Hanover Insurance Group Inc (THG) 2004 Q2 法說會逐字稿

Good day, everyone. Welcome to the Allmerica Financial Corporation's second quarter 2004 earnings conference call. This call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to the Vice President of Investor Relations, Ms. Sujata Mutalik. Please go ahead, ma'am.

Thank you. Good morning, everyone and welcome to Allmerica second quarter earnings conference call. With me on the call today are Fred Eppinger, our President and Chief Executive Officer, Ed Parry, our Executive Vice President and Chief Financial Officer, and Marita Zuraitis, President of Property and Casualty Companies. Also here available for questions are Michael Reardon, President of our Life Companies, and Mark McGitney, Chief Financial Officer of our Property and Casualty Business. In today's call, we will review our second quarter financial results, discuss e-business trends, and we will provide an update on our strategic initiatives for the year. Today's discussion will reference certain nonGAAP financial measures such as segment income after taxes and net operating cash flow. A reconciliation of these nonGAAP financial measures to the closest GAAP measure is included in both the press release and supplement which are posted on our website.

Both our prepared remarks and answers to your questions today may include forward looking statements. In particular, remarks about our general strategy, comments on underwriting conditions, expected growth, retention and lost development as well as expectations regarding capital levels, ratings, future annuity redemption, life Company cash flow and the performance of our GMDB hedging program should be considered forward looking statements. These statements are subject to a number of risks and uncertainties that are discussed in some detail in readily available documents including the Company's annual report on form 10-K for the year-ended December 31st, 2003, our first quarter 10-Q and yesterday's press release which has been furnished to or on file with the SEC. In particular, Allmerica's future operating results and financial conditions may vary materially depending upon equity market and bond market conditions, surrender activities and rating actions among other factors. Allmerica's quarterly earnings call including today's call are earning's press releases, statistical supplements and documents filed with the SEC are available in the investor relations section of our website. With those comments, I will now turn the call over to Fred.

Good morning and thanks for joining our call. As our results for the quarter indicate, we continue to build on the momentum generated in recent quarters. We are making meaningful progress in our journey to create a world class regional property and casualty company. As we begin this call, I will briefly comment on our financial results and review with you some of the progress we have made on our key strategic priorities.

We are very pleased with our earnings for the quarter where we demonstrate continued improvement in our core businesses. After tax segment income of 29 million or 54 cents a share was up by 56% quarter over the prior year quarter. This improvement was driven by our core property and casualty business that generated solid earnings of $49 million. Earnings for the quarter will more than double the 13 million we reported for the second quarter last year and 26% higher than the 39 million we reported for the first quarter this year. Strong underwriting improvement in personal lines and consistent results in commercial lines resulted in a solid quarter. Increased expenses reduced earnings as we continue to invest in our business as planned.

Our life segment generated cash flow of 27 million in the second quarter, meeting expectations. The hedge program we implemented continued to deliver the desired results, enabling us to manage much of the economic volatility associated with our live company's variable annuity business. And we further strengthened our life company statutory capital position by approximately 40 million since year-end. Life company GAAP earnings were adversely affected in the quarter by the derivative losses associated with the GMBD hedging program and increased GMBD expenses. What is more, as you know, our GAAP results reflect volatility arising from several factors, including the equity market movement, interest rates, surrenders and any deviation between the performance of the underlying mutual funds and the indices associated with future contracts in connection with the hedging program. Ed will review our financial results in detail very shortly.

It has been three quarters now since we began our journey to be a top performer. When we met last winter we said we needed to both aggressively improve performance and build a foundation for future success. We have invested a great deal of time and effort during the past 9 months to do exactly that. Over the next few minutes I will share with you some of the progress we have made on the strategic priorities we outlined from February to accomplish the goals sustained top core top performance.

As you know our goals for this year in personal lines are to improve our margins and produce solid earnings improvement while building the team and skills to be a winner over the long-term. In our commercial line segment we are creating the foundation for world class small commercial business. We expect to maintain favorable margins and gain some momentum on top line growth later this year. This will position us for more meaningful growth in 2005 and our objective is to grow the segment of our business so it represents a more significant of our portion of our book over time. To achieve these objectives we have identified key priorities that center around the three business strategies I believe are critical to building a world class company. Improving our local market and agency management, building strong profitable partnerships with the best agents. Enhancing our products, pricing and underwriting in every market we are in. And improving our service and the efficiency and effectiveness of our operating world. In addition we have also focused on what I consider the foundation or underpinnings of a winning company. Building and sustaining a strong financial position, attracting, retaining and developing world class people. And creating a culture, a strong culture of execution.

As I have said, much of last year and this year was about building the foundation that will allow us to grow profitably in the top 4 core performance and I am pleased with the progress we have made in each of these areas. First, our financial position is excellent and getting stronger. We increased property and casualty company surplus by 32 million in the second quarter boosting capital to 1,061 million. Over the past three quarters, since we started this journey we have added 150 million of cash to statutory capital. As a result our capital ratios are soundly in the A range. We have significantly strengthened our balance sheet which is largely comprised of short-term liability. We don't have the legacy issues that confront others and therefore positioned to move forward with confidence. On the life side, statutory capital is now at 592 million and our risk base capital ratio is 429%, up 8% and 23% respectively since our journey began in September of this year.

