NOTES: (a) The financial information for all periods prior to 1996 has been restated for acquisitions accounted for using the pooling of interests method. (b) Based on the weighted average number of common and common equivalent shares, if any, outstanding during the year. (c) Based on the number of employees at year end. (d) Based on the total dividends 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 based on a percentage of the premiums paid by the insured and generally follow premium levels. Lower premium rates and excess capacity prevail among property and 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 during the period.
During the past three years, several catastrophes have caused billions of dollars of insured losses domestically and abroad. According to some estimates, 1996 will rank as the fifth most expensive year on record with over $7 billion in insured property losses. Consolidation in the form of substantial mergers, both in the United States and internationally, continues within the insurance industry resulting in fewer companies writing risks. Financial services reform is likely in the near future. Proposed federal legislation seeks to allow affiliations between banks and insurance entities. A recent report claims the property/casualty insurance industry began to materially weaken its core loss reserves in 1996 which reverses several years of favorable reserving trends. In spite of forces which would reduce competition and weaken profits, there is still little change in property/casualty rates. Sufficient capacity remains and the sharply competitive environment continues. Management believes insurance pricing will not change significantly in 1997.
Along with the soft market conditions, the growth of the alternative insurance market has slowed during the past year. Although the property/casualty pricing environment has resulted in some buyers returning to first dollar coverage, the Company still believes a move from the traditional approach of purchasing insurance will continue. The Company anticipates new sales in the risk management, benefits and self-insurance services areas will again be a major factor in fee revenue growth in 1997.
Historically, inflation has contributed to increased property replacement costs and higher litigation awards causing some clients to seek higher levels of insurance coverage. These factors have the effect of generating higher premiums to customers and higher commissions to the Company. More recently, the United States and other parts of the world have experienced low rates of inflation along with business downsizing, reduced sales and lower payrolls. These events have resulted in lower levels of exposures to insure. In general, premium rates have had a greater effect on the Company's revenues than inflation.
Salaries and employee benefits increased by $7.7 million or 3% in 1996 due principally to salary increases and the annualized effect of prior year hires along with a corresponding increase in employee benefit expenses. These increases were mitigated by a wage freeze for certain management employees. Salaries and employee benefits increased by $21.7 million or 10% in 1995 due principally to salary increases and the annualized effect of prior year hires along with a corresponding increase in employee benefit expenses and changes in certain benefit plan actuarial assumptions. In 1996, 1995 and 1994, salaries and employee benefits have represented 52%, 53% and 53%, respectively, as a percentage of total revenues.
Other operating expenses increased by $8.4 million or 6% in 1996. This increase is due primarily to an increase in professional fees related to the outsourcing of certain distribution functions, increased performance fees for funds invested with professional money fund managers, an increase in brokerage expenses due to increased business with other brokers, additional rent and utility expenses resulting from leasing new office space and expanding and upgrading existing office facilities and increased bad debt write-offs. Other operating expenses increased by $14.4 million or 11% in 1995. This increase is due primarily to additional office facilities (rent and utilities, miscellaneous office and supply expenses) resulting from leasing new office space and expanding and upgrading existing facilities, and significantly higher business insurance costs.
The insurance brokerage industry is not capital intensive. The Company has historically been profitable and positive cash flow from operations and funds available under various loan agreements have been sufficient to finance the operations and capital expenditures of the Company. Cash generated from operating activities was $33.6 million and $43.5 million for the years ended December 31, 1996 and 1995, respectively. Funds restricted as to the Company's use (primarily premiums held as fiduciary funds) have not been included in determining the Company's liquidity.
Net capital expenditures for fixed assets amounted to $10.1 million, $10.3 million and $7.5 million in 1996, 1995 and 1994, respectively. In 1997, the Company intends to make additional capital improvements of approximately $11.0 million to upgrade and modernize existing space, furniture and equipment.
The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) related deferred income taxes, excluded from earnings and reported as a separate component of stockholders' equity. In addition, securities designated as trading are required to be carried at fair value, with unrealized gains and losses included in the statement of earnings. Previously, the Company carried these investments at either the lower of cost or fair value, or at amortized cost. As of January 1, 1994, the Company adopted the provisions of the standard for investments held as of or acquired after that date. In accordance with SFAS 115, prior period financial statements have not been restated to reflect the change in accounting principle. The cumulative effect as of January 1, 1994 of adopting SFAS 115 increased the opening balance of stockholders' equity by $1,456,000 (net of deferred income taxes of $970,000) to reflect the net unrealized holding gains on securities classified as available for sale previously carried at the lower of cost or fair value, or at amortized cost. There was no cumulative effect on net earnings as a result of the adoption of SFAS 115 because the securities classified as trading were carried as a current asset and had a fair value below cost at January 1, 1994. Accordingly, such unrealized losses were recorded in prior period earnings.
Marketable securities are considered available for sale and consist primarily of preferred and common stocks. Gains and losses are recognized in income when realized using the specific identification method. The fair value for marketable securities is based on quoted market prices.
