The Company's executive offices and certain subsidiary and branch facilities are located at Two Pierce Place, Itasca, Illinois, where the Company leases approximately 200,000 square feet of space. The lease commitment on the above mentioned property expires February 28, 2006. The Company operates virtually all of its branch and service offices in leased premises. Certain of these leases for office space have options permitting renewals for additional periods. In addition to minimum fixed rentals, a number of leases contain escalation clauses related to increases in the cost of living in future years. See Note 11 to the Consolidated Financial Statements for information with respect to the Company's lease commitments at December 31, 1998.
In recent years insured losses have reached into the billions of dollars. Substantial mergers, both domestically and internationally, have resulted in fewer insurance companies. Increased underwriting losses and reduced competition tend to raise premium rates. In spite of these forces, there have been mitigating factors including a favorable equity market, increased underwriting capital (more supply of insurance product) and economies of scale after consolidations, all of which tend to lower premium rates. The net result is that property/casualty premium rates have remained low. Management believes these conditions in the insurance marketplace will continue and overall premium pricing will remain under pressure and not improve in 1999.
Although the property/casualty insurance pricing environment has resulted in some "risk" buyers returning to first-dollar coverage, management believes the overall trend will continue to move toward the alternative insurance market, which would tend to have a favorable effect on our Risk Management Services segment. The Company anticipates that new sales in the areas of risk management, claims management, insurance captive and self-insurance services will continue to be a major factor in the Company's fee revenue growth during 1999.
The Company continues to look to the future and to explore not only the core segments of Insurance Brokerage and Risk Management Services, but also expansion within the alternative insurance markets and financial and related investment services. Management believes these areas continue to hold opportunities for diversification and profitable growth.
Investment income and other decreased by $5.7 million or 23% in 1998. This decrease is due primarily to lower returns on funds invested with outside fund managers which were adversely affected by volatility in global
equity markets during 1998. In addition, the Company liquidated a portion of its investment portfolio, thereby reducing the aggregate value of these portfolios by $24.0 million during 1998. Investment income and other was virtually unchanged in 1997 from the same period in 1996.
Other operating expenses increased by $11.2 million or 7% in 1998. This increase is due primarily to increases associated with travel, entertainment and temporary personnel costs for new business, technology upgrades, office consolidation expenses and commissions paid to sub-brokers. Other operating expenses increased by $6.4 million or 4% in 1997. This increase is due primarily to higher business insurance costs, additional rent and utility expenses resulting from leasing new office space, expanding and upgrading existing office facilities and the costs associated with closing certain underperforming operations.
The Company's revenues vary from quarter to quarter generally as a result of the timing of policy inception dates which traditionally are heaviest in the third quarter. Expenses, on the other hand, are fairly uniform throughout the year. See Note 13 to the Consolidated Financial Statements.
Risk Management Services includes the Company's third party claims administration operations which are principally engaged in providing claims management services for the Company's clients. Total revenues in 1998 were $168.8 million or 18% over 1997 due to strong new business production and favorable retention rates on existing business. U.S. revenues of $156.8 million in 1998 were up 15% over 1997 due primarily to new business. In 1998, foreign revenues of $12.0 million, principally from the United Kingdom and Australia, increased 107% over 1997 due mainly to new business and significant revenues from Australian operations for claim work performed as a result of a pervasive and extended power outage in New Zealand. Earnings before income taxes in 1998 increased 50% over 1997 due primarily to large revenue increases. Total revenues in 1997 were $142.7 million or 3% over 1996 due to new business production partially offset by lost business. In 1997, U.S. revenues increased 1% over 1996 due primarily to new business partially offset by lost business. Earnings before income taxes in 1997 decreased 18% from 1996 due primarily to lost business partially offset by new business.
The insurance brokerage industry is not capital intensive. The Company has historically been profitable, and cash flows from operations and short-term borrowings under various credit agreements have been sufficient to fund operating, investment and capital expenditure needs of the Company. Cash generated from operating activities was $56.4 million, $67.0 million and $45.6 million in 1998, 1997 and 1996, respectively. Because of the variability related to the timing of premiums and fees receivable and premiums payable, net cash flows from operations vary substantially from year to year. Funds restricted as to the Company's use, primarily premiums held as fiduciary funds, have not been included in determining the Company's overall liquidity.