With result to people we have been -- with respect to people we have been regressive and successful in attracting some of the best talent in the industry. Over the last three quarters we significantly strengthened our leadership team upgrading 30% of our top 150 people. We have attracted talent from some of the finest companies in our industry, Travelers, White Mountain, Hartford and Progressive. We also attracted people from outstanding companies outside our industry adding valuable experience and talent development and marketing. Our focus has been to add talent across the board. With a particular emphasis on marketing and agency management, underwriting, product development and technology. I believe we are assembling one of the better senior teams in the industry. During the second quarter alone we made several key appointments, adding leaders for our personal lines and inland marine businesses, two new regional presidents and a number of field executives. Each of these individuals bring tremendous market knowledge and experience that will help us better penetrate our markets and profit grow. At the same time we have substantially up graded our capability adding approximately 20 new underwriters and underwriting managers and investing in the further development of our entire underwriting staff. Along with building talent we have a culture of execution. An essential element in any high performing organization. We are designing new compensation plans for our employees and our agents that tied it for our strategic priorities. Variable compensation plans have been pushed further into the organization and we established clear performance metrics. With the monthly tracking of performance against our goals we are able to see trends sooner and respond to them proactively.

Turning to our business strategy, we have had significant progress here as well. And our progress is reflected I believe in our results. I will provide a quick update of these strategies within the context of our personal and commercial line segments. And in just a few minutes Maria will address the property and casuality operations in more detail. In personal lines we continue to build momentum in the quarter, accomplishing our goals to achieve meaningful margin improvements. The combined ratio in the business improved by 8 points to 98% in the quarter from 106% in the second quarter of last year. The primary focus of our improvement efforts in this business has been centered on products, pricing and underwriting. We increased our average base rate by about 7% consistent with our plan. We continued improvement in our loss frequency trends and our margins improved significantly. Improved results in Massachusetts have also contributed to earnings growth for the quarter. Clearly the initiatives taken with more intense management focus in the state is generating improved results. Maria will discuss these initiatives in greater detail.

While we are pleased with this improvement we have much more opportunity to make additional gain. Auto reform is making strong headway in Massachusetts and if enacted will help us further improve margins in our Massachusetts book. The governor, the attorney general and the insurance commissioner have taken the lead and we believe the forms that are being discussed and will create a healthier market for companies, agents and consumers. We continue to improve our position by investing and enhancing in our products. During our call last quarter I mentioned we introduced insurance with the core tiering product and the roll out is proceeding on schedule. While this product greatly enhances our segment capabilities and solidifies our competitive position in existing markets, we view it as a transitional product. Our ultimate goal is to develop a multi variant product. Toward that end we have begun to invest in the development of a multi variant product we expect will be competitive with those offered by the best national companies. By using more variables this will driven product exponentially increases the capability to differentiate pricing at this level of granularity will greatly improve our competitive position and help us achieve greater rate accuracy per risk. Scheduled for deployment in the first half of 2005 this product will support our efforts to boost penetration and expand to new states.

In addition to moving forward with the development of multi variant personal lines, we are looking to improve our data mining capability of this product in our commercial line segment as well. We believe data mining is equally applicable in small commercial market place and we have taken the first step making increased use of data to effectively automate our renewal process. Today 80% of the renewals are being handled without underwriter involvement and we will continue to push in this area going forward. We have also made meaningful progress across commercial lines where our goal is to develop the foundation of growth in 2005. We achieved top line growth of 7% both in the second quarter and year to date. This growth is driven primarily by planned rate increases. Importantly we have seen production in our target market middle market accounts of 25 to 100,000 accounts in premiums has grown as a proportion of our business. And in addition much of that growth has come from our winning agents. Despite industry concerns about the softening market, we continue to achieve our target rate increases largely because small to midsize accounts we target are less sensitive to the pricing cycles.

We made substantial progress on local markets and agency management in the quarter focusing considerable effort to improve retention which is key it achieving our profitable top line growth. Retention continued to improve and is up 5 points through the fix -- first 6 quarters of this month. The improvement in this measure demonstrates the effectiveness of changes we made earlier in the year and the smaller renewal and endorsement process. Along with improving retention these processes and work flow changes have had a positive impact on the flow we expected. Business was up in the quarter of the year by 13%. A mix of business also continues to improve. Standard package products continue to represent a higher percentage of the business flow and we are rounding out the product portfolio to better serve our agent partners. We have also begun to build out our inland marine insurity businesses, selectively and thoughtfully expanding our specialty businesses and lines that have traditionally offered greater margins and complement our position in the market place.

With the significant investment in people, product and service improvements under way, our combined ratio and commercial lines which is 100% on a year to date basis is clearly higher than our target. However, results in our major drive lines have continued to be strong and we focus on building the operating model that will reduce our underwriting expenses. We will continue to stay focused on underwriting discipline, thoughtful expansion and building an operating model that will distinguish us in the small to middle market segment. They will help us improve and sustain markets for a long-term.

In closing, we are please wed our results for the quarter and with the progress we make on strategic priorities. The financial and operational improvements we have made over the first two quarters of year are encouraging and position us well for our journey. However, we know there's a lot more work to be done before we are a top core company. And we are committed to do the hard work necessary to achieve this vision. With that I will turn the call over to Ed who will review our financial results in some detail. And I will be happy to answer questions after ed and Marita make their remarks.

Thank you, Fred. Good morning, everyone, thanks for joining the call. As Fred pointed out, we are very please with the results from the second quarter. Earnings in our core P&C business were very solid. And were driven by strong underwriting results in personal lines as Fred mentioned. Our life company earnings were negatively impacted by derivative losses with our hedging program. However, cash flow was consistent with expectations at 27 million for the quarter, up from 23 million a year ago. We reported net income of 32 million or 60 cents a share in the quarter versus 24 million or 46 cents per share last year.

Now let's turn to segment income after taxes which was 29 million for the quarter, an increase of $10 million over a year ago. As a reminder, after tax segment income excludes certain items included in net income, such as realized gains and losses and certain other items. These items total a gain of 3 million or 6 cents per share for the quarter compared to a gain of 6 million or 11 cents per share a year ago. Let's now talk about our pretax segment results. First, our P&C -- P&C operations contributed a solid 49 million on a pretax segment income basis up from 13 million for the same period last year. You may recall that last year's results included a pretax charge of $23 million related to our participation in an insurance pool that we exited in 1996. What is more, catastrophe losses were 15 million for the current quarter versus 6 million a year ago. So on a precat basis and adjusting for this par a year pool reserve charge, P&C income increased by 7 million or 12% from a year ago.

