- benefit of Lender and shall continue for the purposes of this Agreement regardless of the termination of the Existing Credit Agreement or Lender's participation therein, or any amendment of, or any consent to any deviation from or other modification of, the Existing Credit Agreement; provided that references in -------- Section 7 of the Existing Credit Agreement to (i) the "Agreement" and "Lenders" and (ii) "Administrative Agent" shall be deemed to mean this Agreement and Lender, respectively. Covenants So long as this Agreement shall remain in effect and until the - --------- Commitment has been terminated and all amounts owing hereunder and the Note shall have been paid in full, Allmerica shall (a) comply with and be bound by the covenants contained in Section 8 of the Existing Credit Agreement, which provisions, together with the related definitions, as in effect on the date hereof are hereby incorporated herein by 3 reference (mutatis mutandis) for the benefit of Lender and ------- -------- shall continue for the purposes of this Agreement regardless of the termination of the Existing Credit Agreement or Lender's participation therein, or any amendment of, or any consent to any deviation from or other modification of, the Existing Credit Agreement; provided that references in Section -------- 8 of the Existing Credit Agreement to (i) the "Administrative Agent" or "Lender(s)," (ii) "Loans" and (iii) "Default" shall be deemed to mean Lender, Loans and a default hereunder or under the Note, respectively. Indemnity The Borrowers, jointly and severally agree to indemnify Lender - --------- against, and hold Lender harmless from, any and all losses, claims, damages, liabilities and related expenses, including the reasonable fees, charges and disbursements of any counsel for Lender, incurred by or asserted against Lender arising out of, in connection with, or as a result of (i) the execution or delivery of this Agreement or any agreement or instrument contemplated hereby, the performance by the parties hereto of their respective obligations hereunder or the consummation of the transactions contemplated hereby, (ii) any Loan or the use of the proceeds therefrom, or (iii) any actual or prospective claim, litigation, investigation or proceeding relating to any of the foregoing, whether based on contract, tort or any other theory and regardless of whether Lender is a party thereto; provided that such indemnity shall not, as to Lender, be -------- available to the extent that such losses, claims, damages, liabilities or related expenses resulted from the gross negligence or wilful misconduct of Lender. Default Events which may cause the acceleration of the maturity of any - ------- Loan ("Events of Default") are specified in the Note. Lender ----------------- may terminate the Commitment upon the occurrence of any Event of Default, but it shall terminate immediately upon the occurrence of any "bankruptcy" or "insolvency" Event of Default. Joint and Several Each Borrower hereby accepts joint and several liability for Liability the obligations under this Agreement in consideration of the - --------- financial accommodation provided by the Bank hereunder and agrees that if and to the extent that a Borrower shall fail to make any payment due hereunder as and when due in accordance with the terms hereof, then the other Borrower will make such payment. The liability of each Borrower hereunder is absolute and unconditional irrespective of any defense, setoff or counterclaim with respect to this Agreement and the Note and the transactions contemplated thereby which might constitute a defense available to, or discharge of, a Borrower or a guarantor. Governing Law; This Agreement shall be governed by the laws of the State of Jurisdiction New York. Borrowers consent to the nonexclusive jurisdiction - ------------ and venue of the state and federal courts located in the City of New York. Service of process by Lender in connection with any dispute hereunder shall be binding on Borrowers if sent to Borrowers by registered mail at the address specified therefor in the Note. EACH BORROWER AND LENDER WAIVES, TO THE FULLEST EXTENT PERMITTED BY LAW, ANY RIGHT IT MAY HAVE TO JURY TRIAL IN ANY LEGAL PROCEEDING DIRECTLY OR INDIRECTLY 4 ARISING OUT OF OR RELATING TO THIS AGREEMENT, THE NOTE OR TRANSACTIONS CONTEMPLATED HEREBY (WHETHER BASED ON CONTRACT, TORT OR ANY OTHER THEORY). Very truly yours, THE CHASE MANHATTAN BANK By: -------------------------------------- Name: Title: Agreed and Accepted: ALLMERICA FINANCIAL CORPORATION By: -------------------------------------- Name: Title: CITIZENS ACQUISITION CORPORATION By: -------------------------------------- Name: Title: 5 EXHIBIT A (Letterhead of counsel to the Borrowers) [Date of Initial Borrowing] The Chase Manhattan Bank 270 Park Avenue New York, New York 10017 Ladies and Gentlemen: We have acted as counsel to Allmerica Financial Corporation and Citizens Acquisition Corporation (the "Borrowers") in connection with the --------- execution and delivery of that certain Letter Agreement (the "Letter Agreement") ---------------- dated as of December 1, 1998 between the Borrowers and The Chase Manhattan Bank (the "Lender") and the Note (as defined in the Letter Agreement; the Note ------ together with the Letter Agreement, the "Facility Documents") executed by the ------------------ Borrowers in connection with the Letter Agreement. Except as otherwise defined herein, all terms used herein and defined in the Letter Agreement, the Note or any agreement delivered thereunder shall have the meanings assigned to them therein. In rendering the opinions expressed below, we have examined the Facility Documents. We have also examined such certificates, documents and records, and have made such examination of law, as we have deemed necessary to enable us to render the opinions expressed below. In addition, we have examined and relied as to matters of fact upon representations and warranties contained in the Facility Documents and in certificates and upon covenants contained in the Facility Documents as to the application of the proceeds of the loans made pursuant thereto. We call your attention to the fact that each of the Facility Documents provides that it is to be governed by and construed in accordance with the laws of the State of New York, and we understand that you are relying on the advice of your own counsel with respect to all matters involving New York law. For purposes of rendering the opinions expressed in paragraph 3 below, we have assumed that each Facility Document is to be governed by and construed in accordance with the internal laws of The Commonwealth of Massachusetts. The opinions expressed below are limited to matters governed by the internal laws of The Commonwealth of Massachusetts, the Federal laws of the United States of America and the Delaware General Corporation Law. The following opinions do not purport to cover matters relating to Regulations T, U or X of the Board of Governors of the Federal Reserve System. In connection with this opinion, we have examined executed copies of the Facility Documents and such other documents, records, agreements and certificates as we have deemed appropriate. We have also reviewed such matters of law as we have considered relevant for the purpose of this opinion. Based upon the foregoing, we are of the opinion that: 1. Each Borrower is a corporation duly incorporated, validly existing and in good standing under the laws of the jurisdiction of its incorporation, has the corporate power and authority to borrow under the Facility Documents and to execute and deliver and to perform is obligations under, the Facility Documents. 6 2. The execution, delivery and performance by each Borrower of the Facility Documents have been duly authorized by all necessary corporate action and do not and will not (a) contravene such Borrower's charter or by-laws, (b) violate any applicable law, rule or regulation of the United States of America, The Commonwealth of Massachusetts or the Delaware General Corporation law, or (c) result in a breach of, constitute a default under, require any consent under, or result in the acceleration or required prepayment of any indebtedness pursuant to the terms of, any agreement or instrument to which such Borrower or any of its Subsidiaries is a party, or by which any of them is bound or to which any of them is subject, and which has been or is required to be filed with the Securities and Exchange Commission, or result in the creation or imposition of any Lien upon any Property of such Borrower pursuant to, the terms of any such agreement or instrument. 3. Each Facility Document is, or when delivered under the Letter Agreement will be, a legal, valid and binding obligation of each Borrower, enforceable against such Borrower in accordance with its terms. Our opinions that each of the Facility Documents being delivered to you today constitute the legal, valid and binding obligation of the Borrowers, enforceable against them in accordance with its terms, are subject to (a) bankruptcy, insolvency, reorganization, moratorium and other laws of general application affecting the rights and remedies of creditors and secured parties and (b) general principles of equity, regardless of whether enforcement is sought in proceedings in equity or at law. We express no opinion with respect to the applicability of Section 548 of the Bankruptcy Code or any other fraudulent conveyance provision. In particular, we express no opinion as to whether a subsidiary may guarantee or otherwise become liable for, or pledge its assets to secure, indebtedness incurred by its parent or another subsidiary of its parent, except to the extent such subsidiary may be determined to have received a benefit from the incurrence of such indebtedness by its parent or such other subsidiary, or as to whether such benefit may be measured other than by the extent to which the proceeds of the indebtedness incurred by the parent or such other subsidiary are directly or indirectly made available to such subsidiary for its corporate purposes. We call your attention to the fact that certain cases have held that an obligation of a corporation incurred to purchase a corporation's stock may under certain circumstances become subordinate to the claims of general creditors upon the bankruptcy or insolvency of the corporation. The foregoing opinions are subject to the following comments and qualifications: (A) The enforceability of the Facility Documents may be limited by laws rendering unenforceable indemnification contrary to Federal or state securities laws and the public policy underlying such laws. (B) The enforceability of provisions in the Facility Documents to the effect that terms may not be waived or modified except in writing may be limited under certain circumstances (C) We express no opinion as to (i) the effect of the laws of any jurisdiction in which the Lender is located that limit the interest, fees or other charges the Lender may impose and (ii) the second sentence of the section of the Letter Agreement captioned "Governing Law; Jurisdiction" and the first sentence of Section 5(e) of the Note, insofar as such sentences relate to the subject matter jurisdiction of the United States District Court for the Southern District of New York to adjudicate any controversy related to the Facility Documents. 7 The foregoing opinion is solely for your benefit and may not be relied on by any other Person. Very truly yours, 8 EXHIBIT B [Chase Logo Appears Here] PROMISSORY NOTE New York, New York December 1, 1998 FOR VALUE RECEIVED, ALLMERICA FINANCIAL CORPORATION and CITIZENS ACQUISITION CORPORATION (collectively, the "Borrowers"), jointly and severally, --------- unconditionally promises to pay to the order of THE CHASE MANHATTAN BANK (the "Bank"), at its principal office, 270 Park Avenue, New York, New York l0017 (the - ----- "Principal Office"), for the account of the Principal Office (or such other ---------------- office or affiliate as the Bank may from time to time specify), the principal amount of each Loan endorsed on the schedule attached hereto and made a part hereof (including any continuations, the "Schedule") on the maturity date of -------- such Loan as shown on the Schedule, and to pay interest on the unpaid balance of the principal amount of such Loan from and including the date of such Loan (as shown on the Schedule ) to such maturity date at (a) a variable rate per annum equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Prime Rate (such higher rate being the "Base Rate" and such Loan a "Base Rate --------- --------- Loan"); or (b) a fixed rate per annum equal to the Eurodollar Rate applicable to - ---- such Loan (a "Eurodollar Loan"), plus the Applicable Margin; or (c) a fixed rate --------------- per annum as the Bank may in its discretion offer to the Borrowers and the Borrowers may accept (an "Offered Rate Loan"). Any principal not paid when due ----------------- shall bear interest from maturity until paid in full at a rate per annum equal to the Default Rate. Interest shall be payable on the relevant Interest Payment Date. Interest shall be calculated on the basis of a year of 360 days for the actual days elapsed, except that interest computed by reference to the Prime Rate shall be calculated on the basis of a year of 365 days (or 366 days, in the case of a leap year) for the actual days elapsed. All payments hereunder shall be made in lawful money of the United States and in immediately available funds. Any extension of time for the payment of the principal of this note resulting from the due date falling on a non-Banking Day shall be included in the computation of interest. The date, and interest periods of, and the interest rates with respect to, the Loans and any payments of principal shall be recorded by the Bank on its books and prior to any transfer of this note (or, at the discretion of the Bank, at any other time) endorsed by the Bank on the Schedule, which shall be conclusive in the absence of manifest error; provided, however, -------- ------- that the Bank's failure to endorse the Schedule shall not affect the Borrowers' obligations hereunder. 1. Certain Definitions. Unless otherwise defined herein, capitalized ------------------- terms shall have the meanings assigned to them in the Letter Agreement (as defined in Section 2 hereof). As used herein, the following terms shall have the corresponding meanings. (a) "Applicable Margin" means, with respect to any Eurodollar Loan, ----------------- (i) 0.45% for such Eurodollar Loan drawn at or before 12:00 p.m. on December 4, 1998, (ii) 0.60% for such Eurodollar Loan drawn after 12:00 p.m. on December 4, 1998 but at or before 12:00 p.m. on December 18, 1998, (iii) 1.0% for such Eurodollar Loan drawn after 12:00 p.m. on December 18, 1998 but at or before 5:00 p.m. on January 8, 1999 and (iv) 0.45% for such Eurodollar Loan drawn after 8:00 a.m. on January 11, 1999; provided that if Allmerica's short term debt -------- rating from S&P or Moody's shall be reduced from the respective rating from S&P or Moody's in existence on the date hereof at any time during the period from the date hereof until the date of the drawdown of the initial Loan hereunder, the Applicable Margin shall be increased by 0.10%. 9 (b) "Banking Day" means any day on which commercial banks are not ----------- authorized or required to close in New York City and, where such term is used in the definition of "Eurodollar Rate" or refers to the Eurodollar Rate, which is also a day on which dealings in U.S. dollar deposits are carried out in the London interbank market. (c) "Default Rate" means, in respect of any amount not paid when due, ------------ a rate per annum during the period commencing on the due date until such amount is paid in full equal to a floating rate 2% above the Base Rate; provided that, -------- if the amount in default is principal of an Offered Rate Loan or Eurodollar Loan, a fixed rate 2% above the rate of interest in effect thereon (including the margin) at the time of default until the end of the then current interest period therefor and, thereafter, a floating rate 2% above the Base Rate. (d) "Eurodollar Rate" means the rate per annum (rounded upwards, if --------------- necessary, to the nearest 1/100 of 1%) quoted by the Bank at approximately 11:00 a.m. London time (or as soon thereafter as practicable) two Banking Days' prior to the first day of an interest period during which the Eurodollar Rate will accrue for the offering by the Bank to leading banks in the London interbank market of U.S. dollar deposits having a term comparable to such loan and in an amount comparable to the principal amount of such loan. (e) "Federal Funds Rate" means, for any day, the rate per annum ------------------ (expressed on a 360 day basis of calculation) equal to the weighted average of the rates on overnight Federal funds transactions as published by the Federal Reserve Bank of New York for such day (or for any day that is not a Banking Day, for the immediately preceding Banking Day). (f) "Interest Payment Date" means for any loan hereunder, the first --------------------- day commencing after such loan as follows: (i) for any Base Rate Loan, the last Banking Day of each March, June, September and December; (ii) for any Offered Rate Loan, at 90-day intervals; (iii) for any Eurodollar Loan, at three-month intervals; (iv) for any amount accruing interest at the Default Rate, on demand; and (v) for any amount, upon maturity and any prepayment or repayment. (g) "Prime Rate" means the rate of interest per annum publicly ---------- announced from time to time announced by the Bank as its prime rate in effect at the Principal Office; each change in the Prime Rate shall be effective from and including the date such change is publicly announced as being effective. (h) "Regulatory Change" means any change after the date hereof in ----------------- United States federal, state or foreign laws or regulations (including Regulation D of the Board of Governors of the Federal Reserve System) or the adoption or making after such date of any interpretations, directives or requests applying to a class of banks including the Bank of or under any United States federal or state, or any foreign, laws or regulations (whether or not having the force of law) by any court or governmental or monetary authority charged with the interpretation or administration thereof. 2. Related Letter Agreement. Loans evidenced hereby are made pursuant ------------------------ to that certain letter agreement dated December 1, 1998 between the Bank and the Borrowers (the "Letter Agreement"). ---------------- 3. Additional Costs, Etc. (a) If, as a result of any Regulatory ---------------------- Change, the Bank reasonably determines that the cost to the Bank of making or maintaining any Eurodollar Loan evidenced hereby is increased, or any amount received or receivable by the Bank hereunder is reduced, or the Bank is required to make any payment in connection with any transaction contemplated hereby, then the Borrowers jointly and severally agree to pay to the Bank on demand such additional amount or amounts as the Bank determines will compensate the Bank for such increased cost, reduction or payment. The Bank shall furnish the Borrowers with calculations of such amounts due, in the absence of demonstrable error, shall be conclusive. 10 (b) If there is any payment of a Eurodollar Loan or Offered Rate Loan prior to its stated maturity (by reason of acceleration or otherwise), the Borrowers jointly and severally agree that they will promptly pay the Bank on demand an amount determined by the Bank in good faith sufficient to compensate it for such payment. Without limiting the effect of the preceding sentence, such compensation shall include an amount equal to the excess, if any, of (i) the amount of interest which would have accrued on the principal amount of such Loan had Borrowers not so paid, for the period from the date of such payment to the last day of the current interest period therefor over (ii) the amount of interest which would accrue on such principal amount for such period at the interest rate which Lender would bid were it to bid, at the commencement of such period, for dollar deposits of a comparable amount and period from other banks in the London interbank market (as reasonably determined by Lender), or if Lender shall cease to make such bids, the equivalent bid rate, as reasonably determined by Lender, derived from display page 3750 (British Bankers Association - LIBOR) of the Dow Jones Markets (Telerate) Screen (or any successor or substitute therefor). 4. Events of Default. If any of the following events shall occur and ----------------- be continuing: (a) the Borrowers shall fail to pay the principal of this Note when due; or interest on, or any other amount payable under, this Note, within three Banking Days of when due and payable; (b) any Borrower shall breach any representation or warranty made by it in this Note or the Letter Agreement or any other document executed in connection with this Note (this Note, the Letter Agreement and any such other document being the "Facility Documents") or which ------------------ is contained in any certificate, document, opinion, financial or other statement furnished by such Borrower at any time under or in connection with any Facility Documents shall prove to have been incorrect in any material respect on or as of the date made; (c) Allmerica shall fail to perform or observe any term, covenant or agreement contained in Section 8.04, 8.05, 8.06, 8.08, 8.10 or 8.11 of the Existing Credit Agreement as in incorporated herein by reference pursuant to the section of the Letter Agreement captioned "Covenants"; (d) any Borrower shall fail to perform or observe any term, covenant or agreement (other than the covenants referenced in clause (c) above) contained in any Facility Document and such failure shall continue for 30 days after written notice from the Bank thereof; (e) Allmerica or any of its Subsidiaries (as defined in the Existing Credit Agreement) shall default in the payment when due (after giving effect to any applicable grace periods) of any principal of or interest on any of its other Indebtedness (as defined in the Existing Credit Agreement) aggregating $10,000,000 or more; or any event specified in any note, agreement, indenture or other document evidencing or relating to such Indebtedness shall occur if the effect of such event is to cause, or (with the giving of any notice or the lapse of time or both) to permit the holder or holders of such indebtedness (or a trustee or agent on behalf of such holder or holders) to cause, such Indebtedness to become due, or to be prepaid in full (whether by redemption, purchase, offer to purchase or otherwise), prior to its stated maturity or to have the interest rate thereon reset to a level so that securities evidencing such Indebtedness trade at a level specified in relation to the par value thereof; (f) Allmerica shall fail to pay when due (after giving effect to any applicable grace periods) of any amount aggregating $10,000,000 or more on any of its Rate Hedging Obligations (as defined in the Existing Credit Agreement) or any event specified in any agreement or document relating to any such Rate Hedging Obligations shall occur if the effect of such event is to cause, or (with the giving of notice or the lapse of time or both) to permit, termination or liquidation payment or payments aggregating $10,000,000 or more to become due; (g) Citizens Acquisition or Allmerica or any of its Insurance Subsidiaries (as defined in the Existing Credit Agreement): (i) shall generally not, or be unable to, or shall admit in writing its inability to, pay its debts as its debts become due; (ii) shall make an assignment for the benefit of creditors; (iii) shall file a petition in bankruptcy or for any relief under any law of any jurisdiction relating to reorganization, arrangement, readjustment of debt, dissolution or liquidation; (iv) shall have any such petition filed against it in which an adjudication is made or order for relief is entered or which shall remain undismissed for a period of 60 days or shall consent or acquiesce thereto; (v) shall have had a receiver, custodian or trustee appointed for all or a substantial part of its property; (h) any event described in Sections 9(h), (i), (j), (k) or (l) of the Existing Credit Agreement shall have occurred, THEN, in any such case, if the Bank shall elect by notice to the Borrowers, the unpaid principal amount of this Note, together with accrued interest, shall become 11 forthwith due and payable; provided that in the case of an event of default -------- under clause (g) above, the unpaid principal amount of this Note, together with accrued interest, shall immediately become due and payable without any notice or other action by the Bank. 5. Miscellaneous. (a) Each Borrower hereby accepts joint and several ------------- liability for the obligations under this Note in consideration of the financial accommodation provided by the Bank under the Letter Agreement and agrees that if and to the extent that a Borrower shall fail to make any payment due hereunder as and when due in accordance with the terms hereof, then the other Borrower will make such payment. The liability of each Borrower hereunder is absolute and unconditional irrespective of any defense, setoff or counterclaim with respect to the Letter Agreement and this Note and the transactions contemplated thereby which might constitute a defense available to, or discharge of, a Borrower or a guarantor. (b) Each Borrower waives presentment, notice of dishonor, protest and any other formality with respect to this Note. (c) The Borrowers jointly and severally agree to reimburse the Bank on demand for all costs, expenses and charges (including without limitation, reasonable fees and charges of external legal counsel for the Bank and costs allocated by its internal legal department) in connection with the preparation, interpretation, performance or enforcement of this Note and the Letter Agreement. (d) This Note shall be binding on the Borrowers and their successors and assigns and shall inure to the benefit of the Bank and its successors and assigns, except that no Borrower may delegate any obligations hereunder without the prior written consent of the Bank. This Note may not be assigned by the Bank except with the prior written consent of the Borrowers, which consent shall not be unreasonably withheld. (e) Each Borrower consents to the nonexclusive jurisdiction and venue of the state and federal courts located in the City of New York. Service of process by the Bank in connection with any dispute shall be binding on each Borrower if sent to such Borrower by registered mail at the address specified below. EACH OF THE BANK AND EACH BORROWER HEREBY WAIVES, TO THE FULLEST EXTENT PERMITTED BY LAW, ANY RIGHT IT MAY HAVE TO JURY TRIAL IN ANY LEGAL PROCEEDING DIRECTLY OR INDIRECTLY ARISING OUT OF OR RELATING TO THIS NOTE OR TRANSACTIONS CONTEMPLATED HEREBY (WHETHER BASED ON CONTRACT, TORT OR ANY OTHER THEORY). (f) This Note shall be governed by and interpreted and construed in accordance with the laws of the State of New York, provided that the foregoing -------- is not intended to limit the maximum rate of interest which may be charged or collected by the Bank hereon if, under the law applicable to it, the Bank may charge or collect such interest at a higher rate than is permissible under the law of said State. In no case shall the interest hereon exceed the maximum amount which the Bank may charge or collect under such law applicable to it. ALLMERICA FINANCIAL CORPORATION CITIZENS ACQUISITION CORPORATION By: By: -------------------------------- -------------------------------- Name: Name: Title: Title: Address: Address: Allmerica Financial Corporation Citizens Acquisition Corporation 440 Lincoln Street c/o Allmerica Financial Corporation Worcester, Massachusetts 01653 440 Lincoln Street Worcester, Massachusetts 01653 12 SCHEDULE
Amount of Payment and Principal Loan Number Balance Notation Date and Amount of Loan Maturity to Which Remaining Made By Loan Number and Interest Rate Date Applied Unpaid
13 [Chase Logo Appears Here] PROMISSORY NOTE New York, New York December 1, 1998 FOR VALUE RECEIVED, ALLMERICA FINANCIAL CORPORATION and CITIZENS ACQUISITION CORPORATION (collectively, the "Borrowers"), jointly and severally, --------- unconditionally promises to pay to the order of THE CHASE MANHATTAN BANK (the "Bank"), at its principal office, 270 Park Avenue, New York, New York l0017 (the - ----- "Principal Office"), for the account of the Principal Office (or such other ---------------- office or affiliate as the Bank may from time to time specify), the principal amount of each Loan endorsed on the schedule attached hereto and made a part hereof (including any continuations, the "Schedule") on the maturity date of -------- such Loan as shown on the Schedule, and to pay interest on the unpaid balance of the principal amount of such Loan from and including the date of such Loan (as shown on the Schedule ) to such maturity date at (a) a variable rate per annum equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Prime Rate (such higher rate being the "Base Rate" and such Loan a "Base Rate --------- --------- Loan"); or (b) a fixed rate per annum equal to the Eurodollar Rate applicable to - ---- such Loan (a "Eurodollar Loan"), plus the Applicable Margin; or (c) a fixed rate --------------- per annum as the Bank may in its discretion offer to the Borrowers and the Borrowers may accept (an "Offered Rate Loan"). Any principal not paid when due ----------------- shall bear interest from maturity until paid in full at a rate per annum equal to the Default Rate. Interest shall be payable on the relevant Interest Payment Date. Interest shall be calculated on the basis of a year of 360 days for the actual days elapsed, except that interest computed by reference to the Prime Rate shall be calculated on the basis of a year of 365 days (or 366 days, in the case of a leap year) for the actual days elapsed. All payments hereunder shall be made in lawful money of the United States and in immediately available funds. Any extension of time for the payment of the principal of this note resulting from the due date falling on a non-Banking Day shall be included in the computation of interest. The date, and interest periods of, and the interest rates with respect to, the Loans and any payments of principal shall be recorded by the Bank on its books and prior to any transfer of this note (or, at the discretion of the Bank, at any other time) endorsed by the Bank on the Schedule, which shall be conclusive in the absence of manifest error; provided, however, -------- ------- that the Bank's failure to endorse the Schedule shall not affect the Borrowers' obligations hereunder. 1. Certain Definitions. Unless otherwise defined herein, capitalized ------------------- terms shall have the meanings assigned to them in the Letter Agreement (as defined in Section 2 hereof). As used herein, the following terms shall have the corresponding meanings. (a) "Applicable Margin" means, with respect to any Eurodollar Loan, ----------------- (i) 0.45% for such Eurodollar Loan drawn at or before 12:00 p.m. on December 4, 1998, (ii) 0.60% for such Eurodollar Loan drawn after 12:00 p.m. on December 4, 1998 but at or before 12:00 p.m. on December 18, 1998, (iii) 1.0% for such Eurodollar Loan drawn after 12:00 p.m. on December 18, 1998 but at or before 5:00 p.m. on January 8, 1999 and (iv) 0.45% for such Eurodollar Loan drawn after 8:00 a.m. on January 11, 1999; provided that if Allmerica's short term debt -------- rating from S&P or Moody's shall be reduced from the respective rating from S&P or Moody's in existence on the date hereof at any time during the period from the date hereof until the date of the drawdown of the initial Loan hereunder, the Applicable Margin shall be increased by 0.10%. (b) "Banking Day" means any day on which commercial banks are not ----------- authorized or required to close in New York City and, where such term is used in the definition of "Eurodollar Rate" or refers to the Eurodollar Rate, which is also a day on which dealings in U.S. dollar deposits are carried out in the London interbank market. 14 (c) "Default Rate" means, in respect of any amount not paid when due, ------------ a rate per annum during the period commencing on the due date until such amount is paid in full equal to a floating rate 2% above the Base Rate; provided that, -------- if the amount in default is principal of an Offered Rate Loan or Eurodollar Loan, a fixed rate 2% above the rate of interest in effect thereon (including the margin) at the time of default until the end of the then current interest period therefor and, thereafter, a floating rate 2% above the Base Rate. (d) "Eurodollar Rate" means the rate per annum (rounded upwards, if --------------- necessary, to the nearest 1/100 of 1%) quoted by the Bank at approximately 11:00 a.m. London time (or as soon thereafter as practicable) two Banking Days' prior to the first day of an interest period during which the Eurodollar Rate will accrue for the offering by the Bank to leading banks in the London interbank market of U.S. dollar deposits having a term comparable to such loan and in an amount comparable to the principal amount of such loan. (e) "Federal Funds Rate" means, for any day, the rate per annum ------------------ (expressed on a 360 day basis of calculation) equal to the weighted average of the rates on overnight Federal funds transactions as published by the Federal Reserve Bank of New York for such day (or for any day that is not a Banking Day, for the immediately preceding Banking Day). (f) "Interest Payment Date" means for any loan hereunder, the first --------------------- day commencing after such loan as follows: (i) for any Base Rate Loan, the last Banking Day of each March, June, September and December; (ii) for any Offered Rate Loan, at 90-day intervals; (iii) for any Eurodollar Loan, at three-month intervals; (iv) for any amount accruing interest at the Default Rate, on demand; and (v) for any amount, upon maturity and any prepayment or repayment. (g) "Prime Rate" means the rate of interest per annum publicly ---------- announced from time to time announced by the Bank as its prime rate in effect at the Principal Office; each change in the Prime Rate shall be effective from and including the date such change is publicly announced as being effective. (h) "Regulatory Change" means any change after the date hereof in ----------------- United States federal, state or foreign laws or regulations (including Regulation D of the Board of Governors of the Federal Reserve System) or the adoption or making after such date of any interpretations, directives or requests applying to a class of banks including the Bank of or under any United States federal or state, or any foreign, laws or regulations (whether or not having the force of law) by any court or governmental or monetary authority charged with the interpretation or administration thereof. 2. Related Letter Agreement. Loans evidenced hereby are made pursuant ------------------------ to that certain letter agreement dated December 1, 1998 between the Bank and the Borrowers (the "Letter Agreement"). ---------------- 3. Additional Costs, Etc. (a) If, as a result of any Regulatory ---------------------- Change, the Bank reasonably determines that the cost to the Bank of making or maintaining any Eurodollar Loan evidenced hereby is increased, or any amount received or receivable by the Bank hereunder is reduced, or the Bank is required to make any payment in connection with any transaction contemplated hereby, then the Borrowers jointly and severally agree to pay to the Bank on demand such additional amount or amounts as the Bank determines will compensate the Bank for such increased cost, reduction or payment. The Bank shall furnish the Borrowers with calculations of such amounts due, in the absence of demonstrable error, shall be conclusive. (b) If there is any payment of a Eurodollar Loan or Offered Rate Loan prior to its stated maturity (by reason of acceleration or otherwise), the Borrowers jointly and severally agree that they will promptly 15 pay the Bank on demand an amount determined by the Bank in good faith sufficient to compensate it for such payment. Without limiting the effect of the preceding sentence, such compensation shall include an amount equal to the excess, if any, of (i) the amount of interest which would have accrued on the principal amount of such Loan had Borrowers not so paid, for the period from the date of such payment to the last day of the current interest period therefor over (ii) the amount of interest which would accrue on such principal amount for such period at the interest rate which Lender would bid were it to bid, at the commencement of such period, for dollar deposits of a comparable amount and period from other banks in the London interbank market (as reasonably determined by Lender), or if Lender shall cease to make such bids, the equivalent bid rate, as reasonably determined by Lender, derived from display page 3750 (British Bankers Association - LIBOR) of the Dow Jones Markets (Telerate) Screen (or any successor or substitute therefor). 4. Events of Default. If any of the following events shall occur and ----------------- be continuing: (a) the Borrowers shall fail to pay the principal of this Note when due; or interest on, or any other amount payable under, this Note, within three Banking Days of when due and payable; (b) any Borrower shall breach any representation or warranty made by it in this Note or the Letter Agreement or any other document executed in connection with this Note (this Note, the Letter Agreement and any such other document being the "Facility Documents") or which ------------------ is contained in any certificate, document, opinion, financial or other statement furnished by such Borrower at any time under or in connection with any Facility Documents shall prove to have been incorrect in any material respect on or as of the date made; (c) Allmerica shall fail to perform or observe any term, covenant or agreement contained in Section 8.04, 8.05, 8.06, 8.08, 8.10 or 8.11 of the Existing Credit Agreement as in incorporated herein by reference pursuant to the section of the Letter Agreement captioned "Covenants"; (d) any Borrower shall fail to perform or observe any term, covenant or agreement (other than the covenants referenced in clause (c) above) contained in any Facility Document and such failure shall continue for 30 days after written notice from the Bank thereof; (e) Allmerica or any of its Subsidiaries (as defined in the Existing Credit Agreement) shall default in the payment when due (after giving effect to any applicable grace periods) of any principal of or interest on any of its other Indebtedness (as defined in the Existing Credit Agreement) aggregating $10,000,000 or more; or any event specified in any note, agreement, indenture or other document evidencing or relating to such Indebtedness shall occur if the effect of such event is to cause, or (with the giving of any notice or the lapse of time or both) to permit the holder or holders of such indebtedness (or a trustee or agent on behalf of such holder or holders) to cause, such Indebtedness to become due, or to be prepaid in full (whether by redemption, purchase, offer to purchase or otherwise), prior to its stated maturity or to have the interest rate thereon reset to a level so that securities evidencing such Indebtedness trade at a level specified in relation to the par value thereof; (f) Allmerica shall fail to pay when due (after giving effect to any applicable grace periods) of any amount aggregating $10,000,000 or more on any of its Rate Hedging Obligations (as defined in the Existing Credit Agreement) or any event specified in any agreement or document relating to any such Rate Hedging Obligations shall occur if the effect of such event is to cause, or (with the giving of notice or the lapse of time or both) to permit, termination or liquidation payment or payments aggregating $10,000,000 or more to become due; (g) Citizens Acquisition or Allmerica or any of its Insurance Subsidiaries (as defined in the Existing Credit Agreement): (i) shall generally not, or be unable to, or shall admit in writing its inability to, pay its debts as its debts become due; (ii) shall make an assignment for the benefit of creditors; (iii) shall file a petition in bankruptcy or for any relief under any law of any jurisdiction relating to reorganization, arrangement, readjustment of debt, dissolution or liquidation; (iv) shall have any such petition filed against it in which an adjudication is made or order for relief is entered or which shall remain undismissed for a period of 60 days or shall consent or acquiesce thereto; (v) shall have had a receiver, custodian or trustee appointed for all or a substantial part of its property; (h) any event described in Sections 9(h), (i), (j), (k) or (l) of the Existing Credit Agreement shall have occurred, THEN, in any such case, if the Bank shall elect by notice to the Borrowers, the unpaid principal amount of this Note, together with accrued interest, shall become forthwith due and payable; provided that in the case of an event of default -------- under clause (g) above, the unpaid principal amount of this Note, together with accrued interest, shall immediately become due and payable without any notice or other action by the Bank. 16 5. Miscellaneous. (a) Each Borrower hereby accepts joint and several ------------- liability for the obligations under this Note in consideration of the financial accommodation provided by the Bank under the Letter Agreement and agrees that if and to the extent that a Borrower shall fail to make any payment due hereunder as and when due in accordance with the terms hereof, then the other Borrower will make such payment. The liability of each Borrower hereunder is absolute and unconditional irrespective of any defense, setoff or counterclaim with respect to the Letter Agreement and this Note and the transactions contemplated thereby which might constitute a defense available to, or discharge of, a Borrower or a guarantor. (b) Each Borrower waives presentment, notice of dishonor, protest and any other formality with respect to this Note. (c) The Borrowers jointly and severally agree to reimburse the Bank on demand for all costs, expenses and charges (including without limitation, reasonable fees and charges of external legal counsel for the Bank and costs allocated by its internal legal department) in connection with the preparation, interpretation, performance or enforcement of this Note and the Letter Agreement. (d) This Note shall be binding on the Borrowers and their successors and assigns and shall inure to the benefit of the Bank and its successors and assigns, except that no Borrower may delegate any obligations hereunder without the prior written consent of the Bank. This Note may not be assigned by the Bank except with the prior written consent of the Borrowers, which consent shall not be unreasonably withheld. (e) Each Borrower consents to the nonexclusive jurisdiction and venue of the state and federal courts located in the City of New York. Service of process by the Bank in connection with any dispute shall be binding on each Borrower if sent to such Borrower by registered mail at the address specified below. EACH OF THE BANK AND EACH BORROWER HEREBY WAIVES, TO THE FULLEST EXTENT PERMITTED BY LAW, ANY RIGHT IT MAY HAVE TO JURY TRIAL IN ANY LEGAL PROCEEDING DIRECTLY OR INDIRECTLY ARISING OUT OF OR RELATING TO THIS NOTE OR TRANSACTIONS CONTEMPLATED HEREBY (WHETHER BASED ON CONTRACT, TORT OR ANY OTHER THEORY). (f) This Note shall be governed by and interpreted and construed in accordance with the laws of the State of New York, provided that the foregoing -------- is not intended to limit the maximum rate of interest which may be charged or collected by the Bank hereon if, under the law applicable to it, the Bank may charge or collect such interest at a higher rate than is permissible under the law of said State. In no case shall the interest hereon exceed the maximum amount which the Bank may charge or collect under such law applicable to it. ALLMERICA FINANCIAL CORPORATION CITIZENS ACQUISITION CORPORATION By: By: -------------------------------- -------------------------------- Name: Name: Title: Title: Address: Address: Allmerica Financial Corporation Citizens Acquisition Corporation 440 Lincoln Street c/o Allmerica Financial Corporation Worcester, Massachusetts 01653 440 Lincoln Street Worcester, Massachusetts 01653 17 SCHEDULE
