Notes: (a) The financial information for all periods prior to 1998 has been restated for four 1998 acquisitions accounted for using the pooling of interests method. (b) Based on the weighted average number of common and common equivalent shares outstanding during the year. (c) Based on the number of employees at year end. (d) Based on the total dividends declared on a share of common stock outstanding during the entire year. (e) Includes non-recurring gains.
Fluctuations in premiums charged by insurance companies have a material effect on the insurance brokerage industry. Commission revenues are based on a percentage of the premiums paid by insureds and generally follow premium levels. For more than a decade, lower premium rates have prevailed among property/casualty insurance carriers resulting in heavy competition for market share. This "soft market" (i.e., lower premium rates) has generally resulted in flat or reduced renewal commissions.
Historically, increased property replacement costs due to inflation and increasingly large litigation awards have caused some clients to seek higher levels of insurance coverage. These factors generally have the effect of generating higher premiums to clients and higher commissions to the Company. In recent years, lower rates of inflation along with increased underwriting capital have resulted in a highly competitive insurance marketplace and flat to lower premiums. In general, the downward trend in premium rates has had a greater effect on the Company's revenues than inflation.
The Company's results of operations for periods prior to 1998 have been restated for four acquisitions as if they had operated as part of the Company prior to their joining the Company. The Company continues to search for merger partners which complement existing operations, provide entry into new markets, add new products and enhance local sales and service capabilities. For the effect of these restatements, in the aggregate, on year-to-year comparisons, see Note 2 to the Consolidated Financial Statements.
Commission revenues increased by $27.9 million or 10% in 1998. This increase is the result of new business production of $54.1 million, significantly offset by lost business of $35.2 million, with the balance coming from net increases on renewals and contingent commissions. Commission revenues increased by $8.5 million or 3% in 1997. This increase is the result of new business production partially offset by lost business.
Fee revenues increased by $26.9 million or 15% in 1998. This increase, generated primarily from the Risk Management Services segment, resulted from strong new business production of $39.0 million and favorable retention rates on existing business. Fee revenues increased by $9.2 million or 5% in 1997. This increase, also generated primarily from Risk Management Services, resulted from new business production partially offset by lost business.
In 1997, the Company recognized non-recurring pretax gains of $7.2 million on the sale of underperforming or geographically undesirable operations and $1.8 million on a real estate transaction. There were no material non- recurring pretax gains recorded in either 1998 or 1996.
Salaries and employee benefits increased by $27.1 million or 11% in 1998 due primarily to an 8% increase in employee head count, salary increases, the annualized effect of prior year new hires along with a corresponding increase in employee benefit expenses, and a $4.8 million non-recurring gain recognized in 1997 from the settlement of a defined benefit pension plan at one of the Company's United Kingdom subsidiaries. Salaries and employee benefits increased by $4.8 million or 2% in 1997 due to salary increases and the annualized effect of prior year new hires substantially offset by a 3% reduction in employee head count in 1997, the non-recurring pension gain mentioned above and a wage freeze for certain management employees in 1997.
The Company's effective income tax rates of 33.2%, 33.6% and 34.0% in 1998, 1997 and 1996, respectively, are less than the statutory federal income tax rate of 35% due primarily to the effect of tax benefits generated by certain investments which are substantially offset by state and foreign taxes. See Note 12 to the Consolidated Financial Statements.
The Company's foreign operations recorded earnings before income taxes of $5.4 million, $6.6 million and $5.2 million in 1998, 1997 and 1996, respectively. The decrease in 1998 is due to the non-recurring gains recognized in 1997 associated with the pension and real estate transactions mentioned above, substantially offset by growth in operating results generated by new business. The 1997 increase is due to the non-recurring gains associated with the pension and real estate transactions mentioned above. See Notes 12 and 14 to the Consolidated Financial Statements.
In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 (SFAS 131), "Disclosure about Segments of an Enterprise and Related Information." SFAS 131 establishes standards for the way that public business enterprises report information about operating segments and related disclosures. The following discussion describes and compares the results of operations and geographic data between 1998, 1997 and 1996 with respect to the way the Company views its operating segments.
