We lease our principal corporate office in Briarcliff Manor, New York, and our operating unit offices in various states. These properties are suitable for our use. Information regarding lease commitments is set forth in Note 10 “Lease Commitments” to our Consolidated Financial Statements included in Part II, Item 8 of this report. The disclosure set forth in Note 10, “Lease Commitments” is incorporated herein by reference.
We have two operating segments-Insurance Brokerage and Specialized Benefits Services-and a third administrative segment-Corporate.
We are a leading distributor of property and casualty (“P&C”) insurance and employee benefits products and related consulting and administrative services primarily to small and mid-sized business clients and individuals. In our role as an insurance intermediary, we may act as an agent on behalf of the insurance companies we represent, or as a broker, working without any particular insurance company affiliation.
As a service provider, our largest cost of doing business is compensation and employee benefits expense. In 2006, compensation and employee benefits expense was $310.6 million, or 56.3% of our total revenues. Of our total compensation and employee benefits expenses, approximately one third was variable compensation paid to our salespeople. Our salespeople are generally paid on a standard formula based on a percentage of the retained revenues they manage and a percentage of new business written. Most of the remaining two thirds of compensation expense is semi-variable in nature and tied to our insurance operations employees, such as customer service representatives and account managers, whose primary responsibilities are client service oriented.
In addition to the state Attorney General investigations described above, a number of state departments of insurance have inquired into compensation practices of brokers, agents and insurers as they affect consumers in their respective states. We have received and responded to inquiries from insurance regulators in several states.
Some of the other insurance brokers and insurance carriers that have been subject to governmental investigations and/or lawsuits arising out of these matters have chosen to settle some of these matters. Marsh & McLennan, Aon Corporation, Arthur J. Gallagher & Co., Hilb, Rogal & Hobbs Company (“HRH”), Brown & Brown Insurance and Willis Group Holdings Ltd., among others, have each entered into agreements with governmental agencies, which collectively involve significant business practice changes and substantial payments by these brokers to agencies and certain of their clients. While no government agency, including the Attorney General of the State of New York, has made any demands (other than information and/or document requests) on us, or filed suit against us, there can be no assurance that their continuing inquiries referenced above will not result in demands upon us or suits filed against us, or that the resolution of these matters would not materially harm our business or have a material adverse impact on our results of operations. Additionally, due to the uncertainties involved, we cannot currently estimate a range of possible loss, if any, from these investigations.
Since October 2004, the industry’s long-standing contingent commission agreements have been a focal point of scrutiny by various regulators and, in fact, with the exception of the settlements entered into by HRH, which included an agreement that HRH would discontinue acceptance of only certain types of contingent compensation, and Brown & Brown, which required written disclosure of all compensation prior to binding coverage, the settlement agreements of the other above-referenced brokers provided that these brokers would discontinue acceptance of all contingent commissions. Moreover, certain insurance carriers that have been subject to governmental investigations and/or lawsuits arising out of these matters have chosen to accept significant modifications to the circumstances under which they will pay contingent commissions. Indeed, certain carriers have agreed to settlements which provide for the termination on their part of the payment of contingent commissions in certain lines of insurance if certain market conditions exist. In addition, certain carriers have agreed not to pay any contingent commissions in certain lines of business until a date certain. Further, certain carriers have agreed to cease paying contingent commissions altogether, but have retained the right to pay supplemental commissions. Supplemental commissions can be set as a fixed percentage of premium, or they can be based on the amount of premium in force with that carrier during a previous year. Either way, the percentage payable to the producer must be fixed prior to the start of the year in which payable. Some of the carriers who have chosen to cease paying contingent commissions have tendered new agreements providing for supplemental commission opportunities in lieu of prior contingent commissions.
We believe we have substantial defenses to the claims made in these class action proceedings and intend to defend ourselves vigorously; however, because the cases are in their early stages, the sufficiency of the complaints has not yet been tested, the plaintiff class has not yet been certified and discovery is ongoing, we are unable to provide a reasonable estimate of the range of possible loss attributable to these class action proceedings or the impact they may have on our results of operations or our cash flows (to the extent not covered by insurance). Consequently, we have not recorded a loss contingency for any of these lawsuits.
