We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from HUB Midwest, one of our subsidiaries. This facility, totaling approximately 12,300 square feet, contains corporate, finance, administration, sales and customer support functions. The lease on the premises expires on March 31, 2018. In addition, our brokerages lease office space in the locations in which they operate, none of which is individually material. In total, we hold 192 leases covering approximately 1.1 million square feet with a total annual base rent for all of these locations of approximately $16.1 million.
are only included from the date of acquisition forward. Accordingly, the results in each period are not directly comparable.
Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP and U.S. GAAP as it relates to us, see note 20 to our audited consolidated financial statements included elsewhere in this Form 10-K.
Summarized balance sheet disclosure for the Discontinued Business are as follows:
The following discussion and analysis should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report. Certain information contained in “Management’s discussion and analysis of financial condition and results of operations” are forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements because of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the heading “Risk Factors”. Reference to “Hub,” the “company,” “we,” “us,”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (U.S. GAAP) and to the extent that they affect us are described in Note 20 to our audited consolidated financial statements.
Hub International is one of the leading insurance brokers in North America, providing a broad array of property and casualty, life and health, employee benefits and risk management products and services. We focus on both commercial and personal accounts in the United States and Canada, which we serve through our approximately 3,300 employees in nearly 200 offices, using a variety of retail and wholesale distribution channels. Since our company was formed in 1998 through the merger of 11 Canadian insurance brokerages, we have acquired an additional 116 brokerages and have established a strong presence in the northeastern, midwestern and western United States and in the Canadian provinces of Ontario, Quebec and British Columbia. We have grown our revenue from $38.7 million in 1998 to $442.6 million in 2005, with 79% of the increase being attributable to acquisitions.
During the three years ended December 31, 2005, we acquired 24 brokerages in the United States and another seven brokerages in Canada. Of these acquisitions, six were hubs, all based in the United States. United States revenue has grown to 70% of our total revenue primarily as a result of acquisitions and organic growth. Organic growth is similar to the same-store-sales calculation used by retailers. It includes revenue growth from units included in our financial statements for at least 12 months. Because we apply the purchase method of accounting for acquisitions, acquired brokerages’ financial results are included only from the date of acquisition.
Contingent commissions - additional compensation based on the profit the insurance company makes on the book of business a brokerage places with the insurance company (See “Contractual Obligations - Other” for information regarding our legal proceedings) and
Each hub addresses a specific regional or specialty market, operating with its own management team and structure, business plan and operating benchmarks. Regional hubs are generally larger than $10 million in annual revenue, while a hub that focuses on a specialty product line or market might have a smaller revenue base. Each hub brokerage is responsible for not only the development of its own business, but also the identification, acquisition and integration of smaller, fold-in brokerages. Fold-in acquisitions allow each hub brokerage an opportunity to strengthen its market position by acquiring new or complementary products and services and management talent. Fold-in acquisitions also provide the opportunity for improved profit margins through the reduction or elimination of redundant administrative functions, facilities and systems.
Our structure enables our hub brokerages to more effectively and quickly meet the changing needs of our clients in various markets, while benefiting from the operating efficiencies and leverage of a large brokerage. We seek to operate largely on a decentralized basis, believing that the best operating decisions are made close to the customer. At the same time, we recognize that our growth has created demand for increased coordination by our head office. In 2004 and 2005, we invested more in the coordination of additional functions from our head office to enhance cross-selling, international collaboration, marketing efficiencies, total expense management and financial control initiatives. As a general operating guideline, we work to centralize those activities that do not touch the customer directly, while adopting a more decentralized approach for functions that connect directly with customers.
For us, as for other brokers, falling rates can present both positive and negative effects. Falling premiums usually yield reduced commissions, if the insurance buyer maintains its coverage levels. However, many insurance buyers will respond to falling rates by increasing total coverage, often by lowering deductibles, increasing limits of coverage, or by adding new risks to those already insured. During 2005, we started to see more evidence of insurance buyers increasing coverage levels as a result of the softening of insurance rates. For 2006 we expect a slower pace of rate reductions as the year unfolds. We also anticipate that contingent commissions could decline this year due to loss experience for insurers in 2005. In addition, the economic environment could lead to higher or lower sales and employee headcounts at client companies, leading in turn to increased or reduced demand for employee benefits, liability and other types of coverage tied to business activity levels.
Organic growth figures include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2005, the rise of the Canadian dollar versus the U.S. dollar contributed three percentage points of our 6% organic growth rate in total revenue.
As shown above, the compensation related to the Talbot acquisition increased $14.3 million to $28.7 million in 2005 from $14.4 million in 2004, due to 2005 reflecting twelve months of expense whereas 2004 only reflected six months of expense from the July 1, 2004 acquisition date. The contingent payment to Talbot management is recorded by us as a charge to earnings over the period the payments are earned because it is a compensation based arrangement and specifically a performance award. The management of Talbot was and is to be compensated for future services based on achieving certain performance targets during each of the 12 months ending December 31, 2004, 2005, and 2006. See “Contractual Obligations - Acquisitions.” Severance costs relate to a specific cost reduction program that was implemented during the third quarter 2005, in an effort to reduce compensation expense to targeted levels. These severance costs were in addition to regular recurring severance costs which we may incur in the ordinary course of business. In addition, we benefited from the gain on forgiveness of debt of $2.9 million, after tax, as part of a settlement of an early payment of a term loan. Included in 2004 was the write-off of trademarks of $1.7 million after tax associated with the name change of certain of our regional brokerages. We further benefited from the gain on disposition of assets of certain brokerages of $1.9 million, after tax, as compared to a gain of $1.1 million in 2004.
