Reflects the implementation of the following accounting changes mandated by recently enacted accounting standards:
GAFRI strengthened its capital and liquidity during 2003 with stockholders' equity (excluding unrealized gains) growing by more than $108 million (16%) to $779.9 million and reduced its debt to capital ratio from 36% at December 31, 2002 to 31% at December 31, 2003. In addition, the combined statutory capital of GAFRI's insurance subsidiaries increased more than $100 million (23%) in 2003.
GAFRI and its subsidiaries completed several major cash transactions in 2003, including the following:
Sold $60 million (4.3 million shares) of Common Stock in a rights offering in September;
GAFRI's consolidated debt to capital ratio was 31% at December 31, 2003 compared to 36% at December 31, 2002. For purposes of this calculation, consolidated debt includes notes payable, payable to subsidiary trusts in 2003 and redeemable preferred securities of consolidated subsidiary trusts in 2002; capital represents the sum of consolidated debt and stockholders' equity (excluding unrealized gains on fixed maturity securities).
To pay interest and principal on borrowings and other holding company costs, GAFRI (parent) and AAG Holding use primarily capital distributions from their directly-owned insurance subsidiaries, (Great American Life Insurance Company ("GALIC") and GA Life of Puerto Rico ("GAPR")), bank borrowings and cash and investments on hand. Capital distributions from GAFRI's insurance subsidiaries are subject to regulatory restrictions relating to statutory surplus and earnings. The maximum amount of dividends payable by GALIC and GAPR in 2004 without prior regulatory approval is $56.5 million and $32.9 million, respectively. In 2003, GALIC paid $11.0 million in dividends and GAPR paid $1.2 million in dividends. In 2003, GAFRI made capital contributions to GALIC of $47.2 million.
The Company has an unsecured bank credit agreement that matures on December 31, 2004. Amounts borrowed bear interest at floating rates based on prime or Eurodollar rates. Almost 75% of the combined net proceeds from a $60 million common stock rights offering in September 2003 and a $112.5 million issuance of 30 year Senior Debentures in November 2003 were used to repay borrowings under GAFRI's bank line. The remaining proceeds were used to increase insurance subsidiary capital and for general corporate purposes. GAFRI's credit agreement provides up to $155 million of availability; there were no borrowings outstanding under the line of credit at March 1, 2004.
GAFRI's operations could be materially and adversely affected by ratings downgrades. In connection with recent reviews by independent rating agencies, management indicated that it intends to maintain lower ratios of debt to capital than it has in recent years and intends to maintain the capital of its significant insurance subsidiaries at levels currently indicated by the rating agencies as appropriate for the current ratings. Items which could adversely affect capital levels include (i) a sustained decrease in the stock market; (ii) a significant period of low interest rates and a resulting significant narrowing of annuity "spread" (the difference between earnings received by the Company on its investments less the amount credited to policyholders' annuity accounts); (iii) investment impairments; (iv) adverse mortality, and (v) higher than planned dividends paid due to liquidity needs by GAFRI and AAG Holding.
GAFRI's investment portfolio at December 31, 2003, contained $7.8 billion in "Fixed maturities" classified as available-for-sale, which are carried at market value with unrealized gains and losses reported as a separate component of stockholders' equity on an after-tax basis. At December 31, 2003, GAFRI had pretax net unrealized gains of $277 million on fixed maturities and $37 million on equity securities.
The NAIC assigns quality ratings to publicly traded as well as privately placed securities. At December 31, 2003, 94% of GAFRI's fixed maturity portfolio was comprised of investment grade bonds (NAIC rating of "1" or "2"). Management believes that a high quality investment portfolio is more likely to generate a stable and predictable investment return.
Summarized information for the unrealized gains and losses recorded in GAFRI's balance sheet at December 31, 2003, is shown in the following table (dollars in millions). Approximately $82 million of "Fixed Maturities" and $6 million of "Equity Securities" had no unrealized gains or losses at December 31, 2003.
GAFRI's investment in equity securities of Provident Financial Group, a Cincinnati-based commercial banking and financial services company, represents $30 million of the $37 million in unrealized gains on equity securities at December 31, 2003.(See Note R)
*Excludes $82 million of fixed maturities with no unrealized gains and losses.
Although GAFRI had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular credit or industry, or to modify asset allocation within the portfolio. None of the securities were sold out of a necessity to raise cash. GAFRI has the ability and intent to hold securities with unrealized losses at December 31, 2003, for a period of time sufficient to allow for a recovery in market value.
