Item 1. Business
Overview
We are a leading North American insurance brokerage providing a broad array of property and casualty, life and health, employee benefits, investment and risk management products and services. We focus primarily on middle-market commercial accounts in the United States and Canada, which we serve through our approximately 2,500 employees in more than 150 locations, using a variety of retail and wholesale distribution channels. We define the middle market as those clients with 20 to 1,500 employees, which typically generate annual commissions and fees ranging from $2,500 to $250,000. Since our company was formed in 1998 through the merger of 11 Canadian insurance brokerages, we have acquired an additional 95 brokerages and have established a strong presence in the northeastern, midwestern and western United States and in the Canadian provinces of Ontario, Quebec and British Columbia. Through a combination of acquiring quality brokerages with proven track records and organic growth, we have grown our revenue from $38.7 million in 1998 to $286.4 million in 2003, of which 78% of the increase is attributable to acquisitions.
We operate through an organizational structure comprised of our head office, larger regional brokerages that we call “hub” brokerages and smaller brokerages that we call “fold-ins.” Our head office oversees the acquisition of hub brokerages, coordinates selling and marketing efforts, identifies cross-selling opportunities among our brokerages, negotiates significant contracts with insurers and handles certain general administrative functions. We have 10 hub brokerages, five operating in the United States and five in Canada. Each hub brokerage has a significant market presence in a geographic region of the United States or Canada. Each hub provides insurance brokerage services and is responsible for integrating the fold-in acquisitions in its region.
We have traditionally operated our hub brokerages in a decentralized manner so they may more effectively address their local market conditions. A hub brokerage is responsible not only for the development of its own business, but also the identification of fold-ins that can be acquired by and integrated into the operations of the hub brokerage. This process allows each hub brokerage an opportunity to strengthen its regional market presence by acquiring new or complementary products and services and management talent and improve profit margins through the reduction or elimination of redundant administrative functions, premises and systems. Our structure enables our hub brokerages to more effectively and quickly meet the changing needs of our clients in various markets, while benefiting from the operating efficiencies and leverage of a large brokerage. As we continue to grow, however, it is likely that added investment will be made to coordinate more functions from our head office to enhance the potential for cross-selling, international coordination, marketing efficiency, total expense management and financial controls.
Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports will be made available free of charge through the Investor Relations section of our Internet website (http://www.hubinternational.com) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.
Our products and services
We offer commercial and specialized insurance products and services to businesses, personal insurance products and services to individuals and program products to affinity groups and associations. We offer three categories of commercial products and services: property and casualty products, employee benefits and risk management services. We offer two categories of personal products and services: property and casualty products and life, health and financial products and services. Our program products involve the development, in collaboration with insurance companies, of baskets of insurance products for members of affinity groups or associations, such as lawyers’ associations, medical associations and other professional groups. Our specialized risk products cover diverse exposures such as environmental, professional liability and directors’ and officers’ liability.
Our business is compromised of two geographic segments, the United States and Canada. The mix of products and services we offer in the United States differs from those we offer in Canada. Our product mix in the United States is comprised of more commercial line products and services as compared with more personal line products and
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services in Canada. In the United States in 2003, 89% of our commission income was generated from the sale of commercial lines and 11% from personal lines. In Canada in 2003, 58% of our commission income was generated from the sale of commercial lines and 42% from personal lines.
The chart below lists a selection of our commercial and personal insurance products and services.
Commercial insurance
Personal insurance
Strategy
Our primary goals are to further develop our position as a leading North American insurance brokerage and to generate significant sustained shareholder value. We plan to achieve these objectives by executing the following strategies:
Focus on middle-market commercial accounts. We focus our sales efforts on middle-market companies. We believe that the insurance and risk management needs of these companies are underserved because many of the brokers that target them have limited capital resources and lack the breadth of products and services that we are able to offer due to our scale and strong insurer relationships. We primarily target commercial accounts because they generally generate higher profit margins than personal accounts. Commercial accounts also provide us with the opportunity to sell personal insurance products and employee benefits to the employees of those businesses.
