Risk and Insurance Brokerage Services. Brokerage segment results are affected by a number of key drivers, including:
•conditions in insurance markets generally (particularly fluctuations in premiums charged by insurance companies)
In addition, in 2005 and 2004, this segment was affected by matters discussed under "Key Recent Events-Investigation by the New York Attorney General (NYAG) and Other Regulatory Authorities" and our related decision to terminate contingent commission arrangements.
•our clients' employment levels, which are driven mainly by economic conditions
In addition, in 2005 and 2004, this segment was also affected by the matters discussed under "Key Recent Events-Investigation by the New York Attorney General (NYAG) and Other Regulatory Authorities" and our related decision to terminate contingent commission arrangements.
•the loss of $100 million in contingent commissions compared to 2004.
Income from continuing operations before provision for income tax and minority interest increased $138 million from 2004. The primary drivers for this change were:
•During the first quarter of 2005, we settled investigations with the NYAG and other regulatory authorities. We recorded expenses of $180 million related to this settlement in our 2004 results. The accretion of the discount on this settlement resulted in an expense of $5 million in 2005. We also incurred an expense of $40 million related to the Daniel class action lawsuit in 2004.
•Beginning in the third quarter of 2005, we began a corporate-wide restructuring effort, including workforce reductions and office closures. As a result of this effort, we incurred $158 million in severance expenses, lease consolidation costs, asset impairments and other associated costs.
•The net impact of activity involving our Endurance investment reduced 2005 pretax income by $75 million.
•The remaining increase is primarily attributable to effectively managing our costs.
Income from discontinued operations included a $239 million pretax gain resulting from the fourth quarter sale of our Swett & Crawford operation. The goodwill allocated to Swett & Crawford was not tax deductible, resulting in a high effective tax rate for the transaction.
(see Note 15 to the consolidated financial statements) and $25 million to repurchase outstanding common stock. These cash decreases were offset by increases in our operating cash flow and cash received from the sale of Swett & Crawford.
•paid down $12 million of total debt in 2005. We paid down $250 million of domestic long-term debt that was scheduled to be redeemed this year. That decrease was mostly offset by an increase in borrowings at our foreign subsidiaries, in part to offset earnings repatriated to the U.S.
In August 2005, we announced that we were reviewing the revenue potential and cost structure of each of our businesses. As a result of this review, we adopted restructuring initiatives and currently expect these initiatives to result in cumulative pretax charges totaling $262 million over a three-year period, of which we have incurred $158 million. Expected restructuring costs include workforce reductions and lease consolidation costs, asset impairments and other expenses. We expect the remaining expenses to affect our continuing operations through the end of 2007. We anticipate that these initiatives will lead to annualized cost savings of approximately $180 million by 2008.
The 2005 Restructuring Plan is expected to result in the elimination of 1,800 job positions and space consolidation in certain locations. Office closures will require that we recognize losses on subleases or lease buy-outs and may also trigger asset impairments. See the Critical Accounting Policies and Estimates section for detailed information on significant judgments and estimates, key assumptions and relevant accounting guidance related to our accounting for restructuring costs.
The following chart is a summary of the 2005 restructuring costs and estimated restructuring and related expenses by type through the end of 2007.
•$5 million in other related expenses, which represents fees paid to outside parties for work related to the restructuring.
We are restructuring to improve our profitability through operational efficiency. We project that our savings, net of restructuring expenses, will become positive by 2006, with a targeted annualized savings of approximately $180 million by 2008. However, we cannot guarantee that we will achieve the targeted savings given the factors discussed in the note to the preceding table.
Investigation by the New York Attorney General (NYAG) and Other Regulatory Authorities
(2)The impact of the March 2005 settlement was included in our 2004 operations. Since the settlement amount was fixed and determinable, we discounted the liability to the net present value of the payments based on our incremental borrowing rate, following Accounting Principle Board's (APB) Opinion No. 21. This discount is reflected in the $10 million difference between the
Below is a summary of our liability for the settlement as of December 31, 2004, changes during the year and the ending liability as of December 31, 2005.
•our automotive finance servicing business, which had been in run-off since first quarter 2001.
In addition, at December 31, 2005, we were in the process of selling a small non-core brokerage business in Australia. We completed the transaction in January 2006.
We have classified the operating results of all of these businesses as discontinued operations and reclassified prior year's operating results to discontinued operations, as follows:
See Note 6 to the consolidated financial statements, "Disposal of Operations," for further information.
In April 2005, we announced that Gregory C. Case had become our president and chief executive officer, effective immediately. Mr. Case was also elected to our Board of Directors. He succeeds Patrick G. Ryan, who had served as Aon's CEO since the company's founding. Mr. Ryan continues to serve as Executive Chairman of the Aon Board of Directors.
Restructuring costs are expensed as incurred in accordance with FASB Statement No. 112, Employers Accounting for Postemployment Benefits and FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Statement No. 146 applies to one-time workforce reduction benefits and requires companies to use Statement No. 112 when severance is paid under an ongoing severance policy. Lease consolidation costs, asset impairments and other costs associated with restructuring are accounted for under Statement No. 146 and FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Accounting guidance requires that our exit and disposal accruals reflect the fair value of the liability. Where material, we discount back sublease loss calculations to arrive at their net present value.
Asset impairments may result from large-scale restructurings and we account for these impairments in the period when they become known. Furthermore, we record impairments in accordance with Statement No. 144 by:
The U.S. pension plans are closed to new employees. All employees hired after 2003 participate in a defined contribution plan. Over time, this change will reduce the volatility inherent in the accounting for the U.S. pension plans.
As of year-end 2005, the market-related value of assets does not yet reflect accumulated asset losses of $69 million. These losses will increase pension expense as they are graded into the market-related asset value and may be offset by future asset gains. As of year-end 2005, we reported a fair value of pension assets of $1,326 million, while the market-related value of assets is $1,395 million. The Company contributed $300 million to the major U.S. pension plan during 2005 to strengthen the funding of the program.
Under FASB Statement No. 87, Employers' Accounting for Pensions, the full gain or loss on assets and obligations is not recorded as expense in the current period. Statement No. 87 allows changes in the projected benefit obligation and market value of assets to be deferred and amortized as a component of pension expense over several years, based on the average expected future service of active employees, which is currently nine years. Gains and losses on pension obligations include the net effects of changes in the discount rate and other actuarial assumptions, as well as demographic changes in the employee data.
