(1)In first quarter 2002, Aon adopted FASB Statement No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. Beginning in 2002, amortization of goodwill is no longer included in net income. (See note 2 to the consolidated financial statements).
This Management's Discussion and Analysis is divided into six sections. First, an overview of the key drivers influencing our financial performance is provided by segment, along with an executive summary of 2003 financial results. Key recent events are then described that affected our financial results in 2003. Critical accounting policies and estimates are discussed, including certain accounting judgments important to understanding our financial statements. We then review our consolidated results and segments with year-to-year comparisons. Finally, we cover our financial condition and liquidity along with related disclosures as well as information on our off balance sheet arrangements.
The outline for our Management's Discussion and Analysis is as follows:
•entering the alternative insurance market (which can also increase our revenues because we offer these services).
Consulting. Consulting segment results are principally affected by (i) the employment levels of our clients that are mainly driven by economic conditions, (ii) governmental regulations affecting the health care market, employee benefit programs, and our clients' respective industries, (iii) success in attracting new clients and retaining existing clients, (iv) our success in cross selling services across business units, and (v) managing our overall level of expenses.
Corporate and Other. The key driver of results in this segment has been investment income. For further information, see "Corporate and Other" in the Review by Segment section, below.
•Offering additional services to existing clients who can benefit from our wide range of resources.
•Consulting revenues rose due to the full year impact of a large outsourcing contract, but were restrained by declining employment levels at many of our clients.
•Our insurance underwriting business grew due to higher premiums within the warranty, credit and property & casualty lines.
•Our investment in Endurance Specialty stock and warrants increased our total investment income by $105 million over last year.
•a significant decline in the pretax income of our claims services business of $48 million
•paid down more than $300 million of long-term debt in 2003. At year-end, our total level of debt and preferred stock outstanding was 33% of our total capitalization, which is down from 40% at the beginning of the year.
•reduced the amount we spent on cash acquisitions by 50% compared with 2002.
In third quarter 2003, we decided to sell our automotive finance servicing business, which has been in run-off since first quarter 2001, and completed the sale in fourth quarter 2003 for net proceeds of approximately $18 million. Operating results from prior periods attributable to this unit have been reclassified as discontinued operations. Revenues from this business were $13 million in 2003 versus $15 million in 2002. The pretax loss recorded in 2003 of $55 million is comprised of operating losses of $32 million and a loss from the revaluation of the business of $23 million. In 2002, our pretax loss was $31 million. (See note 1 to the consolidated financial statements for more information about this discontinued operation).
We are evaluating options within our portfolio of other non-core businesses. In 2003, we announced that we were evaluating various strategic options for our claims services group. In early 2004, we reached an agreement in principle for the sale of two pieces of our claims services business in the U.K., and we are examining opportunities for the remaining claims units.
To resume business operations and minimize the loss caused by the World Trade Center disaster, we secured temporary office space in Manhattan. Subsequently, we leased permanent space, and during first quarter 2003, we assigned this temporary space to another company. The 2003 costs relating to this assignment were $46 million pretax.
In conjunction with this common stock investment, we received approximately 4 million stock warrants, which allow us to purchase additional Endurance common stock through December 2011. These warrants meet the definition of a derivative as described in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, which requires them to be recorded in the financial statements at fair value, with changes in fair value recognized in earnings each quarter.
Through December 31, 2002, these warrants had been carried at zero value, which approximated their original cost. In first quarter 2003, Endurance completed its initial public offering, which provided a market value for the underlying shares and removed much of the uncertainty regarding the fair value of Endurance and the warrants. At December 31, 2003, we determined that the warrants had a fair value of approximately $80 million.
Aon's consolidated financial statements have been prepared according to accounting principles generally accepted in the United States (GAAP). To prepare these financial statements, we made estimates, assumptions, and judgments that affect:
•what we disclose as contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented.
Under FASB Statement No. 87 accounting, the full gain or loss on assets and obligations are not recorded as expense in the current period. Statement No. 87 allows changes in the projected benefit obligation and market value of assets to be deferred and amortized as a component of pension expense over several years, based on the average expected future service of active employees, which is currently nine years. Gains and losses on pension obligations include the net effects of changes in the discount rate as well as demographic changes in the employee data. For the 2003 valuation year, the pension plans have a combined deferred loss of $496 million (comprised of unrecognized asset losses of $185 million and other than deferred asset losses of $311 million) that has not yet been recognized through income in the financial statements. Only the other than deferred asset losses of $311 million
outside of a corridor, defined as 10% of the greater of the market related value of plan assets or the projected benefit obligation, is subject to amortization over a nine year period. For 2004, the estimated amortization amount to be recognized in expense is $23 million. To the extent not offset by future gains, the incremental amortization as calculated above will continue to affect future pension expense in a similar manner until fully amortized.
Required cash contributions are also sensitive to assumptions, but assumptions used to determine contributions to the plan are changed infrequently. Under current rules and assumptions, we anticipate cash funding requirements of $28 million in 2004 and $236 million in 2005. Legislation being considered in Congress will relieve some of these requirements if passed. If so, contribution requirements are estimated to be $3 million in 2004 and $128 million in 2005.
Generally, the trustees of the U.K. plans determine the investment policy for each plan. In the aggregate, at the end of 2003 the plans were invested 65% in equities and 35% in fixed income securities. In determining the expected rate of return, the redemption yields available on the type of fixed income securities (corporate and U.K. government securities) used in the pension plans are reviewed. For equity returns, the expectations of the investment managers for the next 10 to 15 years are considered taking into account projected rates of future inflation and real returns. The expected long-term rate of return assumption was 7.5%.
With respect to U.K. pension liabilities, a one percentage point decrease in the Company's estimated discount rate would increase the estimated 2004 U.K. pension expense by approximately $56 million. A one percentage point increase in the estimated discount rate would decrease the U.K. pension expense for 2004 by approximately $49 million.
Cash flow requirements are also sensitive to assumptions, but assumptions used for funding the U.K. plans are changed infrequently. Under current rules and assumptions, we anticipate U.K. funding requirements of $144 million in 2004 and $185 million in 2005. Such contributions reflect minimum funding requirements plus such other amounts agreed to with the trustees of the U.K. plans.
the incremental amortization as calculated above will continue to affect future pension expense in a similar manner until fully amortized.
A one percentage point decrease in the Company's estimated long-term rate of return on plan assets would increase the pension expense for the year ending December 31, 2004 by approximately $3 million, while a one percentage point increase in the estimated long-term rate of return would decrease pension expense by approximately $3 million for the same period.
To establish policy liabilities, we rely upon estimates for reported and anticipated claims, our historical experience, other actuarial data and, with respect to accident, health and life liabilities, assumptions on investment yields. We base interest rate assumptions on factors such as market conditions and expected investment returns. Although mortality and interest rate assumptions are locked-in when we issue new insurance policies, we may need to provide for expected losses on a product by reducing previously capitalized acquisition costs established for that product, or by establishing premium deficiency reserves if there are significant changes in our experience or assumptions. The process of estimating and establishing policy and contract liabilities is inherently uncertain and the actual ultimate cost of a claim may vary materially from the estimated amount reserved.
While we made every effort to estimate these liabilities effectively, the results we report in our consolidated financial statements could be affected by trends which do not match historical experience
or which differ from our underlying assumptions. Furthermore, when our actual experience differs from our previous estimate, the difference will be reflected in the results we report for the period when we changed our estimate. We always consider trends in actual experience as a significant factor in helping us determine claim reserve levels.
In the discussion of operating results, we sometimes refer to supplemental information extracted from consolidated financial information which is not required to be presented in the financial statements by U.S. GAAP.
