We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from Mack and Parker, one of our subsidiaries. This facility, totaling approximately 3,500 square feet, contains corporate, finance, administration, sales and customer support functions. The lease on the premises expires on October 1, 2011. In addition, our brokerages lease office space in the locations in which they operate, none of which is material. In total, we hold 158 leases covering approximately 720,000 square feet with a total annual base rent for all of these locations of approximately $10 million.
We believe that our facilities are well maintained and in good condition and are adequate for our current needs. We expect that suitable additional space will be available as required.
Our results for the five year period ended December 31, 2003 reflect the acquisition of brokerages that occurred in each respective period. These acquisitions were accounted for using the purchase method. Thus, results of acquisitions are only included from the date of acquisition forward. Accordingly, the results in each period are not directly comparable.
Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP and U.S. GAAP as it relates to us, see note 18 to our audited consolidated financial statements included elsewhere in this Form 10-K.
Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars at the exchange rate in effect at September 30, 2001 of C$1.00 = $0.6338.
As discussed in note 2, “Summary of significant accounting policies,” of the notes to the audited consolidated financial statements, we adopted Canadian Institute of Chartered Accountants (CICA) Section 3062 on January 1, 2002. Upon adoption of CICA Section 3062, goodwill is no longer amortized. The following table illustrates the effect that CICA Section 3062 would have had on net earnings and per share information under Canadian GAAP for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 had goodwill not been amortized:
We adopted Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 (SFAS No. 142) on January 1, 2002. Upon adoption of SFAS No. 142 goodwill is no longer amortized. The following table illustrates the effect that SFAS No. 142 would have had on net earnings and per share information under U.S. GAAP for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 had goodwill not been amortized:
The following discussion and analysis should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report. Certain information contained in “Management’s discussion and analysis of financial condition and results of operations” are forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements because of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the heading “Risk Factors”. Reference to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (U.S. GAAP) and to the extent that they effect us are described in Note 18 to our audited consolidated financial statements.
As of December 31, 2003, our operations included 10 regional “hub” brokerages - five in the United States and five in Canada - and more than 150 offices staffed by approximately 2,500 people. Our strategic plan calls for the addition of approximately 10 additional U.S. hubs to extend our geographic footprint. Brokerages large enough to be considered hubs will generally have annual revenue in excess of $10 million. In addition to larger, “hub” acquisitions by the parent corporation, each regional hub is tasked with pursuing smaller, fold-in acquisitions that either expand its geographic penetration or add new specialization or expertise to the regional operation.
We generally acquire larger, “hub” brokerages, for a combination of cash and stock. Although there are variations in the purchase terms for each hub, our goal is to pay 30% - 70% of the “hub” purchase price in our common stock, while setting escrow periods of up to 10 years for the sellers to hold these shares. We believe the use of escrowed stock in major acquisitions creates increased alignment of interests between senior managers and the public shareholders of the corporation. We have paid all cash for the acquisition of certain brokerages, and may pay an all cash purchase price for brokerages in the future. As of December 31, 2003, senior managers of the company and its hubs owned approximately 4,129,000 shares, or 12.5% of shares outstanding, while all employees as a group held approximately 9,176,000 shares, or 27.8% of total shares outstanding.
During the three years ended December 31, 2003, we acquired 24 brokerages in the United States and another 9 brokerages in Canada, adding a combined $156.5 million to our revenue as of the dates of acquisition. Of these acquisitions, 4 were regional hubs, all based in the United States. United States revenue has grown to 62% of our total in 2003 from 21% in 2000, reflecting primarily acquisition growth but also organic growth and our strategic plan to use acquisitions to expand across the United States. Organic growth is similar to the same-store-sales calculation used by retailers. It includes revenue growth from units included in our financial statements for at least 12 months. Because we apply the purchase method of accounting for acquisitions, acquired brokerages’ financial results are included only from the date of acquisition.
We acquired brokerages with aggregate annual revenue of $8.1 million in 2003, down from approximately $59.6 million of acquired revenue in 2002. The slower pace of acquisitions in 2003 resulted from a number of factors, including competition for brokerages by banks and other buyers willing to acquire insurance brokers at higher valuations than we and most industry peers have been willing to pay.