For the 2005 valuation year, the pension plans have a combined deferred loss of $623 million (comprised of unrecognized asset losses of $69 million and other than deferred asset losses of $554 million) that has not yet been recognized through income in the financial statements. We amortize the non-asset losses of $554 million outside of a corridor, over about nine years; this corridor is defined as 10% of the greater of the market-related value of plan assets or the projected benefit obligation. For 2006, the estimated amortization amount to be recognized in expense is projected to be $46 million. To the extent not offset by future gains, the incremental amortization as calculated above will continue to affect future pension expense in a similar manner until fully amortized.
•decrease in our estimated discount rate would increase our estimated 2006 pension expense by approximately $42 million and the estimated 2006 postretirement medical benefit expense by approximately $0.3 million and
•increase in our estimated discount rate would decrease the 2006 estimated pension expense by approximately $35 million and the postretirement medical benefit expense by approximately $0.2 million.
•increase in the estimated long-term rate of return on plan assets would decrease pension expense by approximately $14 million.
For the 2005 valuation year, the major U.K. pension plans have a combined deferred loss (from asset and liability experience) of $1,629 million that has not yet been recognized through income in the financial statements. We amortize the accumulated loss outside of a corridor over 16 years; this corridor is defined as 10% of the greater of the fair value of plan assets or the projected benefit obligation. For 2006, the estimated amortization amount to be recognized in expense is $79 million. To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense in a similar manner until fully amortized.
•decrease in our estimated discount rate would increase the estimated 2006 pension expense by approximately $55 million and
•increase in our estimated long-term rate of return on plan assets would decrease estimated 2006 pension expense by approximately $26 million.
Cash flow requirements are also sensitive to assumptions, however, assumptions used for funding the U.K. plans are changed infrequently. Under current rules and assumptions, we anticipate U.K. funding requirements of $159 million in both 2006 and 2007. These contributions reflect minimum funding requirements plus other amounts agreed to with the trustees of the U.K. plans.
•decrease in our estimated discount rate would increase the estimated 2006 pension expense by approximately $7 million and
•increase in our estimated discount rate would decrease the estimated 2006 pension expense by approximately $5 million.
Through our insurance underwriting operations, we collect premiums from policyholders and we establish liabilities (reserves) to pay benefits to policyholders. The liabilities for policy benefits, claims and unearned premiums are a large portion of the total policy liabilities shown on our balance sheet and are comprised primarily of estimated future payments to policyholders, policy and contract claims and unearned and advance premiums and contract fees.
Liabilities for incurred but unpaid claims include estimated costs relating to incurred and reported claims and incurred but not reported claims. We base the liability for unpaid claims on the estimated
Except for products that meet the definition of FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, we accrue a liability for future policy benefits relating to long-duration contracts when we recognize premium revenue. The liability represents the present value of future benefits to be paid to policyholders less the present value of future premiums and we estimate the liability using methods that include estimates of expected investment yields, mortality, morbidity and policy persistency.
Reserves for future policy benefits were $1,671 million, $1,542 million and $1,396 million as of December 31, 2005, 2004 and 2003, 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 $7 million.
Compared to traditional underwriting businesses, our warranty business is unique, in that we typically (1) receive a multi-year single premium and (2) claims have low severity and relatively high frequency. Individual program reserves are reviewed quarterly to verify an appropriate amount is held for past and future warranty claims. Our coverage on new products has a long waiting period and does not begin until after the underlying manufacturers warranty expires. Despite an average 31/2 year duration overall, terms may extend as far as seven years with a few warranties lasting up to ten years.
These methods result in a point estimate of our liability, which was $759 million as of December 31, 2005. We believe that the ultimate development of the recorded liability could be as much as 10% more or 5% less.
Sources of uncertainty include technological innovations such as plasma TVs and liquid crystal displays. In addition, some of our policies include profit sharing, where the client participates in underwriting profits, but we pay all underwriting losses.
We base the selected ultimate loss estimates on the range of estimates discussed above. Typically, we select the average of the estimates, but that selection may be influenced by the consistency of the estimates, knowledge of emerging loss trends and rate or benefit changes.
At December 31, 2005, our recorded liability was $292 million. Given the current knowledge of the overall variability of property and casualty exposures, we expect loss reserves to fall within 10 loss ratio points (or approximately $22 million) of our selected estimate 95% of the time.
We periodically review securities with material unrealized losses and evaluate them for other-than-temporary impairment. We analyze various risk factors and determine if any specific asset impairment exists. If there is a specific asset impairment, we recognize a realized loss and adjust the cost basis of the impaired asset to its fair value.
(1)Assets with unrealized losses due to issuer-specific events, which are segmented among four categories: fixed-maturity investments; publicly-traded preferred stocks; publicly-traded common stocks; and private common and preferred stocks and other invested assets.
(2)Assets with unrealized losses due to market conditions or industry-related events.
•review the creditworthiness of corporate obligors for changes by nationally recognized credit rating agencies and changes in fundamental financial performance of the underlying entity
•evaluate all bonds and asset-backed securities whose financial performance has declined for other-than- temporary impairment.
Publicly-traded preferred stocks. At least quarterly, we review issuer creditworthiness, including changes in ratings by nationally recognized credit agencies and changes in financial performance of the underlying issuer. We monitor all preferred stock investments with declining financial performance for other-than-temporary impairment.
Publicly-traded common stocks. Quarterly, we review each common stock investment to determine if its decline in value is deemed other-than-temporary. Our review includes analyzing issuer financial trends and market expectations based on third-party forward-looking analytical reports, when available.
Private common and preferred stocks and other invested assets. Every quarter, we review private issue valuations, which include recent transaction valuations between the issuer and a third party; financial performance reviews; and financial trend comparisons with publicly-traded companies in the same or similar industries.
We evaluate other-than-temporary impairment for preferred and common stock and other investments with continuous material unrealized losses for two consecutive quarters due to market conditions or industry-related events. We recognize an other-than-temporary impairment loss based upon each investment's facts and circumstances. We continue to monitor these securities quarterly to ensure that unrealized losses are not the result of issuer-specific events.
