Elsewhere, we generally operate in leased premises related to the facilities of our brokerage and risk management operations. We prefer to lease office space rather than own real estate related to the branch facilities of our brokerage and risk management segments. Certain of our office space leases have options permitting renewals for additional periods. In addition to minimum fixed rentals, a number of our leases contain annual escalation clauses generally related to increases in an inflation index. See Note 15 to our 2016 consolidated financial statements for information with respect to our lease commitments as of December 31, 2016.
The following selected consolidated financial data for each of the five years in the period ended December 31, 2016 have been derived from our consolidated financial statements. Such data should be read in conjunction with our consolidated financial statements and notes thereto in Item 8 of this annual report.
(1) Based on the weighted average number of common and common equivalent shares outstanding during the year.
(3) Represents net earnings divided by total stockholders’ equity, as of the beginning of the year.
(4) Prior to September 1, 2016, most of Gallagher’s India-based workforce was provided by a third-party on a cost-pass-through basis. During the third quarter of 2016, Gallagher consummated a transaction whereby it now directly employees those associates, thereby adding approximately 2,700 employees to our global workforce counts shown above. We revised the workforce number as of December 31, 2015, 2014, 2013 and 2012 to conform to the current period presentation.
We are engaged in providing insurance brokerage and third party property/casualty claims settlement and administration services to entities in the U.S. and abroad. We believe that one of our major strengths is our ability to deliver comprehensively structured insurance and risk management services to our clients. Our brokers, agents and administrators act as intermediaries between insurers and our customers and we do not assume net underwriting risks. We are headquartered in Itasca, Illinois, have operations in 33 other countries and offer client-service capabilities in more than 150 countries globally through a network of correspondent brokers and consultants. In 2016, we expanded, and expect to continue to expand, our international operations through both acquisitions and organic growth. We generate approximately 69% of our revenues for the combined brokerage and risk management segments domestically, with the remaining 31% derived internationally, primarily in Australia, Bermuda, Canada, the Caribbean, New Zealand and the U.K. (based on 2016 revenues). We expect that our international revenue as a percentage of our total revenues in 2017 will be comparable to 2016. We have three reportable segments: brokerage, risk management and corporate, which contributed approximately 63%, 13% and 24%, respectively, to 2016 revenues. Our major sources of operating revenues are commissions, fees and supplemental and contingent commissions from brokerage operations and fees from risk management operations. Investment income is generated from invested cash and fiduciary funds, clean energy and other investments, and interest income from premium financing.
The following provides information that management believes is helpful when comparing revenues, net earnings, EBITDAC and diluted net earnings per share for 2016 and 2015. In addition, these tables provide reconciliations to the most comparable GAAP measures for adjusted revenues, adjusted EBITDAC (non-GAAP measure) and adjusted diluted net earnings per share. Reconciliations of EBITDAC for the brokerage and risk management segments are provided on pages 35 and 42 of this filing.
* For 2016, the pretax impact of the brokerage segment adjustments totals $80.5 million, with a corresponding adjustment to the provision for income taxes of $23.9 million relating to these items. The pretax impact of the risk management segment adjustments totals $2.2 million, with a corresponding adjustment to the provision for income taxes of $0.7 million relating to these items. The pretax impact of the corporate segment adjustments totals $20.2 million, with a corresponding adjustment to the provision for income taxes of $4.1 million relating to these items. For the year ended December 31, 2015, the pretax impact of the brokerage segment adjustments totals $155.2 million, with a corresponding adjustment to the provision for income taxes of $51.5 million relating to these items. The pretax impact of the risk management segment adjustments totals $5.6 million, with a corresponding adjustment to the provision for income taxes of $1.3 million relating to these items. The pretax impact of the corporate segment adjustments totals ($16.2) million, with a corresponding adjustment to the provision for income taxes of $1.5 million relating to these items.
Fluctuations in premiums charged by property/casualty insurance carriers have a direct and potentially material impact on the insurance brokerage industry. Commission revenues are generally based on a percentage of the premiums paid by insureds and normally follow premium levels. Insurance premiums are cyclical in nature and may vary widely based on market conditions. Various factors, including competition for market share among insurance carriers, increased underwriting capacity and improved economies of scale following consolidations, can result in flat or reduced property/casualty premium rates (a “soft” market). A soft market tends to put downward pressure on commission revenues. Various countervailing factors, such as greater than anticipated loss experience and capital shortages, can result in increasing property/casualty premium rates (a “hard” market). A hard market tends to favorably impact commission revenues. Hard and soft markets may be broad-based or more narrowly focused across individual product lines or geographic areas. As markets harden, certain insureds, who are the buyers of insurance
The Council of Insurance Agents & Brokers (which we refer to as the CIAB) 2016 quarterly surveys indicated that U.S. commercial property/casualty rates decreased by 3.7%, 3.9%, 3.2% and 3.3% on average across all lines, for the first, second, third and fourth quarters of 2016, respectively. The fourth quarter 2016 CIAB survey indicated that rates declined for the eighth straight quarter. CIAB survey respondents noted that the decrease in rates during the fourth quarter of 2016 were fairly consistent with the third quarter of 2016, signaling some stability in the market. In 2017, while we see retail property/casualty rates as a headwind, we do see property/casualty exposure growth offsetting this partially. We also see employment growth and complexity surrounding the Affordable Care Act as tailwinds for our employee benefit units. In addition, our history of strong new business generation, solid retentions and enhanced value-added services for our carrier partners should all result in further organic growth opportunities around the world. We believe similar conditions exist as we start the January 1, 2017 renewal season. Internationally, we see a similar market in U.K. retail Canada, Australia and New Zealand, but more softening in London Specialty. Overall, we believe a modestly-down rate environment can be partially mitigated through exposure unit growth in certain lines and by our professionals demonstrating our expertise and high quality value added capabilities by strengthening our clients’ insurance portfolio in these times. Based on our experience, insurance carriers appear to be making rational pricing decisions. In lines and accounts where rate increases or decreases are warranted, the underwriters are pricing accordingly. As carriers reach their profitability targets in lines, rates may start to flatten. In summary, in this environment, rates decreased at a moderate pace, clients can still obtain coverage, businesses continue to stay in standard-line markets and there is adequate capacity in the insurance market. It is not clear whether the rate retraction will continue due to the uncertainty of the current economic environment. The CIAB represents the leading domestic and international insurance brokers, who write approximately 85% of the commercial property/casualty premiums in the U.S.
We also own a 46.5% controlling interest in Chem-Mod, which has been marketing The Chem-Mod™ Solution proprietary technologies principally to refined fuel plants that sell refined fuel to coal-fired power plants owned by utility companies, including those plants in which we hold interests. Based on current production estimates provided by licensees, Chem-Mod could generate for us approximately $4.0 million to $5.0 million of net after-tax earnings per quarter.
Our current estimate of the 2017 annual net after tax earnings that could be generated from all of our clean energy investments in 2017 is between $117.0 million to $133.0 million.
Uncertain tax positions are measured based upon the facts and circumstances that exist at each reporting period and involve significant management judgment. Subsequent changes in judgment based upon new information may lead to changes in recognition, derecognition and measurement. Adjustments may result, for example, upon resolution of an issue with the taxing authorities, or expiration of a statute of limitations barring an assessment for an issue. We recognize interest and penalties, if any, related to unrecognized tax benefits in our provision for income taxes. See Note 17 to our consolidated financial statements for a discussion regarding the possibility that our gross unrecognized tax benefits balance may change within the next twelve months.
Intangible Assets/Earnout Obligations - See Intangible Assets in Note 1 to our consolidated financial statements.
See Note 3 to our consolidated financial statements for a discussion of our 2016 business combinations. We did not have any material dispositions in 2016, 2015 and 2014.
In the discussion and analysis of our results of operations that follows, in addition to reporting financial results in accordance with GAAP, we provide information regarding EBITDAC, EBITDAC margin, adjusted EBITDAC, adjusted EBITDAC margin, diluted net earnings per share, as adjusted (adjusted EPS) for the brokerage and risk management segments, adjusted revenues, adjusted compensation and operating expenses, adjusted compensation expense ratio, adjusted operating expense ratio and organic revenue measures for each operating segment. These measures are not in accordance with, or an alternative to, the GAAP information provided in this report. We believe that these presentations provide useful information to management, analysts and investors regarding financial and business trends relating to our results of operations and financial condition. Our industry peers may provide similar supplemental non-GAAP information with respect to one or more of these measures, although they may not use the same or comparable terminology and may not make identical adjustments. The non-GAAP information we provide should be used in addition to, but not as a substitute for, the GAAP information provided. As disclosed in our most recent Proxy Statement, we do not make determinations regarding executive officer incentive compensation on the basis of “adjusted” measures such as those described below in “Adjusted revenues and expenses” or “Adjusted EBITDAC”. Instead, incentive compensation determinations for executive officers are made on the basis of revenue and EBITAC (defined as earnings before interest, taxes, amortization and change in estimated earnout payables) for the combined brokerage and risk management segments. Certain reclassifications have been made to the prior-year amounts reported in this report in order to conform them to the current year presentation.
