The Company leases its corporate office in Glen Allen, Virginia. The Company’s subsidiaries also conduct their business operations from leased office space in various states where located. Information on the Company’s lease commitments is incorporated by reference to the material contained in “Note H-Leases” of Notes to Consolidated Financial Statements included in Item 8 of this report. The Company believes that its properties are in good condition and are suitable and adequate for its purposes.
The following discussion should be read in conjunction with our consolidated financial statements and the related notes included in Item 8 of this report.
The income of an insurance and risk management intermediary such as the Company is principally derived from commissions earned, which are generally percentages of premiums placed with insurance underwriters. Premium pricing within the insurance underwriting industry has been cyclical, varied by region and has displayed a high degree of volatility based on prevailing economic and competitive conditions. Increases and decreases in underlying premium rates may result directly in revenue changes to the Company. From 1987 until 1999, the property and casualty insurance industry had been in a “soft market;” however, beginning in 2000, the industry experienced a firming of commercial premium rates which continued through 2002. In 2003, the industry observed more moderate increases in commercial premium rates. Beginning in the second quarter of 2004, the industry began to observe another softening in property and casualty premium rates which has continued through 2006. In addition, the level of contingent commissions received by the Company, which is based upon the application of certain factors, including profitability of the business, premium growth, total premium volume or some combination of these factors, is subject to annual fluctuations and cannot be reasonably predicted. The Company’s 2006 revenues have increased primarily due to net new business and acquisitions, partially offset by lower contingent commissions. The reduction in contingent commission payments can be attributed to the factors noted above and the elimination of national override commissions as a result of recent industry regulatory matters (see “Contingent and National Override Agreements Commissions” for additional discussion). Management cannot predict the timing or extent of contingent commissions or premium pricing changes due to market conditions or their effects on the Company’s results of operations in the future.
Total commissions and fees increased $38.0 million, or 5.8%, from $658.0 million for 2005 to $696.0 million for 2006. This change reflects a $42.4 million, or 7.0%, increase in core commissions and fees, partially offset by reduced contingent commissions of $4.4 million, or 9.0%. In 2005, commissions and fees increased 7.9%, or $48.3 million, from $609.7 million for the year ended December 31, 2004. These changes are outlined below by segment:
Compensation and employee benefits for 2006 were $397.3 million, an increase of $31.8 million, or 8.7%, from 2005. The adoption of Statement 123R increased 2006 compensation costs by $6.6 million as the fair value of stock options was not expensed in prior periods. The increase between 2006 and 2005 also includes approximately $16.0 million related to 2006 and 2005 purchase acquisitions, partially offset by decreases of $4.6 million related to agencies and accounts sold. Higher performance-based compensation and investments in new talent, most notably in the Company’s Domestic Retail segment and an international subsidiary, primarily account for the remaining increase in compensation and employee benefit expenditures.
Compensation and employee benefits for 2005 were $365.5 million compared to $333.1 million in 2004, an increase of $32.4 million, or 9.7%. The year-over-year increase includes approximately $33.7 million related to 2005 and 2004 purchase acquisitions, partially offset by decreases of $5.2 million related to agencies and accounts sold. Additional compensation and employee benefit costs in 2005 are primarily attributed to continued investments in new sales and service talent, primarily in the Domestic Retail segment and an international subsidiary.
Investment income for 2006 increased $3.9 million, or 59.7%, over the prior year period primarily due to a higher interest rate environment and an increase in average cash balances. Investment income for 2005 increased $3.4 million over 2004 primarily for the same reasons. Higher investment income balances are partially offset by increased interest expense. Interest expense was $18.4 million, $16.2 million and $10.3 million in 2006, 2005 and 2004, respectively. Interest expense in 2006 was impacted by the higher interest rate environment, partially offset by more favorable terms under the Credit Agreement. Interest expense in 2005 was impacted by increased average borrowings and higher interest rates.
As of December 31, 2006, the Company had, under its Credit Agreement, outstanding term loans of $99.3 million which are due in various amounts through 2013, and outstanding revolving credit facility borrowings of $130.6 million with $193.5 million available under the revolving credit facility for future borrowings. In January 2007, the Company borrowed an additional $65.0 million under its revolving credit facility to assist with the funding of its acquisition program.
The Company has three interest rate swap agreements with a total notional amount of $100.0 million. The Company uses these interest rate swaps to manage interest cost and cash flows associated with variable interest rates.
