Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP and U.S. GAAP as it relates to us, see note 19 to our audited consolidated financial statements included elsewhere in this Form 10-K.
We adopted Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 (SFAS No. 142) on January 1, 2002. Upon adoption of SFAS No. 142 goodwill is no longer amortized. The following table illustrates the effect that SFAS No. 142 would have had on net earnings and per share
information under U.S. GAAP for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 had goodwill not been amortized:
The following discussion and analysis should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report. Certain information contained in “Management’s discussion and analysis of financial condition and results of operations” are forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements because of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the heading “Risk Factors”. Reference to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (U.S. GAAP) and to the extent that they effect us are described in Note 19 to our audited consolidated financial statements.
As of December 31, 2004, our operations included 14 regional “hub” brokerages - nine in the United States and five in Canada - and nearly 200 offices staffed by approximately 3,300 people. Our strategic plan calls for the addition of approximately 6 additional U.S. hubs to extend our geographic footprint. Brokerages large enough to be considered hubs will generally have annual revenue in excess of $10 million. In addition to larger, “hub” acquisitions by the parent corporation, each regional hub is tasked with pursuing smaller, fold-in acquisitions that either expand its geographic penetration or add new specialization or expertise to the regional operation.
We acquired brokerages with aggregate annual revenue of $115.4 million in 2004, up from approximately $8.1 million of acquired revenue in 2003.
In accordance with our strategic plan, on July 1, 2004 we purchased Talbot Financial Corporation, (“Talbot”) based in New Mexico. We purchased all of the common shares of Satellite Acquisition Corporation (“Satellite”), a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation for $90 million in cash. We will purchase Talbot management’s special shares of Satellite over the next three years, using a combination of both our restricted and unrestricted common shares. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month period ending December 31, 2004, 2005 and 2006, respectively. The contingent payments to Talbot management are a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. Based on Talbot’s financial performance for 2004, we anticipate total earnout payments in the $45-$50 million range. During the third and fourth quarter of 2004 we expensed $14.4 million of non-cash stock based compensation related to this acquisition.
We employ a number of distribution channels to deliver products and services to clients. Among the distribution channels we employ are:
Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago and Chilliwack, British Columbia;
During the 1990s, insurance rates were generally considered low, or “soft,” as insurance companies sought to maximize the flow of premium dollars that they could invest profitably in a rising stock market and in other investments. Beginning in 2000, as return on investment began to shrink, insurance rates began to rise, or “harden,” at a pace that accelerated rapidly after the terrorist attacks of September 11, 2001. During the two years after September 11, 2001, premium rates remained firm for most types of coverage, rising 10% to 15% per year in many cases. During the latter part of 2003, the Canadian market remained firm, but the U.S. market experienced some softening of premium rates for property and casualty coverage. During the first six months of 2004, Canadian and U.S. markets both softened, although rates for certain types of coverage continued to increase. During the third and fourth quarters of 2004 however, insurance rates for many types of coverage began falling at a much more rapid pace than during the first six months of the year.
For us, as for other brokers, falling rates can present both positive and negative effects. Falling premiums yield less commission income, if the insurance buyer maintains its coverage levels. However, many insurance buyers will respond to falling rates by increasing total coverage, often by lowering deductibles, increasing limits of coverage, or by adding new risks to those already insured. Although insurance rates fell during the last six months of 2004 we have not yet experienced any significant positive reactions from insurance buyers, although we expect we may in the months ahead. In addition, the economic environment could lead to higher or lower sales and employee headcounts at client companies, leading in turn to increased or reduced demand for employee benefits, liability and other types of coverage tied to business activity levels.
Year ended December 31, 2004 compared to year ended December 31, 2003
Of the $74.5 million in new revenue we reported, $59.6 million, or 80% reflected growth through acquisition, while $14.9 million, or 20% resulted from organic growth. By comparison, acquired revenue added $40.0 million, or 60% of 2003’s sales growth, while organic growth contributed $26.4 million, or 40% of our revenue increases. Organic growth figures include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2004, the rise of the Canadian dollar versus the U.S. dollar contributed three percentage points of our 5% organic growth rate in revenue.