Adjusted Non-GAAP presentation - We believe that the adjusted Non-GAAP presentation of our 2016, 2015 and 2014 information, presented on the following pages, provides stockholders and other interested persons with useful information regarding certain financial metrics that may assist such persons in analyzing our operating results as they develop a future earnings outlook for us. The after-tax amounts related to the adjustments were computed using the normalized effective tax rate for each respective period.
Adjusted revenues and expenses - We define these measures as revenues, compensation expense and operating expense, respectively, each adjusted to exclude the following:
Acquisition integration costs, which include costs related to certain of our large acquisitions, outside the scope of our usual tuck-in strategy, not expected to occur on an ongoing basis in the future once we fully assimilate the applicable acquisition. These costs are typically associated with redundant workforce, extra lease space, duplicate services and external costs incurred to assimilate the acquisition with our IT related systems.
Adjusted EBITDAC and Adjusted EBITDAC Margin - Adjusted EBITDAC is EBITDAC adjusted to exclude gains realized from sales of books of business, acquisition integration costs, workforce related charges, lease termination related charges, claim portfolio transfer ramp up fees/costs, client run-off/bankruptcy costs, acquisition related adjustments, and the period-over-period impact of foreign currency translation, as applicable and Adjusted EBITDAC margin is Adjusted EBITDAC divided by total adjusted revenues (defined above). These measures for the brokerage and risk management segments provide a meaningful representation of our operating performance, and are also presented to improve the comparability of our results between periods by eliminating the impact of the items that have a high degree of variability.
Organic Revenues (a non-GAAP Measure) - For the brokerage segment, organic change in base commission and fee revenues excludes the first twelve months of net commission and fee revenues generated from acquisitions and the net commission and fee revenues related to operations disposed of in each year presented. These commissions and fees are excluded from organic revenues in order to help interested persons analyze the revenue growth associated with the operations that were a part of our business in both the current and prior year. In addition, change in base commission and fee revenue organic growth excludes the period-over-period impact of foreign currency translation. For the risk management segment, organic change in fee revenues excludes the first twelve months of fee revenues generated from acquisitions and the fee revenues related to operations disposed of in each year presented. In addition, change in organic growth excludes the impact of claim portfolio transfer ramp up fees, client run-off bankruptcy costs, and the period-over-period impact of foreign currency translation to improve the comparability of our results between periods by eliminating the impact of the items that have a high degree of variability or due to the limited-time nature of these revenue sources.
These revenue items are excluded from organic revenues in order to determine a comparable, but non-GAAP, measurement of revenue growth that is associated with the revenue sources that are expected to continue in 2017 and beyond. We have historically viewed organic revenue growth as an important indicator when assessing and evaluating the performance of our brokerage and risk management segments. We also believe that using this non-GAAP measure allows readers of our financial statements to measure, analyze and compare the growth from our brokerage and risk management segments in a meaningful and consistent manner.
Litigation and Regulatory Matters - A portion of our brokerage business includes the development and management of “micro-captives,” through operations we acquired in 2010 in our acquisition of the assets of Tribeca Strategic Advisors (Tribeca). A “captive” is an insurance company that insures the risks of its owner, affiliates or a group of companies. Micro-captives are captive insurance companies that are subject to taxation only on net investment income under IRC Section 831(b). Our micro-captive advisory services are under investigation by the Internal Revenue Service (IRS). Additionally, the IRS has initiated audits for the 2012 tax year of over 100 of the micro-captive insurance companies organized and/or managed by us. Among other matters, the IRS is investigating whether we have been acting as a tax shelter promoter in connection with these operations. While the IRS has not made specific allegations relating to our operations or the pre-acquisition activities of Tribeca, if the IRS were to successfully assert that the micro-captives organized and/or managed by us do not meet the requirements of IRC Section 831(b), we could be subject to monetary claims by the IRS and/or our micro-captive clients, and our future earnings from our micro-captive operations could be materially adversely affected, any of which event could negatively impact the overall captive business and adversely affect our consolidated results of operations and financial condition. We may also experience lost earnings due to the negative effect of an extended IRS investigation on our clients’ and potential clients’ businesses. Annual renewals for micro-captive clients generally occur during the fourth quarter. Therefore, any negative impact from this investigation would likely have a disproportionate impact on fourth-quarter results. In 2016, 2015 and 2014, our micro-captive operations contributed less than $3.5 million of net earnings and less than $5.0 million of EBITDAC to our consolidated results in any one year. Due to the fact that the IRS has not made any allegation against us or completed all of its audits of our clients, we are not able to reasonably estimate the amount of any potential loss in connection with this investigation.
Financial information relating to our brokerage segment results for 2016, 2015 and, 2014 (in millions, except per share, percentages and workforce data):
* Prior to September 1, 2016, most of our India-based workforce was provided by a third party on a cost-pass-through basis. During 2016, we consummated a transaction whereby we now directly employ those associates thereby adding approximately 2,700 employees to our global workforce counts, of which approximately 2,200 employees were included in the 2016 number above. We revised the workforce number as of December 31, 2015 and 2014 to conform to the current period presentation.
The following provides information that management believes is helpful when comparing EBITDAC and adjusted EBITDAC for 2016, 2015 and 2014 (in millions):
Items excluded from organic revenue computations yet impacting revenue comparisons for 2016, 2015 and 2014 include the following (in millions):
* For 2016 we issued 1,998,000 shares in connection with tax-free exchange acquisitions and repurchased 2,265,000 shares to fully offset the impact of the issued shares.
Through January 26, 2017, we closed an additional 5 acquisitions with estimated annualized revenues of approximately $32.2 million. No shares were issued related to these acquisitions.
Investment income and gains realized on books of business sales - This primarily represents interest income earned on cash, cash equivalents and restricted funds, interest income from premium financing and one-time gains related to sales of books of business, which were $6.6 million, $6.7 million and $7.3 million in 2016, 2015 and 2014, respectively. Investment income in 2016 decreased compared to 2015 primarily due to decreases in interest income from our premium financing business and in interest income earned on client held funds, both of which were related to a decline in interest rates in Australia and New Zealand. Investment income in 2015 increased compared to 2014 primarily due to the interest income from premium financing generated by our Australia and New Zealand operations which were acquired on June 16, 2014.
The increase in compensation expense in 2016 compared to 2015 was primarily due to an increase in the average number of employees, salary increases, one-time compensation payments and increases in incentive compensation linked to our overall operating results ($81.1 million in the aggregate), increases in employee benefits expense ($15.7 million), stock compensation expense ($4.7 million), deferred compensation ($3.5 million) and temporary staffing ($0.5 million), offset by decreases in severance related costs ($2.5 million) and earnout related compensation expense ($0.9 million). The increase in employee headcount in 2016 compared to 2015 primarily relates to the addition of employees associated with the acquisitions that we completed in 2016 and new production hires.
The increase in operating expense in 2015 compared to 2014 was due primarily to increases in technology expenses ($30.5 million), outside consulting fees ($16.3 million), business insurance ($12.9 million), real estate expenses ($11.4 million), meeting and client entertainment expenses ($10.0 million), professional and banking fees ($7.7 million), bad debt expense ($6.4 million), licenses and fees ($4.8 million), employee expense ($2.4 million), lease termination charges ($2.4 million), other expense ($2.3 million), outside services expense ($0.6 million), premium financing interest expense ($0.4 million), interest expense ($0.1 million) and unfavorable foreign currency translation ($1.3 million), slightly offset by a decrease in office supplies ($1.4 million). Also contributing to the increase in operating expense in 2015 were increased expenses associated with the acquisitions completed in 2015.
Amortization - The increases in amortization in 2016 compared to 2015 and in 2015 compared to 2014 were due primarily to amortization expense of intangible assets associated with acquisitions completed during these years. Expiration lists, non-compete agreements and trade names are amortized using the straight-line method over their estimated useful lives (three to fifteen years for expiration lists, three to five years for non-compete agreements and five to ten years for trade names). Based on the results of impairment reviews in 2016, 2015 and 2014, we wrote off $1.8 million, $11.5 million and $1.8 million of amortizable intangible assets related to the brokerage segment acquisitions.
