We actively monitor our real estate needs in light of our current operations. We believe that our existing facilities are well maintained and in good condition and that we can acquire any necessary additional facility capacity on reasonably acceptable terms within a reasonably short timeframe.
This Annual Report on Form 10-K contains, and from time to time management may make, “forward-looking statements,” as defined in Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that reflect our current expectations regarding our future growth, results of operations, cash flows, performance and business prospects, and opportunities, as well as assumptions made by, and information currently available to, our management. We have used words such as “anticipate,” “believe,” “expect,” “intend,” “plan,” “project,” “will continue,” “will likely result,” and similar expressions to indicate forward-looking statements, however, these words are not the exclusive means of identifying these forward-looking statements. These statements are based on information currently available to us and are subject to various risks, uncertainties, and other factors that could cause our actual growth, results of operations, financial condition, cash flows, performance and business prospects, and opportunities to differ materially from those expressed in, or implied by, these statements, including, but not limited to:
resolution of regulatory issues and litigation, including those related to compensation arrangements with insurance carriers;
fluctuations in the premiums charged by insurance carriers, with corresponding fluctuations in our premium-based revenue;
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to assist the reader in better understanding our business, results of operations, financial condition, changes in financial condition and position, critical accounting estimates, and significant trends and developments. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes thereto appearing in Part II, Item 8 of this Annual Report on Form 10-K.
Hub is a leading insurance broker in North America, providing a broad array of products and services to our clients, including, but not limited to, property and casualty, life and health, employee benefits, and risk management. We focus on both commercial and personal client accounts in the U.S. and Canada, which we serve through our approximately 3,820 employees in approximately 200 offices, using a variety of retail and wholesale distribution channels. Since our founding in 1998 through the merger of 11 Canadian insurance brokerages, we have acquired approximately 135 insurance brokerages, establishing a strong presence in the northeastern, midwestern, and western U.S. and in the Canadian provinces of Ontario, Quebec, and British Columbia. We have increased our revenue from $38.7 million during 1998 to $543.9 million during 2006. Approximately 78% of our revenue increase during this period was attributable to acquired brokerages. Approximately 72% of our total revenue during 2006 was attributable to our U.S. based operations. Our common shares are listed under the symbol “HBG” on both the New York Stock Exchange (“NYSE”) and the Toronto Stock Exchange (“TSX”).
We manage our operations by utilizing an organizational structure comprised of our corporate head office, larger regional or specialty insurance brokerages that we refer to as “hub brokerages” or “hubs” and smaller brokerages that are managed by our hub brokerages that we refer to as “fold-in brokerages” or “fold-ins.” As of December 31, 2006, we operated 18 hub brokerages, 13 located in the U.S. and five located in Canada. We have structured our hub brokerages so as to take advantage of a specific regional or specialty market. Each of our hubs has its own management team that is responsible for, in addition to the day-to-day operations of the hub brokerage, maintaining and developing organic growth and identifying and integrating fold-in brokerage acquisition candidates. Our hubs generally generate $10 million or greater in annual revenue, however, certain of our hubs that focus on a specific specialty product line or market may generate less than $10 million in annual revenue.
Our hub structure provides our hub brokerages with the flexibility to effectively meet changing market conditions in a timely manner, while benefiting from the economies of scale, leverage, and operating efficiencies provided by a large multi-national insurance brokerage network. We have decentralized our client service functions because we believe that client service related decisions are best made by those individuals that deal with our clients on a day-to-day basis. However, we recognize that our continued growth has created a scenario that demands increased coordination of our hub brokerages. To meet these challenges, we continue to develop strategies that enable our head office to coordinate the functions of our hubs, which in-turn, will enhance cross-selling initiatives between each of our hub brokerages, international collaboration between our Canadian and U.S. hub brokerages, marketing efficiencies, expense management, and financial control initiatives. In addition, to improve the operating efficiency and expense management of our business, we are in the process of centralizing those activities that do not directly affect our client relations functions, including, finance and accounting, human resources, information technology, and certain other administrative functions.
Excluding the impact of acquisitions, the results of operations of our U.S. and Canadian based hubs fluctuate on a quarterly basis, primarily as a result of revenue recognized in connection with contingent commission arrangements. We recognize contingent commission and volume override revenue during the period that the amounts are reasonably estimable, which generally occurs during the first and second quarters upon receipt of payment. As a result of these factors, total revenue, excluding the impact of acquisitions, is typically highest in the first and second
quarters and lowest in the third quarter and fourth quarters. Our operating costs do not fluctuate as significantly on a quarterly basis. We anticipate that these seasonal trends will continue.
2006 Overview. 2006 represented a year of opportunities and challenges for us and the insurance brokerage industry in general. During 2006, we increased our total revenue by approximately 23%, including organic revenue growth of 4.9%, or 2.8% excluding the favorable changes in foreign currency exchange rates. A significant portion of our revenue increase was attributable to business acquisitions completed during 2006 and 2005. During 2006, we completed 21 brokerage acquisitions, of which five represented hub brokerages. We were able to generate positive organic growth rates during 2006 despite the continued overall insurance premium rate “softness” in most of the markets where our hub brokerages are concentrated, which we cannot control. We believe our organic growth is primarily attributable to our continued sales focus during 2006, which was designed to generate new client business as well as improve retention of existing client accounts. In addition, during the second quarter of 2006, we completed a public offering in the U.S. of 4.6 million common shares at a price of $26.25 per share. Net cash proceeds of $114.9 million from this offering were primarily utilized to repay outstanding long-term debt balances and fund certain brokerage acquisitions.
In addition to the risk factors discussed in Part I, Item 1A of this Annual Report on Form 10-K, we have identified a number of key factors and trends related to our business and industry that represent opportunities, challenges, and risks.
Organic Growth Initiatives. We define organic revenue growth as the net increase in revenue as the result of (1) new client accounts, (2) retention and expansion of existing client accounts, and (3) the impact of changes in insurance premium rates. Organic revenue growth excludes (1) the change in revenue attributable to business acquisitions during the preceding 12-month period, and (2) all revenue attributable to business dispositions. We believe that organic revenue growth is a meaningful indicator of the overall effectiveness of our sales initiatives, the long-term sustainability of our profits, and the demand for our products and services. Our ability to generate organic revenue growth is impacted not only by increases or decreases of insurance premium rates, but also by a complex combination of general economic trends, access to coverage from insurance carriers, and our marketing and sales performance.
business as well as improve the retention of existing client accounts. Gains in organic commission income growth were realized despite the continued insurance premium rate softness in most of the markets where our hub brokerages are concentrated.
Fluctuations in premiums charged by insurance carriers have a direct and potentially significant effect on the insurance brokerage industry. Commission income is generally based on a percentage of the premiums paid by clients and is normally closely linked to premium rates. Insurance premium rates may vary widely based on specific market conditions. Various factors, including, but not limited to, competition for market share among insurance carriers, increased underwriting capacity, and improved economies of scale following consolidations in the insurance industry, typically result in flat or declining premium rates, which we generally refer to as a “soft” market. A soft market generally results in decreased commission income for insurance brokerages. Various other factors, including but not limited to, greater than expected loss experiences and capital shortages, typically result in increasing premium rates, which we generally refer to as a “hard” market. A hard market generally results in increased commission income for insurance brokerages. Hard and soft markets may be broad-based trends or focused across individual insurance product lines or geographic areas.
Contingent Commissions Arrangements. During the latter part of 2006, two insurance carriers with which we have contingent commission arrangements announced that during 2007 they will be suspending the practice of paying contingent commissions for certain lines of coverage. This decision appears to be based on the ongoing
Consistent with our current revenue recognition policy, we recognize contingent commissions during the period that amounts are reasonably estimable, which generally occurs upon receipt of payment. Historically, we have received payment for contingent commission arrangements in arrears; thus, revenue earned for contingent commission arrangements during 2006 would be recorded during 2007 when paid. Under the proposed changes, it appears that revenue earned for these new contingent commission arrangements will be known in the period earned; thus, revenue earned for these arrangements during 2007 will be recorded during 2007. We expect that contingent commission income earned and recorded during 2007 will be paid in the following year. Accordingly, we may record contingent commission income earned for both the years ended December 31, 2006 and 2007, during 2007.
As of December 31, 2006, we have recognized total Talbot earnout compensation of $55.3 million, of which $19.8 million remains payable and is included as a component of accounts payable and accrued liabilities on our consolidated balance sheet.