Now let's focus on each of the P&C segments. Personal lines reported segment earnings of 36 million in the quarter compared to essentially break even results a year ago. A favorable change in prior action year loss reserve development and personal auto taken together with rate increases and reduced loss frequency in both personal auto and homeowners drove the results for the quarter. Catastrophe losses of 12 million dollars in the quarter were about 2 million less than a year ago. The x-cat calendar year loss ratio improved by 9 points to 58%. In the personal lines combined ratio was 98% for the quarter or 8 points better than last year. In personal auto, the x-cat calendar year loss ratio improved by 10 points to 63%. Favorable prior year reserve development in the quarter versus adverse development in the prior year contributed 6 points to this improvement. The favorable development in the quarter was in personal auto while the unfavorable development last year was due primarily to adverse experience in our Michigan PIP coverage. You may recall we saw several several qualifiers in Michigan PIP in the last few years. And we have been taking aggressive pricing throughout last year and at this point are pleased to see the development of the trend in this line and that the -- that the rate has covered the adverse loss development. For the current accent year, the personal auto loss ratio excluding cat is one point better than last year. Continued rate increases and lower loss frequency drove these results. Our auto results in Massachusetts also improved significantly. It contributed meaningfully to the improvement in the overall loss ratio for the quarter. Our accident year loss ratio from mass auto has improved 4 points over the 2003 accident year.

Now with those comments let's focus on homeowners. Underwriting results in homeowners also improved. The calendar year loss ratio excluding cats improved by 7 points to 47% in the quarter. Once again, the homeowners line benefited from rate increases and from lower frequency of losses. This is partially offset by a modest increase in severity. Turning to premium, overall personal lines net written premium was 385 million compared to 388 million a year ago. Written premium decreased by 3% in auto, and increased by about 6% in homeowners. Rate increases in both auto and home owners have been offset by declines in policies in force. Policy counts are down both in personal, auto and homeowners down 6% in the second quarter of last year and about 4% from year-end. Some of this decrease is related to our plan to reduce our concentration in certain states and to not renew certain sponsored business. However, production is somewhat lower in other markets due to a variety of factors that marita will discuss in her comments.

Now, let's discuss the results of commercial lines that produced segment income of 13 million, a decrease of 23 million from a year ago. This decrease is primarily due to higher levels of expenses, adverse loss reserve development in the current period and less favorable reserve changes in LAE. The expense ratio and commercial lines increased from 34% in the prior year quarter to 38% in the current quarter. Expenses were up by 11 million primarily due to increased staffing, increased technology costs associated with the build out of our commercial lines business and higher contingent commissions. Our LAE ratio for the quarter is 10%, up about 3 points from last year. Last year's second quarter LAE expenses were unusually low and benefited from reduced prior and current reserves. For the first six months of '04, our LAE ratio stands at 9%. We believe this level is more representative of our on going LAE ratio.

Now let's look at losses where the commercial lines x-cat calendar year loss ratio was 56%, up 5 points from the second quarter of last year. We continue to experience some adverse development in the pre2000 accident year in workers compensation as current trends in pain management and attendant care has increased estimates for settlement of certain of these older claims. Additionally in the quarter, we increased reserves in our so-called other commercial lines business. Primarily commercial umbrella and general liability coverages. These two lines are small lines for us, representing less than 5% of our overall commercial lines book. Accordingly, these reserve increases had a disproportional impact on our commercial lines results for the quarter. The current x-cat accident year loss ratio for commercial lines is about 2 points higher than the '03 accident year. As we look at it we believe our overall calendar year, 2004 and 2004 accident year loss ratios, provide a solid basis on which to build and grow our commercial lines business.

Now let's turn to commercial lines growth. Net written premium was 195 million for the quarter or 7% higher than the prior year quarter. We continue to benefit from rate increases which averaged about 8% across all lines. The benefit of rate on the top line was partially offset by 5% decrease in policies in force from the end of the second quarter of 2003. However, since the end of last year, PIF has been relatively stable as new business counts have started to increase and our retention rates have also improved. Year to date commercial lines retention stands at 78% versus 73% for the first 6 months of last year. And then again in earnings for our so-called other properties and casualty segment we are 23 million better than a year ago. Last year's second quarter results included a 23 million-dollar charge for our participation in this insurance pool we exited in 1996.

Now let's talk about our life companies. The life company -- the life segment report aide loss of 6 million for the quarter versus income of 14 million a year ago. The prior year's quarter earnings were favorably impacted by a rising equity market that reduced the amortization of deferred acquisition costs. The current year's quarter earnings were negatively impacted by derivative losses related to the GMDB hedging program and to a lesser degree the results were impacted by increased mortality for our variable universal lifeline. During the quarter we incurred nearly $6 million in derivative losses. These losses were not unusual given the equity market movements during the quarter. Also during the quarter we recorded a net charge of just over $1 million for GMDB reserve activity. Including the impact of the equity market and DAC accounting related to the GMDB relative losses. The GMDB reserve charges and related income statement impact were not unexpected as the net amounted risk related to the GMDB feature on a variable annuity product was largely unchanged during the quarter.

As we have said before, we expect volatility in our GAAP segment income due to the impact of our hedging program, the new SOP, 03-01 rules on GMDB reserves and DAC accounting. The expected volatility is due to several factors including equity market movements, but can relate to interest rate changes, surrender activity and to any difference in a given period between the performance of the underling mutual funds in the products and the indices associated with the future contracts related to our hedging program. With that how about -- let me cover a brief comment on our hedging program. As you know we implemented the hedging program in late 2003. The program continues to perform as we expected it would. That is to say we have seen a reduction in the economic liability of the hedge benefit that is consistent with the losses associated with the futures contracts.

Now let's turn to cash flow. As you know last year we introduced the concept of net operating cash flow. This nonGAAP metric was intended as a measure of operating performance and liquidity. It represents our GAAP segment income adjusted for certain noncash items such as DAK amortization and GMDB reserve activity. We have provided a reconciliation of this nonGAAP measure to our GAAP earnings in our press release and our statistical supplement. As I said before, this cash flow measure does not represent distributable capital from our life companies. The distribution of capital is directly related to statutory earnings and statutory capital. In the quarter, the life companies generated net operating cash flow of $27 million which is in line with our expectation and our guidance. Consistent with that guidance we expect life company cash flow to be about $120 million for the full year.

I'll now comment on a few key trends in the life segment. First, operating expenses were lower by around $22 million or 44% compared to a year ago. This reflects the shutdown of our broker dealer business at the latter part of last year, together with our on going expense management efforts in this segment of our business. Second, variable annuity redemptions were 556 million for the quarter compared to 553 million in the prior year quarter. Redemption rates were 20% for the current quarter compared to 22% in the first quarter. And now let's look at statutory capital. As Fred said in the first half of the year, statutory surplus for a life companies increased by 39 million, bringing our total adjusted capital to nearly 600 million up from just over 550 million at the end of last year. Our risk base capital ratio has also improved to a level of 428% at quarter end up from 365% a year ago. With those comments, let me turn the call over now to Marita.

Thanks, Ed. Good morning. I'm very pleased to be here at Allmerica and to have the opportunity to participate in this call. I've had the opportunity to meet several of you since joining the Company and I look forward to meeting more of you going forward. I'm very encouraged by both the activity and the initiatives that we have under way. And I'm confident that we can and will reposition both Citizens and Hanover as world class regional insurance companies. This morning I'll take just a few minutes to review for you the key trends in each of our business segments.

The personal line segment had a strong quarter with 36 million in contribution compared to break even a year ago and a combined ratio of 98% which as you know is 8 points better than last year. Several factors have contributed to the improvement in our personal lines business. We have been able to take more overall rate across the board. That's in both auto and homeowners and in each of our markets. The majority of the rate increases planned for this year have already been taken. In the most recent quarter we averaged base rate increases of over 7%.

We also have benefited from product enhancements. Our insurance score tiering product launched at the beginning of the year in Michigan as of today has been ruled out for new business and renewal in the majority of the states targeted for implementation this year. I'm sorry, just for new business. In Michigan, it's been rolled out for both new and renewal business. This product enables us to better differentiate among risks and to price each of them accordingly. The combination of rate increases, the introduction of our insurance score tiering product and effective agency management actions has led to important improvement in our loss ratio while allowing us to be competitive on the best business. At the same time, we have continued to benefit from favorable loss frequency in both personal auto and the homeowner's line as well as improved severity in personal auto. It was about 6% lower than average, lower on average than last year as Ed mentioned.

Finally, our focus on improving performance in Massachusetts is beginning to pay dividends. Our results in Massachusetts personal auto have improved. Fewer weather-related losses and on going progress in the state to control fraud have improved claim frequency. In addition, our Massachusetts operation has benefited from actions around aggressive premium pursuit as well as an effective session strategy. We continue to focus a great deal of attention on Massachusetts market, supporting the auto reform process and doing whatever else we can to improve our performance. In fact, we recently launched a program to identify and review more closely certain types of claims that would be prone to fraud. This initiative together with progress on reform should result in further improvement in our Massachusetts results.

Turning to production, policies enforced declined in the quarter and down 6% compared to the prior year quarter. While our operating plan called for us to reduce our presence in both Massachusetts and in New Jersey, the number of policies in force in other core states such as Michigan have also declined slightly. In response, we are evaluating our marketing and pricing strategies in order to ensure we are being as aggressive as we can on both fronts while still maintaining commitment to our focus on margin improvement.

Now turning to commercial lines, the commercial lines operations resulted in 13 million in segment income. Our combined ratio is at 105 for the quarter and just over 100 on a year to date basis. This is clearly higher than our competitors largely due to an expense ratio of 38%. The increase in our expense ratio is the result of our efforts to invest in our business and to clearly build for the future. Over the past several months we have invested significantly in our field personnel and the corporate support that will help drive the commercial line's growth. We are also investing in technology and processes to create an operating platform that will effectively service needs of the middle market segment. This development work is essential to our commercial lines expansion strategy. Nonetheless, these enhancements are putting pressure on the combined ratio. The good news, however, is that this investment has already had a positive impact on both retention and new business flow. Our top line growth in the quarter was approximately 7%. While this was primarily driven by average rate increases of approximately 8%, we have begun to see favorable underling trends.

We believe these are positive indicators of future growth. Retention and new business production are good examples. Retention for the first six months -- for the six months of the year is up 5 points compared to the first two quarters of last year. While our retention is still not where we want it to be, we have certainly made good progress. Improved work flows and increased effectiveness in the small renewal and endorsement processes have improved our retention. As Fred mentioned earlier, at the close of the second quarter, more than 80% of our small renewals were being effectively handled without an underwriter's involve meant. As a result, our underwriters could focus great attention on middle market accounts and new business and have more effectively managed our renewals in this segment. With timely and careful underwriting of renewal accounts, retention in the middle market segment is also starting to improve and should provide the impetus for continued retention.

Our ability to generate new business has increased as a result of work flow enhancements and more effective agency management. For the quarter, new business production increased to 48 million, up approximately 13%. In addition, our mix of business is now more in line with our targets. For example, our standard package business which is the line we most want to grow accounted for almost 24% of new business at mid year up 5 points from the same quarter last year. Similarly, we have been able to grow our manufacturing and retail classes of business while reducing our contractor segment, all consistent with our plan. Furthermore, the middle market segment which we define as accounts with premiums between 25 and $100,000 represents almost 25% of our new business at the close of the quarter. This is good business with the right agents.