Amount of Payment and Principal Loan Number Balance Notation Date and Amount of Loan Maturity to Which Remaining Made By Loan Number and Interest Rate Date Applied Unpaid
18 EX-13 8 SECTIONS OF THE ANNUAL REPORT TO STOCKHOLDERS Exhibit 13.1 Five Year Summary of Selected Financial Highlights
- ------------------------------------------------------------------------------------------------------------------------------------ For the Years Ended December 31 1998 1997 1996 1995 1994 - ------------------------------------------------------------------------------------------------------------------------------------ (In millions, except per share data) - ------------------------------------------------------------------------------------------------------------------------------------ Statement of Income Revenues Premiums $ 2,305.0 $ 2,311.1 $ 2,236.3 $ 2,222.8 $ 2,181.8 Universal life and investment product policy fees 296.6 237.3 197.2 172.4 156.8 Net investment income 624.2 653.4 672.6 709.5 743.1 Net realized gains 60.9 76.2 65.9 39.8 1.1 Other income 145.8 117.6 113.1 119.4 124.7 ------------------------------------------------------------- Total revenues 3,432.5 3,395.6 3,285.1 3,263.9 3,207.5 ------------------------------------------------------------- Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 2,051.2 2,004.7 1,957.0 2,010.3 2,047.0 Policy acquisition expenses 452.8 411.8 457.5 455.4 475.7 Sales practice litigation expense 31.0 - - - - Loss from exiting reinsurance pools 25.3 - - - - Loss from cession of disability income business - 53.9 - - - Restructuring costs 13.0 - - - - Other operating expenses 579.6 559.7 538.9 496.4 531.3 ------------------------------------------------------------- Total benefits, losses and expenses 3,152.9 3,030.1 2,953.4 2,962.1 3,054.0 ------------------------------------------------------------- Income before federal income taxes 279.6 365.5 331.7 301.8 153.5 Federal income tax expense 49.1 93.6 75.2 82.7 53.4 ------------------------------------------------------------- Income before minority interest, extraordinary item and cumulative effect of accounting changes 230.5 271.9 256.5 219.1 100.1 Minority interest (29.3) (62.7) (74.6) (73.1) (51.0) ------------------------------------------------------------- Income before extraordinary item and cumulative effect of accounting changes 201.2 209.2 181.9 146.0 49.1 Extraordinary item demutualization expenses - - - (12.1) (9.2) Cumulative effect of accounting changes - - - - (1.9) ------------------------------------------------------------- Net income $ 201.2 $ 209.2 $ 181.9 $ 133.9 $ 38.0 ------------------------------------------------------------- Earnings per common share (diluted) (1) $ 3.33 $ 3.82 $ 3.63 $ 0.82 $ - ------------------------------------------------------------- Dividends declared per common share (diluted) $ 0.15 $ 0.20 $ 0.20 $ 0.05 $ - ------------------------------------------------------------- Adjusted net income (2) $ 216.9 $ 181.0 $ 137.9 $ 116.4 $ 90.4 ------------------------------------------------------------- Balance Sheet (at December 31) Total assets $27,607.9 $22,549.0 $18,970.3 $17,757.7 $15,921.5 Long-term debt 199.5 202.1 202.2 202.3 2.7 Total liabilities 24,849.3 19,714.8 16,461.6 15,425.0 14,299.4 Minority interest 300.0 452.9 784.0 758.5 629.7 Shareholders equity 2,458.6 2,381.3 1,724.7 1,574.2 992.4
(1) Represents earnings per common share for the period October 1, 1995 through December 31, 1995. Pro forma earnings per common share (unaudited) for the year ended December 31, 1995 was $2.61. The pro forma information is based on a weighted average of the number of shares that would have been outstanding between January 1, 1995 and December 31, 1995 had the demutualization transaction occurred on January 1, 1995. This information is provided for informational purposes only and should not be construed to be indicative of the Company's consolidated results of operations had the transaction been consummated at the beginning of 1995 and does not represent a projection or forecast of the Company's consolidated results of operation for any future period. (2) Represents net income adjusted for certain items which management believes are not indicative of overall operating trends, including net realized investment gains (losses), net gains and losses on disposals of businesses, extraordinary items, the cumulative effect of accounting changes, restructuring costs, differential earnings tax adjustments, and certain other items. While these items may be significant components in understanding and assessing the Company's financial performance, management believes adjusted net income enhances an investors understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, adjusted net income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. 25 Management's Discussion and Analysis of Financial Condition and Results of Operations The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Consolidated Financial Statements and related consolidated footnotes included elsewhere herein. Introduction - -------------------------------------------------------------------------------- The results of operations for Allmerica Financial Corporation and subsidiaries ("AFC" or the "Company") include the accounts of AFC, First Allmerica Financial Life Insurance Company ("FAFLIC"), its wholly-owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), Allmerica Property & Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non- insurance holding company), The Hanover Insurance Company ("Hanover", a wholly- owned subsidiary of Allmerica P&C), Citizens Corporation ("Citizens", a wholly- owned subsidiary of Hanover), Citizens Insurance Company of America (a wholly- owned subsidiary of Citizens) and certain other insurance and non-insurance subsidiaries. The results of operations reflect minority interest in Allmerica P&C and its subsidiary, Hanover, of approximately 40.5% prior to the acquisition of minority interest on July 16, 1997. The results of operations also reflect minority interest in Citizens, prior to the acquisition of minority interest on or about December 3, 1998, of approximately 16.8% and 17.5% in 1998 and 1997, respectively. Description of Operating Segments - -------------------------------------------------------------------------------- The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company conducts business principally in four operating segments. These segments are Property and Casualty; Corporate Risk Management Services; Allmerica Financial Services; and Allmerica Asset Management. Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standard No. 131 "Disclosures About Segments of an Enterprise and Related Information" ("Statement No. 131"). Consistent with the Company's adoption of this statement, the separate financial information of each segment was redefined consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the significant changes in reportable segments is included below. The Risk Management group includes two segments: Property and Casualty and Corporate Risk Management Services. The Property and Casualty segment includes property and casualty insurance products, such as automobile insurance, homeowners insurance, commercial multiple peril insurance, and workers compensation insurance. These products are offered by Allmerica P&C through its operating subsidiaries, Hanover and Citizens. Substantially all of the Property and Casualty segments earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). Prior to 1998, certain corporate overhead expenses were allocated to the Property and Casualty business and were reflected in the results of this segment. In addition, results of operations from the property and casualty holding companies and certain non-insurance subsidiaries of Allmerica P&C were reflected in the results of this segment. These overhead expenses and the activity from the holding companies are now reported in the Corporate segment, as discussed below. Results from certain non-insurance subsidiaries are no longer being reflected in the results of the Property and Casualty segment. The Corporate Risk Management Services segment includes group life and health insurance products and services which assist employers in administering employee benefit programs and in managing the related risks. Prior to 1998, certain corporate overhead expenses were allocated to the Corporate Risk Management Services business and were reflected in the results of this segment. These overhead expenses are now reported in the Corporate segment. In addition, results from certain non-insurance subsidiaries, which were previously reported in the Property and Casualty segment, are now being reported in the Corporate Risk Management Services segment. The Retirement and Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Prior to 1998, certain corporate overhead expenses were allocated to the Allmerica Financial Services business and were reflected in the results of this segment. These overhead expenses are now reported in the Corporate segment. Certain products (including defined benefit and defined contribution plans, group variable universal life) and certain other non-insurance operations (telemarketing and trust services) previously reported in the Allmerica Financial Institutional Services segment have been combined with the Allmerica Financial Services segment. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in three types of Guaranteed Investment Contracts (GICs); the traditional GIC, the synthetic GIC and the floating rate GIC. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. Prior to 1998, certain corporate overhead expenses were allocated to the Allmerica Asset Management business and were reflected in the results of this segment. These overhead 26 expenses are now reported in the Corporate segment. Additionally, the GIC products, now offered through Allmerica Asset Management, were previously reported in the results of the Allmerica Financial Institutional Services segment. In addition to the four operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Series A Capital Securities ("Capital Securities") and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. Through implementation of Statement No. 131, the definition of the Corporate segment was redefined to include all holding companies, as well as the parent company. Corporate overhead expenses, which were previously allocated to the operating segments, are now included in the Corporate segment. Results of Operations Consolidated Overview - -------------------------------------------------------------------------------- The Company's consolidated net income decreased $8.0 million to $201.2 million in 1998. In 1997, the Company's consolidated net income increased $27.3 million to $209.2 million. Net income includes certain items which management believes are not indicative of overall operating trends, such as net realized investment gains and losses, net gains and losses on disposals of businesses, extraordinary items, the cumulative effect of accounting changes, and certain other items. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of adjusted net income enhances its understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, adjusted net income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. For purposes of assessing each segment's contribution to adjusted net income, management evaluates the results of these segments on a pre-tax and minority interest basis. The following table reflects each segment's contribution to adjusted net income and a reconciliation to consolidated net income as adjusted for these items. - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Segment income (loss) before income taxes and minority interest: Risk Management Property and Casualty $ 151.4 $ 172.9 $ 170.7 Corporate Risk Management Services 7.6 27.0 28.3 ------------------------------- Subtotal 159.0 199.9 199.0 Retirement and Asset Accumulation Allmerica Financial Services 166.7 134.6 106.8 Allmerica Asset Management 23.7 18.4 11.5 ------------------------------- Subtotal 190.4 153.0 118.3 Corporate (50.9) (48.0) (58.0) ------------------------------- Segment income before income taxes and minority interest 298.5 304.9 259.3 ------------------------------- Federal income taxes on segment income (55.8) (72.4) (59.9) Minority interest: Distributions on Capital Securities (16.0) (14.5) -- Equity in earnings (9.8) (37.0) (61.5) ------------------------------- Adjusted net income 216.9 181.0 137.9 Adjustments (net of taxes, minority interest and amortization, as applicable): Net realized investment gains 29.9 37.5 31.0 Sales practice litigation expense (20.2) -- -- Loss from exiting reinsurance pools (16.4) -- -- Gain from change in mortality assumptions -- 30.5 -- Loss from cession of disability income business -- (35.0) -- Differential earnings tax adjustment -- -- 10.2 Contingency payment from sale of mutual fund processing business -- -- 3.1 Restructuring costs (8.4) -- -- Other items (0.6) (4.8) (0.3) ------------------------------- Net income $ 201.2 $ 209.2 $ 181.9 =============================== 27 1998 Compared to 1997 The Company's segment income before taxes and minority interest decreased $6.4 million, or 2.1%, to $298.5 million during 1998. This decrease is primarily attributable to reduced income of $40.9 million from the Risk Management group and increased losses of $2.9 million from the Corporate segment. These decreases were partially offset by increased income of $37.4 million from the Retirement and Asset Accumulation group. Property and Casualty segment income declined $21.5 million in 1998 primarily due to increased catastrophe losses of $63.8 million and decreased net investment income of $24.4 million resulting from lower average invested assets in the segment. These decreases were partially offset by lower loss adjustment expenses ("LAE"), lower policy acquisition and other operating expenses and increased fee revenue. The decrease of $19.4 million in Corporate Risk Management Services segment income was primarily due to unfavorable loss experience in the risk-sharing and long-term disability lines of business, as well as increased operating expenses. The increase of $32.1 million in the Allmerica Financial Services segment was primarily attributable to growth from new deposits and market appreciation in the variable annuity and variable universal life assets resulting in increased fee revenue, partially offset by an increase in related policy acquisition and other operating expenses incurred as a result of this growth. Segment income before taxes and minority interest increased $5.3 million in the Allmerica Asset Management segment, primarily due to increased sales on floating rate GICs. The operating loss in the Corporate segment increased $2.9 million, primarily due to the absence of $9.1 million of net investment income earned on the proceeds from the prior year's issuance of Capital Securities and to increased overhead costs. This was partially offset by additional net investment income generated by transfers of investments from the Property and Casualty segment. The effective tax rate for segment income was 18.7% in 1998 compared to 23.7% in 1997. The decrease in the tax rate resulted from the reduction in underwriting income from the Property and Casualty segment and a greater proportion of pre-tax income from tax-exempt bonds in 1998. Net realized gains on investments, after taxes, minority interest and amortization, were $29.9 million during 1998, primarily due to after-tax net realized gains from sales of appreciated equity securities of $43.3 million, and after-tax gains on real estate of $8.9 million. These were partially offset by $20.1 million of after-tax realized losses from impairments recognized on fixed maturities, and $12.0 million of after-tax realized losses on partnership investments. During 1997, net realized gains on investments, after taxes, minority interest and amortization, of $37.5 million, resulted primarily from the sale of appreciated equity securities, due to the Company's strategy of shifting to a higher level of debt securities, as well as sales of real estate investment properties. Minority interest on segment income decreased in the current period as compared to the prior year due primarily to the Company's merger with Allmerica P&C on July 16, 1997. Prior to the acquisition, minority interest reflected 40.5% of the results of operations from this subsidiary. In addition, on or about December 3, 1998, the Company acquired all of the outstanding common stock of Citizens that it did not already own in exchange for cash of $195.9 million. The Citizens acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. Prior to the acquisition, minority interest reflected 16.8% and 17.5% of the results of operations from Citizens in 1998 and 1997, respectively. In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998, and has scheduled a hearing in March 1999 to consider final approval. Accordingly, AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of benefits to be provided to members of the class. Effective July 1, 1998, the Company entered into a reinsurance agreement with a highly rated reinsurer that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the Company's accident and health assumed reinsurance pool business. These pools consist primarily of the Corporate Risk Management Services segment's assumed stop loss business, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. The agreement is consistent with managements decision to exit this line of business, which the Company expects to run-off over the next three years. As a result of this transaction, the Company recognized a $16.4 million loss, net of taxes, in the third quarter of 1998. 28 Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of business. The Company recognized a $35.0 million loss, net of taxes, during the first quarter of 1997 upon entering into an agreement in principal to transfer the business. Additionally, effective October 1, 1997, the Company revised the mortality assumptions used to determine the amortization of policy acquisition costs and recognition of certain fees for its universal life and variable universal life lines of business. As a result of this change in assumptions, the Company recognized a benefit of $30.5 million, net of taxes, during 1997. On October 29, 1998, the Company announced that it is restructuring its Risk Management business. As part of this initiative, the Company, in its Corporate Risk Management Services segment, has exited its accident and health assumed reinsurance pool business, as well as its administrative services only business. Additionally, it has commenced the closing of nearly half of its nationwide Corporate Risk Management Services' sales offices, eliminated certain staff, and discontinued certain automation initiatives. The Property and Casualty segment is consolidating its field support activities from fourteen regional branches into three hub locations. As a result of this restructuring initiative, the Company recognized a loss of $8.4 million, net of taxes, in the fourth quarter of 1998. 1997 Compared to 1996 The increase in the Companys segment income before taxes and minority interest of $45.6 million, or 17.6%, is primarily attributable to increases of $34.7 million from the Retirement and Asset Accumulation group, $10.0 million from the Corporate segment and $0.9 million from the Risk Management group. Allmerica Financial Services segment income increased $27.8 million primarily due to additional deposits and appreciation in variable products' account balances, partially offset by lower net investment income due to a shift from general account to separate account assets in its retirement products. The increase in segment income of $6.9 million in Allmerica Asset Management is primarily attributable to improved interest margins on GICs. The Corporate segment's operating loss decreased primarily due to $9.1 million of net investment income generated from the temporary investment of the proceeds related to the issuance of Capital Securities. Additionally, the Property and Casualty segments contribution increased primarily due to a $20.1 million growth in net investment income, partially offset by a $15.8 million increase in underwriting losses and a $3.8 million decrease in partnership income in 1997. These increases were partially off-set by a decrease of $1.3 million in the Corporate Risk Management Services segment. The effective tax rate for segment income was 23.7% in 1997 compared to 23.1% in 1996. The increase results primarily from increased income from the life insurance companies, partially offset by higher underwriting losses in the Property and Casualty segment and a greater proportion of pre-tax income from tax-exempt bonds in 1997. Net realized gains on investments were $37.5 million and $31.0 million, after taxes, minority interest and amortization, in 1997 and 1996, respectively. Through the first quarter of 1997, the Property and Casualty segment continued its investment strategy of shifting its portfolio from equity investments to tax-exempt and higher-yielding debt securities. This resulted in the sale of a portion of its equity portfolio and the recognition of realized gains totaling approximately $28.5 million on an after-tax and minority interest basis. In addition, real estate sales generated realized gains of approximately $11.8 million, net of taxes, in the Allmerica Asset Management segment. In 1996, the Property and Casualty segment realized gains of $17.6 million, net of taxes and minority interest, primarily due to the aforementioned shift in investment strategy, while the Allmerica Asset Management segment recognized gains of $10.3 million, net of taxes, due to the sale of real estate properties. Minority interest on segment income decreased in the current period as compared to the prior year due primarily to the Companys merger with Allmerica P&C on July 16, 1997. Prior to the acquisition, minority interest reflected 40.5% of the results of operations from this subsidiary. This decrease was partially offset by distributions related to the Companys Capital Securities. Effective October 1, 1997, the Company ceded substantially all of its individual disability income line of business. The Company recognized a $35.0 million loss, net of taxes, during the first quarter of 1997 upon entering into an agreement in principal to transfer the business. Additionally, effective October 1, 1997, the Company revised the mortality assumptions used to determine the amortization of policy acquisition costs and recognition of certain fees for its universal life and variable universal life lines of business. As a result of this change in assumptions, the Company recognized a benefit of $30.5 million, net of taxes, during 1997. During 1996, the Company recognized a $3.1 million contingency payment, net of taxes, related to the 1995 sale of its mutual fund processing business. Additionally, in 1996, the Company adjusted its 1994 federal income tax deduction for policyholder dividends, resulting in the recognition of a $10.2 million benefit. 29 Risk Management - -------------------------------------------------------------------------------- Property and Casualty The following table summarizes the results of operations for the Property and Casualty segment: - -------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------- Segment revenues Net premiums earned $ 1,966.3 $ 1,953.1 $ 1,898.3 Net investment income 228.9 253.3 233.2 Other income 9.6 4.6 14.3 ------------------------------------ Total segment revenues 2,204.8 2,211.0 2,145.8 Losses and LAE (1) 1,493.7 1,441.9 1,383.4 Policy acquisition expenses 379.7 399.9 396.6 Other operating expenses 180.0 196.3 195.1 ------------------------------------ Segment income $ 151.4 $ 172.9 $ 170.7 ------------------------------------ (1) Includes policyholders dividends of $11.9 million, $9.3 million and $11.5 million in 1998, 1997 and 1996, respectively. Income Before Taxes - -------------------------------------------------------------------------------- 1998 Compared to 1997 [BAR GRAPH APPEARS HERE] 1996 101.2 1997 102.8 1998 100.0 Statutory combined ratio Excluding catastrophe leases Property and Casualty's segment income before taxes and minority interest decreased $21.5 million, or 12.4%, to $151.4 million in 1998, compared to $172.9 million in 1997. The decrease in income is primarily the result of an increase in losses due to increased catastrophes of $63.8 million, to $90.3 million in 1998, compared to $26.5 million in 1997, partially offset by lower loss adjustment expenses. Also contributing to the decrease in the segment,s results, was a decrease in net investment income before taxes of $24.4 million, or 9.6%, to $228.9 million in 1998, compared to $253.3 million in 1997. This decrease is primarily the result of a reduction in Hanover's average invested assets and a $7.0 million decrease in limited partnership income. These were partially offset by lower policy acquisition and other operating expenses of $20.2 million and $16.3 million, respectively. In addition, other income increased $5.0 million, to $9.6 million in 1998, primarily as a result of an increase in finance charges on installment premiums at Hanover. 1997 Compared to 1996 Property and Casualty's segment income before taxes and minority interest increased $2.2 million, or 1.3%, to $172.9 million in 1997, compared to $170.7 million in 1996. This increase is attributable to a $20.1 million increase in net investment income, partially offset by a $15.8 million increase in the underwriting loss. The growth in net investment income resulted primarily from an increase in average invested assets and the Company's portfolio shift from equity securities to higher-yielding debt securities, begun in 1996 and substantially completed in the first quarter of 1997. This was partially offset by a $3.8 million decrease in partnership income in 1997. The decline in underwriting results is primarily attributable to a decrease in favorable development on prior year reserves in Hanover's personal automobile, homeowners and commercial multiple peril lines, as well as increased current year claims severity in Hanover's personal automobile and commercial automobile lines. These factors were partially offset by a $38.9 million decrease in catastrophe losses at Hanover. Citizens underwriting results primarily reflect an increase in claims activity in the commercial multiple peril and homeowners lines and an increase in catastrophes, partially offset by favorable claims experience on current and prior accident years in the personal automobile and workers compensation lines. Net income during 1996 was favorably impacted by a $5.7 million arbitrated settlement from a voluntary pool at Hanover, of which $2.9 million was included in losses and LAE and $2.8 million was included in other income. Lines Of Business Results - -------------------------------------------------------------------------------- Personal Lines of Business The personal lines represented 61.9%, 61.9% and 61.2% of total net premiums earned in 1998, 1997 and 1996, respectively. - ----------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 1998 1997 1996 1998 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------- (In millions) - ----------------------------------------------------------------------------------------------------------------------------- Hanover Citizens Total Property and Casualty - ----------------------------------------------------------------------------------------------------------------------------- Net premiums earned $ 619.8 $ 625.7 $ 607.3 $ 598.1 $ 583.3 $ 554.6 $ 1,217.9 $ 1,209.0 $ 1,161.9 Losses and LAE incurred 462.5 487.4 452.0 454.8 440.7 404.1 917.3 928.1 856.1 Policy acquisition expenses 131.5 144.3 144.0 100.2 103.1 103.8 231.7 247.4 247.8 Other underwriting expenses 49.1 53.3 49.5 49.6 47.1 46.0 98.7 100.4 95.5 - ----------------------------------------------------------------------------------------------------------------------------- Underwriting (loss) profit $ (23.3) $ (59.3) $ (38.2) $ (6.5) $ (7.6) $ 0.7 $ (29.8) $ (66.9) $ (37.5) - -----------------------------------------------------------------------------------------------------------------------------
30 1998 Compared to 1997 Revenues Personal lines' net premiums earned increased $8.9 million, or 0.7%, to $1,217.9 million in 1998, compared to $1,209.0 million in 1997. Hanover's personal lines' net premiums earned decreased $5.9 million, or 0.9%, to $619.8 million in 1998. This decrease is primarily due to decreases in policies in force, since December 31, 1997, of 5.8% and 5.4%, in the personal automobile and homeowners lines', respectively. This decline is associated with the Company's decision last year to exit certain western and southern states. A mandated 4.0% decrease in Massachusetts's personal automobile rates, which became effective January 1, 1998, also contributed to the decrease in net premiums earned. In 1997, Hanover began offering a safe driver's discount on automobile insurance premiums. Management believes that rate and discount changes may unfavorably impact premium growth in Massachusetts. At December 31, 1998, approximately 36% of Hanover's personal automobile business was written in Massachusetts. Citizen's personal lines' net premiums earned increased $14.8 million, or 2.5%, to $598.1 million in 1998. This increase is primarily attributable to rate increases in Michigan's personal automobile and homeowners lines' and continued expansion into Ohio and Indiana. These increases are partially offset by decreases in policies in force in Michigan during 1998, of 3.1% and 3.6% in the personal automobile and homeowners lines', respectively. While management has taken steps to increase penetration in affinity groups and has initiated other marketing programs, heightened competition may continue to result in reduced growth in the personal lines. Underwriting results The personal lines' underwriting results for 1998 improved $37.1 million, to a loss of $29.8 million, compared to a loss of $66.9 million in 1997. Hanover's underwriting results improved $36.0 million, to a loss of $23.3 million. Citizen's underwriting results improved $1.1 million, to a loss of $6.5 million. The improvement in underwriting results is attributable to a $27.1 million increase in favorable development on prior year reserves, primarily at Hanover, as well as favorable current year claims activity at both Hanover and Citizens. Both of these favorable variances are primarily a result of significant reductions in claims settlement expenses in 1998. Partially offsetting these benefits, are $15.9 million and $25.4 million increases at Hanover and Citizens, respectively, in catastrophe losses, primarily in the homeowners line. Policy acquisition expenses in the personal lines' decreased $15.7 million, or 6.3%, to $231.7 million, while other underwriting expenses decreased $1.7 million, or 1.7%, to $98.7 million in 1998. These decreases primarily resulted from efficiencies gained through consolidation and re-engineering of claims and underwriting processes at both Hanover and Citizens. Cost savings were also achieved through reductions in employee related expenses at both Hanover and Citizen's and decreased rent expense resulting from the consolidation of processing centers at Citizens. 1997 Compared to 1996 Revenues Personal lines' net premiums earned increased $47.1 million, or 4.1%, to $1,209.0 million in 1997, compared to $1,161.9 million in 1996. Hanover's personal lines' net premiums earned increased $18.4 million, or 3.0%, to $625.7 million during 1997. This increase is primarily attributable to a 6.7% increase in policies in force in the personal automobile line, as well as a 1.5% increase in policies in force in the homeowners line, during 1997. These increases were partially offset by the effect of a mandated 6.2% decrease in Massachusetts personal automobile rates on January 1, 1997. Citizen's personal lines' net premiums earned increased $28.7 million, or 5.2 %, to $583.3 million in 1997. This growth is attributable to rate increases in the personal automobile and homeowners lines' and a 2.8% increase in policies in force in the homeowners line. The growth is partially offset by a 0.6% decrease in policies in force in the personal automobile line due to continued strong competition in Michigan. Underwriting results The personal lines' underwriting loss in 1997 increased $29.4 million, to a loss of $66.9 million. Hanover's underwriting results deteriorated $21.1 million to a loss of $59.3 million, while Citizen's underwriting loss deteriorated $8.3 million to a loss of $7.6 million. The decline in Hanover's underwriting results is primarily attributable to an increase in current year claims severity and a $25.0 million reduction in favorable development on prior year reserves in the personal automobile line. These factors were partially offset by a $25.8 million decrease in catastrophes, primarily in the homeowners line. The decline in Citizen's underwriting results reflects a decrease in prior year favorable development in the personal automobile line of $10.5 million and an increase in catastrophe losses of $0.9 million, to $14.3 million, primarily in the homeowners line. Policy acquisition expenses in the personal lines' decreased $0.4 million, or 0.2%, to $247.4 million, while other underwriting expenses increased $4.9 million, or 5.1%, to $100.4 million in 1997. Hanover's policy acquisition expenses increased $0.3 million, or 0.2%, to $144.3 million in 1997. This increase resulted from increased net premiums earned, significantly offset by decreased commission rates in the personal automobile and homeowners lines' and lower employee related expenses. The $3.8 million increase in Hanover's other underwriting expenses resulted from an increase in net premiums earned, partially offset by decreased employee related expenses, as well as reductions in contingent commissions. Policy acquisition expenses in the personal lines' at Citizens decreased $0.7 million, or 0.7%, to $103.1 million in 1997, primarily reflecting lower commission rates for 1997, partially offset by higher earned premiums. Citizen's other underwriting expenses increased $1.1 million, or 2.4%, to $47.1 million due to an increase in net premiums earned offset by reductions in employee related expenses. 31 Commercial Lines of Business The commercial lines represented 38.1%, 38.1% and 38.8% of net premiums earned in 1998, 1997 and 1996, respectively.