Insurance Brokerage Services includes the Company's retail, reinsurance and wholesale brokerage operations. Total revenues in 1998 were $362.5 million, a 9% increase over 1997. This increase is due primarily to new business production and the positive effect of acquisitions, significantly offset by lost business. U.S. revenues of $330.2 million were up 9% over 1997. Revenues in 1998 from foreign operations, principally in the United Kingdom were up 8% or $2.3 million over 1997 due mainly to new business partially offset by lost business. Earnings before income taxes in 1998 increased 19% over 1997 as a result of increased revenues. Total revenues in 1997 were $333.8 million, an increase of 4% over 1996. This increase again is due to new business production partially offset by lost business. U.S. revenues of $303.8 million were up 4% over 1996. Revenues in
1997 from foreign operations, primarily in the United Kingdom, were virtually flat with 1996. Earnings before income taxes of $57.4 million in 1997 increased 9% over 1996 due mainly to increased revenues.
Financial Services is responsible for investments and certain non-recurring events. The Company's comprehensive investment portfolio includes investment strategies held as trading, marketable securities held as available for sale, tax advantaged investments, investments on the equity method of accounting, real estate partnerships and notes receivable from investees. Revenues in 1998 were $9.3 million or $14.7 million less than revenues in 1997 and earnings before income taxes decreased $16.9 million or 76% from 1997. These decreases relate to $9.0 million and $13.8 million of non-recurring gains in revenues and earnings before taxes, respectively, recognized in 1997 and less favorable returns on funds invested with outside fund managers due to equity market conditions in 1998. Revenues in 1997 increased 80% over 1996 and earnings before income taxes in 1997 increased 166% over 1996 due primarily to the non- recurring gains mentioned above and favorable returns on funds invested with outside fund managers. Financial Services' revenues are generated principally in the U.S.
Corporate consists of unallocated administrative costs and the provision for income taxes which is not allocated to the Company's operating entities. Revenues are not recorded in this segment and all costs are generated in the U.S. See Note 14 to the Consolidated Financial Statements.
The Company also has line of credit facilities of $27.5 million which expire on April 30, 1999. Periodically, the Company will make short-term borrowings under these credit facilities to meet short-term cash flow needs. During 1998 and 1997, the Company borrowed $60.0 million and $30.9 million and repaid $60.0 million and $25.9 million of short-term borrowings, respectively, under these facilities. As of December 31, 1998 and 1997,
At December 31, 1997, the Company had commitments to invest $26.0 million in several of its equity and tax advantaged investments. In addition, the Company had contingently committed to invest an additional $3.0 million in 1998 related to a line of credit arrangement with one of its equity investments. As of December 31, 1998, approximately $29.0 million had been invested under these arrangements, which were funded primarily from the $24.0 million of proceeds from the sales and maturities of trading and marketable securities investments. At December 31, 1998, the Company has committed to invest an additional $7.5 million related to two letter of credit arrangements with one of its equity investments and to unconditionally guarantee $30.0 million of debt that will be incurred by another of its equity investments. In addition, the Company has guaranteed an aggregate $8.7 million of funds through letters of credit or other arrangements related to several investments and insurance programs of the Company.
The Company paid $23.2 million in cash dividends on its common stock in 1998. The Company's dividend policy is determined by the Board of Directors and payments are fixed after considering the Company's available cash from earnings and its known or anticipated cash needs. In each quarter of 1998, the Company's Board of Directors declared a dividend of $.35 per share which was $.04 or 13% greater than each quarterly dividend in 1997. In January 1999, the Company announced a first quarter dividend of $.40 per share, a 14% increase over the first quarter dividend in 1998.
