Our business activities are conducted principally in leased office space in cities throughout the world. Certain of our subsidiaries do own and occupy a few office buildings, primarily in certain foreign countries. In general, no difficulty is anticipated in negotiating renewals as leases expire or in finding other satisfactory space if the premises become unavailable. In certain circumstances, we may have unused space and may seek to sublet such space to third parties, depending upon the demands for office space in the locations involved.
•the effectiveness and collectability of our reinsurance contracts, particularly in programs where we serve as the fronting company, ceding substantially all risk
Liquidity is derived from cash flows from our business, excluding funds held on behalf of clients and from financing. We use liquidity for capital expenditures, to repay debt, to fund acquisitions and pension obligations, to repurchase shares and to pay dividends to our stockholders. Because we are a holding company, our subsidiaries may not have available cash to pay us dividends; in the case of the insurance underwriting subsidiaries, this ability is limited by regulatory and rating agency considerations. Our access to cash generated from operations outside the U.S. may be affected by tax considerations and by pension funding requirements in our international pension plans.
Our revenues from continuing operations were down 1% or $94 million compared to 2004 due to:
•In 2004, we sold virtually all of our investment in Endurance common stock, although we continue to hold Endurance warrants. In 2004, we recognized a $48 million pretax gain from selling the stock, plus $38 million from our equity investment. In 2005, we recognized a $10 million pretax gain from the change in the fair value of the warrants.
•The absence of $212 million of claim services revenue, principally from our Cambridge Integrated Services Group, Inc. ("Cambridge") business, which we sold late in 2004. This more than offset improved operating results, principally in our U.S. retail brokerage business.
These factors more than offset higher revenues generated by our core brokerage businesses, especially in the U.S.
Organic revenue growth (which adjusts revenue growth for the effects of foreign exchange and other factors) was flat for the year. Excluding contingent commissions, organic revenue growth was 1%.
We continue to do a better job of generating and managing our cash and investments. More specifically, we:
•are managing our cash to improve our debt to capital ratio, fund our pension plans and increase our return on assets. The decrease in our cash balance of $94 million reflects $463 million of pension contributions, a $76 million payment to the settlement fund for the NYAG investigation
•are aggressively restructuring our businesses to reflect changes in our industry. We anticipate these efforts will generate approximately $180 million in annualized cash savings by 2008.
The following chart details the restructuring and related expenses incurred in 2005 and estimated for 2006 and 2007 by geographic region:
(1)Our estimated costs are forward looking and should be read in connection with our risk factors. Actual costs may vary due to changes in the assumptions built into this plan. Some of the assumptions likely to change when plans are finalized and approved include changes in severance calculations, the assumptions underlying our sublease loss calculations due to changing market conditions and our overall analysis that might cause us to add or cancel component initiatives. Year-to-date, restructuring and related expenses amounted to $158 million, which include:
•$17 million in asset impairments, of which $13 million related to an automated client renewal software program in the U.K. that was abandoned as part of our restructuring efforts.
(1)Our revenue was $100 million lower in 2005 than 2004 because we terminated contingent commission arrangements.
settlement amount of $190 million and the expense of $180 million. $5 million of the discount was accreted in 2005 and the remainder will accrete into our financial statements as outlined below.
Below is a summary of the expense and cash payments we have incurred and that we are scheduled to incur because of the settlement.
In November 2004, we sold our Cambridge claims administration business to Scandent Holdings Mauritius Limited ("SHM") for $90 million in cash plus convertible preferred stock in SHM, valued at $15 million. Because of our convertible preferred stock holding and other factors, we included Cambridge's results before the sale's effective date, as well as a pretax gain on the sale of $15 million, in income from continuing operations.
From time to time, we explore strategic alternatives for our various businesses. In fourth quarter 2005, we announced that we were exploring alternatives to our ownership of our warranty, credit and property and casualty businesses to determine if the potential of these businesses can be more fully realized under different ownership.
In November 2005, we announced that our Board of Directors had authorized the repurchase of up to $1 billion of Aon's common stock. Any repurchased common stock will be available for employee stock plans and for other corporate purposes. From time to time, we may purchase shares through the open market or in privately negotiated transactions based on prevailing market conditions, which will be funded from available capital. During fourth quarter 2005, we repurchased 675,000 shares for $25 million.
Aon's consolidated financial statements have been prepared according to U.S. generally accepted accounting principles (GAAP). To prepare these financial statements, we made estimates, assumptions and judgments that affect:
•regularly evaluate our estimates, assumptions and judgments, including those concerning revenue recognition, investments, intangible assets, income taxes, financing operations, policy liabilities (including future policy benefit reserves, unearned premium reserves and policy and contract claim reserves), restructuring costs, retirement benefits and contingencies and litigation
•identify the specific classification (or functions) and locations of the employees being terminated
When employees are receiving incentives to stay beyond the legally required notification period, we spread the entire cost of their severance over the remaining service period.
Where we have provided notice of cancellation pursuant to a lease agreement or abandoned space and have no intention of reoccupying it, we recognize a loss. The loss reflects our best estimate of the net present value of the future cash flows associated with the lease at the date we vacate the property or sign a sublease arrangement. To determine the loss, we make assumptions about the time period over which the building will remain vacant and the sublease terms.
•reducing the book value to the net present value of future cash flows (in situations where the asset had an identifiable cash flow stream) or
As we incur restructuring expenses, we classify them in our income statement in these categories:
•general expenses includes workforce reduction and lease consolidation costs, along with other costs, and
Aon uses a market-related valuation of assets to calculate pension expense. This valuation reflects a five-year average of the difference between the expected return on plan assets and the actual market value return. The prior year market-related value is projected to the current date by adjusting for contributions, benefit payments and expected returns. The asset gain or loss is the difference between the expected return on assets and the actual return on assets. Twenty percent of the asset gain or loss is recognized in the current year's market-related value, with the remaining eighty percent spread evenly over the next four years.
To determine future pension expense, we currently assume a long-term rate of return of approximately 8.4%. This expected long-term return was based on capital market expectations for various asset classes (see following table). U.S. equities and fixed income expectations were built using a theoretical Capital Asset Pricing ("CAP") Model. The CAP Model included three factors for equities: current dividend yield (1.6%); corporate earnings nominal growth (7.2%); and P/E ratio repricing (0.0%). The 5.8% fixed income expectation factor included the then current 10-year U.S. Treasury Note yields and simulations of future yields based on expected inflation and other factors. Other asset classes expectations were based on risk premiums relative to U.S. equities and fixed income expected returns. Estimates of volatilities and correlations among asset classes were based on historical data. We then weight the expected returns for each asset class by the plan's target allocation.
This table shows the result of the calculation based on the target asset allocation for year-end 2005. The actual return for the 2005 valuation year of 11.8% was in excess of the assumed return.
Required cash contributions are also sensitive to assumptions, however the assumptions used to determine contributions to the plan are changed infrequently. We anticipate cash funding requirements of $6 million in 2006. Under current rules and assumptions, we anticipate funding requirements of $199 million in 2007. Legislation being considered in Congress may reduce the 2007 requirement to $43 million if passed. Pension reform legislation may further change this requirement.
The U.K. pension plans are closed to new entrants and all employees hired after 1999 become participants in a defined contribution plan. As with the U.S. plans, this change will reduce the volatility inherit in the accounting for U.K. pension plans. The other international plans and the U.K. plans are solely obligations of Aon Corporation subsidiaries.
This table shows the result of the calculation based on the target asset allocation as of year-end 2005. Since there are six major pension plans maintained in the U.K., the Target Allocation represents a weighted average of the target allocation of each plan. Further, target allocations are subject to change. The actual return for the 2005 valuation year of 19% was in excess of the assumed return.
•increase in our estimated discount rate would decrease the estimated 2006 pension expense by approximately $60 million.
At year-end 2005, a U.K. pension plan had a prepaid pension asset of $16 million. In the future, if the funded status of the plan deteriorates, this amount could be reflected in a minimum pension liability, which would reduce stockholders' equity.
To determine pension expense, we use the fair market value of plan assets that, at year-end 2005, amounted to $349 million. At the end of 2005, the Dutch pension plan has a combined deferred loss of $108 million that has not yet been recognized through income in the financial statements. We amortize the accumulated loss outside of a corridor over 20 years; this corridor is defined as 10% of the greater of the fair value of plan assets or the projected benefit obligation. For 2006, the estimated amortization amount to be recognized in expense is $3 million. To the extent not offset by future gains, the incremental amortization as calculated above will continue to affect future pension expense in a similar manner until fully amortized.
