GAFRI and GALIC rent office space in Cincinnati, Ohio totaling approximately 145,000 square feet under leases expiring in 2011. Several of the Company's subsidiaries lease marketing and administrative offices in locations throughout the United States.
GAFRI owns a building in Mission, Kansas totaling 45,000 square feet that is used by Continental General and Central Reserve Life for their operations. GAFRI owns a building in Omaha, Nebraska totaling approximately 61,400 square feet. GAFRI expects to complete the sale of that building in March 2007.
GAFRI owns facilities related to its former manufacturing operations totaling approximately 150,000 square feet in North Adams, Massachusetts and 60,000 square feet in Longwood, Florida. The facility located in North Adams, Massachusetts is vacant and expected to be demolished later this year. The Longwood, Florida facility is currently being leased to companies using it for manufacturing operations.
GAFRI also owns and operates certain real estate investments, comprised primarily of hotels and marinas. See Note F to the Financial Statements.
The following financial data has been summarized from, and should be read in conjunction with, the Company's Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations." GA-PR's results of operations and the results and gains on the sales of the Chatham Bars Inn (sold in June 2006) and the Driskill Hotel (sold in October 2005) are reflected as discontinued for all periods presented below. The data includes the acquisitions of the Ceres Group, Inc. in August 2006, Old West Annuity and Life Insurance Company in January 2006, the fixed annuity blocks of business written by Old Standard Life Insurance Company and National Health Insurance Company in January 2006 and May 2004, respectively, and Manhattan National Life Insurance Company in June 2002 (in millions, except per share amounts).
GAFRI has significantly strengthened its capital and liquidity over the last several years. Since December 31, 2002, stockholders' equity (excluding unrealized gains) grew by more than $376 million (56%) to $1.0 billion and its debt to capital ratio decreased from more than 36% to approximately 20%; in addition, the statutory adjusted capital of GAFRI's largest insurance subsidiary increased $260 million (54%) to $746 million.
GAFRI believes that its exposure to interest rate risk, particularly a rising interest rate environment, is mitigated by the nature of its annuity business. The Company's primary strategic business is in the flexible premium, teachers' 403(b) market. Historically, this market has proven to be less interest rate and lapse sensitive than other annuity markets, as demonstrated in the persistency table below, which illustrates GALIC's annual persistency rates for its major fixed annuity product groups over the past five years. Persistency rates reflect the proportion of reserves maintained by the Company and not paid out in the form of surrenders, annuitizations or death benefits during the applicable year
Moreover, due to the two-tier nature of many of its annuity products, GAFRI has significant surrender charge protection, averaging approximately 10% of the annuitization value. While the Company continues to receive premiums on in-force two-tier annuities, it no longer sells this type of annuity. (For additional information on risks associated with GAFRI's two-tier annuities, see Note O to the Financial Statements.) In total, nearly 75% of the Company's annuity reserves had a surrender charge of 5% or greater at December 31, 2006, and nearly 35% had a surrender charge of 10% or greater. While it is likely that persistency will decrease (i) as more policies begin to emerge out of their surrender charge period and (ii) in a rising interest rate environment, the Company believes it should not experience surrender rates that will have a material impact on its financial condition.
Indexed-annuities comprised nearly 9% of the Company's insurance reserves at December 31, 2006. Indexed-annuities have interest rate risk similar to other fixed annuities. They have contractually guaranteed minimum surrender values, the majority of the asset portfolio backing them is invested in fixed income securities similar to other fixed deferred annuities, and GAFRI seeks to earn a spread on those fixed income assets. GAFRI purchases index options, which hedges the policyholders' index participation, minimizing equity market risk.
