In general, no difficulty is anticipated in negotiating renewals as leases expire or in finding other satisfactory space if the premises become unavailable. We believe that the facilities we occupy are adequate for the purposes for which they are currently used and are well maintained. In certain circumstances, we may have unused space and may seek to sublet such space to third parties, depending upon the demands for office space in the locations involved.
The insurance industry continued to experience a soft market, characterized by reduced premium rates, throughout 2008. In the second half of the year, the disruption in the global credit markets, the repricing of credit risk and the deterioration of the financial markets have created increasingly difficult conditions for financial institutions, including those in the insurance industry. Despite this difficult market environment, we grew the business organically, took further steps to streamline our product portfolio around our core businesses while reducing capital requirements, and improved the financial flexibility of our balance sheet.
Organic growth in 2008 was 2%, with growth in both our Risk and Insurance Brokerage Services (2%) and Consulting (3%) segments. We use supplemental information related to organic revenue growth to help us and our investors evaluate business growth from existing operations. Organic revenue growth excludes the impact of foreign exchange rate changes, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses and unusual items from reported revenues.
Our consolidated pretax margins from continuing operations declined from 13.7% in 2007 to 11.3% in 2008 driven principally by higher restructuring charges relating to our 2007 restructuring program that we announced in October 2007. We incurred $254 million of restructuring charges in 2008 compared with $85 million in 2007. Restructuring costs in 2007 included $39 million related to our 2005 restructuring program, which has been completed.
•Diluted earnings per share from continuing operations were $2.06 in 2008, essentially even with 2007's $2.07 per share. The one cent decline was driven by lower net income, mostly offset by lower diluted shares outstanding resulting from our stock repurchase program, and a lower effective tax rate.
•Beginning in the third quarter 2007, we began a new global restructuring effort. This restructuring program is estimated to result in cumulative pretax charges totaling approximately $550 million. As a result of this effort, we:
-incurred $251 million in 2008 for workforce reduction and lease consolidation costs, asset impairments and other associated costs, and
In August 2008, we announced that we had entered into an agreement to merge with Benfield, a leading independent reinsurance intermediary. The merger was completed in November 2008. We funded the transaction through cash on hand. We intend to integrate the Benfield business with our existing reinsurance operations (Aon Re Global) and operate the division globally under the newly created Aon Benfield brand. See Note 5 to the consolidated financial statements, "Business Combinations" for further information.
incur a pretax loss of approximately $191 million on the sale of these operations, which has been recorded in 2008 in discontinued operations.
In October 2008, we reached a definitive agreement to sell AIS Management Corporation ("AIS"), a broker for non-standard personal lines automobile coverage, which was previously included in our Risk and Insurance Brokerage Services segment, to Mercury General Corporation, for approximately $120 million in cash, plus a potential earn-out of up to $35 million, payable over the two years following the completion of the agreement. The sale was completed in early first quarter 2009. AIS's operating results are included in discontinued operations for all periods presented. We expect to record a pretax gain from the sale of AIS in the first quarter 2009 of approximately $85 million.
In December 2007, we announced that we signed definitive agreements to sell our CICA and Sterling subsidiaries. These two subsidiaries were previously included in an Insurance Underwriting segment. Both of these transactions were completed on April 1, 2008. In more detail:
•Sterling was sold to Munich Re Group for cash consideration of $341 million, after final adjustments.
•Construction Program Group ("CPG"), a managing general underwriter whose policies were underwritten by Aon's property and casualty operation, which was previously included in both the Risk and Insurance Brokerage Services and Insurance Underwriting segments.
In December 2008, we signed a definitive agreement to sell the U.S. operations of our premium finance business (Cananwill) to AFCO Credit Corporation. This sale did not qualify as a discontinued operation because we will have a continuing interest in the operations after the sale, and thus Cananwill's results continue to be included in the Risk and Insurance Brokerage Services segment. This transaction was completed in February 2009. We recorded a preliminary loss on the sale of this business of approximately $5 million in 2008. In connection with Aon's sale of its U.S. premium finance
We also sold other, smaller operations during 2008. We recognized a pretax gain of $4 million on these dispositions, which is included in our income from continuing operations.
The restructuring plan, before any potential reinvestment of savings, is expected to deliver cumulative cost savings of approximately $33-41 million in 2009, $84-94 million in 2010 and $122 million in 2011. All of the components of the restructuring plan are not finalized and actual savings, total costs and timing may vary from those estimated due to changes in the scope, underlying assumptions of the plan, and to foreign exchange rates.
The following table summarizes the 2007 restructuring and related expenses by type incurred and estimated to be incurred through the end of the restructuring initiative (in millions):
The following table summarizes actual restructuring and related expenses incurred and estimated to be incurred through the end of the restructuring initiative, by segment (in millions):
In 2008, we repurchased 42.6 million shares at a cost of $1.9 billion. Since the program began, we have repurchased 90.8 million shares at a cost of $3.7 billion. Of the shares repurchased since the program's inception, we have reissued approximately 23.3 million shares for stock options, stock awards, and other benefit plans.
We believe the following critical accounting policies affect the more significant estimates, assumptions, and judgments we used to prepare these consolidated financial statements.
We recognize other restructuring costs as they are incurred, including moving costs and consulting and legal fees.
We sponsor defined benefit pension plans throughout the world. Our most significant plans are located in the United States (U.S.), the United Kingdom (U.K.), the Netherlands and Canada.
The U.S. pension plans use the market-related value of assets to determine expected return on assets.
•the market-related value of pension assets does not yet reflect accumulated asset losses of $217 million. These losses will increase pension expense as they are graded into the market-related asset value and may be offset by future asset gains. We recognize 20% of the asset gain or loss in the current year's market-related value, with the remaining 80% spread over the next four years.
Unrecognized gains and losses are amortized as a component of pension expense based on the average expected future service of active employees for our plans in the Netherlands and Canada, or the average life expectancy of the U.S. and U.K. plan members. Prior to the U.S. plan amendment to cease crediting future benefits relating to salary and service, we amortized unrecognized gains and
As of December 31, 2008, the pension plans have deferred losses that have not yet been recognized through income in the financial statements. We amortize unrecognized actuarial losses outside of a corridor, which is defined as 10% of the greater of market-related value of plan assets or projected benefit obligation ("PBO"). To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense similarly until fully amortized.
(1)Includes investments in infrastructure, real estate, limited partnerships and hedge funds. We base our U.S. expected long-term return on capital market expectations for various asset classes. 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:
A fixed income expectation factor of 4.9% included the then-current 10-year U.S. Treasury Note yields and simulations of future yields based on expected inflation and other factors. We based:
•other asset class expectations on risk premiums relative to U.S. equities and fixed income expected returns, and
The actual allocation at December 31, 2008 was 67% equities and 33% fixed income securities.
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 2008 or 2007. 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.
In 2006, we adopted Statement No. 123(R), Share-Based Payments, and changed our method of valuation for stock options granted. Beginning in 2006, we moved to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model. Lattice-based option valuation models:
•estimate expected volatilities based on the average of the historical volatility of Aon's stock price and the implied volatility of traded options on Aon's stock.
•use historical data to estimate option exercise and employee terminations within the valuation model, differentiating between executives and key employees,
The largest performance-based stock plan is the Leadership Performance Plan ("LPP"). The 2006 to 2008 performance period ended on December 31, 2008. The LPP has two ongoing performance periods: 2007 to 2009 and 2008 to 2010. A 10% upward adjustment in our estimated performance achievement percentage would have increased our current year's expense by approximately $1 million, while a 10% downward adjustment would have decreased our expense by approximately $3 million. As the percent of expected performance increases or decreases, the potential change in expense can go from 0% to 200% of the targeted total expense.
