We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from HUB Illinois, one of our subsidiaries. This facility, totaling approximately 8,200 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, we hold 198 leases covering approximately 974,000 square feet with a total annual base rent for all of these locations of approximately $12.4 million.
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, 2004, 2003, 2002, 2001 and 2000 had goodwill not been amortized:
We generally acquire larger, “hub” brokerages, for a combination of cash and stock. Although there are variations in the purchase terms for each hub, our goal is to pay 30%-70% of the “hub” purchase price in our common stock, while setting escrow periods of up to 10 years for the sellers to hold these shares. We believe the use of escrowed stock in major acquisitions creates increased alignment of interests between senior managers and the public shareholders of the corporation. We have paid all cash for the acquisition of certain brokerages, and may pay an all cash purchase price for brokerages in the future. As of December 31, 2004, senior managers of the company and its hubs owned approximately 2,129,000 shares, or 7% of total shares outstanding, while all employees as a group held approximately 7,075,000 shares, or 23.3% of total shares outstanding.
During the three years ended December 31, 2004, we acquired 19 brokerages in the United States and another 8 brokerages in Canada, adding combined revenue of $183.2 million from the dates of acquisition. Of these acquisitions, 7 were regional hubs, all based in the United States. United States revenue has grown to 66% of our total revenue primarily as a result of acquisitions and organic growth. Organic growth is similar to the same-store-sales calculation used by retailers. It includes revenue growth from units included in our financial statements for at least 12 months. Because we apply the purchase method of accounting for acquisitions, acquired brokerages’ financial results are included only from the date of acquisition.
Our management believes pricing discipline is a key to successful acquisition efforts and has chosen not to complete potential acquisitions that did not meet our pricing criteria. We have a goal of acquiring an average of 2 hub operations per year, increasing our base of U.S. hubs to 15 from the current 9. Acquisitions will be driven by opportunity, pricing and fit, however, not by a rigid timetable.
Commercial lines have increased to 79% of our total revenue, largely as a result of our more rapid expansion in the United States, where middle market companies and other commercial clients are the primary source of revenue. In 2004, commercial lines constituted 89% of U.S. revenue and 60% of Canadian revenue. In British Columbia (Canada), we are the largest broker of government underwritten auto insurance, a personal line. In addition, Canada’s public health care system eliminates a significant portion of the demand for employer-provided health insurance, a major commercial product line for us in the United States.
Retail sales and service centers that target middle-market companies, providing a broad range of property and casualty insurance, life and health insurance, risk management and financial services;
Wholesale life and financial services centers, known as managing general agents, provide life, financial and investment products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal, Toronto, San Francisco, Albuquerque and Mechanicsburg, PA; and
We have a diverse mix of products, services, insurer relationships and distribution channels, and as a result, our revenue and profitability levels are not usually highly susceptible to major changes related to a single product or service. However, general economic trends may influence overall insurance rates, commissions and availability or costs of individual types of coverage, which in turn may affect our revenue and profitability levels. Our ability to achieve organic revenue growth is not solely dependent on rising or declining rates, but results from a more complex mixture of general economic growth, access to coverage from insurers and marketing/ sales expertise.
Our strategic plan has traditionally included a highly decentralized structure that offered a large degree of autonomy to each regional “hub” operation. We have sought to acquire strong businesses and retain the services and commitment of the management teams that built those businesses successfully. Decentralization has been a core component of this growth plan. In 2004 we began investing more in the coordination of additional functions from our head office to enhance a cross-selling, international collaboration, marketing efficiencies, total expense management and financial control initiatives.
Because we are a service organization, compensation and other personnel costs make up the largest component of total expenses - 70% in 2004. Property and equipment are comprised primarily of furniture, computer systems and office equipment. Therefore, Hub’s capital resources, including external borrowings, internally generated cash flow and issuance of common shares, are targeted primarily toward acquisitions.
A significant portion of our revenue growth in 2004 was the result of brokerages acquired. During 2004, we acquired seven insurance brokerages, including Talbot, and divested of three small brokerages in Canada. Total annual revenue of these acquired brokerages was $115.4 million of which $57.8 million is included in our 2004 revenue. As a result of these acquisitions and 5% organic growth, which includes the strengthening of the Canadian dollar in 2004 compared to the U.S. dollar, we reported a 26% increase in revenue to $360.9 million in 2004.
