We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from our HUB Midwest brokerage. Our corporate headquarters contain corporate finance, administration, sales, legal, and human resource functions. Our brokerages are located throughout the U.S. and Canada. See Part I, Item 1 of this Annual Report on Form 10-K for a detailed listing of each of our hub brokerage home office locations.
We lease our head office location and substantially all of our brokerage locations. None of our lease arrangements is individually significant. As of January 31, 2007, our lease agreements have remaining terms ranging from 1 to 12 years. The lease on our head office location expires on March 31, 2018. See Note 9 “Commitments and Contingencies - ’Leases’” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion of our lease arrangements and commitments.
The following selected historical consolidated financial and other data are qualified in their entirety by reference to, and should be read in conjunction with, our consolidated financial statements and the related notes thereto appearing elsewhere herein and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” Included in Part II,
the possibility that the receipt of contingent compensation from insurance carriers could be prohibited;
the passage of new federal, state or provincial legislation subjecting our business to increased regulation in the jurisdictions in which we operate; and
those discussed in Item 1A “Risk Factors” in Part I of this Annual Report on Form 10-K.
These uncertainties and other factors also include, but are not limited to, risks associated with our Arrangement Agreement (the “Arrangement Agreement”) to be acquired by Maple Tree Acquisition Corporation, a British Columbia corporation, an entity formed by funds advised by Apax Partners L.P. and Morgan Stanley Principal Investment, Inc. (collectively the “transaction”), including the occurrence of any event, change or other circumstances that could give rise to the termination of the Arrangement Agreement, the inability to complete the transaction due to the failure to obtain shareholder approval or the failure to satisfy other conditions to completion of the transaction, including the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, the failure to obtain the necessary debt financing arrangements set forth in commitment letters received in connection with the transaction, risks that the proposed transaction disrupts current plans and operations and the potential difficulties in employee retention as a result of the transaction.
Except as expressly required by federal securities laws, we undertake no obligation to update or publicly announce the revision of any of the forward-looking statements contained herein to reflect new information, future events, developments, or changed circumstances or for any other reason.
As used in this MD&A, the terms “Hub,” “we,” “us,” and “our” refer to Hub International Limited and our wholly-owned subsidiaries, unless otherwise expressly stated.
As used in this MD&A, the terms “dollars” or “$” refer to United States (“U.S.”) dollars and the terms “Canadian dollars” and “C$” refer to Canadian dollars, unless otherwise expressly stated. We publish our consolidated financial statements and the accompanying notes thereto in U.S. dollars.
Except as otherwise indicated, our consolidated financial statements, the notes to our consolidated financial statements, and select financial data contained in this Annual Report on Form 10-K have been prepared in accordance with accounting principles generally accepted in Canada (“Canadian GAAP”), which differs in certain respects from accounting principles generally accepted in the U.S. (“U.S. GAAP”). See Note 19 “Reconciliation to U.S. GAAP and Effect of New U.S. GAAP Accounting Pronouncements” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a reconciliation of our Canadian GAAP consolidated financial statements to U.S. GAAP.
We evaluate our business based on our operating segments, which we define as our individual hub brokerages. We evaluate the performance of our hub brokerages based primarily on earnings before interest, taxes, depreciation, and amortization (“EBITDA”). For segment reporting purposes we have identified two reportable segments: the Canadian segment and the U.S. segment. The Canadian segment represents an aggregation of our Canadian based hubs and our U.S. segment represents an aggregation of our U.S. based hubs. See Note 16, “Segment Reporting” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for further discussion of the financial results of our reporting segments for each of the years ended December 31, 2006, 2005 and 2004.
On February 26, 2007, we announced that we have entered into an agreement to be acquired by Maple Tree Acquisition Corporation, a British Columbia corporation, an entity formed by funds advised by Apax Partners L.P. and Morgan Stanley Principal Investments, Inc., through an Arrangement Agreement and related Plan of Arrangement. See Footnote 21 “Subsequent Events” to the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a discussion of the transaction.
During the years ended December 31, 2006 and 2005, we generated organic commission income growth of approximately 4.9% and 3.7%, respectively, or 2.8% and 1.1%, respectively, excluding the favorable effect of changes in foreign currency exchange rates. Increases in organic commission income growth during 2006 relative to 2005 are primarily attributable to our continued focus on sales and marketing efforts designed to generate new client
Growth Through Acquisitions. During the third quarter of 2006, we completed the acquisition of Fortun, headquartered in Coral Gables, Florida, which became our first hub brokerage in the southeastern U.S. During the fourth quarter of 2006 we acquired R.D.K. Management, Inc. (doing business as Kaufman & Kaufman Insurance, “Kaufman”). Kaufman specializes in the transportation insurance market and represents a platform for our expansion into this market. During 2007, we expect to pursue additional hub brokerage and fold-in acquisition targets throughout the southeastern, southwestern, and gulf coast regions of the U.S. so as to expand our geographical footprint into these strategically important markets. As previously discussed, on February 14, 2007, we announced that we have agreed to acquire Hibernia, which is based in Louisiana and serves clients throughout the southeastern U.S.
Premium Rate Trends. General economic trends may influence overall premium rates, our commission rates, and the availability or cost of individual types of insurance coverage, which, in turn, may affect our ability to maintain or expand our current revenue and profitability levels.
During the two years after the events of September 11, 2001, premium rates remained strong for most types of coverage in many markets throughout the U.S. and Canada. During the latter part of 2003 and during 2004, premium rates in both Canada and the U.S., for many types of insurance coverage, declined. During 2005, premium rates in both the U.S. and Canadian markets continued to decline an average of three to five percent. During 2006, premium rates in both the U.S. and Canadian markets continued to decline.
Since the catastrophic hurricanes in the gulf coast region during 2006, insurance premium rates have generally increased in the gulf coast and southeastern U.S. markets, where we currently have a comparatively small presence. However, our reinsurance operations did benefit from such increases in insurance premium rates in the affected areas and other catastrophe exposed areas in those markets that we serve. Conversely, we continue to see soft markets or, in certain instances, significant rate reductions in non-catastrophe exposed regions of the U.S. and Canada, such as the midwestern U.S. and Ontario, where we have a relatively more significant concentration of our business as compared to our peers.
Soft markets can present both positive and negative opportunities for us and the insurance brokerage industry in general. Soft markets typically result in a reduction in commission income if our clients maintain their current coverage levels. However, during a period of declining premiums many of our clients will increase their overall insurance coverage levels, often by (1) lowering deductible levels, (2) increasing limits of coverage, or (3) insuring new risks.
investigations and litigation related to the practice of paying contingent commissions in the insurance brokerage industry. These insurance carriers are in the process of developing new compensation models for insurance brokerages that are designed to replace current contingent commission arrangements. Other insurance carriers may also decide to terminate contingent commission arrangements during 2007 or thereafter. However, while we do not anticipate that any such changes in contingent commissions arrangements will have a significant impact on our operations, if insurance carriers were to eliminate contingent commission arrangements without offering comparative alternative compensation arrangements, our results of operations, cash flows and financial position could be materially adversely affected.
On September 30, 2005, we made the first Talbot earnout payment of $16.4 million in cash. The first Talbot earnout payment was based upon Talbot’s earnings for the year ended December 31, 2004.
On March 31, 2006, we made the second Talbot earnout payment of $19.0 million by issuing 746,000 of our common shares to the Talbot Management Group. The second Talbot earnout payment was based upon Talbot’s earnings for the year ended December 31, 2005.