The carrying values of deferred income tax assets and liabilities reflect the application of our income tax accounting policies in accordance with FASB Statement No. 109, Accounting for Income Taxes, and are based on management's:
As disclosed earlier, we signed a definitive agreement in January 2009 to sell our P&C operations. Assets and liabilities of these operations are reported in our consolidated statement of financial position as assets and liabilities held-for-sale. Included in liabilities held-for-sale are loss reserves of $122 million and $114 million at December 31, 2008 and 2007, respectively, which represent our best estimate of unpaid claims and claims adjustment expenses for reported and unreported losses incurred
Because setting loss reserve levels is inherently uncertain, we cannot guarantee that our current reserves will prove adequate in light of subsequent events. Loss reserves represent our best estimate of what we expect the ultimate settlement and administration of claims will cost, given our informed judgments based on:
In our discussion of operating results, we sometimes refer to supplemental information derived from consolidated financial information.
We use supplemental information related to organic revenue growth to help us and our investors evaluate business growth from existing operations. Organic revenue growth excludes the impact of foreign exchange rate changes, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses, and unusual items.
Because 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 may be significant and may distort true period-to-period comparisons of changes in revenue or pretax income. Therefore, we have:
•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 impact on expenses and earnings per share, and
•lower realized gains from the sale of investments compared to 2007, and
•U.S. revenue decreased $25 million or 1%, reflecting declines in U.S. retail operations due to a slowdown in private equity and commercial construction activity and soft market conditions, partially offset by growth in our affinity and reinsurance business.
•Americas other than U.S. revenue increased $82 million or 10%, due to strong organic growth in Latin America and the impact of foreign exchange rates.
•United Kingdom revenue decreased $56 million or 4% driven by unfavorable foreign exchange, lower investment income and soft market conditions, partially offset by the impact of acquisitions.
•Europe, Middle East & Africa revenue increased $237 million or 13% as a result of favorable foreign exchange, acquisitions and organic revenue growth, most notably in Italy, Spain, Africa and the Middle East, partially offset by lower investment income.
The increase in total operating expenses of $357 million or 6% from 2007 is driven by:
•$88 million or 5% increase in other general expenses, were driven by higher E&O expenses, costs related to anti-bribery investigations and compliance initiatives, and higher restructuring charges. The increase in costs was partially offset by foreign exchange transaction gains and one-time expenses in 2007 relating to the settlement of litigation for acquired employees in our U.K. reinsurance business and the resolution of a U.K. balance sheet reconciliation difference.
•$29 million increase in depreciation and amortization due to increased amortization due to acquisitions along with restructuring-related impairments and higher software amortization.
Interest expense declined $12 million, due primarily to the redemption of our 3.5% Senior Convertible Debentures during 2007.
Income from continuing operations before income taxes was $863 million, a 15% decrease from $1,010 million in 2007. The decrease was driven by higher restructuring costs, costs associated with acquiring Benfield, and expenses related to anti-bribery investigations and compliance initiatives, which more than offset organic growth in both our segments and the favorable impact of foreign exchange.
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. In:
•2007, the lower U.K. tax rate required us to remeasure our U.K. deferred tax assets using the new enacted tax rate, resulting in a one-time non-cash expense of $24 million.
•Basic net income per share from continuing operations decreased to $2.18 in 2008 from $2.23 in 2007.
Revenue from discontinued operations decreased to $775 million in 2008 from $2.6 billion in 2007 as only one quarter of CICA and Sterling was included in 2008, versus a full year in 2007. After-tax income from discontinued operations increased $639 million to $841 million, driven by:
•the gain on the sale of CICA and Sterling ($935 million), partially offset by only one quarter of operations in 2008 for CICA and Sterling versus a full year in 2007 ($150 million) and
•the estimated loss on the sale of the P&C operations ($116 million). The sale of these operations eliminates any future exposure to the run-off of the P&C operations.
See Note 7 to the consolidated financial statements, "Disposal of Operations," for further information.
•Asia Pacific revenue increased $65 million to $626 million, driven by favorable foreign exchange and organic revenue growth in most Asian countries, which more than offset softness in Australia and the impact of certain regulatory changes in Japan.
The $306 million or 5% increase in operating expenses versus 2006 is driven by:
•$169 million or 4% increase in compensation and benefits, reflecting $189 million of unfavorable foreign exchange as well as higher salary and incentive costs, which more than offset significant pension savings, lower restructuring costs and the benefits of the 2005 restructuring program. Reduced pension expense was due primarily to plan amendments in the U.S. and U.K.
Other income increased $8 million, resulting from the gain on sale of businesses in 2007 partially offset by the gain on the 2006 sale of our building in Spain.
Income from continuing operations was $1,010 million, a 39% increase from $728 million in 2006. The increase was driven by improved profitability in our brokerage and consulting segments and distributions from our PEPS I investment.
The effective tax rate on income from continuing operations was 34.5% in 2007 and 32.8% in 2006. In 2007 and 2006, our effective tax rate reflects the favorable resolution of tax examination issues, adjustments, and tax credits. In addition, our 2007 rate was impacted by changes in corporate tax rates in certain foreign countries, most notably in the United Kingdom, which decreased the enacted corporate tax rate from 30% to 28%. We had to remeasure our U.K. deferred tax assets using the new enacted tax rate, resulting in a one-time non-cash expense of $24 million.
•Basic net income per share from continuing operations increased to $2.23 from $1.54.
Aon classifies its businesses into two operating segments: Risk and Insurance Brokerage Services and Consulting (see Note 18 to the consolidated financial statements for further information).
Aon's operating segments report separate financial information and we evaluate them regularly when we are deciding how to allocate resources and assess performance.
The following tables and commentary provide selected financial information on the operating segments (in millions):
Aon is a leader in many sectors of the insurance industry. Aon was ranked in 2008 by Business Insurance as the world's largest insurance broker, by A.M. Best as the number one global insurance brokerage in 2008 and 2007 based on brokerage revenues, and voted the best insurance intermediary and best reinsurance intermediary in 2008 and 2007 by the readers of Business Insurance.
We are facing increasingly difficult conditions as a result of unprecedented disruptions in the global economy, the repricing of credit risk and the deterioration of the financial markets. Continued volatility and further deterioration in the credit markets may reduce our customers' demand for our brokerage and reinsurance services and products, which could hurt our operational results and financial condition. In addition, overall capacity in the industry could decrease if a significant insurer either fails or withdraws from writing insurance coverages that we offer our clients. This failure could reduce our revenues and profitability, since we would no longer have access to certain lines and types of insurance.
Risk and Insurance Brokerage Services generated approximately 82% of Aon's total operating segment revenues in 2008. Revenues are generated primarily through:
•addresses the highly specialized product development and risk management needs of commercial enterprises, professional groups, insurance companies, governments, healthcare providers, and non-profit groups, among others;
•provides actuarial, loss prevention, and administrative services to businesses and consumers; and
In December 2008, we signed a definitive agreement to sell the U.S. operations of the premium finance business of Cananwill. The transaction was completed in February 2009.
•Risk Management and Insurance Brokerage encompasses our retail brokerage services, affinity products, managing general underwriting, placement and captive management services, and premium finance services in: Americas; United Kingdom; Europe, Middle East & Africa; and Asia Pacific.