The Company had a current ratio (current assets to current liabilities) of 1.13 to 1.00 at December 31, 2006. Shareholders’ equity of $603.4 million at December 31, 2006 increased from $514.4 million at December 31, 2005. The debt to equity ratio of 0.38 to 1.00 at December 31, 2006 decreased from the prior year-end ratio of 0.49 to 1.00 due to net income and the issuance of Common Stock partially offset by common stock repurchases.
As of December 31, 2006, approximately 46% of the Company’s debt is effectively fixed rate. The Company has variable rate debt, maintains certain investments and utilizes derivative financial instruments (on a limited basis) which are subject to market risk; however, the Company believes that exposure to market risk associated with these instruments is not material.
As a result of the industry and regulatory developments, controversy continues to surround the longstanding insurance industry practice of contingent and override commissions paid to agents and brokers by underwriters. The Company has historically entered into contingent and override commission agreements with various underwriters. Contingent commissions are commissions paid by underwriters based on profitability of the business, premium growth, total premium volume or some combination of these factors. Revenue from contingent commissions is heavily weighted in the first and second quarters. Income from the National Override Agreements was typically volume-based and paid quarterly by underwriters in excess of the standard commission rates on specific classes of business. National Override Agreements, as defined in the agreement with the Attorney General, mean corporate-wide compensation agreements negotiated by the Company with certain insurance companies on behalf of all of the Company’s offices to receive commissions in lieu of standard contingent compensation arrangements with each office of the Company.
In addition to state regulatory inquiries, the Company has been named as a defendant in a purported class action brought against a number of brokers in the insurance industry and a purported securities class action. For information on industry and other litigation, see “Note Q-Commitments and Contingencies” of Notes to Consolidated Financial Statements.
The Company records an income tax provision for the expected tax consequences of its reported results. The Company’s provision includes deferred income taxes to reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company evaluates its ability to realize the deferred tax assets in the future and records a valuation allowance when necessary. The determination of income taxes and assessment of realization of deferred tax assets requires significant judgment due to the complexity of tax laws and the Company’s operation in multiple states.
In 2006, the Company adopted Statement 123R. For additional information on the adoption of Statement 123R, see “Note C-Recent Accounting Pronouncements” of Notes to Consolidated Financial Statements.
Statement of Consolidated Income for the years ended December 31, 2006, 2005 and 2004
Statement of Consolidated Cash Flows for the years ended December 31, 2006, 2005 and 2004
Principles of Consolidation-The accompanying financial statements include the accounts of the Company and its subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. Certain amounts for the prior years have been reclassified to conform to current year presentation.
Restatement-See Note B concerning a restatement of the Company’s previously issued consolidated financial statements.
The Company carries a reserve for policy cancellations which is periodically evaluated and adjusted as necessary. Miscellaneous premium and commission adjustments are recorded as they occur. The policy cancellation reserve as of December 31, 2006 and 2005 was $2.6 million and $2.5 million, respectively. For 2006, the cancellation reserve activity was primarily related to new reserves related to acquisitions.
Allowance for Doubtful Accounts-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.
Goodwill is tested for impairment annually in the fourth quarter, or sooner if impairment indicators arise. In reviewing goodwill for impairment, potential impairment is identified by comparing the estimated fair value of a reporting unit with its carrying value. The fair value of a reporting unit is estimated by applying valuation multiples to the reporting unit’s 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 of the net assets of a reporting unit, including goodwill, an impairment loss may be recognized. See Note K for additional information. Intangible assets with finite lives are amortized over their useful lives and, when indicators of impairment are present, are reviewed for recoverability using estimated future undiscounted cash flows related to those assets.
Effective January 1, 2006, the Company recognized compensation cost based upon fair value for only (i) those share-based awards granted or modified with an effective date subsequent to January 1, 2006 and (ii) share-based awards issued in prior periods that remained unvested at January 1, 2006. In 2005 and 2004, no stock-based compensation cost for stock options was reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Stock-based compensation cost relating to restricted stock awards was recognized in both the current and prior periods.
For valuation purposes, the Company uses a Black-Scholes option-pricing model to estimate the fair value of stock option awards. Determining the Black-Scholes fair value of stock options necessitates the development of certain key assumptions. The volatility factor was estimated based on the Company’s historical volatility over the contractual term of the options. The Company also used historical data to derive the option’s expected life and employee forfeiture rates within the valuation model. The risk-free interest rate is based on the U. S. Treasury yield curve in effect at the date of grant. The dividend yield is predicated on the current annualized dividend payment and the average stock price over the year prior to the grant date.
