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HARBINGER GROUP INC. – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operation
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Introduction
This "Management's Discussion and Analysis of Financial Condition and Results of Operations" ofHarbinger Group Inc. ("HGI," "we," "us," "our" and, collectively with its subsidiaries, the "Company") should be read in conjunction with Item 6, "Selected Financial Data," and our accompanying consolidated financial statements and related notes (the "Consolidated Financial Statements") referred to in Item 8 of this Annual Report on Form 10-K (the "Form 10-K"). Certain statements we make under this Item 7 constitute "forward-looking statements" under the Private Securities Litigation Reform Act of 1995. See "Forward-Looking Statements" at the beginning of Part I of this Form 10-K. You should consider our forward-looking statements in light of our Consolidated Financial Statements and other financial information appearing elsewhere in this Form 10-K and our other filings with theSecurities and Exchange Commission (the "SEC").
All references to Fiscal 2012, 2011 and 2010 refer to fiscal periods ended
HGI Overview
We are a holding company and our principal operations are conducted through subsidiaries that offer life insurance and annuity products, and branded consumer products such as batteries, small appliances, pet supplies, home and garden control products and personal care products. Our outstanding common stock is 92.6% owned, collectively, byHarbinger Capital Partners Master Fund I, Ltd. (the "Master Fund "),Global Opportunities Breakaway Ltd. andHarbinger Capital Partners Special Situations Fund, L.P. (together, the "Principal Stockholders"), not giving effect to the conversion rights of the Series A Participating Convertible Preferred Stock or the Series A-2 Participating Convertible Preferred Stock (the "Preferred Stock"). We are focused on obtaining controlling equity stakes in companies that operate across a diversified set of industries and growing acquired businesses. We view the acquisitions in Fiscal 2011 of majority interests inSpectrum Brands Holdings, Inc. ("Spectrum Brands") andFidelity & Guaranty Life Holdings, Inc. ("FGL," formerlyOld Mutual U.S. Life Holdings, Inc. ) as first steps in the implementation of that strategy. In addition to FGL's asset management activities, HGI has begun to expand its asset management business by formingSalus Capital Partners, LLC ("Salus"), a subsidiary engaged in providing secured asset-based loans to entities across a variety of industries. We have identified the following five indicative sectors in which we intend to pursue business opportunities: consumer products/retail, insurance and financial services, energy, natural resources and agriculture. We may also pursue business opportunities in other indicative sectors. In addition to our intention to acquire controlling interests, we may also from time to time make investments in debt instruments, acquire minority equity interests in companies and expand our operating businesses. OnNovember 5, 2012 , we announced a joint venture with EXCO Resources Inc. ("EXCO") to create a private oil and gas limited partnership (the "Partnership") that will purchase and operate EXCO's producing U.S. conventional oil and gas assets, for a total consideration of$725 million (the "EXCO/HGI Production Partners Acquisition.") The Partnership will constitute our initial operating business in the energy sector. We believe that our access to the public equity markets may give us a competitive advantage over privately-held entities with whom we compete to acquire certain target businesses on favorable terms. We may pay acquisition consideration in the form of cash, our debt or equity securities, or a combination thereof. In addition, as a part of our acquisition strategy we may consider raising additional capital through the issuance of equity or debt securities. 93
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We currently operate in two major segments: consumer products through
Consumer Products Segment
ThroughSpectrum Brands , we are a diversified global branded consumer products company with positions in six major product categories: consumer batteries; small appliances; pet supplies; home and garden control products; electric shaving and grooming products and electric personal care products.Spectrum Brands was created in connection with the combination ofSpectrum Brands, Inc. ("SBI") andRussell Hobbs, Inc. ("Russell Hobbs") onJune 16, 2010 (the "SB/RH Merger".)Spectrum Brands manufactures and markets alkaline, zinc carbon and hearing aid batteries, herbicides, insecticides and repellents and specialty pet supplies.Spectrum Brands also designs and markets rechargeable batteries, battery-powered lighting products, electric shavers and accessories, grooming products and hair care appliances. In addition,Spectrum Brands designs, markets and distributes a broad range of branded small appliances and personal care products.Spectrum Brands' operations utilize manufacturing and product development facilities located inthe United States ,Europe ,Latin America andAsia . Substantially, all ofSpectrum Brands' rechargeable batteries and chargers, shaving and grooming products, small household appliances, personal care products and portable lighting products are manufactured by third-party suppliers, primarily located inAsia .Spectrum Brands sells products in approximately 140 countries through a variety of trade channels, including retailers, wholesalers and distributors, hearing aid professionals, industrial distributors and original equipment manufacturers ("OEMs") and enjoys strong name recognition in these markets under theRayovac, VARTA and Remington brands, each of which has been in existence for more than 80 years, and under the Tetra, 8-in-1, Dingo, Nature's Miracle, Spectracide, Cutter, Hot Shot,Black & Decker ,George Foreman , Russell Hobbs, Farberware, Black Flag, FURminator and various other brands. OnOctober 8, 2012 ,Spectrum Brands entered into an agreement with Stanley Black & Decker, Inc. ("Stanley Black and Decker") to acquire the residential hardware and home improvement business (the "HHI Business") currently operated by Stanley Black & Decker and certain of its subsidiaries for$1.4 billion , consisting of (i) the equity interests of certain subsidiaries of Stanley Black & Decker engaged in the HHI Business and (ii) certain assets of Stanley Black & Decker used or held for use in connection with the HHI Business (the "Hardware Acquisition"). The Hardware Acquisition will also include the purchase of shares and assets of certain subsidiaries of Stanley Black & Decker involved in the HHI Business. Furthermore, the Hardware Acquisition will also include the purchase of certain assets of Tong Lung Metal Industry Co. Ltd., aTaiwan Corporation ("TLM Taiwan"), which is involved in the production of residential locksets (the "TLM Residential Business"). The "Spectrum Value Model" is at the heart ofSpectrum Brands' operating approach. This model emphasizes providing value to the consumer with products that work as well as or better than competitive products for a lower cost, while also delivering higher retailer margins. Efforts are concentrated on winning at point of sale and on creating and maintaining a low-cost, efficient operating structure.Spectrum Brands' operating performance is influenced by a number of factors including: general economic conditions; foreign exchange fluctuations; trends in consumer markets; consumer confidence and preferences; overall product line mix, including pricing and gross margin, which vary by product line and geographic market; pricing of certain raw materials and commodities; energy and fuel prices; and general competitive positioning, especially as impacted by competitors' advertising and promotional activities and pricing strategies. 94
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Insurance Segment
Through FGL, we are a provider of annuity and life insurance products to the middle and upper-middle income markets inthe United States . Based inBaltimore, Maryland , FGL operates inthe United States through its subsidiariesFidelity & Guaranty Life Insurance Company ("FGL Insurance ") andFidelity & Guaranty Life Insurance Company of New York ("FGL NY Insurance "). FGL's principal products are deferred annuities (including fixed indexed annuity ("FIA") contracts, immediate annuities, and life insurance products, which are sold through a network of approximately 200 independent marketing organizations ("IMOs") representing approximately 19,000 independent agents and managing general agents. As ofSeptember 30, 2012 , FGL had over 713,000 policyholders nationwide and distributes its products throughoutthe United States .
FGL's most important IMOs are referred to as "
Under accounting principles generally accepted inthe United States of America ("US GAAP"), premium collections for FIAs and fixed rate annuities and immediate annuities without life contingency are reported as deposit liabilities (i.e., contractholder funds) instead of as revenues. Similarly, cash payments to policyholders are reported as decreases in the liability for contractholder funds and not as expenses. Sources of revenues for products accounted for as deposit liabilities are net investment income, surrender and other charges deducted from contractholder funds, and net recognized gains (losses) on investments. Components of expenses for products accounted for as deposit liabilities are interest sensitive and index product benefits (primarily interest credited to account balances or the cost of providing index credits to the policyholder), amortization of intangibles including value of business acquired ("VOBA") and deferred policy acquisition costs ("DAC"), other operating costs and expenses and income taxes. Earnings from products accounted for as deposit liabilities are primarily generated from the excess of net investment income earned over the interest credited or the cost of providing index credits to the policyholder, known as the net investment spread. With respect to FIAs, the cost of providing index credits includes the expenses incurred to fund the annual index credits and where applicable, minimum guaranteed interest credited. Proceeds received upon expiration or early termination of call options purchased to fund annual index credits are recorded as part of the change in fair value of derivatives, and are largely offset by an expense for index credits earned on annuity contractholder fund balances. FGL's profitability depends in large part upon the amount of assets under management, the ability to manage operating expenses, the costs of acquiring new business (principally commissions to agents and bonuses credited to policyholders) and the net investment spreads earned on contractholder fund balances. Managing investment spreads involves the ability to manage investment portfolios to maximize returns and minimize risks such as interest rate changes and defaults or impairment of investments and the ability to manage interest rates credited to policyholders and costs of the options and futures purchased to fund the annual index credits on the FIAs.
Fiscal 2012 Highlights
The following are the most significant developments in our respective businesses during Fiscal 2012:
• Total revenues of
29%, from
Insurance segment, including the benefit of a full year of operations of FGL,
which was acquired inApril 2011 . 95
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Table of Contents • HGI received total dividends of approximately
subsidiaries in Fiscal 2012. In September,
one-time dividend of
million; FGL paid cumulative dividends of$40 million , and Salus paid an inaugural dividend of approximately$1 million in its first year of operation.
• For Fiscal 2012, our Consumer Products segment recorded record net sales of
2011; excluding negative foreign exchange impact, net sales grew 4% versus
the prior year.
• Consumer Products segment operating income grew by
amortization ("Adjusted EBITDA") increased by
million versus the prior year (or 10% excluding unfavorable foreign exchange
impact) on higher sales, synergy benefits and cost reduction initiatives.
Adjusted EBITDA margin on a full-year basis represented 15% of sales.
• Insurance segment product sales for Fiscal 2012 were
the successful introduction of Prosperity EliteSM which resulted in FGL
solidifying a top ten market position in the competitive fixed index annuity
marketplace.
• As of
of
of
AOCI of
available for sale investments were
(
to be conservatively positioned, as it holds cash of
shortened portfolio duration, and remains well matched against its liability
profile. • Salus, in its first year of operation, originated$260 million of
asset-backed loan commitments in Fiscal 2012, for which
were outstanding as of
million to our consolidated earnings for Fiscal 2012.
• HGI stock price appreciation of 66% from
Fiscal 2012 resulted in a
value of the preferred stock equity conversion feature, which represents a
non-cash charge to net income.
• Net income attributable to common and participating preferred stockholders
increased to
controlling interest, compared to
attributable to controlling interest, in Fiscal 2011.
• The non-cash accretion rate on HGI's Preferred Stock decreased from 2% for
the third and fourth fiscal quarters to 0% commencing in the first quarter of
fiscal 2013 due to a 163% increase in HGI's net asset value since the
issuance of its Preferred Stock in
the terms of its certificates of designation. • HGI ended the year with corporate cash and short-term investments of
approximately
supports its business strategy and growth of existing businesses.
Results of Operations
Fiscal 2012 includes the results of HGI, FGL,Spectrum Brands and Russell Hobbs for the full year, the results ofSpectrum Brands' acquisitions of Black Flag and FURminator commencingOctober 31, 2011 andDecember 22, 2011 , respectively, and the results of Salus commencingDecember 1, 2011 . Fiscal 2011 includes the results of HGI,Spectrum Brands and Russell Hobbs for the full year and the results of FGL commencingApril 6, 2011 . Although the acquisition ofSpectrum Brands (the "Spectrum Brands Acquisition") was onJanuary 7, 2011 , its results of operations are included in the full Fiscal 2011 and 2010 years since the acquisition was considered a transaction between entities under common control and accounted for similar to the pooling of interest method. 96
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Fiscal 2010 includes the results ofSpectrum Brands for the full year and the results of Russell Hobbs and HGI commencingJune 16, 2010 . As a result of the Spectrum Brands Acquisition being accounted for similar to the pooling of interest method, we have included the results of HGI fromJune 16, 2010 , the date at which both HGI andSpectrum Brands were entities under common control, through the end of the period. Presented below is a table that summarizes our results of operations and compares the amount of the change between the years endedSeptember 30, 2012 and 2011 (the "2012 Change") and between the years endedSeptember 30, 2011 and 2010 (the "2011 Change") (in millions): Year Ended September 30, Increase/(Decrease) 2012 2011 2010 2012 Change 2011 Change Revenues: Consumer Products and Other - Net Sales $ 3,252 $ 3,187 $ 2,567 $ 65 $ 620 Insurance and Financial Services 1,228 291 - 937 291 Total revenues 4,480 3,478 2,567 1,002 911 Operating costs and expenses: Consumer Products and Other: Cost of goods sold 2,137 2,058 1,646 79 412 Selling, general and administrative expenses 870 947 761 (77 ) 186 3,007 3,005 2,407 2 598 Insurance and Financial Services: Benefits and other changes in policy reserves 777 248 - 529 248 Acquisition and operating expenses, net of deferrals 126 72 - 54 72 Amortization of intangibles 161 (11 ) - 172 (11 ) 1,064 309 - 755 309
Total operating costs and expenses 4,071 3,314 2,407
757 907 Operating income 409 164 160 245 4 Interest expense (251 ) (249 ) (277 ) (2 ) 28 (Increase) decrease in fair value of equity conversion feature of preferred stock (157 ) 28 - (185 ) 28 Bargain purchase gain from business acquisition - 158 - (158 ) 158 Gain on contingent purchase price reduction 41 - - 41 - Other expense, net (17 ) (43 ) (12 ) 26 (31 ) Income (loss) from continuing operations before reorganization items and income taxes 25 58 (129 ) (33 ) 187 Reorganization items expense - - (3 ) - 3 Income (loss) from continuing operations before income taxes 25 58 (132 ) (33 ) 190 Income tax (benefit) expense (85 ) 51 63 (136 ) (12 ) Income (loss) from continuing operations 110 7 (195 ) 103 202 Loss from discontinued operations, net of tax - - (3 ) - 3 Net income (loss) 110 7 (198 ) 103 205 Less: Net income (loss) attributable to noncontrolling interest 21 (35 ) (46 ) 56 11 Net income (loss) attributable to controlling interest 89 42 (152 ) 47 194 Less: Preferred stock dividends and accretion 59 20 - 39 20 Net income (loss) attributable to common and participating preferred stockholders $ 30 $ 22 $ (152 ) $ 8 $ 174 97
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Fiscal Year Ended
Revenues Consumer Products and Other Net sales increased$65 million , or 2%, to$3,252 million in Fiscal 2012 from$3,187 million in Fiscal 2011. Excluding negative foreign exchange impacts of$73 million , net sales increased$138 million , or 4%. Consolidated net sales by product line for Fiscal 2012 and 2011 are as follows (in millions): Fiscal Year Increase / 2012 2011 (Decrease)
Product line net sales Consumer batteries $ 949 $ 954 $ (5 ) Small appliances 772 778 (6 ) Pet supplies 615 579 36 Home and garden control products 387 354 33 Electric shaving and grooming products 279 274 5 Electric personal care products 250 248 2 Total net sales to external customers $ 3,252 $ 3,187 $ 65 Global consumer battery net sales decreased$5 million , or less than 1%, during Fiscal 2012 compared to Fiscal 2011. Excluding negative foreign exchange impacts of$36 million , global consumer battery sales increased$31 million , or 3%. The growth of global consumer battery sales on a constant currency basis was driven by new customer listings as well as increased shelf space at existing customers, coupled with price increases, primarily inLatin America , and geographic expansion. Small appliance net sales decreased$6 million , or 1%, during Fiscal 2012 compared to Fiscal 2011. Excluding negative foreign exchange impacts of$14 million , small appliance sales increased$8 million , or 1%. Latin American and European constant currency sales increases of$16 million and$12 million , respectively, were tempered by a$19 million decrease in North American sales. Latin American sales gains resulted from distribution gains with existing customers as well as price increases. European sales increases were attributable to market share gains in theUnited Kingdom and expansion of the Russell Hobbs brand throughoutEurope . Decreased North American sales were a result of a concerted effort to eliminate certain low margin promotions that occurred in Fiscal 2011. Pet supply product net sales during Fiscal 2012 increased$36 million , or 6%, compared to Fiscal 2011, led by increases in companion animal and aquatics sales of$34 million and$11 million , respectively, tempered by$8 million in negative foreign currency impacts. Gains in companion animal sales were due to the FURminator acquisition, distributional gains and growth in the Nature's Miracle brand in the U.S. Aquatics sales gains resulted from increases in North American aquarium starter kits and pond related sales, including new distribution at major retailers, which were tempered by lower European aquatics sales Home and garden control product net sales increased$33 million , or 9%, during Fiscal 2012 compared to Fiscal 2011, driven by increased household insect control sales of$30 million resulting from the Black Flag acquisition and strong retail distribution gains with existing customers. Lawn and garden control sales increased$3 million in Fiscal 2012 compared to Fiscal 2011 due to increased distribution with existing customers. Electric shaving and grooming product net sales during Fiscal 2012 increased$5 million , or 2%, compared to Fiscal 2011 led by a$14 million increase in European sales and a$4 million increase in Latin American sales. These gains were tempered by a$6 million decline in North American sales and negative foreign exchange impacts of$7 million . European sales gains were driven by successful promotions for new product launches, 98
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while the increase in Latin American sales was due to distribution and customer gains. North American declines resulted from the elimination of lower margin promotions as well as distribution declines. Electric personal care product net sales increased$2 million , or 1%, during Fiscal 2012 compared to Fiscal 2011, driven by gains inNorth America andLatin America of$11 million and$7 million , respectively, which were tempered by an$8 million decline in European sales and negative foreign exchange impacts of$8 million . The gains inNorth America andLatin America were attributable to the continued success in new product categories and distribution gains inLatin America , whereas the decrease in European sales was a result of declining women's hair straightener sales due to a shift in fashion trends combined with decreased promotions in the fourth quarter of Fiscal 2012.