Supplemental information related to organic revenue growth is information that management believes is an important measure to evaluate business production from existing operations. We also believe that this supplemental information is helpful to investors. Organic revenue growth excludes from reported revenues the impact of foreign exchange, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses, unusual items, and for the underwriting segment only, an adjustment between written and earned premium.
•secondarily by revenue gains in the Consulting segment as the result of a large outsourcing contract that began in third quarter 2002. These gains were partially offset by a decrease in revenue in our Accident & Health and Life sub-segment that was primarily from transferring our
While moderating, commercial property and casualty premium rate increases for most lines of coverage continued in 2003. As a broker, we benefit from this through increased commissions. In addition, client demand for risk retention programs and services contributed to this increase, especially reinsurance and wholesale brokerage.
U.K. and Continent of Europe revenue combined increased 21% to $3.3 billion and Rest of World revenue increased 23%, reflecting a positive impact from foreign exchange, strong new business, and increasing premium and retention rates.
•higher revenue from a large consulting segment outsourcing contract begun in third quarter 2002.
Investment income increased by 26% over 2002, and includes related expenses and income or loss on disposals and impairments. The net increase reflects:
•investment income in 2002 included interest on a tax-related settlement of $48 million with no corresponding amount in 2003.
•lower investment income generated by the operating units of $81 million, including $27 million on deposit-type contracts, reflecting lower rates.
Benefit payout ratios have declined, however, due to a shift in product mix.
Total expenses also included a $14 million credit in 2003 and a $29 million credit in 2002 related to the World Trade Center. The 2003 credit represents a $60 million gain from a final settlement of our World Trade Center property insurance claim, net of $46 million related to the assignment to a third party of temporary office space secured in Manhattan after the World Trade Center was destroyed. The 2002 credit represents a gain resulting from a settlement with our insurance carriers regarding reimbursement for depreciable assets destroyed.
Income from continuing operations before income tax and minority interest increased $286 million in 2003 to $1.1 billion. Contributing to this increase were the impact of foreign exchange, the improvement in investment income ($65 million) and 2002 expenses related to the planned spin-off ($50 million) with no corresponding amount in 2003. Approximately 67% of Aon's 2003 consolidated income from continuing operations before income tax and minority interest was from international operations.
The effective tax rate was 37% in both 2003 and 2002. The overall effective tax rate is higher than the U.S. federal statutory rate primarily because of state income taxes.
Income from continuing operations increased to $663 million ($2.08 per dilutive share) from $486 million ($1.71 per dilutive share) in 2002. Basic income from continuing operations per share was $2.08 and $1.72 for 2003 and 2002, respectively. In the fourth quarter 2002, we had a common stock offering, which increased the number of average common and common stock equivalent shares outstanding. After netting the effect of currency hedges, the positive impact of foreign currency translations was approximately $0.13 per share. We have deducted dividends paid for the redeemable preferred stock from net income to compute income per share.
After-tax losses from our discontinued automotive finance servicing business in 2003 were $35 million ($0.11 per both basic and dilutive share). In comparison, losses in 2002 from this discontinued operation were $20 million ($0.07 per both basic and dilutive share). The 2003 results include an after-tax loss on the revaluation of the automotive finance servicing business of $14 million.
Based on current estimates, management believes that these discontinued operations are adequately reserved. The net liability is included as a component of other liabilities on the consolidated statements of financial position. In 2003 and 2002, Aon settled some of these liabilities. The settlements had no material effect on our consolidated financial statements. (See notes 1 and 6 to the consolidated financial statements for more information on discontinued operations.)
Consolidated Results for Fourth Quarter 2003 Compared to Fourth Quarter 2002
Total revenues in the quarter rose 10% to $2.6 billion. Excluding the impact of changes in foreign exchange rates, revenue climbed 4%. The higher revenue is primarily due to:
•very good results from the international risk and insurance brokerage area, combined with improvement in U.S. brokerage and reinsurance
•growth in some warranty and credit programs, along with specialty property and casualty lines
•increased investment income in the Corporate and Other segment, reflecting the change in value of warrants we held in Endurance of $16 million.
•a net charge in the warranty, credit, and property and casualty sub-segment of $44 million for additional losses and reserve strengthening for the NPS run-off program.
Total revenues were $8.8 billion, an increase of 15%. Excluding the effects of foreign exchange rates, revenues increased 14% over the comparable period. This increase results from improvements in brokerage commissions and fees, premiums earned, and investment income.
Brokerage commissions and fees increased 14% to $6.2 billion, primarily from organic growth including increased premium rates, increased new business, and outsourcing contracts. This growth was offset somewhat by revenue disruptions in the early part of the year with our managing general underwriter unit. Acquisitions contributed $90 million of incremental revenue in 2002.
Benefits to policyholders rose $264 million or 24% due to new business volume increases, an increased payout ratio of benefits to policyholders versus net premiums earned, issues related to NPS and a shift in business mix to products with higher benefit payout ratios.
The effective tax rate was 39.5% for 2001 and 37% for 2002. The decline from 2001 was due to the non-deductibility of certain goodwill, which, beginning in 2002, is no longer amortized for book purposes. The overall effective tax rates are higher than the U.S. federal statutory rate primarily because of state income tax provisions.
Segment revenue includes investment income, as well as the impact of related derivatives, generated by operating invested assets of that segment. Investment characteristics mirror liability characteristics of the respective segments:
(1)Intersegment revenues of $68 million were eliminated in 2003. See note 16 to the consolidated financial statements. Risk and Insurance Brokerage Services
Aon is a leader in many sectors of the insurance industry: globally, it is the second largest insurance broker, the largest reinsurance broker and the leading manager of captive insurance companies worldwide. In the U.S., Aon is the largest wholesale broker and underwriting manager. These rankings are based on the most recent surveys compiled and reports printed by Business Insurance.
The devastation caused by the attacks of September 11, 2001 resulted in the largest insurance loss in history. At the same time, there was an unprecedented escalation of insurance premium rates because of larger than anticipated loss experience across most risks, the stock market's steep decline, lower interest rates, and diminished risk capacity.
•Claim Services (Claims) offers claims administration and loss cost management services.
Total 2003 Risk and Insurance Brokerage Services revenue was $5.7 billion, up 14% on a reported basis over last year. Excluding the effect of foreign exchange rates, revenue rose 8% over last year. Operating revenue, on an organic basis, grew approximately 9% in a very competitive environment. Investment income decreased $34 million in 2003 from reduced derivative gains and lower interest rates.
•Brokerage-Americas revenue improved due to organic growth, reflecting improved renewal rates and increased new business in the retail brokerage business. Organic growth in the wholesale business was under pressure due to pricing pressures.
•Claims revenue has increased over last year primarily as a result of a positive foreign exchange impact and higher U.K. volume.
This chart shows Risk and Insurance Brokerage Services revenue by geographic area and pretax income:
•Rest of World revenue increased significantly due to foreign exchange rates, increased market share primarily in the Asian markets, and new business initiatives.
•$29 million from a partial settlement in 2002 with Aon's insurance carriers related to the World Trade Center
•a $6 million credit for the reversal in 2002 of business transformation plan expenses previously incurred for termination benefits with no corresponding amounts in 2003.
•provides a full range of human capital management services from employee benefits to compensation consulting
Consulting services are delivered to corporate clients through five major practice areas:
1.Employee Benefits advises clients regarding the structure, funding and administration of employee benefit programs which attract, retain and motivate employees.
3.Management Consulting assists clients in process improvement and design, leadership, organization and human capital development, and change management.
•the full year impact of a sizable human resources outsourcing agreement.
•Human resource outsourcing revenue improvement was due to the large contract initiated in third quarter 2002.
•U.K., Continent of Europe and Rest of World revenues rose on favorable currency exchange impacts and organic revenue growth.
