We have not amended any other previously-filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by this restatement. The financial information that has been previously filed or otherwise reported for these periods is superseded by the information in this Annual Report on Form 10-K, and the financial statements and related financial information contained in previously-filed reports should no longer be relied upon. The impact of corrected compensation expense is not material to any reporting period. However, the aggregate cumulative impact for the 1994 to 2005 period is considered sufficiently material to warrant restatement.
(2)See the "Explanatory Note" immediately preceding Part 1, Item 1 and Note 2, "Restatement of Consolidated Financial Statements" to the consolidated financial statements of this Form 10-K.
Risk and Insurance Brokerage Services. Brokerage segment results are affected by several key drivers, including:
Liquidity is derived from cash flows from our businesses, 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.
Below is a summary of our 2006 financial results. Refer to our detailed discussion below for further details.
•Expenses rose 5% in 2006, due to an increase in benefits to policyholders that was driven by a provision for underwriting reserves, higher compensation and benefit costs and unfavorable foreign exchange. Partially offsetting these increases were savings related to our restructuring program.
•We sold our Aon Warranty Group (AWG) and Construction Program Group (CPG) businesses; see Key Recent Events for further discussion.
•Our Board of Directors increased our share repurchase program in November 2006 to $2 billion. We repurchased 28.4 million shares for $1,048 million during 2006; further detail is discussed below in Key Recent Events. At December 31, 2006, the Company had $928 million remaining under the authorized share repurchase program.
•spent $1,048 million to repurchase 28.4 million of our outstanding shares
We fundamentally changed the composition of our underwriting segment in 2006 by selling our AWG and CPG operations in two separate, but related, transactions. Virginia Surety Company, Inc. ("VSC"), our principal underwriter for both AWG and CPG, was sold to the buyer of AWG. We received approximately $800 million in gross cash proceeds and realized a pretax gain of $43 million on these sales. On an after-tax basis, the transactions generated a gain of $9 million. The operating results of AWG and CPG and the impact of the sales transactions are included in discontinued operations for all periods presented.
We continually review the adequacy of our policy liabilities. During the third quarter 2006, in connection with the sales of AWG and CPG, we completed a detailed review of all our property and casualty reserves. Based on the results of this review, we increased our property and casualty reserves by approximately $102 million, reflecting adverse development, refined assumptions and additional claim information relating to programs to be disposed of through sale or runoff. We recorded
We estimate 3,600 positions will be eliminated as a result of this initiative. As of December 31, 2006, approximately 2,500 of these eliminations had already occurred. Further, office closures require that we recognize losses on subleases or lease buy-outs, and may also trigger asset impairments.
The following chart details the restructuring and related expenses we incurred through 2006 and our estimates for 2007 by geographic region:
The following chart summarizes the restructuring costs incurred through 2006 and our estimated expenses by type for 2007.
In November 2005, our Board of Directors authorized the repurchase of up to $1 billion of Aon's common stock, and in November 2006, the Board increased that amount to $2 billion. 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 2006, we repurchased 28.4 million shares for $1,048 million.
Our U.S. pension plans are closed to new entrants, and effective January 1, 2007, we will determine future pension benefits using a "career average pay" formula rather than the prior "final average pay" formula.
•the market-related value of assets does not yet reflect accumulated asset gains of $36 million. These gains will decrease pension expense as they are graded into the market-related asset value and may be offset by future asset losses. We recognize twenty percent of the asset gain or loss in the current year's market-related value, with the remaining eighty percent spread over the next four years.
component of pension expense over several years, based on the average expected future service of active employees in the plans, which is currently estimated to be eight years.
As of December 31, 2006, the pension plans have a deferred loss of $485 million (comprised of unrecognized asset gains of $36 million and unrecognized actuarial losses of $521 million) that has not yet been recognized through income in the financial statements. We amortize the actuarial losses of $521 million outside of a corridor, over approximately eight years; this corridor is defined as 10% of the greater of market-related value of plan assets or PBO. For 2007, we estimate that this expense amortization will be approximately $43 million. To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense similarly until fully amortized.
To determine future pension expense, we currently assume a long-term rate of return of approximately 8.6%. We base this expected long-term return on capital market expectations for various asset classes (see following table). U.S. equities and fixed income expectations are estimated using a theoretical Capital Asset Pricing ("CAP") Model. The CAP Model for equities included three factors:
•other asset class expectations on risk premiums relative to U.S. equities and fixed income expected returns.
We use the same assumptions for our pension plans and postretirement benefit plans where applicable. Changes in these assumptions can have a material impact on pension obligations and pension expense. For example, holding all other assumptions constant, a one percentage point:
•increase in our estimated long-term rate of return on plan assets would decrease pension expense approximately $14 million.
Our U.K. pension plans are closed to new entrants, and in November 2006, we proposed ceasing future benefit accruals relating to salary and service in the U.K. plans, subject to trustee approval and member consultation. Proposed changes would take effect in the first half of 2007, and future retirement benefits would be provided in a defined contribution segment of a pension scheme.
•decrease in our estimated liability discount rate would increase the estimated 2007 pension expense approximately $58 million
•decrease in our estimated liability discount rate would increase estimated 2007 pension expense approximately $8 million
•increase in our estimated liability discount rate would decrease estimated 2007 pension expense approximately $7 million.
Through our insurance underwriting operations, we collect premiums from policyholders, and we establish liabilities (reserves) to pay benefits to policyholders. The liabilities for policy benefits, claims, and unearned premiums:
•are comprised primarily of estimated future payments to policyholders, policy and contract claims and unearned and advance premiums and contract fees
If these liabilities prove inadequate, we would be required to increase the reserves, which could hurt our results and financial condition.
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:
Except for products that meet the definition of FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, we accrue a liability for future policy benefits relating to long-duration contracts when we recognize premium revenue. The liability represents the present value of future benefits to be paid to policyholders less the present value of future premiums; we estimate this liability using methods that include estimates of expected investment yields, mortality, morbidity, and policy persistency.
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 variations from our original assumptions. When current estimates of the present value of future benefits and expenses exceed the present value of future premiums for a product line, we recognize all excess amounts as a loss.
•amounts that have been assessed to compensate the insurer for services to be performed over future periods, and
Reserves for claim liabilities were $506 million, $428 million and $422 million as of December 31, 2006, 2005 and 2004, respectively. A 1% increase in the assumed medical cost trends would reduce pretax income by approximately $3 million.
Loss reserves reflect our estimated liability for unpaid claims and claims adjustment expenses and for reported and unreported losses incurred as of the end of each accounting period. Because setting loss reserve levels is inherently uncertain, we cannot guarantee that our current reserves will prove adequate in light of subsequent events.