In 1988, the Company adopted a plan which has been extended through June 30, 1999 to repurchase its common stock. Under the plan, the Company repurchased 215,000 shares at a cost of $8.7 million, 522,000 shares at a cost of $17.1 million and 645,000 shares at a cost of $21.3 million in 1998, 1997 and 1996, respectively. The repurchased shares are held for reissuance in connection with exercises of options under the Company's stock option plans. Under the provisions of the plan, the Company is authorized to repurchase approximately 535,000 additional shares through June 30, 1999. The Company is under no commitment or obligation to repurchase any particular amount of common stock and at its discretion may suspend the repurchase plan at any time.
The Company has evaluated the impact on operations of the Year 2000 on non- information technology systems and has determined that any potential impact would not be material to the Company's operations.
The Company also has an ongoing program to review the status of Year 2000 compliance efforts of its business partners and vendors. While the Company believes it is taking the appropriate steps to assure the Company's Year 2000 compliance, it is also dependent on business partner, vendor and client compliance to some extent. Consequently, any Year 2000 compliance problems that may be experienced by the Company's business partners, vendors or clients could have a material adverse effect on the Company's future financial condition and future operating results. No assurance can be given that the Company's and these other entities' efforts will completely address the Year 2000 issue.
The fair value of the Company's cash and cash equivalents investment portfolio at December 31, 1998 approximated its carrying value due to its short-term duration. Market risk was estimated as the potential decrease in fair value resulting from a hypothetical one percentage point increase in interest rates for the instruments contained in the cash and cash equivalents investment portfolio and the resulting fair value was not materially different from the December 31, 1998 carrying value.
At December 31, 1998, the fair value of the Company's investment strategies portfolio was $57.4 million. From an investment management perspective, this portfolio, which is managed by several outside fund managers, consists of two different components: an equity portfolio of $7.3 million and an alternative investment strategies portfolio of $50.1 million. The equity portfolio is subject to equity price risk. This portfolio, which is not hedged, consists of common stocks and is primarily managed to produce realized gains for the Company. The estimated potential loss in fair value of this equity component at December 31, 1998 resulting from a hypothetical decrease in prices quoted by stock exchanges of 10% would be approximately $730,000. The Company's alternative investment strategies portfolio is also subject to equity pricing risk. However, these investments are actively managed in order to minimize the Company's exposure to equity pricing risk. The objective of this portfolio is to maximize the overall return to the Company, while minimizing the downward price risk in order to preserve the investment's underlying principal balance. The outside fund managers for these alternative investment
The Company is subject to foreign currency exchange rate risk primarily due to the fact that its United Kingdom based subsidiaries incur expenses denominated in British pounds while receiving their revenues in U.S. dollars. The Company does not hedge this foreign currency exchange rate risk. The foreign currency gains (losses) related to this market risk are recorded in earnings before income taxes as they are incurred. Assuming a hypothetical adverse change of 10% in the average foreign currency exchange rate for 1998 (a weakening of the U.S. dollar), earnings before income taxes would decrease by approximately $2.0 million. The Company is also subject to foreign currency exchange rate risk associated with the translation of its foreign subsidiaries into U.S. dollars. However, it is management's opinion that this foreign currency exchange risk is not material to the Company's consolidated operating results or financial position. The Company manages the balance sheets of its foreign subsidiaries such that foreign liabilities are matched with equal foreign assets thereby maintaining a "balanced book" which minimizes the effects of currency fluctuations.
Commission income is generally recognized as of the effective date of insurance policies except for commissions on installment premiums which are recognized periodically as billed. Contingent commissions are generally recognized when received. Fee income is recognized ratably as services are rendered. The income effects of subsequent premium and fee adjustments are recorded when the adjustments become known. Premiums and fees receivable are net of allowance for doubtful accounts of $1,500,000 and $860,000 at December 31, 1998 and 1997, respectively.
As of January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive Income." SFAS 130 establishes new rules for the reporting and display of comprehensive earnings and its components; however, the adoption of SFAS 130 had no impact on the Company's consolidated net earnings or total stockholders' equity. SFAS 130 requires unrealized gains or losses on the Company's available for sale securities, which prior to adoption were reported separately in stockholders' equity, to be included in other comprehensive earnings. Prior year consolidated financial statements have been reclassified to conform to the requirements of SFAS 130.