Grow organically. We intend to increase profitability per customer and attract new clients by leveraging our existing infrastructure to sell a broad range of products and services through the efficient use of a variety of distribution channels, effectively and efficiently identify and target profitable client segments by employing technology to capitalize on our extensive customer databases, and maximize cross-selling opportunities among our brokerages.
Grow through selected acquisitions. The introduction of new brokerages through acquisitions is a fundamental component of our strategy. We have acquired an additional 95 brokerages since our formation in 1998. We acquire brokerages to grow our revenue, complement and supplement our existing products and services and add experienced management. In addition, acquisitions of larger brokerages allow us to further expand our hub platform and geographic footprint. We believe that we are well positioned to compete for quality brokerages and that our proven success in consolidating brokerages in the past will make us attractive to regional brokerages seeking to join with and share in the resources of a larger North American brokerage.
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Standardize procedures to increase operating efficiency and reduce costs. We strive to implement the best operating and sales practices of our brokerages across our company. We provide centralized marketing support to our brokers for many specialized risk programs and group home and auto plans and we integrate promotional programs, internet technology, procurement and risk management across our brokerage offices. Our brokerages share certain systems, such as accounting and payroll processing, which reduce redundancies and increase operating efficiencies. In addition, we continue to implement a comprehensive quality control program and a standardized approach to our sales and marketing efforts across our brokerages.
Recruit, train and retain qualified personnel. We have formalized our recruiting and training program to continue to build and sustain a sales and service team with a wide variety of experience and capabilities. We recruit directly from college campuses and other industries and provide new employees with effective training and attractive compensation packages. In addition, we are developing a company-wide sales culture by promoting the techniques and results of our most successful producers through regular newsletters, sales meetings, sales tracking, awards, recognition programs and training. We have implemented Hub Academy which is a formal program designed to provide educational and training opportunities to our employees who want to advance their professional skill sets. Programs such as the new producer training program are designed to groom selected candidates to be successful producers within our company. Participants spend several weeks learning about the insurance industry, our company, quality standards, products and services and leading sales techniques from our leading producers, members of management, representatives of insurance companies and other members of the industry.
Competitive advantages
We believe the following competitive advantages will enable us to achieve our objectives:
Decentralized hub approach. Our decentralized hub approach allows us to react to regional market conditions while still centrally managing the growth and profitability of our business with consistent standards. Our geographic diversity allows us to balance our revenue stream across markets and better insulate us from regional adverse developments. Our hub structure provides us with a ready platform, capable of reacting quickly to smaller brokerage acquisition opportunities, and to assimilate fold-ins once acquired.
Broad array of products and services offered through multiple distribution channels. We offer a broad array of products and services, which allows us to maintain and maximize existing client relationships and attract new clients. We offer these insurance products and services through four distribution channels: retail, wholesale property and casualty, wholesale life and financial and call-centers. Our diversity provides us not only with the flexibility to determine the most appropriate products and services but also, distribution channels to employ for particular market segments.
Benefits of scale. Our scale, relative to smaller brokerages, provides insurers with greater incentives to work with us. Enhanced insurer relationships often result in mutual cost savings, increased volume overrides and contingent commissions, favorable commission rates, collaborative marketing arrangements and product design, exclusive distribution rights for certain territories and products, and, in some cases, expanded authority to price and approve insurance policies on behalf of insurance companies. Our scale also makes us attractive to smaller brokerages as a potential acquiror.
Committed and experienced management. Most of the senior managers of our brokerages have over 20 years of experience in the industry, extensive contacts in the insurance brokerage industry, and participate in prominent industry associations, brokerage networks and insurance company brokerage councils. Most of management also has significant shareholdings in our company. A significant number of the shares held by management are subject to transfer restrictions, in some cases for up to ten years. In addition, designated key employees in each brokerage are rewarded for their contribution to our success through a bonus program that recognizes brokerage and over-all company performance in excess of specified targets. We believe that these strategies encourage loyalty and align the interests of management of our brokerages with our corporate goals and the interests of our shareholders, combining to create a powerful incentive to maximize financial results.
