S&P Affirms Hanover, Raises Allmerica Ratings

June 9, 2004

Standard & Poor’s Ratings Services has affirmed its ‘BBB+’ counterparty credit and financial strength ratings on Hanover Insurance Co., Citizens Insurance Co. of America (MI), and their property/casualty affiliates: Hanover Lloyd’s Insurance Co. and Massachusetts Bay Insurance Co. (collectively referred to as Allmerica P/C).

At the same time, Standard & Poor’s raised its counterparty credit rating on Allmerica P/C’s holding company, Allmerica Financial Corp. (NYSE:AFC), in Worcester, Mass. to ‘BB’ from ‘BB-‘. The outlook on all these companies is stable.

Standard & Poor’s raised its ratings on AFC to reflect its diminished concern that capital from Allmerica P/C, via AFC, will be needed to support the Allmerica life units: Allmerica Financial Life Insurance & Annuity Co. and First Allmerica Financial Life Insurance Co. (collectively referred to as AFL).

The ratings on Allmerica P/C reflect its favorable market position as a regional insurer, historically good underwriting performance, and capital position that is strong relative to the current rating. These strengths are offset to some degree by the geographic concentration of the property/casualty business. In addition, although Allmerica P/C’s underwriting results have improved, performance has not been as strong as expected by Standard & Poor’s given the strong pricing environment of the past three years. This reflects in large part the challenges faced by insurers writing personal auto business in the states in which the company is concentrated. Personal lines constituted about two-thirds of total net premiums in 2003. Another concern is the lack of premium growth over the past two years despite the current hard market.

Standard & Poor’s expects Allmerica P/C’s underwriting performance to improve modestly in 2004, reflecting continued good market conditions, the impact of rate increases implemented the past couple of years, and lower acquisition costs. Net premiums written are expected to increase moderately in the single digits because of recent rate increases and exposure growth, while the statutory combined ratio is expected to improve to 101%-102% in 2004 from 104% in 2003. Capitalization should improve because dividend requirements of parent AFC should be lower than in prior years, allowing Allmerica P/C to retain its earnings.

Major Rating Factors

— Capital adequacy is strong, although it eroded in 1998-2002 before improving in 2003. Surplus increased 21% in 2003, mainly because of net income, no dividend payments out of the property/casualty companies, and some unrealized gains in investments. In prior years, surplus had declined, primarily because of dividend payments, which were used to support growth in the life insurance business and to shore up capital when the life operations got into trouble in 2002.

— Allmerica P/C is a regional insurer with a good presence in the Northeast and Midwest. Personal lines accounted for about two-thirds of net written premiums in 2003. The personal lines environment in Michigan–Allmerica’s biggest market–is generally favorable. However, in three other states where the company is focused–Massachusetts, New Jersey and New York–market conditions have been challenging because of regulatory pricing restrictions and mandatory participation in involuntary motor pools. These four states account for 70% of net premiums written. The company has well-established relationships with a broad network of independent agents who, for the most part, have continued to support the company through the turbulence of the past two years.

— AFC’s strategic focus is now firmly on the P/C group, whereas it was formerly focused on growing its asset-accumulation businesses. When the life insurance operations foundered in 2002, the company re-focused on the P/C group, which has emerged as the core operation of AFC.

— Allmerica P/C’s profitability has historically been good. However, operating performance has been soft in the past three years because of the residual effects of soft market conditions, concerns among agents and clients about the problems that arose at AFC’s life subsidiaries in 2002, and some reserve strengthening on prior accident years. For 2003, the company recorded a combined ratio of 104.0% versus the property/casualty industry average of 100.1%. This underperformance was despite Allmerica P/C having a higher-than-average proportion of its business in personal lines, where the industry average was 98%. Premium volume has been flat despite the strong pricing environment in 2002 and 2003. Rate increases and re-underwriting efforts should help the group return to stronger results that are more consistent with its longer-term history.

— These strengths have been offset to some degree by problems encountered in 2002 by AFC’s life insurance affiliates. These units experienced a dramatic decline in capitalization as a third year of stock market declines triggered losses on guaranteed minimum death benefits embedded within its variable annuity product. AFC has made substantial progress in addressing the problems in the life operations, such as the implementation of a hedge program. Although the possibility cannot be entirely ruled out, Standard & Poor’s does not expect the life operations to require any additional capital from either AFC or the property/casualty operations.

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