In 2006, the Company’s management reexamined its segment evaluation analysis in response to an SEC review comment and determined that, in accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company has two reportable segments, Domestic Retail and Excess and Surplus, with the remaining profit centers combined as an All Other category for the years ended December 31, 2006, 2005 and 2004. For further information, see “Note R-Segment Information” of Notes to Consolidated Financial Statements included in Item 8. In 2007, the Company expects to report an additional segment, International, due to the Company’s recent acquisition of Glencairn, which has expanded the Company’s foreign operations.
million, or $0.02 per share, and integration costs, net of tax, of $0.5 million, or $0.01 per share. The severance charge represented estimated payments due to the Company’s former president and chief operating officer under terms of his employment agreement. Integration costs represented costs associated with the Company’s integration of Hobbs Group, LLC (Hobbs), which began after the completion of the Hobbs earn-out on June 30, 2003. Integration costs for 2005 represented facility and lease termination costs. In 2006, the Company reduced this accrual by $0.1 million, net of tax, or $0.01 per share, due to new factors regarding a lease termination. Net income for 2006 also included a loss on extinguishment of debt, net of tax, of $0.5 million, or $0.02 per share. The loss on extinguishment of debt was associated with the Company’s entry into a new credit agreement in April 2006 with Bank of America, N.A and other lenders (Credit Agreement). This charge represented financing costs previously deferred in connection with the financing of the Company’s former credit facility in addition to certain lending fees paid in obtaining the Credit Agreement. Non-recurring gains and asset write-offs, net of tax, were $0.7 million, or $0.02 per share, and $2.9 million, or $0.08 per share, for the years ended December 31, 2006 and 2005, respectively. These non-recurring gains were primarily related to the sales of branch offices and various accounts. Independent of these non-recurring balances, the year-to-year increase of $5.9 million, or $0.15 per share, in net income can be primarily attributed to higher commissions and fees and reduced legal, compliance and claims expenditures, partially offset by increased compensation and employee benefit costs. In 2006 the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (Statement 123R). The revised standard requires all companies to recognize compensation costs related to all share-based payments (including stock options) in their financial statements at fair value. The adoption of Statement 123R in 2006 resulted in additional compensation expense, net of tax, of $4.0 million, or $0.11 per share.
For 2005, net income was $56.2 million, or $1.55 per share, compared to $81.4 million, or $2.23 per share for 2004. As noted above, net income for 2005 included a regulatory charge and related costs, net of tax, of $26.3 million, or $0.73 per share; a severance charge, net of tax, of $0.8 million, or $0.02 per share; and integration costs, net of tax, of $0.5 million, or $0.01 per share. Net income for 2004 included a loss on extinguishment of debt, net of tax, of $0.9 million, or $0.03 per share, and integration costs, net of tax, of $1.1 million, or $0.03 per share. The loss on extinguishment of debt was associated with the Company’s entry into the Amended and Restated Credit Agreement (Amended Credit Agreement) in December 2004, and consistent with the 2006 charge, this loss represented financing costs previously deferred in connection with the financing of the Company’s predecessor credit agreement in addition to certain lending fees paid in obtaining the Amended Credit Agreement. Costs related to the Company’s integration of Hobbs included costs such as severance and other employee-related costs, facility and lease termination costs, and branding expenses. Non-recurring losses on the sale of assets, net of tax, were $0.3 million, or $0.01 per share, in 2004 and were primarily related to the sales of branch offices and various accounts. Independent of the charges noted above, net income decreased $3.0 million, or $0.07 per share. The decrease can be attributed to additional compensation costs, higher legal, compliance & claims costs, and increased amortization expense, partially offset by additional commissions and fees from acquired agencies and higher contingent commissions.
In 2006, approximately $25.1 million of the core commissions and fees for Domestic Retail were derived from acquisitions of new insurance agencies and accounts in 2006 and 2005. This increase was partially offset by the reduction of core commissions and fees of approximately $9.2 million from the sale of certain agencies and accounts in 2006 and 2005. Excluding the effect of acquisitions and dispositions, the change in core commissions and fees for Domestic Retail was $20.1 million, or 3.8%. This increase reflects new business production, partially offset by accelerated declines in commercial property and casualty premium rates. Estimated commercial property and casualty premium rate declines have ranged between 2.7% and 9.6% in the 2006 quarterly surveys published by the Council of Insurance Agents and Brokers. The 8.7% increase in Excess and Surplus core commissions and fees can be attributed to new business production and rate increases on certain policy placements. The 8.5% increase in core commissions and fees for the profit centers comprising All Other is primarily attributed to the Company’s international subsidiaries. Core commissions and fees for foreign agencies increased $4.4 million, or 35.6%, as a result of net new business production, primarily resulting from recent investments in new producer talent; increased reinsurance policy placements; and the effect of translating the British pound sterling to American dollars.
