MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollars in millions, except per share data)

Forward-looking Information

Statements made in the following discussion that state the Company's or management's intentions, hopes, beliefs, expectations or predictions of future events or the Company's future financial performance are forward-looking statements and involve known and unknown risks, uncertainties and other factors. It is important to note that the Company's actual results could differ materially from those projected in such forward-looking statements due to, among other risks and uncertainties inherent in the Company's business, the following important factors:

. Changes in the composition of the Company's assets and liabilities.
. Fluctuations in the market value of securities in the Company's investment portfolio and the related after-tax effect on the Company's shareholders' equity and total capital through either realized or unrealized investment losses. In addition, the impact of fluctuations in the financial markets on the Company's defined benefit pension plan assets and the related after-tax effect on the Company's operating expenses, shareholders' equity and total capital.
. Prevailing interest rate levels, including the impact of interest rates on (i) unrealized gains and losses in the Company's investment portfolio and the related after-tax effect on the Company's shareholders' equity and total capital, (ii) the book yield of the Company's investment portfolio and (iii) the Company's ability to maintain appropriate interest rate spreads over the fixed rates guaranteed in the Company's life and annuity products.
. Defaults on interest or dividend payments in the Company's investment portfolio due to credit issues and the resulting impact on investment income.
. The impact of fluctuations in the capital markets on the Company's ability to refinance outstanding indebtedness.
. The frequency and severity of catastrophes such as hurricanes, earthquakes and storms and the ability of the Company to maintain a favorable catastrophe reinsurance program.
. The collectibility of reinsurance receivables.
. Future property and casualty loss experience and its impact on estimated claims and claim settlement expenses for losses occurring in prior years.
. The cyclicality of the insurance industry.
. Business risks inherent in the Company's redesign of its property and casualty claims operation.
. The risk related to the Company's dated and complex information systems, which are more prone to error than advanced technology systems.
. Disruptions of the general business climate, investments, capital markets and consumer attitudes caused by geopolitical acts such as terrorism, war or other similar events.
. The impact of a disaster or catastrophic event affecting the Company's employees or its home office facilities and the Company's ability to recover and resume its business operations on a timely basis.
. The Company's ability to develop and expand its agent force and its direct product distribution systems, as well as the Company's ability to maintain and secure product sponsorships by local, state and national education associations.

. The competitive impact of new entrants such as mutual funds and banks into the tax-deferred annuity products markets, and the Company's ability to profitably expand its property and casualty business in highly competitive environments.
. Changes in insurance regulations, including (i) those affecting the ability of the Company's insurance subsidiaries to distribute cash to the holding company and (ii) those impacting the Company's ability to profitably write property and casualty insurance policies in one or more states.
. Changes in federal income tax laws and changes resulting from federal tax audits affecting corporate tax rates or taxable income.
. Changes in federal and state laws and regulations which affect the relative tax and other advantages of the Company's life and annuity products to customers.
. The impact of fluctuations in the financial markets on the Company's variable annuity fee revenues, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of guaranteed minimum death benefit reserves.
. The Company's ability to maintain favorable claims-paying ability, financial strength and debt ratings.
. Adverse changes in policyholder mortality and morbidity rates.
. The resolution of legal proceedings and related matters.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires the Company's management to make estimates and assumptions based on information available at the time the financial statements are prepared. These estimates and assumptions affect the reported amounts of the Company's assets, liabilities, shareholders' equity and net income. Certain accounting estimates are particularly sensitive because of their significance to the Company's financial statements and because of the possibility that subsequent events and available information may differ markedly from management's judgements at the time the financial statements were prepared. Management has discussed with the Audit Committee the quality, not just the acceptability, of the Company's accounting principles as applied in its financial reporting. The discussions generally included such matters as the consistency of the Company's accounting policies and their application, and the clarity and completeness of the Company's financial statements, which include related disclosures. For the Company, the areas most subject to significant management judgements include: reserves for property and casualty claims and claim settlement expenses, reserves for future policy benefits, deferred policy acquisition costs, value of acquired insurance in force, valuation of investments and valuation of assets and liabilities related to the defined benefit pension plan.

Underwriting results of the property and casualty segment are significantly influenced by estimates of the Company's ultimate liability for insured events. Reserves for property and casualty claims include provisions for payments to be made on reported claims, claims incurred but not yet reported and associated settlement expenses. The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including the Company's experience with similar cases and historical trends involving claim payment patterns, claim payments, pending levels of unpaid claims and product mix, as well as other factors including court decisions, economic conditions and public attitudes. Adjustments may be required as information develops which varies from experience, or, in some cases, augments data which previously were not considered sufficient for use in determining liabilities. The effects of these adjustments may be significant and are charged or credited to income for the period in which the adjustments are made. Due to the nature of the Company's

personal lines business, the Company has no exposure to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under homeowners insurance policies for environmentally related items such as toxic mold.

The Company completes a detailed study of property and casualty reserves based on information available at the end of each quarter and year. Trends of reported losses (paid amounts and case reserves on claims reported to the Company) for each accident year are reviewed and ultimate loss costs for those accident years are estimated. The Company engages an independent property and casualty actuarial consulting firm to prepare an independent study of the Company's property and casualty reserves twice a year - at June 30 and December 31.

Liabilities for future benefits on life and annuity policies are established in amounts adequate to meet the estimated future obligations on policies in force. Liabilities for future policy benefits on certain life insurance policies are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and withdrawals. Mortality and withdrawal assumptions for all policies have been based on actuarial tables which are consistent with the Company's own experience. Liabilities for future benefits on annuity contracts and certain long-duration life insurance contracts are carried at accumulated policyholder values without reduction for potential surrender or withdrawal charges. In the event actual experience varies from the estimated liabilities, adjustments are charged or credited to income for the period in which the adjustments are made.

The Company has established a guaranteed minimum death benefit ("GMDB") reserve on variable annuity contracts and regularly monitors this reserve considering fluctuations in the financial markets. At June 30, 2003 and December 31, 2002, under GAAP, the GMDB reserve was $0.6 million and $0.8 million, respectively. The comparable reserve under statutory accounting principles was $1.1 million and $1.6 million at the respective dates. The Company has a relatively low exposure to GMDB because approximately 25% of contract values have no guarantee; approximately 70% have only a return of premium guarantee; and approximately 5% have a guarantee of premium at an annual interest rate of 3% to 5%. The aggregate in-the-money death benefits under the GMDB provision totaled $74 million and $115 million at June 30, 2003 and December 31, 2002, respectively. Regarding the sensitivity of the GMDB reserve to market fluctuations, an approximation for the impact on the GMDB is: for each 1 point of negative/positive market performance for the underlying mutual funds of the Company's variable annuities, the GMDB reserve would currently increase/decrease less than $0.1 million.

Policy acquisition costs, consisting of commissions, policy issuance and other costs, which vary with and are primarily related to the production of business, are capitalized and amortized on a basis consistent with the type of insurance coverage. For investment (annuity) contracts, acquisition costs, and also the value of annuity business acquired in the 1989 acquisition of the Company ("Annuity VIF"), are amortized over 20 years in proportion to estimated future gross profits. Capitalized acquisition costs for interest-sensitive life contracts are also amortized over 20 years in proportion to estimated future gross profits. The most significant assumptions that are involved in the estimation of future gross profits include future financial market performance, business surrender/lapse rates and the impact of realized investment gains and losses. For the annuity segment, the Company amortizes policy acquisition costs and the Annuity VIF utilizing a 10% reversion to the mean approach with a 200 basis point corridor around the mean. At June 30, 2003 and December 31, 2002, capitalized annuity policy acquisition costs and the Annuity VIF asset represented approximately 3% and 4%, respectively, of the total annuity accumulated cash value. In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to

amortization expense for the period in which the adjustment is made. As noted above, there are a number of assumptions involved in the valuation of capitalized policy acquisition costs and the Annuity VIF. Generally, if all other assumptions are met, with regard to financial market performance assumptions for the underlying mutual funds of the Company's variable annuities, a 1% deviation from the targeted financial market performance would currently impact amortization between $0.1 million and $0.2 million depending on the magnitude and direction of the deviation.

