· determining the right locations for our administration centers and resourcing them so that they can deliver the right level of service value efficiently and cost effectively.
· a clear path of career development for our people; and
· further controlling our expenses by re-examining everything we do on a day-to-day basis and whether we can do it more efficiently;
· salaries and benefits as a percentage of revenues to be less than 54 percent;
Net income in 2006 was $449 million, or $2.84 per diluted share, compared with $281 million, or $1.72 per diluted share, in 2005. This increase reflected good organic revenue growth, improved operating margin and the benefit of a $71 million tax credit in the fourth quarter which primarily related to the resolution of certain prior year tax matters.
Total revenues at $2,428 million were $161 million, or 7 percent, higher than in 2005 as organic revenue growth of 8 percent, reflecting net new business growth in all our business units, more than offset a small reduction in market remuneration.
The year on year improvement in 2006 operating margin also reflected lower pension charges than in 2005, the benefit of net new business and increased productivity from recent hires. These were partly offset by the impact of lower market remuneration.
disposal due to capital losses carried forward, we recognized a tax charge of $8 million on the disposal. The sale of our building, less related leaseback costs, contributed $0.58 to 2006 earnings per diluted share.
We incurred $105 million of costs in 2006 on initiatives to support our “Shaping Our Future’’ strategy set out above. $101 million of this expenditure was incurred in second half 2006 and relates to the following initiatives:
In addition to the significant expenditure in second half 2006, we incurred professional fees for platform redesign of $4 million in the first half of the year.
In 2007, we anticipate that we will continue to grow organic revenue and to expand operating margin modestly. We also expect that our adjusted effective tax rate (tax rate excluding the effect of tax gains and losses on disposals and other one-time items) will be approximately 31 percent.
As announced at our Investor Day in June 2006, we will seek opportunities to acquire new business revenues of $50 million to $100 million per year over the next five years, with acquisitions focused on targeted geographies and areas that will reinforce our core businesses. Through 2006, we spent a total of $98 million on acquisitions: completing eight acquisitions of subsidiaries with annual revenues of approximately $30 million for $73 million, net of cash acquired, and purchasing an additional 5 percent of Gras Savoye & Cie, our French associate, for $25 million which increased our ownership to 38 percent.
Cash at December 31, 2006 was $288 million, $95 million higher than at December 31, 2005. Net cash from operating activities was $147 million despite contributions to the UK and US pension schemes totaling $268 million. This, together with a $200 million drawdown on our revolving credit facility and the $202 million received from the sale of our London headquarters, was used to fund share buybacks of $211 million, dividends of $145 million and acquisitions totaling $98 million.
During 2004, we saw a rapid transition from a hard market, with premium rates stable or increasing, to a soft market, with premium rates falling in most markets. The soft market continued throughout 2005, although the rate of decline moderated in the latter part of the year. In addition to the effect of declining rates, the latter part of 2004 and 2005 were also impacted by widespread changes to market practices following various regulatory investigations. These changes included the elimination of volume and profit-based contingents for global brokers and a significant reduction in other remuneration received from the market.
(ii) Organic revenue growth excludes the impact of foreign currency translation, acquisitions and disposals, and market remuneration from reported revenues. We use organic growth as a measure of business growth generated by operations that were part of the Group at the end of the period. Our method of calculating this measure may differ from that used by other companies and therefore comparability may be limited.
Organic revenues in 2006 were 8 percent higher than in 2005 reflecting strong net new business growth in all our operations. There was a net negligible year on year impact from rates and other market factors as the impact of generally declining rates was offset by other factors, including higher commission rates, higher insureds and changes in limits or exposures, together with significant rate increases in areas with exposures to windstorm and catastrophe.
North America: North America reported 7 percent organic revenue growth in 2006, with strong growth across the business reflecting the results of our hiring strategy over the past two years and our sales culture. Geographies doing particularly well in the year include the Northeast, Central and Southeast. Our Executive Risks and Employee Benefits practices also continued to perform well.
Net acquisitions and disposals added 1 percent to total revenues in 2005 compared with 2004. In Global, the benefit of recent acquisitions, mainly the Coyle Hamilton and Opus acquisitions in second half 2004, was offset by the impact of the Stewart Smith sale in April 2005. In North America, growth attributable to acquisitions was mainly due to the CGI Consulting and Primary acquisitions in first quarter 2005.
