We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from Mack and Parker, one of our subsidiaries. This facility, totaling approximately 3,500 square feet, contains corporate, finance, administration, sales and customer support functions. The lease on the premises expires on October 1, 2011. In addition, our brokerages lease office space in the locations in which they operate, none of which is material. In total, our brokerages hold 154 leases covering 725,800 square feet with a total annual base rent for all of these locations of approximately $9.2 million.
We were formed in November 1998 through the merger of 11 independent insurance brokerages into a new company. The merger was accounted for using the pooling-of-interests method. Accordingly, our results for the year ended December 31, 1998 includes the assets, liabilities, shareholders’ equity, revenue and expenses of the combined companies, without adjustments.
Our results for the four year period ending December 31, 2002 reflect the acquisition of brokerages that occurred in each respective period. These acquisitions were accounted for using the purchase method. Thus, results of acquisitions are only included from the date of acquisition forward. Accordingly, the results in each period are not directly comparable.
Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain significant respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP
As discussed in note 2, “Summary of significant accounting policies,” of the notes to the audited consolidated financial statements, we adopted Canadian Institute of Chartered Accountants (CICA) Section 3062 on January 1, 2002. Upon adoption of CICA Section 3062, goodwill is no longer amortized. The following table illustrates the effect that CICA Section 3062 would have had on net earnings and per share information under Canadian GAAP for the years ended December 31, 2002, 2001, 2000, 1999, and 1998 had goodwill not been amortized:
As discussed in the section “Effects of New Accounting Pronouncements” included in note 18, “Reconciliation to U.S. GAAP” of the notes to the audited consolidated financial statements, we adopted Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 (SFAS No. 142) on January 1, 2002. Upon adoption of SFAS No. 142 goodwill is no longer amortized. The following table illustrates the effect that SFAS No. 142 would have had on net earnings and per share information under US GAAP for the years ended December 31, 2002, 2001, 2000, 1999, and 1998, had goodwill not been amortized:
As part of our acquisition of Kaye, we acquired Old Lyme, which we have sold to a subsidiary of Fairfax. See note 1 to our audited consolidated financial statements for more information. Under U.S. GAAP, interest expense on debt we incurred to finance the purchase of Old Lyme is not charged to earnings. See note 18 to our audited consolidated financial statements for more information.
Under U.S. GAAP, loans granted to employees under the executive share purchase plan must be included as a reduction to shareholders’ equity. See note 18 to our audited consolidated financial statements for more information.
Reference to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (United States GAAP) and to the extent that they effect us are described in Note 18 to our audited consolidated financial statements.
Hub is a leading North American insurance brokerage providing a wide variety of property and casualty, life and health, employee benefits, investment and risk management products and services from 122 locations across North America. We were formed in November 1998 through the merger of 11 independent, privately held insurance brokerages.
Revenue. From 1998 through 2002 our annual revenue increased from $38.7 million to $220.0 million, representing a growth rate compounded annually (CAGR) of 54%. Growth related to acquisitions during this period represented $153.9 million, or 85% of the increase. Organic growth was $27.4 million or 15% of the increase. We define organic growth as an increase in revenue for one period as compared to a prior period, including net new business and net increases in commissions from existing business. Revenue from a brokerage we acquire is excluded from the calculation of organic growth for the first 12 months after the acquisition.
The chart below shows that in the last three years acquisitions and organic growth increased the portion of revenue generated in the United States to 61% in 2002 from 21% in 2000. We expect that future acquisitions in the United States, will further increase the percentage of revenue and earnings derived from our U.S. Operations.
In Canada we operate three personal insurance call centers and we are also the largest broker of government underwritten auto insurance in the province of British Columbia. This causes the weighting of personal lines insurance to be heavier in Canada.
U.S. Operations have a heavier concentration of commissions from group benefits, usually purchased through businesses and therefore classified as commercial insurance, while Canada’s public health care system reduces the insurance premiums from this type of coverage in Canada.
In addition to commissions, we also earn revenue on volume overrides and contingent commissions related to the total of all insurance accounts placed by a brokerage with an insurance company, otherwise known as a book of business.
Volume overrides are additional compensation paid by insurance companies to brokerages on the basis of the overall volume of business a brokerage places with the insurance company.