The Company's methodology of assessing other-than-temporary impairments is based on security-specific facts and circumstances as of the date of the reporting period. Based on these facts, if management believes it is probable that amounts due will not be collected according to the contractual terms of a debt security, or if the Company does not have the ability or intent to hold a security with an unrealized loss until it matures or recovers in value, an other-than-temporary impairment shall be considered to have occurred. As a general rule, if the fair value of a debt security has fallen below 80% of book value for more than six months, this security will be reviewed for an other-than-temporary impairment. Additionally, if events become known that call into question whether the security issuer has the ability to honor its contractual commitments, whether or not such security has been trading above an 80% fair value to book value relationship, such security holding will be evaluated to determine whether or not such security has suffered an other-than-temporary decline in value.

The Company reviews the fair value of all investments in its portfolio on a monthly basis to assess whether an other-than-temporary decline in value has occurred. These reviews, in conjunction with the Company's investment managers' monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the Company's intent and ability to retain the investment long enough to allow for the anticipated recovery in fair value, (3) the stock price trend of the issuer, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer and (6) the cash flows of the issuer, are all considered in the impairment assessment. A write-down of an investment is recorded when a decline in the fair value of that investment is deemed to be other-than-temporary, with a realized investment loss charged to income for the period.

A decline in fair value below amortized cost is not assumed to be other-than-temporary for fixed maturity investments with unrealized losses due to market conditions or industry-related events where there exists a reasonable market recovery expectation and the Company has the intent and ability to hold the investment until maturity or a market recovery is realized. An other-than-temporary impairment loss will be recognized based upon all relevant facts and circumstances for each investment, as appropriate, in accordance with Securities and Exchange Commission Staff Accounting Bulletin ("SAB") No. 59, "Accounting for Non-Current Marketable Equity Securities," Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and related guidance.

The Company's cost estimates for its defined benefit pension plan are determined annually based on assumptions which include the discount rate, expected return on plan assets, anticipated retirement rate and estimated lump sum distributions. Effective April 1, 2002, participants stopped accruing benefits under the defined benefit plan but continue to retain the benefits they had accrued to date. A discount rate of 6.75% was used by the Company at December 31, 2002, which was based on the average yield for long-term, high grade securities having maturities generally consistent with the defined benefit pension payout period. To set its discount rate, the Company looks to leading indicators, including Moody's Aa long-term bond index. The expected annual return on plan assets assumed by the Company at December 31, 2002 was 7.50%.

Management believes that it has adopted realistic assumptions for investment returns, discount rates and other key factors used in the estimation of pension costs and asset values. To the extent that actual experience differs from the Company's assumptions, subsequent adjustments may be required, with the effects of those adjustments charged or credited to income and/or shareholders' equity for the period in which the adjustments are made.

                                                      Six Months Ended      Growth Over
                                                          June 30,          Prior Year
                                                      ----------------   ----------------
                                                        2003     2002    Percent   Amount
                                                       ------   ------   -------   ------
Automobile and property (voluntary) ...............    $265.0   $246.3       7.6%   $18.7
Annuity deposits ..................................     134.3    128.4       4.6%     5.9
Life ..............................................      54.7     55.0      -0.5%    (0.3)
                                                       ------   ------              -----
      Subtotal - core lines .......................     454.0    429.7       5.7%    24.3
Involuntary and other property & casualty .........       0.3      0.6     -50.0%    (0.3)
   Excluding Massachusetts automobile .............       0.3     (0.6)               0.9
   Massachusetts automobile .......................        --      1.2    -100.0%    (1.2)
                                                       ------   ------              -----
      Total .......................................    $454.3   $430.3       5.6%   $24.0
                                                       ======   ======              =====
      Total, excluding Massachusetts automobile ...    $454.3   $429.1       5.9%   $25.2
                                                       ======   ======              =====

                                                      Six Months Ended     Growth Over
                                                          June 30,          Prior Year
                                                      ----------------   ----------------
                                                        2003     2002    Percent   Amount
                                                      -------   ------   -------   ------
Automobile and property (voluntary) ...............    $261.2   $250.2       4.4%   $11.0
   Excluding Massachusetts automobile .............     261.2    242.8       7.6%    18.4
   Massachusetts automobile .......................        --      7.4    -100.0%    (7.4)
Annuity ...........................................       6.7      7.4      -9.5%    (0.7)
Life ..............................................      47.6     45.9       3.7%     1.7
                                                       ------   ------              -----
         Subtotal - core lines ....................     315.5    303.5       4.0%    12.0
         Subtotal - core lines, excluding
            Massachusetts automobile ..............     315.5    296.1       6.6%    19.4
Involuntary and other property and casualty .......       4.2      6.4     -34.4%    (2.2)
      Excluding Massachusetts automobile ..........       4.0      2.8      42.9%     1.2
      Massachusetts automobile ....................       0.2      3.6     -94.4%    (3.4)
                                                       ------   ------              -----
         Total ....................................    $319.7   $309.9       3.2%   $ 9.8
                                                       ======   ======              =====
         Total, excluding Massachusetts
            automobile ............................    $319.5   $298.9       6.9%   $20.6
                                                       ======   ======              =====

The Company restructured its presence in the Massachusetts automobile market and ceased writing automobile insurance policies in that state on December 31, 2001. Through a marketing alliance with an unaffiliated company, The Commerce Group, Inc. ("Commerce"), the Company's agents are authorized to offer Massachusetts customers automobile insurance policies written by Commerce. Horace Mann agents continue to write the Company's other products in Massachusetts, including retirement annuities and property and life insurance.

Premiums written and contract deposits for the Company's core lines increased 5.7% compared to the prior year, primarily resulting from rate increases in the property and automobile lines. In addition, growth in new annuity deposits improved in the second quarter and contributed to the total increase for the six months. Voluntary property and casualty business, a component of the Company's core lines, represents policies sold through the Company's marketing organization and issued under the Company's underwriting guidelines.

The Company's exclusive agent force totaled 883 at June 30, 2003, reflecting growth of 5.6% compared to a year earlier. Of the total, 391 agents were in their first 24 months with the Company, an increase of 20.7% compared to June 30, 2002, with new hires increasing 17.8% in the current period. The number of experienced agents in the agent force, 492, was down 3.9% at June 30, 2003 compared to a year earlier, due primarily to terminations of less-productive agents over the 12 months. In the first half of 2003, average agent productivity for all lines of business combined declined 4.6% compared to the same period in 2002, with total sales slightly ahead of the prior year. However, second quarter 2003 average agent productivity improved both sequentially and compared to the prior year and total sales increased 7.4%, primarily reflecting increased annuity volume. Average agent productivity is measured as new sales premiums per the average number of agents for the period.