Our revenue base is diversified across a large number of insurance products and services, including:
Commercial lines have increased as a percentage of our total revenue, increasing to 77% in 2003 from 18% in 2001, largely as a result of our more rapid expansion in the United States, where middle market companies and other commercial clients are the primary source of revenue. In 2003, commercial lines constituted 89% of U.S. revenue and 58% of Canadian revenue. In British Columbia (Canada), we are the largest broker of government underwritten auto insurance, a personal line. In addition, Canada’s public health care system eliminates a significant portion of the demand for employer-provided health insurance, a major commercial product line for us in the United States.
Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago, and in Saint John, New Brunswick and Chilliwack, British Columbia;
Wholesale life and financial services centers, known as managing general agents, provide life and financial products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal and Toronto;
Because we have a diverse mix of products, services, insurer relationships and distribution channels, revenue and profitability levels are not usually highly susceptible to major changes as a result of a single product or service. (An exception occurred in 2003. See “US Results” on page 25.) However, general economic trends can influence both overall insurance rates - and commissions - and availability or costs of individual types of coverage.
For us, as for other brokers, rising rates can present both positive and negative effects. Rising premiums usually yield stronger commission levels, if the insurance buyer maintains its coverage levels. However, many insurance buyers will respond to rising rates by reducing total coverage, often by raising deductibles, reducing limits of coverage, or by leaving some risks uninsured. In addition, a weak economic environment often leads to lower sales and employee headcounts at client companies, leading in turn to reduced demand for employee benefits, liability and other types of coverage tied to business activity levels. Our ability to achieve organic revenue growth is not solely dependent on
rising or declining rates, but results from a more complex mixture of general economic growth, access to coverage from insurers and marketing/sales expertise.
Our strategic plan has traditionally included a highly decentralized structure that offered a large degree of autonomy to each regional “hub” operation. We have sought to acquire strong businesses and retain the services and commitment of the management teams that built those businesses successfully. Decentralization has been a core component of this growth plan. As the company continues to grow, however, it is likely that added investment will be made to coordinate more functions from the head office, enhancing the potential for cross-selling, international coordination, marketing efficiency, total expense management and financial controls.
Commission income, which usually ranges from 5% to 20% of the premium charged by insurers, provides approximately 91% of our revenue base. In addition to these “core” commissions, the company derives revenue from:
Other income - comprised of fees and interest income, including income earned while we hold client premiums on behalf of insurance companies.
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2003 and 2002 results included a number of factors that can complicate any efforts at
As shown above, we benefited from both a stronger Canadian dollar and the receipt of life insurance proceeds in 2003, while 2002 results were strengthened by the sale of two insurance subsidiaries. The impact of foreign exchange on 2002 earnings was insignificant. In addition, 2003 included a full year’s amortization of non-cash stock based compensation, versus 2002 which included only six months of amortization. Excluding the effects of these items, net income would have increased 37% in 2003, versus 24% under Canadian GAPP, and diluted earnings per share would have increased 18% in 2003, versus 8% under Canadian GAAP.
added nominally to total premium amounts, client response to higher rates often included a reduction in total coverage, increasing deductibles and other cost-savings techniques. In addition, the relative weakness in the U.S. economy led to declines in sales levels and staff headcount at many of our clients. Many products, including employee benefits and product liability coverage, are linked closely to the level of business activity at our clients. A weak economy reduces total risk, total coverage and total premiums for these clients.
As a result, our management believes an economic recovery that adds jobs and revenue at our client could make a meaningful contribution to organic growth in 2004. In addition, stronger revenue and earnings of our clients could lead these clients to reinstate coverages or lower deductibles, which also would have a beneficial impact on total premiums and commissions.
