The following selected consolidated financial data for each of the five years in the period ended December 31, 2008 have been derived from Gallagher’s Consolidated Financial Statements. Such data should be read in conjunction with Gallagher’s Consolidated Financial Statements and related Notes thereto in Item 8 of this annual report.
The following discussion and analysis should be read in conjunction with Arthur J. Gallagher & Co.’s (Gallagher) Consolidated Financial Statements and the related Notes thereto that are included elsewhere herein.
Upon initially obtaining control, the acquiring entity in a business combination must recognize 100% of the fair value of the acquired assets, including goodwill, and assumed liabilities, with only limited exceptions, even if the acquirer has not acquired 100% of its target entity. As a consequence, the current step acquisition model will be eliminated.
Allocations of investment income and certain expenses are based on reasonable assumptions and estimates primarily using revenue, headcount and other information. Gallagher allocates the provision for income taxes to the Brokerage and Risk Management Segments as if those segments were preparing income tax provisions on a separate company basis. As a result, the provision for income taxes for the Financial Services and Corporate Segment reflects the entire benefit to Gallagher of the IRC Section 29-related credits in 2007 and 2006 because that is the segment which produced the credits. The law that provided for IRC Section 29-related credits expired on December 31, 2007. Gallagher anticipates reporting an effective tax rate of approximately 39.0% to 41.0% in both its Brokerage Segment and its Risk Management Segment for the foreseeable future. Reported operating results by segment would change if different allocation methods were applied.
The increase in compensation expense in 2008 compared to 2007 was primarily due to an increase in the average number of employees, salary increases, increases in incentive compensation linked to Gallagher’s overall operating results ($51.5 million in the aggregate) and an increase in severance costs ($1.8 million). These increases were partially offset by a decrease in expense related to employee benefit cost savings ($4.3 million) and stock-based compensation ($0.6 million). The increase in employee headcount in 2008 primarily relates to the addition of employees associated with the acquisitions that were made in the last twelve months. The increase in compensation expense in 2007 compared to 2006 was primarily due to an increase in the average number of employees, salary increases, increases in incentive compensation linked to Gallagher’s overall operating results ($59.8 million in the aggregate), an increase in severance costs ($2.1 million) and the adverse impact of foreign currency translation ($6.2 million). These increases were partially offset by a decrease in expense related to stock-based compensation ($2.6 million) and employee benefit plan cost savings ($7.8 million). The increase in employee headcount in 2007 primarily relates to the addition of employees associated with the acquisitions that were made in the last twelve months.
In 2006, Gallagher recorded a pretax charge of $9.0 million ($5.4 million after tax) to increase its reserve for the costs to be incurred in connection with the regulatory and legal actions by the State Attorneys General and private litigants related to contingent commissions and various other historical business practices, as described more fully in Note 17 to the Consolidated Financial Statements and “Management’s Discussion and Analysis - Contingent Commissions and Other Industry Developments.”
The Risk Management Segment accounted for 28% of Gallagher’s revenue from continuing operations in 2008. It provides contract claim settlement and administration services for enterprises that choose to self-insure some or all of their P/C coverages and for insurance companies that choose to outsource some or all of their P/C claims departments. In addition, Gallagher generates revenues from integrated disability management programs, information services, risk control consulting (loss control) services and appraisal services, either individually or in combination with arising claims. This segment’s revenues for risk management services are substantially in the form of fees that are generally negotiated in advance on a per-claim or per-service basis, depending upon the type and estimated volume of the services to be performed.
The increase in compensation expense in 2008 compared to 2007 was primarily due to an increase in the average number of employees and salary increases ($21.9 million in the aggregate), temporary help ($1.5 million), employee benefit costs ($1.3 million) and the unfavorable impact of foreign currency translation ($0.2 million). The increase in compensation expense in 2007 compared to 2006 was due to an increase in the average number of employees and salary increases ($23.3 million in the aggregate), an increase in incentive compensation ($2.9 million) and the adverse impact of foreign currency translation ($3.8 million), partially offset by a decrease in employee benefit plan costs ($4.9 million) and decreased temporary-help costs ($2.4 million). The increase in employee headcount in 2008 and 2007 relates to the hiring of additional staff to support claims activity related to anticipated new business.
Investment expenses primarily included the operating expenses of the IRC Section 29-related Syn/Coal facilities, and expenses related to a Headwaters Incorporated (Headwaters) royalty expense. The decreases in investment expenses related to the unconsolidated and consolidated facilities in 2008 compared to 2007 were due to the expiration of IRC Section 29 related tax credits as of December 31, 2007. The 2008 amount represents the adjustments from the 2007 amounts recorded based on the estimated 2007
The increase in interest expense in 2008 compared to 2007 was primarily due to the $14.8 million increase in interest related to Gallagher’s $400.0 million Note Purchase Agreement, which was entered into on August 3, 2007, partially offset by a $1.8 million reduction in interest incurred on borrowings made under Gallagher’s unsecured multicurrency credit agreement. The increase in interest expense in 2007 compared to 2006 was primarily related to Gallagher’s $400.0 million Note Purchase Agreement ($10.9 million), plus interest incurred on the 2007 borrowings made under Gallagher’s unsecured multicurrency credit agreement ($4.6 million) (which was fully repaid on August 7, 2007), partially offset by a decrease in interest expense due to the sales of the home office building in December 2006 ($6.4 million) and the airplane leasing company in January 2007 ($1.5 million). Prior to the sale transactions, these two investments were consolidated into Gallagher’s Consolidated Financial Statements and had outstanding debt.
Although Gallagher is not currently experiencing any limitation of access to its revolving credit facility and is not aware of any issues currently impacting the ability or willingness of the lenders under its revolving credit facility to honor their commitment to extend credit, the U.S. and global credit crisis could adversely affect its ability to borrow on its revolving credit facility in the future.
In 2008, Gallagher declared $121.2 million in cash dividends on its common stock, or $1.28 per common share. On January 15, 2009, Gallagher paid a fourth quarter dividend of $.32 per common share to shareholders of record at December 31, 2008, a 3.3% increase over the fourth quarter dividend per share in 2007. On January 29, 2009, Gallagher announced a quarterly dividend for first quarter of 2009 of $.32 per common share. If the dividend is maintained at $.32 per common share throughout 2009, this dividend level would result in an annualized net cash used by financing activities in 2009 of approximately $123.4 million (based on the outstanding shares as of December 31, 2008), or an increase in cash used of approximately $4.9 million.
See Note 5 to the consolidated financial statements for a discussion on the amounts reclassified to discontinued operations related to Gallagher’s global reinsurance and Irish wholesale brokerage businesses.
Under SFAS 157, fair value refers to the price that would be received from the sale of an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts business. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, the standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data, for example, the reporting entity’s own data. Fair value measurements are required to be separately disclosed by level within the fair value hierarchy.
The following table sets forth the computation of basic and diluted net earnings per share (in millions, except per share data):
In 1992, Gallagher amended its health benefits plan to eliminate retiree coverage, except for retirees and those employees who had already attained a specified age and length of service at the time of the amendment. The retiree health plan is contributory, with contributions adjusted annually, and is funded on a pay-as-you-go basis.
As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of sixteen of the thirty-seven acquisitions completed in 2008, which are included in the 2008 consolidated financial statements of Gallagher. Collectively, these acquisitions constituted approximately 2.1% of total assets as of December 31, 2008 and approximately 2.3% of total revenues and 0.6% of earnings from continuing operations for the year then ended. Our audit of internal control over financial reporting of Gallagher also did not include an evaluation of the internal control over financial reporting of these acquired entities.