Volume overrides and contingent commissions are typically calculated in the first or second quarter of the following year by the insurance companies and are paid once calculated. In 2002, $11.5 million, or 5.2% of our total revenue, was derived from contingent commissions and volume overrides.
The table below shows a breakdown of our revenue by segment and type for 2002 including organic growth:
Total revenue from U.S. Operations increased by $58.8 million, or 78%, to $134.2 million in 2002 from $75.4 million in 2001. Excluding the effect of acquisitions, total revenue increased $11.9 million, or 16%, primarily due to increases in commission income. Commission income increased by $49.4 million, or 69%, to $120.6 million in 2002 from $71.2 million in 2001. Excluding the effect of acquisitions, commission income increased $9.4 million, or 13% due to organic growth and higher premium rates. Revenue from contingent commissions and volume overrides increased by $6.1 million, or 360%, to $7.8 million in 2002 from $1.7 million in 2001. Excluding the effect of acquisitions of $4.2 million, contingent commissions and volume overrides increased by $1.9 million, or 111%, as compared with the prior year. Of this increase, $1.2 million was attributable to contingent commissions earned in the third and fourth quarters of 2002 from Fairfax, as previously discussed, and the remainder was the result of enhanced relationships established with other insurance companies. Other income, which includes fees and interest income, increased by $3.3 million, or 129%, to $5.8 million in 2002 from $2.5 million in 2001. Excluding the effect of acquisitions of $2.7 million, other income increased $0.6 million, or 22% from 2001. This increase is due to an increase in income earned related to the financing of client premiums partially offset by lower interest income as a result of a decrease in interest rates compared with the prior year.
or 24%, to $1.9 million in 2002 from $2.5 million in 2001. This decrease was attributable primarily to lower interest rates in 2002 compared with 2001.
Compensation. Compensation costs in 2002 increased by $30.7 million, or 35%, to $118.7 million from $88.0 million in 2001. Compensation costs as a percentage of total revenue decreased 3% to 54% from 57% in 2001. This proportional decrease resulted largely from revenue growth as certain fixed compensation costs remained constant, and from a decrease in the accrual of executive management profitability bonuses (approximately $4.7 million or 2.1% of revenue) associated with the granting of stock options. In 2002 we changed our executive management bonus plan to require that 50% of earned bonuses be paid with stock option awards.
Depreciation. Depreciation expenses increased by $1.6 million, or 39%, to $5.5 million in 2002 from $3.9 million in 2001. Depreciation expenses remained unchanged as a percentage of total revenue at 3% in both 2002 and 2001.
Interest expense. Interest expense decreased by $0.1 million, or 2%, to $7.3 million in 2002 from $7.4 million in 2001. In June 2002, we repaid $122.5 million of our total outstanding long-term debt and subordinated convertible debentures with proceeds from the sale of Old Lyme and our U.S. initial public offering. This reduction in debt decreased interest expense in the third and fourth quarter of 2002 by approximately $1.5 million per quarter compared to 2001.
Gain on put option liability. The gain on put option liability of $0.2 million in 2002, as compared to $0.7 million in 2001, reflect changes in the fair value of put options granted by us. We issued put options as consideration for certain businesses acquired in the second and third quarters of 2001. The related put option liability is classified as long-term debt at fair value until such time as the options are exercised or expire. Factors affecting the fair market value of the put option are the stock price, stock volatility, and interest rates.
Non-cash stock option compensation. Non-cash stock option compensation of $1.1 million in 2002 reflects the impact of approximately 1.3 million stock options granted in June of 2002. The options were granted with an exercise price of $15.67 per share (fair market value at date of grant) and vest evenly over three years. The options expire in seven years. Our policy is to expense the fair value of stock options granted to employees over the period in which entitlement to the compensation vests. Non-cash stock option compensation was 0.5% of total revenue for 2002.
Provision for income tax expense. Income taxes in 2002 and 2001 amounted to $14.3 million and $5.3 million, respectively, resulting in an effective tax rate of 33% and 34% in 2002 and 2001, respectively. This decrease in effective tax rate was primarily the result of the non-taxable gain of $2.6 million on the sale of Old Lyme.
