UNITED STATESSECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Commission file number 1-11840
THE ALLSTATE CORPORATION (Exact name of registrant as specified in its charter)
Registrant's telephone number, including area code: 847/402-5000
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
As of October 31, 2003, the registrant had 703,574,466 common shares, $.01 par value, outstanding.
THE ALLSTATE CORPORATIONINDEX TO QUARTERLY REPORT ON FORM 10-QSeptember 30, 2003
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THE ALLSTATE CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to condensed consolidated financial statements.
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THE ALLSTATE CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
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THE ALLSTATE CORPORATION AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
1. Basis of Presentation
The accompanying condensed consolidated financial statements include the accounts of The Allstate Corporation and its wholly owned subsidiaries, primarily Allstate Insurance Company, a property-liability insurance company with various property-liability and life and investment subsidiaries, including Allstate Life Insurance Company ("ALIC") (collectively referred to as the "Company" or "Allstate").
The condensed consolidated financial statements and notes as of September 30, 2003, and for the three-month and nine-month periods ended September 30, 2003 and 2002 are unaudited. The condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring accruals) which are, in the opinion of management, necessary for the fair presentation of the financial position, results of operations and cash flows for the interim periods. These condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes thereto included in Appendix D of the Notice of Annual Meeting and Proxy Statement dated March 28, 2003. The results of operations for the interim periods should not be considered indicative of results to be expected for the full year.
Non-cash investment exchanges and modifications, which primarily reflect refinancings of fixed income securities and mergers completed with equity securities, totaled $51 million and $129 million for the nine months ended September 30, 2003 and 2002, respectively.
Adopted accounting standards
Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure"
In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure", which amends SFAS No. 123, "Accounting for Stock-Based Compensation". The amendment enables companies that choose to adopt the fair value based method to report the full effect of employee stock options in their financial statements immediately upon adoption. The statement sets forth clearer and more prominent disclosures about the cost of employee stock options and increases the frequency of those disclosures to include publication in quarterly financial statements. Beginning January 1, 2003, the Company began expensing the fair value of all stock options granted on or after January 1, 2003. Based on estimated 2003 stock option grants, the impact to the Company's Consolidated Statements of Operations for the year ending December 31, 2003 is expected to be approximately $7 million, after-tax.
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The following table illustrates the effect on net income and earnings per share as if the fair value based method, adopted prospectively by the Company on January 1, 2003, had been applied to all outstanding and unvested awards in each period.
FASB Interpretation No. 46
In January 2003, the FASB issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities". FIN 46 addresses whether certain types of entities, referred to as variable interest entities ("VIEs"), should be consolidated in a company's financial statements. A VIE is an entity in which the equity investors lack certain essential characteristics of a controlling financial interest or which lacks sufficient equity to finance its own activities without financial support provided by other entities. An enterprise must consolidate a VIE if it has a variable interest that will absorb a majority of the expected losses, receive a majority of the expected returns or both.
Adoption is required for relationships with VIEs entered into on or after February 1, 2003. For VIEs existing prior to that date, the effective date of the interpretation was delayed through the issuance of FASB Staff Position ("FSP") FIN 46-6, until the end of the first interim or annual period ending after December 15, 2003. However, FIN 46 may be applied before the end of the deferral period to some or all affected VIEs.
The Company elected to adopt FIN 46 in the third quarter of 2003 for existing VIEs with the exception of two asset management VIEs that fall within the scope of Proposed FSP FIN 46-c, "Impact of Kick-Out Rights Associated with the Decision Maker on the Computation of Expected Residual Returns under Paragraph 8(c) of FIN 46" and FIN 46-d, "Treatment of Fees Paid to Decision Makers and Guarantors as Described in Paragraph 8 in Determining Expected Losses and Expected Residual Returns of a Variable Interest Entity under FIN 46" which are anticipated to be effective no earlier than the fourth quarter of 2003 and address issues unique to asset management transactions. (See "Pending accounting standards" below for a discussion of those matters.)
Effective July 1, 2003, the Company has applied the guidance in FIN 46 on a prospective basis as follows:
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owns none of the variable interests issued by the VIE, it is not required to consolidate the VIE and will continue to classify funding agreements issued to the VIE as a component of Contractholder funds.
SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities"
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". The statement amends, clarifies and codifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and utilized for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". While this statement applies primarily to certain derivative contracts and embedded derivatives entered into or modified after June 30, 2003, it also codifies conclusions previously reached by the FASB at various dates on certain implementation issues. The impact of adopting the provisions of this statement were not material to the Company's Condensed Consolidated Statements of Operations or Financial Position.
Pending Accounting Standards
FIN 46
As discussed above, the effective date for certain provisions of FIN 46 are being delayed until two Proposed FSPs, "Impact of Kick-Out Rights Associated with the Decision Maker on the Computation of Expected Residual Returns under Paragraph 8(c) of FIN 46" ("Proposed FSP FIN 46-c") and "Treatment of Fees Paid to Decision Makers and Guarantors as Described in Paragraph 8 in Determining Expected Losses and Expected Residual Returns of a Variable Interest Entity under FIN 46" (Proposed FSP FIN 46-d), are issued. The proposed effective date for Proposed FSP FIN 46-c is the beginning of the first fiscal quarter the final FSP is posted, which is expected to be October 1, 2003 and the proposed effective date for Proposed FSP FIN 46-d is the beginning of the first fiscal quarter after the final FSP is posted, which is expected to be January 1, 2004.
The Company uses unconsolidated VIEs to hold assets under the management of an affiliate on behalf of third-party investors ("investment management VIEs"). The Company believes it has no ability to make independent decisions of an operating nature as a result of the existence of substantive kick-out rights (without cause) that exist in each of the investment management VIEs and therefore should not be considered a decision maker pursuant to the guidance in FIN
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46 and Proposed FSPs FIN 46-c and FIN 46-d. Moreover, when analyzing the investment management VIEs in connection with the authoritative guidance provided in Emerging Issues Task Force ("EITF") 97-2, "Application of FASB Statement No. 94 and Accounting Principles Board ("APB") Opinion No. 16 to Physician Practice Management Entities and Certain Other Entities with Contractual Management Arrangements", the Company does not believe it has a controlling financial interest in the investment management VIEs, a condition precedent to consolidation. Accordingly, the Company will continue to not consolidate its investment management VIEs pursuant to its evaluation of the requirements of currently effective authoritative accounting guidance.
In the event the Company is required to consolidate the investment management VIEs, the Company would recognize through consolidation, an estimated $718 million of assets, $701 million of liabilities, and $32 million of minority interest using amounts as of September 30, 2003. The Company's maximum exposure to loss from the investment management VIEs is its current carrying value of $9 million. The impact to the Company's debt-to-equity ratio would be an increase of approximately 3.7 percentage points; however, would not affect the Company's compliance with existing debt covenants.
Statement of Position 03-01
In July 2003, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 03-01 entitled "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts." The accounting guidance contained in the SOP addresses three areas: separate accounts presentation and valuation, accounting for sales inducements such as bonus interest, and the classification and valuation of certain long duration liabilities. The effective date of the SOP is for fiscal years beginning after December 15, 2003, with earlier adoption encouraged.
Based on management's review of the SOP, the most significant impact to the Company is the provision of the SOP that requires the establishment of a liability in addition to the account balance for contracts and contract features that provide guaranteed death or other insurance benefits and guaranteed income benefits. This liability will be based on models that involve numerous estimates and subjective judgments, including those regarding expected market rates of return and volatility, contract surrender rates and mortality experience. The Company does not currently recognize these liabilities. The Company is currently evaluating the provisions of the statement. The Company plans to adopt the provisions of the statement no later than January 1, 2004 and does not expect the effect to have a material impact on the Condensed Consolidated Statements of Operations. However, the amounts may vary based on market conditions. Adoption is not expected to have a material impact on the Company's Condensed Consolidated Statements of Financial Position.