Note 7 to the consolidated financial statements provides additional information regarding our investments, including unrealized losses segregated by type and period of continuous unrealized loss at December 31, 2005.
Intangible assets represent the excess of cost over the value of net tangible assets of acquired businesses.
•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.
•allocate intangible assets between goodwill and other intangible assets and determine estimated useful lives based on our internal valuations or valuations from qualified independent appraisers. We calculate these amounts based on estimates and assumptions using historical and pro forma data and recognized valuation methods. Different estimates or assumptions could produce different results.
•carry intangible assets at cost, less accumulated amortization in the accompanying consolidated statements of financial position.
Although goodwill is not amortized, we test it for impairment at least annually. We test more frequently if there are indicators of impairment or whenever business circumstances suggest that the carrying value of goodwill may not be recoverable. We perform impairment reviews at the reporting unit level. If the fair value of a reporting unit is determined to be less than the carrying value of the reporting unit, we complete further analysis to determine whether there was an impairment loss. No further analysis was required in 2005 or 2004. We determine fair value based on estimates and assumptions related to the amount and timing of future cash flows and future interest rates. Different estimates or assumptions could produce different results.
In our discussion of operating results, we sometimes refer to supplemental information derived from consolidated financial information, which U.S. GAAP does not require in the financial statements.
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, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses, unusual items and for the underwriting segment only, an adjustment between written and earned premium.
Since we conduct business in more than 120 countries, foreign exchange rate fluctuations have a significant impact on our business. In comparison to the U.S. dollar, foreign exchange rate movements may be significant and may distort true period-to-period comparisons of changes in revenue or pretax income. Therefore, we have:
•isolated the impact of the change in currencies between periods by providing percentage changes on a comparable currency basis for revenue and disclosed the effect on earnings per share.
Some tables in the segment discussions reconcile organic revenue growth percentages to the reported revenue growth percentages for the segments and sub-segments. 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 $60 million or 2% from the prior year, driven by growth in our core products and favorable exchange rates, partially offset by reductions in runoff programs and other items as discussed in the Review by Segment section.
Total expenses decreased $232 million or 3% from 2004. Driving factors of this decrease are:
•the 2004 expense from the NYAG and other regulatory authorities as well as the Daniel class action settlements, which accounted for $220 million of expenses in 2004.
•Cambridge expenses, which were $223 million last year. This unit was sold in the fourth quarter of 2004.
Income from continuing operations increased to $642 million ($1.89 per diluted share) from $545 million ($1.63 per diluted share) in 2004. Basic income per share from continuing operations was $1.99 and $1.70 for 2005 and 2004, respectively. Hedging and currency translation gains added $0.08 and $0.05 per share, respectively, to income from continuing operations in 2005.
To compute income per share, we have deducted dividends paid on the redeemable preferred stock from net income. In accordance with Emerging Issues Task Force (EITF) No. 04-8, The Effect of Contingently Convertible Investments on Diluted Earnings per Share, diluted shares outstanding were increased by 14 million to reflect the possible conversion of Aon's 3.5% convertible debt securities. When calculating the diluted income per share, we added after-tax interest expense on these debt securities to income from continuing operations.
After-tax income from discontinued operations in 2005 was $95 million ($0.29 and $0.28 per basic and diluted income per share, respectively). In comparison, after-tax income in 2004 from discontinued operations was $1 million (with no impact on basic and diluted income per share). The increase was primarily attributable to the sale of Swett & Crawford, partially offset by losses from certain insurance underwriting subsidiaries acquired with Alexander and Alexander Services, Inc. (A&A).
Continent of Europe revenue increased $250 million or 17% and Rest of World revenue increased $177 million or 14%, principally reflecting a weakening of the U.S. dollar.
General expenses increased $400 million or 6% over 2003, reflecting the impact of:
Net gains on currency derivative transactions reduced expenses by $45 million in 2004.
Interest expense increased $35 million or 35% primarily due to the adoption of FIN 46 on December 31, 2003, which required the deconsolidation of our trust preferred capital securities and which was offset by an increase in notes payable. Interest expense on the notes payable was $58 million for 2004. Without this item, interest expense declined $23 million due principally to lower debt levels during most of the year (see Notes 1 and 11 to the consolidated financial statements for more information).
Our results include a $180 million provision for settlements resulting from investigations by the NYAG and other regulatory authorities and $40 million for the Daniel class action lawsuit.
In 2003, total expenses included a $14 million credit related to the World Trade Center property insurance settlement. The 2003 credit represents a $60 million final settlement of our World Trade Center property insurance claim, net of $46 million paid to a third party relating to temporary office space in Manhattan after the World Trade Center was destroyed.
Brokerage commission and fees decreased by $66 million or 4% from 2004, driven primarily by $37 million in lower revenue from the disposition of Cambridge in 2004 and $9 million less in contingent commission revenue. This decline was partially offset by the impact of the strengthening U.S. dollar of $36 million.
•$46 million of Cambridge-related expenses in 2004 with no corresponding expenses recorded in 2005 as we sold the business in fourth quarter 2004.
These favorable impacts were partially offset by $123 million in restructuring related expenses.
To compute income per share, we have deducted dividends paid on the redeemable preferred stock from net income. In September 2005, we redeemed all of the preferred stock from the holders and cancelled the shares (see Note 11 to the consolidated financial statements for further information). In accordance with EITF No. 04-8, we increased diluted shares outstanding by 14 million to reflect the
Segment revenue includes investment income generated by invested assets of that segment, as well as the impact of related derivatives. Investment characteristics mirror liability characteristics of the respective segments:
•Our insurance subsidiaries have invested assets that exceed net policy liabilities, which allow us to maintain solid claims paying ratings. Income from these investments is reflected in Corporate and Other segment revenues.
The following tables and commentary provide selected financial information on the operating segments.
(1)Intersegment revenues of $62 million, $72 million and $68 million were included in 2005, 2004 and 2003, respectively. See Note 16 to the consolidated financial statements for further information. Risk and Insurance Brokerage Services
Aon is a leader in many sectors of the insurance industry: globally, it is the second largest insurance broker, the largest reinsurance broker and the leading manager of captive insurance companies worldwide. Until the fourth quarter of 2005, we were the largest wholesale broker; however, we sold our U.S. wholesale brokerage business (Swett & Crawford) in the fourth quarter. 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. More specifically, lower premium rates, or a "soft market," generally result in decreased commission revenues.