- ----------------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 1998 1997 1996 1998 1997 1996 - ----------------------------------------------------------------------------------------------------------------------------------- (In millions) - ----------------------------------------------------------------------------------------------------------------------------------- Hanover Citizens Total Property and Casualty --------------------------------------------------------------------------------------------------- Net premiums earned $ 463.9 $ 472.1 $ 455.5 $ 284.5 $ 272.0 $ 280.9 $ 748.4 $ 744.1 $ 736.4 Losses and LAE incurred (1) 342.9 309.6 319.8 233.5 204.2 207.5 576.4 513.8 527.3 Policy acquisition expenses 102.0 104.0 101.1 46.0 48.5 47.7 148.0 152.5 148.8 Other underwriting expenses 57.1 74.5 69.7 24.2 21.8 22.7 81.3 96.3 92.4 --------------------------------------------------------------------------------------------------- Underwriting (loss) profit $ (38.1) $ (16.0) $ (35.1) $ (19.2) $ (2.5) $ 3.0 $ (57.3) $ (18.5) $ (32.1) ===================================================================================================
(1) Includes policyholders' dividends. 1998 Compared to 1997 Revenues Commercial lines' net premiums earned increased $4.3 million, or 0.6%, to $748.4 million in 1998, compared to $744.1 million in 1997. Hanover's commercial lines' net premiums earned decreased $8.2 million, or 1.7%, to $463.9 million. This decrease is primarily attributable to the effect of the Company's decision to exit the assumed reinsurance business, effective July 1, 1997. The assumed reinsurance business contributed $8.6 million and $34.7 million in net premium earned during 1998 and 1997, respectively. Also contributing to the decline in net earned premium is the Company's decision, in 1997, to exit certain western and southern states, as well as a twelve-month average rate decrease of 12.2% in the workers' compensation line. These decreases are partially offset by increases in policies in force in the workers' compensation and commercial automobile lines of 12.3% and 11.6%, respectively, since December 31, 1997. Citizens' commercial lines' net premiums earned increased $12.5 million, or 4.6%, to $284.5 million in 1998, compared to $272.0 million in 1997. The increase in net premiums earned primarily reflects growth in policies in force of 9.1% in the commercial multiple peril line since December 31, 1997, and twelve month average rate increases of 8.0% and 6.3% in the commercial multiple peril and commercial automobile lines, respectively. These increases are partially offset by a 13.1% decrease in policies in force and a twelve-month average rate decrease of 6.6% in the workers' compensation line. Management believes competitive conditions in the workers' compensation line may impact future growth in net premiums earned for the segment. Underwriting results The commercial lines' underwriting loss for 1998 increased $38.8 million, to a loss of $57.3 million, compared to a loss of $18.5 million for 1997. Hanover's underwriting results declined $22.1 million, to a loss of $38.1 million. Citizens' underwriting results declined $16.7 million, to an underwriting loss of $19.2 million. The decline in Hanover's underwriting results is attributable to an increase in catastrophe losses of $10.1 million, primarily in the commercial multiple peril line, as well as to increased current year claims frequency and severity in the workers' compensation line and increased severity in the commercial multiple peril line. A decrease in favorable development on prior year reserves in the workers' compensation and commercial automobile lines of $19.2 million and $4.4 million, respectively, also contributed to the decline in Hanover's underwriting results. These factors are partially offset by a significant decrease in claims settlement expenses which contributed to a $14.9 million increase in favorable development on prior year reserves in the commercial multiple peril line. The decline in Citizens' underwriting results is primarily attributable to a $12.4 million increase in catastrophe losses, primarily in the commercial multiple peril line, and unfavorable current year claims activity in the workers' compensation line. A decrease in favorable development on prior year reserves in the workers' compensation and commercial multiple peril lines of $13.8 million and $4.0 million, respectively, also contributed to this deterioration. These adverse factors are partially offset by favorable current year claims activity in the non-catastrophe commercial multiple peril line and reduced claims settlement expenses during 1998. Policy acquisition expenses in the commercial lines decreased $4.5 million, or 3.0%, to $148.0 million in 1998 and other underwriting expenses decreased $15.0 million, or 15.6%, to $81.3 million. These decreases primarily resulted from efficiencies gained through consolidation and re-engineering processes at both Hanover and Citizens. Cost savings were also achieved through reductions in employee related expenses at both Hanover and Citizens and decreased rent expense resulting from the consolidation of processing centers at Citizens. 1997 Compared to 1996 Revenues Commercial lines' net premiums earned in 1997 increased $7.7 million, or 1.0%, to $744.1 million in 1997, compared to $736.4 million in 1996. Hanover's commercial lines' net premiums earned increased $16.6 million, or 3.6%, to $472.1 million. This increase is primarily attributable to a $9.4 million 32 increase in assumed premiums in Hanover's reinsurance division, as well as a 7.0% increase in policies in force in Hanover's commercial automobile line during 1997. These increases were partially offset by the effect of an average rate decrease of 12.6%, during 1997, in Hanover's workers' compensation line. Citizens' commercial lines' net premiums earned decreased $8.9 million, or 3.2%, to $272.0 million in 1997. This decrease primarily reflects rate reductions in the workers' compensation line. Rates in the workers' compensation line at Citizens were decreased 8.5%, 7.0%, 6.4% and 8.7% effective May 1, 1995, December 1, 1995, June 1, 1996 and March 1, 1997, respectively. This decrease is partially offset by an increase in policies in force in the commercial multiple peril and commercial automobile lines of 16.6% and 2.7%, respectively. Underwriting results The commercial lines' underwriting loss decreased $13.6 million, or 42.4%, to a loss of $18.5 million in 1997. Hanover's underwriting results improved $19.1 million, or 54.4%, to a loss of $16.0 million and Citizens' underwriting results declined $5.5 million, to a loss of $2.5 million in 1997. The improvement in Hanover's underwriting results reflects an increase in favorable development on prior accident years in the workers' compensation and commercial automobile lines, as well as a decrease in catastrophe losses of $13.1 million, primarily in the commercial multiple peril line. These factors were partially offset by a decrease in favorable development on prior accident years in the commercial multiple peril line, as well as increased current year claim severity in the commercial automobile line. Citizens' underwriting results declined primarily due to an increase in current year severity and frequency in the commercial multiple peril line, less favorable development of prior year reserves in the commercial automobile line, and an increase in catastrophe losses of $1.6 million. These decreases were partially offset by a $13.9 million increase in favorable development of prior year claims in the workers' compensation line. Policy acquisition expenses in the commercial lines increased $3.7 million, or 2.5%, to $152.5 million in 1997 and other underwriting expenses increased $3.9 million, or 4.2%, to $96.3 million. Hanover's policy acquisition expenses increased $2.9 million, or 2.9%, to $104.0 million, primarily attributable to growth in net premiums earned. Other underwriting expenses at Hanover increased $4.8 million, or 6.9%, to $74.5 million, as a result of higher net premiums earned and increased re-engineering costs associated with the underwriting and policy processing in the commercial underwriting segment, partially offset by decreased contingent commissions and employee related expenses. Citizens' policy acquisition expenses increased $0.8 million, or 1.7%, to $48.5 million, primarily as a result of higher commission rates, offset by a decrease in net premiums earned. Other underwriting expenses decreased $0.9 million, or 4.0%, to $21.8 million due to reductions in employee related expenses. Investment Results - -------------------------------------------------------------------------------- Net investment income before taxes was $228.9 million, $253.3 million and $233.2 million in 1998, 1997 and 1996, respectively. The decrease in net investment income in 1998, compared to 1997, primarily reflects a reduction in invested assets as a result of a $117.1 million and a $53.9 million transfer of assets to the Corporate Segment in April, 1998 and December, 1997, respectively. In addition, net investment income in 1998 includes a $0.8 million loss from partnerships, compared to $6.2 million of income from partnerships in 1997. Average pre-tax yields on debt securities remained relatively stable at 6.7% in 1998 compared to 6.8% for 1997. Average invested assets decreased $82.4 million, or 2.1%, to $3,943.4 million in 1998, compared to $4,025.8 million in 1997. The increase in 1997 from 1996 represents an increase in average invested assets and the Company's portfolio shift, in this segment, to higher yielding debt securities, including longer duration and non-investment grade securities. Average pre-tax yields on debt securities increased to 6.8% in 1997 from 6.4% in 1996. Reserve for Losses and Loss Adjustment Expenses - -------------------------------------------------------------------------------- The Property and Casualty segment maintains reserves to provide for its estimated 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, predictions of future events, estimates of future trends in claim severity and judicial theories of liability 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 Property and Casualty segment regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Changes in prior reserve estimates are recorded in results of operations in the year such changes are determined to be needed. 33 The table below provides a reconciliation of the beginning and ending reserve for unpaid losses and LAE as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Reserve for losses and LAE, beginning of year $ 2,615.4 $ 2,744.1 $ 2,896.0 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,609.0 1,564.1 1,513.3 Decrease in provision for insured events of prior years (127.2) (127.9) (141.4) --------------------------------------- Total incurred losses and LAE 1,481.8 1,436.2 1,371.9 --------------------------------------- Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 871.9 775.1 759.6 Losses and LAE attributable to insured events of prior years 643.0 732.1 627.6 --------------------------------------- Total payments 1,514.9 1,507.2 1,387.2 --------------------------------------- Change in reinsurance recoverable on unpaid losses 15.0 (50.2) (136.6) Other (1) -- (7.5) -- --------------------------------------- Reserve for losses and LAE, end of year $ 2,597.3 $ 2,615.4 $ 2,744.1 ======================================= (1) Includes purchase accounting adjustments. As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $127.2 million, $127.9 million and $141.4 million in 1998, 1997 and 1996, respectively. The decrease in favorable development on prior years' reserves of $0.7 million in 1998 results from a $20.7 million decrease in favorable development at Citizens, significantly offset by a $20.0 million increase in favorable development at Hanover. The decrease in favorable development on prior year reserves at Citizens in 1998, reflects a $13.8 million decrease in favorable development, to $21.9 million, in the workers' compensation line. In addition, favorable development in the commercial multiple peril line decreased $4.0 million, to $0.3 million. These declines in favorable development are partially offset by continued favorable development on prior year reserves in the personal automobile line due to tort reform in Michigan, which became effective July 26, 1996. The new legislation requires judges rather than juries to determine if the minimum threshold to allow pain and suffering damage settlements has been met. The increase in favorable development at Hanover during 1998 reflects a $20.6 million increase in favorable development on prior year reserves, to $38.0 million, in the personal automobile line, as well as a $14.9 million increase, to $12.1 million, in the commercial multiple peril line. These increases are primarily attributable to claims' process improvement initiatives taken by the Company over the past two years which are expected to reduce the ultimate costs of settling claims. These increases are partially offset by less favorable development in the workers' compensation line where favorable development on prior year reserves decreased $19.2 million, to $9.6 million. The decrease in favorable development on prior years' reserves of $13.5 million in 1997 results primarily from a $24.6 million decrease in favorable development at Hanover, to $58.4 million, partially offset by an $11.1 million increase in favorable development at Citizens, to $69.5 million. The decrease in Hanover's favorable development of $24.6 million in 1997 reflects a decrease in favorable development of $25.0 million, to $17.4 million, in the personal automobile line, as well as a decrease in favorable development of $8.5 million, to unfavorable development of $2.8 million, in the commercial multiple peril line. These decreases were partially offset by an increase in favorable development in the workers' compensation line of $11.5 million, to $28.8 million. The increase in favorable development at Citizens in 1997 reflects improved severity in the workers' compensation line, where favorable development increased $13.9 million, to $35.7 million, and in the commercial multiple peril line, where favorable development increased $7.0 million, to $4.3 million. These increases are partially offset by less favorable development in the personal automobile line, where favorable development decreased $10.5 million to $22.5 million in 1997. This favorable development reflects the Property and Casualty segment's reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Due to the nature of the business written by the Property and Casualty segment, the exposure to environmental liabilities is relatively small and therefore its reserves are relatively small compared to other types of liabilities. Loss and LAE reserves related to environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $49.9 million, $53.1 million and $50.8 million, net of reinsurance of $14.2 million, $15.7 million and $20.2 million in 1998, 1997 and 1996, respectively. The Company does not specifically underwrite policies that include this coverage, but as case law expands policy provisions and insurers' liability beyond the intended coverage, the Company may be required to defend such claims. The Company estimated 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 claims are not material, their existence gives rise to uncertainty and is discussed because of the possibility, however remote, that they may become material. The Company believes that, 34 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. 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, to anticipate the potential impact of inflation in the projection of ultimate costs. The impact of inflation has been relatively insignificant in recent years. However, inflation 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, changes in 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. Corporate Risk Management Services The following table summarizes the results of operations for the Corporate Risk Management Services segment. - ------------------------------------------------------------------------ For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------ (In millions) - ------------------------------------------------------------------------ Premiums and premium equivalents Premiums $ 336.0 $ 333.0 $ 302.9 Premium equivalents 684.0 603.6 581.4 - ------------------------------------------------------------------------ Total premiums and premium equivalents $ 1,020.0 $ 936.6 $ 884.3 - ------------------------------------------------------------------------ Segment revenues Premiums $ 336.0 $ 333.0 $ 302.9 Net investment income 20.7 23.1 22.1 Other income 57.4 49.5 45.7 - ------------------------------------------------------------------------ Total segment revenues 414.1 405.6 370.7 Policy benefits, claims and losses 248.9 238.9 211.3 Policy acquisition expenses 3.2 3.3 3.1 Other operating expenses 154.4 136.4 128.0 - ------------------------------------------------------------------------ Segment income $ 7.6 $ 27.0 $ 28.3 - ------------------------------------------------------------------------ 1998 Compared to 1997 Segment income before taxes decreased $19.4 million, or 71.9%, to $7.6 million in 1998. This decrease was primarily due to unfavorable loss experience in the risk-sharing and long-term disability lines of approximately $14.0 million, and to increased operating expenses of $18.0 million, primarily from higher claims processing and customer service costs. These decreases were partially offset by an $8.0 million increase in administrative service fees, and to favorable loss experience in the life and fully insured dental product lines of $5.1 million. In addition, segment results reflect the Company's agreement with a highly rated reinsurer to cede the underwriting losses of the accident and health assumed reinsurance pool business, effective July 1, 1998. After consideration of this transaction, segment income before taxes improved $1.5 million in the accident and health assumed reinsurance pool business, primarily attributable to lower underwriting losses recorded during the third and fourth quarters of 1998. This reinsurance agreement is consistent with the Company's restructuring initiative in its Corporate Risk Management Services segment, whereby it announced its exit from the accident and health assumed reinsurance pool business. Premiums increased $3.0 million, or 0.9%, to $336.0 million, primarily due to growth in the risk sharing product line of $8.5 million, accident and health assumed reinsurance pool business of $8.0 million, and the group life product line of $3.5 million. These increases were partially offset by decreases in fully insured medical and dental product lines of $16.1 million, which primarily reflects the cancellation of several large unprofitable accounts. Other income increased $7.9 million, or 16.0%, to $57.4 million in 1998, due to an increase in administrative service fees. In 1998, the Company decided to exit its administrative service only business as part of its restructuring plan. Other income includes $5.5 million and $6.0 million related to this business in 1998 and 1997, respectively. Policy benefits, claims and losses increased $10.0 million, or 4.2%, to $248.9 million in 1998. This increase is primarily attributable to increases of $19.3 million in the risk sharing lines of business due to growth and unfavorable loss experience. In addition, increases of $4.1 million in the accident and health assumed reinsurance pool business resulted from growth, and $3.3 million in the long-term disability insurance product line resulted from unfavorable loss experience. The results of the accident and health assumed reinsurance pool business reflect the effects of the aforementioned reinsurance transaction in the third quarter of 1998, which decreased losses during the third and fourth quarters of 1998. These increases were also partially offset by reduced losses in the fully insured medical and dental product lines totaling $16.4 million, primarily due to decreased revenue in both products and 35 improved loss experience in dental. Additionally, policy benefits, claims and losses in the group life product line decreased primarily due to favorable loss experience, partially offset by growth. Operating expenses increased $18.0 million, or 13.2%, to $154.4 million in 1998, primarily due to increased claims processing, customer service, and technology expenses, as well as growth related increases in commissions, expense allowances, and premium taxes. 1997 Compared to 1996 Segment income before taxes decreased $1.3 million, or 4.6%, to $27.0 million in 1997. This decrease was primarily due to unfavorable mortality in the group life product line of $8.4 million, partially offset by a reduction in employee and administrative costs of $4.8 million, a $1.0 million contribution from the assumption of a block of affinity group life and health business in January 1997, and improved experience in the long-term disability, stop loss and risk sharing product lines. Premiums increased $30.1 million, or 9.9%, to $333.0 million in 1997, primarily due to increases in reinsurance, fully insured group dental and stop loss product lines totaling $30.2 million, including $18.9 million resulting from the aforementioned assumption of a block of affinity group life and health business. These increases were partially offset by decreases in the risk sharing product line of $2.6 million. The decline in risk sharing premiums primarily reflects the Company's emphasis on stop loss coverage and administrative services arrangements. Other income increased $3.8 million, or 8.3%, to $49.5 million in 1997, due to growth in administrative service fees. Policy benefits, claims and losses increased $27.6 million, or 13.1%, to $238.9 million in 1997. This increase is primarily due to growth in reinsurance products, including the aforementioned assumption of a block of affinity group life and health business, which contributed $12.0 million in policy benefits during the year. Additionally, group life benefits increased $8.2 million due to unfavorable mortality experience in 1997. Fully insured group dental increased by $7.3 million due to growth in the product line. These increases were partially offset by decreased benefits in the fully insured medical product line and improved experience in the long-term disability, stop loss and risk sharing product lines. Other operating expenses increased $8.4 million, or 6.6%, to $136.4 million in 1997, primarily due to increases of $6.2 million in premium taxes and commissions resulting from the growth in premiums and administrative service fees. In addition, 1997 expenses included $5.9 million related to the aforementioned affinity group life and health business. These items were partially offset by decreases in employee and administrative costs of $4.8 million. Retirement and Asset Accumulation ====================================================================== Allmerica Financial Services The following table summarizes the results of operations, including the Closed Block, for the Allmerica Financial Services segment. - ---------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ---------------------------------------------------------------------- (In millions) - ---------------------------------------------------------------------- Segment revenues Premiums $ 58.1 $ 83.0 $ 96.8 Fees 296.6 241.5 197.1 Net investment income 306.4 335.0 363.8 Other income 62.9 54.4 42.3 ------------------------------ Total segment revenues 724.0 713.9 700.0 Policy benefits, claims and losses 314.3 356.6 374.3 Policy acquisition expenses 62.5 61.0 64.0 Other operating expenses 180.5 161.7 154.9 ------------------------------ Segment income $ 166.7 $ 134.6 $ 106.8 ============================== 1998 Compared to 1997 Segment income before taxes increased $32.1 million, or 23.8%, to $166.7 million in 1998. This increase is primarily attributable to higher asset-based fee income driven by growth and market appreciation in the variable annuity and variable universal life product lines, partially offset by an increase in policy acquisition and other operating expenses incurred as a result of this growth. Additionally, in 1997, the Company revised the mortality assumptions used to determine the amortization of policy acquisition costs and recognition of certain fees for this segment's universal life and variable universal life lines of business, which resulted in decreased policy acquisition costs in 1998 of approximately $8.4 million in these product lines. In addition, as a result of a January 1, 1998 agreement with a highly rated reinsurer to reinsure the mortality risk on the universal life and variable universal life lines of business, policy benefits, claims and losses decreased approximately $3.1 million. The terms and provisions of the reinsurance contract are consistent with the aforementioned change in mortality assumptions. These increases were partially offset by lower net investment income which included losses incurred on hedge fund partnership investments during 1998. Premiums decreased $24.9 million, or 30.0%, to $58.1 million in 1998. This decrease is due primarily to the cession, in 1997, of substantially all of the Company's individual disability income line of business, which contributed premiums of $0.6 million in 1998 compared to $22.8 million during 1997. The remaining decrease in premiums is a result of the Company's continued shift in focus from traditional life insurance products to variable life insurance and annuity products. The increase in fee revenue of $55.1 million, or 22.8%, to $296.6 million in 1998, is due to additional deposits and 36 appreciation on variable products' account balances. Fees from individual annuities increased $47.1 million, or 52.4%, to $137.0 million in 1998. Distribution arrangements with several third party mutual fund advisors continue to contribute to the increase in annuity sales in 1998. Fees from individual variable universal life policies increased $10.8 million, or 20.0%, to $64.7 million in 1998. These increases were partially offset by a continued decline in fees from non-variable universal life of $4.9 million. The Company expects fees from this product to continue decreasing as policies in force and related contract values decline. Net investment income decreased $28.6 million, or 8.5%, to $306.4 million in 1998, primarily due to a reduction in average fixed maturities invested resulting from the aforementioned cession of the Company's individual disability income line of business, asset transfers to the separate accounts in the annuity and group retirement product lines and from losses incurred on hedge fund partnership investments in the current year. Other income increased $8.5 million, or 15.6%, to $62.9 million in 1998, primarily due to increased investment management fee income resulting from growth in variable product assets under management. Policy benefits, claims and losses decreased $42.3 million, or 11.9%, to $314.3 million in 1998. This decrease is primarily due to the aforementioned cession of substantially all of the individual disability income line of business, which incurred policy benefits of $3.4 million in 1998, compared to $32.3 million in 1997. Also contributing to the overall decrease was a reduction in interest credited on group retirement products of $3.8 million due to the aforementioned shift to the separate accounts and to $3.1 million of improved mortality experience in the universal life and variable universal life lines of business. Policy acquisition expenses increased $1.5 million, or 2.5%, to $62.5 million in 1998. This increase is primarily due to growth in the individual variable annuity lines, partially offset by a reduction in amortization in the individual universal life and variable universal life lines of the business resulting from the aforementioned change in the Company's mortality assumptions in 1997. Other operating expenses increased $18.8 million, or 11.6%, to $180.5 million in 1998. This increase was primarily attributable to continued growth in the variable product lines, to increased technology costs, and to increased interest expense related to commercial paper used to manage short-term cash flows. These increases were partially offset by reductions in employee related costs resulting from the restructuring of the group retirement business during the fourth quarter of 1997. 1997 Compared to 1996 Segment income before taxes increased $27.8 million, or 26.0%, to $134.6 million in 1997. This increase is primarily attributable to growth in variable product lines, partially offset by lower net investment income due to a reduction in average fixed maturities invested. The decrease in premiums of $13.8 million, or 14.3%, to $83.0 million in 1997 is primarily due to the aforementioned cession of the Company's individual disability income line of business, which contributed premiums of $22.8 million in 1997 compared to $32.9 million in 1996. The remaining decrease reflects the Company's continued shift in focus from traditional life insurance products to variable life insurance and annuity products. The increase in fee revenue of $44.4 million, or 22.5%, to $241.5 million in 1997 is due to additional deposits and appreciation in variable products' account balances. Fees from variable annuities increased $32.9 million, or 57.7%, to $89.9 million in 1997. New distribution arrangements with several third party mutual fund advisors contributed to the increase in annuity sales in 1997. Fees from variable universal life policies increased $10.2 million, or 23.6%, to $53.5 million in 1997. Net investment income decreased $28.8 million, or 7.9%, to $335.0 million in 1997. This decrease is primarily due to a reduction in average invested assets, as a result of the aforementioned cession of the individual disability income line of business, transfers of assets to the separate accounts and cancellations of defined benefit plans. Other income increased $12.1 million, or 28.6%, to $54.4 million in 1997. This increase was primarily attributable to increased investment management fee income resulting from growth in assets under management. Policy benefits, claims and losses decreased $17.7 million, or 4.7%, to $356.6 million in 1997. This decrease reflects the aforementioned cession of the Company's individual disability income line of business, cancellations of defined benefit plans and asset transfers to the separate accounts. The increase in other operating expenses of $6.8 million, or 4.4%, to $161.7 million in 1997 was primarily attributable to increased premium taxes and administrative expenses related to the significant growth in the variable product lines during 1997, partially offset by reductions in employee related costs. Interest Margins The results of the Allmerica Financial Services segment depend, in part, on the maintenance of profitable margins between investment results from investment assets supporting universal life and general account annuity products and the interest credited on those products. 37 The following table sets forth interest earned, interest credited and the related interest margin. - ----------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ----------------------------------------------------------------------- (In millions) - ----------------------------------------------------------------------- Net investment income $ 129.8 $ 141.2 $ 145.9 Less: Interest credited 93.5 99.2 101.3 - ----------------------------------------------------------------------- Interest margins (1) $ 36.3 $ 42.0 $ 44.6 - ----------------------------------------------------------------------- (1)Interest margins represent the difference between income earned on investment assets and interest credited to customers' universal life and general account annuity policies. Earnings on surplus assets are excluded from net investment income in the calculation of the above interest margins. Interest margins decreased in 1998 due to the introduction of a new annuity program which provides, for a limited time, enhanced crediting rates on deposits made into the Company's general account. Interest margins decreased slightly in 1997, as compared to 1996, due to a decline in investment income and related policies in force in the universal life and general account annuity product lines. Allmerica Asset Management The following table summarizes the results of operations for the Allmerica Asset Management segment. - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Interest margins on GICs Net investment income $ 111.3 $ 82.3 $ 101.5 Interest credited 89.3 64.2 89.2 --------------------------------- Net interest margin 22.0 18.1 12.3 Fees and other income: External 4.0 2.2 1.8 Internal 6.4 6.6 7.2 Other operating expenses 8.7 8.5 9.8 --------------------------------- Segment income $ 23.7 $ 18.4 $ 11.5 --------------------------------- 1998 Compared to 1997 Segment income before taxes increased $5.3 million, or 28.8%, to $23.7 million in 1998, primarily due to an increase in GIC interest margins of $3.9 million and additional asset management fees of $1.6 million. Interest margins on new floating rate GICs increased $9.8 million in 1998, to $10.2 million, as compared to $0.4 million in 1997. This increase more than offset a decrease in the traditional GIC interest margins of $5.9 million, from $17.7 million in 1997, which resulted from the continued run-off of the traditional GIC product. Included in the traditional GIC interest margin in 1998 is the receipt of $2.6 million from a mortgage loan equity participation payment, while 1997 reflects approximately $1.5 million of one-time benefits. Additionally, fee revenue increased $1.6 million in 1998 due to growth in assets under management. 1997 Compared to 1996 Segment income before taxes increased $6.9 million, or 60.0%, to $18.4 million in 1997, primarily due to an increase in GIC interest margins of $5.8 million, and a reduction in employee related costs of $0.8 million. Net investment income related to GICs and interest credited to GIC contractholders declined as a result of declining traditional GIC deposits. During 1997, the interest margin on GICs increased due to a reallocation of general account assets to this line, and to the combination of slightly higher investment yields and lower average crediting rates on remaining contracts. Effective January 1, 1997, capital and investment assets were reallocated between defined benefit plan, defined contribution plan and GIC product lines. This reallocation resulted in an increase in GIC capital and investment assets of approximately $61.0 million. Had this reallocation occurred in 1996, interest earned in the GIC product line for the year ended December 31, 1996, would have been $103.3 million. Corporate The following table summarizes the results of operations for the Corporate segment for the periods indicated. - ----------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ----------------------------------------------------------------------- (In millions) - ----------------------------------------------------------------------- Segment revenues Investment and other income $ 12.9 $ 16.1 $ 6.9 Interest expense 16.0 18.1 16.6 Other operating expenses 47.8 46.0 48.3 - ----------------------------------------------------------------------- Segment loss $ (50.9) $ (48.0) $ (58.0) - ----------------------------------------------------------------------- 1998 Compared to 1997 [BAR CHART APPEARS HERE] Segment loss before taxes and minority interest increased $2.9 million, or 6.0%, to $50.9 million in 1998, primarily due to lower investment and other income and higher corporate overhead costs, partially offset by reduced interest and other corporate expenses. Investment and other income decreased $3.2 million in 1998 primarily from the absence of $9.1 million of short-term income generated by the temporary investment of the net proceeds from the issuance of Capital Securities in 1997. This was partially offset by additional income due to higher average invested assets resulting from transfers of $117.1 million and $53.9 million from the Property and Casualty segment in April 1998 and December 1997, respectively. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. In addition, interest expense in 1998 includes $0.7 million related to 38 the Company's short term revolving credit loan which commenced on December 4, 1998 to affect the acquisition of Citizens' minority interest, while interest expense in 1997 includes $2.8 million of Allmerica P&C merger-related interest expense. Other operating expenses increased $1.8 million, or 3.9%, to $47.8 million in 1998. This expense category consists primarily of corporate overhead expenses, which reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. The increase in other operating expenses is primarily due to $5.8 million of higher corporate overhead costs, partially offset by a reduction in other corporate expenses. 1997 Compared to 1996 Segment loss before taxes and minority interest decreased $10.0 million, or 17.2%, to $48.0 million in 1997, primarily due to increased investment and other income resulting from the investment of the net proceeds from the February 3, 1997 issuance of Capital Securities. These proceeds were invested in the short- term investment portfolio, and were used to finance the July 16, 1997 merger with Allmerica P&C. Interest expense for both periods relates principally to the interest paid on the Senior Debentures of the Company. Interest expense in 1997 also reflects a $2.8 million expense related to the Company's short-term revolving credit loan which commenced August 15, 1997 and was repaid and matured on December 15, 1997. Other operating expenses decreased $2.3 million, or 4.8%, to $46.0 million in 1997, primarily due to a decrease in corporate overhead costs of $4.6 million. Investment Portfolio The Company had investment assets diversified across several asset classes, as follows: - -------------------------------------------------------------------------------- December 31 1998 (1) 1997 (1) - -------------------------------------------------------------------------------- (Dollars in millions) - -------------------------------------------------------------------------------- % of Total % of Total Carrying Carrying Carrying Carrying Value Value Value Value Fixed maturities (2) $ 8,195.0 79.0% $ 7,726.6 79.8% Equity securities (2) 397.1 3.8 479.0 4.9 Mortgages 698.3 6.7 679.5 7.0 Policy loans 365.2 3.5 360.7 3.7 Real estate 20.4 0.2 50.3 0.5 Cash and cash equivalents 559.7 5.4 240.1 2.5 Other invested assets 142.7 1.4 148.3 1.6 ---------------------------------------------------- Total $ 10,378.4 100.0% $ 9,684.5 100.0% ---------------------------------------------------- (1) Includes Closed Block invested assets with a carrying value of $770.5 million and $768.7 million at December 31, 1998 and 1997, respectively. (2) The Company carries the fixed maturities and equity securities in its investment portfolio at market value. Total investment assets increased $693.9 million, or 7.2%, to $10.4 billion during 1998. This increase is primarily attributable to an increase in fixed maturities due to sales of floating rate GICs, and an increase in cash and cash equivalents due to a new annuity program initiated by the Allmerica Financial Services segment in 1998. This program provides, for a limited time, enhanced crediting rates for funds temporarily deposited into the Company's general account. Under this program, the funds are then transferred ratably, over a period of time, into the Company's separate account investments. Due to the limited holding period of these funds in the general account, the Company invests the related deposits in cash equivalents. Fixed maturities increased $468.4 million, or 6.1%, due primarily to an increase in funds available for investment generated from net GIC deposits of $794.2 million, partially offset by decreased investments due to a shift from general to separate account assets. In addition, proceeds from the sale of equity securities in the Property and Casualty segment were subsequently reinvested in tax-exempt fixed maturities during 1998. Equity securities decreased $81.9 million, or 17.1%, to $397.1 million, as a result of the shift in the Property and Casualty segment's portfolio holdings from equity securities to fixed maturity investments. Mortgage loans increased $18.8 million, or 2.8%, to $698.3 million, due primarily to new loan originations. The real estate portfolio decreased $29.9 million, or 59.4%, to $20.4 million during 1998, due to continued sales of investment properties. The Company intends to sell its remaining holdings in this portfolio. [PIE CHART APPEARS HERE] Bond portfolio credit quality The Company's fixed maturity portfolio is comprised of primarily investment grade corporate securities, tax-exempt issues of state and local governments, U.S. government and agency securities and other issues. Based on ratings by the National Association of Insurance Commissioners, investment grade securities comprised 84.7% and 82.5% of the Company's total fixed maturity portfolio at December 31, 1998 and 1997, respectively. The average yield on debt securities was 7.3% and 7.6% for 1998 and 1997, respectively. Although management expects that new funds will be invested primarily in investment grade fixed maturities, the Company may invest a portion of new funds in below investment grade fixed maturities or equity interests. 39 The following table illustrates asset valuation allowances and additions to or deductions from such allowances for the periods indicated. - -------------------------------------------------------------------------------- For the Years Ended December 31 - -------------------------------------------------------------------------------- (Dollars in millions) - -------------------------------------------------------------------------------- Real 1997 Mortgages Estate Total Beginning balance $ 19.6 $ 14.9 $ 34.5 Provisions 2.5 6.0 8.5 Write-offs (1) (1.4) (20.9) (22.3) ---------------------------------------- Ending balance $ 20.7 $ -- $ 20.7 Valuation allowance as a percentage of carrying value before reserves 3.0% -- 3.0% 1998 Provisions (6.8) -- (6.8) Write-offs (1) (2.4) -- (2.4) ---------------------------------------- Ending balance $ 11.5 $ -- $ 11.5 Valuation allowance as a percentage of carrying value before reserves 1.6% -- 1.6% (1) Write-offs reflect asset sales, foreclosures, and forgiveness of debt upon restructuring and reserve releases due to permanent impairments. The write-offs of real estate reserves during 1997 reflects the permanent write down of all real estate assets to the estimated fair value less costs of disposal. During 1997, the Company adopted a definitive plan to sell its real estate holdings. Market Risk and Risk Management Policies Interest Rate Sensitivity 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, sectors, and in the case of mortgages and real estate, property types and geographic locations. In addition, the Company carries long and short-term debt, as well as mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. The Company uses derivative financial instruments, primarily interest rate swaps, with indices that correlate to on-balance sheet instruments to modify its indicated net interest sensitivity to levels deemed to be appropriate. Specifically, for floating rate GIC liabilities that are matched with fixed rate securities, the Company manages the interest rate risk by hedging with interest rate swap contracts designed to pay fixed and receive floating interest. Additionally, the Company uses exchange traded financial futures contracts to hedge against interest rate risk on anticipated GIC sales. The following table provides information about the Company's financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted-average interest rates by expected maturities. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage backed and asset backed securities are included in the category representing their expected maturity. Available-for-sale securities include both U.S. and foreign-denominated bonds, but exclude interest rate swap contracts and foreign currency swap contracts, which are disclosed in separate tables. Foreign-denominated bonds are also shown separately in the table of financial instruments subject to foreign currency risk. For liabilities that have no contractual maturity, the table presents principal cash flows and related weighted-average interest rates based on the Company's historical experience, management's judgment, and statistical analysis, as applicable, concerning their most likely withdrawal behaviors. Additionally, the Company has assumed its available for sale securities are similar enough to aggregate those securities for presentation purposes. Specifically, variable rate available for sale securities and mortgage loans comprise an immaterial portion of the portfolio and do not have a significant impact on weighted average interest rates. Therefore, the variable rate investments are not presented separately; instead they are included in the table at their current interest rate. 40
