GAFRI owns a building in Austin, Texas totaling approximately 40,000 square feet which is used by UTA for its own operations.
Management believes that its corporate offices are generally well maintained and adequate for the Company's present needs. However, significant growth or consolidation of operations could result in additional office space requirements.
At the same time, perfectly matched durations can often be overly risk-averse, resulting in less than optimal profits and added exposure to the risk of falling interest rates. The merit of a modest amount of mismatch depends on current market conditions. At December 31, 2006, the duration of GAFRI's assets and liabilities were 5.3 years and 5.4 years, respectively.
At December 31, 2006, the fair value of GAFRI's fixed maturity portfolio was approximately 0.2% higher than its book value. If interest rates were to immediately increase 50 basis points from levels at December 31, 2006, GAFRI estimates that the fair value of the Company's fixed maturity portfolio would be approximately 2.5% lower than its book value. Under this scenario, higher than expected surrenders would have very little impact on the liquidity, earnings or capital of GAFRI or its subsidiaries.
GAFRI seeks to earn a stable and appropriate spread between investment income and interest credited on its fixed annuity products. Adverse experience on investments may cause spreads to be reduced. Alternatively, if GAFRI seeks to maintain spreads, crediting rates may not be competitive in the marketplace, which could result in adverse policy surrender experience and the need to liquidate a portion of the investment portfolio at a loss, or use funds from new sales in order to fund cash surrender value benefits.
GAFRI's traditional fixed annuity reserves comprise approximately 70% of the Company's total insurance reserves. GAFRI may adjust renewal crediting rates on its deferred annuities monthly or quarterly, subject to guaranteed minimum interest rates ("GMIR") ranging from 1% to 4% and other contractual guarantees. The higher minimums apply to in-force blocks of older products that are no longer marketed. Many annuity insurance customers have the right to surrender their policies at account value less a surrender charge that grades to zero over periods that generally range from 5 to 10 years from policy issue date. In some cases, policyholders can only gain the benefit of a higher-tier accumulation rate upon death, or if they annuitize rather than surrender. In other cases, a market value adjustment may also apply. Due to GAFRI's ability to change crediting rates to reflect investment experience on the majority of its traditional annuity products, the underlying assets are assumed to be a good balance for the interest rate risk inherent in these liabilities. The Company believes this assumption is appropriate for probable movements in interest rates over the next 12 months.
Interest rates have generally been low in recent years. Should interest rates remain at December 31, 2006 levels, the average earned rate of return on GAFRI's annuity investment portfolios will decline. Declining portfolio yields may cause the spreads between investment portfolio yields and the interest rate credited to policyholders to narrow, as GAFRI's ability to manage spreads can become limited by GMIRs on its fixed annuity policies. The GMIRs on annuity policies range from 1% to 4%, with a weighted average guaranteed rate of approximately 3.4%. The following table provides detail of the differences between the current interest rates being credited to policyholders and the respective GMIRs at the end of 2006. As of December 31, 2006, new policies are being issued with a GMIR of 3%.
The maturity structure and call provisions of a portion of GAFRI's investment asset portfolio are constructed to afford some protection against erosion of investment portfolio yields during periods of declining interest rates. GAFRI devotes extensive effort to evaluating the risks associated with falling interest rates by simulating asset and liability cash flows for a wide range of interest rate scenarios. GAFRI seeks to manage these exposures by maintaining a suitable maturity structure and by limiting its exposure to call risk in its investment portfolios. For a discussion of GAFRI's investment in mortgage-backed securities, see "Investments."
Variable annuity policyholders may choose to invest a portion of their funds in a "fixed" option; these fixed funds represented less than 2% of GAFRI's total insurance reserves at December 31, 2006, and have interest rate risk similar to other fixed annuities. (For additional information on risks associated with GAFRI's variable annuities, see Note O to the Financial Statements.)
The Company believes its exposure to interest rate risk will not result in a material impact on capital, earnings, operations or liquidity. In the unlikely event that a material impact occurs, GAFRI believes that it has adequate resources to meet its liquidity or capital needs (see "Liquidity and Capital Resources").
Significant accounting policies are described in Note B to the Financial Statements. The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the following items are the areas where
GAFRI's chief executive officer and chief financial officer, with the participation of management, have evaluated GAFRI's disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rule 13a-14(c)) as of a date within 90 days prior to filing this report. Based on the evaluation, they concluded that the controls and procedures are effective. During the fourth quarter of 2006, there have been no changes in GAFRI's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, GAFRI's internal controls over financial reporting. During the fourth quarter of 2006, modifications were made to the controls of certain of GAFRI's information systems to modify the procedures with respect to emergency access by programmers. During the quarter, modifications were made to certain procedures with respect to the quarterly financial statement close process at the Company's operations in Austin, Texas. However, the related business processes and procedures did not materially change as a result of the modifications and, accordingly, management does not believe such changes are likely to materially affect GAFRI's internal controls over financial reporting.
