We were formed in November 1998 through the merger of 11 independent insurance brokerages into a new company. The merger was accounted for using the pooling-of-interests method.
Our results for the five year period ended December 31, 2005 reflect the acquisition of brokerages that occurred in each respective year. These acquisitions were accounted for using the purchase method. Thus, results of acquisitions
During 2005, the Company adopted a formal plan of disposition related to it U.S. financial services operation (the “Discontinued Business”). The Company sold this operation January 1, 2006. See note 5 “Discontinued Operations”. As a result of this plan of disposal, the results of operations for the Discontinued Business have been reported as net earnings from discontinued operations in the Consolidated Statements of Earnings for all periods presented.
Summarized statements of earnings disclosure for the Discontinued Business are as follows:
Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars using the exchange rate in effect at September 30, 2001 of C$1.00 = $0.63.
Summarized statements of cash flows disclosure for the Discontinued Business are as follows:
We have a diverse mix of products, services, insurer relationships and distribution channels, and as a result, our revenue and profitability levels are not usually highly susceptible to major changes related to a single product or service. However, general economic trends may influence overall insurance rates, commissions and availability or costs of individual types of coverage, which in turn may affect our revenue and profitability levels. Our ability to
achieve organic revenue growth is not solely dependent on rising or declining rates, but results from a more complex mixture of general economic growth and demand, access to coverage from insurers and our marketing and sales performance.
Our business is comprised of two geographic segments, the United States and Canada. The mix of products and services we offer in the United States differs from those we offer in Canada. In the United States in 2005, 86% of our commission income was generated from the sale of commercial lines and 14% from personal lines. In Canada in 2005, 61% of our commission income was generated from the sale of commercial lines and 39% from personal lines. Our purchase of a major personal lines insurance broker in 2005 is expected to increase the percentage of U.S. commission income derived from personal lines to approximately 19% in 2006.
Commission income, which usually ranges from 5% to 20% of the premium charged by insurers, provides approximately 88% of our revenue base. In addition to these “core” commissions, the company derives revenue from:
Volume overrides - additional compensation based on the overall volume of business a brokerage places with the insurance company (See “Contractual Obligations - Other” for information regarding our legal proceedings)
We operate through an organizational structure comprised of our head office, larger regional or specialty brokerages that we call “hub” brokerages and smaller brokerages managed by the regional hubs. Our head office implements the acquisition of hub brokerages and oversees the acquisition of smaller, “fold-in” brokerages by the hubs. Our head office also coordinates selling and marketing efforts, identifies cross-selling opportunities among our brokerages, and handles certain general administrative functions. At December 31, 2005, we had 15 “hub” brokerages - ten in the United States and five in Canada.
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 2004 insurance rates in both Canada and in the U.S., for many types of coverage, declined. In 2005, in both Canada and the US we saw average declines in premiums in the range of three to five percent. As a result of the 2005 hurricane
season, property rates for coastal areas in 2006 will increase. However, we anticipate all other areas of North America to see modest decreases in rates in the range of two to three percent. We do not have a significant client base in the coastal areas.
Because we are a service organization, compensation and other personnel costs make up the largest component of total expenses - 56% in 2005. Property and equipment are comprised primarily of furniture, computer systems and office equipment. Therefore, our capital resources, including external borrowings, internally generated cash flow and proceeds from the issuance of common shares, are devoted primarily toward acquisitions.
As a result of acquisitions and 6% organic growth, which includes the strengthening of the Canadian dollar as compared to the U.S. dollar in 2005, we reported a 25% increase in revenue to $442.6 million in 2005. During 2005, we acquired 15 insurance brokerages, including Personal Lines Insurance Brokerage, Inc. (PLI) from The Chubb Corporation on October 1, 2005, and divested of three offices in the United States and Canada.
The table below shows a breakdown of our revenue by segment and type for 2005 and 2004 and organic growth for 2005:
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2005 and 2004 results included a number of factors that can complicate direct comparisons. To increase investor understanding the following chart shows the impact specific items would have had if they had not occurred, on net earnings and diluted earnings per share over the past two years.