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Our operations
We were created in November 1998 when 11 Canadian brokerages merged to form Hub. Significant events that have occurred since our formation in the last five years include:
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January 1999 - Fairfax Financial Holdings Limited (Fairfax) purchased 5.4 million common shares of Hub for $34.2 million cash.
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January 1999 - We completed a financing whereby we issued a total of 2,838,080 common shares, on a private placement basis, at a price of $8.60 per common share or approximately $24.4 million in the aggregate. Fairfax purchased, through certain of its wholly-owned subsidiaries, 1,185,184 of the common shares.
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February 1999 - We completed a public offering in Canada of 865,624 common shares at a price of $8.60 per share for total proceeds of approximately $7.4 million and listed our common shares on the Toronto Stock Exchange (TSX).
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During 1999 - We acquired 44 brokerages in Canada and completed our first acquisition in the United States, Mack and Parker, Inc. (Mack and Parker).
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During 2000 - We acquired 18 brokerages in Canada and the United States including C.J. McCarthy Insurance Agency, Inc.
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During 2001 - We acquired 16 brokerages in Canada and the United States including J.P. Flanagan Corporation (Flanagan), Kaye Group Inc. (Kaye) and Burnham Insurance Group, Inc.
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June 2002 - We completed an initial public offering in the United States of 6,900,000 common shares, at a price of $14.00 per share. Total net proceeds from the offering after deducting total expenses were approximately $88.1 million.
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During 2002 - we acquired 8 brokerages in the United States and Canada including Hooper, Hayes and Associates, Inc. (Hooper Hayes) and Fifth Third Insurance Services, Inc., which we have renamed Hub International of Indiana Limited (Hub Indiana).
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During 2003 - we acquired 9 brokerages in the United States and in Canada with total annualized revenue of $8.0 million.
Our operations are currently conducted from principal offices located in Chicago, New York, Los Angeles, Boston, Battle Creek, MI, Toronto, Vancouver and Montreal.
Acquisition process
Our senior management is responsible for identifying and negotiating the acquisition of hub brokerages that are strategically suited to our growth strategy. Typically we are familiar with the owners and management of the acquisition target well before we initiate discussions. Most of the hub brokerages we acquire are owner operated. We perform extensive diligence on potential targets and we determine what the budget of the acquired brokerage, including payroll and other adjustments, will be prior to completing the acquisition.
We anticipate that we will selectively acquire more hub brokerages in geographic regions where we currently have a limited presence, most notably the southeastern and southwestern United States. There are many more brokerages in the United States that we would consider suitable hub brokerage acquisition candidates than in Canada due to the market size of the United States. Each new hub will be characterized by the following attributes:
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an experienced and talented management team prepared to make a long-term commitment to executing our strategic business plan;
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the ability to identify, acquire and seamlessly integrate smaller brokerages (fold-ins) in its region;
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specialization in certain products or services that may be beneficial to or complement our other brokerages; and
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a demonstrated record of organic growth and profitability, operating at, or capable of achieving in the near term, minimum financial performance targets.
We expect that future acquisitions will be financed with available cash, the issuance of common shares, the proceeds of other financings, or a combination of the foregoing.
The retention of existing management at the hub brokerages we acquire is important to the successful integration and subsequent operation of acquired brokerages. We have in the past encouraged, and may continue in the future to encourage, existing management to stay with the acquired hub brokerage by using our common shares to pay a large portion of the acquisition price. The shares the owner/management receive are, in some cases, subject to transfer restrictions, for up to ten years. We also utilize our equity incentive plan to grant options to acquire our shares, restricted shares and restricted share units (in lieu of cash compensation or in consideration of non-competition covenants) which have vesting, exercise and transfer restrictions that are designed to encourage the long-term commitment of management to our company.
Distribution channels
We utilize retail, wholesale and call-center distribution channels, and have the ability to employ these distribution channels for specific market segments. Our brokerages use one of, or a combination of the following different distribution channels:
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Retail sales and service centers that target middle-market companies provide a broad range of property and casualty insurance, life and health insurance, risk management and financial services from traditional office locations leased by our brokerages in local communities.