Industry Trends and Uncertainties Which May Impact Future Results of Operations
Our future results of operations will be impacted by the full year impact of those companies that we acquired during 2006, as well as the consolidation of any additional company that may be acquired in the future. These acquisitions may negatively impact our operating margins as we integrate the operations of the acquired entities. These acquisitions will affect both the total amounts of our reported revenues and expenses. In addition, our future results of operations also may be impacted by the following factors which affect the property and casualty and employee benefits markets generally.
terms and conditions. Insurance brokers also serve as a distribution channel for insurers and often perform much of the administrative and customer service functions that insurers would have to otherwise perform were they to sell insurance coverage directly. Insurance brokers, especially those who operate in the middle market, are typically compensated through commissions paid by insurers on the premium volume that they place. Brokers can also be paid on a fee basis for their insurance placement and other risk management services.
Insurance premium pricing within the commercial P&C insurance industry has historically been cyclical, based on the underwriting capacity of the insurance industry and economic conditions. We use the terms “soft market” and “hard market” to describe the business cycles experienced by the industry. A soft market is an insurance market characterized by a period of declining premium rates, which negatively affects commissions earned by insurance brokers. A hard market is an insurance market characterized by a period of rising premium rates which, absent other changes, positively affects commissions earned by insurance brokers. Additionally, the insurance industry was affected by the events of September 11, 2001, resulting in the one of the largest insurance losses in America’s history, which accelerated increases in premium rates for particular lines of commercial P&C insurance. In response to rising premiums, a number of our customers increased their deductibles and/or reduced their insurance coverage in order to reduce the impact of the premium increases. These trends, prompted by the hard market, negatively impacted our revenues, somewhat offsetting the positive impact of the hard market. The hard market, for many lines of insurance, began to slow in the second half of 2002. By the second half of 2003, premiums in most P&C lines of insurance began to flatten or decline, other than certain catastrophe property issues mentioned below. Since 2004, the soft market has generally persisted, negatively affecting brokers’ revenue throughout the P&C insurance market, including our company. Some clients use the savings on insurance premiums to purchase more coverage, somewhat offsetting the negative impact in commissions due to falling premiums. Some clients have also had an increase in exposures on which their premiums are based, e.g., revenues, payroll and building replacement costs, consistent with a general improvement in the economy. The competitive pricing dynamic is consistent throughout all account sizes and most geographic regions. If the soft market persists, our P&C insurance brokerage revenues may continue to be negatively impacted.
Employee benefits brokers and consultants principally serve businesses and their employees by providing access to individual and group medical, life and disability insurance products and services. In addition to functioning as a distributor, employee benefits brokers and consultants also provide advice on benefit plan design and often perform administrative and outsourcing services for their clients. Through single source solutions for employee benefits insurance, consulting and administration needs, mid-sized businesses can fully outsource their employee benefits program design, management and administration without committing the time and cost of in-house staff or investing substantial capital in systems.
an overall aging workforce. As businesses struggle with medical inflation, this may result in benefit reductions and cost-shifting to employees, which may cause participants to opt out of their employers’ plan or otherwise serve to reduce insurance premiums, which would negatively affect our revenues. However, the trend toward defined contribution health care, where employees direct their benefit dollars to purchase voluntary benefits a la carte, may lead to greater opportunities for our workplace benefits business.
Cash earnings per share (“CEPS”), which we define as income from continuing operations plus amortization of intangible assets on a diluted per share basis. (In 2006, CEPS was adjusted for acquisition integration expenses, non-cash stock-based compensation related to the implementation of Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised) “Share-Based Payment”, early extinguishment of debt expense, an impairment charge on the intangible assets of one acquisition and costs related to the proposed purchase of our common stock by GS Capital Partners. In 2005 and 2004, CEPS was adjusted for expenses related to acquisition integration efforts, the margin improvement plan and other charges.)