Contingent commissions decreased $4.4 million, or 9.0%. The change in contingent commissions can be primarily attributed to activity in the Domestic Retail segment. Reduced contingent commissions are the result of the elimination of fee based contingent commission income and reduced payments from certain carriers in the current year.
Insurance agencies and accounts purchased in 2005 and 2004 accounted for $40.8 million of additional core commissions & fees in the Domestic Retail segment in 2005. The core commissions and fees impact from 2005 and 2004 dispositions in Domestic Retail was $9.7 million for 2005. Excluding the effect of acquisitions and dispositions, the change in core commissions and fees for Domestic Retail was (1.3)%. The decrease in core commissions and fees principally reflected a continued decline in property and casualty premium rates and lower than normal retention rates primarily related to producer culling. Acquired insurance agencies accounted for $3.5 million of additional core commissions and fees in 2005 in Excess and Surplus. Excluding these acquired branches, Excess and Surplus core commissions and fees decreased 1.5% as a result of lower property and casualty premium rates and reduced wholesale placements. For the branches comprising the All Other reportable segment, an acquisition accounted for $11.6 million in additional core commissions and fees in 2005, and the divestiture of certain accounts resulted in a $0.1 million reduction in core commissions and fees. Independent of these transactions, core commissions and fees for this reporting segment increased 11.2% in comparison to 2004. This increase can be attributed to new business production at one of the Company’s international branches.
Contingent commissions increased $6.2 million, or 14.6%, between 2005 and 2004. Approximately $9.1 million of the increase in contingent commissions was derived from insurance agencies purchased in 2005 and 2004, primarily relating to the Domestic Retail segment. These additional contingent commissions are partially offset by the termination of National Override Agreements. National Override Agreements are defined in “Note N-Regulatory Charge and Related Matters” of Notes to Consolidated Financial Statements. See “Contingent and National Override Agreements Commissions” for additional discussion of the Company’s contingent and override commission arrangements.
Other operating expenses for 2006 decreased $4.4 million, or 3.4%, from 2005 due to lower legal, compliance and claims expenditures, partially offset by increased travel, promotional and meeting expenses. Legal, compliance and
claims expenditures in 2006 and 2005 include $5.0 million and $4.4 million, respectively, of insurance recoveries. The 2006 insurance recovery is related to legal fees incurred in 2006 and 2005 to defend the Company in industry-related class action litigation, while the 2005 recovery is attributed to contested claims. Independent of the impact of these legal recoveries, legal, compliance and claims expenses decreased $9.6 million due to reduced expenditures for regulatory inquiries related to governmental investigations into the insurance intermediary industry’s business practices and broker compensation arrangements and lower costs related to the protection of restrictive covenants in employment matters. Travel, promotional and meeting expenses increased as a result of acquisitions, increased sales efforts and various customer related meetings and training events.
Other operating expenses for 2005 were $127.7 million, or 13.7%, higher than 2004. Other operating expenses increased mainly due to increased legal, compliance and claims expenses and acquisitions. Legal, compliance and claims expenditures increased $7.0 million due primarily to various regulatory inquiries and the protection of restrictive covenants in employment contracts as well as expenditures for compliance with Section 404 of the Sarbanes-Oxley Act. The $7.0 million increase is net of $4.4 million in insurance recoveries on contested claims.
Amortization expense reflects the amortization of intangible assets acquired in the purchase of insurance agencies and accounts. Amortization expense increased $2.8 million in 2006, which is attributable to acquisitions consummated during 2006 and 2005. Amortization expense increased $4.9 million in 2005 due to acquisitions consummated during 2005 and 2004. Depreciation expense for 2006 decreased $0.1 million from 2005 to $8.3 million. Depreciation expense for 2005 decreased $0.3 million, or 3.3%, from 2004 to $8.4 million. In both periods, depreciation expense decreased due to the impact of fully depreciated assets and disposed assets, partially offset by higher amounts for purchases and acquisitions.
The effective tax rate for the Company was 38.5%, 39.5% and 41.0% in 2006, 2005 and 2004, respectively. The 2006 rate decreased primarily due to higher tax-exempt investment income and a favorable mix of state tax rates. The 2005 rate decreased primarily due to a favorable mix of state tax rates, higher tax exempt investment income and fewer permanent tax differences on non-operating gains, partially offset by certain non-deductible items in the regulatory charge.
Net cash provided by operations was $125.3 million, $102.2 million and $117.3 million for 2006, 2005 and 2004, respectively, and is primarily dependent upon the timing of the collection of insurance premiums from clients and payment of those premiums to the appropriate insurance underwriters.