Since we cannot calculate estimated liabilities exactly, reserves represent our best estimate of what we expect the ultimate settlement and administration of claims will cost, given our informed judgments based on:
Many of these factors are not quantifiable in advance, and both internal and external events, such as changes in claims handling procedures, inflation, judicial and legal developments, and legislative changes, can cause our estimates to vary. The inherent uncertainty of estimating reserves is greater for certain types of liabilities, where the variables affecting the claims are subject to change and long periods of time may elapse before we can definitively determine liability. We:
•periodically refine our reserve estimates as further losses are reported and settled and we continue to refine our experience.
•reflect adjustments to reserves in the results of the periods during which such estimates are changed.
We estimate loss reserves for all property and casualty lines of business by accident year using several standard actuarial techniques, which include, but are not limited to:
We project ultimate losses on a direct, assumed, ceded and net basis, and deduct paid losses from the selected ultimate losses to arrive at the total indicated reserve. The total reserve includes case reserves and incurred but not reported reserves.
We periodically review securities with unrealized losses and evaluate them for other-than-temporary impairment. We analyze various risk factors and determine if any specific asset impairment exists. If there is a specific asset impairment, we recognize a realized loss and adjust the cost basis of the impaired asset to its fair value.
At least quarterly, we review the following types of information, depending on the type of security:
•the creditworthiness of corporate obligors for changes in ratings and fundamental financial performance of the underlying entity
•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 unrealized losses due to issuer-specific events. We base our decision on the facts and circumstances for each investment.
In certain circumstances, 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 from which 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 conclude that we do not have the intent or ability to hold an investment to maturity, we will reevaluate that investment for other-than-temporary impairment.
Although goodwill is not amortized, we test it for impairment at least annually. We test more frequently if there are indicators of impairment or whenever business circumstances suggest that the carrying value of goodwill may not be recoverable. We perform impairment reviews at the reporting unit level. If the fair value of a reporting unit is determined to be less than the carrying value of the reporting unit, we complete further analysis to determine whether there was an impairment loss. No further analysis was required in 2006 or 2005. We determine fair value based on estimates and assumptions related to the amount and timing of future cash flows and future interest rates. Different estimates or assumptions could produce different results.
On January 1, 2006, Aon adopted FASB Statement No. 123 (revised 2004), Share-Based Payment ("Statement No. 123(R)"), which requires that we measure and recognize compensation expense for all share-based payments to employees, including grants of employee stock options and awards as well as employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair values. Aon adopted Statement No. 123(R) using the modified prospective transition method. Our consolidated financial statements as of and for the year ended December 31, 2006, reflect the impact of Statement No. 123(R). In accordance with the modified prospective transition method, we have not restated the Company's consolidated financial statements for prior periods due to the adoption of Statement No. 123(R).
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that we ultimately expect to vest during that period. Stock-based compensation expense recognized in our consolidated statements of income for the year ended December 31, 2006 includes compensation expense for share-based payment awards granted:
•before, but not yet vested by, December 31, 2005, based on the grant date fair value estimated according to the pro forma provisions of Statement No. 123
•after December 31, 2005, based on the grant date fair value estimated according to the provisions of Statement No. 123(R).
forfeitures differ from those estimates. In Aon's pro forma information required under Statement No. 123 for periods prior to 2006, we accounted for forfeitures on restricted stock units (RSUs) as they occurred, but estimated forfeitures on stock options. When the terms of an award require no additional service, the award is fully expensed at the grant date. When awards are modified, the incremental shares are accounted for at the fair market value at the date of modification. Expense recognition begins on the date the service period begins, which can precede or be after the grant date, depending on the provisions of the award.
•use historical data to estimate option exercise and employee terminations within the valuation model, differentiating between executives and key employees.
During 2006, we recognized $25 million of expense related to stock options.
Prior to 2006, RSUs granted to employees were generally service-based and accounted for by expensing the total award value over the service period. The total award value was calculated by multiplying the total number of shares to be delivered by the quoted market value on the date of grant. Beginning in 2006, we adopted the provisions of Statement No. 123(R), requiring that we apply forfeitures as well as dividend discounts, if appropriate, when determining the fair value of the award to be expensed over the service period.
•recognize the resulting value by multiplying the fair value to be delivered times the percentage of the performance period completed.
During 2006, we recognized $26 million of expense related to performance-based awards, including both individual and group awards. Based on estimates as of December 31, 2006, we will incur an additional $71 million of expense related to these awards between 2007 and 2012.
•assumptions and estimates about future operating results and levels of taxable income
We assess carryforwards and tax credits for realization as a reduction of future taxable income by using a "more likely than not" determination. We have not recognized a U.S. deferred tax liability for undistributed earnings of certain foreign subsidiaries because they are considered permanently reinvested. Distributions may be subject to additional U.S. income taxes if we either distribute these earnings, or are deemed to have distributed these earnings, according to the Internal Revenue Code.
We operate in many foreign jurisdictions where tax laws relating to the insurance broking, consulting, and underwriting businesses are not well developed. In such jurisdictions, we obtain professional guidance and consider existing industry practices before using tax planning strategies and meeting our tax obligations. Tax returns are routinely subject to audit in most jurisdictions, and tax liabilities are frequently finalized through negotiations. While historically we have not experienced significant adjustments to previously recognized tax assets and liabilities as a result of finalizing tax returns, there can be no assurance that significant adjustments will not arise in the future. In addition, there are several factors that could increase the future level of uncertainty over our tax liabilities, including the following:
In July 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes which are recognized in a company's financial statements in accordance with Statement No. 109. FIN 48 prescribes a recognition threshold and measurement of a tax position taken, or expected to be taken, in a company's tax return. We are required to adopt FIN 48 in first quarter 2007 and are evaluating the impact FIN 48 will have, if any, on our consolidated financial statements.
Since we conduct business in more than 120 countries, foreign exchange rate fluctuations have a significant impact on our business. In comparison to the U.S. dollar, foreign exchange rate movements
•isolated the impact of the change in currencies between periods by providing percentage changes on a comparable currency basis for revenue, and have disclosed the effect on earnings per share.
•provided this form of reporting to give financial statement users more meaningful information about our operations.
•U.S. revenues increased $253 million or 6%, reflecting improved results in our retail business, increases in sales of our supplemental health product, and increased investment income.
•Europe, Middle East & Africa revenues increased $115 million or 7%, as a result of acquisitions and organic revenue growth in our retail business.
Total expenses increased $346 million or 5% from 2005 for three primary reasons:
•Benefits to policyholders increased $190 million or 20% due to growth in our supplemental health product and property and casualty reserve strengthening.