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Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago, Saint John, New Brunswick and Chilliwack, British Columbia;
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Wholesale life and financial services centers, known as managing general agents, provide life and financial products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal and Toronto; and
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Wholesale property and casualty insurance centers provide products, international risk solutions, captive management programs and specialty lines to independent brokers and corporations in North America and internationally from our locations in New York, Toronto, Montreal and Vancouver.
In addition, we are a member of the Worldwide Broker Network, a consortium of international brokerages which we can access to service clients resident in the United States and Canada who require insurance internationally.
Competition
The insurance brokerage industry is highly competitive. We face several sources of competition including other brokerages, insurance companies, banks and other financial services companies. Brokerage consolidators have been active in the market over several years. Consolidators, often publicly traded corporations, consolidate small to medium size independent brokerages with a view to strengthening their competitive position and increasing their market share. In addition to direct competition from the insurance companies, new sources of competition are emerging as banks in the United States accelerate their efforts to diversify their financial services to include insurance brokerage services (often through the acquisition of established insurance brokerages) and as the Canadian chartered banks lobby for greater flexibility to create and market insurance products.
We compete for clients in both the United States and in Canada on the basis of reputation, client service, program and product offerings and the ability to tailor our products and risk management services to the specific needs of a client. We believe that we are in a favorable competitive position in most of the meaningful aspects of our business because of our broad array of products and services, diversity of distribution channels, industry focus and expertise, and management experience.
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Like some of our competitors, we focus our sales efforts primarily on middle-market commercial accounts. We believe that the most likely source of competition for us in the United States will be other brokerages who pursue an acquisition or consolidation strategy similar to ours. We believe that our primary competitors in Canada are local retail brokers.
Government regulation
Licenses
In every state, province and territory in which we do business, the relevant brokerage is required to be licensed or to have received regulatory approval to conduct business. In addition to licensing requirements, most jurisdictions require individuals who engage in brokerage and certain insurance service activities to be licensed personally.
Our operations depend on the validity of and continued good standing under the licenses and approvals pursuant to which we operate. Licensing laws and regulations vary from jurisdiction to jurisdiction and are always subject to amendment or interpretation by regulatory authorities. Such authorities generally have the discretion to grant, renew and revoke licenses and approvals.
Privacy
The management and dissemination of information is critical to our business. We gather information from our clients to assess and address their insurance needs. We share information both internally, among our employees, and, where appropriate and permitted, between our brokerages, as well as externally, with insurers. We believe we have taken appropriate steps to safeguard our clients’ information. In both the United States and Canada comprehensive privacy laws have been introduced to protect the privacy of individuals from the undisclosed or non-consensual sharing of sensitive information for commercial purposes. As the gathering and use of information is such an integral component of our business, we must always be alert for changes in the information regulatory environment.
Employees
As of December 31, 2003, we employed 2,472 persons on a full-time basis, 2,022 of whom were employed in sales and customer service and 450 of whom were employed in corporate, finance and administration. None of our employees are represented by a labor union and we have never experienced a work stoppage. We believe our relationship with our employees is good.
We have generally entered into agreements containing confidentiality and non-disclosure provisions with our employees and consultants who have access to our proprietary information. In addition, each member of senior management of our brokerages is subject to an employment agreement that sets out the terms of his or her employment. These agreements typically include non-solicitation and non-competition covenants, which continue for up to two years after the cessation of employment.
Risks related to our business
We may be unsuccessful in identifying and acquiring suitable acquisition candidates, which could impede our growth and ability to remain competitive in our industry.
Our strategic plan includes the regular and systematic evaluation and acquisition of insurance brokerages in new and existing markets. Since our formation in 1998, approximately 78% of our revenue growth has been attributable to acquisitions. However, we may not successfully identify suitable acquisition candidates. Prospective acquisition candidates may not become available or we may not be able to complete an acquisition once negotiations have commenced. We compete for acquisition and expansion opportunities with entities that have substantially greater resources than we do and these entities may be able to outbid us for these acquisition targets. If we fail to execute our acquisition strategy, our revenue growth is likely to suffer and we may be unable to remain competitive.