In conducting GAFRI's evaluation of the effectiveness of its internal control over financial reporting, GAFRI has excluded the 2006 acquisition of Ceres Group, Inc. This acquisition 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. Refer to Note D to the consolidated financial statements for further discussion of this acquisition.
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, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. 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.
Great American Financial Resources, Inc. ("GAFRI" or "the Company"), through its subsidiaries, markets fixed, indexed and variable annuities, and various forms of supplemental insurance through independent agents. To a lesser extent, the Company also markets certain of its supplemental insurance products through a captive agency force.
American Financial Group, Inc. ("AFG") and its subsidiaries owned 81% of GAFRI's Common Stock at December 31, 2006. See Note Q to the Financial Statements for information regarding AFG's proposed merger transaction with GAFRI.
Fixed maturity securities and equity securities classified as "available-for-sale" are reported at fair value with unrealized gains and losses reported as a separate component of stockholders' equity. Fixed maturities classified as "trading" are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Short-term investments are carried at cost; mortgage loans on real estate are carried at the unpaid principal balance adjusted for any unamortized premium or discounts; and policy loans are carried at the aggregate unpaid balance. Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
Derivatives included in GAFRI's balance sheet are recorded at fair value and consist primarily of (i) the interest component of certain life reinsurance contracts (included in other liabilities), (ii) interest rate swaps (included in long-term debt), (iii) the equity-based component of certain indexed-annuity products (included in annuity benefits accumulated), and (iv) related call options (included in other assets) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those indexed-annuity products. Changes in the fair value of derivatives are included in current earnings.
Under certain of these agreements, GAFRI's insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses.
The PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
GAFRI's variable annuity contracts contain a guaranteed minimum death benefit ("GMDB") to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder's account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.
Two wholly-owned subsidiary trusts were formed to issue preferred securities and, in turn, purchase a like amount of subordinated debt from their parent company. Interest and principal payments from the parent fund the respective trust obligations. Accordingly, the subordinated debt due to the trusts is shown as "Long-term debt" in the Balance Sheet, and the related interest expense is included in "Interest and debt expenses" in the Income Statement.
Under a tax agreement with AFG that became effective in 2006, GAFRI and its subsidiaries in the consolidated tax return group generally pay or recover taxes based on each subsidiary's contribution to amounts due under AFG's consolidated return. The tax allocation agreements with AFG have not impacted the recognition of income tax expense and income tax payable in GAFRI's financial statements. 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.
Deferred income tax assets and liabilities are determined based on differences between financial reporting and tax basis and are measured using enacted tax rates. The Company recognizes deferred tax assets if it is more likely than not that a benefit will be realized. Current and deferred tax assets and liabilities of companies in AFG's consolidated tax group are aggregated with other amounts receivable from or payable to affiliates. Current and deferred tax assets and liabilities of companies not in AFG's consolidated tax group are shown in "Other liabilities" in the Balance Sheet.
FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)" ("FIN 48") is effective for fiscal years beginning after December 15, 2006. FIN 48 sets forth criteria for recognition and measurement of tax positions taken or expected to be taken in a tax return. FIN 48 requires that companies recognize the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods and disclosure. Management is currently evaluating the impact of adopting this interpretation and anticipates that it will not have a significant impact on GAFRI's results of operations or financial condition.
Prior to the implementation of SFAS No. 123(R), GAFRI accounted for stock options and other stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under this method, no compensation expense for stock option grants was recognized because options were granted at exercise prices equal to the fair value of the shares at the dates of grant. See Note J to the Financial Statements for further information on stock options.
Prior to July 1, 2006, the Company maintained a defined contribution plan that combined a retirement plan and 401(k) plan. Effective that date, the Company's plan was merged with a similar plan sponsored by AFG. As a result, Company employees who meet the eligibility requirements participate in that plan. At the discretion of the GAFRI Board of Directors, GAFRI makes all contributions to the retirement fund portion of the Plan and matches a percentage of employee contributions to the savings fund. Employees are permitted to direct the investment of all contributions to independently managed investment securities as well as funds comprised of GAFRI and AFG securities. Company contributions are expensed in the year for which they are declared.
Basic earnings per share is calculated using the weighted-average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes the following dilutive effect of common stock options: 2006 - 0.7 million shares, 2005 - 0.5 million shares and 2004 - 0.2 million shares.
In January 2006, GAFRI sold Great American Life Assurance Company of Puerto Rico ("GA-PR") for $37.5 million in cash. In connection with the sale, a $7.9 million letter of credit was established to provide for potential liabilities. Prior to the sale, in December 2005, GA-PR reinsured approximately two-thirds of its in-force business with the buyer for $60 million. During 2005, GA-PR paid dividends totaling $100 million to GAFRI.