Volume overrides - additional compensation paid by insurance companies to brokerages on the basis of the overall volume of business a brokerage places with the insurance company;
Contingent commissions - additional compensation based on the profit an insurance company makes on the book of business a brokerage places with the insurance company; and
As shown above, we benefited less from a stronger Canadian dollar in 2004 as compared to 2003. The impact of foreign exchange on 2004 earnings generated an increase of $1.7 million as compared to an increase of $2.3 million in 2003. In 2004, we wrote off $1.7 million (after tax) of intangible assets related to trademarks as part of our corporate branding initiative and recorded $14.4 million of non-cash stock based compensation related to the Talbot acquisition.
Changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada and do not use derivatives to manage our Canadian pre-tax income, foreign exchange fluctuations will continue to impact our results. We have highlighted the impact of these changes because currency translation effects can lead to reported results that are less meaningful than local-currency results as an indicator of underlying operations. In 2004, the strength of the Canadian dollar versus the U.S. dollar had a less positive impact on our results than in 2003. Any decline in the Canadian dollar relative to the U.S. dollar would have a negative effect on our results. See “Market Risk”.
U.S. revenue grew 35% to $239.0 million, or 66% of consolidated revenue in 2004. Acquisitions in 2004 added $61.4 million to revenue - 100% of the increase. Our U.S. operations posted an organic growth rate of 0% in 2004, as compared to 3% in 2003, primarily as a result of the rapid softening of premium rates for property and casualty coverage in the third and fourth quarters of 2004. Core commission income increased 37%, while contingent commissions and volume overrides grew 10%. Higher premium rates in 2003 contributed strongly to a significant increase in contingent profitability income from insurance companies in 2004.
Canadian revenue grew 12% to $121.8 million, or 34% of consolidated revenue, in 2004 as compared to 2003, primarily as a result of organic growth and strengthening of the Canadian dollar against the U.S. dollar. Canadian brokerages posted organic growth of 13%, of which eight percentage points reflected a stronger Canadian dollar. Dispositions lowered revenue by $2.5 million while acquisitions added $0.6 million, for a net decrease of $1.9 million. Similar to the United States, premium rates in Canada fell significantly in the third and fourth quarters of 2004. Canadian operations benefited from an increase in contingent commissions and volume overrides, which grew 36% in 2004, versus 37% growth rate in 2003. Higher premium rates in 2003 contributed strongly to a significant increase in contingent profitability income from insurance companies in 2004.
Our non-cash stock based compensation includes stock options and restricted share units for senior employees as well as the amortization of $14.4 million, or $0.41 per diluted share, of non-cash stock based compensation related to the estimated earnout due to management of Talbot over the next three years. In response to investor interest in the true impact of these costs, we began recognizing the expense of non-cash stock based compensation during 2003. Options vest evenly over three years and expire in seven years from issuance. Shares derived from the options are held in escrow for a period of five years from the date the options are granted, subject to early releases in certain circumstances. Restricted share units vest over periods ranging from 48 months to 95 months. Our policy is to expense the fair value of non-cash stock based compensation to employees over the period in which entitlement to the compensation vests. The amount of expense recognized in each year related to stock options will vary with respect to exercise and forfeiture of options.
Non-cash stock based compensation for the years ended December 31, 2004, 2003 and 2002 is comprised of the following:
Depreciation increased 16% to $7.3 million in 2004 but remained constant at 2% of revenue.
Interest expense increased 44% to $7.5 million from $5.2 million in 2003. This increase reflected borrowings for the Talbot acquisition in July 2004, partially offset by the benefits of an interest rate swap in 2004. The interest rate swap effectively converted $65 million of fixed interest rate senior notes into floating rate instruments, reducing interest expense on the senior notes by $1.3 million in 2004 compared to $0.8 million in 2003.
Intangible asset amortization increased 72% to $5.5 million in 2004 as a result of the acquisition of Talbot.
In January 2004, we adopted a corporate marketing and positioning strategy to build awareness of the Hub brand across all of our markets and to encourage greater coordination and collegial identity among our employees. As part of this corporate consolidation and identity development program, we have reassigned a number of key executives to new or expanded areas of responsibility and determined that future marketing and communications will be conducted under the Hub International name, rather than the traditional corporate names of acquired brokerages. As a result, in the first quarter of 2004 certain of our subsidiaries changed their names and as a result, we recognized a non-cash impairment expense of approximately $2.6 million before tax related to trademarks.
Our effective tax rate increased to 43% in 2004 from 34% in 2003 due primarily to non-cash stock based compensation expense related to the acquisition of Talbot which is not deductible for tax purposes. Excluding the non-cash stock based compensation the effective tax rate for 2004 was 33%.