We seek to maximize organic growth opportunities by pursuing a balanced mix of revenue from P&C insurance and employee benefits products. We also seek to drive organic growth through the following:
Increased Specialization within Property & Casualty Insurance Market. While our employee benefits business is relatively differentiated through value-added services, we have found that focusing on specific industries within the P&C insurance market generates sales opportunities by capitalizing on the expertise and recognition we develop in those industries. We have found that our specialized P&C insurance sales professionals are more productive than their non-specialized counterparts, as measured by revenues per sales professional.
Increased Focus on Sales Force Retention, Recruiting and Management. We seek to grow organically through incentivizing and consistently managing our sales professionals. Our competitive commission-based compensation package is designed to retain and attract sales professionals. As a direct result, we improve customer retention and drive our sales professionals to generate new business. In addition, we have developed internal standards for sales force management processes for our operations. As a result of these standards, we actively manage our sales force through assistance in the generation of new business, cross-selling opportunities and retention of existing clients.
Our core acquisition strategy will focus primarily on fold-in acquisitions that are easy to integrate. We maintain an active pipeline of potential acquisition candidates and intend to review these opportunities on a selective basis for those opportunities that offer economies of scale to our local operations.
We have a disciplined, due-diligence intensive program to evaluate, execute and integrate acquisitions.
As part of our review of internal controls in compliance with Sarbanes-Oxley Section 404, we determined the need to enhance field office and corporate controls over our receivables (and related producer compensation expense) recorded for revenue on policies billed directly by insurance companies, or direct bill receivables. Beginning in the third quarter of 2004 and throughout 2005, we implemented new processes, which now allow us to calculate and record the receivable and revenue and the related compensation payable and expense for each commercial lines P&C direct bill policy at the time it is effective. As a result of these processes, beginning in the second quarter of 2005, we obtained reliable information which management utilized to adjust its estimate of the direct bill receivable and related compensation payable. All such material adjustments had been completed as of December 31, 2005.
We record fees and/or commissions related to benefit enrollment services when earned. We consider the earnings cycle complete when we have substantially completed our obligations under the service contract, we can reasonably estimate the revenue earned and when collection is reasonably assured. At the completion of an enrollment, we record an estimate of first year fee and/or commission income less an estimate of policy cancellations. This policy cancellation allowance is based on historical attrition rates by carrier and type of policy. The allowance for policy cancellations on benefit enrollment services is established through a charge to revenue and receivables and was $3.7 million and $3.3 million at December 31, 2006 and 2005, respectively. If our estimate of policy cancellations is too low, we may need to reverse previously recognized enrollment revenues.
In the fourth quarter of 2006, we recorded a downward adjustment to revenues and direct bill accounts receivable in our enrollment business of $2.5 million. The adjustment arose from a periodic review of our historical policy cancellation experience in this business. We found that the cancellation estimate used in our revenue recognition model, which is based on the performance of a large volume of similar policies over a number of years, was not accurate with respect to certain large enrollment cases. As a result, we increased the cancellation assumption on two cases to our best estimate of the actual cancellation trend on each case and recorded a cumulative adjustment to revenues and receivables.
We are subject to various claims, lawsuits and proceedings that arise in the normal course of business. Except as otherwise discussed in Note 14, “Contingencies” to our Consolidated Financial Statements included in Part II, Item 8 of this report and “Insurance Industry Investigations and Other Developments” above, we do not believe we are a party to any claims, lawsuits or legal proceedings that will have a material adverse effect on our reported results of operations. We have accrued a liability in accordance with GAAP for our best estimate of the cost to resolve those claims where our liability is probable and can be reasonably estimated. This estimate has been developed in consultation with internal and external counsel that is handling our defense in these matters and is based upon a combination of litigation and settlement strategies. The establishment of reserves for claims and litigation requires management’s judgment. To the extent additional information arises or our strategies change, it is possible that our estimate of our accrued liability in these matters may change, which could have a material adverse effect on our results of operations for any particular quarterly or annual period.
On June 29, 2006, we acquired Frederick E. Penn Insurance Agency, Inc. (“Penn”), a P&C insurance operation. The aggregate preliminary purchase price of approximately $39.0 million, consisting of cash of $35.1 million and debt issued of $3.9 million, was allocated primarily to goodwill and other intangible assets. This acquisition is included in the Insurance Brokerage segment.