During the years ended December 31, 2006, 2005 and 2004, we recorded compensation expense in connection with the Talbot earnout of $12.2 million, $28.7 million, and $14.4 million, respectively.
As discussed above, a key component of our growth strategy since our inception in 1998 has been the acquisition of hub brokerages and fold-in brokerages.
CFGB. On April 1, 2006, we acquired 100% of the issued and outstanding membership interests of three brokerages (the “CFG Brokerages” or “CFGB”) from Citizens Financial Group Inc., for approximately $80.8 million. With offices in Pennsylvania and Massachusetts, our acquisition of CFGB increases our presence in Pennsylvania and New England. We anticipate that the acquisition of CFGB will add approximately $45.0 million of annualized revenue to our total consolidated revenue.
Fortun. On August 1, 2006, we acquired the assets of Fortun, which included 100% of the issued and outstanding shares of a Fortun premium financing subsidiary, for approximately $26.2 million. Fortun is based in Coral Gables, Florida. Fortun is our first hub brokerage located in the southeastern U.S. We anticipate that the acquisition of Fortun will add approximately $10.0 million of annualized revenue to our total consolidated revenue.
Kaufman. On October 1, 2006, we acquired the assets of Kaufman, for approximately $28.2 million. Kaufman is based in Salt Lake City, Utah and specializes in transportation related insurance coverage. We anticipate that the acquisition of Kaufman will add approximately $9.0 million of annualized revenue to our total consolidated revenue.
PLI. On October 1, 2005, we acquired 100% of the issued and outstanding shares of Personal Lines Insurance Brokerage, Inc. (“PLI”) from The Chubb Corporation, for approximately $38.7 million. Our acquisition of PLI expands our position in the personal insurance market across most of the U.S.
See Note 9 “Commitments and Contingencies - Litigation and Investigations” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K for a detailed discussion of legal and regulatory matters as of December 31, 2006.
Revenue for Hub consolidated and each of our reportable segments for the years ended December 31, 2006 and 2005, and organic revenue growth statistics for the year ended December 31, 2006, were as follows (dollars in thousands).
Contingent commissions and volume overrides income increased $4.3 million, or 11%, to $44.7 million during the year ended December 31, 2006. The increase is attributable to acquisitions of U.S. based insurance brokerages during 2005 and 2006.
Contingent commissions and volume overrides income increased 10% during 2006 relative to 2005. The increase in contingent commissions and volume overrides income was attributable to acquisitions completed during 2005 and 2006, and offset, in part, by negative contingent commissions and volume overrides organic growth of 4.7%, which was primarily attributable to the timing of a 2005 acquisition-related contingent commission.
Canadian Operations. Total revenue generated by our Canadian operations increased $16.7 million, or 13%, to $148.1 million during the year ended December 31, 2006. The increase was primarily attributable to a 12% increase in commission income during 2006 relative to 2005. The increase in commission income was primarily attributable to organic commission income growth of 9.8%, or 2.8% excluding the positive effects of the strengthening of the Canadian dollar as compared to the U.S. dollar during 2006. Organic commission income growth for our Canadian operations was primarily due to improvements in new business generation and client retention during 2006 as compared to 2005. Increases in commission income during 2006 relative to 2005 were negatively impacted by continued declines in insurance premium rates experienced in most of the Canadian markets that we serve.
Total compensation expense increased $32.5 million, or 12%, to $314.7 million during the year ended December 31, 2006. The increase was primarily attributable to a 20% increase in employee cash compensation during 2006 relative to employee cash compensation during 2005. Total compensation expense as a percentage of revenue decreased to 58% during 2006. The decrease was primarily attributable to the overall decrease in compensation recognized in connection with the Talbot earnout during 2006 relative to compensation recognized in connection with the Talbot earnout during 2005.
Employee cash compensation increased $49.7 million, or 20%, to $296.0 million during the year ended December 31, 2006. The increase was primarily attributable to employee cash compensation related to brokerages acquired during 2005 and 2006. Employee cash compensation expense as a percentage of total revenue, which we refer to as our “compensation ratio,” declined to 54% during the year ended December 31, 2006, primarily attributable to continued cost reduction efforts to improve overall profitability as well as the fact that compensation expense during 2005 included one-time severance costs of $1.6 million. Our compensation ratio during the year ended December 31, 2005, excluding the effect of these one-time severance costs, was 55%.
Other non-cash share-based compensation decreased $0.6 million, or 9%, to $6.6 million during the year ended December 31, 2005. Other non-cash share-based compensation represents expense incurred in relation to grants of share-based awards, primarily restricted share units (“RSUs”), to members of our Board of Directors, our Executive Management Team (“EMT”), and certain other employees. In accordance with Canadian and U.S. GAAP, we estimate the fair value of share-based awards on the date of grant and recognize this fair value as compensation expense over the vesting period of the underlying awards using the straight-line method. Total other non-cash share-based compensation for the years ended December 31, 2006 and 2005, was comprised of the following (in thousands):
Based on outstanding share-based awards as of December 31, 2006, we estimate future other non-cash share-based compensation expense will be as follows (in thousands):
Selling, occupancy, and administration expense increased $18.2 million, or 22%, to $101.1 million during the year ended December 31, 2006. The increase was primarily attributable to selling, occupancy, and administration expenses related to brokerages acquired during 2005 and 2006. Selling, occupancy, and administration expense as a percentage of revenue during 2006 remained consistent with 2005 levels.
Intangible asset amortization expense increased $11.9 million, or 142%, to $20.3 million during the year ended December 31, 2006. The increase was primarily attributable to $5.7 million of amortization expense incurred during 2006 for intangible assets recorded in connection with acquisitions completed during 2005 and 2006. In addition, for customer relationship intangible assets acquired in connection with hub brokerage acquisitions during the fourth quarter of 2005 and during 2006, we refined our method to better align the amortization with the pattern of consumption of the expected benefits derived from client relationships existing as of the date of an acquisition. This change in estimate resulted in approximately $4.9 million of additional amortization expense recognized during the year ended December 31, 2006.
paid during 2006 as compared to interest rates paid during 2005. Our average outstanding debt balance and interest rate on outstanding debt during 2006 was approximately $148.8 million and 7.1%, respectively, compared to our average outstanding debt and interest rate on outstanding debt during 2005 of approximately $143.6 million and 5.2%, respectively.
Our net earnings and diluted net earnings per share are affected by a number of factors, including, but not limited to, acquisitions and changes in organic revenue growth rates. In addition to these factors, we recognized the following items during the years ended December 31, 2006 and 2005, which affected the comparability of net earnings and diluted earnings per share on a year-over-year basis (in thousands, except per share amounts):
The summary of selected financial data table below should be referenced in connection with a review of the following discussion of our results of operations for the year ended December 31, 2005, compared to the year ended December 31, 2004 (dollars in thousands).
Revenue for Hub consolidated and each of our reportable segments for the years ended December 31, 2005 and 2004, and organic revenue growth statistics for the year ended December 31, 2005, were as follows (dollars in thousands).
revenue during 2005 as compared to total revenue during 2004 were offset, in part, by the divesture of three of our offices located in the U.S. and Canada during 2005.
During 2005, we acquired 15 insurance brokerages, including one hub brokerage located in the U.S., as discussed under the caption “Acquisitions” included herein.