The table below (dollars in millions) summarizes the unrealized gains and losses on all securities by dollar amount.
The following table (dollars in millions) summarizes the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Based on its analysis of the factors enumerated above, management believes (i) GAFRI will recover its cost basis in the securities with unrealized losses and (ii) that GAFRI has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required.
While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. While management believes it is not likely that future impairment charges will have a significant effect on GAFRI's liquidity, impairment charges could have an effect on the Company's ratings.
Does not include an $8.4 million write-down of certain collateralized debt obligations, which was recorded as the cumulative effect of an adoption of an accounting change at April 1, 2001.
Projected payments in each of the next five years and for all years thereafter on GAFRI's fixed annuity liabilities at December 31 are as follows (dollars in millions):
Approximately one-half of GAFRI's fixed annuity liabilities at December 31, 2003, were two-tier in nature in that policyholders can receive a higher amount if they annuitize rather than surrender their policy, even if the surrender charge period has expired. At December 31, 2003, the average stated crediting rate on the in-force block of GAFRI's principal fixed annuity products was approximately 4.1%. The current stated crediting rates (excluding bonus interest) on new sales of GAFRI's products generally range from 2.8% to 3.3%. GAFRI estimates that its effective weighted-average crediting rate on its in-force business over the next five years will approximate 3.8%. This rate reflects actuarial assumptions as to: (i) expected investment spread (ii) deaths; (iii) annuitizations; (iv) surrenders and (v) renewal premiums. Actual experience and changes in actuarial assumptions may result in different effective crediting rates than those above.
GAFRI's equity-indexed fixed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. GAFRI attempts to mitigate the risk in the equity-based component of these products through the purchase of call options on the appropriate index. The Company's strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be substantially offset by unrealized and realized gains on the call options purchased by the Company. Under SFAS No. 133, both the equity-based component of the annuities and the related call options are considered derivatives and marked to market through current earnings as annuity benefits.
Adjusting these derivatives to market value had a net effect of less than 1% of annuity benefits in 2003 and 2002. In 2002, GAFRI chose to suspend new sales of equity-indexed annuities due primarily to lack of volume.
In December 2003, GAFRI entered into an interest rate swap agreement under which it effectively converted $40 million principal amount of its 6-7/8% Senior Notes due 2008 from fixed to floating rate interest. At December 31, 2003, the effective interest rate on this debt was approximately 4.1%. The Company expects to enter into similar swap agreements in 2004 covering up to an additional $60 million principal amount of these notes.
In the normal course of business, GAFRI's insurance subsidiaries cede reinsurance to other companies under various coinsurance agreements to diversify risk and limit maximum exposure.
To the extent that any reinsuring companies are unable to meet obligations under agreements covering reinsurance ceded, GAFRI's insurance subsidiaries would remain liable. GAFRI reviews the financial condition of its reinsurers and monitors the amount of reinsurance it has with each company. At December 31, 2003, approximately 25% of the Company's total face amount of life insurance in force was reinsured with a single company.
Proposed Regulatory Changes Various competitors, schools and other entities have proposed measures that would restrict product designs and the number of companies qualified to sell annuities to teachers. In addition, certain school districts have proposed charging policy fees to annuity providers. While efforts in these areas have been largely unsuccessful to date, widespread acceptance of such measures could negatively impact GAFRI's 403(b) annuity operations to the extent the Company's access to school districts is limited or reduced, and to the extent policy fees are not recovered by GAFRI.
Results of operations as shown in the accompanying financial statements are prepared in accordance with generally accepted accounting principles. Operating earnings before income taxes increased $30.7 million in 2003 compared to 2002. The 2003 results reflect significantly lower realized losses on investments and improved operating results in the Company's life, supplemental insurance and variable annuity operations, partially offset by the effects of lower interest rates on the Company's fixed annuity operations.
Variable annuity premiums decreased in 2003 and 2002 compared to 2001, reflecting the poor performance of the stock market and GAFRI's exit from certain segments of the variable annuity market. GAFRI now primarily focuses on selling its variable annuity products in the 403(b) market.
The increase in premiums and benefits for the supplemental insurance products represents the addition of new distribution sources. The increase in supplemental insurance product benefits, due to higher premiums, was partially offset by favorable experience on the Medicare supplement products in 2003 compared to 2002.
Net investment income decreased $16.9 million (3%) in 2003 compared to 2002, due primarily to lower reinvestment rates on GAFRI's fixed maturity portfolio. The yield on GAFRI's fixed maturity portfolio was approximately 6.2% at December 31, 2003 compared to approximately 7.0% at December 31, 2002 and 7.7% at December 31, 2001.