Proposed standards
EITF Topic No. 03-01
The EITF discussed Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments", which attempts to define other-than-temporary impairment and highlight its application to investment securities accounted for under both SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" and APB Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stocks." The current issue summary, which has yet to be finalized, proposes that if, at the evaluation date, the fair value of an investment security is less than its carrying value then an impairment exists for which a determination must be made as to whether that impairment is other-than-temporary. If it is determined that an impairment is other-than-temporary, then an impairment loss should be recognized equal to the difference between the investment's carrying value and its fair value at the reporting date. In recent deliberations, the EITF discussed different models to assess whether impairment is other-than-temporary for different types of investments (e.g. SFAS 115 marketable equity securities, SFAS 115 debt securities, and equity and cost method investments subject to APB Opinion No. 18). Due to the uncertainty of the final model or models that may be adopted, the estimated impact to the Company's Condensed Consolidated Statements of Operations and Financial Position is presently not determinable.
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2. Earnings per share
Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average number of common and dilutive potential common shares outstanding. For Allstate, dilutive potential common shares consist of the common shares underlying outstanding stock options.
The computations of basic and diluted earnings per share are presented in the following table.
Options to purchase 8.9 million and 9.1 million Allstate common shares, with exercise prices ranging from $37.06 to $50.72 and $36.66 to $50.72, were outstanding at September 30, 2003 and 2002, respectively, but were not included in the computation of diluted earnings per share for the three-month periods ended September 30, 2003 and 2002 since inclusion of these options would have an anti-dilutive effect as the options' exercise prices exceeded the average market price of Allstate common shares in the three-month period. Options to purchase 11.3 million and 11.2 million Allstate common shares, with exercise prices ranging from $35.84 to $50.72 and $36.61 to $50.72, were outstanding at September 30, 2003 and 2002, respectively, but were not included in the computation of diluted earnings per share for the nine-month periods ended September 30, 2003 and 2002 since inclusion of these options would have an anti-dilutive effect.
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3. Reserve for Property-Liability Insurance Claims and Claims Expense
The Company establishes reserves for claims and claims expense on reported and unreported claims of insured losses. These reserve estimates are based on known facts and interpretations of circumstances and internal factors including the Company's experience with similar cases, historical trends involving claim payment patterns, loss payments, pending levels of unpaid claims, loss management programs and product mix. In addition, the reserve estimates are influenced by external factors including law changes, court decisions, changes to regulatory requirements, economic conditions, and public attitudes. The Company, in the normal course of business, may also supplement its claims processes by utilizing third party adjusters, appraisers, engineers, inspectors, other professionals and information sources to assess and settle catastrophe and non-catastrophe related claims. The effects of inflation are implicitly considered in the reserving process.
Because reserves are based on estimations of future losses, the establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain process. The ultimate costs of losses may vary materially from recorded amounts, which are based on management's best estimates of future losses. Allstate regularly updates its reserve estimates as new information becomes available and as events unfold that may impact the resolution of unsettled claims. Changes in prior year reserve estimates, which may be material, are reflected in the results of operations in the period such changes are determinable.
Management believes that the reserve for claims and claims expense, net of reinsurance recoverables, at September 30, 2003 is appropriately established in the aggregate and adequate to cover the ultimate net cost of reported and unreported claims arising from losses which had occurred by that date.
Allstate's reserves for asbestos claims were $1.10 billion and $635 million, net of reinsurance recoverables of $520 million and $269 million at September 30, 2003 and December 31, 2002, respectively. Reserves for environmental claims were $286 million and $304 million, net of reinsurance recoverables of $77 million and $89 million at September 30, 2003 and December 31, 2002, respectively. Approximately 58% and 54% of the total net asbestos and environmental reserves at September 30, 2003 and December 31, 2002, respectively, were for incurred but not reported estimated losses.
Allstate's reserves for asbestos and environmental exposures could be affected by tort reform, class action litigation, and other potential legislation and judicial decisions. Environmental exposures could also be affected by a change in the existing federal Superfund law and similar state statutes. There can be no assurance that any reform legislation will be enacted or that any such legislation will provide for a fair, effective and cost-efficient system for settlement of asbestos or environmental claims. Management is unable to determine the effect, if any, that such legislation will have on results of operations or financial position.
Management believes its net loss reserves for environmental, asbestos and other discontinued lines exposures are appropriately established based on available facts, technology, laws and regulations. However, due to the inconsistencies of court coverage decisions, unresolved legal issues regarding policy coverage, unresolved legal issues regarding the determination, availability and timing of exhaustion of policy limits, plaintiffs' evolving and expanded theories of liability, the risks inherent in major litigation, availability and collectibility of recoveries from reinsurance, retrospectively determined premiums and other contractual agreements, and estimating the extent and timing of any contractual liability, and other uncertainties, the ultimate cost of these claims may vary materially from the amounts currently recorded, resulting in an increase or decrease in loss reserves. In addition, while the Company believes that improved actuarial techniques and databases have assisted in its ability to estimate asbestos, environmental, and other discontinued lines net loss reserves, these refinements may subsequently prove to be inadequate indicators of the extent of probable losses. Due to the uncertainties and factors described above, management believes it is not practicable to develop a meaningful range for any such additional net loss reserves that may be required.
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4. Reinsurance
Property-liability insurance premiums and life and annuity premiums and contract charges are net of the following reinsurance ceded:
Property-liability insurance claims and claims expense and life and annuity contract benefits are net of the following reinsurance recoveries:
5. Regulation, Legal Proceedings and Guarantees
Regulation
The Company is subject to changing social, economic and regulatory conditions. State and federal regulatory initiatives and proceedings have varied and have included efforts to adversely influence and restrict premium rates and require the return of excess profits, to restrict the Company's ability to cancel policies, to impose underwriting standards, to remove barriers preventing banks from engaging in the securities and insurance businesses, to change tax laws affecting the taxation of insurance companies and the tax treatment of either insurance products or competing non-insurance products that may impact the relative desirability of various personal investment products and to expand overall regulation. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
Legal proceedings
There are two active nationwide class action lawsuits against Allstate regarding its specification of after-market (non-original equipment manufacturer) replacement parts in the repair of insured vehicles. One of these suits alleges that the specification of such parts constitutes breach of contract and fraud, and this suit mirrors to a large degree lawsuits filed against other carriers in the industry. The plaintiffs allege that after-market parts are not "of like kind and quality" as required by the insurance policy, and they are seeking actual and punitive damages. In the second lawsuit, plaintiffs allege that Allstate and three co-defendants have violated federal antitrust laws by conspiring to manipulate the price of auto physical damage coverages in such a way that not all savings realized by the use of aftermarket parts are passed on to the policyholders. The plaintiffs seek actual and treble damages. In November 2002, a nationwide class was certified in this case. The defendants filed a petition to appeal the certification, and the Eleventh Circuit Court of Appeals granted review of the certification. The Company has been vigorously defending both of these lawsuits, and their outcome is uncertain.
There are a number of statewide and nationwide class action lawsuits pending against Allstate alleging that its failure to pay "inherent diminished value" to insureds under the collision, comprehensive, uninsured motorist property damage, or auto property damage liability provisions of auto policies constitutes breach of contract and fraud. Plaintiffs define "inherent diminished value" as the difference between the market value of the insured automobile before an accident and the market value after repair. Plaintiffs allege that they are entitled to the payment of inherent diminished
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value under the terms of the policy. To a large degree, these lawsuits mirror similar lawsuits filed against other carriers in the industry. These lawsuits are pending in various state and federal courts, and they are in various stages of development. A class has been certified in only one case, a multi-state class action. The Company has been vigorously defending these lawsuits and, since 1998, has been implementing policy language in a majority of states reaffirming that its collision and comprehensive coverages do not include diminished value claims. In addition, there are three statewide putative class action lawsuits pending against Allstate alleging that it improperly deducts betterment in connection with the repair of vehicles. The outcome of these disputes is currently uncertain.
There are a number of state and nationwide class action lawsuits pending in various state courts challenging the legal propriety of Allstate's medical bill review processes on a number of grounds, including, among other things, the manner in which Allstate determines reasonableness and necessity. One nationwide class action has been certified. These lawsuits, which to a large degree mirror similar lawsuits filed against other carriers in the industry, allege these processes result in a breach of the insurance policy as well as fraud. The Company denies those allegations and has been vigorously defending these lawsuits. The outcome of these disputes is currently uncertain.