•Reinsurance Brokerage and Related Services (Reinsurance) offers sophisticated advisory services in program design and claim recoveries that:
This subsegment also provides investment banking products and services for insurance companies.
In 2008, commissions, fees and other increased $286 million or 5% from 2007 reflecting organic growth in our reinsurance and most of our retail operations, as well as the impact of favorable foreign exchange rates.
The 1% reported growth in Americas reflects strong new business growth in Latin America, as well as growth in our Affinity and Canadian operations, partially offset by a decline in U.S. retail, primarily due to soft market conditions, as well as our premium financing operations.
United Kingdom commissions, fees and other declined 3% driven by unfavorable foreign currency translation and soft market conditions, partially offset by acquisitions and growth in our Captives operation.
Reinsurance commissions, fees and other increased 11%, due to the Gallagher Re and Benfield purchases, favorable foreign currency translation, and 1% organic revenue growth reflecting growth in facultative and treaty placements, partially offset by soft market conditions and greater client retention.
The following table sets forth our Risk and Insurance Brokerage Services revenue by geographic area and total pretax income (in millions):
Americas other than U.S. revenue increased 11% due to the favorable impact of foreign currency translation and organic revenue growth in our Latin American and Affinity operations, partially offset by lower investment income.
The 4% decrease in United Kingdom revenue is driven by the impact of unfavorable foreign currency translation, lower investment income, and soft market conditions.
Europe, Middle East & Africa revenue increased 12% due to positive foreign currency translation, investment income gains and organic revenue growth, most notably in Italy, Spain, the Middle East and Africa.
•a $21 million litigation settlement for acquired employees in our U.K. reinsurance business in 2007,
In 2008, commissions, fees and other of $1,353 million were 1% higher than 2007. On an organic basis, revenue increased 3% from 2007.
This table details Consulting commissions, fees and other by subsegment (in millions):
This table reconciles organic revenue growth to reported commissions, fees and other growth in 2008 versus 2007:
•Consulting services increased $32 million or 3%, reflecting growth in most major practice groups and geographies partially offset by the disposal of a small business.
•Outsourcing revenue declined $22 million or 9%, driven by lower revenue from AT&T. AT&T, our largest outsourcing client, terminated many of its outsourcing services with us in 2006 and terminated our remaining services during 2007.
•U.S. revenue decreased $34 million in 2008, primarily due to reduced outsourcing business related to the loss of revenue from AT&T (see above) and a $5 million gain on the sale of an investment in 2007, partially offset by organic revenue growth in Consulting Services.
Pretax income was $213 million, an increase of $24 million or 13% from 2007. 2008 pretax margins in this segment were 15.7%, an increase of 170 basis points from 14.0% in 2007. The pretax income and margin improvement was principally driven by:
•a $29 million decrease in income from our PEPS I investment, partially offset by
•higher investment income from marketable securities due to the investment of proceeds from the sale of CICA and Sterling.
•$50 million of hedging costs related to the merger with Benfield and
•the 2007 resolution of a $15 million reconciliation difference in the U.K.,
•2007 expenses associated with a review of historical equity compensation practices.
Interest expense, which represents the cost of our worldwide debt obligations, decreased $12 million in 2008 to $126 million, principally due to the redemption of our 3.5% Senior Convertible Debentures in 2007.
Our parent company's routine liquidity needs include paying corporate expenses, servicing debt, and paying dividends on Aon's outstanding stock. We meet these requirements primarily through dividends and internal financing from our operating subsidiaries. We may also use available liquidity for capital expenditures and repurchasing common stock.
In 2008, total cash contributions to our major defined benefit pension plans were $177 million, compared with cash contributions of $211 million in 2007. Under current rules and assumptions, we anticipate 2009 contributions to our major defined benefit pension plans of approximately $400 million.
In 2007, our principal U.K. subsidiary agreed with the trustees of the plan to contribute £9.4 million per year to one of our U.K. pension plans for the next six years, with the amount payable increasing by approximately 5% on each April 1. In 2008, we contributed £9.7 million ($19 million). The trustees of the plan:
•have certain rights to request that our U.K. subsidiary advance an amount equal to an actuarially determined winding-up deficit. As of December 5, 2008, the estimated winding-up deficit was £440 million ($642 million at December 31, 2008 exchange rates).
Cash flows from operations represent the net income we earned in the reported periods adjusted for non-cash charges and changes in operating assets and liabilities.
In 2008 and 2007, our insurance underwriting operations include accident & health and life and certain P&C operations in run-off. These insurance products have distinct differences in the timing of premiums earned and payment of future liabilities. As noted earlier, we sold our CICA and Sterling businesses on April 1, 2008.
Our operating cash flows from our insurance subsidiaries was $5 million for 2008, a decrease of $330 million compared to 2007. Due to the sale of CICA and Sterling, cash flows for 2008 include activity only through the date of sale. For 2008, operating cash flows, analyzed by major income statement component, indicated that premium and other fees collected, net of reinsurance, were $624 million compared to $2,339 million in 2007. Investment and other miscellaneous income received was $49 million and $183 million in 2008 and 2007, respectively.
Our operating cash flows from our Risk and Insurance Brokerage Services and Consulting segments, as well as related corporate items, was $429 million in 2008 compared to $904 million in 2007. The decline in operating cash flows, in part, is due to $376 million of taxes paid on the gain from the sales of CICA and Sterling. These amounts exclude the change in funds held on behalf of clients as described above. The operating cash flows depend on the timing of receipts and payments related to revenues, incentive compensation, other operating expenses and income taxes.
Aon uses the excess cash generated by our brokerage and consulting businesses as well as dividends received from CICA prior to its sale to meet its liquidity needs, which consist of acquisitions, servicing its debt, paying dividends to its stockholders and repurchasing outstanding shares.
Our financing needs were $2.2 billion. Financing uses primarily included share repurchase activity, net of reissuance for our employee benefit plans of $1.7 billion, cash dividends paid to shareholders of $171 million, and debt repayments, net of issuance, of $386 million.
In our capacity as an insurance broker or agent, we collect premiums from insureds and, after deducting our commission, remit the premiums to the respective insurance underwriter. We also collect claims or refunds from underwriters on behalf of insureds. Unremitted insurance premiums and claims are held by us in a fiduciary capacity as short-term investments.
In our consolidated statements of financial position, we report fiduciary assets equal to our fiduciary liabilities. Our fiduciary assets include short-term investments of $3,178 million and $3,122 million at December 31, 2008 and 2007, respectively.
•Assets and liabilities held-for-sale both declined substantially from 2007 as a result of the disposition of CICA and Sterling.
•Long-term debt decreased by $21 million, as higher Euro Credit facility borrowings were more than offset by the impact of foreign currency translation.
•increase our commercial paper interest rates or possibly restrict our access to the commercial paper market altogether. Although we have committed backup lines, we cannot ensure that our financial position will not be hurt if we can no longer access the commercial paper market.
Stockholders' equity decreased $911 million during 2008 to $5.3 billion, driven by share repurchase activity, net of reissuances for our employee benefit plans of $1,678 million, an increase in our net post-retirement benefit obligation of $497 million and a decrease in our foreign currency translation of $182 million, offset in part by our 2008 net income of $1,462 million.