The amounts initially recorded as earnout payables for our 2012 to 2016 acquisitions were measured at fair value as of the acquisition date and are primarily based upon the estimated future operating results of the acquired entities over a two- to three-year period subsequent to the acquisition date. The fair value of these earnout obligations is based on the present value of the expected future payments to be made to the sellers of the acquired entities in accordance with the provisions outlined in the respective purchase agreements. In determining fair value, we estimate the acquired entity’s future performance using financial projections developed by management for the acquired entity and market participant assumptions that were derived for revenue growth and/or profitability. We estimate future earnout payments using the earnout formula and performance targets specified in each purchase agreement and these financial projections. Subsequent changes in the underlying financial projections or assumptions will cause the estimated earnout obligations to change and such adjustments are recorded in our consolidated statement of earnings when incurred. Increases in the earnout payable obligations will result in the recognition of expense and decreases in the earnout payable obligations will result in the recognition of income.
Financial information relating to our risk management segment results for 2016, 2015 and 2014 (in millions, except per share, percentages and workforce data):
On November 18, 2014, we announced that a contract for the administration of workers’ compensation claims with the New South Wales Workers Compensation Scheme in Australia would be moved to run-off status on December 31, 2014. Our net earnings from this contract were approximately $3.5 million in 2014. We took a $12.9 million charge in the fourth quarter of 2014 primarily relating to a non-cash impairment of capitalized software and personnel costs dedicated to servicing the New South Wales run-off contract, and in 2015 during we broke even on this contract in the run-off period.
Items excluded from organic fee computations yet impacting revenue comparisons in 2016, 2015 and 2014 include the following (in millions):
Investment income - Investment income primarily represents interest income earned on our cash and cash equivalents. Investment income in 2016 increased compared to 2015 primarily due to higher levels of invested assets in 2016. Investment income in 2015 decreased compared to 2014 primarily due to lower levels of invested assets in 2015.
The decrease in compensation expense in 2016 compared to 2015 was primarily due to favorable foreign currency translation ($2.6 million) and decreases in salaries ($0.4 million in the aggregate), temporary-staffing expense ($2.2 million) and severance related costs ($0.3 million), offset by increased headcount, increases in employee benefits ($1.6 million), stock compensation expense ($0.9 million) and deferred compensation ($0.3 million).
The increase in compensation expense in 2015 compared to 2014 was primarily due to increased headcount and increases in salaries ($27.9 million in the aggregate), employee benefits ($1.8 million), severance related costs ($1.4 million), offset by favorable foreign currency translation ($12.6 million), decreases in claim portfolio transfer ramp up costs ($3.6 million), temporary-staffing expense ($1.3 million) and deferred compensation ($0.6 million).
Operating expense - The following provides non-GAAP information that management believes is helpful when comparing 2016 and 2015 operating expense and 2015 and 2014 operating expense (in millions):
The increase in operating expense in 2015 compared to 2014 was primarily due to increases in professional and banking fees ($6.3 million), outside consulting fees ($5.2 million), technology expenses ($4.3 million), business insurance ($2.5 million), licenses and fees ($1.1 million), meeting and client entertainment expense ($0.7 million), bad debt expense ($0.5 million), lease termination related charges ($0.5 million) and outside services ($0.4 million), offset by decreases in other expense ($10.6 million), claim portfolio transfer ramp up costs ($2.8 million), office supplies ($2.0 million), real estate expenses ($1.1 million) and employee expense ($0.3 million).
Depreciation - Depreciation expense increased in 2016 compared to 2015 and 2015 compared to 2014, which reflects the impact of purchases of furniture, equipment and leasehold improvements related to office expansions and moves and expenditures related to upgrading computer systems.
Change in estimated acquisition earnout payables - The increase in income from the change in estimated acquisition earnout payables in 2016 compared to 2015 and the decrease in income from the change in estimated acquisition earnout payable 2015 compared to 2014 was due primarily to adjustments made in 2015 to the estimated fair value of an earnout obligation related to a revised projections of future performance for two acquisitions. During 2016, 2015 and 2014, we recognized zero, $0.5 million and $0.1 million, respectively, of income related to net adjustments in the estimated fair value of earnout obligations related to revised projections of future performance for two acquisitions.
Provision for income taxes - We allocate the provision for income taxes to the risk management segment using local statutory rates. The risk management segment’s effective tax rate in 2016, 2015 and 2014 was 38.2%, 38.0% and 37.5%, respectively. We anticipate reporting an effective tax rate on adjusted results of approximately 36.0% to 38.0% in our risk management segment for the foreseeable future.
Financial information relating to our corporate segment results for 2016, 2015 and 2014 (in millions, except per share and percentages):
Expenses related to royalty income of Chem-Mod were $2.4 million, $3.0 million and $3.1 million in 2016, 2015 and 2014, respectively. These expenses are included in the operating expenses discussed below.
The losses in 2016, 2015 and 2014 were low because the vast majority of our operations are now consolidated.
In 2015, we settled litigation against certain former U.K. executives and their advisors for a pretax $31.0 million gain ($22.3 million net of costs and taxes). Incremental expenses that arose in connection with this matter will result in after-tax charges of approximately $4.5 million per quarter through June 30, 2017, which will also be presented as an adjustment to the corporate segment. Also in 2015 we recognized $0.7 million of equity basis accounting losses related to our legacy investments and $0.2 million of rental income related to our new headquarters facility.
Cost of revenues - Cost of revenues from consolidated clean coal production plants in 2016, 2015 and 2014 consists of the cost of coal, labor, equipment maintenance, chemicals, supplies, management fees and depreciation incurred by the clean coal production plants to generate the consolidated revenues discussed above, including the costs to run the leased facilities.
Compensation expense - Compensation expense for 2016, 2015 and 2014, respectively, was $72.6 million, $62.0 million and $50.3 million.
The $11.7 million increase in 2015 compared to 2014 was primarily due to retention agreement compensation related to the litigation settlement, compensation for corporate staff working outside the U.S., an increase in incentive compensation due to clean energy performance, offset by the reduction in expense related to the 2014 de-risking strategy of our U.S. defined pension plan.
Interest expense - The increase in interest expense in 2016 compared to 2015 and 2015 compared to 2014 was due to the following:
The capitalization of interest costs related to the purchase and development of our new corporate headquarters building will occur until the development of it is completed in early 2017.
Depreciation - The increase in depreciation expense in 2016 compared to 2015 primarily relates to clean coal plants re-deployed in 2016 and 2015. The increase in depreciation expense in 2015 compared to 2014, primarily relates to the assets of the additional ownership interests in the clean coal plants that we acquired from co-investors in 2014 and clean coal plants re-deployed in 2015.
Benefit for income taxes - We allocate the provision for income taxes to the brokerage and risk management segments using local statutory rates. As a result, the provision for income taxes for the corporate segment reflects the entire benefit to us of the IRC Section 45 credits generated, because that is the segment which produced the credits. The law that provides for IRC Section 45 tax credits substantially expires in December 2019 for our fourteen 2009 Era Plants and in December 2021 for our twenty 2011 Era Plants. Our consolidated effective tax rate was (24.7)%, (32.6)% and (12.3)% for 2016, 2015 and 2014, respectively. The tax rates for 2016, 2015 and 2014 were lower than the statutory rate primarily due to the amount of IRC Section 45 tax credits recognized during the year. There were $194.4 million, $181.3 million and $145.5 million of tax credits produced and recognized in 2016, 2015 and 2014, respectively.
Net earnings attributable to noncontrolling interests - The amounts reported in this line for 2016, 2015 and 2014 primarily include noncontrolling interest earnings of $32.7 million, $36.9 million and $35.3 million, respectively, related to the non-Gallagher owned interest in Chem-Mod. As of December 31, 2016, 2015 and 2014, we held a 46.5% controlling interest in Chem-Mod. Also, included in net earnings attributable to noncontrolling interests are offsetting amounts related to non-Gallagher owned interests in several clean energy investments.
The following provides non-GAAP information that we believe is helpful when comparing 2016, 2015 and 2014 operating results for the corporate segment (in millions):
(1) Pretax earnings are presented net of amounts attributable to noncontrolling interests of $27.0 million in 2016, $30.6 million in 2015 and $23.2 million in 2014.
(3) During the third quarter of 2015, we settled litigation against certain former U.K. executives and their advisors for a pretax gain of $31.0 million ($22.3 million net of costs and taxes in third quarter). Incremental expenses that arose in connection with this matter will result in after-tax charges of up to $4.5 million per quarter through June 30, 2017.
(4) In fourth quarter 2014, we recognized a non-cash after-tax settlement charge of $12.5 million related to retirement plan de-risking strategies.
During 2017 we will be relocating our corporate office headquarters to a nearby suburb of Chicago. One-time move and after-tax lease abandonment charges are expected to total approximately $2.5 million, $4.0 million and $1.5 million in first, second and third quarters of 2017. These charges will be presented in the corporate segment.
The following table provides a summary of our clean coal plant investments as of December 31, 2016 (in millions):
We are aware that some of the coal-fired power plants that purchase the refined coal are considering changing to burning natural gas rather than coal, or shutting down completely for economic reasons. The entities that own such plants are prepared to move the refined coal plants to another coal-fired power plant, if necessary. If these potential developments were to occur, we estimate those refined coal plants will not operate for 12 to 18 months during their movement and redeployment, and the new coal-fired power plant may be a higher or lower volume plant, all of which could have a material impact on the amount of tax credits that are generated by these plants.