Financing activities provided (utilized) cash of $(55.5) million, $(51.5) million and $30.0 million for 2006, 2005 and 2004, respectively, as the Company repurchased Common Stock and made dividend and debt payments. For 2004, these uses of cash were offset by proceeds from the Company’s entry into the Amended Credit Agreement, which provided additional term loan borrowings. The Company has annually increased its dividend rate and anticipates the continuance of its dividend policy. During 2006, the Company repurchased, on the open market, 633,300 shares of its Common Stock for $25.0 million under its stock repurchase program. In 2005, the Company repurchased, on the open market, 612,800 shares of its Common Stock for $21.8 million under its stock repurchase program. The Company is currently authorized for 2007 and later years to purchase up to $50.0 million annually of its Common Stock subject to market conditions and other factors.
As of December 31, 2005, the Company had, under its Amended and Restated Credit Agreement (the Amended Credit Agreement), outstanding term loans of $243.0 million which were due in various amounts through 2011, and no outstanding revolving credit facility borrowings. On April 26, 2006, the Company entered into the Credit Agreement which provides for a revolving credit facility of $325.0 million and a term loan facility of $100.0 million. Upon entry into the Credit Agreement, the Company borrowed $140.6 million under the revolving credit facility and $100.0 million under the term loan facility. The Company used these proceeds to repay its $240.6 million of borrowings under the Amended Credit Agreement outstanding at April 26, 2006. The Credit Agreement replaced the Amended Credit Agreement.
The Credit Agreement permits the Company to request additional facilities in amounts up to $125.0 million and provides that a portion of the revolving credit facility will be available for the issuance of letters of credit. Borrowings bear interest at variable rates based on LIBOR plus a negotiated spread (1.50% at December 31, 2006). In addition, the Company pays commitment fees (0.30% at December 31, 2006) on the unused portion of the revolving credit facility. The principal payments of the term loan facility are payable quarterly while the principal balance of the revolving credit facility is due and payable upon the maturity date. The revolving credit facility matures on April 26, 2011 and the term loan facility matures on April 26, 2013. Annual payments of the outstanding principal amounts under the term loan facility will total $1.0 million in 2007, 2008, 2009, 2010, 2011, and 2012 and $93.3 million in 2013. The Credit Agreement represents senior secured indebtedness and contains, among other provisions, requirements for maintaining certain financial ratios and specific limits or restrictions on acquisitions, indebtedness, investments, payment of dividends and repurchases of Common Stock. In connection with the Credit Agreement, the Company deferred $1.6 million of debt issuance costs which will be amortized as additional interest expense over the term of the credit facility.
(2) Long-term debt reflects debt payments based upon their contractual payment dates. The schedule of these payments for purposes of the table differs from the maturities disclosed in the Company’s notes to consolidated financial statements. As disclosed in the notes to consolidated financial statements, the Company has classified term loans included in the credit facility as maturing in a later period based upon the Company’s intent and ability to refinance this obligation on a long-term basis under its revolving credit facility. This treatment results in the table reflecting earlier payment for these obligations than as disclosed in the notes to consolidated financial statements.
On August 31, 2005, the Company entered into an agreement with the Attorney General of the State of Connecticut (the Attorney General) and the Insurance Commissioner of the State of Connecticut (the Commissioner) to resolve all issues related to investigations conducted by the Attorney General and the Commissioner into certain insurance brokerage and insurance agency practices (the Investigations) and to settle an action commenced on August 31, 2005 by the Attorney General in the Connecticut Superior Court alleging violations of the Connecticut Unfair Trade Practices Act and the Connecticut Unfair Insurance Practices Act. In the agreement, the Company agreed to take certain actions including establishing a $30.0 million national fund for distribution to certain clients, enhancing disclosure practices for agency and broker clients, and to not accept or request contingent compensation on brokerage business. For further information on this agreement, see “Note N-Regulatory Charge and Related Matters” of Notes to Consolidated Financial Statements.
For 2006, 2005 and 2004, the Company recognized contingent and National Override Agreements commissions of $44.2 million, $48.5 million and $42.4 million, respectively. Of the 2006 amount, 100% was from standard contingency agreements and none were from National Override Agreements. Of the 2005 and 2004 annual amounts, 94% and 81%, respectively, was from standard contingency agreements and 6% and 19%, respectively, was from National Override Agreements. The standard contingency agreements are entered into and maintained at the local office level. Effective for business written on or after January 1, 2005, these National Override Agreements reverted into standard local contingency arrangements with those underwriters on an office by office basis, which will be paid and recorded, if at all, annually beginning in early 2006. There can be no assurance that the loss of National Override Agreements commissions resulting from the reversion to standard local contingency arrangements will be offset by additional contingent commissions in future periods.