•Risk Management and Insurance Brokerage-Americas (Brokerage-Americas) encompasses our retail brokerage services, affinity products, managing general underwriting, placement and captive management services and premium finance services in North and South America, the Caribbean and Bermuda.
•Risk Management and Insurance Brokerage-International (Brokerage-International)offers similar products and services to the parts of the world not included in Brokerage-Americas.
This table details Risk and Insurance Brokerage Services revenue by sub-segment.
The insurance market remained soft in 2005. Total 2005 Risk and Insurance Brokerage Services revenue was $5.4 billion, a decline of 2% from last year reflecting the impact of $85 million of lost contingent commissions and $212 million due to the sale of our claims services businesses, partially offset by favorable foreign exchange and strong growth in our U.S. retail business.
The 5% reported growth in Brokerage-Americas is driven by strong renewals, new business and the positive foreign currency impact of $26 million, partially offset by eliminating $58 million in contingent commissions.
International Brokerage revenue results include a positive impact of foreign exchange, acquisitions and the impact of refining our techniques for estimating revenue on installment policies in the U.K., resulting in a $23 million increase to revenue. The organic revenue growth of (2)% is driven largely by pricing, less new business and changes in the model for compensation from underwriters in U.K. Specialty.
•U.S. revenue decreased 7% over 2004 due to the sale of our claims services business and lower contingent commissions, which more than offset growth in our U.S. retail business.
•$153 million provision allocation in 2004 for regulatory settlements, which resulted from the investigation by the NYAG and other regulatory authorities
•positive impact on pretax income and margins resulting from the elimination of Cambridge's operating results in 2005.
Contingent commissions decreased $15 million from 2004 in connection with terminating our contingent fee arrangements.
Overall Consulting revenue was up $8 million from 2004, as growth from small acquisitions more than offset $15 million of lost contingent commissions.
On a subsegment basis, Consulting services was up $32 million or 3% due to growth in core services partially offset by the loss of contingent commission revenue. Outsourcing revenue was down 8% due to loss of certain clients and lower employment levels at certain clients.
•U.S. revenue decreased in 2005, primarily reflecting lower results in the employee benefits and outsourcing practices, along with lower contingent commissions
•$27 million provision allocation in 2004 for regulatory settlements, which resulted from the investigation by the NYAG and other regulatory authorities
•$6 million provision allocation in 2004 for costs to settle the Daniel class action lawsuit
our subsidiaries. Our revenues are affected by our success in attracting and retaining these career agents;
•offers extended warranty and credit insurance products that are sold through retailers, automotive dealers, insurance agents and brokers and real estate brokers. Our revenues are affected by new and continuing relationships with these retailers, dealers, agents and brokers;
•offers select commercial property and casualty business on a limited basis through managing general underwriters, primarily Aon-owned companies;
•has operations in the U.S., Canada, Europe, Asia/Pacific and South America;
•decided to run off certain non-core special risk accident and health business in the U.S. and the U.K., as well as our accident and health insurance underwriting operations in Latin America.
The table below reflects written and earned premiums and associated reserves:
In 2005, revenues of $3.2 billion increased 1% over 2004. Excluding the effect of foreign exchange rates, revenues were flat to last year.
The favorable impacts were partially offset by planned reductions in certain programs and our runoff businesses.
Warranty, credit and property & casualty revenue decreased $46 million, primarily due to planned run-off of programs and declines in our European credit business, partially offset by increased investment income, positive foreign exchange and growth in our core business. During the fourth quarter, we determined certain transactions between our warranty businesses were not being properly eliminated. This matter resulted in an $11 million reduction to pretax income.
Pretax income of $314 million increased 24% from 2004. Pretax margins rose from 8.1% in 2004 to 9.8% in 2005.
Private equities are principally carried at cost; however, where we have significant influence, they are carried under the equity method. These investments usually do not pay dividends.
Although our portfolios are highly diversified, they still remain exposed to market, equity and credit risk.
•periodically review securities with material unrealized losses and evaluate them for other-than- temporary impairments
Corporate and Other revenue decreased $53 million to $56 million in 2005, due primarily to:
•the sale of the remainder of our common stock investment in Endurance, resulting in a $1 million gain in 2005 versus a $48 million gain in 2004, when we sold virtually all of our holdings
Corporate and Other total expenses were $17 million or 8% higher than in 2004 as a result of increased consulting, recruiting and other employee benefit costs, certain transferred costs from the segments to Corporate, as well as $4 million of restructuring and related expenses.
Interest expense declined $11 million, primarily due to the repayment of our $250 million 6.9% notes that matured in July 2004.
Our major U.S. insurance subsidiaries' statutory capital and surplus at year-end 2005 significantly exceeded the risk-based capital target set by the NAIC.
In 2005, total cash contributions to our major defined benefit pension plans were $463 million, an increase of $274 million from 2004. In 2004, we made an early contribution of $18 million to our Netherlands defined benefit pension plan. Under current rules and assumptions, we currently anticipate approximately $186 million in 2006 contributions to our major defined benefit pension plans.
Cash flows provided by operating activities for the years ended December 31, 2005 and 2004 are as follows:
Change in funds held on behalf of brokerage and consulting clients
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 2005, Combined Insurance Company of America, one of our major underwriting subsidiaries, declared and paid a cash dividend of $100 million to Aon.
Our insurance subsidiaries' policy liabilities are segmented among multiple accident and health and property casualty portfolios. Those portfolios have widely varying estimated durations and interest rate characteristics. Generally, our policy liabilities are not subject to interest rate volatility risk. Therefore, in many of the portfolios, asset and policy liability duration are not closely matched. Interest rate sensitive policy liabilities are generally supported by floating rate assets.
The operating cash flow from our Risk and Insurance Brokerage Services and Consulting segments, as well as related corporate items, was $463 million in 2005 compared to $693 million in 2004. 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 2005 to 2004, the net decrease in cash from our Risk and Insurance Brokerage Services and Consulting segments and related corporate items of $230 million was primarily affected by an increase in defined benefit pension contributions, a payment pursuant to the settlement agreement with the NYAG and other regulatory authorities and the timing of income tax payments.