Canadian revenue grew 27% to $109.2 million, or 38% of consolidated revenue, in 2003, primarily as a result of a strengthening of the Canadian dollar against the U.S. dollar as well as organic growth. Canadian brokerages posted organic growth of 26%, of which 14 percentage points reflected a stronger Canadian dollar. Acquisitions added only $1.3 million, or 6%, of the revenue increase, reflecting a slower pace of fold-in acquisitions in Canada than in the United States. Apart from foreign currency gains, in Canada, our brokerages benefited from strong organic growth and a sustained pace of increases in insurance premium rates. Canadian rate trends have trailed those of the United States, leading to expectations that Canadian premium rates will continue to be firm for much of 2004, with some softening as the year progresses. Because Canadian revenue includes a lower percentage of commercial business and more personal lines, any acceleration in economic growth that adds to payrolls is not expected to have as strong a benefit in Canada as in the United States. The strong rate of organic growth in Canada reflected both increased market penetration and continued strength in premium rates. Our strong relationships with and access to insurers in Canada proved to be an important competitive advantage in 2003, leading to increased sales to clients who were unable to obtain coverage from other sources. As was the case in the United States, Canadian operations benefited strongly from an increase in contingent commissions and volume overrides, which grew 37% in 2003, versus a decline of 12% in 2002.
The majority of our expenses are related to compensation, which increased 35% in 2003 to $161.1 million. As a percentage of revenue, compensation increased to 56% from 54% in 2002, due in large part to an increase in non-cash stock based compensation. Total compensation includes both cash based salaries and benefits and non-cash stock based compensation. Cash-based compensation grew 32% to $156.3 million in 2003, while non-cash stock based compensation increased 341% to $4.8 million.
expected to be earnings-neutral in 2004, the long-term effect is to reduce compensation costs as a percentage of revenue.
In addition to cash compensation, we have employed non-cash compensation tools such as stock options, restricted shares and restricted share units for senior employees. In response to investor interest in the true impact of these costs, we began recognizing the expense of non-cash stock based compensation during 2002. We recognized $4.8 million of expense for the full year in 2003, including both stock options and restricted share units, versus $1.1 million of expense for two quarters of 2002. Options vest evenly over three years and expire in seven years from issuance. Shares derived from the options are held in escrow for a period of five years from the date the options are granted, subject to early release in certain circumstances. Restricted share units vest over periods ranging from 48 months to 95 months. Our policy is to expense the fair value of non-cash stock based compensation to employees over the period in which entitlement to the compensation vests. The amount of expense recognized in each quarter related to stock options will vary with respect to exercise and forfeiture of options.
Depreciation declined slightly to 2.2% of revenue in 2003 from 2.5% in 2002. The lower relative impact reflected control of capital expenditures while revenue grew. This number is not particularly important, as our business is not driven by capital expenditures.
In addition to the issuance of stock options, we issued put options to a number of individuals as part of the sale of their brokerages to us. These put options allowed the former owners to require us to repurchase our shares issued to them when we acquired their brokerages. We negotiated the cancellation of put options with one group of former owners during 2002 and negotiated the cancellation of all remaining put options during 2003.
Our net earnings increased 24% to $36.5 million in 2003, primarily as a result of growth in revenue. As a percentage of revenue, net earnings declined approximately 0.6 percentage points to 12.8% in 2003 from 13.4% in 2002. Diluted earnings per share increased at a somewhat slower rate than net earnings - 8% to $1.14, due primarily to a larger number of shares outstanding.
Our use of shares as a core component of our acquisition proceeds and as a form of executive compensation has led to significant increases in the number of shares outstanding over the past few years. In addition, we issued 6.9 million common shares in our June 2002 U.S. IPO and listing on the New York Stock Exchange. The weighted average number of diluted shares outstanding increased from 20.1 million in 2001 to 30.2 million in 2002 and 33.8 million in 2003. The impact of new acquisitions on the level of weighted average diluted shares outstanding in 2004 will be determined by both the size of acquisitions and their timing within the coming year.
We increased total revenue by $65.9 million, or 43%, to $219.9 million in 2002 from $154.0 million in 2001. Of this increase, $46.1 million or 70% was attributable to acquisitions, primarily from the acquisitions of Kaye, Burnham and
Flanagan in 2001, and $19.9 million or 30% was attributable to organic growth. Commission income increased by $57.9 million, or 40%, to $200.9 million in 2002, from $143.1 million in 2001. Excluding the effect of acquisitions, commission income increased by $18.7 million, or 13%, due to organic growth, including the continued firming of insurance premium rates. In 2002, revenue from contingent commissions and volume overrides increased by $5.6 million, or 94%, to $11.5 million from $5.9 million in 2001. Excluding the effects of acquisitions of $4.2 million, contingent commissions and volume overrides increased by $1.4 million or 23% as compared with the prior year. This increase resulted primarily from contingent commissions earned in the third and fourth quarters of 2002 from Fairfax related to premium volume placed with Old Lyme. In 2002, other income, which includes fees and interest income, increased by $2.5 million, or 49%, to $7.5 million from $5.0 million in 2001. Excluding the effects of acquisitions of $2.7 million, other income decreased by $0.2 million.
