GAFRI and GALIC rent office space in Cincinnati, Ohio totaling approximately 140,000 square feet under leases expiring in 2011. In addition, GAFRI rents approximately 40,000 square feet in Cincinnati under a lease that expires in August 2006. Several of the Company's subsidiaries lease marketing and administrative offices in locations throughout the United States.
Reflects the results of GA-PR, which was sold in January 2006. See Note C to the Financial Statements.
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 $273 million (41%) to $945 million and its debt to capital ratio decreased from more than 36% to less than 24% (following GAFRI's February 2006 repurchase of debt - See Note I); in addition, the statutory adjusted capital of GAFRI's largest insurance subsidiary increased $247 million (51%) to $733 million.
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 September 30, 2005, the duration of GAFRI's assets and liabilities were 5.3 years and 5.2 years, respectively.
At December 31, 2005, the fair value of GAFRI's fixed maturity portfolio was approximately 1% higher than its book value. If interest rates were to immediately increase 50 basis points from levels at December 31, 2005, GAFRI estimates that the fair value of the Company's fixed maturity portfolio would be approximately 1% 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.
Provided interest rates continue to gradually return to levels that are more typical from a long-term perspective, GAFRI does not view the near-term risk relating to spreads over the next twelve months as being material. Management believes that the impact of the probable range of interest rate changes over the next twelve months will be mitigated by the Company's asset-liability management strategies, flexibility in adjusting policy crediting rate levels and protection afforded by policy surrender charges. The interest rate scenarios that could have a higher negative impact on earnings are those in which there is a substantial, relatively rapid increase or decrease in interest rates that is then sustained over a long period. Management does not believe these scenarios are likely.
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:
Variable annuity policyholders may choose to invest a portion of their funds in a "fixed" option; these fixed funds represented less than 3% of GAFRI's total insurance reserves at December 31, 2005, and have interest rate risk similar to other fixed annuities. (For additional information on risks associated with GAFRI's variable annuities, see Note P.)
Indexed-annuities comprised less than 3% of the Company's insurance reserves at December 31, 2005. 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 a relatively small volume of index options, which hedges the policyholders' index participation, minimizing equity market risk.
Recoverability of Unamortized Insurance Acquisition Costs and Establishment of Insurance Reserves
The carrying value of certain assets and liabilities (primarily deferred policy acquisition costs ("DPAC"), liabilities for excess deaths and annuitization 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. The Company performs an in-depth review of its assumptions and tests for recoverability on an annual basis as well as more limited reviews on a quarterly basis. If necessary, DPAC, UREV and EDAR balances may be adjusted ("unlocked") up or down based on new assumptions.
Approximately 40% of GAFRI's fixed annuity liabilities at December 31, 2005, 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 ($175 million at December 31, 2005) 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,"
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
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, 2005 and 2004, 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, 2005, and our report dated February 28, 2006 expressed an unqualified opinion thereon.
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, 2005, 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 28, 2006 expressed an unqualified opinion thereon.
Great American Financial Resources, Inc. ("GAFRI" or "the Company"), through its subsidiaries, markets fixed and variable annuities, and various forms of supplemental insurance through independent agents.
American Financial Group, Inc. ("AFG") and its subsidiaries owned 82% of GAFRI's Common Stock at December 31, 2005.
The terms of the interest rate swaps match those of the hedged debt; therefore, the swaps are considered to be (and are accounted for as) 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 notes payable 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.
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. Effective October 1, 2003, the Company implemented Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue B36 ("B36"). Under B36, 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 a change 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 adjusting to fair value 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 adjustment to fair value of the related trading portfolios.
As a result of the 2004 implementation of Statement of Position ("SOP") 03-1, reserves for two-tier annuities (annuities with different stated account values depending on whether a policyholder annuitizes, dies or surrenders) are 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.
As permitted under SFAS No. 123, "Accounting for Stock-Based Compensation," GAFRI accounts for stock options and other stock-based compensation plans using the intrinsic value based method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under GAFRI's employee and director stock option plans, options are granted at exercise prices equal to the fair value of the shares at the date of grant. No compensation expense has been recognized for employee and director stock option grants.
For SFAS No. 123 purposes, the "fair value" of $5.28 per option granted in 2005, $4.63 in 2004 and $4.80 in 2003 was calculated using the Black-Scholes option pricing model and the following assumptions: dividend yield of less than 1%; expected volatility of 20% for 2005, 2004 and 2003; risk-free interest rate of 4% for 2005 and 2004 and 3% for 2003; and expected option life of 7.5 years. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value."
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payments." SFAS No. 123(R) revises SFAS No. 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS No. 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the non-vested portions of prior awards, based on their fair value at the date of grant. GAFRI will implement the new standard on January 1, 2006 on a modified prospective basis. After that date, all share-based grants will be recognized as compensation expense over the vesting period. GAFRI intends to use the Black-Scholes pricing model to measure the fair value of stock options. Had GAFRI adopted SFAS No. 123(R) in prior periods, the impact on net earnings and earnings per share would have been similar to the proforma amounts discussed above.
GA-PR's results are reflected as discontinued for all periods presented in the Consolidated Income Statement; Balance Sheet amounts have not been reclassified. The carrying amount of the major classes of GA-PR's assets and liabilities and a summary of the discontinued operations follow (in millions):
The decrease in cash and investments in 2005 reflects the dividends paid by GA-PR to GAFRI. The decrease in DPAC in 2005 reflects the reinsurance transaction with Triple-S.