Annuity benefits reflect amounts accrued on annuity policyholders' funds accumulated. On its deferred annuities (annuities in the accumulation phase), GAFRI generally credits interest to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), GAFRI accrues an additional liability to provide for expected deaths and annuitizations. Changes in interest and crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect this accrual.
Historically, management has been able to react to changes in market interest rates and maintain a desired interest rate spread. The recent interest rate environment has resulted in a spread compression that could continue through at least 2004. Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The increase in insurance acquisition expenses in 2002 reflects (i) DPAC write-offs; (ii) the amortization costs associated with GAFRI's purchase of MNL in June 2002 and (iii) higher commission expense due to the Company's growth in premiums. Included in 2002 and 2001 were DPAC write-offs related to variable annuities of $13.5 million and $3.0 million, respectively, resulting from the actual performance of the equity markets and a reduction of assumed future returns.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to further write-offs of DPAC in the future.
The increase in interest and other debt expenses in 2003 compared to 2002 reflects the paydown of lower interest rate bank debt with proceeds from a 7-1/2% Senior Debenture offering in the fourth quarter of 2003.
The Company will adopt the SOP effective January 1, 2004. Although interpretation of accounting for certain items covered by the SOP has not been finalized, the effect of initially adopting this SOP is expected to be less than 2% of stockholders' equity and will be reported as a cumulative effect of a change in accounting principle in the 2004 results of operations. This effect results primarily from the change in accounting for persistency bonuses and the Company's two-tier annuities. GAFRI does not expect that the final amount will have a material adverse impact on the Company.
We have audited the accompanying consolidated balance sheet of Great American Financial Resources, Inc. and subsidiaries as of December 31, 2003 and 2002, 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, 2003. 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.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Great American Financial Resources, Inc. and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In July 2003, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP")03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts."
The most significant accounting implications to GAFRI of the SOP are as follows: (1) changing GAFRI's method of accounting for assets and liabilities related to two-tier annuities and persistency bonuses; (2) amortizing DPAC over the life of deferred annuity contracts excluding the annuitization phase; and (3) establishing an additional liability for guaranteed minimum death benefits for variable annuity contracts.
American Financial Group, Inc. ("AFG") and its subsidiaries owned 82% of GAFRI's Common Stock at December 31, 2003.
Policy acquisition costs (principally commissions, advertising, underwriting, policy issuance and sales expenses that vary with and are primarily related to the production of new business) are deferred to the extent that such costs are deemed recoverable.
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, net" in the stockholders' equity section of the Balance Sheet.
Life and health insurance contracts are reviewed periodically using actuarial assumptions revised based on actual and anticipated experience, to determine if there is a potential premium deficiency. If any such deficiency exists, it is recognized by a charge to income and a reduction in unamortized acquisition costs.
Included in insurance acquisition costs are amounts representing the present value of future profits on business in force of acquired insurance companies, which represent 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.
The liability for future policy benefits for interest sensitive life and universal life policies is equal to the sum of the accumulated fund balances under such policies.
compute taxes on a separate return basis. GALIC is obligated to make payments to (or receive benefits from) AFG based on taxable income without regard to temporary differences. If GALIC's taxable income (computed on a statutory accounting basis) exceeds a current period net operating loss of GAFRI, the taxes payable or receivable by GALIC associated with the excess are payable to or receivable from AFG. If the AFG tax group utilizes any of GAFRI's net operating losses or deductions that originated prior to GAFRI's entering AFG's consolidated tax group, AFG will pay to GAFRI an amount equal to the benefit received. The tax allocation agreements with AFG have not
impacted the recognition of income tax expense and income tax payable in GAFRI's financial statements.
Methods and assumptions used in estimating fair values are described in Note P to the financial statements. These fair values represent point-in-time estimates of value that might not be particularly relevant in predicting GAFRI's future earnings or cash flows.
On June 28, 2002, GAFRI's principal insurance subsidiary acquired Manhattan National Life Insurance Company ("MNL") from a subsidiary of Conseco, Inc. for $48.5 million in cash. While MNL is no longer writing new policies, as of December 31, 2003, it had approximately 80,000 policies in force (primarily term life). GAFRI has reinsured 90% of the business in force.