Prior to the adoption of Statement 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Consolidated Cash Flows. Statement 123R requires the cash flows resulting from the benefits of tax deductions in excess of recognized compensation costs be reported as financing cash flows. The $2.7 million excess tax benefit classified as a financing cash inflow for 2006 would have been classified as an operating cash inflow if the Company had not adopted Statement 123R.
Rent Expense-Minimum rental expenses are recognized over the term of the lease. When a lease contains a predetermined fixed escalation of the minimum rent, the related rent expense is recognized on a straight-line basis. Lease incentives are amortized as a reduction to rent expense over the lease term. Contingent rent and rent escalations are included in rent expense when it is probable that the expense will be incurred and the amount can be reasonably estimated.
Income Taxes-The Company (except for its foreign subsidiaries) files a consolidated federal income tax return with its subsidiaries. Deferred taxes result from temporary differences between the income tax and financial statement bases of assets and liabilities and are based on tax laws as currently enacted.
Accrued Expenses-Accrued expenses included compensation and employee benefits of $36.7 million and $29.5 million at December 31, 2006 and 2005, respectively.
On February 21, 2007, the Company announced that the Company’s management had reexamined its segment evaluation analysis and determined that, in accordance with Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” an error had been made in its identification of reportable segments for the years ended December 31, 2005 and 2004.
Also, on February 21, 2007, the Company announced that it was restating previously filed financial statements to correct the Company’s accounting for goodwill impairment testing under Statement 142. The Company determined that it incorrectly applied Statement 142’s provisions for identifying reporting units since adoption and, as a result, tested goodwill impairment at a higher reporting unit level than was appropriate. The correction of this error resulted in a non-cash intangible asset impairment charge, primarily related to goodwill, of $45.0 million, or $31.9 million net of income taxes, for the year ended December 31, 2003. The Company has restated the consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 and its unaudited quarterly results for those years and 2006. All applicable information contained in this report gives effect to those restatements. Consequently, reliance should not be placed upon the financial statements for the above mentioned periods that have been filed with or furnished to the SEC or included in previous announcements.
In addition, the goodwill impairment resulted in an asset impairment indicator for the long-lived assets of these reporting units. Consistent with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” the Company completed its impairment testing and recorded a $1.4 million impairment charge relating to the customer relationships and noncompete intangible assets of four of the six reporting units noted above.
The line items that changed on the Statement of Consolidated Income for the year ended December 31, 2003 due to the restatement are as follows:
The line items that changed on the Consolidated Balance Sheet at December 31, 2003, 2004 and 2005 due to the restatement follow. Deferred income taxes at December 31, 2003 reflect a reclassification in order to conform to the current year presentation.
modified with an effective date subsequent to the company’s date of adoption and share-based awards issued in prior periods that remain unvested at the date of adoption. The modified-retrospective method allows a company to restate, based upon pro forma amounts previously disclosed under the requirements of Statement 123, for either all prior periods presented or prior interim periods included in the year of adoption.
Effective January 1, 2006, the Company adopted Statement 123R and accounted for the adoption using the modified-prospective method. No prior period results have been restated. See Note A for more information on stock-based compensation.
Maturities of long-term debt for the years ending after December 31, 2007 are $2.0 million in 2008, $0.1 million in 2009, none in 2010, $135.6 million in 2011, and $94.3 million thereafter. At December 31, 2006, the Company had term loans included in the credit facility with $1.0 million due within one year classified as long-term debt in accordance with the Company’s intent and ability to refinance this obligation on a long-term basis under its revolving credit facility. In January 2007, the Company borrowed an additional $65.0 million under its revolving credit facility to assist with the funding of its acquisition program.