Selling, occupancy and administration expenses increased by $9.6 million, or 27%, to $44.9 million in 2002 from $35.3 million in 2001. As a percentage of total revenue, selling, occupancy and administration expenses decreased to 20% in 2002 from 23% in 2001. This decrease was due to efforts to ensure that certain fixed costs remained constant while revenue grew.
Depreciation expenses increased by $1.6 million, or 39%, to $5.5 million in 2002 from $3.9 million in 2001. Depreciation expenses remained unchanged as a percentage of total revenue at 3% in both 2002 and 2001.
Gain on Disposal of Investment Held for Sale, Property, Equipment and Investments
Non-cash stock option compensation of $1.1 million in 2002 reflects the impact of approximately 1.3 million stock options granted in June of 2002. The options were granted with an exercise price of $15.67 per share (fair market value at date of grant) and vest evenly over three years. The options expire in seven years. Our policy is to expense the fair value of stock options granted to employees over the period in which entitlement to the compensation vests. Non-cash stock option compensation was 0.5% of total revenue for 2002.
Net earnings in 2002 increased by $19.4 million, or 194%, to $29.4 million in 2002 compared with $10.0 million in 2001. Basic earnings per share increased 140% to $1.27 in 2002 compared with $0.53 per share in 2001. Diluted earnings per share increased 112% to $1.06 in 2002 from $0.50 in 2001.
On July 16, 2003, we entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% and 6.16% on $10 million and $55 million, respectively, of the senior notes in order to ensure that we pay a market related interest rate on a portion of our borrowings. Under Canadian GAAP, we account for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at
December 31, 2003, we estimate the fair value of the swap to be $2.6 million, which is not recognized in these financial statements. Accordingly, $2.6 million is the estimated amount that we would need to pay to terminate the swap as of December 31, 2003.
Also at December 31, 2003, we had outstanding $35.0 million aggregate principal amount of 8.5% convertible subordinated notes due June 28, 2007 held by certain subsidiaries of Fairfax (the Fairfax notes). The Fairfax notes are convertible by the holders at any time into our common shares at C$17.00 per share. If Fairfax converted all of the Fairfax notes, Fairfax would own approximately 32% of our total outstanding common shares as of December 31, 2003, versus the 26% of outstanding shares held on that date.
At the close of 2003, our cash position included approximately $35.1 million deployed as working capital at the brokerage level and approximately $47.0 million available for acquisitions. It is impossible to define exactly how many acquisitions or how much new revenue could be acquired through the use of this cash, additional cash flow from operations and application of credit facilities, as acquisition pricing and other factors vary during the course of the year. However, we intend to use common shares as compensation for approximately 30-70% of the value of a hub acquisition, and generally have paid a multiple of 5-8 times earnings before interest, taxes, depreciation and amortization (frequently referred to as EBITDA) for acquired brokerages.
Our debt to capitalization ratio (defined as debt expressed as a percentage of debt and shareholders’ equity) decreased to 25% at December 31, 2003, compared with 27% at December 31, 2002. If all lines of credit and other loan facilities were fully utilized by the company at December 31, 2003, our ratio of debt to capitalization would have been 34%, which is below the range 35% to 38% that our management believes is suitably conservative for our business model. Under our loan covenants, our debt to capitalization ratio must be maintained below the 45% level. As of December 31, 2003, we were in compliance with the financial covenants under all of our debt instruments.
In connection with the acquisition of Hooper Hayes and Associates, Inc., in 2002 we issued 196,000 shares (the “Retractable Shares”) that are being held in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2003, 63,000 shares have been released from escrow.
share units to be issued in the first quarter of 2004. In addition, whereas the management bonus agreement was previously contractual in nature, the restructured plan is no longer contractual and may be subject to change as we deem necessary. Our management has estimated that approximately $16.9 million of restricted share units will be issued in connection with the modifications. The amount of restricted share units to be issued was based upon a multiple of the previous two years average bonus. The restricted share units will vest in full on July 1, 2011, subject to continued employment of the awardee. Although the impact of this change is expected to be earnings-neutral in 2004, the long-term effect is intended to be a slower rate of increase in compensation expense relative to revenue growth.