•financing needs of $204 million. Financing uses primarily included cash dividends paid to shareholders of $193 million and long-term debt repayments, net of issuances, of $17 million, which were partially offset by net issuance of short-term borrowings of $5 million.
In 2005, total investments increased $0.6 billion to $9.1 billion from December 31, 2004. Fixed maturities increased $736 million, primarily relating to an asset management program. Short-term investments fell $157 million, primarily as a result of a decrease in funds held on behalf of clients.
Other assets decreased $527 million from December 31, 2004. Other assets are comprised principally of prepaid premiums related to reinsurance, prepaid pension assets and assets from
companies considered held for sale. The decrease from year-end 2004 is due to the sale of Swett & Crawford in 2005. In 2004, the assets of Swett & Crawford, $511 million, were considered held-for-sale.
Policy liabilities increased $115 million, but were partially offset by a corresponding increase in reinsurance receivables (reflected in other receivables).
See Note 7 to our consolidated financial statements for more information on our investments.
In 2002, we completed an offering of $300 million aggregate principal amount of 3.5% convertible senior debentures due 2012. The debentures are unsecured obligations and are convertible into our common stock at an initial conversion price of approximately $21.475 per common share under certain circumstances, including the following:
At December 31, 2005, 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, 2005, we had available to us:
•a 364-day £37.5 million ($65 million) facility and a 10 million Canadian dollar ($9 million) facility, both of which expire in September 2006.
The major rating agencies' ratings of our debt at February 28, 2006 appear in the table below.
•Moody's affirmed its ratings for Aon and changed its outlook from negative to stable.
Stockholders' equity increased $200 million during 2005 to $5.3 billion, primarily reflecting:
Accumulated other comprehensive loss increased $474 million since December 31, 2004. Compared to year-end 2004:
In past years, some of our defined benefit pension plans, particularly in the U.K., incurred losses due to reduced actuarial return assumptions. U.S. generally accepted accounting principles require a company to maintain, at a minimum, a liability on its balance sheet equal to the difference between the present value of benefits incurred to date for pension obligations and the fair value of the assets supporting these obligations. At year-end 2005, the change in pension obligation caused a $173 million (after-tax) decrease to stockholders' equity. We maintain the related pension plan assets in separate trust accounts; they are not part of our consolidated financial statements. This non-cash adjustment to other comprehensive income did not affect 2005 net income.
•$246 million in pension expense for our major defined benefit plans. This expense is significantly affected by a lower discount rate.
Our total debt as a percentage of total capital was 28.5% at December 31, 2005. This is compared to our total debt and preferred securities as a percentage of total capital of 29.8% at year-end 2004. In September 2005, we redeemed all of the outstanding shares of our redeemable preferred stock for $50 million plus accrued but unpaid dividends.
Aon and its subsidiaries have issued letters of credit to cover contingent payments of approximately $11 million for taxes and other business obligations to third parties. We accrue amounts in our consolidated financial statements for these letters of credit to the extent they are probable and estimable.
Following the guidance of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities and other relevant accounting guidance, we use special purpose entities and qualifying special purpose entities ("QSPE's"), also known as special purpose vehicles, in some of our operations.
We have determined that non-consolidation remains appropriate given that our subsidiaries do not have a significant variable interest in the SPEs.
At both December 31, 2005 and 2004, $1.8 billion was advanced under these programs from the SPEs. We record at fair value the retained interest, which is included in insurance brokerage and consulting services receivables in the consolidated statements of financial position.
We recorded gains associated with the sale of receivables. When we calculate the gain, we include all fees we incurred related to this facility. The gains, which are included in brokerage commissions and fees revenue in the consolidated statements of income, were $65 million, $81 million and $69 million for the years ended December 31, 2005, 2004 and 2003, respectively.
We estimate fair value by discounting estimated future cash flows from the servicing rights and servicing costs using:
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.
Other long-term liabilities reflected on the consolidated balance sheet under GAAP
(2)Also included in purchase obligations is a $226 million contract for information technology services in the U.K. As of December 31, 2005, we can exit this obligation for approximately $35 million. However, given the nature of the contract, we have included it in our contractual obligations table.
Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2005. 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.
Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report on page 70.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A Company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A Company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Aon Corporation as of December 31, 2005 and 2004 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2005 and our report dated March 7, 2006 expressed an unqualified opinion thereon.
We have audited the accompanying consolidated statements of financial position of Aon Corporation as of December 31, 2005 and 2004 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2005. 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 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, 2005 and 2004 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, 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.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. The consolidated financial statements include the accounts of Aon Corporation and its majority-owned subsidiaries ("Aon" or the "Company"), excluding special-purpose entities ("SPEs") considered variable interest entities ("VIEs") for which Aon is not the primary beneficiary. All material intercompany accounts and transactions have been eliminated.
Revenue is recognized when all elements of revenue recognition exist as defined in Staff Accounting Bulleting No. 104. Those elements are (1) persuasive evidence of an agreement with the client; (2) a fixed and determinable price for services; (3) those services have been rendered; and (4) collectibility is reasonably assured.
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. 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. 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, revenue is recognized when the cash is received or amounts due to Aon become determinable. Commissions on premium adjustments are recognized as they occur.
Policy cancellation reserves and revenue accruals are estimates. Policy cancellations are estimated through an historical evaluation of relevant data. Revenue accruals are estimated through an analysis of the specific transactions.
Fees for claims services, benefit consulting, human capital outsourcing, reinsurance services and other services are recognized when the services are rendered. Aon has multiple year outsourcing arrangements with clients. Revenues received from these arrangements are recorded on a gross basis, inclusive of amounts ultimately passed through to subcontractors, when Aon maintains the performance obligation and are recorded ratably over the life of the contract.
The portion of revenues received on extended warranty contracts that are for the marketing, administration and servicing of those contracts are reported as earned consistent with the method used to earn the premium portion of those revenues and revenues that represent administrative fee-for-service arrangements, for which Aon does not bear the underwriting risk, are earned as those services are performed. These fee-for-service arrangements include the marketing and servicing of
extended warranty contracts on behalf of other companies and brokerage commissions for accident and health products placed with non-Aon insurance carriers. These revenues are reported in the Insurance Underwriting segment.