In 2016, the funded status of the Plans was unfavorably impacted by a decrease in the discount rates used in the measurement of the pension liabilities at December 31, 2016, the impact of which was approximately $8.2 million. However, the funded status was favorably impacted by returns on the plan’s assets being higher in 2016 than anticipated by approximately $0.3 million and improvements in the mortality assumptions of $4.3 million and other pension gains of $4.4 million. The net change in the funded status of the Plan in 2016 resulted in a decrease in noncurrent liabilities in 2016 of $0.8 million. While the change in funded status of the Plans had no direct impact on our cash flows from operations in 2016, 2015 and 2014, potential changes in the pension regulatory environment and investment losses in our pension plan have an effect on our capital position and could require us to make significant contributions to our defined benefit pension plan and increase our pension expense in future periods.
Dispositions - During 2016, 2015 and 2014, we sold several books of business and recognized one-time gains of $6.6 million, $6.7 million and $7.3 million, respectively. We received cash proceeds of $7.8 million, $9.2 million and $8.2 million, respectively, related to these transactions.
We use the Credit Agreement to post letters of credit and to borrow funds to supplement our operating cash flows from time to time. During 2016, we borrowed an aggregate of $2,740.0 million and repaid $2,657.0 million under our Credit Agreement. Principal uses of the 2016 borrowings under the Credit Agreement were to fund acquisitions, earnout payments related to acquisitions and general corporate purposes. During 2015, we borrowed an aggregate of $849.0 million and repaid $794.0 million under our Credit Agreement. Principal uses of the 2015 borrowings under the Credit Agreement were to fund acquisitions, earnout payments related to acquisitions and general corporate purposes. During 2014, we borrowed an aggregate of $1,109.9 million and repaid $1,500.4 million under our Credit Agreement. Principal uses of the 2014 borrowings under the Credit Agreement were to fund acquisitions, earnout payments related to acquisitions and general corporate purposes.
At December 31, 2016, we had $2,728.0 million of corporate-related borrowings outstanding under separate note purchase agreements entered into in the period 2007 to 2016 and a cash and cash equivalent balance of $545.5 million. See Note 7 to our consolidated financial statements for a discussion of the terms of the note purchase agreements and the Credit Agreement.
We completed a $275.0 million, ten year maturity, private placement debt transaction in 2016, with a weighted average interest rate of 4.47%. In 2016, we entered into a pre-issuance interest rate hedging transaction related to the $175.0 million 10 year tranche of the $275.0 million private placement debt. We realized a cash gain of approximately $1.0 million on the hedging transaction that will be recognized on a pro rata basis as a reduction in our reported interest expense over the ten year life of the debt.
On November 30, 2016, we funded the $50.0 million 2016 maturity of our Series C note.
We completed a $100.0 million, eleven year maturity, private placement debt transaction on December 1, 2016, with an interest rate of 3.46%. A portion of the proceeds was used to fund the $50.0 million of private placement debt that matured on November 30, 2016.
The note purchase agreements, the Credit Agreement and the Premium Financing Debt Facility contain various financial covenants that require us to maintain specified financial ratios. We were in compliance with these covenants as of December 31, 2016.
In 2016, we declared $272.5 million in cash dividends on our common stock, or $1.52 per common share. On December 16, 2016, we paid a fourth quarter dividend of $0.38 per common share to shareholders of record as of December 2, 2016. On January 25, 2017, we announced a quarterly dividend for first quarter 2017 of $0.39 per common share. If the dividend is maintained at $0.39 per common share throughout 2017, this dividend level would result in an annualized net cash used by financing activities in 2017 of approximately $278.1 million (based on the outstanding shares as of December 31, 2016), or an anticipated increase in cash used of approximately $5.9 million compared to 2016. We can make no assurances regarding the amount of any future dividend payments.
Common Stock Repurchases - We have in place a common stock repurchase plan approved by our board of directors. We repurchased 2.3 million shares of our common stock at cost of $101.0 million (7.7 million remain available). We did not repurchase any shares in 2015 and 2014. Under the provisions of the repurchase plan, we were authorized to repurchase approximately 10,000,000 additional shares at December 31, 2016. The plan authorizes the repurchase of our common stock at such times and prices as we may deem advantageous, in transactions on the open market or in privately negotiated transactions. We are under no commitment or obligation to repurchase any particular number of shares, and the plan may be suspended at any time at our discretion. Funding for share repurchases may come from a variety of sources, including cash from operations, short-term or long-term borrowings under our Credit Agreement or other sources. There were no common stock repurchases made in 2015 and 2014 that impacted our consolidated financial statements.
At-the-Market Equity Program - On November 20, 2013, we entered into an Equity Distribution Agreement with Morgan Stanley & Co. LLC, pursuant to which we may offer and sell, from time to time, up to $200 million (of which $15.6 million is remaining) of our common stock through Morgan Stanley as sales agent. Pursuant to the agreement, shares may be sold by means of ordinary brokers’ transactions, including on the New York Stock Exchange, at market prices prevailing at the time of sale, at prices related to the prevailing market prices, or at negotiated prices, in block transactions, or as otherwise agreed upon by us and Morgan Stanley. During 2016, we did not sell any shares of our common stock under the program.
Common Stock Issuances - Another source of liquidity to us is the issuance of our common stock pursuant to our stock option and employee stock purchase plans. Proceeds from the issuance of common stock under these plans were $45.6 million in 2016, $54.1 million in 2015 and $56.3 million in 2014.
Off-Balance Sheet Debt - Our unconsolidated investment portfolio includes investments in enterprises where our ownership interest is between 1% and 50%, in which management has determined that our level of influence and economic interest is not sufficient to require consolidation. As a result, these investments are accounted for under the equity method. None of these unconsolidated investments had any outstanding debt at December 31, 2016 and 2015 that was recourse to us.
Nature of Operations - Arthur J. Gallagher & Co. and its subsidiaries, collectively referred to herein as we, our, us or the company, provide insurance brokerage and risk management services to a wide variety of commercial, industrial, institutional and governmental organizations through three reportable operating segments. Commission and fee revenue generated by the brokerage segment is primarily related to the negotiation and placement of insurance for our clients. Fee revenue generated by the risk management segment is primarily related to claims management, information management, risk control consulting (loss control) services and appraisals in the property/casualty market. Investment income and other revenue are generated from our premium financing operations and our investment portfolio, which includes invested cash and restricted funds, as well as clean energy and other investments. We are headquartered in Itasca, Illinois, have operations in 33 countries and offer client-service capabilities in more than 150 countries globally through a network of correspondent insurance brokers and consultants.
In the preparation of our consolidated financial statements as of December 31, 2016, management evaluated all material subsequent events or transactions that occurred after the balance sheet date through the date on which the financial statements were issued for potential recognition in our consolidated financial statements and/or disclosure in the notes thereto.
Use of Estimates - The preparation of our consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
Restricted Cash - In our capacity as an insurance broker, we collect premiums from insureds and, after deducting our commissions and/or fees, remit these premiums to insurance carriers. We hold unremitted insurance premiums in a fiduciary capacity until we disburse them, and the use of such funds is restricted by laws in certain states and foreign jurisdictions in which our subsidiaries operate. Various state and foreign agencies regulate insurance brokers and provide specific requirements that limit the type of investments that may be made with such funds. Accordingly, we invest these funds in cash and U.S. Treasury fund accounts. We can earn interest income on these unremitted funds, which is included in investment income in the accompanying consolidated statement of earnings. These unremitted amounts are reported as restricted cash in the accompanying consolidated balance sheet, with the related liability reported as premiums payable to insurance and reinsurance companies. Additionally, several of our foreign subsidiaries are required by various foreign agencies to meet certain liquidity and solvency requirements. We were in compliance with these requirements at December 31, 2016.
Related to our third party administration business and in certain of our brokerage operations, we are responsible for client claim funds that we hold in a fiduciary capacity. We do not earn any interest income on the funds held. These client funds have been included in restricted cash, along with a corresponding liability in premiums payable to insurance and reinsurance companies in the accompanying consolidated balance sheet.
hedged item. These derivative instrument contracts are periodically monitored for hedge ineffectiveness, the amount of which has not been material to the accompanying consolidated financial statements. We do not use derivatives for trading or speculative purposes. In 2014, other net revenues also includes a gain of $1.9 million related to an AU$400.0 million foreign currency derivative investment contract that we executed on April 16, 2014 in connection with the signing of the agreement to acquire the Crombie/OAMPS operations, headquartered in Australia. This contract was designed to hedge a portion of the AU dollar denominated purchase price consideration of this acquisition. The derivative investment contract was exercised on June 16, 2014, the date that the Crombie/OAMPS transaction closed.