The table below shows a breakdown of our revenue by segment and type for 2004 including organic growth for 2004:
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Contingent Liabilities” for information regarding our legal proceedings.
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2004 and 2003 results included a number of factors that can complicate direct comparisons. To increase investor understanding, the following chart shows the net earnings and diluted earnings per share impact specific items would have had if they had not occurred over the past two years.
Cash compensation expense for 2004 increased 28% to $199.5 million from $156.3 million, while non-cash stock based compensation grew 335% to $20.9 million from $4.8 million in 2003. As a percentage of revenue, cash
The Company estimates the non-cash stock based compensation expense for 2005 through 2010 will be:
Selling, occupancy and administration expense increased 29% to $73.2 million in 2004. As a percentage of revenue, selling, occupancy and administration expense remained constant at 20% despite additional costs related to the implementation of the Sarbanes-Oxley Act of 2002 of $2.5 million and legal costs associated with various investigations regarding contingent commissions arrangements of $0.4 million.
Our net earnings decreased 28% or $10.3 million to $26.2 million in 2004 due to the impact of non-cash stock based compensation, write off of trademarks and the impact of foreign exchange. Diluted earnings per share decreased $0.34 per diluted share to $0.80 in 2004.
Of the $66.4 million in new revenue we reported, $40.0 million, or 60% reflected growth through acquisition, while $26.4 million, or 40% resulted from organic growth. By comparison, acquired revenue added $46.1 million, or 70% of 2002’s sales growth, while organic growth contributed $19.9 million, or 30% of our revenue increases. Organic growth figures for both revenue and earnings include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2003, the rise of the Canadian dollar versus the U.S. dollar contributed five percentage points of our 12% organic growth rate in revenue.
The sharp increase in contingent commissions and volume overrides in 2003 reflected increased profitability of business placed by us at higher premium rates and increased concentrations of some placements among a group of selected insurers.
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2003 and 2002 results included a number of factors that can complicate direct comparisons. To increase investor understanding, the following chart shows the net earnings and diluted earnings per share impact specific items would have had if they had not occurred over the past two years.
Changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada and do not use derivatives to manage our Canadian pre-tax income, foreign exchange fluctuations will continue to impact our results. We have highlighted the impact of these changes because currency translation effects can lead to reported results that are less meaningful than local-currency results as an indicator of underlying operations. In 2003, the strength of the Canadian dollar versus the U.S. dollar had a positive impact on our results. A decline would have a negative effect. See Management’s Discussion and Analysis of Financial Condition and Results of Operations - “Market Risk.”
U.S. revenue grew 32% to $177.2 million, or 62% of revenue, in 2003, due to both organic growth and the contributions of operations acquired in 2002. Acquisitions added $38.7 million to revenue - 90% of the increase - while organic growth provided $4.4 million, or 10% of revenue growth. Our U.S. operations posted an organic growth rate of 3% in 2003, an 81% decrease from 16% in 2002. Core commission income increased 2%, while contingent commissions and volume overrides grew 37%.
During 2003, U.S. insurance premium rates remained strong - or hard - for most product lines, although rates for property coverage showed only modest increases as the year progressed. Hard insurance pricing in 2002 contributed strongly to a significant increase in contingent profitability income from insurers in 2003, as these insurers benefited from the near-term impact of higher rates implemented in 2002.
Canadian revenue grew 27% to $109.2 million, or 38% of consolidated revenue, in 2003, primarily as a result of a strengthening of the Canadian dollar against the U.S. dollar as well as organic growth. Canadian brokerages posted
organic growth of 26%, of which fourteen percentage points reflected a stronger Canadian dollar. Acquisitions added only $1.3 million, or 6%, of the revenue increase, reflecting a slower pace of fold-in acquisitions in Canada than in the United States. Apart from foreign currency gains, in Canada, our brokerages benefited from strong organic growth and a sustained pace of increases in insurance premium rates. Canadian rate trends have trailed those of the United States. Because Canadian revenue includes a lower percentage of commercial business and more personal lines, any acceleration in economic growth that adds to payrolls is not expected to have as strong a benefit in Canada as in the United States. The strong rate of organic growth in Canada reflected both increased market penetration and continued strength in premium rates. Our strong relationships with and access to insurers in Canada proved to be an important competitive advantage in 2003, leading to increased sales to clients who were unable to obtain coverage from other sources. As was the case in the United States, Canadian operations benefited strongly from an increase in contingent commissions and volume overrides, which grew 37% in 2003, versus a decline of 12% in 2002.