On August 7, 2006, GAFRI (parent) acquired all of the outstanding shares of Ceres Group, Inc. for approximately $204 million in cash (excluding approximately $8 million of direct transaction costs), using cash on hand and borrowings under its bank line of credit. Prior to the acquisition, Ceres (through its two primary insurance subsidiaries, Continental General Insurance Company ("CGIC") and Central Reserve Life Insurance Company ("CRLIC")) sold health and life insurance products through two primary business segments and had assets of approximately $770 million at December 31, 2005. Its senior segment includes Medicare supplement and other senior health, life and annuity products for individuals age 55 and over. Its medical segment included major medical health insurance for individuals, families, associations and small businesses.
In connection with the acquisition, Ceres' insurance subsidiaries entered into a reinsurance agreement under which all of Ceres' medical business was ceded to an unaffiliated company. In addition, immediately prior to the completion of the acquisition, half of Ceres' in-force senior business was ceded to an unaffiliated company. Ceres' insurance subsidiaries received pre-tax ceding commissions totaling $64 million in connection with the reinsurance transactions. Also prior to the acquisition, the insurance subsidiaries paid dividends totaling $68 million to Ceres. Following the acquisition, Ceres distributed $60 million to GAFRI. GAFRI used a portion of the distribution to repay all amounts borrowed under its bank line in connection with the acquisition. The operating results of Ceres are reflected in the accompanying financial statements since the date of acquisition.
GAFRI views this acquisition as (i) an effective use of its excess capital and (ii) a source of premium and earnings diversification. In addition, GAFRI believes the acquisition of Ceres strengthens its Medicare Supplement operations by placing GAFRI in the top 10 in the U.S. in terms of Medicare Supplement premiums and by broadening its distribution capabilities through Ceres' captive agency force; these factors contributed to the goodwill created in this acquisition. None of the goodwill is deductible for income tax purposes.
The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition (in millions):
Pro forma results of operations for the year ended December 31, 2006, assuming the acquisition of Ceres had taken place at the beginning of 2006, would not differ significantly from actual reported results.
Revenue from GAFRI's annuity operations consist primarily of investment income as well as operating revenues from its real estate investments. GAFRI's annuity products are sold through independent agents primarily to employees of primary and secondary educational institutions and in the non-qualified markets. GAFRI is engaged in a variety of real estate operations including hotels and marinas.
"Corporate and other" consists primarily of GAFRI (parent) and AAG Holding (intermediate holding company) and includes interest expense.
Includes $4.9 million of income resulting from a March 2006 payment received from Palm Beach County, Florida in exchange for the imposition of certain limitations on future development of a marina owned by the Company.
The table below sets forth the scheduled maturities of GAFRI's fixed maturity investments as of December 31, 2006. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. The average maturity of GAFRI's fixed maturity investments was approximately seven and one-half years at December 31, 2006. Mortgage-backed securities had an average life of approximately seven years at December 31, 2006.
At December 31, 2006, 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.
In addition to adjusting securities considered available-for-sale to fair value, SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities," requires that certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments had these gains or losses actually been realized. The following table shows the components of the unrealized gain (loss) on marketable securities (included in accumulated other comprehensive income on the Balance Sheet) and its effect on various balance sheet captions (in millions).
A portion of GAFRI's investment portfolio has historically been comprised of certain real estate investments. These real estate investments are generally acquired with the intention of owning and operating them for a long-term holding period. The table below summarizes the real estate investments in GAFRI's portfolio at December 31, 2006.
In June 2006, GAFRI completed the sale of the Chatham Bars Inn on Cape Cod, Massachusetts for $166 million and recorded an after-tax gain of approximately $31.6 million. Included in mortgage loans at December 31, 2006 is an $86 million mortgage loan issued in connection with the sale of Chatham Bars Inn.
Long-term debt consisted of the following at December 31, (in millions):
In March 2006, the Company replaced its existing $165 million bank credit agreement with a $500 million five-year revolving credit facility shared with AFG. Under terms of the agreement, GAFRI may borrow up to $175 million with the ability to borrow up to $200 million, conditioned on AFG not borrowing in excess of $300 million. AFG has agreed with GAFRI not to borrow more than $325 million under the credit facility and has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. No amounts were borrowed under these agreements at December 31, 2006 or December 31, 2005.
At December 31, 2006, GAFRI had virtually no scheduled principal payments on debt for the next five years other than AAG Holding's Senior Notes due in 2008. See Note Q to the Financial Statements for information regarding the redemption of the Company's 8-7/8% trust preferred securities.