The Company maintains a $20.0 million unsecured revolving credit agreement (the "Credit Agreement") requiring repayment of any loans under the agreement no later than June 30, 2001. During 1998, the Company borrowed and repaid $15.0 million of short-term borrowings under the Credit Agreement. These borrowings were primarily used on a short-term basis to finance a portion of the Company's expanded investment activity. As of December 31, 1998, there were no borrowings outstanding under this agreement. During 1997, the Company made no borrowings under this agreement. The Credit Agreement requires the maintenance of certain financial covenants. The Company is currently in compliance with these covenants. The Company also had two term loan agreements. In 1998, the Company retired the remaining loan balances on these term loan agreements.
$15.0 million was outstanding under these facilities. These borrowings were primarily used on a short-term basis to finance a portion of the Company's expanded investment activity.
Net capital expenditures were $14.0 million, $11.4 million and $10.4 million in 1998, 1997 and 1996, respectively. In 1999, the Company expects to make expenditures for capital improvements of approximately $14.5 million. Capital expenditures by the Company are related primarily to office moves and expansions and updating computer systems and equipment.
Computer programs that have time sensitive software may recognize the date "00" as the Year 1900, rather than the Year 2000 which could result in system failures or miscalculations causing disruptions of operations. With respect to this issue, the Company has completed an assessment of its computer systems and software and has substantially completed the necessary modifications or replacements of its existing software so that its computer systems will function properly in the Year 2000 and beyond. Testing and live use have taken place and will continue into 1999. Any additional modifications found necessary will be made at that time. No contingency plans are deemed necessary.
Generally, system modifications and replacements and the associated costs were contemplated with normal enhancements and improvements being made in conjunction with updating financial reporting and operating systems. To date, the cost of compliance has not been material and is not expected to be material in the future.
The Company is exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest and foreign currency exchange rates and equity prices. The Company does not enter into derivatives or other similar financial instruments for trading or speculative purposes. The following analysis presents the hypothetical loss in fair value of the financial instruments held by the Company at December 31, 1998 that are sensitive to changes in interest rates and equity prices. The range of changes in interest rates used in the analysis reflects the Company's view of changes that are reasonably possible over a one year period. This discussion of market risks related to the Company's consolidated balance sheet includes estimates of future economic environments caused by changes in market risks. The effect of actual changes in these risk factors may differ materially from the Company's estimates. In the ordinary course of business, the Company also faces risks that are either nonfinancial or nonquantifiable, including credit risk and legal risk. These risks are not included in the following analysis.
The Company has a comprehensive and diversified investment portfolio. The Company's invested assets are held as cash and cash equivalents, investment strategies held as trading and marketable securities held as available for sale. Accordingly, these assets are subject to various market risk exposures such as interest rate risk and equity price risk.
strategies hedge their strategies by "selling short" common equity securities in order to mitigate the effects of changes in equity prices thereby making any such fluctuations immaterial. Accordingly, hypothetical changes in equity prices would not cause the resulting fair value to be materially different from the December 31, 1998 carrying value for this portfolio.
At December 31, 1998, the fair value of the Company's marketable securities portfolio was $20.1 million, which was $1.3 million less than its aggregate amortized cost. The overall objective of this portfolio is to provide the Company with a stable after tax yield. This portfolio, which is not hedged, primarily consists of dividend yielding preferred stocks. Accordingly, this portfolio is more sensitive to interest rate risk than it is to equity pricing risk. The estimated potential loss in fair value resulting from a hypothetical one percentage point increase in short-term interest rates at December 31, 1998 would be approximately $2.1 million.
At December 31, 1998, the fair value of the Company's borrowings under the line of credit facilities approximated the carrying value due to their short- term duration and variable interest rates. Market risk was estimated as the potential increase in the fair value resulting from a hypothetical one percentage point decrease in the Company's weighted average short-term borrowing rate at December 31, 1998 and the resulting fair value was not materially different from the year end carrying value.
This annual report contains forward-looking statements. Forward-looking statements made by or on behalf of the Company are subject to risks and uncertainties, including but not limited to the following: the Company's commission revenues are highly dependent on premiums charged by insurers, which are subject to fluctuation; the property/casualty insurance industry continues to experience a prolonged soft market (low premium rates) thereby reducing commissions; lower interest rates will reduce the Company's income earned on invested funds; the insurance brokerage and service businesses are extremely competitive with three competitors being substantially larger than the Company; the alternative insurance market continues to grow which could unfavorably impact commission and favorably impact fee revenue; the Company's revenues vary significantly from period to period as a result of the timing of policy inception dates and the net effect of new and lost business production; the general level of economic activity can have a substantial impact on the Company's renewal business; the Company's operating results and financial position may be adversely impacted by exposure to various market risks such as interest rate, equity pricing and foreign exchange rates; and the Company's Year 2000 compliance efforts depend upon compliance efforts of the Company's business partners, vendors and clients. The Company's ability to grow has been enhanced through acquisitions, which may or may not be available on acceptable terms in the future and which, if consummated, may or may not be advantageous to the Company. Accordingly, actual results may differ materially from those set forth in the forward-looking statements. Attention is also directed to other risk factors set forth in documents filed by the Company with the Securities and Exchange Commission.