Revenue increased 30% to $286.4 million in 2003. Although the pace of acquisitions did not match that of 2002, we benefited from strong organic growth rates in most hubs, contributions from brokerages acquired in 2002 and the currency exchange benefits of a strengthening Canadian dollar.
The table below shows a breakdown of our revenue by segment and type for the year ended December 31, 2003 including organic growth for 2003:
Other income - comprised primarily of premium finance fees, fees charged to clients in lieu of commissions and interest income, including income earned while we hold client premiums on behalf of insurance companies.
During 2003 we experienced an unusual timing issue at a single hub that provides lender-placed auto insurance coverage for financial institutions. Lender-placed coverage is primarily collision coverage on automobiles financed through a financial institution. This is a high-volume business that is generally very profitable for us. However, two financial institutions adjusted their credit policies in 2003, leading to cancellation of several quarters’ worth of policies in a single quarter resulting in 2003 revenue being reduced by approximately $4.3 million. Excluding the impact of this product line, U.S. organic growth was 9% in 2003.
Depreciation declined slightly to 2.2% of revenue in 2003 from 2.5% in 2002. The lower relative impact reflected control of capital expenditures while revenue grew.
Our use of shares as a core component of our acquisition proceeds and as a form of executive compensation has led to significant increases in the number of shares outstanding over the past few years. In addition, we issued 6.9 million common shares in our June 2002 U.S. IPO and listing on the New York Stock Exchange. The weighted average number of diluted shares outstanding increased from 20.1 million in 2001 to 30.2 million in 2002 and 33.8 million in 2003.
As of December 31, 2004, we had cash and cash equivalents of $98.2 million, an increase of 20%, from $82.1 million as of December 31, 2003. Operating activities generated $57.4 million of cash in 2004 compared to $53.9 million in 2003. The amount of cash provided by operating activities is affected by net earnings for the period, non-cash income and expenses, the change in trust cash, the collection of accounts and other receivables and the payment of accounts payable and accrued liabilities. In 2004, $93.3 million of cash was used in investing activities, primarily for the purchase of subsidiaries compared to $20.1 million in 2003. Also in 2004, $48.1 million of cash was provided from financing activities, primarily resulting from long-term debt advances. In 2004, the effect of exchange rate changes on cash and cash equivalents was an increase of $4.0 million compared to $3.1 million in 2003. Net debt, defined as long-term debt ($151.8 million) and subordinated convertible debentures ($35.0 million) less non-trust cash (cash and cash equivalents of $98.2 million) as of December 31, 2004, was $88.6 million compared with $31.7 million as of December 31, 2003.
As a broker, we collect and hold premiums paid by clients, deduct commissions and other expenses from these payments, and hold the remainder in trust, which we remit to the insurers who provide coverage to clients. We earn interest on these funds during the time between receipt of the cash and the time the cash is paid to insurers. The cash held in trust is shown separately on our balance sheet under the caption “Trust Cash”. On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
Demand U.S. dollar base rate loan - We have an undrawn $10.0 million facility which bears interest at the bank’s U.S. base rate, which was 5.75% and 4.50% at December 31, 2004 and 2003, respectively, plus 50 basis points. Borrowings under this facility are repayable on demand.
fair value of the swap to be $2.4 million, which is not recognized in our financial statements. Accordingly, $2.4 million is the estimated amount that we would need to pay to terminate the swap as of December 31, 2004.
In addition to these primary credit sources, we ended 2004 with $14.1 million of subsidiary debt comprised of various notes payable, term loans and capital leases. We intend to repay these liabilities from internally generated cash flow, existing cash balances and/or borrowings under our credit facilities as the subsidiary debt becomes due during 2005 through 2010. Of the outstanding subsidiary debt, $8.4 million is secured by liens on certain assets of our subsidiaries.
At the close of 2004, our cash position included approximately $57.1 million deployed as working capital at the brokerage level and approximately $41.1 million available for acquisitions. This amount combined with available lines of credit leaves us with a total amount of $61.1 million available for acquisitions. It is impossible to define exactly how many acquisitions or how much new revenue could be acquired through the use of this cash, additional cash flow from operations and application of credit facilities, as acquisition pricing and other factors vary during the course of the year. However, we intend to use our common shares as consideration for approximately 30%-70% of the value of a hub acquisition, and generally have paid a multiple of 5-8 times earnings before interest, taxes, depreciation and amortization (frequently referred to as EBITDA, which is not a GAAP measure) for acquired brokerages.