The majority of our expenses are related to compensation, which increased 35% in 2003 to $161.1 million. As a percentage of revenue, compensation increased to 56% from 54% in 2002, due in large part to an increase in non-cash stock based compensation. Total compensation includes both cash based salaries and benefits and non-cash stock based compensation. Cash compensation grew 32% to $156.3 million in 2003, while non-cash stock based compensation increased 341% to $4.8 million.
Interest expense decreased 29% to $5.2 million from $7.3 million in 2002. This decline reflected in large part the application of $80 million in proceeds for the 2002 IPO to pay down debt. In addition, interest expense was reduced by the benefits of performance-based forgiveness of interest payments due under a loan agreement with an insurer and an interest rate swap during the third and fourth quarters of 2003. The interest rate swap effectively converted $65 million of fixed interest rate senior notes into floating rate instruments, reducing interest expense on the senior notes by $0.8 million in 2003.
Intangible asset amortization increased 92% to $3.2 million in 2003 as a result of 2003 and 2002 acquisitions.
Our effective tax rate increased in 2003 to 34% from 33%. The difference in tax rates was affected most directly by non-taxable items in both 2003 and 2002. Approximately $2.6 million of 2002 earnings - resulting from the sale of two subsidiaries, Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively, “Old Lyme”) - were non-taxable, while $1.0 million of 2003 earnings - resulting from life insurance proceeds - were non-taxable. Absent these two items, the tax rates were unchanged at approximately 34.7% in both years.
As shown in the table on page 27, net earnings increased $2.6 million or $0.09 per diluted share, in 2002 on the sale of two insurance subsidiaries and decreased $1.1 million or $0.04 per diluted share due to non-cash stock based compensation. In 2003, diluted earnings per share increased $0.03 per diluted share from life insurance proceeds and
In addition to internally generated cash, we maintain two separate credit facilities:
Revolving U.S. dollar LIBOR loan - This unsecured facility totals $75 million and bears interest at a floating rate of prime plus 1%, or 112.5 basis points above LIBOR. The LIBOR was 2.40% and 1.12% at December 31, 2004 and 2003, respectively. The facility is available on a revolving basis for one year and expires on April 22, 2005. However if the revolving period is not extended, we may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million and $NIL at December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003 we were in compliance with all financial covenants governing this facility.
On July 15, 2003, we entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% senior notes and 6.16% senior notes in amounts of $10 million and $55 million, respectively, to a floating rate of approximately 2.0% and 2.4%, respectively. We account for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at December 31, 2004, we estimated the
Also at December 31, 2004 we had outstanding a $7.5 million term loan from an insurance carrier with which we place insurance. 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 reduces 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). Credits earned for 2004 and 2003 reduced interest payments to zero from $750 for both years.
Also at December 31, 2004, we had outstanding $35.0 million aggregate principal amount of 8.5% convertible subordinated notes due June 28, 2007 held by certain subsidiaries of Fairfax (the Fairfax notes). The Fairfax notes are convertible by the holders at any time into our common shares at C$17.00 per share. If Fairfax had converted all of the Fairfax notes, Fairfax would have owned approximately 32% of our total outstanding common shares as of December 31, 2004, versus the 26% of outstanding shares which it held on that date.
In connection with the acquisition of Hooper Hayes and Associates, Inc., now known as Hub International of California Inc., in 2002 we issued 196,000 shares (the “Retractable Shares”) that were deposited in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2004, 126,000 shares have been released from escrow.