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. 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 July 2004, the Company entered into an interest rate swap agreement with a notional amount of $30.0 million and a maturity date of June 30, 2007. In December 2004, the Company entered into a second interest rate swap agreement with a notional amount of $20.0 million and a maturity date of December 31, 2010. In December 2005, the Company entered into a third interest rate swap agreement with a notional amount of $50.0 million and a maturity date of December 31, 2010. The Company has designated all of its interest rate swaps as cash flow hedges under Statement 133. The Company enters into interest rate swap agreements to manage interest costs and cash flows associated with variable interest rates, primarily short-term changes in LIBOR; changes in cash flows of the interest rate swaps offset changes in the interest payments on the covered portion of the Company’s credit facility. The notional amounts of the interest rate swap agreements are used to measure interest to be paid or received and do not represent the amount of exposure to credit loss. The credit risk to the Company would be a counterparty’s inability to pay the differential in the fixed rate and variable rate in a rising interest rate environment. The Company’s exposure to credit loss on its interest rate swap agreements in the event of non-performance by a counterparty is believed to be remote due to the Company’s requirement that a counterparty have a strong credit rating. The Company is exposed to market risk from changes in interest rates.
Under the current interest rate swap agreements, the Company makes payments based on fixed pay rates of approximately 4.4% and receives payments based on the counterparties’ variable LIBOR pay rates. At the end of the year, the variable rate was approximately 5.4% for each agreement. In connection with these interest rate swap agreements, the Company recorded after-tax income in other comprehensive income of $0.2 million, $0.6 million and $0.3 million in 2006, 2005 and 2004, respectively. There was no impact on net income due to ineffectiveness. The fair market value of the interest rate swaps resulted in assets of $1.0 million and $0.8 million at December 31, 2006 and 2005, respectively, which are included in other non-current assets.
The Company sponsors the HRH Retirement Savings Plan (the Retirement Savings Plan) which covers substantially all employees of the Company and its subsidiaries. The Retirement Savings Plan, which may be amended or terminated by the Company at any time, provides that the Company shall contribute a matching contribution of up to 3% of a participant’s eligible compensation and any additional amounts as the Board of Directors shall determine to a trust fund.
The total expense recorded by the Company under the Retirement Savings Plan for 2006, 2005 and 2004 was $6.1 million, $5.9 million and $5.3 million, respectively.
The Company operates in multiple tax jurisdictions and its tax returns are subject to audit by various taxing authorities. The Company believes that adequate accruals have been made for all tax returns subject to audit. Deferred income taxes reflect the tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Income taxes paid were $37.2 million, $38.1 million and $56.5 million in 2006, 2005 and 2004, respectively.
The net current deferred tax asset, which is included in prepaid expenses and other current assets, was $20.4 million and $7.1 million at December 31, 2006 and 2005, respectively.
Rental expense for all operating leases in 2006, 2005 and 2004 amounted to $28.3 million, $28.2 million and $25.5 million, respectively. Included in rental expense for 2006, 2005 and 2004 is approximately $1.5 million, $1.4 million and $1.9 million, respectively, which was paid to employees or related parties.
The aggregate intrinsic values for shares outstanding and exercisable at December 31, 2006 were $28.5 million and $19.1 million, respectively. The total intrinsic values of options exercised during the years ended December 31, 2006, 2005 and 2004 were $7.5 million, $5.1 million and $17.9 million, respectively.
The fair value of options granted during 2006 was estimated at the grant date using a Black-Scholes option price model with the following weighted average assumptions: risk free rate of 4.66%; dividend yield of 1.17%; volatility factor of 0.276; and an expected life of approximately five years. The weighted average fair value per option granted for 2006 was $11.67.
The fair value of these options was estimated at the grant date using a Black-Scholes option-pricing model with the following weighted average assumptions for 2005 and 2004, respectively: risk free rates of 3.72% and 3.62%; dividend yields of 1.27% and 1.14%; volatility factors of 0.293 and 0.292; and an expected life of approximately five years and seven years. The weighted average fair value per option granted in 2005 and 2004 was $9.71 and $10.79, respectively.
Restricted shares are also awarded to certain employees under the 2000 Stock Incentive Plan. Restricted shares generally vest ratably over a four year period beginning in the second year of continued employment. Stock activity under this portion of the Company’s share-based compensation arrangements is as follows:
The changes in the net carrying amount of goodwill for 2005 and 2006 are as follows (in thousands):
During 2005, the Company acquired certain assets and liabilities of four insurance agencies and other accounts for $15.0 million ($10.7 million in cash, $1.9 million in guaranteed future cash and Common Stock payments, and approximately 69,000 shares of Common Stock). Assets acquired include intangible assets of $14.5 million at the date of purchase. The combined purchase price increased by $2.4 million in 2006, and may be increased by $3.7 million in 2007 and $1.5 million in 2008 based upon revenues earned or net profits realized.
