Our business activities are conducted principally in leased office space in cities throughout the world. In general, no difficulty is anticipated in negotiating renewals as leases expire or in finding other satisfactory space if the premises become unavailable. In certain circumstances, we may have unused space and may seek to sublet such space to third parties, depending upon the demands for office space in the locations involved.
The consolidated financial information below has been restated as set forth in this Form 10-K. The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related notes thereto included in Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below. The information presented in the following tables has been adjusted to reflect the restatement of our financial results, which is more fully described in the "Explanatory Note" immediately preceding Part I, Item 1 and in Note 2 "Restatement of Consolidated Financial Statements" in Notes to Consolidated Financial Statements of this Form 10-K.
(3)Selected Financial Data for 2003 and 2002 have been restated to reflect the adjustments described in the "Explanatory Note" immediately preceding Part 1, Item 1 of this Form 10-K.
Selected Financial Data has also been reclassified to conform to the 2006 financial presentation. The effects of the adjustments and reclassifications are presented in the following table.
The following information has been adjusted to reflect the restatement of our financial results, which is described in the "Explanatory Note" immediately preceding Part I, Item I and in Note 2 to the consolidated financial statements, "Restatement of Consolidated Financial Statements". The net of tax impact of the adjustments, which amounted to $1 million in 2006, was recorded by the Company in its fourth quarter of 2006. The net of tax impact of the restatements on the Company's results of operations amounted to $2 million and $3 million in 2005 and 2004, respectively. The impact of these adjustments was not significant to the Company's operating results, trends, or liquidity for the annual or quarterly periods in 2006, 2005, and 2004.
The key drivers of financial performance vary among our operating segments.
•conditions in insurance markets generally, particularly fluctuations in premiums charged by insurance companies
•governmental regulations affecting the health care market, employee benefit programs and our clients' respective industries
•our success selling new policies, selling existing policyholders more services, and having customers renew their policies
•Our revenues from continuing operations increased $458 million or 5% overall (5% on an organic basis) driven by organic revenue growth in each of our segments. Risk and Insurance Brokerage Services revenue grew $261 million (2% on an organic basis). Our Insurance Underwriting revenue rose $171 million (13% on an organic basis). Consulting revenue increased $27 million or 4% on an organic basis. We use supplemental information related to organic revenue growth to help us and our investors evaluate business growth from existing operations. Organic revenue growth excludes from reported revenues the impact of foreign exchange rate changes, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses and unusual items. Organic revenue growth for the underwriting segment is based on premiums written.
•We continued our restructuring plan which began in late 2005. We expect an additional $40 million of costs to result from this plan in addition to the $325 million already expensed, of which $167 million was incurred in 2006. We expect these efforts to reduce our annual costs by approximately $280 million by 2008.
•repaid certain outstanding indebtedness under our €650 million Euro credit facility by issuing CAD 375 million (U.S. $323 million at December 31, 2006) 5.05% senior unsecured debentures due in 2011
•received approximately $800 million in gross cash proceeds relating to the sales of AWG and CPG
•contributed $185 million in cash and $166 million in non-cash financial instruments to our various pension plans.
We also repaid $250 million of notes payable in January 2007.
Over the last three years, we also sold the following businesses that are included in discontinued operations:
In November 2004, we sold our Cambridge claims administration business to Scandent Holdings Mauritius Limited ("SHM") for $90 million in cash plus convertible preferred stock in SHM, valued at $15 million. Because of our convertible preferred stock holding and other factors, we included Cambridge's results before the sale's effective date, as well as a pretax gain on the sale of $15 million, in income from continuing operations. In 2006, we contributed the preferred stock to one of our U.K. pension plans.
$81 million of this adjustment in continuing operations, of which the majority related to National Program Services, an independent managing general underwriter which wrote habitational risk on behalf of VSC. The remaining $21 million related to CPG and was recorded in discontinued operations.
In 2005, we began executing a broad restructuring initiative to reduce our fixed cost base and increase efficiency. This three-year plan has evolved as new opportunities have been identified and existing initiatives have been finalized. We expect the remaining portion to cost $40 million during 2007, which is in addition to the $325 million already expensed. Restructuring costs include workforce reductions, lease consolidation costs, asset impairments, and other expenses. In 2006, we estimate restructuring benefits were approximately $119 million. These initiatives are expected to lead to annualized cost savings of approximately $280 million by 2008.
(1)Our estimated costs are forward looking and should be read in connection with our risk factors. Actual costs may vary due to changes in the assumptions built into this plan. Some of the assumptions that may change include changes in severance calculations, the assumptions underlying our sublease loss calculations due to changing market conditions, and our overall analysis that might cause us to add or cancel component initiatives.
•what we disclose as contingent assets and liabilities at the date of the financial statements
•regularly evaluate our estimates, assumptions and judgments, including those concerning pensions, contingencies, policy liabilities (including future policy benefit reserves, unearned premium reserves and policy and contract claim reserves), investments, intangible assets, share-based payments and income taxes.
•base our estimates, assumptions and judgments on our historical experience and on factors we believe reasonable under the circumstances.
Gains and losses on pension obligations arise from such things as changes in the discount rate and demographic changes in employee data. Unrecognized gains and losses are deferred and amortized as a
The 5.8% fixed income expectation factor included the then current 10-year U.S. Treasury Note yields and simulations of future yields based on expected inflation and other factors. We based:
We then weighted the expected returns for each asset class by the plan's target allocation.
This table shows the result of our calculation based on target asset allocation for year-end 2006. The actual return for the 2006 calendar year (15.3%) was in excess of the assumed return.
Several assumptions affect the actuarial calculation of pension obligations, and in turn, net periodic pension expense. The most significant of these assumptions are:
•decrease in our estimated liability discount rate would increase our estimated 2007 pension expense approximately $36 million and the estimated 2007 postretirement medical benefit expense $0.1 million
Required cash contributions are also sensitive to assumptions; however, we rarely change the assumptions we use to determine contributions to the plan. We anticipate minimum cash funding requirements of $36 million in 2007. Under the new funding rules of the Pension Protection Act, we anticipate funding requirements of $67 million in 2008.
As of December 31, 2006, our U.K. pension plans have a combined unrecognized loss (from asset and liability experience) of $1,541 million that has not yet been recognized through income in the financial statements. We amortize the unrecognized loss outside of a corridor over 16 years; this corridor is defined as 10% of the greater of fair value of plan assets or PBO. For 2007, we estimate that this expense amortization will be approximately $71 million. To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense similarly until fully amortized.
To calculate pension expense, we use the fair market value of plan assets. Generally, the U.K. plans' trustees determine the investment policy for each plan. In total, at the end of the 2006 valuation year, the plans were invested 63% in equities, 32% in fixed income securities, and 5% in real estate, with a fair value of $3,665 million.
As a result, we assume a rate of return of 7.2% to determine future pension expense.
The table below shows the result of our calculation based on target asset allocation for year-end 2006. Because there are eight pension plans maintained in the U.K., the target allocation represents a
weighted average of the target allocation of each plan. Further, target allocations are subject to change. The actual return for the 2006 calendar year (9.4%) was in excess of the assumed return.
•increase in our estimated liability discount rate would decrease the estimated 2007 pension expense approximately $68 million.
•increase in our estimated long-term rate of return on plan assets would decrease estimated 2007 pension expense approximately $37 million.
Cash flow requirements are also sensitive to assumptions; however, we rarely change the assumptions we use for funding the U.K. plans. Under current rules and assumptions, we anticipate U.K. funding requirements of $182 million in both 2007 and 2008. These contributions reflect minimum funding requirements plus other amounts agreed with U.K. plan trustees.