Market remuneration was significantly lower in 2005 at $29 million compared with $148 million in 2004. This reduction followed our announcement in October 2004 that we were voluntarily abolishing contingent commission arrangements.
Organic revenues in 2005 were 5 percent higher than in 2004, with net new business growth in all our operations and improved client retention in 2005 only partly offset by soft or declining rates in most of our markets.
Global: Organic revenues were 5 percent higher in 2005 compared with 2004. Rates were soft in virtually all the sectors we operated in and in the reinsurance market we saw a trend towards more centralized buying and higher retentions. Despite the highly competitive market, net new business growth improved and we saw some benefit in the London market from market remuneration migrating to fees. Our Aerospace and Niche businesses in Global Specialties performed well.
North America: North America reported 5 percent revenue growth in 2005 compared with 2004 despite declining rates particularly in the first half of 2005. Net new business growth remained robust
across all regions and businesses with improved retention rates also a significant contributor. Overall, most regional sectors performed well and we saw good growth in the financial institutions and large account practices. In our large account practice, we saw a sustained increase in requests for proposals with total new business in 2005 higher than that achieved in 2004.
General and administrative expenses at $1,911 million for 2006 were $122 million, or 7 percent, higher than in 2005. Foreign currency translation had a net 1 percent adverse impact and there was a net nil impact from acquisitions net of disposals.
the pension charge in 2006 was $33 million lower than in 2005 which was mainly attributable to an increased return on assets in the UK plan due to higher asset levels, reflecting the good returns in 2005 and increased contributions by the Company, and an increase in the expected rate of return assumption from 7.25 percent to 7.75 percent. In addition, the US charge benefited from savings attributable to the 2005 headcount reduction program; and
severance costs were $41 million in 2006 of which $35 million related to our strategic initiatives under which nearly 500 positions have been eliminated. Severance costs were $30 million in 2005 of which $28 million related to a headcount reduction program in first quarter 2005 under which approximately 500 positions were eliminated. We do not expect to initiate a major headcount reduction program in 2007 and therefore expect severance costs will be significantly lower in 2007 compared with both 2006 and 2005;
· the $37 million expenditure on strategic initiatives in 2006; partly offset by
· an additional $20 million provision for legal claims following the March 31, 2005 review of legal proceedings and $9 million of legal costs relating to the 2005 regulatory settlements.
As discussed in detail in Note 9 to our Consolidated Financial Statements, we entered into agreements with the New York Attorney General, the New York Superintendent of Insurance and the Minnesota Attorney General in second quarter 2005 under which we paid $51 million into bank accounts for reimbursement funds.
Operating margin was 23 percent in 2006 compared with 20 percent in 2005. Our margins in 2006 and 2005 have been impacted by a number of significant items:
· the $102 million profit on the sale of our UK head office in second half 2006 (equivalent to 4 percent of revenues);
· $105 million of expenditure in 2006 in support of our “Shaping Our Future’’ strategic initiatives (equivalent to 4 percent of revenues);
· first quarter 2005 charges for: regulatory settlements and related costs, $60 million; the first quarter 2005 headcount reduction program, $28 million; and a $20 million additional charge for legal provisions following the March 31, 2005 review of legal proceedings (in total, equivalent to 5 percent of revenues).
The year on year improvement in 2006 operating margin also reflected lower pension charges, the benefit of net new business and increased productivity from recent hires, partly offset by the impact of lower market remuneration.
Operating margin at 20 percent for 2005 was significantly lower than 2004 and was impacted by:
· the first quarter 2005 provision for regulatory settlements of $51 million and related legal costs of $9 million;
· an additional $20 million increase in the provision for claims following the March 31, 2005 review of legal proceedings; and
The net effect of these items was to reduce operating margin by 1 percent. The remaining decline in operating margin was mainly attributable to: the $119 million reduction in market remuneration; increased retention and recruitment costs; the impact of foreign currency translation; and the effect of Stewart Smith which was sold in April 2005.