The Company and certain other companies in the insurance intermediary industry have been subject to investigations and inquiries by various governmental authorities regarding business practices and broker compensation arrangements. On August 31, 2005, the Company entered into an agreement (the 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 (the Action).
The Fund will be allocated $19.5 million between Broker Clients and National Override Clients (the Broker/Override Fund) and $10.5 million to Agent Clients (the Agency Fund), and an Affected Policyholder arising from an acquisition by the Company after December 31, 2000 shall be included only as of the date of acquisition by the Company.
4. By August 21, 2006, the Company will send notice to each client setting forth the amount it will be paid from the Fund if it elects to participate. Clients will have until November 21, 2006 to make an election to receive distributions from the Fund.
to accept certain types of compensation only after disclosing such compensation to a client,
In addition, the plaintiffs in MDL 1663 also filed on August 1, 2005 a First Consolidated Amended Employee Benefits Class Action Complaint (the Employee Benefits Complaint) in the District Court of New Jersey against the Company; Frank F. Haack & Associates, Inc.; O’Neill, Finnegan & Jordan Insurance Agency Inc.; and certain other insurance brokers and insurers. In the Employee Benefits Complaint (Civil Nos. 04-5184, et al.), the named plaintiffs purport to represent two separate classes consisting of ERISA and non-ERISA plan employees and employers, respectively, that have acquired insurance products from the defendants in connection with an employee benefit plan between August 26, 1994 and the date on which class certification may occur. The plaintiffs allege in the Employee Benefits Complaint, among other things, that the broker defendants secretly conspired with the insurer defendants to steer plaintiffs and members of the classes to the insurer defendants in exchange for undisclosed fees, including communication fees, enrollment fees, service fees, finders fees and/or administrative fees, contingent commissions and other payments, including broker bonuses, trips and entertainment, from the insurer defendants; 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; and that the defendants entered into unlawful tying arrangements under which the broker defendants would place primary insurance contracts with insurers on the condition that the insurers use the broker defendants for placing their reinsurance coverage with reinsurance carriers. 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 and punitive 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.
On October 3, 2006, the District Court of New Jersey denied in part the motion to dismiss the Commercial Complaint and the Employee Benefits Complaint and ordered that plaintiffs provide supplemental information regarding each of their consolidated complaints by October 25, 2006. The District Court of New Jersey further ordered that upon receipt of this supplemental information, the District Court of New Jersey will issue a “final ruling” on the motion to dismiss plaintiffs’ claims under the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. § 1962(c) and (d) and that on November 6, 2006, the defendants will be required to inform the District Court of New Jersey whether they intend to move to dismiss the remaining counts or alternatively to move for judgment on the pleadings or summary judgment on the remaining counts, pursuant to the Federal Rules of Civil Procedure. The Company, along with other defendants, filed renewed motions to dismiss, which are fully briefed and awaiting a decision from the District Court of New Jersey. On February 12, 2007, MDL 1663 was transferred to Judge Garrett E. Brown, Jr., Chief Judge of the District Court of New Jersey.
The Company’s remaining profit centers comprise the All Other category. These profit centers include the Company’s international profit centers as well as its Managing General Agencies/Underwriters, reinsurance and other specialized business units.
The accounting policies of the reportable segments are consistent with those described in Note A. Each segment has been allocated a portion of the Company’s corporate overhead based upon a percentage of total revenues, excluding any gains/losses on the sale of assets. Interest income and expense includes intercompany balances allocated to the individual segments through the Company’s internal cash management program. The “Corporate/Elimination” column consists of certain intercompany revenue eliminations; unallocated interest income and expense; certain corporate compensation costs, legal, compliance, and claims expenditures, and other miscellaneous operating expenses not included in the allocation of corporate overhead; and special charges. Total assets for “Corporate/Eliminations” primarily consist of intercompany elimination and reclassification adjustment balances. Summarized information concerning the Company’s reportable segments is shown in the following tables:
Total revenues recognized by the Company’s international profit centers, all of which are included in the All Other category, represented 2.5%, 2.0% and 1.5% of total revenues for the combined segments in 2006, 2005 and 2004, respectively.
As discussed in Note B to the consolidated financial statements, the consolidated balance sheet as of December 31, 2005 and the related consolidated statements of shareholders’ equity for the years ended December 31, 2005 and 2004 have been restated to record the impact of a 2003 intangible asset impairment charge, primarily related to goodwill. The Company’s segment disclosures in the 2005 and 2004 consolidated financial statements also have been restated.