To calculate pension expense, we use the fair market value of plan assets. As of December 31, 2006, the Dutch pension plan had a combined unrecognized loss of $80 million that has not yet been recognized through income in the financial statements. We amortize the unrecognized loss outside of a corridor over 12 years; this corridor is defined as 10% of the greater of fair value of plan assets or PBO. For 2007, we estimate that this amortization will be approximately $3 million. To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense similarly until fully amortized.
The target asset allocation is 28% global equities, 65% fixed income securities, and 7% real estate, with an allowed deviation of 5%. At year-end 2006, actual asset allocation was consistent with target allocation. The expected long-term rate of return on assets is 6%, which results from:
•decrease in our estimated long-term rate of return on plan assets would increase estimated 2007 pension expense approximately $4 million
•increase in our estimated long-term rate of return on plan assets would decrease estimated 2007 pension expense approximately $4 million.
In addition to the critical assumptions described above, all plans use certain assumptions about the life expectancy of plan participants and surviving spouses. Periodic revision of those assumptions can materially change the present value of future benefits, and therefore the funded status of the plans and the resulting periodic pension expense.
We define a contingency as any material condition that involves a degree of uncertainty that will ultimately be resolved. Under GAAP, we are required to establish reserves for contingencies when a loss is probable and we can reasonably estimate its financial impact. We do not recognize gain contingencies until the contingency is resolved.
•are a large portion of the total policy liabilities shown on our balance sheet
•represent our best estimates of what we expect to pay to policyholders in the future.
To establish policy liabilities, we develop estimates of reported and anticipated claims, based on our historical experience, other actuarial data, and assumptions on investment yields. The actuarial data reflects our best estimates of future expectations regarding claim frequency, claim severity, and the
length of time that a customer is insured. Morbidity and mortality patterns may change over time due to many factors including:
Since estimating and establishing policy and contract liabilities is inherently uncertain, the actual ultimate cost of a claim may vary materially from the estimated amount reserved.
•the balance that accrues to the benefit of policyholders at the date of the financial statements
•amounts previously assessed against policyholders that are refundable when the contract terminates.
Reserves for future policy benefits were $1,784 million, $1,671 million and $1,542 million as of December 31, 2006, 2005 and 2004, respectively. If a 1% unfavorable change were to occur in the mortality and morbidity assumptions for both the accident & health and life books of business, pretax income would be decreased by approximately $8 million.
Factors influencing loss reserve estimates include the consistency of the results from actuarial techniques and our knowledge of emerging loss trends and rate or benefit changes.
•issuer financial trends and market expectations based on third-party forward-looking analytical reports, when available
Invested assets with unrealized losses due to market conditions or industry-related events include those affected by increasing U.S. Treasury or local sovereign interest rates; corporate and asset-backed credit spread widening; common stock price volatility due to conditions in the overall market or a particular industry; and illiquid market conditions.
Intangible assets represent the excess of cost over the value of net tangible assets of acquired businesses. We classify our intangible assets as either goodwill, client lists, non-compete agreements, future profits of purchased books of business of the insurance underwriting subsidiaries, or other purchased intangibles.
As the stock-based compensation expense we recognize is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Statement No. 123(R) requires that we estimate forfeitures at the time of grant and revise our estimates, if necessary, in subsequent periods if actual
Before 2006, Aon was subject to Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for its stock-based compensation plans. Under APB No. 25, no compensation expense was recognized for stock options when the exercise price of the options equaled the market price of the stock at the date of grant. During 2006, we discovered certain errors in relation to measurement dates in options granted prior to 2001. See Note 2 to our consolidated financial statements for further details.
Following adoption of Statement No. 123(R), we have also changed our method of valuation for stock options granted: in 2006, we moved to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model, which we previously used for our pro forma information required under Statement No. 123. Lattice-based option valuation models:
•use a range of assumptions over the expected term of the options
•base the expected dividend yield assumption on the company's historical and expected future dividend rate.
Beginning with awards granted in 2006, awards to executives and key employees may also consist of performance-based awards, which ultimately result in the receipt of RSUs if the employee achieves his or her objective. Such objectives may be made on a personal or group level. Generally, our
performance awards are fixed, which means we determine the fair value of the award at the grant date and recognize the expense over the performance or vesting period, whichever is longer.
•estimate the number of shares to be delivered at the end of the performance period multiplied by the fair value of those shares.
The largest performance-based stock plan is the Leadership Performance Plan ("LPP"), which substantially replaced fixed methods of stock compensation to ensure expense is recognized only if targets are achieved. We currently expect to recognize $61 million of expense for the LPP plan over the 3 year performance period (2006-2008), of which $19 million was expensed in 2006. A 10% upward or downward adjustment in our estimated performance targets would increase or decrease expense by approximately $2 million. As the percent of expected performance increases or decreases, the potential change in expense can go from 0% to 150% of the targeted total expense.
Awards that have either an indeterminate number of shares to be delivered or are required to be settled in cash are accounted for as liabilities. These liabilities are marked-to-market at the end of each reporting period at the then fair market value of our stock.
We earn income in numerous foreign countries and are subject to the laws of taxing jurisdictions within those countries, as well as U.S. federal and state tax laws. At December 31, 2006, the Company has a $627 million net deferred income tax asset and $216 million income tax refund receivable.
The carrying values of liabilities for income taxes currently payable are based on management's interpretation of applicable tax laws, and incorporate management's assumptions and judgments regarding the use of tax planning strategies in various taxing jurisdictions. Using different estimates,
assumptions and judgments in accounting for income taxes, especially those which deploy tax planning strategies, may result in materially different carrying values of income tax assets and liabilities and changes in our results of operations.
•To deploy tax planning strategies and conduct foreign operations efficiently, our subsidiaries frequently enter into transactions with affiliates, which are generally subject to complex tax regulations and are frequently reviewed by tax authorities.
•We may conduct future operations in certain tax jurisdictions where tax laws are not well developed, and it may be difficult to secure adequate professional guidance.
•Tax laws, regulations, agreements and treaties change frequently, requiring us to modify existing tax strategies to conform to such changes.
We use supplemental information related to organic revenue growth to help us and our investors evaluate business growth from existing operations. Organic revenue growth excludes from reported revenues the impact of foreign exchange rate changes, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses, and unusual items. Organic revenue growth for the underwriting segment is based on premiums written.
may be significant and may distort true period-to-period comparisons of changes in revenue or pretax income. Therefore, we have:
Some tables in the segment discussions reconcile organic revenue growth percentages to the reported revenue growth percentages for the segments and subsegments. We separately disclose the impact of foreign currency as well as the impact from acquisitions, divestitures, and transfers of business units, which represent the most significant reconciling items. In an "all other" category, we total other reconciling items that are not generally significant individually or in the aggregate. If there is a significant individual reconciling item within the "all other" category, we provide additional disclosure in a note.
•Premiums and other increased $159 million or 9%, driven by 11% organic revenue growth in our accident & health and life business resulting from strong growth in our supplemental health product, partially offset by reductions in property and casualty runoff programs.
•Investment income increased $88 million or 32%. The increase was driven primarily by higher interest rates and a $35 million gain recognized in connection with the contribution of a certain investment to a U.K. pension plan. Investment income includes related investment expense and income or loss on investment disposals and impairments.
We attribute revenues to geographic areas based on the location of the resources producing the revenues.
•Americas other than U.S. revenues increased $96 million or 11%, due to strong growth in Latin America.
•U.K. revenues declined $44 million or 3% as improvements in our accident & health and life and consulting businesses were more than offset by softness in our retail and reinsurance lines.
•Asia Pacific revenue increased $38 million to $658 million, driven by acquisitions and organic revenue growth in emerging markets in Asia.
•General expenses increased $177 million or 3%, primarily reflecting increased compensation and benefits costs, unfavorable foreign exchange, and hedging losses.
Income from continuing operations was $920 million compared to $808 million in 2005. The increase in income was driven by organic revenue growth across each segment along with estimated restructuring savings of $119 million, partially offset by increases in benefits to policyholders and higher compensation and benefits costs.