The departments of insurance of various states may adopt new regulations addressing contingent commission arrangements and disclosure of such arrangements with insureds. In addition, the National Association of Insurance Commissioners has proposed model legislation to implement new disclosure requirements relating to agent and broker compensation arrangements. The Company intends to monitor agent and broker compensation practices and, as warranted by market and regulatory developments, will review its compensation arrangements with underwriters. While it is not possible to predict the outcome of the governmental inquiries and investigations into the insurance industry’s commission payment practices or the responses by the market and regulators, any material decrease in the Company’s contingent commissions is likely to have an adverse effect on its results of operations.
The consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, which require the Company to make estimates and assumptions. The Company believes that of its significant accounting policies (see “Note A-Significant Accounting Policies” of Notes to Consolidated Financial Statements) the following may involve a higher degree of judgment and complexity.
The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its clients to make required payments. The Company monitors its allowance utilizing accounts receivable aging data as the basis to support the estimate. If the financial condition of the Company’s clients were to deteriorate, resulting in an impairment of their ability to make payments, an additional allowance may be required. In addition, the Company has the ability to cancel coverage for clients who have not made required payments.
lives and whether the assets are impaired requires significant judgment and affects the amount of future amortization and possible impairment charges. The Company tests goodwill for impairment annually in the fourth quarter, or sooner if impairment indicators arise. The fair value of the reporting units is estimated by applying valuation multiples to the reporting units’ revenues and operating profits. The selection of multiples is dependent upon assumptions regarding future levels of operating performance as well as business trends, prospects and market and economic conditions. When the fair value is less than the carrying value for the net assets of a reporting unit, including goodwill, an impairment loss may be recognized. Based on our testing, no impairment was identified for the years ended December 31, 2006, 2005 or 2004. However, since the estimated fair values are subject to change based on operating performance and other factors, future impairment charges are possible. In addition, when impairment indicators are present, intangible assets subject to amortization are reviewed for recoverability using estimated future undiscounted cash flows relating to these assets.
Statement of Consolidated Shareholders’ Equity for the years ended December 31, 2006, 2005 and 2004
Hilb Rogal & Hobbs Company, a Virginia corporation, operates offices located in 29 states and in London, England as well as branch locations in Russia, South Africa and Australia. Its principal activity is the performance of insurance and risk management intermediary services which involves placing various types of insurance, including property and casualty, employee benefits and other areas of specialized exposure, with insurance underwriters on behalf of its clients.
Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Revenues-Commission income (and fees in lieu of commission) as well as the related premiums receivable from clients and premiums payable to insurance companies are recorded as of the effective date of insurance coverage or the billing date, whichever is later. Commissions on premiums billed and collected directly by insurance companies on middle-market and major accounts property and casualty business are recorded as revenue on the later of the billing date or effective date. Commissions on premiums billed and collected directly by insurance companies on other property and casualty and employee benefits business are recorded as revenue when received which, in many cases, is the Company’s first notification of amounts earned due to the lack of policy and renewal information. Contingent commissions are recorded as revenue when received. Contingent commissions are commissions paid by insurance underwriters and are based on the estimated profit and/or overall volume of business placed with the underwriter. The data necessary for the calculation of contingent commissions cannot be reasonably obtained prior to receipt of the commission which, in many cases, is the Company’s first notification of amounts earned.
Service fee revenue is recorded on a pro rata basis as the services are provided. Service fee revenue typically relates to claims management and loss control services, program administration and workers compensation consultative services which are provided over a period of time, typically one year. Override commissions are commissions paid by insurance underwriters in excess of the standard commission rates on specific classes of business. These amounts are paid as a percentage of premiums on certain classes of business written with the specific underwriter and are recorded as earned.
Intangible Assets-The Company accounts for goodwill and other intangible assets in accordance with the provisions of Financial Accounting Standards Board Statements No. 141, “Business Combinations,” and No. 142, “Goodwill and Other Intangible Assets” (Statement 142). Goodwill represents the excess of the purchase price over the fair value of identifiable net assets of businesses acquired and accounted for under the purchase method. The fair value of identifiable intangible assets is estimated based upon discounted future cash flow projections.
Accounting for Stock-Based Compensation-At December 31, 2006 and 2005, the Company had three stock-based compensation plans, which are described more fully in Note I. Effective January 1, 2006, the Company adopted Financial Accounting Standards Board Statement No. 123 (revised 2004), “Share-Based Payment” (Statement 123R). See Note C for more information regarding the adoption of Statement 123R.