Insurance and Financial Services
Insurance and financial services revenues consist of the following components (in millions): Fiscal Year Increase / 2012 2011 (Decrease) Premiums $ 55 $ 39 $ 16 Net investment income 723 370 353 Net investment gains (losses) 410 (167 )
577
Insurance and investment product fees and other 40 49
(9 )
Total insurance and financial services revenues
Premiums primarily reflect insurance premiums for traditional life insurance products which are recognized as revenue when due from the policyholder.FGL Insurance has ceded the majority of its traditional life business to unaffiliated third party reinsurers. The remaining traditional life business is primarily related to traditional life contracts that contain return of premium riders, which have not been reinsured to third party reinsurers. Upon the closing of the final acquisition-related reinsurance transaction onOctober 17, 2011 , the term premiums which had been previously retained by FGL were prospectively ceded toWilton Reassurance Company ("Wilton Re"). Premiums for Fiscal 2012 were$55 million and are not comparable to the Fiscal 2011 premiums of$39 million which reflect only the approximate six month period subsequent to the FGL acquisition onApril 6, 2011 . For Fiscal 2012 and 2011, investment income (before deducting investment management fees of$12 million and$7 million , respectively) less$517 million and$264 million of interest credited and option costs on annuity deposits, respectively, resulted in an investment spread of$218 million and$113 million , or 1.28% and 1.24% (annualized), respectively. Changes in investment spread primarily result from the yield earned on FGL's investment portfolio as well as the aggregate interest credited and option costs on its FIA products which can be impacted by the costs of options purchased to fund the annual index credits on FIA contracts. Average cash and invested assets (on an amortized cost basis) atSeptember 30, 2012 and 2011 were$16.3 billion and$16.7 billion , respectively, and the average yield earned on average cash and invested assets was 4.40% and 4.51% (annualized) for Fiscal 2012 and 2011, respectively, compared to interest credited and option costs of 3.12% and 3.27% (annualized), respectively. The lower average yield on average cash and invested assets was primarily due to the sale of bonds with longer durations at gains during the year to strategically re-position the portfolio to shorten the overall portfolio duration in anticipation of rising interest rates.
FGL's net investment spread is summarized as follows:
Fiscal Year 2012 2011 Average yield on cash and invested assets 4.40 % 4.51 % Interest credited and option cost 3.12 % 3.27 % Net investment spread 1.28 % 1.24 % 99
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Net investment gains, reduced by impairment losses, recognized in operations fluctuate from period to period based upon changes in the interest rate and economic environment and the timing of the sale of investments or the recognition of other-than-temporary impairments. For Fiscal 2012 and 2011, fixed maturity available-for-sale securities and equity securities had net investment gains of$287 million and$22 million , respectively, related to security sales offset by other-than-temporary impairments of$23 million and$18 million , respectively, during the year. The other-than-temporary impairments for Fiscal 2012 included impairment losses of$17 million related to change of intent on securities held and$6 million of credit impairments. Realized gains for Fiscal 2012 also included$30 million of gains associated with the asset transfer onOctober 17, 2011 for the closing of the final acquisition-related reinsurance transaction with Wilton Re. The$30 million of gains were payable to Wilton Re as part of the initial asset transfer. For Fiscal 2012 and 2011, there were also net realized and unrealized gains (losses) of$146 million and$(171) million , respectively, on derivative instruments purchased to hedge the annual index credits for FIA contracts. The components of the realized and unrealized gains (losses) on derivative instruments for the Fiscal 2012 and 2011 are as follows (in millions):Fiscal Year 2012 2011 Call options: Loss on option expiration $ (53 ) $ (24 ) Change in unrealized gain (loss) 153 (119 ) Futures contracts: Gain (loss) futures contracts expiration 43 (21 ) Change in unrealized gain (loss) 3 (7 ) $ 146 $ (171 ) Realized and unrealized gains and losses on derivative instruments primarily result from the performance of the indices upon which the call options and futures contracts are based and the aggregate cost of options purchased. A substantial portion of the call options and futures contracts are based upon the Standard and Poors ("S&P") 500 Index with the remainder based upon other equity and bond market indices. Thus, the fair value of the derivatives will fluctuate from period to period primarily based upon changes in the S&P 500 index. Accordingly, the change in the unrealized gain (loss) on derivatives was primarily driven by the 31% increase and 15% decrease in the S&P 500 Index during Fiscal 2012 and 2011, respectively.The average index credits to policyholders were as follows:
Fiscal Year 2012 2011 S&P 500 Index: Point-to-point strategy 2.68 % 4.63 % Monthly average strategy 0.45 % 4.03 % Monthly point-to-point strategy 1.84 % 2.69 % 3 year high water mark 17.51 % 0.04 % The average return to contractholders from index credits during Fiscal 2012 and 2011 was 1.81% and 3.61% (annualized), respectively. Actual amounts credited to contractholder fund balances may be less than the index appreciation due to contractual features in the FIA contracts (caps, participation rates and asset fees) which allow us to manage the cost of the options purchased to fund the annual index credits. The level of realized and unrealized gains and losses on derivative instruments is also influenced by the aggregate cost of options purchased. The aggregate cost of options is primarily influenced by the amount of FIA contracts in force. The aggregate cost of options is also influenced by the amount of contractholder funds allocated to the various indices 100--------------------------------------------------------------------------------
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and market volatility which affects option pricing. The cost of options purchased during Fiscal 2012 and 2011 was
$131 million and$68 million , respectively.Insurance and investment products fees and other for Fiscal 2012 and 2011 were$40 million and$49 million , respectively, and consist primarily of cost of insurance and surrender charges assessed against policy withdrawals in excess of the policyholders' allowable penalty-free amounts (up to 10% of the prior year's value, subject to certain limitations). Withdrawals from annuity and indexed universal life policies subject to surrender charges were$1.2 billion and$572 million for the Fiscal 2012 and 2011, respectively, and the average surrender charges collected on annuity withdrawals were 1.89% and 3.49% for Fiscal 2012 and 2011, respectively. During the first quarter of Fiscal 2012, FGL executed the second acquisition-related reinsurance amendment with Wilton Re, in which it ceded the majority of its indexed universal life insurance block of business to Wilton Re. As a result, the cost of insurance and surrender fees associated with this line of business are now ceded to Wilton Re thus reducing the total amount retained by FGL in Fiscal 2012.Operating Costs and Expenses
Consumer Products and Other
Costs of Goods Sold/Gross Profit. Gross profit, representing net sales minus cost of goods sold, for Fiscal 2012 was$1,115 million compared to$1,129 million during Fiscal 2011, representing a$14 million decrease. Our gross profit margin, representing gross profit as a percentage of net sales, for Fiscal 2012 decreased to 34.3% from 35.4% in Fiscal 2011. The decrease in gross profit and gross profit margin for Fiscal 2012 was driven by$36 million of negative foreign exchange impacts, a$17 million increase in commodity prices and higher costs for sourced goods, primarily fromAsia , a$12 million increase in costs due to changes in product mix and a$2 million increase in restructuring and related charges. These factors contributing to the decline in gross profit were tempered by increased organic sales which contributed$31 million of gross profit and Fiscal 2012 acquisitions which contributed$23 million of gross profit. Selling, General & Administrative Expenses. Selling, general and administrative expenses ("SG&A") decreased$77 million , or 8%, to$870 million in Fiscal 2012 from$947 million in Fiscal 2011. The decrease is primarily due to synergies recognized subsequent to the SB/RH Merger of$25 million , decreased asset impairment charges of$32 million , decreased acquisition and integration charges of$29 million , positive foreign exchange impacts of$20 million and savings fromSpectrum Brands' cost reduction initiatives. These decreases were partially offset by a$34 million increase in HGI's general corporate expenses primarily due to the hiring of new personnel, bonus compensation accruals based on the increase in HGI's net asset value ("Compensation NAV") determined in accordance with the criteria established by HGI's Compensation Committee (as discussed further under "Consolidated" below) and an allocation of overhead costs fromHarbinger Capital Partners LLC , an affiliate of HGI and the Principal Stockholders. Adjusted EBITDA.Spectrum Brands believes that certain non-US GAAP financial measures may be useful in certain instances to provide additional meaningful comparisons between current results and results in prior operating periods. Adjusted earnings before interest, taxes, depreciation and amortization ("Adjusted EBITDA") is a metric used by management and frequently used by the financial community. Adjusted EBITDA provides insight into an organization's operating trends and facilitates comparisons between peer companies, since interest, taxes, depreciation and amortization can differ greatly between organizations as a result of differing capital structures and tax strategies. Adjusted EBITDA can also be a useful measure of a company's ability to service debt and is one of the measures used for determiningSpectrum Brands' debt covenant compliance. Adjusted EBITDA excludes certain items that are unusual in nature or not comparable from period to period. While management believes that non-US GAAP measurements are useful supplemental information, such adjusted results are not intended to replace the Company's US GAAP financial results. Adjusted EBITDA increased$28 million , or 6%, to$485 million for Fiscal 2012 from$457 million for Fiscal 2011. The increase in Adjusted EBITDA was primarily a result of reductions in SG&A expenses at Spectrum 101--------------------------------------------------------------------------------
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Brands, attributable to cost synergies and positive foreign exchange impacts, partially offset by the slight decrease in gross profit resulting from commodity prices and increased costs from sourced goods.The table below shows the adjustments made to the reported operating income of the consumer products segment to calculate its Adjusted EBITDA:
Fiscal Year 2012 2011 Reconciliation to reported operating income: Reported operating income - consumer products segment $ 302 $ 228 Add: Other expense not included above (1 ) (3 ) Add back: Intangible asset impairment - 32 Restructuring and related charges 19 29 Acquisition and integration related charges 31 37 Depreciation and amortization, net of accelerated depreciation 134 134 Adjusted EBITDA - consumer products segment $ 485 $ 457 Insurance Benefits and Other Changes in Policy Reserves. Benefits and other changes in policy reserves of$777 million and$248 million for Fiscal 2012 and 2011, respectively, include the change in the FIA embedded derivative liability which includes the market value option liability change and the present value of future credits and guarantee liability change. The market value option liability increased$178 million and decreased$264 million for Fiscal 2012 and 2011, respectively, primarily due to changes in the equity markets during those periods. The present value of future credits and guarantee liability increased$7 million and$121 million for Fiscal 2012 and 2011, respectively. The increase in Fiscal 2012 was primarily due to lower risk free rates during the year. Fair value accounting for derivative instruments and the embedded derivatives in the FIA contracts creates differences in the recognition of revenues and expenses from derivative instruments including the embedded derivative liability in our fixed index annuity contracts. The change in fair value of the embedded derivatives will not correspond to the change in fair value of the derivatives (purchased call options and futures contracts) because the purchased derivatives cover the next annual index period while the embedded derivative liability covers estimated credits over the expected life of the FIA contracts. Additionally, there were index credits, interest credits and bonuses of$382 million and$292 million , annuity payments of$242 million and$127 million and policy benefits and other reserve movements of$32 million and$28 million during Fiscal 2012 and 2011, respectively. Changes in index credits are attributable to changes in the underlying indices and the amount of funds allocated by policyholders to the respective index options. Benefits also include claims incurred during the period in excess of contractholder fund balances, traditional life benefits and the change in reserves for traditional life insurance products.Below is a summary of the major components included in benefits and other changes in policy reserves for each period (in millions):
Fiscal Year 2012 2011 FIA market value option liability change$ 178 $ (264 )
FIA present value future credits and guarantee liability change 7
121
Index credits, interest credited and bonuses 382292
Annuity payments 242127
Other policy benefits and reserve movements (32 )(28 )
Total benefits and other changes in policy reserves $ 777 $ 248 102--------------------------------------------------------------------------------
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Acquisition and Operating Expenses, net of Deferrals. Acquisition and operating expenses, net of deferrals for Fiscal 2012 and 2011 were$126 million and$72 million , respectively, and includes costs and expenses related to the acquisition and ongoing maintenance of insurance and investment contracts, including commissions, policy issuance expenses and other underwriting and general operating costs of FGL and Salus. These costs and expenses are net of amounts that are capitalized and deferred, which are primarily costs and expenses that are directly related to the successful acquisition of new and renewal insurance and investment contracts, such as first-year commissions in excess of ultimate renewal commissions and other policy issuance expenses. Also included in acquisition and operating expense for Fiscal 2012 is a$31 million ceding commission paid to Wilton Re primarily related to$30 million of investment gains realized on the securities transferred to Wilton Re inOctober 2011 upon closing of the second acquisition-related reinsurance amendment. For Fiscal 2012 and 2011, acquisition and operating expenses included general operating expenses of$96 million and$41 million , respectively. Amortization of Intangibles. For Fiscal 2012 and 2011, amortization of intangibles of$161 million and$(11) million , respectively, includes$174 million and$2 million of net VOBA amortization based on gross margins and$17 million and$1 million of DAC amortization. Partially offsetting these expenses was capitalized accrued interest of$30 million and$14 million , which increases the VOBA and DAC intangible assets. Strong gross margins during Fiscal 2012 resulted in significant amortization of intangibles. In general, amortization of DAC will increase each period due to the growth in FGL's annuity business and the deferral of policy acquisition costs incurred with respect to sales of annuity products, however FGL may experience negative DAC amortization when capitalized accrued interest is greater than the amortization expense. For example, during periods of gross losses, losses are floored at zero for purposes of determining amortization expense. At each period, loss recognition testing is carried out to ensure that DAC and VOBA are recoverable. The anticipated increase in amortization from these factors will be affected by amortization associated with fair value accounting for derivatives and embedded derivatives utilized in our FIA business and amortization associated with net realized gains (losses) on investments and net other-than-temporary impairment losses recognized in operations. Pretax Adjusted Operating Income - Insurance. Pretax adjusted operating income is a non-US GAAP financial measure frequently used throughout the insurance industry and an economic measure FGL uses to evaluate financial performance each period. For Fiscal 2012 and 2011, pretax adjusted operating income was$62 million and$48 million , respectively. Pretax adjusted operating income for Fiscal 2012 was primarily affected by the impact of holding a larger cash balance during the year due to repositioning of the portfolio in advance of FIA surrenders which resulted in lower net investment income as well as the effect of realized gains on fixed maturity securities which are excluded. Additionally, FGL recorded an$11 million liability in Fiscal 2012, net of reinsurance, for estimated unreported death claims resulting from a search of theSocial Security Administration database that produced a listing of deceased policyholders that died while their policy was in force (see Note 19 to our Consolidated Financial Statements for additional information regarding this charge). The table below shows the adjustments made to the reported operating income (loss) of the insurance segment to calculate its pretax adjusted operating income: For the Period Year Ended April 6, 2011 to September 30, September 30, 2012 2011 Reconciliation to reported operating income (loss): Reported operating income (loss) - insurance segment $ 164 $ (18 ) Effect of investment gains, net of offsets (132 ) (1 ) Effect of change in FIA embedded derivative, net of offsets 18 43 Effects of acquisition-related reinsurance 12 24 Pretax adjusted operating income $ 62 $ 48 103--------------------------------------------------------------------------------
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Pretax adjusted operating income is calculated by adjusting the reported insurance segment operating income (loss) to eliminate the impact of net investment gains (losses), excluding gains and losses on derivatives and including net other-than-temporary impairment losses recognized in operations, the effect of changes in the rates used to discount the FIA embedded derivative liability and the effects of acquisition-related reinsurance transactions, net of the corresponding VOBA and DAC impact related to these adjustments. These items fluctuate period to period in a manner inconsistent with FGL's core operations. Accordingly, we believe using a measure which excludes their impact is effective in analyzing the trends of FGL's operations. Together with reported operating income, we believe pretax adjusted operating income enhances the understanding of underlying results and profitability which in turn provides a meaningful analysis tool for investors. Non-US GAAP measures such as pretax adjusted operating income should not be used as a substitute for reported operating income (loss). We believe the adjustments made to the reported operating income (loss) in order to derive pretax adjusted operating income (loss) are significant to gaining an understanding of FGL's results of operations. For example, FGL could have strong operating results in a given period, yet report operating income that is materially less, if during the period the fair value of derivative assets hedging the FIA index credit obligations decreased due to general equity market conditions but the embedded derivative liability related to the index credit obligation did not decrease in the same proportion as the derivative asset because of non-equity market factors such as interest rate movements. Similarly, FGL could also have poor operating results yet report operating income that is materially greater, if during the period the fair value of the derivative assets increases but the embedded derivative liability increase is less than the fair value change of the derivative assets. FGL hedges FIA index credits with a combination of static and dynamic strategies, which can result in earnings volatility, the effects of which are generally likely to reverse over time. The management and board of directors of FGL review pretax adjusted operating income (loss) and reported operating income (loss) as part of their examination of FGL's overall financial results. However, these examples illustrate the significant impact derivative and embedded derivative movements can have on reported operating income (loss). Accordingly, the management and board of directors of FGL perform an independent review and analysis of these items, as part of their review of hedging results each period. The adjustments to reported operating income (loss) noted in the table above are net of amortization of VOBA and DAC. Amounts attributable to the fair value accounting for derivatives hedging the FIA index credits and the related embedded derivative liability fluctuate from period to period based upon changes in the fair values of call options purchased to fund the annual index credits for FIAs, changes in the interest rates used to discount the embedded derivative liability, and the fair value assumptions reflected in the embedded derivative liability. The accounting standards for fair value measurement require the discount rates used in the calculation of the embedded derivative liability to be based on the risk-free interest rates. The impact of the change in risk-free interest rates has been removed from reported operating income. Additionally, in evaluating operating results, the effects of acquisition-related reinsurance transactions have been removed from reported operating income.Consolidated
Consolidated operating costs and expenses are expected to increase as we continue to actively pursue our acquisition strategy and increase corporate oversight due to acquisitions, both of which have entailed the hiring of additional personnel at HGI, and experience continued growth at subsidiaries.