The target asset allocation is 35% equities and 65% fixed income securities, with an allowed deviation of 5%. At year-end 2005, the actual asset allocation was consistent with the target allocation. The expected long-term rate of return is 6%, which results from an expected future return of 8% on equities and a 5% return on fixed income investments.
•decrease in our estimated long-term rate of return on plan assets would increase the estimated 2006 pension expense by approximately $4 million and
•increase in our estimated long-term rate of return on plan assets would decrease the estimated 2006 pension expense by approximately $4 million.
To establish policy liabilities, we develop estimates of reported and anticipated claims, based on our historical experience, other actuarial data and assumptions on investment yields. We base interest rate assumptions on factors such as market conditions and expected investment returns. Although mortality, morbidity, persistency and interest rate assumptions are set when we issue new insurance policies, we may need to provide for additional losses on a product by increasing reserves, reducing previously capitalized acquisition costs established for that product, or establishing premium deficiency reserves if there are significant changes in our experience or assumptions. Since estimating and establishing policy and contract liabilities is inherently uncertain, the actual ultimate cost of a claim may vary materially from the estimated amount reserved.
ultimate cost of settling claims using best estimates of past experience. These estimates reflect current trends and any other factors that influence historical data. Actual experience, however, may vary from our estimates, due to changes in claim reporting, processing patterns and variations from historic averages for the amount paid per claim. Variations from historic patterns and averages could result in additional changes that increase or decrease unpaid claim liabilities. As of December 31, 2005, there were no known changes in reporting or processing patterns.
Of course, actual experience may vary from our estimates, due to emerging trends in morbidity, mortality, persistency and asset yields-and some of these trends can fluctuate significantly over time. As we realize the actual experience, we take into account the financial impacts of these changes to our original assumptions. When current estimates of the present value of future benefits exceed the present value of future premiums for a product line, we recognize all excess amounts as a loss. There are no current estimates of the overall net gain resulting from improvements from original assumptions.
•the balance that accrues to the benefit of policyholders at the date of the financial statements,
Reserves for claim liabilities were $428 million, $422 million and $447 million as of December 31, 2005, 2004 and 2003, respectively. A 1% increase in the assumed medical cost trends would reduce pretax income by approximately $3 million.
Used product warranties are also sold but without underlying manufacturer warranty and so revenue recognition begins immediately.
In addition to the term of the warranty, we take other characteristics into account when we estimate reserves. We review considerations such as the manufacturer or classes of products and embed them in our calculation methodology.
Similar to other underwriting activities, we use historic loss development factors to project the ultimate loss. For recent periods, we use the Bornhuetter-Ferguson method, commonly used in underwriting businesses. Bornhuetter-Ferguson:
•computes the expected loss ratio using either judgment, recent experience, or other commonly used statistical methods, such as the Cape Cod method.
We estimate loss reserves for all property and casualty lines of business by accident year, using a minimum of five standard actuarial techniques; these techniques include, but are not limited to, incurred and paid loss development factors based on both program history and industry development patterns for similar lines of business. We also use the Bornhuetter-Ferguson Method, which incorporates historical loss ratio performance weighted with case emergence to date. When we have the data available, we use frequency and severity methods to evaluate any data on claim count emergence and severity trends.
We evaluate selected ultimate losses for business on a direct, assumed, ceded and net basis. From the selected ultimate losses, we deduct paid losses to arrive at the total reserve. The total reserve includes case reserves and incurred but not reported reserves.
Each quarter, we review invested assets with material unrealized losses. Those assets are separated into two categories:
•monitor cash flow trends and underlying levels of collateral for asset-backed securities
We recognize an other-than-temporary impairment loss when appropriate for these investments with continuous material unrealized losses due to issuer-specific events. We base our decision on the facts and circumstances for each investment.
Invested assets with unrealized losses due to market conditions or industry-related events include those impacted by increasing U.S. Treasury or local sovereign interest rates; corporate and asset-backed credit spread widening; common stock price volatility due to conditions in the overall market or a particular industry; and illiquid market conditions.
Sometimes, we assume that a decline in value below cost is temporary for fixed-maturity investments with unrealized losses due to market conditions or industry-related events when the market is expected to recover and we can hold the investment until maturity or the market recovers, which is a decisive factor when considering an impairment loss. If we decide that holding the investment is no longer appropriate, we will reevaluate that investment for other-than-temporary impairment.
•amortize intangible assets other than goodwill over their estimated useful lives, while goodwill is not subject to amortization.
Brokerage commissions and fees decreased by $176 million or 3% from the prior year driven by $100 million in lower contingent commission revenue and net dispositions of $168 million, partially offset by strong renewals and new business.
In total, investment income was up $22 million or 7% from last year. Investment income includes related investment expense and income or loss on investment disposals and impairments. See our Review by Segment section for further detail.
U.S. revenue, which represents 50% of total revenue, decreased $161 million or 3% in 2005 compared to 2004. The decrease primarily reflects the 2004 sale of Cambridge.
U.K. revenue decreased $165 million or 10%. Excluding the effects of foreign currency exchange, revenue decreased $158 million. This reflects a soft U.K. market and changes in the model for compensation from underwriters in U.K. Specialty, partially offset by a change in the way we estimate installment revenue in the U.K., which added $23 million to revenue in 2005.
Continent of Europe revenue increased $83 million or 5% and Rest of World revenue increased $149 million or 10%, principally reflecting a weaker U.S. dollar.
These favorable impacts were partially offset by $158 million in restructuring related expenses. For further detail on expenses refer to the Review by Segment section.
Income from Continuing Operations Before Provision for Income Tax and Minority Interest
Income from continuing operations before provision for income tax and minority interest increased $138 million to $965 million. A number of significant items account for the fluctuation, as previously discussed. Approximately 68% of Aon's 2005 consolidated income from continuing operations before the provision for income tax and minority interest was from international operations.
The effective tax rate on income from continuing operations was 33.5% in 2005 and 34.1% in 2004. Differences between the overall effective tax rate and the U.S. federal statutory rate are typically due to U.S. state income taxes and differentials between U.S. and international tax rates. Changes in the mix between our U.S. and international pretax income directly affect our effective tax rates. In 2005 and 2004, our effective tax rate reflects the favorable resolution of tax examination issues, partially offset by the impact of deferred tax adjustments. In 2004, a one-time tax benefit resulting from the
difference between our tax and book basis in Cambridge reduced our effective tax rate. For a summary of these effects, please see the rate reconciliation provided in Note 9 to the consolidated financial statements.
In 2004, revenue increased $467 million or 5% over 2003 to $9.9 billion. This increase was mostly from the movement in foreign exchange rates, as revenue increased $67 million excluding foreign exchange effects.
Brokerage commissions and fees increased by $277 million or 4% from the prior year, driven almost entirely by favorable foreign exchange rates. There was no organic revenue growth in the Risk and Insurance Brokerage Services segment in large part due to the termination of contingent commission arrangements, as well as a softer insurance market. Consulting organic revenue grew 1%.
U.S. revenue, which represents 51% of total consolidated revenue, increased $64 million or 1% in 2004 compared to 2003. The low revenue growth reflected the softer U.S. retail market that began late in 2003 after a two-year rapid increase in premiums following the September 11 tragedy and lower contingent commission revenue. Additionally, the November 2004 sale of Cambridge resulted in a $19 million loss of revenue in 2004 as compared to 2003.
U.K. revenue decreased $24 million or 1%. Excluding the positive effects of foreign currency exchange, revenue decreased $198 million or 10%. The decrease in revenue is attributable to the soft
market, which resulted in lower premiums and commissions. Additionally, the sale of our U.K. claims services business resulted in an $82 million loss of revenue in 2004 as compared to 2003.
•increase in net periodic pension expenses of $47 million for our major plans over 2003
•a $40 million provision for costs to settle the Daniel class action lawsuit.
The 6% increase in benefits to policyholders was driven by the combination of growth in underwriting revenue, the change in an insurance program for a specialty accident and health line and foreign exchange rates. In 2003, expenses increased due to higher claims for National Program Services, Inc. (NPS) of $79 million. NPS was hired to handle quoting, binding, premium collection, claims adjusting and other servicing related to general liability insurance policies issued by one of Aon's subsidiaries. In 2002, we stopped NPS from initiating any new business on our behalf. In 2003, actuaries examined the business that NPS had written and reviewed assumptions, such as historical loss development patterns and expected ultimate loss ratio. As a result of this review, we strengthened our reserves, mainly for accident years 2001 and 2002.