Share repurchases. For the year ended December 31, 2003, no common shares were repurchased by us, other than 6,470 common shares under the executive share purchase plan.
Shares reserved for issuance. As of December 31, 2003, 3.6 million common shares were reserved for issuance under our equity incentive plan. As of December 31, 2003, an aggregate of approximately 2.1 million stock options and restricted share units were outstanding which would reduce such shares reserved for issuance. The issuance of approximately 1,090,065 additional restricted share units in the first quarter of 2004 will also reduce such shares reserved for issuance.
Shareholders’ equity increased by $58.5 million, or 21%, to $342.8 million as of December 31, 2003 from $284.3 million as of December 31, 2002. This increase resulted from net earnings of $36.5 million, an increase in contributed surplus of $3.5 million related primarily to non-cash stock based compensation expense, $7.1 million increase due to the release of the put option liability, $0.4 million due to shares issued in conjunction with purchase of subsidiaries and other items, $1.0 million due to shares issued in conjunction with the contingent consideration payments, as well as an increase in the cumulative translation account of $18.0 million, due mainly to the strengthening of the Canadian dollar compared to the U.S. dollar in 2003. The increase in shareholders’ equity was offset by the payment of dividends of $6.1 million in 2003, and a reduction in share capital of $1.9 million as a result of a transfer from long-term assets on company funded loans to executives used to purchase company shares pursuant to our executive share purchase plan. We no longer make loans to our executive officers. This treatment is consistent with U.S. GAAP.
We are exposed to interest rate risk in connection with our senior notes due to the interest rate swap entered into in July which converted the fixed rate interest payments on the $65 million of senior notes outstanding into floating rate payments. At December 31, 2003, we had $65 million of floating rate debt outstanding. Each 100 basis point increase in interest rates charged on the balance of our outstanding floating rate debt as of December 31, 2003 will result in approximately $0.4 million decrease in our earnings.
The Canadian dollar is subject to volatility and had experienced a significant decline in its value compared to the U.S. dollar in 2001 and 2002 but has increased significantly in value throughout 2003. At December 31, 2003 and 2002 one U.S. dollar equaled $1.2924 and $1.5779 Canadian dollars, respectively. The table below summarizes the effect that a $0.01 decline or increase in the value of the Canadian dollar would have had on our revenue, net earnings and cumulative translation account for the twelve months ended December 31, 2003, 2002 and 2001.
The increasing proportion of our revenue derived from our U.S. Operations and earned in U.S. dollars has, in part, offset the potential risk of a decline in the Canadian dollar. We expect that the proportion of revenue earned in U.S. dollars will continue to increase, further mitigating our foreign currency exchange sensitivity. We have not entered into, and do not intend to enter into, foreign currency forward exchange agreements.
impairment. For the past three years ended December 31, 2003, our amortization has been comprised of the following:
During 2003, 2002 and 2001, we incurred expenses related to rental of premises from related parties in the amount of $2,102, $1,691 and $1,373, respectively. At December 31, 2003 and 2002, we also had accounts receivable due from related parties in the amount of $3,530 and $3,801, respectively, of which the majority were loans to employees to enable them to purchase our common shares. Of the accounts receivable, as of December 31, 2003 and 2002, $1,918 and $2,207, respectively, were related to company loans to employees to purchase shares under our executive share purchase plan. As collateral, the employees have pledged 153,000 and 177,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $2,590 and $2,263 as of December 31, 2003 and 2002, respectively.
Under Canadian GAPP, we account for the interest rate swap transaction which converted fixed rate interest payments of 5.71% and 6.16% on the senior notes of $10 million and $55 million, respectively, using the synthetic instruments method. Under this method, we report in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.6 million is not
recognized in our Canadian GAAP financial statements. Under U.S. GAAP, we have designated the swap transaction of a hedge of changes in the fair value of our fixed rate debt caused by changes in interest rates and record the swap on our U.S. GAAP balance sheet at is fair value. Changes in fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt. We have no other material off-balance sheet arrangements.