In December 2001, the North Carolina Commissioner of Insurance (the "Commissioner") ordered a 13% reduction in private passenger automobile insurance premium rates to be effective in April 2002. The Commissioner's Order was in response to a request from the North Carolina Rate Bureau (the "Bureau"), which represents the insurance industry, to increase private passenger automobile insurance rates by 5%. The Bureau voted to appeal the Commissioner's Order in the state appellate court and raise rates while the case is being heard. The difference between the rates ordered by the Commissioner and the Bureau are anticipated to have an adverse impact of approximately $350 million for the insurance industry. The difference in rates between the Commissioner and the Bureau must be held in an escrow account pending the court's decision. If the court should rule in favor of the Bureau, the insurers will be entitled to the funds previously escrowed. If the court should rule in favor of the Commissioner, the escrowed funds plus interest will be refunded to the policyholders. Following the April 2002 effective date, this issue negatively impacted the Company's earned premiums and pretax income by $1.8 million for the twelve months ended December 31, 2002. The Company's 2003 earned premiums and pretax income are expected to be negatively impacted by approximately $2.5 million as a result of this dispute over 2002 rates. A similar dispute between the Commissioner and the Bureau is also in process regarding 2003 rates for policies written or renewed January through June, which requires the Company to escrow additional amounts and had a further adverse impact on 2003 results of $0.6 million pretax. In April 2003, the Commissioner and the Bureau reached an agreement regarding premium rates to be effective in July 2003. Because of this agreement, the Company can cease adding to the escrow for policies written or renewing after July 1, 2003. Escrowed amounts established for the previous disputes will be maintained until final resolution is reached. During the six months ended June 30, 2003, $2.0 million was escrowed due to the 2002 and 2003 rate disputes.

Growth in total voluntary automobile and homeowners premium written was 7.6% for the six months ending June 30, 2003. Voluntary automobile insurance premium written increased 6.4% ($11.8 million) compared to the first six months of 2002, and homeowners premium increased 11.2% ($6.9 million). The increase in property and casualty premiums resulted from the impact of rate increases on average premium per policy. Average written premium was up 6% for voluntary automobile and 14% for homeowners compared to the same period a year earlier; average earned premium also increased 6% for voluntary automobile and 14% for homeowners. As of June 30, 2003, approved rate increases for the Company's automobile and homeowners business were 6% and 16%, respectively. Many of the Company's competitors are believed to have taken similar rate increases. Over the prior 12 months and excluding a 12,000 unit decrease in Massachusetts, automobile policies in force declined slightly compared to both June 30, 2002 and December 31, 2002, reflecting an increase in policies for educators which was more than offset by a decrease in non-educator policies. There were no Massachusetts voluntary automobile policies in force at June 30, 2003 and December 31, 2002. Homeowners policies in force at June 30, 2003 were 7,000 less than at June 30, 2002 and 4,000 less than at December 31, 2002, reflecting expected reductions. At June 30, 2003, there were 572,000 voluntary automobile and 280,000 homeowners policies in force, for a total of 852,000.

Based on policies in force, the property and casualty 12-month retention rate for new and renewal policies was 87%, 1 percentage point lower than the 12 months ended June 30, 2002, reflecting the anticipated reductions in homeowners policies in force and the aggressive pricing and underwriting actions implemented during the period. The Company plans additional rate increases in 2003, with primary emphasis on the homeowners line, which are expected to have a continued adverse impact on retention of homeowners policies.

Involuntary property and casualty business includes allocations of business from state mandatory insurance facilities and assigned risk business. For the first half of 2003, involuntary and other property and casualty premiums written were comparable to the prior year.

In the first six months of 2003, new annuity deposits increased 4.6% compared to the prior year. The growth primarily reflected a 23.7% increase in single premium and rollover deposits partially offset by a 4.0% decrease in new scheduled annuity deposits. New deposits to fixed accounts were 21.6%, or $14.3 million, higher than in the first six months of 2002 and new deposits to variable accounts decreased 13.5%, or $8.4 million, compared to a year earlier.

Annualized new annuity sales by Horace Mann agents increased 10.9% compared to the second quarter of 2002; six month results were comparable to the prior year. Total new annuity sales decreased 1.0% for both the quarter and six months, including Horace Mann's independent agent distribution initiative. As described below, annuity sales for the second quarter of 2002 reflected the successful launch of the independent agent initiative and included over $6 million in new business from Chicago public school employees. Ongoing production from independent agents has shown steady sequential growth for each month in 2003.

In 2001, the Company began building a nationwide network of independent agents who will comprise a second distribution channel for the Company's 403(b) tax-qualified annuity products. The independent agent distribution channel, which included 322 authorized agents at June 30, 2003, generated $6.5 million in annualized Horace Mann annuity contract deposits during the first half of 2003 and $10.5 million for the full year 2002. A significant portion of the 2002 amount was produced as a result of Horace Mann being named as one of four providers for fixed and variable annuity options to Chicago, Illinois public school employees and the Company's partnering with an independent broker/dealer having two decades of experience in providing retirement planning services to Chicago Public School employees.

Fixed accumulated cash value was $1.5 billion at June 30, 2003, $141.9 million, or 9.9% more than a year earlier. Fixed accumulated cash value retention for the 12 months ended June 30, 2003 was 94.5%, 0.5 percentage points better than the prior year. Variable accumulated deposit retention of 92.0% for the twelve months ended June 30, 2003, impacted by financial market performance, decreased 0.8% percentage points compared to a year earlier. Variable accumulated funds on deposit at June 30, 2003 were $1.0 billion, a $20.9 million, or 2.2%, increase from the prior year including the impact of financial market values. The number of annuity contracts outstanding increased 3.5%, or 5,000 contracts, compared to June 30, 2002.

For the six months ended June 30, 2003, annuity segment contract charges earned decreased 9.5%, or $0.7 million, compared to the same period a year earlier. Declines in market valuations during 2002 and the first quarter of 2003 resulted in lower variable accumulated balances in force against which contract charges are principally applied. Market appreciation in the second quarter of 2003, however, resulted in variable annuity accumulated balances at June 30, 2003 which were 2.2%, or $20.9 million, higher than at June 30, 2002.

Life segment premiums and contract deposits for the first six months of 2003 declined slightly compared to a year earlier. The life insurance in force lapse ratio of 8.6% for the twelve months ended June 30, 2003 improved 0.6 percentage points compared to the same period last year. The lapse ratio improved for both the term and whole life portions of the business compared to the prior year.

Consistent with the Company's Value Proposition and overall strategy to meet a broader array of consumer financial needs, the product portfolio that the Company's agents can offer is being expanded through two new marketing alliances. The first is with Jefferson Pilot Financial for universal life insurance. Jefferson Pilot was a leading issuer of universal life policies in the U.S. for 2002. The second alliance is with American Funds for retail mutual funds. Both product rollouts began in the second quarter of 2003 and are intended to help the Company reach more educators while deepening relationships with existing clients.

Net Investment Income

Pretax investment income of $93.1 million for the six months ended June 30, 2003 decreased 6.9%, or $6.9 million, (5.7%, or $3.8 million, after tax) compared to the prior year as a decline in the portfolio yield and lost income related to investment credit issues in 2002 offset growth in the size of the investment portfolio. Average investments (excluding the securities lending collateral) increased 6.7% over the past 12 months. The average pretax yield on the investment portfolio was 6.1% (4.2% after tax) for the first six months of 2003 compared to a pretax yield of 7.0% (4.7% after tax) a year earlier. Throughout 2003, investment income is expected to continue to be under pressure due to lower interest rates and investment credit issues in 2002.

Realized Investment Gains and Losses

Net realized investment losses were $2.5 million for the six months ended June 30, 2003 compared to realized investment losses of $38.7 million in the prior year period. For the first six months of 2003, the Company recorded fixed income security impairment charges totaling $8.1 million, $3.0 million related to one of the Company's collateralized debt obligation ("CDO") securities, $1.9 million related to one manufactured housing asset-backed security and the remaining $3.2 million primarily related to two airline industry issuers. In the second quarter of 2002, $41.3 million of realized investment losses were recorded which included a loss of $19.4 million related to the sale and impairment of securities issued by WorldCom, Inc. Additionally, impairment losses of $21.2 million were recognized in the second quarter of 2002 relating primarily to holdings of fixed income securities of other companies in the communications sector. The first quarter of 2002 included impairment charges of $9.9 million related to fixed income securities issued by two telecommunications companies and a realized investment loss of $2.0 million from the Company's sale of all of its holdings in securities issued by Kmart Corporation. Net realized investment losses for the respective periods also reflected gains realized from ongoing investment portfolio management activity.

The table below presents the Company's fixed maturity securities portfolio as of June 30, 2003 by major asset class, including the ten largest sectors of the Company's corporate bond holdings.

                                                                               Pretax
                                          Number of     Fair     Amortized   Unrealized
                                           Issuers      Value      Cost      Gain(Loss)
                                          ---------   --------   ---------   ----------
Corporate bonds
   Banking and Finance.................       30      $  281.2    $  247.9     $ 33.3
   Energy..............................       35         223.6       198.4       25.2
   Utilities...........................       18         139.5       130.7        8.8
   Food and Beverage...................       16         128.5       118.1       10.4
   Telecommunications..................       16         121.9       104.0       17.9
   Transportation......................       12          76.9        73.6        3.3
   Broadcasting and Media..............       17          75.9        67.2        8.7
   Automobiles.........................        5          72.6        71.2        1.4
   Real Estate.........................        7          71.3        64.7        6.6
   Industry, Manufacturing.............        8          70.2        65.2        5.0
   Health Care, Pharmacy...............       15          59.2        55.2        4.0
   All Other Corporates (1)............       68         427.7       385.9       41.8
                                             ---      --------    --------     ------
      Total corporate bonds............      247       1,748.5     1,582.1      166.4
Mortgage-backed securities
   Government..........................      450         604.6       585.7       18.9
   Other...............................       28          55.0        50.6        4.4
Municipal bonds........................      142         461.9       434.2       27.7
Government bonds
   U.S.................................        5         176.5       165.7       10.8
   Foreign.............................        4          20.9        17.2        3.7
Collateralized debt obligations (2)....       11          81.4        84.8       (3.4)
Asset-backed securities................       11          43.8        42.5        1.3
                                             ---      --------    --------     ------
      Total fixed maturity securities..      898      $3,192.6    $2,962.8     $229.8
                                             ===      ========    ========     ======

The asset-backed security impaired in the second quarter of 2003 was issued by Green Tree Financial and the corporate bond securities impaired in the first quarter of 2003 were issued by Northwest Airlines, Delta Air Lines and UnumProvident, an insurance carrier. The securities issued by Northwest Airlines and UnumProvident were sold in the second quarter of 2003. As of June 30, 2003, the Delta holdings represented the only remaining exposure to the airline sector in the Company's investment portfolio with a fair value of $2.6 million. In addition, one CDO security was impaired in the first quarter. As discussed below, the Company consolidated the management of its fixed maturity securities portfolio in March 2003. As part of the transition to a single manager, BlackRock, Inc., completed a comprehensive appraisal and evaluation of the transferred CDO holdings, which resulted in the first quarter impairment. The securities impaired in the second quarter of 2002 included four telecommunications companies (WorldCom, partial

sale of Qwest, Western Wireless, and American Tower) and three cable companies (Adelphia, Century Communications, and Telewest). Petrozuata Finance, which had declined in value due to political risk associated with Venezuela, was also impaired in the second quarter of 2002. Securities issued by two companies in the telecommunications sector (NTL and Diamond Cable) were impaired in the first quarter of 2002. In each of the periods, the impaired securities were marked to fair value, and the write-downs were recorded as realized investment losses in the Statement of Operations. These impairments were deemed to be other-than-temporary for one or more of the following reasons: the recovery of full value was not likely, the issuer defaulted or was likely to default due to the need to restructure its debt, or the Company had an intent to sell the security in the near future.

At June 30, 2003, the Company's diversified fixed maturity portfolio consisted of 1,141 investment positions and totaled approximately $3.2 billion in fair value. The portfolio was 95.3% investment grade, based on fair value, with an average quality rating of A+. At June 30, 2003, the portfolio had approximately $9 million pretax of total gross unrealized losses related to 55 positions. At December 31, 2002, the total pretax gross unrealized losses were approximately $27 million related to 137 positions. The following table provides information regarding fixed maturity securities that had an unrealized loss at June 30, 2003, including the length of time that the securities have continuously been in an unrealized loss position.

Investment Positions With Unrealized Losses Segmented by Quality and Period of Continuous Unrealized Loss As of June 30, 2003

                                                                            Pretax
                                        Number of    Fair     Amortized   Unrealized
                                        Positions   Value      Cost          Loss
                                        ---------   ------   ---------   ----------
Investment grade
   6 Months or less ....................    25      $155.9     $159.1       $(3.2)
   7 through 12 months .................     6        30.3       31.7        (1.4)
   13 through 24 months ................     5        30.9       33.5        (2.6)
   25 through 36 months ................    --          --         --          --
   37 through 48 months ................    --          --         --          --
   Greater than 48 months ..............     2         4.6        5.0        (0.4)
                                           ---      ------     ------       -----
      Total ............................    38      $221.7     $229.3       $(7.6)
                                           ===      ======     ======       =====

Non-investment grade
   6 Months or less ....................     4      $  4.8     $  4.8           *
   7 through 12 months .................    --          --         --       $  --
   13 through 24 months ................     2         2.1        2.2        (0.1)
   25 through 36 months ................     1         6.0        6.1        (0.1)
   37 through 48 months ................     1         4.5        4.8        (0.3)
   Greater than 48 months ..............     3        20.2       21.6        (1.4)
                                           ---      ------     ------       -----
      Total ............................    11      $ 37.6     $ 39.5       $(1.9)
                                           ===      ======     ======       =====

Not rated
      Total, all 7 through 12 months ...     6      $  2.6     $  2.6           *
                                           ===      ======     ======       =====

         Grand total ...................    55      $261.9     $271.4       $(9.5)
                                           ===      ======     ======       =====

Of the securities with unrealized losses, no issuers had pretax unrealized losses greater than $2 million and no securities were trading below 80% of book value at June 30, 2003. The Company views the decrease in value of all of the securities with unrealized losses at June 30, 2003 as temporary, expects recovery in fair value, anticipates continued payments under the terms of the securities, and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs. Therefore, no impairment of these securities was recorded at June 30, 2003. Future changes in circumstances related to these securities could require subsequent impairment of their value.

Historically, the Company's investment guidelines have limited single corporate issuer exposure to 1% of invested assets. Effective in the third quarter of 2002, the Company revised its guidelines to limit the single corporate issuer exposure to 4.0% (after tax) of shareholders' equity for "AA" or "AAA" rated securities, 2.5% (after tax) of shareholders' equity for "A" rated securities, 2.0% (after tax) of shareholders' equity for "BBB" rated securities, and 1.0% (after tax) of shareholders' equity for non-investment grade securities. The change in the investment guidelines was immediately effective for new purchases of securities. It is anticipated that the existing portfolio will be brought into substantial compliance with the new guidelines by the end of 2003. Additional sub-sector limitations were also developed as part of the revised guidelines.

The Company's investments are managed by outside managers and advisors which follow the investment guidelines established by the Company. In conjunction with the review of investment guidelines, the Company also periodically reviews its overall investment program and the performance of its investment managers. Effective in March 2003, the Company consolidated the management of its fixed maturity securities portfolio with BlackRock, with the exception of a small portion allocated to a specialty high-yield manager. BlackRock has managed a portion of the Company's fixed maturity securities portfolio since 1994. Effective in July 2003, the Company transferred the management of its high yield investment portfolio to Shenkman Capital Management, Inc.

                                                     Six Months Ended      Growth Over
                                                         June 30,          Prior Year
                                                    -----------------   ----------------
                                                      2003     2002     Percent   Amount
                                                     ------   ------    -------   ------
Property and casualty ...........................    $217.5   $204.5       6.4%   $13.0
Annuity .........................................       0.5      0.6     -16.7%    (0.1)
Life ............................................      22.2     20.2       9.9%     2.0
                                                     ------   ------              -----
   Total ........................................    $240.2   $225.3       6.6%   $14.9
                                                     ======   ======              =====

Property and casualty statutory loss ratio (1):
      Before catastrophe losses .................      76.6%    78.8%              -2.2%
      After catastrophe losses ..................      81.6%    80.5%               1.1%
      Impact of litigation charges (2) ..........        --      0.6%              -0.6%

In the first six months of 2003, the Company's benefits, claims and settlement expenses reflected underlying improvement in the homeowners statutory loss ratio as a result of loss containment initiatives and the favorable impact of rate increases on earned premiums which was offset by an increase in catastrophe and other weather-related losses. The voluntary automobile statutory loss ratio for the current period increased compared to the first six months of 2002 primarily reflecting adverse development of prior years' reserves, as described below.

Excluding involuntary business, net adverse development of reserves for property and casualty claims occurring in prior years was $13.7 million for the first six months of 2003, primarily related to automobile liability loss reserves, compared to adverse reserve development of $1.6 million in the prior year which was nearly all due to a provision for the costs of resolving class action lawsuits related to diminished value brought against the Company. Total reserves for property and casualty claims occurring in prior years, including involuntary business, were strengthened $14.2 million in the current year compared to strengthening of $2.5 million for the six months ended June 30, 2002. The Company's property and casualty reserves were $285 million and $274 million at June 30, 2003 and 2002, respectively, net of anticipated reinsurance recoverables.

Over the 15 months ended June 30, 2003, the Company made changes in its property and casualty claims function including hiring of new management and claim adjusters, implementing improved processes and consolidating the previous 17 branch offices into 6 regional claims offices, which began in late-November 2002 and was completed in the first quarter of 2003. As part of the redesign of the claims function, open claim files are being reviewed by the new team, including a re-assessment of reserves on older cases. In the first half of 2003, these reassessments resulted in a re-estimated ultimate liability for claims from accident years 2001, 2000 and 1999 and prior that was higher than the amount previously established. Installation and implementation of the new claims administration system, including related process changes, are planned for the last half of 2003 and the first half of 2004.

While the Company has begun to realize improvements in its claims handling process and is confident in the ultimate benefits to be gained from the redesign of its claims operation, those benefits have not been realized as quickly as the company had originally anticipated. In addition, the estimation of claims costs, settlement rates and severity has been complicated in recent quarters due to the degree of change involved. As a result of these factors, and in light of the pattern of adverse prior years' reserve development observed over the last four quarters, the June 30, 2003 property and casualty claims liability was re-estimated reflecting a strengthening of prior years' reserves, primarily voluntary automobile, and an increased level of conservatism in the less developed 2002 and 2003 accident years.

The following table quantifies the amount of first quarter 2003 and second quarter 2003 adverse/(favorable) development for each line of business and the accident years to which the re-estimates relate:

                                                                               Other
                                                     Voluntary      Total    Property &
                                             Total   Automobile   Property    Casualty
                                             -----   ----------   --------   ----------
Three months ended March 31, 2003
Accident Years:
   2002 ..................................    $0.8      $ 1.1      $(0.9)      $ 0.6
   2001 ..................................     1.4        1.7        0.6        (0.9)
   2000 & Prior ..........................     2.1        2.8       (0.1)       (0.6)
                                              ----      -----      -----       -----
      Total ..............................    $4.3      $ 5.6      $(0.4)      $(0.9)
                                              ====      =====      =====       =====

Three months ended June 30, 2003
Accident Years:
   2002 ..................................    $5.8      $ 6.4      $(0.6)      $  --
   2001 ..................................     0.7        1.0       (0.3)         --
   2000 & Prior ..........................     3.4        2.8        0.2         0.4
                                              ----      -----      -----       -----
      Total ..............................    $9.9      $10.2      $(0.7)      $ 0.4
                                              ====      =====      =====       =====

For the first six months of 2003, incurred catastrophe losses for all lines were $13.5 million compared to $4.3 million for the same period in the prior year. In addition to the catastrophes, widespread severe weather in the second quarter of 2003 resulted in a significant increase in non-catastrophe weather-related losses which generated approximately 1.5 percentage points of the increase in the property and casualty statutory loss ratio.

Including the higher level of weather-related losses, the property statutory loss ratio of 90.0% for the first six months of 2003 increased 8.4 percentage points compared to the same period in 2002. Higher catastrophe losses in the current period accounted for a 10.7 percentage point increase in the loss ratio compared to the prior year while non-catastrophe weather losses increased the ratio by approximately 4 percentage points. These adverse impacts were partially offset by an increase in average premium per policy and loss containment initiatives.

The voluntary automobile statutory loss ratio excluding catastrophe losses was 77.3% for the first six months of 2003 compared to 78.0% for the same period last year. The statutory loss ratio in the current period included 8.2 percentage points due to adverse development of prior years' reserves compared to an impact of 0.8 percentage points a year earlier. The increase in average voluntary automobile premium per policy in 2003 exceeded the increase in average current accident year loss costs.

The annuity benefits in the first six months of 2003 and 2002 reflected mortality charges for annuity contracts on payout status. In addition, annuity benefits in both years included changes in the GMDB reserve on variable annuity contracts due to fluctuations in the financial markets. For the first half of 2003, the GMDB reserve decreased $0.2 million, while the reserve increased $0.3 million in the first six months of 2002.

Life mortality costs in the current period were slightly lower compared to a year earlier.

As disclosed in the Company's Annual Report on Form 10-K for 2002, early in 2001 management discovered deficiencies in the tax compliance testing procedures associated with certain of the Company's life insurance policies that could jeopardize the tax status of some of those life policies. Deficiencies in the Company's computer-based monitoring of premiums, combined with the complexity of certain of the Company's life insurance products, resulted in the acceptance of too much premium for certain policies under the applicable tax test the Company was using. As a result of this discovery, the Company retained outside experts to assist with the investigation and remediation of this issue. The deficiencies in the testing procedures related to compliance with Internal Revenue Code ("IRC") Section 7702 (Definition of Life Insurance) were identified and corrected. Such a problem is not uncommon in the life insurance industry and the Company pursued a remedy following Internal Revenue Service ("IRS") procedures that have been established to address this type of situation. The Company recorded $2.0 million of policyholder benefits in the Corporate and Other segment in the fourth quarter of 2001, as well as $1.0 million of operating expense, which represented the Company's best estimate of the costs to the Company to resolve these problems. In July 2003, the Company entered into agreements with the IRS resolving its compliance with IRC Section 7702 (Definition of Life Insurance). The accrual established at December 31, 2001 was adequate to cover these costs.