Premium Financing - Seven subsidiaries of the brokerage segment make short-term loans (generally with terms of twelve months or less) to our clients to finance premiums. These premium financing contracts are structured to minimize potential bad debt expense to us. Such receivables are generally considered delinquent after seven days of the payment due date. In normal course, insurance policies are cancelled within one month of the contractual payment due date if the payment remains delinquent. We recognize interest income as it is earned over the life of the contract using the “level-yield” method. Unearned interest related to contracts receivable is included in the receivable balance in the accompanying consolidated balance sheet. The outstanding loan receivable balance was $241.2 million and $220.2 million at December 31, 2016 and 2015, respectively.
Income Taxes - Our tax rate reflects the statutory tax rates applicable to our taxable earnings and tax planning in the various jurisdictions in which we operate. Significant judgment is required in determining the annual effective tax rate and in evaluating uncertain tax positions. We report a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in our tax return. We evaluate our tax positions using a two-step process. The first step involves recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination based solely on the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings and case law) and their applicability to the facts and circumstances of the position. If a tax position does not meet the “more likely than not” recognition threshold, we do not recognize the benefit of that position in the financial statements. The second step is measurement. A tax position that meets the “more likely than not” recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that has a likelihood of greater than 50% of being realized upon ultimate resolution with a taxing authority.
The level in the fair value hierarchy within which the fair value measurement is classified is determined based on the lowest level input that is significant to the fair value measure in its entirety.
The carrying amounts of financial assets and liabilities reported in the accompanying consolidated balance sheet for cash and cash equivalents, restricted cash, premiums and fees receivable, premiums payable to insurance carriers, accrued salaries and bonuses, accounts payable and other accrued liabilities, unearned fees and income taxes payable, at December 31, 2016 and 2015, approximate fair value because of the short-term duration of these instruments. See Note 3 to our consolidated financial statements for the fair values related to the establishment of intangible assets and the establishment and adjustment of earnout payables. See Note 7 to our consolidated financial statements for the fair values related to borrowings outstanding at December 31, 2016 and 2015 under our debt agreements. See Note 12 to our consolidated financial statements for the fair values related to investments at December 31, 2016 and 2015 under our defined benefit pension plan.
Defined Benefit Pension and Other Postretirement Plans - We recognize in our consolidated balance sheet, an asset for our defined benefit postretirement plans’ overfunded status or a liability for our plans’ underfunded status. We recognize changes in the funded status of our defined benefit postretirement plans in comprehensive earnings in the year in which the changes occur. We use December 31 as the measurement date for our plans’ assets and benefit obligations. See Note 12 to our consolidated financial statements for additional information required to be disclosed related to our defined benefit postretirement plans.
We anticipate this guidance will have a material impact on our consolidated financial statements. While we are continuing to assess all potential impacts of the new guidance, we currently believe the most significant impact relates to our real estate operating leases and the related recognition of right-of-use assets and lease liabilities in both noncurrent assets and noncurrent liabilities in our consolidated balance sheet.
In March 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting. This new accounting guidance requires that all companies recognize the income tax effects of awards in the income statement when the awards vest or are settled, rather than maintaining an APIC pool and recognizing the tax benefits in excess of compensation costs through stockholders’ equity. As it relates to forfeitures, the new guidance allows for companies to choose whether to continue to estimate forfeitures or account for forfeitures as they occur. This new guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. Early adoption was permitted and the new guidance may be applied either retrospectively or on a prospective basis. Management believes that the adoption of this guidance will not have a material impact on our consolidated financial statements.
In August 2016, the FASB issued ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments (a consensus of the Emerging Issues Task Force), (ASU 2016-15). The amendments in ASU 2016-15 address eight specific cash flow issues and apply to all entities that are required to present a statement of cash flows under ASC 230, Statement of Cash Flows. This new guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. We are currently reviewing the new guidance, and the impact from its adoption on our consolidated financial statements cannot be determined at this time.
In October 2016, the FASB issued ASU No. 2016-17, Consolidation (Topic 810): Interests Held through Related Parties That Are under Common Control. This new accounting guidance affects consolidation of variable interest entities in certain situations involving entities under common control. This new guidance is effective beginning on January 1, 2017 and is to be applied to all periods since adoption of ASU No. 2015-02, which we adopted effective January 1, 2016. We do not expect that the adoption of this new guidance will have a material effect on our consolidated financial statements.
In November 2016, the FASB issued Accounting Standards Update 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash. This new accounting guidance addresses the classification and presentation of changes in restricted cash on the statement of cash flows under Topic 230, Statement of Cash Flows. This guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted for all entities. We are currently assessing the impact that adopting this new guidance will have on our consolidated financial statements.
In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments. The new accounting guidance requires that measurement period adjustments be recognized in the reporting period in which the adjustment amount is determined rather than retrospectively applying the change to the acquisition date. The new guidance was effective in first quarter 2016 and was applied by us. The adoption of this guidance did not have a material impact on our consolidated financial statements.
In 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, as a Topic, ASC 606, which will supersede nearly all existing revenue recognition guidance under U.S. GAAP. The core principal of the new accounting guidance is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The new guidance is effective for us in first quarter 2018 and early adoption is permitted beginning in first quarter 2017. Two methods of transition are permitted upon adoption: full retrospective and modified retrospective. Under the full retrospective method, prior periods would be restated under the new revenue standard, providing a comparable view across all periods presented. Under the modified retrospective method, prior periods would not be restated. Rather, revenues and other disclosures for pre-2018 periods would be provided in the notes to the financial statements as previously reported under the current revenue guidance. We will adopt this new guidance in the first quarter 2018. We are evaluating both methods of transition; however, we currently anticipate adopting the new guidance using the full retrospective method to restate each prior reporting period presented.
Expense - Amendments to ASC Topic 340, Other Assets and Deferred Costs, require the capitalization of costs to obtain and costs to fulfill customer contracts, which are currently expensed as incurred. The assets recognized for the costs to obtain and/or fulfill a contract will be amortized on a systematic basis that is consistent with the transfer of the services to which the asset relates. We are currently determining the nature and quantifying the amount of costs that would qualify for capitalization and the amount of amortization that will be recognized in each period.
Common shares issued in connection with acquisitions are valued at closing market prices as of the effective date of the applicable acquisition. We record escrow deposits that are returned to us as a result of adjustments to net assets acquired as reductions of goodwill when the escrows are settled. The maximum potential earnout payables disclosed in the foregoing table represent the maximum amount of additional consideration that could be paid pursuant to the terms of the purchase agreement for the applicable acquisition. The amounts recorded as earnout payables, which are primarily based upon the estimated future operating results of the acquired entities over a two- to three-year period subsequent to the acquisition date, are measured at fair
The fair value of these earnout obligations is based on the present value of the expected future payments to be made to the sellers of the acquired entities in accordance with the provisions outlined in the respective purchase agreements, which is a Level 3 fair value measurement. In determining fair value, we estimated the acquired entity’s future performance using financial projections developed by management for the acquired entity and market participant assumptions that were derived for revenue growth and/or profitability. Revenue growth rates generally ranged from 3.5% to 16.0% for our 2016 acquisitions. We estimated future payments using the earnout formula and performance targets specified in each purchase agreement and these financial projections. We then discounted these payments to present value using a risk-adjusted rate that takes into consideration market-based rates of return that reflect the ability of the acquired entity to achieve the targets. These discount rates generally ranged from 8.0% to 9.5% for our 2016 acquisitions. Changes in financial projections, market participant assumptions for revenue growth and/or profitability, or the risk-adjusted discount rate, would result in a change in the fair value of recorded earnout obligations.
During 2016, 2015 and 2014, we recognized $16.9 million, $16.2 million and $14.5 million, respectively, of expense in our consolidated statement of earnings related to the accretion of the discount recorded for earnout obligations in connection with our acquisitions. In addition, during 2016, 2015 and 2014, we recognized $15.2 million, $24.4 million and $3.0 million of expense, respectively, related to net adjustments in the estimated fair value of the liability for earnout obligations in connection with revised projections of future performance for 101, 105 and 67 acquisitions, respectively. The aggregate amount of maximum earnout obligations related to acquisitions made in 2013 and subsequent years was $527.2 million as of December 31, 2016, of which $242.3 million was recorded in the consolidated balance sheet as of that date based on the estimated fair value of the expected future payments to be made. The aggregate amount of maximum earnout obligations related to acquisitions made in 2012 and subsequent years was $565.4 million as of December 31, 2015, of which $229.7 million was recorded in the consolidated balance sheet as of that date based on the estimated fair value of the expected future payments to be made.