Through December 31, 2005, the Company accounted for its stock options using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and related interpretations.
Fair Value of Financial Instruments-The carrying amounts of financial instruments reported in the balance sheet for cash and cash equivalents, receivables, other assets, premiums payable to insurance companies, accounts payable, accrued expenses, premium deposits and credits due customers, and long-term debt approximate those assets’ and liabilities’ fair values. Fair values for interest rate swaps are based on third-party pricing models or formulas using current assumptions and are disclosed in Note E.
The Company’s use of derivative instruments is limited to interest rate swap agreements used to modify the interest characteristics for a portion of its outstanding variable rate debt. These interest rate swaps are designated as cash flow hedges and are structured so that there is no ineffectiveness.
The $45.0 million impairment charge involved six business units that were identified as reporting units. The charge consisted of $43.6 million for goodwill and $1.4 million for other intangible assets. Three of these reporting units accounted for $34.4 million of the goodwill impairment and were part of the 2002 acquisition of Hobbs Group, LLC (Hobbs). All of these reporting units experienced declines in market conditions and/or general operating performance which caused the impairment. See Note A for information on estimating fair value for reporting units.
The following tables set forth the net effect of the restatements only for the specific line item amounts that changed as presented in the Company’s Statement of Consolidated Income for the year ended December 31, 2003 and Consolidated Balance Sheet at December 31, 2005, 2004 and 2003.
The Statement of Consolidated Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003 have been restated for the adjustments to net income in 2003 and retained earnings at December 31, 2005, 2004 and 2003 as noted in the tables above.
The restatement represents a non-cash charge that did not impact net cash provided by operating activities or net cash used in investing or financing activities as reported in the Statement of Consolidated Cash Flows for the year ended December 31, 2003. The restatement had no impact on the Statement of Consolidated Cash Flows for the years ended December 31, 2005 and 2004.
Prior to December 2004, Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (Statement 123), as amended by Financial Accounting Standards Board Statement No. 148, established accounting and disclosure requirements using a fair value based method of accounting for stock options. In December 2004, Statement 123R revised Statement 123. The revised standard requires all companies to recognize compensation costs related to all share-based payments (including stock options) in their financial statements at fair value, thereby, upon adoption, eliminating the use of pro forma disclosures to report such amounts.
Statement 123R permits public companies to account for the adoption of this revised standard using one of two methods: the modified-prospective method or the modified-retrospective method. The modified-prospective method requires a company to recognize compensation cost based upon fair value for only those share-based awards granted or
As a result of adopting Statement 123R and no longer accounting for stock-based compensation under APB 25, the Company’s income before income taxes and net income for 2006 were reduced by $6.6 million and $4.0 million, respectively. Basic and diluted net income per share were each lower for 2006 by $0.11 due to the Company’s adoption of Statement 123R.
In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of SFAS No. 109” (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Financial Accounting Standards Board Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on measurement, derecognition and classification and additional disclosure requirements. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, the Company adopted FIN 48 as of January 1, 2007, as required. The Company does not expect the adoption of FIN 48 to have a material impact on its financial position or results of operations.
Interest paid was $18.4 million, $16.1 million and $10.2 million in 2006, 2005 and 2004, respectively.
As of December 31, 2005, the Company had under its Amended and Restated Credit Agreement (the Amended Credit Agreement), outstanding term loans of $243.0 million and no outstanding revolving credit facility borrowings. On April 26, 2006, the Company signed a credit agreement with Bank of America, N.A. and other lenders (the Credit Agreement) which provides for a revolving credit facility of $325.0 million and a term loan facility of $100.0 million. Upon entry into the Credit Agreement, the Company borrowed $140.6 million under the revolving credit facility and $100.0 million under the term loan facility. The Company used these proceeds to repay its outstanding borrowings under the Amended Credit Agreement. The Credit Agreement replaced the Amended Credit Agreement.
In 2006, the Company recognized losses of $0.9 million related to the extinguishment of the debt outstanding under the Amended Credit Agreement. This loss on extinguishment primarily included various financing and professional costs previously deferred in connection with the financing of the Amended Credit Agreement and certain lending fees paid in obtaining the Credit Agreement.
In December 2004, the Company signed the Amended Credit Agreement to replace the Second Amended and Restated Credit Agreement. The Company recognized losses of $1.6 million in 2004 related to the extinguishment of the Second Amended and Restated Credit Agreement. This loss on extinguishment primarily included various financing and professional costs previously deferred in connection with the financing of the Company’s predecessor credit agreement and certain lending fees paid in obtaining the Amended Credit Agreement.
Prior to merger with the Company, certain of the other merged companies had separate profit sharing or benefit plans. These plans were terminated or frozen at the time of merger with the Company.