In connection with other various acquisitions completed through December 31, 2004, we may be obligated to pay contingent consideration up to a maximum sum of approximately $12.4 million in cash and $3.6 million in common shares based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through August 2007 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2004, the financial statements reflect a liability to pay cash of $0.2 million as of December 31, 2004.
Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, we retained external counsel to assist us in responding to the New York Attorney General’s inquiries and, among other things, requested that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to our other hubs, both for internal purposes and in the course of assisting us in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes. While it is not possible to predict the outcome of this investigation, if such compensation agreements were to be restricted or no longer permitted, our financial condition, results of operations and liquidity may be materially adversely affected.
We did not record a liability at December 31, 2004 related to the above contingent liabilities.
In the normal course of business, we are involved in various claims and legal proceedings relating to insurance placed by us and other contractual matters. Our management does not believe that any such pending or threatened proceedings will have a material adverse effect on our consolidated financial position or future results of operations.
Share repurchases. For the year ended December 31, 2004, no common shares were repurchased by us, other than shares equal in value to $94,000 under the executive share purchase plan.
Shares reserved for issuance. As of December 31, 2004, 3.6 million common shares were reserved for issuance under our equity incentive plan of which approximately 3.3 million stock options and restricted share units were outstanding.
Shareholders’ equity increased by $39.0 million, or 11%, to $381.8 million as of December 31, 2004 from $342.8 million as of December 31, 2003. This increase resulted from net earnings of $26.2 million, an increase in contributed surplus of $7.9 million related primarily to non-cash stock based compensation, $3.4 million due to shares issued in conjunction with acquisitions, $0.9 million due to shares issued in conjunction with the contingent consideration payments, an exercise of stock options for $0.5 million, and an increase in the cumulative translation account of $6.9 million, (due mainly to the strengthening of the Canadian dollar compared to the U.S. dollar in 2004). The increase in shareholders’ equity was offset by the declaration of dividends of $6.1 million in 2004.
We completed our impairment testing on the balance of goodwill and intangible assets as of January 1, 2005, 2004 and 2003. Based on the testing performed, no impairment losses were incurred.
The amounts allocated to customer relationships were determined by discounting the expected future net cash flows from commissions with consideration given to remaining economic lives, renewals, and associated expenses. The amounts allocated to non-competition covenants were determined using an income approach with consideration given to economic benefits associated with having the covenants in place versus damages that would ensue absent the agreements. In the case of trademarks, a cash flow royalty savings approach, addressing the economic benefits of the trademarks to Hub was used. The balance of the excess purchase price is allocated to goodwill.
Customer relationships are amortized on a straight-line basis over their estimated economic useful life, typically ten to fifteen years. Many factors outside our control determine the persistency of our customer relationships and we cannot be sure that the value we have allocated will ultimately be realized. Non-competition covenants are intangible assets that have an indefinite life and accordingly, are not amortized but are evaluated for impairment. When an employee leaves Hub, the non-competition covenant becomes effective and the value assigned is then amortized over the life of the covenant. During the first quarter 2004, certain of our subsidiaries initiated a plan to change their names and as a result we recognized a non-cash loss on the write-off of trademarks of $2.6 million before tax. Prior to 2003, we amortized goodwill primarily over a period of forty years. Under the new accounting standards adopted in 2003, goodwill is not amortized and is evaluated annually for impairment. For the year ended December 31, 2004, 2003 and 2002, our amortization has been comprised of the following:
As of December 31, 2004 and December 31, 2003, subordinated convertible debentures of $35 million were held by certain subsidiaries of Fairfax.
During 2004, 2003 and 2002, we incurred expenses related to rental of premises from related parties in the amount of $2.4 million, $2.1 million and $1.7 million respectively. At December 31, 2004 and 2003, we also had accounts receivable due from related parties in the amount of $2.6 million and $3.5 million respectively, of which the majority were loans to employees to enable them to purchase our common shares. Of these accounts receivable, as of December 31, 2004 and 2003, $1.8 million and $1.9 million respectively, were related to Company loans to employees to purchase shares under our executive share purchase plan. As collateral, the employees have pledged 143,000 and 153,000 common shares as of December 31, 2004 and 2003, respectively, which have a market value of $2.6 million for both December 31, 2004 and 2003, respectively.