The effective tax rate was 34.1% in 2004 and 36.9% in 2003. Typically, differences between the overall effective tax rate and the U.S. federal statutory rate are due to U.S. state income taxes and differentials between U.S. and international tax rates. Changes in the mix between our U.S. and international pretax income directly impact our effective tax rates. In 2004, a one-time tax benefit resulting from the difference between our tax and book basis in Cambridge reduced our effective tax rate. For a summary of these effects, see the rate reconciliation provided in Note 9 to the consolidated financial statements.
Income from continuing operations decreased to $545 million ($1.63 per diluted income per share) from $642 million ($1.94 per diluted income per share) in 2003. Basic income per share from continuing operations was $1.70 and $2.01 for 2004 and 2003, respectively. Hedging and currency translation gains added $0.11 and $0.07 per share, respectively, to 2004 income from continuing operations.
To compute income per share, we have deducted dividends paid on the redeemable preferred stock from net income. In accordance with EITF No. 04-8, we increased diluted shares outstanding by 14 million to reflect the possible conversion of Aon's 3.5% convertible debt securities. When calculating the diluted income per share, we added the after-tax interest expense on these debt securities to income from continuing operations.
Consolidated Results for Fourth Quarter 2005 Compared to Fourth Quarter 2004
Premiums and other increased $13 million or 2% from the prior year, primarily driven by strong growth in a supplemental health product and other warranty programs, which more than offset a decline in our European credit business.
In total, investment income is down $17 million or 14% from fourth quarter 2004. The Risk and Insurance Brokerage Services segment is up $16 million primarily due to an increase in short-term interest rates. Insurance Underwriting is up $7 million, driven by the movement to longer-term, higher-yield investments and improved cash flow. The Corporate segment is down $40 million, driven by the $37 million gain on the sale of virtually all of our Endurance common stock in 2004.
Total expenses decreased $183 million from 2004. The significant drivers of the change include:
•$180 million recorded in 2004 for the settlement with the NYAG and other regulatory authorities compared to $1 million associated with these settlements in 2005.
•$40 million of expense in 2004 relating to the Daniel class action settlement.
Income from continuing operations before provision for income tax increased from $93 million in 2004 to $206 million in 2005. This increase is due primarily to the impact of the $220 million charge relating to the NYAG and other regulatory authorities and Daniel class action settlements in 2004, which was partially offset by $123 million in restructuring related expenses in 2005.
The effective tax rate was 30.1% in 2005 and 21.5% in 2004. The tax rate for the quarter was positively impacted by favorable resolution of tax issues and lower effective state tax rates, partially offset by the impact of restructuring charges. In 2004, a one-time benefit resulting from the difference between the tax and book basis in Cambridge reduced our effective tax rate.
Income from continuing operations increased to $144 million ($0.42 per diluted income per share) from $73 million ($0.22 per diluted income per share) in 2004. Basic income per share from continuing operations was $0.44 and $0.23 for 2005 and 2004, respectively.
possible conversion of Aon's 3.5% convertible debt securities. We have added after-tax interest expense on these debt securities back to income from continuing operations when calculating the diluted income per share.
After-tax income from our discontinued businesses in 2005 was $80 million ($0.25 and $0.23 per basic and diluted income per share, respectively), reflecting primarily the sale of Swett & Crawford. In comparison, income in 2004 from these discontinued operations was $8 million ($0.02 per basic and diluted income per share).
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting (see Note 16 to the consolidated financial statements for further information).
Risk and Insurance Brokerage Services generated approximately 55% of Aon's total operating segment revenues in 2005. Revenues are generated primarily through:
Our risk brokerage companies operate in a highly competitive industry and compete with many retail insurance brokerage and agency firms, as well as with individual brokers and agents and direct writers of insurance coverage. Specifically, this segment:
•addresses the highly specialized product development and risk management needs of commercial enterprises, professional groups, insurance companies, governments, healthcare providers and non-profit groups, among others
•provides affinity products for professional liability, life, disability income and personal lines for individuals, associations and businesses
•provides wholesale brokerage, managing underwriting and premium finance services to independent agents and brokers as well as corporate clients. In 2005, we sold our U.S. wholesale brokerage business, Swett & Crawford, and therefore will no longer provide wholesale brokerage services in the U.S.
•provides actuarial, loss prevention and administrative services to businesses and consumers
•offers claims management and loss cost management services to insurance companies and firms with self-insurance programs. During 2004, we exited most of these activities by completing the sale of our U.K. claims operations in second quarter 2004 and our U.S. third party claims administration business in fourth quarter 2004.
•Claims Services (Claims) offered claims administration and loss cost management services. We exited most of these activities in 2004 by selling our U.S. and U.K. claims administration businesses.
In total, excluding the impact of contingent commissions, organic revenue growth would have been 1%.
Reinsurance is down 2%, despite a favorable foreign exchange impact of $7 million. Organic revenue growth of (5)% is driven primarily by weaker pricing, lower renewal rates, loss of certain accounts in 2004 and higher risk retention by clients.
Claims Services revenue included results from Cambridge, which was sold in fourth quarter 2004.
•U.K. revenue declined $42 million or 4%. Excluding the impact of foreign exchange rates, revenue would have declined $37 million. Both the retail and reinsurance sectors declined, primarily as a result of increased pricing pressures, higher retention of risk by clients and less new business.
•Continent of Europe revenue increased 1%; however, absent the impact of favorable foreign exchange rates, revenue was flat.
•The $75 million or 7% growth in the Rest of World is driven primarily by a favorable foreign currency impact and acquisitions.
Pretax income increased $143 million or 25% from 2004 to $719 million. In 2005, pretax margins in this segment were 13.3%, up from 10.5% in 2004.
•$34 million provision allocation in 2004 for costs to settle the Daniel class action lawsuit
•$143 million in restructuring costs in 2005 with no corresponding costs in 2004
•$85 million reduction in contingent commission revenue in 2005 compared to 2004 caused by the discontinuance of such arrangements
1.Employee Benefits advises clients about the structure, funding and administration of employee benefit programs that attract, retain and motivate employees. Benefits consulting includes health and welfare, retirement, executive benefits, absence management, compliance, employer commitment, investment advisory and elective benefit services.
2.Compensation focuses on designing salary, bonus, commission, stock option and other pay structures, with special expertise in the financial services and technology industries.
4.Communications advises clients on how to communicate initiatives that support their corporate vision.
•Outsourcing, which offers employment processing, performance improvement, benefits administration and other employment-related services.
This table reconciles organic revenue growth to reported revenue growth in 2005 versus 2004.
•Continent of Europe and Rest of World revenues rose on favorable currency exchange impacts, organic revenue growth and the impact of small acquisitions.
Pretax income was $110 million, up $5 million or 5% from 2004. 2005 pretax margins in this segment were 8.8%, up from 8.4% in 2004.
•provides supplemental accident, health and life insurance coverage mostly through direct distribution networks, primarily through more than 6,900 career insurance agents working for
•administers certain extended warranty services on automobiles, electronic goods, personal computers and appliances;
•generated approximately 32% of Aon's total operating segment revenues in 2005.
•expanded product distribution to include affinity groups and worksite marketing, which has created access to new markets and potential new policyholders
•Accident & Health and Life, through which we provide an array of accident, sickness, short-term disability and other supplemental insurance products. Most of these products are primarily fixed-indemnity obligations and are not subject to escalating medical cost inflation.
(1)The difference between written and earned premiums and fees, as a percentage change, was (1)% for accident & health, 1% for warranty and 0% for total revenue. In accident & health and life, revenue increased $84 million, reflecting a 5% increase. The primary drivers of this increase were strong growth in a supplemental health product, improved international revenue and a $16 million favorable impact from foreign exchange rates.
•In 2005, U.S. revenue increased as a result of growth in a supplemental health product and other accident, health & life core products, along with growth in certain warranty programs, which more than offset a change in our role in certain programs from an insurer to an administrator, as well as planned reductions in certain programs and runoff businesses.