Gains and losses on disposition of assets are not an unusual item, but they are included here to highlight the difference between the two reporting periods. Similarly, changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada, 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. The strength of the Canadian dollar versus the U.S. dollar increased our net earnings and diluted earnings per share, as shown above, for 2005 and 2004. Any decline in the Canadian dollar versus the U.S. dollar would have a negative effect on our results. See “Market Risk.”
Compensation for the Talbot earnout for the years ended December 31, 2005 and 2004 is comprised of the following:
Selling, occupancy and administration expense increased 15% to $82.8 million in 2005. As a percentage of revenue, selling, occupancy and administration expense decreased to 19% from 20% in 2004. This decrease was primarily due to increased revenue and lower external audit fees.
Interest expense increased 44% to $10.7 million from $7.4 million in 2004, primarily as a result of higher debt levels and higher interest rates in 2005. The $65 million of debt incurred for the Talbot acquisition was outstanding for twelve months in 2005 compared to six months in 2004. In addition, our average interest rate on outstanding debt in 2005 was approximately 5.2% compared to 2.9% in 2004.
In anticipation of funding an acquisition we entered into a foreign exchange forward contract to convert Canadian dollars to U.S. dollars. The difference between the forward rate contracted and the spot rate at the date of conversion generated a foreign exchange loss of $0.6 million, or $0.4 million after tax, and reduced diluted earnings per share for 2005 by $0.01.
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 a result, certain of our subsidiaries changed their names and we recognized a non-cash pre-tax expense of approximately $2.6 million related to the write-off of trademarks.
Net Earnings (Loss) and Diluted Earnings (Loss) per Share from Discontinued Operations
A significant portion of our revenue growth in 2004 was the result of brokerages acquired. During 2004, we acquired seven insurance brokerages, including Talbot, and divested of three small brokerages in Canada. As a result of these acquisitions and 5% organic growth, which includes the strengthening of the Canadian dollar in 2004 compared to the U.S. dollar, we reported a 24% increase in revenue to $355.1 million in 2004.
As shown above, 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 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
Canadian revenue grew 12% to $121.8 million, or 34% of consolidated revenue in 2004 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. Higher premium rates in 2003 contributed strongly to a significant increase in contingent profitability income from insurance companies in 2004.
Other non-cash stock based compensation includes stock options and restricted share units. 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.
Selling, occupancy and administration expense increased 27% to $71.9 million in 2004. As a percentage of revenue, selling, occupancy and administration expense remained constant at 20% despite additional costs related to the
Interest expense increased 43% to $7.4 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 our outstanding senior notes by $1.3 million in 2004 compared to $0.8 million in 2003.
Intangible asset amortization increased 70% to $5.5 million in 2004 as a result of the acquisition of Talbot.
Our effective tax rate increased to 44% in 2004 from 34% in 2003 due primarily to compensation expense related to the acquisition of Talbot which is not deductible for tax purposes. Excluding this compensation the effective tax rate for 2004 was 33%.
Our net earnings decreased 29% or $10.7 million to $25.8 million in 2004 due to the impact of compensation for the Talbot earnout, other non-cash stock based compensation, write off of trademarks and the impact of foreign exchange. Diluted earnings per share decreased $0.35 per diluted share to $0.79 in 2004.
During 2005, we adopted a formal plan of disposition related to our U.S. financial services operation. The sale was completed January 1, 2006. See note 5 “Discontinued Operations”. Results for discontinued operations have been removed from continuing operations for 2004 and reflected on our Consolidated Statements of Earnings as “Net earnings (loss) from discontinued operations.” These results are not applicable to 2003 as the operation was not acquired until 2004. Net earnings and diluted earnings per share from discontinued operations were $0.5 million and $0.01 per diluted share for 2004.
dividends of $7.4 million in 2005. Funding these acquisitions was the primary reason cash decreased by $28.1 million in 2005 to $70.1 million at December 31, 2005.
On March 1, 2006, we signed a definitive agreement to purchase three large insurance brokerages, based in Massachusetts and Pennsylvania, from subsidiaries of Citizens Financial Group, Inc. The transaction is expected to close in April, 2006. The purchase price is expected to be $80 million in cash as well as an earnout in cash and our common shares based on future performance. The earnout will be at least $3 million. Subsequent to December 31, 2005, we have secured a commitment for a new $75 million non-revolving credit facility to have terms similar to our current $75 million revolving U.S. dollar Libor loan. These funds will be available for this acquisition. In addition, we will continue to investigate and evaluate all avenues for expansion capital.