U.S. Operations. Total revenue generated by our U.S. operations increased $76.5 million, or 33%, to $309.7 million during the year ended December 31, 2005. Revenue generated by our U.S. operations as a percentage of total consolidated revenue increased 400 basis points to 70% during the year ended December 31, 2005. These increases were primarily attributable to a 28% increase in commission income and a 107% increase in contingent commission and volume override income during 2005 relative to commission income and contingent commission and volume override income during 2004, which, were primarily attributable to the acquisition of U.S. based insurance brokerages completed during 2004 and 2005. Acquisitions, net of business dispositions, contributed $65.5 million to our increase in total U.S. revenue during 2005 relative to total U.S. revenue during 2004. Also, contributing to the increase in total revenue during 2005, compared to total revenue during 2004, was organic revenue growth of 2.6% during 2005 compared to organic revenue growth of 0.2% during 2004.
Canadian Operations. Total revenue generated by our Canadian operations increased $10.2 million, or 8%, to $131.4 million during the year ended December 31, 2005. The increase was primarily attributable to organic revenue growth of 11.8%, or 4.0% excluding the positive effects of the strengthening of the Canadian dollar as compared to the U.S. dollar during 2005. Increases in total revenue during 2005 relative to total revenue during 2004, were offset, in-part, by prior year business dispositions, net of acquisitions, of $4.4 million.
Compensation expense increased $64.0 million, or 30%, to $280.6 million during the year ended December 31, 2005. Total compensation expense as a percentage of revenue increased to 63% during 2005. These increases were primarily attributable to (1) a 25% increase in employee cash compensation, net of severance costs, during
2005 relative to employee cash compensation during 2004 and (2) a 100% increase in compensation incurred in connection with the Talbot earnout during 2005 relative to Talbot earnout compensation during 2004.
Total compensation expense incurred in connection with the Talbot earnout increased $14.3 million, or 100%, to $28.7 million during the year ended December 31, 2005. The increase was primarily attributable to the fact that 2005 included twelve months of expense incurred for the Talbot earnout as compared to 2004, which only included 6 months of expense incurred for the Talbot earnout; beginning from our acquisition of Talbot on July 1, 2004.
Intangible asset amortization expense increased $2.9 million, or 53%, to $8.4 million during the year ended December 31, 2005, primarily as a result of amortization expense incurred during 2005 for intangible assets recorded in connection with our acquisition of Talbot on July 1, 2004.
Interest expense increased $3.3 million, or 44%, to $10.7 million during the year ended December 31, 2005, primarily as a result of increased outstanding debt levels and increased interest rates during 2005 as compared to outstanding debt levels and interest rates during 2004. Our average interest rate on outstanding debt during 2005 was approximately 5.2% compared to our average interest rate on outstanding debt during 2004 of approximately 2.9%. In addition, we incurred interest expense for twelve months during 2005 on the $65.0 million debt incurred in connection with our acquisition of Talbot, compared to six months of interest expense incurred during 2004.
Provision for income taxes increased $11.0 million, or 55%, to $31.0 million during the year ended December 31, 2005. Our effective tax rate increased from 44% during the year ended December 31, 2004, to 55% during the year ended December 31, 2005, primarily attributable to the increase in compensation expense incurred in connection with the Talbot earnout during 2005 relative to Talbot earnout compensation expense during 2004, which is not deductible for tax purposes. Excluding the effect of the Talbot earnout compensation expense, our effective tax rate would have been 36% and 33%, respectively, for the years ended December 31, 2005 and 2004. The increase in our effective tax rate is also attributable to adjustments made during 2004 to record the tax benefits of the utilization of certain tax losses.
As of December 31, 2006, cash and cash equivalents totaled $99.2 million. Our cash flows from operations have historically been adequate to fulfill our liquidity requirements. We finance our operating activities primarily through cash generated from operations.
We cannot reasonably determine the number of potential acquisitions we may be able to fund by utilizing all of our cash available for acquisitions as of December 31, 2006, or the impact on our liquidity from these potential acquisitions, as the purchase price of each potential acquisition is dependant on numerous factors, some of which may not be in our control. Generally, the historical purchase prices we have paid for acquisitions have been based on a multiple in the range of five to seven times the acquisition target’s EBITDA.
We anticipate that we will be able to satisfy the cash requirements associated with, among other things, our working capital needs, capital expenditures, and lease commitments, but excluding certain acquisitions, through at least the next 12 months primarily with cash generated by our operations, existing cash balances, and, if necessary, borrowings under our existing credit facilities. We are not able to reasonably assess the effect of loss contingencies on future cash requirements and liquidity, see Note 9 “Commitments and Contingencies” of the notes to our
Our primary sources of cash flows from operating activities are commissions collected from insurance carriers with which we have placed insurance coverage on behalf of our clients. We generally receive two types of compensation from insurance carriers: core commissions and contingent commissions and volume overrides. In addition to commissions, we also generate cash flows from operations from investment income earned on cash, cash equivalents, and trust cash balances.
Our primary uses of cash to support our operating activities include, among other things, cash paid to employees for services, to vendors for products and services, to lessors for rents and operating costs associated to leased facilities, and to federal, state, and provincial governments for income and other taxes.
Other Contingent Consideration Arrangements. In connection with various other business acquisitions completed through December 31, 2006, we may be obligated to pay contingent consideration up to a maximum of approximately $44.5 million in cash and $12.0 million in our common shares. This is based upon management’s best estimate as of December 31, 2006, of acquired insurance brokerages achieving certain financial and operational targets. These contingent payments are payable on various dates through October 2011 according to the terms and conditions of each purchase agreement. As of December 31, 2006, we have recorded, as a component of accounts payable and accrued liabilities, earned but unpaid contingent consideration of $4.0 million, which is payable in cash.
Cash flows used for investing activities increased $85.3 million, or 133%, from $63.9 million during the year ended December 31, 2005, to $149.2 million during the year ended December 31, 2006.
Subordinated Convertible Debentures. During June 2001, we issued to certain subsidiaries of Fairfax Financial Holdings Limited (“Fairfax”) 8.5% subordinated convertible debentures in the amount of $35.0 million, which were due on June 28, 2007 (the “Fairfax notes”). The Fairfax notes were convertible by the holders at any time into our common shares at a price of C$17.00 per share. Beginning on June 28, 2006, we could require conversion of the Fairfax notes if, at any time, the weighted average closing price per share of our common shares on the Toronto Stock Exchange (“TSX”) equaled or exceeded C$19.00 per share for twenty consecutive trading days. On June 29, 2006, we exercised our conversion option, and on that date the Fairfax notes were converted into approximately 2.3 million of our common shares. This transaction did not result in any cash inflows or outflows.
Selected consolidated balance sheet account changes from December 31, 2006, to December 31, 2005, were as follows:
Accounts and Other Receivables, net. The increase in accounts and other receivables, net was primarily attributable to amounts associated with brokerages acquired during 2006.
Future Income Tax Assets and Liabilities, long-term. The increases in future income tax assets and liabilities, long-term, were primarily attributable to the reversal of long-term future tax liabilities as a result of the realization of previously deferred foreign exchange gains on long-term debt and the establishment of long-term future tax assets and liabilities related to intangible assets acquired during 2006.
Income Taxes Payable. The increase in income taxes payable was primarily attributable to the realization of previously deferred taxable foreign exchange gains on long-term debt.
As of December 31, 2006 and 2005, the carrying value of goodwill and the gross carrying value and total accumulated amortization of other intangible assets were as follows (in thousands):
We amortize customer relationship assets over the estimated useful life, which we generally estimate to be between 10 and 15 years. Our determination of the useful life for customer relationship assets is based upon our
Non-competition Covenants. We amortize non-competition covenant assets on a straight-line basis over the estimated useful life, which generally includes for each applicable employee who is subject to a non-competition covenant (1) his or her effective term of employment plus (2) a contractually determined period, which typically ranges from two years to four years, after his or her employment is terminated. Upon the employee’s termination, we amortize the outstanding net book value of the related non-competition covenant on a straight-line basis over the applicable contractual period. Based on our historical experience, we estimate that the average useful life of our non-competition covenant assets is generally 16 years.