THB. On May 2, 2005, we acquired 100% of the issued and outstanding shares of THB Intermediaries, Inc. (“THB”), for approximately $5.6 million. The acquisition of THB represented our first hub brokerage that specializes in the facultative reinsurance brokerage market, with offices in New York, Los Angeles, Chicago, and Dallas.
See Note 21 “Subsequent Events” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a detailed discussion of subsequent events.
Year Ended December 31, 2006, Compared to Year Ended December 31, 2005
The summary of selected financial data table below should be referenced in connection with a review of the following discussion of our results of operations for the year ended December 31, 2006, compared to the year ended December 31, 2005 (in thousands).
Total revenue increased $101.3 million, or 23%, to $543.9 million during the year ended December 31, 2006. The increase was primarily attributable to the acquisition of U.S.-based insurance brokerages completed during 2005 and 2006 and organic revenue growth of 4.9% from our existing insurance brokerages, or 2.8% excluding the positive effects of the strengthening of the Canadian dollar as compared to the U.S. dollar.
Other income increased $3.7 million, or 31%, to $15.9 million during the year ended December 31, 2006. The increase was primarily attributable to an increase in interest income due to an increase in average invested cash balances and an increase in investment yields earned during 2006 as compared to investment yields earned during 2005.
U.S. Operations. Total revenue generated by our U.S. operations increased $83.7 million, or 27%, to $393.4 million during the year ended December 31, 2006. Revenue generated by our U.S. operations as a percentage of total consolidated revenue increased by 200 basis points to 72% during the year ended December 31, 2006. The increases were primarily attributable to a 29% increase in commission income during 2006 relative to 2005, which, was primarily attributable to the acquisition of U.S. based insurance brokerages completed during 2005 and 2006. Acquisitions, net of business disposition, contributed $70.7 million of our increase in U.S. commission income during 2006 relative to U.S. commission income during 2005. Also contributing to the increase in commission income during 2006, compared to commission income during 2005, was organic commission income growth of 2.8% during 2006; compared to organic growth of 0.6% during 2005.
Increases in commission income during 2006 relative to 2005 were negatively impacted by continued declines in insurance premium rates experienced in most of the U.S. markets that we serve.
Total compensation expense and each of the significant components of compensation expense for the years ended December 31, 2006 and 2005, were as follows (dollars in thousands).
Total compensation expense recognized in connection with the Talbot earnout decreased $16.5 million, or 58%, to $12.2 million during the year ended December 31, 2006. The decrease is primarily attributable to the greater pro-rata distribution of compensation expense during 2005 as compared to the pro-rata compensation expense recognized during 2006. Expense recorded in connection with the Talbot earnout was more greatly weighted during the earlier portion of the earnout period. See our discussion under the caption “Our Business - Current Business and Industry Opportunities, Challenges, and Risks - Talbot Earnout” included herein for detail of the Talbot earnout arrangement.
Interest expense increased $1.6 million, or 15%, to $12.3 million during the year ended December 31, 2006. The increase was primarily attributable to an increase in average outstanding debt balances and an increase in interest rates
Provision for income taxes increased $4.7 million, or 15% to $35.7 million during the year ended December 31, 2006. Our effective tax rate decreased from 55% during the year ended December 31, 2005, to 41% during the year ended December 31, 2006. The decrease was primarily attributable to the decrease in compensation expense incurred in connection with the Talbot earnout during 2006 relative to Talbot earnout compensation expense during 2005, which is not deductible for income tax purposes. Excluding the effect of the Talbot earnout compensation expense, our effective tax rate would have been 36% for both of the years ended December 31, 2006 and 2005.
Net earnings increased $25.2 million, or 98%, to $50.9 million during the year ended December 31, 2006, due to the cumulative effect of the factors discussed above.
Diluted net earnings per share increased from $0.76 per diluted share during the year ended December 31, 2005, to $1.35 per diluted share during the year ended December 31, 2006, due to the cumulative effect of the factors discussed above, offset, in part, by an increase in our diluted weighted average shares outstanding. The increase in diluted weighted average shares outstanding during 2006 as compared to diluted weighted average shares outstanding during 2005 was primarily attributable to shares issued in connection with our secondary U.S. public offering during 2006, and shares issued upon the conversion, during 2006, of outstanding debt instruments held by a related party.
None of the items listed in the table above were considered unusual, however, we have included the effects of these items on net earnings and diluted earnings per share so as to highlight the impact on the comparability of net earnings and diluted earnings per share on a year-over-year basis as a result of fluctuations in these amounts. In addition, because we derive a significant portion of our revenue from our Canadian operations and we report our financial results in U.S. dollars, fluctuations in the amount of gains or losses incurred on foreign exchange transactions will continue to impact our financial results going forward. See our discussion of “Market Risk” herein for an analysis of the potential impact of foreign exchange fluctuations on our operating results.
Year ended December 31, 2005, Compared to Year ended December 31, 2004
Total revenue increased $87.5 million, or 25%, to $442.6 million during the year ended December 31, 2005. The increase was primarily attributable to the acquisition of U.S. based insurance brokerages completed during 2004 and 2005 and organic revenue growth of 5.9% from our existing insurance brokerages, or 3.3% excluding the positive effects of the strengthening of the Canadian dollar as compared to the U.S. dollar during 2005. Increases in total
Other income increased $2.0 million, or 19%, to $12.2 million during the year ended December 31, 2005.
Total compensation expense and each of the significant components of compensation expense for the years ended December 31, 2005 and 2004, were as follows (dollars in thousands).
In anticipation of funding an acquisition we entered into a foreign exchange forward contract to convert Canadian dollars to U.S. dollars. The difference between the forward rate contracted and the spot rate as of the date of conversion resulted in us incurring a foreign exchange loss of $0.6 million.
During 2005, we negotiated an early payment settlement with respect to our $7.5 million loan from an insurance carrier, which resulted in (1) a reduction of the principal due on this debt from $7.5 million to $3.0 million and (2) the elimination of interest payments due during 2005.
During January 2004, we adopted a corporate marketing and positioning strategy to build awareness of the Hub brand across all of the markets that we serve and to encourage greater coordination and collegial identity among our employees. As a result of this strategy, certain of our subsidiaries changed trademarks and, thus, we recorded a $2.6 million charge to write-off the related trademark intangible assets.
Net earnings decreased $0.5 million, or 2%, to $25.7 million during the year ended December 31, 2005, due to the cumulative effect of the factors discussed above.
Diluted net earnings per share decreased from $0.80 per diluted share during the year ended December 31, 2004, to $0.76 per diluted share during the year ended December 31, 2005. Contributing to the decrease in diluted net earnings per share was the increase in the number of dilutive shares related to the Talbot earnout payment during 2005 compared to the Talbot earnout payment during 2004.
Our net earnings and diluted net earnings per share are affected by a number of factors, including, but not limited to, acquisitions and changes in organic growth revenue growth rates. In addition to these factors, we recognized the following items during the years ended December 31, 2005 and 2004, which affected the comparability of net earnings and diluted earnings per share on a year-over-year basis (dollars in thousands):
These severance costs included in the table above were recorded in connection with a specific cost reduction program implemented during the third quarter of 2005 in an effort to reduce compensation expense to targeted levels, and represent costs above-and-beyond normal recurring severance costs which we may incur in the ordinary course of business.
We finance acquisitions primarily through funding from a combination of cash generated from operations, equity issuances, and borrowings from our credit facilities or other debt financing options. As of December 31, 2006, we have $85.3 million of credit availability under our existing lines of credit. In addition, we may use equity issuances as partial consideration for certain acquisitions. Historically, cash used for capital expenditures, which include primarily expenditures for furniture, computer systems, and office equipment, have not been significant in relation to our overall cash requirements. Thus, we are able to devote a significant portion of our capital resources, including external borrowings, internally generated cash flows, and proceeds from equity issuances toward cash requirements for acquisitions.
As an insurance broker, we collect premiums paid by clients and hold such cash, net of our earned commissions and other deductions, in trust until we remit the cash to the applicable insurance carriers that provide coverage to our clients. Our use of trust cash is restricted by contractual obligations and by law in certain of the states and provinces in which we operate. As permitted by law, we generally invest trust cash in interest bearing accounts and earn investment interest income on trust cash balances during the time between our receipt of the cash from our clients and the time the cash is remitted to the insurance carrier. Cash held in trust is shown separately on our consolidated balance sheets under the caption “Trust Cash.” We report changes in trust cash balances as a change in non-cash working capital in our determination of cash provided from operating activities in our consolidated statements of cash flows.
consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a detailed discussion of commitments and contingencies as of December 31, 2006.