Intangible assets consist primarily of the excess of cost over the value of net tangible assets of acquired businesses and are amortized principally over forty years using the straight-line method. Accumulated amortization at December 31, 1996 was $6,316,000 ($7,234,000 at December 31, 1995).
In 1996, the Company acquired substantially all the net assets of five insurance brokerage firms and one investigative services company in exchange for 1,115,000 shares of its common stock. In 1995, the Company acquired substantially all the net assets of nine insurance brokerage firms in exchange for 723,000 shares of its common stock. These acquisitions were accounted for as poolings of interests and, except for three of the 1996 acquisitions and seven of the 1995 acquisitions whose results were not significant, the financial statements for all periods prior to the acquisition dates have been restated to include the operations of these companies.
The gross realized gains on sales of marketable securities totaled $1,652,000, $1,079,000 and $2,004,000 for the years ended December 31, 1996, 1995, and 1994, respectively. The gross realized losses totaled $881,000, $1,918,000 and $312,000 for the years ended December 31, 1996, 1995, and 1994, respectively.
Substantially all fixed maturity securities mature in 2000 or later. Actual maturities may differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations.
At December 31, 1996, securities sold under agreements to repurchase the identical securities are collateralized by government backed small business administration loans and government securities with a carrying value of $23,034,000 and a fair value of $23,262,000. The securities collateralizing the agreements were held by two primary dealers. At December 31, 1995, these securities had a carrying value of $20,071,000 and a fair value of $20,253,000.
Terms of the loan agreements include various covenants which require the Company to maintain specified levels of tangible net worth and restrict the amount of payments on certain expenditures.
Maturities of long-term debt total $1,130,000 for 1997 and $1,130,000 for 1998.
The table below summarizes certain information about the Company's capital stock at December 31:
Non-voting Rights, authorized by the Board of Directors on March 10, 1987 and approved by stockholders on May 12, 1987, were distributed May 12, 1987 as a dividend to holders of the Company's common stock at the rate of one Right for each common share held. Under certain conditions, each Right may be exercised to
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) purchase one share of common stock at an exercise price of $100. The Rights become exercisable and transferable apart from the common stock after a public announcement that a person or group 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 the Company is acquired in a merger or business combination, each Right may be exercised to purchase the common stock of the surviving company having a market value of twice the exercise price of each Right. The Rights Plan was amended in 1996 to extend the expiration of the Rights to May 12, 2007. The Rights may be redeemed by the Company at 5 cents per Right at any time prior to the public announcement of the acquisition of 20% of the common stock. At December 31, 1996, 25,000,000 shares of common stock were reserved for potential exercise of the Rights.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) For purposes of the pro forma disclosures, the estimated fair values of the option grants are amortized to expense over the options' expected lives. The fair value of options at the date of grant was estimated using the Black- Scholes option pricing model with the following weighted-average assumptions:
Options with respect to 1,500,000 shares were available for grant at December 31, 1996.
The Company has a noncontributory defined benefit pension plan which covers substantially all domestic employees who have attained a specified age and one year of employment. Benefits under the plan are based on years of service and salary history. The Company's contributions to the plan satisfy the minimum funding requirements of ERISA. Plan assets consist primarily of common stocks and bonds invested under the terms of a group annuity contract managed by a life insurance company.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company accounts for the defined benefit pension plan in accordance with Statement of Financial Accounting Standards No. 87 (SFAS 87), "Employers' Accounting for Pensions." The difference beteween the present value of the projected benefit obligation at the date of adoption of SFAS 87 and the fair value of plan assets at that date is being amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits.
The assumed healthcare cost trend rate used for the next year is 8.5%, scaling down to 4.5% after 12 years. A 1% increase in the assumed healthcare cost trend rate would increase the accumulated postretirement benefit obligation by $1,341,000 at December 31, 1996 and would increase the net periodic postretirement benefit cost for 1996 by $93,000.
The Company is engaged in various legal actions incident to the nature of its business. Management is of the opinion that none of the litigation will have a material effect on the Company's financial position or operating results.
Total rent expense, including rent relating to cancelable leases and leases with initial terms of less than one year, amounted to $28,236,000 in 1996, $27,520,000 in 1995 and $26,112,000 in 1994.
Due to changes in the U.S. federal income tax laws effective in 1994, the Company began providing for U.S. income taxes on the undistributed earnings of its foreign subsidiaries. Prior to 1994, the Company did not provide for U.S. income taxes on the undistributed earnings ($19,200,000 at December 31, 1996) of certain foreign subsidiaries which are considered permanently invested outside of the U.S. The amount of unrecognized deferred tax liability on these undistributed earnings is $5,000,000.
Exchange gains (losses) were approximately $253,000 in 1996, $85,000 in 1995 and ($81,000) in 1994.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arthur J. Gallagher & Co. at December 31, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.