Gallagher's executive offices and certain subsidiary and branch facilities are located at Two Pierce Place, Itasca, Illinois, where Gallagher leases approximately 225,000 square feet of space. The lease commitment on the above mentioned property expires February 28, 2006. Gallagher generally operates in leased premises. Certain office space leases have options permitting renewals for additional periods. In addition to minimum fixed rentals, a number of leases contain annual escalation clauses generally related to increases in an inflation index. See Note 10 to the Consolidated Financial Statements for information with respect to Gallagher's lease commitments at December 31, 1999.
Notes: (a) The financial information for all periods prior to 1999 has been restated for six 1999 acquisitions accounted for using the pooling of interests method. (b) All information relating to shares of common stock of Gallagher has been adjusted to reflect a two-for-one stock split, effected in the form of a 100% stock dividend, that was declared in January 2000 and paid on March 15, 2000. (c) Includes non-recurring gains. (d) Based on the weighted average number of common and common equivalent shares outstanding during the year. (e) Based on the number of employees at year end. (f) Based on the total dividends declared on a share of common stock outstanding during the entire year.
Fluctuations in premiums charged by insurance companies have a material effect on the insurance brokerage industry. Commission revenues are primarily based on a percentage of the premiums paid by insureds and generally follow premium levels. For more than a decade, lower premium rates have prevailed among property/casualty insurance carriers resulting in heavy competition for market share. This "soft market" (i.e., lower premium rates) has generally resulted in flat or reduced renewal commissions.
In recent years insured losses have reached into the billions of dollars. Substantial mergers, both domestically and internationally, have resulted in fewer insurance companies. Increased underwriting losses and reduced competition tend to raise premium rates. Historically, increased property replacement costs and increasingly large litigation awards have caused some clients to seek higher levels of insurance coverage. These factors generally have the effect of generating higher premiums to clients and higher commissions to Gallagher. In spite of these forces, there have been mitigating factors including a favorable equity market, increased underwriting capital and improved economies of scale following consolidations, all of which tend to lower premium rates. The net result is that property/casualty premium rates have remained low. Although the insurance marketplace has seen "pockets" of premium rate increases, management believes that competitive conditions will continue and overall premium pricing will remain under pressure and not improve significantly in 2000. In recent years, lower rates of inflation and the soft market have resulted in a highly competitive insurance marketplace and flat to lower premiums. In general, the downward trend in premium rates has had a greater effect on Gallagher's revenues than inflation.
Although the property/casualty insurance pricing environment has resulted in some "risk" buyers returning to first-dollar coverage, management believes the overall trend will be to continue to move toward the alternative insurance market, which would tend to have a favorable effect on our Risk Management Services segment. Gallagher anticipates that new sales in the areas of risk management, claims management, insurance captive and self-insurance services will continue to be a major factor in Gallagher's fee revenue growth during 2000.
Gallagher continues to look to the future and to explore not only the core segments of Insurance Brokerage and Risk Management Services, but also expansion within the alternative insurance markets and financial and related investment services. Management believes these areas continue to hold opportunities for diversification and profitable growth.
Gallagher's results of operations for periods prior to 1999 have been restated for six acquisitions as if they had operated as part of Gallagher prior to the date of merger. Gallagher continues to search for merger partners who complement existing operations, provide entry into new markets, add new products and enhance local sales and service capabilities. For the effect of these restatements, in the aggregate, on year-to-year comparisons, see Note 2 to the Consolidated Financial Statements.
In 1997, Gallagher recognized non-recurring pretax gains of $7.2 million on the sale of underperforming or geographically undesirable operations and $1.8 million on a real estate transaction in the United Kingdom. There were no material non-recurring pretax gains of this nature recorded in either 1999 or 1998.
Salaries and employee benefits increased by $21.6 million or 7% in 1999 due primarily to a 5% increase in employee head count, salary increases and the annualized effect of prior year new hires along with a corresponding increase in employee benefit expenses. In 1998, salaries and employee benefits increased by $23.6 million or 9% due to salary increases, the annualized effect of prior year new hires, a 6% increase in employee head count and the impact of a $4.8 million non-recurring gain recognized in 1997 from the settlement of a defined benefit pension plan at one of Gallagher's United Kingdom subsidiaries.
Other operating expenses increased by $6.7 million or 4% in 1999 and $10.9 million or 6% in 1998. These increases are due primarily to increases associated with travel, entertainment and temporary personnel costs for new business, technology upgrades, office consolidation expenses and commissions paid to sub-brokers.