During Fiscal 2012, HGI's Compensation Committee established salary, bonus and equity-based compensation arrangements with certain of HGI's corporate employees, including performance-based bonus targets based on the achievement of personal performance goals, and performance-based bonus targets based on performance measured in terms of the change in the value of HGI's Compensation NAV. Performance-based bonuses paid based on the growth of the Compensation NAV allow management to participate in a portion of HGI's performance. Consolidated operating costs increased by approximately$25 million for Fiscal 2012 as a result of the accrual for these new bonus compensation expenses. These amounts reflect the underlying performance and growth in the Compensation NAV, which has grown substantially in Fiscal 2012. Such growth in Fiscal 2012 104--------------------------------------------------------------------------------
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will result in a mix of cash and equity awards being paid over the next three years. We expect to recognize approximately$25 million of deferred bonus compensation expense as it vests over the next three fiscal years, subject to clawback provisions if the subsequent increase in Compensation NAV does not exceed specified threshold returns. Interest Expense. Interest expense increased$2 million to$251 million for Fiscal 2012 from$249 million for Fiscal 2011. The nominal net change in interest expense was the result of an$18 million increase in interest expense due to the full period effect of the full amount of our 10.625% senior secured notes due 2015 (the "10.625% Notes"), of which$350 million and$150 million were issued onNovember 15, 2010 andJune 28, 2011 , respectively. This increase was partially offset by a$16 million decrease in interest expense from the replacement ofSpectrum Brands' 12% senior subordinated toggle notes due 2019 (the "12% Notes") with its 6.75% senior notes due 2020 (the "6.75% Notes"), lower principal balances and effective interest rates related to its senior secured term loan dueJune 17, 2016 (the "Term Loan") and lower expenses for interest rate swaps and other fees and expenses, all partially offset by higher interest expense from increased principal related toSpectrum Brands' 9.5% senior secured notes due 2018 (the "9.5% Notes"). During Fiscal 2012 and 2011,Spectrum Brands recorded$31 million and$37 million , respectively, of charges related to debt refinancings, prepayments and amendments, consisting of$26 million and$6 million , respectively, of cash fees and expenses and$5 million and$31 million , respectively, of non-cash charges for the write-off and accelerated amortization of debt issuance costs and discount/premium. (Increase) Decrease in Fair Value of Equity Conversion Feature of Preferred Stock. For Fiscal 2012, the fair value of equity conversion feature of Preferred Stock increased$157 million due to the effect of a mark to market change in the fair value of the derivative liability for the bifurcated equity conversion feature of our Preferred Stock. The liability increased significantly in Fiscal 2012 principally due to an increase in the market price of our common stock from$5.07 to$8.43 per share during Fiscal 2012. For Fiscal 2011, the fair value of the derivative liability decreased$28 million from the May andAugust 2011 issuance dates of our Preferred Stock.Bargain Purchase Gain from Business Acquisition. Refer to the comparison of Fiscal 2011 with Fiscal 2010 below for a detailed discussion of the
$158 million bargain purchase gain from the FGL acquisition in the prior year.Gain on Contingent Purchase Price Reduction. During Fiscal 2012, we recorded a$41 million increase in the estimated fair value of a contingent purchase price reduction receivable related to the FGL acquisition due to the regulatory non-approval of a proposed reinsurance transaction that was the basis of the contingency. See Note 22 to our Consolidated Financial Statements for additional information.Other Expense, net. Other expense, net in Fiscal 2012 and 2011 relates primarily to
$17 million and$41 million , respectively, of net recognized losses on trading securities held principally for investing purposes of HGI.Income Taxes. Our tax rates are affected by many factors, including our worldwide earnings from various countries, changes in legislation and the tax character of our income. For Fiscal 2012, we recorded an income tax benefit despite pretax income, representing an effective tax rate of (336)%, primarily as a result of (i) the net reversal of$142 million of valuation allowance principally related to our assessment of the amount of FGL's deferred tax assets that are more-likely-than-not realizable, (ii) pretax income in foreign jurisdictions that is subject to tax at rates that are lower than the U.S. Federal statutory income tax rate and (iii) a$41 million gain on a contingent purchase price reduction receivable, for which no tax provision is necessary. Partially offsetting these factors was (i)$157 million of expense for the increase in fair value of the equity conversion feature of preferred stock, for which no tax benefit is available, (ii) deferred income tax provision related to changes in the book versus tax bases of indefinite lived intangible assets that are amortized for tax purposes, but not for book purposes, and (iii) U.S. and foreign taxes on remitted and unremitted foreign income. 105--------------------------------------------------------------------------------
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Net operating loss ("NOL") and tax credit carryforwards of HGI andSpectrum Brands are subject to full valuation allowances and those of FGL are subject to partial valuation allowances, as we concluded all or a portion of the associated tax benefits are not more-likely-than-not realizable. Utilization of NOL and other tax carryforwards of HGI,Spectrum Brands and FGL are subject to limitations under Internal Revenue Code ("IRC") Sections 382 and 383. Such limitations resulted from ownership changes of more than 50 percentage points over a three-year period. For Fiscal 2011, our effective tax rate of 87% was higher thanthe United States Federal statutory rate of 35% principally due to (i) deferred income tax expense due to changes in the tax bases of indefinite lived intangible assets that are amortized for tax purposes, but not for book purposes, and (ii) U.S. and foreign tax expense on remitted income from certain foreign jurisdictions. Partially offsetting these factors was (i) a$158 million bargain purchase gain from the FGL acquisition, for which no tax provision is necessary, and (ii) the reversal of$30 million of valuation allowance based on our reassessment of the amount of FGL's deferred tax assets that we determined are more-likely-than-not realizable. Noncontrolling Interest. The net income (loss) attributable to noncontrolling interest reflects the share of the net income (loss) ofSpectrum Brands attributable to the noncontrolling interest not owned by HGI. Such amount varies in relation toSpectrum Brands' net income or loss for the period and the percentage interest not owned by HGI, which was 42.6% and 46.9% as ofSeptember 30, 2012 and 2011, respectively. Preferred Stock Dividends and Accretion. The Preferred Stock dividends and accretion consist of (i) an accruing cumulative quarterly cash dividend at an annualized rate of 8%, (ii) a quarterly non-cash principal accretion at an annualized rate of 4% throughMarch 31, 2012 , that was reduced to 2% for the remainder of Fiscal 2012 since we achieved a specified rate of growth measured by the increase in the value of HGI's net assets (the "Preferred Stock NAV") calculated in accordance with the certificates of designation of the Preferred Stock, and (iii) accretion of the carrying value of our Preferred Stock, which was discounted by the bifurcated equity conversion feature and issuance costs. The increase in the Preferred Stock dividends and accretion for Fiscal 2012 compared to Fiscal 2011 is due to the additional dividends and accretion related to the full period effect in Fiscal 2012 of our Series A-2 Preferred Stock issued inAugust 2011 and our Series A Preferred Stock issued inMay 2011 , partially offset by the decrease in the quarterly non-cash principal accretion rate from 4% to 2% midway through Fiscal 2012. For purposes of determining the Preferred Stock accretion amount, we calculate the Preferred Stock NAV in accordance with terms of the certificates of designation of the Preferred Stock. In accordance with the certificates of designation, we are required to calculate the Preferred Stock NAV onSeptember 30 andMarch 31 of each calendar year. The accretion rate will be set for the following six months based on the performance of our Preferred Stock NAV as of the date of such calculation. The Preferred Stock NAV as ofSeptember 30, 2012 , calculated in accordance with the certificates of designation, was approximately$1.5 billion . This calculation will result in no quarterly non-cash accretion for the first half of Fiscal 2013, although it could increase to an annualized rate of 2% or 4% in subsequent periods based upon changes in the Preferred Stock NAV. 106--------------------------------------------------------------------------------
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Fiscal Year Ended
September 30, 2011 Compared to Fiscal Year EndedSeptember 30, 2010 Revenues Consumer Products and Other Net sales increased$620 million , or 24%, to$3,187 million in Fiscal 2011 from$2,567 million in Fiscal 2010. Consolidated net sales by product line for Fiscal 2011 and 2010 were as follows (in millions): Fiscal Year Increase / 2011 2010 (Decrease)Product line net sales Consumer batteries $ 954 $ 954 $ - Small appliances 778 231 547 Pet supplies 579 566 13 Home and garden control products 354 343 11 Electric shaving and grooming products 274 257 17 Electric personal care products 248 216 32 Total net sales to external customers $ 3,187 $ 2,567 $ 620 Global consumer battery net sales during Fiscal 2011 was flat compared to Fiscal 2010, primarily driven by decreased sales inLatin America of$41 million , which were tempered by increased sales inNorth America andEurope of$24 million and$5 million , respectively, coupled with favorable foreign exchange impacts of$12 million . Sales decreases inLatin America were driven by decreased alkaline battery sales of$11 million , zinc carbon battery sales of$26 million and portable lighting sales of$4 million primarily due to decreased volumes inBrazil as a result of competitive pressures in the region. North American sales increased as a result of strong holiday sales during our first fiscal quarter, distribution gains throughout the year, incremental sales due to strong weather patterns during Fiscal 2011 and a successful new product line launch at a major customer. The sales increases inEurope were primarily attributable to the successful promotion of ourVarta value sub-brands as well as customer gains. Small appliances contributed$778 million or 24% of total net sales for Fiscal 2011 compared to$231 million or 9% of sales in Fiscal 2010. This represents a full year of sales related to Russell Hobbs during Fiscal 2011 as compared to Fiscal 2010 in which we realized sales of the acquired business from the date of the SB/RH Merger,June 16, 2010 , throughSeptember 30, 2010 , the close of our Fiscal 2010. Pet product net sales during Fiscal 2011 increased$13 million , or 2%, compared to Fiscal 2010. The increase of$13 million was attributable to increased companion animal product sales of$15 million , of which$7 million was a direct result of the SB/RH Merger with the remaining$8 million being driven by the acquisition of Birdola, successful product launches and continued expansion inEurope . Favorable foreign exchange impacted sales by$8 million . These gains were partially offset by decreased aquatics sales of$10 million resulting from overall macroeconomic conditions. Home and garden control product net sales increased$11 million , or 3%, during Fiscal 2011 compared to Fiscal 2010. This increase was a result of increased household insect controls sales of$14 million , of which$4 million related to the SB/RH Merger. The remaining growth in household insect control sales was driven by increased distribution and product placements with major customers. These gains were partially offset by a$3 million decrease in lawn and garden control sales due to unseasonable weather conditions inthe United States , which negatively impacted the lawn and garden season. Electric shaving and grooming product net sales during Fiscal 2011 increased$17 million , or 7%, compared to Fiscal 2010 primarily due to increased sales withinNorth America ,Europe andLatin America of$6 million , 107--------------------------------------------------------------------------------
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$4 million and$3 million , respectively, coupled with favorable foreign exchange translation of$4 million . North American sales increases were driven by distribution and customer gains and increased online sales. Latin American sales increases were driven by distribution gains. Electric personal care product net sales increased$32 million , or 15%, during Fiscal 2011 compared to Fiscal 2010. The increase of$32 million during Fiscal 2011 was attributable to increases inNorth America ,Europe andLatin America of$12 million ,$14 million and$2 million , respectively, coupled with favorable foreign exchange impacts of$4 million . The increases in North American and European sales were a result of successful product launches, distribution and customer gains and increased online sales while increases in Latin American sales were driven by distribution gains.Insurance
Refer to the discussion of insurance revenues in the above comparison of Fiscal 2012 with Fiscal 2011 for details regarding the components in Fiscal 2011. There were no insurance revenues or expenses in Fiscal 2010, which was prior to the FGL acquisition.Operating Costs and Expenses
Consumer Products and Other
Costs of Goods Sold/Gross Profit. Gross profit for Fiscal 2011 was$1,129 million compared to$921 million during Fiscal 2010, representing a$208 million increase. Our gross profit margin for Fiscal 2011 decreased slightly to 35.4% from 35.9% in Fiscal 2010. The increase in gross profit was primarily attributable to increased sales coupled with the non-recurrence of a$34 million increase in cost of goods sold that resulted from the sale of inventory that was revalued in connection with the adoption of fresh-start reporting upon SBI's emergence from Chapter 11 of the Bankruptcy Code which was recognized during the first quarter of Fiscal 2010. The increased sales due to the SB/RH Merger accounted for a gross profit increase of$152 million during Fiscal 2011 as compared to Fiscal 2010. The decrease in gross profit margin was attributable to the change in overall product mix as a result of the SB/RH Merger as well as increasing commodity prices during Fiscal 2011. Selling, General & Administrative Expenses. SG&A increased$186 million , or 24%, to$947 million in Fiscal 2011 from$761 million in Fiscal 2010. The increase was primarily due to$111 million of SG&A for the addition of Russell Hobbs, an impairment charge on trade name intangible assets of$32 million principally in the small appliances and pet supplies product lines, an increase in stock compensation expense atSpectrum Brands of$14 million and an increase in corporate expenses at HGI of$38 million . The increase in corporate expenses at HGI was primarily due to a full year of corporate overhead in Fiscal 2011 compared to a partial year in Fiscal 2010 commencingJune 16, 2010 (the date that common control was first established overSpectrum Brands and HGI),$4 million of start-up costs forFront Street and$20 million of higher acquisition related costs. The acquisition related costs at HGI were$27 million during Fiscal 2011 and included$23 million for the FGL acquisition,$1 million for the Spectrum Brands Acquisition and$3 million of other project related expenses. These increases were partially offset by savings fromSpectrum Brands' integration efforts, global cost reduction initiatives and favorable foreign exchange translations in Fiscal 2011. Adjusted EBITDA. Adjusted EBITDA of the consumer products segment increased$25 million , or 6%, to$457 million for Fiscal 2011 from$432 million for Fiscal 2010 primarily as a result of increased sales, cost savings and foreign exchange impacts, tempered by decreased margins. 108--------------------------------------------------------------------------------
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The table below shows the adjustments made to the reported operating income of the consumer products segment to calculate Adjusted EBITDA:
Fiscal Year 2011 2010 Reconciliation to reported operating income: Reported operating income - consumer products segment $ 228 $ 169 Add: Other expense not included above (3 ) (12 ) Add back: Intangible asset impairment 32-