the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical:
Approximately 40% of GAFRI's fixed annuity liabilities at December 31, 2006, were two-tier in nature in that policyholders can receive a higher amount if they die or if they annuitize rather than surrender their policy, even if the surrender charge period has expired. For these policies, reserves are recorded at their lower-tier value plus additional reserves for (i) accrued persistency and premium bonuses and (ii) excess benefits expected to be paid on future deaths and annuitizations that require payment of the upper-tier value. The liability for EDAR (approximately $200 million at December 31, 2006) is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization. Actual experience and changes in actuarial assumptions and tests for recoverability have caused GAFRI's accounting estimates to change in the past and could cause the Company's accounting estimates to change in the future (see "Results of Operations - Annuity Benefits," "
GAFRI's management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including GAFRI's principal executive officer and principal financial officer, GAFRI conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2006, based on the criteria set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on GAFRI's evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2006. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2006, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is set forth on the following page.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that Great American Financial Resources, Inc. (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Great American Financial Resources, Inc.'s management is responsible for maintaining effective internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
As indicated in the accompanying Management's Report on Internal Control over Financial Reporting, management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Ceres Group, Inc., which is included in the 2006 consolidated financial statements of Great American Financial Resources, Inc. and constituted less than 6% of total assets as of December 31, 2006, and less than 7% of total revenues and less than 5% of net earnings for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at this entity because the Company acquired this entity during 2006. Our audit of internal control over financial reporting of Great American Financial Resources, Inc. also did not include an evaluation of the internal control over financial reporting of this acquired entity.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Great American Financial Resources, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006, and our report dated February 27, 2007 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of Great American Financial Resources, Inc. (the Company) and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
As discussed in Note B to the consolidated financial statements, in connection with implementing new accounting standards, the Company changed its methods of accounting for stock-based compensation in 2006 and certain non-traditional long duration insurance contracts and separate accounts in 2004.
We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Great American Financial Resources, Inc.'s internal control over financial reporting as of December 31, 2006, based upon criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2007 expressed an unqualified opinion thereon.
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on GAFRI's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Goodwill represents the excess of cost of subsidiaries over GAFRI's equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. Goodwill is included in "Other assets" in the Balance Sheet.
In the normal course of business, GAFRI's insurance subsidiaries cede business to other companies under various reinsurance agreements to diversify risk and limit maximum exposure. These transactions may also provide a source of additional capital and liquidity. GAFRI remains obligated for amounts ceded in the event that the reinsurers do not meet their obligations. GAFRI reviews the financial condition of its reinsurers and monitors the amount of reinsurance it has with each company.
Unamortized insurance acquisition costs consist of deferred policy acquisition costs ("DPAC") and the present value of future profits on business in force ("PVFP" or "VOBA") of acquired insurance companies.
Insurance acquisition expenses in the income statement reflect primarily the amortization of DPAC and VOBA. In addition, certain commission costs are expensed as paid and included in insurance acquisition expenses. All other uncapitalized acquisition costs such as marketing and underwriting expenses are included in "Other expenses" in the Income Statement.
To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains on marketable securities, a component of "Accumulated other comprehensive income, net" in the stockholders' equity section of the Balance Sheet.
) Insurance acquisition costs include the PVFP on business in force of acquired insurance companies, which represents the portion of the costs to acquire such companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition.
As a result of the 2004 implementation of Statement of Position ("SOP") 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Contracts", reserves for two-tier annuities (annuities with different stated account values depending on whether a policyholder annuitizes, dies or surrenders) are now recorded at the lower-tier value plus additional reserves for (i) accrued persistency and premium bonuses; and (ii) excess benefits expected to be paid on future deaths and annuitizations ("EDAR") that require payment of the upper-tier value. The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that accruals are in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income. Prior to the adoption of the SOP, reserves for two-tier annuities were generally recorded at the lower-tier value plus the EDAR reserve.
Policy charges that represent fees for future services are deferred as unearned revenue and recognized as income using the same assumptions and estimated gross profits used to amortize DPAC.
Effective January 1, 2006, GAFRI implemented Statement of Financial Accounting Standards ("SFAS") No. 123(R), "Share-Based Payment" using the modified prospective method under which prior year amounts are not restated. Under SFAS No. 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their calculated "fair value" at the date of grant. Beginning in 2006, all share-based grants are recognized as compensation expense over the vesting period. GAFRI uses the Black-Scholes pricing model to measure the fair value of its stock options.
On June 2, 2006, GAFRI sold Chatham Bars Inn, a resort hotel located on Cape Cod, Massachusetts, for $166 million, and recognized an after-tax gain of approximately $31.6 million ($0.66 per diluted share). GAFRI sold the Driskill Hotel in October 2005 for $53 million, and recognized an after-tax gain of approximately $10.7 million ($0.22 per diluted share). The operating results and the gains on sales of these properties are included in discontinued operations in the Consolidated Income Statement. Balance Sheet amounts prior to the hotel sales have not been reclassified.
Included in net earnings from discontinued operations in 2005 is a deferred tax benefit of $5.0 million related to the excess of tax basis over financial reporting basis of GAFRI's investment in GA-PR common stock; also included are certain expenses attributable to the sale and a pre-tax charge of $2.0 million reflecting the difference between estimated sales price and GAFRI's financial reporting basis in GA-PR.