As of December 31, 2006 and 2005, we had “net debt,” which we define as total long-term debt less non-trust cash and cash equivalents, of $45.4 million and $105.2 million, respectively. Our “debt to capitalization ratio,” calculated as total long-term debt as a percentage of total long-term debt plus total shareholders’ equity, decreased from 29% as of December 31, 2005, to 18% as of December 31, 2006. If we had fully utilized available credit on our outstanding credit facilities as of December 31, 2006, our debt to capitalization ratio would have been 26%. Our management believes that a reasonable and conservative range of debt to capitalization ratios for our business model is between 35% and 38%. Under our current debt covenants we must maintain a debt to capitalization ratio less than 45%.
Cash flows provided by operating activities increased $40.6 million, or 88%, from $46.0 million during the year ended December 31, 2005, to $86.6 million during the year ended December 31, 2006.
Talbot Earnout. During the year ended December 31, 2006, the Talbot earnout was paid in our common shares, thus, no cash was used to pay the 2006 Talbot earnout. During the year ended December 31, 2005, we paid cash in connection with the Talbot earnout of $16.4 million. During the years ended December 31, 2006 and 2005, respectively, we recorded total compensation expense in connection with the Talbot earnout of $12.2 million and $28.7 million, of which $2.7 million and $11.6 million were recorded in connection with the non-cash share-based portion of the Talbot earnout payment, which was made on March 31, 2006. The final Talbot earnout payment will be made on March 31, 2007, and will be based upon Talbot’s earnings for the year ended December 31, 2006. We estimate that the final Talbot earnout payment will be approximately $21.8 million, and will most likely be paid in cash. Refer to our discussion under the caption “Our Business - Current Business and Industry Opportunities, Challenges, and Risks - Talbot Earnout,” included herein, for details regarding to the Talbot earnout.
Business Acquisitions, net of cash received. During the years ended December 31, 2006 and 2005, respectively, we used cash of $150.1 million and $66.1 million in connection with our acquisitions of insurance brokerages. Refer to our discussion under the caption “Our Business - Acquisitions,” included herein, for significant acquisitions and related cash outlays, during the years ended December 31, 2006 and 2005.
Cash flows from financing activities were $91.7 million for the year ended December 31, 2006, compared to cash flows used for financing activities of $11.7 million during the year ended December 31, 2005.
Proceeds From Share Issuance, and Sale of Senior Notes, Net of Issuance Costs. During the second quarter of 2006, we completed a secondary public offering in the U.S. of 4.6 million common shares at a price of $26.25 per share. Cash proceeds from this offering, net of issuance costs of $5.9 million, were approximately $114.9 million.
On April 4, 2006, we completed a private sale of $75.0 million of senior notes in the U.S. In connection with this sale of senior notes, we incurred issuance costs of $0.2 million.
During the year ended December 31, 2006, we used the combined proceeds from our share issuance and sale of senior notes as follows: (1) $65.0 million to repay amounts outstanding on our U.S. Credit Facility; (2) $14.2 million to repay bank debt acquired in connection with the third quarter 2006 acquisition of Fortun; and (3) the remainder was used to fund various 2006 acquisitions and to repay various other long-term debt obligations.
Dividends Paid. During the years ended December 31, 2006 and 2005, we paid cash dividends to our common shareholders of $10.3 million and $7.4 million, respectively. We have no formal dividend policy; the declaration and payment of quarterly dividends on our common shares are subject to the discretion of our Board of Directors. The decision of our Board of Directors to pay quarterly dividends depends on a number of factors, including, but not limited to, our quarterly results of operations, financial position, capital requirements, general business conditions, contractual restrictions, and other factors that our Board of Directors may consider relevant.
Credit Facilities. As of December 31, 2006, we had no amounts outstanding under our $75.0 million U.S. Credit Facility or our C$12.0 million ($10.3 million U.S. dollars) Canadian Credit Facility.
As of December 31, 2006, minimum future cash payments due under contractual obligations were as follows (in thousands):
See Note 8 “Debt” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a detailed discussion of the significant terms, conditions, and, if applicable, financial covenants related to our Series A and B senior notes, our senior notes, our credit facilities, and various other notes payable and long-term debt.
Interest on Long-term Debt. Represents cash payments for interest due on long-term debt obligations based on outstanding principle balances and applicable interest rates in effect as of December 31, 2006.
Operating Lease Obligations. We lease substantially all of our facilities and certain equipment under non-cancellable operating leases expiring at various dates through 2018. Lease terms are generally five years with one or more renewal options for extended terms. The amounts included in the table above represent future minimum lease payments for non-cancellable operating leases.
On July 15, 2003, we entered into an interest rate swap agreement to effectively convert our fixed rate interest payments on the Series A senior notes of 5.71% and the Series B senior notes of 6.16% to a floating rate. The notional amount of the swap agreement is equal to the outstanding principle balance of our Series A and B senior notes. As a result of the swap agreement, we incurred interest expense of approximately $1.0 million during the year ended December 31, 2006, and realized interest expense savings of approximately $0.2 million during the year ended December 31, 2005. In accordance with Canadian GAAP, we account for the swap transaction using the synthetic instruments method. Under this method, we record the net interest expense on the swap and associated debt in our consolidated statement of earnings as if it were a single synthetic financial instrument. Also, under this method we do not recognize the estimated fair value of the interest rate swap arrangement on our consolidated balance sheets, which we have estimated to be approximately $4.0 million as of December 31, 2006, which also represents the amount that we would have to pay to terminate the swap as of this date.
Changes in Financial Position - December 31, 2006, compared to December 31, 2005
Cash and Cash Equivalents. The increase in cash and cash equivalents was primarily attributable to (1) operating cash flows generated during the period, (2) proceeds from our public offering during 2006, and (3) proceeds from the sale of senior notes during 2006, offset, in-part, by cash paid in connection with business acquisitions and repayments of long-term debts.
Goodwill and Other Intangible Assets. See our discussion included herein under the caption “Goodwill and Other Intangible Assets,” for a detail of the changes in goodwill and other intangible assets from December 31, 2005, to December 31, 2006.
Subordinate Convertible Debentures. On June 29, 2006, we exercised our conversion option on the Fairfax notes. As of that date, the Fairfax notes were converted into approximately 2.3 million of our common shares.
Share Capital and Contributed Surplus. See our discussion included herein under the caption “Shareholders’ Equity,” for a detail of the changes in share capital and contributed surplus from December 31, 2005, to December 31, 2006.
The following sections should be read in conjunction with our discussions under the captions “Critical Accounting Estimates - ‘Business Acquisitions’ and ‘Review of Goodwill and Other Long-lived Assets for Impairment,’” included herein, which details our accounting for goodwill and other intangible assets.
Goodwill. The increase in goodwill is primarily attributable to $110.1 million of goodwill recorded in connection with 2006 business acquisitions, which includes amounts recorded in connection with hub brokerage acquisitions as follows; $43.5 million recorded in connection with our acquisition of CFGB, $20.5 million recorded in connection with our acquisition of Kaufman, and $18.5 million recorded in connection with our acquisition of Fortun.
Customer Relationships. We generally amortize customer relationship assets on a straight-line basis. For customer relationship intangible assets acquired in connection with hub brokerages during the fourth quarter of 2005 and during 2006, we refined our method to better align the amortization with the pattern of consumption of the expected benefits derived from client relationships existing as of the date of the acquisition. This change in estimate resulted in approximately $4.9 million of additional amortization expense recognized during the year ended December 31, 2006.
estimate of the timeframe over which the acquired customer relationship is expected to contribute directly or indirectly to the future cash flows of the acquired insurance brokerage.
The increase in customer relationships is primarily attributable to $64.6 million of customer relationship intangible assets recorded in connection with 2006 business acquisitions, which includes amounts recorded in connection with hub brokerage acquisitions as follows; $35.6 million recorded in connection with our acquisition of CFGB, $9.7 million recorded in connection with our acquisition of Kaufman, and $6.1 million recorded in connection with our acquisition of Fortun.
The following table includes a reconciliation of the changes from December 31, 2005 to December 31, 2006, for each of the components that comprised our total shareholders’ equity balance as of December 31, 2006 (in thousands):
See Note 15 “Related Party Transactions” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a detailed discussion of our related party transactions.