•Continent of Europe and Rest of World posted significant revenue improvement primarily as a result of favorable exchange rates and improvements in our European auto and warranty programs. Rest of World's revenue was impacted negatively by the return of warranty premiums and fees related to a mutual agreement with a Japanese company to retroactively terminate a warranty agreement.
The increase in pretax income and margin results from revenue growth in the accident & health and life products along with a $25 million increase in investment income. These gains were partially offset by $11 million of adjustments for the warranty, credit and property & casualty area as discussed above.
Corporate and Other segment revenue included income from Endurance common stock, which was accounted for under the equity method before the sale of virtually all of our holdings in December 2004 and changes in the valuation of Endurance warrants. We carry our investment in Endurance warrants at fair value and record changes in the fair value through Corporate and Other segment revenue.
•analyze various risk factors and identify any specific asset impairments. If we determine there is a specific asset impairment, we recognize a realized loss and adjust the cost basis of the impaired asset to its fair value
•a decline of $38 million in our equity earnings from Endurance, due to the sale of virtually all of our stock in 2004.
•a $10 million non-cash increase in the valuation of our Endurance stock warrants
These revenue and expense comparisons contributed to the overall Corporate and Other pretax loss of $178 million in 2005 versus a pretax loss of $108 million in 2004.
Our routine liquidity needs are for servicing debt and paying dividends on outstanding stock. Our primary source for meeting these requirements is from dividends and internal financing from our operating subsidiaries. After meeting our routine dividend and debt servicing requirements, we used a portion of the remaining funding we received throughout the year for capital expenditures and to repurchase 675,000 shares of common stock.
Cash in our consolidated statements of financial position includes funds available for general corporate purposes. We segregate funds we are holding on behalf of clients and to satisfy policyholder liabilities.
During 2005, we paid the first $76 million installment of the $190 million required under the settlement reached with the NYAG and other regulatory authorities. The remaining payments are scheduled to be paid over the next two years as follows:
In addition to the NYAG and other regulatory authorities' investigations, we have $40 million accrued for costs to settle the Daniel class action lawsuit.
In connection with one of our U.K. pension plans, our principal U.K. subsidiary has agreed with the trustees of the plan to contribute £20 million ($35 million) per year to the plan for six years with the amount payable increasing by 5.3% on each January 1, beginning in 2005. These contributions are in addition to the normal employer contributions to the plan. The trustees of the plan:
•have certain rights to request that our U.K. subsidiary advance an amount equal to an actuarially determined winding up deficit. As of December 31, 2004, the estimated winding up deficit was £335 million ($580 million)
At the last valuation date, September 30, 2005, the estimated deficit between the value of the plan assets and the projected benefit obligation, calculated under U.S. GAAP, was $232 million, of which $199 million was recorded as a minimum pension liability. The U.K. pension plans have been closed to new employees since 1999.
Cash flows from operations, excluding the change in funds held on behalf of brokerage and consulting clients declined $348 million compared with 2004. This decline is primarily attributed to an increase in U.S. defined benefit pension contributions to major plans of $274 million and a payment pursuant to the settlement agreement with the NYAG and other regulatory authorities of $76 million, somewhat offset by lower income tax payments of approximately $104 million.
Our insurance underwriting operations include accident & health and life and warranty, credit and property & casualty businesses. These insurance products have distinct differences in the timing of premiums earned and payment of future liabilities.
We used revenues generated from premiums, investments and other miscellaneous income to pay claims and other cash benefits, commissions and general expenses and taxes. Claims and other cash benefits paid were $1,393 million in 2005 versus $1,382 million in 2004. Commissions and general expenses paid were $1,446 million for 2005, compared to $1,325 million in 2004. Tax payments for 2005 were $158 million compared to $78 million last year. The increase reflects payments made on the gain on sale of virtually all our Endurance common stock investment.
We used the consolidated cash flow from operations (net of funds held on behalf of clients) of $886 million for:
•investing activities of $769 million. The cash flows used by investing activities included purchases of investments, net of sales, of $926 million and acquisitions, principally made by our international brokerage operations, of $81 million. Additionally, our investing activities included capital expenditures, net of disposals, of $126 million and proceeds from the sale of operations of $364 million, mainly reflecting the sale of Swett & Crawford.
In fourth quarter 2005, we announced that our Board of Directors had authorized the repurchase of up to $1 billion of Aon's common stock. Any repurchased common stock will be available for use in connection with employee stock plans and for other corporate purposes. During 2005, we repurchased 675,000 shares at a cost of $25 million.
Risk and Insurance Brokerage Services and Consulting receivables decreased $163 million in 2005. Corresponding insurance premiums payable decreased $348 million over the same period. The decrease in receivables and payables reflects:
We invest in broad asset categories related to our diversified operations. In managing our investments, our objective is to maximize earnings while monitoring asset and liability durations, interest and credit risks and regulatory requirements.
The Corporate and Other segment contains invested assets and related investment income not directly required to support the insurance brokerage and consulting businesses, together with the assets in excess of net policyholder liabilities of the underwriting business and related income. These insurance assets are publicly traded equities, as well as less liquid private equities and LPs. These assets, owned by the insurance underwriting companies:
In 2001, we securitized $450 million of our LP investments and associated LP commitments, which represented most of our limited partnership investments, via a sale of PEPS I. The securitization gives our underwriting subsidiaries greater liquidity.
Total debt at December 31, 2005 was $2.1 billion, down $5 million from December 31, 2004. Our notes payable decreased by $10 million compared to year-end 2004. This decrease is due to retiring $250 million of outstanding domestic debt securities due in May 2005, mostly offset by an increase in our Euro credit facility of $247 million.
•If the closing price of our common stock during any fiscal quarter exceeds 120% of the conversion price (i.e. $25.77) for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the previous fiscal quarter.
•Subject to certain exceptions, during the five business day period after any ten consecutive trading day period in which the trading price per $1,000 principal amount of the debentures for each day of the ten trading day period was less than 95% of the product of the closing sale price of our common stock and the number of shares issuable upon conversion of $1,000 principal amount of the debentures.
•a five-year €650 million ($770 million) multi-currency facility, of which $581 million was outstanding at December 31, 2005. See Note 8 to the consolidated financial statements for further discussion on both the U.S. and Euro facilities.
•Fitch, Inc. lowered its ratings on our senior debt from "A-" to "BBB+" and affirmed our commercial paper rating of "F2." They changed their outlook on us from negative to stable.
•S&P affirmed its ratings for Aon, removed us from credit watch and changed their outlook first to stable and then to positive.
•increase our borrowing costs and reduce our financial flexibility. Our 6.20% notes due 2007 ($250 million of which are outstanding with a current interest rate of 6.95%) expressly provide for interest rate increases in the case of certain ratings downgrades.
•increase our commercial paper interest rates or may restrict our access to the commercial paper market altogether. Although we have committed backup lines we cannot ensure that our financial position will not be hurt if we can no longer access the commercial paper market.
•a $152 million increase in paid-in-capital principally due to stock issued in connection with employee benefit plans.
These equity increases were partially offset by dividends paid to stockholders of $194 million and an increase in our accumulated other comprehensive loss.
•$186 million in cash contributions to our major defined benefit pension plans, although we may elect to contribute more cash or certain non-cash assets to the plans.
We record various contractual obligations as liabilities in our consolidated financial statements. Other items, such as certain purchase commitments and other executory contracts, are not recognized as liabilities in our consolidated financial statements, but we are required to disclose them.
Some of our subsidiaries make short-term loans (generally with terms of 12 months or less) to businesses to finance insurance premiums and then sell or "securitize," the finance receivables. Our subsidiaries make these sales through securitization transactions that meet the criteria for sale accounting following Statement No. 140. These premium-financing securitizations use special purpose entities which are considered QSPEs, according to Statement No. 140 and FIN 46 and commercial
Through the premium financing agreements, we or one of our QSPEs sells undivided interests in specified premium finance receivables to the independent SPEs. Under the terms of these agreements, new receivables increase the amounts available to securitize as collections (administered by Aon) and reduce previously sold receivables. The amount advanced from third parties at any one time under the accounts receivable sales agreement is limited to a maximum of $1.9 billion.
We retain servicing rights for sold receivables and earn a servicing fee as income over the servicing period. The servicing fees are included in the gain/loss calculation. At December 31, 2005 and 2004, the fair value of the servicing rights approximates the estimated costs to service the receivables and accordingly, we have not recorded any servicing assets or liabilities related to this servicing activity.