A number of nationwide and statewide putative class actions are pending against Allstate, which challenge Allstate's use of certain automated database vendors in valuing total loss automobiles. To a large degree, these lawsuits mirror similar lawsuits filed against other carriers in the industry. Plaintiffs allege that flaws in these databases result in valuations to the detriment of insureds. The plaintiffs are seeking actual and punitive damages. The lawsuits are in various stages of development and Allstate has been vigorously defending them, but the outcome of these disputes is currently uncertain.
One putative statewide and a number of putative nationwide class action lawsuits have been filed in various courts seeking actual and punitive damages from Allstate and alleging that Allstate violated the Fair Credit Reporting Act or state law by failing to provide appropriate notices to applicants and/or policyholders when adverse action was taken as a result of information in a consumer report or by ordering consumer reports without a permissible purpose. These cases are all pending in federal courts, and all but one, recently filed in federal court in Louisiana, have been centralized in the federal court in Nashville, Tennessee. The Company is also defending a putative nationwide class action that alleges that the Company discriminates against non-Caucasian policyholders, through underwriting and rate-making practices including the use of credit by charging them higher premiums. The Company is also defending two putative statewide class actions challenging its use of credit under certain state insurance statutes. The Company denies these allegations and has been vigorously defending these lawsuits. The outcome of these disputes is currently uncertain.
Allstate is defending various lawsuits involving worker classification issues. These lawsuits include a number of putative class actions and one certified class action challenging the overtime exemption claimed by the Company under the Fair Labor Standards Act or state wage and hour laws. These class actions mirror similar lawsuits filed recently against other carriers in the industry and other employers. Another lawsuit involves the worker classification of staff working in agencies. In this putative class action, plaintiffs seek damages under the Employee Retirement Income Security Act ("ERISA") and the Racketeer Influenced and Corrupt Organizations Act alleging that agency secretaries were terminated as employees by Allstate and rehired by agencies through outside staffing vendors for the purpose of avoiding the payment of employee benefits. A putative nationwide class action filed by former employee agents also includes a worker classification issue; these agents are challenging certain amendments to the Agents Pension Plan and are seeking to have exclusive agent independent contractors treated as employees for benefit purposes. Allstate has been vigorously defending these and various other worker classification lawsuits. The outcome of these disputes is currently uncertain.
The Company is also defending certain matters relating to the Company's agency program reorganization announced in 1999. These matters include an investigation by the U.S. Department of Labor and a lawsuit filed in December 2001 by the U.S. Equal Employment Opportunity Commission ("EEOC") with respect to allegations of retaliation under the Age Discrimination in Employment Act, the Americans with Disabilities Act and Title VII of the Civil Rights Act of 1964. A putative nationwide class action has also been filed by former employee agents alleging various violations of ERISA, breach of contract and age discrimination. Allstate has been vigorously defending these lawsuits and other matters related to its agency program reorganization. In addition, Allstate is defending certain matters relating to its life agency program reorganization announced in 2000. These matters include an investigation by the
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EEOC with respect to allegations of age discrimination and retaliation. Allstate is cooperating fully with the agency investigation and will continue to vigorously defend these and other claims related to the life agency program reorganization. The outcome of these disputes is currently uncertain.
The Company is defending various lawsuits and regulatory proceedings that allege that it engaged in business or sales practices inconsistent with state or federal law. The Company has been vigorously defending these matters, but their outcome is currently uncertain.
Various other legal and regulatory actions are currently pending that involve the Company and specific aspects of its conduct of business. Like other members of the insurance industry, the Company is the target of an increasing number of class action lawsuits and other types of litigation, some of which involve claims for substantial and/or indeterminate amounts (including punitive and treble damages) and the outcomes of which are unpredictable. This litigation is based on a variety of issues including insurance and claim settlement practices. However, at this time, based on their present status, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not expected to have a material effect on the results of operations, liquidity or financial position of the Company.
Shared markets
As a condition of maintaining its licenses to write personal property and casualty insurance in various states, the Company is required to participate in assigned risk plans, reinsurance facilities and joint underwriting associations that provide various types of insurance coverage to individuals or entities that otherwise are unable to purchase such coverage from private insurers. Underwriting results related to these arrangements, which tend to be adverse, have been immaterial to the results of operations.
Guarantees
The Company provides residual value guarantees on leased automobiles. If all outstanding leases were terminated effective September 30, 2003, the Company's maximum potential amount of future payments, assuming the automobiles have no residual value, is $21 million at September 30, 2003. The term of each residual value guarantee is equal to the term of the underlying lease which range from less than one year to three years. Historically, the Company has not made any material payments pursuant to these guarantees.
The Company owns certain fixed income securities which contain credit default swaps or credit guarantees which contain obligations to exchange credit risk or to forfeit principal due, depending on the nature or occurrence of specified credit events for the referenced entities. In the event of a specified credit event, the Company's maximum amount at risk, assuming the value of the referenced credits become worthless, is $110 million at September 30, 2003. The credit default swaps and credit guarantees contained in these fixed income securities expire at various times during the next seven years.
Lincoln Benefit Life Company ("LBL"), a wholly owned subsidiary of ALIC, has issued universal life insurance contracts to third parties who finance the premium payments on the universal life insurance contracts through a commercial paper program. LBL has issued a repayment guarantee on the outstanding commercial paper balance which is fully collateralized by the cash surrender value of the universal life insurance contracts. At September 30, 2003, the amount due under the commercial paper program is $300 million and the cash surrender value of the policies is $308 million. The repayment guarantee expires April 30, 2006.
In the normal course of business, the Company provides standard indemnifications to counterparties in contracts in connection with numerous transactions, including indemnifications for breaches of representations and warranties, taxes and certain other liabilities, such as third party lawsuits. The indemnification clauses are often standard contractual terms and were entered into in the normal course of business based on an assessment that the risk of loss would be remote. The terms of the indemnifications vary in duration and nature. In many cases, the maximum obligation is not explicitly stated and the contingencies triggering the obligation to indemnify have not occurred and are not expected to occur. Because the obligated amounts of the indemnifications are not explicitly stated in many cases, the maximum amount of the obligation under such indemnifications is not determinable. Historically, the Company has not made any material payments pursuant to these obligations.
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In addition, the Company and its subsidiaries indemnify their respective directors, officers, non-officer employees and other individuals serving at the request of the Company as a director or officer or in a similar capacity in another entity to the extent provided in their charters and by-laws. Since these indemnifications are generally not subject to limitation with respect to duration or amount, the Company does not believe that it is possible to determine the maximum potential amount due under these indemnifications.
The aggregate liability balance related to all guarantees was not material as of September 30, 2003.
6. Business Segments
Summarized revenue data for each of the Company's business segments are as follows:
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Summarized financial performance data for each of the Company's reportable segments are as follows:
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7. Other Comprehensive Income
The components of other comprehensive income on a pretax and after-tax basis are as follows:
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8. Company Restructuring
In the first nine months of 2003, the Company recorded restructuring and related charges of $56 million pretax ($36 million after-tax). The charges include employee termination and relocation benefits and a non-cash charge resulting from pension benefit payments made to agents in connection with the 1999 reorganization of employee agents to a single exclusive agency independent contractor program.
In 2001, the Company announced new strategic initiatives to improve the efficiency of its claims handling and certain other back-office processes primarily through a consolidation and reconfiguration of field claim offices, customer information centers and satellite offices. This restructuring program involves a reduction of the total number of field claim offices and an increase in the average size per claim office. In addition, two customer information centers and two satellite offices were closed. As part of the program, employees working in facilities to be closed will elect to either relocate or collect severance benefits. The Company anticipates the plan will produce approximately $140 million of annual pretax expense reductions. The implementation of the plan is expected to be substantially complete by year-end 2003.
The Company completed its program announced on November 10, 1999 to aggressively expand its selling and service capabilities and reduce current annual expenses by approximately $600 million. The reduction in expenses was achieved through field realignment, the reorganization of employee agents to a single exclusive agency independent contractor program, the closing of a field support center and four regional offices, and reduced employee related expenses and professional services as a result of reductions in force, attrition and consolidations.