As of December 31, 2006, estimated future amortization expense for customer relationships and non-competition covenants was as follows (in thousands):
We have an unlimited number of common shares authorized, of which 39,479,000 and 30,952,000 were issued and outstanding as of December 31, 2006 and 2005, respectively. During the second quarter of 2006, we completed a secondary public offering in the U.S. of 4.6 million common shares at a price of $26.25 per share. In addition, on June 29, 2006, we exercised our option to convert the $35.0 million of outstanding Fairfax notes into approximately 2.3 million of our common shares.
See our discussion herein under the caption “Liquidity, Capital Resources, and Financial Position - Sources and Uses of Cash - Financing Cash Flows” for information regarding shares issued during 2006 in connection with our share offering and the conversion of the Fairfax notes.
Share-Based Compensation. Under our Amended and Restated 2005 Equity Incentive Plan (the “equity incentive plan”), non-employee members of our Board of Directors, officers, and other employees may receive grants of, among other things, RSUs. We are authorized to grant shared-based awards under the equity incentive plan up to a maximum of 12 percent of our issued and outstanding common shares, as adjusted on a quarterly basis. As of December 31, 2006, we have reserved approximately 4.7 million of our common shares for the issuance of outstanding RSUs and the exercise of outstanding stock options. As of December 31, 2006, approximately 1.1 million of our common shares were available for grant under the equity incentive plan.
During 2006, under the equity incentive plan we granted 334,000 RSUs as follows:
268,000 granted to other, non-EMT employees, a majority of which were granted in connection with acquisitions.
As of December 31, 2006, we have outstanding RSUs with vesting terms ranging from 9 months to 120 months. During 2006, we did not grant any stock options under the equity incentive plan.
We are exposed to financial market risks, including changes in interest rates and foreign currency exchange rates. We use various techniques to manage our risk, including, from time to time, the use of derivative instruments. We do not use derivative financial instruments for speculative purposes.
As a result of our interest rate swap arrangement for our Series A and B senior notes, we are exposed to interest rate risk. The interest rate swap agreement effectively converted our fixed rate interest payments into floating rate payments. In addition, outstanding borrowings under our U.S. Credit Facility incur interest at a floating rate. As of December 31, 2006, we had no outstanding borrowings under our U.S. Credit Facility. Each 100 basis point increase in the interest rates charged on the balance of our outstanding floating rate debt as of December 31, 2006, will result in a decrease of our net earnings of approximately $0.4 million.
The Canadian dollar is subject to volatility, and has experienced significant changes in its value compared to the U.S. dollar during 2002 through 2006. As of both December 31, 2006 and 2005, one U.S. dollar equaled $1.17 Canadian dollars. The table below summarizes the effect that a $0.01 increase or decrease in the value of the Canadian dollar as compared to the U.S. dollar would have had on our revenue, net earnings and CTA balance as of and for the years ended December 31, 2006, 2005 and 2004 (dollars in thousands).
The increasing proportionate distribution of our revenue derived from our U.S. operations, whose functional currency is the U.S. dollar, has, in part, offset our risk related to a decline in the Canadian dollar. We expect that
Agency Billed Commissions. In an agency bill arrangement, we are responsible for billing and collecting premiums and fees due from our clients for insurance policies. We generally bill our clients on or before the effective date. We subsequently remit client premiums, net of our commission income earned, to the applicable insurance carrier.
Direct Billed Commissions. In a direct bill arrangement, our client is billed by the insurance carrier directly for any premiums or fees related to the policy. We are subsequently paid by the insurance carrier for our brokerage services, generally in the form of commission income. Accordingly, we do not bill or collect premiums or fees directly from our clients. For certain insurance coverages that are direct billed we must estimate revenue recognized during a given period due to the fact that we are unable to determine the actual revenue that will be recognized on the policy as of the effective date or we may not have received such information from the insurance carrier. We initially recognize revenue for these direct billed policies on a cash basis during the period and then we estimate revenue for earned but uncollected policies based on the historical average daily revenue earned on such policies over an estimated period representing the timeframe between the effective date of the policy and the date
Any adjustments to commission income earned, including but not limited to, those related to changes in commission rates, are recognized during the period in which they occur. In addition, we maintain an allowance for estimated policy cancellations and commission returns. We have established this allowance by applying our historical policy cancellation and commission return rates to current year commission income, adjusted for any known trends or factors that may indicate that historical experience may not be indicative of expected policy cancellation or commission return rates. Adjustments to the allowance for policy cancellations and commission returns are classified as a reduction of commission income in our consolidated statements of earnings. Our estimation of policy cancellations and commission returns is based on management’s judgment, and is regularly evaluated by management taking into consideration factors including, among other things, changes in the nature and volume of policies we place for clients, trends in actual and forecasted policy cancellations and commission returns, and current economic conditions that may affect the likelihood of client policy changes or cancellations. As of December 31, 2006 and 2005, our allowance for estimated policy cancellations and commission returns was $2.7 million and $2.0 million, respectively, or 0.56% and 0.50% of our total commission income during the years ended December 31, 2006 and 2005. During the years ended December 31, 2006, 2005 and 2004, we reduced commission income by $0.3 million, $0.1 million, and $0.5 million, respectively, as a result of adjustments to our allowance for policy cancellations and commission returns. If our actual policy cancellation and commission return rates are significantly different from our historical policy cancellation and commission return rates used to estimate our allowance for policy cancellations and policy returns, our actual commission income may be significantly affected. Our historical average policy cancellation and commission return rate has been approximately 0.17% of total annual commission income. If we had experienced an actual policy cancellation rate of 0.17% of our total commissions income during the year ended December 31, 2006, we would have decreased our total revenue during the year ended December 31, 2006, by approximately an additional $0.6 million.
We account for business acquisitions using the purchase method, whereby the results of acquired businesses are included in our consolidated financial results from the date of acquisition going forward. In connection with a business acquisition, we may enter into an agreement with the management or shareholders of the acquired business to pay consideration that is contingent on maintaining or achieving specified revenue, earnings, or other financial performance measures in future periods. We record such contingent consideration as goodwill on our consolidated balance sheets when the contingency is resolved and the consideration is issued or becomes issuable. In certain circumstances, we may make payments to non-shareholders as consideration for the acquired business with the characteristics of compensation. We account for such payments as compensation expense in our consolidated statements of earnings. When such compensation payments are made by issuing our common shares, we apply the policies discussed under the caption “Share-based Compensation” included in Note 2 “Summary of Significant Accounting Policies,” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K. The estimation of fair value for such compensation arrangements may be based on significant estimates. The use of different estimates could produce results that are significantly different than our results of operations.
In connection with a business acquisition, we allocate the total purchase price to the estimated fair values of acquired tangible and intangible assets and assumed liabilities as of the date of the acquisition. We determine the fair value of acquired tangible and intangible assets and assumed liabilities using various valuation methods, including, but not limited to, net realizable values, quoted market prices, and discounted cash flows. For significant business acquisitions, we engage qualified third party valuators to assist us in conducting such fair value valuations. The use of assumptions and estimates is inherent in each of these valuation methods. Valuation methods and their underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates, or assumptions could produce different allocations of the purchase price and, as a result, different results of operations.