U.S. revenue grew 33% to $310.3 million, or 70% of consolidated revenue in 2005 due to both acquisitions and organic growth. Acquisitions net of dispositions added $70.7 million to revenue or 92% of the increase while organic growth provided $6.3 million or 8% of revenue growth. Our U.S. operations posted an organic growth rate of 3% in 2005, an increase from 0% in 2004, primarily due to an increase in contingent commissions and volume overrides
and other income. Core commission income increased 28%, while contingent commissions and volume overrides grew 107%.
Employee cash compensation expense for 2005 increased 26% to $246.3 million from $195.7 million. Excluding severance costs, the increase was 25%. As a percentage of revenue, employee cash compensation expense, excluding severance, remained constant at 55% in 2005 as compared to 2004. The increase in compensation for the Talbot earnout in 2005 reflects twelve months of expense as compared to 2004, which only reflects six months of expense from the July 1, 2004 acquisition date. Compensation for the Talbot earnout includes a cash and a non-cash stock based component as set out in the table below. The first Talbot earnout payment in the amount of $16.4 million was paid in cash on September 1, 2005. The second earnout payment of approximately $19.0 million will be paid on March 31, 2006. Management expects this payment and future payments to be made in common shares although the earnout may be made in cash, common shares or a combination thereof depending on circumstances at the time.
Other non-cash stock based compensation includes stock options and restricted share units. Our policy is to expense the fair value of non-cash stock based compensation over the period in which entitlement to the compensation vests. The amount of expense recognized in each year related to stock options will vary with respect to exercise and forfeiture of options.
Total other non-cash stock based compensation for the years ended December 31, 2005, and 2004 is comprised of the following:
We estimate the compensation for the Talbot earnout for 2006 through 2011 will be:
In total, as of December 31, 2005, we had issued and outstanding approximately 1.1 million stock options at a weighted average exercise price of $15.39. Our closing share price on the New York Stock Exchange was $25.80 on December 30, 2005.
Depreciation increased 20% to $8.7 million in 2005 but remained constant at 2% of revenue from 2004.
During 2005 we sold assets and shares of certain brokerages primarily in Canada resulting in a gain of $2.9 million, compared with a gain of $1.9 million in 2004. Approximately $0.5 million of the 2005 gain is non-taxable.
During 2005 an early payment settlement was negotiated in respect of our $7.5 million loan from an insurance carrier. The early settlement negotiations resulted in the $7.5 million principal amount of the term loan being reduced to $3.0 million and interest payments for 2005 being reduced to zero.
Our effective tax rate increased to 55% in 2005 from 44% in 2004 due primarily to increased compensation related to the acquisition of Talbot which is not deductible for tax purposes. Excluding the compensation for the Talbot earnout, the effective tax rate was 36% and 33% for 2005 and 2004, respectively. The lower effective tax rate for 2004 is primarily due to adjustments made in 2004 to record the tax benefits of the utilization of certain tax losses.
Our net earnings from continuing operations remained constant at $25.7 million, notwithstanding higher compensation related to Talbot and severance costs as discussed above. Diluted earnings per share from continuing operations was $0.76 per diluted share compared to $0.79 per diluted share for 2005 and 2004, respectively. This decrease in diluted earnings per share was primarily due to an increase in the number of dilutive shares related to the Talbot earnout estimate in 2005 compared to 2004.
As reflected on the table on page 25 net earnings for 2005 decreased $1.0 million or $0.03 per diluted share due primarily to the impact of severance costs in 2005 and decreased $28.7 million or $0.78 per diluted share due to the impact of compensation for the Talbot earnout in 2005.
During 2005, we adopted a formal plan of disposition related to our U.S. financial services operation. We completed the sale of this operation January 1, 2006. See note 5 “Discontinued Operations”. Results for discontinued operations have been removed from continuing operations for 2005 and 2004 and reflected on our Consolidated Statements of Earnings, as “Net earnings (loss) from discontinued operations.” Net earnings from discontinued operations were NIL and $0.5 million for 2005 and 2004, respectively. Diluted earnings per share from discontinued operations were NIL and $0.01 for 2005 and 2004, respectively.
The table below shows a breakdown of our revenue by segment and type for 2004 and 2003 and organic growth for 2004:
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2004 and 2003 results included a number of factors that can complicate direct comparisons. To increase investor understanding the following chart shows the impact specific items would have had if they had not occurred, on net earnings and diluted earnings per share over the past two years.
underlying operations. In 2004, the strength of the Canadian dollar versus the U.S. dollar had a less positive impact on our results than in 2003. Any decline in the Canadian dollar relative to the U.S. dollar would have a negative effect on our results. See “Market Risk”.