The effective tax rate in 2006 was 12 percent compared with 34 percent in 2005. The lower effective tax rate was primarily attributable to a $65 million tax credit arising in fourth quarter 2006 and a low effective tax rate on the capital gain on the disposal of our UK head office building. The tax credit reflects the resolution of complex tax issues relating to the original KKR acquisition structure and subsequent internal restructurings. In addition, there was a $6 million credit in fourth quarter 2006 relating to deferred tax on acquired intangibles. The $71 million fourth quarter tax credit contributed $0.45 to diluted earnings per share in 2006.
equivalent to $0.22 per diluted share; the $19 million post-tax cost of the first quarter 2005 headcount reduction program, equivalent to $0.12 per diluted share; the $14 million post-tax cost of the additional $20 million provision for legal claims following the March 31, 2005 review of legal cases, equivalent to $0.09 per diluted share; and the $41 million post-tax net gain on disposal of operations primarily relating to the second quarter 2005 sale of Stewart Smith, equivalent to $0.25 per diluted share. The decrease excluding these significant items was mainly attributable to the reduction in market remuneration; increased retention and recruitment costs; the impact of foreign currency translation; and the effect of Stewart Smith which was sold in April 2005; partly offset by the lower tax rate.
Excluding the gain on disposal in second quarter 2005, Stewart Smith’s results contributed $Nil to net income per diluted share in 2005 and $0.12 in 2004. The following table shows the impact of Stewart Smith on results in the periods prior to sale:
Foreign currency translation reduced net income per diluted share by approximately $0.06 for fiscal 2005 compared with fiscal 2004.
The Company has two principal defined benefit plans: one in the United Kingdom and the other in the United States. Prior to January 1, 2006, the market-related value of the UK pension plan assets was determined using a calculated value that recognized asset gains or losses over five years whereas the market-related value of US pension plan assets was determined on a fair value basis. Effective January 1, 2006, the Company changed its method for determining the market-related value of UK pension plan assets to a fair value basis. The Company believes that fair value is a preferable measure of determining the market-related value of plan assets as it more fairly reflects the actual value of pension plan assets as of the balance sheet date. In addition, it aligns the methodology used for calculating the market-related value of plan assets for the Company’s two principal defined benefit plans.
The impact of this retrospective adjustment is to increase the UK pension charge for 2005 by $10 million to $41 million and for 2004 by $27 million to $35 million, with a related adverse impact on diluted earnings per share for 2005 of $0.04 and on 2004 diluted earnings per share of $0.09. The increase in the 2005 and 2004 UK pension charges as a result of the change in accounting methodology is mainly attributable to the recognition under the fair value method of net prior period asset losses brought forward at January 1, 2005 and 2004 that had previously been deferred under the calculated value methodology. The recognition of these losses:
If we had used the previous calculated value methodology in 2006, the UK pension expense for 2006 would have been $23 million higher. The lower charge under the new fair value methodology mainly reflects the recognition of net asset gains at January 1, 2006 that would have been deferred under the calculated value methodology. The recognition of these gains:
· In September 2006, the Financial Accounting Standards Board issued FAS 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R) (‘FAS 158’), which required an employer to:
· disclose additional information in the notes to the financial statements about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits and transition asset or obligation.
The requirements of FAS 158 are applied prospectively upon adoption. The requirements to recognize the funded status of a defined benefit postretirement plan and provide related disclosures are effective for fiscal years ending after December 15, 2006, and have been applied for the year ended December 31, 2006. The adoption of FAS 158 has resulted in a $189 million post tax charge to other comprehensive income as at December 31, 2006.
We maintain defined benefit pension plans that cover almost all our employees in the United States and United Kingdom, although the UK plan was closed to new entrants in January 2006. New entrants in the United Kingdom will now be offered the opportunity to join a defined contribution plan. Elsewhere, pension benefits are typically provided through defined contribution plans.
Effective January 1, 2006 we increased our long-term expected rate of return assumption for our UK pension plan assets from 7.25 percent to 7.75 percent. This change reflects management’s best estimate of the longer term performance of the UK fund taking into account average returns over the last ten years, the current asset mix and market expectations. The increase in the long-term rate of return on assets assumption benefited the 2006 pension expense by approximately $9 million.
Net pension expense for our defined benefit pension plans in 2006 was $29 million, a decrease of $33 million compared with 2005 of which $25 million related to the UK plan. The decrease in the UK expense was mainly attributable to an increased return on assets in the UK plan due to higher asset
The expected long-term rate of return used for determining the net US pension expense in 2006 was 8.0 percent, compared with an actual return of 14.6 percent. The rate used to discount US plan liabilities at December 31, 2006 was 6.0 percent, determined based on expected plan cash flows discounted using a corporate bond yield curve, an increase of 0.25 percent compared with the rate used at December 31, 2005.
