Because of soft market conditions, the growth of the alternative insurance market has slowed during the past two years. Although the property/casualty pricing environment has resulted in some insurance buyers returning to first- dollar coverage, management believes movement from this traditional approach of purchasing insurance will continue. The Company anticipates that new sales in the areas of risk management, benefits, insurance captive and self- insurance services will be a major factor in fee revenue growth in 1998.
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 generally have the effect of generating higher premiums to clients and higher commissions to the Company. In recent years, lower rates of inflation along with business downsizing, reduced sales and lower payrolls have resulted in lower levels of exposure to insure. In general, the downward trend in premium rates has had a greater effect on the Company's revenues than inflation.
Fee revenues increased by $9.1 million or 5% in 1997. This increase, generated primarily by Gallagher Bassett Services, Inc., resulted from new business production and increases in existing business partially offset by lost business. Fee revenues increased by $9.7 million or 6% in 1996. This increase, again generated primarily by Gallagher Bassett, resulted from new business production and modest increases in existing business partially offset by lost business. The rate of increase in fee revenues in 1997 and 1996 has been adversely affected by strong price competition within the insurance industry, causing some buyers to choose first-dollar coverage over self-funded plans.
Investment income and other increased by $9.1 million or 38% in 1997. This increase is due primarily to gains of $6.8 million recognized on the sale of underperforming or geographically undesirable operations during the year, a $1.8 million gain on a real estate transaction recorded in the second quarter and net realized gains on marketable securities of $1.9 million. Investment income and other increased by $2.1 million or 10% in 1996. This increase is due primarily to an increase in unrealized gains on investment strategies accounted for on a trading basis, which are invested with outside fund managers.
The Company's foreign operations recorded earnings before income taxes of $6.6 million, $4.2 million and $3.4 million in 1997, 1996 and 1995, respectively. The 1997 increase is due to the non-recurring gains associated with the foreign benefit plan and real estate transactions mentioned above. The 1996 increase is due primarily to a decrease in compensation-related costs at the Company's London subsidiaries. See Notes 12 and 13 to the Consolidated Financial Statements.
The Company's total revenues vary from quarter to quarter as a result of the timing of policy renewals and net new/lost business production, whereas expenses are fairly uniform throughout the year. See Note 14 to the Consolidated Financial Statements.
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 $65.6 million and $44.9 million for the years ended December 31, 1997 and 1996, respectively. Because of the variability related to the timing of fees receivable and premiums receivable and payable, net cash flow from operations for the Company can vary substantially from period to period. Funds restricted as to the Company's use, primarily premiums held as fiduciary funds, have not been included in determining the Company's liquidity.
The Company maintains a $20.0 million unsecured revolving credit agreement (the "Credit Agreement") requiring repayment of any loans under the agreement no later than June 30, 2001. As of December 31, 1997
The Company has made commitments to invest additional funds in several of its equity and tax advantaged investments. At December 31, 1997, the Company has commitments to invest $26.0 million in these investments in 1998. In addition, the Company has contingently committed to invest an additional $3.0 million in 1998 related to a line of credit arrangement with one of its equity investments. At December 31, 1997, the Company has agreed to unconditionally guarantee $30.0 million of debt that will be incurred by two of the Company's equity investments in 1998.
Net capital expenditures for fixed assets amounted to $11.3 million, $10.2 million and $10.4 million in 1997, 1996 and 1995, respectively. In 1998, the Company expects to make expenditures for capital improvements of approximately $11.5 million. The planned capital expenditures by the Company in 1998 are related primarily to expanded offices and updating computer systems and equipment. With respect to dates in the year 2000 and thereafter, the Company has completed an assessment of its computer systems and software. The Company plans to modify or replace portions of its existing software so that its computer systems will function properly in the year 2000. Generally, these modifications and replacements were contemplated with normal system enhancements and improvements. The cost of compliance is not expected to be material and the Company plans to complete the required software modifications or replacements in 1998.
In 1988, the Company adopted a plan, which has been extended through June 30, 1998, to repurchase its common stock. Under the plan, the Company repurchased 522,000 shares at a cost of $17.1 million, 645,000 shares at a cost of $21.3 million, and 437,000 shares at a cost of $15.1 million in 1997, 1996 and 1995, respectively. The repurchased shares are held for reissuance in connection with exercises of options under its stock option plans. Under the provisions of the plan, the Company is authorized to repurchase approximately 300,000 additional shares through June 30, 1998. The Company is under no commitment or obligation to repurchase any particular amount of common stock and at its discretion may suspend the repurchase plan at any time.