Employee cash compensation expense for 2004 increased 25% to $195.7 million from $156.3 million. Compensation for the Talbot earnout was $14.4 million for 2004, while other non-cash stock based compensation grew 35% to $6.5 million from $4.8 million in 2003. As a percentage of revenue, employee cash compensation expense increased to 55% in 2004 from 54% in 2003, primarily due to a relatively higher level of compensation costs as a percentage of revenue at Talbot.
In total, as of December 31, 2004, we had issued and outstanding approximately 1.5 million stock options at a weighted average exercise price of $15.34. Our closing share price on the New York Stock Exchange was $18.41 on December 31, 2004.
implementation of the Sarbanes-Oxley Act of 2002 of $2.5 million and legal costs associated with various investigations regarding contingent commissions arrangements of $0.4 million.
Our 2004 results included gains of $1.9 million on the sale of investments and assets and shares of certain brokerages compared with a gain of $0.2 million in 2003. Approximately $1.6 million of the 2004 gain was non-taxable.
In January 2004, we adopted a corporate marketing and positioning strategy to build awareness of the Hub brand across all of our markets and to encourage greater coordination and collegial identity among our employees. As part of this corporate consolidation and identity development program, we have reassigned a number of key executives to new or expanded areas of responsibility and determined that future marketing and communications will be conducted under the Hub International name, rather than the traditional corporate names of acquired brokerages. In the first quarter of 2004 certain of our subsidiaries changed their names and as a result, we recognized a non-cash impairment expense of approximately $2.6 million before tax related to trademarks.
We began 2005 with cash and cash equivalents of $98.2 million. Operating activities in 2005 generated $46.0 million of cash. In 2005 we paid $66.1 million for acquisitions, including PLI which was $38.0 million. In addition, we repaid long-term debt net of advances of $8.9 million, made property and equipment purchases of $8.0 million and paid
At the close of 2005, our cash position of $70.1 million included approximately $19.2 million available for acquisitions. This amount combined with available lines of credit leaves us with a total amount of $39.5 million available for acquisitions compared to the $61.1 million available at December 31, 2004. It is impossible to define exactly how many acquisitions or how much new revenue could be acquired through the use of this cash, additional cash flow from operations and application of credit facilities, as acquisition pricing and other factors vary during the course of the year. However, we intend to use our common shares as partial consideration for any hub acquisition, and generally have paid a multiple of 5-8 times earnings before interest, taxes, depreciation and amortization (frequently referred to as EBITDA, which is a non-GAAP measure) for acquired brokerages. We believe that our capital resources, including existing cash, funds generated from operations and borrowings available under credit facilities, will be sufficient to satisfy the company’s financial requirements, excluding some acquisitions, during the next twelve months. We may finance acquisitions with available cash or an existing credit facility, but may, depending on the number and size of future acquisitions, need to supplement our finance requirements with the proceeds from debt financing, the issuance of additional equity securities, or a combination of both. In November 2003, a universal “shelf” registration statement that we filed with the Securities and Exchange Commission (SEC) covering the public offering and sale, from time to time, of an aggregate of up to $100 million of debt and/or equity securities, was declared effective. The net proceeds from the sale of such securities could be used to fund acquisitions and for general corporate purposes, including capital expenditures, and to meet working capital needs. As of December 31, 2005, the full amount of the $100 million of the universal “shelf” registration remained available. If we need to publicly raise additional funds, we may need to register additional securities with the SEC.
As an insurance broker, we collect and hold premiums paid by clients, deduct commissions and other expenses from these payments, and hold the remainder in trust, which we remit to the insurers who provide coverage to clients. We earn interest on these funds during the time between receipt of the cash and the time the cash is paid to insurers. The cash held in trust is shown separately on our balance sheet under the caption “Trust Cash.” On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
Revolving U.S. dollar LIBOR loan - This unsecured facility totals $75 million and bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR. The LIBOR was 4.39% and 2.40% at December 31, 2005 and 2004, respectively. The facility is available on a revolving basis for one year. In April 2005 we successfully renewed this loan with terms identical to the existing loan. The new loan expires April 19, 2006. However if the revolving period is not extended, we may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate which was 4.14% and 3.45% at December 31, 2005 and 2004, respectively. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million at December 31, 2005 and 2004, respectively. As of December 31, 2005 we were in compliance with all financial covenants governing this facility.
On July 15, 2003, we entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% senior notes and 6.16% senior notes in amounts of $10 million and $55 million, respectively, to a floating rate resulting in a savings of approximately $0.2 million and $1.3 million for the years ended December 31, 2005 and 2004, respectively. We account for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at December 31, 2005, we estimated the fair value of the swap to be $4.0 million, which is not recognized in our financial statements. Accordingly, $4.0 million is the estimated amount that we would need to pay to terminate the swap as of December 31, 2005.
During the first quarter 2005 an early payment settlement was negotiated in respect of our $7.5 million loan from an insurance carrier. The loan agreement provided for an incentive agreement whereby a credit could be earned to reduce interest payments (based on target premiums placed with the carrier) and principal amounts (based on target premiums placed with the carrier as well as loss ratios on those premiums). The early settlement negotiations resulted in the $7.5 million principal amount of the term loan being reduced to $3.0 million and interest payments for the first quarter 2005 being reduced to zero. We paid $3.0 million in March 2005 and recorded a gain on forgiveness of debt of $4.5 million for the first quarter 2005.