We are subject to the income tax laws of the various tax jurisdictions in which we operate, principally the United States and United Kingdom. These tax laws are complex and subject to different interpretations by taxpayers and the tax authorities. When establishing income tax provisions, we therefore make a number of judgments and interpretations about the application and interaction of these tax laws. We have estimated tax reserves that we believe are adequate in relation to the potential for future assessments. Once established, we only adjust tax reserves when more information is available or when an event occurs necessitating a change to tax reserves. Changes in these tax laws or our interpretations of these laws and the resolution of current and future tax audits could significantly impact our effective tax rate and results of operations in a given period.
We purchase professional indemnity insurance which in part covers the errors and omission claims arising in the ordinary course of business. The terms of this insurance vary by policy year and self-insured risks have increased significantly over recent years. We have established provisions against various actual and potential claims, lawsuits and other proceedings relating principally to alleged errors and omissions in connection with the placement of insurance and reinsurance in the ordinary course of business. Such provisions cover claims that have been reported but not paid and also claims that have been incurred but not reported. These provisions are established based on actuarial estimates together with individual case reviews and are believed to be adequate in the light of current information and legal advice.
The Company has evaluated the impact of adopting FIN 48 and has concluded that it will not be material.
On July 26, 2006 the Board authorized a new share buyback program for $1 billion. This replaced our previous $500 million buyback program and its remaining $140 million authorization. We purchased 5.4 million shares in 2006 at a cost of $211 million, including 3.8 million shares under an accelerated share repurchase program, leaving us with $789 million remaining under our $1 billion buyback authorization at December 31, 2006. Market conditions permitting, we expect to utilize the remaining authorization over the next two years or sooner if possible. We believe that the strength of our balance sheet would allow us to increase our leverage to fund some of these additional buybacks.
In September 2006, we acquired a further 5 percent of Gras Savoye & Cie, our French associate, for $25 million bringing our total interest to 38 percent. The acquisition was pursuant to a put arrangement we entered into in 1997, see ‘Contractual Obligations’ below.
In September 2006, we also completed the sale of our UK head office at Ten Trinity Square. Gross proceeds from the sale were $202 million. We have leased back the property at an annual rental of $12 million until 2008 when we expect to move into our new London offices.
Cash used for acquisitions in 2004 totaled $147 million (net of cash acquired). The cash was used primarily for the acquisitions of: Coyle Hamilton, the Republic of Ireland’s largest privately owned insurance broker; the controlling interest in Willis A/S, Denmark’s largest insurance broker; two reinsurance brokers in Italy and Denmark; and Opus, a regional insurance broking business in the United Kingdom.
We continued to buy back shares in 2006, repurchasing 5.4 million shares for $211 million during the year compared with 10.3 million shares for $360 million in 2005 and 9.3 million shares at a cost of $339 million in 2004.
We increased our external debt by $200 million in 2006 by drawing down on our revolving credit facility, with the increase primarily funding our increased pension contributions. In 2005, the completion of our senior notes offering of $600 million in July 2005 and the subsequent repayment of the $450 million term loan generated a net cash inflow of $143 million. There was a net inflow of $63 million from refinancing debt in 2004.
Cash dividends paid in 2006 were $145 million compared with $135 million in 2005 and $115 million in 2004. In February 2007, the quarterly cash dividend declared was increased by 6 percent to $0.25 per share, an annual rate of $1.00 per share. At this rate, the expected annual cost of dividends payable in 2007 will be approximately $150 million. We have funded dividends from cash generated internally by operations and expect to do so in the future.
(ii) Based on the earliest dates on which options could be exercised
In November 2004, we entered into a 25 year agreement with British Land plc relating to our new UK headquarters in London. Construction commenced in early 2005 and our occupancy is targeted for early 2008. Our contractual obligations in relation to this commitment totaling $918 million are included in the table above, but are contingent upon the successful completion of construction.
Following changes to UK pensions legislation in 2005, we are now required to agree a funding strategy for our UK defined benefit plan with the plan’s trustees. In January 2006, we agreed to make additional 2007 contributions of $98 million.