Deferred income taxes are provided for the effect of temporary differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted marginal tax rates and laws that are currently in effect. Valuation allowances are recorded to reduce the net deferred tax assets to an amount that is more likely than not realizable.
price of the common shares. The number of options excluded from the calculation was 18 million in 2005, 20 million in 2004 and 24 million in 2003.
Aon follows Accounting Principles Board Opinion (APB) 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 is recognized for stock options when the exercise price of the options equals the market price of the stock at the date of grant. Compensation expense is recognized on a straight-line basis for stock awards based on the vesting period and market price at the date of the award.
The following table illustrates pro forma net income and pro forma earnings per share as if Aon had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
Stock-based compensation expense included in reported net income, net of tax
The model assumes: the warrants are "European-style," which means that they are valued as if the exercise can only occur on the expiration date; the spot and exercise prices are reduced by expected future dividends; and the dividend remains unchanged during the period the warrants are outstanding. Although Endurance currently pays a dividend, a zero dividend yield is used in the Endurance warrants valuation because the future dividend payment value has been reflected in the spot and exercise prices.
Limited partnership investments are carried using the equity method of accounting. Certain of the limited partnerships in which Aon invests have holdings in publicly-traded equity securities. Changes in market value of these indirectly-held equity securities flow through the limited partnerships' financial statements. Aon's proportionate share of these valuation changes is included in investment income in Aon's Corporate and Other segment.
PEPS I - In 2001, Aon securitized $450 million of limited partnership investments, plus associated limited partnership commitments, via a sale to Private Equity Partnership Structures I, LLC (PEPS I). Aon received $171 million in cash, plus $279 million of newly-issued fixed maturity and preferred stock securities of PEPS I. The underlying equity in the limited partnerships was the basis for determining the fair value of the cash and securities received in the securitization. No significant management assumptions were used in determining the fair value of the cash and securities received in the securitization or the value at December 31, 2005 or 2004.
Aon's policy for equity securities is to recognize impairment losses on specific securities that have had continuous material unrealized losses for more than three consecutive quarters, or less due to market conditions or industry-related events.
Aon's policy for estimating allowances for doubtful accounts with respect to receivables is to record an allowance based on a historical evaluation of write-offs, aging of balances and other qualitative and quantitative analyses.
Statement No. 123(R) originally required adoption no later than July 1, 2005. In April 2005, the Securities and Exchange Commission ("SEC") issued a release that amended the compliance dates for Statement No. 123(R). Under the SEC's new rule, the Company will be required to apply Statement No. 123(R) as of January 1, 2006. Aon plans to adopt Statement No. 123(R) using the modified-prospective method, in which compensation cost is recognized beginning January 1, 2006 (a) based on the requirements of Statement No. 123(R) for all share-based payments granted after January 1, 2006 and (b) based on the requirements of Statement No. 123 for all awards granted to employees prior to January 1, 2006 that remain unvested as of January 1, 2006.
Goodwill represents the excess of cost over the fair market value of the net assets acquired. Goodwill is allocated to various reporting units, which are either its operating segments or one reporting level below the operating segment. Goodwill is not amortized but is subject to impairment testing at least annually. The impairment testing requires Aon to compare the fair value of its reporting units to their carrying value to determine if there is potential impairment of goodwill. If the fair value of a reporting unit is less than its carrying value at the valuation date, an impairment loss would be recorded to the extent that the implied fair value of the goodwill within the reporting unit is less than the recorded amount of goodwill. Fair value is estimated based on various valuation approaches. In the fourth quarter 2005 and 2004, Aon completed its annual impairment review that affirmed there was no impairment as of October 1 (the annual evaluation date).
The cost of other intangible assets is being amortized over a range of 2 to 10 years, with a weighted average original life of 7.6 years. Amortization expense for intangible assets for the years ending December 31, 2006, 2007, 2008, 2009 and 2010 is estimated to be $40 million, $21 million, $17 million, $15 million and $12 million, respectively.
In 2003, the pretax net additional minimum pension liability adjustment of $225 million included $(4) million related to defined benefit pension plans in Canada.
In 2005, 2004 and 2003, 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 results of operations of these acquisitions are included in the consolidated financial statements from the dates they were acquired. Pro forma results of these acquisitions are not materially different from reported results.
In 2005, the Company announced that it was reviewing the revenue potential and cost structure of each of its businesses. As a result of this review, the Company has adopted restructuring initiatives that are expected to be completed in 2007 and result in cumulative pretax charges totaling approximately $262 million, including workforce reductions and lease consolidation costs, asset impairments and other expenses necessary to implement the restructuring initiative. Costs related to the restructuring are included in general expenses and depreciation and amortization in the accompanying consolidated statements of income.
The following is a summary of 2005 restructuring and related expenses by type incurred and estimated to be incurred through the end of the restructuring initiative:
The following is a summary of our restructuring and related costs by segment incurred and estimated to be incurred through the end of the restructuring initiative:
In 1996 and 1997, Aon recorded restructuring liabilities as a result of the acquisition of Alexander & Alexander Services, Inc. ("A&A") and Bain Hogg. The remaining liability of $26 million is primarily for lease abandonments and is being paid out over a number of years, as planned.
In fourth quarter 2005, Aon completed the sale of Swett & Crawford ("Swett"), its U.S.-based wholesale insurance brokerage unit. Previously, Swett was included in the Risk and Insurance Brokerage Services segment. The sale resulted in a pretax gain of $239 million.
•A small non-core U.S. brokerage unit, resulting in a pretax loss of $4 million on the revaluation of this business, which was previously included in the Risk and Insurance Brokerage Services segment.
•Its U.K. reinsurance brokerage runoff unit, which was previously included in the Risk and Insurance Brokerage Services segment, resulting in a pretax gain of $1 million.
As of December 31, 2005 and 2004, the liabilities associated with the foregoing indemnities were included in other liabilities in the consolidated statements of financial position. Such liabilities amounted to $5 million and $16 million, respectively, net of reinsurance recoverables and other assets of $83 million and $82 million, respectively. 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. The 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.
(1)In addition to losses on disposals, includes other-than-temporary impairment write-downs of $11 million, $3 million and $36 million in 2005, 2004 and 2003, respectively. The components of net unrealized investment gains are as follows:
The pretax changes in net unrealized investment gains are as follows:
The following table analyzes our investment positions with unrealized losses segmented by type and period of continuous unrealized loss as of December 31, 2005.