The following is a summary of the estimated fair values of the net assets acquired at the date of each acquisition made in 2016 (in millions):
Provisional estimates of fair value are established at the time of the acquisition and are subsequently reviewed within the first year of operations subsequent to the acquisition date to determine the necessity for adjustments. The fair value of the tangible assets and liabilities for each applicable acquisition at the acquisition date approximated their carrying values. The fair value of expiration lists was established using the excess earnings method, which is an income approach based on estimated financial projections developed by management for each acquired entity using market participant assumptions. Revenue growth and attrition rates generally ranged from 1.0% to 3.0% and 2.5% to 12.5% for our 2016 acquisitions, respectively, for which a valuation was performed. We estimate the fair value as the present value of the benefits anticipated from ownership of the subject customer list in excess of returns required on the investment in contributory assets necessary to realize those benefits. The rate used to discount the net benefits was based on a risk-adjusted rate that takes into consideration market-based rates of return and reflects the risk of the asset relative to the acquired business. These discount rates generally ranged from 12.0% to 19.0% for our 2016 acquisitions, for which a valuation was performed. The fair value of non-compete agreements was established using the profit differential method, which is an income approach based on estimated financial projections developed by management for the acquired company using market participant assumptions and various non-compete scenarios.
Of the $218.1 million of expiration lists, $2.8 million of non-compete agreements and $0.4 million of trade names related to the 2016 acquisitions, $92.6 million, $1.4 million and $0.4 million, respectively, is not expected to be deductible for income tax purposes. Accordingly, we recorded a deferred tax liability of $27.3 million, and a corresponding amount of goodwill, in 2016 related to the nondeductible amortizable intangible assets.
Our consolidated financial statements for the year ended December 31, 2016 include the operations of the acquired entities from their respective acquisition dates. The following is a summary of the unaudited pro forma historical results, as if these entities had been acquired at January 1, 2015 (in millions, except per share data):
The carrying amount of goodwill at December 31, 2016 and 2015 allocated by domestic and foreign operations is as follows (in millions):
The changes in the carrying amount of goodwill for 2016 and 2015 are as follows (in millions):
We are a party to a note purchase agreement dated November 30, 2009, with certain accredited institutional investors, pursuant to which we issued and sold $150.0 million in aggregate principal amount of our 5.85% Senior Notes, Series C, due in three equal installments on November 30, 2016, November 30, 2018 and November 30, 2019, in a private placement. These notes require semi-annual payments of interest that are due in May and November of each year. On November 30, 2016, we funded the $50.0 million 2016 maturity of our Series C note.
We are a party to a note purchase agreement dated June 24, 2014, with certain accredited institutional investors, pursuant to which we issued and sold $50.0 million in aggregate principal amount of our 2.80% Senior Notes, Series K, due June 24, 2018, $50.0 million in aggregate principal amount of our 3.20% Senior Notes, Series L, due June 24, 2019, $50.0 million in aggregate principal amount of our 3.48% Senior Notes, Series M, due June 24, 2020, $200.0 million in aggregate principal amount of our 4.13% Senior Notes, Series N, due June 24, 2023, $200.0 million in aggregate principal amount of our 4.31% Senior Notes, Series O, due June 24, 2025 and $150.0 million in aggregate principal amount of our 4.36% Senior Notes, Series P, due June 24, 2026. These notes require semi-annual payments of interest that are due in June and December of each year. We incurred approximately $2.6 million of debt acquisition costs that was capitalized and will be amortized on a pro rata basis over the life of the debt.
The Credit Agreement provides that we may elect that each borrowing in U.S. dollars be either base rate loans or eurocurrency loans, each as defined in the Credit Agreement. However, the Credit Agreement provides that all loans denominated in currencies other than U.S. dollars will be eurocurrency loans. Interest rates on base rate loans and outstanding drawings on letters of credit in U.S. dollars under the Credit Agreement will be based on the base rate, as defined in the Credit Agreement, plus a margin of 0.00% to 0.45%, depending on the financial leverage ratio we maintain. Interest rates on eurocurrency loans or outstanding drawings on letters of credit in currencies other than U.S. dollars under the Credit Agreement will be based on adjusted LIBOR, as defined in the Credit Agreement, plus a margin of 0.85% to 1.45%, depending on the financial leverage ratio we maintain. Interest rates on swing loans will be based, at our election, on either the base rate or an alternate rate that may be quoted by the lead lender. The annual facility fee related to the Credit Agreement is 0.15% and 0.30% of the revolving credit commitment, depending on the financial leverage ratio we maintain. In connection with entering into the Credit Agreement, we incurred approximately $2.0 million of debt acquisition costs that were capitalized and will be amortized on a pro rata basis over the term of the Credit Agreement.
The terms of the Credit Agreement include various financial covenants, including covenants that require us to maintain specified financial ratios. We were in compliance with these covenants as of December 31, 2016. The Credit Agreement also includes customary provisions for transactions of this type, including events of default, with corresponding grace periods and cross-defaults to other agreements evidencing our indebtedness.
Premium Financing Debt Facility - On May 18, 2015 we entered into a Syndicated Facility Agreement, revolving loan facility, which we refer to as the Premium Financing Debt Facility, that provides funding for the three acquired Australian (AU) and New Zealand (NZ) premium finance subsidiaries. The Premium Financing Debt Facility is comprised of: (i) Facility B is separate AU$150.0 million and NZ$35.0 million tranches, (ii) Facility C is an AU$25.0 million equivalent multi-currency overdraft tranche and (iii) Facility D is a NZ$15.0 million equivalent multi-currency overdraft tranche. The Premium Financing Debt Facility expires May 18, 2017.
The terms of our Premium Financing Debt Facility include various financial covenants, including covenants that require us to maintain specified financial ratios. We were in compliance with these covenants as of December 31, 2016. The Premium Financing Debt Facility also includes customary provisions for transactions of this type, including events of default, with corresponding grace periods and cross-defaults to other agreements evidencing our indebtedness. Facilities B, C and D are secured by the premium finance receivables of the Australian and New Zealand premium finance subsidiaries.
See Note 15 to these consolidated financial statements for additional discussion on our contractual obligations and commitments as of December 31, 2016.
Upon exercise, the option exercise price may be paid in cash, by the delivery of previously owned shares of our common stock, through a net-exercise arrangement, or through a broker-assisted cashless exercise arrangement. The compensation committee determines all of the terms relating to the exercise, cancellation or other disposition of an option or stock appreciation right upon a termination of employment, whether by reason of disability, retirement, death or any other reason. Stock option and stock appreciation right awards under the LTIP are non-transferable.
During 2016, 2015 and 2014, we recognized $14.7 million, $11.2 million and $9.5 million, respectively, of compensation expense related to our stock option grants.
For purposes of expense recognition in 2016, 2015 and 2014, the estimated fair values of the stock option grants are amortized to expense over the options’ vesting period. We estimated the fair value of stock options at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:
The following is a summary of our stock option activity and related information for 2016, 2015 and 2014 (in millions, except exercise price and year data):
The total intrinsic value of options exercised during 2016, 2015 and 2014 amounted to $19.3 million, $27.0 million and $30.5 million, respectively. At December 31, 2016, we had approximately $41.4 million of total unrecognized compensation cost related to nonvested options. We expect to recognize that cost over a weighted average period of approximately four years.
We have a Deferred Equity Participation Plan, (which we refer to as the DEPP), which is a non-qualified plan that generally provides for distributions to certain of our key executives when they reach age 62 (or the one-year anniversary of the date of the grant for participants over the age of 61 as of the grant date) or upon or after their actual retirement. Under the provisions of the DEPP, we typically contribute cash in an amount approved by the compensation committee to a rabbi trust on behalf of the executives participating in the DEPP, and instruct the trustee to acquire a specified number of shares of our common stock on the open market or in privately negotiated transactions based on participant elections. Distributions under the DEPP may not normally be made until the participant reaches age 62 (or the one-year anniversary of the date of the grant for participants over the age of 61 as of the grant date) and are subject to forfeiture in the event of voluntary termination of employment prior to then. DEPP awards are generally made annually in the first quarter. In the second quarter of 2016, we made awards under sub-plans of the DEPP for certain production staff, which generally provide for vesting and/or distributions no sooner than five years from the date of awards, although certain awards vest and/or distribute after earlier of fifteen years or the participant reaching age 65. All contributions to the plan (including sub-plans) deemed to be invested in shares of our common stock are distributed in the form of our common stock and all other distributions are paid in cash.