The pretax margins for 2003 were also influenced by a lower margin human resources outsourcing contract, as discussed above.
•offers extended warranty and credit insurance products that are sold through retailers, automotive dealers, insurance agents and brokers, and real estate brokers. Our revenues are also affected by the addition and retention of these retailers, dealers, agents and brokers.
•offers select commercial property and casualty business on a limited basis through managing general underwriters, primarily Aon-owned companies
•implemented a "back-to-basics" strategy, focusing on products and regions with predictable cash flows and the best return on investment
•announced plans in February 2003 to place in run-off our accident and health insurance underwriting operations in Latin America. We stopped operations in Argentina and have transitioned into run-off status in Brazil and Mexico during 2003.
Written premiums and fees are the basis for organic revenue growth in this segment; however, reported revenues reflect earned premiums.
A table reflecting written and earned premiums and associated reserves follows:
In 2003, revenues of $2.9 billion increased 3% over 2002. Excluding the effect of foreign exchange rates, revenues were flat year-over-year.
(1)The difference between written and earned premiums and fees, as a percentage change, was 0% for accident & health, (2)% for warranty and (1)% for total revenue. The change in warranty and total revenue also resulted from a one-time assumption of premiums ceded from a client's captive in 2002.
•Growth in the select property and casualty business, as well European credit and warranty programs, drove the revenue improvement in warranty, credit and property & casualty.
•a decline in investment income of $47 million, significantly impacted by a $27 million decline in interest earned on investments underlying deposit-type contracts, as that business has been placed in run-off
•U.K., Continent of Europe, and Rest of World posted significant revenue improvement during the year. This increase is primarily the result of a favorable currency exchange rate impact and organic revenue growth in European direct sales, warranty and credit operations.
•provision for non-claims litigation issues of $15 million in 2002, with no corresponding amount in 2003
•reduced losses in Europe warranty and improvements in property & casualty, excluding NPS.
•a revised cost allocation methodology, which resulted in increased expense allocations of $12 million for 2003.
Corporate and Other segment revenue consists primarily of investment income (including income or loss on disposals, including other-than-temporary impairment losses), which is not otherwise reflected in the operating segments. This segment includes:
Corporate and Other segment revenue includes income from Endurance common stock, accounted for under the equity method, and changes in the valuation of Endurance warrants. Aon carries its investment in Endurance warrants at fair value and records changes in the fair value through Corporate and Other segment revenue, in accordance with FASB Statement No. 133.
Limited partnerships (LP) are accounted for under the equity method and changes in the value of the underlying LP investments flow through Corporate and Other segment revenue. Because the LP investments include exchange-traded securities, Corporate and Other segment revenue fluctuates with the market values of underlying publicly traded equity investments. LP investments have historically provided higher returns over a longer time than broad market common stock. However, in the short run, the returns are inherently more variable. In December 2001, we securitized $450 million of our LP investments plus associated LP commitments, which represented the majority of our LP interests. This transaction has lessened the variability of revenue reported in this segment. (See note 7 to the consolidated financial statements for additional information regarding the securitization.)
Corporate and Other revenue improved by $146 million to $125 million in 2003. The revenue improvement was primarily driven by:
•equity earnings from the Endurance common stock investment of $46 million compared to $21 million in 2002
•lower impairment writedowns of certain fixed-maturity and equity investments of $36 million in 2003 versus $130 million in 2002 (including $51 million cumulative effect of the change in policy relating to prior periods).
These positive comparisons were somewhat offset by $48 million of interest on a tax settlement in 2002 with no comparable amount in 2003.
•a net $14 million credit related to the World Trade Center. To allow us to resume business operations and minimize the loss caused by the disaster, we secured temporary office space in Manhattan. Later, we leased permanent space, and during first quarter 2003, we assigned this temporary space to another company. The costs related to this assignment were $46 million pretax. In fourth quarter 2003, we reached a final settlement of approximately $200 million for our overall World Trade Center property insurance claim. We received a cash payment of approximately $92 million during the fourth quarter, in addition to the $108 million we had already collected. As a result, we recognized a $60 million pretax gain on this settlement.
These revenue and expense comparisons contributed to the overall Corporate and Other pretax loss of $23 million in 2003 versus a loss of $242 million in 2002.
In 2003, total cash contributions to our major defined benefit pension plans were $217 million, an increase of $141 million over 2002. This exceeded the original expectation due to an early contribution of $100 million to the U.S. defined benefit pension plan in fourth quarter 2003. No corresponding early contributions were made in 2002. Under current rules and assumptions, we anticipate that 2004 contributions to our major defined benefit pension plans will be approximately $195 million. However, legislation being considered by the U.S. Congress will relieve some of these requirements, if passed. If so, we expect our 2004 contributions to our major defined benefit plans will be approximately $170 million.
In connection with one of our U.K. pension plans, our principal U.K. subsidiary has agreed with the trustees of the plan to contribute £20 million per year to the plan for six years with the amount payable increasing by 5.3% on each January 1, commencing in 2005. These contributions are in addition to the normal employer contributions to the plan. The trustees of the plan have certain rights to request that our U.K. subsidiary advance an amount equal to an actuarially determined winding up
deficit. In practice, the trustees have accepted the agreed schedule of contributions and have not requested such an advance. As of December 31, 2002, the estimated winding up deficit was £340 million. The winding up deficit has not yet been determined as of December 31, 2003. At the last valuation date, September 30, 2003, the estimated deficit between the value of the plan assets and the projected benefit obligation, calculated under U.S. GAAP, was £134 million, of which £125 million was recorded as a minimum pension liability. In 1999, all U.K. pension plans were closed to new entrants.
Proceeds of $48 million from the sale of operations included $30 million from the divestiture of Sheffield, which was sold for approximately book value.
In 2003, available cash flows from operations were used primarily to:
Included in cash flows from operations are cash contributions to our major defined benefit pension plans of $217 million versus expense of $187 million.
In 2003, total investments increased $738 million to $7.3 billion from December 31, 2002. Fixed maturities increased $662 million, primarily relating to an asset management program at our insurance underwriting subsidiaries that became effective in second quarter 2003, which resulted in a shift from short-term to long-term investments. As a consequence of this decision, short-term investments in the insurance underwriting businesses decreased, but were offset by changes in foreign exchange rates, along with an increase in funds held on behalf of clients, resulting in an overall decline of $20 million.
•the continued rise in premium rates across most lines of business
-was partially offset by retiring $300 million of outstanding debt securities due in January and June 2003.
•Short-term debt declined $64 million, primarily due to a decrease in foreign short-term debt.
The major rating agencies' ratings of our debt securities at December 31, 2003 appear in the table below. Standard and Poor's outlook on Aon is negative. Ratings from Moody's Investor Services and Fitch, Inc. are on stable outlook.
Aon's principal insurance underwriting subsidiaries are rated "A", with a stable outlook by A.M. Best for their claims paying ability.
Stockholders' equity increased $603 million during 2003 to $4.5 billion, primarily reflecting:
These equity increases were partially offset by dividends paid to stockholders of $190 million.
During 2003, some of our defined benefit pension plans, particularly in the U.K., incurred losses due to reduced discount rates. Accounting principles generally accepted in the U.S. require a company to maintain, at a minimum, a liability on its balance sheet equal to the difference between the present
value of benefits incurred to date for pension obligations and the fair value of the assets supporting these obligations. At year-end 2003, this increased pension obligation caused a $186 million (after-tax) reduction to stockholder's equity. We maintain the related pension plan assets in separate trust accounts; they are not part of our consolidated financial statements. This non-cash adjustment did not affect 2003 earnings.