Aon's fixed-maturity portfolio in total had a $56 million gross unrealized loss at December 31, 2005 and is subject to interest rate, market and credit risks. No single position had an unrealized loss greater than $2 million. With a carrying value of approximately $4.2 billion at December 31, 2005, Aon's total fixed-maturity portfolio is approximately 98% investment grade based on market value. Fixed-maturity securities with an unrealized loss are all investment grade and have a weighted average rating of "Aa" based on amortized cost. Aon's non publicly-traded fixed maturity portfolio had a carrying value of $366 million, including $81 million in notes issued by PEPS I to Aon since December 2001. In February 2006, Aon, via its U.K. subsidiary, contributed $33 million of these notes to one of the U.K. pension plans. Valuations of these securities primarily reflect the fundamental analysis of the issuer and current market price of comparable securities.
Aon's equity portfolio is comprised of non-redeemable preferred stocks, publicly traded common stocks and other common and preferred stocks not publicly traded. This portfolio had $1 million of gross unrealized losses at December 31, 2005 and is subject to interest rate, market, credit, illiquidity, concentration and operational performance risks.
PEPS I invests cash collected from the limited partnerships pending distribution to holders of beneficial interests. PEPS I invests only in relatively risk free investments with maturities no later than an expected distribution date.
(1)Rate increased to 6.7% in January 2003 and 6.95% in January 2005. 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. Aon determined that it is not the primary beneficiary of Aon Capital A, a VIE and was required to deconsolidate Aon Capital A upon the adoption of FIN 46 on December 31, 2003. As a result of the deconsolidation, Aon increased its notes payable for the subordinated debt by $726 million. See Note 11, "Redeemable Preferred Stock, Capital Securities and Stockholders' Equity" for further information on Aon Capital A.
In 2001, certain of Aon's European subsidiaries entered into a committed bank credit facility. At December 31, 2004, Aon had borrowed €250 million ($334 million) under the facility, which was classified as notes payable in the consolidated statements of financial position. In February 2005, Aon replaced this facility with a new €650 million multi-currency revolving loan credit facility. The new
facility included a €325 million three-year and a €325 million five-year revolving loan facility. In October 2005, Aon amended this facility. The amendment extends the term of each revolving loan facility to five years from the date of the amendment, with an option to extend each facility for two additional one-year periods. Thus, this facility will mature in October 2010, unless Aon opts to extend the facility. In addition, the amendment eliminates the requirement that a representation regarding material adverse change be made at the time of each borrowing request and on the first day of each interest period, deletes certain covenants related to acquisitions and investments and revises certain covenants related to mergers and dispositions. Commitment fees of 8.75 basis points are payable on the unused portion of the facility. At December 31, 2005, Aon has borrowed €490 million ($581 million) under this facility, which is classified as notes payable in the consolidated statements of financial position. Aon has guaranteed the obligations of its subsidiaries with respect to this facility.
For both the U.S. and Euro facilities, Aon is required to maintain consolidated net worth, as defined, of at least $2.5 billion, a ratio of consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) to consolidated interest expense of 4 to 1 and a ratio of consolidated debt to EBITDA of not greater than 3 to 1.
Information related to notes payable and short-term borrowings is as follows:
Income from continuing operations before income tax and minority interest 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.
Aon recognized, as an adjustment to additional paid-in-capital, income tax benefits attributable to employee stock compensation as follows: 2005, $11 million; 2004, $0 million; and 2003, $2 million.
U.S. deferred income taxes are not provided on unremitted foreign earnings that are considered permanently reinvested, which at December 31, 2005 amounted to approximately $1.8 billion. It is not practicable to determine the income tax liability that might be incurred if all such earnings were remitted to the U.S. The American Jobs Creation Act of 2004 introduced a temporary incentive for U.S. multinationals to repatriate, in 2004 or 2005, certain foreign earnings at an effective tax rate of
5.25%. In 2005, Aon repatriated $101 million pursuant to this legislation and incurred a current tax expense of $5 million.
At December 31, 2005, Aon had domestic federal operating loss carryforwards of $27 million that will expire at various dates from 2006 to 2021, state operating loss carryforwards of $349 million that will expire at various dates from 2006 to 2024 and foreign operating loss carryforwards of $89 million, which expire at various dates.
Prior to 1984, life insurance companies were required to accumulate certain untaxed amounts in a memorandum policyholders' surplus account ("PSA"). Under the Tax Reform Act of 1984, the PSA balances were "capped" at December 31, 1983 and the balances were to be taxed only to the extent distributed to stockholders or when they exceed certain prescribed limits. The American Jobs Creation Act of 2004 suspended for 2005 and 2006 the application of the rules imposing income tax on distributions from the PSA. As of December 31, 2005, the combined PSA of Aon's life insurance subsidiaries is approximately $262 million. Aon's life insurance subsidiaries do not intend to make any taxable distributions or exceed the prescribed limits in the foreseeable future; therefore, no income tax provision has been made. However, if such taxes were assessed, the amount of taxes payable would be approximately $92 million.
(1)For 2003, prior years' incurred losses primarily represent losses from business produced by NPS. NPS stopped initiating any new business in mid-2002.
Aon Capital A issued $800 million of 8.205% capital securities in January 1997. The proceeds from the issuance of the Capital Securities were used to finance a portion of the A&A acquisition. Aon received $800 million in cash and a $24 million investment in 100% of the common equity of Aon Capital A by issuing $824 million of subordinated debt. During 2002, approximately $98 million (face value) of the Capital Securities were repurchased on the open market and were used to retire $98 million of the debt to Aon Capital A. The Capital Securities are subject to mandatory redemption on January 1, 2027 (upon the maturity of the subordinated debt) or are redeemable in whole, but not in part, at the option of Aon (through its prepayment of the subordinated debt) upon the occurrence of certain events. Interest is payable semi-annually on the Capital Securities.
In 2005, Aon issued 4.1 million new shares of common stock for employee benefit plans, 0.7 million shares in connection with employee stock purchase plans and 0.2 million shares in connection with acquisitions.
Dividends paid per common share were $0.60 for the years ended December 31, 2005, 2004 and 2003.