As a result of the 1999 program, Allstate established a $69 million restructuring liability during the fourth quarter of 1999 for certain employee termination costs and qualified exit costs. Additionally, during 2001, an additional $96 million was accrued in connection with the new program for certain employee termination costs and qualified exit costs.
The following table illustrates the inception to date change in the restructuring liability at September 30, 2003:
The payments applied against the liability for employee costs primarily reflect severance costs, and the payments for exit costs generally consist of post-exit rent expenses and contract termination penalties.
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9. Shareholder Rights Agreement
On November 11, 2003, the Company announced it would terminate the Rights Agreement entered into in February 1999 and buy back the share purchase rights (the "Rights") at the redemption price of $0.01 per Right (approximately $7 million), payable on January 2, 2004. The Rights Agreement, under which all shareholders received a dividend distribution of one Right on each outstanding share of the Company's common stock, would have expired on February 12, 2009.
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INDEPENDENT ACCOUNTANTS' REVIEW REPORT
To the Board of Directors and Shareholders of The Allstate Corporation:
We have reviewed the accompanying condensed consolidated statement of financial position of The Allstate Corporation and subsidiaries (the "Company") as of September 30, 2003, and the related condensed consolidated statements of operations for the three-month and nine-month periods ended September 30, 2003 and 2002, and the condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2003 and 2002. These financial statements are the responsibility of the Company's management.
We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated statement of financial position of The Allstate Corporation and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, comprehensive income, shareholders' equity, and cash flows for the year then ended, not presented herein. In our report dated February 5, 2003, which report includes an explanatory paragraph as to a change in the Company's method of accounting for goodwill and other intangible assets in 2002, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial position as of December 31, 2002 is fairly stated, in all material respects, in relation to the consolidated statement of financial position from which it has been derived.
/s/ Deloitte & Touche LLP
Chicago, IllinoisNovember 12, 2003
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 30, 2003 AND 2002
The following discussion highlights significant factors influencing results of operations and changes in financial position of The Allstate Corporation (the "Company" or "Allstate"). It should be read in conjunction with the condensed consolidated financial statements and notes thereto found under Part I. Item 1. contained herein, and with the discussion, analysis, consolidated financial statements and notes thereto in Part I. Item 1. and Part II. Item 7. and Item 8. of The Allstate Corporation Annual Report on Form 10-K for 2002 and in Appendix D of the Notice of Annual Meeting and Proxy Statement dated March 28, 2003.
The Company has four reporting segments: Allstate Protection, Discontinued Lines and Coverages, Allstate Financial and Corporate and Other. Property-Liability operations include the Allstate Protection and the Discontinued Lines and Coverages segments.
HIGHLIGHTS
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CONSOLIDATED NET INCOME
Summarized financial data and Net income by business unit are shown in the following table.
CONSOLIDATED REVENUES
Consolidated revenues increased 12.3% in the third quarter of 2003 when compared to the third quarter of 2002 and increased 8.6% for the nine months ended September 30, 2003 from the first nine months of 2002. The increases were primarily due to higher Property-Liability insurance premiums and Realized capital gains versus Realized capital losses in the same periods of 2002.
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PROPERTY-LIABILITY HIGHLIGHTS
PROPERTY-LIABILITY OPERATIONS
Summarized financial data, key operating ratios and a reconciliation of Underwriting income to Net income are presented in the following table.
Underwriting income is Premiums earned, less Claims and claims expense ("losses"), Amortization of DAC, Operating costs and expenses and Restructuring and related charges as determined using GAAP. Management uses this measure in its evaluation of results of operations to analyze the profitability of the Property-Liability insurance operations separately from investment results. It is also an integral component of incentive compensation. It is useful for investors to evaluate the components of income separately and in the aggregate when reviewing performance. Underwriting income (loss) should not be considered as a substitute for Net income and does not reflect the overall profitability of the business. Net income is the most directly comparable GAAP measure.
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ALLSTATE PROTECTION SEGMENT
Premiums written, an operating measure, is the amount of premiums charged for policies issued during a period. Premiums earned is a GAAP measure. Premiums are considered earned and are included in financial results on a pro-rata basis over the policy period. The portion of Premiums written applicable to the unexpired terms of the policies is recorded as Unearned premiums on the Company's Condensed Consolidated Statements of Financial Position.
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The following table presents the reconciliation of Premiums written to Premiums earned for the three months and nine months ended September 30.
Premiums written by brand are shown in the following table.
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The following table presents Premiums written by product, showing new and renewal business.
Standard auto premiums written increased 5.6% to $3.83 billion in the third quarter of 2003 from $3.63 billion in the same period of 2002 and 5.4% during the first nine months of 2003 as compared to the first nine months of 2002.
The Allstate brand standard auto results are shown in the following table.
The increases in Allstate brand standard auto average premium in the third quarter 2003 and in the first nine months of 2003 compared to the same periods of 2002 were primarily due to higher average renewal premiums. Despite declining at September 30, 2003 compared to September 30, 2002, Allstate brand standard auto PIF increased 0.9% at September 30, 2003 compared to June 30, 2003. In the third quarter of 2003, positive sequential quarterly growth was achieved in 35 states representing 88.1% of total PIF.
Allstate continues to take steps, including increasing premium rates, changing down payment requirements and making other underwriting changes, to improve the standard auto loss ratio in certain markets including the states of California, Texas and Florida. Collectively, these three states represent 28.8% of Allstate brand standard auto premiums written at September 30, 2003. The Allstate brand standard auto results, excluding the states of California, Texas and Florida, are shown in the following table.
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As the profitability of the California, Texas and Florida standard auto markets improves, the potential for profitable growth is evaluated and pursued when deemed appropriate. Because of profitable growth in these markets during 2003, the countrywide trends in standard auto new business premiums and renewal business premiums are more favorable than the trends excluding California, Texas and Florida. However, these markets' results have lower renewal ratios and PIF increases due to the timing of the growth. PIF in each of these states increased compared to June 30, 2003 levels.
Excluding the states of California, Texas and Florida, the renewal ratio for Allstate brand standard auto increased 0.9 points in the third quarter of 2003 as compared to the third quarter of 2002; increased 0.4 points in the first nine months of 2003 as compared to the first nine months of 2002; and increased 0.5 points in the first nine months of 2003 as compared to the fourth quarter of 2002. Excluding the states of California, Texas and Florida, at September 30, 2003, Allstate brand standard auto PIF increased 0.8% compared to June 30, 2003.
The Ivantage standard auto results are shown in the following table.
Management expects Ivantage standard auto PIF to continue to decline as the Company pursues actions to improve profitability. At September 30, 2003, Ivantage standard auto PIF decreased 2.7% compared to June 30, 2003.
Increases in standard auto average premium in both the Allstate brand and Ivantage were due to rate actions taken during 2002 and the first nine months of 2003, and to a lesser degree due to a normal shift to newer and more expensive autos by Allstate brand policyholders. The following table shows the net rate changes that were approved during the third quarter and first nine months of 2003.
Non-standard auto premiums written decreased 14.0% to $533 million in the third quarter of 2003 from $620 million in the same period of 2002 and 12.9% during the first nine months of 2003 as compared to the first nine months of 2002. Declines during the third quarter and first nine months of 2003 compared to the same periods in 2002 were primarily due to a decline in the number of policies that were available to renew in the Allstate brand. This decline was due to prior year actions that were taken to address adverse profitability
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trends. These actions varied by state and included changes to premium down payment requirements, tighter underwriting requirements, rate increases and certain other administrative actions.
The Allstate brand non-standard auto results are shown in the following table.
The increase in Allstate brand non-standard auto average premium during the third quarter of 2003 and first nine months of 2003 was due primarily to higher average renewal premiums. Management expects Allstate brand non-standard auto PIF to continue to decline but at a lower rate. As non-standard auto continues to show improved profitability in certain large markets, the Company will continue to evaluate opportunities for growth.
The Ivantage non-standard auto results are shown in the following table.
Renewal business premiums increased in the third quarter and first nine months of 2003 due to the re-entry of Deerbrook in the non-standard business during 2002. Since December 31, 2002, Deerbrook has been writing business in 19 states and consequently more stable trends in new business premiums and PIF have emerged in 2003 when compared to the prior year.