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Our continued growth is partly based on our ability to successfully integrate acquired brokerages and our failure to do so may have an adverse effect on our revenue and expenses.
We may be unable to successfully integrate brokerages that we may acquire in the future. The integration of an acquisition involves a number of factors that may affect our operations. These factors include:
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diversion of management’s attention;
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difficulties in the integration of acquired operations and retention of personnel;
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entry into unfamiliar markets;
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unanticipated problems or legal liabilities; and
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tax and accounting issues.
A failure to integrate acquired brokerages may be disruptive to our operations and negatively impact our revenue or increase our expenses.
Insurance brokerages that we have acquired may have liabilities that we are not aware of and may not be as profitable as we expect them to be.
Since our formation in November 1998 through the merger of 11 insurance brokerages, we have acquired an additional 95 brokerages. Although we conduct due diligence in respect of the business and operations of each of the brokerages we acquire, we may not have identified all material facts concerning these brokerages. For example, on one occasion we discovered a brokerage’s liability for unaccrued corporate taxes only after we had completed the acquisition of the brokerage. Unanticipated events or liabilities relating to these brokerages could have a material adverse effect on our financial condition. Furthermore, once we have integrated an acquired brokerage, it may not achieve levels of revenue, profitability, or productivity comparable to our existing locations, or otherwise perform as expected. Our failure to integrate one or more acquired brokerages so that they achieve our performance goals may have a material adverse effect on our results of operations and financial condition.
If we fail to obtain additional financing for acquisitions, we may be unable to expand our business.
Our acquisition strategy may require us to seek additional financing. If we are unable to obtain sufficient financing on satisfactory terms and conditions, we may not be able to maintain or increase our market share or expand our business through acquisitions. Our ability to obtain additional financing will depend upon a number of factors, many of which are beyond our control. We may not be able to obtain additional satisfactory financing because we already have debt outstanding and because we may not have sufficient cash flow to service or repay our existing or additional debt. For example, as of December 31, 2003, we had $113.8 million of total debt and our two credit facilities contain covenants that, among other things, require us to maintain certain financial ratios and restrict our ability to incur additional debt.
We cannot accurately forecast our commission revenue because our commissions depend on premium rates charged by insurance companies, which historically have varied and are difficult to predict. Any declines in premiums may adversely impact our profitability.
In 2003, we derived approximately 91% of our revenue from commissions paid by insurance companies on the sale of their insurance products to our clients. Our revenue from commissions fluctuates with premiums charged by insurers, as commissions typically are determined as a percentage of premiums. When premiums decline, we experience downward pressure on our revenue and earnings. Historically, property and casualty premiums have been cyclical in nature and have varied widely based on market conditions. Significant reductions in premium rates occurred during the years 1988 through 2000 as a result of expanded underwriting capacity of property and casualty insurance companies and increased competition. In some cases, property and casualty insurance companies lowered commission rates. The years 2001 through 2003 saw premium rates increase. Although we cannot predict changes in premium pricing, we did begin to see some reductions in pricing in the latter part of 2003 in the United States. Canadian rate trends have trailed those of the United States, leading to expectations that Canadian premium rates
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will continue to be firm for much of 2004, with some softening as the year progresses. Because we cannot determine the timing and extent of premium pricing changes, we cannot accurately forecast our commission revenue, including whether it will significantly decline. If premiums decline or commission rates are reduced, our revenue, earnings and cash flow could decline. In addition, our budgets for future acquisitions, capital expenditures, dividend payments, loan repayments and other expenditures may have to be adjusted to account for unexpected changes in revenue.
Insurance company contingent commissions and volume overrides are less predictable than normal commissions, which impairs our ability to forecast the amount of such revenue that we will receive and may negatively impact our operating results.