The effective tax rate on income from continuing operations was 32.0% in 2006 and 29.7% in 2005.
Differences between the overall effective tax rate and the U.S. federal statutory rate are typically due to U.S. state income taxes and differences between U.S. and international tax rates. Changes in the mix between our U.S. and international pretax income directly affect our effective tax rates. In 2006 and 2005, our effective tax rate also reflects the favorable resolution of tax examination issues, adjustments, and tax credits. For a summary of these effects, please see the rate reconciliation provided in Note 9 to the consolidated financial statements.
•Basic income per share from continuing operations increased to $1.98 from $1.75.
•Investment income decreased $3 million or 1%. Investment income includes related investment expense and income or loss on investment disposals and impairments.
•Americas other than U.S. revenue increased 11% to $844 million, as a result of growth in Latin America and favorable foreign exchange rates.
Total expenses decreased $186 million or 2% from 2004 for three primary reasons:
•The 2004 expense from the New York Attorney General ("NYAG") and other regulatory authorities as well as the Daniel class action settlements, which accounted for $220 million of expenses in 2004.
These favorable impacts were partially offset by $158 million in restructuring related expenses.
•29.7% in 2005 reflecting the favorable resolution of tax examination issues
•34.0% in 2004 which was reduced by a one-time tax benefit resulting from the difference between our tax and book basis in Cambridge, which was sold in 2004.
•Basic income per share from continuing operations rose to $1.75 from $1.51.
•$59 million in 2004 ($0.18 per both basic and diluted income per share).
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting (see Note 17 to the consolidated financial statements for further information).
•Our Risk and Insurance Brokerage Services and Consulting businesses invest funds held on behalf of clients and operating funds in short-term obligations.
Aon is a leader in many sectors of the insurance industry: globally, it is the largest insurance broker, the largest reinsurance broker, and the leading manager of captive insurance companies worldwide. These rankings are based on the most recent surveys compiled and reports printed by Business Insurance.
Changes in premiums have a direct and potentially material impact on the insurance brokerage industry, as commission revenues are generally based on a percentage of the premiums paid by insureds.
Risk and Insurance Brokerage Services generated approximately 63% of Aon's total operating segment revenues in 2006. Revenues are generated primarily through:
•addresses the highly specialized product development and risk management needs of commercial enterprises, professional groups, insurance companies, governments, healthcare providers, and non-profit groups, among others
•provides reinsurance services to insurance and reinsurance companies and other risk assumption entities by acting as brokers or intermediaries on all classes of reinsurance
•provides managing underwriting and premium finance services to independent agents and brokers as well as corporate clients
•provides actuarial, loss prevention, and administrative services to businesses and consumers
•Risk Management and Insurance Brokerage encompasses our retail brokerage services, affinity products, managing general underwriting, placement and captive management services, and premium finance services in the following areas: Americas; United Kingdom; Europe, Middle East & Africa; and Asia Pacific.
•Claims Services (Claims) offered claims administration and loss cost management services. We exited these activities in 2004 by selling our U.S. and U.K. claims administration businesses.
In 2006, revenue increased $261 million or 5% from 2005 due to growth in our retail and reinsurance operation and higher investment income, partially offset by weakness in the U.K.
•a $35 million gain related to the contribution of a preferred stock investment to one of our U.K. pension plans, received in connection with the sale of our Cambridge operation.
U.K. revenue fell 8%. Organic revenue decreased 2%, driven by revenue declines from soft pricing, low retention rates, and lower new business. In addition, 2005 revenue included $23 million resulting from refinement of the techniques we used to estimate revenues on installment contracts. This refinement has been excluded from our calculation of organic revenue growth.
Europe, Middle East & Africa revenue was up 2%, driven by acquisitions and organic revenue growth especially in Africa, the Middle East, Netherlands, Spain, and France, and partially offset by declines in Germany and the Nordic region.
Reinsurance revenue improved 9%, due to higher investment income and organic revenue growth in most areas of the world.
This table shows Risk and Insurance Brokerage Services revenue by geographic area and total pretax income:
U.S. revenue rose 8% over 2005 as a result of organic revenue growth, increased investment income, including the gain on the contribution of a preferred stock, and the realignment of certain businesses from Consulting.
Americas other than U.S. revenue increased 11% due to growth in Latin America.
The decline in U.K. revenues reflect low retention rates, lower new businesses, and the restructuring of the U.K. insurance market.
•estimated savings of $97 million achieved as a result of the restructuring program
•an increase in investment income of $67 million, including the $35 million gain on the contribution of a preferred stock
•a $30 million gain on the sale of a building in Spain
Negative impacts to this year's income and margins included higher staff expense, driven principally by increased incentives and benefit costs.
Aon Consulting is one of the world's largest integrated human capital consulting organizations. Our consulting segment:
1.Employee Benefits advises clients about how to structure, fund, and administer employee benefit programs that attract, retain, and motivate employees. Benefits consulting includes health and welfare, retirement, executive benefits, absence management, compliance, employer commitment, investment advisory and elective benefit services.
6.Financial Advisory and Litigation Consulting provide consulting services including white collar and financial statement investigation, securities litigation, financial due diligence, financial valuation services, and other related specialties.
Outsourcing revenue rose 7% during the year, due primarily to $13 million of fees we received from a client terminating an outsourcing contract, as well as from an acquisition made late in 2005.
•U.S. revenue decreased in 2006, primarily reflecting lower revenue in the health and welfare practice, offset in part by the termination fee previously noted.
•Americas other than U.S. revenue grew 13%, reflecting improved results in Canada and favorable foreign exchange.
•Start-up costs for the Financial Advisory & Litigation Consulting practice reduced both profits and margins.
•generated approximately 23% of Aon's total operating segment revenues in 2006.
(1)See Note 10 to the consolidated financial statements for additional information. This table details Insurance Underwriting revenue by subsegment:
This table reconciles organic revenue growth to reported revenue growth in 2006 versus 2005:
In Accident & health and life, revenue increased $200 million, or 11%, primarily driven by strong growth in a supplemental health product, favorable impact from foreign exchange rates, and higher investment income.
Property & casualty revenue decreased $29 million, primarily due to the decision to run off the property and casualty business in 2006.
This table details Insurance Underwriting revenue by geographic area and pretax income:
Pretax income of $137 million decreased 26% from 2005. Pretax margins fell from 9.9% in 2005 to 6.7% in 2006. Both decreases are primarily attributable to an $81 million reserve increase recorded in third quarter 2006 in our property and casualty subsegment. See the Key Recent Events section.
•invested assets and related investment income not directly required to support the risk and insurance brokerage services and consulting businesses
•the assets in excess of net policyholder liabilities of the insurance underwriting subsidiaries and related income.
Unallocated expenses include corporate governance costs not attributable to the operating segments. These expenses decreased to $106 million in 2006 from $109 million in 2005.
Our operating subsidiaries obtain their liquidity through selling their products and services and collecting their receivables. Funds collected are used to pay creditors and employees and to fund acquisitions. Funds that we are holding on behalf of clients and to satisfy policyholder liabilities are segregated and are not available for other uses. We believe that our operating subsidiaries will have adequate liquidity to meet their needs in the foreseeable future and to provide funds to the parent company. Payment of dividends from our underwriting subsidiaries are limited by government regulation and depend on the surplus and future earnings of these subsidiaries.
•paid the second $76 million installment of the $190 million required under the settlement we reached with the NYAG and other regulatory authorities. We are scheduled to pay the remaining $38 million in 2007. In addition to the NYAG and other regulatory authorities' investigations, we have $40 million accrued for the settlement in the Daniel class action lawsuit and related costs.
•spent $1,048 million to repurchase 28.4 million of our outstanding shares of common stock.