Globe Re Limited ("Globe Re") is a limited-life reinsurance vehicle. In June 2008, Globe Re entered into a reinsurance agreement with a third party reinsurance company, whereby Globe Re provides reinsurance coverage for a defined portfolio of property catastrophe reinsurance contracts underwritten by the third party. The reinsurance coverage is for a one-year period. Globe Re is deemed a VIE since the equity investors at risk lack a controlling financial interest. A subsidiary of Aon Benfield owns an 85% equity economic interest in Globe Re, and therefore is deemed to be the primary beneficiary. As such, Aon is required to consolidate Globe Re under the provisions of FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities. At December 31, 2008, Globe Re had assets of $187 million and liabilities of $105 million. If a disaster such as U.S. wind damage, which accounts for approximately 80% of the coverage, occurs, we could lose our equity investment in Globe Re of approximately $20 million. In addition, if the counterparty bank which we have a total return swap with defaults, we could also lose our equity investment.
We record various contractual obligations as liabilities in our consolidated financial statements. While we do not recognize other items as liabilities in the financial statements, such as certain purchase commitments and other executory contracts, we are required to disclose them.
•have issued letters of credit to cover contingent payments of approximately $3 million for taxes and other business obligations to third parties,
•accrue amounts in our consolidated financial statements for these letters of credit to the extent they are probable and estimable, and
These reinsurance recoverables amount to $649 million at December 31, 2008. Trust balances and letters of credit offsetting these reinsurance recoverables were approximately $145 million. The balance of the liability was $9 million and $12 million at December 31, 2008 and 2007, respectively, reflecting the fair value of this indemnification.
The liability represents the present value of the indemnification on the credit risk of the reinsurers. With the sale of the remaining P&C insurance underwriting operations, which we expect to be completed by mid 2009, the buyer will assume the guarantee with respect to reinsurance recoverables.
In the U.S. and U.K., premium finance agreements are sold to SPEs, which are considered QSPEs as defined by Statement No. 140. The QSPEs fund their purchases of premium finance agreements by selling undivided beneficial interests in the agreements to Bank SPEs. In Canada and Australia, undivided interests in the premium finance agreements are sold directly to Bank SPEs. The Bank SPEs are variable interest entities as defined by FIN 46R.
We have not consolidated the QSPEs used in the U.S. and U.K. in our financial statements because we have met the criteria for sale accounting under Statement No. 140.
For the Canadian and Australian sales, we determined that non-consolidation of the Bank SPEs is appropriate in accordance with FIN 46R because we are not their primary beneficiary. We have reached this determination by analyzing specific qualitative and quantitative factors related to our transactions with the Bank SPEs, including:
Our variable interest in the Bank SPEs in these jurisdictions is limited to our retained interests in premium finance agreements sold to the Bank SPEs. We review all material off-balance sheet transactions annually or whenever a reconsideration event occurs for the continued propriety of our accounting.
The Bank SPEs had advanced to us $981 million and $1.4 billion at December 31, 2008 and 2007, respectively, on portfolios sold to the Bank SPEs of $1.1 billion and $1.5 billion at December 31, 2008 and 2007, respectively.
•retain servicing rights for sold agreements, and earn servicing fee income over the servicing period. Because the servicing fees represent adequate compensation for the servicing the receivables, we have not recorded any servicing assets or liabilities.
The third-party bank sponsors or other participants in the Bank SPEs provide the liquidity support and bear the credit risks on the receivables, subject to limited recourse, in the form of over-collateralization, which we (and other sellers) provide, as required by the sales agreements. The over-collateralization of our sold receivables represents our maximum exposure to credit-related losses, and was approximately $171 million at December 31, 2008. We also:
With the exception of our Australian sales agreements, all our other sales agreements require us to meet the following covenants:
•the over-collateralization requirements have increased significantly (a total of $50 million on the renewal dates),
Moreover, as our ability to originate and fund new premium finance agreements is dependent on the pass-through funding costs of the Bank SPEs, disruptions in the markets through which the Bank
SPEs obtain funds could further diminish our premium finance results of operations and cash flows. Our Australian facility expires in June 2009, and we expect similar restrictive terms.
•Before 2007, the income distributions we received from PEPS I were limited to interest payments on various PEPS I debt instruments.
Whether we receive additional preferred returns will depend on the performance of the LP interests underlying PEPS I, which we expect to vary from period to period. We do not control the timing of the distributions.
We derive the estimated fair value of our $101 million preferred stock investments in PEPS I primarily from valuations received from the general partners of the LP interest held by PEPS I.
(5)The contractual obligations for the property and casualty insurance underwriting operations are for policy and contract claims.
Management assessed the effectiveness of the company's internal control over financial reporting as of December 31, 2008. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
On November 28, 2008, the Company acquired the 100% interest in Benfield Group Limited and its subsidiaries. Refer to Note 5 of Notes to Consolidated Financial Statements for additional information regarding this transaction. In accordance with SEC Staff guidance, management has excluded these acquired businesses from its evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2008. Total revenues attributable to these acquired businesses represented approximately 0.5 percent of the Company's consolidated total revenues for the year ended December 31, 2008, and the aggregate total assets represented approximately 18 percent of the Company's consolidated total assets of December 31, 2008.
The effectiveness of our internal control over financial reporting as of December 31, 2008 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report on page 63.
As indicated in the accompanying Management's Report on Internal Control over Financial Reporting, management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Benfield Group Limited and its subsidiaries, which are included in the 2008 consolidated financial statements of Aon Corporation and constituted 0.5 percent of consolidated total revenue for the year ended December 31, 2008 and 18 percent of consolidated total assets as of December 31, 2008. Our audit of internal control over financial reporting of Aon Corporation also did not include an evaluation of the internal control over financial reporting of Benfield Group Limited and its subsidiaries.
We have also 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, 2008 and 2007, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2008 and our report dated February 27, 2009 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated statements of financial position of Aon Corporation as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
As discussed in Note 2 to the financial statements, in 2006 the Company changed its method of accounting for stock-based compensation and defined benefit pension and postretirement plans.
Financial Accounting Standards Board ("FASB") Statement No. 123 (revised 2004), Share-Based Payment ("Statement No. 123(R)"), 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. Stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period. Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The adoption of Statement No. 123(R) resulted in a cumulative effect of an accounting change as of January 1, 2006 of $1 million, net of tax. Upon adoption of Statement No. 123(R), Aon also 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.
Basic net income per share is computed by dividing net income available for common stockholders by the weighted-average number of common shares outstanding. Diluted net income per share is computed by dividing net income by the weighted-average number of common shares outstanding, plus the dilutive effect of stock options and awards. The dilutive effect of stock options and awards is
calculated under the treasury stock method using the average market price for the period. Certain common stock equivalents related to options were not included in the computation of diluted income per share because those options' exercise price was greater than the average market price of the common shares. Aon includes in its diluted net income per share computation the impact of any contingently convertible instruments regardless of whether the market price trigger has been met. Prior to their redemption in November 2007, Aon's 3.5% convertible debt securities, which were issued in November 2002, were able to be converted into a maximum of 14 million shares of Aon common stock, and these shares were included in the computation of diluted net income per share.
Aon maintained premium trust balances for premiums collected from insureds but not yet remitted to insurance companies of $3.2 billion and $3.1 billion at December 31, 2008 and 2007, respectively. These funds and a corresponding liability are included in fiduciary assets and fiduciary liabilities, 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 $101 million and $91 million at December 31, 2008 and 2007, respectively.