Stock-based compensation includes both stock options, restricted shares and restricted share units. Our accounting policy is to recognize the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
We measure the fair value of stock options at the date of grant of the award and recognize this amount as compensation expense over the vesting period of the options. An alternative accounting treatment would be to follow the intrinsic value method for accounting for stock options.
Report of Independent Auditors to the Board of Directors and Shareholders of Hub International Limited:
During the second quarter of 2003, the Company completed a private placement of $65 million unsecured senior notes (see note 8). Net proceeds on the sale of the notes were used to pay down $50 million of existing indebtedness and for general corporate purposes which may include future acquisitions.
The operations of the Company’s subsidiaries outside of the U.S. are self-sustaining. The assets and liabilities of these subsidiaries as at December 31, 2003 and 2002 were translated to U.S. dollars at the year-end exchange rate. Revenue and expenses for 2003 and 2002 were translated to U.S. dollars at the average exchange rate for the period. Accordingly, the unrealized gains and losses which result from this translation are deferred and included in shareholders’ equity under the caption “Cumulative translation account.”
Commission income and fees, (including commission income related to installment billing arrangements) are recognized as of the effective date of the policy unless information is not available relating to the determination of the client’s policy premiums, in which case commission income and fees related to that policy are recognized when that information becomes available and the revenue can be reasonably determined. Commission income is reported net of sub-broker commission expense. Commission and other adjustments are recorded when they occur and the Company maintains an allowance for estimated policy cancellations and commission returns by applying historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The Company is entitled to contingent commissions and volume overrides from insurance companies which are recorded in the earlier of the period in which amounts can be reasonably estimated or the period in which the amounts are received. Amounts related to contingent commissions and volume overrides can be reasonably estimated when information pertaining to the calculation, such as premium volumes, loss ratios and expenses, can be obtained from the insurance companies. Other revenue primarily includes investment income, policy service fees and income earned related to the financing of client premiums. Investment income is recorded when earned. Policy service fees are recorded on the effective date of the policy, at which time the service has been provided. Income earned related to the financing of client premiums is recorded when known.
Goodwill and intangible assets with indefinite useful lives are no longer amortized but are subject to impairment tests on at least an annual basis. Goodwill is allocated to reporting units and any potential goodwill impairment is identified by comparing the carrying value of a reporting unit with its fair value. If any potential impairment is indicated, it is quantified by comparing the carrying value of goodwill to its fair value, based on the fair value of the assets and liabilities of the reporting unit.
The effect of the adoption of Section 3062 on net earnings and earnings per share for the years ended December 31, 2003, 2002 and 2001 was as follows:
In February 2003, the CICA issued an accounting guideline on the disclosure of guarantees, which broadens the definition of guarantees and requires substantially expanded disclosure. This new guideline was effective for the Company this year. As this guideline requires disclosure only, there was no impact on the consolidated statements of earnings and retained earnings and consolidated balance sheets. See note 10(b). A guarantee is a contract that contingently requires the guarantor to make payments to a third party based on (i) changes in an underlying interest rate, foreign exchange rate or other variable, including the occurrence or non-occurrence of an event, that is related to an asset, liability or equity security held by the guaranteed party, (ii) an indemnification provided to the third party with the characteristics listed above, (iii) another entity’s failure to perform under an obligating agreement, or (iv) another entity’s failure to perform related to its indebtedness.
The fair value of put options issued by the Company as consideration for businesses acquired is classified as long-term debt until such time as the option is exercised or expires. Changes in the fair value of these options are recorded in earnings. As part of the negotiations of contingent consideration the former owners of certain companies acquired in 2001 agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2003 no put options are outstanding on the Company’s common shares.
During 2002, the Company purchased all of the issued and outstanding shares of Hooper Hayes & Associates, Inc. (Hooper Hayes), and Fifth Third Insurance Services, Inc. which was renamed Hub International of Indiana Limited (Hub Indiana), as well as outstanding shares or net assets of 6 other brokerages, all of which were acquired using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2001 are summarized as follows:
In addition to the consideration shown above, the previous owners of certain other acquisitions are entitled to contingent consideration if certain revenue or profitability targets are met. See note 10 “Commitments and contingencies.”