In 2006, total cash contributions to our major defined benefit pension plans were $185 million. In addition, we contributed $166 million of non-cash financial instruments to our U.K. pension plans. The total contributed of $351 million represents a $112 million decrease from 2005. Under current rules and assumptions, we currently anticipate 2007 contributions to our major defined benefit pension plans of approximately $233 million.
In connection with one of our U.K. pension plans, our principal U.K. subsidiary has agreed with the trustees of the plan to contribute £20 million ($39 million) per year to the plan for six years with the amount payable increasing by 5.3% on each January 1, which began in 2005. These contributions are in addition to the normal employer contributions to the plan. The trustees of the plan:
For cash flow reporting, our insurance underwriting operations include accident & health and life and warranty, credit and property & casualty businesses. These insurance products have distinct differences in the timing of premiums earned and payment of future liabilities.
We used revenues generated from premiums, investments and other miscellaneous income to pay claims and other cash benefits, commissions, general expenses and taxes. Claims and other cash benefits paid were $1,632 million in 2006 versus $1,393 million in 2005. Commissions and general expenses paid were $1,483 million for 2006, compared to $1,446 million in 2005. Tax payments for 2006 were $144 million compared to $158 million last year.
We will invest and use operating cash flows to satisfy future benefits to policyholders and when appropriate, make them available to pay dividends to the Aon parent company. During 2006, Combined Insurance Company of America, one of our major underwriting subsidiaries, declared and paid a cash dividend of $250 million to Aon. At the time of sale, AWG made a dividend to Aon of $361 million, of which $66 million was in cash and $295 million was a dividend-in-kind, which were primarily equity investments. Aon received proceeds of $662 million from the sale of AWG and CPG, net of direct costs and cash sold.
In our Risk and Insurance Brokerage Services and Consulting segments, we typically hold funds on behalf of clients as a result of:
The operating cash flow from our Risk and Insurance Brokerage Services and Consulting segments, as well as related corporate items, was $596 million in 2006 compared to $463 million in 2005. These amounts exclude the change in funds held on behalf of clients as described above. The operating cash flows depend on the timing of receipts and payments related to revenues, incentive compensation, other operating expenses and income taxes. Comparing 2006 to 2005, the net increase in cash from our Risk and Insurance Brokerage Services and Consulting segments and related corporate items of $133 million was primarily influenced by higher non-cash incentives, investment income, and organic revenue growth.
We used the consolidated cash flow from operations (net of funds held on behalf of clients) for:
•investing activities of $190 million. The cash flows used by investing activities included purchases of investments, net of sales, of $582 million; capital expenditures, net of disposals, of $152 million; and cash provided by investing activities from divestitures of subsidiaries, net of acquisitions, of $544 million.
•Total investments increased $0.5 billion to $7.6 billion. Fixed maturities increased $138 million. Short-term investments increased $452 million, primarily as a result of funds received in connection with the sales of AWG and CPG.
•Risk and Insurance Brokerage Services and Consulting premium and fee receivables increased $668 million. Insurance premiums payable increased $324 million over the same period. The increase in receivables and payables reflects:
•Other assets decreased $180 million. Other assets are comprised principally of prepaid premiums related to reinsurance and prepaid pension assets. The decline from last year primarily reflects the impact of adopting FASB Statement No. 158 in 2006.
•Policy liabilities decreased $652 million to $2.8 billion due to a decline in policy and contract claims. Other receivables declined in a similar manner. In connection with the sale of AWG and CPG, certain reinsured property and casualty balances that were previously reported in policy liabilities and other receivables are no longer direct obligations of Aon and, therefore, are no longer reported in Aon's consolidated statement of financial position. Aon has issued a corporate guarantee covering these reinsurance balances. See Note 10 to the consolidated financial statements for further information.
We invest in broad asset categories related to our diversified operations. In managing our investments, our objective is to maximize earnings while monitoring asset and liability durations, interest and credit risks, and regulatory requirements.
•assets in excess of net policyholder liabilities of the underwriting business and related income.
These insurance assets are publicly traded equities, as well as less liquid private equities and LPs. These assets, owned by the insurance underwriting companies:
•are necessary to support strong claims paying ratings by independent rating agencies
Total debt at December 31, 2006, was $2.3 billion, an increase of $173 million from December 31, 2005. Our notes payable increased by $138 million compared to year-end 2005. This increase results from issuing CAD 375 million (U.S. $323 million at December 31, 2006) of 5.05% senior unsecured debentures due in 2011, offset by a partial reduction in the amount borrowed under our Euro credit facility. Our total debt as a percentage of total capital was 30.5% and 28.4% at December 31, 2006 and 2005, respectively.
We have disclosed future payments of notes payable and operating lease commitments (with initial or remaining non-cancelable lease terms in excess of one year) in Note 8 to the consolidated financial statements.
•Subject to certain exceptions, during five business days after any ten consecutive trading days in which the trading price per $1,000 principal amount of the debentures for each day of the ten trading day period was less than 95% of the product of the closing sale price of our common stock and the number of shares issuable upon conversion of $1,000 principal amount of the debentures.
At December 31, 2006, we had a $600 million unused U.S. committed bank credit facility, which expires in February 2010, to support commercial paper and other short-term borrowings. This facility allows us to issue up to $150 million in letters of credit.
We also have several foreign credit facilities available. At December 31, 2006, we had available to us:
The major rating agencies' ratings of our debt at February 19, 2007 appear in the table below:
During 2006, Moody's Investor Services changed its outlook on Aon to positive from stable for both our senior long-term debt and commercial paper. Standard & Poor's changed its outlook on Aon's senior long-term debt from positive to stable.
•$178 million in paid-in-capital principally due to stock issued in connection with employee benefit plans.
In addition, the impact of the adoption of Statement No. 158 increased the accumulated other comprehensive loss by $349 million.
In connection with the AWG transaction we issued an indemnification which protects the purchaser from credit exposure relating to the property and casualty reserves that have been reinsured. We recorded a $13 million liability reflecting the fair value of this indemnification as of November 30, 2006. The loss was included in the AWG gain. The value remained approximately $13 million as of December 31, 2006. The indemnification represents the present value of the indemnification on the credit risk of the reinsurers.
Certain of our U.S., U.K., Canadian, and Australian subsidiaries originate short-term loans (generally with terms of 12 months or less) to businesses to finance their insurance premium obligations, and then sell these premium finance agreements in securitization transactions that meet the criteria for sale accounting under Statement No. 140. These sales involve:
We record gains associated with the sale of receivables. When we calculate the gain, we include all fees we incurred for this facility. The gains, which are included in commissions and fees revenue in the consolidated statements of income, were $63 million, $65 million, and $81 million for the years ended December 31, 2006, 2005, and 2004, respectively.
We record at fair value our retained interest in the sold premium finance agreements, and report it in insurance brokerage and consulting services receivables in the consolidated statements of financial position. We also:
•earn servicing fee income over the servicing period, and include these servicing fees in the gain/loss calculation.
At December 31, 2006 and 2005, since the fair value of the servicing rights approximates the estimated costs to service the receivables, we have not recorded any servicing assets or liabilities.
We intend to renew these conduit facilities when they expire. If there were adverse bank, regulatory, tax, or accounting rule changes, our access to the conduit facilities and special purpose vehicles would be restricted. These special purpose vehicles are not included in our consolidated financial statements, following the appropriate accounting standards.
In 2001, we sold the vast majority of our LP portfolio, valued at $450 million, to PEPS I, a QSPE. The common stock interest in PEPS I is held by a limited liability company owned by one of our subsidiaries (49%) and by a charitable trust, which we do not control, established for victims of the September 11th attacks (51%).