Pre-acquisition earnings of Russell Hobbs -66
Restructuring and related charges 2924
Acquisition and integration related charges 3738
Inventory fair value adjustments for fresh-start accounting and Russell Hobbs acquisition
-37
Depreciation and amortization, net of accelerated depreciation 134
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Adjusted EBITDA - consumer products segment $ 457 $ 432 Insurance Refer to the discussion of insurance operating costs and expenses in the above comparison of Fiscal 2012 with Fiscal 2011 for details regarding the components in Fiscal 2011. Consolidated Interest Expense. Interest expense decreased$28 million to$249 million in Fiscal 2011 from$277 million in Fiscal 2010. The decrease in interest expense was the result of a$46 million decrease in charges related to debt refinancings and prepayments atSpectrum Brands from$83 million in Fiscal 2010 to$37 million in Fiscal 2011, a$23 million decrease in other interest expense atSpectrum Brands primarily due to a reduction in interest rates and average outstanding balances due to its debt refinancing and prepayments, partially offset by$39 million of interest expense related to our 10.625% Notes initially issued inNovember 2010 . During Fiscal 2010,Spectrum Brands recorded$83 million of charges related to the refinancing ofSpectrum Brands' debt in connection with the SB/RH Merger consisting of (i)$66 million for the write-offs of the unamortized portion of the discounts, premiums and debt issuance costs related toSpectrum Brands' debt that was refinanced, (ii)$9 million related to bridge commitment fees whileSpectrum Brands was refinancing its debt, (iii)$5 million of prepayment penalties, and (iv)$3 million related to the termination of a Euro-denominated interest rate swap. During Fiscal 2011,Spectrum Brands recorded$37 million of charges related to term debt refinancings and prepayments consisting of (i) the accelerated amortization of debt issuance costs and original issue discount totaling$31 million and (ii) prepayment penalties of$6 million . (Increase) Decrease in Fair Value of Equity Conversion Feature of Preferred Stock. For Fiscal 2011, there was a$28 million mark to market decrease in the fair value of the derivative liability for the bifurcated equity conversion feature of our Preferred Stock, which resulted primarily from a decline in the market price of our common stock since the Preferred Stock was issued in the second half of Fiscal 2011. Bargain Purchase Gain from Business Acquisition. The FGL acquisition was accounted for under the acquisition method of accounting, which requires the total purchase price to be allocated to the assets acquired and liabilities assumed based on their estimated fair values, which resulted in a bargain purchase gain under US GAAP. We believe that the resulting bargain purchase gain of$158 million in Fiscal 2011 was reasonable based on the following circumstances: (a) the seller was highly motivated to sell FGL, as it had publicly announced its intention to do so approximately a year prior to the sale, (b) the fair value of FGL's investments and statutory capital increased between the date that the purchase price was initially negotiated and the date of the FGL 109--------------------------------------------------------------------------------
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acquisition, (c) as a further inducement to consummate the sale, the seller waived, among other requirements, any potential upward adjustment of the purchase price for an improvement in FGL's statutory capital between the date of the initially negotiated purchase price and the date of the FGL Acquisition and (d) an independent appraisal of FGL's business indicated that its fair value was in excess of the purchase price. Other Expense, net. Other expense, net was$43 million for Fiscal 2011 compared to$12 million for Fiscal 2010. Fiscal 2011 other expense consisted principally of$41 million of net recognized losses on trading securities, including$44 million of unrealized losses on those still held atSeptember 30, 2011 , reflecting the general stock market decline since those securities were purchased in the second half of Fiscal 2011. Other expense, net of$12 million for Fiscal 2010 included a$10 million expense for a foreign exchange loss recognized in connection with the designation ofSpectrum Brands' Venezuelan subsidiary as being in a highly inflationary economy, as well as the devaluation ofVenezuela's currency. AtJanuary 4, 2010 , the beginning of our second quarter of Fiscal 2010, we determined thatVenezuela met the definition of a highly inflationary economy under US GAAP. As a result, beginningJanuary 4, 2010 , the U.S. dollar was the functional currency forSpectrum Brands' Venezuelan subsidiary. Accordingly, beginningJanuary 4, 2010 , currency remeasurement adjustments for this subsidiary's financial statements and other transactional foreign exchange gains and losses have been reflected in earnings. ThroughJanuary 3, 2010 , prior to being designated as highly inflationary, translation adjustments related to the Venezuelan subsidiary were reflected in stockholders' equity as a component of accumulated other comprehensive income (loss).Reorganization Items. During Fiscal 2010, SBI, in connection with its reorganization under Chapter 11 of the Bankruptcy Code in 2009, recorded reorganization items expense of
$3 million , which primarily consisted of legal and professional fees.Income Taxes. For Fiscal 2011, our effective tax rate of 87% was higher than the United States Federal statutory rate of 35% principally due to (i) deferred income tax expense due to changes in the tax bases of indefinite lived intangible assets that are amortized for tax purposes, but not for book purposes, and (ii) U.S. and foreign tax expense on remitted income from certain foreign jurisdictions. Partially offsetting these factors was (i) a$158 million bargain purchase gain from the FGL acquisition, for which no tax provision is necessary, and (ii) the reversal of$30 million of valuation allowance based on our reassessment of the amount of FGL's deferred tax assets that we determined are more-likely-than-not realizable. For the year endedSeptember 30, 2010 , our effective tax rate of (48)%, representing a tax provision despite a pretax loss, was negatively impacted by (i) a deferred income tax provision related to the change in book versus tax basis of indefinite lived intangibles, which are amortized for tax purposes but not for book purposes, (ii) pretax losses inthe United States and some foreign jurisdictions for which no tax benefit can be recognized due to full valuation allowances we provided on its net operating loss carryforward tax benefits and other deferred tax assets and (iii) pretax income in certain non-U.S. jurisdictions that was subject to tax. Discontinued Operations. Loss from discontinued operations of$3 million in Fiscal 2010 related to the shutdown ofSpectrum Brands' growing products line of business, which included the manufacturing and marketing of fertilizers, enriched soils, mulch and grass seed, following an evaluation of the historical lack of profitability and the projected input costs and significant working capital demands for growing products during Fiscal 2009. Noncontrolling Interest. The net loss attributable to noncontrolling interest of$35 million in Fiscal 2011 reflected the share of the net loss ofSpectrum Brands during Fiscal 2011 attributable to the noncontrolling interest not owned by HGI (45.5% throughJuly 3, 2011 and 46.9% thereafter). The net loss attributable to noncontrolling interest of$46 million in Fiscal 2010 reflected the 45.5% share of the net loss ofSpectrum Brands fromJune 16, 2010 throughSeptember 30, 2010 attributable to the noncontrolling interest not owned by HGI. 110--------------------------------------------------------------------------------
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Preferred Stock Dividends and Accretion. The Preferred Stock dividends and accretion for Fiscal 2011 of$20 million consisted of a cumulative quarterly cash dividend of 8%, a quarterly non-cash principal accretion at an annualized rate of 4% and accretion of the carrying value of our Preferred Stock, which was discounted by the bifurcated equity conversion feature and issuance costs. As the Preferred Stock was issued in the second half of Fiscal 2011, there were no comparable charges in Fiscal 2010.Liquidity and Capital Resources
HGI
HGI is a holding company and its liquidity needs are primarily for interest payments on the 10.625% Notes (approximately$53 million per year), dividend payments on its Preferred Stock (approximately$33 million per year), professional fees (including advisory services, legal and accounting fees), salaries and benefits, office rent, pension expense, insurance costs, funding certain requirements of its insurance and other subsidiaries, and certain support services and office space provided byHarbinger Capital to HGI. HGI's current source of liquidity is its cash, cash equivalents and investments and distributions from FGL,Spectrum Brands and Salus. During Fiscal 2012, we received dividends totaling$40 million from FGL. We currently expect to receive dividends from FGL in future periods sufficient to fund a substantial portion of the interest payments on the 10.625% Notes. In addition, inSeptember 2012 , we received a dividend of$30 million fromSpectrum Brands as HGI's portion of a$1.00 per share special dividend declared bySpectrum Brands to its stockholders. We currently expect to receive quarterly dividends of$0.25 per share fromSpectrum Brands totaling approximately$30 million (based on our current ownership ofSpectrum Brands ) in Fiscal 2013. The remainder of HGI's operating cash needs for Fiscal 2013, including if the EXCO/HGI Production Partners Acquisition is completed, is expected to be satisfied out of cash and investments on hand. The ability of HGI's subsidiaries to generate sufficient net income and cash flows to make upstream cash distributions is subject to numerous factors, including restrictions contained its subsidiaries' financing agreements, availability of sufficient funds in such subsidiaries and applicable state laws and regulatory restrictions and the approval of such payment by such subsidiary's board of directors, which must consider various factors, including general economic and business conditions, tax considerations, strategic plans, financial results and such other factors such subsidiary's board of directors considers relevant, including, in the case of FGL target capital ratios and ratio levels anticipated by rating agencies to maintain or improve current ratings (see "FGL" below for more detail). At the same time, HGI's subsidiaries may require additional capital to maintain or grow their businesses. Such capital could come from HGI, retained earnings at the relevant subsidiary or from third-party sources. For example,Front Street Re, Ltd. ("Front Street"), aBermuda -based reinsurer and wholly-owned subsidiary of ours, will require additional capital in order to engage in reinsurance transactions, including any possible transaction with FGL, and may require additional capital to meet regulatory capital requirements. We expect our cash, cash equivalents and investments to continue to be a source of liquidity except to the extent they may be used to fund investments in operating businesses or assets, such as if theEXCO/HGI Production Partners Acquisition is completed. AtSeptember 30, 2012 , HGI's cash, cash equivalents and short-term investments were$433 million . Based on current levels of operations, HGI does not have any significant capital expenditure commitments and management believes that its consolidated cash, cash equivalents and investments on hand will be adequate to fund its operational and capital requirements for at least the next twelve months. Depending on the size and terms of future acquisitions of operating businesses or assets, HGI and its subsidiaries may raise additional capital through the issuance of equity, debt, or both. There is no assurance, however, that such capital will be available at the time, in the amounts necessary or with terms satisfactory to HGI. We also continuously evaluate our capital structure and in addition to raising additional debt or equity financing may seek to purchase, repay, redeem or retire any of our outstanding debt or preferred equity securities in privately negotiated or open market transactions, by tender offer or otherwise. 111--------------------------------------------------------------------------------
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Spectrum Brands Spectrum Brands expects to fund its cash requirements, including capital expenditures, dividends, and interest and principal payments due on debt in the fiscal year endingSeptember 30, 2013 ("Fiscal 2013"), including if the Hardware Acquisition is completed, through a combination of cash on hand ($158 million atSeptember 30, 2012 ) and cash flows from operations and available borrowings under its revolving credit facility (the "ABL Facility"). Going forward its ability to satisfy financial and other covenants in its senior credit agreements and senior unsecured indenture and to make scheduled payments or prepayments on its debt and other financial obligations will depend on its future financial and operating performance. There can be no assurances that its business will generate sufficient cash flows from operations or that future borrowings under the ABL Facility will be available in an amount sufficient to satisfy its debt maturities or to fund its other liquidity needs.Spectrum Brands is not treating Fiscal 2012 and future earnings as permanently reinvested. AtSeptember 30, 2012 , there are no significant foreign cash balances available for repatriation. For Fiscal 2013,Spectrum Brands expects to generate between$60 million and $90 million of foreign cash, which does not include the HHI Business, that will be repatriated for its general corporate purposes. OnNovember 16, 2012 Spectrum Brands Escrow Corp. issued$520 million aggregate principal amount of 6.375% Senior Notes due 2020 (the "2020 Notes") and$570 million aggregate principal amount of 6.625% Senior Notes due 2022 (the "2022 Notes".) The 2020 Notes and the 2022 Notes will be assumed bySpectrum Brands upon the closing of the Hardware Acquisition.Spectrum Brands intends to use the net proceeds from the offering to fund a portion of the purchase price and related fees and expenses for the Hardware Acquisition.Spectrum Brands intends to finance the remaining portion of the Hardware Acquisition, as well as refinance its existing Term Loan, with a new$800 million senior secured term loan, which is expected to close concurrently with the Hardware Acquisition.From time to time we may repurchase our existing indebtedness, including outstanding securities of
Spectrum Brands or its subsidiaries, in the open market or otherwise.FGL
FGL conducts all its operations through operating subsidiaries. Dividends from its subsidiaries are the principal sources of cash to pay dividends to HGI and to meet its obligations. Other principal sources of cash include sales of assets. The liquidity requirements of FGL's regulated insurance subsidiaries principally relate to the liabilities associated with their various insurance and investment products, operating costs and expenses, the payment of dividends to FGL, payment of principal and interest on their outstanding debt obligations and income taxes. Liabilities arising from insurance and investment products include the payment of benefits, as well as cash payments in connection with policy surrenders and withdrawals, policy loans and obligations to redeem funding agreements. FGL's insurance subsidiaries have used cash flows from operations and investment activities to fund their liquidity requirements. FGL's insurance subsidiaries' principal cash inflows from operating activities are derived from premiums, annuity deposits and insurance and investment product fees and other income. The principal cash inflows from investment activities result from repayments of principal, investment income and, as necessary, sales of invested assets. FGL's insurance subsidiaries maintain investment strategies intended to provide adequate funds to pay benefits without forced sales of investments. Products having liabilities with longer durations, such as certain life insurance, are matched with investments having similar estimated lives such as long-term fixed maturity securities. Shorter-term liabilities are matched with fixed maturity securities that have short- and medium-term fixed maturities. In addition, FGL's insurance subsidiaries hold highly liquid, high-quality short-term investment 112--------------------------------------------------------------------------------