The SPEs bear the credit risks on the receivables, subject to limited recourse in the form of credit loss reserves, which we formerly guaranteed. During 2005, we eliminated the percentage guarantee for all facilities, replacing it with other collateral enhancements. In January 2005, the Canadian facility was amended, reducing the ratings trigger and adding the financial covenants from the credit facility. In December 2005, this facility was extended to December 2008. In June 2005, the Australian facility was renewed for three years and the facility was increased by Australian dollar (AUD)$50 million. In July 2005, the U.S. facility was amended, extending the facility to July 2006 and reducing its size by $100 million.
We intend to renew these conduit facilities when they expire. If there were adverse bank, regulatory, tax or accounting rule changes, our access to the conduit facilities and special purpose vehicles would be restricted. These special purpose vehicles are not included in our consolidated financial statements, following the appropriate accounting standards.
Standard & Poor's Ratings Services rated the fixed-maturity securities our subsidiaries received from PEPS I as investment grade. As part of this transaction, the insurance companies had been required to purchase additional fixed-maturity securities from PEPS I in an amount equal to the unfunded LP commitments as they are requested. Beginning in July 2004, Aon Parent assumed this responsibility and funded $12 million of commitments in 2005. As of December 31, 2005, the unfunded commitments amounted to $48 million. These commitments have specific expiration dates and the general partners may decide not to draw on these commitments.
In previous years, Aon has recognized other than temporary impairment writedowns of $59 million, equal to the original cost of one tranche. The preferred stock interest represents a beneficial interest in securitized limited partnership investments. The fair value of the private preferred stock interests depends on the value of the limited partnership investments held by PEPS I. Management assesses other-than-temporary declines in the fair value below cost using a financial model that considers the:
•summarizes our significant contractual obligations at December 31, 2005 and the future periods during which we expect to settle these obligations in cash
We have provided additional details about these obligations in our notes to the financial statements as noted below.
(1)Included in purchase obligations is a $380 million contract for information technology outsourcing with Computer Sciences Corporation. We are free to terminate this contract at any time for an amount calculated per the contract. However, given the nature of the contract, we have included it in our contractual obligations table.
(3)The $109 million net present value of this liability has been reflected on the December 31, 2005 balance sheet in other liabilities.
We also have obligations with respect to our pension and other benefit plans (see Note 12 to our consolidated financial statements and our discussion on liquidity above).
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Aon Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Aon Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
In our opinion, management's assessment that Aon Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Aon Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
As discussed in Note 1, as of December 31, 2003 the Company changed its method of accounting for its involvement with certain variable interest entities.
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting. A fourth segment, Corporate and Other, when combined with the operating segments and after the elimination of intersegment revenues, totals to the amounts included in the consolidated financial statements. Certain amounts in prior years' consolidated financial statements relating to segments have been reclassified to reflect the results of discontinued operations.
In order to resume business operations and minimize the loss caused by the World Trade Center disaster, Aon secured temporary office space in Manhattan. Subsequently, permanent space was leased and, during first quarter 2003, Aon assigned this temporary space to another company. The costs relating to this assignment were $46 million pretax in 2003. In fourth quarter 2003, Aon reached a final settlement of $200 million for its overall World Trade Center property insurance claim. A cash payment of $92 million was received during fourth quarter 2003, in addition to the $108 million already collected in prior years. This settlement resulted in a pretax gain of $60 million. This gain and the $46 million expense discussed above, were combined and reported as a $14 million Unusual credit - World Trade Center in the 2003 consolidated statement of income.
As required by Emerging Issues Task Force (EITF) Issue No. 04-8, The Effect of Contingently Convertible Investments on Diluted Earnings Per Share, Aon includes in its diluted net income per share computation the impact of any contingently convertible instruments regardless of whether the market price trigger has been met. Aon's 3.5% convertible debt securities, issued in November 2002, may be converted into a maximum of 14 million shares of Aon common stock and these shares have been included in the computation of diluted net income per share (see Note 8 for further information).
Stock-based compensation expense determined under fair value method for all awards and options, net of tax
The fair value per share of options and awards granted is estimated as $6.34 and $23.63 in 2005, $6.15 and $25.32 in 2004 and $3.59 and $18.33 in 2003, respectively, on the grant date using the Black-Scholes option pricing model with the following weighted-average assumptions:
In conjunction with the initial common stock investment, Aon also received 4.1 million stock purchase warrants, which allow Aon to purchase additional Endurance common stock through December 2011. These warrants meet the definition of a derivative, which requires them to be recorded in the financial statements at fair value, with changes in fair value recognized in earnings on a current basis. Aon has valued the warrants using the Black-Scholes pricing methodology with the assistance of an independent third party. Aon has determined that the warrants had a fair value of $90 million and $80 million at December 31, 2005 and 2004, respectively.
The change in value during the period was recognized as investment income in the Corporate and Other segment and was $10 million and $80 million in 2005 and 2003, respectively. There was no net change in value during 2004. The future value of the warrants may vary considerably from the value at December 31, 2005 due to the price movement of the underlying shares, as well as the passage of time and changes in other factors that are employed in the valuation model.
Declines in the fair value of investments below cost are evaluated for other-than-temporary impairment losses on a quarterly basis. Impairment losses for declines in the value of investments attributable to issuer-specific events are determined based upon all relevant facts and circumstances for each investment and are recognized when appropriate in accordance with Staff Accounting Bulletin (SAB) 59, FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities and related guidance. For fixed-maturity investments with unrealized losses due to market conditions or industry-related events where Aon has the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are assumed to be temporary.
Aon maintains premium trust bank accounts for premiums collected from insureds but not yet remitted to insurance companies of $2.9 billion and $3.0 billion at December 31, 2005 and 2004, respectively. These funds and a corresponding liability, are included in short-term investments and insurance premiums payable, respectively, in the accompanying consolidated statements of financial position.
Costs of acquiring new and renewal insurance underwriting business, principally the excess of new commissions over renewal commissions, and underwriting and sales expenses that vary with and are primarily related to, the production of new business, are deferred and reported as assets. For long-duration life and health products, amortization of deferred policy acquisition costs is related to and based on, the expected premium revenues of the policies. In general, amortization is adjusted to reflect current withdrawal experience. Expected premium revenues are estimated by using the same assumptions used in estimating future policy benefits. For extended warranty and short-duration health
insurance, costs of acquiring and renewing business are deferred and amortized as the related premiums and contract fees are earned.
Property and equipment is stated at cost, less accumulated depreciation. Depreciation is generally calculated using the straight-line method over estimated useful lives. Included in this category is internal use software, which is software that is acquired, internally developed or modified solely to meet internal needs, with no plan to market externally. Costs related to directly obtaining, developing or upgrading internal use software are capitalized. These costs are generally amortized using the straight-line method over a range of 1 to 10 years. The weighted-average original life of Aon's software at December 31, 2005 is 5 years.
Depreciation expense for the years ended December 31, 2005, 2004 and 2003 was $227 million, $253 million and $251 million, respectively.
Derivative financial instruments: Fair value is based on quoted prices for exchange-traded instruments or the cost to terminate or offset with other contracts.
Other investments are comprised of Aon's investment in Endurance warrants, mortgage loans, policy loans, private equity investments and limited partnerships.
Future policy benefit liabilities on life, accident and health products have been provided on the net level premium method. The liabilities are calculated based on assumptions as to investment yield, mortality, morbidity and withdrawal rates that were determined at the date of issue and provide for possible adverse deviations. Interest assumptions have been graded and range from 2% to 6% at December 31, 2005. The interest assumption used on most current issues is a level 4%. Withdrawal assumptions are based principally on insurance subsidiaries' experience and vary by plan, year of issue and duration.
Foreign revenues and expenses are translated at average exchange rates. Foreign assets and liabilities are translated at year-end exchange rates. Net foreign exchange gains and losses on translation are reported in stockholders' equity, in accumulated other comprehensive income or loss ("OCI"), net of applicable deferred income taxes. In 2005, management deemed all undistributed earnings of Aon's foreign subsidiaries to be permanently reinvested. The impact of this decision did not have a material effect on Aon's net income. Because of the decision to reinvest the undistributed earnings of these foreign subsidiaries, the deferred tax liability of $31 million previously accrued related to the cumulative foreign currency translation adjustment ("CTA") of those subsidiaries was no longer required, resulting in a credit to OCI in 2005. Aon continues to record deferred taxes related to the CTA of its foreign branches of U.S. underwriting subsidiaries.