The accompanying consolidated financial statements include the accounts of the Company and all of its majority owned subsidiaries. Investments in partially owned entities in which ownership is 20% to 50% are accounted for using the equity method. Accordingly, the Company's share of the net earnings of these entities is included in consolidated net earnings. Investments in partially owned entities in which ownership is less than 20% are carried at cost. All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to the prior years' financial statements in order to conform to the current year presentation.
As of December 31, 1998, the Company adopted Statement of Financial Accounting Standards No. 131 (SFAS 131), "Disclosure about Segments of an Enterprise and Related Information," which superseded Statement of Financial Accounting Standards No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to stockholders. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The adoption of SFAS 131 had no impact on the Company's consolidated operating results or financial position, but did affect the disclosure of segment information. Prior year segment information has been reclassified to conform to the requirements of SFAS 131. See Note 14 to the consolidated financial statements.
Short-term investments, consisting principally of commercial paper and certificates of deposit which have a maturity of ninety days or less at date of purchase, are considered cash equivalents.
Marketable securities are considered available for sale and consist primarily of preferred and common stocks. Securities designated as available for sale are carried at fair value in the accompanying consolidated balance sheet, with unrealized gains and losses, less related deferred income taxes, excluded from net earnings and reported as accumulated other comprehensive earnings. Gains and losses are recognized in net earnings when realized using the specific identification method. The fair value for marketable securities is based on quoted market prices.
The Company primarily grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," and, accordingly, recognizes no compensation expense for these stock options granted to employees.
The following summarizes the restatement of the 1997 and 1996 consolidated financial statements to reflect the operations of the 1998 acquisitions (in thousands, except per share data):
In 1998, the Company acquired the net assets of three insurance brokerage firms in exchange for cash and notes payable. These acquisitions were accounted for as purchases. In 1997, the Company acquired a majority equity interest in a risk management company which was also accounted for as a purchase. The Company paid cash in this transaction. These purchase transactions were not material to either the 1998 or 1997 consolidated financial statements.
The gross realized gains on sales of marketable securities totaled $3,054,000, $2,257,000 and $1,652,000 for 1998, 1997 and 1996, respectively. The gross realized losses totaled $1,179,000, $346,000 and $881,000 for 1998, 1997 and 1996, respectively.
3. Investments--(Continued) Tax advantaged investments represent amounts invested by the Company in limited partnerships that operate qualified affordable housing or alternative energy projects. The Company receives tax benefits in the form of tax deductions for operating losses and tax credits from these investments. The tax advantaged investments are primarily accounted for using the effective yield method and are carried at amortized cost in the consolidated balance sheet. Under the effective yield method, the Company recognizes the tax credits as they are allocated by the partnerships, which are included, net of amortization of the investment, as a component of the provision for income taxes. During 1998 and 1997, the Company received tax benefits related to $20,159,000 and $21,934,000 of the aggregate amount invested in the tax advantaged investments at December 31, 1998 and 1997, respectively. Investments in real estate partnerships primarily represent an investment in a limited partnership that owns 10,000 acres of land to be developed near Orlando, Florida. Investments in real estate partnerships are carried at cost in the consolidated balance sheet, which approximated fair value at December 31, 1998. Notes receivable from investees represent secured loans made by the Company to several of its equity and limited partnership investments. Interest rates on the loans at December 31, 1998 ranged from 6% to 9.75%. The carrying value of these loans at December 31, 1998 approximated fair value.
The Company also has line of credit facilities of $27,500,000 which expire on April 30, 1999. Short-term borrowings under these facilities totaled $15,000,000 at December 31, 1998 and 1997. The weighted average interest rate on the short-term borrowings were 5.9% and 6.5% during 1998 and 1997, respectively.