Revenue. We increased total revenue by $58.8 million, or 62%, to $154.0 million in 2001 from $95.2 million in 2000. Of this increase, $55.6 million or 95% was attributable to acquisitions and reflects the inclusion of the results of each brokerage we acquired during the year from the respective date of each acquisition. Commission income increased by $56.7 million or 66%, to $143.1 million in 2001 from $86.4 million in 2000. Excluding the effect of acquisitions, commission income increased $4.5 million or 5%, primarily due to organic growth, including premium rate increases. Revenue from contingent commissions and volume overrides increased by $1.0 million or 20% to $5.9 million in 2001 from $4.9 million in 2000. This increase resulted primarily from acquisitions. For 2001, other income, which includes fees and interest income, increased by $1.1 million or 28% to $5.0 million from $3.9 million in 2000. This increase resulted primarily from acquisitions.
Total revenue from U.S. Operations increased by $55.4 million, or 277%, to $75.4 million in 2001 from $20.0 million in 2000. This increase was primarily due to acquisitions. Excluding the effect of acquisitions, total revenue increased $2.1 million or 10% primarily due to organic growth.
Selling, occupancy and administration. Selling, occupancy and administration expenses increased by $13.5 million, or 62%, to $35.3 million in 2001 from $21.8 million in 2000. Selling, occupancy and administration expenses as a percentage of total revenue of 23% remained unchanged in both 2001 and 2000.
Depreciation. Depreciation expenses increased by $2.0 million, or 105%, to $3.9 million in 2001 from $1.9 million in 2000. Depreciation expenses as a percentage of total revenue increased to 3% in 2001 from 2% in 2000. This increase was primarily due to property and equipment that we acquired with our brokerage acquisitions.
Provision for income tax expense. Income taxes for 2001 and 2000 amounted to $5.3 million and $5.4 million, respectively, resulting in an effective tax rate of 34% and 47% for 2001 and 2000, respectively. The decrease in our effective income tax rate was the result of a greater proportion of our revenue earned outside of Canada, where income is taxed at lower rates.
We act as an intermediary between insurance companies and their insured clients. As such, we collect and hold premiums paid by clients on behalf of the insurers. We deduct commissions and other expenses from these payments and hold the remainder in trust for the insurers. We earn interest on those funds during the time between receipt of the cash and the time the cash is paid out to the insurers. However, we may not use the funds for any purpose and we must remit the funds within a specified period after the effective date of the respective policy. The cash we hold in trust is shown separately on our balance sheet. On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
In 2002, $2.9 million of cash was provided by financing activities. $80.7 million was used to repay short-term and long-term debt, $4.5 million was used for the payment of dividends, and $88.1 million of net proceeds was provided from our U.S. initial public offering.
In 2002, $8.4 million of cash was used by investing activities. The sale of Old Lyme, other brokerages and investments generated $46.8 million, the purchase of property and equipment used $4.5 million, and the purchase of brokerages used $50.7 million.
As of December 31, 2001, we had cash and cash equivalents of $27.0 million an increase of $7.1 million from $19.9 million as of December 31, 2000. During 2001, $8.8 million of cash was provided by operating activities, primarily as a result of increased net earnings. Long-term debt financing and bank debt financing generated $137.8 million of cash and share capital issued, net of repurchases, also generated cash of $3.3 million. From these amounts and existing cash balances, $123.4 million (net of $25.4 million cash received) was used to acquire brokerages, $5.2 million was used to repay long-term debt and capital leases, $3.6 million was used to pay dividends, and $10.9 million was used for additions to property and equipment and other assets.
As of December 31, 2000, we had cash and cash equivalents of $19.9 million, a decrease of $1.5 million from $21.4 million as of December 31, 1999. During 2000, $10.9 million of cash was provided from operating activities primarily as a result of increased net earnings adjusted for non-cash income and expenses. Long-term debt financing generated $29.8 million of cash and the sale of other assets generated $2.8 million of cash. From these amounts and existing cash balances, $18.9 million was used to acquire brokerages, $2.8 million was used to repurchase our common shares, $18.9 million was used to repay long-term debt, capital leases, and bank debt, $2.5 million was used to pay dividends, and $2.1 million was used for additions to property and equipment.