We generally determine the amount of purchase price for an acquisition allocated to customer relationships as the sum of the discounted expected future net commissions cash flows that will be generated by the acquired entities’ current customer base, with consideration given to, among other things, the remaining economic lives of such relationships, renewal history, and associated expenses. For those acquisition transactions that include non-competition covenants, we determine the amount of purchase price allocated to the non-competition covenants using an “income approach,” with consideration given to, among other things, the economic benefits associated with having the covenants in place versus the potential damages that would ensue absent the covenants.
Goodwill represents the excess of cost over fair value of identifiable net assets acquired through business acquisitions. In accordance with Canadian and U.S. GAAP, goodwill is not amortized but, instead, is reviewed for
The use of assumptions and estimates is inherent in our determination of our reporting unit’s fair value. The valuation method and the underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests and, as a result, significantly different results of operations.
When assessing the need for a valuation allowance, we consider projected future, as well as historical taxable income, prudent and feasible tax planning strategies, and the future reversal of existing taxable temporary differences. Should a change in circumstances lead to a change in our judgments about the reliability of future tax assets in future years, we would adjust the related valuation allowances in the period that the change in circumstances occurs, along with a corresponding charge or credit to income.
If actual results are not consistent with our estimates and judgments, our results of operations could be significantly different than reported. Our effective tax rate in a given period may be significantly impacted by these estimates and judgments.
In the ordinary conduct of our business, we are subject to various claims and lawsuits that arise primarily from alleged errors and omissions in connection with the placement of insurance. While we currently believe that such claims and lawsuits, individually or in aggregate, will not have a significant adverse impact on our financial position, cash flows, or results of operations, these claims and lawsuits are subject to inherent uncertainties, and management’s view of these matters may change in the future. We are self-insured for certain losses related to errors or omission claims. Our reserve estimate of self-insured losses for errors or omissions claims is based on a third party actuarial estimate of our expected future losses primarily based on our actual claims history. In addition, we are self-insured for certain general insurance deductibles and a portion of our group medical insurance. Our reserve estimate of self-insured group medical insurance costs covers incurred but not reported claims and is based on actual claims history over an estimated time period between the date a claim is incurred and the date that it is reported to our plan administrator. The amounts in excess of our self-insured levels are fully insured by third parties, subject to certain limitations and exclusions. We periodically evaluate our assumptions used to calculate self-insured reserves and may make changes to such assumptions in the future. Any routine changes to such assumptions would be considered changes in estimates. As of December 31, 2006 and 2005, we have recorded reserves for all self-insurance exposures of approximately $10.4 million and $7.1 million, respectively, which are included as a component of accounts payable and accrued liabilities on our consolidated balance sheets.
Periodically, management reviews its assumptions and valuations to determine the adequacy of our self-insured reserves. Uncertainty is associated with our self-insured liabilities because management must make estimates and apply judgments to estimate the ultimate cost to settle reported claims and incurred but not reported claims as of our balance sheet date. If actual results are not consistent with our estimates and judgments, our results of operations could be significantly different than reported results.
See Note 2 “Summary of Significant Accounting Policies” and Note 19 “Reconciliation to U.S. GAAP and Effect of New U.S. GAAP Accounting Pronouncements” of the notes to our consolidated financial statements in Part II, Item 8 of this Annual Report on Form 10-K, for a discussion of recent Canadian and U.S. GAAP accounting announcements that may affect our consolidated financial statements.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the U.S. Securities Exchange Act of 1934 to provide reasonable assurance regarding the reliability of our financial reporting and preparation of the financial statements for external purposes in accordance with generally accepted accounting principles.
Management has used the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Report”) to evaluate the effectiveness of our internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF HUB INTERNATIONAL LIMITED
(The accompanying notes form an integral part of these consolidated financial statements.)
U.S. Public Offering. During the second quarter 2006, we completed a secondary public offering in the U.S. of 4.6 million common shares at a price of $26.25 per share. Cash proceeds from this offering, net of issuance costs of $5.9 million, were approximately $114.9 million, of which approximately $56.0 million was used to repay long-term debt during the second quarter 2006. The remainder of the cash proceeds were primarily used to fund certain 2006 business acquisitions.
Except as otherwise indicated, our consolidated financial statements and the notes to our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in Canada (“Canadian GAAP”), which differs in certain respects from accounting principles generally accepted in the U.S. (“U.S. GAAP”). See Note 19 “Reconciliation to U.S. GAAP and Effect of New U.S. GAAP Accounting Pronouncements” of these notes to our consolidated financial statements for a reconciliation of our Canadian GAAP consolidated financial statements to U.S. GAAP.
Certain reclassifications have been made to prior years’ financial statements to conform to the current year presentation.
Any adjustments to commission income earned, including, but not limited to those related to changes in commission rates, are recognized during the period that they occur. In addition, we maintain an allowance for estimated policy cancellations and commission returns. We have established this allowance by applying our historical policy cancellation and commission return rates to current year commission income, adjusted for any known trends or factors that may indicate that historical experience may not be indicative of expected policy cancellation or commission return rates. Adjustments to the allowance for policy cancellations and commission returns are classified as a reduction of commission income in our consolidated statements of earnings. Our estimation of policy cancellations and commission returns is based on management’s judgment, and is regularly evaluated by management, taking into consideration factors including, among other things, changes in the nature and volume of policies we place for clients, trends in actual and forecasted policy cancellations and commission returns, and current economic conditions that may affect the likelihood of client policy changes or cancellations.
In connection with a business acquisition, we allocate the total purchase price to the estimated fair values of acquired tangible and intangible assets and assumed liabilities as of the date of the acquisition. We determine the
In our capacity as an insurance broker, we collect premiums from clients and, after deducting our commissions, remit those premiums to the respective insurance carrier. We also collect claims or refunds from clients on behalf of insurance carriers. Uncollected premiums, claims, or refunds from clients are recorded as accounts receivable on our consolidated balance sheets.
For share-based payments to employees, non-employee directors, and in certain circumstances in connection with an acquisition, including grants of restricted share units (“RSUs”) and stock options, we recognize compensation expense in our consolidated statements of earnings based on the estimated fair value of the equity or liability instruments issued. The fair value of RSUs is equal to the fair market value of our common shares as of the date of grant. The fair value of option grants is estimated on the date of grant using the Black-Scholes-Merton option pricing model. We recognize the fair value of share-based awards as compensation expense during the vesting period of the underlying awards using the straight-line method. We estimate forfeitures of share-based awards at the time of grant and revise such estimates in subsequent periods if actual forfeitures differ from those estimates.
Advertising costs are expensed as incurred. Advertising costs, which are included in selling, occupancy, and administration expense in our consolidated statements of earnings, were approximately $6.7 million, $5.2 million, and $4.8 million, respectively, for the years ended December 31, 2006, 2005 and 2004.
Our overall business and growth strategy includes the regular and systematic evaluation and acquisition of insurance brokerages in new and existing markets. An insurance brokerage, due to the nature of its operations, typically maintains a low capital to earnings ratio, which generally results in our recognizing significant goodwill and other intangible assets in connection with such acquisitions.
We generally pay a significant portion of the consideration for acquisitions in cash. In addition to cash, we generally issue our common shares as consideration for the acquired business. Consideration paid in the form of our common shares is based on the fair market value of our common shares as traded on the NYSE or the TSX, and is defined and calculated pursuant to the acquisition agreement. In addition, previous owners of certain acquired entities are entitled to contingent consideration if certain revenue or profitability targets are met after the acquisition date. See Note 9 “Commitments and contingencies,” of these notes to our consolidated financial statements for a discussion of significant contingent consideration arrangements.