- ----------------------------------------------------------------------------------------------------------------------------------- Fair Value (Dollars in millions) 1999 2000 2001 2002 2003 Thereafter Total 12/31/98 - ----------------------------------------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------------------------------------- Rate Sensitive Assets: Available for sale securities $ 527.4 $ 558.8 $ 574.8 $ 783.8 $ 811.7 $ 4,466.9 $ 7,723.4 $ 8,223.5 Average interest rate 8.22% 8.00% 7.71% 7.38% 6.90% 7.17% 7.33% Mortgage loans $ 91.9 $ 143.8 $ 64.8 $ 33.5 $ 44.5 $ 331.3 $ 709.8 $ 729.5 Average interest rate 8.31% 9.24% 7.89% 8.30% 7.42% 7.79% 8.16% Policy loans $ -- $ -- $ -- $ -- $ -- $ 365.2 $ 365.2 $ 365.2 Average interest rate -- -- -- -- -- 6.73% 6.73% Rate Sensitive Liabilities: Fixed interest rate GICs $ 337.1 $ 83.7 $ 25.8 $ 32.3 $ -- $ -- $ 478.9 $ 489.3 Average interest rate 6.51% 7.28% 6.87% 7.22% -- -- 6.71% Variable interest rate GICs $ 151.0 $ 57.2 $ -- $ 301.6 $ 803.1 $ -- $ 1,312.9 $ 1,341.5 Average interest rate 5.14% 5.32% -- 5.31% 5.41% -- 5.35% Supplemental contracts without life contingencies $ 16.0 $ 4.1 $ 3.7 $ 3.3 $ 2.9 $ 7.3 $ 37.3 $ 37.3 Average interest rate 4.25% 4.56% 4.57% 4.58% 4.60% 4.61% 4.44% Other individual contract deposit funds $ 16.1 $ 12.7 $ 9.7 $ 7.2 $ 4.8 $ 11.1 $ 61.6 $ 61.1 Average interest rate 4.08% 4.06% 4.04% 4.02% 4.00% 3.80% 4.01% Other group contract deposit funds $ 243.8 $ 274.0 $ 77.3 $ 43.0 $ 28.2 $ 34.1 $ 700.4 $ 704.0 Average interest rate 6.23% 5.96% 5.77% 5.66% 5.18% 5.93% 5.97% Individual fixed annuity contracts $ 108.7 $ 107.6 $ 103.6 $ 97.3 $ 90.9 $ 602.5 $ 1,110.6 $ 1,073.6 Average interest rate 4.49% 4.44% 4.40% 4.27% 4.20% 3.50% 3.90% Long term debt $ -- $ -- $ -- $ -- $ -- $ 199.5 $ 199.5 $ 213.4 Average interest rate -- -- -- -- -- 7.63% 7.63% Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company $ -- $ -- $ -- $ -- $ -- $ 300.0 $ 300.0 $ 334.7 Average interest rate -- -- -- -- -- 8.21% 8.21%
The following table provides information about the Company's derivative financial instruments used for purposes other than trading that are sensitive to changes in interest rates. The table presents notional amounts and, as applicable, weighted-average interest rates by contractual maturity date. Notional amounts are used to calculate the contractual payments to be exchanged under the contracts. Weighted-average variable rates are indicated by the applicable floating rate index. 41
- -------------------------------------------------------------------------------------------------------------------------------- (Dollars in millions) 1999 2000 2001 2002 2003 - -------------------------------------------------------------------------------------------------------------------------------- Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ -- $ 44.0 $ -- $ 102.5 $ 273.0 Average pay rate -- 6.16% -- 6.23% Average receive rate -- 3 Mo. LIBOR -- 3 Mo. LIBOR 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ -- $ -- $ -- $ 44.0 $ 337.5 Average pay rate -- -- -- 6.22% 5.75% Average receive rate -- -- -- 1 Mo. LIBOR 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ -- $ -- $ -- $ 88.0 $ 200.0 Average pay rate -- -- -- 5.81% 5.80% Average receive rate -- -- -- FED Funds FED Funds Futures Contracts (long) $ 86.5 $ -- $ -- $ -- $ -- Number of Contracts 758,000 -- -- -- -- (5 Year T Notes) Weighted average opening price 114.098 -- -- -- -- - ------------------------------------------------------------------------------------------------ Fair Value (Dollars in millions) Thereafter Total 12/31/98 - ------------------------------------------------------------------------------------------------ Rate Sensitive Derivative Financial Instruments: Pay fixed/receive 3 month LIBOR swaps $ 23.6 $ 443.1 $ (13.6) Average pay rate 5.71% 7.34% 5.96% Average receive rate 3 Mo. LIBOR 3 Mo. LIBOR Pay fixed/receive 1 month LIBOR swaps $ -- $ 381.5 $ (6.1) Average pay rate -- 5.80% Average receive rate -- 1 Mo. LIBOR Pay fixed/receive Fed Funds rate swaps $ -- $ 288.0 $ (8.6) Average pay rate -- 5.80% Average receive rate -- FED Funds Futures Contracts (long) $ -- $ 86.5 $ 85.9 Number of Contracts -- 758,000 (5 Year T Notes) Weighted average opening price -- 114.098
Foreign Currency Sensitivity A portion of the Company's investments consists of fixed interest 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, Canadian Dollar, Japanese Yen, British Pound, and Finnish Markkas. 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 contracts to hedge all of its net foreign currency exposure. The following tables 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 table summarizes information on instruments that are sensitive to foreign currency exchange rates, including fixed interest securities denominated in foreign currencies, and foreign currency forward exchange agreements. For foreign currency denominated securities with contractual maturities, the table presents principal cash flows, related weighted-average interest rates by contractual maturities, and applicable current forward foreign currency exchange rates. For foreign currency forward exchange agreements, the table presents 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. 42
- ------------------------------------------------------------------------------------------------------------------------------- (Currencies in millions) 1999 2000 2001 2002 2003 Thereafter - ------------------------------------------------------------------------------------------------------------------------------- Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs -- 10.0 -- -- -- -- Current forward foreign exchange rate -- 0.7077 -- -- -- -- Fixed interest rate securities denominated in Canadian Dollars 20.0 -- -- -- -- -- Current forward foreign exchange rate 0.6535 -- -- -- -- -- Fixed interest rate securities denominated in Japanese Yen -- 620.0 -- -- -- -- Current forward foreign exchange rate -- 0.0088 -- -- -- -- Fixed interest rate securities denominated in British Pounds -- -- -- -- -- 9.5 Current forward foreign exchange rate -- -- -- -- -- 1.6595 Fixed interest rate securities denominated in Finnish Markkas 47.3 -- -- -- -- -- Current forward foreign exchange rate 0.1962 -- -- -- -- -- Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency -- 10.0 -- -- -- -- Average contract rate -- 0.664 -- -- -- -- Current forward foreign exchange rate -- 0.7077 -- -- -- -- Pay Canadian Dollars Notional amount in foreign currency 20.0 -- -- -- -- -- Average contract rate 0.750 -- -- -- -- -- Current forward foreign exchange rate 0.653 -- -- -- -- -- Pay Japanese Yen Notional amount in foreign currency -- 620.0 -- -- -- -- Average contract rate -- 0.0081 -- -- -- -- Current forward foreign exchange rate -- 0.0088 -- -- -- -- Pay British Pounds Notional amount in foreign currency -- -- -- -- -- 9.5 Average contract rate -- -- -- -- -- 1.980 Current forward foreign exchange rate -- -- -- -- -- 1.6595 Pay Finnish Markkas Notional amount in foreign currency 47.3 -- -- -- -- -- Average contract rate 0.211 -- -- -- -- -- Current forward foreign exchange rate 0.1962 -- -- -- -- -- - ----------------------------------------------------------------------------------------- Fair Value (Currencies in millions) Total 12/31/98 - ----------------------------------------------------------------------------------------- Fixed Interest Securities Denominated in Foreign Currencies: Fixed interest rate securities denominated in Swiss Francs 10.0 $ 7.0 Current forward foreign exchange rate 0.7077 Fixed interest rate securities denominated in Canadian Dollars 20.0 $ 15.3 Current forward foreign exchange rate 0.6535 Fixed interest rate securities denominated in Japanese Yen 620.0 $ 5.5 Current forward foreign exchange rate 0.0088 Fixed interest rate securities denominated in British Pounds 9.5 $ 25.0 Current forward foreign exchange rate 1.6595 Fixed interest rate securities denominated in Finnish Markkas 47.3 $ 10.1 Current forward foreign exchange rate 0.1962 Currency Swap Agreements Related to Fixed Interest Securities: Pay Swiss Francs Notional amount in foreign currency 10.0 $ (0.9) Average contract rate 0.664 Current forward foreign exchange rate 0.7077 Pay Canadian Dollars Notional amount in foreign currency 20.0 $ 1.9 Average contract rate 0.750 Current forward foreign exchange rate 0.6535 Pay Japanese Yen Notional amount in foreign currency 620.0 $ (0.1) Average contract rate 0.0081 Current forward foreign exchange rate 0.0088 Pay British Pounds Notional amount in foreign currency 9.5 $ (2.3) Average contract rate 1.980 Current forward foreign exchange rate 1.6595 Pay Finnish Markkas Notional amount in foreign currency 47.3 $ 1.2 Average contract rate 0.211 Current forward foreign exchange rate 0.1962
43 Income Taxes AFC and its domestic subsidiaries (including certain non-insurance operations) file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or a non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Prior to the July 16, 1997 merger, Allmerica P&C and its subsidiaries filed a separate United States federal income tax return. FAFLIC, as a mutual insurance company until October 1995, was required to adjust its deduction for policyholder dividends by the differential earnings amount under Section 809 of the Internal Revenue Code. This amount was computed, for each tax year, by multiplying the average equity base of the FAFLIC/AFLIAC consolidated group, as determined for tax purposes, by the estimate of an excess of an imputed earnings rate over the average mutual life insurance companies' earnings rate. The differential earnings amount for each tax year was subsequently recomputed when actual earnings rates were published by the Internal Revenue Service ("IRS"). As a stock company, FAFLIC is no longer required to reduce its policyholder dividend deduction by the differential earnings amount. The differential earnings amount in 1996 related to an adjustment for the 1994 tax year based on the actual average mutual life insurance companies' earnings rate issued by the IRS in 1996. The provision for federal income taxes before minority interest was $49.1 million during 1998 compared to $93.6 million during 1997. These provisions resulted in consolidated effective federal tax rates of 17.6% and 25.6%, respectively. The effective tax rates for FAFLIC and AFLIAC and their non-insurance subsidiaries were 27.7% and 37.4% during 1998 and 1997, respectively. The decrease in the rate for AFLIAC and FAFLIC and its non-insurance subsidiaries resulted primarily from an increase in available tax credits, as well as the reduction, in 1998, of any net increase in reserves for prior year tax liabilities. The effective tax rates for Allmerica P&C and its subsidiaries were 10.7% and 16.5% during 1998 and 1997, respectively. The decrease in the rate for Allmerica P&C and its subsidiaries reflects higher underwriting losses and a greater proportion of pre-tax income from tax-exempt bonds in 1998. Provision for federal income taxes before minority interest was $93.6 million during 1997 compared to $75.2 million during 1996. These provisions resulted in consolidated effective federal tax rates of 25.6% and 22.7%, respectively. The effective tax rates for FAFLIC and AFLIAC and their non- insurance subsidiaries were 37.4% and 28.9% during 1997 and 1996, respectively. The increase in the rate for FAFLIC in 1997 resulted primarily from the absence, in 1997, of a $10.2 million differential earnings benefit recognized in 1996, and from an increase in reserves for prior year tax liabilities. The effective tax rates for Allmerica P&C and its subsidiaries were 16.5% and 18.4% during 1997 and 1996, respectively. The decrease in the rate for Allmerica P&C and its subsidiaries reflects a higher underwriting loss and greater proportion of pre- tax income from tax-exempt bonds in 1997. Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. As a holding company, AFC's primary source of cash is dividends from its insurance subsidiaries. However, dividend payments to AFC by its insurance subsidiaries are subject to limitations imposed by state regulators, such as the requirement that cash dividends be paid out of unreserved and unrestricted earned surplus and restrictions on the payment of "extraordinary" dividends, as defined. Sources of cash for the Company's insurance subsidiaries are from premiums and fees collected, investment income and maturing investments. Primary cash outflows are paid benefits, claims, losses and loss adjustment expenses, policy acquisition expenses, other underwriting expenses and investment purchases. Cash outflows related to benefits, claims, losses and loss adjustment expenses can be variable because of uncertainties surrounding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. The Company periodically adjusts its investment policy to respond to changes in short-term and long-term cash requirements. Net cash provided by operating activities was $37.9 million in 1998 and $156.0 million in 1996, compared to net cash used in operating activities of $173.2 million in 1997. The increase in 1998 resulted primarily from the absence of a $207.0 million payment made during 1997 for the cession of the disability income line of business, partially offset by a 1998 payment of $30.3 million related to exiting reinsurance pools. Also, cash was used in 1998 operations to fund increased commissions and other deferred expenses related to continued growth in the variable annuity product lines of the Allmerica Financial Services segment, and to pay the federal taxes resulting from audits of prior return years. The decrease from 1996 to 1997 was primarily attributable to the aforementioned $207.0 million payment during 1997, a significant acceleration of claims payments in the Property and Casualty segment and increased commissions and other deferred expenses related to growth in the annuity and variable life product lines. Net cash used in investing activities was $617.1 million in 1998, while net cash provided by investing activities was $120.5 million and $424.6 million in 1997 and 1996, respectively. The change in 1998 primarily reflects the absence of proceeds from sales of fixed maturities in 1997 used to fund the aforementioned cession of the disability income line of business, the purchase of the minority interest of Citizens during 1998 for $195.9 million, and greater net purchases of fixed maturities resulting from an increase in funds available from floating rate GIC deposits. These were partially offset by increased net sales of equity securities in 1998. In 1997, $425.6 million was used to purchase the minority interest of Allmerica P&C. The decrease from 1996 to 1997 primarily reflects the aforementioned purchase of the minority interest of Allmerica P&C and fewer sales of investments used to finance net GIC withdrawals. The decrease was partially offset by a 44 decreased amount of funds being reinvested in fixed maturity investments. The proceeds from the sale of fixed maturities were instead used to finance the cession of the disability income line of business, $140.0 million of the aforementioned purchase price of the acquisition of minority interest of Allmerica P&C, and the acceleration of claims payments in the Property and Casualty segment. Net cash provided by financing activities was $898.7 million and $90.3 million in 1998 and 1997, while net cash used by financing activities was $685.1 million in 1996. In 1998, cash provided by financing activities was positively impacted by net GIC deposits of $794.2 million compared to net GIC withdrawals of $189.6 million in 1997. In addition, short term borrowings increased to $188.3 million primarily related to the Citizens merger in 1998. These increases were partially offset by the 1997 receipt of net proceeds of $296.3 million from the issuance of capital securities and $82.7 million of treasury stock purchases in 1998. During 1998, FAFLIC's Board of Directors declared and paid a common stock dividend to AFC of $50.0 million. In addition, assets of $117.1 million and $53.9 million were transferred from the Property and Casualty segment to the Corporate segment in April 1998 and December 1997, respectively. AFC has sufficient funds at the holding company or available through dividends from FAFLIC and Allmerica P&C to meet its obligations to pay interest on the Senior Debentures, Capital Securities and dividends, when and if declared by the Board of Directors, on the common stock. Whether the Company will pay dividends in the future depends upon the costs of administering a dividend program as compared to the benefits conferred, and upon the earnings and financial condition of AFC. Based on current trends, the Company expects to continue to generate sufficient positive operating cash to meet all short-term and long-term cash requirements. The Company maintains a high degree of liquidity within the investment portfolio in fixed maturity investments, common stock and short-term investments. Effective May 29, 1998, AFC entered into a credit agreement which replaces lines of credit previously held by FAFLIC and Allmerica P&C, provides for a $150.0 million credit facility, which expires on May 28, 1999. 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. These lines of credit generally had terms of less than one year, and required the Company to pay annual commitment fees limited to 0.06% of the available credit. In addition, effective December 4, 1998, AFC entered into a second credit agreement that provided for a $150.0 million credit facility. All available borrowings were outstanding under this line at December 31, 1998. These borrowings were repaid, and the related credit agreement matured, on February 5, 1999. Additionally, the Company had commercial paper borrowings and repurchase agreements outstanding at December 31, 1998 of $41.3 million and $30.0 million, respectively. Contingencies In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998, and has scheduled a hearing in March 1999 to consider final approval. Accordingly, AFC recognized a $20.2 million expense, net of taxes, during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. Recent Developments In December 1997, the AICPA issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SoP No. 97-3"). SoP No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and how to measure the liability. This statement allows for the discounting of the liability if the amount and timing of the cash payments are fixed and determinable. In addition, it provides criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges. This statement is effective for fiscal years beginning after December 15, 1998. The Company believes that the adoption of this statement will not have a material effect on the results of operations or financial position. In June 1998, the Financial Accounting Standards Board ("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 an entity recognize all derivatives as either assets or liabilities at fair value in the statement of financial position, and establishes special accounting for the following three types of hedges: fair value hedges, cash flow hedges, and hedges of foreign currency exposures of net investments in foreign operations. This statement is effective for fiscal years beginning after June 15, 1999. The Company is currently assessing the impact of the adoption of Statement No. 133. On October 27, 1998, the Board of Directors of AFC authorized the repurchase of up to $200.0 million of its issued common stock. As of December 31, 1998, AFC had repurchased 45 1.5 million shares of its common stock for an aggregate cost of approximately $82.7 million. Through February 26, 1999, an additional 1.6 million shares have been repurchased. On October 29, 1998, the Company announced that it is restructuring its Risk Management business. As part of this initiative, the Company, in its Corporate Risk Management Services segment, has exited its accident and health assumed reinsurance pool business, as well as its administrative services only business. Additionally, it has commenced the closing of nearly half of its nationwide Corporate Risk Management Services' sales offices, eliminated certain staff, and discontinued certain automation initiatives. The Property and Casualty segment is consolidating its field support activities from fourteen regional branches into three hub locations. As a result of this restructuring initiative, the Company recognized a pre-tax loss of $13.0 million, in the fourth quarter of 1998. On February 5, 1999, the Company announced it sustained pre-tax catastrophe losses estimated at $44.5 million in January 1999, as a result of winter snow storms and adverse weather that struck the Midwest, Northeast and the South. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on a third party assessment, the Company determined that significant portions of its software required modification or replacement to enable its computer systems to properly process dates beyond December 31, 1999. The Company is presently completing the process of modifying or replacing existing software and believes that this action will resolve the Year 2000 issue. However, if such modifications and conversions are not made, or are not completed timely, or should there be serious unanticipated interruptions from unknown sources, the Year 2000 issue could have a material adverse impact on the operations of the Company. Specifically, the Company could experience, among other things, an interruption in its ability to collect and process premiums, process claim payments, safeguard and manage its invested assets, accurately maintain policyholder information, accurately maintain accounting records, and perform customer service. Any of these specific events, depending on duration, could have a material adverse impact on the results of operations and the financial position of the Company. The Company has initiated formal communications with all of its suppliers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 issue. The Company's total Year 2000 project cost and estimates to complete the project include the estimated costs and time associated with the Company's involvement on a third party's Year 2000 program, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have material adverse effect on the Company. The Company does not believe that it has material exposure to contingencies related to the Year 2000 issue for the products it has sold. Although the Company does not believe that there is a material contingency associated with the Year 2000 issue, there can be no assurance that exposure for material contingencies will not arise. The cost of the Year 2000 project will be expensed as incurred and is being funded primarily through a reallocation of resources from discretionary projects and a reduction in systems maintenance and support costs. Therefore, the Year 2000 project is not expected to result in any significant incremental technology cost and is not expected to have a material effect on the results of operations. The Company has incurred and expensed approximately $54 million related to the assessment, plan development and substantial completion of the Year 2000 project, through December 31, 1998. The total remaining cost of the project is estimated between $20 - 30 million. Approximately 10% of the Company's Year 2000 resources to be utilized in 1999 have been allocated to the Company's remediation plan, which has three mission critical elements: internal systems, desktop systems, and external partners. Internal Systems Over 98% of the Company's internal systems have been corrected, tested for year 2000 dates, and returned to production. The remaining systems, which include relatively small systems waiting for vendor upgrade or scheduled for elimination or replacement, are targeted to be complete by June 30, 1999. Desktop Systems The Company has verified that all desktop computers are capable of correctly processing year 2000 dates. Additionally, over 98% of the third party software installed on the Company's desktop machines has been confirmed capable of processing year 2000 dates properly. The remaining desktop systems are expected to be upgraded, eliminated, or replaced by June 30, 1999. 46 External Partners The Company has verified that 50% of its electronic interfaces will process year 2000 dates correctly. Eighty percent of the Property and Casualty agents have confirmed that they are capable of properly processing year 2000 dates. Sixty percent of the Company's non-electronic partners have responded that they are capable of properly processing year 2000 dates. Most external partners have informed the Company that they expect to be compliant. The Company hopes for full compliance of external partners by July 1, 1999. In partnership with an outside consulting firm, the Company has completed an enterprise-wide year 2000 business risk identification and assessment. The Continuity of Operations Plan (COOP) requirements have been identified for all business units of the Company and applicable plans are currently being developed. These plans will contain immediate steps needed to keep business functions operating while unforeseen Year 2000 issues are being addressed. It outlines responses to situations that may affect critical business functions and also provides triage guidance, a documented order of actions to respond to problems. During the triage process, business priorities are established and "Critical Points of Failure" are identified as having a significant impact on the business. The Company's contingency plans are designed to keep business unit operations functioning in the event of a failure or delay due to Year 2000 record format and date calculation changes. All plans, including individual plans by business segment, are scheduled to be completed by September 30, 1999. Contingency planning will utilize approximately 15% of the Company's Year 2000 resources in 1999. The remaining 75% of the Company's Year 2000 resources will be utilized to address on-going compliance issues. These include periodic reviews of applications, installation and testing of new hardware and software packages, testing new software maintenance and testing internally developed software. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party responsiveness and modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the Year 2000 readiness of suppliers and business partners, and similar uncertainties. Forward-Looking Statements The Company wishes to caution readers that the following important factors, among others, in some cases have affected and in the future could affect, the Company's actual results and could cause the Company's actual results for 1998 and beyond to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. When used in the MD&A discussion, the words "believes," "anticipated," "expects" and similar expressions are intended to identify forward-looking statements. See "Important Factors Regarding Forward-Looking Statements" incorporated herein by reference and filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K for the period ended December 31, 1998. Factors that may cause actual results to differ materially from those contemplated or projected, forecast, estimated or budgeted in such forward looking statements include among others, the following possibilities: (i) adverse catastrophe experience and severe weather; (ii) adverse loss development for events the Company insured in prior years or adverse trends in mortality and morbidity; (iii) heightened competition, including the intensification of price competition, the entry of new competitors, and the introduction of new products by new and existing competitors; (iv) adverse state and federal legislation or regulation, including decreases in rates, limitations on premium levels, increases in minimum capital and reserve requirements, benefit mandates, limitations on the ability to manage care and utilization, and tax treatment of insurance and annuity products; (v) changes in interest rates causing a reduction of investment income or in the market value of interest rate sensitive investments; (vi) failure to obtain new customers, retain existing customers or reductions in policies in force by existing customers; (vii) higher service, administrative, or general expense due to the need for additional advertising, marketing, administrative or management information systems expenditures; (viii) loss or retirement of key executives; (ix) increases in medical costs, including increases in utilization, costs of medical services, pharmaceuticals, durable medical equipment and other covered items; (x) termination of provider contracts or renegotiations at less cost-effective rates or terms of payment; (xi) changes in the Company's liquidity due to changes in asset and liability matching; (xii) restrictions on insurance underwriting, based on genetic testing and other criteria; (xiii) adverse changes in the ratings obtained from independent rating agencies, such as Moody's, Standard and Poor's, A.M. Best, and Duff & Phelps; (xiv) lower appreciation on and decline in value of managed investments, resulting in reduced variable products' assets and related fees; (xv) possible claims and liabilities relating to sales practices for insurance products; (xvi) uncertainty related to the Year 2000 issue; (xvii) failure of a reinsurer of the Company's policies to pay its liabilities under reinsurance contracts; (xviii) earlier than expected withdrawals from the Company's general account annuities, GICs, and other insurance products; and (xix) changes in the mix of assets comprising the Company's investment portfolio and the fluctuation of the market value of such assets. 47 Report of Independent Accountants PRICEWATERHOUSECOOPERS To the Board of Directors and Shareholders of Allmerica Financial Corporation In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows present fairly, in all material respects, the financial position of Allmerica Financial Corporation and its subsidiaries (the "Company") at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide reasonable basis for the opinion expressed above. /s/ PRICEWATERHOUSECOOPERS LLP Boston, Massachusetts February 2, 1999 Management Report on Responsibility for Financial Reporting The management of Allmerica Financial Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in conformity with generally accepted accounting principles and include amounts based on management's informed estimates and judgments. We believe that these statements present fairly the Company's financial position and results of operations and that the other information contained in the annual report is accurate and consistent with the financial statements. Allmerica Financial Corporation's Board of Directors annually appoints independent accountants to perform an audit of its consolidated financial statements. The financial statements have been audited by PricewaterhouseCoopers LLP, independent accountants, in accordance with generally accepted auditing standards. Their audit included consideration of the Company's system of internal control in order to determine the audit procedures required to express their opinion on the consolidated financial statements. Management of Allmerica Financial Corporation has established and maintains a system of internal control that provides reasonable assurance that assets are safeguarded and that transactions are properly authorized and recorded. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees with significant roles in the financial reporting process and updated as necessary. Management continually monitors the system of internal control for compliance. Allmerica Financial Corporation and its subsidiaries maintain a strong internal audit program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. Management recognizes the inherent limitations in all internal control systems and believes that our system of internal control provides an appropriate balance between the costs and benefits desired. Management believes that the Company's system of internal control provides reasonable assurance that errors or irregularities that would be material to the financial statements are prevented or detected in the normal course of business. The Audit Committee of the Board of Directors, composed solely of outside directors, oversees management's discharge of its financial reporting responsibilities. The committee meets periodically with management, our internal auditors and our independent accountants, PricewaterhouseCoopers LLP. Both our internal auditors and PricewaterhouseCoopers LLP have direct access to the Audit Committee. Management recognizes its responsibility for fostering a strong ethical climate. This responsibility is reflected in the Company's policies which address, among other things, potential conflicts of interest; compliance with all domestic and foreign laws including those relating to financial disclosure and the confidentiality of proprietary information. Allmerica Financial Corporation maintains a systematic program to assess compliance with these policies. /s/ John F. O'Brien /s/ Edward J. Parry, III John F. O'Brien Edward J. Parry, III President and Chief Vice President, Executive Officer Chief Financial Officer, Treasurer and Principal Accounting Officer 48 Consolidated Statements of Income