$50 million facility. Borrowings under this facility are accessed at a floating rate of 112.5 basis points above LIBOR, which was 1.42% as of December 31, 2002. This facility expires on June 20, 2003 and requires us to maintain certain financial ratios. We intend to extend this facility for a further period of one year, but if the revolving period is not extended, any amounts outstanding will automatically convert into a three-year term
As of December 31, 2002, we had $8.3 million of subsidiary debt comprised of various notes payable, term loans and capital leases. We intend to repay these liabilities from internally generated cash flow, existing cash balances and/or borrowings under our credit facilities as the subsidiary debt becomes due during 2003 through 2010. Of the outstanding subsidiary debt, $2.7 million is secured by liens on certain assets of our subsidiaries.
As of December 31, 2002, we had outstanding $35 million aggregate principal amount of 8.5% convertible subordinated notes due June 28, 2007 held by certain subsidiaries of Fairfax (the Fairfax notes).
We believe that our existing cash, funds generated from operations and borrowings available under our credit facilities, will be sufficient to satisfy our financial requirements, including some strategic acquisitions, during the next twelve months. We may finance acquisitions with available cash or an existing credit facility, but may, depending on the number and size of future acquisitions, need to supplement our finance requirements with the proceeds from debt financing, the issuance of additional equity securities, or a combination of both. If we are unable to obtain additional financing on acceptable terms, the extent to which we can increase our market share or expand our business through acquisitions may be limited.
The table below summarizes our contractual obligations and commercial commitments as of December 31, 2002:
In the ordinary course of business, we are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on our consolidated financial position or our results of operations.
We report our revenue in U.S. dollars. Our Canadian operations earn revenue and incur expenses in Canadian dollars. Given our significant Canadian dollar revenue, we are sensitive to the fluctuations in the value of the Canadian dollar and are therefore exposed to foreign currency exchange risk. Foreign currency exchange risk is the potential for loss in revenue and net income as a result of a decline in the U.S. dollar value of Canadian dollar revenue due to a decline in the value of the Canadian dollar compared to the U.S. dollar.
Our significant accounting polices are more fully described in Note 2 to our consolidated financial statements. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts and policies, our observance of trends in the insurance industry, information provided by our clients and information provided by outside sources, as appropriate. Our critical accounting policies include the recognition of commission income, the allocation of the purchase price of an acquisition, the measurement of goodwill and other intangibles, the valuation of put options granted on our common shares and the valuation of stock-based compensation. These policies are discussed below.
We recognize commission income and fees as of the effective date of our client’s policy unless information is not available relating to the determination of their policy premiums, in which case we recognize commission income and fees related to that policy when that information becomes available and the revenue can be reasonably determined. We maintain an allowance for estimated policy cancellations and commission returns based upon the application of historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The allowance for estimated policy cancellations is based on our management’s judgment, and is regularly evaluated by management by taking into consideration factors such as changes in the nature and volume of policies; trends in actual and forecasted policy cancellations; and current economic conditions that may affect the likelihood of
client policy changes or cancellations. If our actual policy cancellation rates are significantly different from our historical policy cancellation rates, and those changes have not been adjusted for in the allowance, our actual commission income may be significantly different from what we estimated.
Effective January 1, 2002, we adopted Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board Handbook Section 3062 and the U.S. Financial Accounting Standards Board SFAS No. 142, which change and conform the recognition, measurement and disclosure of “Goodwill and Other Intangible Assets” under Canadian and U.S. GAAP.
These new accounting standards require that we no longer amortize goodwill and intangible assets with indefinite useful lives. We test at least annually for impairment at the reporting unit level. We determine impairment by comparing the fair value of a reporting unit to its carrying value. The fair value of a reporting unit may be determined using a number of market valuation methods including quoted market prices, discounted cash flows and net realizable values. The use of assumptions and estimates is inherent in each of these valuation techniques. The valuation method and the underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests and, as a result, significantly different results of operations.
The cost of definite lived intangible assets is amortized over the estimated remaining useful life of the assets. We regularly evaluate whether events or changes in circumstances indicate the carrying amount of intangibles, other than goodwill, may warrant revision or may not be recoverable. The estimation of the useful economic lives and the selection of estimates and assumptions used in conducting impairment tests require the exercise of judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests of the assets and, as a result, significantly different results of operations.
As described in note 8 to our audited consolidated financial statements, we have granted put options on certain of our common shares which were issued to the former owners of brokerages we acquired in 2001. In preparing our financial statements in accordance with Canadian GAAP, the fair value of the put options has been classified as long-term debt until such time as the options are exercised or expire. Changes in the fair value of these options are recorded in earnings. The fair value of the put options is determined using the Black-Scholes valuation model, which requires underlying assumptions and estimates. In particular, management uses its judgment to determine the volatility of the underlying common shares and dividend yield. The fair value model is particularly sensitive to the changes in the price and price volatility of our common shares. The assumptions used are based on management’s
judgment and the use of different judgments, estimates, and assumptions may produce significantly different results of fair value of the options and, as a result, significantly different results of operations.
During 2002, our shareholders approved an equity incentive plan and we granted stock options for 1.27 million common shares to employees. As of December 31, 2002, we have an obligation to issue approximately $1.2 million of additional stock options for 2002 executive management bonuses. We measure the fair value of stock options at the date of grant of the award and recognize this amount as compensation expense over the vesting period of the options. An alternative accounting treatment would be to follow the intrinsic value method for accounting for stock options.
We estimate the fair value of the stock options granted using the Black-Scholes valuation model, which requires us to make assumptions in relation to the expected term of the stock option, volatility in the price of the underlying common shares, interest rates and dividend yield. The fair value model is particularly sensitive to the changes in the price and price volatility of our common shares. The assumptions used are based on management’s judgment and the use of different judgments, estimates, and assumptions could produce significantly different results of fair value of the stock options and, as a result, significantly different results of operations.
Both Section 3062 and SFAS No. 142 eliminate the amortization of goodwill, require annual impairment testing of goodwill and introduce the concept of definite and indefinite life intangible assets. Indefinite life intangible assets, similar to goodwill, will no longer be amortized and will be tested at least annually for impairment. Definite life intangible assets will be amortized over the estimated useful life of the asset.
In accordance with Section 3062 and SFAS No. 142, we completed our impairment testing on the balance of goodwill and intangible assets as of January 1, 2002 and January 1, 2003. Based on the testing performed, no impairment losses were incurred.
As required under Section 3062 and SFAS No. 142, no goodwill amortization expense was incurred for the year ended December 31, 2002. The following tables illustrate the effect that Section 3062 and SFAS No. 142 would have had on net earnings and per share information under Canadian and U.S. GAAP respectively for the years ended December 31, 2001 and 2000 if goodwill had not been amortized:
In November 2001, the CICA Accounting Standards Board issued Handbook Section 3870, “Stock-based Compensation and Other Stock-based Payments”, effective for fiscal years beginning on or after January 1, 2002 for public enterprises. We issued stock-based compensation for the first time in 2002 and adopted Section 3870.
Hub International Limited (the “Company”) is an international insurance brokerage that provides a variety of property and casualty, life and health, employee benefits, investment and risk management products and services. The Company’s shares are listed on both the Toronto Stock Exchange (TSX: HBG) and the New York Stock Exchange (NYSE: HBG).
From the date of acquisition, the net assets and liabilities of Old Lyme were recorded at their original cost in the Company’s consolidated balance sheet as an investment held for sale. The net earnings of the Old Lyme operations from the date of acquisition in June 2001 were excluded from the Company’s consolidated statements of earnings. On December 31, 2001, the Company entered into a stock purchase agreement with Fairfax Inc. to sell all of the issued and outstanding shares of Old Lyme, pending regulatory approval. Fairfax Inc. is a subsidiary of Fairfax Financial Holdings Limited (Fairfax), which owns approximately 27% of the Company’s outstanding shares as of December 31, 2002. The sale of Old Lyme to Fairfax Inc. was completed on May 30, 2002. The agreed upon purchase price (which was considered to be fair market value) was Old Lyme’s December 31, 2001 shareholder’s equity of approximately $42.8 million determined in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP), plus interest at four percent per annum from January 1, 2002 until May 30, 2002, resulting in total sale proceeds of approximately $43.5 million. The difference between the actual purchase price and the carrying amount of the investment held for sale was recorded as a gain on the sale of investment during the second quarter of 2002 in the amount of approximately $2.6 million. This gain increased annual basic earnings per share and diluted earnings per share by $0.11 and $0.09, respectively. This gain was not taxable. Approximately $36.5 million of the sale proceeds were used to repay bank debt. As a result of agreements entered into with Fairfax Inc. on the closing of the sale of Old Lyme, the Company is eligible to earn contingent commissions from Fairfax Inc. related to loss ratios on premium volume placed with Old Lyme.
Cash and cash equivalents consist of cash, and highly-liquid investments having maturities of three months or less.
The Company’s financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains cash with banks in excess of federally insured limits and is exposed to the credit risk from this concentration of cash. The Company performs ongoing credit evaluations of its customers financial condition and generally requires no collateral. No single client accounted for more than ten percent of total client premiums nor more than ten percent of revenue for the years ended December 31, 2002, 2001 and 2000, respectively.
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recorded based on useful economic lives of the related assets which range from three to ten years, on a declining balance method or on a straight line basis. Leasehold improvements are amortized on the straight-line method over the term of the related lease. Upon sale or retirement, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is reflected in earnings.
Acquisitions of subsidiaries have been accounted for using the purchase method, whereby the results of acquired companies are included only from the date of acquisition.
Intangible assets other than goodwill which do not have indefinite lives are amortized over their useful lives. These intangible assets are subject to an annual impairment test comparing carrying values to net recoverable amounts.
In accordance with Section 3062, the Company completed its impairment testing on the balance of goodwill and intangible assets as of January 1, 2002 and January 1, 2003. Based on the testing performed, no impairment losses were incurred.
In accordance with Section 3062, no goodwill amortization expense was incurred for the year ended December 31, 2002. For the year ended December 31, 2001 and 2000, the Company incurred goodwill amortization expense of $4,125 and $3,260 before tax and approximately $3,996 and $2,820 after tax ($0.20 and $0.15 per diluted share), respectively.
The effect of the adoption of Section 3062 on net earnings and earnings per share for the years ended December 31, 2002, 2001 and 2000 was as follows:
Basic earnings per share, excluding the dilutive effect of common share equivalents, is calculated by dividing net earnings by the weighted average number of common shares outstanding for the period. Diluted earnings per share is calculated using the treasury stock method and includes the effects of all potentially dilutive securities. Stock options under the equity incentive plan were not dilutive for the year ended December 31, 2002 and were not included in the calculation of diluted earnings per share as the exercise price of the options exceeds the average market price of the Company’s common shares for the period that the options were outstanding during the year. Earnings per common share have been calculated as follows:
During the fourth quarter 2002, the Company changed the presentation of its cash flow statement. Previously, the cash flow statement reported changes in cash and cash equivalents and trust cash. The new presentation reports changes in cash and cash equivalents only. The new basis of presentation conforms the Company’s cash flow statement presentation in its financial statements prepared in accordance with Canadian GAAP to the requirement of U.S. GAAP.
During 2001, the Company purchased all of the issued and outstanding shares of Kaye, Burnham Stewart Group, Inc. (Burnham) and J.P. Flanagan Corporation (Flanagan), as well as the outstanding shares or net assets of 13 other brokerages, all of which were acquired using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages are summarized as follows:
In addition to the consideration shown above, the previous owners of Flanagan and Nenner are entitled to contingent consideration if certain revenue and profitability targets are met. Purchase price allocations for Flanagan are subject to adjustment for future consideration issued. See note 10 “Commitments and contingencies.”
Included in computer equipment is computer software with a net book value of $2,641 and $1,939 at December 31, 2002 and 2001, respectively. Depreciation expense of $1,087, $621 and $182 was charged against these assets for the year ended December 31, 2002, 2001 and 2000.
As of December 31, 2002 and 2001 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
The Company is unable to estimate the useful life of non-competition covenants and trademarks. These indefinite life intangible assets will be reviewed annually for impairment. Once a non-competition covenant is triggered, following the employee leaving the Company, the Company’s policy is to amortize the related intangible asset over the period of the remaining contractual obligation.
The changes in the carrying amount of goodwill for the years ended December 31, 2002 and 2001, are as follows:
We estimate that our amortization charges for 2003 through 2007 for all acquisitions consummated to date will be:
This term loan is from an insurance carrier. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) and reduce the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Under this incentive arrangement both the annual interest payments as well as the principal payment can be reduced to zero. Credits were earned for 2002 which reduced interest payments to zero from $229.
Certain property and equipment have been pledged as collateral in amounts not less than the outstanding balance at December 31, 2002 and December 31, 2001, respectively.
Borrowings under this $50 million facility totaled $50.0 million and $49.5 million at December 31, 2002 and December 31, 2001, respectively, and are accessed at a floating rate of 112.5 basis points above LIBOR, which was 1.42% and 2.09% at December 31, 2002 and 2001, respectively. This facility expires on June 20, 2003 and requires the Company to maintain certain financial ratios. The Company intends to extend the facility for a further period of one year; however, if the revolving period is not extended, any amounts outstanding will automatically convert into a three-year term loan at a fixed interest rate equal to the Canadian dollar interest swap rate quoted by the lender plus 1.375%. At December 31, 2002, no amounts under this facility remained available to be drawn by the Company. The Company was in compliance with all financial covenants governing this facility as of December 31, 2002 and 2001.
As discussed in note 3(a), the former owners of Burnham have relinquished their right to put options on 1,423 common shares of the Company. Accordingly, an amount of $11,768 previously classified as long-term debt has been reclassed as share capital (see note 11).
The Company will not be required to settle the liabilities in cash if the common share price exceeds C$17.00 on each of the above mentioned exercise dates. Any put options not exercised on the exercise date immediately expire.
In connection with the acquisition of Kaye on June 28, 2001, the Company issued (1) a $28.2 million aggregate principal amount, 8.5% convertible subordinated debenture due June 28, 2006 to a third party (the third-party note); and (2) a $35 million aggregate principal amount, 8.5% convertible subordinated debentures due June 28, 2007 to certain subsidiaries of Fairfax (the Fairfax notes).
The Company has committed to award, under the Company’s equity incentive plan, an aggregate of 266 restricted shares that will be paid for by the participants with loans either from the Company or from a bank (guaranteed by the Company). In addition, the Company has committed to award an aggregate of 471 restricted share units that are exercisable for common shares, without payment of cash consideration. As of December 31, 2002, no restricted shares or restricted share units had been awarded or issued.
Contingent consideration may be payable in connection with the acquisition of Flanagan as follows:
On May 10, 2002, the shareholders of the Company approved an equity incentive plan under which up to 2,100 awards of common shares may be issued to employees and directors of the Company. Awards under the plan may be in the form of restricted shares, restricted share units or stock options. Currently, the maximum number of awards under the equity incentive plan that may be newly issued common shares is limited to 500 and the maximum number of common shares that may be subject to an award granted to participants in any calendar year may not
exceed 1,000 common shares. However, subject to shareholder ratification, the Company’s Board of Directors has approved removing the 500 and 1,000 share limitations currently in the plan.
The aggregate fair value of options granted of $5,995 was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: (i) dividend yield of 1.15%, (ii) expected volatility range of 30%, (iii) risk-free interest rate of 4.14% and (iv) expected life of five years. The fair value of the options granted is being recognized as an expense over the vesting period. For the year ended December 31, 2002, non-cash stock option compensation of $1,078 was expensed with an offsetting credit to contributed surplus.
The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts and other receivables, accounts payable and accrued liabilities at December 31, 2002 and 2001, approximate fair value because of the short maturity of these instruments. The carrying value of the Company’s variable rate debt at December 31, 2002, of $50,587 approximates fair market value.
In connection with the acquisition of Kaye, the Company issued the following subordinated convertible debentures:
The Company believes it is not practicable to estimate the fair value of its subordinated convertible debentures due to the conversion features.
The provision for income tax expense differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 38.6% for 2002, 41.7% for 2001 and 44.0% for 2000, as follows:
The components of the future tax assets and liabilities at December 31, 2002 and 2001, were as follows:
Interest and income taxes paid for the years ending December 31 were:
The Company is an international insurance brokerage, which provides a variety of property, casualty, life and health, employee benefits, investment and risk management products and services. In addition to its Corporate Operations, the Company has identified two operating segments within its insurance brokerage business; Canadian Operations and U.S. Operations. Corporate Operations consist primarily of investment income, unallocated administrative costs, interest expense and the income tax expense or benefit which is not allocated to the Company’s operating segments. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends. Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2002, 2001 and 2000 is as follows:
During 2002, 2001 and 2000, the Company incurred expenses related to rental of premises from related parties in the amount of $1,691, $1,373 and $993, respectively. At December 31, 2002 and 2001, the Company also had accounts receivable due from related parties in the amount of $3,256 and $4,586, respectively, of which the majority were loans to employees to enable them to purchase shares of the Company.