Gallagher's effective income tax rates were 35.0%, 32.6% and 32.8% in 1999, 1998 and 1997, respectively. These rates are net of the effect of tax benefits generated by investments in limited partnerships that operate qualified affordable housing and alternative energy projects, which are substantially offset by state and foreign taxes. See Note 11 to the Consolidated Financial Statements.
Gallagher's foreign operations recorded earnings before income taxes of $5.0 million, $5.3 million and $6.5 million in 1999, 1998 and 1997, respectively. The decrease in 1999 is due primarily to the write-off of intangible assets associated with lost business. The decrease in 1998 is due to the non-recurring gains recognized in 1997 associated with the pension and real estate transactions mentioned above, substantially offset by growth in operating results generated by new business. See Notes 11 and 13 to the Consolidated Financial Statements.
The Risk Management Services segment includes Gallagher's third party claims administration operations which are principally engaged in providing claims management services for Gallagher's clients. Total revenues in 1999 were $188.4 million or 12% over 1998 due to strong new business production and favorable retention rates on existing business. United States revenues of $174.4 million in 1999 were up 11% over 1998 due primarily to new business. In 1999, foreign revenues of $13.9 million, principally from the United Kingdom and Australia, increased 16% over 1998 due to new business production partially offset by lost business. Earnings before income taxes in 1999 of $22.3 million increased 43% over 1998 due primarily to revenue increases and moderate increases in expenses. Total revenues in 1998 were $168.8 million or 18% over 1997 due mainly to new business production and a significant increase in revenues from Gallagher's Australian operations for claim work performed as a result of a pervasive and extended power outage in New Zealand. In 1998, United States revenues increased 15% over 1997 due primarily to new business partially offset by lost business. In 1998, foreign revenues of $12.0 million, principally from the United Kingdom and Australia, increased 107% over 1997 due principally to the claim work of the Australian operations mentioned above. Earnings before income taxes in 1998 increased 49% over 1997 due primarily to increased revenues offset by a moderate increase in expenses.
Corporate consists of unallocated administrative costs and the provision for income taxes which is not allocated to Gallagher's operating entities. Revenues are not recorded in this segment and all costs are generated in the United States.
The insurance brokerage industry is not capital intensive. Gallagher has historically been profitable, and cash flows from operations and short-term borrowings under various credit agreements have been sufficient to fund operating, investment and capital expenditure needs of Gallagher. Cash generated from operating activities was $63.7 million, $55.4 million and $72.7 million in 1999, 1998 and 1997, respectively. Because of the variability related to the timing of premiums and fees receivable and premiums payable, net cash flows from operations vary substantially from year to year. Funds restricted as to Gallagher's use, primarily premiums held as fiduciary funds, have not been included in determining Gallagher's overall liquidity.
Gallagher maintains a $20.0 million unsecured revolving credit agreement (the "Credit Agreement") requiring repayment of any loans under the agreement no later than June 30, 2001. During 1999, Gallagher borrowed and repaid $20.0 million of short-term borrowings under the Credit Agreement. During 1998, Gallagher borrowed and repaid $15.0 million of short-term borrowings under the Credit Agreement. These borrowings were primarily used on a short-term basis to finance a portion of Gallagher's operations and
At December 31, 1999, Gallagher has contingently committed to invest an additional $7.2 million related to two letter of credit arrangements with one of its equity investments. In addition, Gallagher has guaranteed an aggregate $14.6 million of funds through letters of credit or other arrangements related to several investments and insurance programs of Gallagher.
Gallagher paid $28.0 million in cash dividends on its common stock in 1999. Gallagher's dividend policy is determined by the Board of Directors and quarterly dividends are declared after considering Gallagher's available cash from earnings and its known or anticipated cash needs. In each quarter of 1999, Gallagher's Board of Directors declared a dividend of $.20 per share which was $.025 or 14% greater than each quarterly dividend in 1998. In January 2000, Gallagher declared a first quarter dividend of $.23 per share, a 15% increase over the first quarter dividend in 1999.
Net capital expenditures were $16.6 million, $13.3 million and $12.2 million in 1999, 1998 and 1997, respectively. In 2000, Gallagher expects to make capital expenditures of approximately $17.0 million. Capital expenditures by Gallagher are related primarily to office moves and expansions and updating computer systems and equipment.