We are subject to foreign currency exchange exposures from current and anticipated transactions denominated in currencies other than the U.S. dollar and from the translation of foreign currency balance sheet accounts into U.S. dollar balance sheet accounts. Specifically, given the significance of our Canadian operations, whose functional currency is the Canadian dollar, we are subject to risks associated with fluctuations in the value of the Canadian dollar as compared to the U.S. dollar. A change in value of the Canadian dollar creates the potential for declines in our revenue and net earnings. Unrealized foreign currency translation gains and losses are recorded on our consolidated balance sheets in the cumulative translation account (“CTA”), and do not currently impact our net earnings.
our U.S. operations will continue to increase as an overall portion of our business, further mitigating our foreign currency exchange sensitivity.
Core Commission Income. We generally recognize commission income earned upon the placement of insurance with an insurance carrier, as of the “effective date” of the policy unless at that time we are unable to reasonably determine the actual policy premium. In these circumstances, we defer the recognition of commission income until we are able to reasonably determine the amount of commission earned on the policy, which generally occurs on the date that the client is billed for the policy. The term “effective date” refers to the date from which protection is afforded to our client under an insurance policy. As of the effective date, we become entitled to the commission because the insurance coverage has been placed with the insurance carrier and the premium is owed by the client. In accordance with the revenue recognition criteria set forth in the Securities and Exchange Commission’s (“SEC”) Staff Accounting Bulletins (“SAB”) No. 101 and No. 104 Revenue Recognition in Financial Statements, as of the effective date we are entitled to commission income for the policy as our earnings process is substantially complete because we have performed all contracted services for our clients and substantially all of the related costs to produce, market, and place the coverage have been incurred.
We generally bill our clients in the same month that the effective date occurs. We have two primary types of billing arrangements: (1) direct billed commissions and (2) agency billed commissions.
we receive payment from the insurance carrier. We periodically evaluate our assumptions for estimated direct billed revenue and may make changes to our historical average daily revenue assumptions or estimated range of days between the effective date of the policy and payment date. Any routine changes to such assumptions would be considered changes in estimates.
We record commission income net of sub-broker commission expense. Sub-broker commission expense represents amounts paid by us to third-party insurance brokerages or non-employee individuals who assist us in placing insurance coverage for our clients.
Other Income. Other income consists primarily of investment income earned on cash and trust cash balances, certain policy service fees, and income earned in connection with the financing of client premiums. Investment income is recognized as it is earned. Policy service fee revenue is recognized as of the effective date of the policy. Revenue related to the financing of client premiums is recognized during the period that the amounts are reasonably estimable, which generally occurs upon receipt of payment.
In our capacity as an insurance broker, we collect premiums from clients and, after deducting our commissions, remit those premiums to the respective insurance carrier. We also collect claims or refunds from clients on behalf of insurance carriers. Uncollected premiums, uncollected claims or refunds from clients are recorded as accounts receivable on our consolidated balance sheets.
Accounts receivable are stated at estimated net realizable values. We maintain an allowance for doubtful accounts based on the length of time receivables are past due and the financial health of specific clients. Adjustments to the allowance for doubtful accounts are classified as bad debt expense, which is a component of selling, occupancy, and administration expense in our consolidated statements of earnings. As of December 31, 2006 and 2005, our allowance for doubtful accounts was $2.4 million and $1.9 million, respectively, or 1.22% and 1.25% of our client premium receivable balance as of December 31, 2006 and 2005. During the years ended December 31, 2006, 2005 and 2004, we recorded bad debt expense of $0.8 million, $0.7 million, and $0.3 million, respectively. If our actual write-offs of client premium receivables were significantly different from our estimated bad debt expense, our actual operating results may be significantly affected. Historically, our allowance for doubtful accounts balance has been approximately 0.77% of our total client premiums receivable balance, If we had experienced an actual allowance for doubtful accounts balance of 0.77% of our total client premiums receivable balance as of December 31, 2006, we would have decreased our total selling, occupancy, and administration expense during the year ended December 31, 2006, by approximately $0.9 million.
impairment on at least an annual basis by applying a fair-value-based test. In evaluating the recoverability of the carrying value of goodwill we must (1) allocate acquired goodwill to reporting units, (2) make assumptions regarding the fair value of our reporting units, and (3) determine if an indicator of goodwill impairment exists by comparing the carrying value of our reporting units with the estimated fair value. If we determine that an indicator of goodwill impairment exists for any of our reporting units, we must then quantify the actual goodwill impairment charge, if any, by comparing the carrying value of goodwill to its estimated fair value, based on the fair value of the reporting units’ assets and liabilities as of the impairment test date.
We have completed our annual review of goodwill for impairment as of January 1, 2007, 2006 and 2005. The results of the tests indicated no goodwill impairment, as, for all reporting units, our estimate of reporting unit fair value exceeded the carrying value of the reporting unit. Our estimate of the fair value of each of our reporting units was based primarily on historical operating results and market multiples.
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.
We accrue for costs associated with certain contingencies, including, but not limited to, settlement of legal proceedings and regulatory compliance matters, when such costs are probable and reasonably estimable. In addition, we accrue for legal fees incurred in defense of asserted litigation and regulatory matters as such legal fees are incurred. To the extent it is probable under our existing insurance coverage that we are able to recover losses and legal fees related to contingencies, we record such recoveries concurrently with the accrual of the related loss or legal fees. Significant management judgment is required to estimate the amounts of such contingent liabilities and the related insurance recoveries. In our determination of the probability and estimability of contingent liabilities and related insurance recoveries we consider the following: litigation exposure based on currently available information, consultations with external legal counsel, adequacy and applicability of existing insurance coverage, and other pertinent facts and circumstances regarding the contingency. Liabilities established to provide for contingencies are adjusted as further information develops, circumstances change, or contingencies are resolved.
Based upon the evaluation under the framework in the COSO Report, management has assessed the effectiveness of our internal control over financial reporting as at December 31, 2006, and has concluded that such internal control over financial reporting was effective.
In conducting management’s assessment of the effectiveness of our internal controls over financial reporting, management has excluded Fortun Insurance Agency (“Fortun”), R.D.K Management, Inc. (doing business as Kaufman & Kaufman Insurance, “Kaufman”), and three brokerages (the “CFG Brokerages” or “CFGB”) acquired from Citizens Financial Group Inc. from its assessment of internal control over financial reporting as of December 31, 2006, because these brokerages were acquired by us in purchase business combinations during the year ended December 31, 2006. Fortun, Kaufman, and CFGB are wholly-owned subsidiaries of Hub whose total assets and total revenues represent 18% and 7%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2006.
PricewaterhouseCoopers LLP, who has audited our consolidated financial statements for the year ended December 31, 2006, has also audited management’s assessment of the effectiveness of our internal control over financial reporting as at December 31, 2006, as stated in their report which appears in Part II, Item 8 and is incorporated by reference in Part II, Item 9A of this Annual Report on Form 10-K.
We have completed integrated audits of Hub International Limited’s 2006, 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2006. Our opinions, based on our audits, are presented below.
We have audited the accompanying consolidated balance sheets of Hub International Limited (the “Company”) as of December 31, 2006 and 2005 and the related consolidated statements of earnings, retained earnings and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits of the Company’s financial statements as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006 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.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in accordance with Canadian generally accepted accounting principles.
We have also audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting appearing under item 8, that the Company maintained effective control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
As described in Management’s Annual Report on Internal Control over Financial Reporting, management has excluded Fortun Insurance Agency (“Fortun”), R.D.K Management, Inc. (doing business as Kaufman & Kaufman Insurance, “Kaufman”) and three brokerages (the “CFG Brokerages” or “CFGB”) acquired from Citizens Financial Group Inc. from its assessment of internal control over financial reporting as of December 31, 2006 because these brokerages were acquired by the Company in purchase business combinations during the year ended December 31, 2006. We have also excluded Fortun, Kaufman, and CFGB from our audit of internal control over financial reporting. Fortun, Kaufman, and CFGB are wholly-owned subsidiaries of the Company whose total assets and total revenues represent 18% and 7%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2006.
As used in these financial statements, the terms “dollars” or “$” refer to United States (“U.S.”) dollars and the terms “Canadian dollars” and “C$” refer to Canadian dollars, unless otherwise expressly stated. We publish our consolidated financial statements and the notes to our consolidated financial statements in U.S. dollars.
These consolidated financial statements include the accounts of Hub and our wholly-owned subsidiaries. All significant inter-company accounts and transactions have been eliminated. The results of operations of all acquired businesses have been consolidated for all periods subsequent to the date of acquisition.