During the period from 1994 to 1996, the Company provided for U.S. income taxes on the undistributed earnings of its foreign subsidiaries. Due to changes in the United States federal income tax laws effective in 1997, the Company no longer provides for U. S. income taxes on these undistributed earnings ($27.2 million at December 31, 1997), which are considered permanently invested outside the United States. See Note 12 to the Consolidated Financial Statements. Although not available for domestic needs, the undistributed earnings generated by certain foreign subsidiaries referred to above may be used to finance foreign operations and acquisitions.
Marketable securities are considered available for sale and consist primarily of preferred and common stocks. Securities designated as available for sale are carried at fair value in the accompanying consolidated balance sheet, with unrealized gains and losses, less related deferred income taxes, excluded from earnings and
Intangible assets consist of the excess of cost over the value of net tangible assets of acquired businesses, non-compete agreements and expirations lists. The excess of cost over the value of net tangible assets is amortized principally over forty years using the straight-line method. Non-compete agreements and expiration lists are amortized principally over ten years using the straight-line method. Accumulated amortization at December 31, 1997 and 1996 was $6,029,000 and $6,335,000, respectively.
The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," and, accordingly, recognizes no compensation expense for the stock options granted to employees.
In June 1997, the FASB also issued Statement of Financial Accounting Standards No. 131 (SFAS 131), "Disclosure about Segments of an Enterprise and Related Information," which is effective for years beginning after December 15, 1997. SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to stockholders. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company has not completed all of the analyses required to determine the full impact of SFAS 131.
The following is a summary of available for sale marketable securities (in thousands):
The gross realized gains on sales of marketable securities totaled $2,257,000, $1,652,000 and $1,079,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The gross realized losses totaled $346,000, $881,000 and $1,918,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
The cost or amortized cost and fair value of fixed maturities at December 31, 1997, by contractual maturity, are as follows (in thousands):
The Company maintains a $20,000,000 variable-rate (based on LIBOR plus .4%) unsecured revolving credit agreement which expires on June 30, 2001. As of December 31, 1997 and 1996, there were no borrowings outstanding under this agreement.
The Company also has line of credit facilities of $27,500,000 which expire on April 30, 1998. Short-term borrowings under these facilities totaled $15,000,000 and $10,000,000 at December 31, 1997 and 1996, respectively. The weighted average interest rate on the short-term borrowings during 1997 and 1996 were 6.5% and 6.9%, respectively.
Other information regarding stock options outstanding and exercisable at December 31, 1997 is summarized as follows (in thousands, except exercise price data):
The assumed healthcare cost trend rate used for the next year is 8.5%, scaling down to 4.5% after 11 years. A 1% increase in the assumed healthcare cost trend rate would increase the accumulated postretirement benefit obligation by $1,471,000 at December 31, 1997 and would increase the net periodic postretirement benefit cost for 1997 by $98,000.
Minimum aggregate rental commitments at December 31, 1997 under noncancelable operating leases having an initial term of more than one year are as follows (in thousands):
The Company has made commitments to invest additional funds in several of its equity and tax advantaged investments. At December 31, 1997, the Company has made commitments to invest $26,000,000 in these investments in 1998. In addition, the Company has contingently committed to invest an additional $3,000,000 in 1998 related to a line of credit arrangement with one of its equity investments. At December 31, 1997, the Company has agreed to unconditionally guarantee $30,000,000 of debt that will be incurred by two of the Company's equity investments in 1998.
During the period from 1994 to 1996, the Company provided for U.S. income taxes on the undistributed earnings of its foreign subsidiaries. Due to changes in the U.S. federal income tax laws effective in 1997 the Company no longer provides for U.S. income taxes on the undistributed earnings ($27,200,000 at December 31, 1997) 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 $6,500,000 at December 31, 1997.
The accompanying consolidated financial statements include liabilities of $127,048,000 and $107,053,000 at December 31, 1997 and 1996, respectively, after elimination of intercompany balances, applicable to foreign operations.
The 1996 and first three quarters of 1997 net earnings per share amounts have been restated to conform to the SFAS 128 requirements.
The Management of Arthur J. Gallagher & Co. is responsible for the preparation and integrity of the consolidated financial statements and the related financial comments appearing in this annual report. The consolidated financial statements were prepared in accordance with generally accepted accounting principles and include certain amounts based on management's best estimates and judgments. Other financial information presented in the annual report is consistent with the consolidated financial statements.
Ernst & Young LLP, independent auditors, has audited the Company's consolidated financial statements and their report is presented herein.
We have audited the accompanying consolidated balance sheet of Arthur J. Gallagher & Co. as of December 31, 1997 and 1996, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.