We have various contractual obligations that are recorded as liabilities in our consolidated financial statements. Other items, such as certain purchase commitments and other executory contracts, are not recognized as liabilities in our consolidated financial statements but are required to be disclosed.
Aon and its subsidiaries have issued letters of credit to cover contingent payments of approximately $90 million for taxes and other business obligations to third parties. We accrue amounts in our consolidated financial statements for these letters of credit to the extent they are probable and estimable.
PEPS sold approximately $171 million of investment grade fixed-maturity securities to unaffiliated third parties. It then paid our insurance underwriting subsidiaries the $171 million in cash and issued them an additional $279 million in fixed-maturity and preferred stock securities.
Standard & Poor's Ratings Services rated the fixed-maturity securities our subsidiaries received from PEPS I as investment grade. As part of this transaction, the insurance companies must purchase from PEPS I additional fixed-maturity securities in an amount equal to the unfunded LP commitments as they are requested. Approximately $20 million of these commitments were funded in 2003. As of December 31, 2003, the unfunded commitments amounted to $80 million. These commitments have specific expiration dates and the general partners may decide not to draw on these commitments.
Based on the rating agencies' downgrades of Aon's credit ratings in October 2002 on Aon's senior debt, credit support agreements were purchased in January 2003 whereby $100 million of cash of one of our underwriting subsidiaries has been pledged as collateral for these commitments. This collateral has been reduced to $77 million at December 31, 2003.
If the insurance companies fail to purchase additional fixed-maturity securities as commitments are drawn down, we have guaranteed their purchase.
Aon has recognized other-than-temporary impairment writedowns equal to the original cost of one tranche, including $32 million in 2002 and $27 million in first quarter 2003. The preferred stock interest represents a beneficial interest in the securitized limited partnership investments. The fair value of the private preferred stock interests depends on the value of the limited partnership investments held by PEPS I. Management assesses other-than-temporary declines in the fair value below cost using a financial model that considers:
In 1998, CICA, an Aon subsidiary, formed Combined Global Funding, LLC, a Cayman Islands-based special purpose entity (SPE), to issue notes to investors under a European Medium-Term Note Program (EMTN). The proceeds of the notes were used to purchase funding agreement policies issued by CICA. The contract terms of the funding agreement mirror the terms of the trust medium-term notes. Historically, the SPE has been consolidated by CICA based on the guidance in ARB 51 and EITF Topic D-14, with the EMTNs being classified as a policyholder liability in Aon's consolidated financial statements rather than notes payable, given that the liquidation preference of the underlying debt more closely resembled the characteristics of a policyholder liability. The interest expense on the EMTNs has been included in benefits to policyholders in the consolidated statements of income. The amounts of EMTNs outstanding at December 31, 2003 and 2002 were $50 million and $79 million, respectively. In 2005, the remaining outstanding EMTN and the corresponding funding agreement are scheduled to be redeemed.
Upon the adoption of FIN 46, Aon has determined that the SPE is a VIE and CICA is not the primary beneficiary, because CICA does not have a variable interest in the SPE. As a result, CICA was required to deconsolidate the trust on December 31, 2003. There was no effect on the consolidated statements of financial position or income statements as a result of this deconsolidation, as the funding agreement liability between CICA and the SPE is now classified as a policyholder liability.
•summarizes our significant contractual obligations at December 31, 2003 and the future periods during which we expect to settle these obligations in cash.
COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED CAPITAL SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY THE COMPANY'S JUNIOR SUBORDINATED DEBENTURES
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States. The consolidated financial statements include the accounts of Aon Corporation and its majority-owned subsidiaries (Aon), except for the consolidated statement of financial position as of December 31, 2003, which includes the accounts of Aon Corporation and its majority-owned subsidiaries (excluding special-purpose entities ("VIEs") considered variable interest entities for which Aon is not the primary beneficiary).
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services (previously called Insurance Brokerage and Other Services), Consulting and Insurance Underwriting. A fourth segment, Corporate and Other, when aggregated with the operating segments, and after the elimination of intersegment revenues, totals to the amounts included in the consolidated financial statements.
Commission income is recognized at the later of the billing or effective date of the policy. However, in circumstances where a binding order has been received before the end of the accounting period and coverage is effective, but processing has not yet occurred in the billing system due to timing, an accrual is recorded. Aon's policy for estimating allowances for return commissions on policy cancellations is to record an allowance based on a historical evaluation of cancellations as a percentage of related revenue. Certain life insurance commissions, commissions on premiums billed directly by insurance companies and certain other carrier compensation are generally recognized as income when received. Revenues may be recorded in advance of the cash receipts in cases where the amounts due to be received have been confirmed by the insurance company, or when Aon has sufficient information in its records to estimate amounts for premium based revenue accruals in accordance with agreements Aon has with insurance carriers. Commissions on premium adjustments are recognized as they occur.
The portion of the revenues received on extended warranty contracts that are for the marketing, administration and servicing of those contracts are reported as earned consistent with the method used to earn the premium portion of those revenues, and revenues that represent administrative fee-for-service arrangements, for which Aon does not bear the underwriting risk, are earned as those services are performed. These fee-for-service arrangements include the marketing and servicing of extended warranty contracts on behalf of other companies and brokerage commissions for accident and health products placed with non-Aon insurance carriers. These revenues are reported in the Insurance Underwriting segment.
For investment products, generally there is no requirement for payment of premium other than to maintain account values at a level sufficient to pay mortality and expense charges. Consequently, premiums for investment products are not reported as revenue, but as deposits. Policy fee revenue for investment products consists of charges for the cost of insurance, policy administration and surrenders assessed during the period. Expenses include interest credited to policy account balances and benefit claims incurred in excess of policy account balances.
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
Short-term investments include certificates of deposit and highly liquid debt instruments purchased with maturities of up to one year (generally three months or less) and money market funds and are carried at cost, which approximates fair value.
Fixed-maturity securities are available for sale and are carried at fair value. The amortized cost of fixed maturities is adjusted for amortization of premiums and the accretion of discounts to maturity that are included in investment income.
Marketable equity securities that are held directly are carried at fair value.
The model assumes: the warrants are "European-style," which means that they are valued as if the exercise can only occur on the expiration date; the spot and exercise prices are reduced by expected future dividends; and the dividend remains unchanged during the period the warrants are outstanding. Although Endurance currently pays a dividend, a zero dividend yield as used in the Endurance warrants valuation since the value of future dividend payments have been reflected in the spot and exercise price used in the valuation.
Limited partnership investments are carried under the equity method. Certain of the limited partnerships in which Aon invests have holdings in publicly-traded equities. Changes in market value of these indirectly-held equities flow through the limited partnerships' financial statements. Aon's ownership share of these valuation changes is included in Aon's Corporate and Other segment revenue.
General - Income or loss on disposal of any securities held is computed using the specific costs of the securities sold and is reported as investment income in the consolidated statements of income.
Prior to January 1, 2002, goodwill relating to business acquisitions had been amortized into income over periods not exceeding 40 years using the straight-line method. Goodwill related to acquisitions made after June 30, 2001 has not been amortized. Beginning in January 2002, goodwill has not been amortized but instead has been tested for impairment annually. See Accounting and Disclosure Changes for further information. The cost of other intangible assets is being amortized over a range of 2 to 10 years with a weighted-average original life of 8.2 years.
The following methods and assumptions were used to estimate fair values for financial instruments:
Endurance common stock: Aon's investment in Endurance common stock is accounted for on the equity method. Accordingly, its carrying value ($298 million at December 31, 2003) is determined by adjusting the initial cost of the investment with Aon's share of Endurance's net income and unrealized gains or losses since acquisition. Shares of Endurance common stock are publicly traded and quoted market prices are available. Based on the December 31, 2003 quoted market price of $33.55 per share (NYSE:ENH), Aon's investment in Endurance has a fair market value of $380 million. Aon carries Endurance on the equity method due to its influence on Endurance's board of directors and various board committees.