Earnings per share are computed based on the weighted average number of common and common equivalent shares outstanding during the respective period. Common equivalent shares include incremental shares from dilutive stock options, which are calculated from the date of grant under the treasury stock method using the average market price for the period.
Fixed assets are carried at cost in the accompanying consolidated balance sheet. Furniture and equipment with a cost of $86,862,000 and $78,839,000 at December 31, 1998 and 1997, respectively, are depreciated using the straight- line method over the estimated useful lives of the assets. Leasehold improvements with a cost of $11,400,000 and $9,190,000 at December 31, 1998 and 1997, respectively, are amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the lease terms.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 1. Summary of Significant Accounting Policies--(Continued)
Intangible assets consist of the excess of cost over the value of net tangible assets of acquired businesses, non-compete agreements and expiration lists. The excess of cost over the value of net tangible assets is amortized over twenty to forty years using the straight-line method. Non-compete agreements and expiration lists are amortized principally over ten years using the straight-line method. Accumulated amortization at December 31, 1998 and 1997 was $4,618,000 and $6,487,000, respectively.
In 1998, the Company acquired substantially all of the net assets of twelve insurance brokerage firms and one benefits consulting company in exchange for 681,000 shares of its common stock. In 1997, the Company acquired substantially all of the net assets of one insurance brokerage firm and two benefits consulting companies in exchange for 263,000 shares of its common stock. These acquisitions were accounted for as poolings of interests and, except for nine of the 1998 acquisitions and two of the 1997 acquisitions whose results were not significant, the consolidated financial statements for all periods prior to the acquisition dates have been restated to include the operations of these companies.
The cost or amortized cost and fair value of fixed maturities at December 31, 1998, by contractual maturity, are as follows (in thousands):
At December 31, 1998, securities sold under agreements to repurchase the identical securities are collateralized by government backed small business administration loans and government securities with a carrying value of $21,714,000 and a fair value of $21,817,000. The securities collateralizing the agreements were held by two primary dealers. At December 31, 1997, these securities had a carrying value of $22,121,000 and a fair value of $22,360,000.
The Company maintains a $20,000,000 variable rate (based on LIBOR plus .4%) unsecured revolving credit agreement which expires on June 30, 2001. As of December 31, 1998 and 1997, there were no borrowings outstanding under this agreement. Terms of the revolving credit agreement include various covenants which require the Company to maintain specified levels of tangible net worth and restrict the amount of payments on certain expenditures.
Non-voting Rights, authorized by the Board of Directors on March 10, 1987 and approved by stockholders on May 12, 1987, are outstanding on each share of outstanding common stock. Under certain conditions, each Right may be exercised to purchase one share of common stock at an exercise price of $100. The Rights become exercisable and transferable after a public announcement that a person or group has acquired 20% or more of the common stock or after commencement or public announcement of a tender offer for 30% or more of the common stock. If the Company is acquired in a merger or business combination, each Right exercised gives the holder the right to purchase $200 of market value of common stock of the surviving company for the $100 exercise price. The Rights Plan was amended in 1996 to extend the expiration of the Rights to May 12, 2007. The Rights may be redeemed by the Company at five cents per Right at any time prior to the public announcement of the acquisition of 20% of the common stock. At December 31, 1998 and 1997, 25,000,000 shares of common stock were reserved for potential exercise of the Rights.
Options to purchase 20,000, 644,000 and 1,313,000 shares of common stock were outstanding during 1998, 1997 and 1996, respectively, but were not included in the computation of the dilutive effect of stock options. These options were excluded from the computation because the options' exercise prices were greater than the average market price of the common shares and, therefore, would be antidilutive.