Under Canadian GAAP, the fair value of the put options (determined using the Black-Scholes model) issued in connection with the Burnham and Flanagan acquisitions was allocated to equity instruments on the balance sheet. The balance of the purchase price was allocated to debt. Changes in the value of the put options in periods subsequent to the acquisition dates are included in earnings. Under U.S. GAAP, the fair value of the share consideration and the attached put options is initially recorded in equity. The redemption value of the shares to which the put options are attached has been reclassified as mezzanine equity outside of shareholders’ equity as a result of the put options granted on those shares to certain of the selling shareholders. The fair value of the put options at the date of issuance is also recorded as a debit to shareholders’ equity, representing an unearned compensation expense, as the put options require the selling shareholders to remain employed by the Company in order to be able to exercise the put options. Compensation expense is being recognized using the straight-line method over the period from the issue date to the exercise date.
Section 3062 and SFAS No. 142 - Goodwill and Other Intangible Assets
As required under Section 3062 and SFAS No. 142, no goodwill amortization expense was incurred for the year ended December 31, 2002. The following tables illustrate the effect that Section 3062 and SFAS No. 142 would have had on net earnings and per share information under Canadian and U.S. GAAP respectively for the years ended December 31, 2001 and 1999 if goodwill had not been amortized:
SFAS No. 144, Section 3063 and Section 3475 - Accounting for the impairment or disposal of long-lived assets
The Company adopted SFAS No. 144 effective January 1, 2002 for its U.S. GAAP reporting. The transitional guidance of SFAS No. 144 generally permits long-lived assets classified as held for disposal as a result of disposal activities that were initiated prior to SFAS No. 144’s initial application to continue to be accounted for in accordance with the prior pronouncement applicable for that disposal. As such, the Company’s investment in Old Lyme, which was classified as held for disposal at December 31, 2001, continued to be accounted for in accordance with Canadian and U.S. generally accepted accounting principles applicable at the date that the disposal activities were initiated until its sale on May 30, 2002.
Section 3870 and SFAS No. 148 - Stock-based Compensation and other Stock-based Payments
In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”, effective for financial statements for fiscal years ending after December 15, 2002.
SFAS No. 148 did not have an impact on the Company’s financial position or results of operations as reported under U.S. GAAP as the Company issued stock-based compensation for the first time in 2002.
This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements to remove the inconsistency between Statement No. 4 and APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions regarding the treatment of gains and losses on extinguishment of debt. Statement No. 4 required such gains and losses, where material, to be disclosed as extraordinary which was an exception to Opinion No. 30.
This Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers, which was introduced to provide accounting guidance on the effects of the transition to the provisions of the Motor Carrier Act of 1980 and is no longer required as the transition is completed.
This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions.
The Company will adopt SFAS No. 145 effective January 1, 2003 and does not anticipate that the provisions of SFAS No. 145 will have a material impact on its financial position or results of operations as reported under US GAAP.
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for costs associated with exit or disposal activities”, effective for exit or disposal activities that are initiated after December 31, 2002.
SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and establishes that fair value is the objective for initial measurement of the liability. This Statement rescinds Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” which required that a liability for a cost associated with an exit was recognized at the date of an entity’s commitment to an exit plan.
AcG 13 specifies the circumstances in which hedge accounting is appropriate, including the identification, documentation, designation and effectiveness of hedges and the discontinuance of hedge accounting.
FIN No. 45 - Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others
FIN No. 45 provides a definition and examples of a guarantee and requires disclosure of the nature of the guarantee, the maximum potential amount of future payments, the carrying amount of the related liability, if any, the recourse provisions and assets held as collateral under the terms of the guarantee and the extent to which the proceeds of collateral would cover the maximum potential liability.