Notes payable: Fair value is based on quoted market prices for the publicly-traded portion and on estimates using discounted cash flow analyses based on current borrowing rates for similar types of borrowing arrangements for the nonpublicly-traded portion.
In June 2001, the FASB issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Statement No. 141 superceded Accounting Principles Board (APB) Opinion No. 16, Business Combinations, and amended or superceded a number of interpretations of APB No. 16. Certain purchase accounting guidance in APB No. 16, as well as certain of its amendments and interpretations, have been carried forward. The statement eliminated the pooling of interests method of accounting for business combinations. It also changed the criteria to recognize intangible assets apart from goodwill. The requirements of Statement No. 141 were effective for any business combination accounted for by the purchase method that was completed after June 30, 2001. Statement No. 142 supercedes APB No. 17, Intangible Assets. Under Statement No. 142, goodwill is no longer amortized but is reviewed annually for impairment, or more frequently if impairment indicators arise. Separable intangible assets that have finite lives will continue to be amortized over their useful lives. The amortization provisions of Statement No. 142 apply to goodwill and intangible
In accordance with Statement No. 141, other intangible assets which resulted from acquisitions made prior to July 1, 2001, that did not meet the criteria for recognition apart from goodwill (as defined by Statement No. 141) were to be classified as goodwill upon adoption of the statement. Accordingly, Aon reclassified $287 million of these intangibles, net of accumulated amortization, to goodwill as of January 1, 2002. In addition, Aon re-examined the useful lives of all intangibles in accordance with Statement No. 142. Reported amortization expense for all other intangibles was $63 million, $54 million and $40 million for the years ended December 31, 2003, 2002 and 2001, respectively.
In 2001, the FASB issued Emerging Issues Task Force (EITF) No. 01-14, Income Statement Characterization of Reimbursements Received for "Out-of-Pocket" Expenses Incurred. This EITF required companies to reflect reimbursements received for out-of-pocket expenses incurred as revenue and the corresponding obligation as expense, in the consolidated statements of income.
Aon adopted the disclosure requirements of Statement No. 148 effective with its 2002 Annual Report. Aon is evaluating its position regarding its accounting for stock-based compensation based on recent FASB initiatives.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (FIN 46). In December 2003, the FASB modified FIN 46 to make certain technical corrections and address certain implementation issues that had arisen. FIN 46 provides a new framework for identifying VIEs and determining when a company should include the assets, liabilities, non-controlling interests and results of activities of a VIE in its consolidated financial statements.
In January 1997, Aon created Aon Capital A, a wholly-owned statutory business trust, for the purpose of issuing mandatorily redeemable preferred capital securities (Capital Securities). The sole asset of Aon Capital A is a $726 million aggregate principal amount of Aon's 8.205% Junior Subordinated Deferrable Interest Debentures due January 1, 2027. The Capital Securities are categorized in the December 31, 2002 consolidated statement of financial position as "Company-Obligated Mandatorily Redeemable Preferred Capital Securities of Subsidiary Trust Holding Solely Aon's Junior Subordinated Debentures." (See Note 11).
In April 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The intent of this Statement is more consistent reporting of contracts as either freestanding derivative instruments subject to Statement No. 133 in its entirety, or as hybrid instruments with debt host contracts and embedded derivative features. Statement No. 149 amends Statement No. 133 as a result of (1) decisions previously made as part of the Derivatives Implementation Group (DIG) process, (2) changes made in connection with other FASB projects dealing with financial instruments, and (3) deliberations in connection with issues raised in relation to the application of the definition of a derivative.
In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity.
Statement No. 150 must be applied immediately to instruments entered into or modified after May 15, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period beginning after June 15, 2003. In October 2003, the FASB indefinitely deferred the application of certain portions of Statement No. 150. The adoption of the provisions of Statement No. 150 that became effective in 2003 did not have a material impact on Aon's consolidated financial statements. The remaining provisions of Statement No. 150, when they become effective, are not expected to have a material impact on Aon's consolidated financial statements. Aon's $50 million redeemable preferred stock will be reclassed to liabilities after the occurrence of a certain future event.
The provisions of the original Statement 132 remain in effect until the provisions of the revised Statement are adopted. Except as noted below, the revised Statement is effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by the revised Statement are effective for interim periods beginning after December 15, 2003. The additional disclosure of information about foreign plans required by the revised statement is effective for fiscal years ending after June 15, 2004. In addition, disclosure of the benefits expected to be paid in each of the next five fiscal years, and in the aggregate for the five fiscal years thereafter is effective for fiscal years ending after June 15, 2004.
In 2002, the pretax amount of $876 million for net additional minimum pension liability adjustment includes $30 million related to the defined benefit pension plans in Canada, recognized for the first time in 2002.
In 2003, Aon completed several immaterial acquisitions, mostly related to the insurance brokerage operations. In these transactions, Aon paid an aggregate of approximately $56 million in cash and $8 million in common stock. Internal funds, short-term borrowings and common stock financed the acquisitions. Goodwill of approximately $45 million and other intangible assets of approximately $11 million, accounted for on a preliminary basis, resulted from these acquisitions.
In 2002, Aon completed several immaterial acquisitions, mostly related to the insurance brokerage operations. In these transactions, Aon paid an aggregate of approximately $111 million in cash and $3 million in common stock. Internal funds, short-term borrowings and common stock financed the acquisitions. Goodwill of approximately $51 million and other intangible assets of approximately $48 million resulted from these acquisitions.
In 2001, Aon acquired ASI Solutions Incorporated (ASI), a worldwide provider of human resource outsourcing and compensation consulting services, and First Extended, Inc. (FEI), an underwriter and administrator of automotive extended warranty products, and certain other insurance brokerage and consulting operations. In these transactions, Aon paid an aggregate of approximately $107 million in cash and $197 million in common stock. Internal funds, short-term borrowings and common stock financed the acquisitions. Goodwill of approximately $282 million and other intangible assets of approximately $72 million, resulted from these acquisitions.
The results of operations of these acquisitions, all of which were accounted for by the purchase method, are included in the consolidated financial statements from the dates they were acquired. Pro forma results of these acquisitions are not materially different from reported results.
In 2003, Aon made payments of $10 million on restructuring charges and purchase accounting liabilities related to business combinations.
In fourth quarter 2000, after final approval by its Board of Directors, Aon began a comprehensive business transformation plan designed to enhance client service, improve productivity through process redesign, and accelerate growth. Costs of the plan include special charges and transition costs. In connection with the overall plan and strategic initiatives, Aon recorded total net expenses of $294 million of which $6 million of income, $218 million of expenses and $82 million of expenses were recorded in 2002, 2001 and 2000, respectively, and are reflected in general expenses in the consolidated statements of income.
For 2001, expenses included costs related to termination benefits of $109 million, covering notification to 3,150 employees. Other costs to exit an activity of $21 million were incurred, which included $10 million for abandoned leases and $11 million for direct costs necessary to complete portions of the business transformation plan and cash settlements necessary to exit contractual obligations.
During 2001, Aon exited four other joint venture operations as a part of its business transformation process. The total cost to exit these four joint ventures was $12 million. Additional expenses in 2001 included a provision of $14 million for discontinuing supplemental accident and health insurance business operations in Mississippi. The expense included severance costs and expenses associated with the reassignment of agents, as well as estimated costs for resolving asserted and unasserted claims and suits. A $5 million expense was recorded relating to the write-down of certain agent receivables in conjunction with the restructuring of a worksite marketing agent commission pay structure and operations.