In addition, the Company has a non-employee directors' stock option plan which currently authorizes 200,000 shares for grant, with Discretionary Options granted at the direction of the Option Committee and Retainer Options granted in lieu of the directors' annual retainer. Discretionary Options shall be exercisable at such rates as shall be determined by the Committee on the date of grant. Retainer Options shall be cumulatively exercisable at the rate of 25% of the total Retainer Option at the end of each full fiscal quarter succeeding the date of grant. The excess of fair value at the date of grant over the option price for these nonqualified stock options is considered compensation and is charged against earnings ratably over the vesting period.
In 1998, all of the aforementioned stock option plans were modified to provide for the immediate vesting of all outstanding stock option grants in the event of a change in control of the Company. A change in control of the Company is defined as the acquisition by a person (or entity) of the beneficial ownership of 50% or more of the Company's common stock; the cessation, for any reason, of a majority of directors of the Company to serve as directors during any two year period; or the approval by the stockholders of the Company of the sale of substantially all of the assets of the Company.
8. Stock Option Plans--(Continued) The Company accounts for stock option grants in accordance with APB 25 and, accordingly, recognizes no compensation expense for stock options that are granted to employees at the fair value of the underlying shares at the date of grant. Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," requires disclosure of pro forma information regarding net earnings and net earnings per share, using pricing models to estimate the fair value of stock option grants. Had compensation expense for the Company's stock option plans been determined based on the estimated fair value at the date of grant consistent with the methodology prescribed under SFAS 123, approximate net earnings and net earnings per share would have been as follows (in thousands, except per share data):
The pro forma disclosures above only include the effect of options granted subsequent to January 1, 1995. Accordingly, the effects of applying the SFAS 123 pro forma disclosures to future periods may not be indicative of future effects.
Options with respect to 1,328,000 shares were available for grant at December 31, 1998.
The discount rate used to measure the postretirement benefit obligation was 7.5% at December 31, 1998 and 1997. The transition obligation is being amortized over a 20 year period. For measurement purposes, an 8.5% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1999. This rate was assumed to gradually scale down to 4.5% for 2009 and remain at that level thereafter. The assumed health care cost trend rate has a significant effect on the amounts reported and disclosed herein. A one percentage point change in the assumed health care cost trend rate would have the following effects (in thousands):
The Company is engaged in various legal actions incident to the nature of its business. Management is of the opinion that none of the litigation will have a material effect on the Company's consolidated financial position or operating results.
Minimum aggregate rental commitments at December 31, 1998 under noncancelable operating leases having an initial term of more than one year are as follows (in thousands):
Significant components of earnings before income taxes and the provision for income taxes are as follows (in thousands):
A reconciliation of the provision for income taxes with the U.S. federal income tax rate is as follows (in thousands):
During the period from 1994 to 1996, the Company provided for U.S. income taxes on the undistributed earnings of its foreign subsidiaries. Due to changes in the U.S. federal income tax laws effective in 1997, the Company no longer provides for U.S. income taxes on the undistributed earnings ($21,800,000 at December 31, 1998) of certain foreign subsidiaries which are considered permanently invested outside of the U.S. The amount of unrecognized deferred tax liability on these undistributed earnings is $6,100,000 at December 31, 1998.
Allocations of investment income and certain expenses are based on assumptions and estimates, and reported operating results by segment would change if different methods were applied. Certain assets are not individually identifiable by segment and, accordingly, have been allocated based on formulas. Financial information relating to the Company's operating segments for 1998, 1997 and 1996 is as follows (in thousands):
The Management of Arthur J. Gallagher & Co. is responsible for the preparation and integrity of the consolidated financial statements and the related financial comments appearing in this annual report. The consolidated financial statements were prepared in accordance with generally accepted accounting principles and include certain amounts based on management's best estimates and judgments. Other financial information presented in this annual report is consistent with the consolidated financial statements.
The Board of Directors has an Audit Committee composed entirely of outside directors. Ernst & Young LLP has direct access to the Audit Committee and periodically meets with the Committee to discuss accounting, auditing and financial reporting matters.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arthur J. Gallagher & Co. at December 31, 1998 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.