We believe that our capital resources, including existing cash, funds generated from operations and borrowings available under credit facilities, will be sufficient to satisfy the company’s financial requirements, including some strategic acquisitions, during the next twelve months. We may finance acquisitions with available cash or an existing credit facility, but may, depending on the number and size of future acquisitions, need to supplement our finance requirements with the proceeds from debt financing, the issuance of additional equity securities, or a combination of both.
Our debt to capitalization ratio (debt as a percentage of debt and shareholders’ equity) increased to 33% at December 31, 2004, compared with 25% at December 31, 2003. If all lines of credit and other loan facilities were fully utilized by the company at December 31, 2004, our ratio of debt to capitalization would have been 35%, which is within the range of 35% to 38% that our management believes is suitably conservative for our business model. Under our loan covenants, our debt to capitalization ratio must be less than the 45%. As of December 31, 2004, we were in compliance with the financial covenants under all of our debt instruments.
The table below summarizes our contractual obligations and commercial commitments as of December 31, 2004:
In connection with the acquisition of Talbot on July 1, 2004, we will purchase special shares of Satellite Acquisition Corp., (“Satellite”) owned by the management of Talbot, over the next three years, using a combination of both our restricted and unrestricted common shares. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12-month periods ending December 31, 2004, 2005 and 2006, respectively. We will record the contingent payment to Talbot management as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. In 2004, we recorded $14.4 million of non-cash stock based compensation with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004, management estimates we may be obligated to pay contingent payments of approximately $30-$35 million in our common shares, in addition to the $14.4 million of amounts accrued to date mentioned above.
In April 2004, Hub International Northeast Limited (“HUB Northeast”), formerly known as Kaye Insurance Associates, Inc., a subsidiary of Hub, received a subpoena from the Office of the Attorney General of the State of New York seeking information regarding certain compensation agreements between insurance brokers and insurance companies. The New York Attorney General subpoenaed information on such compensation agreements from several other major insurance brokers and insurance companies as well. Such compensation agreements, also known as contingent agreements, between insurance companies and brokers are a long-standing and common practice within the insurance industry. HUB Northeast discloses such agreements on its invoices to clients and on its web site. In addition, we disclose the arrangements in our public filings. In August 2004, HUB Northeast received a second subpoena from the Office of the Attorney General of the State of New York seeking information regarding all revenue that HUB Northeast may have derived from insurance companies. In September 2004, HUB Northeast received a third subpoena from the Office of the Attorney General of the State of New York seeking information
regarding any “fictitious” and “inflated” insurance quotes to which HUB Northeast may have been a party. We continue to fully cooperate with the Attorney General’s inquiry.
From August 2004 through February 2005, various other subsidiaries of Hub received and responded to letters of inquiry and subpoenas from authorities in California, Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec.
In October 2004, we were named as a defendant in a class action lawsuit (the “Opticare case”) filed in Federal District Court in New York against 30 different insurance brokers and insurance companies. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, we were also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. In January 2005 we were named as one of several defendants in a third class action filed in Federal District Court in Illinois, containing allegations substantially similar to those in the Opticare case and other Illinois federal class actions. None of the complaints contain any specific factual allegations against us, but rather generally assert that all of the broker defendants engaged in the types of conduct of which the New York Attorney General charged the Marsh & McLennan companies in his suit against them. On February 17, 2005 the Federal Judicial Panel on Multidistrict Litigation transferred the Opticare case as well as three other class actions in which we are not named to the District of New Jersey. We expect that the three class actions filed in Federal District Court in Illinois will also be transferred to New Jersey. We deny the allegations made in these lawsuits and intend to vigorously defend these cases.
In January, 2005 we and our affiliates were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through Hub International of Illinois Limited (formerly Mack and Parker, Inc.) and claims that an undisclosed contingent commission was received with respect to its policy. We deny this and the other allegations of the complaint and intend to vigorously defend this case.
In connection with our executive share purchase plan, under certain circumstances, we may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4.3 million and $4.5 million as of December 31, 2004 and 2003, respectively, to assist in purchasing our common shares. As collateral, the employees have pledged 431,000 and 478,000 common shares as of December 31, 2004 and 2003, respectively, which had a market value of $7.9 million and $8.1 million as of December 31, 2004 and 2003, respectively. Interest on the loans in the amount of $192,000, $279,000 and $264,000 for the years ended December 31, 2004, 2003 and 2002, respectively, was paid by us and is included in cash compensation expense. We no longer make loans to our executive officers and directors.