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.
For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, we account for such payment as an expense. Where such compensation is stock based, our accounting policy for stock based compensation is followed. The fair value of such compensation is a significant estimate. The use of different estimates could produce results that are significantly different than our results of operations.
Intangible assets primarily represent goodwill, associated with our acquisitions. Goodwill represents the excess of the cost of purchase of acquired businesses over the fair market value of their identifiable net assets.
We do not amortize goodwill and intangible assets with indefinite useful lives. We do, however, test these assets 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 that the carrying amount of intangibles, other
The Canadian Accounting Standards Board has issued two new accounting standards that will affect the Company in 2007. These new standards align Canadian GAAP to U.S. GAAP. Accordingly, information currently presented in our “Reconciliation to U.S. GAAP” note will be incorporated into our financial statements and these GAAP differences will be eliminated.
New Section 3855 will affect our reporting of our interest rate swap whereby the swap will be recorded on our balance sheet at its fair value. Currently, the fair value of the swap is not recognized on our balance sheet.
Report of Independent Registered Public Accounting Firm to the Board of Directors and Shareholders of Hub International Limited:
We conducted our audits of the Company’s financial statements in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial statement audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We conducted our audit of the effectiveness of the Company’s internal control over financial reporting and management’s assessment thereof in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as at December 31, 2004 and 2003 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004 in accordance with Canadian generally accepted accounting principles. Also, in our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as at December 31, 2004 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as at December 31, 2004 based on criteria established in Internal Control - Integrated Framework issued by the COSO.
Management is responsible for establishing and maintaining adequate internal control over Hub’s financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the U.S. Securities Exchange Act of 1934).
The Company purchased Talbot which is based in New Mexico on July 1, 2004, in accordance with the following terms: The Company purchased all of the common shares of Satellite Acquisition Corporation (“Satellite”), a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company will purchase special shares of Satellite owned by the management of Talbot, over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. For 2004 the Company recorded $14.4 million of non-cash stock based compensation relating to the Talbot acquisition with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004 the Company anticipates total earnout payments in the $45-$50 million range.
During the second quarter of 2003, the Company completed a private placement of $65 million unsecured senior notes (see note 9). Net proceeds on the sale of the notes were used to pay down $50 million of existing indebtedness and for general corporate purposes including acquisitions.
These consolidated financial statements of the Company are expressed in United States (U.S.) dollars and have been prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from U.S. GAAP and to the extent that they affect the Company, the differences are described in note 19 “Reconciliation to U.S. GAAP.” The more significant of the accounting policies are as follows:
The operations of the Company’s subsidiaries outside of the U.S. are self-sustaining. The assets and liabilities of these subsidiaries as at December 31, 2004 and 2003 were translated to U.S. dollars at the year-end exchange rate. Revenue and expenses for 2004, 2003 and 2002 were translated to U.S. dollars at the average exchange rate. Accordingly, the unrealized gains and losses which result from this translation are deferred and included in shareholders’ equity under the caption “Cumulative translation account.”
Cash and cash equivalents consist of cash, and highly-liquid investments having maturities of three months or less at the acquisition date.
In addition, the Company is also party to interest rate swap transactions which are subject to credit risk. Credit risk arises from the possibility that counterparties may default on their obligations to the Company. Derivative contracts generally expose the Company to credit loss if changes in market rates affect a counterparty’s position unfavorably and the counterparty defaults on payment.
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. Consideration which is contingent on maintaining or achieving specified earnings levels in future periods is recognized as an additional cost of the purchase when the contingency is resolved and the additional consideration is issued or becomes issuable. For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, we account for such payment as an expense. Where such compensation is stock based, our accounting policy for stock based compensation is followed.
The Company recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
The fair value of put options issued by the Company as consideration for businesses acquired is classified as long-term debt until such time as the option is exercised or expires. Changes in the fair value of these options are recorded in earnings. As part of the negotiations of contingent consideration the former owners of certain companies acquired in 2001 agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2004 and 2003 no put options were outstanding on the Company’s common shares.