We derive a portion of our revenue from contingent commissions and volume overrides. The aggregate of these sources of revenue generally has accounted for approximately 6% of our total revenue. Contingent commissions may be paid by an insurance company based on the profit it makes on the overall volume of business that we place with it. Volume overrides and contingent commissions are typically calculated in the first or second quarter of the following year by the insurance companies and are paid once calculated. As a result of recent developments in the property and casualty insurance industry, including changes in underwriting criteria due in part to the higher numbers and dollar value of claims as compared to the premiums collected by insurance companies, we cannot predict the payment of this performance-based revenue as accurately as we have been able to in the past. Further, we have no control over the process by which insurance companies estimate their own loss reserves, which affects our ability to forecast contingent commissions. Because these contingent commissions affect our revenue, any decrease in their payment to us could adversely affect our results of operations. Recently, legal proceedings challenging the appropriateness of revenue sharing arrangements between insurance companies and brokerages, including contingent profit and volume override arrangements, have been commenced against certain insurance brokerages. These proceedings allege that such revenue sharing arrangements conflict with a broker’s duty to its clients. While we have not been named as a defendant in any such proceeding, and disagree with the underlying premise that these revenue sharing arrangements create a conflict of interest, we could be the subject of a similar action in the future. A finding that such arrangements conflict with a broker’s duty to its clients could have a material adverse affect on our revenue and profitability.
Proposed tort reform legislation in the United States, if enacted, could decrease demand for liability insurance, thereby reducing our commission revenue.
Legislation concerning tort reform is currently being considered in the United States Congress and in several states. Among the provisions being considered for inclusion in such legislation are limitations on damage awards, including punitive damages, and various restrictions applicable to class action lawsuits, including lawsuits asserting professional liability of the kind for which insurance is offered under certain policies we sell. Enactment of these or similar provisions by Congress, or by states or countries in which we sell insurance, could result in a reduction in the demand for liability insurance policies or a decrease in policy limits of such policies sold, thereby reducing our commission revenue.
A substantial portion of our total assets are represented by goodwill and other intangible assets as a result of our acquisitions and under new accounting standards, we may be required to write down the value of our goodwill and other intangible assets.
When we acquire a brokerage, virtually the entire purchase price for the acquisition is allocated to goodwill and other identifiable intangible assets. The amount of purchase price allocated to goodwill is determined by the excess of the purchase price over the net identifiable assets paid by us to acquire the brokerage.
On July 1, 2001, we adopted the Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board Handbook Section 1581, “Business Combinations”. These new rules require that all business combinations after
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June 30, 2001 be accounted for in accordance with the purchase method of accounting and expand the definition of other identifiable intangible assets acquired in a business combination using the purchase method.
On January 1, 2002, we adopted CICA’s Section 3062, “Goodwill and Other Intangible Assets”. For all business combinations accounted for using the purchase method prior to June 30, 2001, Section 3062 eliminates the amortization of goodwill, requires annual impairment testing of goodwill and introduces the concept of definite life and indefinite life intangible assets. Indefinite life intangible assets, similar to goodwill, will no longer be amortized and will be tested at least annually for impairment. A deterioration in our operating results may adversely affect the carrying value of our goodwill and other indefinite life intangible assets. The loss of a significant client at one of our brokerages could result in an impairment of goodwill associated with such brokerage, which would cause us to take an impairment to goodwill. Such an impairment would adversely affect our earnings.
The loss of members of our senior management or a significant number of our brokers could negatively affect our financial plans, marketing and other objectives.
The loss of or failure to attract key personnel could significantly impede our financial plans, growth, marketing and other objectives. Our success depends to a substantial extent not only on the ability and experience of our senior management but also on the individual brokers and teams that service our clients and maintain client relationships. In the past, we have experienced short-term disruptions to certain brokerage operations due to the early retirement of senior members of management at those brokerages. Our operations are not generally dependent on any one individual; however, the loss of Martin Hughes, our Chairman and Chief Executive Officer could negatively impact our acquisition strategy in the United States due to his significant relationships and expertise in the insurance industry.
