GAPR rents office space in Puerto Rico totaling approximately 74,000 square feet under leases expiring primarily in 2006 - 2009.
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." The data includes the acquisitions of a fixed annuity block of business written by National Health Insurance Company in May 2004 and Manhattan National Life Insurance Company in June 2002 (in millions, except per share amounts).
GAFRI strengthened its capital and liquidity significantly during 2004. Its stockholders' equity (excluding unrealized gains) grew by more than $98 million (13%) to $878 million and its debt to capital ratio decreased from 31.4% at December 31, 2003 to 28.9% at December 31, 2004. In addition, the combined statutory capital of GAFRI's insurance subsidiaries increased more than $70 million (13%) in 2004.
In January 2004, GAFRI issued just over $86 million of senior debt and used the proceeds to retire higher coupon rate trust preferred securities. In addition, in August 2004, the Company replaced its bank line facility with a four-year agreement maturing in 2008.
GAFRI's net income for 2004 was $101.8 million ($2.15 per diluted share) compared to $49.7 million ($1.13 per diluted share) in 2003 and $16.2 million ($0.38 per diluted share) in 2002. GAFRI's 2004 results reflect significantly higher realized gains on investments and improved operating results in each of the Company's lines of business. These items were partially offset by an accounting change in 2004, as well as the effect of the issuance in late 2003 and early 2004 of long-term debt to pay down bank debt with a lower effective interest rate having a shorter maturity, resulting in higher interest expense in 2004.
The carrying value of certain assets and liabilities (primarily deferred policy acquisition costs ("DPAC"), excess deaths and annuity reserves ("EDAR") and unearned revenues ("UREV")) are based, in part, upon assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Actual results have varied from these assumptions in the past and have caused these accounting estimates to change (see "Results of Operations - Insurance Acquisition Expenses"), and could cause the Company's accounting estimates to change in the future.
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-14c) 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. There have been no significant changes in GAFRI's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
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, 2004, based on the criteria set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In conducting GAFRI's evaluation of the effectiveness of its internal control over financial reporting, GAFRI has excluded the 2004 acquisition of the fixed annuity business of National Health Insurance Company. Under applicable rules, we were not required to test internal controls with respect to the NHIC block for the report as of December 31, 2004. This acquisition constituted less than 7% of total assets as of December 31, 2004, and less than 3% of total revenues and less than 2% of net earnings for the year then ended. Refer to Note C to the consolidated financial statements for further discussion of this acquisition.
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 the fixed annuity business of National Health Insurance Company, which is included in the 2004 consolidated financial statements of Great American Financial Resources, Inc. and constituted less than 7% of total assets as of December 31, 2004 and less than 3% of total revenues and less than 2% 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 2004. Our audit of internal control over financial reporting of GAFRI also did not include an evaluation of the internal control over financial reporting of the entity referred to above.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Great American Financial Resources, Inc. as of December 31, 2004 and 2003 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, 2004 and our report dated March 9, 2005 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheet of Great American Financial Resources, Inc. and subsidiaries as of December 31, 2004 and 2003, 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, 2004. 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, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, 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.
Under 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 (including realized gains and losses) of the retained assets. Effective October 1, 2003, the Company implemented SFAS No. 133 Implementation Issue B36 ("B36")"Embedded Derivatives in Reinsurance Contracts." Under B36, these reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) 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. As permitted under B36, the Company reclassified the securities related to these transactions from "available-for-sale" to "trading." The $16.1 million cumulative effect of marking to market the derivatives embedded in the payables at October 1, 2003, was offset by the initial effect of transferring the related securities from available-for-sale to trading. The mark to market on the embedded derivatives offsets the investment income recorded on the mark to market 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 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.
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. Prior to the adoption of SOP 03-1, death benefits in excess of the variable annuity account balances were expensed when paid.
For interest sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses. Surrender benefits reduce the account value. Death benefits are expensed when incurred, net of the account value.
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.
The following table illustrates the effect on net income and earnings per share had compensation cost been recognized and determined based on the fair values at grant dates consistent with the method prescribed by SFAS No. 123. See Note J "Stockholders' Equity" for further information on stock options.