•Depreciation and amortization decreased $23 million reflecting asset disposals and impairments in prior years.
•Income from continuing operations rose to $626 million ($1.86 per diluted income per share) from $568 million ($1.68 per diluted income per share). Hedging and currency translation losses were $0.03 and $0.04 per share, respectively, which were included in income from continuing operations in 2006. Hedging and currency translation gains of $0.08 and $0.05 per share, respectively, were included in 2005.
To compute income per share in 2005, we have deducted dividends paid on the redeemable preferred stock from net income. The redeemable preferred stock was redeemed and retired in September 2005. To comply with Emerging Issues Task Force (EITF) No. 04-8, The Effect of Contingently Convertible Investments on Diluted Earnings per Share, 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 after-tax interest expense on these debt securities to income from continuing operations.
•$93 million in 2006 ($0.29 and $0.27 per basic and diluted income per share, respectively). These results include eleven months of operations of AWG and CPG, as those businesses were sold on November 30, 2006, and the gain on the sale of those operations ($0.03 per both basic and diluted income per share).
•$167 million in 2005 ($0.52 and $0.49 per basic and diluted income per share, respectively). Results in 2005 include twelve months of results for AWG and CPG ($0.22 per basic and $0.21 diluted income per share), along with nine months of operations and the gain on sale ($0.33 per basic and $0.31 per diluted income per share) of our Swett & Crawford operation.
•Commissions and fees decreased by $125 million or 2%, driven by $100 million in lower contingent commission revenue and net dispositions of $168 million, partially offset by strong renewals and new business.
•Premiums and other increased $17 million or 1%, driven by growth in our core products and favorable exchange rates, partially offset by reductions in runoff programs.
•U.S. revenue, which represented 46% of total revenue, decreased $184 million or 4%. The decrease primarily reflected the 2004 sale of Cambridge.
•U.K. revenue decreased $63 million or 4%; this decline reflected a soft U.K. market and changes in the model for compensation from underwriters, partially offset by a refinement in the techniques we used to estimate installment revenue in the U.K., which added $23 million to revenue in 2005.
•Europe, Middle East & Africa revenue increased 2% to $1.7 billion, due to higher revenue in France, Austria, Sweden and Africa.
•Asia Pacific revenue increased $27 million or 5% to $620 million, reflecting growth in Japan, Australia and New Zealand.
•Cambridge expenses, which were $223 million in 2004. This unit was sold in the fourth quarter of 2004.
Income from continuing operations before provision for income tax increased $75 million to $808 million; as previously discussed, this fluctuation reflects several significant items.
Differences between the overall effective tax rate and the U.S. federal statutory rate are typically due to U.S. state income taxes and differences 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.
•Income from continuing operations increased to $568 million ($1.68 per diluted income per share) from $484 million ($1.45 per diluted income per share). Hedging and currency translation gains added $0.08 and $0.05 per share, respectively, to income from continuing operations in 2005. In 2004, hedging and currency translation gains were $0.11 and $0.07 per share, respectively.
To compute income per share, we deducted dividends paid on the redeemable preferred stock from net income. To comply 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 after-tax interest expense on these debt securities to income from continuing operations.
•$167 million in 2005 ($0.52 and $0.49 per basic and diluted income per share, respectively). This increase was due to improved operations at AWG and CPG, along with the gain on the sale of our Swett & Crawford operation ($0.33 and $0.31 per basic and diluted income per share, respectively), partially offset by lower operating results at Swett.
•In Insurance Underwriting, policyholder claims and other types of non-interest sensitive insurance liabilities are primarily supported by intermediate to long-term fixed-maturity instruments. For this business segment, operating invested assets are approximately equal to average net policy liabilities.
•Our insurance subsidiaries have invested assets that exceed net policy liabilities, which allow us to maintain solid claims paying ratings. Income from these investments is reflected in unallocated revenues.
Insurance premiums are cyclical in nature and may vary widely based on market conditions. Heavier than anticipated loss experience or capital shortages can result in increasing premium rates, which is referred to as a "hard market." A hard market tends to favorably impact commission revenues. Conversely, increased competition for market share among insurance carriers or increased underwriting capacity can result in flat or reduced premium rates, or a "soft market." A soft market tends to put downward pressure on commission revenues. Hard and soft markets may be broad-based or more narrowly focused across certain product lines or geographic areas.
•provides affinity products for professional liability, life, disability income, and personal lines for individuals, associations, and businesses
Asia Pacific revenue rose 8%, driven by acquisitions and organic growth in emerging markets in Asia.
Europe, Middle East & Africa and Asia Pacific revenue both rose 7%, due to acquisitions and organic revenue growth.
2.Compensation focuses on designing salary, bonus, commission, stock option, and other pay structures, with special expertise in the financial services and technology industries.
In 2006, revenues of $1,282 million were 2% over 2005. Revenue on an organic basis was up 4% from last year.
This table reconciles organic revenue growth to reported revenue growth in 2006 versus 2005.
On a subsegment basis, Consulting services was up $8 million or 1%, resulting from:
•Growth in the U.K., driven by pension revaluation engagements mandated by recent pension reforms in that country
This growth more than offset a decline in our health and welfare practice and the transfer of certain small units to the Risk and Insurance Brokerage Services segment.
•United Kingdom revenue rose 11%, due to growth in pension revaluation consulting as discussed previously.
•Europe, Middle East & Africa and Asia Pacific increases were due to organic revenue growth.
Pretax income was $120 million, up $10 million or 9% from 2005. 2006 pretax margins in this segment were 9.4%, up from 8.8% in 2005.
•Organic revenue growth, especially in the U.K., increased income before income tax and pretax margins.
The $13 million termination fee discussed above was offset by $13 million of expenses related to the termination of the contract, resulting in no net impact to income before income taxes.
•provides accident, health, and life insurance coverage mostly through direct distribution networks, primarily through more than 7,000 career insurance agents working for our subsidiaries. Our revenues are affected by our success in attracting and retaining these career agents.
•previously offered select commercial property and casualty business on a limited basis through managing general underwriters. We have ceased writing property and casualty business and have placed all programs in runoff.
Written premiums and fees are the basis for organic revenue growth in this segment; however, reported revenues reflect earned premiums and fees.
•Accident & Health and Life, through which we provide an array of accident, sickness, short-term disability, and other insurance products. Most of these products are primarily fixed-indemnity obligations and are not subject to escalating medical cost inflation.
In this subsegment, we formerly included the results of our warranty and credit operations, as well as a portion of our specialty property and casualty business, CPG. We divested these businesses in
November 2006, as discussed in Key Recent Events, and the results of those businesses and the sale transactions are included in discontinued operations.