Effective with changes in the United States federal income tax laws in 1997, Gallagher no longer provides for federal income taxes on the undistributed earnings of its foreign subsidiaries which are considered permanently invested outside the United States. At December 31, 1999, Gallagher had $22.0 million of undistributed earnings from its foreign subsidiaries. See Note 11 to the Consolidated Financial Statements. Although not considered available for domestic needs, the undistributed earnings generated by certain foreign subsidiaries referred to above may be used to finance foreign operations and acquisitions.
systems. It is estimated that Gallagher spent less than $1.0 million in the aggregate from 1997 through 1999 for specific Y2K "fixes" outside the routine efforts discussed above.
At the time of change from the Year 1999 to the Year 2000 and forward, Gallagher has neither experienced major internal system failures nor been materially affected by compliance problems with the systems of business partners, vendors or clients. Gallagher believes it has successfully weathered any Y2K problems, but continues to monitor its internal systems and maintains an awareness of any problems which could arise with the systems of business partners, vendors or clients.
The accompanying consolidated financial statements include the accounts of Gallagher and all of its majority owned subsidiaries. Investments in partially owned entities in which ownership is 20% to 50% are accounted for using the equity method. Accordingly, Gallagher's share of the net earnings of these entities is included in consolidated net earnings. Investments in partially owned entities in which ownership is less than 20% are carried at cost. All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to the prior years' financial statements in order to conform to the current year presentation.
Commission income is generally recognized as of the effective date of insurance policies except for commissions on installment premiums which are recognized periodically as billed. Contingent commissions are generally recognized when received. Fee income is primarily recognized ratably as services are rendered. The income effects of subsequent premium and fee adjustments are recorded when the adjustments become known. Premiums and fees receivable are net of allowance for doubtful accounts of $905,000 and $1,500,000 at December 31, 1999 and 1998, respectively.
In its capacity as an insurance broker, Gallagher collects premiums from insureds and, after deducting its commissions and/or fees, remits these premiums to insurance carriers. Unremitted insurance premiums are held in a fiduciary capacity until disbursed by Gallagher. Various state and foreign agencies that regulate insurance brokers provide specific requirements that limit the type of investments that may be made with such funds. Accordingly Gallagher invests these funds in cash, money market accounts, commercial paper and certificates of deposit. Gallagher earns interest income on these unremitted funds, which is reported as investment income and other in the accompanying consolidated statement of earnings.
Investment strategies are considered trading securities and consist primarily of limited partnerships which invest in common stocks. Securities designated as trading are carried at fair value in the accompanying consolidated balance sheet, with unrealized gains and losses included in the consolidated statement of earnings. The fair value of investment strategies is determined by reference to the fair values of the underlying common stocks which are based on quoted market prices.
Fixed assets are carried at cost in the accompanying consolidated balance sheet. Furniture and equipment with a cost of $97,762,000 and $88,329,000 at December 31, 1999 and 1998, respectively, are depreciated using the straight- line method over the estimated useful lives (three to ten years) of the assets. Leasehold improvements with a cost of $14,588,000 and $12,039,000 at December 31, 1999 and 1998, respectively, are amortized using the straight-line method over the shorter of the estimated useful lives of the assets or the lease terms. Gallagher periodically reviews long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. If the fair value is less than the carrying amount of the asset, a loss would be recognized for the difference.
Intangible assets consist of the excess of cost over the value of net tangible assets of acquired businesses, non-compete agreements and expiration lists. The excess of cost over the value of net tangible assets is amortized over fifteen to forty years using the straight-line method. Non-compete agreements and expiration lists are amortized over three to ten years using the straight-line method. Accumulated amortization at December 31, 1999 and 1998 was $6,852,000 and $4,640,000, respectively. Amortization expense was $3,020,000, $1,062,000 and $1,061,000 for 1999, 1998 and 1997, respectively. Gallagher periodically reviews intangible assets for impairment whenever events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. If the fair value is less than the carrying amount of the asset, a loss would be recognized for the difference.
Gallagher primarily grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. Gallagher accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," and, accordingly, recognizes no compensation expense for these stock options granted to employees.
In January 2000, the Board of Directors declared a two-for-one stock split of Gallagher's common stock, effected in the form of a 100% stock dividend paid on March 15, 2000 to shareholders of record as of March 1, 2000. As a result of this action, par value of the common stock remains at $1.00 per share. All information relating to the number of common shares and per common share amounts in the accompanying consolidated financial statements and notes thereto have been restated to give retroactive effect to the stock split for all periods presented. Accordingly, $18,420,000 in the aggregate was transferred to common stock from capital in excess of par value ($15,835,000) and retained earnings ($2,585,000) in the accompanying December 31, 1999 consolidated balance sheet.