Aon subsidiaries maintain savings plans with both contributory and non-contributory accounts for the benefit of U.S. salaried and commissioned employees. The non-contributory accounts were established in lieu of a defined pension benefit in 2004 for certain U.S. employees. Provisions made for these plans were $47 million, $43 million and $54 million in 2005, 2004 and 2003, respectively.
December 31, 2005 and 2004, for both qualified and nonqualified plans. The measurement date for the U.S. plans is November 30.
$ (432 ) $ (577 ) $ (67 ) $ (71 )
$ (288 ) $ (452 ) $ (81 ) $ (79 )
The increase in amounts recognized in other comprehensive income related to the minimum pension liability for U.S. pension plans was $27 million and $108 million in 2005 and 2004, respectively.
In 2004, plans with a PBO and ABO in excess of the fair value of plan assets had a PBO of $1.5 billion, an ABO of $1.4 billion and plan assets with a fair value of $1.0 billion.
6.0 % 6.25 % 7.0 % 6.0 % 6.25 % 7.0 %
Aon's U.S. pension plan asset allocation as of December 31, 2005 and 2004 is as follows:
In 2004, plans with a PBO in excess of the fair value of plan assets had a PBO of $3.8 billion and plan assets with a fair value of $2.7 billion and plans with an ABO in excess of the fair value of plan assets had an ABO of $3.0 billion and plan assets with a fair value of $2.4 billion.
The investment policies for international plans are established by the local pension plan trustees and seek to maintain the plans' ability to meet liabilities and to comply with local minimum funding requirements. Plan assets are invested, within asset allocation ranges as shown above, in diversified portfolios that provide adequate levels of return at an acceptable level of risk. The investment policies are reviewed at least annually and revised, as deemed appropriate to ensure that the objectives are being met.
Based on current assumptions, Aon expects to contribute $180 million to its international pension plans during 2006 to satisfy minimum funding requirements.
Aon's Stock Incentive Plan provides for the grant of non-qualified and incentive stock options, stock appreciation rights, restricted stock and restricted stock units. The annual rate at which awards are granted each year is based upon financial and competitive business conditions. The number of shares authorized to be issued under the plan is equal to 18% of the number of common shares outstanding.
Aon has an employee stock purchase plan that provides for the purchase of a maximum of 7.5 million shares of Aon's common stock by eligible U.S. employees. Under the plan, shares of Aon's common stock may be purchased at 3-month intervals at 85% of the lower of the fair market value of the common stock on the first or the last day of each 3-month period. In 2005, 2004 and 2003, 697,000 shares, 754,000 shares and 734,000 shares, respectively, were issued to employees under the plan. There was no compensation expense associated with this plan.
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. 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
Changes in the fair value of a derivative that is not designated as an accounting hedge (known as an "economic hedge") are recorded in either investment income or general expenses (depending on the hedged exposure) in the current period's consolidated statements of income.
Aon also uses foreign currency forward contracts to offset foreign exchange risk associated with foreign denominated (primarily British pounds) inter-company notes. These derivatives were not designated as a hedge because changes in their fair value were largely offset in earnings by remeasuring
Aon also uses foreign currency forward contracts to hedge certain of its net investments in foreign underwriting operations (primarily Canadian dollar, Euro and British pound). During 2005, this hedge had no ineffectiveness, and a $15 million pretax loss has been included in OCI.
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 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.
Certain of Aon's subsidiaries make short-term loans (generally with terms of 12 months or less) to businesses to finance insurance premiums and then sell ("securitize") the finance receivables through securitization transactions that meet the criteria for sale accounting in accordance with FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. These premium financing securitizations are accomplished by using special purpose entities which are considered qualifying SPEs ("QSPEs") pursuant to Statement No. 140 and FIN 46 and commercial paper multi-seller, non-qualified bank conduits (SPEs). Statement No. 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates (Aon's subsidiaries).
Aon intends to renew these conduit facilities when they expire. If there are adverse bank, regulatory, tax or accounting rule changes, the Company's access to the conduit facilities and SPEs would be restricted.
Accounting standards require the disclosure of fair values for certain financial instruments. The fair value disclosures are not intended to encompass the majority of policy liabilities, various other non-financial instruments or other intangible assets related to Aon's business. Accordingly, care should be exercised in deriving conclusions about Aon's business or financial condition based on the fair value disclosures. The basis for determining the fair value of financial instruments is discussed in Note 1. The carrying value and fair value of certain of Aon's financial instruments are as follows:
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 $17 million at December 31, 2005.
As required by the Settlement Agreement, within 60 days of the effective date of that agreement, the Company commenced the implementation of certain business reforms, including agreeing not to accept contingent compensation as defined in the Settlement Agreement.
In May 2005, the Office of the U.S. Attorney for the Southern District of New York and the Securities and Exchange Commission sent to Aon subpoenas seeking information relevant to these agencies' industry-wide investigations of finite risk insurance. Aon is fully cooperating with these investigations.
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting. A fourth segment, Corporate and Other, when combined with the operating segments and after the elimination of intersegment revenues, totals to the amounts in the accompanying consolidated financial statements. Certain segment information in prior periods' consolidated financial statements has been reclassified to reflect sold business reported as discontinued operations.
The Risk and Insurance Brokerage Services segment consists principally of Aon's retail and reinsurance brokerage operations, as well as related insurance services, including underwriting management, captive insurance company management services, claims services and premium financing. During 2004, Aon sold essentially all of its claim services businesses.
(2)Insurance underwriting general expenses include amortization of deferred acquisition costs of $433 million, $437 million and $399 million in 2005, 2004 and 2003, respectively.
Selected information for Aon's Corporate and Other segment is as follows:
A bank provides overdraft facilities for certain of Aon's foreign subsidiaries. Aon has guaranteed repayment of these facilities in the unlikely event that the foreign subsidiaries are unable to repay. Aon has also issued guarantees and/or other letters of support for various bank lines and various other credit facilities for certain of its foreign operations (including the Euro credit facility discussed in Note 8 to the consolidated financial statements). Aon's maximum potential liability with regard to these exposures was $581 million at December 31, 2005.
(4)Deduction principally represents write-off of uncollectible reinsurance receivable related to the World Trade Center, which was previously fully reserved.