Fluctuations in Allstate brand and Ivantage non-standard auto average premium were partially due to rate actions taken for both the Allstate brand and Ivantage during 2002 and the first nine months of 2003. The following table shows the net rate changes that were approved in the third quarter and first nine months of 2003.
Homeowners premiums written increased 10.4% to $1.61 billion in the third quarter of 2003 from $1.46 billion in the same period of 2002 and 10.7% during the first nine months of 2003 as compared to the first nine months of 2002.
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The Allstate brand homeowners results are shown in the following table.
The increase in Allstate brand homeowners average premium during the third quarter and first nine months of 2003 was primarily due to higher average renewal premiums. Allstate brand homeowners PIF increased 1.3% at September 30, 2003 compared to June 30, 2003. In the third quarter of 2003, positive sequential quarterly growth was achieved in 38 states representing 92.1% of Allstate brand homeowners PIF.
The Ivantage homeowners results are shown in the following table.
Management expects Ivantage homeowners PIF to continue to decline as the Company pursues actions to improve profitability. At September 30, 2003, Ivantage homeowners PIF decreased 1.2% compared to June 30, 2003.
Increases in Allstate brand and Ivantage homeowners average premium were due to rate actions taken during 2002 and the first nine months of 2003. The following table shows the net rate changes that were approved during the third quarter and first nine months of 2003.
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Premiums earned by brand are shown in the following table.
Underwriting Results are shown in the following table.
Underwriting income totaled $726 million during the third quarter of 2003 compared to $269 million in the third quarter of 2002. For the nine months ended September 30, 2003, Allstate Protection generated underwriting income of $1.41 billion compared to $301 million for the first nine months of last year. The increase in Underwriting income during both periods was the result of increased Premiums earned, continued improvement in auto and homeowners claim frequency (rate of claim occurrence), and favorable prior year reserve reestimates, partially offset by increased catastrophe losses and moderate increases in current year claim severity (average cost per claim). Increased catastrophe losses in both periods included Hurricane Isabel in September, severe weather in the Midwest in July, and the first nine months of the year also included a large number of tornadoes with resulting damage to properties in many markets.
Claim severity was impacted by inflationary pressures in medical costs and auto repair and home repair costs. Increased severity was offset by lower auto and homeowner claim frequencies, excluding catastrophe claims. If future development of current year claim severity differs from the current reserve expectations by 1%, reserve reestimates would impact Net income by approximately $100 million. The following tables show
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the net reserves representing the estimated cost of outstanding claims as they were recorded at the beginning of years 2003 and 2002, and the impact of prior year reserve reestimates on Claims and claims expense and the loss ratio.
Favorable reserve reestimates in 2003 were primarily related to reserves established for the last three years, and were the result of auto injury severity development that was better than expected and the release of $38 million of incurred but not reported ("IBNR") reserves due to lower than anticipated losses in Texas related to mold claims. In 2002, reestimates of prior year reserves were primarily due to increasing claim severities, mold claims in the state of Texas and late reported losses, which were greater than trends anticipated in reserve estimates as of January 1, 2002.
Allstate Protection loss, expense and combined ratio statistics are shown in the following table. The loss ratio, which is the percentage of losses to Premiums earned, is a measure of profitability.
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Standard auto loss ratio for Allstate Protection decreased 7.0 points in the third quarter of 2003 and 3.8 points during the first nine months of 2003, as compared to the same periods last year. The standard auto loss ratio declines were due to increased premiums earned, favorable claim frequency and favorable reserve reestimates related to prior years, partially offset by a moderate increase in claim severity in the current year.
Non-standard auto loss ratio for Allstate Protection decreased 13.6 points in the third quarter of 2003 and 5.8 points during the first nine months of 2003 as compared to the same periods last year. The decrease in the non-standard auto loss ratio during both periods was due to lower claim frequency, partly offset by lower premiums earned and a moderate increase in claim severity in the current year.
Homeowners loss ratio for Allstate Protection decreased 9.7 points in the third quarter of 2003 and 17.9 points during the first nine months of 2003 as compared to the same periods last year. The homeowners loss ratio decreased during both periods due to increased premiums earned, favorable reestimates of prior year reserves, including lower losses in Texas related to mold claims, and lower current
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year claim frequency, partially offset by higher catastrophe losses and an increase in current year claim severity. Due to actions taken in 2002 and 2001 to improve the profitability of homeowners, Allstate achieved management's target loss ratio. Allstate plans to continue the programs implemented in prior years to maintain targeted profitability.
Because Allstate includes catastrophe losses in claims and claims expense, catastrophe losses affect both the underwriting results and loss ratios. For the third quarter of 2003, catastrophe losses totaled $378 million compared with $96 million for the same period in 2002. For the first nine months of 2003, catastrophe losses totaled $1.08 billion, compared with $494 million for the same period in 2002.
Expense ratio for Allstate Protection decreased 0.2 points in the third quarter of 2003 compared to the third quarter of 2002 and increased 0.5 points in the first nine months of 2003 compared to the first nine months of 2002. The third quarter decrease was due to higher premiums earned offset by higher agent incentives and marketing expenses. The increase in the first nine months of this year was due to higher pension expenses and employee and agent incentives. The Company expects advertising expenses in 2003 to exceed prior year advertising expenses by approximately $75 million to $125 million.
The impact of specific costs and expenses on the expense ratio are included in the following table.
DISCONTINUED LINES AND COVERAGES SEGMENT
Summarized underwriting results are presented in the following table.
Underwriting losses of $471 million in the third quarter of 2003 were primarily related to reestimates of asbestos reserves totaling $442 million, a $14 million reestimate of the allowance for future uncollectible reinsurance recoverables, and other discontinued lines and coverages reserve reestimates of $8 million. Underwriting losses of $562 million in the first nine months of 2003 were primarily due to reestimates of asbestos reserves.
During the third quarter of 2003, management completed the annual comprehensive "ground up" review of reserves for the Discontinued Lines and Coverages segment. Reserve reestimates are recorded in
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the reporting period in which they are determined. This review employed established industry and actuarial best practices within the context of the legal, legislative and economic environment.
The Company's net asbestos reserves by type of exposure and total reserve additions by quarter and year-to-date are shown in the following table.
During the first nine months of 2003, 65 direct primary and excess insurance policyholders reported new claims, and claims of 22 policyholders' were closed, so that the number of direct insurance policyholders with active claims increased by 43.
Reserve additions for asbestos in the third quarter of 2003, totaling $442 million, were primarily for products-related coverage. This increase essentially was a result of more claimants being reported by excess insurance policyholders with existing active claims and new claims being reported in our assumed reinsurance business. This trend is consistent with the trends of other carriers in the industry. Management believes it is related to increased publicity and awareness of coverage, ongoing litigation, potential congressional activity and bankruptcy actions. Reserve additions for asbestos for the nine-months ended September 30, 2003, totaled $514 million.
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The Company's exposure to non-products-related losses represents approximately 5% of total reserves. Management does not anticipate significant changes in this percentage as insureds' retentions associated with excess insurance programs, which are the Company's principal direct insurance, and assumed reinsurance exposure are seldom exceeded. The Company did not write direct primary insurance on policyholders with the potential for significant non-products-related loss exposure.
Liability for actual and potential asbestos losses has caused a number of companies to file for bankruptcy protection. Of 63 companies with significant asbestos exposure, all but one of which are in bankruptcy, on a direct insurance basis, we:
Although management does not believe a greater exposure is probable for the remaining 3, the Company's maximum additional exposure to full policy limits for the remaining 3 in the aggregate is $26 million after-tax.
Reserves related to asbestos manufacturers in bankruptcy, whose claims are still in the process of resolution, are established based on claims that have occurred and other related information. The Company also establishes reserves for assumed reinsurance written by another carrier on these manufacturers in proportion to our participation share in the reinsurance agreements. The claim resolution process in these bankruptcies is lengthy and involves, among other factors, filing notices of claim by all current claimants, evaluating pre-petition and post-petition claims, negotiations among the various creditor groups and the debtors and, if necessary, evidentiary hearings by the bankruptcy court. Management will continue to monitor the relevant bankruptcies.