Our principal source of liquidity is our operating cash flow and borrowings under our credit facilities. Operating cash flow is affected by net earnings, non-cash items such as amortization, depreciation, compensation for the Talbot earnout, and non-cash working capital items. For 2005, operating cash flows were lower than for 2004 by $12.0 million primarily due to payment of the Talbot earnout in cash of $16.4 million.
Demand U.S. dollar base rate loan - We have an undrawn $10.3 million facility which bears interest at the bank’s U.S. base rate, which was 7.75% and 5.75% at December 31, 2005 and 2004, respectively, plus 50 basis points. Borrowings under this facility are repayable on demand.
As of December 31, 2005, we had outstanding $65 million in 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 due of $3.3 million due annually, June 15, 2008 through June 15, 2010. Series B represents $55 million aggregate principal amount of 6.16% senior notes with interest due semi-annually, and principal due of $11 million 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. We 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 senior notes. As of December 31, 2005 we were in compliance with all financial covenants governing the senior notes.
C$19.00 per share. If converted, Fairfax would have owned approximately 31% of our total outstanding common shares as of December 31, 2005, versus the 26% of outstanding shares which it held on that date. Based on the current price of our common shares, it is more likely than not that the Fairfax notes will be converted into our common shares.
The table below summarizes our contractual obligations and commercial commitments as of December 31, 2005:
As previously disclosed, the insurance brokerage industry in general and certain of our subsidiaries in particular have been the subject of ongoing investigations by state attorneys general and insurance regulators regarding contingent commissions and other practices. As also previously reported, various class actions have been filed with respect to such matters. We have not recorded a liability at December 31, 2005 related to these matters.
We are exposed to interest rate risk in connection with our $75 million revolving U.S. dollar LIBOR loan and senior notes due to the interest rate swap entered into in July 2003, which converted the fixed rate interest payments on the $65 million aggregate principal amount of senior notes into floating rate payments. 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, 2005 will result in a decrease of approximately $0.8 million in our annual earnings.
We report our revenue in U.S. dollars. Our Canadian operations earn revenue and incur expenses in Canadian dollars. Given our significant Canadian dollar revenue, we are sensitive to the fluctuations in the value of the Canadian dollar and are therefore exposed to foreign currency exchange risk. Foreign currency exchange risk is the potential for loss in revenue and net income as a result of a decline in the U.S. dollar value of Canadian dollar revenue due to a decline in the value of the Canadian dollar compared to the U.S. dollar. Unrealized foreign currency translation gains and losses are recorded in the cumulative translation account (CTA), a balance sheet account, and does not currently impact net earnings.
The Canadian dollar is subject to volatility, and has experienced significant changes in its value compared to the U.S. dollar during 2001 through 2005. At December 31, 2005 and 2004 one U.S. dollar equaled $1.17 and $1.20 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 CTA for the twelve months ended December 31, 2005, 2004 and 2003.
The amounts allocated to customer relationships were determined by discounting the expected future net cash flows from commissions with consideration given to remaining economic lives, renewals, and associated expenses. The amounts allocated to non-competition covenants were determined using an income approach with consideration given to economic benefits associated with having the covenants in place versus damages that would ensue absent the agreements. The balance of the excess purchase price is allocated to goodwill.
of the covenant. During the first quarter 2004, certain of our subsidiaries changed their names and as a result we recognized a non-cash loss on the write-off of trademarks of $2.6 million before tax.
We estimate that our amortization charges for intangible assets from 2006 through 2010 for all acquisitions consummated through December 31, 2005 will be:
As of December 31, 2005 and December 31, 2004, subordinated convertible debentures of $35.0 million were held by certain subsidiaries of Fairfax.