As of December 31, 2003 and 2002 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
For the years ended December 31, 2003, 2002 and 2001, amortization has been comprised of the following:
Included in computer equipment is computer software with a net book value of $5,137 and $2,641 at December 31, 2003 and 2002, respectively. Depreciation expense of $1,538, $1,087 and $621 was charged against these assets for the years ended December 31, 2003, 2002 and 2001, respectively.
During 2003 and 2002, property and equipment were acquired at an aggregate cost of $8,272 and $4,494, respectively, of which $2,147 and $25, respectively, were acquired by means of capital leases and other financing.
The cost above reflects certain property and equipment held under capital leases of which the remaining liability at December 31, 2003 and 2002 was $650 and $993, respectively.
Senior Notes - In June 2003, the Company, completed a private placement of $65 million in principal amount of unsecured senior notes. The senior notes were issued in two series. Series A represents $10 million of 5.71% senior notes with interest due semi-annually, and principal of $3,333 due annually, June 15, 2008 through June 15, 2010. Series B represents $55 million of 6.16% senior notes with interest due semi-annually, and principal of $11,000 due annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of the Company’s revolving U.S. Dollar LIBOR Loan with the balance held for general corporate purposes, which may include future acquisitions. The Company incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2003, $65 million was outstanding under these senior notes. The Company is in compliance with all financial covenants governing these notes.
On July 16, 2003, the Company entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% and 6.16% on $10 million and $55 million, respectively, of the senior notes in order to ensure that the Company pays a market related interest rate on a portion of its borrowings. As at December 31, 2003, the Company estimated the fair value of the swap to be $2.6 million, which is not recognized in these financial statements. Accordingly, $2.6 million is the estimated amount that the Company would need to pay to terminate the swap as of December 31, 2003.
In connection with the acquisition of Kaye on June 28, 2001, the Company issued $35 million aggregate principal amount, 8.5% convertible subordinated debentures (the Fairfax notes) due June 28, 2007 to certain subsidiaries of Fairfax Financial Holdings Limited (Fairfax). The Fairfax notes are convertible by the holders at any time into the Company’s common shares at C$17.00 per share. Beginning June 28, 2006, the Company may require conversion of the Fairfax notes into common shares at C$17.00 per share if, at any time, the weighted average closing price of the Company’s common shares on the TSX for twenty consecutive trading days equals or exceeds C$19.00 per share. If converted, Fairfax would have owned approximately 32% of the Company’s outstanding common shares as of December 31, 2003.
Rent expense for the year ended December 31, 2003, 2002, and 2001 amounted to $11,503, $9,684 and $7,665 respectively, net of sublease rental income of $1,282, $737 and $620 respectively.
In connection with the Company’s executive share purchase plan, under certain circumstances, the Company may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4,513 and $5,077 as of December 31, 2003 and 2002 respectively, to assist in purchasing common shares of the Company. The Company no longer makes loans to its executive officers and directors. As collateral, the employees have pledged 478,000 and 602,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $8,105 and $7,677 as of December 31, 2003 and 2002, respectively. Interest on the loans in the amount of $279, $264 and $377 for the years ended December 31, 2003, 2002 and 2001, respectively, was paid by the Company and is included in compensation expense.
In connection with other various acquisitions completed through December 31, 2003, the Company may be obligated to pay contingent consideration up to a maximum sum of approximately $8.2 million cash and $0.2 million in common shares based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through September, 2006 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2003, the
financial statements reflect a liability to pay cash of $71 and to issue common shares valued at approximately $635 as of December 31, 2003.
At December 31, 2003 and 2002, there were an unlimited number of non-voting, preferred shares authorized, issuable in series on such terms and conditions as set by the Board of Directors, of which no shares were issued. At December 31, 2003 and 2002, there were an unlimited number of common shares authorized, of which 30,143 and 29,025 were issued and outstanding as at December 31, 2003 and December 31, 2002 respectively.
On February 28, 2003, the Company issued options exercisable for 267,000 common shares at an exercise price of $13.79 per share, the U.S. dollar equivalent of the closing sales price of the Company’s common shares on the TSX on that date. The maximum option term is seven years, and the options vest as to one-third per year over three years of continuous employment. The number of common shares that may be issued under the Equity Incentive Plan is limited to 3,631,820 common shares.