The Company is in the process of identifying and correcting any related deficiencies in the testing procedures and quantifying any potential exposure associated with IRC Section 7702A (Modified Endowment Contracts). The Company recorded $0.8 million of operating expense in the Corporate and Other segment which represents its current best estimate of the costs to the Company to complete this correction and assessment process. The Company expects to determine if any IRS filings are required under Section 7702A by the end of 2004.

                                             Six Months Ended      Growth Over
                                                 June 30,          Prior Year
                                             ----------------   ----------------
                                               2003    2002     Percent   Amount
                                              -----   -----     -------   ------

Annuity...................................    $35.3   $33.5       5.4%     $1.8
Life......................................     15.6    15.1       3.3%      0.5
                                              -----   -----                ----
   Total..................................    $50.9   $48.6       4.7%     $2.3
                                              =====   =====                ====

The increase in annuity segment interest credited reflected a 9.0% increase in average accumulated fixed deposits, partially offset by a decline in the average annual interest rate credited of 20 basis points compared to the first six months of 2002. Life insurance interest credited increased as a result of the growth in interest-sensitive life insurance reserves.

Operating Expenses

For the first six months of 2003, operating expenses increased $2.4 million, or 3.8%, compared to the prior year. The current period included an increase in investments in technology and property and casualty underwriting initiatives.

In 2001, the Company determined that it would freeze its defined benefit pension plan in 2002 and move to a defined contribution structure. Costs of transitioning to the new structure, based upon assumptions of future events, were $6.2 million in 2002 and are currently estimated to be approximately $6.0 million for 2003. These costs are largely as a result of settlement accounting provisions that are expected to be triggered as a result of the higher retirement rate

currently being experienced by the Company, coupled with more retirees choosing lump sum distributions, and the impact of declines in the market value of the pension plan's assets.

The Company's policy with respect to funding the defined benefit pension plan is to contribute amounts which are actuarially determined to provide the plan with sufficient assets to meet future benefit payments consistent with the funding requirements of federal laws and regulations. In 2002, the Company contributed $7.9 million to the defined benefit pension plan, which was greater than the $1.8 million actuarially-determined required minimum amount, reflecting a degree of conservatism which the Company believed to be appropriate in light of the current volatility in the financial markets. Based on assumptions at the time of this Report on Form 10-Q, the Company anticipates contributing approximately $9.0 million to the defined benefit pension plan in 2003, an amount which is also anticipated to be in excess of the required minimum amount. All defined benefit pension plan investments have been set aside in a trust fund.

The property and casualty statutory expense ratio was 23.6% for the six months ended June 30, 2003, comparable to the same period a year ago.

Amortization of Policy Acquisition Expenses and Intangible Assets

For the first six months of 2003, the combined amortization of policy acquisition expenses and intangible assets was $36.3 million compared to $31.6 million recorded for the same period in 2002.

Amortization of intangible assets was $2.5 million for the six months ended June 30, 2003 compared to $2.7 million for the same period in 2002. The valuations of annuity value of business acquired in the 1989 acquisition of the Company ("Annuity VIF") resulted in a decrease in amortization of $0.1 million for both the current period and the six months ended June 30, 2002.

Policy acquisition expenses amortized for the six months ended June 30, 2003 of $33.8 million were $4.9 million more than the prior year, primarily related to the property and casualty segment. Over the past 12 months, this segment has experienced accelerated growth in new business and the acquisition cost amortization period matches the terms of the insurance policies (six and twelve months). The increase in amortization for the property and casualty segment was augmented by a $1.3 million increase in amortization for the annuity and life segments combined, primarily as a result of the current year valuation compared to the impact of the 2002 valuation. For the annuity segment, the current year valuation increased amortization $0.2 million compared to a decrease of $0.5 million in 2002. The current year valuation reduced amortization $0.2 million for the life segment compared to a decrease of $0.6 million in the prior year.

Income Tax Expense

The effective income tax rate on income, including realized investment gains and losses, was a tax of 23.9% for the six months ended June 30, 2003 compared to a benefit of 57.6% a year earlier.

Income from investments in tax-advantaged securities reduced the effective income tax rate 18.1 and 25.2 percentage points for the six months ended June 30, 2003 and 2002, respectively. While the amount of income from tax-advantaged securities in the current year increased marginally compared to the prior year, the reduced level of income before income taxes in the prior period resulted in this having a more significant impact on the effective income tax rate.

Net Income

For the first six months of 2003, net income was $10.2 million, or $0.24 per share, compared to a net loss of $2.8 million, or $0.07 per share, for the first half of 2002. Realized investment losses, primarily related to fixed income securities of companies in the communications sector, significantly impacted the six month net loss in 2002.

For the six months ended June 30, 2003, net income was unfavorably affected by adverse development of property and casualty prior years' reserves, which resulted in an after-tax charge of $9.2 million for the six months, $6.4 million of which was recorded in the second quarter. Net income was also adversely impacted by widespread severe weather experienced in the current period, particularly in the second quarter. For the six months, catastrophe losses of $8.7 million after tax were three times greater than the same period a year earlier, representing a $5.9 million reduction in net income. Also, non-catastrophe weather-related losses were approximately $3.2 million after tax greater in the 2003 period compared to the prior year. In addition, net income comparisons to prior year continued to be negatively impacted by (1) lower interest rates and decreases in investment income related to investment credit issues in 2002 and (2) lower margins on variable annuities.

These negative prior year comparisons were partially offset by the impact of property and casualty rate increases on earned premiums, with the growth in average premium per policy outpacing current accident year loss costs, underwriting initiatives and the Company's restructuring of its Massachusetts automobile business.

Net income (loss) by segment and net income (loss) per share were as follows:

                                                      Six Months Ended      Growth Over
                                                          June 30,          Prior Year
                                                      ----------------   ----------------
                                                        2003    2002     Percent   Amount
                                                       -----   ------    -------   ------
Net income (loss)
   Property & casualty
      Before catastrophe losses ...................    $10.8   $ 13.3     -18.8%   $(2.5)
      Catastrophe losses, after tax ...............     (8.7)    (2.8)              (5.9)
                                                       -----   ------              -----
         Total including catastrophe costs ........      2.1     10.5     -80.0%    (8.4)
   Annuity ........................................      5.8      9.2     -37.0%    (3.4)
   Life ...........................................      7.5      9.1     -17.6%    (1.6)
   Corporate and other (1) ........................     (5.2)   (31.6)              26.4
                                                       -----   ------              -----
         Total ....................................    $10.2   $ (2.8)             $13.0
                                                       =====   ======              =====
Net income (loss) per share, diluted ..............    $0.24   $(0.07)             $0.31
                                                       =====   ======              =====

Property and casualty statutory combined ratio (2):
      Before catastrophe losses ...................    100.2%   102.0%              -1.8%
      After catastrophe losses ....................    105.2%   103.7%               1.5%
      Impact of litigation charges ................       --      0.6%              -0.6%

As discussed above, adverse development of prior years' reserves and severe weather were the primary drivers of the decrease in property and casualty net income compared to a year earlier. For the first six months of 2003, the Company's increase in average voluntary automobile insurance premium per policy exceeded the increase in average current accident year loss costs. The Company is continuing to approach the pricing and underwriting of its property and casualty products aggressively -- most notably the homeowners line -- to accelerate margin recovery.

The property and casualty statutory combined ratio increased 1.5 percentage points compared to the first six months of 2002. Adverse development of prior years' reserves represented 5.3 percentage points of the statutory combined ratio in the current period compared to 1.0 percentage point in the prior year, an increase of 4.3 percentage points. In addition, severe weather resulted in increases in the combined ratio of 3.3 percentage points related to catastrophe losses and 1.5 percentage points related to non-catastrophe weather-related losses.