Pending, new, total closed and closed without payment claims for asbestos since December 31, 2002 are summarized in the following table:
Number of Asbestos Claims
The changes in claim counts may not correlate directly to the change in recorded reserves because estimated net loss reserves for asbestos are subject to uncertainties that are greater than those presented by other types of claims.
To further limit our asbestos exposure, the Company purchased significant reinsurance, primarily to reduce our exposure to loss in our direct excess insurance business. The Company's reserves recoverable
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from reinsurers are estimated to be approximately 32.1% of our gross estimated losses, after a reduction for known reinsurer insolvencies.
The Company's three-year average survival ratio, as updated above, is viewed to be a more representative prospective measure of current reserve adequacy than other survival ratio calculations. Now at 23.3 years as of December 31, 2002, the Company's survival ratio is at a level management considers a strong asbestos reserve position. Comparatively, at September 30, 2003 excluding commutations, policy buy-backs and settlement agreements the three-year average survival ratio is 21.5 years and the one-year survival ratio is 17.3 years. A one-year increase in the three-year average asbestos survival ratio at September 30, 2003 would require an after-tax increase in reserves of approximately $33 million.
Management believes that the Company's reserves are appropriately established based on assessments of pertinent factors and characteristics of exposure (e.g. claim activity, potential liability, jurisdiction, products versus non-products exposure) presented by individual policyholders, assuming no change in the legal, legislative or economic environment. Another comprehensive "ground up" review will be completed in the third quarter next year, as well as assessments each quarter to determine if any intervening significant events or developments require an interim adjustment to reserves.
Property-Liability net investment income decreased 2.8% in the third quarter of 2003 and 1.1% for the first nine months of 2003 as compared to the same periods last year due to the effects of lower portfolio yields and lower income from partnerships, partially offset by higher portfolio balances due to positive cash flows from operations. The lower portfolio yields were primarily due to purchases of fixed income securities with interest rates lower than the current portfolio average.
Property-Liability realized capital gains and losses are described in the following table.
For a further discussion of realized capital gains and losses, see "Investments".
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ALLSTATE CANADA
Allstate Protection includes property and casualty insurance sold in Canada. The underwriting results of the Canadian business are included in the Allstate brand results. The impacts to the Property-Liability results are presented separately in the following table.
The decreases in the total Canada loss ratio for the third quarter and first nine months of 2003 are related to increases in premiums earned and lower prior year reserve reestimates. The following table shows the net rate changes that were approved for Allstate Canada in the third quarter and first nine months of 2003.
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ALLSTATE FINANCIAL HIGHLIGHTS
ALLSTATE FINANCIAL OPERATIONS
Summarized financial data is presented in the following table.
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Life and annuity premiums and contract charges, included in the Condensed Consolidated Statements of Operations, represent premiums generated from traditional life, immediate annuities with life contingencies and other insurance products that have significant mortality or morbidity risk. Contract charges are generated from interest-sensitive life products, variable annuities, fixed annuities and other investment products for which deposits are classified as Contractholder funds or Separate Accounts liabilities. Contract charges are assessed against these contractholder account values for maintenance, administration, cost of insurance and surrender prior to contractually specified dates. As a result, changes in Contractholder funds and Separate Accounts are considered in the evaluation of growth and as indicators of future levels of revenues.
The following table summarizes premiums and contract charges by product.
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The following table summarizes Life and annuity premiums and contract charges by distribution channel.
Total Life and annuity premiums increased 8.8% to $309 million in the third quarter of 2003 from $284 million in the third quarter of 2002. The increase was primarily the result of higher premiums from immediate annuities with life contingencies and workplace products, partially offset by declines in premiums from the discontinuance of direct response credit insurance. The increase of immediate annuities with life contingencies was due to consumer preference as well as market and competitive conditions, which drive the level and mix of immediate annuities sold with or without life contingencies.
Total Life and annuity contract charges were $229 million in the third quarter of 2003 compared to $228 million in the third quarter of 2002. Higher interest-sensitive life insurance contract charges from in-force business growth were mostly offset by lower surrender charges.
For the first nine months of 2003, Life and annuity premiums and contract charges increased 4.8% compared to the first nine months of 2002. Premiums increased 8.3% in the first nine months of 2003 compared to the same period in the prior year as a result of higher premiums from immediate annuities with life contingencies and workplace products partially offset by the discontinuance of direct response credit insurance and lower traditional life premiums. Contract charges were consistent with the prior year as higher interest-sensitive life contract charges resulting from in-force business growth were offset by lower variable annuity contract charges, which resulted from lower average variable annuity account balances during the period.
Contractholder funds, included in the Condensed Consolidated Statements of Financial Position, represent interest-bearing liabilities arising from the sale of individual products, such as interest-sensitive life, fixed annuities and bank deposits, and institutional products, such as funding agreements and guaranteed investment contracts. The balance of Contractholder funds is equal to the cumulative deposits received and interest credited to the contractholder less cumulative contract maturities, surrenders, withdrawals and contract charges for mortality or administrative expenses.
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The following table shows the changes in Contractholder funds.
Contractholder funds deposits increased in the third quarter and first nine months of 2003 compared to the same periods in the prior year due to significant increases in funding agreement and fixed annuity deposits. Period to period fluctuations in funding agreement deposits are largely due to management's assessment of market opportunities. Average Contractholder funds increased 16.0% in the third quarter and 18.4% in the first nine months of 2003 compared to the same periods in the prior year.
Separate Accounts liabilities, included in the Condensed Consolidated Statements of Financial Position, are legally segregated from the Company's general accounts and represent contractholders' claims to the related Separate Accounts assets. Separate Accounts liabilities primarily arise from the sale of variable annuities and variable life insurance. The balance of the Separate Accounts liabilities is equal to the cumulative deposits received plus the investment performance of the related assets less the cumulative contract surrenders, withdrawals, net transfers to/from the general account and cumulative contract charges for mortality or administrative expenses.
The following table shows the changes in Separate Accounts liabilities.
Separate Accounts liabilities increased $354 million during the third quarter of 2003 compared to a $1.86 billion decline in the third quarter of 2002, reflecting significant improvement in investment results,
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lower surrenders as well as higher variable annuity deposits. Improved market results and the ongoing effect of the introduction of the Allstate Advisor variable annuity products have resulted in a sequential quarterly increase in variable annuity deposits.
For the first nine months of 2003 compared to the same period in the prior year, higher Separate Account liabilities reflect significant improvement in investment results, partially offset by lower variable annuity deposits and higher surrenders.
Net investment income increased 3.7% in the third quarter and 4.8% in the first nine months of 2003, compared to the same periods in the prior year. The increase in both periods was due to higher portfolio balances resulting from positive cash flows from product sales and deposits, partially offset by lower portfolio yields. The lower portfolio yields were primarily due to purchases of fixed income securities with interest rates lower than the current portfolio average. Investments as of September 30, 2003, excluding unrealized net capital gains, increased 13.2% from December 31, 2002.
Analysis of net income is presented in the following table.
Investment margin represents the excess of investment income earned over interest credited to policyholders and contractholders and interest expense. Investment margin increased 14.4% in the third quarter of 2003 and 5.1% in the first nine months of 2003 compared to the same periods in the prior year due to growth of in-force business and management actions to reduce crediting rates where possible, partially offset by the decline in the fixed income securities portfolio yields. For interest-sensitive fixed annuities and life products in which management has the ability to modify crediting rates, the weighted average interest crediting rate was approximately 85 basis points above the long-term underlying guaranteed rate as of September 30, 2003.
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The following table summarizes the annualized weighted average investment yield, interest crediting rates and investment spreads for the three months ended September 30.
The following table summarizes the annualized weighted average investment yield, interest crediting rates and investment spreads for the nine months ended September 30.
Declines in the weighted average investment spreads for fixed annuities-immediate in both periods were the result of lower fixed income securities portfolio yields. Declines in the weighted average investment spreads for institutional-fixed rate contracts in both periods were due to lower fixed income securities portfolio yields and higher average crediting rates resulting from maturities of contracts with lower crediting rates than those remaining in force.