On July 27, 2006, we acquired Tandem Benefits (“Tandem”), a benefits communications and enrollment solutions provider. The aggregate preliminary purchase price of approximately $10.1 million, consisting entirely of cash, was allocated primarily to goodwill and other intangible assets. This acquisition is included in the Specialized Benefits Services segment.
On August 18, 2006, we acquired Universal American Insurance Agency, Inc. (“Lennar”), a P&C insurance operation. The aggregate preliminary purchase price of $18.5 million, consisting entirely of cash, was allocated primarily to other intangible assets. This acquisition is included in the Insurance Brokerage segment.
On December 20, 2004, our Board of Directors approved plans to sell, or otherwise dispose of, three operations in our Insurance Brokerage and Specialized Benefits Services segments that either exhibited significant earnings volatility or did not fit with our core business strategy. Additionally, in 2005, we announced plans to sell or otherwise dispose of four additional operations in the Insurance Brokerage segment that exhibited significant earnings volatility or that did not fit with our core business strategy, three of which were acquired in the first quarter of 2005 in the SGP acquisition. As a result of these actions, we recorded impairment charges in 2005 and 2004 of $5.8 million and $9.5 million, respectively, on the goodwill and other intangible assets of some of the operations. The historical results of operations for these entities have been reflected in our financial statements as discontinued operations in accordance with Statement of Financial Accounting Standards, or SFAS, No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” As of December 31, 2005, we had consummated the sale of substantially all of the assets of the businesses classified in discontinued operations.
The assets, liabilities and results of operations for these discontinued operations have been disaggregated in our financial statements. Discontinued operations had net losses of $10.2 million and $7.8 million for the years ended December 31, 2005 and 2004, respectively. The net loss for the years ended December 31, 2005 and 2004 include pre-tax impairment charges of $5.8 million and $9.5 million, respectively. For the year ended December 31, 2006, no income or loss from discontinued operations was recorded.
Integration Efforts: Historically, we have worked to integrate acquired businesses. Common activities include combining offices and eliminating redundant positions. Many of these activities happen over time following the close of an acquisition and the related expense is recorded in compensation and other operating expenses as a part of our continuing operations and as a deduction in determining GAAP net income. In 2006 and 2005, we recorded $1.4 million and $8.6 million, respectively, of such integration expenses. For purposes of evaluating performance of our operating companies, these expenses are excluded from the calculation of operating income.
Margin Improvement Plan: In the fourth quarter of 2004, we announced that our Board of Directors had approved a margin improvement plan in order to reduce ongoing operating expenses. As a result of this action, we recorded expense of $12.4 million for employee severance and related benefits for 28 employees of $3.4 million, facilities closures of $3.4 million, the modification of 34 sales professionals’ agreements of $2.9 million and service contract termination fees of $2.7 million. In 2005, we recorded an additional expense of $8.1 million for employee severance and related benefits of $6.1 million and the modification of 58 sales professionals’ agreements of $2.0 million. No such expenses were recorded in 2006. For purposes of evaluating performance of our operating companies, these expenses are excluded from the calculation of operating income.
While we are always focused on increasing margins, the 2004/2005 margin improvement plan was unique in its magnitude in that it principally addressed legacy issues from prior acquisitions. Similar future expenses are likely to be prospective and related to new acquisitions and will be captured as integration costs. Although we incurred $1.1 million in 2006 related to the closure of one office, we do not expect another margin improvement plan initiative similar in scope to the 2004/2005 plan. However, no assurances can be given that changes in economic circumstances, such as the loss of material revenues, could cause us to have to incur material similar expenses.
In March, 2006, we entered into a new $285.0 million senior secured credit facility. The proceeds from borrowings under the credit facility were drawn to repay all amounts under our previously existing credit facility. As a result of repaying the previously existing credit facility we recorded an expense of $2.1 million as early extinguishment of debt in remaining capitalized financing costs from the previous credit facility. At December 31, 2006, the balance in deferred financing costs was $2.6 million.