(1)The difference between written and earned premiums and fees, as a percentage change, was (1)% for accident & health and life and (2)% for total revenue.
(2)Organic revenue growth for property and casualty is no longer meaningful as the remaining business is in run-off. In 2006, revenues of $2.0 billion increased 9% over 2005.
•Americas other than U.S. reflect organic revenue growth in Canada, along with favorable foreign exchange rates.
•The U.K. and Europe, Middle East & Africa represents organic revenue growth.
•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
•changes in the valuation of Endurance warrants. Through March 31, 2006, we carried our investment in Endurance warrants at fair value and recorded changes in the fair value through unallocated investment income. On March 31, 2006, the investment in Endurance warrants was contributed to our U.K. pension plans.
Private equities are principally carried at cost; however, where we have significant influence, they are carried under the equity method. These investments usually do not pay dividends. Limited partnerships (LP) are accounted for under the equity method and changes in the value of the underlying LP investments flow through unallocated investment income.
Unallocated income rose $12 million in 2006 to $57 million. Increased investment income - due to higher interest rates and amounts invested, along with lower losses on disposals of securities - more than offset the impact of negative mark-to-market adjustments to our Endurance warrants in 2006 ($17 million), versus a positive adjustment in 2005 ($10 million).
Interest expense, which represents the cost of our worldwide debt obligations, rose $4 million in 2006 to $129 million due to carrying higher debt balances and refinancing part of our Euro facility balance to a 5.05% fixed rate note due in 2011.
•received approximately $800 million in gross cash proceeds from the sales of AWG and CPG.
Cash flows provided by operating activities for the twelve months ended December 31, 2006 and 2005 are as follows:
The operating cash flow from our insurance subsidiaries, which also includes related corporate items, was $522 million for 2006, an increase of $99 million compared to 2005. Included in these cash flows are the operations of AWG and CPG through November 30, 2006, the date of sale. The increase in operating cash flows was primarily related to organic revenue growth. For 2006, operating cash flows, analyzed by major income statement component, indicated that premium and other fees collected, net of reinsurance, were $3,546 million compared to $3,193 million in 2005. Investment and other miscellaneous income received was $235 million and $227 million in 2006 and 2005, respectively. Investment income improved in 2006 due to favorable interest rates and an increase in invested assets.
Generally, we invest in highly liquid and marketable investment grade securities to support policy liabilities. These invested assets are subject to insurance regulations set forth by the various governmental jurisdictions in which we operate, both domestically and internationally. The insurance regulations may restrict both the quantity and quality of various types of assets within the portfolios.
Aon uses the excess cash generated by our brokerage and consulting businesses as well as dividends received from our insurance company subsidiaries to meet its liquidity needs, which consist of servicing its debt, paying dividends to its stockholders and repurchasing outstanding shares.
•financing needs of $964 million. Financing uses primarily included cash dividends paid to shareholders of $189 million, and net share activity of $916 million. Financing provided cash of $141 million from debt issuances, net of repayments.
•Total assets decreased $3.5 billion to $24.3 billion. The major reason for the decline is the sale of AWG and CPG, which had assets of $4.2 billion at December 31, 2005.
•invested assets or related investment income not directly required to support the insurance brokerage and consulting businesses
•are unavailable for other uses, such as debt reduction or share repurchases, without considering regulatory requirements (see Note 11 to the consolidated financial statements).
•a five-year €650 million ($853 million) multi-currency facility, of which $403 million was outstanding at December 31, 2006. See Note 8 to the consolidated financial statements for further discussion on both the U.S. and Euro facilities.
•£37.5 million ($74 million) facility, a 364-day 10 million Canadian dollar (U.S. $9 million) facility, and a 364-day €25 million (U.S. $33 million) facility.
Stockholders' equity decreased $99 million during 2006 to $5.2 billion, driven primarily by an $886 million increase in treasury stock repurchases, net of reissuance of stock in connection with employee benefit plans. Offsetting this decline were increases in equity of:
Accumulated other comprehensive loss decreased $145 million since December 31, 2005. Compared to year-end 2005:
•net foreign exchange translation increased by $237 million because of the weakening of the U.S. dollar against foreign currencies
•our net additional minimum pension liability adjustment decreased by $210 million.
For 2007, we project we will make $233 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.
Aon and its subsidiaries have issued letters of credit to cover contingent payments of approximately $32 million for taxes and other business obligations to third parties. We accrue amounts in our consolidated financial statements for these letters of credit to the extent they are probable and estimable.
At December 31, 2006, Aon no longer reports reinsurance recoverables related to its property and casualty business, which was not part of the sale of AWG. Aon has provided a corporate guaranty with respect to these reinsurance recoverables which amount to $790 million at December 31, 2006.
•special purpose entities ("SPEs"), which are considered qualified special purpose entities ("QSPEs") by Statement No. 140 and per Statement No. 140 should not be consolidated in the financial statements of a transferor or its affiliates (Aon's subsidiaries).
•generally have the risks and rewards of ownership of the assets of the Bank SPEs.
Thus, we have concluded that non-consolidation of the Bank SPEs is appropriate in accordance with FIN 46, given that our subsidiaries do not have significant variable interests.
Through the securitization agreements, we, or one of our QSPEs, sell undivided interests in specified premium finance agreements to the Bank SPEs. The total amount advanced on premium finance agreements sold to the Bank SPEs at any one time is limited by the securitization agreements to $1.8 billion. The Bank SPEs had advanced $1.7 billion and $1.8 billion at December 31, 2006 and 2005, respectively. We can receive additional advances as:
•collections, which we administer, on previously sold agreements reduce available advances.
All but the Australian facility require Aon to maintain consolidated net worth, as defined, of at least $2.5 billion, and:
•consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) to consolidated net interest of at least 4 to 1
•consolidated indebtedness to consolidated EBITDA of no more than 3 to 1.
•summarizes our significant contractual obligations at December 31, 2006, and the future periods during which we expect to settle these obligations in cash
We have provided additional details about certain of these obligations in our notes to the financial statements:
(1)Included in purchase obligations are contracts for information technology outsourcing. As of December 31, 2006, we can exit these obligations for termination payments of $94 million. However, given the nature of these contracts, we have included them in our contractual obligations table.
(3)The $38 million net present value of this liability has been included in the December 31, 2006 balance sheet in other liabilities.
Based on our assessment, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2006.
Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report on page 68.
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, 2006, 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.
A Company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A Company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Aon Corporation as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006 and our report dated February 28, 2007 expressed an unqualified opinion thereon.
The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from the amounts reported.