During 2005, 2004 and 2003, we incurred expenses related to rental of premises from related parties in the amount of $2.8 million, $2.3 million and $2.1 million, respectively. At December 31, 2005 and 2004, we also had accounts receivable due from related parties in the amount of $2.2 million and $2.6 million, respectively, of which the majority were loans to employees to enable them to purchase our common shares. Of these accounts receivable, as of December 31, 2005 and 2004, $1.5 million and $1.8 million respectively, were related to company loans to employees to purchase shares under our executive share purchase plan. The loans will mature June, 2011 and bear interest at a rate of prime plus 0.5%. The interest rate at December 31, 2005 was 5.5%. As collateral, the employees
have pledged 122,000 and 143,000 common shares as of December 31, 2005 and 2004, respectively, which have a market value of $3.2 million and $2.6 million as of December 31, 2005 and 2004, respectively.
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 resulting in a savings of approximately $0.2 million and $1.3 million for the years ended December 31, 2005 and 2004, respectively, or 0.54% and 2.00% for the years ended December 31, 2005 and 2004, 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 $4.0 million, is not recognized in our Canadian GAAP financial statements. We have no other material off-balance sheet arrangements, that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.
We recognize commission income and fees as of the effective date of our client’s policy unless information is not available relating to the determination of their policy premiums, in which case we recognize commission income and fees related to that policy when that information becomes available and the revenue can be reasonably determined. The term effective date means the date from which protection is afforded under an insurance policy. At the effective date, we become entitled to the commission because the insurance coverage has been placed with the underwriter and the premium is owed by the client. On the effective date our work has been substantially completed and the related costs to produce, market and place the coverage have been incurred. We generally bill in the month of the effective date. As such, the amount of the commission related to the services provided has been determined and the premium is receivable as of that date. Accordingly, on the policy effective date the earnings process is complete and the services which we have been contracted to perform have been provided. This is in accordance with the criteria set forth in SAB 101 and SAB 104.
We maintain an allowance for estimated policy cancellations and commission returns based upon the application of historical policy cancellation and commission return rates to the current year revenue, adjusted for any known items. Adjustments to the allowance for policy cancellations are recorded in commission revenue on our consolidated statements of earnings. The allowance for estimated policy cancellations is based on our management’s judgment, and is regularly evaluated by management by taking into consideration factors such as changes in the nature and volume of policies; trends in actual and forecasted policy cancellations; and current economic conditions that may affect the likelihood of client policy changes or cancellations. If our actual policy cancellation rates are significantly different from our historical policy cancellation rates, and those changes have not been adjusted for in the allowance, our actual commission income may be significantly different from what we estimated. We maintain an allowance for doubtful accounts that estimates uncollectible receivables based on the length of time receivables are past due and the financial health of specific customers. Adjustments to the allowance for doubtful accounts are recorded in selling, occupancy and administration expenses on our consolidated statements of earnings. If our actual doubtful accounts are significantly different than what we estimated, and those changes have not been adjusted for in the allowance, our results may be significantly different from what we estimated.
For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, primarily for Talbot, we account for such payment as an expense. Where such compensation is stock based, our accounting policy for stock based compensation is followed. The fair value of such compensation is a significant estimate. The use of different estimates could produce results that are significantly different than our results of operations.
The cost of definite lived intangible assets is amortized over the estimated remaining economic useful life of the assets. We regularly evaluate whether events or changes in circumstances indicate that the carrying amount of intangibles, other than goodwill and intangible assets with indefinite useful lives, may warrant revision or may not be recoverable. The estimated useful life of customer relationships is generally ten to fifteen years. The estimation of the useful economic lives and the selection of estimates and assumptions used in conducting impairment tests require
the exercise of judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests of the assets and, as a result, significantly different results of operations.
Stock based compensation includes stock options, restricted shares and restricted share units (RSUs). 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 estimate the fair value of the stock options granted using the Black-Scholes valuation model, which requires us to make assumptions in relation to the expected term of the stock option, volatility in the price of the underlying common shares, interest rates and dividend yield. The fair value model is particularly sensitive to the changes in the price and price volatility of our common shares. The assumptions used are based on our management’s judgment and the use of different judgments, estimates, and assumptions could produce significantly different results of fair value of the stock options and, as a result, significantly different results of operations.