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securities and other liquid investment grade fixed maturity securities to fund anticipated operating expenses, surrenders and withdrawals. The ability of FGL's subsidiaries to pay dividends and to make such other payments is limited by applicable laws and regulations of the states in which its subsidiaries are domiciled, which subject its subsidiaries to significant regulatory restrictions. These laws and regulations require, among other things, FGL's insurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends these subsidiaries can pay. Along with solvency regulations, the primary driver in determining the amount of capital used for dividends is the level of capital needed to maintain desired financial strength ratings from the rating agencies. In that regard, we may limit dividend payments from our major insurance subsidiary to the extent necessary for its risk based capital ratio to be at a level anticipated by the rating agencies to maintain or improve its current rating. Given recent economic events that have affected the insurance industry, both regulators and rating agencies could become more conservative in their methodology and criteria, including increasing capital requirements for FGL's insurance subsidiaries which, in turn, could negatively affect the cash available to FGL from its insurance subsidiaries and, in turn, to us.Investment Portfolio - Insurance and Financial Services
The types of assets in which FGL may invest are influenced by various state laws, which prescribe qualified investment assets applicable to insurance companies. Within the parameters of these laws, FGL invests in assets giving consideration to three primary investment objectives: (i) income-oriented total return, (ii) yield maintenance/enhancement and (iii) capital preservation/risk mitigation. FGL's investment portfolio is designed to provide a stable earnings contribution and balanced risk portfolio across asset classes and is primarily invested in high quality corporate bonds with low exposure to consumer-sensitive sectors. As ofSeptember 30, 2012 and 2011, FGL's investment portfolio, including asset-backed loans originated by Salus, was approximately$16.7 billion and$15.8 billion , respectively, and was divided among the following asset classes (dollars in millions): September 30, 2012 September 30, 2011 Asset Class Fair Value Percent Fair Value Percent Asset-backed securities $ 1,028 6.1 % $ 500 3.2 % Commercial mortgage-backed securities 554 3.3 % 566 3.6 % Corporates 11,009 65.8 % 11,856 75.3 % Equities 248 1.5 % 287 1.8 % Hybrids 528 3.2 % 659 4.2 % Municipals 1,224 7.3 % 936 5.9 % Agency residential mortgage-backed securities 155 0.9 % 222 1.4 % Non-agency residential mortgage-backed securities 661 4.0 % 445 2.8 % U.S. Government 930 5.6 % 183 1.2 % Other (primarily derivatives, asset-backed loans and policy loans) 400 2.3 % 97 0.6 % Total investments $ 16,737 100.0 % $ 15,751 100.0 %
Fixed Maturity Securities Insurance statutes regulate the type of investments that FGL's life insurance subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and FGL's business and investment strategy, FGL generally seeks to invest inUnited States government and government-sponsored agency securities and corporate securities rated investment grade by established nationally recognized statistical rating organizations (each, an "NRSRO") or in securities of comparable investment quality, if not rated. 113--------------------------------------------------------------------------------
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As ofSeptember 30, 2012 and 2011, FGL's fixed maturity available-for-sale portfolio was approximately$16.1 billion and$15.4 billion , respectively. The following table summarizes the credit quality, by NRSRO rating, of FGL's fixed income portfolio (dollars in millions): September 30, 2012 September 30, 2011 Rating Fair Value Percent Fair Value Percent AAA $ 1,842 11.4 % $ 1,236 8.0 % AA 2,044 12.7 % 1,660 10.8 % A 4,280 26.6 % 4,886 31.8 % BBB 7,084 44.0 % 6,862 44.7 % BB 459 2.9 % 579 3.8 % B and below 380 2.4 % 144 0.9 % Total $ 16,089 100.0 % $ 15,367 100.0 % The NAIC's Securities Valuation Office ("SVO") is responsible for the day-to-day credit quality assessment and valuation of securities owned by state regulated insurance companies. Insurance companies report ownership of securities to the SVO when such securities are eligible for regulatory filings. The SVO conducts credit analysis on these securities for the purpose of assigning an NAIC designation and/or unit price. Typically, if a security has been rated by an NRSRO, the SVO utilizes that rating and assigns an NAIC designation based upon the following system: NAIC Designation NRSRO Equivalent Rating 1 AAA/AA/A 2 BBB 3 BB 4 B 5 CCC and lower 6 In or near defaultThe tables below presents FGL's fixed maturity securities by NAIC designation as of
September 30, 2012 and 2011 (dollars in millions):September 30, 2012 Percent of Total Carrying NAIC Designation Amortized Cost Fair Value Amount 1 $ 8,070 $ 8,634 53.7 % 2 6,569 7,047 43.8 % 3 381 387 2.4 % 4 9 9 0.1 % 5 8 8 0.0 % 6 4 4 0.0 % $ 15,041 $ 16,089 100.0 % 114--------------------------------------------------------------------------------
Table of Contents September 30, 2011 Percent of Total Carrying NAIC Designation Amortized Cost Fair Value Amount 1 $ 7,833 $ 8,134 52.9 % 2 6,271 6,435 41.9 % 3 683 648 4.2 % 4 117 110 0.7 % 5 34 35 0.2 % 6 6 5 0.1 % $ 14,944 $ 15,367 100.0 % Unrealized LossesThe amortized cost and fair value of fixed maturity securities and equity securities that were in an unrealized loss position as of
September 30, 2012 and 2011 were as follows (dollars in millions):September 30, 2012 Number of Amortized Unrealized Fair securities Cost Losses Value Fixed maturity securities, available for sale:United States Government full faith and credit 6 $ 1 $ - $ 1United States Government sponsored agencies 10 7 - 7United States municipalities, states and territories 18 72 (1 ) 71 Corporate securities: Finance, insurance and real estate 31 242 (5 ) 237 Manufacturing, construction and mining 10 96 (3 ) 93 Utilities and related sectors 7 48 - 48 Wholesale/retail trade 7 59 (1 ) 58 Services, media and other 4 22 (1 ) 21 Hybrid securities 8 131 (10 ) 121 Non-agency residential mortgage-backed securities 26 119 (4 ) 115 Commercial mortgage-backed securities 9 13 (2 ) 11 Asset-backed securities 17 179 (2 ) 177 Equity securities 3 46 (1 ) 45 156 $ 1,035 $ (30 ) $ 1,005 115--------------------------------------------------------------------------------
Table of Contents September 30, 2011 Number of Amortized Unrealized Fair securities Cost Losses Value Fixed maturity securities, available for sale:United States Government full faith and credit 4 $ 2 $ (1 ) $ 1United States Government sponsored agencies 17 25 - 25United States municipalities, states and territories 9 1 - 1 Corporate securities: Finance, insurance and real estate 155 1,798 (82 ) 1,716 Manufacturing, construction and mining 19 197 (10 ) 187 Utilities and related sectors 46 386 (16 ) 370 Wholesale/retail trade 32 383 (10 ) 373 Services, media and other 46 448 (12 ) 436 Hybrid securities 31 501 (51 ) 450 Non-agency residential mortgage-backed securities 67 398 (23 ) 375 Commercial mortgage-backed securities 47 357 (18 ) 339 Asset-backed securities 20 278 (3 ) 275 Equity securities 12 109 (9 ) 100 505 $ 4,883 $ (235 ) $ 4,648 The gross unrealized loss position on the portfolio was$(30) million atSeptember 30, 2012 , an improvement from$(235) million atSeptember 30, 2011 . The following is a description of the factors causing the change in unrealized losses by investment category as ofSeptember 30, 2012 : Corporate/Hybrid securities: ThroughSeptember 30, 2012 , spreads on corporate bonds continued to narrow. Confidence in the unfolding economic recovery along with steps that companies have taken to strengthen their balance sheets as well as maturity profiles have improved the prospects of corporate issuers. Accordingly, the prices of their securities continue to strengthen. Finance, finance-related corporates and hybrids remain the largest component of the$20 million unrealized loss position for corporate securities and hybrids, which in turn is the largest component of the total gross unrealized loss position. As risk premiums have narrowed and sentiment has improved, the total realized loss position has declined from the prior year and represents an even smaller percentage of the total gross loss position. FGL expects spread levels in finance and finance-related names to remain elevated as long as concerns over the Eurozone remain. Non-agency residential mortgage-backed securities: Prices on FGL's legacy non-agency residential mortgage-backed security positions remain below amortized cost due to continued challenges in the housing market. However, the unrealized loss position relating to this asset class has declined from$23 million to $4 million as risk aversion has decreased and as home prices have recovered in some of the hardest hit markets. FGL selectively added to its non-agency residential mortgage backed holdings during the year, focusing on NAIC-1 rated securities. The decision to increase exposure to this asset class was predicated by the emerging recovery in housing fundamentals, including an increase in the number of cities that are experiencing year-over-year appreciation in home prices. Commercial mortgage-backed securities: The portfolio's commercial mortgage-backed security exposure is concentrated in earlier vintage/higher quality securities. FGL has not made additional investments in this asset class. As spreads narrowed, the unrealized loss position declined from$18 million to $2 million . 116--------------------------------------------------------------------------------
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The amortized cost and fair value of fixed maturity securities and equity securities (excludingUnited States Government andUnited States Government sponsored agency securities) in an unrealized loss position greater than 20% and the number of months in an unrealized loss position with fixed maturity securities that carry an NRSRO rating of BBB/Baa or higher considered investment grade as ofSeptember 30, 2012 , were as follows: September 30, 2012 Gross Number of Amortized Unrealized securities Cost Fair Value Losses Investment grade: Six months or more and less than twelve months 3 $ 3 $ 1 $ (2 ) Total investment grade 3 3 1 (2 ) Below investment grade: Six months or more and less than twelve months 1 1 1 - Twelve months or greater 1 - - - Total below investment grade 2 1 1 - Total 5 $ 4 $ 2 $ (2 ) As ofSeptember 30, 2011 no securities were in an unrealized loss position greater than 6 months as the amortized cost of all investments was adjusted to fair value as of the FGL acquisition date. However, FGL held 15 securities that had unrealized losses greater than 20% during the period. This included 6 fixed maturity securities (excludingUnited States Government andUnited States Government sponsored agency securities) that were investment grade (NRSRO rating of BBB/Baa or higher) with an amortized cost and estimated fair value of$9 million and$7 million , respectively, as well as 9 securities below investment grade with an amortized cost and estimated fair value of$31 million and$24 million , respectively.Other-Than-Temporary Impairments
FGL has a policy and process in place to identify securities in its investment portfolio for which it should recognize impairments. See Significant Accounting Policies and Practices -Available-for-sale Securities - Evaluation for Recovery of Amortized Cost included in Note 2 to our Consolidated Financial Statements and Evaluation of Other-Than-Temporary Impairments included under Critical Accounting Policies and Estimates in this Management's Discussion and Analysis. At each balance sheet date, FGL identifies invested assets which have characteristics (i.e. significant unrealized losses compared to amortized cost and industry trends) creating uncertainty as to FGL's future assessment of an other-than-temporary impairment. As part of this assessment FGL reviews not only a change in current price relative to its amortized cost but the issuer's current credit rating and the probability of full recovery of principal based upon the issuer's financial strength. Specifically for corporate issues, FGL evaluates the financial stability and quality of asset coverage for the securities relative to the term to maturity for the issues it owns. On a quarterly basis FGL reviews structured securities for changes in default rates, loss severities and expected cash flows for the purpose of assessing potential other than temporary impairments and related credit losses to be recognized in operations. A security which has a 20% or greater change in market price relative to its amortized cost and a possibility of a loss of principal will be included on a list which is referred to as FGL's watch list. AtSeptember 30, 2012 and 2011, FGL's watch list included only 9 and 18 securities in an unrealized loss position with an amortized cost of$4 million and$41 million , unrealized losses of$2 million and$9 million , and fair value of$2 million and$32 million , respectively. 117--------------------------------------------------------------------------------
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There were 9 and 7 structured securities on the watch list as ofSeptember 30, 2012 and 2011, respectively. FGL's analysis of these structured securities included cash flow testing results which demonstrated theSeptember 30, 2012 carrying values were fully recoverable. A summary of FGL's residential mortgage-backed securities by collateral type and split by NRSRO designation, as well as a separate summary of securities for which FGL has recognized other-than-temporary impairments and those it has not yet recognized any other-than-temporary impairments is as follows as ofSeptember 30, 2012 (dollars in millions): NAIC Principal Amortized Fair Collateral Type Designation Amount Cost Value Other-than-temporary impairment has not been recognized: Government agency 1 $ 234 $ 149 $ 155 Prime 1 129 116 122 2 28 27 28 3 7 6 7 5 4 4 4 6 4 4 4 Alternative-A 1 172 109 119 2 3 3 3 Subprime 1 (53 ) 181 186 2 3 13 14 3 7 6 6 4 (1 ) 2 2 Other 1 169 109 118 2 7 7 7 3 13 11 12 $ 726 $ 747 $ 787 Other-than-temporary impairment has been recognized: Prime 1 $ 1 $ - $ - Subprime 1 344 27 24 2 16 1 1 4 5 - - Other 1 6 4 4 $ 372 $ 32 $ 29 Total by collateral type: Government agency $ 234 $ 149 $ 155 Prime 173 157 165 Alternative-A 175 112 122 Subprime 321 230 233 Other 195 131 141 $ 1,098 $ 779 $ 816 Total by NAIC designation: 1 $ 1,002 $ 695 $ 728 2 57 51 53 3 27 23 25 4 4 2 2 5 4 4 4 6 4 4 4 $ 1,098 $ 779 $ 816 118--------------------------------------------------------------------------------
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Exposure to European Sovereign Debt
FGL's investment portfolio has no direct exposure to European sovereign debt. The exposure to peripheral European financial institutions is limited to obligations of two Spanish banks; all exposures are denominated in U.S. dollars. FGL's portfolio has exposure to bonds issued by two foreign subsidiaries of the largest Spanish bank,Banco Santander :Banco Santander USA and Banco Santander Chile which had fair values of$37 million and$44 million , respectively, atSeptember 30, 2012 . While the parent company of these issuers is inSpain , FGL does not view these particular foreign holdings as vulnerable to any prolonged weakness in the domestic Spanish economy given their focus on business in their home markets, mainly the U.S. andChile . In addition toBanco Santander , FGL also owns bonds issued byBBVA , the second largest Spanish banking concern, which had a fair value of$29 million atSeptember 30, 2012 . These securities are obligations of the domestic subsidiary, and are exposed to the domestic Spanish economy. As such, the ratings on these securities are likely to reflect any changes to the sovereign rating ofSpain . With the recovery in capital markets during the past quarter, FGL has seen improvement in pricing of bothBanco Santander obligations as well as theBBVA bonds. During Fiscal 2012 FGL recorded a gain of$3 million on the elimination of the portfolio's exposure to the Italian banking concern Unicredito by the sale of HVB Funding Trust I and III, which were previously written down due to a change of intent to a sell bias.Available-for-sale securities
For additional information regarding FGL's available-for-sale securities, including the amortized cost, gross unrealized gains (losses), and fair value of available-for-sale securities as well as the amortized cost and fair value of fixed maturity available-for-sale securities by contractual maturities as ofSeptember 30, 2012 and 2011, refer to Note 5 to our Consolidated Financial Statements.Net Investment Income and Net Investment Gains (Losses)
For discussion regarding FGL's net investment income and net investment gains (losses), refer to Note 5 to our Consolidated Financial Statements.