As part of the 1997 acquisition of our initial 33 percent shareholding of Gras Savoye, we entered into a put arrangement, whereby the other shareholders in Gras Savoye (primarily two families, two insurance companies and Gras Savoye’s executive management team) could put their shares to us. Until 2011, we will be obligated to buy the shares of certain shareholders to the extent those shareholders put their shares, potentially increasing our ownership from 38 percent to 90 percent if all shareholders put their shares, at a price determined by a contractual formula based on earnings and revenue. We acquired an additional 5 percent of Gras Savoye at a cost of $25 million under these arrangements in September 2006. Management shareholders of Gras Savoye (representing approximately 10 percent of shares) do not have general put rights before 2011, but have certain put rights on their death, disability or retirement from which payments, at December 31, 2006 based on the formula would not have exceeded $64 million. The shareholders may put their shares individually at any time during the put period.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for each of the three years in the period ended December 31, 2006
We have also audited in accordance with the standards of the Public Company Accounting Oversight Board (United States) the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
As discussed in Note 2, the accompanying 2005 and 2004 financial statements have been retrospectively adjusted for the adoption of Statement of Financial Accounting Standards No. 123R, Share Based Payment, and retrospectively adjusted for the change in method for determining the market related value of plan assets of the Company’s UK defined benefit pension plan from a calculated value method to the fair value method.
(a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FAS 123, Accounting for Stock-Based Compensation, and
In September 2006, the Financial Accounting Standards Board (‘‘FASB’’) issued FAS 158 which required an employer to:
· the line items in the consolidated financial statements as a result of the adoption of FAS 158.
The following tables present the line items on the consolidated statement of operations for the years ended December 31, 2005 and 2004 that were retrospectively adjusted to reflect the accounting changes:
The following table presents the line items on the consolidated balance sheet at December 31, 2005 which were retrospectively adjusted to reflect the accounting changes:
The following table presents the cumulative effect of the accounting changes as of January 1, 2005:
The following table presents the line items on the consolidated statement of comprehensive income at December 31, 2006 that were affected by the change in the method for determining the market related value of plan assets:
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in tax positions.
Fiduciary funds-restricted represent unremitted premiums received from insureds and unremitted claims received from insurers. Fiduciary funds are generally required to be kept in certain regulated bank accounts subject to guidelines which emphasize capital preservation and liquidity; such funds are not available to service the Company’s debt or for other corporate purposes. Notwithstanding the legal relationships with clients and insurers, the Company is entitled to retain investment income earned on
fiduciary funds in accordance with industry custom and practice and, in some cases, as supported by agreements with insureds.
Included in fiduciary funds-restricted are cash and cash equivalents consisting primarily of time deposits. The debt securities are classified as available-for-sale. Accordingly, they are recorded at fair market value with unrealized holding gains and losses reported, net of tax, as a component of other comprehensive income. As of December 31, 2006 and 2005, the amortized cost of such securities approximated fair value.
Long-lived assets and certain identifiable intangible assets are required to be reviewed for impairment in accordance with FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. An
Rentals payable on operating leases are charged to expense over the lease term as the rentals become payable.
For certain subsidiaries and associates, the Company has the right to purchase shares (a call option) from co-shareholders at various dates in the future. In addition, the co-shareholders of certain subsidiaries and associates have the right to sell their shares (a put option) to the Company at various dates in the future. Generally, the exercise price of such puts and calls is formula-based (using revenues and earnings) and is designed to reflect fair value. These put and call options fall outside the scope of FAS 133, Accounting for Derivative Instruments and Hedging Activities, and are not therefore marked to market. Hence provision is made for any put options that are out of the money at the balance sheet date.
The Company accounts for income taxes under the provisions of FAS No. 109, Accounting for Income Taxes (“FAS 109”). The Company is subject to the income tax laws of the various tax jurisdictions in which the Company operates, principally the United States and United Kingdom. These tax laws are complex and subject to different interpretations by taxpayers and the tax authorities. When establishing income tax provisions, the Company therefore makes a number of judgments and interpretations about the application and interaction of these tax laws. The Company has estimated tax reserves that management believe are adequate in relation to the potential for future assessments. Once established, the Company only adjusts tax reserves when more information is available or when an event occurs necessitating a change to tax reserves. Changes in these tax laws or our interpretations of these laws and the resolution of current and future tax audits could significantly impact the Company’s effective tax rate and results of operations in a given period.
FAS 109 requires recognition of deferred tax assets and liabilities for the estimated future tax consequences of events attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating and capital loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted rates in effect for the year in which the differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of changes in tax rates is recognized in the statement of operations in the period in which the enactment date changes. Deferred tax assets and liabilities are reduced through the establishment of a valuation allowance at such time as, based on available evidence, it is more likely than not that the deferred tax assets will not be realized.