Approximately 3,700 employees have either departed voluntarily or have positions that have been eliminated. All of the terminations have occurred and are related to the Risk and Insurance Brokerage Services segment in the U.S. and the U.K.
All of Aon's unpaid liabilities relating to the business transformation plan are reflected in general expense liabilities in the consolidated statements of financial position. Termination benefits of $6 million and $3 million are expected to be paid in 2004 and 2005, respectively, with the remainder payable thereafter.
Aon's fixed-maturity portfolio in total had a $27 million gross unrealized loss at December 31, 2003, excluding $3 million related to deferred amortizable derivative losses, and is subject to interest rate, market, and credit risks. No single position had an unrealized loss greater than $1 million. With a carrying value of over $2.75 billion at December 31, 2003, our total fixed-maturity portfolio is over 96% investment grade based on market value. Fixed-maturity securities with an unrealized loss are all investment grade and have a weighted average rating of "Aa" based on amortized cost. Aon's non publicly-traded fixed maturity portfolio had a carrying value of $276 million, including $115 million in notes received from PEPS I on December 31, 2001 related to the securitization of limited partnerships and $64 million in notes issued by PEPS I to Aon during 2003 and 2002. Valuations of these securities primarily reflect the fundamental analysis of the issuer and current market price of comparable securities.
Aon reviews invested assets with material unrealized losses each quarter. Those assets are separated into two categories:
(1)assets with unrealized losses due to issuer-specific events, which are segmented among four categories: fixed-maturity investments; preferred stocks; publicly traded common stocks; and private common stocks and other invested assets.
•reviews the creditworthiness of corporate obligors for changes by nationally recognized credit rating agencies and changes in fundamental financial performance of the underlying entity,
•evaluates all bonds and asset-backed securities whose financial performance has declined for other than temporary impairment.
Private common stocks and other invested assets. Aon reviews quarterly private issue valuations, which include recent transaction valuations between the issuer and a third party; financial performance reviews; and financial trend comparisons with publicly-traded companies in the same or similar industries.
Invested assets with unrealized losses due to market conditions or industry-related events include those negatively impacted by increasing U.S. Treasury or local sovereign interest rates; corporate and asset-backed credit spread widening; common stock price volatility due to conditions in the overall market or a particular industry; and illiquid market conditions.
Limited Partnership Securitization. On December 31, 2001, Aon sold the vast majority of its limited partnership (LP) portfolio, valued at $450 million, to PEPS I, a QSPE. The common stock interest in PEPS I is held by a limited liability company which is owned by one of Aon's subsidiaries (49%) and by a charitable trust, which is not controlled by Aon, established for victims of the September 11th attacks (51%). Approximately $171 million of investment grade fixed-maturity securities were sold by PEPS I to unaffiliated third parties. PEPS I then paid Aon's insurance underwriting subsidiaries the $171 million in cash and issued to them an additional $279 million in fixed-maturity and preferred stock securities. The fixed-maturity securities Aon subsidiaries received from PEPS I are rated as investment grade by Standard & Poor's Ratings Services. Aon recognized impairment writedowns on a portion of the preferred stock securities of $27 million and $32 million in 2003 and 2002, respectively.
PEPS I will invest cash collected from the limited partnerships pending distribution to holders of beneficial interests. PEPS I invests only in relatively risk free investments with maturities no later than an expected distribution date.
Aon maintains premium trust bank accounts for premiums collected from insureds but not yet remitted to insurance companies of $3.1 billion and $2.8 billion at December 31, 2003 and 2002, respectively.
At December 31, 2003 and 2002, Aon had $136 million and $129 million, respectively, of non-income producing investments, which excludes private equity investments carried on the equity method, held for at least twelve months, that have not declared dividends during 2003 and 2002.
Notes payable, due in varying installments, with interest at 1.2% to 17.76%
In November 2002, Aon completed a private offering of $300 million aggregate principal amount of 3.5% convertible senior debentures due 2012. Net proceeds from this offering were $296 million. The debentures are unsecured obligations and are convertible into Aon common stock at an initial conversion price of approximately $21.475 per common share under certain circumstances including (1) during any fiscal quarter beginning after December 31, 2002, if the closing price of Aon's common stock exceeds 120% of the conversion price (i.e. $25.77) for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the previous fiscal quarter or (2) subject to certain exceptions, during the five business day period after any ten consecutive trading day period in which the trading price per $1,000 principal amount of the debentures for each day of the ten trading day period was less than 95% of the product of the closing sale price of Aon's common stock and the number of shares issuable upon conversion of $1,000 principal amount of the debentures. Aon will be required to pay additional contingent interest, beginning November 15, 2007, if the trading price of the debentures for each of the five trading days immediately preceding the first day of the six month interest period equals or exceeds 120% of the par value of the debentures. Aon has reserved approximately 14 million shares for the potential conversion of these debentures. Beginning November 19, 2007, Aon may redeem any of the debentures at an initial redemption price of 101% of the principal amount plus accrued interest. The debentures were sold to qualified institutional buyers. In 2003, Aon filed a registration statement with the SEC to register the resale of the debentures.
In December 2002, Aon completed a private offering of $225 million aggregate principal amount of 7.375% senior notes due 2012. Net proceeds from this offering were $223 million. During 2003, Aon completed an offer to exchange these notes for notes registered under the Securities Act of 1933 and having identical terms.
Aon has used the net proceeds of both offerings to repay outstanding commercial paper, other short-term debt, and certain other notes payable. In addition, some of the funds were used to repurchase a portion of Aon Capital A's 8.205% Mandatorily Redeemable Preferred Capital Securities (see note 11). A portion of the funds were invested and utilized to repay $150 million of LIBOR +1% debt securities that matured in January 2003.
In December 2001, Aon issued $150 million of debt securities with a floating interest rate of LIBOR +1% due January 2003 and $250 million of 6.2% debt securities due January 2007. The interest rate payable on the 6.2% debt securities is subject to adjustment in the event that Aon's credit ratings change. Due to the ratings downgrades during 2002, the interest rate on the 6.2% debt securities was increased to 6.7%, effective January 2003.
Interest is payable semi-annually on most debt securities. In addition, the debt securities, including Aon Capital A's, are not redeemable by Aon prior to maturity except for the 3.5% convertible debt securities, which are redeemable by Aon beginning in 2007. There are no sinking fund provisions. Maturities of notes payable are $318 million, $255 million, $5 million, $254 million and $8 million in 2004, 2005, 2006, 2007 and 2008, respectively.
The amount of income taxes paid in 2003, 2002 and 2001 was $296 million, $238 million and $193 million, respectively.
Aon's insurance subsidiaries are involved in both the cession and assumption of reinsurance with other companies. Aon's reinsurance consists primarily of short-duration contracts that are entered into with the captive insurance operations of numerous automobile dealerships and insurers, certain newer accident and health initiatives, as well as certain property casualty lines. Aon's insurance subsidiaries remain liable to the extent that the reinsurers are unable to meet their obligations.
(1)For 2003 and 2002, prior years' incurred losses primarily represent losses from business produced by NPS. Aon stopped NPS from initiating any new business in mid-2002.
Interest is payable semi-annually on the Capital Securities. The Capital Securities are categorized in the December 31, 2002 consolidated statements of financial position as "Company-Obligated Mandatorily Redeemable Preferred Capital Securities of Subsidiary Trust Holding Solely Aon's Junior Subordinated Debentures."