Concentrations of Financial Instruments
For detail regarding FGL's concentration of financial instruments, refer to Note 5 to our Consolidated Financial Statements.
Derivatives
For additional information regarding FGL's derivatives, refer to Note 6 to our Consolidated Financial Statements.
FGL is exposed to credit loss in the event of nonperformance by their counterparties on the call options. FGL attempts to reduce the credit risk associated with such agreements by purchasing such options from large, well-established financial institutions.
FGL will also hold cash and cash equivalents received from counterparties for call option collateral, as well as Government securities pledged as call option collateral, if FGL's counterparty's net exposures exceed pre-determined thresholds. See Note 6 to our Consolidated Financial Statements for additional information regarding FGL's exposure to credit loss on call options. 119--------------------------------------------------------------------------------
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Discussion of Consolidated Cash Flows
Summary of Consolidated Cash Flows
Fiscal Year Cash provided by (used in): 2012 2011 2010 (In millions) Operating activities $ 619 $ 153 $ 51 Investing activities (186 ) 532 49 Financing activities (99 ) 194 66 Effect of exchange rate changes on cash and cash equivalents (1 ) 1 (7 ) Net increase in cash and cash equivalents $ 333 $ 880 $ 159 Operating Activities Cash provided by operating activities totaled$619 million for Fiscal 2012 as compared to$153 million for Fiscal 2011. The$466 million improvement was the result of a$202 million increase in cash provided by FGL, a$236 million increase in cash provided by HGI corporate, and a$28 million increase in cash provided bySpectrum Brands . FGL's$202 million increase in cash provided from operating activities is primarily due to a$379 million increase in investment income, a decrease of$99 million cash used due to lower level of collateral required for equity option derivatives in the current year, a$63 million decrease in benefits paid and a$12 million increase in insurance premiums and investment product fees, all partially offset by a$222 million increase in policy acquisition and operating expenses and a$124 million increase in transfers of cash to reinsurers relating to reinsurance transactions in the respective periods. The increase in cash provided from FGL's operating activities is partly due to the inclusion of FGL in our results for the full year in Fiscal 2012 versus only six months in Fiscal 2011. The$63 million decrease in benefits paid in Fiscal 2012 is mostly due to the effects of reinsurance transactions entered into in Fiscal 2011 and early Fiscal 2012. The$236 million increase at HGI corporate was primarily due to a$135 million increase in excess of sales over purchases of trading securities acquired for resale, the return to us of$49 million that had been posted as collateral for an FGL subsidiary, a decrease in acquisition related costs of$24 million primarily related to the FGL acquisition in Fiscal 2011, a decrease in the use of cash for working capital of$13 million , primarily due to higher accrued expenses, and cash provided by Salus' operations of$13 million . The$28 million increase in cash provided atSpectrum Brands was primarily due to an increase of$42 million in income before interest, depreciation and amortization and impairment charges, a$12 million reduction in cash acquisition, integration and restructuring costs and an$11 million decrease in operating cash interest payments, all partially offset by a$21 million increased use of cash for working capital, and use of cash for other items totaling$16 million . The$21 million increase in cash used for working capital and other items was driven by higher inventories, partially offset by lower accounts receivable, higher accounts payable and higher accrued salaries and employee benefit obligations. Cash provided by operating activities totaled$153 million for Fiscal 2011 compared to$51 million for Fiscal 2010. The$102 million increase in cash provided by operations was the result of higher income fromSpectrum Brands' continuing operations of$105 million , primarily related to the SB/RH Merger;$53 million of cash generated bySpectrum Brands from their working capital, which was primarily driven by lower inventories and partially offset by lower accounts payable;$48 million of cash provided by FGL;$47 million of cash payments forSpectrum Brands' administrative related reorganization items during Fiscal 2010 which did not recur; and cash used in discontinued operating activities of$11 million during Fiscal 2010 which relates to the shutdown ofSpectrum Brands' line of growing products which did not recur. Partially offsetting these sources was an increased use of$103 million at corporate, which included payments of$49 million for collateral posted on 120--------------------------------------------------------------------------------
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behalf of FGL (returned inOctober 2011 ),$22 million of increased acquisition related costs and$18 million for an interest payment on the 10.625% Notes; higher cash interest payments of$29 million atSpectrum Brands related primarily to the 12% Notes which was paid-in-kind during Fiscal 2010; net purchases by HGI of trading securities for resale of$16 million ; higher cash acquisition and restructuring costs atSpectrum Brands of$6 million , primarily related to the SB/RH Merger; and other general operating uses of$8 million .Investing Activities
Cash used in investing activities was$186 million for Fiscal 2012, as compared to cash provided of$532 million for Fiscal 2011. The$718 million decrease in cash provided by investing activities is principally due to a decrease in net cash provided from acquisitions of$869 million , cash used by Salus in originating$181 million of asset-backed loans in Fiscal 2012 and the non-recurrence of a$7 million cash inflow related to the sale of assets held for sale in Fiscal 2011, all partially offset by a$343 million increase in cash provided from sales, maturities and repayments, net of purchases, of fixed maturity securities and other investments principally due to a reduction of investment purchases with excess cash at HGI corporate. The$869 million decrease in net cash provided from acquisitions relates to the$139 million , net of cash acquired, acquisition ofFURminator, Inc. , and the$44 million acquisition of Black Flag in Fiscal 2012, as compared to the$695 million of net cash provided from the acquisition of FGL and the$11 million of cash used in the acquisition ofSeed Resources, Inc. , net of cash acquired, in Fiscal 2011. Net cash provided by investing activities was$532 million during Fiscal 2011 compared to$49 million during Fiscal 2010. The$483 million increase in cash provided by investing activities is due to net cash acquired in our acquisition of FGL of$695 million , partially offset by the cash use of$109 million , net of maturities, for the purchase of investments, which included net purchases of$322 million for HGI and$214 million of sales by FGL during Fiscal 2011. In addition, during Fiscal 2010,$66 million of HGI cash was added to the consolidated balance sheet as ofJune 16, 2010 in connection with the common control accounting for the Spectrum Brands Acquisition.Financing Activities
Cash used in financing activities was$99 million for Fiscal 2012 compared to cash provided of$194 million for Fiscal 2011. The$293 million decrease in cash provided by financing activities was primarily related to (i) a$386 million decrease in cash provided from the proceeds of our Preferred Stock issuances in Fiscal 2011, (ii) the increased use of cash of$294 million , net, relating to the$270 million repayment in the Fiscal 2012 of the 12% Notes bySpectrum Brands , including a bond call/tender premium, and$254 million of other debt obligations including a$95 million surplus note payable of FGL, compared to the$230 million of term loan repayments, including prepayment penalties in Fiscal 2011, (iii)$85 million of cash used to repurchaseSpectrum Brands' common stock by both HGI andSpectrum Brands , (vi)$32 million of dividends paid by HGI on its Preferred Stock, and (v) a$24 million dividend paid bySpectrum Brands to noncontrolling interests, all partially offset by a$526 million decrease in cash used for redemptions and benefit payments on, net of issuances of, investment contracts including annuity and universal life insurance contracts by FGL. Net cash provided by financing activities was$194 million during Fiscal 2011 compared to$66 million during Fiscal 2010. The$128 million increase in cash provided by financing activities was primarily related to the issuance of our 10.625% Notes, for which we received$498 million of proceeds, net of original issue discount. In addition, we issued the Preferred Stock, for which we received net proceeds of$386 million . This was partially offset by net cash used by FGL of$465 million relating to net redemptions and benefit payments on investment contracts, including annuity and universal life contracts; and the issuance and repayment of borrowings and an increase in net cash used for financing activities of$276 million bySpectrum Brands in Fiscal 2011 compared to Fiscal 2010. The net cash used bySpectrum Brands of$210 million during Fiscal 2011 is primarily driven by term loan repayments of$230 million , including pre-payment penalty, partially offset by net stock issuances of$26 million . The net cash provided by financing activities of$66 million during Fiscal 2010 is 121--------------------------------------------------------------------------------
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primarily attributable to
Spectrum Brands entering into a$750 million Term Loan, issuing a$750 million aggregate principal amount of 9.5% Notes and entering into the$300 million ABL Facility, the proceeds from such financing were used to repay its then-existing senior term credit facility and its then-existing asset based revolving loan facility.Debt Financing Activities
HGI
OnNovember 15, 2010 andJune 28, 2011 , we issued$350 million and$150 million , respectively, or$500 million aggregate principal amount of the 10.625% Notes. The 10.625% Notes were sold only to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933 ("Securities Act") and to certain persons in offshore transactions in reliance on Regulation S, but were subsequently registered under the Securities Act. The 10.625% Notes were issued at an aggregate price equal to 99.31% of the principal amount thereof, with a net original issue discount of$3.4 million . Interest on the 10.625% Notes is payable semi-annually throughNovember 15, 2015 . The 10.625% Notes are collateralized with a first priority lien on substantially all of the assets directly held by us, including stock in our subsidiaries (with the exception of Zap.Com Corporation, but includingSpectrum Brands ,Harbinger F&G LLC ("HFG"),HGI Funding LLC and the securities of other subsidiaries formed since the issuance dates) and our directly held cash and investment securities. We have the option to redeem the 10.625% Notes prior toMay 15, 2013 at a redemption price equal to 100% of the principal amount plus a make-whole premium and accrued and unpaid interest to the date of redemption. At any time on or afterMay 15, 2013 , we may redeem some or all of the 10.625% Notes at certain fixed redemption prices expressed as percentages of the principal amount, plus accrued and unpaid interest. At any time prior toNovember 15, 2013 , we may redeem up to 35% of the original aggregate principal amount of the 10.625% Notes with net cash proceeds received by us from certain equity offerings at a price equal to 110.625% of the principal amount of the 10.625% Notes redeemed, plus accrued and unpaid interest, if any, to the date of redemption, provided that redemption occurs within 90 days of the closing date of such equity offering, and at least 65% of the aggregate principal amount of the 10.625% Notes remains outstanding immediately thereafter. If a change of control occurs, each holder of 10.625% Notes may require us to repurchase all or a portion of its 10.625% Notes for cash at a price equal to 101% of the aggregate principal amount of such 10.625% Notes, plus any accrued and unpaid interest to the date of repurchase. The indenture governing the 10.625% Notes (the "Indenture") contains covenants limiting, among other things, and subject to certain qualifications and exceptions, our ability, and, in certain cases, the ability of our subsidiaries, to incur additional indebtedness; create liens; engage in sale-leaseback transactions; pay dividends or make distributions in respect of capital stock; make certain restricted payments; sell assets; engage in certain transactions with affiliates; or consolidate or merge with, or sell substantially all of our assets to, another person. These covenants are subject to a number of important exceptions and qualifications. We are also required to maintain compliance with certain financial tests, including minimum liquidity and collateral coverage ratios that are based on the fair market value of the collateral, including our equity interests inSpectrum Brands and our other subsidiaries such asHFG and HGI Funding LLC . AtSeptember 30, 2012 , we were in compliance with all covenants under the 10.625% Notes. The Indenture contains customary events of default which could, subject to certain conditions, cause the 10.625% Notes to become immediately due and payable, including, but not limited to, the failure to make premium or interest payments; failure by us to accept and pay for 10.625% Notes tendered when and as required by the change of control and asset sale provisions of the Indenture; failure to comply with certain covenants in the Indenture; failure to comply with certain agreements in the Indenture for a period of 60 days following written notice by the Trustee or the holders of at least 25% in aggregate principal amount of the 10.625% Notes then outstanding; failure to pay any debt within any applicable grace period after the final maturity or acceleration of such debt by the holders thereof because of a default, if the total amount of such debt unpaid or accelerated exceeds$25 million ; failure to pay final judgments entered by a court or courts of competent jurisdiction aggregating$25 million or more (excluding amounts covered by insurance), which judgments are not paid, discharged or stayed, for a period of 60 days; and certain events of bankruptcy or insolvency. 122--------------------------------------------------------------------------------
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In order to permit the collateral agent to exercise the remedies under the Indenture and foreclose on theSpectrum Brands common stock pledged as collateral for the 10.625% Notes upon an event of default under the Indenture, onJanuary 7, 2011 , simultaneously with the closing of theSpectrum Brands Acquisition, the collateral agent became a party to a stockholder agreement, dated as ofFebruary 9, 2010 (the "Spectrum Brands Holdings Stockholder Agreement"), and will, upon an event of default under the Indenture, and subject to certain exceptions, become subject to all of its covenants, terms and conditions to the same extent as HGI prior to such event of default.