The following summarizes the restatement of the 1998 and 1997 consolidated financial statements to reflect the operations of the 1999 acquisitions (in thousands, except per share data):
The cost or amortized cost and fair value of fixed maturities at December 31, 1999, by contractual maturity, are as follows (in thousands):
Tax advantaged investments represent amounts invested by Gallagher in limited partnerships that operate qualified affordable housing or alternative energy projects. Gallagher receives tax benefits in the form of tax deductions for operating losses and tax credits from these investments. The tax advantaged investments are primarily accounted for using the effective yield method and are carried at amortized cost in the consolidated balance sheet. Under the effective yield method, Gallagher recognizes the tax credits as they are allocated by the partnerships, which are included, net of amortization of the investment, as a component of the provision for income taxes. During 1999 and 1998, Gallagher received tax benefits related to $37,180,000 and $20,159,000 of the aggregate amount invested in the tax advantaged investments at December 31, 1999 and 1998, respectively. Investments in real estate partnerships primarily represent an investment in a limited partnership that owns 10,000 acres of land to be developed near Orlando, Florida. Investments in real estate partnerships are carried at cost in the consolidated balance sheet, which approximated fair value at December 31, 1999 and 1998. Notes receivable from investees represent secured loans made by Gallagher to several of its equity and limited partnership investments. Interest rates on the loans at December 31, 1999 and 1998 ranged from 6% to 10.5%. The carrying value of these loans at December 31, 1999 and 1998 approximated fair value.
The net change in unrealized gain (loss) on investment strategies included in the foregoing table amounted to $889,000 in 1999, ($611,000) in 1998 and ($1,813,000) in 1997. In 1999, Gallagher sold a portion of its interests in limited partnerships that operate qualified affordable housing projects for cash proceeds of $6,264,000. The gain recognized in 1999 on this sale of limited partnership interests was $3,015,000, which has been included in net realized and unrealized gains in the foregoing table. In 1997, Gallagher sold several underperforming or geographically undesirable operations and recorded aggregate gains on these sales of $7,203,000. The gains on these sales of operations have been reported as non-recurring gains. The net assets sold and the operating results included in the consolidated statement of earnings related to these operations were not material to the consolidated financial statements. Also in 1997, Gallagher recorded a gain on a real estate transaction of $1,790,000, which has also been reported as a non-recurring gain.
Gallagher maintains a $20,000,000 variable rate (based on LIBOR plus .4%) unsecured revolving credit agreement which expires on June 30, 2001. As of December 31, 1999 and 1998, there were no borrowings outstanding under this agreement. Terms of the revolving credit agreement include various covenants which require Gallagher to maintain specified levels of tangible net worth and restrict the amount of payments on certain expenditures. Gallagher was in compliance with these covenants as of December 31, 1999 and 1998.
Non-voting Rights, authorized by the Board of Directors on March 10, 1987 and approved by stockholders on May 12, 1987, are outstanding on each share of outstanding common stock. The Rights Plan was amended in 1996 to extend the expiration of the Rights to May 12, 2007. Under certain conditions, each Right may be exercised to purchase one share of common stock at an exercise price of $50. The Rights become exercisable and transferable after a public announcement that a person or group (as defined) has acquired 20% or more of the common stock or after commencement or public announcement of a tender offer for 30% or more of the common stock. If Gallagher is acquired in a merger or business combination, each Right exercised gives the holder the right to purchase $100 of market value of common stock of the surviving company for the $50 exercise price. The Rights may be redeemed by Gallagher at $.025 per Right at any time prior to the public announcement of the acquisition of 20% of the common stock.
Gallagher has incentive and nonqualified stock option plans for officers and key employees of Gallagher and its subsidiaries. The options are primarily granted at the fair value of the underlying shares at the date of grant. Options granted under the nonqualified plan primarily become exercisable at the rate of 10% per year beginning the calendar year after the date of grant or earlier in the event of death, disability or retirement. Options expire ten years from the date of grant, or earlier in the event of termination of the employee.