•Fixed-maturity securities are classified as available for sale and are reported at fair value. The amortized cost of fixed maturity securities is adjusted for amortization of premiums and the accretion of discounts to maturity, which is included in investment income. Unrealized gains and losses on fixed maturity securities are excluded from income and are recorded directly in stockholders' equity as accumulated other comprehensive income or loss, net of deferred income taxes. The majority of the Company's fixed maturity securities are reported as "assets held-for-sale" in the consolidated statements of financial position.
•Cost method investments - Equity investments where Aon does not have an ownership interest of greater than 20% or the ability to exert significant influence over the operations of the investee are carried at cost.
Income or loss on the disposal of investments is calculated using the amortized cost of the security sold and is reported in investment income in the consolidated statements of income. Impairment losses are included in investment income in the consolidated statements of income. In general, Aon ceases to accrue investment income when interest or dividend payments are in arrears.
Accounting policies relating to derivative financial instruments are discussed in Note 15.
Foreign revenues and expenses are translated at average exchange rates. Foreign assets and liabilities are translated at year-end exchange rates. Net foreign exchange gains and losses on translation are reported in stockholders' equity, in accumulated other comprehensive income or loss ("OCI"), net of applicable deferred income taxes. The effect of foreign exchange gains and losses on the consolidated statements of income, including derivative hedging losses of $36 million in 2008 and $3 million in 2006 and gains of $16 million in 2007, were gains of $18 million and $11 million in 2008 and 2007, respectively, and losses of $13 million in 2006.
Aon adopted FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 clarified 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 recognition and measurement provisions for a tax position taken, or expected to be taken, in a company's tax return. As a result of the implementation of FIN 48, Aon did not recognize any material adjustments in the liability for unrecognized tax benefits. See Note 11 for further discussion of the effect of adopting FIN 48 on the Company's consolidated financial statements.
In December 2007, the FASB issued Statement No. 141 (revised 2007), Business Combinations ("Statement No. 141(R)") and Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. Statement No. 141(R) replaces Statement No. 141 and applies to all transactions or other events in which an entity obtains control over one or more businesses. This Statement requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. Business combinations achieved in stages require recognition of the identifiable assets and liabilities, as well as the noncontrolling interest in the acquiree, at the full amounts of their fair values. Statement No. 141(R) also changes the requirements for recognizing assets acquired and liabilities assumed arising from contingencies, and requires direct acquisition costs to be expensed. In addition, Statement No. 141(R) provides certain changes to income tax accounting for business combinations which applies to both new and previously existing business combinations.
Statement No. 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interests in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This Statement also requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. Statement No. 160 requires retrospective adjustments, for all periods presented, of stockholders' equity and net income for noncontrolling interests.
In May 2008, the FASB issued Staff Position APB14-1 ("FSP APB14-1"), Accounting for Convertible Instruments That May Be Settled in Cash upon Conversion. The FSP requires the issuer of certain convertible debt instruments that may be settled in cash on conversion to separately account for the liability and equity components of the instrument in a manner that reflects the issuer's nonconvertible debt borrowing rate. FSP APB14-1 is effective for Aon in 2009. The FSP requires retrospective application to all periods presented. Aon is currently evaluating the FSP to determine what impact, if any, it will have on its consolidated financial statements.
in 2009. All prior periods earnings per share data that are disclosed must be adjusted to conform to the current presentation. Early application is not permitted. Aon is currently evaluating the FSP to determine what impact it will have on its consolidated financial statements.
In December 2008, the FASB issued Staff Position FAS 132(R)-1 ("FSP FAS 132(R)-1"), Employers' Disclosures about Postretirement Benefit Plan Assets, which amends Statement No. 132(R), Employers' Disclosures about Pensions and Other Postretirement Benefits, to provide guidance on an employer's disclosures about plan assets of a defined benefit pension or other postretirement plan. The staff position requires that for plan assets, disclosures should be made as to how investment allocation decisions are made, disclose separately for pension plans and other postretirement plans the fair value of each major category of plan assets based on the nature and risks of assets in the plans, and disclose information that enables users to assess the inputs and valuation techniques used to develop fair value measurements of plan assets. FSP EITF 132(R)-1 is effective for Aon's 2009 annual report. Aon is currently evaluating the FSP to determine what additional disclosures will be necessary to comply with the staff position.
On November 28, 2008, Aon completed the acquisition of the shares of Benfield Group Limited ("Benfield"), a leading independent reinsurance intermediary, with more than 50 locations worldwide. The Company purchased all of the outstanding shares of common and preferred stock of Benfield for $1,281 million in cash. The total cost of the acquisition also includes direct costs of the transaction totaling $32 million. Benfield is known for its client service, analytic capability and innovation. As a result of the merger, Aon believes that it will add to its capabilities in developing markets around the world, its use of global analytics, modeling and client facing technologies as well as increase and expand its client relationships. The results of Benfield's operations are included in the Company's consolidated financial statements since the date of closing.
In connection with the acquisition, the Company recorded goodwill and other intangibles of $1.1 billion and $583 million, respectively, all of which is reported within the Risk and Insurance Brokerage Services segment. None of the goodwill is deductible for tax purposes. Of the acquired intangible assets, $128 million was assigned to registered trademarks, which were determined to have indefinite useful lives. Of the remaining balance of intangible assets acquired, $453 million were assigned to customer relationships, and $2 million was assigned to non-competition agreements, which are being amortized over weighted average useful lives of 12 and 1 years, respectively.
The preliminary estimated fair values of assets acquired and liabilities assumed at the merger date are as follows (in millions):
The Company is in the process of obtaining third-party valuations for certain amounts; thus, the allocation of the purchase price is subject to refinement.
The following unaudited pro forma consolidated results of operations assume that the merger of Benfield was completed as of January 1 for each of the fiscal years shown below (in millions, except per share amounts):
Pro forma data may not be indicative of the results that would have been obtained had the acquisition actually occurred at the beginning of the periods presented, nor does it intend to be a projection of future results. The pro forma financial information include adjustments to historical Benfield numbers to conform their results to U.S. GAAP from International Financial Reporting Standards and amortization charges from acquired intangibles and related tax effects.
The results of operations of these acquisitions are included in the consolidated financial statements from the dates they were acquired. These acquisitions would not produce a materially different result if they had been reported from the beginning of the period.
The changes in the net carrying amount of goodwill by operating segment for the years ended December 31, 2008 and 2007, respectively, are as follows (in millions):
In December 2008, Aon signed a definitive agreement to sell the U.S. operations of the premium finance business of Cananwill. Cananwill's results are included in the Risk and Insurance Brokerage Services segment. This disposition was completed in February 2009. A pretax loss of $5 million was recorded in 2008, which is included in other expense (income) in the consolidated statements of income. This disposal did not meet the criteria for discontinued operations reporting. Aon may receive up to $10 million from the buyer over the next two years based on the amount of insurance premiums and related obligations financed by the buyer over such period that are generated from certain of Cananwill's producers.
Aon also sold four other, smaller operations. Total pretax gains of $13 million were recognized on these sales, which are included in other expense (income) in the consolidated statements of income.
In 2007, Aon sold Media Professionals, Inc. and two other, smaller operations, which were included in the Risk and Insurance Brokerage Services segment. Total pretax gains of $32 million were recognized on these sales, which are included in other expense (income) in the consolidated statements of income. Also in 2007, Aon sold 25% of its Botswana subsidiary, which is included in the Risk and Insurance Brokerage Services segment. A pretax gain of $4 million was recognized on the sale, which is included in other expense (income) in the consolidated statements of income. These disposals did not meet the criteria for discontinued operations reporting.
The P&C operations have reinsurance agreements to both cede and assume reinsurance. As of November 30, 2006, in connection with the sale of Aon Warranty Group ("AWG'), Aon sold Virginia Surety Company ("VSC"). VSC remains liable to policyholders to the extent reinsurers of the property and casualty businesses do not meet their obligations. In connection with the AWG sale, Aon provided an indemnification which protects the purchaser from credit exposure related to the property and casualty balances that were reinsured. These reinsurance recoverables amount to $649 million at December 31, 2008. Trust balances and letters of credit offsetting these reinsurance recoverables totaled approximately $145 million at December 31, 2008. The balance of the liability was $9 million at December 31, 2008, reflecting the estimated fair value of this indemnification. The Company is not aware of any event of default by any reinsurer which would require it to satisfy the indemnification. In conjunction with the sale of the P&C operations, the buyer will assume the guarantee with respect to these reinsurance balances.
In 2007, the Company announced that it had signed separate definitive agreements to sell its Combined Insurance Company of America ("CICA") and Sterling Life Insurance Company ("Sterling") subsidiaries. These two subsidiaries were previously included in the Company's former Insurance Underwriting segment. On April 1, 2008, the CICA business was sold to ACE Limited and Sterling was sold to Munich Re Group. After final adjustments, Aon received $2,525 million in cash for CICA and $341 million in cash for Sterling. Additionally, CICA paid a $325 million dividend to Aon before the sale transaction was completed. A pretax gain of $1.4 billion was recognized on the sale of these businesses, which include the reversal of the cumulative translation adjustment account (related to selling CICA's foreign entities) of $134 million.
In accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Aon has reclassified the assets and liabilities of all of these businesses to assets held-for-sale and liabilities held-for-sale, respectively, in both the December 31, 2008 and 2007 consolidated statements of financial position.
The assets and liabilities reported as held-for-sale are as follows (in millions):
In 2007, the Company announced a global restructuring plan intended to create a more streamlined organization and reduce future expense growth to better serve clients ("2007 Plan"). The 2007 Plan includes an estimated 3,900 job eliminations beginning in the third quarter of 2007 and continuing into 2009. The Company also expects to close or consolidate several offices resulting in sublease losses or lease buy-outs. The Company estimates that the 2007 Plan will result in cumulative pretax charges totaling approximately $550 million. Expenses will include workforce reduction and lease consolidation costs, asset impairments, as well as other expenses necessary to implement the restructuring initiative. Costs related to the restructuring are included in compensation and benefits, other general expenses and depreciation and amortization in the accompanying consolidated statements of income. The Company expects the restructuring and related expenses to affect continuing operations through the end of 2009.
(1)Actual costs, when incurred, will vary due to changes in the assumptions built into this plan. Significant assumptions likely to change when plans are finalized and approved include, but are not limited to, changes in severance calculations, changes in the assumptions underlying sublease loss calculations due to changing market conditions, and changes in the overall analysis that might cause the Company to add or cancel component initiatives. The following is a summary of actual restructuring and related expenses incurred and estimated to be incurred through the end of the restructuring initiative, by segment (in millions):
As of December 31, 2008, the Company's liabilities for the 2007 Plan are as follows (in millions):
In 2005, the Company commenced a restructuring that resulted in cumulative pretax charges totaling $369 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 compensation and benefits, other general expenses and depreciation and amortization in the accompanying consolidated statements of income.
The following table sets forth the activity related to the 2005 restructuring plan liabilities (in millions):
Prior to 2007, income distributions received from PEPS I were limited to interest payments on PEPS I debt instruments. Beginning in 2007, PEPS I had redeemed or collateralized all of its debt, and began to pay preferred income distributions to Aon. Whether Aon receives additional preferred returns will depend on the performance of the underlying limited partnership interests, which is expected to vary from period to period. Aon does not control the timing of the distribution. In 2008 and 2007, Aon received $32 million and $61 million, respectively, of income distributions from PEPS I, which are included in investment income. Aon did not receive any distributions in 2006.
(1)Includes other-than-temporary impairment write-downs of $2 million and $1 million in 2007 and 2006, respectively. There were no impairments in 2008. Endurance warrants
Aon previously held investments in 4.1 million common stock purchase warrants in Endurance Specialty Holdings, Ltd. ("Endurance"). The warrants were recorded in the financial statements at fair value, with changes in fair value included in investment income. In March 2006, Aon contributed all of the Endurance warrants to its U.K. pension plans. The change in the fair value was included in income and was a decrease of $14 million in 2006.
For both the U.S. and Euro facilities, Aon is required to maintain a ratio of consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) to consolidated interest expense of 4 to 1 and a ratio of consolidated debt to EBITDA of not greater than 3 to 1. Aon was in compliance with all debt covenants as of December 31, 2008.
Aon also has a €25 million ($35 million) 364-day facility available.
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 86% of Aon's lease obligations are for the use of office space.
Aon recognized, as an adjustment to additional paid-in-capital, income tax benefits attributable to employee stock compensation as follows: 2008 - $45 million; 2007 - $40 million; and 2006 - $24 million.
U.S. deferred income taxes are not provided on unremitted foreign earnings that are considered permanently reinvested, which at December 31, 2008 amounted to approximately $2.1 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. due to foreign tax credits and exclusions that may become available at the time of remittance.
The amount of income taxes paid in 2008, 2007 and 2006 was $696 million, $195 million and $536 million, respectively.
As described in Note 2, the Company adopted FIN 48 on January 1, 2007. The effect of adopting FIN 48 was not material to the Company's financial statements.
State insurance laws and regulations prescribe accounting practices for determining statutory capital and surplus and net income for insurance companies and require, among other matters, the filing of financial statements prepared in accordance with statutory accounting practices prescribed or permitted for insurance companies. State insurance laws and regulations in the U.S. also require the maintenance of a minimum capital and surplus based on various factors. In 2008, Aon's insurance companies included only the run-off P&C operations. In 2007 and 2006, CICA and Sterling were also included. At December 31, 2008, the Company's insurance subsidiaries were in compliance with these minimum requirements. Statutory capital and surplus of the insurance subsidiaries were $62 million and $971 million at December 31, 2008 and 2007, respectively. Statutory net income of the insurance subsidiaries was $2 million, $259 million and $206 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Aon subsidiaries maintain defined contribution savings plans for the benefit of its U.S. and U.K. employees. The expense recognized for these plans, which is included in compensation and benefits and discontinued operations in the accompanying consolidated statements of income, is as follows (in millions):
The Company's U.S., U.K. and Canadian plans are closed to new entrants. Effective January 1, 2009, the Company's Netherlands plan was also closed to new entrants. Effective April 1, 2009, the Company will cease crediting future benefits relating to salary and service in its U.S. defined benefit pension plan. This change will affect approximately 6,000 active employees covered by the U.S. plan. For those employees, the Company will increase its contribution to the defined contribution savings plan. Effective January 1, 2007, future benefits in the Company's U.S. defined benefit pension plan were calculated based on a "career average pay" formula instead of a "final average pay" formula. Effective March 31, 2007, the Company ceased crediting future benefits relating to salary and service in its U.K. defined benefit pension plans. The change affected approximately 1,700 active employees covered by the U.K. plans.
Amounts recognized in the statements of financial position consist of (in millions):
Amounts recognized in accumulated other comprehensive loss that have not yet been recognized as components of net periodic benefit cost at December 31, 2008 and 2007 consist of (in millions):
In 2007, U.S. plans with a PBO and ABO in excess of the fair value of plan assets had a PBO of $198 million, an ABO of $198 million and no plan assets. International plans with a PBO in excess of the fair value of plan assets had a PBO of $4.8 billion and plan assets with a fair value of $4.0 billion, and plans with an ABO in excess of the fair value of plan assets had an ABO of $4.8 billion and plan assets with a fair value of $4.0 billion.
The amounts in accumulated other comprehensive loss expected to be recognized as components of net periodic benefit cost during 2009 are as follows (in millions):
The U.S. amount of $31 million includes the impact of ceasing crediting future benefits relating to salary and services to U.S. plan participants effective April 1, 2009.
The following table provides an overview of the accumulated projected benefit obligation, fair value of plan assets, funded status and net amount recognized as of December 31, 2008 and 2007 for the Company's other post-retirement benefit plans (in millions):
Amounts recognized in accumulated other comprehensive income that have not yet been recognized as components of net periodic benefit cost at December 31, 2008 are $4 million and $26 million of net gain and prior service credit, respectively. The amount in accumulated other comprehensive income expected to be recognized as a component of net periodic benefit cost during 2009 is $4 million of prior service credit.
•Estimated future benefit payments will be approximately $5 million each year for the years 2009 - 2013 and $22 million in aggregate for 2014 - 2018.
Aon's liability for future plan cost increases for pre-65 and Medical Supplement plan coverage is limited to 5% per annum. Because of this cap, net employer trend rates for these plans are effectively limited to 5% per year in the future. During 2007, Aon recognized a plan amendment which phases out post-65 retiree coverage over the next three years. As a result, a 1% change in assumed healthcare cost trend rates has no effect on the service and interest cost components of net periodic post-retirement healthcare benefit cost or on the accumulated post-retirement benefit obligation for the measurement period ended in 2008.
Stock-based compensation expense recognized includes amounts for RSUs, stock options, performance plan awards and stock purchases related to the Employee Stock Purchase Plan, and is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Aon's consolidated statements of income since January 1, 2006 includes compensation expense for stock-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 stock-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). Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised prospectively, as necessary, if actual forfeitures differ from those estimates.
Information regarding Aon's performance-based plans as of December 31, 2008, 2007 and 2006 follows (shares in thousands, dollars in millions):
The following weighted average assumptions were used to estimate the fair value of options granted:
The expected life of employee stock options represents the weighted-average period stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. The expected life of option grants made during both 2008 and 2007 were 5 years for executives and 6 years for key employees.
During 2008, a majority of option exercises and award vestings were satisfied through the reissuance of treasury shares.
In order for a derivative to qualify for hedge accounting, the derivative must be formally designated as a fair value, cash flow, or a net investment hedge by documenting the relationship between the derivative and the hedged item. The documentation will include a description of the hedging instrument, the hedge item, the risk being hedged, Aon's risk management objective and strategy for undertaking the hedge, the method for assessing the effectiveness of the hedge, and the method for measuring hedge ineffectiveness. Additionally, the hedge relationship must be expected to be highly effective at offsetting changes in either the fair value or cash flows of the hedged item at both inception of the hedge and on an ongoing basis. Aon assesses the ongoing effectiveness of its hedges and measures and records hedge ineffectiveness, if any, at the end of each quarter.
Changes in the fair value of a derivative that is not designated as an accounting hedge (known as an "economic hedge") are recorded in either investment income or other general expenses (depending on the hedged exposure and the Company's policy) in the current period's consolidated statement of income.
Aon discontinues hedge accounting prospectively when (1) the derivative expires or is sold, terminated, or exercised, (2) it determines that the derivative is no longer effective in offsetting changes in the hedged item's fair value or cash flows, (3) a hedged forecasted transaction is no longer probable of occurring in the time period described in the hedge documentation, (4) the hedged item matures or is sold, or (5) management elects to discontinue hedge accounting voluntarily.
When hedge accounting is discontinued because the derivative no longer qualifies as a cash flow hedge, Aon will continue to carry the derivative in the consolidated statements of financial position at its fair value, recognize subsequent changes in the fair value of the derivative in current-period earnings, and continue to defer the derivative gain or loss in accumulated OCI until the hedged forecasted transaction affects earnings. If the hedged forecasted transaction is probable of not occurring in the time period described in the hedge documentation or within a two month period of time thereafter, the deferred derivative gain or loss would be reclassified immediately to earnings.
Aon uses over-the-counter 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 other general expenses in the consolidated statements of income.
Aon also uses foreign currency option contracts to hedge its net investments in foreign operations. During 2008, this hedge had no ineffectiveness, and a $55 million cumulative pretax gain has been included in OCI at December 31, 2008. As of December 31, 2008, Aon has received collateral of $49 million from the counterparty for this hedge.
Several of Aon's subsidiaries have negotiated outsourcing service agreements in currencies that differ from their functional currencies; primarily the Philippine Peso and the Indian Rupee. The subsidiary's functional currency expense will fluctuate as the currency exchange rates change. To reduce this variability, Aon uses foreign exchange forwards to hedge the foreign exchange risk of the forecasted expense for the life of the contract or up to six years. Aon has designated these derivatives as cash flow hedges of its forecasted foreign currency denominated expense. As of December 31, 2008, a $9 million pretax loss has been deferred to OCI, $2 million of which is expected to be reclassified to earnings as an adjustment to other general expenses in 2009. Deferred gains or losses will be reclassified from OCI to other general expenses when the hedged expense is recognized. The hedge did not have any ineffectiveness in 2008 or 2007.
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, Euro and Australian dollar denominated brokerage funds held on behalf of U.S., European, U.K., and Australian clients and other U.S., European, U.K., and Australian 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. As of December 31, 2008, a $31 million pretax gain related to this hedge was recorded in OCI, $23 million of which is expected to be reclassified to investment income in 2009. This hedge had no material ineffectiveness in 2008, 2007 or 2006.
obligations, and then sell these premium finance agreements in securitization transactions that meet the criteria for sale accounting under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. In December 2008, Aon signed a definitive agreement to sell the U.S. operations of the premium finance business (Cananwill). This disposition was completed in February 2009.
In the U.S. and U.K., premium finance agreements are sold to SPEs, which are considered qualified special purpose entities ("QSPEs"), as defined by Statement No. 140. The QSPEs fund their purchases of premium finance agreements by selling undivided beneficial interests in the agreements to multi-seller commercial paper conduit SPEs sponsored by unaffiliated banks ("Bank SPEs"). In Canada and Australia, undivided interests in the premium finance agreements are sold directly to Bank SPEs. The Bank SPEs are variable interest entities as defined by FIN 46R.
The QSPEs used in the U.S. and U.K are not consolidated in Aon's financial statements because the criteria for sale accounting have been met under Statement No. 140.
Aon's variable interest in the Bank SPEs in these jurisdictions is limited to the retained interests in premium finance agreements sold to the Bank SPEs. The Company reviews all material off-balance sheet transactions annually or whenever a reconsideration event occurs for the continued propriety of its accounting.
Pursuant to the sale agreements, the total amount advanced by the Bank SPEs on premium finance agreements sold to them at any one time is limited by the sale agreements to $1.2 billion and $1.8 billion at December 31, 2008 and 2007, respectively. The Bank SPEs had advanced $981 million and $1.4 billion at December 31, 2008 and December 31, 2007, respectively, on portfolios sold to the Bank SPEs of $1.1 billion and $1.5 billion at December 31, 2008 and December 31, 2007, respectively.