In May 2004, GAFRI acquired the fixed annuity block of business of National Health Insurance Company ("NHIC"). See Note O. At the date of acquisition, the block consisted of approximately 33,000 policies with GAAP reserves of approximately $765 million.
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 continues to service its in-force block of these policies.
Includes pre-tax charge of $9.5 million related to environmental liabilities associated with the Company's former manufacturing operations. See Note N.
At December 31, 2005, gross unrealized losses in the 2005 table above relate to 524 securities with no single unrealized loss in excess of $1.4 million. Investment grade securities (as determined by nationally recognized rating agencies) represented about 92% and 95% of the total unrealized loss and fair value, respectively. Of the mortgage-backed securities, more than 98% of the unrealized loss relates to AAA rated securities. Management believes that GAFRI will recover its cost basis in the securities having unrealized losses at December 31, 2005. GAFRI has the ability and intent to hold such securities until they fully recover to amortized cost or mature.
(a) Includes adjustments to reflect the impact of realized gains and losses on the amortization of DPAC.
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, 2005.
In total, these real estate investments had a carrying value at December 31, 2005 of approximately $118 million (net of $27 million of accumulated depreciation) and operating cash flows of approximately $15.8 million in 2005. At December 31, 2004, real estate investments had a carrying value of approximately $109 million (net of $36 million of accumulated depreciation) and operating cash flows of approximately $15.1 million in 2004.
In October 2005, GAFRI completed the sale of the Driskill Hotel in Austin, Texas. Included in other income in 2005 is a gain of approximately $16.5 million after sale expenses, profit sharing payments, and after a write-off of $11.0 million of DPAC associated with the gain.
GAFRI's investment portfolio is managed by a subsidiary of AFG. Investment expenses included investment management charges from this subsidiary amounting to $4.9 million in 2005, $3.9 million in 2004 and $4.4 million in 2003.
In 2004, GAFRI recorded a goodwill impairment charge of $4.0 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.
In the fourth quarter of 2005, GAFRI conducted its annual impairment testing, which resulted in no additional charge.
The decrease in DPAC reflects a reinsurance transaction entered into by GA-PR (see Note C). The unrealized DPAC adjustment reflects the change in DPAC assuming the unrealized gains on securities had actually been realized (see Note B).
A progression of GAFRI's present value of future profits acquired is as follows (in millions):
The interest accrual rates used for PVFP range from 4% to 7%. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
Notes payable consisted of the following at December 31 (in millions):
In January 2004, the Company issued $86.3 million of 7-1/4%, 30-year Senior Debentures, using the proceeds to redeem all of its $65.0 million principal amount of its 9-1/4% trust preferred securities at face value and to repurchase a portion of its outstanding 8-7/8% preferred securities.
* Includes $0.5 million of income related to a foreign subsidiary in India owned by GAFRI; this business was sold in 2003.
At December 31, 2005, GAFRI had net operating loss carryforwards for federal income tax purposes of approximately $1.1 million, which are scheduled to expire primarily in 2006. In addition, GAFRI had net capital loss carryforwards for federal income tax purposes of approximately $3.3 million, which are scheduled to expire in 2008.
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, 2005 are payable as follows: 2006 - $2.3 million; 2007 - $2.4 million; 2008 - $2.4 million; 2009 - $2.4 million; 2010 - $2.5 million; 2011 and beyond- $2.6 million. In addition, GAFRI has land leases with 5 years and 91 years remaining at two of its real estate properties. Minimum lease payments under these leases are expected to be approximately $170,000 in 2006 and are adjusted annually for inflation.
Federal and state laws and regulations, including the Federal Comprehensive Environmental Response, Compensation, and Liability Act and similar state laws, impose liability on the Company, as the successor to Sprague Technologies, Inc., for the investigation and clean-up of hazardous substances disposed of or spilled by its former manufacturing operations at facilities still owned by the Company, and facilities transferred in connection with the sales of certain operations, as well as at disposal sites operated by third parties. In addition, the Company has indemnified the purchasers of its former operations for the cost of such activities. At several sites, the Company is conducting clean-up activities of soil and ground water contamination in accordance with consent agreements between the Company and state environmental agencies. At one site, the Company is performing a remedial investigation feasibility study under an administrative order by consent with federal regulators. The Company has also conducted or is aware of investigations at a number of other locations of its former operations that have disclosed environmental contamination that could cause the Company to incur additional investigative, remedial and legal costs. The Company has also been identified by state and federal regulators as a potentially responsible party at a number of other disposal sites.
At December 31, 2005, based on prior costs and discussion with independent environmental consultants, the Company believes the range of aggregate costs for environmental work at all sites for which it has responsibility is as follows:
O. STATUTORY INFORMATION; RESTRICTIONS ON TRANSFERS OF FUNDS AND ASSETS OF
In order to take advantage of operational efficiencies, GAFRI shares certain information technology services with AFG. GAFRI paid approximately $3 million, $2 million and $3 million in 2005, 2004 and 2003, respectively, to AFG for these services.
At December 31, 2005, GAFRI had a liability for EDAR of $175 million to cover the excess benefits above the lower-tier value. The net amount at risk associated with these benefits was approximately $460 million and the weighted average attained age of contract holders was 63 years old. During 2005, GAFRI expensed $14.6 million for excess death and annuitization benefits, which is included in "Annuity benefits" on the Consolidated Income Statement and paid $16.6 million associated with those benefits.
The information required by the following Items will be included in GAFRI's definitive Proxy Statement for the 2006 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:
The following is a list of subsidiaries of GAFRI at December 31, 2005. All corporations are subsidiaries of GAFRI and, if indented, subsidiaries of the company under which they are listed.