Annuity segment net income in the first six months of 2003 decreased compared to the prior year. Current year income was adversely impacted by an after-tax reduction in the net interest margin of $2.9 million, primarily reflecting lower investment income due to lower interest rates and investment credit issues in 2002. In addition, as discussed above, valuation of annuity segment deferred acquisition costs and value of acquired insurance in force at June 30, 2003 resulted in an after-tax charge of $0.1 million reflecting higher-than-expected market appreciation and improved persistency, partially offset by a decline in the interest margin. Similar valuations a year earlier decreased after-tax amortization $0.4 million for the first six months. A decrease in the GMDB reserves increased current year net income by $0.2 million compared to a decrease in after-tax income of $0.2 million a year earlier. Fee income related to variable annuity deposits decreased compared to the prior year, primarily as a result of financial market conditions, as discussed above.

Life segment net income decreased $1.6 million compared to the first six months of 2002, primarily reflecting a decline in investment income. Valuation of life segment deferred acquisition costs at June 30, 2003 resulted in a reduction in amortization of $0.1 million after tax. In the prior year, a similar valuation resulted in a reduction in amortization of $0.4 million after tax. Mortality experience on ordinary life business was slightly lower compared to a year earlier.

The decrease in the net loss for the corporate and other segment compared to last year primarily reflected the significant reduction in realized investment losses, including impairment charges, compared to the first six months of 2002. Interest expense on the Company's outstanding debt decreased compared to the prior year, reflecting refinancing transactions completed in the last eight months of 2002.

In May 2002, the Company used a portion of the proceeds from the sale of its Convertible Notes to repay the balance outstanding under the previous Bank Credit Agreement and repurchase $55.0 million of its outstanding Senior Notes. The debt retirement resulted in an after-tax charge of $1.5 million. In June 2002, the Company recorded an after-tax charge of $1.0 million to net income, representing the Company's best estimate of the costs of resolving class action lawsuits related to diminished value brought against the Company. Both of these charges were reflected in the Corporate and Other net loss for the six months ended June 30, 2002.

Return on shareholders' equity based on net income was 5% for the 12 months ended June 30, 2003.

At the time of this Quarterly Report on Form 10-Q, management anticipates that 2003 full year net income before realized investment gains and losses will be within a range of $0.90 to $1.00 per share. This projection reflects the property and casualty prior years' reserve strengthening, the high level of catastrophe losses recorded in the second quarter and lower investment income. Compared to 2002 results, this projection includes an approximate $0.09 reduction in per share net income as a result of the Company's capital transactions completed in the fourth quarter of 2002. In addition, this projection reflects management's anticipation of continued improvement in the underlying property and casualty statutory combined ratio, mitigated by the pressure on investment income and compression in the Company's annuity margins. As described in "Critical Accounting Policies," certain of the Company's significant accounting measurements require the use of estimates and assumptions. As additional information becomes available, adjustments may be required. Those adjustments are charged or credited to income for the period in which the adjustments are made and may impact actual results compared to management's current estimate. A projection of net income is not accessible on a forward-looking basis because it is not possible to provide a reliable forecast of realized investment gains and

losses, which can vary substantially from one period to another and may have a significant impact on net income. At the time of this Quarterly Report on Form 10-Q, any other reconciling items to net income are assumed to be zero in 2003.

Liquidity and Financial Resources

Special Purpose Entities

At June 30, 2003 and 2002, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.

Related Party Transactions

The Company does not have any contracts or other transactions with related parties that are required to be reported under the applicable securities laws and regulations.

Ariel Capital Management, Inc., HMEC's largest shareholder with 30% of the common shares outstanding per their SEC filing on Form 13F as of June 30, 2003, is the investment adviser for two of the mutual funds offered to the Company's annuity customers. In addition, T. Rowe Price Associates, Inc., HMEC's third largest shareholder with 8% of the common shares outstanding per their SEC filing on Form 13F as of March 31, 2003, is the investment advisor for two of the mutual funds offered to the Company's annuity customers.

Investments

The Company's investment strategy emphasizes investment grade, publicly traded fixed income securities. At June 30, 2003, fixed income securities represented 96.7% of investments excluding the securities lending collateral. Of the fixed income investment portfolio, 95.3% was investment grade and 99.9% was publicly traded. The average quality of the total fixed income portfolio was A+ at June 30, 2003.

The duration of the investment portfolio is managed to provide cash flow to satisfy policyholder liabilities as they become due. The average option adjusted duration of total investments was 5.7 years at June 30, 2003 and 4.8 years at December 31, 2002. The Company has included in its annuity products substantial surrender penalties to reduce the likelihood of unexpected increases in policy or contract surrenders. All annuities issued since 1982, and approximately 79% of all outstanding fixed annuity accumulated cash values, are subject in most cases to substantial early withdrawal penalties.

Additional discussion of the Company's investment guidelines is included in "Results of Operations--Realized Investment Gains and Losses."

Cash Flow

The short-term liquidity requirements of the Company, within a 12-month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow in excess of these amounts has been used to fund business growth, retire short-term debt, pay dividends to shareholders and repurchase shares of the Company's common stock. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance policy claims and benefits and retirement of long-term debt.

Operating Activities

As a holding company, HMEC conducts its principal operations in the personal lines segment of the property and casualty and life insurance industries through its subsidiaries. HMEC's insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash generated by the insurance subsidiaries. For the first six months of 2003, net cash provided by operating activities declined compared to the prior year, primarily reflecting a decrease in investment income received and an increase in federal income taxes paid.

Payment of principal and interest on debt, fees related to the catastrophe-linked equity put option and reinsurance agreement, dividends to shareholders and parent company operating expenses, as well as the share repurchase program, are dependent upon the ability of the insurance subsidiaries to pay cash dividends or make other cash payments to HMEC, including tax payments pursuant to tax sharing agreements. The insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. Dividends which may be paid by the insurance subsidiaries to HMEC during 2003 without prior approval are approximately $43 million, of which none had been paid as of June 30, 2003. Although regulatory restrictions exist, dividend availability from subsidiaries has been, and is expected to be, adequate for HMEC's capital needs.

Investing Activities

HMEC's insurance subsidiaries maintain significant investments in fixed maturity securities to meet future contractual obligations to policyholders. In conjunction with its management of liquidity and other asset/liability management objectives, the Company, from time to time, will sell fixed maturity securities prior to maturity and reinvest the proceeds in other investments with different interest rates, maturities or credit characteristics. Accordingly, the Company has classified the entire fixed maturity securities portfolio as "available for sale."

Financing Activities

Financing activities include primarily payment of dividends, the receipt and withdrawal of funds by annuity contractholders, repurchases of the Company's common stock, and borrowings, repayments and repurchases related to its debt facilities. Fees related to the catastrophe-linked equity put option and reinsurance agreement, which augments the Company's traditional reinsurance program, have been charged directly to additional paid-in capital.

For the six months ended June 30, 2003, receipts from annuity contracts increased 4.6%. Annuity contract maturities and withdrawals decreased $37.4 million, or 43.0%, compared to the same period last year. Cash value retentions for variable and fixed annuity options were 92.0% and 94.5%, respectively, for the 12 month period ended June 30, 2003. Net transfers to variable annuity accumulated cash values increased $15.1 million compared to the same period last year.