Restricted share units. In 2004, restricted share units totaling 977,000 were issued in connection with the restructuring of our management bonus agreement and 84,000 restricted share units were issued in connection with the renegotiation of contingent consideration for J.P. Flanagan Corporation.
We are exposed to interest rate risk in connection with our senior notes due to the interest rate swap entered into in 2003, which converted the fixed rate interest payments on the $65 million aggregate principal amount of senior notes outstanding into floating rate payments and on our revolving U.S. dollar LIBOR loan. As a result each 100 basis point increase in interest rates charged on the balance of our outstanding floating rate debt as of December 31, 2004 will result in approximately $0.8 million decrease in our earnings.
The Canadian dollar is subject to volatility. It experienced a significant decline in its value compared to the U.S. dollar in 2001 but has increased significantly in value throughout 2003 and 2004. At December 31, 2004 and 2003 one U.S. dollar equaled $1.2036 and $1.2924 Canadian dollars, respectively. The table below summarizes the effect that a $0.01 decline or increase in the value of the Canadian dollar would have had on our revenue, net earnings and cumulative translation account for the twelve months ended December 31, 2004, 2003 and 2002.
The increasing proportion of our revenue derived from our U.S. operations and earned in U.S. dollars has, in part, offset the potential risk of a decline in the Canadian dollar. We expect that the proportion of revenue earned in U.S. dollars will continue to increase, further mitigating our foreign currency exchange sensitivity. We have not entered into, and do not intend to enter into, foreign currency forward exchange agreements.
We estimate that our amortization charges for intangible assets from 2005 through 2009 for all acquisitions consummated through December 31, 2004 will be:
As of December 31, 2004 and 2003, we had accounts receivable and accounts payable balances with the above related parties in the amounts of $4.6 million and $17.8 million for 2004, respectively, and $3.2 million and $18.0 million for 2003, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in the normal course of business. The companies listed above except for OLIC, are related through common ownership by Fairfax Financial Holdings Limited (Fairfax), which owns approximately 26% of our common shares as of December 31, 2004. During the second quarter of 2004, Fairfax sold OLIC to Old Lyme Insurance Group, Ltd, a company owned primarily by a group of Hub employees, including Bruce Guthart, our Chief Operating Officer and a director of Hub, and Michael Sabanos, Chief Financial Officer of HUB Northeast. We continue to place insurance with OLIC. The compensation that Hub earns from the business placed with OLIC and the fees it earns from managing OLIC are substantially the same as if Fairfax continued to own the company.
Under Canadian GAAP, we use the synthetic instruments method to account for the interest rate swap transaction - which converted fixed rate interest payments of 5.71% and 6.16% on the senior notes of $10 million and $55 million, respectively to a floating rate of approximately 2.00% and 2.40% for 2004 and 2003, respectively. Under this method, we report in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.4 million is not recognized in our Canadian GAAP financial statements. Under U.S. GAAP, we have designated the swap transaction as a hedge of changes in the fair value of our fixed rate debt caused by changes in interest rates and record the swap on our U.S. GAAP balance sheet at its fair value. Changes in the fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt. We have no other material off-balance sheet arrangements.
Our significant accounting polices are more fully described in Note 2 to our audited consolidated financial statements. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses its judgment to
determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts and policies, our observance of trends in the insurance industry, information provided by our clients and information provided by outside sources, as appropriate. Our critical accounting policies include the recognition of commission income, the allocation of the purchase price of an acquisition, the measurement of goodwill and other intangibles and related impairment evaluation, and the valuation of stock-based compensation. These policies are discussed below.
Stock based compensation includes both stock options, restricted shares and restricted share units. Our accounting policy is to recognize the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
We measure the fair value of stock options at the date of grant of the award and recognize this amount as compensation expense over the vesting period of the options.
New Section 1530 establishes standards for the reporting and display of comprehensive income. Unrealized gains and losses on debt and equity securities as well as foreign currency translation adjustments will be included in comprehensive income. Currently, we do not record these unrealized gains and losses and foreign currency translation adjustments are recorded in equity through the cumulative translation account.
Management has assessed the effectiveness of Hub’s internal control over financial reporting as at December 31, 2004, and has concluded that such internal control over financial reporting was effective. Based on management’s assessment, there were no material weaknesses in Hub’s internal control over financial reporting as at December 31, 2004.
