Fitch Downgrades Trio of Kemper Companies Primary Underwriters

January 8, 2003

Fitch Ratings has downgraded the insurer financial strength ratings of three primary insurance underwriters of the Kemper Insurance Companies (KIC) to ‘B+’ from ‘BBB’. Additionally, Fitch has downgraded the surplus notes issued by group member Lumbermens Mutual Casualty Company (Lumbermens) to ‘CCC’ from ‘BB-‘. All ratings remain on Rating Watch Negative.

The rating actions reflect Fitch’s concerns regarding the prospective financial condition of KIC. Included in these concerns is the increasing likelihood that future interest payments on Lumbermen’s surplus notes may not be made as scheduled. Given the regulatory oversight of surplus notes payments, and the organization’s strained capital position, Fitch is concerned that Lumbermens will have difficulty maintaining minimum capital requirements and therefore could experience difficulties in maintaining approvals from regulators to pay interest on its surplus notes.

KIC management recently announced that the company has reached an agreement-in-principle with Berkshire Hathaway Inc. subsidiary, National Indemnity Company (which has a ‘AAA’ IFS rating by Fitch), whereby National Indemnity will provide a cut-through endorsement on policies issued under the agreement beginning Jan. 1, 2003. The company indicated that this cut-through will enable KIC to continue operating its core businesses while restructuring its operations prior to a planned demutualization.

Fitch believes that the cut-through was necessitated by rating downgrades of KIC by Fitch and other peer rating agencies. Fitch feels that the successful execution of the cut-through agreement with Berkshire Hathaway is likely a necessary step to remain viable in the current market, though even with a cut through, there is some risk the company could experience adverse selection within its book of business. The implementation of the cut-through agreement does not come without a cost. Earnings will be reduced by fees paid for the cut through. Future earnings will also be impacted by costs associated with finite reinsurance contracts currently in place and potentially from prior year adverse reserve development.

In connection with the cut-through transaction, KIC will also repurchase for $125 million Berkshire’s minority equity investment in a KIC subsidiary company that was made in 2002. Closing of the transaction is expected in the first quarter of 2003. Fitch believes that the repurchase of the Berkshire investment will adversely impact KIC’s capital and liquidity position. The reduction in capital following Berkshire Hathaway’s exit strains an already thin capital base that is heavily levered. Lumbermens surplus notes comprise over 50 percent of KIC’s total capital at Sept. 30, 2002.

The $125 million capital repurchase is subject to regulatory approval, and Fitch understands that National Indemnity’s provision of the cut through is also contingent upon the approval of the capital transaction. If the cut through is indeed enacted, Fitch believes that in order to remain viable, Kemper would need to be able to demutualize and complete an initial public offering within the 18 month period that the cut through is in place. Further, the IPO would need to provide sufficient capital to support higher financial strength ratings. It is unclear to Fitch if management will be able to successfully execute on such a plan.

Among the ratings actions were: Lumbermens Mutual Casualty Co. downgrade ‘B+’/Negative; American Motorists Insurance Co. downgrade ‘B+’/Negative; American Manufacturers Mutual Ins. Co. downgrade ‘B+’/Negative.

Surplus Note Rating: Lumbermens Mutual Casualty Co. downgrade ‘CCC’/Negative.

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