In the first quarter of each of 2016, 2015 and 2014, the compensation committee approved $10.1 million, $8.9 million and $9.2 million, respectively, of awards in the aggregate to certain key executives under the DEPP that were contributed to the rabbi trust in the first quarters of 2016, 2015 and 2014. We contributed cash to the rabbi trust and instructed the trustee to acquire a specified number of shares of our common stock on the open market to fund these 2016, 2015 and 2014 awards. In the second quarter of 2013, we instructed the trustee for the DEPP to liquidate all investments held under the DEPP, other than our common stock, and use the proceeds to purchase additional shares of our common stock on the open market. As a result, the DEPP sold all of the funded cash award assets and purchased 1.2 million shares of our common stock at an aggregate cost of $52.4 million during the second quarter of 2013. During 2016, 2015 and 2014, we charged $7.5 million, $7.2 million and $7.4 million, respectively, to compensation expense related to these awards.
In 2016, the compensation committee approved $13.6 million of awards under the sub-plans referred to above, which were contributed to the rabbi trust in second quarter 2016. During 2016, we charged $1.3 million to compensation expense related to these awards. There were no distributions from the sub-plans during 2016.
At December 31, 2016 and 2015, we recorded $46.8 million (related to 2.4 million shares) and $33.5 million (related to 2.1 million shares), respectively, of unearned deferred compensation as an reduction of capital in excess of par value in the accompanying consolidated balance sheet. The total intrinsic value of our unvested equity based awards under the plan at December 31, 2016 and 2015 was $125.5 million and $85.2 million, respectively. During 2016, 2015 and 2014, cash and equity awards with an aggregate fair value of $7.6 million, $2.3 million and $18.8 million, respectively, were vested and distributed to employees under the DEPP.
The agreements awarding restricted stock units under the LTIP will specify whether such awards may be settled in shares of our common stock, cash or a combination of shares and cash and whether the holder will be entitled to receive dividend equivalents, on a current or deferred basis, with respect to such award. Prior to the settlement of a restricted stock unit, the holder of a restricted stock unit will have no rights as a stockholder of the company. The maximum number of shares available under the LTIP for restricted stock, restricted stock units and performance unit awards settled with stock (i.e., all awards other than stock options and stock appreciation rights) is 2.0 million. At December 31, 2016, 1.0 million shares were available for grant under the LTIP for such awards.
In 2016, 2015 and 2014, we granted 479,167, 394,975 and 376,541 restricted stock units, respectively, to employees under the LTIP, with an aggregate fair value of $20.4 million, $16.7 million and $16.0 million, respectively, at the date of grant.
The 2016, 2015 and 2014 restricted stock units vest as follows: 466,600 units granted in first quarter 2016, 362,600 units granted in first quarter 2015 and 323,550 units granted in first quarter 2014, vest in full based on continued employment through March 17, 2021, March 11, 2020 and March 12, 2018, respectively, while the other 2016, 2015 and 2014 restricted stock unit awards generally vest in full based on continued employment through the vesting period on the anniversary date of the grant. In the third quarter of 2014, we granted 33,741 restricted stock units to employees with an aggregate fair value of $1.5 million at the date of grant. These grants vest at the rate of 34%, 33% and 33% on the anniversary date of the grant in 2015, 2016 and 2017, respectively from the date of grant. For certain of our executive officers age 55 or older, restricted stock units awarded in 2016, 2015 and 2014 are no longer subject to forfeiture upon such officers’ departure from the company after two years from the date of grant.
We account for restricted stock unit awards at historical cost, which equals its fair market value at the date of grant, which is amortized to compensation expense ratably over the vesting period of the participants. Future changes in the fair value of our common stock that is owed to the participants do not have any impact on the amounts recorded in our consolidated financial statements. During 2016, 2015 and 2014, we charged $18.2 million, $14.4 million and $12.7 million, respectively, to compensation expense related to restricted stock awards granted in 2007 through 2016. The total intrinsic value of unvested restricted stock at December 31, 2016 and 2015 was $80.0 million and $56.1 million, respectively. During 2016 and 2015, equity awards (including accrued dividends) with an aggregate fair value of $14.2 million and $10.2 million were vested and distributed to employees under this plan.
On March 12, 2014, pursuant to the Program, the compensation committee approved the provisional cash awards of $10.8 million in the aggregate for future grants to our officers and key employees that are denominated in units (229,000 units in the aggregate), each of which was equivalent to the value of one share of our common stock on the date the provisional awards were approved. Terms of the 2014 provisional award were similar to the terms of the 2015 provisional awards. Based on our performance for 2014, we granted 220,000 units under the Program in first quarter 2015 that will fully vest on January 1, 2017. During 2016 and 2015, we charged $4.5 million and $4.9 million to compensation expense related to these awards. We did not recognize any compensation expense during 2014 related to the 2014 awards.
We have a noncontributory defined benefit pension plan that, prior to July 1, 2005, covered substantially all of our domestic employees who had attained a specified age and one year of employment. Benefits under the plan were based on years of service and salary history. In 2005, we amended our defined benefit pension plan to freeze the accrual of future benefits for all U.S. employees, effective on July 1, 2005. Since the plan is frozen, there is no difference between the projected benefit obligation and accumulated benefit obligation at December 31, 2016 and 2015. In the table below, the service cost component represents plan administration costs that are incurred directly by the plan. A reconciliation of the beginning and ending balances of the pension benefit obligation and fair value of plan assets and the funded status of the plan is as follows (in millions):
Plan assets are invested in various pooled separate accounts under annuity contracts managed by two life insurance carriers. The plan’s investment policy provides that investments will be allocated in a manner designed to provide a long-term investment return greater than the actuarial assumptions, maximize investment return commensurate with risk and to comply with the Employee Income Retirement Security Act of 1974, as amended (which we refer to as ERISA), by investing the funds in a manner consistent with ERISA’s fiduciary standards. The weighted average expected long-term rate of return on plan assets assumption was determined based on a review of the asset allocation strategy of the plan using expected ten-year return assumptions for all of the asset classes in which the plan was invested at December 31, 2016 and 2015. The ten-year return assumptions used in the valuation were based on data provided by the plan’s external investment advisors.
We also have a qualified contributory savings and thrift (401(k)) plan covering the majority of our domestic employees. For eligible employees who have met the plan’s age and service requirements to receive matching contributions, we match 100% of pre-tax and Roth elective deferrals up to a maximum of 5.0% of eligible compensation, subject to Federal limits on plan contributions and not in excess of the maximum amount deductible for Federal income tax purposes. Effective January 1, 2014, employees must be employed and eligible for the plan on the last day of the plan year to receive a matching contribution, subject to certain exceptions enumerated in the plan document. Matching contributions are subject to a five-year graduated vesting schedule. We expensed $48.7 million, $42.5 million and $38.0 million related to the plan in 2016, 2015 and 2014, respectively.
We also have a nonqualified deferred compensation plan, the Supplemental Savings and Thrift Plan, for certain employees who, due to Internal Revenue Service (which we refer to as the IRS) rules, cannot take full advantage of our matching contributions under the 401(k) plan. The plan permits these employees to annually elect to defer a portion of their compensation until their retirement or a future date. Our matching contributions to this plan (up to a maximum of the lesser of a participant’s elective deferral of base salary, annual bonus and commissions or 5.0% of eligible compensation, less matching amounts contributed under the 401(k) plan) are also at the discretion of our board of directors. We contributed $5.6 million, $4.7 million and $3.7 million to a rabbi trust maintained under the plan in 2016, 2015 and 2014, respectively. The fair value of the assets in the plan’s rabbi trust at December 31, 2016 and 2015, including employee contributions and investment earnings, was $263.3 million and $201.2 million, respectively, and has been included in other noncurrent assets and the corresponding liability has been included in other noncurrent liabilities in the accompanying consolidated balance sheet.
We also have several foreign benefit plans, the largest of which is a defined contribution plan that provides for us to make contributions of 5.0% of eligible compensation. In addition, the plan allows for voluntary contributions by U.K. employees, which we match 100%, up to a maximum of an additional 5.0% of eligible compensation. Net expense for foreign retirement plans amounted to $30.6 million, $31.7 million and $29.7 million in 2016, 2015 and 2014, respectively.
In 1992, we amended our health benefits plan to eliminate retiree coverage, except for retirees and those employees who had already attained a specified age and length of service at the time of the amendment. The retiree health plan is contributory, with contributions adjusted annually, and is funded on a pay-as-you-go basis. The postretirement benefit obligation and the unfunded status of the plan as of December 31, 2016 and 2015 were $2.7 million and $2.7 million, respectively. The net periodic postretirement benefit (income) cost of the plan amounted to ($0.3 million), ($0.3 million) and ($0.5 million) in 2016, 2015 and 2014, respectively.
Chem-Mod LLC - At December 31, 2016, we held a 46.5% controlling interest in Chem-Mod. Chem-Mod possesses the exclusive marketing rights, in the U.S. and Canada, for technologies used to reduce emissions created during the combustion of coal. The refined coal production plants discussed below, as well as those owned by other unrelated parties, license and use Chem-Mod’s proprietary technologies, The Chem-Mod™ Solution, in the production of refined coal. The Chem-Mod™ Solution uses a dual injection sorbent system to reduce mercury, sulfur dioxide and other emissions at coal-fired power plants.