On July 1, 2004, we purchased all of the common shares of Satellite Acquisition Corporation (Satellite), a corporation formed by senior management at Talbot Financial Corporation (Talbot). In turn, Satellite purchased 100% of Talbot from Safeco Corporation. We are to purchase special shares of Satellite owned by the management of Talbot using a combination of both restricted and unrestricted Hub common shares or cash. The first payment of $16.4 million was made in cash on September 1, 2005, based upon Talbot’s earnings for the 12 months ending December 31, 2004. The remaining payments will be made on March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2005 and 2006, respectively. We estimate the March 31, 2006 payment to be approximately $19.0 million. The contingent payment to Talbot management is recorded by us as a charge to earnings over the period in which the payments are earned because it is a compensation based arrangement and specifically a performance award. The management of Talbot was and is to be compensated for future services based on achieving certain performance target during each of the 12 months ending December 31, 2004, 2005 and 2006. We estimate that the aggregate value of compensation which will be recognized under this arrangement will be approximately $56 million of which $28.7 million and $14.4 million were recognized in 2005 and 2004, respectively. At December 31, 2005, $26.7 million of compensation relating to the Talbot acquisition was included in accounts payable and accrued liabilities.
In connection with other various acquisitions completed through December 31, 2005, we may be obligated to pay contingent consideration up to a maximum sum of approximately $14.3 million in cash and $8.6 million in common shares based upon management’s best estimate of acquired brokerages achieving certain targets. The contingent payments are payable on various dates through July 2009 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2005, the financial statements reflect a liability to pay cash of $0.5 million as of December 31, 2005.
In connection with our executive share purchase plan, under certain circumstances, we may be obligated to purchase loans for certain employees from a Canadian chartered bank totaling $3.9 million and $4.3 million as of December 31, 2005 and 2004, respectively, to assist in purchasing our common shares. As collateral, the employees have pledged 383,000 and 431,000 common shares as of December 31, 2005 and 2004, respectively, which had a market value of $9.9 million and $7.9 million as of December 31, 2005 and 2004, respectively. The loans will mature during 2009 and 2010 and bear interest at a rate of prime plus 0.5%. The interest rate at December 31, 2005 was 5.5%. Interest on the loans in the amount of $197,000, $192,000 and $279,000 for the years ended December 31, 2005, 2004 and 2003, respectively, was paid by us and is included in employee cash compensation expense.
In the normal course of business, we are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of our management, the ultimate resolution of all such asserted and potential claims and lawsuits will not have a material adverse effect on our consolidated financial position or results of operations.
Restricted share units. In 2005, 226,000 restricted share units were granted to our Executive Management Team (EMT). In addition 26,000 restricted share units were granted in relation to employment agreements entered into with other non-EMT employees and 12,000 restricted share units were granted in connection with an acquisition.
Share repurchases. During 2005, we repurchased 160,608 common shares from a private related party in exchange for an equal number of our common shares.
Shareholder’s equity as of December 31, 2005 is comprised of the following:
The increasing proportion of our revenue derived from our U.S. operations and earned in U.S. dollars has, in part, offset the potential risk of a decline in the Canadian dollar. We expect that the proportion of revenue earned in U.S. dollars will continue to increase, further mitigating our foreign currency exchange sensitivity.
We completed our impairment testing on the balance of goodwill and intangible assets as of January 1, 2006, 2005 and 2004. Based on the testing performed, no impairment losses were incurred.
Customer relationships are generally amortized over their estimated economic useful life, typically ten to fifteen years. Many factors outside our control determine the persistency of our customer relationships and we cannot be sure that the value we have allocated will ultimately be realized. Non-competition covenants are intangible assets that have an indefinite life and accordingly, are not amortized but are evaluated for impairment. When an employee leaves Hub, the non-competition covenant becomes effective and the value assigned is then amortized over the life
For the years ended December 31, 2005, 2004 and 2003, our amortization has been comprised of the following:
As of December 31, 2005 and 2004, we had accounts receivable and accounts payable balances with the above related parties in the amounts of $10.0 million and $36.7 million for 2005, respectively, and $4.6 million and $17.8 million for 2004, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in the normal course of business. The companies listed above, except for OLIC, are related through common ownership by Fairfax which owns approximately 26% of our common shares as of December 31, 2005. During the second quarter of 2004, Fairfax sold OLIC to Old Lyme Insurance Group, Ltd, a company owned primarily by a group of Hub employees, including Bruce Guthart, our Chief Operating Officer and a director of Hub. We continue to place insurance with OLIC. The compensation that Hub earns from the business placed with OLIC and the fees it earns from managing OLIC are substantially the same as if Fairfax continued to own the company.
As an insurance brokerage we generally have two types of commissions: direct billed commissions and agency billed commissions. With direct bill, the insured is billed by the underwriter directly. The underwriter collects directly from the insured. We are then paid for our brokerage services (generally commission income) directly by the underwriter. Accordingly, we do not bill or collect fees directly from the insured. Commission income for direct billed commissions is recognized on the policy effective date. The other type of commission income is agency billed commission. In these arrangements we bill the insured directly, normally on or before the effective date of the policy. Premiums collected are remitted net of commission income to the insurance carriers.