The acquisition has been accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations". The following table presents the preliminary allocations of the aggregate purchase price for the Ceres acquisition based on their estimated fair values. Such amounts are subject to change upon finalizing valuations.
In 2004, GAFRI acquired the fixed annuity block of business of National Health Insurance Company ("NHIC"). See Note N to the Financial Statements. At the date of acquisition, the block consisted of approximately 33,000 policies with GAAP reserves of approximately $765 million.
GAFRI manages its business as four segments: (i) annuity operations; (ii) supplemental insurance; (iii) life operations; and (iv) corporate and other, which includes holding company assets and costs as well as interest and other debt expenses.
GAFRI's supplemental insurance businesses (United Teacher Associates Insurance Company ("UTA"), Loyal American Life Insurance Company, CGIC and CRLIC) primarily offer a variety of Medicare supplement and limited benefit policies to supplement primary health insurance and other insurance coverage. These products are offered through independent agents and, to a lesser extent, captive agents.
Traditional term and universal life insurance products had been marketed through national marketing organizations. In 2004, GAFRI suspended new sales of these life insurance products due to inadequate volume and returns. The Company continues to service its in-force block of these policies.
2005 amounts include a $15.8 million charge to GAFRI's annuity operations related primarily to the low interest rate environment; 2005 amounts also include a $13.6 million charge to GAFRI's life operations related to an unexpected increase in mortality. See Item 7 - "Results of Operations."
Includes pre-tax charge of $9.5 million related to environmental liabilities associated with the Company's former manufacturing operations. See Note M to the Financial Statements.
In total, these real estate investments had a carrying value at December 31, 2006 of approximately $78 million (net of $10 million of accumulated depreciation) and operating cash flows of approximately $10.4 million in 2006. At December 31, 2005, real estate investments had a carrying value of approximately $118 million (net of $27 million of accumulated depreciation) and operating cash flows of approximately $15.8 million in 2005.
In October 2005, GAFRI completed the sale of the Driskill Hotel in Austin, Texas for $53 million and recorded an after-tax gain of approximately $10.7 million.
From time-to-time, GAFRI may decide to sell or market for sale selected real estate investments. These decisions are based on factors impacting the operations and value of specific properties or real estate investments in general. No assurance can be given as to the outcome of any marketing of these investments, including the sales price. GAFRI may decide to purchase and/or sell additional real estate investments in the future.
* Includes income on fixed maturities, mortgage loans, policy loans and short-term investments.
GAFRI's investment portfolio is managed by a subsidiary of AFG. Investment expenses included investment management charges from this subsidiary amounting to $3.9 million in 2006, $4.9 million in 2005 and $3.9 million in 2004.
In the fourth quarter of 2006, GAFRI completed its annual impairment test which resulted in a goodwill impairment charge of $4.2 million related to an insurance agency subsidiary in the fixed annuity segment. A review for impairment was prompted by a decrease in estimated future earnings from this agency, based on a reduction in forecasted revenues. Fair value of the agency was estimated using the present value of expected future cash flows.
The unrealized DPAC adjustment reflects the change in DPAC assuming the unrealized gains on securities had actually been realized (see Note B to the Financial Statements).
* Called for redemption in 2007 (see Note Q to the Financial Statements).
To achieve its desired balance between fixed and variable rate debt, GAFRI entered into interest rate swaps, which effectively convert its 6-7/8% Senior Notes to a floating rate of 3-month LIBOR plus 2.9% (effective rate of approximately 8.3% and 7.4% at December 31, 2006 and 2005, respectively).
Cash interest payments, net of swap interest received, were $21.1 million, $26.7 million, and $27.4 million in 2006, 2005 and 2004, respectively.
At December 31, 2006, there were 6.2 million shares of GAFRI Common Stock reserved for issuance under GAFRI's stock option plans. Options are granted with an exercise price equal to the market price of GAFRI Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and generally expire ten years after the date of grant. Data for stock options issued under GAFRI's stock option plans is presented below:
The total intrinsic value of options exercised during 2006, 2005 and 2004 was $2.8 million, $4.8 million and $0.3 million, respectively. During 2006, GAFRI received $4.7 million from the exercise of stock options. The total tax benefit realized from the exercises was $0.5 million.