Cumulative effect of a change in accounting principle, net of tax
(1)See Note 2, "Restatement of Consolidated Financial Statements". Change in Accounting Principles
On January 1, 2006, Aon adopted FASB Statement No. 123 (revised 2004), Share-Based Payment ("Statement No. 123(R)"), which requires the measurement and recognition of compensation expense for all share-based payments to employees including grants of employee stock options and awards as well as employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair value. Aon adopted Statement No. 123 (R) using the modified prospective transition method. The
In September 2006, the FASB issued FASB Statement No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No 87, 88, 106, and 132(R). Statement No. 158 requires plan sponsors of defined benefit pension and other postretirement benefit plans (collectively, "postretirement benefit plans") to recognize the funded status of their postretirement benefit plans in the statement of financial position, measure the fair value of plan assets and benefit obligations as of the date of the fiscal year-end statement of financial position, and provide additional disclosures. On December 31, 2006, the Company adopted the provisions of Statement No. 158. The effect of adopting Statement No. 158 on the Company's financial condition at December 31, 2006 has been included in the accompanying 2006 consolidated financial statements. Adoption of the measurement date provisions of Statement No. 158 resulted in the Company changing the measurement date of its U.S. plans (previously November 30) and U.K. plans (previously September 30) to December 31. Retrospective application of the provisions of Statement No. 158 to prior periods is not permitted. See Note 12 for further discussion of the effect of adopting Statement No. 158 on the Company's consolidated financial statements.
Short-term investments include certificates of deposit, money market funds and highly liquid debt instruments purchased with maturities of up to one year and are carried at amortized cost, which approximates fair value.
Fixed-maturity securities are available for sale and are carried at fair value. The amortized cost of fixed maturities is adjusted for amortization of premiums and the accretion of discounts to maturity, which are included in investment income.
Endurance common stock and warrants - In 2001, Aon invested $227 million in Endurance Specialty Holdings, Ltd. ("Endurance"), a Bermuda-based insurance and reinsurance company. During 2004, Aon sold virtually all of its common stock investment in Endurance, which resulted in a pretax gain of $48 million. In 2005, Aon sold its remaining common stock investment in Endurance, resulting in a pretax gain of $1 million.
Accounting policies relating to derivative financial instruments are discussed in Note 14.
Aon maintained premium trust bank accounts for premiums collected from insureds but not yet remitted to insurance companies of $2.9 billion at both December 31, 2006 and 2005. 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.
Aon's policy for estimating allowances for doubtful accounts with respect to receivables is to record an allowance based on a historical evaluation of write-offs, aging of balances and other qualitative and quantitative analyses. Total receivables included an allowance for doubtful accounts of $93 million and $85 million at December 31, 2006 and 2005, respectively.
Depreciation expense for the years ended December 31, 2006, 2005 and 2004 was $196 million, $219 million and $243 million, respectively.
Cash and cash equivalents, including short-term investments: Carrying amounts approximate fair value.
Policy loans: Fair value is estimated using discounted cash flow analysis, using interest rates currently being offered for similar loans to borrowers with similar credit ratings.
Deposit-type contracts: Fair value is estimated using discounted cash flow calculations based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued.
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, 2006. 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.
The incremental impact from recognizing stock compensation expense is as follows (in millions):
reported, adjustments, as restated, reclassifications and as presented in 2006 consolidated statements of income for 2005 and 2004 (in millions except per share data) follow:
The consolidated statements of cash flows have been restated to reflect the non-cash expense and related tax impacts reflected in the statements of income for 2005 and 2004. A summary reconciliation of the as reported, adjustments, and as restated statements of cash flow follow:
In 2006, the pretax net additional minimum pension liability adjustment of $321 million included $28 million related to defined benefit pension plans in Canada and $7 million related to defined benefit pension plans in Germany.
The results of operations of these acquisitions are included in the consolidated financial statements from the dates they were acquired. These acquisitions do not produce a materially different result than if they had been reported from the beginning of the period.
In 2005, the Company commenced a broad restructuring initiative that is expected to result in cumulative pretax charges totaling approximately $365 million, including workforce reductions, lease consolidation costs, asset impairments and other expenses necessary to implement the restructuring initiative. Costs related to the restructuring are included in general expenses and depreciation and amortization in the accompanying consolidated statements of income.
The following is a summary of our restructuring and related expenses incurred and estimated to be incurred by segment through the end of the restructuring initiative:
In 1996 and 1997, Aon recorded restructuring liabilities as a result of the acquisition of Alexander & Alexander Services, Inc. ("A&A") and Bain Hogg. The remaining liability of $22 million is primarily for lease abandonments and is being paid out over a number of years, as planned.
•A non-core Australian brokerage unit, which was previously included in the Risk and Insurance Brokerage Services segment. A pretax gain of $1 million was recognized on the sale.
Aon reclassified the assets and liabilities of these businesses to assets held-for-sale and liabilities held-for-sale, respectively, in the December 31, 2005 consolidated statement of financial position. Goodwill was allocated to these businesses based on their estimated fair value compared to the fair value of the reporting units in which they were previously included.
In 2005 Aon sold Swett & Crawford ("Swett"), its U.S.-based wholesale insurance brokerage unit. Previously, Swett was included in the Risk and Insurance Brokerage Services segment. The sale resulted in a pretax gain of $239 million.
In 2004, Aon sold the following businesses, all of which were previously included in the Risk and Insurance Brokerage Services segment:
•A small non-core U.S. brokerage unit, resulting in a pretax loss of $4 million on the revaluation of this business.
Also in 2004, Aon sold a non-core Consulting subsidiary, resulting in a pretax gain of $4 million.
The pretax changes in net unrealized investment gains (losses) are as follows:
The amortized cost and fair value of investments in fixed maturities by type and equity securities are as follows:
The amortized cost and fair value of fixed maturities by contractual maturity as of December 31, 2006, are as follows:
The following table analyzes our investment positions with unrealized losses segmented by type and period of continuous unrealized loss as of December 31, 2006.
Aon's fixed-maturity portfolio in total had a $55 million gross unrealized loss at December 31, 2006 and is subject to interest rate, market and credit risks. No single position had an unrealized loss greater than $3 million. With a carrying value of approximately $2.8 billion at December 31, 2006, Aon's total fixed-maturity portfolio is approximately 100% investment grade based on market value. Fixed-maturity securities with an unrealized loss are approximately 100% investment grade and have a weighted average rating of "Aa" based on amortized cost. Aon's non publicly-traded fixed maturity
Aon's equity portfolio is comprised of non-redeemable preferred stocks, publicly traded common stocks and other common and preferred stocks not publicly traded. This portfolio had $6 million of gross unrealized losses at December 31, 2006 and is subject to interest rate, market, credit, illiquidity, concentration and operational performance risks.