We believe that many analysts and investors regularly rely on non-GAAP financial measures to compare a company’s assessment of its operating profitability against that of its peers. We believe that investors use Organic Revenue growth (decline) to provide a financial measure by which to compare a company’s internally generated (as opposed to acquired) revenue to that of its peers. Organic Revenue growth (decline) may be helpful by eliminating the impact of acquired revenue from total revenues. This financial measure should not be considered as an alternative to other financial measures determined in accordance with GAAP.
Year Ended December 31, 2006 Compared with Year Ended December 31, 2005
Compensation and Employee Benefits Expenses. For 2006, the increase of $20.1 million was primarily due to the effect of acquisitions and to stock option expense of $3.2 million, offset somewhat by a decrease in bonus compensation of $1.9 million due to operating results. As a percentage of revenues, compensation and employee benefits expenses were 56.3% and 57.1% for 2006 and 2005, respectively. The improvement was due to the decrease in bonus expense and efficiencies from the margin improvement plan.
Other Operating Expenses. For 2006, the increase of $17.1 million was primarily due to the effect of acquisitions, higher enrollment costs in the Specialized Benefits Services segment and to $2.7 million in costs related to the transaction with GS Capital Partners. In 2006, we experienced a net decrease of $3.8 million in costs related to various insurance industry investigations, the implementation of Sarbanes-Oxley Section 404 procedures and corporate move expenses. As a percentage of revenues, other operating expenses were 24.0% for 2006, compared to 22.7% for 2005.
Total expenses. The $37.5 million increase in total expenses was due to the items noted above as well as an increase in interest expense of $5.7 million due to greater borrowings at higher interest rates, an increase in amortization expense of $4.0 million due to the impact of recent acquisitions, an impairment charge of $3.2 million and an increase in early extinguishment of debt of $2.1 million, offset by a decrease in margin improvement plan expense and acquisition integration expense of $8.1 million and $7.2 million, respectively.
Revenues. Of the $105.1 million in revenue growth, $103.1 million was due to acquisitions, net of disposed businesses, and $2.0 million was due to Organic Revenue growth (including contingents, interest and other income). Organic Revenue growth in 2005 was negatively affected by the softening rate environment for P&C insurance products, the direct bill adjustment and a decline in contingent and other income, net of acquired business.
Other Operating Expenses. For 2005, the increase of $22.2 million was primarily due to the effect of acquisitions. Additionally, for 2005, we incurred a net increase of $2.4 million in costs related to legal fees and costs related to various insurance industry investigations offset by a decrease of $3.0 million in costs related to the implementation of Sarbanes-Oxley Section 404 procedures and corporate move expenses. As a percentage of revenues, other operating expenses were 22.7% for 2005, compared to 23.1% for 2004.
Income From Continuing Operations. Comparisons of 2005 to 2004 are affected by the expense and revenue variances noted above and a lower effective tax rate in 2005.
In 2006 and 2005, revenues were positively impacted by approximately $31.8 million and $90.9 million, respectively, due to acquisitions. Organic Revenue growth (decline) in 2006 and 2005 was 2.0% and (1.2)%, respectively. Market conditions include the effect on our commission revenues due to the impact of premium rate changes and changes in our clients’ underlying exposure base. In 2006 and 2005, market conditions were generally soft in the P&C insurance market, leading to flat to negative Organic Revenues in that line of business. However, the market for employee benefits, which typically runs in a counter cycle to P&C insurance, was positive, mitigating the weakness in P&C insurance revenues. P&C insurance NCF represented 53.4%, 55.0% and 56.7% of our total consolidated NCF in 2006, 2005 and 2004, respectively, and employee benefits NCF represented 37.4%, 35.9% and 36.5% of our total consolidated NCF in 2006, 2005 and 2004, respectively.
The $3.6 million increase in revenues in 2006 is attributable to acquisitions of $7.9 million, offset somewhat by an Organic Revenue decline of $4.3 million. The Organic Revenue decline in 2006 is due to lower than expected performance on enrollments in the fourth quarter and the $2.5 million revenue adjustment related to the change in estimated policy cancellations on two large cases. The increase in revenues in 2005 was due to Organic Revenue growth, somewhat offset by the $1.4 million adjustment to direct bill revenues. Organic Revenue (decline) growth was (10.0)% and 20.7% in 2006 and 2005, respectively. Specialized Benefits Services NCF represented 9.2%, 9.1% and 6.8% of our total consolidated NCF in 2006, 2005 and 2004, respectively.