Chem-Mod is determined to be a variable interest entity (which we refer to as a VIE). We are the manager (decision maker) of Chem-Mod and therefore consolidate its operations into our consolidated financial statements. At December 31, 2016, total assets and total liabilities of this VIE included in our consolidated balance sheet were $11.1 million and $0.8 million, respectively. At December 31, 2015, total assets and total liabilities of this VIE were $10.3 million and $0.9 million, respectively. For 2016, total revenues and expenses were $63.5 million and $2.4 million, respectively. For 2015, total revenues and expenses were $72.1 million and $3.0 million, respectively. We are under no obligation to fund Chem-Mod’s operations in the future.
Chem-Mod International LLC - At December 31, 2016, we held a 31.5% non-controlling ownership interest in Chem-Mod International. Chem-Mod International has the rights to market The Chem-Mod™ Solution in countries other than the U.S. and Canada. Such marketing activity has been limited to date.
C-Quest Technology LLC and C-Quest Technologies International LLC (together, C-Quest) - At December 31, 2016, we held a non-controlling 12% interest in C-Quest’s global entities. C-Quest possesses rights, information and technology for the reduction of carbon dioxide emissions created by burning fossil fuels. Thus far, C-Quest’s operations have been limited to laboratory testing. C-Quest is determined to be a VIE, but we do not consolidate this investment into our consolidated financial statements because we are not the primary beneficiary or decision maker. We have an option to acquire an additional 15% interest in C-Quest’s global entities for $7.5 million at any time on or prior to August 1, 2017.
We have a non-controlling interest in one plant, which is owned by a limited liability company (which we refer to as a LLC). We have determined that this LLC is a VIE, for which we are not the primary beneficiary. At December 31, 2016, total assets and total liabilities of this VIE were $15.7 million and $13.4 million, respectively. For 2016, total revenues and expenses of this VIE were $57.4 million and $71.1 million, respectively.
Other Investments - At December 31, 2016, we owned a non-controlling, minority interest in four venture capital funds totaling $3.7 million, twelve certified low-income housing developments with zero carrying value and two real estate entities with zero carrying value. The low-income housing developments and real estate entities have been determined to be VIEs, but are not required to be consolidated due to our lack of control over their respective operations. At December 31, 2016, total assets and total liabilities of these VIEs were approximately $60.0 million and $20.0 million, respectively.
We has not received or pledged any collateral related to derivative arrangements at December 31, 2016.
The notional and fair values of derivative instruments are as follows at December 31, 2016 and 2015 (in millions):
(1) Included within other current assets $12.5 million and zero at December 31, 2016 and 2015, respectively and other non-current assets $1.0 million and zero at December 31, 2016 and 2015, respectively.
The amounts of derivative gains (losses) recognized in accumulated other comprehensive loss were as follows (in millions):
We estimate that approximately $0.4 million of pretax losses currently included within accumulated other comprehensive loss will be reclassified into earnings in the next twelve months. The amount of gain (loss) recognized in earnings on the ineffective portion of derivatives for 2016, 2015 and 2014 was $1.6 million, $0.7 million and zero, respectively.
In connection with our investing and operating activities, we have entered into certain contractual obligations and commitments. See Notes 7 and 13 to our consolidated financial statements for additional discussion of these obligations and commitments. Our future minimum cash payments, including interest, associated with our contractual obligations pursuant to the note purchase agreements, Credit Agreement, Premium Financing Debt Facility, operating leases and purchase commitments at December 31, 2016 were as follows (in millions):
Operating Lease Obligations - Our corporate segment’s executive offices and certain subsidiary and branch facilities of our brokerage and risk management segments are located at Two Pierce Place, Itasca, Illinois, where we lease approximately 306,000 square feet of space, or approximately 60% of the building. The lease commitment on this property expires February 28, 2018. In August 2015, we announced that we will be relocating our headquarters to the city of Rolling Meadows, Illinois, which will have approximately 360,000 square feet of space and will accommodate 2,000 employees at peak capacity. We anticipate
Outstanding Purchase Obligations - We typically do not have a material amount of outstanding purchase obligations at any point in time. The amount disclosed in the contractual obligations table above represents the aggregate amount of unrecorded purchase obligations that we had outstanding at December 31, 2016. These obligations represent agreements to purchase goods or services that were executed in the normal course of business.
Off-Balance Sheet Commitments - Our total unrecorded commitments associated with outstanding letters of credit, financial guarantees and funding commitments at December 31, 2016 were as follows (in millions):
Since January 1, 2002, we have acquired 420 companies, all of which were accounted for using the acquisition method for recording business combinations. Substantially all of the purchase agreements related to these acquisitions contain provisions for potential earnout obligations. For all of our acquisitions made in the period from 2013 to 2016 that contain potential earnout obligations, such obligations are measured at fair value as of the acquisition date and are included on that basis in the recorded purchase price consideration for the respective acquisition. The amounts recorded as earnout payables are primarily based upon estimated future potential operating results of the acquired entities over a two- to three-year period subsequent to the acquisition date. The aggregate amount of the maximum earnout obligations related to these acquisitions was $527.2 million, of which $242.3 million was recorded in our consolidated balance sheet as of December 31, 2016 based on the estimated fair value of the expected future payments to be made.
Off-Balance Sheet Debt - Our unconsolidated investment portfolio includes investments in enterprises where our ownership interest is between 1% and 50%, in which management has determined that our level of influence and economic interest is not sufficient to require consolidation. As a result, these investments are accounted for under the equity method. None of these unconsolidated investments had any outstanding debt at December 31, 2016 or 2015 that was recourse to us.
At December 31, 2016, we had posted two letters of credit totaling $9.3 million in the aggregate, related to our self-insurance deductibles, for which we had a recorded liability of $12.3 million. We have an equity investment in a rent-a-captive facility, which we use as a placement facility for certain of our insurance brokerage operations. At December 31, 2016, we had posted seven letters of credit totaling $6.3 million to allow certain of our captive operations to meet minimum statutory surplus requirements and for additional collateral related to premium and claim funds held in a fiduciary capacity, one letter of credit totaling $5.0 million to support our potential obligation under a client’s insurance program and one letter of credit totaling $0.5 million as a security deposit for a 2015 acquisition’s lease. These letters of credit have never been drawn upon.
Our commitments associated with outstanding letters of credit, financial guarantees and funding commitments at December 31, 2016 were as follows (all dollar amounts in table are in millions):
Reconciliations of direct to net premiums, on a written and earned basis, for 2016, 2015 and 2014 related to the wholly-owned insurance company subsidiary discussed above are as follows (in millions):
The total amount of net unrecognized tax benefits that, if recognized, would affect the effective tax rate was $10.0 million and $10.8 million at December 31, 2016 and 2015, respectively. We accrue interest and penalties related to unrecognized tax benefits in our provision for income taxes. At December 31, 2016 and 2015, we had accrued interest and penalties related to unrecognized tax benefits of $2.8 million and $1.1 million, respectively.
We do not provide for U.S. Federal income taxes on the undistributed earnings ($243.0 million and $231.9 million at December 31, 2016 and 2015, respectively) of foreign subsidiaries which are considered permanently invested outside of the U.S. The amount of unrecognized deferred tax liability on these undistributed earnings was $15.6 million and $10.4 million at December 31, 2016 and 2015, respectively.
Quarterly operating results for 2016 and 2015 were as follows (in millions, except per share data):
Financial information relating to our segments for 2016, 2015 and 2014 is as follows (in millions):
In conducting our assessment of the effectiveness of its internal control over financial reporting, we have excluded eleven of the thirty-seven entities acquired in 2016, which are included in our 2016 consolidated financial statements. Collectively, these acquired entities constituted approximately 0.3% of total assets as of December 31, 2016 and approximately 0.2% of total revenues and approximately 0.1% of net earnings for the year then ended.
Based on our assessment under the framework in Internal Control - Integrated Framework, management concluded that our internal control over financial reporting was effective as of December 31, 2016. In addition, the effectiveness of our internal control over financial reporting as of December 31, 2016 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their attestation report which is included herein.
As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of eleven of the thirty-seven entities acquired in 2016, which are included in the 2016 consolidated financial statements of Gallagher. Collectively, these acquired entities constituted approximately 0.3% of total assets as of December 31, 2016 and approximately 0.2% of total revenues and approximately 0.1% of net earnings for the year then ended. Our audit of internal control over financial reporting of Gallagher also did not include an evaluation of the internal control over financial reporting of these acquired entities.
In our opinion, Arthur J. Gallagher & Co. maintained in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Arthur J. Gallagher & Co. as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive earnings, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2016 of Arthur J. Gallagher & Co. and our report dated February 10, 2017 expressed an unqualified opinion thereon.