For SFAS No. 123 purposes, the "fair value" of $4.63 per option granted in 2004, $4.80 in 2003 and $6.23 in 2002 was calculated using the Black-Scholes option pricing model and the following assumptions: dividend yield of less than 1%; expected volatility of 20% for 2004, 2003 and 2002; risk-free interest rate of 4% for 2004, 3% for 2003 and 5% for 2002; and expected option life of 7.5 years. There is no single reliable
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payments." SFAS 123(R) revises SFAS 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS 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 fair value at the date of grant. GAFRI expects to implement the new standard on July 1, 2005 on a prospective basis. After that date, all share-based grants will be recognized as compensation expense over the vesting period. While GAFRI currently uses the Black-Scholes pricing model to measure the fair value of stock options for purposes of disclosing pro forma earnings, the use of other models is also permitted. GAFRI has not yet determined which model it will use to measure the fair value of future stock option grants.
For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include annuity receipts, benefits and withdrawals and obtaining resources from owners and providing them with a return on their investments. All other activities are considered "operating." Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
Methods and assumptions used in estimating fair values are described in Note O 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.
GAFRI's life and annuity operations offer fixed and variable annuity 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 the second quarter of 2004, GAFRI suspended new sales of these life insurance products due to inadequate volume and returns. The Company will continue to service its in-force block of these policies. The Company continues to sell life products through its supplemental insurance operations and GA Life of Puerto Rico (see below).
GAFRI's supplemental insurance businesses (United Teacher Associates Insurance Company ("UTA") and Loyal American Life Insurance Company) offer a variety of limited benefit policies to supplement primary health insurance and other insurance coverage. UTA offers its products through independent agents.
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 (in millions).
securities. Management believes that GAFRI will recover its cost basis in the securities having unrealized losses at December 31, 2004. GAFRI has the ability and intent to hold such securities until they recover in value or mature.
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, 2004 and December 31, 2003.
At December 31, 2004, 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.
The table below summarizes the real estate investments in GAFRI's portfolio at December 31, 2004.
* Includes income on fixed maturities, mortgage loans, policy loans and
GAFRI completed its initial impairment test in the fourth quarter of 2002, which resulted in a $17.7 million after-tax ($0.41 per share) impairment charge reported by restating first quarter 2002 results for the cumulative effect of a change in accounting principle. The impairment charge recorded was primarily related to a decrease in estimated future earnings of two subsidiaries based upon lower forecasted new business sales.
In the third quarter of 2004, GAFRI recorded a goodwill impairment charge of $4.0 million related to an insurance agency subsidiary in the life and 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.
*Reflects the change in DPAC assuming the unrealized gains on securities had actually been realized (see Note B).
The interest accrual rates used for PVFP range primarily from 4% to 7%. During each of the next five years, the PVFP is expected to decrease at a rate of approximately 14% of the balance at the beginning of each respective year.
Included in DPAC at December 31, 2004, are unamortized sales inducements of $63.6 million. As a result of adopting SOP 03-1, unamortized insurance acquisition costs increased by $50 million due to required balance sheet reclassifications. During 2004, the Company capitalized $9.6 million relating to sales inducement and amortized $7.7 million. Included in PVFP at December 31, 2004 is an estimate of $15.6 million relating to the May 2004 acquisition of the fixed annuity business of NHIC. The PVFP amounts in the table above are net of $73.2 million and $65.8 million of accumulated amortization at December 31, 2004 and December 31, 2003, respectively. Amortization of the PVFP was $7.4 million in 2004 compared to $8.5 million in 2003.
In August 2004, AAG Holding replaced its existing bank credit agreement with a $150 million unsecured, four-year credit facility. Amounts borrowed will bear interest at rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating. Loans under this agreement will mature on August 28, 2008 (or February 26, 2008, if the Company's senior notes have not been effectively retired). No bank borrowings were outstanding at December 31, 2004 and 2003.
GAFRI has 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%. The swaps realign GAFRI's mix of floating and fixed rate debt. At December 31, 2004, the effective interest rate on this debt was approximately 5.4%.