In connection with accounting guidance issued by the Institute of Chartered Accountants in the U.K., Aon, like others in the industry, reassessed whether and to what extent its U.K. businesses have legal obligations to provide future claims handling and administrative services for brokerage clients. With the assistance of outside legal counsel, Aon performed a detailed factual and legal review of each different business and each of several classes of clients. This review was completed in October 2005. Where a legal obligation was determined to exist, the Company estimated and accrued the costs of such an obligation. The liability recorded during 2005 was $22 million.
Also in connection with accounting guidance issued by the Institute of Chartered Accountants in the U.K., Aon refined techniques used to estimate revenue on installment policies in the U.K. This change in estimate resulted in a one-time $23 million increase to Aon's revenue, which was recorded during 2005.
In 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (FIN 46). FIN 46 provides a framework for identifying variable interest entities (VIEs) and determining when a company should include the assets, liabilities, non-controlling interests and result of activities of a VIE in its consolidated financial statements. FIN 46 was effective immediately for VIEs created after January 31, 2003. The provisions of FIN 46 were adopted as of December 31, 2003 for Aon's interests in VIEs that are special purpose entities (SPEs).
Aon adopted the provisions of FIN 46 for its variable interests in all other VIEs as of March 31, 2004, which did not have a material effect on the consolidated financial statements. See Note 11 for additional information.
In 2004, the FASB issued Statement No. 123 (revised 2004) Share-Based Payment ("Statement No. 123(R)"), which is a revision of Statement No. 123. Statement No. 123(R) supersedes APB No. 25 and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement No. 123(R) is similar to the approach described in Statement No. 123. However, Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
Certain amounts in prior years' consolidated financial statements have been reclassified to conform to the 2005 presentation.
In 2005, the pretax net additional minimum pension liability adjustment of $253 million includes $19 million related to defined benefit pension plans in Canada and $4 million related to defined benefit plans in Germany.
The following table sets forth the activity related to these liabilities:
In fourth quarter 2005, Aon committed to sell a non-core Australian brokerage unit, which was previously included in the Risk and Insurance Brokerage Services segment. This operation was sold in early first quarter 2006 for a nominal pretax gain, which will be recognized in first quarter 2006.
•Its U.K. claims services businesses, which were previously included in the Risk and Insurance Brokerage Services segment, resulting in a pretax loss of $24 million.
•A non-core Consulting subsidiary, resulting in a pretax gain of $4 million.
Prior to its acquisition by Aon, A&A discontinued its property and casualty insurance underwriting operations in 1985, some of which were then placed into run-off, with the remainder sold in 1987. In connection with those sales, A&A provided indemnities to the purchaser for various estimated and potential liabilities, including provisions to cover future losses attributable to insurance pooling arrangements, a stop-loss reinsurance agreement and actions or omissions by various underwriting agencies previously managed by an A&A subsidiary.
The operating results of all these businesses are classified as discontinued operations and prior years' operating results have been reclassified to discontinued operations, as follows.
The amortized cost and fair value of fixed maturities by contractual maturity as of December 31, 2005, are as follows:
For categorization purposes, Aon considers any rating of Baa or higher by Moody's Investor Services or equivalent rating agency to be investment grade. Aon had no fixed maturities below investment grade with an unrealized loss.
Limited Partnership Securitization. In 2001, Aon sold the vast majority of its limited partnership (LP) portfolio, valued at $450 million, to PEPS I, a QSPE. The common stock interest in PEPS I is held by a limited liability company which is owned by one of Aon's subsidiaries (49%) and by a charitable trust, which is not controlled by Aon, established for victims of the September 11th attacks (51%). Approximately $171 million of investment grade fixed-maturity securities were sold by PEPS I to unaffiliated third parties. PEPS I then paid Aon's insurance underwriting subsidiaries the $171 million in cash and issued to them an additional $279 million in fixed-maturity and preferred stock securities. The fixed-maturity securities Aon subsidiaries received from PEPS I are rated as investment grade by Standard & Poor's Ratings Services. Aon recognized impairment writedowns on a portion of the preferred stock securities of $27 million in 2003.
As part of this transaction, the insurance underwriting subsidiaries were required to purchase from PEPS I additional fixed-maturity securities in an amount equal to the unfunded limited partnership commitments, as they are requested. In 2004, Aon's insurance underwriting subsidiaries funded $13 million of commitments. Beginning in July 2004, Aon Parent is funding all future commitments. Aon Parent funded $12 million and $7 million of commitments in 2005 and 2004, respectively. As of December 31, 2005, these unfunded commitments amounted to $48 million. These commitments have specific expiration dates and the general partners may decide not to draw on these commitments.
To achieve the benefits of the securitization, Aon gave up all future voting interests in and control over the limited partnership interests sold to PEPS I and has no voting interest, control or significant influence over the business activities of PEPS I. Aon obtained a true sale/non-consolidation opinion from qualified external legal counsel.
PEPS I holds limited partnership investments. The legal documents that established PEPS I specify the actions that PEPS I and the servicer will undertake when PEPS I is required to make a voting decision (due to the general partner of a limited partnership calling for the vote of limited partners or proxy voting on a money market fund that PEPS I is invested in). Additionally, the legal documents contain specific instructions regarding actions to be taken if PEPS I receives (or has the ability to receive) distributions of investments held by limited partnerships in which it is invested. In instances where the general partner of a given investment may distribute underlying invested company shares to the limited partners (such as PEPS I), the legal documents that establish PEPS I outline specific disposal instructions.
Throughout the life of PEPS I, at least 10% of the beneficial interests will be held by parties other than Aon, its affiliates, or its agents. This 10% threshold is accomplished through the first tranche notes outstanding to unaffiliated third party investors.
Securities on deposit for regulatory authorities as required by law, all relating to the insurance underwriting subsidiaries, amounted to $739 million at December 31, 2005 and $606 million at December 31, 2004.
In 2001, Aon issued $250 million of 6.2% debt securities due January 2007. The interest rate on these debt securities is subject to adjustment in the event that Aon's credit ratings change. Due to ratings downgrades during 2002 and 2004, the interest rate on the 6.2% debt securities was increased to 6.7% effective January 2003 and 6.95% effective January 2005.
At December 31, 2004, Aon had a $775 million U.S. committed bank credit facility to support commercial paper and other short-term borrowings. No amounts were outstanding under this facility at December 31, 2004. In February 2005, Aon replaced this facility with a new $600 million three-year revolving credit facility. This facility permits the issuance of up to $150 million in letters of credit. In September 2005, Aon amended the facility. The three-year term of the facility was extended to a five-year term with a maturity date of February 2010, certain covenants related to guarantors and acquisitions were deleted and certain covenants related to mergers, acquisitions and indebtedness were revised. At December 31, 2005, Aon had $20 million in letters of credit outstanding. Based on Aon's current credit ratings, commitment fees of 10 basis points are payable on the unused portion of the facility.
Outstanding debt securities, including Aon Capital A's, are not redeemable by Aon prior to maturity except for the 3.5% convertible debt securities, which are redeemable by Aon beginning in 2007. There are no sinking fund provisions. Interest is payable semi-annually on most debt securities. Repayments of notes payable are $593 million, $255 million, $2 million, $1 million and $1 million in 2006, 2007, 2008, 2009 and 2010, respectively.
Aon has noncancelable operating leases for certain office space, equipment and automobiles. These leases expire at various dates and may contain renewal and expansion options. In addition to base rental costs, occupancy lease agreements generally provide for rent escalations resulting from increased assessments for real estate taxes and other charges. Approximately 82% of Aon's lease obligations are for the use of office space. Rental expense for operating leases amounted to $345 million, $387 million and $381 million for 2005, 2004 and 2003, respectively, after deducting rentals from subleases ($29 million, $34 million and $31 million for 2005, 2004 and 2003, respectively).
At December 31, 2005, future minimum rental payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year, net of sub-lease rental income, most of which pertain to real estate leases, are as follows:
Income from continuing operations before income tax and minority interest and the provision for income tax consist of the following:
Valuation allowances have been established primarily with regard to the tax benefits of certain net operating loss and tax credit carryforwards. Valuation allowances were reduced to $26 million in 2005 from $41 million in 2004, attributable largely to the assessment of the potential future utilization of U.S. Federal tax net operating loss carryforwards and the realization of U.S. federal alternative minimum tax credit carryforwards. To the extent valuation allowances were provided originally through acquisition accounting, the tax benefits recognized for such items have been recorded as a reduction in goodwill. Although future earnings cannot be predicted with certainty, management believes that the realization of the net deferred tax asset is more likely than not.