Spectrum Brands At
September 30, 2012 , the aggregate amount of principal outstanding underSpectrum Brands' debt instruments was as follows: (i)$370 million under the Term Loan, maturingJune 17, 2016 ; (ii)$950 million under the 9.5% Notes, maturingJune 15, 2018 ; (iii)$300 million under the 6.75% Notes, maturingMarch 15, 2020 ; and (iv) no amounts currently outstanding under the ABL Facility, expiringMay 3, 2016 .At
September 30, 2012 ,Spectrum Brands had aggregate borrowing availability under the ABL Facility of approximately$198 million , net of lender reserves of$8 million and outstanding letters of credit of$25 million .AtSeptember 30, 2012 ,Spectrum Brands was in compliance with all covenants under the Term Loan credit agreement, the indenture governing the 9.5% Notes, the indenture governing the 6.75% Notes and the credit agreement governing the ABL Revolving Credit Facility. OnNovember 16, 2012 ,Spectrum Brands Escrow Corp. issued$520 million aggregate principal amount of the 2020 Notes and$570 million aggregate principal amount of the 2022 Notes. The 2020 Notes and the 2022 Notes will be assumed by SBI upon the closing of the Hardware Acquisition.Spectrum Brands intends to use the net proceeds from the offering to fund a portion of the purchase price and related fees and expenses for the Hardware Acquisition.Spectrum Brands intends to finance the remaining portion of the Hardware Acquisition, as well as refinance its existing Term Loan with a new$800 million senior secured term loan, which is expected to close concurrently with the Hardware Acquisition.See Note 29 to our Consolidated Financial Statements for additional information regarding
Spectrum Brands' 2020 Notes and 2022 Notes.See Note 12 to our Consolidated Financial Statements for additional information regarding
Spectrum Brands' debt activity during Fiscal 2012.Interest Payments and Fees
In addition to principal payments on the senior credit facilities referred to above,Spectrum Brands has annual interest payment obligations of approximately$90 million under the 9.5% Notes,$20 million under the 6.75% Notes and$19 million under the Term Loan (using market interest rates and foreign exchange rates in effect atSeptember 30, 2012 and assuming no further principal repayments.) Additionally, upon issuance of the 2020 Notes and the 2022 Notes,Spectrum Brands will have annual interest payments of$34 million and$38 million , respectively. Such interest obligations would increase borrowings under the ABL Facility if cash were not otherwise available for such payments. Interest on the 9.5% Notes and interest on the 6.75% Notes is payable semi-annually in arrears and interest under the Term Loan and ABL Facility is payable on various interest payment dates as provided in the applicable agreements.Spectrum Brands is required to pay certain fees in connection with its senior credit facilities. Such fees include a quarterly commitment fee of up to 0.375% on the unused portion of the ABL Facility and certain additional fees with respect to the letter of credit sub-facility under the ABL Facility.FGL
On
April 7, 2011 , a wholly-owned reinsurance subsidiary of FGL issued a$95 million surplus note to the prior owner of FGL. The surplus note was issued at par and carried a 6% fixed interest rate. The note had a maturity123--------------------------------------------------------------------------------
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date which was at the later of (i)December 31, 2012 or (ii) the date on which all amounts due and payable to the lender have been paid in full. The note was settled onOctober 17, 2011 at face value without the payment of interest.Preferred Stock
OnMay 13, 2011 andAugust 5, 2011 , we issued 280,000 shares of Series A Preferred Stock and 120,000 shares of Series A-2 Preferred Stock, respectively, in private placements for total gross proceeds of$400 million . The Preferred Stock (i) is redeemable for cash (or, if a holder does not elect cash, automatically converted into common stock) onMay 13, 2018 , (ii) is convertible into our common stock at an initial conversion price of$6.50 per share for the Series A and$7.00 per share for the Series A-2, both subject to anti-dilution adjustments, (iii) has a liquidation preference of the greater of 150% of the purchase price or the value that would be received if it were converted into common stock, (iv) accrues a cumulative quarterly cash dividend at an annualized rate of 8% and (v) has a quarterly non-cash principal accretion at an annualized rate of 4% that will be reduced to 2% or 0% if we achieve specified rates of growth measured by increases in the Preferred Stock NAV. As previously discussed, such rate was reduced from 4% to 2% effectiveApril 1, 2012 , and then again from 2% to 0% effectiveSeptember 30, 2012 . The accretion rate is expected to remain at zero in future periods, but is subject to adjustment back to 2% or 4% at each future semi-annual re-evaluation date based on the level of the Preferred Stock NAV. The Preferred Stock is entitled to vote, subject to certain regulatory limitations, and to receive cash dividends and in-kind distributions on an as-converted basis with the common stock. Upon a change of control (which is defined in the Certificate of Designation), holders of the Preferred Stock are entitled to cause us to redeem their Preferred Stock at a price per share of Preferred Stock equal to the sum of 101% of the Purchase Price and any accrued and unpaid dividends, including accrued and unpaid cash and accreting dividends for the then current dividend period. At any time afterMay 13, 2014 , we may redeem the Preferred Stock, in whole but not in part, at a price per share equal to 150% of the Purchase Price plus accrued but unpaid dividends, subject to the holder's right to convert prior to such redemption. AfterMay 13, 2014 , we may force the conversion of the Preferred Stock into shares of our common stock if the thirty day volume weighted average price of shares of our common stock ("VWAP") and the daily VWAP exceed 150% of the then applicable Conversion Price for at least twenty trading days out of the thirty trading day period used to calculate the thirty day VWAP. In the event of a forced conversion, the holders of Preferred Stock will have the ability to elect cash settlement in lieu of conversion if certain market liquidity thresholds for our common stock are not achieved. In addition, for so long as the Fortress Purchaser owns sufficient combined voting power (through ownership of Preferred and shares of our common stock) to entitle it to nominate directors to our Board or appoint observers (as described below) or exercise certain consent rights, our ability to force conversion of the Preferred Stock is limited such that after any such conversion the Fortress Purchaser will have the right to retain one share of Preferred Stock, enabling it to continue to exercise its right to nominate directors, appoint observers or exercise consent rights associated with the Preferred Stock, but such Preferred Stock will have no other rights or preferences. Once the Fortress Purchaser ceases to own sufficient combined voting power to exercise these rights, the retained share of Preferred Stock will be automatically cancelled. In the event of our liquidation or wind up, the holders of Preferred Stock will be entitled to receive per share the greater of (i) 150% of the Purchase Price, plus any accrued and unpaid dividends and (ii) the value that would be received if the share of Preferred Stock were converted into shares of our common stock immediately prior to the liquidation or winding up. Prior toMay 13, 2016 with respect to the Series A Preferred Stock, and prior toAugust 5, 2016 with respect to the Series A-2 Preferred Stock, subject to meeting certain ownership thresholds, certain Preferred Stock Purchasers will be entitled to participate, on a pro rata basis in accordance with their ownership percentage, 124--------------------------------------------------------------------------------
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determined on an as converted basis, in issuances of equity and equity linked securities by us. In addition, subject to meeting certain ownership thresholds, certain Preferred Stock Purchasers will be entitled to participate in issuances of preferred securities and in debt transactions.Consent of the holders of Preferred Stock, and in certain cases Fortress individually, is required before any fundamental change can be made to the Preferred Stock, or any material action can be taken with respect thereto.
Subject to certain approval from certain insurance regulatory authorities, so long as the Fortress Purchaser owns at least 50% of the Preferred Stock purchased on the Initial Preferred Stock Issue Date or 10% of our outstanding shares of common stock on an as converted basis, the Fortress Purchaser will have the right to appoint one director, or observer to our board of directors ("Board"), any committee of our Board (except for any special committee formed to consider a related party transaction involving the Fortress Purchaser), and the board of any of our wholly owned subsidiaries on which it does not have a director. Upon a specified breach event (described below) the size of our Board will be increased by one or two directors, depending on whether the Fortress Purchaser has appointed a director to our Board prior to such breach. The Fortress Purchaser, or a majority of Preferred Stock Purchasers if the Fortress Purchaser at that time owns less than a threshold amount, in either shares of our common stock or Preferred Stock, will have the right to appoint one or two directors, reasonably acceptable to our Board. Subject to meeting certain ownership thresholds, in the event thatMr. Falcone , the Chairman of the Board and our Chief Executive Officer, ceases to have principal responsibility for our investments for a period of more than 90 consecutive days, other than as a result of temporary disability, and the Fortress Purchaser does not approve our proposed business continuity plan (a "Director Addition Event"), the Fortress Purchaser may appoint such number of directors that, when the total number of directors appointed by the Fortress Purchaser is added to the number of independent directors, that number of directors is equal to the number of directors employed by or affiliated with us orHarbinger Capital .Notwithstanding all of the foregoing, the Fortress Purchaser's representation on our Board will always be less than or proportionate to its ownership of our securities and must otherwise comply with the rules of the
NYSE and certain insurance regulatory authorities.We are subject to additional restrictions under the Certificate of Designation, including that upon a specified breach event (such as an event of default under the Indenture, our failure to pay any dividends on the Preferred Stock for a period longer than 90 days, our failure to perform certain covenants under the Certificate of Designation or the delisting of our shares of common stock) we will be prohibited from making certain restricted payments, incurring certain debt, and entering into certain agreements to purchase debt or equity interests in portfolio companies ofHarbinger Capital or its affiliates (other than HGI) or to sell equity interests in portfolio companies of HGI toHarbinger Capital or its affiliates. The holders of the Preferred Stock have certain registration rights pursuant to a Registration Rights Agreement, by and among us and the Preferred Stock Purchasers (the "Preferred Registration Rights Agreement"). Pursuant to the Preferred Registration Rights Agreement, we filed a registration statement with respect to the shares of our common stock underlying the Preferred Stock and are obligated to use our commercially reasonable efforts to keep the registration statement effective until all of the shares of our common stock covered therein has been sold or may be sold without volume or manner of sale restrictions under Rule 144 of the Securities Act. Our registration statement was declared effective onOctober 28, 2011 . 125--------------------------------------------------------------------------------
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Contractual Obligations
The following table summarizes our contractual obligations as ofSeptember 30, 2012 and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in millions). The table excludes certain other obligations that have been reflected on our Consolidated Balance Sheet as ofSeptember 30, 2012 included in this report. Payments Due by Period Total 2013 2014 to 2015 2016 to 2017 After 2017 Annuity and universal life products (a) $ 18,562 $ 2,117 $ 3,955 $ 3,836 $ 8,654 Debt, excluding capital lease obligations (b) 2,138 13 16 859 1,250 Interest payments, excluding capital lease obligations (b) 903 184 365 241 113 Capital lease obligations (c) 27 3 5 4 15 Operating lease obligations (d) 177 34 53 41 49 Employee benefit obligations (e) 117 11 21 22 63 Letters of credit (f) 26 19 7 - - Unfunded asset-based lending commitments (g) 64 15 49 - - Other liabilities (h) 12 - 3 2 7Total contractual obligations
$ 22,026 $ 2,396 $ 4,474 $ 5,005$ 10,151 (a) Consists of projected payments through the year 2030 that FGL is
contractually obligated to pay to annuity and universal life policyholders.
The payments are derived from actuarial models which assume a level interest
rate scenario and incorporate assumptions regarding mortality and persistency, when applicable. These assumptions are based on historical experience.(b) For more information concerning debt, see Note 12 to our Consolidated
Financial Statements.
(c) Capital lease payments due by fiscal year include executory costs and imputed
interest.
(d) For more information concerning operating leases, see Note 19 to our
Consolidated Financial Statements.
(e) Employee benefit obligations represent the sum of our estimated future
minimum required funding for our qualified defined benefit plans through
fiscal year 2022 based on actuarially determined estimates and projected
future benefit payments from our unfunded postretirement plans. For
additional information about our employee benefit obligations, see Note 15 to
our Consolidated Financial Statements.
(f) Consists entirely of standby letters of credit that back the performance of
certain entities under various credit facilities, insurance policies and
lease arrangements.
(g) Consists entirely of unfunded asset-based lending commitments of Salus.
(h) At
September 30, 2012 , our Consolidated Balance Sheet includes$6 million oftax reserves for uncertain tax positions. However, it is not possible to
predict or estimate the timing of payments for these obligations and,
accordingly, they are not reflected in the above table. We cannot predict the
ultimate outcome of income tax audits currently in progress for certain of
our companies; however, it is reasonably possible that during the next
12 months some portion of our unrecognized tax benefits could be recognized.
Shareholder Contingencies
The Master Fund has pledged all of its shares of the HGI's common stock, together with securities of other issuers to secure a certain portfolio financing, which as of the date hereof, constitutes a majority of the outstanding shares of the HGI's common stock. The sale or other disposition of a sufficient number of such shares (including any foreclosure on or sale of the HGI's shares pledged as collateral) to non-affiliates could cause HGI and its subsidiaries to experience a change of control, which may accelerate certain of the HGI's and its subsidiaries' debt instruments and other obligations (including the 10.625% Notes and Preferred Stock) and/or allow certain counterparties to terminate their agreements. Any such sale or disposition may also cause HGI and its subsidiaries to be unable to utilize certain of their net operating loss and other tax carryforwards for income tax purposes. 126--------------------------------------------------------------------------------
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Off-Balance Sheet Arrangements
Throughout our history, we have entered into indemnifications in the ordinary course of business with our customers, suppliers, service providers, business partners and in certain instances, when we sold businesses. Additionally, we have indemnified our directors and officers who are, or were, serving at our request in such capacities. Although the specific terms or number of such arrangements is not precisely known due to the extensive history of our past operations, costs incurred to settle claims related to these indemnifications have not been material to our financial statements. We have no reason to believe that future costs to settle claims related to our former operations will have a material impact on our financial position, results of operations or cash flows. The First Amended and Restated Stock Purchase Agreement, datedFebruary 17, 2011 (the "F&G Stock Purchase Agreement") betweenHFG and OM Group (UK ) Limited ("OMGUK") includes a Guarantee and Pledge Agreement which creates certain obligations for FGL as a grantor and also grants a security interest to OMGUK of FGL's equity interest inFGL Insurance in the event that HFG fails to perform in accordance with the terms of the F&G Stock Purchase Agreement. We are not aware of any events or transactions that resulted in non-compliance with the Guarantee and Pledge Agreement. Seasonality On a consolidated basis our financial results are approximately equally weighted between quarters, however, sales of certain product categories tend to be seasonal. Sales in the consumer battery, electric shaving and grooming and electric personal care product categories, particularly inNorth America , tend to be concentrated in the December holiday season (our first fiscal quarter). Demand for pet supplies products remains fairly constant throughout the year. Demand for home and garden control products typically peaks during the first six months of the calendar year (our second and third fiscal quarters). Small appliance sales peak from July through December primarily due to the increased demand by customers in the late summer for "back-to-school" sales and in the fall for the holiday season. Revenues of our insurance segment are not seasonal.The seasonality of our net sales during the last three fiscal years is as follows:
Percentage of Annual Net Sales
Fiscal Year Ended September 30, Fiscal Quarter Ended 2012 2011 2010 December 26 % 27 % 23 % March 23 % 22 % 21 % June 25 % 25 % 25 % September 26 % 26 % 31 %Recent Accounting Pronouncements Not Yet Adopted
Presentation of Comprehensive Income
InJune 2011 , theFinancial Accounting Standards Board ("FASB") issued amended disclosure requirements to report comprehensive income in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. This guidance will be effective for us in Fiscal 2013. We do not expect the guidance to impact our financial statements, as it only requires a change in the format of presentation.Impairment Testing
InSeptember 2011 , the FASB issued new accounting guidance intended to simplify how an entity tests goodwill for impairment. The guidance will allow an entity to first assess qualitative factors to determine whether it is 127--------------------------------------------------------------------------------
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necessary to perform the two-step quantitative goodwill impairment test. An entity no longer will be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. This accounting guidance is effective for us for the annual and any interim goodwill impairment tests performed beginning in Fiscal 2013. We do not expect the adoption of this guidance to have a significant impact on our consolidated financial statements. Additionally, inJuly 2012 , the FASB issued new accounting guidance intended to simplify how an entity tests indefinite-lived intangible assets for impairment. The guidance will allow an entity to first assess qualitative factors to determine whether it is necessary to perform the quantitative impairment test. An entity will no longer be required to calculate the fair value of an indefinite-lived intangible asset unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. This accounting guidance is effective for us for the annual and any interim indefinite-lived intangible asset impairment tests performed for Fiscal 2013. We do not expect the adoption of this guidance to have a significant impact on our consolidated financial statements.Offsetting Assets and Liabilities
InDecember 2011 , the FASB issued amended disclosure requirements for offsetting financial assets and financial liabilities to allow investors to better compare financial statements prepared under US GAAP with financial statements prepared under International Financial Reporting Standards. The new standards are effective for us beginning in the first quarter of our fiscal year endingSeptember 30, 2014 . We are currently evaluating the impact of this new accounting guidance on the disclosures included in our consolidated financial statements.Critical Accounting Policies and Estimates
Our Consolidated Financial Statements have been prepared in accordance with US GAAP and fairly present our financial position and results of operations. We believe the following accounting policies are critical to an understanding of our financial statements. The application of these policies requires management's judgment and estimates in areas that are inherently uncertain.General
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to be recovered or settled. The Company has the ability and intent to recover in a tax-free manner assets (or liabilities) with book/tax basis differences for which no deferred taxes have been provided, in accordance with Accounting Standards Codification ("ASC") Topic 740, Income Taxes,("ASC 740"). Accordingly, the Company did not provide deferred income taxes on the bargain purchase gain of$158 million on the FGL acquisition or the gain on contingent purchase price reduction of$41 million in Fiscal 2011 and 2012, respectively. The effect on deferred tax assets and liabilities of a change in the tax rates is recognized in earnings in the period that includes the enactment date. Additionally, taxing jurisdictions could retroactively disagree with our tax treatment of certain items, and some historical transactions have income tax effects going forward. Accounting guidance requires these future effects to be evaluated using current laws, rules and regulations, each of which can change at any time and in an unpredictable manner. In accordance with ASC 740, we establish valuation allowances for deferred tax assets when, in our judgment, we conclude that it is more likely than not that the deferred tax assets will not be realized. We base these 128--------------------------------------------------------------------------------
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judgments on projections of future income, including tax-planning strategies, by individual tax jurisdiction. Changes in industry and economic conditions and the competitive environment may impact the accuracy of our projections. In accordance with ASC 740, during each reporting period, we assess the likelihood that our deferred tax assets will be realized and determine if adjustments to our valuation allowance are appropriate. As a result of this assessment, as ofSeptember 30, 2012 , our consolidated valuation allowance was$660 million . The increase and/or decrease of valuation allowances has had and could have a significant negative or positive impact on our current and future earnings. In Fiscal 2012, we recorded a net reversal of valuation allowances of$142 million . In Fiscal 2011 and 2010, we recorded net charges for the establishment of valuation allowances of$72 million and$93 million , respectively. We also apply the accounting guidance for uncertain tax positions under ASC 740 which prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Our reserve for uncertain tax positions totaled$6 million and$9 million as ofSeptember 30, 2012 and 2011, respectively.See further discussion in Note 17, Income Taxes, to our Consolidated Financial Statements.