On August 1, 2006, we acquired the assets of the Fortun Insurance Agency, Inc. (“Fortun”), which included 100% of the issued and outstanding shares of a Fortun premium financing subsidiary, for approximately $26.2 million. Fortun is based in Coral Gables, Florida. Fortun is our first hub brokerage located in the southeastern U.S.
On October 1, 2006, we acquired the assets of R.D.K Management, Inc. (doing business as Kaufman & Kaufman Insurance, “Kaufman”), for approximately $28.2 million. Kaufman is based in Salt Lake City, Utah and specializes in transportation related insurance coverage.
The purchase price, including acquisition costs, for each of our 2006 acquisitions has been preliminarily allocated to the estimated fair values of acquired tangible and intangible assets and assumed liabilities, including goodwill, as summarized in the table below. Subsequent adjustments may be made to the purchase price allocation based upon, among other things, finalization of our tangible and intangible asset valuations. The table below also summarizes the consideration we paid for each acquisition and the number of our common shares, if any, issued as consideration for the acquisition.
We expect that approximately $78.2 million of the goodwill identified in the table above will be deductible for income tax purposes.
In addition, during 2005 we acquired the assets of 13 other insurance brokerages, which were not significant, individually or in the aggregate, to our consolidated financial statements taken as a whole.
The purchase price, including acquisition costs, for each of these acquisitions has been allocated to the estimated fair values of acquired tangible and intangible assets and assumed liabilities, including goodwill, as summarized in the table below. The table below also summarizes the consideration we paid for each acquisition and the number of our common shares, if any, issued as consideration for the acquisition.
We expect that approximately $41.0 million of the goodwill identified in the table above will be deductible for income tax purposes.
During 2005, we disposed of certain of our insurance brokerage subsidiaries by selling 100% of the issued and outstanding shares or the assets of the subsidiary. In connection with such dispositions, we received proceeds of $5.4 million and recognized a gain on disposal of subsidiaries of $2.5 million. None of the subsidiaries that we disposed of during 2005 were significant, individually or in the aggregate, to our consolidated financial statements.
On July 1, 2004, we acquired, for approximately $93.9 million Talbot Financial Corporation (“Talbot”). As part of the Talbot acquisition, we purchased 100% of the common shares of Satellite Acquisition Corporation (“Satellite”), a corporation formed by the senior management of Talbot, which we refer to as the “Talbot Management Group.” In turn, Satellite purchased 100% of the issued and outstanding common shares of Talbot from Safeco Corporation. Talbot is located in Albuquerque, New Mexico. Our acquisition of Talbot expanded our geographic footprint across several states in the southwestern and western U.S. See Note 9 “Commitments and Contingencies - Contingent Consideration in Connection with Business Acquisitions,” of these notes to our consolidated financial statements for a detailed discussion of contingent consideration arrangements we entered into in connection with our acquisition of Talbot.
Goodwill in the “Other” column above of $10.7 million includes $3.1 million primarily related to goodwill arising from adjustments to preliminary purchase price allocations and contingent consideration payments earned on certain prior year acquisitions.
Accounts and other receivables consist of the following as of December 31, 2006 and 2005 (in thousands):
The estimated cost basis and accumulated depreciation of property and equipment as of December 31, 2006 and 2005, are as follows (in thousands):
As of December 31, 2006 and 2005, the gross carrying amount, accumulated amortization, and weighted average remaining useful lives of intangible assets, other than goodwill, are as follows (dollars in thousands):
We generally amortize customer relationship assets on a straight-line basis. For customer relationship intangible assets acquired in connection with hub brokerages during the fourth quarter of 2005 and during 2006, we refined our method to better align the amortization with the pattern of consumption of the expected benefits derived from client relationships existing as of the date of the acquisition. This change in estimate resulted in approximately $4.9 million of additional amortization expense recognized during the year ended December 31, 2006.
We amortize customer relationship assets over the estimated useful life, which we generally estimate to be between 10 and 15 years. Our determination of the useful life for customer relationship assets is based upon our estimate of the timeframe over which the acquired customer relationship is expected to contribute directly or indirectly to the future cash flows of the acquired insurance brokerage.
As of December 31, 2006, estimated total future amortization expense for other intangible assets is as follows (in thousands):
Accounts payable and accrued liabilities consist of the following as of December 31, 2006 and 2005 (in thousands):
As of December 31, 2006, we have outstanding $62.5 million aggregate principal amount of unsecured senior notes issued June 10, 2003. The senior notes were issued in two series. “Series A” represents $7.5 million aggregate principal amount of 5.71% senior notes with interest due semi-annually in June and December, and principal of $7.5 million due April 14, 2011. “Series B” represents $55.0 million aggregate principal amount of 6.16% senior notes with interest due semi-annually in June and December, and principal of $4.6 million due annually June 15, 2008, through June 15, 2010; $19.3 million due June 15, 2011; and $11.0 million due June 15, 2012 and 2013. The senior notes were sold on a private basis in the U.S. to institutional accredited investors. During the second quarter of 2006, we repaid $2.5 of the Series A senior notes. We incurred approximately $1.5 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized over the term of the notes.
Under the provisions of our senior notes, we are limited in our ability to take certain actions, including, among other things, incurring other senior or subordinated debt in excess of specified amounts, and selling or disposing of assets or subsidiaries in excess of certain amounts. We are also required to satisfy certain financial covenants on a periodic basis, including the maintenance of a minimum level of consolidated net worth, a maximum consolidated debt to capitalization percentage of 45%, and a minimum interest coverage ratio of 3:1. As of December 31, 2006, we are in compliance with all covenants governing these senior notes.
U.S. Credit Facility. As of December 31, 2006, we have an unsecured credit facility with a Canadian financial institution (the “U.S. Credit Facility”). On April 4, 2006, we simultaneously terminated the U.S. Credit Facility and entered into a new unsecured credit facility with terms identical to the original U.S. Credit Facility. Under our U.S. Credit Facility, we may borrow up to the U.S. dollar equivalent of $75.0 million under a revolving credit facility. We may prepay outstanding loans under the U.S. Credit Facility at any time and without penalty. The stated maturity of our U.S. Credit Facility is April 4, 2007. If we do not extend the U.S. Credit Facility on April 4, 2007, any outstanding borrowings on the facility will be converted into a three-year non-revolving loan with interest at 0.25 percentage points greater than the interest rate applicable for our U.S. Credit Facility.
Borrowings under the U.S. Credit Facility bear interest at variable interest rates per annum that are tied to the U.S. prime rate and the LIBOR rate as follows:
(1) the higher of the U.S. prime rate plus 100 basis point, or
As of December 31, 2006, we have no revolving loans outstanding under our U.S. Credit Facility. As of December 31, 2006 and 2005, respectively, the LIBOR rate was 5.32% and 4.39% and the U.S. prime rate was 8.25% and 7.25%.
As of December 31, 2006, we have no revolving loans outstanding under our Canadian Credit Facility.