The amount of income taxes paid in 2005, 2004 and 2003 was $309 million, $413 million and $296 million, respectively.
At December 31, 2004, 1 million shares of redeemable preferred stock were outstanding. Dividends were cumulative at an annual rate of $2.55 per share. These shares were redeemable at the option of Aon or the holders, in whole or in part, at $50.00 per share plus accrued but unpaid dividends, beginning one year after the death of the last of the original two owners, which occurred in September 2004. In September 2005, Aon redeemed all of the outstanding shares of redeemable preferred stock.
Aon Capital A is a wholly-owned statutory business trust created for the purpose of issuing mandatorily redeemable preferred capital securities ("Capital Securities"). The sole asset of Aon Capital A is the $726 million aggregate principal amount of Aon's 8.205% Junior Subordinated Deferrable Interest Debentures (subordinated debt) due January 1, 2027. The back-up guarantees, in the aggregate, provide a full and unconditional guarantee of Aon Capital A's obligations under the Capital Securities.
Aon has determined that it is not the primary beneficiary of Aon Capital A, a VIE and was required to deconsolidate the Trust upon the adoption of FIN 46 on December 31, 2003, which was completely offset by an increase in notes payable. Prior to the deconsolidation of Aon Capital A, the after-tax interest incurred on the Capital Securities was reported as minority interest in the consolidated statements of income. Beginning in 2004, interest expense on these notes payable was reported as part of interest expense in the consolidated statements of income. There was no effect on net income or consolidated stockholders' equity as a result of this deconsolidation.
In November 2005, Aon announced that its Board of Directors had authorized the repurchase of up to $1 billion of Aon's common stock. Shares may be repurchased through the open market or in privately negotiated transactions from time to time, based on prevailing market conditions and will be funded from available capital. Any repurchased shares will be available for use in connection with employee stock plans and for other corporate purposes. The Company repurchased 0.7 million shares at a cost of $25 million in 2005. In 2004, Aon did not repurchase any of its common stock. In 2003, Aon repurchased 0.1 million shares. In 2006, through March 6, the Company has repurchased 3.2 million shares at a cost of $126 million.
Generally, the capital and surplus of Aon's insurance subsidiaries available for transfer to the parent company is limited to the amount that the insurance subsidiaries' statutory capital and surplus exceeds minimum statutory capital requirements; however, payments of the amounts as dividends in excess of $197 million may be subject to approval by regulatory authorities. See Note 9 for possible tax effects of distributions made out of untaxed earnings.
Statutory capital and surplus of the insurance subsidiaries are summarized as follows:
The following tables provide a reconciliation of the changes in obligations and fair value of assets for the years ended December 31, 2005 and 2004 and a statement of the funded status as of
In 2005, plans with a projected benefit obligation ("PBO") and an accumulated benefit obligation ("ABO") in excess of the fair value of plan assets had a PBO of $1.8 billion, an ABO of $1.6 billion and plan assets with a fair value of $1.3 billion.
Pension plan assets did not include any Aon common stock at December 31, 2005. At December 31, 2004, pension plan assets included $30 million of Aon common stock. Dividends from Aon stock received by the plan in 2005 and 2004 were $0.4 million and $0.9 million, respectively. In November 2005, Aon contributed $200 million to its U.S. pension plan. As of the plan measurement date, these funds were invested in invested cash.
Aon's U.S. other benefit plan assets of $8 million at both December 31, 2005 and 2004 were invested in money market instruments.
Based on current assumptions, Aon expects to contribute $6 million to U.S. pension plans during 2006 to satisfy minimum funding requirements and $4 million to fund other postretirement benefit plans during 2006.
Estimated future benefit payments for U.S. plans are as follows at December 31, 2005:
The following tables provide a reconciliation of the changes in the benefit obligations and fair value of assets for the years ended December 31, 2005 and 2004 and the funded status as of December 31, 2005 and 2004, for material international pension plans, which are located in the U.K.
The change in amounts recognized in other comprehensive income related to the minimum pension liability was an increase of $98 million and a decrease of $46 million in 2005 and 2004, respectively.
In 2005, plans with a PBO in excess of the fair value of plan assets had a PBO of $4.2 billion and plan assets with a fair value of $2.9 billion and plans with an ABO in excess of the fair value of plan assets had an ABO of $3.4 billion and plan assets with a fair value of $2.6 billion.
The range of weighted-average assumptions used to determine the international net periodic benefit costs are as follows:
4.5 - 5.6 % 5.25 - 5.5 % 5.5 - 5.75 %
Aon's international pension plan asset allocation at December 31, 2005 and 2004 is as follows:
Estimated future pension benefit payments for international plans are as follows at December 31, 2005:
Stock awards, in the form of restricted stock units, are granted to certain officers and employees of Aon. Generally, employees are required to complete three continuous years of service before stock awards begin to vest in increments until the completion of a 10-year period of continuous employment. In 2003 and 2002, a large number of stock awards were granted that vest annually over five years, with the initial vesting occurring after one year of continuous service. In 2005 and 2004, a large number of stock awards were granted that will not vest until five years after the date of grant. For most employees, beginning in 2005, individual incentive compensation over $50,000 will partially be paid in restricted stock units, which will vest ratably over three years. In general, most stock awards are issued as they become vested. In certain circumstances, an employee can elect to defer the receipt of vested shares to a later date. With certain limited exceptions, any break in continuous employment will cause forfeiture of all unvested awards. The compensation cost associated with each stock award is deferred and amortized over the period of continuous employment using the straight-line method. At December 31, 2005, 2004 and 2003, the number of shares available for stock awards is included with options available for grant.
Options to purchase common stock are granted to certain officers and employees of Aon and its subsidiaries at 100% of market value on the date of grant. Generally, employees are required to complete two continuous years of service before the options begin to vest in increments until the completion of a 4-year period of continuous employment. For all grants made prior to an amendment to the former stock option plan in 2000, employees were required to complete three continuous years of service before the options began to vest in increments until the completion of a 6-year period of continuous employment.
Certain derivatives also give rise to credit risks from the possible non-performance by counterparties. The credit risk is generally limited to the fair value of those contracts that are favorable to Aon. Aon has limited its credit risk by using master netting agreements, entering into non-exchange-traded derivatives with highly rated major financial institutions and by using exchange-traded instruments. Aon closely monitors the credit-worthiness of, and exposure to, its counterparties and considers its credit risk to be minimal. At December 31, 2005 and 2004, Aon placed cash and securities relating to these derivative contracts in escrow amounting to $6 million and $5 million, respectively.
All derivative instruments are recognized in the consolidated statements of financial position at fair value. Unless otherwise noted, derivative instruments with a positive fair value are reported in other receivables and derivative instruments with a negative fair value are reported in other liabilities in the consolidated statements of financial position. Where Aon has entered into master netting agreements with counterparties, the derivative positions are netted by program and are reported accordingly in other receivables or other liabilities. Changes in the fair value of derivative instruments are recognized immediately in earnings, unless the derivative is designated as a hedge and qualifies for hedge accounting.
immediately in earnings. For a net investment hedge, the effective portion of the change in fair value of the hedging instrument is reported in OCI as part of the cumulative translation adjustment while the ineffective portion is recognized immediately in earnings.
Certain of Aon's foreign brokerage subsidiaries, primarily in the U.K., receive revenues in currencies (primarily in U.S. dollars) that differ from their functional currencies. The foreign subsidiary's functional currency revenue will fluctuate as the currency exchange rates change. To reduce this variability, Aon uses foreign exchange forwards to hedge the foreign exchange risk of the forecasted revenue for up to a maximum of three years in the future. Aon has designated these derivatives as cash flow hedges of its forecasted foreign currency denominated revenue. As of December 31, 2005, a $13 million pretax loss has been deferred to OCI, $9 million of which is expected to be reclassified to earnings as an adjustment to general expenses in 2006. Deferred gains or losses will be reclassified from OCI to general expenses when the hedged revenue is recognized. This hedge had no material ineffectiveness in 2005. Aon also uses over-the-counter options and forward contracts, which have not been designated as hedges for accounting purposes, to hedge economic risks that arise from fluctuations in the currency exchange rates. Changes in the fair value of these derivatives are recorded in general expenses in the consolidated statements of income.