The acquisition of new brokerages is a fundamental component of our strategy. When we acquire a business, the cost of the purchase is allocated to all of the tangible and intangible assets acquired and liabilities assumed based on their fair values, with the excess recorded as goodwill. Any additional contingent consideration is recorded as an adjustment to goodwill once the contingency is resolved. For significant acquisitions, we engage qualified third party valuators to assist us in conducting asset valuations.
Intangible assets primarily represent goodwill associated with our acquisitions. Goodwill represents the excess of the cost of purchase of acquired businesses over the fair market value of their identifiable net assets.
We do not amortize goodwill and intangible assets with indefinite useful lives. We do, however, test these assets at least annually for impairment at the reporting unit level. We determine impairment by comparing the fair value of a reporting unit to its carrying value. The fair value of a reporting unit may be determined using a number of market valuation methods. To determine fair value we apply a market multiple to adjusted earnings for each reporting unit. The use of assumptions and estimates is inherent in each of these valuation techniques. The valuation method and the underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests and, as a result, significantly different results of operations.
We estimate the fair value of RSUs granted at the fair market value on the date of grant.
We account for income taxes in accordance with Canadian GAAP which requires that future tax assets and liabilities be recognized for the effect of temporary differences between the book and tax basis of recorded assets and liabilities. Futures taxes are recognized using tax rates expected to be in effect for the year in which the temporary differences are expected to reverse. Future tax assets are required to be reduced by valuation allowances if it is more likely than not that some portion of the future tax asset will not be realized.
Management’s assessment may be developed in consultation with the Company’s professional advisors and is based on an analysis of possible outcomes under various strategies. This assessment requires management to make estimates and apply judgment to estimate the cost to settle these claims and lawsuits and to estimate the probability of loss contingencies actually occurring.
We are self insured for certain losses related to errors or omission claims, certain general insurance deductibles and a portion of our group medical insurance. The amounts in excess of self-insured levels are fully insured by third
parties, subject to certain limitations and exclusions. We utilize third party actuaries to assist in the valuation of certain of these liabilities. We accrue an estimated liability for these self-insured losses, including an estimate for incurred but not reported claims, based on known claims and past claims history, as well as an estimate for known claims. Reserves for self-insurance at December 31, 2005 were approximately $7.1 million and are included in accounts payable and accrued liabilities on our consolidated balance sheet.
Periodically, management reviews its assumptions and valuations to determine the adequacy of our self-insured reserves. We have not made any material changes in the methodology used to establish these reserves over the past two years. Uncertainty is associated with our self-insured liabilities because management must make estimates and apply judgments to estimate the ultimate cost to settle reported claims and incurred but not reported claims as of our balance sheet date. If actual results are not consistent with our estimates and judgments our results of operations could be significantly different than reported results.
Management has used the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) to evaluate the effectiveness of Hub’s internal control over financial reporting.
In conducting management’s assessment of the effectiveness of Hub’s internal controls over financial reporting, management has excluded Personal Lines Insurance Brokerage, Inc. (PLI) from its assessment of internal control over financial reporting as of December 31, 2005 because it was acquired by Hub in a purchase business combination on October 1, 2005. PLI is a wholly-owned subsidiary of Hub whose total assets and total revenues represent 4.7% and 1.7%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.
PricewaterhouseCoopers LLP, who has audited the Company’s consolidated financial statements for the year ended December 31, 2005, has also audited management’s assessment of the effectiveness of Hub’s internal control over financial reporting as at December 31, 2005 as stated in their report which appears in Item 8 and is incorporated by reference in Item 9A of this Annual Report on Form 10-K.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may
As described in Management’s Annual Report on Internal Control over Financial Reporting, management has excluded Personal Lines Insurance Brokerage, Inc. (“PLI”) from its assessment of internal control over financial reporting as of December 31, 2005 because it was acquired by the Company in a purchase business combination on October 1, 2005. We have also excluded PLI from our audit of internal control over financial reporting. PLI is a wholly-owned subsidiary whose total assets and total revenues represent 4.7% and 1.7%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.
(in thousands of U.S. dollars, except per share amounts or as otherwise indicated)
On July 1, 2004, the Company purchased Talbot Financial Corporation (Talbot) as described below, which was accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of Talbot are included in the Company’s consolidated results from the date of acquisition.
The Company purchased all of the common shares of Satellite Acquisition Corporation (Satellite), a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company will purchase special shares of Satellite owned by the management of Talbot, using a combination of both restricted and unrestricted common shares of the Company or cash. The first payment of $16.4 million, was made in cash on September 1, 2005, based upon Talbot’s earnings for the 12 months ending December 31, 2004. The remaining payments will be made on March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the twelve months ending December 31, 2005 and 2006, respectively. The contingent payment to Talbot management is recorded by the Company as a charge to earnings over the period in which the payments are earned, because it is a compensation based arrangement and specifically a performance award. The Company estimates that the aggregate value of compensation which will be recognized under this arrangement will be approximately $56 million, of which $28.7 million and $14.4 million were recognized in 2005 and 2004, respectively. At December 31, 2005, $26.7 million of compensation relating to the Talbot acquisition was included in accounts payable and accrued liabilities.