The fair value of the stock options granted in 2003 was approximately $1.2 million (weighted average exercise price was $13.79 per share). The aggregate fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions for the options issued in 2003:
Non-cash stock based compensation for the year ended December 31, 2003 and 2002 is comprised of the following:
In connection with the acquisition of Kaye in 2001, the Company issued 8.5% subordinated convertible debentures due June 28, 2007 with a carrying amount and aggregate principal of $35 million. These debentures remain
The provision for income tax expense differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 36.62%, 38.62% and 41.7% in 2003, 2002 and 2001, respectively, as follows:
The Company has net operating loss carryforwards of $13,970 at December 31, 2003 that expire 2008 through 2010 resulting in a future tax asset of $2,724. In addition, the Company has state net operating loss carryforwards in the U.S. of approximately $3,610 which expire 2019 through 2023 resulting in a future tax asset of $171. Such net operating losses are currently available to offset certain future state and local taxable income.
The Company is an international insurance brokerage, which provides a variety of property, casualty, life and health, employee benefits, investment and risk management products and services. In addition to its Corporate Operations, the Company has identified two operating segments within its insurance brokerage business: Canadian Operations and U.S. Operations. Corporate Operations consist primarily of investment income, unallocated administrative costs, interest expense and the income tax expense or benefit which is not allocated to the Company’s operating segments. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends.
Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2003, 2002 and 2001 is as follows:
As of December 31, 2003 and 2002, the Company had accounts receivable and accounts payable balances with the above related parties in the amounts of $3,185 and $17,999, for 2003, respectively, and $2,104 and $12,180 for 2002, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in
the normal course of business. The companies above are related through common ownership by Fairfax, which owns approximately 26% of the Company’s common shares as of December 31, 2003.
The impact of the above noted Canadian and U.S. GAAP differences on earnings were as follows:
The aggregate impact of these differences has been presented in the reconciliation of shareholders’ equity for Canadian to U.S. GAAP under the caption “cumulative translation account.”
Under Canadian GAAP, the fair value of the put options (determined using the Black-Scholes model) issued in connection with certain 2001 acquisitions was allocated to equity instruments on the balance sheet. The balance of the purchase price was allocated to debt. Changes in the value of the put options in periods subsequent to the acquisition date are included in earnings. Under U.S. GAAP prior to July 1, 2003, the fair value of the share consideration and the attached put options was initially recorded in equity and the redemption value of the shares to which the put options are attached was reclassified as mezzanine equity
outside of shareholders’ equity as a result of the put options granted on those shares to certain of the selling shareholders. On July 1, 2003, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement requires that an issuer classify financial instruments meeting certain criteria as liabilities (or assets in some circumstances) rather than equity. As a result of the adoption of this new standard, the Company changed its accounting policy with respect to the financial instruments issued in connection with certain 2001 acquisitions. Effective July 1, 2003, the Company remeasured the fair value of the put options (using the Black-Scholes model) and classified this amount as liability. Amounts previously classified as mezzanine equity were reclassified as shareholders’ equity. The difference between the estimated fair value of the put options as at July 1, 2003 and May 31, 2001 was reported as a cumulative adjustment to net earnings under U.S. GAAP. Comparative financial statements were not restated. Under U.S. GAAP, changes in the estimated fair value of the put options are included in earnings.
The condensed consolidated statements of earnings and cash flows for the years ended December 31, 2003, 2002 and 2001 and the condensed consolidated balance sheets as at December 31, 2003 and 2002, under U.S. GAAP are as follows:
Under Canadian GAAP, the Company accounts for the interest rate swap transaction which converted fixed rate interest payments of 5.71% and 6.16% on the Senior Notes of $10 million and $55 million, respectively, using the synthetic instruments method. Under this method, the Company reports in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.6 million, is not recognized in the Company’s Canadian GAAP financial statements. Under U.S. GAAP, the Company has designated the swap transaction of a hedge of changes in the fair value of its fixed rate debt caused by changes in interest rates. Under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, the Company records the swap on its U.S. GAAP balance sheet at its fair value. Changes in fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt.