The Company's executive offices and certain subsidiary and branch facilities are located at Two Pierce Place, Itasca, Illinois where the Company leases approximately 200,000 square feet of space. The lease commitment on the above mentioned property expires February 28, 2006. The Company operates all of its branch and service offices in leased premises. Certain of these leases for office space have options permitting renewals for additional periods. In addition to minimum fixed rentals, a number of leases contain escalation clauses related to increases in the cost of living in future years. See Note 11 to the Consolidated Financial Statements for information with respect to the Company's lease commitments at December 31, 1997.
Fluctuations in premiums charged by insurance companies have a material effect on the insurance brokerage industry. Commission revenues are based on a percentage of the premiums paid by insureds and generally follow premium levels. Lower premium rates currently prevail among property/casualty insurance carriers resulting in heavy competition for market share. This "soft market" (i.e., lower premium rates) has generally resulted in flat or reduced renewal commissions.
Although 1997 may prove to have the lowest insured property loss experience in a decade, the years 1996 and 1995 were marked with worldwide catastrophes causing billions of dollars of insured losses. Substantial mergers, both domestically and internationally, have resulted in fewer companies in the insurance industry. In spite of these forces which would tend to increase underwriting losses and reduce competition, there have been offsetting factors including favorable investment income, increased underwriting capital and economies of scale after consolidations. The net result has shown no apparent increase in property/casualty rates. Management believes the competitive environment will continue and insurance pricing will not change significantly in 1998.
The Company is looking to the future and exploring not only the core businesses of brokering insurance and risk management services, but is also expanding within the alternative insurance markets and financial and related investment services. Management believes these areas hold opportunities for diversification and future, profitable growth.
The Company's results of operations for all periods prior to December 31, 1997 have been restated to include the operations of Byerly & Company, Inc. on a combined basis as if it had operated as part of the Company. The Company continues to search for merger partners which complement existing operations and provide entry into new market niches and geographic areas. For the effect of this restatement in the aggregate on year-to-year comparisons, see Note 2 to the Consolidated Financial Statements.
Commission revenues increased by $7.8 million or 3% in 1997. This increase is the result of new business production partially offset by lost business. Commission revenues increased by $4.4 million or 2% in 1996. This increase is the result of new business partially offset by lost business and modest renewal rate decreases.
Salaries and employee benefits increased by $4.8 million or 2% in 1997 due principally to salary increases and higher employee benefit costs partially offset by a $4.8 million non-recurring gain recognized in the second quarter of 1997 from the settlement of a defined benefit pension plan at one of the Company's United Kingdom subsidiaries and a 3% reduction in employee head count between December 31, 1997 and 1996. Salaries and employee benefits increased by $9.3 million or 4% in 1996 due principally to salary increases and the annualized effect of prior year new hires along with a corresponding increase in employee benefit expenses. These increases were mitigated by a wage freeze for certain management employees. In 1997, 1996 and 1995, salaries and employee benefits have represented 51%, 53% and 53%, respectively, as a percentage of total revenues.
The Company's overall tax rate of 34% in 1997 and 1996 is less than the statutory federal rate due primarily to the effect of tax benefits generated by certain investments which are substantially offset by state and foreign taxes. The Company's overall tax rate of 38% in 1995 is greater than the statutory federal rate due primarily to the net effect of state and foreign taxes which were partially offset by the tax benefits generated by certain investments and by pre-acquisition income of pooled entities which was taxed to the previous owners. See Note 12 to the Consolidated Financial Statements.
and 1996, there were no borrowings existing under this agreement. The Company also has two term loan agreements (the "Term Loan Agreements") that had outstanding balances of $630,000 and $500,000 at December 31, 1997. Loans under the Term Loan Agreements are due in 1998. In January 1998, the Company retired the remaining loan balance of $630,000 on one of the Term Loan Agreements.
The Company has line of credit facilities of $27.5 million which expire on April 30, 1998. Periodically, the Company will make short-term borrowings under these credit facilities to meet short-term cash flow needs and as of December 31, 1997 and 1996, $15.0 million and $10.0 million, respectively, in short-term borrowings existed under these facilities. These borrowings were used to finance expanded investment activity.
The Company paid $20.0 million in cash dividends on its common stock in 1997. The Company's dividend policy is determined by the Board of Directors and payments are fixed after considering the Company's available cash from earnings and its known or anticipated cash needs. In each quarter of 1997, the Company's Board of Directors declared a dividend of $.31 per share which is $.02 or 7% greater than each quarterly dividend in 1996. In January 1998, the Company announced a first quarter dividend of $.35 per share, a 13% increase over the quarterly dividend in 1997.
Arthur J. Gallagher & Co. (the Company) provides insurance brokerage and risk management services to a wide variety of commercial, industrial, institutional and governmental organizations. Commission revenue is principally generated through the negotiation and placement of insurance for its clients. Fee revenue is generated by providing other risk management services including claims management, information management, risk control services and appraisals in either the property/casualty market or human resource/employee benefit market. The Company operates through approximately 200 offices throughout the United States and six countries abroad.
The accompanying consolidated financial statements include the accounts of the Company and all of its wholly owned subsidiaries. Investments in partially owned entities in which ownership is 50 percent or less are accounted for using the equity method. All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to the prior years' financial statements in order to conform to the current year presentation.
Commission income is generally recognized as of the effective date of insurance policies except for commissions on installment premiums which are recognized periodically as billed. Contingent commissions are recognized when received. Fee income is recognized ratably as services are rendered. The income effects of subsequent premium and fee adjustments are recorded when the adjustments become known. Premiums and fees receivable are net of allowance for doubtful accounts of $859,000 and $889,000 at December 31, 1997 and 1996, respectively.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) reported as a separate component of stockholders' equity. Gains and losses are recognized in income when realized using the specific identification method. The fair value for marketable securities is based on quoted market prices.
Investment strategies are considered trading securities and consist primarily of limited partnerships which invest in common stocks. Securities designated as trading are carried at fair value in the accompanying consolidated balance sheet, with unrealized gains and losses included in the consolidated statement of earnings. The fair value of the investment strategies is determined by reference to the fair values of the underlying common stocks which are based on quoted market prices.
Fixed assets are carried at cost in the accompanying consolidated balance sheet. Furniture and equipment with a cost of $77,591,000 and $72,617,000 at December 31, 1997 and 1996, respectively, are depreciated using the straight- line method over the estimated useful lives of the assets. Leasehold improvements with a cost of $9,167,000 and $8,177,000 at December 31, 1997 and 1996, respectively, are amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the lease terms.
In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per Share," which was required to be adopted on December 31, 1997. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effect of stock options. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. Where appropriate, all earnings per share amounts for all periods have been restated to conform to the SFAS 128 requirements.
Earnings per share are computed based on the weighted average number of common and common equivalent shares outstanding during the respective period. Common equivalent shares include incremental shares from dilutive stock options since the date of grant using the treasury stock method.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES--(CONTINUED) of general purpose financial statements. SFAS 130 will require that enterprises (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and capital in excess of par value in the stockholders' equity section of the consolidated balance sheet. SFAS 130 will not have any impact on the Company's consolidated results of operations, financial position or cash flows.
In 1997, the Company acquired substantially all of the net assets of one insurance brokerage firm and two benefits consulting companies in exchange for 263,000 shares of its common stock. In 1996, the Company acquired substantially all of the net assets of five insurance brokerage firms and one investigative services company in exchange for 1,115,000 shares of its common stock. These acquisitions were accounted for as poolings of interests and, except for two of the 1997 acquisitions and three of the 1996 acquisitions whose results were not significant, the consolidated financial statements for all periods prior to the acquisition dates have been restated to include the operations of these companies.
In 1997, the Company acquired a majority equity interest in a risk management company which was accounted for as a purchase. In 1996, the Company also acquired a majority equity interest in a risk management company which was accounted for as a purchase. The Company paid cash in both of these transactions, which were not material to the consolidated financial statements.
The net change in unrealized gain (loss) on investment strategies included in the table above amounted to ($1,813,000) in 1997, $3,928,000 in 1996 and ($171,000) in 1995. In 1997 and 1995, the Company sold several underperforming or geographically undesirable operations and recorded aggregate gains on these sales of $6,757,000 and $2,035,000, respectively. The gains on these sales of operations have been included in other income in the foregoing table. The net assets sold and the operating results included in the consolidated statement of earnings related to these operations are not material to the consolidated financial statements. Also in 1997, the Company recorded a gain on a real estate transaction of $1,790,000, which has also been included in other income in the foregoing table.
4. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE--(CONTINUED) carrying value of $22,121,000 and a fair value of $22,360,000. The securities collateralizing the agreements were held by two primary dealers. At December 31, 1996, these securities had a carrying value of $23,034,000 and a fair value of $23,262,000.
The table below summarizes certain information about the Company's capital stock at December 31, 1997 and 1996 (in thousands, except per share data):
Options to purchase 644,000, 1,313,000 and 22,000 shares of common stock were outstanding during 1997, 1996 and 1995, respectively, but were not included in the computation of the dilutive effect of stock options. These options were excluded from the computation because the options' exercise prices were greater than the average market price of the common shares and, therefore, would be antidilutive.
The Company has incentive and nonqualified stock option plans for officers and key employees of the Company and its subsidiaries. The options are granted at the fair market value of the underlying shares at the date of grant. Options granted under the nonqualified plan become exercisable at the rate of 10% per year beginning the calendar year after the date of grant or earlier in the event of death, disability or retirement. Options expire ten years from the date of grant, or earlier in the event of termination of the employee. No options may be granted under the plan ten years after its inception.
In addition, the Company has a non-employee director's stock option plan which currently authorizes 200,000 shares for grant, with Discretionary Options granted at the direction of the Option Committee and Retainer Options granted in lieu of the directors' annual retainer. Discretionary Options shall be exercisable at such rates as shall be determined by the Committee on the date of grant. Retainer Options shall be cumulatively exercisable at the rate of 25% of the total Retainer Option at the end of each full fiscal quarter succeeding the date of grant. The excess of fair market value at the date of grant over the option price for these nonqualified stock options is considered compensation and is charged against earnings ratably over the vesting period.
The Company also has an incentive stock option plan for its officers and key employees resident in the United Kingdom. The United Kingdom plan is essentially the same as the Company's domestic employee stock option plans, with certain modifications to comply with United Kingdom law and to provide potentially favorable tax treatment for grantees resident in the United Kingdom.
The Company accounts for stock option grants in accordance with APB 25, and, accordingly, recognizes no compensation expense for stock options granted to employees. Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," requires disclosure of pro forma information regarding net earnings and net earnings per share, using pricing models to estimate the fair value of stock option grants. Had compensation expense for the Company's stock option plans been determined based on the estimated
8. STOCK OPTION PLANS--(CONTINUED) fair value at the date of grant consistent with the methodology prescribed under SFAS 123, approximate net earnings and net earnings per share would have been as follows (in thousands, except per share data):
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee and director stock options have characteristics significantly different from those of traded options, and because changes in the selective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee and director stock options.
The following is a summary of all of the Company's stock option activity and related information (in thousands, except exercise price data):
Options with respect to 1,525,000 shares were available for grant at December 31, 1997.
The Company accounts for the defined benefit pension plan in accordance with Statement of Financial Accounting Standards No. 87 (SFAS 87), "Employers' Accounting for Pensions." The difference between the present value of the projected benefit obligation at the date of adoption of SFAS 87 and the fair value of plan assets at that date is being amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits.
The following table sets forth the plan's estimated funded status and amounts recognized in the accompanying consolidated financial statements (in thousands):
Pension expense for the plan consists of the following (in thousands):
The following assumptions were used in determining the actuarial present value of the plan's projected benefit obligation for 1997, 1996 and 1995:
The Company has a contributory savings and thrift plan covering the majority of its employees. Company contributions are at the discretion of the Company's Board of Directors and may not exceed the maximum amount deductible for federal income tax purposes. The Company contributed $2,651,000, $3,151,000 and $1,179,000 in 1997, 1996 and 1995, respectively.
The Company also has a foreign defined contribution plan which provides for basic contributions by the Company and voluntary contributions by employees which are matched 100% by the Company, up to a maximum of 5% of salary, as defined.
Net expense (income) for foreign retirement plans amounted to $(3,180,000) in 1997, $1,383,000 in 1996 and $1,703,000 in 1995.
In 1992, the Company amended its health benefits plan to eliminate retiree coverage, except for current retirees and those employees who had already attained a specified age and length of service. The retiree health plan is contributory, with contributions adjusted annually and is funded on a pay-as- you-go basis.
The following table sets forth the estimated funded status and amounts recognized in the accompanying consolidated financial statements (in thousands):
Total rent expense, including rent relating to cancelable leases and leases with initial terms of less than one year, amounted to $30,446,000 in 1997, $28,519,000 in 1996 and $27,859,000 in 1995.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31 are as follows (in thousands):
Financial data by geographic areas of operation are as follows (in thousands):
Net foreign exchange gains were $74,000 in 1997, $253,000 in 1996 and $85,000 in 1995.
Quarterly operating results for 1997 and 1996 were as follows (in thousands, except per share data):