When considering our liquidity, it is important to note that we hold cash in a fiduciary capacity as a result of premiums received from clients that have not yet been paid to insurance carriers. The fiduciary cash is recorded as an asset on our balance sheet with a corresponding liability for premiums due to insurance carriers. We earn interest on these funds during the time between receipt of the cash and payment to insurance carriers. In some states, fiduciary cash must be kept in separate bank accounts subject to specific guidelines, which generally emphasize capital preservation and liquidity, and it is not available to service debt or for other corporate purposes. Insurance brokerage transactions typically generate large cash flows, and the timing of such cash flows can significantly affect the net cash balances held at month end.
Our revolving credit facility is available for loans denominated in U.S. dollars and for letters of credit. Borrowings under the revolving credit facility bear interest, at our option, at either a base rate plus an applicable margin ranging from 0.75% to 1.25% per annum or the Eurodollar rate plus an applicable margin ranging from 1.75% to 2.25% per annum, based on our total leverage ratio as defined in the credit facility at the time of borrowing. Additionally, there is a commitment fee on the unused portion of the revolving credit facility of from 0.375% to 0.500% per annum, based on our total leverage ratio as defined in the credit facility. The revolving credit facility may be used for acquisition financing and general corporate purposes. At December 31, 2006, availability under the revolving credit facility was $23.8 million having been reduced by $1.2 million for an outstanding letter of credit.
Working capital increased by $15.6 million to $71.2 million at December 31, 2006, compared to $55.6 million at December 31, 2005, principally due to the generation of cash from operating and financing activities, net of cash used in investing activities, primarily acquisitions.
At December 31, 2006, we had federal NOL carry-forwards of $15.1 million, comprised of acquired NOL carry-forwards. Our ability to use these NOL carry-forwards to offset future taxable income, if any, may be subject to limitations under Section 382 of the Internal Revenue Code of 1986, as amended, and similar state provisions. The provisions of Section 382 are triggered by specific ownership changes of our stock. The 2006 federal NOL carry-forwards are subject to Section 382 limitations, the effect of which has been included in our tax provision. If limited, the unused portion may then be carried forward to future years. In 2006 and 2005 we paid $15.8 million and $4.6 million, respectively, for state and federal income taxes.
In the third quarter of 2004, our largest shareholder, Capital Z, exercised warrants to purchase 1,810,000 shares of our stock at a strike price of $15.00 per share. The average of the high and low stock price over the ten trading days prior to exercise, or $15.66 per share, was used to calculate a net share issuance of 76,283 shares. The remaining warrants to purchase 689,997 shares of our stock at $15.00 per share expired unexercised in the third quarter of 2004.
On December 20, 2004, we announced that our Board of Directors authorized an expanded stock repurchase program that permits us to purchase our shares of common stock up to certain limits set forth within our credit facility. We had the capacity to purchase shares valued at up to $9.7 million and $11.0 million in 2005 and 2004, respectively. We did not purchase any shares in 2004. During 2006, we did not purchase any shares of our common stock under the expanded stock repurchase program.
As defined in our credit facility. Adjusted Pro Forma EBITDA is our actual trailing twelve months EBITDA adjusted to reflect the full year impact of businesses acquired or sold.
Substantially all of our office space is leased under operating leases. Many of these leases have options permitting renewals for additional periods and provisions for escalations based on an inflation index.
At December 31, 2006, we had future interest obligations under fixed rate notes, primarily acquisition related, of $1.1 million.
At December 31, 2006, an obligation under a long-term service contract of $0.5 million is included in “Other.”
We have one letter of credit totaling $1.2 million established as collateral for our workers’ compensation insurance program. Letters of credit which are outstanding reduce the borrowing availability under our revolving credit facility. The letter of credit referred to automatically renews annually on the anniversary date of issuance with a final expiration five business days prior to March 24, 2011, the maturity date of our revolving credit facility. Such off-balance sheet commitments are historically immaterial and we do not anticipate an increase in their importance to us in terms of liquidity or other benefits.