In April 2004, Hub International Northeast Limited (“HUB Northeast”), formerly known as Kaye Insurance Associates, Inc., a subsidiary of Hub, received a subpoena from the Office of the Attorney General of the State of New York seeking information regarding certain compensation agreements between insurance brokers and insurance companies. The New York Attorney General subpoenaed information on such compensation agreements from several other major insurance brokers and insurance companies as well. Such compensation agreements, also known as contingent agreements, between insurance companies and brokers are a long-standing and common practice within the insurance industry. HUB Northeast discloses such agreements on its invoices to clients and on its web site. In addition, the Company discloses the arrangements in public filings. In August 2004, HUB Northeast received a second subpoena from the Office of the Attorney General of the State of New York seeking information regarding all revenue that HUB Northeast may have derived from insurance companies. In September 2004, HUB Northeast received a third subpoena from the Office of the Attorney General of the State of New York seeking information regarding any “fictitious” and “inflated” insurance quotes to which HUB Northeast may have been a party.
such compensation agreements were to be restricted or no longer permitted, the Company’s financial condition, results of operations and liquidity may be materially adversely affected.
From August 2004 through February 2005, various other subsidiaries of the Company received and responded to letters of inquiry and subpoenas from authorities in Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec.
In October 2004, the Company was joined as a defendant in a class action lawsuit (the “Opticare case”) against 30 different insurance brokers and insurance companies. The lawsuit was originally filed in August 2004 in the U.S. District Court for the Southern District of New York by OptiCare Health Systems Inc., a client of a Marsh & McLennan subsidiary. It now names the ten largest U.S. insurance brokers and four of the largest commercial insurers. The amended complaint alleges that the defendants used the contingent commission structure of placement service agreements in a conspiracy to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, the Company was also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. None of the complaints contain any specific factual allegations against the Company. The Company disputes the allegations of these complaints and intends to vigorously defend against the suits. However, a finding that the contingent commission structure conflicts with an insurance broker’s duty to its clients as well as the cost of defending against the lawsuit and the diversion of management’s attention could have a material adverse effect on the Company’s financial condition, results of operations and liquidity. See note 21 “Subsequent events”
In connection with the acquisition of Hooper Hayes and Associates, Inc., now known as Hub International California, Inc., in 2002 the Company issued 196,000 shares (the “Retractable Shares”) that were deposited in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2004, 126,000 shares have been released from escrow.
In connection with other various acquisitions completed through December 31, 2004, the Company may be obligated to pay contingent consideration up to a maximum sum of approximately $12.4 million in cash and $3.6 million in common shares of the Company based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through August, 2007 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2004, the financial statements reflect a liability to pay cash of $0.2 million.
Rent expense for the year ended December 31, 2004, 2003, and 2002 amounted to $14,242, $11,503 and $9,684, respectively, net of sublease rental income of $1,536, $1,282 and $737, respectively.
During 2004, the Company purchased Talbot, (as described below), all of the issued and outstanding membership interests of Bush, Cotton and Scott, LLC. located in the State of Washington, as well as the assets of five other insurance brokerages, all of which were accounted for 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 Company purchased Talbot which is based in New Mexico on July 1, 2004, in accordance with the following terms: The Company purchased all of the common shares of Satellite, a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company will purchase special shares of Satellite owned by the management of Talbot over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. For 2004 the Company recorded $14,388 of non-cash stock based compensation relating to the Talbot acquisition with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004 the Company anticipates total earnout payments in the $45-$50 million range.
The allocation of the purchase price, including goodwill and other identifiable assets, and the cost of the acquired brokerages in 2003 are summarized below:
Of the goodwill acquired $1,367 is deductible for tax purposes. In addition, the Company also recognized $1,800 of goodwill associated with contingent consideration relating to prior year acquisitions.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (“Flanagan”), a brokerage purchased in 2001, total additional consideration of 37,500 of the Company’s common shares were earned at December 31, 2003 valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares were recorded as “issuable shares” and included in shareholders’ equity and goodwill has been increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition the Company issued non-cash stock based compensation in the form of 84,375 restricted share units in 2004 valued at $1.4 million. 69,375 of these restricted share units have been canceled. 15,000 remain outstanding, vesting 50% January 1, 2008 and 50% January 1, 2010.