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. Aon funded $2 million and $12 million of commitments in 2006 and 2005, respectively. As of December 31, 2006, these unfunded commitments amounted to $46 million. These commitments have specific expiration dates and the general partners may decide not to draw on these commitments. The carrying value of the PEPS I preferred stock was $210 million and $187 million at December 31, 2006 and 2005, respectively.
Securities on deposit with regulatory authorities amounted to $455 million at December 31, 2006.
At December 31, 2006 and 2005, Aon had $214 million and $195 million, respectively, of non-income producing investments, which excludes derivatives that are marked to market through the income statement, as well as private equity investments carried on the equity method, held for at least twelve months, that have not declared dividends during 2006 and 2005.
The Capital Securities are subject to mandatory redemption on January 1, 2027 (upon the maturity of the subordinated debt) or are redeemable in whole, but not in part, at the option of Aon (through its prepayment of the subordinated debt) upon the occurrence of certain events. Interest is payable semi-annually on the Capital Securities. Aon determined that it is not the primary beneficiary of Aon Capital A, a VIE, and, in accordance with FIN 46, Aon recorded notes payable for the subordinated debt of $726 million.
Certain of Aon's European subsidiaries have a €650 million (U.S. $853 million) multi-currency revolving loan credit facility that includes a €325 million three-year and a €325 million five-year revolving loan facility. This facility will mature in October 2010, unless Aon opts to extend the facility. Commitment fees of 8.75 basis points are payable on the unused portion of the facility. At December 31, 2006 and 2005, Aon has borrowed €307 million ($403 million) and €490 million, respectively, under this facility, which is classified as notes payable in the consolidated statements of financial position. Aon has guaranteed the obligations of its subsidiaries with respect to this facility.
Aon maintains a U.S. committed bank credit facility to support commercial paper and other short-term borrowings. In February 2005, Aon replaced its then current 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, 2006 and 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.
Aon also has other foreign facilities available, which include a £37.5 million ($74 million) facility, 364-day 10 million Canadian dollar ($9 million) and €25 million ($33 million) facilities, and a €20 million ($26 million) facility which has no set expiration date.
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 $360 million, $345 million and $387 million for 2006, 2005 and 2004, respectively, after deducting rentals from subleases ($33 million, $29 million and $34 million for 2006, 2005 and 2004, respectively).
At December 31, 2006, future minimum rental payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year, net of sublease rental income, most of which pertain to real estate leases, are as follows:
Valuation allowances have been established primarily with regard to the tax benefits of certain net operating loss and tax credit carryforwards. Valuation allowances were increased to $43 million in 2006 from $25 million in 2005, attributable largely to the periodic reconciliation of previous provisions to filed or audited and agreed tax returns. Although future earnings cannot be predicted with certainty, management believes that the realization of the net deferred tax asset is more likely than not.
U.S. deferred income taxes are not provided on unremitted foreign earnings that are considered permanently reinvested, which at December 31, 2006 amounted to approximately $1.8 billion. It is not practicable to determine the income tax liability that might be incurred if all such earnings were remitted to the U.S.
At December 31, 2006, Aon had domestic federal operating loss carryforwards of $9 million that will expire at various dates from 2007 to 2021, state operating loss carryforwards of $503 million that will expire at various dates from 2007 to 2025, and foreign operating loss carryforwards of $286 million, which expire at various dates.
Prior to 1984, life insurance companies were required to accumulate certain untaxed amounts in a memorandum policyholders' surplus account ("PSA"). Under the Tax Reform Act of 1984, the PSA balances were "capped" at December 31, 1983 and the balances were to be taxed only to the extent distributed to stockholders or when they exceed certain prescribed limits. The American Jobs Creation Act of 2004 suspended for 2005 and 2006 the application of the rules imposing income tax on distributions from the PSA. As a result of distributions from Aon's life insurance companies during 2005 and 2006, all material PSA balances have been eliminated, and no tax liability was incurred.
In third quarter 2006, in connection with the sales of AWG and CPG, Aon completed a detailed review of all its property and casualty reserves. Based on the results of this review, the Company increased its property and casualty reserves by approximately $102 million, reflecting adverse development, refined assumptions and additional claim information relating to programs to be disposed of through sale or runoff. Aon recorded $81 million of this adjustment in continuing operations. The remaining $21 million is not included in the preceding table because it relates to CPG and is recorded in discontinued operations. Of the $81 million recorded in continuing operations, the majority related to National Program Services, an independent managing general underwriter that wrote habitational risk on behalf of Aon.
Dividends paid per common share were $0.60 for the years ended December 31, 2006, 2005 and 2004.
Statutory capital and surplus of the insurance subsidiaries was $856 million $901 million and $869 million at December 2006, 2005 and 2004, respectively.
Aon sponsors defined benefit pension and post-retirement health and welfare plans that provide retirement, medical and life insurance benefits. The post-retirement healthcare plans are contributory, with retiree contributions adjusted annually; the life insurance and pension plans are noncontributory.
On December 31, 2006, Aon adopted the recognition, disclosure and measurement date provisions of Statement No. 158. Statement No. 158 required Aon to recognize the funded status of its post-retirement benefit plans in the December 31, 2006 statement of financial position, with a corresponding adjustment to accumulated other comprehensive loss, net of tax. The adjustment to accumulated other comprehensive loss at adoption represents net unrecognized actuarial losses and unrecognized prior service costs which were previously netted against the plan's funded status in Aon's statement of financial position pursuant to the provisions of Statement No. 87. These amounts will be subsequently recognized as net periodic benefit cost pursuant to Aon's historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic benefit cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic pension cost on the same basis as the amounts recognized in accumulated other comprehensive loss at adoption of Statement No. 158.
Intangible pension asset and prepaid pension asset (included in other assets)
$ (249 ) $ (288 ) $ (68 ) $ (81 )
Amounts recognized in accumulated other comprehensive loss that have not yet been recognized as components of net periodic benefit cost at December 31, 2006, consist of:
The change in amounts recognized in other comprehensive income related to the minimum pension liability for U.S. pension plans was an increase of $27 million in 2005.
In 2006, 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 $1.7 billion, an ABO of $1.7 billion and plan assets with a fair value of $1.5 billion.
In connection with the sale of AWG in 2006, a Statement No. 88 curtailment gain of $10 million was recognized in discontinued operations.
The weighted-average assumptions used to determine future U.S. benefit obligations are as follows:
5.75 % 6.0 % 6.25 % 5.75 % 6.0 % 6.25 %
The amounts in accumulated other comprehensive loss expected to be recognized as components of net periodic benefit cost during 2007 are as follows:
Aon's U.S. pension plan asset allocation as of December 31, 2006 and 2005 is as follows:
Based on current assumptions, Aon expects to contribute $36 million to U.S. pension plans during 2007 to satisfy minimum funding requirements and $5 million to fund other post-retirement benefit plans during 2007.