- ------------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------- (In millions, except per share data) - ------------------------------------------------------------------------------------------------------------------------------- Revenues Premiums $ 2,305.0 $ 2,311.1 $ 2,236.3 Universal life and investment product policy fees 296.6 237.3 197.2 Net investment income 624.2 653.4 672.6 Net realized investment gains 60.9 76.2 65.9 Other income 145.8 117.6 113.1 ------------------------------------------------- Total revenues 3,432.5 3,395.6 3,285.1 ------------------------------------------------- Benefits, Losses and Expenses Policy benefits, claims, losses and loss adjustment expenses 2,051.2 2,004.7 1,957.0 Policy acquisition expenses 452.8 411.8 457.5 Sales practice litigation 31.0 -- -- Loss from exiting reinsurance pools 25.3 -- -- Loss from cession of disability income business -- 53.9 -- Restructuring costs 13.0 -- -- Other operating expenses 579.6 559.7 538.9 ------------------------------------------------- Total benefits, losses and expenses 3,152.9 3,030.1 2,953.4 ------------------------------------------------- Income before federal income taxes 279.6 365.5 331.7 ------------------------------------------------- Federal income tax expense (benefit) Current 65.5 79.7 90.9 Deferred (16.4) 13.9 (15.7) ------------------------------------------------- Total federal income tax expense 49.1 93.6 75.2 ------------------------------------------------- Income before minority interest 230.5 271.9 256.5 Minority interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (14.5) -- Equity in earnings (13.3) (48.2) (74.6) ------------------------------------------------- Total minority interest (29.3) (62.7) (74.6) ------------------------------------------------- Net income $ 201.2 $ 209.2 $ 181.9 ================================================= Earnings per common share: Basic: Net income per share $ 3.36 $ 3.83 $ 3.63 Weighted average shares outstanding 59.9 54.7 50.1 Diluted: Net income per share $ 3.33 $ 3.82 $ 3.63 Weighted average shares outstanding 60.3 54.8 50.1 =================================================
The accompanying notes are an integral part of these consolidated financial statements. 49 Consolidated Balance Sheets
- ------------------------------------------------------------------------------------------------------------------------------------ December 31 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------------ (In millions, except per share data) - ------------------------------------------------------------------------------------------------------------------------------------ Assets Investments: Fixed maturities-at fair value (amortized cost of $7,618.2 and $7,052.9) $ 7,780.8 $ 7,313.7 Equity securities-at fair value (cost of $253.1 and $341.1) 397.1 479.0 Mortgage loans 562.3 567.5 Real estate 20.4 50.3 Policy loans 154.3 141.9 Other long-term investments 142.7 148.3 ---------------------------- Total investments 9,057.6 8,700.7 ---------------------------- Cash and cash equivalents 550.3 215.1 Accrued investment income 142.3 142.3 Deferred policy acquisition costs 1,161.2 965.5 Reinsurance receivable on unpaid losses, benefits and unearned premiums 1,136.0 1,040.3 Deferred federal income taxes 19.8 -- Premiums, accounts and notes receivable 510.5 554.4 Other assets 529.4 368.6 Closed Block assets 803.1 806.7 Separate account assets 13,697.7 9,755.4 ---------------------------- Total assets $ 27,607.9 $ 22,549.0 ============================ Liabilities Policy liabilities and accruals: Future policy benefits $ 2,802.2 $ 2,598.6 Outstanding claims, losses and loss adjustment expenses 2,816.3 2,825.1 Unearned premiums 843.2 846.8 Contractholder deposit funds and other policy liabilities 2,637.0 1,852.7 ---------------------------- Total policy liabilities and accruals 9,098.7 8,123.2 ---------------------------- Expenses and taxes payable 716.1 670.7 Reinsurance premiums payable 50.2 37.7 Short-term debt 221.3 33.0 Deferred federal income taxes -- 12.9 Long-term debt 199.5 202.1 Closed Block liabilities 872.0 885.5 Separate account liabilities 13,691.5 9,749.7 ---------------------------- Total liabilities 24,849.3 19,714.8 ---------------------------- Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 300.0 Common stock -- 152.9 ---------------------------- Minority interest 300.0 452.9 ---------------------------- Commitments and contingencies (Notes 16 and 21) Shareholders' Equity Preferred stock, $0.01 par value, 20.0 million shares authorized, none issued -- -- Common stock, $0.01 par value, 300.0 million shares authorized, 60.4 million and 60.0 million shares issued, respectively 0.6 0.6 Additional paid-in capital 1,768.8 1,755.0 Accumulated other comprehensive income 180.5 217.9 Retained earnings 599.9 407.8 Treasury stock at cost (1.8 million shares) (91.2) -- ---------------------------- Total shareholders' equity 2,458.6 2,381.3 ---------------------------- Total liabilities and shareholders' equity $ 27,607.9 $ 22,549.0 ============================
The accompanying notes are an integral part of these consolidated financial statements. 50 Consolidated Statements of Shareholders' Equity
- --------------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------------------- (In millions) - --------------------------------------------------------------------------------------------------------------------------------- Preferred Stock $ -- $ -- $ -- Common Stock Balance at beginning of year 0.6 0.5 0.5 Issuance of common stock -- 0.1 -- ----------------------------------------- Balance at end of year 0.6 0.6 0.5 ----------------------------------------- Additional Paid-In Capital Balance at beginning of year 1,755.0 1,382.5 1,382.5 Issuance of common stock 13.8 376.2 -- Issuance costs of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company -- (3.7) -- ----------------------------------------- Balance at end of year 1,768.8 1,755.0 1,382.5 ----------------------------------------- Accumulated Other Comprehensive Income Net Unrealized Appreciation on Investments: Balance at beginning of year 217.9 131.6 153.0 Appreciation (depreciation) during the period: Net (depreciation) appreciation on available-for-sale securities (82.7) 171.3 (35.1) Benefit (provision) for deferred federal income taxes 28.8 (59.9) 12.3 Minority interest 16.5 (25.1) 1.4 ----------------------------------------- (37.4) 86.3 (21.4) ----------------------------------------- Balance at end of year 180.5 217.9 131.6 ----------------------------------------- Retained Earnings Balance at beginning of year 407.8 210.1 38.2 Net income 201.2 209.2 181.9 Dividends to shareholders (9.1) (11.5) (10.0) ----------------------------------------- Balance at end of year 599.9 407.8 210.1 ----------------------------------------- Treasury Stock Balance at beginning of year -- -- -- Shares purchased at cost (91.2) -- -- ----------------------------------------- Balance at end of year (91.2) -- -- ----------------------------------------- Total shareholders' equity $ 2,458.6 $ 2,381.3 $ 1,724.7 =========================================
The accompanying notes are an integral part of these consolidated financial statements. 51 Consolidated Statements of Comprehensive Income
- -------------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------------------------------------------------------- Net income $ 201.2 $ 209.2 $ 181.9 ------------------------------------------ Other comprehensive income: Net (depreciation) appreciation on available-for sale securities (82.7) 171.3 (35.1) Benefit (provision) for deferred federal income taxes 28.8 (59.9) 12.3 Minority interest 16.5 (25.1) 1.4 ------------------------------------------ Other comprehensive income (37.4) 86.3 (21.4) ------------------------------------------ Comprehensive income $ 163.8 $ 295.5 $ 160.5 ==========================================
The accompanying notes are an integral part of these consolidated financial statements. 52 Consolidated Statements of Cash Flows
- --------------------------------------------------------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------------------- (In millions) - --------------------------------------------------------------------------------------------------------------------------------- Cash Flows From Operating Activities Net income $ 201.2 $ 209.2 $ 181.9 ---------------------------------------------- Adjustments to reconcile net income to net cash provided by operating activities: Minority interest 13.3 48.2 74.6 Net realized gains (61.0) (77.5) (65.2) Net amortization and depreciation 21.9 31.6 44.7 Deferred federal income taxes (16.4) 13.9 (15.7) Loss from exiting reinsurance pools 25.3 -- -- Sales practice litigation expense 31.0 -- -- Loss from cession of disability income business -- 53.9 -- Payment related to exiting reinsurance pools (30.3) -- -- Payment related to cession of disability income business -- (207.0) -- Change in deferred acquisition costs (185.8) (189.7) (73.9) Change in premiums and notes receivable, net of reinsurance payable 56.7 (15.1) (16.7) Change in accrued investment income -- 7.0 16.5 Change in policy liabilities and accruals, net 168.1 (134.7) (184.3) Change in reinsurance receivable (115.4) 27.1 123.7 Change in expenses and taxes payable 9.1 46.8 30.6 Separate account activity, net (48.5) 5.7 1.7 Other, net (31.3) 7.4 38.1 ---------------------------------------------- Net cash provided by (used in) operating activities 37.9 (173.2) 156.0 ---------------------------------------------- Cash Flows From Investing Activities Proceeds from disposals and maturities of available-for-sale fixed maturities 2,184.5 3,046.0 4,018.5 Proceeds from disposals of equity securities 285.3 162.7 228.7 Proceeds from disposals of other investments 120.8 116.3 99.3 Proceeds from mortgages matured or collected 171.2 204.7 176.9 Purchase of available-for-sale fixed maturities (2,780.1) (2,727.6) (3,830.7) Purchase of equity securities (119.9) (67.0) (91.6) Purchase of other investments (274.4) (175.0) (168.0) Capital expenditures (0.7) (15.3) (12.8) Purchase of minority interest in Citizens Corporation (195.9) -- -- Purchase of Financial Profiles, Inc. (13.0) -- -- Purchase of minority interest in Allmerica P&C -- (425.6) -- Other investing activities, net 5.1 1.3 4.3 ---------------------------------------------- Net cash (used in) provided by investing activities (617.1) 120.5 424.6 ---------------------------------------------- Cash Flows From Financing Activities Deposits and interest credited to contractholder deposit funds 1,419.2 457.6 268.7 Withdrawals from contractholder deposit funds (625.0) (647.2) (905.0) Change in short-term debt 188.3 (5.4) 7.2 Change in long-term debt (2.6) (0.1) (0.1) Proceeds from the issuance of mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company -- 296.3 -- Dividends paid to shareholders (9.9) (13.7) (13.9) Net proceeds from issuance of common stock 11.4 2.8 -- Treasury stock purchased at cost (82.7) -- -- Subsidiary treasury stock purchased, at cost -- -- (42.0) ---------------------------------------------- Net cash provided by (used in) financing activities 898.7 90.3 (685.1) ---------------------------------------------- Net change in cash and cash equivalents 319.5 37.6 (104.5) Net change in cash held in the Closed Block 15.7 (1.0) (6.5) Cash and cash equivalents, beginning of year 215.1 178.5 289.5 ---------------------------------------------- Cash and cash equivalents, end of year $ 550.3 $ 215.1 $ 178.5 ============================================== Supplemental Cash Flow Information Interest paid $ 21.6 $ 20.1 $ 33.8 Income taxes paid $ 133.5 $ 66.3 $ 68.1
The accompanying notes are an integral part of these consolidated financial statements. 53 Notes To Consolidated Financial Statements Note One Summary of Significant Accounting Policies - -------------------------------------------------------------------------------- A. Basis of Presentation and Principles of Consolidation The consolidated financial statements of Allmerica Financial Corporation ("AFC" or the "Company") include the accounts of First Allmerica Financial Life Insurance Company ("FAFLIC"), its wholly owned life insurance subsidiary, Allmerica Financial Life Insurance and Annuity Company ("AFLIAC"), non-insurance subsidiaries (principally brokerage and investment advisory subsidiaries), and Allmerica Property and Casualty Companies, Inc. ("Allmerica P&C", a wholly-owned non-insurance holding company). The Closed Block (See Note 1B) assets and liabilities and its results of operations are presented in the consolidated financial statements as single line items. Unless specifically stated, all disclosures contained herein supporting the consolidated financial statements exclude the Closed Block related amounts. All significant intercompany accounts and transactions have been eliminated. On or about December 3, 1998, the Company acquired all of the outstanding common stock of Citizens Corporation (formerly an 82.5% owned non-insurance subsidiary of Hanover) that it did not already own in exchange for cash of $195.9 million (See Note 3). The acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. Allmerica P&C and a wholly-owned subsidiary of the Company merged on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash and stock (see Note 2). The merger has been recognized as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million, representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The financial statements reflect minority interest in Allmerica P&C and its subsidiary, The Hanover Insurance Company ("Hanover") of approximately 40.5% prior to the merger on July 16, 1997. In addition, prior to a December 3, 1998 acquisition, the financial statements reflect minority interest in Citizens Corporation and its wholly-owned subsidiary, Citizens Insurance Company of America ("Citizens") of approximately 16.8% and 17.5% in 1998 and 1997, respectively. Minority interest also includes distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company. The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. B. Closed Block FAFLIC established and began operating a closed block (the "Closed Block") for the benefit of the participating policies included therein, consisting of certain individual life insurance participating policies, individual deferred annuity contracts and supplementary contracts not involving life contingencies which were in force as of FAFLIC's demutualization on October 16, 1995; such policies constitute the "Closed Block Business". The purpose of the Closed Block is to protect the policy dividend expectations of such FAFLIC dividend paying policies and contracts. Unless the Commissioner consents to an earlier termination, the Closed Block will continue to be in effect until the date none of the Closed Block policies are in force. FAFLIC allocated to the Closed Block assets in an amount that is expected to produce cash flows which, together with future revenues from the Closed Block Business, are reasonably sufficient to support the Closed Block Business, including provision for payment of policy benefits, certain future expenses and taxes and for continuation of policyholder dividend scales payable in 1994 so long as the experience underlying such dividend scales continues. The Company expects that the factors underlying such experience will fluctuate in the future and policyholder dividend scales for Closed Block Business will be set accordingly. Although the assets and income allocated to the Closed Block inure solely to the benefit of the holders of policies included in the Closed Block, the excess of Closed Block liabilities over Closed Block assets as measured on a GAAP basis represent the expected future post-tax income from the Closed Block which may be recognized in income over the period the policies and contracts in the Closed Block remain in force. 54 If the actual income from the Closed Block in any given period equals or exceeds the expected income for such period as determined at the inception of the Closed Block, the expected income would be recognized in income for that period. Further, any excess of the actual income over the expected income would also be recognized in income to the extent that the aggregate expected income for all prior periods exceeded the aggregate actual income. Any remaining excess of actual income over expected income would be accrued as a liability for policyholder dividends in the Closed Block to be paid to the Closed Block policyholders. This accrual for future dividends effectively limits the actual Closed Block income recognized in income to the Closed Block income expected to emerge from operation of the Closed Block as determined at inception. If, over the period the policies and contracts in the Closed Block remain in force, the actual income from the Closed Block is less than the expected income from the Closed Block, only such actual income (which could reflect a loss) would be recognized in income. If the actual income from the Closed Block in any given period is less than the expected income for that period and changes in dividend scales are inadequate to offset the negative performance in relation to the expected performance, the income inuring to shareholders of the Company will be reduced. If a policyholder dividend liability had been previously established in the Closed Block because the actual income to the relevant date had exceeded the expected income to such date, such liability would be reduced by this reduction in income (but not below zero) in any periods in which the actual income for that period is less than the expected income for such period. C. Valuation of Investments In accordance with the provisions of Statement of Financial Accounting Standards No. 115 ("Statement No. 115"), "Accounting for Certain Investments in Debt and Equity Securities", the Company is required to classify its investments into one of three categories: held-to-maturity, available-for-sale or trading. The Company determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designation as of each balance sheet date. Debt securities and marketable equity securities are classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Mortgage loans on real estate are stated at unpaid principal balances, net of unamortized discounts and reserves. Reserves on mortgage loans are based on losses expected by the Company to be realized on transfers of mortgage loans to real estate (upon foreclosure), on the disposition or settlement of mortgage loans and on mortgage loans which the Company believes may not be collectible in full. In establishing reserves, the Company considers, among other things, the estimated fair value of the underlying collateral. 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. During 1997, the Company adopted a plan to dispose of all real estate assets by the end of 1998. As of December 31, 1998 there were 7 properties remaining in the Company's real estate portfolio, all of which are being actively marketed. As a result of the plan, real estate held by the Company and real estate joint ventures were written down to the estimated fair value less costs of disposal. Depreciation is not recorded on these assets while they are held for disposal. 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 impairment of the value of a specific investment or a group of investments is determined, a realized investment loss is recorded. Changes in the valuation allowance for mortgage loans are included in realized investment gains or losses. D. Financial Instruments In the normal course of business, the Company enters into transactions involving various types of financial instruments, including debt, investments such as fixed maturities, mortgage loans and equity securities, investment and loan commitments, swap contracts and interest rate futures contracts. These instruments involve credit risk and also may be subject to risk of loss due to interest rate fluctuation. The Company evaluates and monitors each financial instrument individually and, when appropriate, obtains collateral or other security to minimize losses. Derivative financial instruments are accounted for under three different methods: fair value accounting, deferral accounting and accrual accounting. Interest rate swap contracts used to hedge interest rate risk are accounted for using a combination of the fair value method and accrual method, with changes in fair value reported in unrealized gains and losses in equity consistent with the underlying hedged security, and the net payment or receipt on the swaps reported in net investment income. Foreign currency swap contracts used to hedge foreign currency exchange risk are accounted for using a combination of the fair value method and accrual method, with changes in 55 fair value reported in unrealized gains and losses in equity consistent with the underlying hedged security, and the net payment or receipt on the swaps reported in net investment income. Futures contracts used to hedge interest rate risk are accounted for using the deferral method, with gains and losses deferred in unrealized gains and losses in equity and recognized in earnings in conjunction with the earnings recognition of the underlying hedged item. Default swap contracts entered into for investment purposes are accounted for using the fair value method, with changes in fair value, if any, reported in realized investment gains and losses in earnings. Premium paid to the Company on default swap contracts is reported in net investment income in earnings. Other swap contracts entered into for investment purposes are accounted for using the fair value method, with changes in fair value reported in realized investment gains and losses in earnings. Any ineffective swaps or futures hedges are recognized currently in realized investment gains and losses in earnings. E. Cash and Cash Equivalents Cash and cash equivalents includes cash on hand, amounts due from banks and highly liquid debt instruments purchased with an original maturity of three months or less. F. Deferred Policy Acquisition Costs Acquisition costs consist of commissions, underwriting costs and other costs, which vary with, and are primarily related to, the production of revenues. Property and casualty, group life and group health insurance business acquisition costs are deferred and amortized over the terms of the insurance policies. Acquisition costs related to universal life products, variable annuities and contractholder deposit funds are deferred and amortized in proportion to total estimated gross profits from investment yields, mortality, surrender charges and expense margins over the expected life of the contracts. This amortization is reviewed annually and adjusted retrospectively when the Company revises its estimate of current or future gross profits to be realized from this group of products, including realized and unrealized gains and losses from investments. Acquisition costs related to fixed annuities and other life insurance products are deferred and amortized, generally in proportion to the ratio of annual revenue to the estimated total revenues over the contract periods based upon the same assumptions used in estimating the liability for future policy benefits. Deferred acquisition costs for each life product and property and casualty line of business are reviewed to determine if they are recoverable from future income, including investment income. If such costs are determined to be unrecoverable, they are expensed at the time of determination. Although realization of deferred policy acquisition costs is not assured, the Company believes it is more likely than not that all of these costs will be realized. The amount of deferred policy acquisition costs considered realizable, however, could be reduced in the near term if the estimates of gross profits or total revenues discussed above are reduced. The amount of amortization of deferred policy acquisition costs could be revised in the near term if any of the estimates discussed above are revised. G. Property and Equipment Property, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation is provided using the straight-line or accelerated method over the estimated useful lives of the related assets which generally range from 3 to 30 years. Amortization of leasehold improvements is provided using the straight-line method over the lesser of the term of the leases or the estimated useful life of the improvements. H. Separate Accounts Separate account assets and liabilities represent segregated funds administered and invested by the Company for the benefit of certain pension, variable annuity and variable life insurance contractholders. Assets consist principally of bonds, common stocks, mutual funds, and short-term obligations at market value. The investment income, 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. I. Policy Liabilities and Accruals 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 21/2% to 71/4% for life insurance and 21/2% to 91/2% for annuities. Estimated liabilities are established for group life and health policies that contain experience rating provisions. Mortality, morbidity and withdrawal assumptions for all policies are based on the Company's own experience and industry standards. Liabilities for universal life 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 outstanding claims, losses and loss adjustment expenses ("LAE") are estimates of payments to be made on property and casualty and health insurance for reported 56 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, group life, and accident and health 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. 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. J. Premium and Fee Revenue and Related Expenses Premiums for individual life and health insurance and individual and group annuity products, excluding universal life and investment-related products, are considered revenue when due. Property and casualty, and group life, accident and health insurance premiums are recognized as revenue over the related contract periods. Benefits, losses and related expenses are matched with premiums, resulting in their recognition over the lives of the contracts. This matching is accomplished through the provision for future benefits, estimated and unpaid losses and amortization of deferred policy acquisition costs. Revenues for investment-related products consist of net investment income and contract charges assessed against the fund values. Related benefit expenses primarily consist of net investment income credited to the fund values after deduction for investment and risk charges. Revenues for universal life products consist of net investment income, with mortality, administration and surrender charges assessed against the fund values. Related benefit expenses include universal life benefit claims in excess of fund values and net investment income credited to universal life fund values. Certain policy charges that represent compensation for services to be provided in future periods are deferred and amortized over the period benefited using the same assumptions used to amortize capitalized acquisition costs. K. Federal Income Taxes AFC and its domestic subsidiaries file a consolidated United States federal income tax return. Entities included within the consolidated group are segregated into either a life insurance or non-life insurance company subgroup. The consolidation of these subgroups is subject to certain statutory restrictions on the percentage of eligible non-life tax losses that can be applied to offset life company taxable income. Prior to the merger on July 16, 1997, Allmerica P&C and its subsidiaries filed a separate United States federal income tax return. Deferred income taxes are generally recognized when assets and liabilities have different values for financial statement and tax reporting purposes, and for other temporary taxable and deductible differences as defined by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes ("Statement No. 109"). These differences result primarily from loss and LAE reserves, policy reserves, policy acquisition expenses and unrealized appreciation or depreciation on investments. L. New Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("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 an entity recognize all derivatives as either assets or liabilities at fair value in the statement of financial position, and establishes special accounting for the following three types of hedges: fair value hedges, cash flow hedges, and hedges of foreign currency exposures of net investments in foreign operations. This statement is effective for fiscal years beginning after June 15, 1999. The Company is currently assessing the impact of the adoption of Statement No. 133. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Cost of Computer Software Developed or Obtained for Internal Use" ("SoP No. 98-1"). SoP No. 98-1 requires that certain costs incurred in developing internal-use computer software be capitalized and provides guidance for determining whether computer software is to be considered for internal use. This statement is effective for fiscal years beginning after December 15, 1998. In the second quarter, the Company adopted SoP No. 98-1 effective January 1, 1998, resulting in an increase in pre-tax income of $12.4 million through December 31, 1998. The adoption of SoP No. 98-1 did not have a material effect on the results of operations or financial position for the three months ended March 31, 1998. In December 1997, the AICPA issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" ("SoP No. 97-3"). SoP No. 97-3 provides guidance on when a liability should be recognized for guaranty fund and other assessments and how to measure the 57 liability. This statement allows for the discounting of the liability if the amount and timing of the cash payments are fixed and determinable. In addition, it provides criteria for when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges. This statement is effective for fiscal years beginning after December 15, 1998. The Company believes that the adoption of this statement will not have a material effect on the results of operations or financial position. In June 1997, the FASB issued Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("Statement No. 131"). This statement establishes standards for the way that public enterprises report information about operating segments in annual financial statements and requires that selected information about those operating segments be reported in interim financial statements. This statement supersedes Statement No. 14, "Financial Reporting for Segments of a Business Enterprise". Statement No. 131 requires that all public enterprises report financial and descriptive information about their reportable operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. This statement is effective for fiscal years beginning after December 15, 1997. The Company adopted Statement No. 131 for the first quarter of 1998, which resulted in certain segment re-definitions, which have no impact on the consolidated results of operations. (See Note 15.) In June 1997, the FASB also issued Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("Statement No. 130"). Statement No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. All items that are required to be recognized under accounting standards as components of comprehensive income are to be reported in a financial statement that is displayed with the same prominence as other financial statements. This statement stipulates that comprehensive income reflect the change in equity of an enterprise during a period from transactions and other events and circumstances from non-owner sources. This statement is effective for fiscal years beginning after December 15, 1997. The Company adopted Statement No. 130 for the first quarter of 1998, which resulted primarily in reporting unrealized gains and losses on investments in debt and equity securities in comprehensive income. In February 1997, the FASB issued Statement No. 128, "Earnings Per Share," which supersedes Accounting Principles Board Opinion No. 15, "Earnings Per Share". This standard replaces the primary and fully diluted earnings per share ("EPS") requirements with a basic and diluted EPS computation, and requires a dual presentation of basic and diluted EPS for those companies with complex capital structures. All earnings per share amounts for all periods have been presented to conform to the Statement No. 128 requirements. The adoption of the aforementioned statement had no effect on the Company's previously reported earnings per share. M. Earnings Per Share Earnings per share for the years ended December 31, 1998, 1997, and 1996 are based on a weighted average of the number of shares outstanding during each year. The Company's EPS in 1998, 1997, and 1996 is based on net income of $201.2 million, $209.2 million, and $181.9 million for both basic and diluted earnings per share. The weighted average shares outstanding which were utilized in the calculation of basic earnings per share were 59.9 million, 54.7 million, and 50.1 million shares in 1998, 1997, and 1996, respectively. This differs from the weighted average shares outstanding used in the calculation of diluted earnings per share due to the 0.3 million share effect of dilutive employee stock options and the 0.1 million share effect of non-vested stock grants, which causes a $0.03 per share difference between basic and diluted EPS for 1998. There was a 0.1 million share effect of dilutive employee stock options in 1997 which caused a $0.01 difference between basic and diluted earnings per share in 1997. There was no dilutive effect in 1996. Options to purchase 97,500 shares and 7,742 shares of common stock were outstanding during 1998 and 1997, respectively, but were not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. There were no such options outstanding during 1996. N. Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. Note Two Merger with Allmerica Property & Casualty Companies, Inc. - -------------------------------------------------------------------------------- The merger of Allmerica P&C and a wholly-owned subsidiary of the Company was consummated on July 16, 1997. Through the merger, the Company acquired all of the outstanding common stock of Allmerica P&C that it did not already own in exchange for cash of $425.6 million and approximately 9.7 million shares of AFC stock valued at $372.5 million. On February 3, 1997, the Company issued $300.0 million of Series A Capital Securities ("Capital Securities"). Net proceeds from the offering of approximately $296.3 million funded a portion of the July 16, 1997 acquisition. 58 The merger has been recognized as a purchase. Total consideration of approximately $798.1 million has been allocated to the minority interest in the assets and liabilities based on estimates of their fair values. The minority interest acquired totaled $703.5 million. A total of $90.6 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The Company's consolidated results of operations include minority interest in Allmerica P&C prior to July 16, 1997. The unaudited pro forma information below presents consolidated results of operations as if the merger and issuance of Capital Securities had occurred at the beginning of 1996 and reflects adjustments which include interest expense related to the assumed financing of a portion of the cash consideration paid and amortization of goodwill. The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the merger and issuance of Capital Securities occurred at the beginning of 1996, nor is it necessarily indicative of future results. - ------------------------------------------------------------------------------ (Unaudited) For the Years Ended December 31 1997 1996 - ------------------------------------------------------------------------------ (In millions, except per share data) - ------------------------------------------------------------------------------ Revenue $ 3,374.1 $ 3,241.6 =========================== Net realized capital gains included in revenue $ 62.7 $ 45.8 =========================== Income before taxes and minority interest $ 341.6 $ 294.1 Income taxes (85.7) (62.8) Minority Interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (16.0) Equity in earnings (16.6) (14.9) --------------------------- Net income $ 223.3 $ 200.4 =========================== Net income per common share: Basic $ 3.73 $ 3.35 Diluted $ 3.72 $ 3.35 =========================== Weighted average shares outstanding (diluted) 60.0 59.8 =========================== Note Three Acquisition of Minority Interest of Citizens Corporation - -------------------------------------------------------------------------------- On December 3, 1998 Citizens Acquisition Corporation, a wholly owned subsidiary of the Company, completed a cash tender offer to acquire the outstanding shares of Citizens Corporation common stock that AFC or its subsidiaries did not already own at a price of $33.25 per share. Approximately 99.8% of publicly held shares of Citizens Corporation common stock were tendered. On December 14, 1998, the Company completed a short-form merger, acquiring all shares of common stock of Citizens Corporation not purchased in its tender offer, through the merger of its wholly-owned subsidiary, Citizens Acquisition Corporation with Citizens Corporation at a price of $33.25 per share. Total consideration for the transactions amounted to $195.9 million. The acquisition has been recognized as a purchase. The minority interest acquired totaled $158.5 million. A total of $40.8 million representing the excess of the purchase price over the fair values of the net assets acquired, net of deferred taxes, has been allocated to goodwill and is being amortized over a 40-year period. The Company's consolidated results of operations include minority interest in Citizens prior to December 3, 1998. The unaudited pro forma information below presents consolidated results of operations as if the acquisition had occurred at the beginning of 1997. The following unaudited pro forma information is not necessarily indicative of the consolidated results of operations of the combined Company had the acquisition occurred at the beginning of 1997, nor is it necessarily indicative of future results. - ----------------------------------------------------------------------------- (Unaudited) For the Years Ended December 31 1998 1997 - ----------------------------------------------------------------------------- (In millions, except per share data) - ----------------------------------------------------------------------------- Revenue $ 3,418.2 $ 3,377.7 =========================== Net realized capital gains included in revenue $ 58.1 $ 71.5 =========================== Income before taxes and minority interest $ 264.4 $ 346.6 Income taxes (44.1) (87.4) Minority Interest: Distributions on mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company (16.0) (14.5) Equity in earnings -- (31.6) --------------------------- Net income $ 204.3 $ 213.1 =========================== Net income per common share: Basic $ 3.41 $ 3.90 Diluted $ 3.39 $ 3.89 =========================== Weighted average shares outstanding (diluted) 60.3 54.8 =========================== 59 Note Four Significant Transactions - -------------------------------------------------------------------------------- On October 29, 1998, the Company announced that it had adopted a formal restructuring plan for its Risk Management business. As part of this initiative, the Company, in its Corporate Risk Management Services segment, has exited its accident and health assumed reinsurance pool business, as well as its administrative services only business. Additionally, it has commenced the closing of nearly half of its nationwide Corporate Risk Management Services' sales offices, eliminated certain staff and discontinued certain automation initiatives. In addition to the aforementioned initiatives in the Corporate Risk Management Services segment, the Property and Casualty segment is consolidating its field support activities from fourteen regional branches into three hub locations. As a result of the Company's restructuring initiative, it recognized a pre-tax loss of $13.0 million in the fourth quarter of 1998. Approximately $5.5 million of this loss relates to severance and other employee related costs resulting from the elimination of 339 positions, of which 129 employees had been terminated as of December 31, 1998. In addition, contract terminations and lease cancellations resulted in losses of approximately $4.1 million and $3.4 million, respectively. During 1998, the Company made payments of approximately $1.6 million related to this restructuring initiative. On October 27, 1998, the AFC Board of Directors authorized the repurchase of up to $200.0 million of its issued common stock. As of December 31, 1998, AFC had repurchased 1.5 million shares at an aggregate cost of approximately $82.7 million. Effective July 1, 1998, the Company entered into a reinsurance agreement with a highly rated reinsurer that cedes current and future underwriting losses, including unfavorable development of prior year reserves, up to a $40.0 million maximum, relating to the Company's accident and health assumed reinsurance pool business. These pools consist primarily of the Corporate Risk Management Services segment's assumed stop loss business, small group managed care pools, long-term disability and long-term care pools, student accident and special risk business. The agreement is consistent with management's decision to exit this line of business, which the Company expects to run-off over the next three years. As a result of this transaction, the Company recognized a $25.3 million pre-tax loss in the third quarter of 1998. Effective January 1, 1998, the Company entered into an agreement with a highly rated reinsurer to reinsure the mortality risk on the universal life and variable universal life blocks of business. The agreement did not have a material effect on its results of operations or financial position. On April 14, 1997, the Company entered into an agreement in principle to cede substantially all of the Company's individual disability income line of business under a 100% coinsurance agreement with a highly rated reinsurer. The coinsurance agreement became effective October 1, 1997. The transaction has resulted in the recognition of a $53.9 million pre-tax loss in the first quarter of 1997. On February 3, 1997, AFC Capital Trust (the "Trust"), a subsidiary business trust of AFC, issued $300.0 million Series A Capital Securities, which pay cumulative dividends at a rate of 8.207% semiannually commencing August 15, 1997. The Trust exists for the sole purpose of issuing the Capital Securities and investing the proceeds thereof in an equivalent amount of 8.207% Junior Subordinated Deferrable Interest Debentures due 2027 of AFC (the "Subordinated Debentures"). Through certain guarantees, the Subordinated Debentures and the terms of related agreements, AFC has irrevocably and unconditionally guaranteed the obligations of the Trust under the Capital Securities. Net proceeds from the offering of approximately $296.3 million funded a portion of the acquisition of the 24.2 million publicly held shares of Allmerica P&C pursuant to the merger on July 16, 1997. On August 7, 1997, AFC and the Trust exchanged the Series A Capital Securities for a like amount of Series B Capital Securities and related guarantees which are registered under the Securities Act of 1933 as required under the terms of the initial transaction. During the years ended December 31, 1998 and 1997, distributions of $16.0 million and $14.5 million, respectively, net of federal income taxes, were reflected in minority interest. 60 Note Five Investments - -------------------------------------------------------------------------------- A. Summary of Investments The Company accounts for its investments, all of which are classified as available-for-sale, in accordance with the provisions of Statement No. 115. The amortized cost and fair value of available-for-sale fixed maturities and equity securities were as follows:
- -------------------------------------------------------------------------------------------------------------------------------- December 31 1998 - -------------------------------------------------------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost (1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 194.5 $ 12.1 $ 24.6 $ 182.0 States and political subdivisions 2,408.9 83.0 5.2 2,486.7 Foreign governments 107.9 7.7 4.5 111.1 Corporate fixed maturities 4,340.5 168.4 83.4 4,425.5 Mortgage-backed securities 566.4 11.9 2.8 575.5 -------------------------------------------------- Total fixed maturities $ 7,618.2 $ 283.1 $ 120.5 $ 7,780.8 ================================================== Equity securities $ 253.1 $ 151.1 $ 7.1 $ 397.1 ================================================== - -------------------------------------------------------------------------------------------------------------------------------- December 31 1997 - -------------------------------------------------------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost (1) Gains Losses Value U.S. Treasury securities and U.S. government and agency securities $ 269.6 $ 9.5 $ 0.9 $ 278.2 States and political subdivisions 2,200.6 78.3 3.1 2,275.8 Foreign governments 111.6 8.6 2.2 118.0 Corporate fixed maturities 4,044.3 175.1 12.3 4,207.1 Mortgage-backed securities 426.8 9.8 2.0 434.6 -------------------------------------------------- Total fixed maturities $ 7,052.9 $ 281.3 $ 20.5 $ 7,313.7 ================================================== Equity securities $ 341.1 $ 141.9 $ 4.0 $ 479.0 ==================================================
(1) Amortized cost for fixed maturities and cost for equity securities. In connection with AFLIAC's voluntary withdrawal of its license in New York, AFLIAC agreed with the New York Department of Insurance to maintain, through a custodial account in New York, a security deposit, the market value of which will at all times equal 102% of all outstanding liabilities of AFLIAC for New York policyholders, claimants and creditors. At December 31, 1998, the amortized cost and market value of these assets on deposit in New York were $268.5 million and $284.1 million, respectively. At December 31, 1997, the amortized cost and market value of assets on deposit were $276.8 million and $291.7 million, respectively. In addition, fixed maturities, excluding those securities on deposit in New York, with an amortized cost of $105.4 million and $105.1 million were on deposit with various state and governmental authorities at December 31, 1998 and 1997, respectively. There were no contractual fixed maturity investment commitments at December 31, 1998 and 1997, respectively. The amortized cost and fair value by maturity periods for fixed maturities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the 61 right to call or prepay obligations with or without call or prepayment penalties, or the Company may have the right to put or sell the obligations back to the issuers. Mortgage-backed securities are included in the category representing their ultimate maturity. - -------------------------------------------------------------------------------- December 31 1998 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Amortized Fair Cost Value Due in one year or less $ 388.0 $ 394.7 Due after one year through five years 2,329.3 2,361.2 Due after five years through ten years 2,193.6 2,219.0 Due after ten years 2,707.3 2,805.9 -------------------------- Total $ 7,618.2 $ 7,780.8 ========================== The proceeds from voluntary sales of available-for-sale securities and the gross realized gains and gross realized losses on those sales were as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Proceeds from Voluntary Gross Gross 1998 Sales Gains Losses Fixed maturities $ 913.6 $ 13.8 $ 11.7 ========================================== Equity securities $ 276.4 $ 76.3 $ 9.6 ========================================== 1997 Fixed maturities $ 1,972.4 $ 27.9 $ 16.2 ========================================== Equity securities $ 145.5 $ 55.8 $ 1.3 ========================================== 1996 Fixed maturities $ 2,463.3 $ 19.3 $ 31.0 ========================================== Equity securities $ 228.7 $ 56.3 $ 1.3 ========================================== Unrealized gains and losses on available-for-sale and other securities, are summarized as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Equity Fixed Securities 1998 Maturities and Other(1) Total Net appreciation, beginning of year $ 133.3 $ 84.6 $ 217.9 ---------------------------------- Net depreciation on available-for-sale securities (108.8) (1.5) (110.3) Purchased minority interest related to the acquisition of minority interest in Citizens 10.7 10.7 21.4 Net appreciation from the effect on deferred policy acquisition costs and on policy liabilities 6.2 -- 6.2 Benefit for deferred federal income taxes and minority interest 40.5 4.8 45.3 ---------------------------------- (51.4) 14.0 (37.4) ---------------------------------- Net appreciation, end of year $ 81.9 $ 98.6 $ 180.5 ================================== 1997 Net appreciation, beginning of year $ 71.1 $ 60.5 $ 131.6 ---------------------------------- Net appreciation (depreciation) on available-for-sale securities 83.6 (5.8) 77.8 Purchased minority interest related to the merger with Allmerica P&C 50.7 59.6 110.3 Net depreciation from the effect on deferred policy acquisition costs and on policy liabilities (16.8) -- (16.8) Provision for deferred federal income taxes and minority interest (55.3) (29.7) (85.0) ---------------------------------- 62.2 24.1 86.3 ---------------------------------- Net appreciation, end of year $ 133.3 $ 84.6 $ 217.9 ================================== 1996 Net appreciation, beginning of year $ 108.7 $ 44.3 $ 153.0 ---------------------------------- Net (depreciation) appreciation on available-for-sale securities (94.3) 36.1 (58.2) Net appreciation from the effect on deferred policy acquisition costs and on policy liabilities 23.1 -- 23.1 Benefit (provision) for deferred federal income taxes and minority interest 33.6 (19.9) 13.7 ---------------------------------- (37.6) 16.2 (21.4) ---------------------------------- Net appreciation, end of year $ 71.1 $ 60.5 $ 131.6 ================================== (1) Includes net appreciation on other investments of $0.8 million, $1.8 million, and $0.6 million in 1998, 1997 and 1996, respectively. 62 B. Mortgage Loans and Real Estate AFC's mortgage loans and real estate are diversified by property type and location. Real estate investments have been obtained primarily through foreclosure. Mortgage loans are collateralized by the related properties and generally are no more than 75% of the property's value at the time the original loan is made. The carrying values of mortgage loans and real estate investments net of applicable reserves were as follows: - -------------------------------------------------------------------------------- December 31 1998 1997 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Mortgage loans $ 562.3 $ 567.5 Real estate held for sale 20.4 50.3 ---------------------- Total mortgage loans and real estate $ 582.7 $ 617.8 ====================== Reserves for mortgage loans were $11.5 million and $20.7 million at December 31, 1998 and 1997, respectively. During 1997, the Company committed to a plan to dispose of all real estate assets by the end of 1998. At December 31, 1998, there were 7 properties remaining, in the Company's real estate portfolio, which are being actively marketed. As a result of the plan, during 1997, real estate assets with a carrying amount of $54.7 million were written down to the estimated fair value less cost of disposal of $50.3 million, and a net realized investment loss of $4.4 million was recognized. Depreciation is not recorded on these assets while they are held for disposal. There were no non-cash investing activities, including real estate acquired through foreclosure of mortgage loans, in 1998 and 1997. During 1996, non-cash investing activities included real estate acquired through foreclosure of mortgage loans, which had a fair value of $0.9 million. There were no contractual commitments to extend credit under commercial mortgage loan agreements at December 31, 1998. Mortgage loans and real estate investments comprised the following property types and geographic regions: - ------------------------------------------------------------------------------- December 31 1998 1997 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Property type: Office building $ 304.4 $ 265.1 Residential 52.8 66.6 Retail 108.5 132.8 Industrial / warehouse 110.0 107.2 Other 18.5 66.8 Valuation allowances (11.5) (20.7) ------------------------ Total $ 582.7 $ 617.8 ======================== Geographic region: South Atlantic $ 136.1 $ 173.4 Pacific 155.1 152.8 East North Central 80.5 102.0 Middle Atlantic 61.2 73.8 New England 60.7 46.9 West South Central 54.7 34.9 Other 45.9 54.7 Valuation allowances (11.5) (20.7) ------------------------ Total $ 582.7 $ 617.8 ======================== At December 31, 1998, scheduled mortgage loan maturities were as follows: 1999 - $84.7 million; 2000 - $131.6 million; 2001 - $33.9 million; 2002 - $28.4 million; 2003 - $42.5 million and $241.2 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 1998, the Company did not refinance any mortgage loans based on terms which differed from those granted to new borrowers. 63 C. Investment Valuation Allowances Investment valuation allowances which have been deducted in arriving at investment carrying values as presented in the consolidated balance sheets and changes thereto are shown below. - -------------------------------------------------------------------------------- For the Years Ended December 31 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Balance at Balance at 1998 January 1 Provisions Write-offs December 31 Mortgage loans $ 20.7 $ (6.8) $ 2.4 $ 11.5 ================================================= 1997 Mortgage loans $ 19.6 $ 2.5 $ 1.4 $ 20.7 Real estate 14.9 6.0 20.9 -- ------------------------------------------------- Total $ 34.5 $ 8.5 $ 22.3 $ 20.7 ================================================= 1996 Mortgage loans $ 33.8 $ 5.5 $ 19.7 $ 19.6 Real estate 19.6 -- 4.7 14.9 ------------------------------------------------- Total $ 53.4 $ 5.5 $ 24.4 $ 34.5 ================================================= Provisions on mortgages during 1998 reflect the release of redundant reserves. Write-offs of $20.9 million to the investment valuation allowance related to real estate in 1997 primarily reflect write downs to the estimated fair value less costs to sell pursuant to the aforementioned 1997 plan of disposal. The carrying value of impaired loans was $22.0 million and $30.5 million, with related reserves of $6.0 million and $13.8 million as of December 31, 1998 and 1997, respectively. All impaired loans were reserved as of December 31, 1998 and 1997. The average carrying value of impaired loans was $26.1 million, $30.8 million and $50.4 million, with related interest income while such loans were impaired, of $3.2 million, $3.2 million and $5.8 million as of December 31, 1998, 1997 and 1996, respectively. D. Futures Contracts AFC purchases long futures contracts and sells short futures contracts on margin to hedge against interest rate fluctuations associated with the sale of Guaranteed Investment Contracts ("GICs"). The Company is 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. Futures contract activity increased significantly in 1998 due to the increase in sales of GICs. The Company's exposure to credit risk under futures contracts is limited to the margin deposited with the broker. The Company only trades futures contracts with nationally recognized brokers, which the Company believes have adequate capital to ensure that there is minimal danger of default. The Company does not require collateral or other securities to support financial instruments with credit risk. The notional amount of futures contracts outstanding at December 31, 1998 was $92.7 million. There were no futures contracts outstanding at December 31, 1997. The notional amounts of the contracts represent the extent of the Company's investment but not future cash requirements, as the Company generally settles open positions prior to maturity. The maturity of all futures contracts outstanding are less than one year. The fair value of futures contracts outstanding was $92.5 million at December 31, 1998. Gains and losses on hedge contracts related to interest rate fluctuations are deferred and recognized in income over the period being hedged corresponding to related guaranteed investment contracts. If instruments being hedged by futures contracts are disposed, any unamortized gains or losses on 64 such contracts are included in the determination of the gain or loss from the disposition. Deferred hedging gains (losses) were $(1.8) million in 1998. There were no deferred hedging gains or losses in 1997. Gains and losses on hedge contracts that are deemed ineffective by the Company are realized immediately. There was $0.1 million of gains realized on ineffective hedges in 1998. There was no gain or loss in 1997 or 1996. A reconciliation of the notional amount of futures contracts is as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Contracts outstanding, beginning of year $ -- $ (40.0) $ 74.7 New contracts 1,117.5 (6.5) (44.0) Contracts expired (1,024.8) 46.5 (70.7) ------------------------------------ Contracts outstanding, end of year $ 92.7 $ -- $ (40.0) ==================================== E. Foreign Currency Swap Contracts The Company enters into foreign currency swap contracts with swap counterparties to hedge foreign currency exposure on specific fixed income securities. Interest and principal related to foreign fixed income securities payable in foreign currencies, at current exchange rates, are exchanged for the equivalent payment in U.S. dollars translated at a specific currency exchange rate. The primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. The Company's maximum exposure to counterparty credit risk is the difference between the foreign currency exchange rate, as agreed upon in the swap contract, and the foreign currency spot rate on the date of the exchange, as indicated by the fair value of the contract. The fair values of the foreign currency swap contracts outstanding were $1.2 million and $1.3 million at December 31, 1998 and 1997, respectively. Changes in the fair value of contracts are reported as an unrealized gain or loss, consistent with the underlying hedged security. The Company does not require collateral or other security to support financial instruments with credit risk. The difference between amounts paid and received on foreign currency swap contracts is reflected in the net investment income related to the underlying assets and is not material in 1998, 1997 and 1996. Any gain or loss on the termination of swap contracts is deferred and recognized with any gain or loss on the hedged transaction. The Company had no deferred gain or loss on foreign currency swap contracts in 1998 or 1997. A reconciliation of the notional amount of foreign currency swap contracts is as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Contracts outstanding, beginning of year $ 42.6 $ 47.6 $ 69.4 New contracts -- 5.0 -- Contracts expired -- (10.0) (21.8) ---------------------------------- Contracts outstanding, end of year $ 42.6 $ 42.6 $ 47.6 ================================== Expected maturities of such foreign currency swap contracts outstanding at December 31, 1998 are $24.0 million in 1999, $8.3 million in 2000 and $10.3 million thereafter. There are no expected maturities of such foreign currency swap contracts in 2001, 2002 and 2003. F. Interest Rate Swap Contracts The Company enters into interest rate swap contracts to hedge exposure to interest rate fluctuations. Specifically, for floating rate GIC liabilities that are matched with fixed rate securities, the Company manages the interest rate risk by hedging with interest rate swap contracts. Under these swap contracts, the Company agrees to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated on an agreed-upon notional principal amount. The use of interest rate swap contracts increased during 1998 due to the increase in floating rate GIC liabilities. As with foreign currency swap contracts, the primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. Because the underlying principal of swap contracts is not exchanged, the Company's maximum exposure to counterparty credit risk is the difference in payments exchanged, which at December 31, 1998 was a net payable of $3.9 million. The Company does not require collateral or other security to support financial instruments with credit risk. The net amount receivable or payable is recognized over the life of the swap contract as an adjustment to net investment income. The (decrease) or increase in net investment income related to interest rate swap contracts was $(2.8) million, 65 $(0.4) million and $0.6 million for the years ended December 31, 1998, 1997 and 1996, respectively. The fair value of interest rate swap contracts outstanding was $(28.3) million and $(2.3) million at December 31, 1998 and 1997, respectively. Changes in the fair value of contracts are reported as an unrealized gain or loss, consistent with the underlying hedged security. Any gain or loss on the termination of interest rate swap contracts accounted for as hedges are deferred and recognized with any gain or loss on the hedged transaction. The Company had no deferred gain or loss on interest rate swap contracts in 1998 or 1997. A reconciliation of the notional amount of interest rate swap contracts is as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Contracts outstanding, beginning of year $ 244.1 $ 5.0 $ 17.5 New contracts 873.5 244.7 5.0 Contracts expired (5.0) (5.6) (17.5) ------------------------------------- Contracts outstanding, end of year $ 1,112.6 $ 244.1 $ 5.0 ===================================== Expected maturities of such interest rate swap contracts outstanding at December 31, 1998 is $44.0 million in 2000, $234.5 million in 2002, $810.5 million in 2003, and $23.6 million thereafter. There are no expected maturities of such interest rate contracts in 1999 or 2001. G. Other Swap Contracts The Company enters into security return-linked and insurance portfolio-linked swap contracts for investment purposes. Under the security return-linked contracts, the Company agrees to exchange cash flows according to the performance of a specified security or portfolio of securities. Under the insurance portfolio-linked swap contracts, the Company agrees to exchange cash flows according to the performance of a specified underwriter's portfolio of insurance business. As with interest rate swap contracts, the primary risk associated with these transactions is the inability of the counterparty to meet its obligation. The Company regularly assesses the financial strength of its counterparties and generally enters into forward or swap agreements with counterparties rated "A" or better by nationally recognized rating agencies. Because the underlying principal of swap contracts is not exchanged, the Company's maximum exposure to counterparty credit risk is the difference in payments exchanged, which at December 31, 1998, was not material to the Company. The Company does not require collateral or other security to support financial instruments with credit risk. In 1998, the Company also entered into credit default swap agreements. Under the terms of these agreements, the Company assumes the default risk of a specific high credit quality issuer in exchange for a stated annual premium. In the case of default, the Company will pay the counterparty par value for a pre-determined security of the issuer. The primary risk associated with these transactions is the default risk of the underlying companies. The Company regularly assesses the financial strength of the underlying companies and generally enters into default swap agreements for companies rated "A" or better by nationally recognized rating agencies. The swap contracts are marked to market with any gain or loss recognized currently. The fair values of swap contracts outstanding were $(0.1) million at December 31, 1998 and 1997. The net amount receivable or payable under security returned-linked and insurance portfolio-linked swap contracts is recognized when the contracts are marked to market. The net increase (decrease) in realized investment gains related to these contracts was $1.1 million in 1998 and $(1.6) million in 1997. There were no realized investment gains or losses on other swap contracts recognized in 1996. The stated annual premium under credit default swap contracts is recognized currently in net investment income. The net increase to investment income related to credit default swap contracts was $0.2 million in 1998. There was no investment income recognized in 1997 and 1996. A reconciliation of the notional amount of other swap contracts is as follows: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Contracts outstanding, beginning of year $ 15.0 $ 58.6 $ -- New contracts 266.3 192.1 58.6 Contracts expired (26.3) (211.6) -- Contracts terminated -- (24.1) -- ----------------------------------- Contracts outstanding, end of year $ 255.0 $ 15.0 $ 58.6 =================================== Expected maturities of such other swap contracts outstanding at December 31, 1998 are as follows: $115.0 million in 1999, $115.0 million in 2000, and $25.0 million in 2001. There are no expected maturities of other swap contracts in 2002 or 2003. H. Other At December 31, 1998, AFC had no concentration of investments in a single investee exceeding 10% of shareholders' equity. At December 31, 1997, AFC had no concentration of investments in a single investee exceeding 10% of Shareholders' equity except for investments with the U.S. Treasury with a carrying value of $264.4 million. 66 Note Six Investment Income and Gains and Losses - -------------------------------------------------------------------------------- A. Net Investment Income The components of net investment income were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Fixed maturities $ 539.1 $ 544.4 $ 555.8 Mortgage loans 58.3 57.5 69.5 Equity securities 7.4 10.6 11.1 Policy loans 11.9 10.9 10.3 Real estate 7.2 20.1 40.8 Other long-term investments (0.4) 12.4 19.0 Short-term investments 16.4 21.9 11.3 ---------------------------------- Gross investment income 639.9 677.8 717.8 Less investment expenses (15.7) (24.4) (45.2) ---------------------------------- Net investment income $ 624.2 $ 653.4 $ 672.6 ================================== At December 31, 1998, there was one mortgage loan on non-accrual status which had an outstanding principal balance of $4.3 million. This loan was restructured and fully impaired. There were no fixed maturities which were on non-accrual status at December 31, 1998. The effect of non-accruals, compared with amounts that would have been recognized in accordance with the original terms of the investments, had no impact in 1998 and 1997, and reduced net income by $0.5 million in 1996. The payment terms of mortgage loans may from time to time be restructured or modified. The investment in restructured mortgage loans, based on amortized cost, amounted to $28.7 million, $40.3 million and $51.3 million at December 31, 1998, 1997 and 1996, respectively. Interest income on restructured mortgage loans that would have been recorded in accordance with the original terms of such loans amounted to $3.3 million, $3.9 million and $7.7 million in 1998, 1997 and 1996, respectively. Actual interest income on these loans included in net investment income aggregated $3.3 million, $4.2 million and $4.5 million in 1998, 1997 and 1996, respectively. There were no fixed maturities which were non-income producing for the year ended December 31, 1998. There was, however, one mortgage loan which was non-income producing for the year ended December 31, 1998, which had an outstanding principal balance of $4.3 million and was fully impaired. Included in other long-term investments is a loss from limited partnerships of $7.5 million in 1998, and income of $7.8 million and $13.7 million in 1997 and 1996, respectively. B. Net Realized Investment Gains and Losses Realized gains (losses) on investments were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Fixed maturities $ (13.5) $ 14.0 $ (10.1) Mortgage loans 8.8 (1.2) (2.4) Equity securities 66.6 53.2 55.0 Real estate 13.7 12.8 21.1 Other (14.7) (2.6) 2.3 --------------------------------- Net realized investment gains $ 60.9 $ 76.2 $ 65.9 ================================= C. Other Comprehensive Income Reconciliation The following table provides a reconciliation of gross unrealized gains to the net balance shown in the Statement of Comprehensive Income: - -------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Unrealized gains on securities: Unrealized holding gains arising during period (net of taxes and minority interest of $(20.7) million, $122.0 million and $23.5 million in 1998, 1997 and 1996 respectively) $ (1.1) $ 125.5 $ 7.3 Less: reclassification adjustment for gains included in net income (net of taxes and minority interest of $24.6 million, $37.0 million and $37.2 million in 1998, 1997 and 1996 respectively) 36.3 39.2 28.7 ------------------------------- Other comprehensive income $ (37.4) $ 86.3 $ (21.4) =============================== 67 Note Seven Fair Value Disclosures of Financial Instruments - -------------------------------------------------------------------------------- Statement 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. Included in the fair value of fixed maturities are swap contracts used to hedge fixed maturities with a fair value of $(27.1) million at December 31, 1998. Fair values of swap contracts were not material at December 31, 1997. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents For these short-term investments, the carrying amount approximates fair value. Fixed Maturities 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. Equity Securities 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. Mortgage Loans Fair values are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of below investment grade mortgage loans are limited to the lesser of the present value of the cash flows or book value. Reinsurance Receivables The carrying amount reported in the consolidated balance sheets approximates fair value. Policy Loans The carrying amount reported in the consolidated balance sheets approximates fair value since policy loans have no defined maturity dates and are inseparable from the insurance contracts. Investment Contracts (Without Mortality Features) 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. Other liabilities are based on surrender values. Debt The carrying value of short-term debt reported in the balance sheet approximates fair value. The fair value of long-term debt was estimated using market quotes, when available, and when not available, discounted cash flow analyses. Mandatorily Redeemable Preferred Securities of a Subsidiary Trust Holding Solely Junior Subordinated Debentures of the Company 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. 68 The estimated fair values of the financial instruments were as follows:
- ------------------------------------------------------------------------------------------------------------------------------------ December 31 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------------ (In millions) - ------------------------------------------------------------------------------------------------------------------------------------ Carrying Fair Carrying Fair Value Value Value Value Financial Assets Cash and cash equivalents $ 550.3 $ 550.3 $ 215.1 $ 215.1 Fixed maturities 7,780.8 7,780.8 7,313.7 7,313.7 Equity securities 397.1 397.1 479.0 479.0 Mortgage loans 562.3 587.1 567.5 597.0 Policy loans 154.3 154.3 141.9 141.9 ------------------------------------------- $ 9,444.8 $ 9,469.6 $ 8,717.2 $ 8,746.7 =========================================== Financial Liabilities Guaranteed investment contracts $ 1,791.8 $ 1,830.8 $ 985.2 $ 1,004.7 Supplemental contracts without life contingencies 37.3 37.3 22.4 22.4 Dividend accumulations 88.4 88.4 87.8 87.8 Other individual contract deposit funds 61.6 61.1 57.9 55.7 Other group contract deposit funds 700.4 704.0 714.8 715.5 Individual fixed annuity contracts 1,110.6 1,073.6 907.4 882.2 Short-term debt 221.3 221.3 33.0 33.0 Long-term debt 199.5 213.4 202.1 216.6 Mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debentures of the Company 300.0 334.7 300.0 326.8 ------------------------------------------- $ 4,510.9 $ 4,564.6 $ 3,310.6 $ 3,344.7 ===========================================
69 Note Eight Closed Block - -------------------------------------------------------------------------------- Included in other income in the Consolidated Statements of Income in 1998, 1997 and 1996 is a net pre-tax contribution from the Closed Block of $10.4 million, $9.1 million and $8.6 million, respectively. Summarized financial information of the Closed Block as of December 31, 1998 and 1997 and for the period ended December 31, 1998, 1997 and 1996 is as follows: - -------------------------------------------------------------------------------- December 31 1998 1997 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Assets Fixed maturities, at fair value (amortized cost of $399.1 and $400.1, respectively) $ 414.2 $ 412.9 Mortgage loans 136.0 112.0 Policy loans 210.9 218.8 Cash and cash equivalents 9.4 25.1 Accrued investment income 14.1 14.1 Deferred policy acquisition costs 15.6 18.2 Other assets 2.9 5.6 ------------------- Total assets $ 803.1 $ 806.7 ==================== Liabilities Policy liabilities and accruals $ 862.9 $ 875.1 Other liabilities 9.1 10.4 ------------------- Total liabilities $ 872.0 $ 885.5 =================== - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Revenues Premiums and other income $ 55.4 $ 58.3 $ 61.7 Net investment income 53.3 53.4 52.6 Realized investment gain (loss) 0.1 1.3 (0.7) -------------------------------- Total revenues 108.8 113.0 113.6 -------------------------------- Benefits and expenses Policy benefits 95.0 100.5 101.2 Policy acquisition expenses 2.7 3.0 3.2 Other operating expenses 0.7 0.4 0.6 -------------------------------- Total benefits and expenses 98.4 103.9 105.0 -------------------------------- Contribution from the Closed Block $ 10.4 $ 9.1 $ 8.6 ================================ Cash flows Cash flows from operating activities: Contribution from the Closed Block $ 10.4 $ 9.1 $ 8.6 Change in: Deferred policy acquisition costs, net 2.6 2.9 3.4 Premiums and other receivables 0.3 -- 0.2 Policy liabilities and accruals (13.5) (11.6) (13.9) Accrued investment income -- 0.2 2.3 Deferred taxes 0.1 (5.1) 1.0 Other assets 2.4 (2.9) (1.6) Expenses and taxes payable (2.9) (2.0) 1.7 Other, net (0.1) (1.2) 1.4 -------------------------------- Net cash (used in) provided by operating activities (0.7) (10.6) 3.1 -------------------------------- Cash flows from investing activities: Sales, maturities and repayments of investments 83.6 161.6 188.1 Purchases of investments (106.5) (161.4) (196.9) Other, net 7.9 11.4 12.2 -------------------------------- Net cash (used in) provided by investing activities (15.0) 11.6 3.4 -------------------------------- Net (decrease) increase in cash and cash equivalents (15.7) 1.0 6.5 Cash and cash equivalents, beginning of year 25.1 24.1 17.6 -------------------------------- Cash and cash equivalents, end of year $ 9.4 $ 25.1 $ 24.1 ================================ 70 There were no valuation allowances on mortgage loans at December 31, 1998, 1997 and 1996, respectively. 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. Note Nine Debt ================================================================================ Short and long-term debt consisted of the following: - -------------------------------------------------------------------------------- December 31 1998 1997 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Short-term Commercial paper $ 41.3 $ 32.6 Borrowings under bank credit facility 150.0 -- Repurchase agreements 30.0 -- Other -- 0.4 -------------------- Total short-term debt $ 221.3 $ 33.0 ==================== Long-term Senior Debentures (unsecured) $ 199.5 $ 199.5 Other -- 2.6 -------------------- Total long-term debt $ 199.5 $ 202.1 ==================== AFC issues commercial paper primarily to manage imbalances between operating cash flows and existing commitments. Commercial paper borrowing arrangements are supported by a credit agreement. At December 31, 1998, the weighted average interest rate for outstanding commercial paper was approximately 5.34%. Effective May 29, 1998, AFC entered into a credit agreement which replaces lines of credit previously held by FAFLIC and Allmerica P&C, and provides for a $150.0 million credit facility, which expires on May 28, 1999. 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. At December 31, 1998, the Company had approximately $150.0 million in committed lines of credit, of which $108.7 million was available for borrowing. These lines of credit generally had terms of less than one year, and required the Company to pay annual commitment fees limited to 0.06% of the available credit. Effective December 4, 1998, AFC entered into a credit agreement that expired on February 5, 1999. Borrowings under this agreement were unsecured and incurred interest at a rate per annum equal to the eurodollar rate plus applicable margin. Borrowings outstanding under this credit facility at December 31, 1998 were $150.0 million. The Company utilized repurchase agreements to finance certain transactions and had approximately $30.0 million in such agreements outstanding at December 31, 1998. In June 1997, the Company entered into a credit agreement providing for a $225.0 million revolving line of credit that expired on December 15, 1997. During 1997, the Company drew $140.0 million on the line of credit. Borrowings under the line of credit were unsecured and bore interest at a rate per annum equal to, at the Company's option, a designated base rate or the eurodollar rate plus an applicable margin. These borrowings were repaid in full by December 15, 1997. 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 $23.4 million, $21.7 million and $32.1 million in 1998, 1997 and 1996, respectively. Interest expense included $15.3 million related to the Company's Senior Debentures for each year. Interest expense related to borrowings under the credit agreements was approximately $0.7 million in 1998 and $2.8 million in 1997. During 1996, interest expense also included $11.0 million related to interest payments of repurchase agreements. All interest expense is recorded in other operating expenses. 