The net periodic cost of the Company’s defined benefit plans are measured on an actuarial basis using the projected unit credit method and several actuarial assumptions. The most significant of which are the discount rate and the expected long-term rate of return on plan assets. Other material assumptions include rates of participant mortality, the expected long-term rate of compensation and pension increases and rates of employee termination.
Gains and losses occur when actual experience differs from actuarial assumptions. If such gains or losses exceed ten percent of the greater of plan assets or plan liabilities the Company amortizes those gains or losses over the average remaining service period of the employees.
Contributions to the Company’s defined contribution plans are recognized as they fall due. Differences between contributions payable in the year and contributions actually paid are shown as either other assets or other liabilities in the consolidated balance sheet.
The Company accounts for share-based compensation in accordance with FAS 123R which replaced FAS 123 and superseded APB 25. The main provisions of FAS 123R require that
· the fair value is recognized (generally as compensation cost) over the requisite service period for all awards that vest; and
· compensation cost is not recognized for awards that do not vest because service or performance conditions are not satisfied.
received, or when formal, written notification of the actual amount due was received from the insurance carrier. If some of the commissions received were potentially subject to full or partial repayment to the carrier, then recognition was deferred until the conditions for repayment had passed.
Total proceeds for 2006 were $6 million, inclusive of $3 million relating to 2006 dispositions of subsidiaries and associates and $3 million of deferred proceeds, with a loss on disposal of $4 million recorded in the consolidated statement of operations.
Total proceeds relating to 2004 dispositions of subsidiaries and associates amounted to $10 million, inclusive of deferred proceeds amounting to $2 million, with a gain of $11 million recorded in the consolidated statement of operations.
(2005: $110 million) is reduced in future years to recognize deferred tax assets, an amount of up to $73 million (2005: $77 million) will be allocated to reduce goodwill.
The Company recognizes deferred tax balances (2005: current and deferred tax balances) related to the undistributed earnings of subsidiaries when the Company expects that it will recover those undistributed earnings in a taxable manner, such as through receipt of dividends or sale of the investments. The Company does not, however, provide for income taxes on the unremitted earnings of certain other subsidiaries where, in management’s opinion, such earnings have been indefinitely reinvested in those operations, or will be remitted either in a tax free liquidation or as dividends with taxes substantially offset by foreign tax credits. It is not practical to determine the amount of unrecognized deferred tax liabilities for temporary differences related to these investments.
This plan, which was established on December 18, 1998, provides for the granting of time-based and performance-based options to employees of the Company. There are 30,000,000 shares available for grant under this plan provided, however, that in no event the total number of shares subject to options and other equity for current and future participants exceed 25 percent of the equity of Willis Group Holdings on a fully diluted basis. All options granted under this plan are exercisable at £2 per share ($3.92 using the year-end exchange rate of £1 = $1.96) except for 111,111 time-based options which are exercisable at $13.50. No further grants are to be made under this plan.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model that uses the assumptions noted in the following table. Expected volatility is based on historical volatility of the Company’s stock. With effect from January 1, 2006, the Company uses the simplified method set out in Staff Accounting Bulletin No.107 to derive the expected term of options granted. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
A summary of option activity under the Plans at December 31, 2006, and changes during the year then ended is presented below:
(1) Certain options are exercisable at £2 per share. The year-end exchange rate of £1 = $1.96 has been used as of December 31, 2006.
The weighted average grant-date fair value of time-based options granted during the year ended December 31, 2006 was $9.82 (2005: $8.33; 2004: $5.98). The total intrinsic value of options exercised during the year ended December 31, 2006 was $26 million (2005: $77 million; 2004: $234 million). At December 31, 2006 there was $72 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements under time-based stock option plans; that cost is expected to be recognized over a weighted average period of two years.
No performance-based options were granted during the three years ended December 31, 2006. The total intrinsic value of options exercised during the year ended December 31, 2006 was $18 million (2005: $68 million; 2004: $149 million). At December 31, 2006 there was no unrecognized compensation cost related to nonvested share-based compensation arrangements under performance-based stock option plans.
A summary of restricted stock unit activity under the Plans at December 31, 2006, and changes during the year then ended is presented below:
For the year ended December 31, 2006, time-based and performance-based options to purchase 15.0 million and 0.4 million (2005: 11.8 million and 1.0 million; 2004: 14.0 million and 3.0 million) shares, respectively, and 1.1 million restricted shares (2005: 0.3 million and 2004: 0.4 million), respectively, were outstanding.