Aon records gains on the sale of premium finance agreements. When Aon calculates the gain, all costs expected to be incurred for the relevant Bank SPEs are included. The gains, which are included in commissions, fees and other revenue in the consolidated statements of income, were $55 million, $64 million and $63 million for the years ended December 31, 2008, 2007 and 2006.
Aon also retains servicing rights for sold agreements, and earns servicing fee income over the servicing period. Because the servicing fees represent adequate compensation for the servicing of the receivables, the Company has not recorded any servicing assets or liabilities.
The third-party bank sponsors or other participants in the Bank SPEs provide the liquidity support and bear the credit risks on the receivables, subject to limited recourse, in the form of over-collateralization provided by Aon (and other sellers) as required by the sales agreements. The over-collateralization of the sold receivables represents Aon's maximum exposure to credit-related
losses, and was approximately $171 million at December 31, 2008. Aon also remains contingently liable should the funding costs of the U.S. Bank SPEs exceed the interest and late fees accrued or collected on the sold U.S. portfolio. The Company continually reviews the retained interest in the sold portfolio, taking into consideration credit loss trends in the sold portfolio, conditions in the credit markets and other factors, and adjusts its carrying value accordingly.
•consolidated EBITDA to consolidated net interest of at least 4 to 1, and
•Juniperus Insurance Opportunity Fund Limited ("Juniperus"), which is an investment vehicle that invests in an actively managed and diversified portfolio of insurance risks; and
In connection with Aon's sale of its U.S. premium finance business, Aon has guaranteed the collection of the principal amount of the premium finance notes sold to the buyer, estimated at closing to be approximately $745 million, if losses exceed the historical credit loss reserve for the business. Historical losses in this business have been very low since the premium finance notes are generally fully collateralized by the lender's right, in the event of non-payment, to cancel the underlying insurance contract and collect the unearned premium from the insurance carrier. The Company does not expect to incur any significant losses relating to this guarantee.
Aon has total letters of credit ("LOCs") outstanding for approximately $327 million at December 31, 2008. A letter of credit for approximately $170 million is for the benefit of VSC related to a non-performance risk of reinsurers of VSC's worker's compensation business in California. There is an additional LOC for $12 million related to the VSC workers compensation program. A letter of credit for approximately CAD 43 million ($35 million at December 31, 2008 exchange rates) was put in place to cover the beneficiaries related to Aon's Canadian pension plan scheme. A $20 million letter of credit, which was issued against the current U.S. credit facility, secures one of the U.S. pension plans. LOCs for $86 million relate to the U.S. Cananwill facility and were put in place to replace overcollateralization for the Cananwill conduits. These LOCs assets were cancelled in February 2009 upon the sale of the U.S. operations. Aon has issued letters of credit to cover contingent payments of approximately $3 million for taxes and other business obligations to third parties. Aon has also issued various other guarantees for miscellaneous purposes at its international subsidiaries for $13 million. Amounts are accrued in the consolidated financial statements to the extent the guarantees are probable and estimable.
Aon has certain contractual contingent guarantees for premium payments owed by clients to certain insurance companies. Costs associated with these guarantees, to the extent estimable and probable, are provided in Aon's allowance for doubtful accounts. The maximum exposure with respect to such contractual contingent guarantees was approximately $11 million at December 31, 2008.
Statement No. 157 establishes a hierarchy of fair value measurements based on whether the inputs to those measurements are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions.
•Level 1 - Quoted prices for identical instruments in active markets.
Aon's Level 3 fair value measurements consist primarily of its PEPS I investment, the retained interests in the sold premium finance agreements and the VSC guarantee.
Other investments are comprised principally of Aon's investment in private equity investments and limited partnerships. Carrying amounts approximate fair value.
Retained interests in the sold premium finance agreements of Aon's premium financing operations are recorded at fair value by discounting estimated future cash flows using discount rates that are commensurate with the underlying risk, expected future prepayment rates, and credit loss estimates.
Guarantees: Fair value is based on discounted estimated future cash flows using published historical cumulative default rates and discount rates commensurate with the underlying exposure.
The following table presents, for each of the fair-value hierarchy levels, the Company's assets and liabilities that are measured at fair value on a recurring basis at December 31, 2008 (in millions):
Gains (losses), both realized and unrealized, included in earnings for the year ended December 31, 2008 are as follows (in millions):
Following inquiries from regulators, the Company commenced an internal review of its compliance with certain U.S. and non-U.S. anti-corruption laws, including the U.S. Foreign Corrupt Practices Act ("FCPA"). An outside law firm with significant experience in the area is overseeing the review. Certain governmental agencies, including the U.K. Financial Services Authority ("FSA"), the U.S. Securities and Exchange Commission ("SEC"), and the U.S. Department of Justice ("DOJ"), have also been investigating these matters. Aon is fully cooperating with these investigations, and has agreed with the U.S. agencies to toll any applicable statute of limitations pending completion of the investigations. On January 8, 2009, the FSA and Aon announced a settlement under which the FSA concluded its investigation by assessing a £5.25 million ($7.9 million) fine on Aon Limited, Aon's principal U.K. brokerage subsidiary, for failing to maintain effective systems and controls. Based on current information, the Company is unable to predict at this time when the remaining SEC and DOJ matters will be concluded, or what regulatory or other outcomes may result.
appeal of this preliminary decision. In July 2008, Aon reached a settlement with the underwriters under which the underwriters agreed to pay a portion of the ultimate recovery by Standard Life in exchange for Aon dropping its appeal of the preliminary decision. In subsequent proceedings in the Commercial Court, Aon will vigorously contest Standard Life's claims based on a variety of legal and factual arguments. Aon has a potential negligence claim against a different third party which provided advice with respect of the relevant policy language, and Aon further believes that, as a result of an indemnity given to Aon by a third party, Aon is entitled to indemnification in whole or part for any losses in this matter.
Although the ultimate outcome of all matters referred to above cannot be ascertained, and liabilities in indeterminate amounts may be imposed on Aon or its subsidiaries, on the basis of present information, amounts already provided, availability of insurance coverages and legal advice received, it is the opinion of management that the disposition or ultimate determination of such claims will not have a material adverse effect on the consolidated financial position of Aon. However, it is possible that future results of operations or cash flows for any particular quarterly or annual period could be materially affected by an unfavorable resolution of these matters.
Aon classifies its businesses into two operating segments: Risk and Insurance Brokerage Services and Consulting. Unallocated income and expenses, when combined with the operating segments and after the elimination of intersegment revenues, total to the amounts in the accompanying consolidated financial statements. Results relating to Aon's remaining property and casualty insurance underwriting operations that are in runoff, which were previously included in unallocated income and expense, have been reclassified to discontinued operations for all periods presented.
The accounting policies of the operating segments are the same as those described in Note 2, 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 accounts for intersegment revenue as if the revenue were from third parties, that is, considered by management to be at current market prices.
The Risk and Insurance Brokerage Services segment consists principally of Aon's retail and reinsurance brokerage operations, as well as related insurance services, including underwriting management, captive insurance company management services, investment banking products and services, and premium financing.
Commissions, fees and other by subsegment is as follows (in millions):
(2)Includes depreciation and amortization expense. A reconciliation of segment income before tax to income from continuing operations before provision for income tax is as follows (in millions):
Unallocated expenses include administrative costs not attributable to the operating segments, such as corporate governance costs. Interest expense represents the cost of worldwide debt obligations.