The following table summarizes Contractholder funds and the Reserve for life-contingent contract benefits associated with the weighted average investment yield and weighted average interest crediting rates at September 30.
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The following table summarizes investment margin by product group.
Mortality margin, which represents premiums and cost of insurance contract charges less related policy benefits was $138 million or 11.0% lower in the third quarter of 2003 compared to the third quarter of 2002. During the quarter, higher variable annuity guaranteed minimum death benefit ("GMDBs") payments and the effect of the discontinuance of direct response credit insurance more than offset new business growth. Third quarter 2003 GMDB payments of $18 million, net of reinsurance, hedging losses and other contractual arrangements ("net GMDB payments"), were $7 million higher than the third quarter of 2002, but $9 million lower compared to the second quarter of 2003. The non-renewal of direct response credit insurance resulted in a $3 million decline in the mortality margin during the third quarter of 2003 compared to the third quarter of 2002.
For the first nine months of 2003, the mortality margin was $406 million or 14.3% below the first nine months of 2002. The impact of GMDBs in the first nine months of 2003 compared to the same period of 2002 represents $51 million of the $68 million decline. The remaining decline was due to a large number of life claims in the first quarter of 2003 and the effect of the discontinuance of direct response credit insurance, partially offset by higher mortality margin from new interest-sensitive life business and workplace products.
The following table summarizes mortality margin by product group.
Amortization of DAC decreased 34.2% and 3.2% in the third quarter and first nine months of 2003, respectively, compared to the same periods in 2002. The decline in the third quarter of 2003 compared to the same period in the prior year was primarily due to the recognition in the prior period of a net $65 million acceleration of amortization, commonly known as DAC unlocking. The decline in the first nine months of 2003 compared to the same period in the prior year was due to lower amortization on variable annuities and certain fixed annuities resulting from lower gross margins, partially offset by higher net DAC unlocking.
Operating costs and expenses increased 6.3% during the third quarter of 2003 compared to the third quarter of 2002. The increase was primarily attributable to higher employee related benefit and technology related expenses as well as increased non-deferrable commissions. Operating costs and expenses increased 5.5% during the first nine months of 2003 compared to the same period of 2002 due to higher employee related benefit and technology expenses as well as increased non-deferrable commissions, partly offset by lower litigation related expenses.
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Realized capital gains and losses are presented in the following table. After-tax realized capital gains and losses are presented net of the effects of DAC amortization to the extent that such amortization effects resulted from the recognition of realized capital gains and losses.
INVESTMENTS
The composition of the investment portfolio at September 30, 2003 is presented in the following table.
Total investments increased to $101.50 billion at September 30, 2003 from $90.65 billion at December 31, 2002 due to positive cash flows from operating and financing activities, increased funds associated with securities lending and dollar roll programs and increased unrealized gains on fixed income securities generated in a lower interest rate environment.
Property-Liability investments were $37.46 billion at September 30, 2003 compared to $34.25 billion at December 31, 2002, due to positive cash flows from operations partially offset by dividends paid by Allstate Insurance Company ("AIC") to The Allstate Corporation.
Allstate Financial investments were $62.71 billion at September 30, 2003 compared to $55.26 billion at December 31, 2002. The increase in Allstate Financial investments was primarily due to positive cash flows from operating and financing activities, increased funds associated with securities lending and dollar roll programs and increased unrealized gains on fixed income securities.
Total investment balances related to funds associated with securities lending and dollar roll programs increased to $4.65 billion at September 30, 2003, from $2.98 billion at December 31, 2002.
The Unrealized net capital gains on fixed income and equity securities at September 30, 2003 were $6.45 billion, an increase of $957 million or 17.4% since December 31, 2002. The net unrealized gain for the fixed income portfolio totaled $5.59 billion, comprised of $5.97 billion of unrealized gains and $382 million of unrealized losses at September 30, 2003, compared to a net unrealized gain for the fixed income
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portfolio totaling $5.03 billion at December 31, 2002, comprised of $5.51 billion of unrealized gains and $481 million of unrealized losses. At September 30, 2003, 49.0% of the unrealized losses for the fixed income portfolio were concentrated in the corporate fixed income portfolio and 24.9% of fixed income unrealized losses were in the municipal portfolio. Corporate fixed income net unrealized gains totaled $2.51 billion comprised of $2.70 billion of unrealized gains and $187 million of unrealized losses. The unrealized losses for the corporate fixed income portfolio were concentrated in the transportation, banking and basic industry sectors. These sectors comprised $97 million or 51.9% of the unrealized losses and $670 million or 24.8% of the unrealized gains in the corporate fixed income portfolio. No other sector accounted for more than 10% of unrealized losses in the corporate fixed income portfolio.
The net unrealized gain for the equity portfolio totaled $858 million, comprised of $895 million of unrealized gains and $37 million of unrealized losses at September 30, 2003, compared to a net unrealized gain for the equity portfolio totaling $460 million at December 31, 2002, comprised of $562 million of unrealized gains and $102 million of unrealized losses. At September 30, 2003, the consumer non-cyclical sector represented $163 million or 18.2% of the unrealized gains and $12 million or 32.4% of the unrealized losses in the equity portfolio. The remaining unrealized gains and losses were spread across multiple sectors.
Securities with an unrealized loss greater than or equal to 20% of cost for equity securities or amortized cost for fixed income securities for a period of six or more consecutive months but less than 12 consecutive months had unrealized losses of $36 million at September 30, 2003, compared to $67 million of unrealized losses at December 31, 2002. This decrease was primarily related to a decline in unrealized losses for the utility sector, partially offset by an increase in unrealized losses for the transportation sector. Securities with an unrealized loss greater than or equal to 20% of cost for equity securities or amortized cost for fixed income securities for 12 or more consecutive months had unrealized losses of $12 million at September 30, 2003 compared to unrealized losses of $15 million at December 31, 2002.
Approximately 93.6% of the Company's fixed income securities portfolio is rated investment grade, which is defined by the Company as a security having a rating from the National Association of Insurance Commissioners ("NAIC") of 1 or 2, a Moody's equivalent rating of Aaa, Aa, A or Baa, a Standard & Poor's equivalent rating of AAA, AA, A or BBB, or a comparable Company internal rating.
Allstate monitors the quality of its fixed income portfolio, in part, by categorizing certain investments as problem, restructured or potential problem. Problem fixed income securities are securities in default with respect to principal and/or interest and/or securities issued by companies that have gone into bankruptcy subsequent to Allstate's acquisition of the security. Restructured fixed income securities have modified terms and conditions that were not at current market rates or terms at the time of the restructuring. Potential problem fixed income securities are current with respect to contractual principal and/or interest, but because of other facts and circumstances, management has serious concerns regarding the borrower's ability to pay future principal and interest in accordance with the contractual terms of the security, which causes management to believe these securities may be classified as problem or restructured in the future.
The following table summarizes problem, restructured and potential problem fixed income securities.
As of September 30, 2003, the balance of fixed income securities that the Company categorizes as potential problem declined from the balance as of year-end 2002. The decrease was related primarily to the sale of holdings in this category due to specific developments in the first nine months of the year causing a
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change in Allstate's outlook and intent to hold those securities. The Company evaluated each of these securities through its watch list process at September 30, 2003 and recorded write-downs on securities that are deemed to be other than temporarily impaired. Approximately $29 million of net unrealized losses at September 30, 2003 are related to securities that the Company has included in the problem, restructured or potential problem categories. These securities represent 0.8% of the fixed income portfolio. The Company concluded, through its watch list monitoring process, that these unrealized losses were temporary in nature. While these balances may increase in the future, particularly if economic conditions are unfavorable, management expects that the total amount of securities in these categories will remain a relatively low percentage of the total fixed income securities portfolio.
The following table describes the components of realized capital gains and losses.
Sales of fixed income securities in the third quarter and first nine months of 2003 resulted from actions taken to reduce credit exposure to certain issuers or industries and to provide liquidity for the purchase of investments that better meet investment objectives. Sales also include fees received from prepayments of fixed income securities and mortgage loans totaling $21 million and $46 million for the third quarter and first nine months of 2003, respectively, compared to $22 million and $55 million for the same periods of 2002, respectively.