PricewaterhouseCoopers LLP, who has audited the Company’s consolidated financial statements for the year ended December 31, 2004, has also audited management’s assessment of the effectiveness of Hub’s internal control over financial reporting as at December 31, 2004 as stated in their report which appears in Item 8 of this Annual Report on Form 10-K.
(In thousands of U.S. dollars, except per share amounts or as otherwise indicated)
During 2004, the Company purchased Talbot Financial Corporation (“Talbot”) as described below, which was accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of Talbot are included in the Company’s consolidated results from the date of acquisition.
On April 23, 2004 the Company renegotiated an existing unsecured loan facility increasing the funds available from $65 million to $75 million (see note 9). $65 million of this facility was drawn and used for the acquisition of Talbot.
Effective June 28, 2001, the Company acquired Kaye Group Inc., now known as Hub International Group Northeast Inc., including its subsidiary Kaye Insurance Associates, Inc. now known as Hub International Northeast Limited (“HUB Northeast”). HUB Northeast, primarily an insurance broker, also underwrote insurance risks through its subsidiaries Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively Old Lyme). The Company indicated prior to the effective date of the HUB Northeast acquisition that it intended to find a purchaser for the Old Lyme operations as soon as possible after closing.
On May 30, 2002 the Company completed the sale of Old Lyme to Fairfax Inc, a related party, and recorded a non-taxable gain on the sale of $2.6 million. This gain increased 2002 annual basic earnings per share and diluted earnings per share by $0.11 and $0.09, respectively. Fairfax subsequently sold Old Lyme Insurance Company, Ltd. to a related party. See note 18 “Related Party Transactions.”
Preparation of the financial statements in conformity with Canadian and U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the reported amount of revenue and expense during the reporting period. The principal estimates used in the preparation of these financial statements are the determination of the provision for cancelled policies relating to revenue recognition, allowance for doubtful accounts, the allocation of the purchase price on acquisitions, the valuation of reporting units when testing the recoverability of goodwill and other intangible assets, the estimation of the useful lives of definite life intangible assets, and the measurement of non-cash stock based compensation. Actual results could differ from those estimated.
The Company’s financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains cash with banks in excess of federally insured limits and is exposed to the credit risk from this concentration of cash. The Company performs ongoing credit evaluations of its customers’ financial condition and generally requires no collateral. No single client accounted for more than ten percent of total client premiums or more than ten percent of revenue for the years ended December 31, 2004, 2003 and 2002, respectively.
Premiums collected (less commissions and other deductions), but not yet remitted to insurance companies, are included in trust cash. Trust cash is restricted as to use by contractual obligations and by laws in certain states and provinces in which the Company operates.
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recorded based on the estimated useful economic lives of the related assets as follows: for computer equipment on a straight-line basis from 3 to 5 years or on a 30% declining balance method; for furniture, fixtures, and office equipment on a straight-line basis from 5 to 7 years or on a 20% declining balance method. Leasehold improvements are amortized on the straight-line method over the term of the related lease. Upon sale or retirement, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is reflected in earnings. If the carrying value of property and equipment is identified as impaired, it is written down to its fair value.
The Company completed its impairment testing on the balance of goodwill and indefinite lived intangible assets as of January 1, 2005, 2004 and 2003. Based on the testing performed, no impairment losses were incurred.
Intangible assets other than goodwill which do not have indefinite lives are amortized on a straight-line basis over their useful lives. These intangible assets are subject to an impairment test comparing carrying values to net recoverable amounts. If the carrying value of intangible assets is identified as impaired, it is written down to its fair value.
The Company accounts for interest rate swaps with respect to its long-term debt using the synthetic instruments method under which the net interest on the swap and associated debt is reported in earnings as if it were a single synthetic financial instrument. The fair value of the derivative is not recognized in the balance sheet.
Income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities and their tax bases. Future income tax assets and liabilities are determined for each temporary difference based on the tax rates which are expected to be in effect when the asset or liability is settled. The benefit of loss carry forwards is recognized as an asset to the extent that it is more likely than not to be realized.
Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, the Company retained external counsel to assist in responding to the New York Attorney General’s inquiries and, among other things, requested that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to other hubs, both for internal purposes and in the course of assisting it in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes. While it is not possible to predict the outcome of this investigation, if
The Company has not recorded a liability at December 31, 2004 related to these matters.