In re Insurance Brokerage Antitrust Litigation. As previously disclosed, in October, 2004, we were first named as a defendant in a federal class action lawsuit. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” A number of substantially similar federal class actions were filed against us and many other defendants. On February 17, 2005, the Federal Judicial Panel on Multidistrict Litigation transferred these and other class action lawsuits in which we were not named to the District of New Jersey. In August 2005 and February 2006, amended complaints were filed in the consolidated federal court proceedings pending in New Jersey and styled In re Insurance Brokerage Antitrust Litigation. In addition, certain of our subsidiaries have been named as additional defendants. The case has now been divided into two cases, one for employee benefits and the other for commercial insurance. A small number of allegations specifically pertaining to us have been added, but remain vague. The judge in these actions has permitted discovery to take place, which is continuing. We dispute the allegations made in these lawsuits and are vigorously defending these cases.
that a Talbot earnout is due are not entitled to share in that or any future earnout payments. No member of the Talbot Management Group was a shareholder of Talbot or received any portion of the purchase price paid to Safeco Corporation. Accordingly, we determined that the Talbot earnout arrangement is, in substance, a performance-based contingent compensation arrangement, and, thus, have recorded the Talbot earnout payments as a charge to compensation expense over the period that the payments are earned. In accordance with the Talbot earnout, the Talbot Management Group is being compensated for future services based on remaining with Talbot and achieving certain performance targets during each of the applicable three years. Upon our distribution of the final Talbot earnout payment on March 31, 2007, we will have purchased 100% of the special shares of Satellite from the Talbot Management Group. We estimate that total compensation expense to be incurred in accordance with the Talbot earnout agreement will be approximately $57.3 million.
On March 31, 2006, we made the second Talbot earnout payment of $19.0 million by issuing 746,000 of our common shares to the Talbot Management Group. This payment was based upon Talbot’s earnings for the year ended December 31, 2005.
The final Talbot earnout payment of approximately $21.8 million will be made on March 31, 2007, and will be based upon Talbot’s earnings for the year ended December 31, 2006. The final payment will most likely be made in cash.
During the years ended December 31, 2006, 2005 and 2004, we recognized compensation expense in connection with the Talbot earnout of $12.2 million, $28.7 million, and $14.4 million, respectively.
As of December 31, 2006 and 2005, we have guaranteed outstanding loans under the ESPP totaling $3.8 million and $3.9 million, respectively. As collateral, these individuals have pledged 369,000 and 383,000 of our common shares as of December 31, 2006 and 2005, respectively, which have an aggregate market value as of December 31, 2006 and 2005, of $11.6 million and $9.9 million. The interest rate in effect for these loans as of December 31, 2006 and 2005, was 6.50% and 5.54%, respectively. During the years ended December 31, 2006, 2005, and 2004,
Rent expense, exclusive of related taxes, insurance, and maintenance costs and net of sublease rental income of $1.4 million, $1.4 million, and $1.5 million, respectively, for the years ended December 31, 2006, 2005 and 2004, totaled $21.5 million, $16.7 million, and $14.0 million.
During the years ended December 31, 2006, 2005 and 2004, the provision for income taxes differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 36.12%, as follows (in thousands):
As of December 31, 2006, we have recognized net operating loss carryforwards totaling approximately $4.5 million, which expire beginning in 2008 through 2013, resulting in a future tax asset of $1.6 million. In addition, as of December 31, 2006, we have recognized state net operating loss carryforwards in the U.S. totaling approximately $5.2 million, which expire beginning in 2021 through 2022, resulting in a future tax asset of $0.2 million. Our net operating loss carryforwards are currently available to offset certain future state and local taxable income.
As of December 31, 2006 and 2005, we have recorded a valuation allowance, as reflected in the table above, to reduce the carrying value of future income tax assets to the amount that will likely be realized in the future. The
We have an unlimited number of common shares authorized, of which 39,479,000, 30,952,000, and 30,411,000 were issued and outstanding as of December 31, 2006, 2005 and 2004, respectively. During the second quarter 2006, we completed a secondary public offering in the U.S. of 4.6 million common shares at a price of $26.25 per share. Cash proceeds from this offering, net of issuance costs of $5.9 million, were approximately $114.9 million, of which approximately $56.0 million was used to repay long-term debt during the second quarter 2006. The remainder of the cash proceeds were primarily used to fund certain 2006 business acquisitions. In addition, on June 29, 2006, we exercised our option to convert the $35.0 million of Fairfax notes into approximately 2.3 million of our common shares. See Note 8 “Debt - Subordinated Convertible Debentures,” of these notes to our consolidated financial statements for a discussion of the Fairfax notes conversion.
During the years ended December 31, 2006, 2005 and 2004, we declared aggregate per share cash dividends of $0.28, $0.24, and $0.20, respectively.
Under our Amended and Restated 2005 Equity Incentive Plan (the “equity incentive plan”), non-employee members of our Board of Directors, officers, and other employees may receive grants of, among other things, stock options and RSUs. We are authorized to grant share-based awards under the equity incentive plan up to a maximum of 12 percent of our issued and outstanding common shares, as adjusted on a quarterly basis. As of December 31, 2006, approximately 1.1 million of our common shares were available for grant under the equity incentive plan. As of December 31, 2006, we have reserved approximately 4.7 million of our common shares for the issuance of outstanding RSUs and the exercise of outstanding stock options as of December 31, 2006.
The original vesting term for RSUs granted during 2006 ranges from 2 months to 120 months.
Stock Options. The exercise price of stock options granted under the equity incentive plan is equal to the fair market value of our common shares on the date of grant. Stock options generally become exercisable ratably over a three-year period from the date of grant and expire seven years after the date of grant, unless an earlier expiration date is set at the time of grant. Stock options are subject to possible earlier exercise and termination in certain circumstances. Since the inception of the equity incentive plan, grants of stock options have only been subject to the service conditions discussed previously. No stock option grants have included performance or market conditions that affect the stock options vesting or other pertinent factors.
As reflected in the table above, as of December 31, 2006, all stock options outstanding are fully-vested.
The following table summarizes information with respect to stock options outstanding under the equity incentive plan as of December 31, 2006 (stock options in thousands):
On September 30, 2005, we made the first Talbot earnout payment of $16.4 million in cash. On March 31, 2006, we made the second Talbot earnout payment of $19.0 million by issuing 746,000 of our common shares. The final Talbot earnout payment of approximately $21.8 million will be made on March 31, 2007, and will be based upon Talbot’s earnings for the year ended December 31, 2006. The final Talbot earnout will most likely be made in cash.
Compensation expense recorded in connection with the Talbot earnout includes both cash and non-cash share-based compensation. Compensation expense incurred in connection with the Talbot earnout is not deductible for income tax purposes. A summary of the cash and non-cash share-based Talbot earnout compensation expense incurred during the years ended December 31, 2006, 2005 and 2004, is as follows (in thousands):
In accordance with Canadian and U.S. GAAP, we recognize compensation expense in our consolidated statements of earnings based on the estimated fair value of equity or liability instruments granted to employees. The fair value of RSUs is equal to the fair market value of our common shares as of the date of grant. The fair value of stock option grants is estimated on the date of grant using the Black-Scholes-Merton option pricing model. We recognize
The following table summarizes share-based compensation expense recognized during the years ended December 31, 2006, 2005 and 2004 (in thousands):
Non-cash share-based compensation for the Talbot earnout included in the table above is not deductible for income tax purposes, thus, we have not recorded a tax benefit in relation to this expense for the years ended December 31, 2006, 2005 and 2004.
This expense will be recognized over the remaining requisite service period applicable to grantees, which, on a weighted-average basis, is approximately 3.43 years. We expect to satisfy the exercise of stock options and vesting of RSUs by issuing new shares of our common stock.
We calculate basic earnings per share, excluding the dilutive effect of common share equivalents, by dividing net earnings by the weighted average number of common shares outstanding for the applicable period. We calculate diluted earnings per share using the “if-converted” method for outstanding convertible debentures and the
“treasury stock” method for outstanding stock options and RSUs and include the effects of all potentially dilutive securities.