•sold approximately $171 million of investment grade fixed-maturity securities to unaffiliated third parties
Standard & Poor's Ratings Services rated the fixed-maturity securities our subsidiaries received from PEPS I as investment grade. As part of this transaction, the insurance companies had been required to purchase additional fixed-maturity securities from PEPS I in an amount equal to the unfunded LP commitments as they are requested. These fixed-maturity securities are rated below investment grade. Beginning in July 2004, Aon Parent assumed this responsibility. As of December 31, 2006, the unfunded commitments amounted to $46 million. These commitments have specific expiration dates, and the general partners may decide not to draw on these commitments.
In previous years, Aon has recognized other-than-temporary impairment writedowns of $59 million, equal to the original cost of one tranche. The preferred stock interest represents a beneficial interest in securitized limited partnership investments. The fair value of the private preferred stock interests depends on the value of the limited partnership investments held by PEPS I. We assess other-than-temporary declines in the fair value below cost using a financial model that considers the:
(2)Also included in purchase obligations is a $434 million contract for claims outsourcing in the U.K. We can exit this obligation after 2013 for approximately $39 million.
(4)Pension and other postretirement benefit plan obligations include estimates of our minimum funding requirements, pursuant to ERISA and other regulations and agreements with the Trustees of our U.K. Pension Plans. Nonqualified pension and other postretirement benefit obligations are based on estimated future benefit payments. We may make additional discretionary contributions.
Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.
In our opinion, management's assessment that Aon Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Aon Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have audited the accompanying consolidated statements of financial position of Aon Corporation as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Aon Corporation as of 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 schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 1, in 2006 the Company changed its method of accounting for stock-based compensation and defined benefit pension and postretirement plans. As discussed in Note 2, the Company restated its consolidated financial statements to record additional stock-based compensation expense.
(1)See Note 2 "Restatement of Consolidated Financial Statements" See accompanying notes to consolidated financial statements.
Commission revenue is primarily recognized at the later of the billing or the effective date of the related insurance policy, net of an allowance for estimated policy cancellations. The allowance is based on an evaluation of the relevant historical data. Where all of the elements of revenue recognition have been met, but processing has not yet occurred in the billing system due to timing, an accrual is recorded based on analysis of the specific transactions. For policies that are billed in installments, revenue is recognized when Aon has sufficient information to estimate the amounts. When insurance underwriters directly bill clients, Aon's revenue is recognized when the cash is received or amounts due to Aon become determinable. Commissions on premium adjustments are recognized as they occur.
Fees for claims and consulting services are recognized when the services are rendered. For some clients, Aon has outsourcing arrangements that are spread over multiple years. Revenues received from these arrangements are recorded on a gross basis, inclusive of amounts ultimately passed through to subcontractors, as long as Aon maintains the performance obligation, and are recorded ratably over the life of the contract.
Reinsurance premiums, commissions and expense reimbursements on reinsured business are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums and benefits to policyholders ceded to other companies have been reported as a reduction of premium revenue and benefits to policyholders. Reinsurance receivables and prepaid reinsurance premium amounts are reported as assets.
Basic net income per share is computed by dividing net income available for common stockholders by the weighted-average number of common shares outstanding. Net income available for common stockholders is net of all preferred stock dividends. Diluted net income per share is computed by dividing net income available for common stockholders by the weighted-average number of common shares outstanding, plus the dilutive effect of stock options and awards. The dilutive effect of stock options and awards is calculated under the treasury stock method using the average market price for the period. Certain common stock equivalents related to options were not included in the computation of diluted income per share because those options' exercise price was greater than the average market price of the common shares. The number of options excluded from the calculation was 8 million in 2006, 18 million in 2005 and 20 million in 2004. Aon includes in its diluted net income per share computation the impact of any contingently convertible instruments regardless of whether the market price trigger has been met. Aon's 3.5% convertible debt securities, issued in November 2002, may be converted into a maximum of 14 million shares of Aon common stock and these shares have been included in the computation of diluted net income per share (see Note 8 for further information).
Prior to 2006, Aon was subject to Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and related Interpretations in accounting for its stock-based compensation plans. Under APB No. 25, no compensation expense was recognized for stock options when the exercise price of the options equaled the market price of the stock at the date of grant. Compensation expense was recognized on a straight-line basis over the vesting period for stock awards based on the market price at the date of the award, and for options with an exercise price less than the market price at the date of grant based on the intrinsic value at the date of grant.
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Aon's consolidated statements of income for the year ended December 31, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of Statement No. 123, and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of Statement No. 123(R). Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Statement No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The adoption of Statement No. 123(R) resulted in recording the cumulative effect of an accounting change as of January 1, 2006 of $1 million, net of tax, due to the requirement to adjust compensation recognized through that date on restricted stock units (RSUs) to reflect forfeitures on an estimated method rather than the previous method, as they occurred. See Note 13 for further discussion of the effect of adopting Statement No. 123(R) on the Company's consolidated financial statements.
Upon adoption of Statement No. 123(R), Aon also changed its method of valuation for stock options granted beginning in 2006 to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model, which was previously used for Aon's pro forma information required under Statement No. 123. Lattice-based option valuation models utilize a range of assumptions over the expected term of the options. Expected volatilities are based on the average of the historical volatility of Aon's stock price and the implied volatility of traded options on Aon's stock. Aon uses historical data to estimate option exercise and employee terminations within the valuation model, stratifying between executive and key employees. The expected dividend yield assumption is based on the Company's historical and expected dividend rate. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
Policy loans are generally carried at cost or unpaid principal balance.
Private equity investments are generally carried at cost, which the Company believes approximates fair value, except where Aon has significant influence, in which case they are carried using the equity method of accounting.
In conjunction with the initial common stock investment, Aon also received 4.1 million stock purchase warrants, which allowed Aon to purchase additional Endurance common stock through December 2011. These warrants met the definition of a derivative, which required them to be recorded in the financial statements at fair value, with changes in fair value recognized in earnings on a current basis. On March 31, 2006, Aon contributed all of the Endurance warrants to its U.K. pension plans. The warrants had a fair value of approximately $73 million and $90 million at March 31, 2006 and December 31, 2005, respectively. The change in the fair value during the period was included in income and was a decrease of $17 million in 2006 and an increase of $10 million in 2005. There was no net change in value during 2004.
General - Income or loss on the disposal of investments is calculated using the amortized cost of the security sold and is reported as income in the consolidated statements of income.
Costs of acquiring new and renewal insurance underwriting business, principally the excess of first year commissions over renewal commissions, and underwriting and sales expenses that vary with and are primarily related to, the production of new business, are deferred and reported as assets. For long-duration life and health products, amortization of deferred policy acquisition costs is related to and based on, the expected premium revenues of the policies. In general, amortization is adjusted to reflect current withdrawal experience. Expected premium revenues are estimated by using the same assumptions used in estimating future policy benefits. For short-duration health insurance, costs of acquiring and renewing business are deferred and amortized as the related premiums are earned.
Other investments are comprised of Aon's investment in policy loans, private equity investments and limited partnerships.
Unearned premiums and contract fees generally are calculated using the pro rata method based on gross premiums. However, in the case of disability products, the unearned premiums are calculated such that the premiums are earned over the period of risk in a reasonable relationship to anticipated claims. The Company considers anticipated investment income in determining whether a premium deficiency exists.
In accordance with FASB Statement No. 154, Accounting Changes and Error Corrections, the consolidated statements of income, stockholders' equity and cash flows for the years ended December 31, 2005 and 2004 and the consolidated statement of financial position as of December 31, 2005 have been restated for certain errors made in the measurement of stock-based compensation expense.
Delegated Grants. Prior to 2001, the Organization and Compensation Committee of the Board of Directors authorized block grants of stock options that were to be allocated to the Company's operating units, and then further allocated to particular individuals. The final authority to award individual option awards to employees was delegated by the Committee to the Company's Chief Executive Officer, subject to the overall parameters set by the Committee. Concurrent with the authorization of the block grant, the Committee established a grant date, using either the date of the Committee meeting or by designating a specified future date. For purposes of establishing measurement dates for accounting purposes, the practice of using the grant date set by the Committee rather than the later dates at which the recipients and the number of options each recipient would receive was determined, resulted in incorrect measurement dates and, therefore, financial statement errors. The vast majority of option grants with incorrect measurement dates resulted from this practice of delegated grants.