In connection with the acquisition of Talbot on July 1, 2004, the Company will purchase special shares of Satellite owned by the management of Talbot over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. During 2004, the Company recorded $14.4 million of non-cash stock based compensation with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004, management estimates the Company may be obligated to pay contingent payments of approximately $30-$35 million in common shares of the Company in addition to the $14.4 million of amounts accrued to date mentioned above.
respectively. Interest on the loans in the amount of $192, $279 and $264 for the years ended December 31, 2004, 2003 and 2002, respectively, was paid by the Company and is included in cash compensation expense.
The Company is committed under lease agreements for office premises and computer equipment. At December 31, 2004, aggregate minimum rental commitments (net of expected sub-lease receipts) under operating leases are as follows:
In the ordinary course of business, the Company and its subsidiaries are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on the consolidated financial position or results of operations of the Company.
During 2004, the Company sold assets and shares of certain insurance brokerages for $9,166 resulting in a gain of $2,086. Annual revenue for 2003 of these brokerages was approximately $7,400.
During 2002, the Company purchased all of the issued and outstanding shares of Hooper Hayes & Associates, Inc., now known as Hub International of California Inc., and Fifth Third Insurance Services, Inc. which was renamed Hub International of Indiana Limited (HUB Midwest), as well as outstanding shares or net assets of 6 other brokerages, all of which were acquired using the purchase method of accounting.
In addition to the consideration shown above, the previous owners of certain acquisitions are entitled to contingent consideration if certain revenue or profitability targets are met. See note 3 “Commitments and contingencies.”
As of December 31, 2004 and 2003 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
recognized a non-cash loss on the write-off of trademarks during the first quarter 2004 of $2,587, before income taxes.
The Company is unable to estimate the useful life of certain non-competition covenants. These indefinite life intangible assets will be reviewed annually for impairment. Once a non-competition covenant is triggered, following the employee leaving the Company, the Company’s policy is to amortize the related intangible asset over the period of the remaining contractual obligation.
During 2004 and 2003, property and equipment were acquired at an aggregate cost of $7,293 and $8,272, respectively, of which $NIL and $2,147, respectively, were acquired by means of capital leases and other financing.
The cost above reflects certain property and equipment held under capital leases of which the remaining liability at December 31, 2004 and 2003 was $468 and $650, respectively.
Senior Notes - As at December 31, 2004 the Company has outstanding $65 million aggregate principal amount of unsecured senior notes issued June 10, 2002. The senior notes were issued in two series: Series A represents $10 million aggregate principal amount of 5.71% senior notes with interest due semi-annually, and principal of $3,333 due annually, June 15, 2008 through June 15, 2010 and Series B represents $55 million aggregate principal amount of 6.16% senior notes with interest due semi-annually, and principal of $11,000 due annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of the Company’s revolving U.S. Dollar LIBOR Loan with the balance for general corporate purposes and acquisitions. The Company incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2004, $65 million was outstanding under these senior notes, and the Company was in compliance with all financial covenants.
This term loan is from an insurance carrier. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) which reduces the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Under this incentive arrangement, both the annual interest payments as well as the principal payment can be reduced to zero. Credits were earned for 2004 and 2003 which reduced interest payments to zero from $750, for both years.
Certain property and equipment have been pledged as collateral in amounts not less than the outstanding balance of the loan at December 31, 2004 and 2003, respectively.
No options were issued in 2004. On February 28, 2003, the Company issued options exercisable for 267,000 common shares at an exercise price of $13.79 per share, the U.S. dollar equivalent of the closing sales price of the Company’s common shares on the TSX on that date. The maximum option term is seven years, and the options vest at one-third per year over three years of continuous employment. The number of common shares that may be issued under the Equity Incentive Plan is limited to 3,631,820 common shares.
There were no stock options issued in 2004. The fair value of the stock options granted in 2003 was approximately $1.2 million (weighted average exercise price was $13.79 per share). The aggregate fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions for the options issued in 2003 and 2002:
Shares derived from the options are held in escrow and subject to transfer restrictions for a period of five years from the date the options are granted, subject to early release in certain circumstances.
Non-cash stock based compensation for the year ended December 31, 2004, 2003 and 2002 is comprised of the following:
Income taxes for 2004, 2003 and 2002, amounted to $20.0 million, $18.8 million and $14.3 million, respectively, resulting in an effective tax rate of 43%, 34% and 33% in 2004, 2003, and 2002, respectively.