Aon has determined that it is not the primary beneficiary of Aon Capital A, a VIE, and was required to deconsolidate the Trust upon the adoption of FIN 46 on December 31, 2003. As a result of the deconsolidation, Company-Obligated Mandatorily Redeemable Preferred Capital Securities of Subsidiary Trust Holding Solely Aon's Junior Subordinated Debentures decreased by $702 million, completely offset by an increase in notes payable and other receivables of $726 million and $24 million, respectively, as of December 31, 2003. Prior to the deconsolidation of Aon Capital A, the after-tax interest incurred on the Capital Securities was reported as minority interest in the consolidated statements of income. Beginning in 2004, interest expense on these notes payable will be reported as part of interest expense on the consolidated statements of income. There was no effect on net income or consolidated stockholders' equity as a result of this deconsolidation. (Prior periods were not restated.)
In December 2001, Aon filed a universal shelf registration on Form S-3 for the issuance of $750 million of debt and equity securities. In November 2002, Aon completed a public offering of 36.8 million shares of its common stock at $17.18 per share, raising net proceeds of $607 million. Aon has used the net proceeds to repay commercial paper and other short-term debt. A portion of the funds were invested and were utilized to repay debt maturing in 2003.
Aon repurchased 0.1 million, 0.4 million and 0.1 million shares in 2003, 2002 and 2001, respectively, of its common stock. In 2003, Aon issued 2.6 million new shares of common stock for
Generally, the capital and surplus of Aon's insurance subsidiaries available for transfer to the parent company are limited to the amounts that the insurance subsidiaries' statutory capital and surplus exceed minimum statutory capital requirements; however, payments of the amounts as dividends in excess of $133 million may be subject to approval by regulatory authorities. See note 9 for possible tax effects of distributions made out of untaxed earnings.
Aon sponsors defined benefit, pension and postretirement health and welfare plans that provide retirement, medical and life insurance benefits. The postretirement healthcare plans are contributory, with retiree contributions adjusted annually; the life insurance and pension plans are noncontributory.
Previously, Aon's U.K. pension plans became closed to new entrants. All new employees became participants in a defined contribution plan.
The following tables provide a reconciliation of the changes in obligations and fair value of assets for the years ended December 31, 2003 and 2002 and a statement of the funded status as of
December 31, 2003 and 2002, for both qualified and nonqualified plans. The measurement date for the U.S. plans is November 30.
$ (268 ) $ (213 ) $ (78 ) $ (78 )
In 2003, plans with a projected benefit obligation (PBO) and an accumulated benefit obligation (ABO) in excess of the fair value of plan assets had a PBO of $1.3 billion, an ABO of $1.2 billion and plan assets with a fair value of $0.9 billion.
In 2002, plans with a PBO and ABO in excess of the fair value of plan assets had a PBO of $1.1 billion, an ABO of $1.0 billion and plan assets with a fair value of $0.8 billion.
The weighted-average assumptions used to determine future U.S. benefit obligations are shown in the following table:
The policy, as established by the Aon Pension Plan Investment Committee, seeks reasonable asset growth at prudent risk levels within target allocations. Plan assets are invested within the asset allocation target ranges shown above, are well-diversified, and are of appropriate quality. Asset allocation target ranges are reviewed quarterly and re-balanced to within policy target allocations. The investment policy is reviewed at least annually, and revised, as deemed appropriate by the Investment Committee.
Aon's U.S. other benefit plan assets of $8 million at both December 31, 2003 and 2002 were invested in money market instruments.
Estimated future benefit payments reflecting expected future service for the years ending December 31:
Aon's liability for future plan cost increase for pre-65 and Medical Supplement plan coverage is limited in any year to 5% per annum. Because of this cap, net employer trend rates for these plans are effectively limited to 5% per year in the future. The $50 per month subsidy for future post-65 retirees is assumed not to increase in future years. Therefore, there is no employer trend for future post-65 retirees.
As a result, a 1% change in assumed healthcare cost trend rates has no effect on the service and interest cost components of net periodic postretirement healthcare benefit cost and on the accumulated postretirement benefit obligation for the measurement period ended in 2003.
The following tables provide a reconciliation of the changes in obligations and fair value of assets for the years ended December 31, 2003 and 2002 and a statement of the funded status as of December 31, 2003 and 2002, for material international pension plans, which are located in the U.K.
and The Netherlands. The measurement date for these plans is September 30 and December 31, respectively.
The increases in amounts recognized in other comprehensive income related to minimum pension liability are $225 million and $635 million for 2003 and 2002, respectively.
In 2001, Aon stockholders approved the Aon Stock Incentive Plan, which replaced all existing incentive compensation plans, including the Aon Stock Award Plan and the Aon Stock Option Plan. Under the new plan, non-qualified and incentive stock options, stock appreciation rights and stock awards may be granted. The annual rate of which awards are granted each year is based upon financial and competitive business conditions. The number of shares authorized to be issued under the new plan is equal to 18% of the number of common shares outstanding.
Effective July 1, 1998, Aon adopted an employee stock purchase plan that provides for the purchase of a maximum of 7.5 million shares of Aon's common stock by eligible U.S. employees. Under the original plan, shares of Aon's common stock could be purchased at 6-month intervals at 85% of the lower of the fair market value of the common stock on the first or the last day of each 6-month period. Effective July 1, 2000, the plan was amended by changing the purchase period to 3-month intervals. In 2003, 2002 and 2001, 734,000 shares, 312,000 shares, and 680,000 shares, respectively, were issued to employees under the plan. In first quarter 2002, the plan was suspended in anticipation of the planned divestiture of the insurance underwriting businesses (note 1). The plan was reactivated as of January 1, 2003. There was no compensation expense associated with this plan.
Certain derivatives also give rise to credit risks from the possible non-performance by counterparties. The credit risk is generally limited to the fair value of those contracts that are favorable to Aon. Aon has limited its credit risk by entering into non-exchange-traded derivatives with highly rated major financial institutions and by using exchange-traded instruments. Aon closely monitors the credit-worthiness of, and exposure to, its counterparties and considers its credit risk to be minimal.
At December 31, 2003 and 2002, Aon placed cash and securities relating to these derivative contracts in escrow amounting to $4 million and $11 million, respectively.
Foreign currency forward contracts (forwards) and interest rate swaps entered into require no up-front premium. Forwards settle at the expiration of the related contract. The net effect of swap payments is settled periodically and reported in income. The premium and commission paid for purchased options, including interest rate caps and floors, and premium received, net of commission paid, for written options represents the cost basis of the position until it expires or is closed. The commission paid for futures contracts represents the cost basis of the position, until it expires or is closed. Exchange-traded futures are valued and settled daily. Unless otherwise noted, derivative instruments are generally reported in other receivables and liabilities in the consolidated statements of financial position.
All derivative instruments are recognized in the consolidated statements of financial position at fair value. Changes in fair value are recognized immediately in earnings unless the derivative is designated as a hedge and qualifies for hedge accounting.
Statement No. 133 identifies three hedging relationships where a derivative (hedging instrument) may qualify for hedge accounting: a hedge of the change in fair value of a recognized asset or liability or firm commitment (fair value hedge), a hedge of the variability in cash flows from a recognized asset or liability or forecasted transaction (cash flow hedge) and a hedge of the net investment in a foreign subsidiary.
The change in fair value of a hedging instrument designated and qualified as a fair value hedge and the change in fair value of the hedged item attributable to the risk being hedged are both recognized currently in earnings. The effective portion of the change in fair value of a hedging
Aon issued fixed-rate notes in May 2000. Aon purchased options on interest rate swaps to hedge against a change in interest rates prior to the issuance of the fixed-rate notes. These options qualified as a hedge of an anticipated transaction under prior accounting guidance and related gains were deferred and are being amortized as an offset to interest expense over the remaining life of the notes. Upon the adoption of Statement No. 133, pretax deferred gains of $5 million were reclassified to OCI. At December 31, 2003, $2 million remains in OCI, $1 million of which is expected to offset interest expense in 2004.