Comprehensive income is defined as all changes in Stockholders' Equity except those arising from transactions with shareholders. Comprehensive income includes net income and other comprehensive income, which consists of changes in net unrealized gains or losses on available for sale securities. The components of accumulated other comprehensive income (loss) were as follows (in millions):
At December 31, 2006, GAFRI had net operating loss carryforwards ("NOL") for federal income tax purposes of approximately $9.6 million, which are scheduled to expire primarily in 2021. In addition, GAFRI had net capital loss carryforwards for federal income tax purposes of approximately $2.7 million, which are scheduled to expire in 2008.
The American Jobs Creation Act of 2004 ("American Jobs Creation Act") allowed a deduction of 85% of repatriated qualified foreign earnings received as dividends in 2005. GAFRI's subsidiaries paid dividends of $91.8 million that qualified for this special tax treatment. As a result of deferred taxes previously accrued on these earnings, GAFRI only had to record additional income tax expense of $0.8 million in 2005 as a result of the payments of these dividends. Cash tax allocation payments, net of reimbursements, to AFG were $30 million, $24 million and $18 million in 2006, 2005 and 2004, respectively.
The increase in the valuation allowance in 2006 relates to the net operating loss carryforward of an acquired subsidiary.
The likelihood of realizing this asset (due to certain Internal Revenue Code limitations) will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period when the developments on which they are based become known.
Rental expense for operating leases, net of sublease revenues, was $3.6 million, $5.2 million and $7.4 million in 2006, 2005 and 2004, respectively.
The Company's results of operations included charges to increase environmental reserves by $9.5 million in 2005 and $2.0 million in 2004.
Based on the consultants review, the Company believes the remaining cost of environmental work at all sites to range from a low estimate of $7.6 million to a high estimate of $43.3 million. A significant portion of the known costs are associated with long-term remediation and monitoring. Management believes that reserves recorded are sufficient in all material respects to satisfy the known liabilities and that the ultimate cost will not, individually, or in the aggregate, have a material adverse effect on the financial condition or results of operations of GAFRI. However, the regulatory standards for clean-up are continually evolving and may impose more stringent requirements. In addition, many of the environmental investigations at the Company's former operating locations and third-party sites are still preliminary and, where clean-up plans have been proposed, they have not yet received full approval from the relevant regulatory agencies.
There are certain other claims involving the Company, including claims relating to the generation, disposal or release into the environment of allegedly hazardous substances. In management's opinion, the outcomes of these claims will not, individually or in the aggregate, have a material adverse effect on the Company's financial condition.
N. STATUTORY INFORMATION; RESTRICTIONS ON TRANSFERS OF FUNDS AND ASSETS OF
* Does not include approximately $90 million of capital and surplus and AVR of Ceres' insurance subsidiaries.
Dividends that can be paid by GAFRI's insurance subsidiaries without prior approval of regulatory authorities are subject to restrictions relating to capital and surplus and statutory net income. Based on these restrictions, GALIC and Ceres subsidiaries may pay dividends of $121 million and $19 million, respectively, in 2006 without prior approval. In 2006, GALIC paid $147.7 million in dividends.
At December 31, 2006, the aggregate guaranteed minimum death benefit value (assuming every variable annuity policyholder died on those dates) exceeded the fair value of the underlying variable annuities by $59 million, compared to $83 million at December 31, 2005. This benefit is on all of GAFRI's variable annuity policies. Death benefits paid in excess of the variable annuity account balances were $0.4 million, $0.8 million and $1.3 million for 2006, 2005 and 2004, respectively. The weighted average age of these policyholders was 50 years old at December 31, 2006.
Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the seasonal nature of the Company's hotel operations and the discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. The quarterly results also include certain significant items as discussed in Item 7 - "Results of Operations." The following table represents quarterly results of operations for the years ended December 31, 2006 and 2005 (in millions, except per share data).
The information required by the following Items will be included in GAFRI's definitive Proxy Statement for the 2007 Annual Meeting of Stockholders which will be filed with the Securities and Exchange Commission within 120 days of the Company's fiscal year-end and is herein incorporated by reference:
(See Item 5 "Market for Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities")
(a) Includes net unrealized gains on marketable securities of $25.2 million and
(b) Life, accident and health premiums are shown in Column F.
(c) Not applicable - shown as Discontinued Operations on Income Statement.
The names of certain subsidiaries are omitted; as such subsidiaries in the aggregate would not constitute a significant subsidiary.