Options to purchase 5.7 million shares for the year ended December 31, 2006 were not included in the computation of the dilutive effect of stock options because the effect was antidilutive (2005: 4.9 million shares; 2004: 5.0 million shares).
Of the $41 million charge for severance costs for the twelve months ended December 31, 2006, $27 million was paid in the year and $14 million has been carried forward at December 31, 2006. In some countries, termination cash payments are spread over periods of up to two years. The Company expects to have paid the majority of the remaining $14 million of these costs by December 31, 2007.
As of December 31, 2006, the aggregate future minimum rental commitments under all non-cancellable operating lease agreements are as follows:
Guarantees issued by certain of Willis Group Holdings’ subsidiaries with respect to the Senior Credit Facility are discussed elsewhere in these consolidated financial statements.
Errors and omissions claims, lawsuits and other proceedings arising in the ordinary course of business are covered in part by professional indemnity or other appropriate insurance. The terms of this insurance vary by policy year and self-insured risks have increased significantly over recent years. In respect of self-insured risks, the Company has established provisions which are believed to be adequate in the light of current information and legal advice, and the Company adjusts such provisions from time to time according to developments.
On the basis of current information, the Company does not expect that the actual claims, lawsuits and other proceedings, to which the Company is subject, or potential claims, lawsuits and other proceedings relating to matters of which it is aware will ultimately have a material adverse effect on the Company’s financial condition, results of operations or liquidity. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company’s results of operations or cash flows in particular quarterly or annual periods.
with regulators and attorneys general about their investigations but cannot predict at this time how or when those investigations will be resolved.
Our operations in nine European countries have received questionnaires from either the European Commission pursuant to its Sector Inquiry or, in respect of Norway, the European Free Trade Association Surveillance Authority, related to insurance business practices, including compensation arrangements for brokers. At least 150 other European brokers received similar questionnaires. We responded to the European Commission questionnaires within the timeframe set and have filed the European Free Trade Association Surveillance Authority for two of our Norwegian entities within the agreed timeframes. The European Commission reported on an interim basis on January 24, 2007. The Interim Report included preliminary findings of potential conflicts of interest relating to remuneration by assuming a dual role for clients and insurers. The European Commission has requested by way of consultation, responses to the Interim Report by April 10, 2007 and anticipates publishing a final report in September 2007. We continue to co-operate with both the European Commission and the European Free Trade Association Surveillance Authority.
In August 2004, a proceeding was commenced in the Superior Court of the State of California, County of San Diego against the Company by United Policyholders, an organization purporting to act in a representative capacity on behalf of the California general public. The complaint alleged that the compensation arrangements between the Company and insurance carriers constituted deceptive trade practices, and it sought both injunctive and equitable relief, including restitution. This action was dismissed in December 2004, but United Policyholders filed an appeal. The dismissal of the complaint was based on the retroactive application of newly passed legislation. In July 2006 the Supreme Court of California confirmed in a ruling that the newly passed legislation applies to cases, like the United Policyholders case, that were pending before the new legislation was enacted. Based on this ruling, United Policyholders has dismissed its case.
The Company’s fiduciary funds-restricted and short-term investments consist mainly of cash and time deposits. Accrued interest on investments is recorded as other assets.
The Company holds a number of investments which it accounts for using the equity method. The Company’s interest in the outstanding stock of the more significant associates is as follows:
The revolving credit facility agreement contains numerous operating and financial covenants, including requirements to maintain minimum ratios of consolidated EBITDA to consolidated net interest expense and maximum levels of net indebtedness in relation to consolidated EBITDA, in each case subject to certain adjustments.
Excluding the $300 million revolving credit facility, the Company also has available $7 million (2005: $3 million) in lines of credit, of which $nil (2005: $nil) was drawn as of December 31, 2006.
The following table provides information for the Company’s UK and US defined benefit pension plans:
The expected return on plan assets was determined on the basis of the weighted-average of the expected future returns of the various asset classes, using the target allocations shown below. The expected returns on UK plan assets are UK and foreign equities 8.8 percent, debt securities 5.3 percent and real estate 6.3 percent. The expected returns on US plan assets are US and foreign equities 9.25 percent and debt securities 5.75 percent.