We record valuation allowances to reduce future tax assets to the amounts that we estimate are not more likely than not to be realized. When assessing the need for valuation allowance, we consider projected future as well as historical taxable income, prudent and feasible tax planning strategies and the future reversal of existing taxable temporary differences. Should a change in circumstances lead to a change in our judgments about the reliability of future tax assets in future years, we would adjust the related valuation allowances in the period that the change in circumstances occurs, along with a corresponding charge or credit to income.
We record an estimated income tax liability based on our best judgment of the amounts likely to be paid in the various tax jurisdictions in which we operate. The tax liabilities ultimately paid are dependent on a number of factors, including the filing of tax returns and the resolution of tax audits, and may differ from the amounts recorded. Tax liabilities are adjusted through income when it becomes probable that the actual liability differs from the amount recorded.
If actual results are not consistent with our estimates and judgments, our results of operations could be significantly different than reported. Our effective tax rate in a given period may be materially impacted by these estimates and judgments.
In the normal course of business, we are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. Based on Canadian GAAP, which is consistent with FAS No. 5 “Accounting for Contingencies,” we determine whether to disclose and/or accrue for loss contingencies based on the assessment of whether the risk is remote, reasonably possible or probable, and is estimatable.
In December 2004, the Financial Accounting Standards Board (FASB) issued revised Statement of Financial Accounting Standards (SFAS) No. 123 (R), “Share-Based Payment,” which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” This revised statement, which requires that the cost of all share-based payment transactions be recognized in the financial statements, establishes fair value as the measurement objective and requires entities to apply a fair-value-based measurement method in accounting for share-based payment transactions. The Company currently recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests. SFAS No. 123 (R) also requires the benefits of tax deductions in excess of compensation amounts recognized for book purposes, to be reported as a financing cash flow rather than as an operating cash flow as required under prior rules. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. The Company will adopt SFAS No. 123 (R) on its effective date, which is January 1, 2006.
Management has assessed the effectiveness of Hub’s internal control over financial reporting as at December 31, 2005, and has concluded that such internal control over financial reporting was effective.
We have audited the accompanying consolidated balance sheets of Hub International Limited (the “Company”) as at December 31, 2005 and 2004 and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three-year period ended December 31, 2005. We have also audited the effectiveness of the Company’s internal control over financial reporting as at December 31, 2005 based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and management’s assessment thereof included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting appearing under item 8. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on the Company’s consolidated financial statements for the three year period ended December 31, 2005, an opinion on management’s assessment as at December 31, 2005 and an opinion on the effectiveness of the Company’s internal control over financial reporting as at December 31, 2005 based on our audits.
We conducted our audits of the Company’s consolidated financial statements in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial statement audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We conducted our audit of the effectiveness of the Company’s internal control over financial reporting and management’s assessment thereof in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as at December 31, 2005 and 2004 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005 in accordance with Canadian generally accepted accounting principles. Also, in our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as at December 31, 2005 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the COSO. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as at December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the COSO.
On October 1, 2005, the Company purchased Personal Lines Brokerage, Inc. (PLI) from The Chubb Corporation, which was accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of PLI are included in the Company’s consolidated results from the date of acquisition.
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, the measurement of non-cash stock based compensation, the measurement of income tax liabilities and the recoverability of future income tax assets, and the measurement of self-insured liabilities and contingent liabilities. Actual results could differ from those estimated.
The operations of the Company’s subsidiaries outside of the U.S. are self-sustaining. The assets and liabilities of these subsidiaries as at December 31, 2005 and 2004 were translated to U.S. dollars at the year-end exchange rate. Revenue and expenses for 2005, 2004 and 2003 were translated to U.S. dollars at the average exchange rate for those periods. Accordingly, the unrealized gains and losses which result from this translation are deferred and included in shareholders’ equity under the caption “Cumulative translation account.”
Commission income is reported net of sub-broker commission expense. Commission and other adjustments are recorded when they occur and the Company maintains an allowance for estimated policy cancellations and commission returns by applying historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The Company also maintains an allowance for doubtful accounts based on the length of time receivables are past due and the financial health of specific customers.
Cash and cash equivalents consist of cash, and highly liquid investments having maturities of three months or less at the acquisition date.