Administrative Errors. Other accounting errors occurred when, for example, during the awarding process, oral communication of certain stock option grants occurred in connection with employment agreements or other circumstances, but documents evidencing the required approval were not processed until later. For purposes of establishing measurement dates for accounting purposes, the practice of using the communication date rather than the later date at which the required approval was documented resulted in incorrect measurement dates and, therefore, financial statement errors.
The consolidated statements of income for 2005 and 2004 have been restated to reflect the adjustment. As discussed in Note 6, in 2006 Aon reclassified certain businesses to discontinued operations. The following tables include the effect of these reclassifications. The reconciliation of the as
The cumulative impact of additional stock-based compensation, net of tax, is reflected in the December 31, 2005 statement of financial position. The reconciliation of the as reported, adjustments, as restated, reclassifications and as presented in 2006 consolidated statement of financial position for 2005 is as follows:
Note 13, "Stock Compensation Plans" reflects the adjustments to pro forma stock compensation expense for 2005 and 2004, as required by Statement No. 123(R). The reconciliation of the as reported, adjustments, and as restated disclosure for 2005 and 2004 follows:
In 2005, the pretax net additional minimum pension liability adjustment of $253 million included $19 million related to defined benefit pension plans in Canada and $4 million related to defined benefit plans in Germany.
In 2004, the pretax net additional minimum pension liability adjustment of $18 million included $17 million related to defined benefit pension plans in Canada and $38 million related to defined benefit plans in Germany.
In 2006, 2005 and 2004, Aon completed several small acquisitions, primarily related to its insurance brokerage operations. The following table includes the aggregate amounts paid and intangible assets recorded as a result of the acquisitions.
The following is a summary of 2005 and 2006 restructuring and related expenses by type incurred and estimated to be incurred through the end of the restructuring initiative:
Aon's unpaid liabilities are included in general expense liabilities in the consolidated statements of financial position.
In 2004, Aon sold Cambridge Integrated Services Group ("Cambridge"), its U.S. claims services business, which was included in the Risk and Insurance Brokerage Services segment, to Scandent Holdings Mauritius Limited ("SHM"), for $90 million in cash plus convertible preferred stock in SHM valued at $15 million.
•Aon Warranty Group ("AWG") and its worldwide warranty and credit operations, which was previously included in the Insurance Underwriting segment. A pretax gain of $16 million was recognized on the sale.
•Its U.K. reinsurance brokerage runoff unit, resulting in a pretax gain of $1 million.
•Its U.K. claims services businesses, resulting in a pretax loss of $24 million.
Prior to its acquisition by Aon, A&A discontinued its property and casualty insurance underwriting operations in 1985, some of which were then placed into runoff, with the remainder sold in 1987. In connection with those sales, A&A provided indemnities to the purchaser for various estimated and potential liabilities, including provisions to cover future losses attributable to insurance pooling arrangements, a stop-loss reinsurance agreement and actions or omissions by various underwriting agencies previously managed by an A&A subsidiary.
As of December 31, 2006 and 2005, the liabilities associated with the foregoing indemnities were included in other liabilities in the consolidated statements of financial position. Such liabilities amounted to $81 million and $88 million, respectively. Reinsurance recoverables and other assets related to these liabilities are $94 million and $83 million, respectively. The remaining insurance liabilities represent estimates of known and future claims expected to be settled over the next 20 to 30 years, principally with regards to asbestos, pollution and other health exposures. Although these insurance liabilities represent a best estimate of the probable liabilities, adverse developments may occur given the nature of the information available and the variables inherent in the estimation processes. In 2006, an agreement was reached relating to the settlement of certain legacy reinsurance claims, which resulted in a pretax gain, net of expenses, of $13 million. In 2005, a pretax expense of $11 million was recorded for consulting and legal costs related to completed and contemplated settlements and actuarial refinements to claims reserves and reinsurance recoverables.
(1)Includes other-than-temporary impairment write-downs of $2 million, $11 million and $3 million in 2006, 2005 and 2004, respectively. The components of net unrealized investment gains are as follows:
portfolio had a carrying value of $195 million. Valuations of these securities primarily reflect the fundamental analysis of the issuer and current market price of comparable securities.
Limited Partnership Securitization. In 2001, Aon sold the vast majority of its limited partnership (LP) portfolio, valued at $450 million, to PEPS I, a QSPE. The common stock interest in PEPS I is held by a limited liability company which is owned by one of Aon's subsidiaries (49%) and by a charitable trust, which is not controlled by Aon, established for victims of September 11 (51%). Approximately $171 million of investment grade fixed-maturity securities were sold by PEPS I to unaffiliated third parties. PEPS I then paid Aon's insurance underwriting subsidiaries the $171 million in cash and issued to them an additional $279 million in fixed-maturity and preferred stock securities. The fixed-maturity securities Aon subsidiaries received from PEPS I are rated as investment grade by Standard & Poor's Ratings Services.
Notes payable, due in varying installments, with interest at 0.9% to 15.9%
Aon created Aon Capital A, a wholly-owned statutory business trust, for the purpose of issuing mandatorily redeemable preferred capital securities. Aon received cash and an investment in 100% of the common equity of Aon Capital A by issuing 8.205% Junior Subordinated Deferrable Interest Debentures (subordinated debt) to Aon Capital A.
In April 2006, an indirect wholly-owned subsidiary of Aon issued CAD 375 million (US $323 at December 31, 2006 exchange rates) of 5.05% senior unsecured debentures due in April 2011. The principal and interest on the debentures is unconditionally and irrevocably guaranteed by Aon. The net proceeds from the offering were used to repay outstanding indebtedness under the Company's €650 million Euro credit facility.
In 2002, Aon completed a private offering of $300 million aggregate principal amount of 3.5% convertible senior debentures due in 2012. The net proceeds from this offering were $296 million. The debentures are unsecured obligations and are convertible into Aon common stock at an initial conversion price of approximately $21.475 per common share under certain circumstances including (1) during any fiscal quarter, if the closing price of Aon's common stock exceeds 120% of the conversion price (i.e. $25.77) for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the previous fiscal quarter, or (2) subject to certain exceptions, during the five business day period after any ten consecutive trading day period in which the trading price per $1,000 principal amount of the debentures for each day of the ten trading day period was less than 95% of the product of the closing sale price of Aon's common stock and the number of shares issuable upon conversion of $1,000 principal amount of the debentures. Aon will be required to pay additional contingent interest, beginning November 15, 2007, if the trading price of the debentures for each of the five trading days immediately preceding the first day of the six month interest period equals or exceeds 120% of the par value of the debentures. Aon has reserved approximately 14 million shares for the potential conversion of these debentures. Beginning November 19, 2007, Aon may redeem any of the debentures at an initial redemption price of 101% of the principal amount, plus accrued interest. The debentures were sold to qualified institutional buyers.
Aon had issued $250 million of 6.2% debt securities due January 2007. The interest rate on these debt securities is subject to adjustment in the event that Aon's credit ratings change. Due to ratings downgrades during 2002 and 2004, the interest rate on the 6.2% debt securities was increased to 6.7% effective January 2003 and 6.95% effective January 2005. These securities were redeemed in January 2007.
Income from continuing operations before provision for income tax and the provision for income tax consist of the following:
Income from continuing operations before provision for income tax shown above is based on the location of the corporate unit to which such earnings are attributable. However, because such earnings in some cases may be subject to taxation in more than one country, the income tax provision shown above as U.S. or International may not correspond to the geographic attribution of the earnings.