Estimated future benefit payments for U.S. plans are as follows at December 31, 2006:
The following tables provide a reconciliation of the changes in the benefit obligations and fair value of assets for the years ended December 31, 2006 and 2005 and the funded status as of
Prepaid benefit cost and intangible pension asset (included in other assets)
In 2006, plans with a PBO in excess of the fair value of plan assets had a PBO of $4.5 billion and plan assets with a fair value of $3.6 billion and plans with an ABO in excess of the fair value of plan assets had an ABO of $4.1 billion and plan assets with a fair value of $3.5 billion.
The range of weighted-average assumptions used to determine the international net periodic benefit costs:
The estimated costs that will be amortized from accumulated other comprehensive loss into net periodic benefit cost during 2007 will be $74 million of net loss.
Aon's international pension plan asset allocation at December 31, 2006 and 2005 is as follows:
Based on current assumptions, Aon expects to contribute $197 million to its international pension plans during 2007 to satisfy minimum funding requirements.
Aon's Stock Incentive Plan (as amended and restated) provides for the grant of non-qualified and incentive stock options, stock appreciation rights, restricted stock and restricted stock units ("RSUs"). The annual rate at which awards are granted each year is based upon financial and competitive business conditions. The number of shares authorized to be issued under the plan is equal to 18% of the number of common shares outstanding.
Stock based compensation expense recognized during 2006, which includes RSUs, stock options, performance plan awards and stock purchases related to the Employee Stock Purchase Plan, are based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Aon's consolidated statements of income for 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of Statement No. 123, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of Statement No. 123(R). As stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Statement No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
As a result of adopting Statement No. 123(R) on January 1, 2006, the Company's income before income taxes and net income for the year ended December 31, 2006 are $29 million and $20 million lower, respectively, than if it has continued to account for share-based compensation under Opinion No. 25. Basic and diluted earnings per share for the year ended December 31, 2006 are both $0.06 lower than if the Company had continued to account for share-based compensation under Opinion No. 25.
The following table summarizes stock-based compensation expense related to all share-based payments recognized in the consolidated statements of income in general expenses.
(1)See Note 2 "Restatement of Consolidated Financial Statements." The following table illustrates pro forma net income and pro forma earnings per share as if Aon had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation in 2004 and 2005.
The fair value per share of options and awards granted were estimated using the Black-Scholes option pricing model with the following weighted-average assumptions:
Stock awards, in the form of RSUs, are granted to certain executives and key employees of Aon. Prior to 2006, RSUs granted to employees were service-based. Beginning with awards granted in 2006, awards to employees may consist of performance-based RSUs and service-based RSUs. For service-based awards, employees are generally 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. Beginning in 2002, a large number of awards have been granted that vest in various patterns over five years from the date of grant. For most employees, individual incentive compensation over $50,000 is paid in RSUs, which will vest ratably over three years. In general, most stock awards are issued as they become vested. In years prior to 2006, in certain circumstances, an employee was able to 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. Dividend equivalents are paid on certain service-based RSUs, based on the initial grant amount. At December 31, 2006, 2005 and 2004, the number of shares available for stock awards is included with options available for grant.
In 2006, performance-based RSUs were granted to certain executives and key employees, whose vesting is contingent upon meeting various individual, divisional or company-wide performance goals, including revenue generation or growth in revenue, pretax income or earnings per share over a one- to five-year period. Aon accounts for these awards as performance condition RSUs. The performance condition is not considered in the determination of grant date fair value of these awards. Compensation cost is recognized over the performance period, and in certain cases an additional vesting period, based on management's estimate of the number of units expected to vest. Compensation cost will be adjusted to reflect the actual number of shares paid out at the end of the programs. The payout of shares under these performance-based plans may range from 0-150% of the number of units granted, based on the plan. Dividend equivalents are not paid on the performance-based RSUs.
Information regarding Aon's performance-based plans as of December 31, 2006 follows:
Upon adoption of Statement No. 123(R), Aon changed its method of valuation for stock options granted beginning in 2006 to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model, which was previously used for Aon's pro forma information required under Statement No. 123. Lattice-based option valuation models utilize a range of assumptions over the expected term of the options. Expected volatilities are based on the average of the historical volatility of Aon's stock price and the implied volatility of traded options and Aon's stock. Aon uses historical data to estimate option exercise and employee terminations within the valuation model, stratifying between executives and key employees. The expected dividend yield assumption is based on the company's historical and expected future dividend rate. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
The weighted-average estimated fair value of employee stock options granted during 2006 was $11.08 per share for executives and $10.75 per share for key employees. The following weighted average assumptions were used to estimate fair value.
The aggregate intrinsic value represents the total pretax intrinsic value, based on options with an exercise price less than the Company's closing stock price of $35.34 as of December 31, 2006, which would have been received by the option holders had those option holders exercised their options as of that date. The aggregate intrinsic value of options outstanding and exercisable as of December 31, 2006 was $223 million and $96 million, respectively.
The aggregate intrinsic value of options exercised during 2006, 2005 and 2004 was $45 million, $20 million and $2 million, respectively.
Unamortized deferred compensation expense, which includes both options and awards, amounted to $293 million as of December 31, 2006, with a remaining weighted-average amortization period of approximately 2.4 years.
Cash received from the exercise of stock options was $121 million, $63 million, and $12 million during 2006, 2005, 2004, respectively. The tax benefit realized from stock options exercised was $14 million and $3 million in 2006 and 2005, respectively. No tax benefits for stock option exercises were realized in 2004.
hedge"), (ii) a hedge of the variability in cash flows from a recognized variable-rate asset or liability or forecasted transaction ("cash flow hedge"), and (iii) a hedge of the net investment in a foreign subsidiary ("net investment hedge"). Under hedge accounting, recognition of derivative gains and losses can be matched in the same period with that of the hedged exposure and thereby minimize earnings volatility.
subsidiary's functional currency revenue will fluctuate as the currency exchange rates change. To reduce this variability, Aon uses foreign exchange forwards and over-the-counter options 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, 2006, a $22 million pretax gain has been deferred to OCI, $14 million of which is expected to be reclassified to earnings as an adjustment to general expenses in 2007. Deferred gains or losses will be reclassified from OCI to general expenses when the hedged revenue is recognized. The hedge had no ineffectiveness in either 2006 or 2005. For the year ended December 31, 2006, the Company recognized immaterial losses on cash flow hedges that were discontinued due to forecast revisions. Aon also uses 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 basket options 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.