CAPITAL RESOURCES AND LIQUIDITY
Capital Resources consist of shareholders' equity, mandatorily redeemable preferred securities and debt, representing funds deployed or available to be deployed to support business operations. The following table summarizes Allstate's capital resources.
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Shareholders' equity increased $1.92 billion in the first nine months of 2003 when compared to year-end 2002, as Net income and unrealized net capital gains on investments were partially offset by dividends paid to shareholders and share repurchases. During the first nine months of 2003, the Company acquired 3.26 million shares of its stock at a cost of $111 million primarily as part of the current 3-year $500 million stock repurchase program. This program was 22.2% complete at September 30, 2003.
Debt increased in the first nine months of 2003 compared to December 31, 2002 due to the adoption of Financial Accounting Standards Board ("FASB") Interpretation No. 46 ("FIN 46") "Consolidation of Variable Interest Entities" and increases in long-term borrowings outstanding, partly offset by declines in short-term borrowings outstanding. The adoption of FIN 46, effective July 1, 2003, increased long-term debt by $346 million, including $102 million for the consolidation of a variable interest entity ("VIE") for a headquarters office building and up to 38 automotive collision repair stores, $44 million for the consolidation of the debt of a previously unconsolidated investment security, and $200 million of debt for a VIE that issued mandatorily redeemable preferred securities and had previously been consolidated but is no longer required to be consolidated. For more information on the adoption of FIN 46, see Note 2 of the Condensed Consolidated Financial Statements. In June 2003, the Company issued $400 million of 5.350% Senior Notes due in 2033, utilizing the registration statement filed with the Securities and Exchange Commission ("SEC") in June 2000. The proceeds of this issuance were used to redeem the $300 million of 63/4% Notes due 2003 and for general corporate purposes.
At September 30, 2003, the Company had no outstanding commercial paper borrowings.
Financial Ratings and Strength In June 2003, Standard & Poor's revised the insurance financial strength rating of Allstate Life Insurance Company ("ALIC") and its rated subsidiaries and affiliates from AA+ to AA and revised the rating outlook from negative to stable. Standard & Poor's stated that the rating change was due to several factors including their negative outlook on the life insurance industry, the recent decline in ALIC's Net income and their view that a subsidiary's rating cannot exceed the rating of its parent. ALIC's rating is now the same rating as AIC, its parent. Moody's and A.M. Best's insurance financial strength ratings of ALIC and AIC remain unchanged. In reaffirming the A+ ratings of ALIC and AIC, A.M. Best assigned a positive outlook for these companies' ratings.
Liquidity The following table summarizes consolidated cash flow activities by business segment for the first nine months of 2003.
The Company's operations typically generate substantial positive cash flows from operations as most premiums are received in advance of the time when claim and benefit payments are required. These positive operating cash flows are expected to continue to meet the liquidity requirements of the Company. The Corporate and Other segment also includes $1.16 billion of investments held by the Company's subsidiary, Kennett Capital.
The payment of dividends by AIC is limited by Illinois insurance law to formula amounts based on statutory net income and statutory surplus, as well as the timing and amount of dividends paid in the preceding twelve months. In the twelve-month period ending October 31, 2003, AIC paid dividends of $694 million. Based on the greater of 2002 statutory net income or 10% of statutory surplus, the maximum amount of dividends AIC is able to pay without prior Illinois Department of Insurance approval at a given point in time during 2003 is $1.43 billion, less dividends paid during the preceding twelve months measured at that point in time. Notification and approval of intercompany lending activities is also required by the Illinois Department of Insurance for those transactions that exceed formula amounts based on statutory admitted assets and statutory surplus.
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A portion of Allstate Financial's diversified product portfolio, primarily fixed annuity and interest-sensitive life insurance products, is subject to surrender and withdrawal at the discretion of contractholders and therefore represents a significant potential use of cash in each fiscal period. These surrenders and withdrawals for Allstate Financial for the three-month and nine-month periods ending September 30, 2003 were $704 million and $2.00 billion compared with $524 million and $1.49 billion for the same periods last year. These surrenders and withdrawals for the first nine months of 2003 represented 4.4% of the Contractholder funds balance at September 30, 2003, compared to 3.8% in the first nine months of last year.
The Company has made contributions to its pension plans during the nine months ended September 30, 2003 totaling $331 million, and estimates that it will make an additional contribution totaling approximately $530 million during October 2003. The Company updates its minimum pension liability on October 31 of each year and estimates that the minimum pension liability at December 31, 2003, after the impact of these contributions, will be approximately $350 million to $400 million, after-tax, compared to $820 million at December 31, 2002. Changes in the minimum pension liability are reflected in Accumulated other comprehensive income on the Company's Condensed Consolidated Statements of Financial Position.
The Company has access to additional borrowing to support liquidity as follows:
OFF-BALANCE SHEET ARRANGEMENTS
The Company's use of off-balance sheet arrangements is limited to two VIEs, none of which have been invested in by members of management, used to hold assets managed by Allstate Investment Management Company on behalf of unrelated third-party investors. At September 30, 2003, these VIEs had assets consisting of bank loans, bonds and cash totaling $718 million and liabilities in the form of long-term notes totaling $701 million. The Company and unrelated third parties made initial equity investments in these VIEs of $24 million and $32 million, respectively. The Company's maximum loss exposure to these VIEs is limited to its current carrying value of $9 million, reflected and accounted for in the investment section of the Company's Condensed Consolidated Statements of Financial Position. The Company recognized revenue and received cash in the form of management fees of $2 million from these VIEs for the nine months ended September 30, 2003.
The Company is in the process of assessing if the VIEs used to hold assets managed by Allstate Investment Management Company on behalf of unrelated third-party investors meet the criteria to be considered variable interest entities pursuant to the pending accounting guidance of FIN 46, "Consolidation of Variable Interest Entities" and will require consolidation.
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RECENT DEVELOPMENTS
FORWARD-LOOKING STATEMENTS
This document contains "forward-looking statements" that anticipate results based on management's estimates, assumptions and plans that are subject to uncertainty. These statements are made subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. Allstate assumes no obligation to update any forward-looking statements as a result of new information or future events or developments.
These forward-looking statements do not relate strictly to historical or current facts and may be identified by their use of words like "plans," "seeks," "expects," "will," "should," "anticipates," "estimates," "intends," "believes," "likely," "targets" and other words with similar meanings. These statements may address, among other things, the Company's strategy for growth, product development, regulatory approvals, market position, expenses, financial results and reserves. Management believes that these statements are based on reasonable estimates, assumptions and plans. However, if the estimates, assumptions or plans underlying the forward-looking statements prove inaccurate or if other risks or uncertainties arise, actual results could differ materially from those communicated in these forward-looking statements. Factors which could cause actual results to differ materially from those suggested by such forward-looking statements, include but are not limited to those discussed or identified in this document (including the risk factors described below) and in the Company's public filings with the SEC.
RISK FACTORS
The following risk factor should be considered in addition to the risk factors identified in the Management's Discussion and Analysis of Financial Condition and Results of Operations, under the heading "Forward-Looking Statements and Risk Factors Affecting Allstate," in Appendix D to the Company's Notice of Annual Meeting and Proxy Statement dated March 28, 2003.
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markets are declining over an extended period of time. The effect of decreasing Separate Accounts balances resulting from volatile equity markets, lower underlying fund performance or declining consumer confidence could cause contract charges earned to decrease. These factors could also result in accelerated DAC amortization and require increases in statutory reserves, which reduce statutory capital and surplus.
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Item 4. Controls and Procedures
With the participation of our principal executive officer and principal financial officer, we carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic reports filed with the Securities and Exchange Commission. However, the design of any system of controls and procedures is based in part upon assumptions about the likelihood of future events and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives and are effective at the "reasonable assurance" level.
During the last fiscal quarter, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The discussion "Regulation, Legal Proceedings and Guarantees" in Part I, Item 1, Note 5 of this Form 10-Q is incorporated herein by reference.
Item 6. Exhibits and Reports on Form 8-K
An Exhibit Index has been filed as part of this report on page E-1.
July 16, 2003, Items 7 and 9, regarding results of operations and financial condition for the quarter ended June 30, 2003
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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E-1
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