The Company has the Supplemental Executive Retirement Plan (the Plan) for key executives. The Plan provides that participants shall be credited each year with an amount that is calculated by determining the total Company match and profit sharing contribution that the participant would have received under the Retirement Savings Plan absent the compensation limitation that applies to such plan, reduced by the amount of actual Company match and profit sharing contributions to such plan. The Plan also provides for the crediting of interest to participant accounts. Expense recognized by the Company in 2006, 2005 and 2004 related to these Plan provisions amounted to $1.4 million, $0.9 million and $0.9 million, respectively. At December 31, 2006 and 2005, the Company’s accrued liability for benefits under the Plan was $5.0 million and $4.0 million, respectively, and is included in other long-term liabilities.
Significant components of the Company’s deferred tax liabilities and assets on the consolidated balance sheet are as follows:
The Company has adopted and the shareholders have approved the 2000 Stock Incentive Plan (as amended and restated in 2003), the Non-employee Directors Stock Incentive Plan and the Hilb, Rogal and Hamilton Company 1989 Stock Plan which provide for the granting of stock awards to purchase up to an aggregate of approximately 5,557,000 and 5,522,000 shares of common stock as of December 31, 2006 and 2005, respectively. There were 945,000 and 1,509,000 shares available for future grants under these plans as of December 31, 2006 and 2005, respectively. Stock options granted have seven to ten year terms and vest and become fully exercisable at various periods up to five years. Stock option activity under the plans was as follows:
No compensation expense related to stock options was recognized in operations for 2005 or 2004. As disclosed in Note A, the Company accounted for its stock options using the intrinsic value method prescribed in APB 25. The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of Statement 123 to stock-based compensation prior to 2006. The 2005 net expense of $3.3 million includes a $1.7 million net expense reduction for stock options that were forfeited prior to vesting. These stock option forfeitures relate to stock options granted from 2002 through 2004.
The total fair value of shares vested during the years ended December 31, 2006, 2005 and 2004 was $2.5 million, $3.2 million and $2.2 million, respectively.
At December 31, 2006, there was $7.7 million and $4.2 million of total unrecognized compensation cost related to non-vested stock options and non-vested restricted shares, respectively. These costs are expected to be recognized over a weighted average period of approximately two years.
The Company accounts for goodwill and other intangible assets as disclosed in Note A. In accordance with Statement 142, the Company performed the annual impairment tests of goodwill in 2006, 2005 and 2004. No impairment charge resulted from these tests. See Note B concerning a 2003 impairment that resulted in a prior period restatement.
Aggregate amortization expense for 2006, 2005 and 2004 was $21.5 million, $18.8 million and $13.8 million, respectively.
During 2006, the Company acquired certain assets and liabilities of three insurance agencies and other accounts for $75.0 million ($58.9 million in cash, $2.4 million in guaranteed future cash and Common Stock payments and approximately 340,000 shares of Common Stock). Assets acquired include intangible assets of $73.8 million at the date of purchase. The combined purchase price may be increased by $8.9 million in 2007, $18.9 million in 2008 and $0.4 million in 2009 based upon revenues earned or net profits realized. For certain acquisitions, the allocation of purchase price is preliminary and subject to refinement as the valuations of certain intangible assets are not final.
During 2004, the Company acquired certain assets and liabilities of nine insurance agencies and other accounts for $142.6 million ($99.1 million in cash, $20.4 million in guaranteed future cash and Common Stock payments and approximately 667,000 shares of Common Stock). Assets acquired include intangible assets of $146.9 million at the date of purchase. The combined purchase price increased by $8.2 million in 2006 and $8.1 million in 2005, and may be increased by $11.9 million in 2007 and $3.2 million in 2008 based upon net profits realized.
The financial statements of the Company reflect the combined operations of the Company and each acquisition from the respective closing date of each acquisition.
During 2006, 2005 and 2004, the Company disposed of certain insurance accounts and other assets resulting in net gains of $1.1 million, $5.1 million and $2.1 million, respectively. These amounts are included in other revenues in the Statement of Consolidated Income. Income taxes related to these gains were $0.2 million, $2.2 million and $2.4 million in 2006, 2005 and 2004, respectively. Revenues, expenses and assets of these operations were not material to the consolidated financial statements.
5. The Company will make distributions from the Fund on January 15, 2007 and, if necessary, January 15, 2008 to participating clients that elected to receive a distribution.