These improvements and mix and increase in flow position us for growth in our target business. At the same time, we have made substantial progress on local market and agency management. We have identified approximately 275 high potential partner agents who we are working with to develop 3 year business plans by year-end and have been talking with a number of regional and national brokers about establishing new relationships. We fully expect that these activities will generate significant growth next year. We have a solid base of profitable base of profitable business and have made solid progress during the quarter on our goal to create a foundation of growth in 2005. We will continue to invest in our business. The investments we are making in people, product and service will drive a mix of business and flow of business we need for future growth and profitability. It is not inexpensive to invest in the future, but at the same time, we are thoughtfully managing our expenses. Over time we will improve our expense ratio both through expense reductions, efficiency gains and by leveraging growth. Thank you and with that we will be happy to respond to questions.

Thank you, ma'am. Our question and answer session will be conducted electronically. If you would like to ask a question, please press the star key followed by the digit 1 on your touch-tone telephone. We will prompt you in the order you signal and if you find your question has been asked and answered before you can ask it and you would like to remove yourself from the roster, please firmly press the pound key. Also, if you are on a speaker phone, make sure your mute button is disengaged so you can reach us. Press the star key followed by the digit 1. And for our first question we go to Colin Devine with Smith Barney.

Good morning, everybody.

Good morning.

I was wondering, Fred, I noticed in your comments and to me the one thing that was missing was the discussion on your strategy to improve the stock price. And to that end I was wonder figure you could give us some guidance as to where things stand in a couple of areas. First, with respect to the P&C businesses will you be taking a dividend our of those in 05 now that your surplus ratio is down 2 to 1? Secondly, if you could let us know what sort of dividends you've gone into the Massachusetts this year with the life company to get that up? Any further updates on the reestablishment on a common dividend or the initiation of a shared program would be helpful. And lastly I gather you are in the market for an M&A specialist and perhaps you could give us an update on your MNA strategy to augment your business.

Those are a number of comments and a number of financial questions. I try to hit on those because I think they have a lot to do with the rating agency and regular discussions. On the P&C dividend in 05, we don't expect to take a dividend of our P&C business. As you point out, our operating leverage ratio has improved and it is certainly down 2 to 1. As Fred as said and he can comment on this better than I can, you know, we are building a balance sheet in our P&C business because we think it will be helpful to the growth of that business going down the road. We maintain we don't expect to take a dividend from the P&C business. I think your other question was around the life business. And dividends there, as you know and others know, as we said before, we continue to feel good about our capital position both in relative terms as measured by RVC as well as an absolute dollar amount. We continue to feel the way we hedged in the equity market with our hedging program so we think we have our arms around the risks and we think our capital position there is more than it needs to be and we will continue to look to the life company to take dividends. Obviously that involves dialogue with the regulators which you reference. And those dialogues are on going and we think we continue to have a very positive relationship. Any dividends around the life company really though are more news as we get toward the end of the year and as the books are closed out and the statutory blanks are filed, you know, as the third and fourth quarter numbers are completed. It is premature to get specific on where we might be with rig late every -- with regulators with regard to a dividend. And then lastly on your comment about -- I don't know, investment banker on wall street, as you know, Colin, we continue to have regular dialogue with folks around the life properties. And as Fred as said and we said, the objectives for our life companies is to do whatever we can do to maximize value for our shareholders. Whether it is around retaining those blocks of business or disposing of them in part and in whole and consistent with that as you suspect we have dialogue with the people that would be -- you know, be able to be helpful with us. And we continue to have regular dialogue with lots of people about that.

My question wasn't on the life side. It was on the property casualty side.

Right. Right. Let me go to the property casualty side and just amplify a couple things for you. Fundamentally what we are doing about share price is building a top core financially performing P&C company and we are absolutely dedicated to consistent profitable growth in that business which we think comes from having capabilities, -- world class capabilities in the skills we have articulated and that's the fundamental way we will drive share price in this institution and it takes some time to build those capabilities. We all know about P&C companies that have tried to skimp on what it takes to do that over the long-term and only have short spurts of increase in price and then disasters. We are dedicated. Your question on M&A, I have said before and will continue to say I believe it is a consolidating industry. There will be a flight to quality. As we continue to see asbestos word in the market place and more write off and you will see more. It isn't over. For us, we must be prepared to have the skills and capability in our operating model and front line people to participate in that consolidation and be prepared for it. At this moment I don't think we are ready and/or aggressively pursuing any kind of acquisition or book roles et cetera except for those based on our capabilities. But from my point of view, we should have the skill set and be ready for that if it comes to bear. Object casuality balance sheets are dangerous things to do, so it is highly likely that transactions that occur in this industry going forward are more likely to be about buying renewal rights versus balance sheets. Part of what we are trying to do is repair institution to be prepared for the transactions and the things that could happen. And again we're always paying attention. On the life side, Ed's point, we are a nose stick about when whether we keep it. It is been creasing shareholder value. We aggressively and continue look at how we maximize cash flow and how we think about whether we dispose of the assets or we paint it because people are discounting it too much. So in my view we continue to do that and will continue to do that and obviously will be keeping folks up-to-date if anything significant occurs.

You said were you driving variable comp further down into the organization. How are you -- or are you tying that to the stock price? And also, you know, development of return on equity.

Yeah, I mean, it's really about ROE. So, when I got here there was roughly 200 or so folks that were really tied with Pacific All Star and we now have 700 folks are -- or so that are -- they are folks that drive the organization tied to the goals we have, financial goals, operational goals and essentially tied back to ROE. Our senior team, as I think you all know, we have put performance shares in place, totally tied to top core tile ROE performance for our institution. So what we have tried to do is absolutely align folks with the incentive to increase the performance of the institution and we would argue if we consistently achieve the top core, the share price will follow.