GAFRI uses the Black-Scholes option-pricing model to calculate the "fair value" of its option grants. GAFRI began using the SEC's simplified method of calculating expected term with its 2006 grants. The fair value of options granted in 2006, 2005 and 2004 was $6.38 per share, $5.28 per share and $4.63 per share, respectively, based on the following assumptions: dividend yield of less than 1%; expected volatility of 20% (due to limited trading volume of GAFRI's common stock, implied volatility of a peer group's publicly traded options was used); risk-free interest rate of 4.6% in 2006, 4.3% in 2005 and 3.7% in 2004; and expected option life of 6.5 years for 2006 and 7.5 years for 2005 and 2004.
GAFRI's total stock compensation expense for 2006 was $2.2 million. Related tax benefits totaled $0.4 million for the year. As of December 31, 2006, there was a total of $5.6 million of total unrecognized compensation expense related to nonvested stock options granted under GAFRI's plan. That cost is expected to be recognized over a weighted average of 3.3 years.
The following table illustrates the effect on net income (in millions) and earnings per share for the years ended 2005 and 2004, had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the methods used beginning in 2006.
Future minimum lease payments, net of sublease revenues, under operating leases having initial or remaining non-cancelable lease terms in excess of one year at December 31, 2006 are payable as follows: 2007 - $4.6 million; 2008 - $4.9 million; 2009 - $4.8 million; 2010 - $4.7 million; 2011 - $4.8 million; 2012 and beyond- $9.6 million.
The Company's balance sheet includes a liability of approximately $13.4 million at December 31, 2006 and $15 million at December 31, 2005 for the estimated future costs of environmental clean-up activities at certain sites from the Company's former manufacturing operations as well as third-party sites. The Company performs an in-depth review of this reserve on an annual basis as well as more limited reviews on a quarterly basis. For the annual review, the Company receives written reports from consultants responsible for each of the sites, which provide a range of estimated future costs. These reports are then used as a starting point to arrive at management's best estimate of the total future costs. On a quarterly basis, Company personnel review information on each of the involved sites to determine whether any events have occurred that have caused information on the estimated future costs to be materially different than those estimated at the prior year-end. Variances can be caused by changes in the extent of the environmental problem or the costs of remediation. From year-to-year, estimates of future costs have varied as more complete knowledge of the extent of clean-up costs have been obtained.
Further, the presence of Company-generated wastes at third-party disposal sites exposes the Company to joint and several liability for the potential additional costs of cleaning up wastes generated by others. Accordingly, there can be no assurance that the costs of environmental clean-up for the Company may not be significantly higher in future years, possibly necessitating additional charges.
For statutory purposes, the acquisitions of the fixed annuity block of business of Old Standard and NHIC were recorded as reinsurance transactions under which GAFRI was paid negative ceding commissions of $9 million and $38 million, respectively, to assume the blocks of business.
Securities owned by insurance subsidiaries having a carrying value of $70 million at December 31, 2006 were on deposit as required by regulatory authorities.
In order to take advantage of operational efficiencies, GAFRI shares certain information technology services with AFG. GAFRI paid approximately $2 million, $3 million and $2 million in 2006, 2005 and 2004, respectively, to AFG for these services.
At December 31, 2006, GAFRI had a liability for EDAR of approximately $200 million to cover the excess benefits above the lower-tier value. The net amount at risk associated with these benefits was approximately $440 million and the weighted average attained age of contract holders was 63 years old at December 31, 2006. During 2006, GAFRI expensed $24.0 million for excess death and annuitization benefits, which is included in "Annuity benefits" on the Consolidated Income Statement and paid $28.7 million associated with those benefits.
The decrease in provision for benefits of prior years is primarily due to better claims development than anticipated.
The Company has reinsured approximately $23 billion in face amount of life insurance, excluding GA-PR, as of December 31, 2006 and 2005 respectively. Life premiums ceded, excluding GA-PR, were $65 million, $68 million and $86 million for 2006, 2005 and 2004, respectively.
Selected Quarterly Financial Data is included in Note P to the Consolidated Financial Statements.
Tax allocation agreement dated as of December 31, 2005 by and between American Financial Group, Inc. and its subsidiaries.
Common Stock Registration Agreement, dated December 31, 1992, between the Registrant and American Financial Corporation and its wholly-owned subsidiary Great American Insurance Company incorporated herein by reference to Exhibit 10.22 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993.
The following is a list of subsidiaries of GAFRI at December 31, 2006. All corporations are subsidiaries of GAFRI and, if indented, subsidiaries of the company under which they are listed.
We consent to the incorporation by reference in the following Registration Statements and related Prospectuses of Great American Financial Resources, Inc. of our reports dated February 27, 2007 with respect to the consolidated financial statements and schedules of Great American Financial Resources, Inc., Great American Financial Resources, Inc. management's assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of Great American Financial Resources, Inc. included in the Annual Report on Form 10-K for the year ended December 31, 2006.