7. Within 60 days of executing the Agreement, the Company will undertake the implementation of certain business reforms for both brokerage business and agency business. These reforms include:
In 2005, the Company recorded a $42.3 million charge, and related income tax benefit of $16.0 million, primarily relating to the Agreement with the Attorney General and the Commissioner. This charge included the $30.0 million national fund established by the Agreement; $5.1 million of estimated legal and administrative costs to be incurred related to the Fund and complying with the Agreement’s other provisions; and $1.4 million of legal costs relating to the Agreement incurred in the 2005 third quarter. The regulatory charge also included $5.8 million of estimated costs for pending regulatory matters. These estimated costs represented the Company’s best estimate of the probable outcomes of the various pending regulatory matters and included related legal and administrative costs incurred or expected to be incurred for these regulatory matters.
Included in cash and cash equivalents and premium deposits and credits due customers are $0.8 million and $2.2 million of funds held in escrow at December 31, 2006 and 2005, respectively. In addition, premiums collected from insureds but not yet remitted to insurance companies are restricted as to use by laws in certain states in which the Company operates. The amount of cash and cash equivalents so restricted was approximately $59.1 million and $52.4 million at December 31, 2006 and 2005, respectively.
In August 2004, OptiCare Health Systems Inc. filed a putative class action in the U.S. District Court for the Southern District of New York (Case No. 04-CV-06954) against a number of the country’s largest insurance brokers and several large commercial insurers. The Company was named as a defendant in the OptiCare suit in November 2004. In December 2004, two other purported class actions were filed in the U.S. District Court for the Northern District of Illinois, Eastern Division, by Stephen Lewis (Case No. 04-C-7847) and Diane Preuss (Case No. 04-C-7853), respectively, against certain insurance brokers, including the Company, and several large commercial insurers. On February 17, 2005, the Judicial Panel on Multidistrict Litigation (the Panel) ordered that the OptiCare suit, along with three other purported antitrust class actions filed in New York, New Jersey and Pennsylvania against industry
participants, be centralized and transferred to the U.S. District Court for the District of New Jersey (District Court of New Jersey). In addition, by Conditional Transfer Order dated March 10, 2005, the Panel conditionally transferred the Lewis and Preuss cases to the District Court of New Jersey. The transfer subsequently became effective and as a result of the Panel’s transfer orders, the OptiCare, Lewis and Preuss cases are proceeding on a consolidated basis with other purported class action suits styled as In re: Insurance Brokerage Antitrust Litigation (MDL 1663).
On August 1, 2005, the plaintiffs in MDL 1663 filed a First Consolidated Amended Commercial Class Action Complaint (the Commercial Complaint) in the District Court of New Jersey (Civil No. 04-5184) against the Company and certain other insurance brokers and insurers. In the Commercial Complaint, the named plaintiffs purport to represent a class consisting of all persons who, between August 26, 1994 and the date on which class certification may occur, engaged the services of any one of the broker defendants or any of their subsidiaries or affiliates to obtain advice with respect to the procurement or renewal of insurance and who entered into or renewed a contract of insurance with one of the insurer defendants. The plaintiffs allege in the Commercial Complaint, among other things, that the broker defendants engaged in improper steering of clients to the insurer defendants for the purpose of obtaining undisclosed additional compensation in the form of contingent commissions from insurers; that the defendants were engaged in a bid-rigging scheme involving the submission of false and/or inflated bids from insurers to clients; that the broker defendants improperly placed their clients’ insurance business with insurers through related wholesale entities where an intermediary was unnecessary for the purpose of generating additional commissions from insurers; that the broker defendants entered into unlawful tying arrangements to obtain reinsurance business from the defendant insurers; and that the defendants created centralized internal departments for the purpose of monitoring, facilitating and advancing the collection of contingent commissions, payments and other improper fees. The plaintiffs allege violations of federal and state antitrust laws, violations of the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. § 1962(c) and (d), fraudulent misrepresentation, breach of fiduciary duty, aiding and abetting breach of fiduciary duty and unjust enrichment. The plaintiffs seek monetary relief, including treble damages, injunctive and declaratory relief, restitution, interest, attorneys’ fees and expenses, costs and other relief; however, no actual dollar amounts have been stated as being sought.
The Company, along with other defendants, filed a motion to dismiss both the Commercial Complaint and the Employee Benefits Complaint. Also, on February 13, 2006, the plaintiffs filed their motions for class certification in each case. On May 5, 2006, the defendants filed their oppositions to the motions for class certification. On May 31, 2006, the plaintiffs filed a reply brief in support of their motions for class certification. The motion for class certification is fully briefed and awaiting a decision from the District Court of New Jersey.