On April 23, 2004 the Company renegotiated an existing unsecured loan facility, increasing the funds available from $65 million to $75 million (see note 10 “Debt”). $65 million of this facility was drawn and was used for the acquisition of Talbot.
These consolidated financial statements of the Company are expressed in United States (U.S.) dollars and have been prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from U.S. GAAP and to the extent that they affect the Company, the differences are described in note 20 “Reconciliation to U.S. GAAP.” The more significant of the accounting policies are as follows:
Commission income and fees (including commission income related to installment billing arrangements) are recognized as of the effective date of the policy unless information is not available relating to the determination of the client’s policy premiums, in which case commission income and fees related to that policy are recognized when that information becomes available and the revenue can be reasonably determined. The term effective date means the date from which protection is afforded under an insurance policy. At the effective date, the Company becomes entitled to the commission because the insurance coverage has been placed with the underwriter and the premium is owed by the client. On the effective date the Company’s work has been substantially completed and the related costs to produce, market and place the coverage have been incurred. The Company generally bills in the month of the effective date. As such, the amount of the commission related to the services provided has been determined and the premium is receivable as of that date. Accordingly, on the policy effective date the earnings process is complete and the services which the Company has been contracted to perform have been provided. This is in accordance with the criteria set forth in SAB 101 and SAB 104.
As an insurance brokerage the Company generally has two types of commission income: direct billed commissions and agency billed commissions. With direct bill, the insured is billed by the underwriter directly. The underwriter collects directly from the insured. The Company is then paid for brokerage services (generally commission income) directly by the underwriter. Accordingly, the Company does not bill or collect fees directly from the insured. Commission income for direct billed commissions is recognized on the effective policy date. The other type of commission income is agency billed commission. In these arrangements the Company bills the insured directly, normally on or before the effective date of the policy. Premiums collected are remitted net of commission income to the insurance carriers.
Premiums collected (less commissions and other deductions), but not yet remitted to insurance companies, are included in trust cash. Trust cash is restricted as to use by contractual obligations and by laws in certain states and provinces in which the Company operates. Other deductions from premiums collected include advance payments to underwriters as well as advance claim payments and return premiums to clients. The cash held in trust is shown separately on the Company’s balance sheet under the caption “Trust Cash.” On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
Acquisitions of subsidiaries have been accounted for using the purchase method, whereby the results of acquired companies are included only from the date of acquisition. Consideration which is contingent on maintaining or achieving specified earnings levels in future periods is recorded as goodwill when the contingency is resolved and the additional consideration is issued or becomes issuable. For significant acquisitions, the Company engages qualified third party valuators to assist it in conducting asset valuations. The fair value of assets, including intangible assets, and liabilities may be determined using a number of valuation methods including net realizable values, market prices and discounted cash flows. For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, the Company accounts for such payment as an expense. Where such compensation is stock based, the Company’s accounting policy for stock based compensation is followed.
Intangible assets other than goodwill which do not have indefinite lives are amortized over their economic useful lives. The estimated economic useful life of customer relationships is generally ten to fifteen years. These intangible assets are regularly evaluated to see whether events or changes in circumstances indicate that the carrying value may warrant revision or may not be recoverable.
The Company recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests under the fair value based measurement method.
Future income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities and their tax bases. Future income tax assets and liabilities are determined for each temporary difference based on the tax rates which are expected to be in effect when the asset or liability is settled. The benefit of loss carry forwards is recognized as an asset to the extent that it is more likely than not to be realized.
The fair value of put options issued by the Company as consideration for businesses acquired is classified as long-term debt until such time as the option is exercised or expires. Changes in the fair value of these options are recorded in earnings. As part of the negotiations of contingent consideration the former owners of certain companies acquired in 2001 agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2005 and 2004 no put options were outstanding on the Company’s common shares.
During the third quarter 2005, the Company adopted a formal plan of disposition related to its U.S. financial services operation (the “Discontinued Business”). Preparation of the financial statements in conformity with Canadian and U.S. GAAP requires management to report revenue and expenses for the reporting period as “Discontinued Operations”, and as such is shown separately from continuing operations. See note 5 “Discontinued Operations”.
The Company typically pays a significant portion of the consideration for an acquired brokerage in cash. Consideration for the remainder of the purchase price is normally in the form of the Company’s common shares based on the fair market value of the Company’s common shares as traded on the NYSE or TSX, and is defined and calculated pursuant to the acquisition agreement. In addition previous owners of certain acquired entities are entitled to contingent consideration if certain revenue or profitability targets are met. See note 4 “Commitments and contingencies.”
allocations and contingent consideration, relating to prior period acquisitions. The allocation of purchase price will be finalized when certain tangible net worth adjustments are made in the first quarter of 2006.
In anticipation of funding an acquisition in 2005, the Company entered into a foreign exchange forward contract to convert Canadian dollars to U.S. dollars. The difference between the forward rate contracted and the spot rate at the date of conversion generated a foreign exchange loss of $0.6 million, which is included in the Consolidated Statements of Earnings. During 2005, the Company sold stock and assets of certain insurance brokerages for $5,388, resulting in a gain of $2,485.