At December 31, 1997, the Company had two unsecured term loan agreements with outstanding balances of $630,000 and $500,000 and stated interest rates of 6.64% and 6.30%, respectively. In 1998, the Company retired the remaining balances on these term loan agreements.
The table below summarizes certain information about the Company's capital stock at December 31, 1998 and 1997 (in thousands, except per share data):
The Company has incentive and nonqualified stock option plans for officers and key employees of the Company and its subsidiaries. The options are primarily granted at the fair value of the underlying shares at the date of grant. Options granted under the nonqualified plan primarily become exercisable at the rate of 10% per year beginning the calendar year after the date of grant or earlier in the event of death, disability or retirement. Options expire ten years from the date of grant, or earlier in the event of termination of the employee.
8. Stock Option Plans--(Continued) The following is a summary of all of the Company's stock option activity and related information (in thousands, except exercise price data):
Other information regarding stock options outstanding and exercisable at December 31, 1998 is summarized as follows (in thousands, except exercise price data):
The Company accounts for the defined benefit pension plan in accordance with Statement of Financial Accounting Standards No. 87 (SFAS 87), "Employers' Accounting for Pensions." The difference between the present value of the pension benefit obligation at the date of adoption of SFAS 87 and the fair value of plan assets at that date is being amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits.
The Company has a contributory savings and thrift plan covering the majority of its employees. Company contributions are at the discretion of the Company's Board of Directors and may not exceed the maximum
9. Retirement Plans--(Continued) amount deductible for federal income tax purposes. The Company contributed $2,823,000, $2,760,000 and $3,220,000 in 1998, 1997 and 1996, respectively. The Company also has a foreign defined contribution plan which provides for basic contributions by the Company and voluntary contributions by employees which are matched 100% by the Company, up to a maximum of 5% of salary, as defined. Net expense (income) for foreign retirement plans amounted to $3,128,000 in 1998, ($2,922,000) in 1997 and $1,485,000 in 1996.
In 1997, the Company settled a foreign defined benefit plan and enrolled the participants into a foreign defined contribution plan. At the time of the settlement of the foreign plan, there was a surplus of plan assets in excess of benefit obligations. Previously vested benefits of the plan participants were settled by the purchase of annuity policies with a life insurance company. As a result of the defined benefit plan settlement, the Company recognized a $4,830,000 gain in 1997 which was recorded as a reduction of salaries and employee benefits expense.
In 1992, the Company amended its health benefits plan to eliminate retiree coverage, except for retirees at the time of the amendment and those employees who had already attained a specified age and length of service. The retiree health plan is contributory, with contributions adjusted annually and is funded on a pay-as-you-go basis.
Total rent expense, including rent relating to cancelable leases and leases with initial terms of less than one year, amounted to $32,057,000 in 1998, $30,724,000 in 1997 and $28,796,000 in 1996.
At December 31, 1998, the Company has contingently committed to invest an additional $7,500,000 in 1999 related to two letter of credit arrangements with one of its equity investments. At December 31, 1998, the Company has agreed to unconditionally guarantee $30,000,000 of debt that will be incurred by one of the Company's equity investments in 1999. In addition, the Company has guaranteed an aggregate $8,700,000 of funds through letters of credit or other arrangements related to several investment and insurance programs of the Company.
Quarterly operating results for 1998 and 1997 were as follows (in thousands, except per share data):
The Company has identified three operating segments in addition to its corporate operations. Insurance Brokerage Services encompasses operations that, for commission or fee compensation, place or arrange to place insurance directly related to the clients' funding of risk. This segment also provides consulting, for fee compensation, related to clients' risk financing programs. Risk Management Services includes the Company's third party administration, loss control and risk management consulting, workers' compensation investigations and insurance property appraisal operations. Third party administration is principally claims management services for the Company's clients. Financial Services includes alternative investment strategies and tax advantaged investments. It manages the Company's own investment portfolio while expanding these services in conjunction with the insurance products the Company markets. Corporate consists primarily of unallocated administrative costs and the provision for income taxes which is not allocated to the Company's operating segments.
The Company maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and that transactions are executed as authorized and are recorded and reported properly. This system of controls is based on written policies and procedures, appropriate divisions of responsibility and authority, careful selection and training of personnel and the utilization of an internal audit function. Policies and procedures prescribe that the Company and all employees are to maintain the highest ethical standards and that business practices throughout the world are to be conducted in a manner which is above reproach.
We have audited the accompanying consolidated balance sheet of Arthur J. Gallagher & Co. as of December 31, 1998 and 1997, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.