In accordance with the purchase agreement dated July 1, 2001, the former owners of Burnham Stewart Group, Inc. (“Burnham”), now known as HUB Midwest were entitled to additional consideration based upon certain acquired operations of Burnham achieving 2002 profitability targets. The additional consideration to be issued was a multiple of the final adjusted profitability as of December 31, 2002 for those operations. The total additional consideration was $22,166 of which $8,423 was cash and the remainder of $13,743 in 1,228 common shares of the Company. The Company issued the common shares in March 2003. As of December 31, 2002, the Company had accrued the cash portion of the contingent consideration and the share portion of the contingent consideration had been recorded as “issuable shares” and included in shareholders’ equity. As part of the negotiations of the contingent consideration, the former owners of Burnham agreed to relinquish their rights to put options on all of the 1,423 common shares issued as part of the 2002 acquisition, as well as on shares issued as contingent consideration in exchange for release from escrow provisions on those same common shares. The total additional consideration of $22,794 is shown as an addition to goodwill and customer relationships in the table below.
During the first quarter 2004 the Company adopted a strategic plan to make use of the “Hub” brand throughout the Company. Certain of the Company’s subsidiaries have decided to change their names and as a result the Company
The changes in the carrying amount of goodwill for the years ended December 31, 2004 and 2003, are as follows:
The Company estimates the amortization charges for 2005 through 2009 for all acquisitions consummated through December 31, 2004 will be:
Revolving U.S. dollar LIBOR loan - This unsecured facility totals $75 million, bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR. LIBOR was 2.40% and 1.12% at December 31, 2004 and 2003, respectively. The facility is available on a revolving basis for one year and expires on April 22, 2005. However, if the revolving period is not extended, the Company may convert the outstanding balance under the facility to a three year non- revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million and $NIL at December 31, 2004 and 2003, respectively. As of December 31, 2004, the Company was in compliance with all financial covenants governing this facility.
In connection with the acquisition of HUB Northeast on June 28, 2001, the Company issued $35 million aggregate principal amount, 8.5% convertible subordinated debentures (the Fairfax notes) due June 28, 2007 to certain subsidiaries of Fairfax Financial Holdings Limited (Fairfax). The Fairfax notes are convertible by the holders at any time into the Company’s common shares at C$17.00 per share. Beginning June 28, 2006, the Company may require conversion of the Fairfax notes into common shares at C$17.00 per share if, at any time, the weighted average closing price of the Company’s common shares on the TSX for twenty consecutive trading days equals or exceeds C$19.00 per share. If converted, Fairfax would have owned approximately 32% of the Company’s outstanding common shares as of December 31, 2004.
Substantially all officers and employees of the Company in the United States are entitled to participate in a qualified retirement savings plan (defined contribution plan). The cost to the Company was $2,397, $1,781 and $1,425 for 2004, 2003 and 2002, respectively. In 2004 a defined contribution plan was put in place for Canadian employees. The cost to the Company was $362 for 2004.
At December 31, 2004, 2003 and 2002 there were an unlimited number of non-voting, preferred shares authorized, issuable in series on such terms and conditions as set by the Board of Directors, of which no shares were issued. At December 31, 2004, 2003 and 2002 there were an unlimited number of common shares authorized, of which 30,411, 30,143 and 29,025 were issued and outstanding as at December 31, 2004, 2003 and 2002, respectively.
A summary of the stock option activity and related information for the years ended December 31, 2004, 2003 and 2002 consists of the following:
Non-cash stock based compensation related to stock options of $2,400, $2,309 and $1,089 for the year ended December 31, 2004, 2003 and 2002, respectively, was expensed with offsetting credits to contributed surplus. The Company recognizes the fair value of non-cash stock based compensation as an expense over the period in which entitlement to the compensation vests.
In 2004, restricted share units totaling 977,000 were issued in connection with the restructuring of the Company management bonus agreement and 84,000 restricted share units were issued in connection with the renegotiation of contingent consideration for Flanagan. The fair value of the restricted share units awarded in 2004 was approximately $16.1 million ($16.50 per share). In addition 45,000 restricted share units were awarded to certain employees valued at approximately $0.8 million ($17.06 per share) in 2004.