The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2004 are summarized below:
Of the goodwill acquired, $1,367 is deductible for tax purposes. In addition, the Company also recognized $1,800 of goodwill associated with contingent consideration relating to prior year acquisitions.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (Flanagan), a brokerage purchased in 2001, total additional consideration of 37,500 of the Company’s common shares was earned at December 31, 2003, valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares were recorded as “issuable shares” and included in shareholders’ equity, and goodwill was increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition the Company issued non-cash stock based compensation in the form of 84,375 restricted share units in 2004 valued at $1.4 million.
The Company was first named as a defendant in a federal class action lawsuit in October 2004. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” A number of substantially similar federal class actions were filed against the Company and many other defendants. On February 17, 2005, the Federal Judicial Panel on Multidistrict Litigation transferred these and other class actions in which the Company was not named to the District of New Jersey. In August 2005 and February 2006, amended complaints were filed in the consolidated federal court proceedings pending in New Jersey and styled In re Insurance Brokerage Antitrust Litigation. The case has now been divided into two cases, one for employee benefits and the other for commercial insurance. Certain of our subsidiaries have been named as additional defendants. A handful of allegations specifically pertaining to the Company have been added, but remain vague. The judge in these actions has permitted limited discovery to take place which is continuing. The Company disputes the allegations made in these lawsuits and intends to vigorously defend these cases.
In January, 2005 the Company and its affiliates were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through the Chicago office of what is now HUB Midwest and claims that an undisclosed contingent commission was received with respect to its policy. The Company disputes the allegations of this lawsuit and is vigorously defending this case.
The Company is committed under lease agreements for office premises and computer equipment. At December 31, 2005, aggregate minimum rental commitments (net of expected sub-lease receipts) under operating leases are as follows:
Rent expense for the years ended December 31, 2005, 2004, and 2003 amounted to $16,653, $13,998, and $11,503, respectively, net of sublease rental income of $1,392, $1,479 and $1,282, respectively.
Summarized balance sheet disclosure for the Discontinued Business is as follows:
Summarized statement of cash flows disclosure for the Discontinued Business is as follows:
As of December 31, 2005 and 2004 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
The Company is unable to estimate the economic useful life of certain non-competition covenants. These indefinite life intangible assets as well as goodwill are reviewed annually, on January 1, for impairment. Once a non-competition covenant is triggered, following departure of an employee from the Company, the Company’s policy is to amortize the related intangible asset over the period of the contractual obligation.
Additions, excluding dispositions, to intangible assets during 2005 and 2004 were as follows:
For the years ended December 31, 2005, 2004 and 2003, amortization has been comprised of the following:
Included in computer equipment is computer software with a net book value of $5,865 and $6,331 at December 31, 2005 and 2004, respectively. Depreciation expense of $2,391, $1,906 and $1,538 was charged against these assets for the years ended December 31, 2005, 2004 and 2003, respectively.
During 2005 and 2004, property and equipment were acquired at an aggregate cost of $7,982 and $7,293 respectively, of which NIL were acquired by means of capital leases and other financing.
The cost above reflects certain property and equipment held under capital leases of which the remaining liability at December 31, 2005 and 2004 was $185 and $468, respectively.
Future repayments of long-term debt and capital leases are as follows:
During the first quarter 2005, an early payment settlement was negotiated in respect of the Company’s $7.5 million loan from an insurance carrier. The loan agreement provided for an incentive agreement whereby a credit could be earned to reduce interest payments (based on target premiums placed with the carrier) and principal amounts (based on target premiums placed with the carrier as well as loss ratios on those premiums). The early settlement negotiations resulted in the $7.5 million principal amount of the term loan being reduced to $3.0 million and interest payments for the first quarter 2005 being reduced to zero. The Company paid $3.0 million in March 2005 and recorded a gain on forgiveness of debt of $4.5 million for the first quarter 2005. Interest expense on this loan totalled $0.1 million and $0.8 million in 2005 and 2004 (which was subsequently reduced to zero).
The Company has an undrawn $10.3 million facility which bears interest at the bank’s U.S. rate which was 7.75% and 5.75% at December 31, 2005 and 2004, respectively, plus 50 basis points. Borrowings on the facility are repayable on demand.
The Company has outstanding 8.5% subordinated convertible debentures (the “Fairfax notes”) in the amount of $35 million due June 28, 2007 held by certain subsidiaries of Fairfax Financial Holdings Limited (Fairfax). The Fairfax notes are convertible by the holders at any time into the Company’s common shares at Canadian (C) $17.00 per share. Beginning June 28, 2006, the Company may require conversion of the Fairfax notes into common shares at C$17.00 per share if, at any time, the weighted average closing price of the Company’s common shares on the TSX for twenty consecutive trading days equals or exceeds C$19.00 per share. If converted, Fairfax would have owned approximately 31% of the Company’s total outstanding common shares as of December 31, 2005.
Substantially all officers and employees of the Company are entitled to participate in a qualified retirement savings plan (defined contribution plan). The cost to the Company was $3,581, $2,662 and $1,781 for 2005, 2004 and 2003, respectively.
At December 31, 2005, 2004 and 2003 there were an unlimited number of non-voting, preferred shares authorized, issuable in series on such terms and conditions as set by the Board of Directors, of which no shares were issued. At December 31, 2005, 2004 and 2003 there were an unlimited number of common shares authorized, of which 30,952,000, 30,411,000 and 30,143,000 were issued and outstanding as at December 31, 2005, 2004 and 2003, respectively.
In 2005, 226,000 restricted share units were granted to the Company’s Executive Management Team (EMT) and 12,000 restricted share units were granted in connection with an acquisition. In addition, 26,000 restricted share units were granted in relation to employment agreements entered into by the Company with other non-EMT employees. The fair value of all restricted share units awarded in 2005 was approximately $5.1 million ($19.41 per share) and they vest over periods ranging from 46 months to 60 months.
On June 30, 2003, the Company awarded 605,000 restricted share units to employees of the Company. The restricted share units are exercisable for common shares without payment of cash consideration and vest over periods ranging from 68 months to 95 months.
Compensation for the Talbot earnout for the years ended December 31, 2005, 2004 and 2003 is comprised of the following:
The Company estimates other non-cash stock based compensation expense for 2006 through 2011 will be:
The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts and other receivables, accounts payable and accrued liabilities at December 31, 2005 and 2004, approximate fair value because of the short-term nature of these instruments. The carrying value of the Company’s variable rate debt at December 31, 2005 and 2004, of $67,606 and $68,723, respectively, approximates fair market value.
In connection with the acquisition of HUB Northeast in 2001, the Company issued 8.5% subordinated convertible debentures due June 28, 2007 with a carrying amount and aggregate principal of $35 million. These debentures remain outstanding at December 31, 2005. The Company believes it is not practicable to estimate the fair value of the Fairfax notes due to the conversion features.
Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2005, 2004 and 2003 is as follows:
The Company had transactions with, and recorded revenue from, the following related parties:
continues to place insurance with OLIC. The compensation that Hub earns from the business placed with OLIC and the fees it earns from managing OLIC are substantially the same as if Fairfax continued to own the company.
As of December 31, 2005 and 2004, subsidiaries of Fairfax held the Fairfax notes, in the amount of $35,000.
During 2005, 2004 and 2003, the Company incurred expenses related to rental of premises from related parties in the amount of $2,831, $2,306 and $2,102, respectively. At December 31, 2005 and 2004, the Company also had accounts receivable due from related parties in the amount of $2,191 and $2,613, respectively, of which the majority were loans to employees to enable them to purchase shares of the Company. Of these accounts receivable, as of December 31, 2005 and 2004, $1,495 and $1,793, respectively, were related to Company loans to employees to purchase shares under the executive share purchase plan. The loans will mature in June, 2011 and bear interest at a rate of prime plus 0.5%. The interest rate at December 31, 2005 was 5.5%. As collateral, the employees have pledged 122,000 and 143,000 common shares as of December 31, 2005 and 2004, respectively, which have a market value of $3,156 and $2,619 as of December 31, 2005 and 2004, respectively.
The table below sets out the differences between Canadian GAAP and U.S. GAAP that affect shareholders’ equity at December 31, 2005, 2004 and 2003:
Under U.S. GAAP, changes in the estimated fair value of the put options are included in earnings.
The condensed consolidated statements of earnings and cash flows for the years ended December 31, 2005 and 2004 were the same under Canadian and U.S. GAAP but differ for the year ended December 31, 2003.
Under U.S. GAAP, comprehensive income is measured in accordance with SFAS No. 130, Reporting Comprehensive Income. This standard defines comprehensive income as all changes in equity other than those resulting from investments by owners and distributions to owners and includes the change in unrealized gains (losses) on debt and equity securities and foreign currency translation adjustments. Under Canadian GAAP unrealized gains and losses (arising from a temporary decline in value) on equity securities are not recorded and foreign currency translation adjustments are presented as movements in the cumulative translation account. Certain disclosures required by SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, have not been included as such disclosures related to the Company’s investments in debt and equity securities are immaterial to the overall financial statement presentation.
Under Canadian GAAP, investments held for sale are recorded at cost. No further adjustments are made to the carrying value of the investment until it is sold. Under U.S. GAAP investments held for sale are recorded at cost and adjusted to fair value until sold. The adjustment of $1,716 reflects the difference in accounting for investments held for sale and subsequently sold by the company under Canadian vs. U.S. GAAP.
transactions be recognized in the financial statements, establishes fair value as the measurement objective and requires entities to apply a fair-value-based measurement method in accounting for share-based payment transactions. The Company currently recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests. SFAS No. 123 (R) also requires the benefits of tax deductions in excess of compensation amounts recognized for book purposes, to be reported as a financing cash flow rather than as an operating cash flow as required under current rules. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. The Company will adopt SFAS No. 123 (R) on its effective date, which is January 1, 2006.
Subsequent to December 31, 2005, the Company secured a commitment for a new $75 million non-revolving credit facility to have terms similar to our current $75 million revolving U.S. dollar Libor loan. These funds will be available for the acquisition of CFG’s insurance brokerage subsidiaries.