Goodwill and intangible assets with indefinite useful lives are not amortized but are subject to impairment tests on at least an annual basis. Goodwill is allocated to reporting units and any potential goodwill impairment is identified by comparing the carrying value of a reporting unit with its fair value. If any potential impairment is indicated, it is quantified by comparing the carrying value of goodwill to its fair value, based on the fair value of the assets and liabilities of the reporting unit.
The Company completed its impairment testing on the balance of goodwill and indefinite lived intangible assets as of January 1, 2006, 2005 and 2004. Based on the testing performed, no impairment losses were incurred.
During 2005, the Company purchased all of the issued and outstanding shares of PLI from The Chubb Corporation, and THB Intermediaries, Inc. (THB) as well as the assets of 13 other insurance brokerages, all of which were accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
The preliminary allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2005 are summarized below, as well as adjustments to preliminary
Of the goodwill acquired, $40,986 is deductible for tax purposes. Goodwill includes $9,336 associated with adjustments to preliminary allocations and contingent consideration relating to prior period acquisitions.
Of the goodwill acquired $67,792 is deductible for tax purposes. Goodwill includes $3,051 associated with adjustments to preliminary allocations and contingent consideration relating to prior period acquisitions.
During 2004, the Company sold assets and shares of certain insurance brokerages for $9,166, resulting in a gain of $2,086.
During 2003, the Company acquired nine brokerages, all of which were accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
The insurance industry in general, and certain of the Company’s subsidiaries, have been the subject of scrutiny by various regulatory bodies, including state attorneys general and the departments of insurance for various states, with respect to certain contingent commission arrangements between insurance companies and brokers.
As previously reported, HUB Northeast formerly known as Kaye Insurance Associates, Inc., a subsidiary of the Company, received three subpoenas from the Office of the Attorney General of the State of New York seeking information regarding certain contingent agreements and other business practices. Since August 2004, various other subsidiaries of Hub have received and responded to letters of inquiry and subpoenas from authorities in California, Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec. The Company retained external counsel to assist in responding to the New York Attorney General’s and other inquiries and, among other things, requested that such external counsel conduct an investigation of HUB Northeast and of our hubs to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes or other illegal practices. Such investigation having been concluded to date, management is unaware of any incidents of falsifying or inflating insurance quotes or other illegal practices. State attorneys general and insurance departments continue their investigations of various industry practices. The Company continues to review its practices in light of these investigations and resulting charges brought against other brokers.
The cost of defending against the lawsuits, and diversion of management’s attention, may be significant and could have a material adverse effect on the Company’s results of operations. In addition, an adverse finding in a regulatory investigation or a class action or similar lawsuit could result in a significant judgment or imposition of liability against the Company that could have a material adverse effect on the Company’s financial condition, results of operation and liquidity.
In the normal course of business, the Company is involved in various claims and legal proceedings relating to insurance placed by the Company and other contractual matters. Management does not believe that any such pending or threatened proceedings will have a material adverse effect on the Company’s consolidated financial position or future results of operations.
The Company has not recorded a liability at December 31, 2005 and 2004 related to these matters.
On July 1, 2004, the Company purchased all of the common shares of Satellite Acquisition Corporation (Satellite) a corporation formed by senior management at Talbot Financial Corporation (Talbot). In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company is to purchase special shares of Satellite owned by the management of Talbot using a combination of both restricted and unrestricted common shares of the Company or cash. The first payment of $16.4 million was made in cash on September 1, 2005, based upon Talbot’s earnings for the 12 months ending December 31, 2004. The remaining payments will be made on March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2005 and 2006, respectively. The contingent payment to Talbot management is recorded by the Company as a charge to earnings over the period in which the payments are earned because it is a compensation based arrangement and specifically a performance award. The Company estimates that the aggregate value of compensation which will be recognized under this arrangement will be approximately $56 million, of which $28.7 million and $14.4 million were recognized in 2005 and 2004, respectively. At December 31, 2005, $26.7 million has been included in accounts payable and accrued liabilities.
In connection with other various acquisitions completed through December 31, 2005, the Company may be obligated to pay contingent consideration up to a maximum sum of approximately $14.3 million in cash and $8.6 million in common shares of the Company based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through July, 2009 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2005, the financial statements reflect a liability to pay cash of $0.5 million.