GAFRI's life and annuity operations offer fixed and variable annuity products and traditional life insurance products. GAFRI's annuity products are sold through managing general agents and independent agents to employees of primary and secondary educational institutions, hospitals and in the non-qualified markets. Traditional term and universal life insurance products had been marketed through national marketing organizations. In May 2004, GAFRI will suspend new sales of these life insurance products due to inadequate volume and returns. The Company will continue to service its in-force block of over 200,000 policies and $37 billion gross ($12 billion, net) of life insurance in force. The Company continues to sell life products through its supplemental insurance operations and GA Life of Puerto Rico (see below.)
GA Life of Puerto Rico ("GAPR") sells in-home life and supplemental health products through a network of company-employed agents. Sales in Puerto Rico accounted for nearly 20% of GAFRI's life, accident and health premiums in 2003.
The following table shows gross unrealized losses on fixed maturities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2003.
Gross gains and losses on fixed maturity transactions included in GAFRI's Consolidated Statement of Cash Flows consisted of the following (in millions):
The table below sets forth the scheduled maturities of GAFRI's fixed maturity investments based on market value as of December 31. Asset-backed securities and other securities with sinking funds are reported at average maturity. Data based on amortized cost is generally the same. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. Mortgage-backed securities had an average life of approximately six and one-half years at December 31, 2003 compared to five and one-fourth years at December 31, 2002.
At December 31, 2003, GAFRI had no single investment in excess of 10% of stockholders' equity except for certain investments guaranteed by the U.S. Government or government agencies.
GAFRI's investment portfolio is managed by a subsidiary of AFG. Investment expenses included investment management charges related to this subsidiary amounting to $4.4 million in 2003, $3.3 million in 2002 and $1.4 million in 2001.
If the goodwill amortization of $1.8 million ($0.04 per share) in 2001 had not been expensed, net earnings for the period would have been $38.8 million ($0.91 per share).
Changes in the carrying value of goodwill during 2002 and 2003, by reporting segment, are presented in the following table (in millions):
2003 amount relates to purchase accounting adjustment for subsidiary acquired; 2002 amount primarily reflects reinsurance ceding of 90% of Manhattan's life business; 2001 amount primarily reflects reinsurance ceding of 80% of Loyal's life business.
AAG Holding has a floating rate $155 million unsecured credit agreement. Loans under the credit agreement mature on December 31, 2004. At December 31, 2003, there were no borrowings outstanding under the agreement. At December 31, 2002, the weighted-average interest rate on amounts borrowed under its credit line was 2.18%.
In December 2003, GAFRI entered into an interest rate swap agreement under which it effectively converted the interest rate on $40 million principal amount of its 6-7/8% Senior Notes due 2008 from fixed to floating rate interest. At December 31, 2003, the effective interest rate on this debt was approximately 4.1%. The Company expects to enter into similar swap agreements in 2004 covering up to an additional $60 million principal amount of these notes.
At December 31, 2003, GAFRI had net operating loss carryforwards for federal income tax purposes of approximately $4 million, which are scheduled to expire primarily in 2005 and 2006. In addition, GAFRI had net capital loss carryforwards for federal income tax purposes of approximately $5.3 million, which are scheduled to expire in 2006 and 2008.
Rental expense for operating leases, net of sublease revenues, was $7.0 million in 2003 and 2002 and $5.5 million in 2001.
In 2000, GAFRI received an $18.9 million subordinated note in connection with the sale of its minority ownership interest in an ethanol company back to that company. Following the sale, GAFRI's Chairman beneficially owned 100% of the ethanol company. The note bore interest at 12-1/4% and was repaid as follows: $6 million in 2001, $1 million in 2002 and the remaining $11.9 million in 2003. The ethanol company also owed GAFRI $4.0 million under a subordinated note bearing interest at 14%, which was repaid in December 2003.
During 2003, GAFRI invested $12 million (and another AFG subsidiary invested $8 million) in preferred stock and warrants of an unrelated party who utilized the proceeds to repay bank loans, including $3.4 million in loans and fees to the Provident Bank. GAFRI's Chairman and members of his immediate family own approximately one-fourth of Provident's parent company.
The decrease in the provision for benefits of prior years for 2003 and 2002 is due primarily to better than expected results in the medicare supplement line of business.
The Company has reinsured approximately $28 billion and $29 billion in face amount of life insurance as of December 31, 2003 and 2002, respectively. Life premiums ceded were $85 million, $61 million and $49 million for 2003, 2002 and 2001, respectively.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Includes net unrealized gains on marketable securities of $162.6 million and
(b) Includes net unrealized gains on marketable securities of $162.6 million and