The preparation of financial statements in conformity with Canadian and U.S. GAAP, requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the disclosure of contingent liabilities as of the date of the financial statements and reported amount of revenue and expenses during the reported period. The principal estimates used in the preparation of these financial statements include, among others, the determination of the provision for cancelled policies relating to revenue recognition, the recognition of certain revenue for direct bill arrangements, the allowance for doubtful accounts, the allocation of purchase price to the fair value of net assets acquired in connection with business acquisitions, the valuations of liabilities established as of the date of business acquisitions, fair values used for reporting units when testing for goodwill and other intangible asset impairment, the estimation of the useful lives of definite-lived intangible assets, the measurement of non-cash share-based compensation, the measurement of income tax liabilities and the recoverability of future income tax assets, and the measurement of self-insured liabilities and certain contingent liabilities. Actual results could differ from these estimates.
Our revenue is primarily derived from commissions collected from insurance carriers with whom we place insurance coverage on behalf of our clients. Our earned commission rates generally range from 5 percent to 20 percent of the policy premium. We generally receive two types of compensation from insurance carriers; (1) core commissions and (2) contingent commissions and volume overrides.
We generally bill our clients in the same month that the effective date occurs. We have two primary types of billing arrangements: (1) agency billed commissions and (2) direct billed commissions.
Direct Billed Commissions. In a direct bill arrangement, our client is billed by the insurance carrier directly for any premiums or fees related to the policy. We are subsequently paid by the insurance carrier for our brokerage
services, generally in the form of commission income. Accordingly, we do not bill or collect premiums or fees directly from our clients. For certain insurance coverages that are direct billed we must estimate revenue recognized during a given period due to the fact that we are unable to determine the actual revenue that will be recognized on the policy as of the effective date or we may not have received such information from the insurance carrier. We initially recognize revenue for these direct billed policies on a cash basis during the period and then we estimate revenue for earned but uncollected policies based on the historical average daily revenue earned on such policies over an estimated period representing the timeframe between the effective date of the policy and the date we receive payment from the insurance carrier.
While we operate primarily in the U.S., a significant portion of our operations are derived from our subsidiaries that operate in Canada. The functional currency of our Canadian operations, including our parent company, which holds certain U.S. dollar denominated debt, is the Canadian dollar. Our Canadian-based operations are self-sustaining. The assets and liabilities of our Canadian-based subsidiaries as of December 31, 2006 and 2005, have been translated into U.S. dollars at the year-end exchange rate. For the years ended December 31, 2006, 2005 and 2004, revenue and expenses of our Canadian-based subsidiaries have been translated into U.S. dollars at average exchange rates in effect at the time that the underlying transaction occurred. Unrealized gains or losses resulting from such translation are deferred and included on our consolidated balance sheet as a component of shareholders’ equity under the caption “Cumulative Translation Account” (“CTA”). In addition, certain U.S. dollar denominated debt held by our Canadian parent company has been designated as a hedge against our investment in our U.S. operations. Thus, transaction gains and losses related to this U.S. dollar denominated debt are recorded on our consolidated balance sheet as a component of our CTA.
Cash and cash equivalents include cash and short-term investments with a term of maturity of less than 90 days as of the date of acquisition.
Trust cash includes premiums collected from clients, less commissions and other deductions, but not yet remitted to insurance carriers. Our use of trust cash is restricted by contractual obligations and by laws in certain states and provinces in which we operate. As permitted by law, we generally invest trust cash balances in interest bearing accounts and earn interest income on trust cash balances during the time between our receipt of the cash from our customers and the time the cash is remitted to the insurance carrier. Other deductions from premiums collected include advance payments to carriers, as well as advance claim payments and return premiums to clients. Cash held in trust is shown separately on our consolidated balance sheets under the caption “Trust Cash.” We report changes in our trust cash balances as a change in non-cash working capital in our determination of cash provided from operating activities in our consolidated statement of cash flows.
Accounts receivable are stated at estimated net realizable values. We maintain an allowance for doubtful accounts based on the length of time receivables are past due and the financial health of specific customers. In certain circumstances, we may be able to mitigate our risk of loss relating to the non-collection of client premium receivables by cancellation of the underlying insurance policy.
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are recognized over the estimated economic useful lives of the related assets, using the following depreciation and amortization methods:
Upon the disposition of property and equipment through either sale or retirement, we remove both the cost and related accumulated depreciation or amortization from our consolidated balance sheet accounts and any gain or loss recognized upon disposition is recorded in our consolidated statements of earnings. Maintenance, repairs, minor renewals, and betterments are expensed as incurred; major improvements are capitalized.
Goodwill represents the excess of cost over fair value of identifiable net assets acquired through business acquisitions. In accordance with Canadian and U.S. GAAP, goodwill is not amortized but, instead, is reviewed for impairment on at least an annual basis by applying a fair-value-based test. In evaluating the recoverability of the carrying value of goodwill we must (1) allocate acquired goodwill to reporting units, (2) make assumptions regarding the fair value of our reporting units, and (3) determine if an indicator of goodwill impairment exists by comparing the carrying value of our reporting units with the estimated fair value. If we determine that an indicator of goodwill impairment exists for any of our reporting units, we must then quantify the actual goodwill impairment charge, if any, by comparing the carrying value of goodwill to its estimated fair value, based on the fair value of the reporting units’ assets and liabilities as of the impairment test date.
On an ongoing basis, we review property and equipment, definite-lived intangible assets, and other long-lived assets for impairment whenever events or circumstances indicate that carrying amounts may not be recoverable. To date, no such events or changes in circumstances have occurred that have resulted in us having to recognize a significant impairment loss. If such events or changes in circumstances occur, we will recognize an impairment loss if the undiscounted future cash flows expected to be generated by the asset are less than the carrying value of the related asset. The impairment loss would adjust the asset to its fair value.
We account for interest rate swap arrangements with respect to our outstanding long-term debt using the synthetic instruments method. Under this method we record the net interest on the swap and associated debt in our consolidated statement of earnings as if it were a single synthetic financial instrument. Also, under this method we do not recognize the estimated fair value of the interest rate swap arrangement on our consolidated balance sheets.
Both Canadian and U.S. GAAP require the recognition of future income tax assets and liabilities based upon the expected future income tax consequences of temporary differences between the carrying amounts of assets or liabilities and their tax bases by applying statutory income tax rates expected to be in effect when the asset or liability is settled. We reduce the carrying amount of future income tax assets, including the expected future benefit of operating loss carry forwards, by a valuation allowance if it is more likely than not that some portion of the future income tax asset will not be realized.
The Accounting Standards Board issued Canadian Institute of Chartered Accounts (“CICA”) handbook section 1530 Comprehensive Income (“CICA 1530”). CICA 1530 introduced a new requirement to temporarily exclude certain gains and losses from the calculation of net earnings and, instead, present such amounts as a component of
As previously discussed, we account for business acquisitions using the purchase method, whereby the results of acquired businesses are included in our consolidated financial results from the date of acquisition going forward.
On April 1, 2006, we acquired 100% of the issued and outstanding membership interests of three brokerages (the “CFG Brokerages” or “CFGB”) from Citizens Financial Group Inc., for approximately $80.8 million. CFGB’s offices are located in Pennsylvania and Massachusetts. Our acquisition of CFGB increases our presence in Pennsylvania and New England.
In addition, during 2006 we acquired the assets of 16 other insurance brokerages, which were not significant individually or in the aggregate to our consolidated financial statements.
During 2006, we repaid in full the $14.2 million bank debt assumed as part of the Fortun acquisition.
Goodwill in the “Other” column above of $27.5 million includes $7.4 million primarily related to goodwill arising from contingent consideration payments earned on certain prior year acquisitions and $19.2 million related to certain current and prior year acquisitions.
During 2006, we disposed of certain of our insurance brokerage subsidiaries by selling 100% of the issued and outstanding shares or the assets of the subsidiary. In connection with such dispositions, we received proceeds of $1.7 million and recognized a gain on disposal of subsidiaries of $0.2 million. None of the subsidiaries that we disposed of during 2006 were significant, individually or in the aggregate, to our consolidated financial statements.
On May 2, 2005, we acquired 100% of the issued and outstanding shares of THB Intermediaries, Inc. (“THB”), for approximately $5.6 million. The acquisition of THB represented our first hub brokerage that specializes in the facultative reinsurance brokerage market, with offices in New York, Los Angeles, Chicago, and Dallas.
On October 1, 2005, we acquired 100% of the issued and outstanding shares of Personal Lines Insurance Brokerage, Inc. (“PLI”) from The Chubb Corporation, for approximately $38.7 million. Our acquisition of PLI expanded our position in the personal insurance market across most of the U.S.