In connection with the Company’s executive share purchase plan, under certain circumstances, the Company may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $3,915 and $4,287 as of December 31, 2005 and 2004, respectively, to assist in purchasing common shares of the Company. The Company no longer makes loans to its executive officers and directors. As collateral, the employees have pledged 383,000 and 431,000 common shares as of December 31, 2005 and 2004, respectively, which have a market value of $9,877 and $7,885 as of December 31, 2005 and 2004, respectively. The loans will mature during 2009 and 2010 and bear interest at a rate of prime plus 0.5%. The interest rate at December 31, 2005 was 5.5%. Interest on the loans in the amount of $197, $192 and $279 for the years ended December 31, 2005, 2004 and 2003, respectively, was paid by the Company and is included in cash compensation expense.
During 2005, the Company adopted a formal plan of disposition related to its U.S. financial services operation (the “Discontinued Business”). The Company sold those operations January 1, 2006. As a result of this plan of disposal, the results of operations for the Discontinued Business have been reported as net earnings from discontinued operations in the Consolidated Statements of Earnings for all periods presented. In conjunction with the sale, the Company will continue to receive certain fees received by the buyer. These payments will be contingent consideration on the sale and therefore not direct cash flows of the disposed component and will be recorded net of tax as net earnings from discontinued operations in future periods. These payments will not provide the Company with the ability to otherwise be involved in the operations of the disposed component.
Summarized statement of earnings disclosure for the Discontinued Business is as follows:
Losses relating to the non-collection of client premium receivables may be mitigated by cancellation of the underlying insurance policy.
The changes in the carrying amount of goodwill for the years ended December 31, 2005 and 2004, are as follows:
The Company estimates the amortization charges for 2006 through 2010 for all acquisitions consummated through December 31, 2005 will be:
Senior Notes - As at December 31, 2005 the Company had 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. 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 used 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, 2005, $65 million was outstanding under these senior notes, and the Company was in compliance with all financial covenants governing the senior notes.
Revolving U.S. dollar LIBOR loan - This unsecured facility totals $75 million and bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR. LIBOR was 4.39% and 2.40% at December 31, 2005 and 2004, respectively. The facility is available on a revolving basis for one year. The loan expires on April 19, 2006.
However, if the revolving period is not extended, the Company may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate which was 4.14% and 3.45% at December 31, 2005 and 2004, respectively. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million at December 31, 2005 and 2004, respectively. As of December 31, 2005, the Company was in compliance with all financial covenants governing this facility.
Certain U.S. denominated debt, including subordinated convertible debentures, has been designated as a hedge against the Company’s investment in its U.S. operations. Therefore, translation gains or losses on the U.S. denominated debt are recorded in the cumulative translation account.
No options were issued in 2005. The maximum option term for all options issued is seven years, and all options vest at one third per year over three years of continuous employment. The number of common shares authorized and that may be issued under the Equity Incentive Plan is limited to 3,631,820 common shares. A summary of the stock option activity and related information for the years ended December 31, 2005, 2004 and 2003 consists of the following:
The following table summarizes information about the stock options outstanding at December 31, 2005, 2004 and 2003:
Shares derived from the options may be held in escrow and subject to transfer restrictions for a period of five years from the date the options are granted, if the optionee does not hold a specified amount of shares in the Company.
In 2004, restricted share units totaling 977,000 were issued in connection with the restructuring of the Company’s management bonus agreement and 84,000 restricted share units were issued in connection with the renegotiation of contingent consideration for Flanagan. The fair value of the restricted share units awarded in 2004 was approximately $16.1 million ($16.50 per share). In addition 45,000 restricted share units were awarded to certain employees valued at approximately $0.8 million ($17.06 per share) in 2004. The restricted share units vest over periods ranging from 60 months to 84 months.
Non-cash stock based compensation, including both compensation for the Talbot acquisition and other non-cash stock based compensation, of $35,900, $20,890 and $4,801 for the years ended December 31, 2005, 2004 and 2003, respectively, was expensed with offsetting credits to contributed surplus, and accounts payable and accrued liabilities. The Company recognizes the fair value of non-cash stock based compensation as an expense over the period in which entitlement to the compensation vests.