In addition, Gallagher has a non-employee directors' stock option plan which currently authorizes 400,000 shares for grant, with Discretionary Options granted at the direction of the Option Committee and Retainer Options granted in lieu of the directors' annual retainer. Discretionary Options shall be exercisable at such rates as shall be determined by the Committee on the date of grant. Retainer Options shall be cumulatively exercisable at the rate of 25% of the total Retainer Option at the end of each full fiscal quarter succeeding the date of grant. The excess of fair value at the date of grant over the option price for these nonqualified stock options is considered compensation and is charged against earnings ratably over the vesting period.
Gallagher accounts for stock option grants in accordance with APB 25 and, accordingly, recognizes no compensation expense for stock options that are granted to employees at the fair value of the underlying shares at the date of grant. Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," requires disclosure of pro forma information regarding net earnings and net earnings per share, using pricing models to estimate the fair value of stock option grants. Had compensation expense for Gallagher's stock option plans been determined based on the estimated fair value at the date of grant consistent with the methodology prescribed under SFAS 123, approximate net earnings and net earnings per share would have been as follows (in thousands, except per share data):
Options with respect to 2,422,000 shares were available for grant at December 31, 1999.
The following assumptions were used in determining the plan's pension benefit obligation for 1999, 1998 and 1997:
Gallagher has a qualified contributory savings and thrift (401(k)) plan covering the majority of its employees. Gallagher matching contributions (up to a maximum of 2% of eligible compensation) are at the discretion of Gallagher's Board of Directors and may not exceed the maximum amount deductible for federal income tax purposes. Gallagher contributed $3,257,000, $3,263,000 and $3,190,000 in 1999, 1998 and 1997, respectively. Effective January 1, 1999, Gallagher implemented a nonqualified deferred compensation plan for certain employees, who due to Internal Revenue Service rules, cannot take full advantage of the Gallagher matching contributions under the savings and thrift plan. The plan permits these employees to annually elect to defer a portion of their compensation until their retirement. Gallagher matching contributions to this plan are also at the discretion of Gallagher's Board of Directors. Gallagher contributed $236,000 to the plan in 1999. The fair value of the plan's assets as of December 31, 1999, including employee contributions and investment earnings thereon, was $2,419,000 and has been included in other noncurrent assets and the corresponding liability has been included in other noncurrent liabilities in the accompanying consolidated balance sheet.
In 1992, Gallagher amended its health benefits plan to eliminate retiree coverage, except for retirees and those employees who had already attained a specified age and length of service at the time of the amendment. The retiree health plan is contributory, with contributions adjusted annually and is funded on a pay-as-you-go basis.
The discount rate used to measure the postretirement benefit obligation was 7.5% at December 31, 1999, 1998 and 1997. The transition obligation is being amortized over a 20 year period. For measurement purposes, a 7.5% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2000. This rate was assumed to gradually scale down to 4.5% for 2009 and remain at that level thereafter. The assumed health care cost trend rate has a significant effect on the amounts reported and disclosed herein. A one percentage point change in the assumed health care cost trend rate would have the following effects (in thousands):
Total rent expense, including rent relating to cancelable leases and leases with initial terms of less than one year, amounted to $37,308,000 in 1999, $32,562,000 in 1998 and $31,442,000 in 1997.
At December 31, 1999, Gallagher has contingently committed to invest an additional $7,200,000 related to two letter of credit arrangements with one of its equity investments. In addition, Gallagher has guaranteed an aggregate $14,600,000 of funds through letters of credit or other arrangements related to several investments and insurance programs of Gallagher.
During the period from 1994 to 1996, Gallagher provided for United States income taxes on the undistributed earnings of its foreign subsidiaries. Due to changes in the United States federal income tax laws effective in 1997, Gallagher no longer provides for United States income taxes on the undistributed earnings ($22,000,000 at December 31, 1999) of certain foreign subsidiaries which are considered permanently invested outside of the United States. The amount of unrecognized deferred tax liability on these undistributed earnings is $5,500,000 at December 31, 1999.
Allocations of investment income and certain expenses are based on assumptions and estimates, and reported operating results by segment would change if different methods were applied. Certain assets are not individually identifiable by segment and, accordingly, have been allocated based on formulas. Financial information relating to Gallagher's operating segments for 1999, 1998 and 1997 is as follows (in thousands):
We have audited the accompanying consolidated balance sheet of Arthur J. Gallagher & Co. (Gallagher) as of December 31, 1999 and 1998, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1999. These financial statements are the responsibility of Gallagher's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arthur J. Gallagher & Co. at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States.