The insurance brokerage industry has in the past experienced intense competition for the services of leading individual brokers and brokerage teams. We believe that our future success will depend in large part on our ability to attract and retain additional highly skilled and qualified personnel and to expand, train and manage our employee base. We may not be successful in doing so because the competition for qualified personnel in our industry is intense. If we fail to recruit and retain top producers, our organic growth may be adversely affected.
Competition in our industry is intense, and if we are unable to compete effectively, we may lose market share and our business may be materially adversely affected.
The insurance brokerage business is highly competitive and we actively compete with other insurance brokerages for customers and insurance company markets, many of which have existing relationships with insurance companies or have a significant presence in niche insurance markets that may give them an advantage over us. Because relationships between insurance brokers and insurance companies or clients are often local or regional in nature, this potential competitive disadvantage is particularly pronounced. See “Business - Competition” for a further discussion of the level of competition in our industry.
We face competition in all markets in which we operate, based on product breadth, innovation, quality of service and price. We compete with a number of brokerages in the United States, who may have greater resources than we do, as well as with numerous Internet-based, specialist and regional firms in the United States and Canada. If we are unable to compete effectively against our competitors, we will suffer a loss of market share, decreased revenue and reduced operating margins.
In addition, regulatory changes in the financial services industry in the United States and Canada have permitted banks, securities firms and insurance companies to affiliate, causing rapid consolidation in the insurance industry. Some insurance companies are engaged in the direct sale of insurance, primarily to individuals, and do not pay commissions to agents and brokers on policies they sell directly. Increasing competition from insurance companies and from within the financial services industry, generally, could have a negative effect on our operations.
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We do business with certain subsidiaries of our largest shareholder and if a conflict of interest were to arise it may not be resolved in our favor and could adversely affect our revenue.
As of December 31, 2003, Fairfax Financial Holdings Limited owned or controlled 26% of our common shares, 32% if Fairfax converted our convertible subordinated debentures it holds. We do business with certain subsidiaries of Fairfax which represented approximately 10% of our revenue in 2003. We expect that this percentage will decrease as we complete more acquisitions in the United States. If a conflict of interest arose between us and Fairfax or one of its subsidiaries, we cannot assure you that this conflict would be resolved in a manner that would favor us. In addition, if Fairfax were to sell our common shares that it owns, it may no longer be as interested in continuing to do business with us which could have a material adverse effect on our revenue and expenses and such a sale by Fairfax could also impact our share price.
We depend on our information processing systems. Interruption or loss of our information processing systems could have a material adverse effect on our business.
Our ability to provide administrative services depends on our capacity to store, retrieve, process and manage significant databases and expand and upgrade periodically our information processing capabilities. Interruption or loss of our information processing capabilities through loss of stored data, breakdown or malfunctioning of computer equipment and software systems, telecommunications failure, or damage caused by fire, tornadoes, lightning, electrical power outage or other disruption could have a material adverse effect on our business, financial condition and results of operations. Although we have disaster recovery procedures in place for all our hub brokerages and insurance to protect against such contingencies, such procedures may not be effective and any insurance or recovery procedures may not continue to be available at reasonable prices and may not address all such losses or compensate us for the possible loss of clients occurring during any period that we are unable to provide services.
Privacy legislation may impede our ability to utilize our customer database as a means to generate new sales.
We intend to utilize our extensive customer databases for marketing and sales purposes, which we believe will enhance our ability to meet our organic growth targets. However, new privacy legislation, such as the Gramm-Leach-Bliley Act and the Health Insurance Portability and Accountability Act of 1996 in the United States and the Personal Information Protection and Electronic Documents Act (PIPEDA) in Canada, as well as other regulatory changes, may restrict our ability to utilize personal information that we have collected in our normal course of operations to generate new sales. If we become subject to new restrictions, or other regulatory restrictions, which we are not aware of, our ability to grow our business may be adversely affected.
The security of the databases that contain our customers’ personal information may be breached which could subject us to litigation or adverse publicity.
