THG

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2003, for Allmerica Financial Corporation (AFC). The registrant operates through three primary segments: Property and Casualty (P&C), Allmerica Financial Services (AFS), and Asset Management. The filing reflects a strategic transition in the AFS segment, which ceased sales of proprietary variable annuities and life insurance products in late 2002 to focus on distributing third-party products and servicing existing accounts. The company also managed significant liquidity events related to the sale of its universal life business and the retirement of funding agreements.

Key Financial Metrics

Segment Performance (Pre-tax Income):

• Property & Casualty: $44.2 million (up from $39.0 million in Q1 2002).
• Allmerica Financial Services: $2.4 million (down significantly from $29.7 million in Q1 2002).
• Asset Management: $2.5 million (down from $5.1 million in Q1 2002).
• Corporate: $(17.1) million loss.

Material Changes vs. Prior Period

Net income decreased by $10.8 million (22.5%) compared to the first quarter of 2002. This decline was driven primarily by a $25.4 million decrease in total segment income, largely attributable to the AFS segment, which saw a $27.3 million drop in income due to substantially higher policy acquisition expenses (DAC amortization) resulting from increased annuity surrenders and the cessation of proprietary product sales.

Conversely, the P&C segment income increased by $5.2 million. This improvement was fueled by $28.3 million in favorable prior-year reserve development (primarily in commercial lines) and approximately $28 million in net premium rate increases. These gains were partially offset by a $41 million increase in current-year non-catastrophe claims activity and a $6.5 million decrease in net investment income.

Investment results showed a shift from a net realized loss of $12.3 million in Q1 2002 to a net realized gain of $13.2 million in Q1 2003, driven by gains on fixed maturities and derivative instruments, partially offset by impairments.

Guidance, Outlook, and Risks

Management Commentary & Outlook:

• Liquidity: The holding company held $34.8 million in cash and investments as of March 31, 2003. Management believes it can meet 2003 obligations without dividends from subsidiaries but anticipates a need for additional funding in 2004. The annual common stock dividend remains suspended.
• AFS Segment: The segment is transitioning to a non-proprietary distribution model via VeraVest Investments. High surrender rates ($990.4 million in Q1 2003 vs. $506.9 million in Q1 2002) continue to impact results through increased DAC amortization.
• Investment Portfolio: Average yields on fixed maturities declined to 6.2% from 6.5% in the prior year. Management expects continued pressure from lower prevailing rates and potential defaults in the fixed maturities portfolio.

Risks and Contingencies:

• Reserve Uncertainty: P&C reserves are sensitive to assumptions regarding claim frequency and severity. While Q1 2003 saw favorable development, adverse trends in personal automobile medical costs (specifically in Michigan) and commercial lines severity remain risks.
• Guaranteed Minimum Death Benefits (GMDB): The "net amount at risk" for GMDB features was approximately $4.7 billion. Estimated annual GMDB expense is $45 million, with cash costs likely exceeding this in the near term. Market declines increase the net amount at risk.
• Asbestos and Environmental: Reserves for these liabilities totaled $25.6 million (direct) and $45.2 million (assumed reinsurance). While management believes reserves are adequate, the inherent uncertainty of these long-tail claims poses a risk.
• Rating Agency Actions: In April 2003, A.M. Best upgraded life insurance ratings to B- (fair) but downgraded senior debt and Capital Securities ratings. Lower ratings increase the cost and reduce the availability of debt and equity financing.

Investor Verification Checklist

• AFS Surrender Rates: Verify the sustainability of the $990.4 million in annuity redemptions and the resulting impact on DAC amortization and future profitability.
• P&C Reserve Development: Assess the durability of the $28.3 million favorable reserve development, particularly given the noted increase in personal automobile medical costs in Michigan.
• Investment Impairments: Review the $23.5 million in other-than-temporary impairments recognized in Q1 2003 and the $96.0 million in gross unrealized losses to gauge future credit risk.
• Holding Company Liquidity: Confirm the holding company's ability to meet 2004 obligations without requiring dividends from subsidiaries, given the suspended common stock dividend.
• GMDB Exposure: Monitor the $4.7 billion net amount at risk for GMDB features and the sensitivity of this liability to equity market fluctuations.