71 Note Ten Federal Income Taxes - -------------------------------------------------------------------------------- Provisions for federal income taxes have been calculated in accordance with the provisions of Statement No. 109. A summary of the federal income tax expense (benefit) in the consolidated statements of income is shown below: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Federal income tax expense (benefit) Current $ 65.5 $ 79.7 $ 90.9 Deferred (16.4) 13.9 (15.7) ------------------------------------ Total $ 49.1 $ 93.6 $ 75.2 ==================================== The federal income taxes attributable to the consolidated results of operations are different from the amounts determined by multiplying income before federal income taxes by the expected federal income tax rate. The sources of the difference and the tax effects of each were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Expected federal income tax expense $ 97.9 $ 127.9 $ 116.1 Tax-exempt interest (38.9) (37.9) (35.3) Differential earnings amount -- -- (10.2) Dividend received deduction (5.1) (3.2) (1.6) Changes in tax reserve estimates 2.3 7.8 4.7 Tax credits (8.5) (2.7) -- Other, net 1.4 1.7 1.5 --------------------------------- Federal income tax expense $ 49.1 $ 93.6 $ 75.2 ================================= Until conversion to a stock life insurance company, FAFLIC, as a mutual company, reduced its deduction for policyholder dividends by the differential earnings amount. This amount was computed, for each tax year, by multiplying the average equity base of the FAFLIC/AFLIAC consolidated group, as determined for tax purposes, by the estimate of an excess of an imputed earnings rate over the average mutual life insurance companies' earnings rate. The differential earnings amount for each tax year was subsequently recomputed when actual earnings rates were published by the Internal Revenue Service ("IRS"). The differential earnings amount included in 1996 related to an adjustment for the 1994 tax year based on the actual average mutual life insurance companies' earnings rate issued by the IRS in 1996. As a stock life company, FAFLIC is no longer required to reduce its policyholder dividend deduction by the differential earnings amount. The deferred income tax (asset) liability represents the tax effects of temporary differences attributable to the Company's consolidated federal tax return group. Its components were as follows: - ------------------------------------------------------------------------------- December 31 1998 1997 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Deferred tax (assets) liabilities AMT carryforwards $ (16.8) $ (15.6) Loss reserve discounting (406.6) (391.6) Deferred acquisition costs 345.8 291.8 Employee benefit plans (45.3) (48.0) Investments, net 121.6 175.4 Bad debt reserve (1.8) (14.3) Litigation reserves (10.9) -- Other, net (5.8) 15.2 ----------------------- Deferred tax (asset) liability, net $ (19.8) $ 12.9 ======================= Gross deferred income tax assets totaled $538.2 million and $469.5 million at December 31, 1998 and 1997, respectively. Gross deferred income tax liabilities totaled $518.4 million and $482.4 million at December 31, 1998 and 1997, respectively. The Company believes, based on its recent 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, 1998, there are available alternative minimum tax credit carryforwards of $16.8 million. 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 P&C consolidated group's federal income tax returns through 1991. The Company has appealed certain adjustments proposed by the IRS with respect to the federal income tax returns for 1992, 1993 and 1994 for the FAFLIC/AFLIAC consolidated group. Also, certain adjustments proposed by the IRS with respect to FAFLIC/AFLIAC's federal income tax returns for 1982 and 1983 remain unresolved. If upheld, these adjustments would result in additional payments; however, the Company will vigorously defend its position with respect to these adjustments. 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. 72 Note Eleven Pension Plans - -------------------------------------------------------------------------------- AFC provides retirement benefits to substantially all of its employees under a defined benefit pension plan. This plan is based on a defined benefit cash balance formula, whereby the Company annually provides an allocation to each eligible employee based on a percentage of that employee's salary, similar to a defined contribution plan arrangement. The 1998, 1997 and 1996 allocations were based on 7.0% of each eligible employee's salary. 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. Components of net periodic pension cost were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Service cost - benefits earned during the year $ 19.0 $ 19.9 $ 19.0 Interest cost 25.5 23.5 21.9 Expected return on plan assets (34.9) (31.2) (28.3) Recognized net actuarial loss (gain) 0.4 0.1 (0.4) Amortization of transition asset (1.8) (1.9) (1.9) Amortization of prior service cost (1.7) (2.0) (2.3) ------------------------------- Net periodic pension cost $ 6.5 $ 8.4 $ 8.0 =============================== The following table summarizes the status of the plan. At December 31, 1998 and 1997, the plans' assets exceeded their projected benefit obligations. - -------------------------------------------------------------------------------- December 31 1998 1997 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Change in benefit obligations: Projected benefit obligation at beginning of year $ 370.4 $ 344.2 Service cost - benefits earned during the year 19.0 19.9 Interest cost 25.5 23.5 Actuarial losses 20.4 0.3 Benefits paid (21.1) (17.5) -------------------- Projected benefit obligation at end of year 414.2 370.4 -------------------- Change in plan assets: Fair value of plan assets at beginning of year 395.5 347.8 Actual return on plan assets 67.2 65.2 Benefits paid (21.1) (17.5) -------------------- Fair value of plan assets at end of year 441.6 395.5 -------------------- Funded status of the plan 27.4 25.1 Unrecognized transition obligation (23.9) (26.2) Unamortized prior service cost (11.0) (13.9) Unrecognized net actuarial gains (54.9) (44.9) -------------------- Net pension liability $ (62.4) $ (59.9) ==================== As a result of the Company's merger with Allmerica P&C, certain pension liabilities were reduced by $11.7 million in 1997, to reflect their fair value as of the merger date. These pension liabilities were reduced by $10.3 million in 1998, which reflects fair value, net of applicable amortization. Determination of the projected benefit obligations was based on a weighted average discount rate of 6.5% and 7.0% in 1998 and 1997, respectively, and the assumed long-term rate of return on plan assets was 9.0% in both 1998 and 1997. The actuarial present value of the projected benefit obligations was determined using assumed rates of increase in future compensation levels ranging from 5.0% to 5.5%. Plan assets are invested primarily in various separate accounts and the general account of FAFLIC. Plan assets also include 973,262 shares of AFC Common Stock at both December 31, 1998 and 1997, with a market value of $56.3 million and $48.6 million at December 31, 1998 and 1997, respectively. The Company has a defined contribution 401(k) plan for its employees, whereby the Company matches employee elective 401(k) contributions, up to a maximum percentage determined annually by the Board of Directors. During 1998, 1997 and 1996, the Company matched 50% of employees' contributions up to 6.0% of eligible compensation. The total expense related to this plan was $5.6 million, $3.3 million and $5.5 million in 1998, 1997 and 1996, respectively. In addition to this plan, the Company has a defined contribution plan for substantially all of its agents. The Plan expense in 1998, 1997 and 1996 was $3.0 million, $2.8 million and $2.0 million, respectively. 73 Note Twelve Other Postretirement Benefit Plans - -------------------------------------------------------------------------------- In addition to the Company's pension plans, the Company currently provides postretirement medical and death benefits to certain full-time employees and dependents, under a plan sponsored by FAFLIC. Generally, employees become eligible at age 55 with at least 15 years of service. Spousal coverage is generally provided for up to two years after death of the retiree. Benefits include hospital, major medical and a payment at death equal to retirees' final compensation up to certain limits. Effective January 1, 1996, the Company revised these benefits so as to establish limits on future benefit payments and to restrict eligibility to current employees. The medical plans have varying copayments and deductibles, depending on the plan. These plans are unfunded. The plan changes, effective January 1, 1996, resulted in a negative plan amendment (change in eligibility and medical benefits) of $26.8 million and curtailment (no future increases in life insurance) of $5.3 million. The negative plan amendment will be amortized as prior service cost over the average number of years to full eligibility (approximately nine years or $3.0 million per year). Of the $5.3 million curtailment gain, $3.3 million has been deducted from unrecognized loss and $2.0 million has been recorded as a reduction of the net periodic postretirement benefit expense. The plans' funded status reconciled with amounts recognized in the Company's consolidated balance sheet were as follows: - ------------------------------------------------------------------------------- December 31 1998 1997 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Change in benefit obligations: Accumulated postretirement benefit obligation at beginning of year $ 71.8 $ 72.3 Service cost 3.1 3.0 Interest cost 5.1 4.6 Actuarial losses 7.6 (4.7) Benefits paid (3.6) (3.4) -------------------- Accumulated postretirement benefit obligation at end of year 84.0 71.8 Fair value of plan assets at end of year -- -- -------------------- Funded status of the plan (84.0) (71.8) Unamortized prior service cost (12.9) (15.3) Unrecognized net actuarial losses 7.5 0.8 -------------------- Accumulated postretirement benefit costs $ (89.4) $ (86.3) ==================== The components of net periodic postretirement benefit costs were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Service cost $ 3.1 $ 3.0 $ 3.2 Interest cost 5.1 4.6 4.6 Recognized net actuarial loss (gain) 0.1 (0.1) 0.2 Amortization of prior service cost (2.4) (2.7) (3.0) ---------------------------- Net periodic postretirement benefit cost $ 5.9 $ 4.8 $ 5.0 ============================ As a result of the Company's merger with Allmerica P&C in 1997, certain postretirement liabilities were reduced by $6.1 million to reflect their fair value as of the merger date. These postretirement liabilities were reduced by $5.4 million in 1998, which reflects fair value, net of applicable amortization. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 1998, health care costs were assumed to increase 7.0% in 1999, declining thereafter until the ultimate rate of 5.5% is reached in 2001 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, 1998 by $5.7 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 1998 by $0.7 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, 1998 by $5.2 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 1998 by $0.6 million. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 6.5% and 7.0% at December 31, 1998 and 1997, 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 5.5% for FAFLIC agents. 74 Note Thirteen Stock-Based Compensation Plans - -------------------------------------------------------------------------------- The Company has elected to apply the provisions of Accounting Principles Board Opinion No. 25 (APB No. 25) in accounting for its stock-based compensation plans, and thus no compensation cost has been recognized for stock options in the financial statements. The pro forma effect of recognizing compensation cost based on an instrument's fair value at the date of grant, consistent with Statement No. 123, "Accounting for Stock-Based Compensation", results in net income and earnings per share of $194.4 million and $3.23 per share-diluted ($3.25 per share-basic) in 1998, $206.0 million and $3.76 per share-diluted ($3.77 per share- basic) in 1997, and $181.4 million and $3.62 per share (basic and diluted) in 1996. 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. 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 available for award in any given year is equal to 2.25% of the outstanding common stock of the Company at the beginning of the year, plus any awards authorized but unused from prior years. In addition, the maximum number of shares authorized for grants over the life of the plan is equal to 4,432,309 shares as of December 31, 1998, increasing annually by 1.25% of the Company's outstanding stock. Options may be granted to eligible employees 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 vest at the rate of 20% annually for five consecutive years and 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. Information on the Company's stock option plan is summarized below:
- ------------------------------------------------------------------------------------------------------------------------------------ (In whole shares and dollars) 1998 1997 1996 - ------------------------------------------------------------------------------------------------------------------------------------ Weighted Weighted Weighted Average Average Average Options Exercise Price Options Exercise Price Options Exercise Price Outstanding at beginning of year 1,075,044 $ 33.45 209,500 $ 27.50 -- $ -- Granted 807,511 54.06 849,500 35.64 231,500 27.50 Converted from Allmerica P&C merger -- -- 114,509 27.40 -- -- Converted from Citizens acquisition 38,976 28.27 -- -- -- -- Exercised 61,693 31.34 16,021 27.23 -- -- Forfeited 113,599 41.85 82,444 33.74 22,000 27.50 -------------------------------------------------------------------------------- Outstanding at end of year 1,746,239 $ 42.39 1,075,044 $ 33.45 209,500 $ 27.50 ================================================================================ Options exercisable at end of year 240,384 $ 32.61 57,116 $ 27.38 -- $ -- ================================================================================
No options expired during 1998, 1997, or 1996. 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 1998, the exercise price equaled the market price of the stock on the grant date. The weighted average fair value of options granted in 1998, 1997, and 1996 was $23.68 per share, $15.02 per share, and $13.19 per share, respectively. For options converted pursuant to the acquisition of the minority interest in Citizens and Allmerica P&C, the exercise price was less than the fair value of the stock on the conversion date. The weighted average fair values of these options were $27.87 and $28.24 per share, respectively. The following significant assumptions were used to determine fair value for 1998 options granted and converted: - -------------------------------------------------------------------------------- 1998 1997 1996 - -------------------------------------------------------------------------------- Dividend yield 0.4% 0.5% 0.6% Expected volatility 47.49% 31.52% 23.50% Risk-free interest rate 4.84% 5.66% to 6.19% 5.29% to 6.33% Expected lives range (in years) 2.5 to 7 2.5 to 7 2.5 to 7 75 The following table summarizes information about employee options outstanding and exercisable at December 31, 1998.
- ------------------------------------------------------------------------------------------------------------------------------- Options Outstanding Options Currently Exercisable - ------------------------------------------------------------------------------------------------------------------------------- Weighted Average Weighted Weighted Remaining Average Average Contractual Exercise Exercise Range of Exercise Prices Number Lives Price Number Price - ------------------------------------------------------------------------------------------------------------------------------- $24.50 to $30.66 276,666 7.22 $ 27.58 102,390 $ 27.32 $35.375 to $50.00 724,516 8.41 $ 35.88 131,316 $ 35.72 $52.50 to $68.25 745,057 9.14 $ 54.22 6,678 $ 52.63
During 1998 and 1997, the Company granted shares of nonvested stock to eligible employees, which vest after three years of continuous employment. There were no such grants during 1996. During 1998, the Company also granted shares of nonvested stock to certain agents, which vest 60% after three years, and 20% per year thereafter. The following table summarizes information about employee and agent nonvested stock. - -------------------------------------------------------------------------------- Stock Awards 1998 1997 - -------------------------------------------------------------------------------- Common stock granted 237,394 68,127 Weighted average fair value per share at the date of grant $ 37.21 $ 34.13 The Company recognizes compensation expense related to nonvested shares over the vesting period on a pro rata basis. As a result, the Company recognized $3.3 million and $0.7 million of compensation cost in 1998 and 1997, respectively. Note Fourteen Dividend Restrictions - -------------------------------------------------------------------------------- Massachusetts, Delaware, New Hampshire and Michigan have enacted laws governing the payment of dividends to stockholders by insurers. These laws affect the dividend paying ability of FAFLIC, AFLIAC, Hanover and Citizens, respectively. Massachusetts' statute limits the dividends an insurer may pay in any twelve month period, without the prior permission of the Commonwealth of Massachusetts Insurance Commissioner, to the greater of (i) 10% of its statutory policyholder surplus as of the preceding December 31 or (ii) the individual company's statutory net gain from operations for the preceding calendar year (if such insurer is a life company), or its net income for the preceding calendar year (if such insurer is not a life company). In addition, under Massachusetts law, no domestic insurer shall pay a dividend or make any distribution to its shareholders from other than unassigned funds unless the Commissioner shall have approved such dividend or distribution. During 1998, FAFLIC paid dividends of $50.0 million to AFC. No dividends were declared by FAFLIC to AFC during 1997 or 1996. During 1999, FAFLIC could pay dividends of $116.4 million to AFC without prior approval of the Commissioner. Pursuant to Delaware's statute, the maximum amount of dividends and other distributions that an insurer may pay in any twelve month period, without the prior approval of the Delaware Commissioner of Insurance, is limited to the greater of (i) 10% of its policyholders' surplus as of the preceding December 31 or (ii) the individual company's statutory net gain from operations for the preceding calendar year (if such insurer is a life company) or its net income (not including realized capital gains) for the preceding calendar year (if such insurer is not a life company). Any dividends to be paid by an insurer, whether or not in excess of the aforementioned threshold, from a source other than statutory earned surplus would also require the prior approval of the Delaware Commissioner of Insurance. No dividends were declared by AFLIAC to FAFLIC during 1998, 1997 or 1996. During 1999, AFLIAC could pay dividends of $26.1 million to FAFLIC without prior approval. Pursuant to New Hampshire's statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the New Hampshire Insurance Commissioner, is limited to 10% of such insurer's statutory policyholder surplus as of the preceding December 31. Hanover declared dividends to Allmerica P&C totaling $125.0 million, $120.0 million and $105.0 million during 1998, 1997 and 1996, respectively. During 1999, the maximum dividend and other distributions that could be declared to Allmerica P&C by Hanover, without prior approval of the Insurance Commissioner, is approximately $1.6 million, which considers an extraordinary dividend of $125.0 million declared on March 12, 1998. The allowable dividend without prior approval will increase to $126.6 million on March 12, 1999. 76 Pursuant to Michigan's statute, the maximum dividends and other distributions that an insurer may pay in any twelve month period, without prior approval of the Michigan Insurance Commissioner, is limited to the greater of 10% of policyholders' surplus as of December 31 of the immediately preceding year or the statutory net income less realized gains, for the immediately preceding calendar year. Citizens Insurance declared dividends to Citizens Corporation totaling $200.0 million and $6.3 million during 1998 and 1996, respectively. A $180.0 million extraordinary dividend was approved by the Commissioner in 1998. No dividends were declared by Citizens Insurance during 1997. During 1999, Citizens Insurance can declare no dividends to Citizens Corporation without prior approval of the Michigan Insurance Commissioner as a result of the $180.0 million extraordinary dividend declared on December 21, 1998. Note Fifteen Segment Information - -------------------------------------------------------------------------------- The Company offers financial products and services in two major areas: Risk Management and Retirement and Asset Accumulation. Within these broad areas, the Company conducts business principally in four operating segments. Effective January 1, 1998, the Company adopted Statement No. 131. Upon adoption, the separate financial information of each segment was redefined consistent with the way results are regularly evaluated by the chief operating decision maker in deciding how to allocate resources and in assessing performance. A summary of the significant changes in reportable segments is included below. The Risk Management group includes two segments: Property and Casualty and Corporate Risk Management Services. The Property and Casualty segment includes property and casualty insurance products, such as automobile insurance, homeowners insurance, commercial multiple peril insurance, and workers' compensation insurance. These products are offered by Allmerica P&C through its operating subsidiaries, Hanover and Citizens. Substantially all of the Property and Casualty segment's earnings are generated in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The Corporate Risk Management Services segment includes group life and health insurance products and services which assist employers in administering employee benefit programs and in managing the related risks. The Retirement and Asset Accumulation group includes two segments: Allmerica Financial Services and Allmerica Asset Management. The Allmerica Financial Services segment includes variable annuities, variable universal life and traditional life insurance products distributed via retail channels as well as group retirement products, such as defined benefit and 401(k) plans and tax-sheltered annuities distributed to institutions. Through its Allmerica Asset Management segment, the Company offers its customers the option of investing in three types of GICs; the traditional GIC, the synthetic GIC and the floating rate GIC. This segment is also a Registered Investment Advisor providing investment advisory services, primarily to affiliates, and to other institutions, such as insurance companies and pension plans. In addition to the four operating segments, the Company has a Corporate segment, which consists primarily of cash, investments, corporate debt, Capital Securities and corporate overhead expenses. Corporate overhead expenses reflect costs not attributable to a particular segment, such as those generated by certain officers and directors, Corporate Technology, Corporate Finance, Human Resources and the legal department. Significant changes to the Company's segmentation include a reclassification of corporate overhead expenses from each operating segment into the Corporate segment. Additionally, certain products (group retirement products, such as 401(K) plans and tax-sheltered annuities, group variable universal life) and certain other non-insurance operations (telemarketing and trust services) previously reported in the Allmerica Financial Institutional Services segment were combined with the Allmerica Financial Services segment. Also, the Company reclassified the GIC product line previously reported in the Allmerica Financial Institutional Services segment into the Allmerica Asset Management segment. Management evaluates the results of the aforementioned segments based on a pre-tax and minority interest basis. Segment income is determined by adjusting net income for net realized investment gains and losses, net gains and losses on disposals of businesses, extraordinary items, the cumulative effect of accounting changes and certain other items which management believes are not indicative of overall operating trends. While these items may be significant components in understanding and assessing the Company's financial performance, management believes that the presentation of segment income enhances its understanding of the Company's results of operations by highlighting net income attributable to the normal, recurring operations of the business. However, segment income should not be construed as a substitute for net income determined in accordance with generally accepted accounting principles. 77 Summarized below is financial information with respect to business segments: - ------------------------------------------------------------------------------- For the Years Ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Segment revenues: Risk Management Property and Casualty $ 2,204.8 $ 2,211.0 $ 2,145.8 Corporate Risk Management Services 414.1 405.6 370.7 ---------------------------------- Subtotal 2,618.9 2,616.6 2,516.5 ---------------------------------- Retirement and Asset Accumulation Allmerica Financial Services 724.0 713.9 700.0 Allmerica Asset Management 121.7 91.1 110.5 ---------------------------------- Subtotal 845.7 805.0 810.5 ---------------------------------- Corporate 12.9 16.1 6.9 Intersegment revenues (7.6) (11.5) (13.8) ---------------------------------- Total segment revenues including Closed Block 3,469.9 3,426.2 3,320.1 ---------------------------------- Adjustment to segment revenues: Adjustment for Closed Block (98.3) (102.6) (105.7) Change in mortality assumptions -- (4.2) -- Contingency payment from sale of mutual fund processing business -- -- 4.8 Net realized gains 60.9 76.2 65.9 ---------------------------------- Total revenues $ 3,432.5 $ 3,395.6 $ 3,285.1 ================================== Segment income (loss) before income taxes and minority interest: Risk Management Property and Casualty $ 151.4 $ 172.9 $ 170.7 Corporate Risk Management Services 7.6 27.0 28.3 ---------------------------------- Subtotal 159.0 199.9 199.0 ---------------------------------- Retirement and Asset Accumulation Allmerica Financial Services 166.7 134.6 106.8 Allmerica Asset Management 23.7 18.4 11.5 ---------------------------------- Subtotal 190.4 153.0 118.3 ---------------------------------- Corporate (50.9) (48.0) (58.0) ---------------------------------- Segment income before income taxes and minority interest 298.5 304.9 259.3 ---------------------------------- Adjustments to segment income: Net realized investment gains, net of amortization 51.2 76.1 68.7 Sales practice litigation expense (31.0) -- -- Loss on exiting reinsurance pools (25.3) -- -- Gain from change in mortality assumptions -- 47.0 -- Loss on cession of disability income business -- (53.9) -- Contingency payment from sale of mutual fund processing business -- -- 4.8 Restructuring costs (13.0) -- -- Other items (0.8) (8.6) (1.1) Income before taxes and minority interest ---------------------------------- $ 279.6 $ 365.5 $ 331.7 ================================== - -------------------------------------------------------------------------------- December 31 1998 1997 1998 1997 - -------------------------------------------------------------------------------- (Dollars in millions) - -------------------------------------------------------------------------------- Deferred Identifiable Assets Acquisition Costs Risk Management Property and Casualty $ 5,649.0 $ 5,650.4 $ 164.9 $ 167.2 Corporate Risk Management Services 570.0 621.9 2.6 2.9 ---------------------------------------------- Subtotal 6,219.0 6,272.3 167.5 170.1 Retirement and Asset Accumulation Allmerica Financial Services 19,416.6 15,159.2 993.1 794.5 Allmerica Asset Management 1,810.9 1,035.1 0.6 0.9 ---------------------------------------------- Subtotal 21,227.5 16,194.3 993.7 795.4 Corporate 161.4 82.4 -- -- ---------------------------------------------- Total $ 27,607.9 $ 22,549.0 $ 1,161.2 $ 965.5 ============================================== Note Sixteen Lease Commitments - -------------------------------------------------------------------------------- Rental expenses for operating leases, principally with respect to buildings, amounted to $34.9 million, $33.6 million and $34.9 million in 1998, 1997 and 1996, respectively. At December 31, 1998, future minimum rental payments under non-cancelable operating leases were approximately $73.5 million, payable as follows: 1999 - $28.6 million; 2000 - $21.0 million; 2001 - $13.8 million; 2002 - - $6.9 million; and $3.2 million thereafter. It is expected that, in the normal course of business, leases that expire may be renewed or replaced by leases on other property and equipment; thus, it is anticipated that future minimum lease commitments may not be less than the amounts shown for 1999. Note Seventeen Reinsurance - -------------------------------------------------------------------------------- In the normal course of business, the Company seeks to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Reinsurance transactions are accounted for in accordance with the provisions of Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of rein- 78 surers 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. 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"), the Maine Workers' Compensation Residual Market Pool ("MWCRP") and the Michigan Catastrophic Claims Association ("MCCA"). At December 31, 1998, CAR was the only reinsurer which represented 10% or more of the Company's reinsurance business. 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 1998, 1997 and 1996 were $34.3 million and $38.1 million, $32.3 million and $28.2 million, and $38.0 million and $21.8 million, respectively. The Company ceded to MCCA premiums earned and losses and loss adjustment expenses in 1998, 1997 and 1996 of $3.7 million and $18.0 million, $9.8 million and $(0.8) million, and $50.5 million and $(52.9) million, respectively. On June 2, 1998, the Company recorded a $124.2 million one-time reduction of its direct and ceded written premiums as a result of a return of excess surplus from MCCA. This transaction had no impact on the total net premiums recorded by the Company in 1998. Because the MCCA is supported by assessments permitted by statute, and all amounts billed by the Company to CAR, MWCRP and MCCA have been paid when due, the Company believes that it has no significant exposure to uncollectible reinsurance balances. The effects of reinsurance were as follows: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Life and accident and health insurance premiums: Direct $ 416.6 $ 417.4 $ 389.1 Assumed 111.9 110.7 87.8 Ceded (189.8) (170.1) (138.9) ------------------------------------ Net premiums $ 338.7 $ 358.0 $ 338.0 ==================================== Property and casualty premiums written: Direct $ 1,970.4 $ 2,068.5 $ 2,039.7 Assumed 58.8 103.1 108.7 Ceded (74.1) (179.8) (234.0) ------------------------------------ Net premiums $ 1,955.1 $ 1,991.8 $ 1,914.4 ==================================== Property and casualty premiums earned: Direct $ 1,967.9 $ 2,046.2 $ 2,018.5 Assumed 64.5 102.0 112.4 Ceded (66.1) (195.1) (232.6) ------------------------------------ Net premiums $ 1,966.3 $ 1,953.1 $ 1,898.3 ==================================== Life and accident and health insurance and other individual policy benefits, claims, losses and loss adjustment expenses: Direct $ 653.6 $ 656.4 $ 606.5 Assumed 67.9 61.6 44.9 Ceded (164.0) (158.8) (77.8) ------------------------------------ Net policy benefits, claims, losses and loss adjustment expenses $ 557.5 $ 559.2 $ 573.6 ==================================== Property and casualty benefits, claims, losses and loss adjustment expenses: Direct $ 1,589.2 $ 1,464.9 $ 1,299.8 Assumed 62.7 101.2 85.8 Ceded (158.2) (120.6) (2.2) ------------------------------------ Net policy benefits, claims, losses and loss adjustment expenses $ 1,493.7 $ 1,445.5 $ 1,383.4 ==================================== 79 Note Eighteen Deferred Policy Acquisition Costs - -------------------------------------------------------------------------------- The following reflects the changes to the deferred policy acquisition asset: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Balance at beginning of year $ 965.5 $ 822.7 $ 735.7 Acquisition expenses deferred 641.2 617.7 547.4 Amortized to expense during the year (452.8) (476.0) (470.1) Adjustment to equity during the year 7.3 (11.1) 9.7 Adjustment for cession of disability income insurance -- (38.6) -- Adjustment for revision of universal life and variable universal life insurance mortality assumptions -- 50.8 -- ---------------------------------- Balance at end of year $ 1,161.2 $ 965.5 $ 822.7 ================================== At October 1, 1997, the Company revised the mortality assumptions for universal life and variable universal life product lines. These revisions resulted in a $50.8 million recapitalization of deferred policy acquisition costs. Note Nineteen Liabilities for Outstanding Claims, Losses and Loss Adjustment Expenses - -------------------------------------------------------------------------------- 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 in the year such changes are determined to be needed. The liability for future policy benefits and outstanding claims, losses and loss adjustment expenses related to the Company's accident and health business was $568.0 million, $533.6 million and $471.7 million at December 31, 1998, 1997 and 1996, respectively. Accident and health claim liabilities were re-estimated for all prior years and were increased by $14.6 million in 1998, and decreased by $0.2 million and $0.6 million in 1997 and 1996, respectively. The increase in 1998 resulted from the Company's reserve strengthening primarily in the assumed reinsurance and stop loss only business. The following table provides a reconciliation of the beginning and ending property and casualty reserve for unpaid losses and loss adjustment expenses: - ------------------------------------------------------------------------------- For the Years Ended December 31 1998 1997 1996 - ------------------------------------------------------------------------------- (In millions) - ------------------------------------------------------------------------------- Reserve for losses and LAE, beginning of year $ 2,615.4 $ 2,744.1 $ 2,896.0 Incurred losses and LAE, net of reinsurance recoverable: Provision for insured events of current year 1,609.0 1,564.1 1,513.3 Decrease in provision for insured events of prior years (127.2) (127.9) (141.4) ------------------------------------ Total incurred losses and LAE 1,481.8 1,436.2 1,371.9 ------------------------------------ Payments, net of reinsurance recoverable: Losses and LAE attributable to insured events of current year 871.9 775.1 759.6 Losses and LAE attributable to insured events of prior years 643.0 732.1 627.6 ------------------------------------ Total payments 1,514.9 1,507.2 1,387.2 ------------------------------------ Change in reinsurance recoverable on unpaid losses 15.0 (50.2) (136.6) Other (1) -- (7.5) -- Reserve for losses and LAE, end of year $ 2,597.3 $ 2,615.4 $ 2,744.1 ==================================== (1) Includes purchase accounting adjustments. As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $127.2 million, $127.9 million and $141.4 million in 1998, 1997 and 1996, respectively. The decrease in favorable development on prior years' reserves of $0.7 million in 1998 results from a $20.7 million decrease in favorable development at Citizens, significantly offset by a $20.0 million increase in favorable development at Hanover. The decrease in favorable development on prior year reserves at Citizens in 1998, reflects a $13.8 million decrease in favorable development, to $21.9 million, in the workers' compensation line. In addition, favorable development in the commercial multiple peril line decreased $4.0 million, to $0.3 million. These declines in favorable development are partially off- 80 set by continued favorable development on prior year reserves in the personal automobile line due to tort reform in Michigan, which became effective July 26, 1996. The new legislation requires judges rather than juries to determine if the minimum threshold to allow pain and suffering damage settlements has been met. The increase in favorable development at Hanover during 1998 reflects a $20.6 million increase in favorable development on prior year reserves, to $38.0 million, in the personal automobile line, as well as a $14.9 million increase to $12.1 million in the commercial multiple peril line. These increases are primarily attributable to the initiatives taken by the Company over the past two years which are expected to reduce ultimate settlement costs. These increases are partially offset by less favorable development in the workers' compensation line where favorable development on prior year reserves decreased $19.2 million, to $9.6 million. The decrease in favorable development on prior years' reserves of $13.5 million in 1997 results primarily from a $24.6 million decrease in favorable development at Hanover to $58.4 million, partially offset by an $11.1 million increase in favorable development at Citizens to $69.5 million. The decrease in Hanover's favorable development of $24.6 million in 1997 reflects a decrease in favorable development of $25.0 million, to $17.4 million, in the personal automobile line as well as a decrease in favorable development of $8.5 million, to unfavorable development of $2.8 million, in the commercial multiple peril line. These decreases were partially offset by an increase in favorable development in the workers' compensation line of $11.5 million, to $28.8 million. The increase in favorable development at Citizens in 1997, reflects improved severity in the workers' compensation line where favorable development increased $13.9 million, to $35.7 million, and in the commercial multiple peril line where favorable development increased $7.0 million, to $4.3 million. These increases are partially offset by less favorable development in the personal automobile line, where favorable development decreased $10.5 million, to $22.5 million in 1997. This favorable development reflects the Property and Casualty segment's reserving philosophy consistently applied over these periods. Conditions and trends that have affected development of the loss and LAE reserves in the past may not necessarily occur in the future. Due to the nature of the business written by the Property and Casualty segment, the exposure to environmental liabilities is relatively small and therefore its reserves are relatively small compared to other types of liabilities. Loss and LAE reserves related to environmental damage and toxic tort liability, included in the reserve for losses and LAE, were $49.9 million, $53.1 million and $50.8 million, net of reinsurance of $14.2 million, $15.7 million and $20.2 million in 1998, 1997 and 1996, respectively. The Company does not specifically underwrite policies that include this coverage, but as case law expands policy provisions and insurers' liability beyond the intended coverage, the Company may be required to defend such claims. The Company estimated 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 claims are not material, their existence gives rise to uncertainty and is discussed because of the possibility, however remote, that they may become material. 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. Note Twenty Minority Interest - -------------------------------------------------------------------------------- The Company's interest in Allmerica P&C, through its wholly-owned subsidiary FAFLIC, is represented by ownership of 59.5% of the outstanding shares of common stock at December 31, 1996. Subsequent to the merger on July 16, 1997, Allmerica P&C became a wholly owned subsidiary of AFC. Allmerica P&C's interest in Citizens was approximately 82.5% at December 31, 1997 and 1996. Pursuant to the acquisition of minority interest completed on or about December 3, 1998, Citizens became a wholly-owned subsidiary of Allmerica P&C. Minority interest at December 31, 1998 and 1997 also reflects the Company's issuance of Capital Securities (See Note 4). Note Twenty-One Contingencies - -------------------------------------------------------------------------------- Regulatory and Industry Developments Unfavorable economic conditions may contribute to an increase in the number of insurance companies that are under regulatory supervision. This may result in an increase in mandatory assessments by state guaranty funds, or voluntary payments by solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through a reduction in future premium taxes in some states. The Company is not able to reasonably estimate the potential effect on it of any such future assessments or voluntary payments. 81 Litigation In July 1997, a lawsuit on behalf of a putative class was instituted in Louisiana against AFC and certain of its subsidiaries by individual plaintiffs alleging fraud, unfair or deceptive acts, breach of contract, misrepresentation, and related claims in the sale of life insurance policies. In October 1997, the plaintiffs voluntarily dismissed the Louisiana suit and filed a substantially similar action in Federal District Court in Worcester, Massachusetts. In early November 1998, the Company and the plaintiffs entered into a settlement agreement. The court granted preliminary approval of the settlement on December 4, 1998, and has scheduled a hearing in March 1999 to consider final approval. Accordingly, AFC recognized a $31.0 million pre-tax expense during the third quarter of 1998 related to this litigation. Although the Company believes that this expense reflects appropriate recognition of its obligation under the settlement, this estimate assumes the availability of insurance coverage for certain claims, and the estimate may be revised based on the amount of reimbursement actually tendered by AFC's insurance carriers, if any, and based on changes in the Company's estimate of the ultimate cost of the benefits to be provided to members of the class. The Company has been named a defendant in various other legal proceedings arising in the normal course of business. In the Company's opinion, based on the advice of legal counsel, the ultimate resolution of these proceedings will not have a material effect on the Company's consolidated financial statements. However, liabilities related to these proceedings could be established in the near term if estimates of the ultimate resolution of these proceedings are revised. Residual Markets 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 private passenger and commercial automobile lines of business. Year 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Although the Company does not believe that there is a material contingency associated with the Year 2000 project, there can be no assurance that exposure for material contingencies will not arise. Note Twenty-Two Statutory Financial Information - -------------------------------------------------------------------------------- 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, investment reserves are based on different assumptions, postretirement benefit costs are based on different assumptions and reflect a different method of adoption, life insurance reserves are based on different assumptions and income tax expense reflects only taxes paid or currently payable. Statutory net income and surplus are as follows: - -------------------------------------------------------------------------------- 1998 1997 1996 - -------------------------------------------------------------------------------- (In millions) - -------------------------------------------------------------------------------- Statutory Net Income (Combined) Property and Casualty Companies $ 180.7 $ 190.3 $ 155.5 Life and Health Companies 86.4 191.2 133.3 ---------------------------------- Statutory Shareholders' Surplus (Combined) Property and Casualty Companies $ 1,269.3 $ 1,279.6 $ 1,201.6 Life and Health Companies 1,164.1 1,221.3 1,120.1 ---------------------------------- 82 Note Twenty-Three Quarterly Results of Operations (Unaudited) - -------------------------------------------------------------------------------- The quarterly results of operations for 1998 and 1997 are summarized below:
- ---------------------------------------------------------------------------------------------------- For the Three Months Ended - ---------------------------------------------------------------------------------------------------- (In millions, except per share data) - ---------------------------------------------------------------------------------------------------- 1998 March 31 June 30 September 30 December 31 Total revenues $863.9 $856.7 $843.6 $868.3 Net income $ 66.8 $60.3 $ 8.2 $ 65.9 Net income per share: Basic $ 1.11 $1.00 $ 0.14 $ 1.11 Diluted $ 1.11 $1.00 $ 0.13 $ 1.10 Dividends declared per share $ 0.05 $0.05 $ 0.05 $ -- ======================================================= 1997 Total revenues $856.5 $830.9 $ 855.7 $852.5 Net income $ 15.9 $ 37.7 $ 60.7 $ 94.9 Net income per share (basic and diluted) $ 0.32 $ 0.75 $ 1.04 $ 1.58 Dividends declared per share $ 0.05 $ 0.05 $ 0.05 $ 0.05 =======================================================
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. 83 Allmerica Financial Corporation Board of Directors Michael P. Angelini (a) Partner, Bowditch & Dewey, LLP E. Gordon Gee (a) President, Brown University Samuel J. Gerson (a) Chairman and Chief Executive Officer, Filene's Basement, Inc. Gail L. Harrison (d) Founding Principal, The Wexler Group Robert P. Henderson (c) General Partner, Greylock Management Corporation M Howard Jacobson (a) Senior Advisor and Consultant, Bankers Trust Company Robert J. Murray (d) Chairman, President and Chief Executive Officer, New England Business Service, Inc. J. Terrence Murray (d) Chairman and Chief Executive Officer, Fleet Financial Group, Inc. John F. O'Brien President and Chief Executive Officer, Allmerica Financial Corporation John L. Sprague (a) President, John L. Sprague Associates, Inc. Robert G. Stachler (c) Partner, Taft, Stettinius & Hollister, LLP Herbert C. Varnum (c) Former Chairman and Chief Executive Officer, Quabaug Corporation Richard Manning Wall (c) General Counsel and Assistant to the Chairman and CEO, FLEXcon Company, Inc. (a) Audit Committee (c) Compensation Committee (d) Directors Committee Operating Committee Bruce C. Anderson Vice President, Corporate Services Robert E. Bruce Vice President, Chief Information Officer John P. Kavanaugh Vice President, Chief Investment Officer John F. Kelly Vice President, General Counsel and Assistant Secretary J. Barry May President, The Hanover Insurance Company James R. McAuliffe President, Citizens Insurance Company of America John F. O'Brien President and Chief Executive Officer Edward J. Parry, III Vice President, Chief Financial Officer and Treasurer Richard M. Reilly President and Chief Executive Officer, Allmerica Financial Life Insurance and Annuity Company Robert P. Restrepo, Jr. President and Chief Executive Officer, Allmerica Property & Casualty Companies, Inc. Eric A. Simonsen President, Allmerica Services Corporation Phillip E. Soule Vice President, Allmerica Voluntary Benefits 84 SHAREHOLDER INFORMATION ANNUAL MEETING OF SHAREHOLDERS The management and Board of Directors of Allmerica Financial Corporation invite you to attend the company's Annual Meeting of Shareholders. The meeting will be held on May 11, 1999, at 9:00 a.m. at Allmerica Financial, 440 Lincoln Street, Worcester, Massachusetts. COMMON STOCK AND SHAREHOLDER OWNERSHIP PROFILE The common stock of Allmerica Financial Corporation is traded on the New York Stock Exchange under the symbol "AFC." As of the end of business on February 26, 1999, the company had 50,548 shareholders of record. On the same date, the trading price of the company's common stock closed at $53.38 per share. COMMON STOCK PRICES AND DIVIDENDS
1998 High Low Dividends - --------------------------------------------------------------------- First Quarter $66.38 $42.31 $0.05 Second Quarter $72.13 $61.31 $0.05 Third Quarter $72.13 $57.31 $0.05 Fourth Quarter $57.88 $39.25 -- 1997 High Low Dividends - --------------------------------------------------------------------- First Quarter $40.25 $32.63 $0.05 Second Quarter $40.38 $33.50 $0.05 Third Quarter $45.25 $39.25 $0.05 Fourth Quarter $51.00 $42.88 $0.05
DIVIDENDS Allmerica Financial Corporation historically has paid a quarterly dividend of $0.05 per share. On December 15, 1998, Allmerica announced that its Board of Directors had decided to pay dividends on the company's common stock annually rather than on a quarterly basis in 1999. At the same time, Allmerica announced an expected increase in its dividend to $0.25 per share in 1999. REGISTRAR AND STOCK TRANSFER AGENT First Chicago Trust Company, a division of Equiserve 525 Washington Boulevard Jersey City, NJ 07303-2512 (800) 317-4454 INDEPENDENT ACCOUNTANTS PricewaterhouseCoopers LLP 160 Federal Street Boston, MA 02110 INDUSTRY RATINGS
A.M. Standard Duff & Claims Paying Ability Best & Poors Moody's Phelps - ----------------------------------------------------------------------- First Allmerica Financial Life Insurance Company A AA- A1 AA Allmerica Financial Life Insurance and Annuity Company A AA- A1 AA The Hanover Insurance Company A AA- A1 -- Citizens Insurance Company of America A AA- -- -- Standard Duff & Debt Ratings & Poors Moody's Phelps - ----------------------------------------------------------------------- Allmerica Financial Corporation Senior Debt A- A2 A+ Allmerica Financial Corporation Capital Securities BBB+ A2 -- Allmerica Financial Corporation Short Term Debt A1 P1 -- First Allmerica Financial Life Insurance Company Short Term Debt A1+ P1 --
TOLL-FREE INVESTOR INFORMATION LINE Call our toll free investor information line, (800) 407-5222, to receive additional printed information, including Form 10-Ks or quarterly reports on Form 10-Q filed with the Securities and Exchange Commission, fax-on-demand services, access to shareholder services, prerecorded messages, and other services. Alternatively, investors may address questions to: Henry P. St. Cyr, CFA, Vice President, Investor Relations Allmerica Financial Corporation 440 Lincoln Street, Worcester, MA 01653 tel. (508) 855-2959 fax (508) 853-4481 Brian M. Dugan, Director, Investor Relations tel. (508) 855-3883 fax (508) 855-3675 CORPORATE OFFICES AND PRINCIPAL SUBSIDIARIES Allmerica Financial Corporation 440 Lincoln Street Worcester, MA 01653 The Hanover Insurance Company 100 North Parkway Worcester, MA 01605 Citizens Insurance Company of America 645 West Grand River Howell, MI 48843 WEB SITE Please visit our Internet Web site at http://www.allmerica.com EX-21 9 SUBSIDIARIES OF AFC Exhibit 21 - Direct and Indirect Subsidiaries of the Registrant I. Allmerica Financial Corporation (Delaware) A. Allmerica, Inc. (Massachusetts) B. Allmerica Funding Corp. (Massachusetts) C. First Allmerica Financial Life Insurance Company (Massachusetts) 1. SMA Financial Corp. (Massachusetts) a. Allmerica Property & Casualty Companies, Inc. (Delaware) (70.0% owned) i. Allmerica Financial Insurance Brokers, Inc. (Massachusetts) ii. Citizens Insurance Company of Illinois, Inc. (Illinois) iii. The Hanover Insurance Company (New Hampshire) 1. Allmerica Financial Benefit Insurance Company (Pennsylvania) 2. Allmerica Plus Insurance Agency, Inc. (Massachusetts) 3. The Hanover American Insurance Company (New Hampshire) 4. Hanover Texas Insurance Management Company, Inc. (Texas) 5. Citizens Corporation (Delaware) a. Citizens Insurance Company of Ohio (Ohio) b. Citizens Insurance Company of America (Michigan) i. Citizens Management Inc. (Michigan) c. Citizens Insurance Company of the Midwest (Indiana) 6. AMGRO, Inc. (Massachusetts) a. Lloyds Credit Corporation (Massachusetts) 7. Massachusetts Bay Insurance Company (New Hampshire) 8. Allmerica Financial Alliance Insurance Company (New Hampshire) b. Sterling Risk Management Services, Inc. (Delaware) c. Allmerica Trust Company, N.A. (Federally Chartered) (99.2% owned) d. Allmerica Financial Life Insurance and Annuity Company (Delaware) e. Allmerica Investments, Inc. (Massachusetts) f. Allmerica Investment Management Company, Inc. (Massachusetts) g. Allmerica Asset Management, Inc. (Massachusetts) h. Allmerica Financial Services Insurance Agency, Inc. (Massachusetts) i. Allmerica Asset Management, Limited (Bermuda) j. Allmerica Benefits, Inc. (Florida) k. Allmerica Financial Investment Management Services, Inc. (Massachusetts) D. Allmerica Property & Casualty Companies, Inc. (Delaware) (30.0% owned) E. AFC Capital Trust I (Delaware) F. Allmerica Services Corporation (Massachusetts) G. First Sterling Limited (Bermuda) 1. First Sterling Reinsurance Company Limited (Bermuda) H. Financial Profiles, Inc. (California) EX-23 10 CONSENT OF PRICEWATERHOUSECOOPERS LLP Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 333-72491, No. 333-576, No. 333-578, No. 333-580, No. 333-582, No. 333-24929 and No. 333-31397) of Allmerica Financial Corporation of our report dated February 2, 1999, appearing in the Allmerica Financial Corporation 1998 Annual Report to Shareholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the financial statement schedules, which also appears in this Form 10-K. /s/ PricewaterhouseCoopers LLP PricewaterhouseCoopers LLP Boston, Massachusetts March 24, 1999 EX-24 11 POWER OF ATTORNEY EXHIBIT 24 POWER OF ATTORNEY We, the undersigned, hereby severally constitute and appoint John F. O'Brien, John F. Kelly and Edward J. Parry III, and each of them singly, our true and lawful attorneys, with full power in each of them, sign for and in each of our names and in any and all capacities, Form 10-K of Allmerica Financial Corporation (the "Company") and any other filings made on behalf of said Company pursuant to the requirements of the Securities Exchange Act of 1934, and to file the same with all exhibits and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys and each of them, acting alone, full power and authority to do and perform each and every act and thing requisite or necessary to be done, hereby ratifying and confirming all that said attorneys or any of them may lawfully do or cause to be done by virtue hereof. Witness our hands and common seal on the date set forth below. Signature Title Date --------- ----- ---- /s/ John F. O'Brien - ----------------------------- John F. O'Brien Director, President and CEO 2/22/99 /s/ Edward J. Parry III - ----------------------------- Edward J. Parry III Vice President, CFO, Treasurer 2/22/99 and Principal Accounting Officer /s/ Michael P. Angelini - ----------------------------- Michael P. Angelini Director 2/22/99 /s/ E. Gordon Gee Director 2/22/99 - ----------------------------- E. Gordon Gee Director 2/22/99 /s/ Samuel J. Gerson - ----------------------------- Samuel J. Gerson /s/ Gail L. Harrison - ----------------------------- Gail L. Harrison Director 2/22/99 - ----------------------------- Robert P. Henderson Director 2/22/99 /s/ M Howard Jacobson - ----------------------------- M Howard Jacobson Director 2/22/99 /s/ J. Terrence Murray - ----------------------------- J. Terrence Murray Director 2/22/99 /s/ Robert J. Murray - ----------------------------- Robert J. Murray Director 2/22/99 /s/ John L. Sprague - ----------------------------- John L. Sprague Director 2/22/99 /s/ Robert G. Stachler - ----------------------------- Robert G. Stachler Director 2/22/99 /s/ Herbert M. Varnum - ----------------------------- Herbert M. Varnum Director 2/22/99 /s/ Richard Manning Wall - ----------------------------- Richard Manning Wall Director 2/22/99 EX-27 12 FINANCIAL DATA SCHEDULE
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED FINANCIAL STATEMENTS OF ALLMERICA FINANCIAL CORPORATION AS OF DECEMBER 31, 1998 AND FOR THE PERIOD THEN ENDED, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000,000 12-MOS DEC-31-1998 DEC-31-1998 7,781 0 0 397 562 20 9,058 550 1,136 1,161 27,608 2,802 843 2,816 2,637 421 300 0 1 2,458 27,608 2,305 624 61 442 2,051 453 649 280 49 231 0 0 0 201 3.36 3.33 2,615 1,609 (127) 872 643 2,597 0
EX-99.2 13 IMPORTANT FACTORS RE: FORWARD LOOKING STATEMENTS EXHIBIT 99.2 ALLMERICA FINANCIAL CORPORATION IMPORTANT FACTORS REGARDING FORWARD-LOOKING STATEMENTS The Company wishes to caution readers that the following important factors, among others, in some cases have affected the Company's results and in the future could cause actual results and needs of the Company to vary materially from forward-looking statements made from time to time by the Company on the basis of management's then-current expectations. The businesses in which the Company is engaged are in rapidly changing and competitive markets and involve a high degree of risk, and accuracy with respect to forward looking projections is difficult. Concentration of the Property and Casualty Insurance Business in Michigan and the Northeast The Company's property and casualty insurance subsidiaries generate substantially all of their net premiums written and earnings in Michigan and the Northeast (Connecticut, Massachusetts, New York, New Jersey, New Hampshire, Rhode Island, Vermont and Maine). The revenues and profitability of the Company's property and casualty insurance subsidiaries are therefore subject to prevailing economic, regulatory, demographic and other conditions, including adverse weather, in Michigan and the Northeast. Cyclicality in the Property and Casualty Insurance Industry Historically, the property and casualty insurance industry has been highly cyclical and can be affected significantly by the following factors: . price competition . volatile and unpredictable developments such as extreme weather conditions and natural disasters . legal developments affecting insurer liability and the size of jury awards . fluctuations in interest rates . other factors that affect investment returns . general economic conditions and trends that may affect the adequacy of reserves. Over the past several years, the property and casualty insurance industry as a whole has been in a soft market. Competition for premiums in the property and casualty insurance markets may continue to have an adverse impact on the Company's rates and profitability. Catastrophe Losses May Significantly Harm Property and Casualty Insurers The Company may experience catastrophe losses in the future which could signficantly affect its results of operations and financial condition and could have a material adverse impact on the Company. Catastrophes can be caused by various events including hurricanes, earthquakes, tornadoes, wind, hail, fires, severe winter weather and explosions, and the frequency and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of two factors: the total amount of insured exposure in the area affected by the event and the severity of the event. Although catastrophes can cause losses in a variety of property and casualty lines, homeowners and commercial property insurance have in the past generated the vast majority of the Company's catastrophe-related claims. The Company purchases catastrophe reinsurance as protection against catastrophe losses. The Company believes, based upon its review of its reinsurers' financial statements and reputations in the reinsurance marketplace, that the financial condition of its reinsurers is sound. However, there can be no assurance that reinsurance will be adequate to protect the Company against such losses or that such reinsurance will continue to be available to the Company in the future at commercially reasonable rates. Uncertainty Regarding Adequacy of Property and Casualty Loss Reserves The Company's property and casualty insurance subsidiaries maintain reserves to cover their estimated ultimate liability for losses and loss adjustment expenses ("LAE") 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 time, of what the Company's property and casualty insurance subsidiaries expect the ultimate settlement and administration of claims will cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claims severity and judicial theories of liability, legislative activity and other factors. The inherent uncertainties of estimating reserves are greater for certain types of property and casualty insurance lines, particularly workers' compensation, where a longer period of time may elapse before a definitive determination of ultimate liability may be made, and environmental liability, where the technological, judicial and political climates involving these types of claims are changing. The Company's property and casualty insurance subsidiaries regularly review reserving techniques, reinsurance and overall reserve adequacy. Based upon (I) review of historical data, legislative enactments, judicial decision, legal developments in imposition of damages, changes in political attitudes and trends in general economic conditions; (ii) review of per claim information; (iii) historical loss experience of the property and casualty insurance subsidiaries and the industry; and (iv) the relatively short-term nature of most of its property and casualty insurance policies, management believes that adequate provision has been made for reserves. Furthermore, the Company's property and casualty insurance subsidiaries' reserves are annually certified as required by insurance regulatory authorities. However, establishment of appropriate reserves is an inherently uncertain process involving estimates of future losses and there can be no certainty that currently established reserves will be adequate in light of subsequent actual experience. Sensitivity to Interest Rates Relative to Life Insurance Subsidiaries Interest rate fluctuations expose the Company's life insurance subsidiaries to risk of disintermediation and reduction in interest spread or profit margins. Interest rates also affect bond calls, mortgage prepayments, contract surrenders and withdrawals of life insurance policies, annuities and guaranteed investment contracts. Since the Company's life insurance subsidiaries' investment portfolios consist primarily of fixed income assets, the investment portfolio market value and the yields on newly invested and reinvested assets vary depending on interest rates. Management attempts to mitigate any negative impact of interest rate changes through: . asset/liability management . product design (including an increased focus on variable insurance products) . management of crediting rates . use of hedging techniques . relatively high surrender charges . management of mortality charges and dividend scales with respect to its in force life insurance policies The Company's operating results are exposed to changes in exchange rates between the U.S. dollar and certain foreign currencies. Management attempts to mitigate the effect of negative changes in currency exchange rates by entering into foreign exchange swap contracts to hedge all of its net foreign currency exposure. Regulatory Oversight May Adversely Affect the Company Insurance companies are subject to supervision and regulation by the state insurance authority in each state in which they transact business. Such supervision and regulation relate to numerous aspects of an insurance company's business and financial condition, including limitations on the authorization of lines of business, underwriting limitations, the setting of premium rates, the establishment of standards of solvency, the licensing of insurers and agents, concentration of investments, levels of reserves, the payment of dividends, transactions with affiliates, changes of control and the approval of policy forms. Such regulation is concerned primarily with the protection of policyholders. State regulatory oversight and various proposals at the federal level (including the proposed adoption of a federal regulatory framework for insurance companies) may in the future adversely affect the Company's ability to sustain adequate returns in certain lines of business. In recent years, the state insurance regulatory framework has 2 come under increased federal scrutiny, and certain state legislatures have considered or enacted laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioners ("NAIC") and state insurance regulators are reexamining existing laws and regulations, and as a condition to accreditation have required the adoption of certain model laws which specifically focus on insurance company investments, issues relating to the solvency of insurance companies, risk-based capital ("RBC") guidelines, interpretations of existing laws, the development of new laws, and the definition of extraordinary dividends. Statutory Surplus The capacity for an insurance company's growth in premiums is in part a function of its statutory surplus. State insurance regulatory authorities and private agencies that rate insurers' claims-paying abilities and financial strength consider an insurer's statutory surplus level as measured by state insurance regulators, to be important. Failure to maintain certain levels of statutory surplus could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by the private rating agencies. Statutory Capital The NAIC has created a new system for assessing the adequacy of statutory capital for life and health insurers and property and casualty insurers. The new system, known as risk-based capital, is in addition to the states' fixed dollar minimum capital and other requirements. The new system is based on risk-based formulas (separately defined for life and health insurers and property and casualty insurers) that apply prescribed factors to the various risk elements in an insurer's business to report a minimum capital requirement proportional to the amount of risk assumed by the insurer. Ratings Downgrades May Harm the Company In 1997, A.M. Best decided to no longer rate Citizens independently from its majority parent, The Hanover Insurance Company, but instead rated the two separate companies as a group. Consequently, Citizens was assigned Best's "A (Excellent)" rating, despite its "A+ (Superior)" qualifications. Management believes that its strong ratings are important factors in marketing the products of its insurance companies to its agents and customers, since rating information is broadly disseminated and generally used throughout the industry. Insurance company ratings are assigned to an insurer based upon factors relevant to policyholders and are not designed to protect investors. Such ratings are neither a rating of securities nor a recommendation to buy, hold or sell any security. Further downgrades may have a material adverse effect on the Company's business and prospects. State Guaranty Funds, Shared Markets Mechanisms and Pooling Arrangements All fifty states of the United States have insurance guaranty fund laws requiring all life and health and property and casualty insurance companies doing business within the state to participate in guaranty associations, which are organized to pay contractual obligations under insurance policies issued by impaired or insolvent insurance companies. These associations levy assessments (up to prescribed limits) on all member insurers in a particular state, the proportionate share of the premiums written by member insurers in the lines of business in which the impaired or insolvent insurer is engaged. Mandatory assessments by state guaranty funds are used to cover losses to policyholders of insolvent or rehabilitated companies and can be partially recovered through a reduction in future premium taxes in many states. These assessments may increase in the future depending upon the rate of insolvencies of insurance companies. In addition, as a condition to the ability to conduct business in various states, the Company's property and casualty insurance subsidiaries are required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements, which provide various insurance coverages to individuals or other entities that otherwise are unable to purchase such coverage voluntarily provided by private insurers. The Company cannot predict whether its participation in these shared market mechanisms or pooling arrangements will provide underwriting profits or losses to the Company. 3 Competition The Company's business consists of four principal segments: Property and Casualty Insurance, Corporate Risk Management Services, Allmerica Financial Services, and Allmerica Asset Management. Each of these industry segments is highly competitive. The Company's products and services compete not only with those offered by insurance companies, but also with products offered by other financial institutions and health maintenance organizations. In all of its segments, many of the Company's competitors are larger and have greater financial, technical, and operating resources than those of the Company. In addition, the Company may face additional competition from banks and other financial institutions should current regulatory restrictions on the sale of insurance and securities by these institutions be repealed. Dependence on and Retention of Key Executives The Company's success depends, in part, on the efforts and abilities of its executives, and on John F. O'Brien, in particular. The Company does not have an employment agreement with Mr. O'Brien. If the Company is unable to attract and retain qualified executives and key employees, it could be seriously harmed. Federal Income Tax Legislation Currently, under the Code, holders of certain life insurance and annuity products are entitled to tax-favored treatment on these products. For example, income tax payable by policyholders on investment earnings under certain life insurance and annuity products is deferred during the product's accumulation period and is payable, if at all, only when the insurance or annuity benefits are actually paid or to be paid. Also, for example, interest on loans up to $50,000 secured by the cash value of certain insurance policies owned by businesses is eligible for deduction, even though investment earnings during the accumulation period are tax-deferred. In the past, legislation has been proposed that would have curtailed the tax-favored treatment of the life insurance and annuity products offered by the Company. Although Congress has not yet enacted any of these proposals, it is currently considering such proposals or similar proposals. If any such proposals were enacted, market demand for such products offered by the Company would be adversely affected. Sales Practices A number of civil jury verdicts have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgements against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. The Company and its subsidiaries, from time to time are involved in such litigation. The outcome of any litigation cannot be predicted with certainty, to date, no such lawsuit has resulted in the award of any material amount of damages against the Company. In December 1996, the Securities and Exchange Commission (the "Commission") notified the Company that it would be conducting a limited inspection of the Company's marketing and sales practices associated with variable insurance products. The Commission requested that the Company provide it with certain information, which the Company promptly complied with. The Commission has not instituted any litigation, nor has it initiated any further action with respect to this matter. 4 Health Care Reform Legislation There continue to be a number of legislative and regulatory proposals introduced at the federal and state level to reform the current health care system. At the federal level, recent proposals have focused on managed care reform, and patient protection and advocacy. State and federal legislation adopted over the past few years generally limits the flexibility of insurers with respect to underwriting practices for small employer plans that contain less than 50 employees, provides for crediting previous coverage for the purposes of determining pre-existing conditions, and limits the ability to medically underwrite individual risks in the group market. In addition, several states have enacted managed care reform legislation which may change managed care programs. While future legislative activity is unknown, it is probable that limitations on insurers that utilize managed care programs or market health insurance to small employers will continue. However, the Company's rating, underwriting practices, and managed care programs are consistent with the experience rate small cases, nor does it refuse coverage to eligible individuals because of medical histories. Also, its managed care programs provide for coverage outside of the preferred network and allow for open communication between a doctor and his/her patient. Because of its emphasis on managed care and risk sharing partnerships, management believes that it will continue to be able to operate effectively in the event of further reform, even if specified states expand the existing limitations. The Company believes that the proposed federal and state health care reforms would, if enacted, substantially expand access to and mandate the amounts of health care coverage while limiting or eliminating insurer's flexibility and Impact of the Year 2000 Issue The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities. Based on a third party assessment, the Company determined that significant portions of its software required modification or replacement to enable its computer systems to properly process dates beyond December 31, 1999. The Company is presently completing the process of modifying or replacing existing software and believes that this action will cause such systems to be Year 2000 compliant. However, if the Company fails to make such modifications and conversions on a timely basis, or if there are serious unanticipated interruptions from unknown sources, the Year 2000 issue could have a material adverse impact on the operations of the Company. Specifically, the Company could experience, among other things, an interruption in its ability to collect and process premiums, process claim payments, safeguard and manage its invested assets, accurately maintain policyholder information, accurately maintain accounting records, and perform customer service. Any of these specific events, depending on duration, could have a material adverse impact on the results of operations and the financial position of the Company. The Company has initiated formal communications with all of its suppliers to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their own Year 2000 issue. The Company's total Year 2000 project cost and estimates to complete the project include the estimated costs and time associated with the Company's involvement on a third party's Year 2000 program, and are based on presently available information. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have material adverse effect on the Company. The Company does not believe that it has material exposure to contingencies related to the Year 2000 issue for the products it has sold. Although the Company does not believe that there is a material contingency associated with the Year 2000 issue, there can be no assurance that exposure for material contingencies will not arise. The cost of the Year 2000 project will be expensed as incurred and is being funded primarily through a reallocation of resources from discretionary projects and a reduction in systems maintenance and support costs. Therefore, the Year 2000 project is not expected to result in any significant incremental technology cost and is not expected to have a material effect on the results of operations. 5 Approximately 10% of the Company's Year 2000 resources are currently allocated to the Company's remediation plan, which has three mission critical elements: internal systems, desktop systems, and external partners. Internal Systems Over 98% of the Company's internal systems have been corrected, tested for year 2000 dates, and returned to production. The remaining systems, which include relatively small systems waiting for vendor upgrade or scheduled for elimination or replacement, are targeted to be complete by June 30, 1999. Desktop Systems The Company has verified that all desktop computers are capable of correctly processing year 2000 dates. Additionally, over 98% of the third party software installed on the Company's desktop machines has been confirmed capable of processing year 2000 dates properly. The remaining desktop systems are expected to be upgraded, eliminated, or replaced by June 30, 1999. External Partners The Company has verified that 50% of its electronic interfaces will process year 2000 dates correctly. Eighty percent of the Property and Casualty agents have confirmed that they are capable of properly processing year 2000 dates. Sixty percent of the Company's non-electronic partners have responded that they are capable of properly processing year 2000 dates. Most external partners have informed the Company that they expect to be compliant. The Company hopes for full compliance of external partners by July 1, 1999. In partnership with an outside consulting firm, the Company has completed an enterprise-wide year 2000 business risk identification and assessment. The Continuity of Operations Plan (COOP) requirements have been identified for all business units of the Company and applicable plans are currently being developed. These plans will contain immediate steps needed to keep business functions operating while unforeseen Year 2000 issues are being addressed. It outlines responses to situations that may affect critical business functions and also provides triage guidance, a documented order of actions to respond to problems. During the triage process, business priorities are established and "Critical Points of Failure" are identified as having a significant impact on the business. The Company's contingency plans are designed to keep business unit operations functioning in the event of a failure or delay due to Year 2000 record format and date calculation changes. All plans, including individual plans by business segment, are scheduled to be completed by September 30, 1999. Contingency planning will utilize approximately 15% of the Company's Year 2000 resources in 1999. The remaining 75% of the Company's Year 2000 resources will be utilized to address on-going compliance issues. These include periodic reviews of applications, installation and testing of new hardware and software packages, testing new software maintenance and testing internally developed software. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party responsiveness and modification plans, and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, the Year 2000 readiness of suppliers and business partners, and similar uncertainties. 6 -----END PRIVACY-ENHANCED MESSAGE-----