Loss Contingencies Loss contingencies are recorded as liabilities when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. The outcome of existing litigation, the impact of environmental matters and pending or potential examinations by various taxing or regulatory authorities are examples of situations evaluated as loss contingencies. Estimating the probability and magnitude of losses is often dependent upon management's judgment of potential actions by third parties and regulators. It is possible that changes in estimates or an increased probability of an unfavorable outcome could materially affect our business, financial condition or results of operations. The establishment of litigation, regulatory and environmental reserves requires judgments concerning the ultimate outcome of pending claims against us and our subsidiaries. In applying judgment, management utilizes opinions and estimates obtained from outside legal counsel to apply the appropriate accounting for contingencies. Accordingly, estimated amounts relating to certain claims have met the criteria for the recognition of a liability. Other claims for which a liability has not been recognized are reviewed on an ongoing basis in accordance with accounting guidance. A liability is recognized for all associated legal costs as incurred. Liabilities for litigation settlements, regulatory matters, environmental settlements, legal fees and changes in these estimated amounts may have a material impact on our financial position, results of operations or cash flows. If the actual cost of settling these matters, whether resulting from adverse judgments or otherwise, differs from the reserves totaling$28 million we have accrued as ofSeptember 30, 2012 , that difference will be reflected in our results of operations when the matter is resolved or when our estimate of the cost changes.See further discussion in Note 19, Commitments and Contingencies, to our Consolidated Financial Statements.
Consumer Products and Other
Valuation of Embedded Derivative
Our Preferred Stock contains a "down round" provision, whereby the conversion price will be adjusted in the event that we issue certain equity securities at a price lower than the contractual conversion prices of$6.50 for the Series A Preferred Stock or$7.00 for the Series A-2 Preferred Stock. Therefore, in accordance with the guidance in ASC Topic 815, Derivatives and Hedging, this conversion feature required bifurcation and must be separately accounted for as a derivative liability at fair value with any changes in fair value reported in current 129--------------------------------------------------------------------------------
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earnings. We re-measure the fair value of this equity conversion feature on a recurring basis using the Monte Carlo simulation approach, which utilizes various inputs including HGI's stock price, volatility, risk-free rate and discount yield. The estimated fair value of this equity conversion feature was a liability of$232 million atSeptember 30, 2012 compared to$75 million atSeptember 30, 2011 and$103 million at the respective issuance dates of the Preferred Stock in Fiscal 2011. Although we use a consistent approach to valuing this equity conversion feature on a recurring basis, the use of a different approach or underlying assumptions could have a material effect on the estimated fair value. See Note 6, Derivative Financial Instruments, Note 7, Fair Value of Financial Instruments, and Note 13, Temporary Equity, to our Consolidated Financial Statements for a more complete discussion of our Preferred Stock and related derivative liability.Valuation of Assets and Asset Impairment
We evaluate certain long-lived assets to be held and used, such as properties and definite-lived intangible assets for impairment based on the expected future cash flows or earnings projections associated with such assets. Impairment reviews are conducted at the judgment of management when it believes that a change in circumstances in the business or external factors warrants a review. Circumstances such as the discontinuation of a product or product line, a sudden or consistent decline in the sales forecast for a product, changes in technology or in the way an asset is being used, a history of operating or cash flow losses or an adverse change in legal factors or in the business climate, among others, may trigger an impairment review. An asset's value is deemed impaired if the discounted cash flows or earnings projections generated do not support the carrying value of the asset. The estimation of such amounts requires management's judgment with respect to revenue and expense growth rates, changes in working capital and selection of an appropriate discount rate, as applicable. The use of different assumptions would increase or decrease discounted future operating cash flows or earnings projections and could, therefore, change impairment determinations. ASC Topic 350 requires companies to test goodwill and indefinite-lived intangible assets for impairment annually, or more often if an event or circumstance indicates that an impairment loss may have been incurred. In Fiscal 2012, Fiscal 2011 and Fiscal 2010, we tested our goodwill and indefinite-lived intangible assets as required. As a result of this testing, we recorded non-cash pretax impairment charges related to certain trade name intangible assets of approximately$32 million in Fiscal 2011 and no impairment charges in Fiscal 2012 and 2010. We used a discounted estimated future cash flows methodology, third party valuations and negotiated sales prices to determine the fair value of our reporting units (goodwill). Fair value of indefinite-lived intangible assets, which represent trade names, was determined using a relief from royalty methodology. Assumptions critical to our fair value estimates were: (i) the present value factors used in determining the fair value of the reporting units and trade names or third party indicated fair values for assets expected to be disposed; (ii) royalty rates used in our trade name valuations; (iii) projected average revenue growth rates used in the reporting unit and trade name models; and (iv) projected long-term growth rates used in the derivation of terminal year values. We also tested the aggregate estimated fair value of our consumer products reporting units for reasonableness by comparison toSpectrum Brands' total market capitalization, which includes both its equity and debt securities. These and other assumptions are impacted by economic conditions and expectations of management and will change in the future based on period specific facts and circumstances. The fair values of the global batteries & appliances, global pet supplies and home and garden business reporting units exceeded their carry values by 71%, 55% and 30%, respectively, as of the date of the latest annual impairment testing in Fiscal 2012.See Note 2, Significant Accounting Policies and Practices, and Note 10, Goodwill and Intangibles, to our Notes to Consolidated Financial Statements for more information about our asset impairment determinations.
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Insurance and Financial Services
Valuation of
Available-for-Sale Securities FGL's fixed maturity securities (bonds and redeemable preferred stocks maturing more than one year after issuance) and equity securities (common and perpetual preferred stocks) classified as available-for-sale are reported at fair value, with unrealized gains and losses included within accumulated other comprehensive income (loss), net of associated intangibles adjustments and deferred income taxes. Unrealized gains and losses represent the difference between the cost or amortized cost basis and the fair value of these investments. FGL utilizes independent pricing services in estimating the fair values of investment securities. The independent pricing services incorporate a variety of observable market data in their valuation techniques, including: reported trading prices, benchmark yields, broker-dealer quotes, benchmark securities, bids and offers, credit ratings, relative credit information, and other reference data.The following table presents the fair value of fixed maturity and equity securities, available-for-sale, by pricing source and hierarchy level as of
September 30, 2012 (dollars in millions):Quoted Prices in Significant Active Markets for Significant Unobservable Identical Assets Observable Inputs Inputs (Level 1) (Level 2) (Level 3) TotalPrices via third party pricing services $ 930 $ 15,242 $ - $ 16,172 Priced via independent broker quotations - - 133 133 Priced via other methods - - 32 32 Total $ 930 $ 15,242 $ 165 $ 16,337 % of total 6 % 93 % 1 % 100 % Management's assessment of all available data when determining fair value of the available-for-sale securities is necessary to appropriately apply fair value accounting. The independent pricing services also take into account perceived market movements and sector news, as well as a security's terms and conditions, including any features specific to that issue that may influence risk and marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary. FGL generally obtains one value from its primary external pricing service. In situations where a price is not available from this service, FGL may obtain further quotes or prices from additional parties as needed. FGL validates external valuations at least quarterly through a combination of procedures that include the evaluation of methodologies used by the pricing services, comparisons to valuations from other independent pricing services, analytical reviews and performance analysis of the prices against trends, and maintenance of a securities watch list.See Note 5, Investments, and Note 7, Fair Value of Financial Instruments, to our Consolidated Financial Statements for a more complete discussion.
Evaluation of Other-Than-Temporary Impairments
FGL has a policy and process in place to identify securities in its investment portfolio that could potentially have an impairment that is other-than-temporary. This process involves monitoring market events and other items that could impact issuers. The evaluation includes but is not limited to such factors as: the length of time and the extent to which the fair value has been less than cost or amortized cost; whether the issuer is current on all payments and all contractual payments have been made as agreed; the remaining payment terms and the financial condition and near-term prospects of the issuer; the lack of ability to refinance due to liquidity problems in the 131--------------------------------------------------------------------------------
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credit market; the fair value of any underlying collateral; the existence of any credit protection available; the intent to sell and whether it is more likely than not it would be required to sell prior to recovery for debt securities; the assessment in the case of equity securities including perpetual preferred stocks with credit deterioration that the security cannot recover to cost in a reasonable period of time; the intent and ability to retain equity securities for a period of time sufficient to allow for recovery; consideration of rating agency actions; and changes in estimated cash flows of residential mortgage and asset-backed securities. FGL determines whether other-than-temporary impairment losses should be recognized for debt and equity securities by assessing all facts and circumstances surrounding each security. Where the decline in market value of debt securities is attributable to changes in market interest rates or to factors such as market volatility, liquidity and spread widening, and FGL anticipates recovery of all contractual or expected cash flows, FGL does not consider these investments to be other-than- temporarily impaired because it does not intend to sell these investments and it is not more likely than not it will be required to sell these investments before a recovery of amortized cost, which may be maturity. For equity securities, FGL recognizes an impairment charge in the period in which it does not have the intent and ability to hold the securities until recovery of cost or it determines that the security will not recover to book value within a reasonable period of time. FGL determines what constitutes a reasonable period of time on a security-by-security basis by considering all the evidence available, including the magnitude of any unrealized loss and its duration.See Note 2, Significant Accounting Policies and Practices, and Note 5, Investments, to our Consolidated Financial Statements for a more complete discussion.
Valuation of Derivatives
FGL's fixed indexed annuity contracts permit the holder to elect to receive a return based on an interest rate or the performance of a market index. FGL hedges certain portions of its exposure to equity market risk by entering into derivative transactions. In doing so, FGL uses a portion of the deposit made by policyholders pursuant to FIA contracts to purchase derivatives consisting of a combination of call options and futures contracts on the equity indices underlying the applicable policy. These derivatives are used to fund the index credits due to policyholders under the FIA contracts. The options are one, two and three year options purchased to match a majority of the funding requirements underlying the FIA contracts, with the balance of the equity exposure hedged using futures contracts. On the respective anniversary dates of the applicable FIA contracts, the market index used to compute the annual index credit under the applicable FIA contract is reset. At such time, FGL purchases new one, two or three year call options to fund the next index credit. FGL attempts to manage the cost of these purchases through the terms of the FIA contracts, which permits changes to caps or participation rates, subject to certain guaranteed minimums that must be maintained. FGL is exposed to credit loss in the event of nonperformance by its counterparties on the call options. FGL attempts to reduce the credit risk associated with such agreements by purchasing such options from large, well-established financial institutions as well as holding collateral when individual counterparty exposures exceed certain thresholds. All of FGL's derivative instruments are recognized as either assets or liabilities at fair value in the Consolidated Balance Sheets. The change in fair value is recognized in the Consolidated Statements of Operations within "Net investment gains (losses)." Certain products contain embedded derivatives. The feature in the FIA contracts that permits the holder to elect an interest rate return or an equity-index linked component, where interest credited to the contracts is linked to the performance of various equity indices, represents an embedded derivative. The FIA embedded derivative is valued at fair value and included in the liability for contractholder funds in the Consolidated Balance Sheets with changes in fair value included as a component of "Benefits and other changes in policy reserves" in the Consolidated Statements of Operations.The fair value of derivative assets and liabilities is based upon valuation pricing models and represent what FGL would expect to receive or pay at the balance sheet date if it cancelled the options, entered into offsetting
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positions, or exercised the options. The fair value of futures contracts at the balance sheet date represents the cumulative unsettled variation margin (open trade equity net of cash settlements). Fair values for these instruments are determined externally by an independent actuarial firm using market observable inputs, including interest rates, yield curve volatilities, and other factors. Credit risk related to the counterparty is considered when estimating the fair values of these derivatives. However, FGL is largely protected by collateral arrangements with counterparties when individual counterparty exposures exceed certain thresholds.The fair values of the embedded derivatives in FGL's FIA products are derived using market indices, pricing assumptions and historical data.
See Note 6, Derivative Financial Instruments, and Note 7, Fair Value of Financial Instruments, to our Consolidated Financial Statements for a more complete discussion.
Value of Business Acquired (VOBA) and Deferred Policy Acquisition Costs (DAC)
VOBA is an intangible asset that reflects the estimated fair value of in-force contracts in a life insurance company acquisition less the amount recorded as insurance contract liabilities. It represents the portion of the purchase price that is allocated to the value of the rights to receive future cash flows from the business in-force at the acquisition date. Costs relating to the production of new business are not expensed when incurred but instead are capitalized as DAC. DAC consists principally of commissions and certain costs of policy issuance. Deferred sales inducements ("DSI"), which are accounted for similar to and included with DAC, consist of premium and interest bonuses credited to policyholder account balances. Only costs which are expected to be recovered from future policy revenues and gross profits may be deferred.VOBA and DAC are subject to loss recognition testing on a quarterly basis or when an event occurs that may warrant loss recognition.
For annuity products, these costs are being amortized generally in proportion to estimated gross profits from investment spread margins, surrender charges and other product fees, policy benefits, maintenance expenses, mortality net of reinsurance ceded and expense margins, and recognized gain (loss) on investments. Current and future period gross profits for FIA contracts also include the impact of amounts recorded for the change in fair value of derivatives and the change in fair value of embedded derivatives. Current period amortization is adjusted retrospectively through an unlocking process when estimates of current or future gross profits (including the impact of recognized investment gains and losses) to be realized from a group of products are revised. FGL's estimates of future gross profits are based on actuarial assumptions related to the underlying policies' terms, lives of the policies, yield on investments supporting the liabilities and level of expenses necessary to maintain the polices over their entire lives. Revisions are made based on historical results and FGL's best estimates of future experience. Estimated future gross profits vary based on a number of sources including investment spread margins, surrender charge income, policy persistency, policy administrative expenses and recognized gains and losses on investments including credit related other-than-temporary impairment losses. Estimated future gross profits are most sensitive to changes in investment spread margins which are the most significant component of gross profits. See Note 2, Significant Accounting Policies and Practices, and Note 10, Goodwill and Intangibles, to our Consolidated Financial Statements for a more complete discussion.We continually update and assess the facts and circumstances regarding all of these critical accounting matters and other significant accounting matters affecting estimates in our financial statements.
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FLAGSTONE REINSURANCE HOLDINGS, S.A. FILES (8-K) Disclosing Change in Directors or Principal Officers, Other Events, Financial Statements and Exhibits
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