Aon also uses foreign currency forward contracts to hedge certain of its net investments in foreign underwriting operations (primarily Canadian dollar, Euro and British pound). During 2006 and 2005, this hedge had no ineffectiveness, and a $24 million and $15 million cumulative pretax loss has been included in OCI at December 31, 2006 and 2005, respectively.
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 and Euro denominated brokerage funds held on behalf of clients in the U.S., U.K., and Western Europe. 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.
Aon enters into receive-fixed-pay-floating interest rate swaps which are 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.S. and U.K. clients and other U.S. and U.K. operating funds. Forecasted deposit balances are hedged up to a maximum of three years into the future. Changes in the fair value of the swaps are recorded in OCI and will be reclassified to earnings as an adjustment to investment income over the term of the swap. This hedge had no material ineffectiveness in 2006 or 2005.
Through the securitization agreements, Aon, or one of its QSPEs, sells undivided interests in specified premium finance agreements to the Bank SPEs. The aggregate amount advanced on premium finance agreements sold to the Bank SPEs at any one time is limited by the securitization agreements to a maximum of $1.8 billion and $1.9 billion at December 31, 2006 and 2005, respectively. The Bank SPEs had advanced $1.7 billion and $1.8 billion at December 31, 2006 and 2005, respectively. Additional advances are available as additional eligible premium finance agreements are sold to the Bank SPEs and collections (administered by Aon) on previously sold agreements reduce available advances.
All but the Australian facility require Aon to maintain consolidated net worth, as defined, of at least $2.5 billion, consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) to consolidated net interest of at least 4 to 1 and consolidated indebtedness to consolidated EBITDA of no more than 3 to 1.
Aon intends to renew the conduit facilities when they expire. If there were adverse bank, regulatory, tax or accounting rule changes, Aon's access to the conduit facilities and special purpose vehicles would be restricted. Following the appropriate accounting standards, these special purpose vehicles are not included in Aon's consolidated financial statements.
Guarantees associated with Aon's limited partnership securitization are disclosed in Note 7. Indemnities related to discontinued operations are disclosed in Note 6. Guarantees associated with respect to reinsurance recoverables associated with the sale of AWG are disclosed in Note 10.
Aon and its subsidiaries have issued letters of credit to cover contingent payments of approximately $32 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.
Goodwill represents the excess of cost over the fair market value of the net assets acquired. Goodwill is allocated to various reporting units, which are either its operating segments or one reporting level below the operating segment. Goodwill is not amortized but is subject to impairment testing at least annually. The impairment testing requires Aon to compare the fair value of its reporting units to their carrying value to determine if there is potential impairment of goodwill. If the fair value of a reporting unit is less than its carrying value at the valuation date, an impairment loss would be recorded to the extent that the implied fair value of the goodwill within the reporting unit is less than the recorded amount of goodwill. Fair value is estimated based on various valuation approaches. In the fourth quarter 2006 and 2005, Aon completed its annual impairment review that affirmed there was no impairment as of October 1 (the annual evaluation date).
When impairment indicators arise, Aon assesses the recoverability of its intangible assets through an analysis of expected future cash flows.
In 2004, Aon, other insurance brokers, insurers and numerous other industry participants received subpoenas and other requests for information from the office of the Attorney General of the State of New York and from other states relating to certain practices in the insurance industry.
On March 4, 2005, Aon entered into an agreement (the "Settlement Agreement") with the Attorney General of the State of New York, the Superintendent of Insurance of the State of New York, the Attorney General of the State of Connecticut, the Illinois Attorney General and the Director of the Division of Insurance, Illinois Department of Financial and Professional Regulation (collectively, the "State Agencies") to resolve all the issues related to investigations conducted by the State Agencies.
As has been described in detail in Aon's previous financial filings, the Settlement Agreement required Aon to pay between 2005-2007 a total of $190 million into a fund (the "Fund") to be distributed to certain Eligible Policyholder clients and to implement certain business reforms. The Settlement Agreement set forth the procedures under which Aon mailed notices to its Eligible Policyholder clients and distributed the Fund to Participating Policyholder clients.
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. In
March 2005 the Court gave preliminary approval to a nationwide class action settlement under which Aon agreed to pay a total of $38 million to its policyholders. The Court granted final approval to the settlement in March 2006. Parties that objected to the settlement have appealed.
Beginning in late October 2004, several putative securities class actions were 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.
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting. Unallocated income and expenses, when combined with the operating segments and after the elimination of intersegment revenues, totals to the amounts in the accompanying consolidated financial statements. Certain segment information in prior periods' consolidated financial statements has been reclassified to discontinued operations to reflect sold business.
The accounting policies of the operating segments are the same as those described in Note 1, except that the disaggregated financial results have been prepared using a management approach, which is consistent with the basis and manner in which Aon senior management internally disaggregates financial information for the purposes of assisting in making internal operating decisions. Aon evaluates performance based on stand-alone operating segment income before income taxes and generally
The Insurance Underwriting segment provides specialty insurance products including accident, health and life insurance coverage through several distribution networks, most of which are directly owned by Aon's subsidiaries, as well as select property and casualty insurance products. We have ceased writing property and casualty business and have placed the remaining lines of business into runoff.
(3)Insurance underwriting general expenses include amortization of deferred acquisition costs of $136 million, $135 million and $151 million in 2006, 2005 and 2004, respectively.
(4)Includes depreciation and amortization expense. Unallocated income 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 essentially all securities, including those pertaining to assets maintained by the operating segments.
(1)See Note 2, "Restatement of Consolidated Financial Statements". Selected information for Aon's investment income is as follows:
(1)See Note 2 "Restatement of Consolidated Financial Statements" in Aon's Notes to Consolidated Financial Statements See notes to condensed financial statements.
(1)See Note 2 "Restatement of Consolidated Financial Statements" in Aon's Notes to Consolidated Financial Statements
(2)Investments in subsidiaries include approximately $3.0 billion invested in countries outside of the U.S., primarily denominated in the British Pound, the Euro, the Canadian dollar and the Australian dollar.
A bank provides overdraft facilities for certain of Aon's foreign subsidiaries. Aon has guaranteed repayment of these facilities in the unlikely event that the foreign subsidiaries are unable to repay. Aon has also issued guarantees and/or other letters of support for various bank lines and various other credit facilities for certain of its foreign operations (including the Euro credit facility discussed in Note 8 to the consolidated financial statements). Aon's maximum potential liability with regard to these exposures was $403 million at December 31, 2006.
(1)Prior years' amounts have been restated to conform to the 2006 presentation.
(4)See Note 2 "Restatement of Consolidated Financial Statements" in Aon's Notes to Consolidated Financial Statements.