SeeNote 2 "Restatement of Consolidated Financial Statements". Significant components of Aon's deferred tax assets and liabilities are as follows:
Aon recognized, as an adjustment to additional paid-in-capital, income tax benefits attributable to employee stock compensation as follows: 2006 - $24 million; 2005 - $6 million; and 2004 - $0 million.
Aon's insurance subsidiaries are involved in both the cession and assumption of reinsurance with other companies. Aon's reinsurance consists primarily of certain newer accident and health initiatives, as well as certain property and casualty lines that are in runoff. Aon's insurance subsidiaries remain liable to the extent that the reinsurers are unable to meet their obligations. As of November 30, 2006 in connection with the sale of AWG, Aon sold Virginia Surety Company (VSC). VSC will continue to remain liable to policyholders to the extent reinsurers of the property and casualty business do not meet their obligations. As a result, at December 31, 2006, Aon no longer reports reinsurance recoverables related to its property and casualty business, which was not part of the sale of AWG. Aon has provided a corporate guaranty with respect to these reinsurance recoverables which amount to $790 million at December 31, 2006.
Liabilities at end of year (net of recoverables: 2006 - $64; 2005 - $857; 2004 - $861)
Generally, the capital and surplus of Aon's insurance subsidiaries available for transfer to the parent company is limited to the amount that the insurance subsidiaries' statutory capital and surplus exceeds minimum statutory capital requirements; however, payments of the amounts as dividends in excess of $182 million may be subject to approval by regulatory authorities.
Our major U.S. insurance subsidiaries' statutory capital and surplus at year-end 2006 significantly exceeded the risk-based capital target set by the NAIC.
Net statutory income of the insurance subsidiaries was $208 million, $162 million, and $195 million for the years December 31, 2006, 2005, and 2004, respectively.
Aon subsidiaries maintain defined contribution savings plans for the benefit of its U.S. and U.K. employees. The Company recognized expense related to its U.S. plans of $49 million, $47 million and $43 million in 2006, 2005 and 2004, respectively. The Company recognized expense related to its U.K. plans of $19 million, $20 million and $20 million in 2006, 2005, 2004, respectively.
In November 2006, Aon announced proposed changes to its U.S. and U.K. defined benefit plans. Changes to the pension plans will not affect pension plan benefits earned by participants prior to the effective date of the changes. Effective January 1, 2007, future benefits in the Company's U.S. defined benefit pension plan will be calculated based on a "career average pay" formula instead of a "final average pay" formula. The change will affect approximately 11,000 active employees covered by the U.S. plan. For its U.K. defined benefit pension plans, the Company is proposing to cease crediting future benefits relating to salary and service, subject to trustee approval and member consultation. The proposed change would affect approximately 1,700 active employees and is anticipated to take effect during the first half of 2007. Subject to approval of the trustees, it is proposed that the future pension provision will be provided under the defined contribution section of the Aon U.K. Pension Scheme.
Accrued pension and other benefit liabilities (included in pension, post-employment and post-retirement liabilities)
$ (249 ) $ (432 ) $ (68 ) $ (67 )
The following table provides the components of net periodic benefit cost for the U.S. plans:
The investment policy, as established by the Aon Pension Plan Investment Committee, seeks reasonable asset growth at prudent risk levels within target allocations. Aon believes that plan assets are well-diversified and are of appropriate quality. The investment portfolio asset allocation is reviewed quarterly and re-balanced to within policy target allocations. The investment policy is reviewed at least annually and revised, as deemed appropriate by the Aon Pension Plan Investment Committee.
Aon's liability for future plan cost increase for pre-65 and Medical Supplement plan coverage is limited to 5% per annum. Because of this cap, net employer trend rates for these plans are effectively limited to 5% per year in the future. The $50 per month subsidy for future post-65 retirees is assumed not to increase in future years. Therefore, there is no employer trend for future post-65 retirees. As a result, a 1% change in assumed healthcare cost trend rates has no effect on the service and interest cost components of net periodic post-retirement healthcare benefit cost or on the accumulated post-retirement benefit obligation for the measurement period ended in 2006.
December 31, 2006 and 2005, for material international pension plans, which are located in the U.K. and The Netherlands.
The accumulated other comprehensive loss at December 31, 2006 was solely comprised of a net loss of $1,621 million that has not yet been recognized as a component of net periodic benefit cost.
The following table provides the components of net periodic benefit cost for the international plans:
4.0 - 5.1 % 4.5 - 5.6 % 5.25 - 5.5 %
Estimated future pension benefit payments for international plans are as follows at December 31, 2006:
Deduct: Stock-based compensation expense determined under fair value method for all awards and options, net of tax
Options to purchase common stock are granted to certain executives and key employees of Aon and its subsidiaries generally at 100% of market value on the date of grant. Generally, employees are required to complete two continuous years of service before the options begin to vest in increments until the completion of a 4-year period of continuous employment. However, beginning in 2004 a significant number of options were granted that required five continuous years of service before all options would vest. For all grants made prior to an amendment to the former stock option plan in 2000, employees were required to complete three continuous years of service before the options began to vest in increments until the completion of a 6-year period of continuous employment. The maximum contractual term on stock options is generally ten years from the date of grant.
A summary of options outstanding and exercisable as of December 31, 2006 is as follows (shares in thousands):
During 2006, a majority of option exercises and award vestings were satisfied through the reissuance of treasury shares.
Aon also has an employee stock purchase plan which provides for the purchase of approximately 525,000 shares of Aon common stock by eligible U.K. employees after a 3-year period and is similar to the U.S. plan described above. No shares were issued under the plan in 2006, 2005, or 2004. In 2006, compensation expense recognized was less than $1 million. There was no compensation expense associated with this plan in 2005 or 2004.
Certain derivatives also give rise to credit risks from the possible non-performance by counterparties. The credit risk is generally limited to the fair value of those contracts that are favorable to Aon. Aon has limited its credit risk by using master netting agreements, entering into non-exchange-traded derivatives with highly rated major financial institutions and by using exchange-traded instruments. Aon closely monitors the credit-worthiness of, and exposure to, its counterparties and considers its credit risk to be minimal. At December 31, 2006 and 2005, Aon placed cash and securities relating to these derivative contracts in escrow amounting to $9 million and $6 million, respectively.
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, identifies three hedging relationships where a derivative (hedging instrument) may qualify for hedge accounting: (i) a hedge of the change in fair value of a recognized asset or liability or firm commitment ("fair value
In order for a derivative to qualify for hedge accounting, the derivative must be formally designated as a fair value, cash flow, or a net investment hedge by documenting the relationship between the derivative and the hedged item. The documentation will include a description of the hedging instrument, the hedge item, the risk being hedged, Aon's risk management objective and strategy for undertaking the hedge, the method for assessing the effectiveness of the hedge, and the method for measuring hedge ineffectiveness. Additionally, the hedge relationship must be expected to be highly effective at offsetting changes in either the fair value or cash flows of the hedged item at both inception of the hedge and on an ongoing basis. Aon assesses the ongoing effectiveness of its hedges and measures hedge ineffectiveness at the end of each quarter.
For a fair value hedge, the change in fair value of the hedging instrument and the change in fair value of the hedged item attributable to the risk being hedged are both recognized currently in earnings. Aon did not enter into any fair value hedges in 2006. For a cash flow hedge, the effective portion of the change in fair value of a hedging instrument is recognized in OCI and subsequently reclassified to income when the hedged item affects earnings. The ineffective portion of the change in fair value of a cash flow hedge is recognized immediately in earnings. For a net investment hedge, the effective portion of the change in fair value of the hedging instrument is reported in OCI as part of the cumulative translation adjustment while the ineffective portion is recognized immediately in earnings.
When hedge accounting is discontinued because the derivative no longer qualifies as a fair value hedge, Aon will continue to carry the derivative in the consolidated statements of financial position at its fair value, recognize subsequent changes in the fair value of the derivative in current-period earnings, cease to adjust the hedged asset or liability for changes in its fair value, and begin to amortize the hedged item's cumulative basis adjustment into earnings over the remaining life of the hedged item using a method that approximates the level-yield method.