Could you refresh my memory of the ROE goal is for this year or for next year?

We -- well we talked about, Colin, you go back to the meeting we had last winter and we look at top core tile performance as a top ROE for our business. We are looking at achieving out 2 1/2 or 3 years from the beginning of the journey which was just started 7 or 8 months ago. So we finished a year ago with an ROE that was 7% so we are looking at a 5% ROE improvement. We measure ROE for our P&C business because the regular ROE is skewed heavily toward the high GAAP capital and low GAAP earnings in the life business.

Okay. Thank you.

For our next question we go to Bob Glasspiegel with Langen McAlenney

I have two questions, one ife and one PC. If I could start with the life. I guess you guys say the GAAP earnings sort of were -- volatility was in line with what you were expecting. It was more than I was looking for. Just look at Q2 versus Q1 when the S&P was up in Q1 and Q2 of .2% in Q2 and the volatility in the market I think was pretty dampened for the second quarter from my subjective assessment and obviously interest rates went higher, but there was a 15 million sort of sequential swing and I guess I didn't follow from your text, you know, where that 15 million swung and what the macro environment was that swung it just to help me model it for future.

Yeah, let me start by saying it is tough to model. In a normal market environment with normal surrender and interest rate levels we expect a handful of millions of dollars on a quarterly basis in our life business. And those earnings are very leveraged. We have big DAK balances and a lot of activity going through our GMDB reserves and we have potentially large transactions that effect the GAAP P&O related to the hedging program. I'll start by saying that, you know, it is a valid question comparing one quarter to another. It is a difficult question to answer per say just because of what I said. It is the inherent volatility and the expected low base of normal GAAP earnings. One of the factors though, however as we look at those two quarters, clearly the GMDB reserved behaved differently in the second quarter than they did in the first quarter. In part because of the rises of interest rates and its impact on the GMDB reserves and as you know, you know that's not something we have hedged. So that was clearly one of the factors. I think there was more volatility in the equity market during the second quarter than there was in the first quarter and that has an impact on our hedging losses and there was -- there is some basis risk that exists in our hedging program because we are using major indices for the hedge and what we have for real changes in liability is represented by the actual investments, mutual fund investments that are in a variable account products. And in any given quarter there won't be direct correlation over the longer term that we think our regression shows there is direct correlation. But in a given quarter could be dislocation. And in the second quarter we saw the dislocation in the underling funds and the indices. You can see that, Bob, if you look at our net amounted risk quarter after quarter. The net amounted risk at the beginning of the quarter is the same as at the end of the quarter even though there was depreciation in the market. Yeah, those market indices. Those are the principal factors. I appreciate it is difficult to predict and follow, but for our account or for our part it is what we expect for the GAAP earnings. And this is why we get people to focus on cash flow as a measure of operating performance because it takes out of the equation amortization of reserves and DAK that are subject to these things I have gone on and on about.

Okay, well, the first line is your segment income in that page 16 in the model, so the DAK change really wasn't nearly -- when I look at that 26 versus 40 3 -- 40.3, comparatively sequentially, the first was the first big income. The other line items didn't swing quite as much.

Bob, this is Michael Reardon. Maybe I could help a little bit. I think the comparison to the first quarter of the first quarter over the second quarter as Ed mentioned is really a story of two things, one the first quarter was a little bit higher than we expected our run rates to be, and you can see that in both the cash flow numbers as well as the earnings.

Right.

And then the second quarter as Ed mentioned we actually had some negative volatility in the segment related to the hedge program. But if we start with the cash flow let me just do a quick reconciliation of the first quarter to the second quarter. There were really three items that drives the difference between the 40 million in the first quarter and the 27 million in the second quarter.

Right.

The first relates to timing of earnings in the closed block, the traditional participating business. Typically we see and we saw this year higher earnings in the first quarter related to the timing of the dividend payment. That was 3 1/2 million in benefit to the first quarter that is not recurring in the other quarters of the year. Secondly we expected and saw slightly higher surrender rates in the first quarter.

Right.

Relating to shut down [INAUDIBLE]. That was a couple million dollars of additional surrender fees. And then the third point is mortality and I think Ed alluded to it in his remarks. We have a couple million in favorable mortality in the first quarter and a couple million of unfavorable mortality in the second quarter. That's a 4 billion swing. Those differences in cash flow --.

That's very helpful. That's what I was trying to get at.

Okay.

The quick PC question is, Fred, you're outlining invest for growth and commercial lines and less -- don't focus in on underwriting and earnings of that segment, you know and hopefully we get the long-term pay back. And you are saying you still are getting good rates and talk about a softer market, you are bulletproof for the moment. If the market did turn against you harder, you still committed to this investment for growth strategy, or is there some sort of tension on rates? Because you are building infrastructure into the soft cycle. It is somewhat of a roll the dice, risky game plan I think.

Yeah, well, this is about margins. We are not going to buy any business. And let me be clear, there is friction costs in our system because we have turned over a number of folks. Obviously we brought in, but haven't added net a lot of folks. We did a little bit marine. We have done a little in certain geographies like the mid-Atlantic area we will. For the most part it is an upgrade of talent and a turnover of talent. A lot of the automation investments should help on margins. It is about decreasing the operating costs and not increasing the operating costs. But you are right. There is some investment to do that. Particularly around our desk top automation, et cetera. Now, my very strong belief is the reason we are being so surgical and thoughtful about the growth and not willy nilly is we targeted our upgraded talent and matched against the 300 agents we think present themselves with the best opportunity to move books from others to us given the shake out in the industry and their fear they have too little number of companies for their shelf space. And so we are watching like that like a hawk. If the market obviously got softer in our segment I would be more -- I would stand back as far as the growth. What we are doing instead -- remember, we are not the size of -- we have a $700 million business so to get a million from 300 grade agents is not the hardest thing in the world if you are surgical and targeted at it with your marketing approaches. But we are very thoughtful on this point. I get the point that we're -- that the market is softening to some extent. But we are somewhat protected because our average size is smaller, but it isn't like I'm taking that for granted at all. And again I wouldn't say to you we are building infrastructure in a traditional sense. We are getting our operating model much more efficient. The things we're working on like on the imaging and the desk top of the underwriter and the rating engine for package is all about making our operating model more efficient. The re-alignment of our commissions. More tied to profitability and growth. It protects us from historical fixed costs, if you will in some of our contingent commissions. You are absolutely right. I wish it was two years ago in some regards as far as the trend in the market place. But I am pretty darn confident that what we are trying to do we can do while maintaining margins in our commercial block.