On June 30, 2003, the Company awarded 605,000 restricted share units to employees of the Company. The restricted share units are exercisable for common shares without payment of cash consideration and vest over periods ranging from 68 months to 95 months. No restricted share units were awarded in 2002.
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. Earnings per common share have been calculated as follows:
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, 2004 and 2003, approximate fair value because of the short-term nature of these instruments. The carrying value of the Company’s variable rate debt at December 31, 2004 and 2003, of $68,723 and $385, respectively, approximates fair market value.
The Company has net operating loss carryforwards of $16,606 at December 31, 2004 that expire 2008 through 2011 resulting in a future tax asset of $2,637. In addition, the Company has state net operating loss carryforwards in the U.S. of approximately $12,221 which expire 2019 through 2024 resulting in a future tax asset of $580 before valuation allowance. Such net operating losses are currently available to offset certain future state and local taxable income. A valuation allowance in the amount of $409 has been established related to certain U.S. state net operating loss carryforwards. In addition, a valuation allowance of $557 has been established related to certain non-deductible book reserves in the U.S. The Company does not believe that these losses and reserves will be realized.
Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2004, 2003 and 2002 is as follows:
The above includes foreign exchange gains of $1.7 million in 2004 and 2003, respectively, due to the strengthening of the Canadian dollar.
The table below presents the differences between Canadian and U.S. GAAP affecting net earnings and comprehensive income for the years ending December 31, 2004, 2003 and 2002.
The table below sets out the differences between Canadian GAAP and U.S. GAAP that affect shareholders’ equity at December 31, 2004 and 2003:
Under Canadian GAAP, the fair value of the put options (determined using the Black-Scholes model) issued in connection with certain 2001 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 date are included in earnings. Under U.S. GAAP prior to July 1, 2003, the fair value of the share consideration and the attached put options was initially recorded in equity and the redemption value of the shares to which the put options are attached was 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. On July 1, 2003, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement requires that an issuer classify financial instruments meeting certain criteria as liabilities (or assets in some circumstances) rather than equity. As a result of the adoption of this new standard, the Company changed its accounting policy with respect to the financial instruments issued in connection with certain 2001 acquisitions. Effective July 1, 2003, the Company remeasured the fair value of the put options (using the Black-Scholes model) and classified this amount as liability. Amounts previously classified as mezzanine equity were reclassified as shareholders’ equity. The difference between the estimated fair value of the put options as at July 1, 2003 and May 31, 2001 was reported as a cumulative adjustment to net earnings under U.S. GAAP. Comparative financial statements were not restated. Under U.S. GAAP, changes in the estimated fair value of the put options are included in earnings.
As part of the negotiations of contingent consideration the former owners of certain 2001 acquisitions agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2004 and 2003 no put options were outstanding on the Company’s common shares.
The Company is not aware of any new U.S. accounting pronouncements which will impact on its financial reporting.
The Canadian Accounting Standards Board has issued two new accounting standards that will affect the Company in 2007. These new standards align Canadian GAAP to U.S. GAAP. Accordingly, information currently presented in the Company’s “Reconciliation to U.S. GAAP” note will be incorporated into the Company’s financial statements and these GAAP differences will be eliminated.
In January, 2005 the Company was named as one of several defendants in another class action filed in Federal District Court in Illinois, containing allegations substantially similar to those in the Opticare case and other Illinois federal class actions. As with the other class actions there are no specific factual allegations relating to the Company. The Company denies allegations made in these lawsuits and intends to vigorously defend these cases.
In January, 2005 the Company and affiliates were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through Hub International of Illinois Limited (formerly Mack and Parker, Inc.)which claims that an undisclosed contingent commission was received with respect to its policy. The Company denies this and the other allegations of the complaint and intends to vigorously defend this case.
Also in January, 2005, HUB Illinois received a supplemental subpoena from the Illinois Insurance Division. A timely response has been provided.
In February, 2005 one of the Company’s subsidiaries received and responded to a letter of inquiry from authorities in California seeking information regarding its compensation agreements.