                                                       Payments Due By Period
                                                       As of December 31, 2002
                                     ----------------------------------------------------------
                                                                                      More Than
                                              Less Than   1 - 3 Years   3 - 5 Years    5 Years
                                               1 Year      (2004 and     (2006 and    (2008 and
                                      Total    (2003)        2005)         2007)        beyond)
                                     ------   ---------   -----------   -----------   ---------
Long-Term Debt Obligations (1):
   Convertible Notes Due 2032.....   $260.2      $3.5        $ 7.0          $ 5.2       $244.5
   Senior Notes Due 2006..........     35.2       1.9          3.8           29.5           --
                                     ------      ----        -----          -----       ------

      Total.......................   $295.4      $5.4        $10.8          $34.7       $244.5
                                     ======      ====        =====          =====       ======

The Company has entered into various operating lease agreements, primarily for computer equipment, computer software and real estate (agency and claims offices across the country and portions of the home office complex). These leases have varying commitment periods with most in the 1 to 3 year range. Payments on these leases were approximately $4 million for the six months ended June 30, 2003 and 2002. It is anticipated that the Company's payments under operating leases for the full year 2003 will be comparable to payments in 2002 of approximately $8 million. The Company does not have any other arrangements that expose it to material liability that are not recorded in the financial statements.

Capital Resources

The Company has determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the National Association of Insurance Commissioners ("NAIC"). Historically, the Company's insurance subsidiaries have generated capital in excess of such needed capital. These excess amounts have been paid to HMEC through dividends. HMEC has then utilized these dividends and its access to the capital markets to service and retire long-term debt, increase and pay dividends to its shareholders, fund growth initiatives, repurchase shares of its common stock and for other corporate purposes. Management anticipates that the Company's sources of capital will continue to generate capital in excess of its needs for business growth, debt interest payments and shareholder dividends.

The total capital of the Company was $734.6 million at June 30, 2003, including $144.7 million of long-term debt and no short-term debt outstanding. Total debt represented 24.4% of capital excluding unrealized investment gains and losses (19.7% including unrealized investment gains and losses) at June 30, 2003, below the Company's long-term target of 25%.

Shareholders' equity was $589.9 million at June 30, 2003, including an unrealized gain in the Company's investment portfolio of $140.8 million after taxes and the related impact on deferred policy acquisition costs and the value of acquired insurance in force associated with annuity and interest-sensitive life policies. The market value of the Company's common stock and the market value per share were $689.1 million and $16.13, respectively, at June 30, 2003. Book value per share was $13.81 at June 30, 2003, $10.52 excluding investment fair value adjustments.

On May 14, 2002, the Company issued $353.5 million aggregate principal amount of 1.425% senior convertible notes due in 2032 ("Convertible Notes") at a discount of 52.5% resulting in an effective yield of 3.0%. The Convertible Notes were privately offered only to qualified institutional buyers under Rule 144A under the Securities Act of 1933 and outside the United States of America ("U.S.") to non-U.S. persons under Regulation S under the Securities Act of 1933. A Securities and Exchange Commission registration statement registering the Convertible Notes was declared effective on November 4, 2002. Prior to December 31, 2002, the Company repurchased $109.0 million aggregate principal amount, $51.8 million carrying value, of the outstanding Convertible Notes. At June 30, 2003, $244.5 million aggregate principal amount, $116.1 million carrying value, of the Convertible Notes were outstanding. The Convertible Notes are traded in the open market (HMN 1.425).

In January 1996, the Company issued $100.0 million aggregate principal amount of 6 5/8% Senior Notes ("Senior Notes") at a discount of 0.5% which will mature on January 15, 2006. In 2002, the Company repurchased $71.4 million aggregate principal amount of its outstanding Senior Notes utilizing a portion of the proceeds from the issuance of the Convertible Notes. At June 30, 2003, $28.6 million aggregate principal amount of Senior Notes were outstanding. The Senior Notes are traded on the New York Stock Exchange (HMN 6 5/8).

As of June 30, 2003 and December 31, 2002, the Company had no amounts outstanding under its Bank Credit Agreement. The Bank Credit Agreement provides for unsecured borrowings of up to $25.0 million, with a provision that allows the commitment amount to be increased to $35.0 million (the "Bank Credit Facility"). The Bank Credit Facility expires on May 31, 2005. Interest accrues at varying spreads relative to corporate or eurodollar base rates and is payable monthly or quarterly depending on the applicable base rate. The unused portion of the Bank Credit Facility is subject to a variable commitment fee, which was 0.20% on an annual basis at June 30, 2003.

The Company's ratio of earnings to fixed charges for the six months ended June 30, 2003 was 5.3x, reflecting the impact of $2.5 million of pretax realized investment losses recognized during the period, compared to 0x for the same period last year, reflecting the impact of $38.7 million of pretax realized investment losses recognized in the first half of 2002.

Total shareholder dividends were $9.0 million for the six months ended June 30, 2003. In February 2003 and May 2003, the Board of Directors announced regular quarterly dividends of $0.105 per share.

Descriptions of the Company's material property and casualty reinsurance programs and a life reinsurance agreement with Sun Life Reinsurance Company Limited are contained in the Company's Annual Report on Form 10-K for 2002 within "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Financial Resources--Capital Resources." There have been no material changes to the Company's reinsurance coverage as of the time of this Quarterly Report on Form-10-Q.

Market Value Risk

Market value risk, the Company's primary market risk exposure, is the risk that the Company's invested assets will decrease in value. This decrease in value may be due to a change in (1) the yields realized on the Company's assets and prevailing market yields for similar assets, (2) an unfavorable change in the liquidity of the investment, (3) an unfavorable change in the financial prospects of the issuer of the investment, or (4) a downgrade in the credit rating of the issuer of the investment. See also "Results of Operations--Realized Investment Gains and Losses."

Significant changes in interest rates expose the Company to the risk of experiencing losses or earning a reduced level of income based on the difference between the interest rates earned on the Company's investments and the credited interest rates on the Company's insurance liabilities.

The Company manages its market value risk by coordinating the projected cash outflows of assets with the projected cash outflows of liabilities. For all its assets and liabilities, the Company seeks to maintain reasonable durations, consistent with the maximization of income without sacrificing investment quality, while providing for liquidity and diversification. The investment risk associated with variable annuity deposits and the underlying mutual funds is assumed by those contractholders, and not by the Company. Certain fees that the Company earns from variable annuity deposits are based on the market value of the funds deposited.

A more detailed description of the Company's exposure to market value risks and the management of those risks is presented in the Company's Annual Report on Form 10-K for 2002 "Management's Discussion and Analysis of Financial Condition and Results of Operations--Market Value Risk."

Information Systems Risk

The Company administers its insurance business with information systems that are dated and complex, and require extensive manual input, calculation and control procedures. These systems are more prone to error than more advanced technology systems. To address these issues, over the past two and a half years the Company has enhanced its existing systems and technology infrastructure and begun installing new systems, including a new general ledger and financial reporting system which was implemented in the second quarter of 2003. In the meantime, enhanced checks and control procedures have been established to review the output of existing information systems, including periodic internal and external third party reviews. Nevertheless, there are risks that inaccuracies in the processing of data may occur which might not be identified by those procedures and checks.

Business Continuity Risk

Given the events of September 11, 2001, the continuing threat of terrorism and the current geopolitical climate, the Company has undertaken a reassessment of its business continuity plans. While current contingency plans are felt to be adequate to restore some of the more critical business processes and the Company is aggressively working to strengthen its continuity plans, in the current environment there is believed to exist a higher than acceptable level of risk that the Company's ability to recover and resume most or all of its key business operations on a timely basis would be compromised.