Goodwill in the “Other” column above of $23.4 million includes $9.3 million primarily related to goodwill arising from adjustments to preliminary purchase price allocations and contingent consideration payments earned on certain prior year acquisitions.
In anticipation of funding an acquisition during 2005, we entered into a foreign exchange forward contract to convert Canadian dollars to U.S. dollars. The difference between the forward rate contracted and the spot rate as of the date of conversion resulted in us incurring a foreign exchange loss of $0.6 million, which is included in our consolidated statement of earnings for the year ended December 31, 2005.
On April 1, 2004, we acquired 100% of the issued and outstanding membership interests of Bush, Cotton & Scott, LLC. (“BCS”) for approximately $14.8 million. BCS is located in Seattle, Washington, and specializes in providing general insurance and surety bonding for construction firms. BCS has subsequently become Hub Northwest.
In addition, during 2004 we acquired the assets of five other insurance brokerages, which were not significant, individually or in the aggregate, to our consolidated financial statements taken as a whole.
During 2004, we disposed of certain of our insurance brokerage subsidiaries by selling 100% of the issued and outstanding shares or the assets of the subsidiary. In connection with such dispositions, we received proceeds of $9.2 million and recognized a gain on disposal of subsidiaries of $2.1 million. None of the subsidiaries that we disposed of during 2004 were significant, individually or in the aggregate, to our consolidated financial statements.
A summary of the activity in our allowance for doubtful accounts for the years ended December 31, 2006, 2005 and 2004 is as follows (in thousands):
A summary of the activity in our allowance for policy cancellations for the years ended December 31, 2006, 2005 and 2004 is as follows (in thousands):
Included in computer equipment as of December 31, 2006 and 2005, were computer software assets with a net book value of $5.4 million and $5.9 million, respectively. During the years ended December 31, 2006, 2005 and 2004, we incurred depreciation expense for computer software assets of $2.3 million, $2.4 million, and $1.9 million, respectively.
As of December 31, 2006 and 2005, the net book value of property and equipment held under capital leases was not significant.
Increases to other intangible assets during the years ended December 31, 2006 and 2005, as a result of business acquisitions, excluding business dispositions, are as follows (dollars in thousands):
For the years ended December 31, 2006, 2005 and 2004, amortization expense for other intangible assets is as follows (in thousands):
Changes in the carrying amount of goodwill during the years ended December 31, 2006 and 2005, by reportable segment are as follows (in thousands):
As of December 31, 2006, we expect that approximately $350.0 million of our total goodwill balance will be deductible in future periods for income tax purposes.
Our outstanding debt balances as of December 31, 2006 and 2005, consist of the following (in thousands):
As of December 31, 2006, future annual principal payments of our outstanding debt obligations are as follows (in thousands):
Under the provisions of our Series A and Series B senior notes, we are limited in our ability to take certain actions, including, among other things, incurring other senior or subordinated debt in excess of specified amounts, and selling or disposing of assets or subsidiaries in excess of certain amounts. We are also required to satisfy certain financial covenants on a periodic basis, including the maintenance of a minimum level of consolidated net worth, a maximum consolidated debt to capitalization percentage of 45%, and a minimum interest coverage ratio of 3:1. As of December 31, 2006, we are in compliance with all covenants governing these senior notes.
On July 15, 2003, we entered into an interest rate swap agreement to effectively convert our fixed rate interest payments on the Series A senior notes of 5.71% and the Series B senior notes of 6.16% to a floating rate. The notional amount of the swap agreement is equal to the outstanding principle balance on our Series A and B notes. As a result of the swap agreement, we incurred interest expense of approximately $1.0 million during the year ended December 31, 2006, and realized interest expense savings of approximately $0.2 million during the year ended December 31, 2005. In accordance with Canadian GAAP, we account for the swap transaction using the synthetic instruments method. Under this method we record the net interest expense on the swap and associated debt in our consolidated statement of earnings as if it were a single synthetic financial instrument. Also, under this method we do not recognize the estimated fair value of the interest rate swap arrangement on our consolidated balance sheets, which we have estimated to be approximately $4.0 million as of December 31, 2006, and represents the amount that we would have to pay to terminate the swap as of this date.
As of December 31, 2006, we have outstanding $75.0 million aggregate principal amount of unsecured senior notes issued April 4, 2006. The notes were issued at 6.43% with interest payable quarterly in January, April, July, and October and principal of $12.5 million due annually beginning April 4, 2011, through April 4, 2016. The senior notes were sold on a private basis in the U.S. We incurred approximately $0.2 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized over the term of the notes.
Under our U.S. Credit Facility, we are limited in our ability to take certain actions, including, among other things, incurring other senior or subordinated debt in excess of specified amounts, and selling or disposing of assets or subsidiaries in excess of certain amounts. We are also required to satisfy certain financial covenants on a periodic basis, including the maintenance of a minimum level of consolidated net worth, a maximum consolidated debt to capitalization percentage of 45%, and a minimum interest coverage ratio of 3:1. As of December 31, 2006, we are in compliance with all covenants of the facility.
Canadian Credit Facility. We have entered into an unsecured credit facility with a Canadian financial institution (the “Canadian Credit Facility”). Under our Canadian Credit Facility, we may borrow up to C$12.0 million (which is equivalent to $10.3 million U.S. dollars as of December 31, 2006) in Canadian dollars under a revolving credit facility. We may prepay outstanding loans under the Canadian Credit Facility at any time and without penalty. There is no stated maturity under the Canadian Credit Facility; borrowing under the Canadian Credit Facility are payable on demand. Borrowings under the Canadian Credit Facility bear interest at a variable interest rate per annum that is tied to the U.S. base bank rate, which was 9.25% and 7.75%, respectively, as of December 31, 2006 and 2005, plus 50 basis points. We are not charged a commitment fee on undrawn balances under our Canadian Credit Facility. We have no financial covenants related to our Canadian Credit Facility.
In connection with our acquisition of Talbot during 2004, we assumed a $4.1 million term loan bearing interest at variable rates and maturing in December 31, 2007. We prepaid this amount in full in December 2006.
Other notes payable, long-term debt, and capital leases consists primarily of amounts assumed in connection with certain business acquisitions. Certain property and equipment of our subsidiaries is pledged as collateral in amounts not less than the combined outstanding secured balance of other notes payable, long-term debt, and capital leases as of December 31, 2006 and 2005. The outstanding secured balance of other notes payable, long-term debt, and capital leases held by such subsidiaries as of December 31, 2006 and 2005, is $2.1 million and $2.7 million, respectively.
During June 2001, we issued to certain subsidiaries of Fairfax 8.5% convertible subordinated debentures in the amount of $35.0 million, which were due June 28, 2007. The Fairfax notes were convertible by the holders at any time into our common shares at a price of C$17.00 per share. Beginning on June 28, 2006, we could require conversion of the Fairfax notes if, at any time, the weighted average closing price per share of our common shares on the TSX equaled or exceed C$19.00 per share for twenty consecutive trading days. On June 29, 2006, we exercised our conversion option, and on this date the Fairfax notes were converted into approximately 2.3 million of our common shares. See Note 15 “Related Party Transactions,” of these notes to our consolidated financial statements for a discussion of this and other related party transactions with Fairfax.
We are a party to the following investigations and pending legal proceedings that are outside the scope of ordinary routine litigation and investigations incidental to our business.
As previously disclosed, the insurance brokerage industry in general, and certain of our subsidiaries, are the subject of ongoing investigations by various states’ attorneys general and insurance regulators, with respect to contingent commission arrangements between insurance carriers and insurance brokers and certain other practices.
As previously disclosed, HUB Northeast, formerly known as Kaye Insurance Associates, Inc., one of our subsidiaries, received three subpoenas from the Office of the Attorney General of the State of New York seeking information regarding certain contingent agreements and other business practices. From August 2004 to December 31, 2006, various of our other subsidiaries, received and responded to letters of inquiry and subpoenas from authorities in California, Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec. To date, management is unaware of any incidents of falsifying or inflating insurance quotes or other illegal practices. States’ attorneys general and insurance departments continue their investigations of various industry practices. In February 2007 we received a request from the office of the Massachusetts Attorney General requiring us to provide certain information, primarily relating to carrier relationships of HUB New England. We are in the process of complying with this request. We continue to review our practices in light of these investigations and resulting charges brought against other insurance brokers.