Bob, the only thing I would add to that and I think Fred said it quite well is that these investments are the right investments. They are right at the street. They are right at the point of sale and I'm convinced that they are the right ones that will definitely help get us ready for future growth.

Thank you very much.

Thanks, Bob.

And for our next question we go to Jeff Thompson with Keefe, Bruyette & Woods.

Have I a couple on PC and a couple on life. First on property casualty, I was wondering, have you changed anyone in your reserving area? Are you taking a different look at reserves? I see from quarter to quarter, first to second quarter there is movement up and down be it reserve editions, reserve releases and commercial and personal lines and I don't really see much of a trend. It seems a little odd to me. I was wondering, can you comment on that?

Yeah, Jeff, this is Ed. We haven't made any changes in our reserve group. And I think -- in our prepared remarks we talked about what we're seeing going on. I mean, it is very positive in terms of reserves and personal lines because the issues around Michigan PIP have abated so it seems to have turned around the adverse development and we are seeing some favorable development in the more recent years in personal auto which is not unusual when you look across the industry. In commercial lines, you know, we are with are -- as I said we -- I think again like others we have seen adverse development in workers comp in the pre2000 accident years and around these smaller blocks of business umbrella general liability, during the quarter we increased our reserves a little bit quite frankly to get to -- up to an expected long-term target or loss ratio, expected loss ratio. Our loss experience during the first six months of the year was favorable. We didn't think we could sustain that. We made adjustments there. There and those are the reasons for the material changes of reserves and the impact on the P&L. It has nothing -- we haven't changed our practices or our people at all.

It was just that you released commercial lines reserves in the first quarter and now you are adding. It is hard to track.

And again, different story, but the second quarter story was the one I just articulated.

And it looks like if I pull out reserve changes in cats, it looks like commercial lines accident year is trending better and personal lines is up from the first quarter. Is that correct and is there something going on there?

No. I think the current action year in commercial lines is flat to maybe up a little built. -- a little bit and personalized it is improved.

I'm looking from the first quarter are you looking year over year?

Yeah. I'm looking year over year.

There is too much seasonality to look at it that way?

Yeah. There is no trend along those lines. We feel very good about our personal lines results.

Good. The timing of the commercial lines products, can you get a little more specific on that? It sounds like the personal lines will be out for renewals, is it the some time at the end of this year and then expect commercial lines in 05?

Personal lines, the product -- the new product in personal lines is the first half of next year. And so the roll out, that's the plan is the first half of next year on the new multi variant product. Commercial lines is, again, most of the data mine is occurring right now around the renewals. We talk about segmentation stuff we are doing and the mixed management we are doing. It takes a little bit different form. It takes the form of underwriting guidelines, et cetera, for our underwriters and that will be a constant enhancement of what we are doing there. The rating engine we are putting out a new rating engine in commercial lines that will be the first half of next year but that will be as much about efficiency and our operational efficiency as anything else. It's automating more of our under writing engine than we have today.

We are making incremental product improvements this year obviously with the new inland marine products to bolster our specialty strategy. But I would say our business commercial line products right now are pretty good. We are working next year on wrapping up the mechanization around them and bringing them to market in a more efficient way to get at them. But the baseline products themselves are pretty good.

So the growth and commercial lines we'll start to see it next week. It will tweak up and we won't see a point where you will hit a switch and it will be greater?

I see this as steady growth over time, as we improve the way we bring our products to market.

And then last question and I'll give it over to Uka, the long-term expense ratio goals, I know you are building in commercial lines, but can you say what your targets are for personal and commercial lines and experience goals and when you think you might meet them?

Yeah, the company in total, we are 2 to 3 points too high for sure. And that is heavily skewed to the commercial lines being too high and I would say over the next 12 to 18 months we have to get that out of the system and we know exactly where it is. There is friction cost on the personnel and a little it and misalign meant on the commissions. But it is a good in my view 2 to 3 points for the Company. It is something we really focused on.

Thanks and here is Uka.

For the life business outside of a major decline in the markets, what is your expectation in terms of what is the more favorable, less favorable markets for you, slightly down, flat or markets gone up?

Clearly in an appreciating market is better for is. It drives -- it was not hedged and related obviously to our on going costs around the GMBD feature. Certainly to the extent that the more the market gross the better we will like it.

Is a flat market worse than a market that's potentially down a little?

Yeah, a sustained flat market, one over an extended period of time is probably the scenario that's most negative for us declines in market -- sharp declines in market, we feel good about our protection around the hedging program. An increasing market is very positive. But a flat market where we don't get the increase in the fee income, we don't get a reduction in the unhedged net amounted risk and of course the renew tense that drove an increase in mortality is the scenario where we see less cash flow over time and we see less in the way of statutory earnings and capital overturn.

Right and one question regarding the specific numbers on a sequential basis looking at the first quarter versus the second quarter for the v-well line, the positive benefit line number, is there anything else in that number other than the difference in mortality?

I don't believe so. Michael, do you -- nothing certainly comes to mind.

No, not that I can think of.

That's what is driving that.

And the variable annuity benefits line, the 26 million in the first quarter versus 32 this quarter, what's the difference there?