Compensation for the Talbot earnout includes both cash and non-cash stock based compensation and is detailed below.
The Company estimates the compensation for the Talbot earnout for 2006 through 2011 will be:
Income taxes for 2005, 2004 and 2003 amounted to $31.0 million, $20.0 million and $18.8 million, respectively, resulting in an effective tax rate of 55%, 44% and 34% in 2005, 2004, and 2003, 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%, 36.12% and 36.62% in 2005, 2004 and 2003, respectively, as follows:
The components of the future tax assets (liabilities) at December 31, 2005 and 2004, were as follows:
The Company has net operating loss carryforwards of $5,310 at December 31, 2005 that expire 2008 through 2010 resulting in a future tax asset of $1,900. In addition, the Company has state net operating loss carryforwards in the U.S. of approximately $7,435 which expire 2015 through 2022 resulting in a future tax asset of $353. Such net operating losses are currently available to offset certain future state and local taxable income.
Interest and income taxes paid for the years ended December 31, 2005, 2004 and 2003 were:
The Company is an international insurance brokerage, which provides a variety of property, casualty, life and health, employee benefits, investment and risk management products and services. In addition to its Corporate Operations, the Company has identified two operating segments within its insurance brokerage business: Canadian Operations and U.S. Operations. Corporate Operations consist primarily of investment income, compensation for the Talbot earnout, other non-cash stock based compensation, unallocated administrative costs, interest expense and the income tax expense or benefit which is not allocated to the Company’s operating segments. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends.
As of December 31, 2005 and 2004, the Company had accounts receivable and accounts payable balances with the above related parties in the amounts of $9,990 and $36,666, for 2005, respectively, and $4,625 and $17,848 for 2004, 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, 2005. 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. The Company
There were no differences between Canadian and U.S. GAAP affecting net earnings, basic earnings per share and diluted earnings per share for the years ended December 31, 2005 and 2004. The table below presents comprehensive income for the years ended December 31, 2005, 2004 and 2003 and presents the GAAP differences affecting net earnings, basic earnings per share and diluted earnings per share for the year ended December 31, 2003.
Under Canadian GAAP, the fair value of the put options (determined using the Black-Scholes model) issued in connection with certain 2001 acquisitions was allocated to equity instruments on the balance sheet. The balance of the purchase price was allocated to debt. Changes in the value of the put options in periods subsequent to the acquisition date are included in earnings. Under U.S. GAAP prior to July 1, 2003, the fair value of the share consideration and the attached put options was initially recorded in equity and the redemption value of the shares to which the put options are attached was reclassified as mezzanine equity outside of shareholders’ equity as a result of the put options granted on those shares to certain of the selling shareholders. On July 1, 2003, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement requires that an issuer classify financial instruments meeting certain criteria as liabilities (or assets in some circumstances) rather than equity. As a result of the adoption of this new standard, the Company changed its accounting policy with respect to the financial instruments issued in connection with certain 2001 acquisitions. Effective July 1, 2003, the Company remeasured the fair value of the put options (using the Black-Scholes model) and classified this amount as liability. Amounts previously classified as mezzanine equity were reclassified as shareholders’ equity. The difference between the estimated fair value of the put options as at July 1, 2003 and May 31, 2001 was reported as a cumulative adjustment to net earnings under U.S. GAAP. Comparative financial statements were not restated.
As part of the negotiations of contingent consideration the former owners of certain 2001 acquisitions agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2005 and 2004 no put options were outstanding on the Companys’ common shares.
The condensed consolidated balance sheets as at December 31, 2005 and 2004, under U.S. GAAP are as follows:
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 $4.0 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 at its fair value. Changes in fair value of the settlement of the swap are reported in earnings.
In December 2004, the Financial Accounting Standards Board (FASB) issued revised Statement of Financial Accounting Standards (SFAS) No. 123 (R), “Share-Based Payment”, which replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”. This revised statement, which requires that the cost of all share-based payment
On March 1, 2006 the Company announced that it has signed a definitive agreement to purchase three large insurance brokerages, based in Massachusetts and Pennsylvania, from subsidiaries of Citizens Financial Group, Inc. (CFG). The transaction is expected to close in April, 2006. The purchase price is expected to be