Aon uses over-the-counter options and forward contracts to reduce the impact of foreign currency fluctuations on the translation of the financial statements of Aon's foreign operations. These derivatives are not eligible for hedge accounting treatment and changes in the fair value of these derivatives are recorded in general expenses in the consolidated statements of income.
the notes for changes in spot exchange rates. Changes in the fair value of these derivatives were recorded in general expenses in the consolidated statements of income.
Aon enters into exchange-traded futures and options to limit its net exposure to decreasing short-term interest rates, primarily relating to U.S. dollar denominated brokerage funds held on behalf of clients in the U.S. and U.K. These derivatives were not designated as a hedge and changes in their fair value were recorded in investment income in the consolidated statements of income.
In 2005 and 2004, receive-fixed-pay-floating interest rate swaps were designated as cash flow hedges of the interest rate risk of a portion of Aon's U.S. dollar denominated brokerage funds held on behalf of U.K. clients and other U.S. and U.K. operating funds. These interest rate swaps do not have maturities greater than one year. Changes in the fair value of the swaps were recorded in OCI and will be reclassified to earnings as an adjustment to investment income over the term of the swap. As of December 31, 2005, a $2 million pretax loss related to this hedge was recorded in OCI, which is expected to be reclassified to investment income in 2006. This hedge had no material ineffectiveness in 2005.
Premium financing securitizations performed by Aon's U.S., U.K., Canadian and Australian subsidiaries use multi-seller non-qualified SPEs. By analyzing the qualitative and quantitative factors of the SPEs, Aon has determined that these subsidiaries are not the sponsor of the SPEs. Additionally, independent third parties (i) have made substantial equity investments in the SPEs, (ii) have voting control of the SPEs and (iii) generally have the risks and rewards of ownership of the assets of the SPEs. Based on these factors and the fact that these subsidiaries do not have a significant variable interest in the multi-seller SPEs, Aon has determined that non-consolidation is appropriate.
Aon or one of its QSPEs sells undivided interests in specified premium financing receivables to the independent SPEs. Under the terms of these agreements, new receivables increase the amounts available to securitize as collections (administered by Aon) reduce previously sold receivables. The amount advanced from third parties at any one time under the accounts receivable sales agreement was limited to a maximum of $1.9 billion and $2 billion at December 31, 2005 and 2004, respectively.
At both December 31, 2005 and 2004, $1.8 billion was advanced under these programs from the SPEs. Aon records at fair value the retained interest, which is included in insurance brokerage and consulting services receivables in the consolidated balance sheets.
Aon retains servicing rights for sold receivables and a servicing fee is earned as income over the servicing period. The servicing fees are included in the gain/loss calculation. At December 31, 2005 and 2004, the fair value of the servicing rights approximates the estimated costs to service the receivables and accordingly, Aon has not recorded any servicing assets or liabilities related to this servicing activity.
Guarantees associated with Aon's limited partnership securitization are disclosed in Note 7. Indemnities related to discontinued operations are disclosed in Note 6.
Aon and its subsidiaries have issued letters of credit to cover contingent payments of approximately $11 million for taxes and other business obligations to third parties. Amounts are accrued in the consolidated financial statements for these letters of credit to the extent they are probable and estimable.
Aon and its subsidiaries are subject to numerous claims, tax assessments, lawsuits and proceedings that arise in the ordinary course of business. The damages claimed in these matters are or may be substantial, including, in many instances, claims for punitive, treble or extraordinary damages. Aon has purchased errors and omissions ("E&O") insurance and other appropriate insurance to provide protection against losses that arise in such matters. Accruals for these items, net of insurance receivables, when applicable, have been provided to the extent that losses are deemed probable and are reasonably estimable. These accruals and receivables are adjusted from time to time as developments warrant.
As has been described in detail in Aon's previous financial filings, the Settlement Agreement requires Aon to pay between 2005-2007 a total of $190 million into a fund (the "Fund") to be distributed to certain Eligible Policyholder clients. The Settlement Agreement set forth the procedures under which Aon mailed notices to its Eligible Policyholder clients and distributes the Fund to Participating Policyholder clients. In order to obtain a payment from the Fund, Participating Policyholders were required to tender a release of claims against the Company arising from acts, omissions, transactions or conduct that are the subject of the lawsuits.
In accordance with APB Opinion No. 21, Interest on Receivables and Payables, the Company discounted the payment stream associated with the Settlement Agreement and recorded the present value of the liability and corresponding expense of $180 million in the financial statements as of December 31, 2004. The discount was determined using Aon's incremental borrowing rate. The Company did not discount the payment made on September 1, 2005. The settlement was considered fully tax deductible and is not treated as a permanent difference in the Company's tax calculation.
Purported clients have also filed civil litigation against Aon and other companies under a variety of laws and legal theories relating to broker compensation practices and other issues under investigation by New York and other states. As previously reported, a putative class action styled Daniel v. Aon (Affinity) has been pending in the Circuit Court of Cook County, Illinois since August 1999. On March 9, 2005, the Court gave preliminary approval to a nationwide class action settlement within the $40 million reserve established in the fourth quarter of 2004. The Court held hearings in the fourth quarter of 2005 to consider whether to grant final approval to the settlement, and is expected to issue a decision in first quarter 2006.
all of these cases and intends to vigorously defend itself against these claims. The outcome of these lawsuits, and any losses or other payments that may occur as a result, cannot be predicted at this time.
Beginning in late October 2004, several putative securities class actions have been filed against Aon in the U.S. District Court for the Northern District of Illinois. Also beginning in late October 2004, several putative ERISA class actions were filed against Aon in the U.S. District Court for the Northern District of Illinois. Aon believes it has meritorious defenses in all of these cases and intends to vigorously defend itself against these claims. The outcome of these lawsuits, and any losses or other payments that may occur as a result, cannot be predicted at this time.
In July 2004, several subsidiaries of Aon were joined as defendants in an action in a U.K. court between British Petroleum ("BP") and underwriters who subscribed to policies of insurance covering various offshore energy projects on which BP and its co-venturers have incurred losses. BP settled on confidential terms with underwriters, but asserted a claim against Aon for approximately $96 million, which BP claims is a shortfall between its total losses and what it recovered in the settlements with underwriters, plus interest and costs. The trial in this matter concluded in December 2005, and judgment is expected to be issued sometime in the first half of 2006. Aon believes it has meritorious defenses and has vigorously defended itself against these claims. The ultimate outcome of this matter, and any losses or other payments that may occur as a result, cannot be predicted at this time.
In February 2006, Lloyds announced that it had brought suit in London against Benfield and a subsidiary of Aon to recover alleged losses relating to these brokers' placement of insurance for Lloyds's New Central Fund. Lloyds alleges that its brokers did not fairly present the risk to reinsurers and thus that the brokers should be held liable for reinsurers' failure to pay approximately £325 million ($563 million based on December 31, 2005 exchange rate) in claims. Aon disputes Lloyds's allegations, believes that it has meritorious defenses and intends to vigorously defend itself against Lloyd's claims.
The operations of the Consulting segment provide a full range of human capital management services. These services are delivered predominantly to corporate clientele utilizing six major practices: employee benefits, human resource outsourcing, compensation, management consulting, communications and strategic human resource consulting.
(1)Excludes the elimination of intersegment revenues and expenses of $62 million, $72 million and $68 million for 2005, 2004 and 2003, respectively.
(3)Includes depreciation and amortization expense. Corporate and Other segment revenue consists of investment income from equity, fixed-maturity and short-term investments that are assets primarily of the insurance underwriting subsidiaries that exceed policyholders liabilities. These assets may include non-income producing equities, valuation changes in limited partnership investments and income and losses on disposals of all securities, including those pertaining to assets maintained by the operating segments. Corporate and Other segment general expenses include administrative and certain information technology costs.
(1)Includes depreciation expense. Selected information for Aon's investment income is as follows:
(1)Includes $140 million after-tax charge for settlements with the New York Attorney General and other regulatory authorities and for costs to settle the Daniel class action lawsuit.
(2)Investments in subsidiaries include approximately $2.7 billion invested in countries outside of the U.S., primarily denominated in the British Pound, the Euro, the Canadian dollar and the Australian dollar.
(2)Certain prior years' amounts have been reclassified to conform to the 2005 presentation.