The Company’s investment policy includes a mandate to diversify assets and the Company invests in a variety of asset classes to achieve that goal. The UK Plan’s assets are divided into 10 separate portfolios according to asset class and managed by 10 investment managers. The broad target allocations are UK and foreign equities (75 percent), debt securities (20 percent) and real estate (5 percent). The US Plan’s assets are currently invested in 20 funds representing most standard equity and debt security classes. The broad target allocations are US and foreign equities (64 percent) and debt securities (36 percent).
The main risks arising from the Company’s financial instruments are interest rate risk, liquidity risk, foreign currency risk and credit risk. The Company’s board of directors reviews and agrees policies for managing each of these risks as summarized below. The Company has applied FAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, (“FAS 133”), in accounting for these financial instruments.
As a result of the Company’s operating activities, the Company receives cash for premiums and claims which it deposits in short-term investments denominated in US dollars and other currencies. The Company earns interest on these funds, which is included in the Company’s financial statements as investment income. These funds are regulated in terms of access and the instruments in which they may be invested, most of which are short-term in maturity. In order to manage interest rate risk arising from these financial assets, the Company enters into interest rate swaps to receive a fixed rate of interest and pay a variable rate
of interest fixed in the various currencies related to the short-term investments. The use of interest rate contracts essentially converts groups of short-term variable rate investments to fixed rates.
The fair value of these contracts is recorded in other assets and other liabilities. For contracts that are qualifying cash flow hedges as defined by FAS 133, changes in fair value are recorded as a component of other comprehensive income.
Amounts are reclassified from other comprehensive income into earnings when the hedged exposure affects earnings. For contracts that do not qualify for hedge accounting as defined by FAS 133, changes in fair value are recorded in other operating expenses.
A summary of the Company’s interest rate swaps by major currency is as follows:
The Company’s objective is to ensure that it has the ability to generate sufficient cash either from internal or external sources, in a timely and cost-effective manner, to meet its commitments as they fall due. The Company’s management of liquidity risk is embedded within its overall risk management framework. Scenario analysis is continually undertaken to ensure that the Company’s resources can meet its liquidity requirements. These resources are supplemented by a $300 million revolving credit facility which expires on October 17, 2010, of which $200 million was drawn as at December 31, 2006.
The Company’s objective is to maximize its cash flow in US dollars. In all locations, with the exception of the United Kingdom, the Company predominantly generates revenues and expenses in the local currency. In the United Kingdom, however, the Company earns revenues in a number of different currencies but expenses are almost entirely in pounds sterling. This mismatch creates a currency exposure.
The fair value of these contracts is recorded in other assets and other liabilities. For contracts that are qualifying cash flow hedges as defined by FAS 133, changes in fair value are recorded as a component of other comprehensive income. Amounts are reclassified from other comprehensive income into earnings when the hedged exposure affects earnings. For contracts that do not qualify for hedge accounting as defined by FAS 133, changes in fair value are recorded in other operating expenses (see table on previous page).
(1) Forward exchange contracts range in maturity from 2007 to 2009.
Concentrations of credit risk that arise from financial instruments exist for groups of customers or counterparties when they have similar economic characteristics that would cause their ability to meet contractual obligations to be similarly affected by changes in economic or other conditions. Financial instruments on the balance sheet that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, accounts receivable, and derivatives which are recorded at fair value. The Company maintains a policy providing for the diversification of cash and cash equivalent investments and places such investments in an extensive number of high quality financial institutions to limit the amount of credit risk exposure. Concentrations of credit risk with respect to receivables are limited due to the large number of clients and markets in which the Company does business, as well as the dispersion across many geographic areas. Management does not believe significant risk exists in connection with the Company’s concentrations of credit as of December 31, 2006.
(1) Commissions and fees are attributed to countries based upon the location of the subsidiary generating the revenue.
(3) Other than in the United Kingdom and the United States, the Company does not conduct business in any country in which its commissions and fees and/or long-lived assets exceed 10 percent of consolidated commissions and fees and/or long-lived assets, respectively.
21. FINANCIAL INFORMATION FOR PARENT GUARANTOR, OTHER GUARANTOR SUBSIDIARIES AND NON-GUARANTOR SUBSIDIARIES
The Company filed a shelf registration on Form S-3 on June 21, 2006 under which Willis Group Holdings may offer debt securities, preferred stock, common stock and other securities. In addition, Willis North America Inc. may offer debt securities (“the Subsidiary Debt Securities”). The Subsidiary Debt Securities, if issued, will be guaranteed by certain of the Company’s subsidiaries.