Certain of Aon's foreign brokerage subsidiaries, primarily in the U.K., receive revenues in currencies (primarily in U.S. dollars) that differ from their functional currencies. The foreign
Aon uses futures contracts and purchased options on futures contracts to reduce the price volatility of its fixed-maturity portfolio. Derivatives designated as hedging the aggregate interest rate exposure of the fixed-maturity portfolio do not qualify as hedges. Changes in their fair value were recorded in investment income. Derivatives designated as hedging specific fixed-income securities are accounted for as fair value hedges. Changes in the fair value of the hedge and the hedged item are recorded in investment income.
Aon occasionally enters into receive-fixed-pay-floating interest rate swaps to hedge changes in the fair value of its fixed-rate notes. The interest rate swaps qualify as fair value hedges and are expected to have no ineffectiveness because their critical terms (e.g., amount, maturity date) match those of the hedged debt. Upon the termination of this type of hedge, the swap realized gains and losses that have been deferred as an adjustment to the cost basis of the hedged item are amortized into interest
expense over the remaining life of the hedged items. Aon did not enter into any fixed-rate note fair value hedges during 2006.
Certain of Aon's U.S., U.K., Canadian and Australian subsidiaries originate short-term loans (generally with terms of 12 months or less) to businesses to finance their insurance premium obligations, and then sell these premium finance agreements in securitization transactions that meet the criteria for sale accounting under Statement No. 140. These sales involve special purpose entities ("SPEs"), which are considered qualified special purpose entities ("QSPEs") according to Statement No. 140 and multi-seller, non-qualified bank commercial paper conduit SPEs ("Bank SPEs") that are variable interest entities according to FIN 46. Statement No. 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates (Aon's subsidiaries).
The Company has analyzed qualitative and quantitative factors related to Aon subsidiaries' interests in the Bank SPEs and has determined that these subsidiaries are not the sponsors of the Bank SPEs. Additionally, independent third parties (i) have made substantial equity investments in the Bank SPEs, (ii) have voting control of the Bank SPEs, and (iii) generally have the risks and rewards of ownership of the assets of the Bank SPEs.
Thus, Aon has concluded that non-consolidation of the Bank SPEs is appropriate in accordance with FIN 46 given that the subsidiaries do not have significant variable interests.
Aon records gains associated with the sale of receivables. When Aon calculates the gains, all fees related to this facility were included. The gains included in commissions and fees in the consolidated statements of income were $63 million, $65 million and $81 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Aon records at fair value the retained interest in the sold premium finance agreements, and reports it in insurance brokerage and consulting services receivables in the consolidated statements of financial position. Aon also retains servicing rights for sold agreements and earns servicing fee income over the servicing period. The servicing fees are included in the gain/loss calculation. At December 31, 2006 and 2005, the fair value of the servicing rights approximates the estimated costs to service the receivables and accordingly, Aon has not recorded any servicing assets or liabilities related to this servicing activity.
The Bank SPEs bear the credit risks on the receivables, subject to limited recourse in the form of credit loss reserves.
Aon provides a variety of guarantees and indemnifications to its customers and others. The maximum potential amount of future payments represents the notional amounts that could become payable under the guarantees and indemnifications if there were a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions or other methods. These amounts may bear no relationship to the expected future payments, if any, for these guarantees and indemnifications. Any anticipated amounts payable which are deemed to be probable and estimable are accrued in Aon's consolidated financial statements.
Aon has certain contractual contingent guarantees for premium payments owed by clients to certain insurance companies. Costs associated with these guarantees, to the extent estimable and probable, are provided in Aon's allowance for doubtful accounts. The maximum exposure with respect to such contractual contingent guarantees was approximately $12 million at December 31, 2006.
The changes in the net carrying amount of goodwill by operating segment for the years ended December 31, 2006 and 2005, respectively, are as follows:
•"Present Value of Future Profits" represent the future profits of purchased books of business of the insurance underwriting subsidiaries; and
The cost of other intangible assets is being amortized over a range of 2 to 10 years, with a weighted average original life of 8 years. Amortization expense for intangible assets for the years ending December 31, 2007, 2008, 2009, 2010 and 2011 is estimated to be $31 million, $25 million, $23 million, $18 million and $13 million, respectively.
Beginning in June 2004, a number of other putative class actions were filed against Aon and other companies by purported classes of clients under a variety of legal theories, including state tort, contract, fiduciary duty, antitrust and statutory theories and federal antitrust and Racketeer Influenced and Corrupt Organizations Act theories. These actions are currently pending in state court in California and in federal court in New Jersey. Aon believes it has meritorious defenses in all of these cases and intends to vigorously defend itself against these claims. The outcome of these lawsuits, and any losses or other payments that may occur as a result, cannot be predicted at this time.
With respect to the various class actions that have been filed, we are unable to estimate a range of possible losses, as these actions have not yet progressed to the stages where damages can be estimated.
In February 2006, Lloyds announced that it had brought suit in London against Benfield and a subsidiary of Aon to recover alleged losses relating to these brokers' placement of insurance for Lloyds's New Central Fund. Lloyds alleges that its brokers did not fairly present the risk to reinsurers and thus that the brokers should be held liable for reinsurers' failure to pay Lloyds an amount that Lloyds claims is approximately £325 million ($639 million based on December 31, 2006 exchange rates). Aon disputes Lloyds's allegations, believes that it has meritorious defenses and intends to vigorously defend itself against Lloyds's claims. Possible losses in this action range from zero, if Aon prevails, to the £325 million Lloyd's claims.
accounts for intersegment revenue as if the revenue were from third parties, that is, considered by management to be at current market prices.
Revenues are generally attributed to geographic areas based on the location of the resources producing the revenues. Intercompany revenues and expenses are eliminated in computing consolidated revenues and income before tax.
The operations of the Consulting segment provide a broad range of consulting services. These services are delivered predominantly to corporate clientele utilizing seven practice areas: employee benefits, compensation, management consulting, communications, strategic human resource consulting, financial advisory and litigation consulting and human resource outsourcing.
(2)Excludes the elimination of intersegment revenues and expenses of $59 million, $46 million and $58 million for 2006, 2005 and 2004, respectively.
Unallocated expenses include administrative costs not attributable to the operating segments such as corporate governance costs.
A reconciliation of segment income before tax to income from continuing operations before provision for income tax is as follows:
Selected quarterly financial data for the years ended December 31, 2006 and 2005 are as follows (in millions, except per share data):
(1)Adoption of FASB statement No. 123(R), "Share-Based Payments," effective January 1, 2006, net of tax.
2005 Statements of Income have been restated to record the impact of the increased stock compensation expense discussed in Note 2, "Restatement of Consolidated Financial Statements." The following table reconciles the as reported, adjustments, as restated, reclassification (for discontinued operations) and as presented quarterly Statements of Income for 2005 (in millions, except per share data).
Aon provides a variety of guarantees and indemnifications to its customers and others to allow Aon or others to complete a wide variety of business transactions. The maximum potential amount of future payments represents the notional amounts that could become payable under the guarantees and indemnifications if there were a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions or other methods. These amounts may bear no relationship to the expected future payments, if any, for these guarantees and indemnifications. Aon does not currently anticipate making future payments to any of its subsidiaries, or third parties on behalf of its subsidiaries, for these guarantees and indemnifications.
Aon has issued various other guarantees for miscellaneous purposes at its international subsidiaries for $4 million.
(1)The above results reflect allocations of investment income and certain expense elements considered reasonable under the circumstances. Results include income (loss) on disposals of investments and other-than-temporary impairments.
(2)Certain prior years' amounts have been reclassified to conform to the 2006 presentation.