On February 13, 2007, a lawsuit was filed in the District Court of New Jersey by Avery Dennison Corporation (Civil No. 07-757) against the Company, certain Marsh & McLennan companies, and several large commercial insurers making factual and legal claims similar to those raised in the Opticare, Preuss and Lewis cases. Avery Dennison Corporation seeks treble and punitive damages, attorneys’ fees and expenses, forfeiture of compensation paid to the broker defendants, restitution, general damages, interest and injunctive relief; however, no actual dollar amounts have been stated as being sought. This is not a putative class action. Pursuant to the procedures promulgated by the District Court of New Jersey in MDL 1663, the case is likely to be consolidated with the other actions pending before the District Court of New Jersey in MDL 1663.
In June 2005, the Iron Workers Local 16 Pension Fund filed a putative class action complaint in the U.S. District Court for the Eastern District of Virginia (Case No. 1:05-CV-00735-GBL-TCB) against the Company and Andrew L. Rogal, Martin L. Vaughan, III, Timothy J. Korman, Carolyn Jones, Robert W. Blanton, Jr. and Robert B. Lockhart. The plaintiff alleged violations by each of the defendants of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and violations by the individual defendants of Section 20(a) of the Securities Exchange Act of 1934. In October 2005, the appointed Lead Plaintiff filed an amended putative class action complaint. The amended complaint does not state an actual dollar amount that is being sought as damages. On April 27, 2006, an order was entered granting the defendants’ motion and dismissing the amended complaint in its entirety with prejudice. On May 23, 2006, the plaintiff appealed this order to the Fourth Circuit, U.S. Court of Appeals. The Company believes it has substantial defenses to the arguments raised by the plaintiff on appeal and intends to defend itself vigorously. However, due to the uncertainty of this appeal and any subsequent litigation of plaintiff’s claims, the Company is unable to estimate a range of possible loss at this time. In addition, the Company cannot predict the outcome of these claims or their effects on the Company’s financial position or results of operations.
On August 16, 2006, Robert B. Lockhart filed a complaint against the Company in the Circuit Court for the County of Henrico, Virginia (Civil Action No. CL06 - 2141). The plaintiff was the Company’s President and Chief Operating Officer from August 2003 until May 25, 2005. In the complaint, the plaintiff alleges, among other things, that the Company made defamatory public statements arising out of the investigation and settlement of an action by the Connecticut Attorney General. The plaintiff sought a judgment against the Company in an amount not less than $30.0 million, including an award for presumed, compensatory punitive damages and costs. On October 24, 2006, the court submitted the matters set forth in the complaint to arbitration, where the plaintiff raised an additional claim of breach of contract with the Company. On March 14, 2007, the parties entered into a settlement agreement that resolved all claims between the parties relating to the complaint and the arbitration. The settlement is effective without court approval. The amount of the settlement is not material to the Company.
In May 2005, Bensley Construction, Inc. (Bensley Construction) filed a putative class action in the Superior Court of the Commonwealth of Massachusetts (Case No. ESCV2005-00277) against the Company and certain large commercial insurers and brokers. In the amended complaint, the plaintiff alleges, among other things, that the broker defendants entered into contingent commission agreements with the insurer defendants without disclosing the existence and/or terms of the agreements to clients to whom the defendants owed a fiduciary duty and that certain of the defendants engaged in a bid-rigging and customer allocation scheme to maximize their revenues under the contingent commission agreements. The plaintiff alleges breach of fiduciary duty, unjust enrichment, aiding and abetting breaches of fiduciary duty, breach of contract and breach of implied covenant of good faith and fair dealing. The plaintiff seeks monetary damages for each member of the class in an amount not to exceed $74,999 per class member, costs and other relief. The case does not state an actual dollar amount that is being sought in total for all damages, costs and other relief. The defendants removed the case to federal court and it was transferred to the U.S. District Court for the District of New Jersey to be consolidated with the other cases that comprise MDL 1663. On June 22, 2006, Bensley Construction filed a Notice of Voluntary Dismissal with the U.S. District Court for the District of New Jersey, voluntarily dismissing Bensley Construction’s claims in this matter with prejudice.
Beginning in 2004, the Company’s business consists of two reportable segments, Domestic Retail and Excess and Surplus, and an All Other category for the remaining profit centers.
The following is a summary of the quarterly results of operations for the years ended December 31, 2006 and 2005:
Quarterly financial information is affected by seasonal variations. The timing of contingent commissions, policy renewals and acquisitions may cause revenues, expenses and net income to vary significantly from quarter to quarter.
See Note N for discussion of the regulatory charge recorded in the 2005 third quarter.
We have audited the accompanying consolidated balance sheet of Hilb Rogal & Hobbs Company as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of Hilb Rogal & Hobbs Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hilb Rogal & Hobbs Company at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Hilb Rogal & Hobbs Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2007 expressed an adverse opinion on the effectiveness of Hilb Rogal & Hobbs Company’s internal control over financial reporting.