Certain of Aon's subsidiaries make short-term loans (generally with terms of 12 months or less) to businesses for the financing of insurance premiums and then securitize the finance receivables through securitization transactions that meet the criteria for sale accounting in accordance with FASB Statement No. 140. These premium financing securitizations are accomplished through the use of special purpose entities which are considered qualifying SPEs ("QSPEs") pursuant to Statement No. 140 and FIN 46, and commercial paper bank conduits (multi-seller non-qualified SPEs). Statement No. 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates (Aon's subsidiaries).
As of December 31, 2003 and 2002, the maximum commitment contained in these agreements were $1.9 billion and $1.7 billion, respectively, and the maximum credit risk under recourse provisions
Accounting standards require the disclosure of fair values for certain financial instruments. The fair value disclosures are not intended to encompass the majority of policy liabilities, various other non-financial instruments or other intangible assets related to Aon's business. Accordingly, care should be exercised in deriving conclusions about Aon's business or financial condition based on the fair value disclosures. The carrying value and fair value of certain of Aon's financial instruments are as follows:
(2)Capital securities were deconsolidated due to adoption of FIN 46 on December 31, 2003. (See note 11 "Capital Securities" for further information).
Refer to "Other Financial Instruments" above for guarantees associated with Aon's premium financing securitizations. Guarantees associated with Aon's limited partnership securitization are disclosed in note 7. Indemnities related to discontinued operations are disclosed in note 6.
Aon has certain contractual contingent guarantees for premium payments owed by clients to certain insurance companies. Costs associated with these guarantees, to the extent estimable and probable, are provided in Aon's allowance for doubtful accounts. The maximum exposure with respect to such contractual contingent guarantees was approximately $30 million at December 31, 2003.
A reinsurance brokerage subsidiary of Aon has been named in several lawsuits mentioned below relating to a worker's compensation reinsurance pool known as the Unicover Occupational Accident Reinsurance Pool ("Unicover Pool"). The Unicover Pool was managed by Unicover Managers, Inc. ("Unicover"), currently known as Cragwood Managers, LLC ("Cragwood"). Along with another broker, Aon's reinsurance brokerage subsidiary procured certain - although not all - retrocessional cover for the Unicover Pool. It was also involved in arranging further retrocessional protections for certain Unicover retrocessionaires.
Also, as previously reported in August 2002, two retrocessionaires of the Unicover Pool filed a complaint in the United States District Court for the District of Connecticut against the Aon subsidiary seeking to recover any damages, costs and expenses which those retrocessionaires would suffer if the Allianz coverage was rescinded or if Allianz was awarded damages. In January 2003, the carriers dismissed their lawsuit without prejudice.
On May 22, 2003, five lawsuits were filed against Aon's subsidiary by different participants in the Unicover Pool. Each of these lawsuits is premised on the contention that an arbitration panel ruled in October 2002 to rescind the Unicover retrocessionaires' obligation to provide coverage to the Unicover Pool for any business bound or renewed on behalf of the Pool after August 31, 1998. Aon is generally aware of, and has previously reported, this arbitration.
Aon's management has reviewed these complaints and believes that Aon's subsidiary has meritorious defenses and intends to vigorously defend itself against all of these claims. As previously disclosed, the Unicover issues are complex, and therefore the timing and amount of resolution of these claims cannot be determined at this time.
On September 13, 2002, a purported shareholder's derivative action against Aon and each of Aon's directors was filed in the Circuit Court of Cook County, Illinois. This lawsuit made allegations substantially similar to the original class action lawsuits.
In December 2001, Radmanovich v. Combined Insurance Company of America, a putative class action lawsuit seeking compensatory and punitive damages from CICA, was filed on behalf of former and current employees of CICA in the U.S. District Court for the Northern District of Illinois. The action alleges discrimination against women in hiring, training and promotion and in tolerating a hostile work environment. The lawsuit seeks to recover damages for the plaintiff and for all women who worked for CICA since April 1, 1999. In March 2002, a second putative class action lawsuit, Palmer v. Combined, was filed against CICA in the same court, making similar allegations but seeking injunctive
and punitive damages on behalf of a putative class of current CICA employees. On June 26, 2003, the Court in Radmanovich denied plaintiffs' motion for class certification, after which a number of the putative class members filed individual lawsuits in the same court. Aon intends to vigorously defend these lawsuits. On September 2, 2003, the Court in Palmer granted plaintiffs' motion for class certification for injunctive and punitive damages. CICA has filed a Motion for Reconsideration of the Palmer decision, and this motion is currently pending before the court. If the motion is not successful, CICA will seek to appeal the decision. With respect to all of these cases, Aon has established reserves for the expected costs and expenses.
Although the ultimate outcome of all matters referred to above cannot be ascertained and liabilities in indeterminate amounts may be imposed on Aon or its subsidiaries, on the basis of present information, amounts already provided, availability of insurance coverages and legal advice received, it is the opinion of management that the disposition or ultimate determination of such claims will not have a material adverse effect on the consolidated financial position of Aon. However, it is possible that future results of operations or cash flows for any particular quarterly or annual period could be materially affected by an unfavorable resolution of these matters.
Certain amounts in prior periods' consolidated financial statements relating to segments and discontinued operations have been reclassified to conform to the 2003 presentation.
The accounting policies of the operating segments are the same as those described in note 1, except that the disaggregated financial results have been prepared using a management approach, which is consistent with the basis and manner in which Aon senior management internally disaggregates financial information for the purposes of assisting in making internal operating decisions. Aon evaluates performance based on stand-alone operating segment income before income taxes and generally accounts for intersegment revenue as if the revenue were from third parties, that is, at current market prices.
The Risk and Insurance Brokerage Services segment consists principally of Aon's retail, reinsurance and wholesale brokerage operations, as well as related insurance services, including underwriting management, captive insurance company management services, claims services, and premium financing.
products are sold through automobile dealership retailers, independent agents and brokers, Aon brokers and other channels.
(2)Insurance underwriting general expenses include amortization of deferred acquisition costs of $399 million, $306 million and $269 million in 2003, 2002 and 2001, respectively. Corporate and Other segment revenue consists primarily of investment income from equity, fixed-maturity and short-term investments that are assets primarily of the insurance underwriting subsidiaries that exceed policyholders liabilities and which may include non-income producing equities; valuation changes in limited partnership investments, and income and losses on disposals of all securities, including those pertaining to assets maintained by the operating segments. Corporate and Other segment general expenses include administrative and certain information technology costs.
(2)In 2001, the Condensed Statements of Cash Flows exclude the impact of certain non-cash transfers primarily related to notes receivable from subsidiaries and notes payable to subsidiaries.
Aon has provided indemnification under surety bonds issued by third parties of approximately $130 million as of December 31, 2003. The license, performance and other types of surety bonds are issued to permit operating subsidiaries of Aon to conduct business in various jurisdictions and to indemnify third parties for nonperformance by these subsidiaries.
A bank provides overdraft facilities for certain of Aon's foreign subsidiaries. Aon has guaranteed repayment of this facility in the unlikely event that the foreign subsidiaries are unable to repay. Aon has also issued guarantees and/or other letters of support for various bank lines, and various other credit facilities for certain of its foreign operations (including Euro credit facility discussed in note 8 to the consolidated financial statements). Aon's maximum potential liability with regard to these exposures was $55 million at December 31, 2003.
Aon has guaranteed the contractual performance of certain subsidiaries of third-party outsourcing agreements, which extend through 2009. However, in no case can the cumulative amount of these guarantees exceed $50 million.
Aon has guaranteed the obligations of one of its major Netherlands' subsidiaries through 2007. Management believes there is sufficient operating cash flow, liquidity and equity at this subsidiary to cover current obligations and future obligations as they come due.