We have fully cooperated with inquiries from the states’ attorneys’ general and departments of insurance. Due to the inherent uncertainties of such investigations, we cannot predict the outcome of these investigations. As of December 31, 2006, we have not recorded a liability for possible losses related to these investigations as we are unable, at this time, to reasonably estimate the probability of an unfavorable outcome or a possible loss or range of losses. An unfavorable outcome, including the possible restriction or termination of contingent compensation agreements, could have a significant adverse effect on our business, results of operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and other intangible assets for impairment, when applicable.
Due to the inherent uncertainties of litigation, we cannot predict the outcome of these matters. As of December 31, 2006, we have not recorded a liability for possible losses related to these class action lawsuits as we are unable, at this time, to reasonably estimate the probability of an unfavorable outcome or a possible loss or range of losses. As of December 31, 2006, we have recorded a liability related to legal defense costs in connection with these matters, offset, in-part, by expected insurance proceeds, which we have deemed to be reasonable and estimable. An unfavorable outcome of any one or more of these matters could result in a significant judgment or imposition of liability against us and could have a significant adverse impact on our business, results of operations, cash flows, and financial position. In addition, the cost of defending against these lawsuits, and diversion of our management’s attention, may be significant and could have a significant adverse impact on our business, results of operations, cash flows, and financial position. We have evaluated these matters in connection with our ongoing evaluation of goodwill and other intangible assets for impairment, when applicable.
In addition to the legal proceedings and other matters discussed above, we are also subject to a variety of other claims, suits, and investigations that arise from time to time in the ordinary conduct of our business. While we currently believe that such claims, individually or in aggregate, will not have a significant adverse impact on our financial position, cash flows, or results of operations, these litigations and other claims are subject to inherent uncertainties, and management’s view of these matters may change in the future. Were an unfavorable final outcome to occur in any one or more of these matters, there exists the possibility of a significant adverse impact on our business, reputation, financial position, cash flows, and results of operations.
On September 30, 2005, we made the first Talbot earnout payment of $16.4 million in cash. This payment was based upon Talbot’s earnings for the year ended December 31, 2004.
As of December 31, 2006, we have recognized total Talbot earnout compensation expense of $55.3 million, of which $19.8 million remains payable and is included as a component of accounts payable and accrued liabilities on our consolidated balance sheet.
Other Acquisitions. In connection with various other business acquisitions completed through December 31, 2006, we may be obligated to pay contingent consideration up to a maximum of approximately $44.5 million in cash and $12.0 million in our common shares. This estimate is based upon management’s best estimate as of December 31, 2006, of acquired brokerages achieving certain financial and operational targets. These contingent payments are payable on various dates through October 2011 according to the terms and conditions of each individual purchase agreement. Any contingent consideration, in addition to this amount, will be recorded as an adjustment to goodwill once the contingency is resolved. As of December 31, 2006, we have recorded, as a component of accounts payable and accrued liabilities, earned but unpaid contingent consideration of $4.0 million, which is payable in cash.
Following our formation in 1998, we introduced the Executive Share Purchase Plan (“ESPP”) to allow certain of our executives and other key employees to purchase our common shares. Under the ESPP, certain participants obtained loans from a Canadian chartered bank to purchase our common shares. We have fully guaranteed repayment of such loans and each of the loans is fully collateralized by the applicable common shares purchased by the employee. These loans mature on various dates during 2009 and 2010 and bear interest at a rate of Canadian prime plus 0.5%. Shares purchased under the ESPP are owned by the participant; however, transfer of the applicable shares is restricted, with shares vesting ratably over the term of the loan.
Certain of our leases contain rent escalation and lease incentives, including rent abatements and tenant improvement allowances. Rent escalation clauses and lease incentives are considered by us in determining total rent expense to be recognized during the lease term, which begins with the date we take control of the leased space. Renewal options are considered by us in evaluating the overall term of the lease. Differences between periodic rent expense and periodic cash rental payments, caused primarily by the recognition of rent expense on a straight-line basis, and tenant improvement allowances due or received from lessors are recorded as a current liability on our consolidated balance sheet.
As of December 31, 2006, aggregate future minimum lease payments, net of expected sub-lease receipts, under operating leases are as follows (in thousands):
In the ordinary conduct of our business, we are subject to various claims and lawsuits that arise primarily from alleged errors and omissions in connection with the placement of insurance. While we currently believe that such claims and lawsuits, individually or in aggregate, will not have a significant adverse impact on our financial position, cash flows, or results of operations, these claims and lawsuits are subject to inherent uncertainties, and management’s view of these matters may change in the future. We are self-insured for certain losses related to errors or omission claims. In addition, we are self-insured for certain general insurance deductibles and a portion of our group medical insurance. The amounts in excess of our self-insured levels are fully insured by third parties, subject to certain limitations and exclusions. As of December 31, 2006 and 2005, we have recorded reserves for all self-insurance exposures of approximately $10.4 million and $7.1 million, respectively, which are included as a component of accounts payable and accrued liabilities on our consolidated balance sheets.
Our provision for income taxes for the years ending December 31, 2006, 2005 and 2004, totaled $35.7 million, $31.0 million, and $20.0 million, respectively, resulting in an effective tax rate of 41%, 55%, and 44% for the years then ended.
The components of the future tax assets and (liabilities) as of December 31, 2006 and 2005, are as follows (in thousands):
valuation allowance relates to certain non-deductible future capital losses attributable to investments with tax basis in excess of book basis as of December 31, 2006, of $0.6 million and $0.5 million in the U.S. and Canada, respectively.
We have an unlimited number of non-voting, preferred shares authorized and issuable in series on such terms and conditions as set by our Board of Directors, of which no shares were issued or outstanding as of December 31, 2006, 2005 and 2004.
RSUs. As of December 31, 2006, we have outstanding RSUs with vesting terms ranging from 9 to 120 months. RSU activity during the years ended December 31, 2006, 2005 and 2004, under the equity incentive plan is as follows (RSUs in thousands):
The original vesting term for RSUs granted during 2004 ranges from 60 months to 84 months. Approximately 977,000 of the total RSUs granted during 2004 were awarded in connection with the restructuring of our management bonus agreement and approximately 84,000 of the total RSUs granted during 2004 were awarded in connection with the renegotiation of contingent consideration related to our 2001 acquisition of J.P. Flanagan Corporation.
The following table summarizes information with respect to RSUs outstanding under the equity incentive plan as of December 31, 2006 (RSUs in thousands):
Talbot Earnout. As discussed in Note 9 “Commitments and Contingencies - Contingent Consideration in Connection with Business Acquisitions,” in these notes to our consolidated financial statements, in connection with our acquisition of Talbot, we agreed to purchase one-third of the special shares of Satellite during each of the years ended December 31, 2005, 2006 and 2007, at a price contingent on Talbot’s financial performance during the preceding calendar year. Under the agreement, we have the discretion to pay the Talbot earnout, if payable, in cash, issuances of our common shares or a combination thereof. Accordingly, we determined that the Talbot earnout agreement is, in substance, a performance-based contingent compensation arrangement, and thus have recorded the Talbot earnout payments as a charge to compensation expense over the period in which the payments are earned. In accordance with the Talbot earnout, the Talbot Management Group will be compensated for future services based on remaining with Talbot and achieving certain performance targets during the applicable three year period.
the fair value of share-based awards as compensation expense during the vesting period of the underlying award using the straight-line method. We estimate forfeitures of share-based awards at the time of grant and revise such estimates in subsequent periods if actual forfeitures differ form those estimates.
Our determination of the fair value of stock options using the Black-Scholes-Merton option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the expected life of the awards, actual and projected employee stock option exercise behaviour, and expected dividend yield.
Based on share-based awards issued and outstanding as of December 31, 2006, our estimated non-cash share-based compensation expense for the years ended December 31, 2007 through 2012, is as follows (in thousands):
The following table summarizes our calculation of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004 (in thousands except per share amounts):
We maintain defined contribution retirement savings and profit sharing plans covering substantially all of our officers and employees. Under the plans, an eligible employee may elect to defer receipt of a portion of his or her annual pay, including salary and bonus. We contribute this amount to the plan on the employee’s behalf and also make a matching contribution equal to specified percentage of the employees periodic contribution or annual compensation. In addition, at our discretion we generally may make a profit-sharing contribution to the employee equal to a percentage of the employees applicable annual compensation. Employees are 100% vested at all times in the amounts they defer from their annual pay. Employees generally become 100% vested in our matching
contribution ratably over a two or five year period, starting from the date the employee becomes eligible to participate in the plans. During the years ended December 31, 2006, 2005 and 2004, we incurred expense under this plan of $3.9 million, $4.4 million, and $2.7 million, respectively.
During the second quarter of 2004, Fairfax sold 100% of its stake in OLIC to Old Lyme Insurance Group, Ltd, an entity that is primarily owned by a group of current Hub employees, including Bruce Guthart, our Chief Operating Officer and a director of Hub. We continue to place insurance with OLIC and perform certain management functions for OLIC. The revenue we realize from insurance placed with OLIC and the fees we earn from managing OLIC are substantially the same as if Fairfax continued to own OLIC.
As of December 31, 2006 and 2005, we also had accounts receivable from related parties in the amount of $1.7 million and $2.2 million, respectively, of which the majority is receivable from employees in connection with our ESPP. Under the ESPP, we obtained loans from a Canadian chartered bank and in turn lent such amounts to
participants to purchase our common shares. Each of the loans is fully collateralized by the applicable common shares purchased by the employee. These loans mature in June 2011 and bear interest at a rate of Canadian prime plus 0.5%. Shares purchased under the ESPP are owned by the participant; however, transfer of the applicable shares is restricted, with shares vesting ratably over the term of the loan.
We manage our operations by utilizing an organizational structure comprised of our corporate head office, larger regional or specialty insurance brokerages that we refer to as “hub brokerages” or “hubs,” and smaller brokerages that are managed by our hub brokerages that we refer to as “fold-in brokerages” or “fold-ins.” As of December 31, 2006, we operated 18 hubs, 13 located in the U.S. and five located in Canada. We have structured our hub brokerages so as to take advantage of a specific regional or specialty market. Each of our hubs has its own management team that is responsible for, in addition to the day-to-day operations of the hub brokerage, maintaining and developing organic growth and identifying and integrating fold-in brokerage acquisition candidates. Our hub brokerages generally generate $10 million or greater in annual revenue, however, certain of our hubs which focus on a specific specialty product line or market may generate less than $10 million in annual revenue.
Our hub structure provides our hub brokerages the flexibility to effectively meet changing market conditions in a timely manner, while benefiting from the economies of scale, leverage, and operating efficiencies provided by a large multi-national brokerage network. We have decentralized our client service functions because we believe that client service related decisions are best made by those individuals that deal with our clients on a day-to-day basis. However, we recognize that our continued growth has created a scenario that demands increased coordination by our hub brokerages. To meet these challenges, we continue to develop strategies that enable our head office to coordinate the functions of our hubs, which in-turn, will enhance cross-selling initiatives between each of our hub brokerages, international collaboration between our Canadian and U.S. hub brokerages, marketing efficiencies, expense management, and financial control initiatives. In addition, to improve the operating efficiency and expense management of our business, we are in the process of centralizing those activities that do not directly affect our client relations functions, including, finance and accounting, human resources, information technology, and certain other administrative functions.
The hub brokerage is the lowest level in our organization for which discrete financial information is reviewed by our Chief Operating Decision Maker (“CODM”), which we define as our EMT. Our CODM reviews certain financial and operational information for each of our hubs when deciding how to allocate resources and in assessing performance. In accordance with Canadian and U.S. GAAP, we have determined that each of our hub brokerages represents an operating segment. We evaluate the performance of our hub brokerages based primarily on earnings before interest, taxes, depreciation, and amortization (“EBITDA”). EBITDA should not be considered an alternative to, nor is there any implication that it is more meaningful than, any measure of performance or liquidity promulgated under Canadian or U.S. GAAP. We believe that EBITDA is particularly meaningful due principally to the role acquisitions have played in our development. Historically, our growth through acquisition has resulted in significant non-cash depreciation and amortization expense because a significant portion of the purchase price of an acquired brokerage is generally allocated to amortizable definite lived intangible assets and depreciable fixed assets.
We have aggregated the operating results of both our U.S. and Canadian hubs as they (1) exhibit similar long-term economic characteristics, (2) provide similar products and services, (3) distribute products and services through common distribution channels to a common class or type of customer, and (4) operate in a similar regulatory environment. However, when comparing our aggregated Canadian hubs and our aggregated U.S. hubs, there are certain economic and regulatory differences that distinguish our U.S. operations from our Canadian operations.
Excluding the impact of acquisitions, the results of operations of our U.S. and Canadian based hubs fluctuate on a quarterly basis, primarily as a result of revenue recognized in connection with contingent commission arrangements. We recognize contingent commission and volume override revenue during the period that the amounts are reasonably estimable, which generally occurs during the first and second quarters upon receipt of payment. As a result of these factors, total revenue, excluding the impact of acquisitions, is typically highest in the first and second quarters and lowest in the third quarter and fourth quarters. Our operating costs do not fluctuate as significantly on a quarterly basis. We anticipate that these seasonal trends will continue.
Summary financial information by reportable segment is as follows (in thousands):
Our operating segments primarily derive commission income from the placement of insurance on behalf of their clients. Commission income generated by each of our operating segments varies based on the type of insurance products and services offered and placed with insurance carriers on behalf of their clients. The primary insurance products and services offered collectively by our operating segments include commercial lines, personal lines, wholesale, and employee benefits. Commission income derived from other products and services is not individually significant for the years ended December 31, 2006, 2005 and 2004. In addition to commission income, our operating segments also generate revenue from contingent commission arrangements, volume overrides, and other activities, however, we do not distinguish these revenue sources by insurance product and service line. During the years ended December 31, 2006, 2005 and 2004, no individual customer accounted for more than 10% of our consolidated revenue.
The following table summarizes our consolidated commission income by product and service line for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Except as otherwise indicated, our consolidated financial statements and the notes to our consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. The following discussion reconciles our Canadian GAAP financial statements to U.S. GAAP.
(1) Under U.S. GAAP, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 130 Reporting Comprehensive Income, comprehensive income is defined as all changes in equity other than those resulting from investments by owners and distributions to owners and includes the change in unrealized gains (losses) on debt and equity securities and foreign currency translation adjustments. Under U.S. GAAP, comprehensive income is recorded as a component of shareholders’ equity. Under Canadian GAAP, unrealized gains (losses) arising from temporary declines in value of equity securities are not recorded in the financial statements and foreign currency translation adjustments are presented as movements in the cumulative translation account. Beginning on January 1, 2007, in accordance with the Canadian Institute of Chartered Accountants handbook section 1530 (“Section 1530”), Canadian GAAP will require the recording of comprehensive income as a component of shareholders equity, thus, eliminating the differences between Canadian and U.S. GAAP in this area. Certain note disclosures required by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”) have not been included in the notes to our consolidated financial statements as such disclosures related to our investments in debt and equity securities are not significant to our consolidated financial statements as of and for the years ended December 31, 2006, 2005 and 2004.
(3) The adjustment of $1.7 million is attributable to the difference in accounting under Canadian and U.S. GAAP, for investments held-for-sale that we acquired in connection with the purchase of an insurance brokerage during 2001, and which we subsequently sold during 2002. Under Canadian GAAP, investments held-for-sale are recorded at cost. No adjustments are made to the carrying value of the held-for-sale investment until it is sold at which time a gain or loss is recorded based on the difference between the sales proceeds and its carrying value. Under U.S. GAAP, investments held-for-sale are recorded at cost and periodically adjusted to fair value until sold at which time the difference between the sales proceeds and its carrying value was recorded as an adjustment to the related goodwill.
In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of prior-year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover method”) and balance sheet (“iron curtain method”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material to the financial statements taken as a whole. If prior year’s errors that had been previously considered immaterial are considered material in the current year based on the application of either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered. If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption. SAB 108 is effective for the fiscal years ending on or after November 15, 2006, with earlier adoption encouraged. In evaluating prior years misstatements, we have historically applied both approaches to determine materiality, thus, we do not expect our adoption of SAB 108 to have a material effect on our consolidated financial statements.
Under the terms of the Arrangement Agreement, Maple Tree will acquire all of the outstanding Shares, other than certain Shares held by the Rollover Shareholders that will be exchanged as described above, pursuant to a Plan of Arrangement (the “Arrangement”) under the Canada Business Corporations Act (the “CBCA”).
Each Company RSU that does not by its terms accelerate at the Effective Time will remain in effect, with appropriate adjustments determined by Hub pursuant to the terms of our equity incentive plan under which such Company RSU was issued, and will vest in accordance with its terms, unless Hub and Maple Tree determine on or prior to the Effective Time to accelerate the vesting of such Company RSU.