During the years ended December 31, 2006, 2005 and 2004, we recognized revenue in connection with transactions with the following related parties (in thousands):
As of December 31, 2006 and 2005, respectively, we had recorded on our consolidated balance sheets accounts receivable from these related parties of $12.0 million and $10.0 million, and accounts payable to these related parties of $13.7 million and $36.7 million. Revenue generated from, expenses incurred from, and accounts receivable and payable balances recorded in connection with transactions involving the above related parties were conducted in the normal course of business.
Each of the entities in the table above, with the exception of OLIC, is related through common ownership by Fairfax. As of December 31, 2006, Fairfax owns approximately 26% of our common shares.
During June 2001, we issued to certain subsidiaries of Fairfax convertible subordinated debentures in the amount of $35.0 million, which were due on June 28, 2007, and were convertible by us if certain conditions were met. On June 29, 2006, we exercised our conversion option, and on this date the Fairfax notes were converted into approximately 2.3 million of our common shares. See Note 8 “Debt,” of these notes to our consolidated financial statements for a discussion of the conversion features related to the Fairfax notes.
During the years ended December 31, 2006, 2005 and 2004, we incurred rent expense on operating leases for premises leased from related parties in the amount of $3.3 million, $2.8 million, and $2.3 million, respectively.
Amounts due from employees under the ESPP as of both December 31, 2006 and 2005, was $1.5 million. The interest rate applicable to outstanding loans as of December 31, 2006, was 6.50%. As collateral, the employees have pledged 121,000 and 122,000 of our common shares as of December 31, 2006 and 2005, respectively, which have an aggregate market value of $3.8 million and $3.2 million as of December 31, 2006 and 2005.
For segment reporting purposes we have identified two reportable segments: the Canadian segment and the U.S. segment. The Canadian segment represents an aggregation of our five Canadian based hubs and our U.S. segment represents an aggregation of our 13 U.S. based hubs. Adjustments to reconcile segment results to consolidated results are included under the caption “Head Office,” which also includes certain unallocated corporate activity and eliminations.
The accounting policies of each reportable segment are consistent with those described in Note 2 “Summary of Significant Accounting Policies,” of these notes to our consolidated financial statements. A majority of corporate expenses have been charged to the segments as part of a general allocation, however, certain corporate costs are not specifically allocated to the segments, including, but not limited to, compensation expense related to the Talbot earnout, non-cash share-based compensation, certain administrative costs, interest expense on corporate debt, and certain income tax expenses or benefits. Transactions between segments are consummated on a basis intended to reflect the market value of the underlying services. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends.
During the first quarter of 2006, we sold our U.S. financial services operation (the “discontinued business”). In conjunction with the sale, we will continue to receive certain indirect fees from the buyer. These fees do not provide us with the ability to otherwise be involved in the operations of the discontinued business. Total indirect fees received in connection with the discontinued business during the year ended December 31, 2006, are not significant. During the years ended December 31, 2005 and 2004, total revenue and net earnings (loss) from the discontinued business were $6.9 million and $5.8 million, and $(0.03) million and $0.5 million, respectively. Operating results for the discontinued business for the year ended December 31, 2006, were not significant.
19. Reconciliation to U.S. GAAP and effect of new U.S. GAAP accounting pronouncements
For the years ended December 31, 2006, 2005 and 2004, there were no significant differences between Canadian and U.S. GAAP affecting our consolidated statements of earnings, our calculations of basic and diluted earnings per share or our consolidated statements of cash flows.
The following table reconciles our net earnings in accordance with Canadian and U.S. GAAP to our comprehensive income in accordance with U.S. GAAP for the years ended December 31, 2006, 2005 and 2004 (in thousands):
The following table presents our condensed consolidated balance sheets in accordance with U.S. GAAP as of December 31, 2006 and 2005 (in thousands):
The following table reconciles our total shareholders’ equity in accordance with Canadian GAAP to our total shareholders’ equity in accordance with U.S. GAAP as of December 31, 2006, 2005 and 2004 (in thousands):
(2) As discussed in Note 8 “Debt - Series A and Series B Senior Notes” of these notes to our consolidated financial statements, on July 15, 2003, we entered into an interest swap agreement related to both our Series A and Series B notes. Under Canadian GAAP, we account for the swap transaction using the synthetic instruments method. Under this method, we record the net interest expense on the swap and associated debt in our consolidated statements of earnings as if it were a single, synthetic, financial instrument. Also, under this method, we do not recognize the estimated fair value of the interest swap arrangement on our consolidated balance sheets, which we estimate to be approximately $4.0 million as of December 31, 2006. Under U.S. GAAP, we have designated the swap transaction as a hedge of changes in the fair value of our fixed rate debt caused by changes in interest rates. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, we record the swap transaction on our consolidated balance sheets at its estimated fair value. Changes in the estimated fair value of the swap agreement are recognized in our consolidated statements of earnings. Changes in the estimated fair value of the underlying debt that is being hedged that are attributable to changes in interest rates are recognized in our consolidated statements of earnings via an adjustment to the carrying value of the underlying debt.
FIN 48. In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which is an interpretation of SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have evaluated the impact of our adoption of FIN 48 and we do not expect that it will have a material effect on our U.S. GAAP consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 clarifies that the term fair value is intended to mean a market-based measure, not an entity-specific measure and gives the highest priority to quoted prices in active markets in determining fair value. SFAS 157 requires disclosures about (1) the extent to which entities measure assets and liabilities at fair value, (2) the methods and assumptions used to measure fair value, and (3) the effect of fair value measures on earnings. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurement and accordingly, does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We have evaluated the process of our adoption of SFAS 157 and we do not expect that it will have a material effect on our U.S. GAAP consolidated financial statements.
On February 25, 2007, we entered into an Arrangement Agreement (the “Arrangement Agreement”) to be acquired by Maple Tree Acquisition Corporation, a British Columbia corporation (“Maple Tree”), an entity formed by funds advised by Apax Partners L.P. (“Apax”) and Morgan Stanley Principal Investments, Inc. (“MSPI” together with “Apax”, the “Sponsors”). Certain members of our senior management team (collectively, the “Rollover Shareholders”) have agreed in principle, at the request of the Sponsors, to exchange a portion of their outstanding common shares of Hub (the “Shares”) and stock options to purchase Shares (the “Company Options”) for shares and options of Maple Tree or an affiliate thereof.
As of the effective time of the Arrangement (the “Effective Time”), each Share, other than any Shares exchanged by the Rollover Shareholders or by shareholders who properly exercise dissent rights under the CBCA (the “Dissenting Shareholders”), will be deemed to be transferred to Maple Tree in consideration for the right to receive a cash payment from Hub in the amount equal to $40.00 per share, without interest.
Each of Hub RSUs (“Company RSUs”) that by its terms accelerates at the Effective Time will be cancelled in consideration for the right to receive a cash payment from Hub in the amount equal to $40.00, less any amounts we are required to withhold for taxes.
Shares held by Dissenting Shareholders will be deemed to be transferred to Maple Tree at the Effective Time in consideration for the right to receive an amount determined and payable in accordance with the provisions of the CBCA.
On February 14, 2007, we announced that we have agreed to acquire substantially all of the assets of Hibernia Insurance Agency, L.L.C. (“Hibernia”) from Capital One Financial Corp. Hibernia is based in Metairie, Louisiana with offices in Lafayette and Baton Rouge Louisiana. It serves clients throughout the southeastern U.S. including, the states of Louisiana, Alabama, Mississippi, Arkansas, and Texas. Hibernia generates annual revenues of approximately $18.0 million and will become our new hub brokerage, Hub Gulf South.