In January 2004, the Company issued $86.3 million of 7-1/4%, 30-year Senior Debentures, using the proceeds to redeem its 9-1/4% trust preferred securities at face value and to repurchase a portion of its outstanding 8-7/8% preferred securities.
At December 31, 2004, scheduled principal payments on debt for the subsequent five years were as follows (in millions):
under FIN 46. Accordingly, the subordinated debt due the trusts is shown as a liability in GAFRI's balance sheet. The preferred securities supported by the payable to subsidiary trusts consisted of the following:
In the first quarter of 2004, GAFRI redeemed all of its 9-1/4% trust preferred securities at face value and repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash, recognizing a pretax charge of $1.3 million.
The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Consolidated Income Statement (in millions).
At December 31, 2004, GAFRI had net operating loss carryforwards for federal income tax purposes of approximately $5.4 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 $13.9 million, which are scheduled to expire in 2006 and 2008.
Cash tax allocation payments to AFG were $18 million, $5 million and $32 million in 2004, 2003 and 2002, respectively.
GAFRI's wholly owned subsidiary, Great American Life Assurance Company of Puerto Rico ("GAPR"), is currently analyzing the impact of remitting up to $45 million of qualified foreign earnings under this provision. As a result of deferred taxes previously accrued on these earnings, GAFRI anticipates there will be no additional income tax expense upon the repatriation. Due to the current uncertainty, no impact has been reflected in the current financial statements or accompanying footnotes.
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, 2004 are payable as follows: 2005 - $5.2 million; 2006 - $4.5 million; 2007 - $3.1 million; 2008 - $1.6 million; 2009 - $1.3 million; 2010 and beyond- $4.2 million. In addition, GAFRI has land leases with 6 years and 92 years remaining at two of its real estate properties. Minimum lease payments under these leases are expected to be approximately $170,000 in 2005 and are adjusted annually for inflation.
Rental expense for operating leases, net of sublease revenues, was $7.4 million in 2004 and $7.0 million in each of 2003 and 2002.
Insurance companies are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Certain statutory amounts for GALIC, GAFRI's primary insurance subsidiary, were as follows (in millions):
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 GAPR may pay dividends of $81 million and $42.4 million, respectively, in 2005 without prior approval. In 2004, GALIC paid $53.0 million in dividends and GAPR paid $1.5 million in dividends to GAFRI.
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. In December 2003, the ethanol company repaid GAFRI $4.0 million under a subordinated note that bore interest at 14%.
In order to take advantage of operational efficiencies, GAFRI shares certain information technology services with AFG. GAFRI paid approximately $2 million in 2004 and $3 million in 2003 and 2002 to AFG for these services.
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 loans from several banks, including $3.4 million in loans and fees to the Provident Bank. GAFRI's investment was subsequently redeemed for
$15.9 million. At the time of the transaction, GAFRI's Chairman and members of his immediate family owned approximately one-fourth of Provident's parent company.
At December 31, 2004, the aggregate guaranteed minimum death benefit value (assuming every policyholder died on those dates) exceeded the market value of the underlying variable annuities by $106 million, compared to $142 million at December 31, 2004. This benefit is on all of GAFRI's variable annuity policies. Death benefits paid in excess of the variable annuity account balances were $1.3 million, $1.2 million and $1.1 million for 2004, 2003 and 2002, respectively.
The Company has reinsured approximately $26 billion and $28 billion in face amount of life insurance as of December 31, 2004 and 2003, respectively. Life premiums ceded were $86 million, $85 million and $61 million for 2004, 2003 and 2002, respectively.
Assignment of Tax Allocation Payments dated December 31, 1992, between American Financial Corporation and the Registrant incorporated herein by reference to Exhibit 10.15 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993.
Agreement for the Allocation of Federal Income Taxes dated May 13, 1974, between American Financial Corporation and Great American Life Insurance Company, as supplemented on January 1, 1987 incorporated herein by reference to Exhibit 10.16 to the Registrant's Registration Statement on Form S-2 dated January 7, 1993.