That's a more complicated story because the GMBD reserves run through that line. We have sales reducement, amortization that runs through that line. So we would have to do a little research to break out the pieces of that.

I can get back to you on the details of that after the call.

Thank you.

And ladies and gentlemen, we do apologize, however, due to time constraints we have time for one last question and that will come from Angelo Grazzi with Merrill Lynch.

Good morning. Appreciate getting in the last call here. I have a couple questions. One is on the P&C side and just touching upon the reserves again, can you just detail the process on auditing the reserves and what we should expect in the second half? Is there a larger reserve study we should expect by year-end? For some potential reserve development? The second question is regarding the increased costs for staffing and technology and what should we expect going forward in the second half of the year in that regard? And the third is on the ratings and what management is doing or is expecting to do let's say over the next 6 to 12 months, what the target ratings are on the financial strength and particularly on the senior debt ratings. Thank you.

Your first question was on reserve and our process on any major studies. I guess I start by saying, as you may recall we talked shortly after Fred's arrival, shortly after his arrival about a couple of major studies that Fred commissioned on coming in to the company from some outside actuaries and we said at the time their findings were consistent with our own findings and very much in keeping with our recorded reserves. That's the first thing I would say. Secondly we have a normal process where we do our own work and it is the kind you might expect and the nature you might expect. We also of course have our auditors reviewing our reserve and their actuaries are reviewing our reserves on a quarterly basis. And we have had a longstanding process of having an outside consulting actuary review twice a year. Once at midyear and once at year-end. We just concluded the midyear study. And we continue to feel very good about our balance sheet and about our reserve position. Quite frankly if anything we feel better now than we did six months ago. And the findings of our outside consultant, this most recent study was in keeping with our own findings and what we would expect. So that's a little about that whole process. I think you asked about ratings and where we are there. You know, we continue to have regular dialogue, as you might imagine. We just had conversations with the rating agencies as we typically do about our quarterly earnings. I think we have been very clear about what we think. We think that we're very solid on the P&C side from a ratings stand point. We think of ourselves as a solid company with regard to all of rating agencies and rating schemes. We think because of our capital position and the operating leverage and where that is, and the trends that exist in the business in our future plans and on the life side, you know, we understand that it is a closed block. But at the same time we are looking at very high capital. As far as the debt is concerned we feel good about the debt. We have probably $60 million of cash in our holding company that is more than two years of charges on an after tax basis. We've demonstrated we could take dividends from our life business and service their operations and on the P&C side we could take without approval in excess of 100 million in dividends. We feel good about the coverage of the holding company and feel strongly we have investment grade debt. I think though with -- that's our opinion. With regard to what this means from a rating standpoint we made progress. We made progress with S&P and Moody's, but the progress is a little slower than we would like to see that we have full confidence we will see progress in our ratings for all these things over time. I think your other question was on expenses.

Right.

Yeah, I think that our -- for this year, for the remainder of this year you can continue to see expense ratios and expense levels not too dissimilar from what we saw in the second quarters. The benefit of the 18 to 24 months as we March toward this 12% ROE objective we have set, we will start to see as we grow the business and we take some actions around our operating model and other things as we get into '05 and '06.

Is there -- should we expect some more costs related to staffing and technology as you pointed out in this quarter? In 3Q and 4Q?

Yeah, I mean, we will continue to spend money as it makes sense to grow the business. I guess that could result in a couple of text of off and expense ratio over the next couple quarters and we'll continue to invest in the business. As Fred and Marita both said, we are spending in the right place. There may be that financial manifestation of that, but more importantly on a strategic stand point we look for abatement into '05 and going forward.

And what we said is we are building the foundation, but we will have continued improvement. This year is going to be end of the year, we will continue to improve and -- on margins in our business. And on the question of reserves, obviously we looked at these six ways til Sunday and I feel good about where we are in our reserve position. The tweaks we made in workers comp in the pre2000 is as much an indication as what we see in the market police and being thoughtful and making sure we are well reserved there. But we do not have, I don't believe we will have any surprises as we look forward. We have looked at this and had three different firms from the outside look at it and we are confident where we are and how we see our trends and mix going forward.

And on the ratings, go back to that quickly for a second.

Yeah, --

Are there are specific discussions with the rating agencies about the -- about achieving investment grade senior debt ratings and have the agencies laid out specifically what you need to do or is it just a matter of continuing to report more consistent results? Or are there more specific actions that you need to take?

Yeah, I think it's -- we have had -- to parse through the question, we had specific and detailed questions about that. I think probably the most positive development over the last, you know, several months on that is that without identifying the agency, sort of in general they are looking at the senior debt rating to be notched from the underling P&C ratings. Without regard to where life rating stands I think for obvious reasons that is beneficial to us as we look ahead to improvement in that senior debt rating. So with that technical sort of thing in mind there is really nothing that stands in the way other than continued strong performance and perhaps a little bit of time. That's as far as I see it.

And I would say that I am very confident that we are very focused on this. You've heard us talk about the flight of -- the life and quality and particularly on the P&C side. Not just being an a minus, but an A company. It is us delivering against what we said we were going to do and continuing to build our surplus. You know our surplus is quite strong on a P&C side, but we need to continue to deliver against what we've committed to and we are confident and we are right where we thought we would be and maybe ahead of our plan and we will continue to deliver so at the end of the year we can have a very good conversation about where we go next as to the rating agencies.

When you say A financial strength that is not just Moody's and S&P.

It is generic.

It is generic? You are in the A category right now.

Exactly.

Okay great. Thank you.

Yep.

And with that, Ms. Mutalik I would like to turn the call over to you for closing remarks.

Thank you for joining -- thank you for being us with in the call. I will be in my office if you have any further question.

Thank you, everybody.

And ladies and gentlemen, this does conclude the Allmerica financial corporation second quarter 2004 earnings conference call. We do appreciate your participation and you may disconnect at this time.