The provision for income tax expense differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 36.12%, 36.62% and 38.62% in 2004, 2003 and 2002, respectively, as follows:
The components of the future tax assets (liabilities) at December 31, 2004 and 2003, were as follows:
Interest and income taxes paid for the years ending December 31, 2004, 2003 and 2002 were:
As of December 31, 2004 and 2003, the Company had accounts receivable and accounts payable balances with the above related parties in the amounts of $4,625 and $17,848, for 2004, respectively, and $3,185 and $17,999 for 2003, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in the normal course of business. The companies above, except for OLIC, are related through common ownership by Fairfax, which owns approximately 26% of the Company’s common shares as of December 31, 2004. During the second quarter of 2004, Fairfax sold OLIC to Old Lyme Insurance Group, Ltd, a company owned primarily by a group of Hub employees, including Bruce Guthart, Chief Operating Officer and a director of Hub, and Michael Sabanos, Chief Financial Officer of HUB Northeast. The Company continues to place insurance with OLIC. The compensation that Hub earns from the business placed with OLIC and the fees it earns from managing OLIC are substantially the same as if Fairfax continued to own the company.
As of December 31, 2004 and 2003, subordinated convertible debentures of $35,000 at the end of both years, are due to related parties.
During 2004, 2003 and 2002, the Company incurred expenses related to rental of premises from related parties in the amount of $2,352, $2,102 and $1,691, respectively. At December 31, 2004 and 2003, the Company also had accounts receivable due from related parties in the amount of $2,613 and $3,530, respectively, of which the majority were loans to employees to enable them to purchase shares of the Company. Of these accounts receivable, as of December 31, 2004 and 2003, $1,793 and $1,918, respectively, were related to Company loans to employees to purchase shares under the executive share purchase plan. As collateral, the employees have pledged 143,000 and 153,000 common shares as of December 31, 2004 and 2003, respectively, which have a market value of $2,619 and $2,590 as of December 31, 2004 and 2003, respectively.
Under U.S. GAAP, Old Lyme was recorded as an investment held for sale at its fair value of $40,938. Between acquisition and completion of the sale the carrying value of the investment was adjusted for increases in fair value due to changes in its U.S. GAAP net asset value and interest accretion. Such adjustments were reflected as changes in goodwill arising on the HUB Northeast acquisition. Interest on debt financing the purchase of Old Lyme was debited to the carrying value of the investment and did not impact earnings. The difference between the carrying value of the investment as of the date of completion of the sale and the sale proceeds was reflected as an adjustment to goodwill arising on the HUB Northeast acquisition and accordingly no gain or loss was recorded in income.
Under Canadian GAAP, the Company accounts for the interest rate swap transaction which converted fixed rate interest payments of 5.71% and 6.16% on the Senior Notes of $10 million and $55 million, respectively, using the synthetic instruments method. Under this method, the Company reports in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.4 million, is not recognized in the Company’s Canadian GAAP financial statements. Under U.S. GAAP, the Company has designated the swap transaction of a hedge of changes in the fair value of its fixed rate debt caused by changes in interest rates. Under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, the Company records the swap on its U.S. GAAP balance sheet at its fair value. Changes in fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt.
Below is the Company’s unaudited pro forma condensed consolidated statements of earnings information for the year ended December 31, 2004 and 2003, respectively, assuming the acquisition of Talbot, as described in Note 4, had taken place at January 1, 2004 and January 1, 2003, respectively:
This unaudited pro forma information has been prepared for comparative purposes only and does not purport to be indicative of what the actual consolidated results of operations for the years ended December 31, 2004 and 2003, respectively, might have been if the acquisition had been effective at January 1, 2004 and January 1, 2003, respectively.
New Section 3855 will affect the Company’s reporting of the interest rate swap whereby the swap will be recorded on the Company’s balance sheet at its fair value. Currently, the fair value of the swap is not recognized on the Company’s balance sheet.
New Section 1530 establishes standards for the reporting and display of comprehensive income. Unrealized gains and losses on debt and equity securities as well as foreign currency translation adjustments will be included in comprehensive income. Currently, the Company does not record these unrealized gains and losses and foreign currency translation adjustments are recorded in equity through the cumulative translation account.
On February 17, 2005, the Federal Judicial Panel on Multidistrict Litigation transferred the Opticare case, as well as three other class actions in which we are not named, to the District of New Jersey. The Company expects that the three class actions filed in Federal District Court in Illinois will also be transferred to New Jersey.