We depend on computer systems to store information about our customers, some of which is private. Database privacy, identity theft and related computer and internet issues are matters of growing public concern. We have installed privacy protection systems and devices on our network in an attempt to prevent unauthorized access to information in our database. However, our technology may fail to adequately secure the private information we maintain in our databases and protect it from theft or inadvertent leakage. In such circumstances, we may be held liable to our customers, which could result in litigation or adverse publicity that could have a material adverse effect on our business.
Our corporate structure and strategy of operating through decentralized brokerages may make it more difficult for us to become aware of and respond to adverse operating or financial developments at our brokerages.
We depend on timely and accurate reporting of business conditions and financial results from our brokerages to affect our business plan and determine and report our operating results. We receive end of month reports from each of our brokerages regarding their financial condition and operating results. If an adverse business or financial
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development occurs at one or more of our brokerages near the beginning of a month, we may not become aware of the occurrence for several weeks which could make it more difficult for us to effectively respond to that development. In addition, if one of our brokerages was to report inaccurate financial information, we might not learn of these inaccuracies for several weeks, if at all, which could adversely affect our ability to determine and report our financial results. For example, on occasion, inconsistent accounting treatment at a brokerage has not been detected until preparation of our quarterly financial statements. We have implemented enterprise reporting software that enables us to extract financial and operating data from our brokerages electronically; however, in the event of a technical or other failure we may be unable to use this software effectively to compile our financial data or to prevent inconsistent reporting of financial information.
Our profitability and liquidity may be materially adversely affected by errors and omissions.
We have extensive operations and are subject to claims and litigation in the ordinary course of business resulting from alleged errors and omissions. Errors and omissions claims can involve significant defense costs and may result in large damage awards against us. Errors and omissions could include, for example, our employees or sub-agents failing, whether negligently or intentionally, to place coverage or to notify insurance companies of claims on behalf of clients, to provide insurance companies with complete and accurate information relating to the risks being insured or to appropriately apply funds that we hold for our clients on a fiduciary basis. It is not always possible to prevent and detect errors and omissions and the precautions we take may not be effective in all cases.
The amount of coverage limits and related deductible amounts of our errors and omissions insurance policies are established annually based upon our assessment of our errors and omissions exposure, loss experience and the availability and pricing of coverage within the marketplace. While we endeavor to purchase coverage that is appropriate to our assessment of our risk, we are unable to predict with certainty the frequency, nature or magnitude of claims for direct or consequential damages.
Our profitability and liquidity may be adversely affected if in the future our insurance coverage proves to be inadequate or unavailable or there is an increase in liabilities for which we self-insure. In addition, errors and omissions claims may harm our reputation or divert management resources away from operating our business.
If we fail to comply with regulatory requirements for insurance brokerages, we may not be able to conduct our business.
Our business is subject to legal requirements and governmental regulatory supervision in the jurisdictions in which we operate. These requirements are designed to protect our clients by establishing minimum standards of conduct and practice, particularly regarding the provision of advice and product information as well as financial criteria.
Our activities in the United States and Canada are subject to regulation and supervision by state and provincial authorities. Although the scope of regulation and form of supervision by state and provincial authorities may vary from jurisdiction to jurisdiction, insurance laws in the United States and Canada are often complex and generally grant broad discretion to supervisory authorities in adopting regulations and supervising regulated activities. This supervision generally includes the licensing of insurance brokers and agents and the regulation of the handling and investment of client funds held in a fiduciary capacity. Our ability to conduct our business in the jurisdictions in which we currently operate depends on our compliance with the rules and regulations promulgated from time to time by the regulatory authorities in each of these jurisdictions.
Our clients have the right to file complaints with the regulators about our services, and the regulators may investigate and require us to address these complaints. Our failure to satisfy the regulators that we are in compliance with their requirements or the legal requirements governing our activities can result in disciplinary action, fines, reputational damage and financial harm.
In addition, changes in legislation or regulations and actions by regulators, including changes in administration and enforcement policies, could from time to time require operational improvements or modifications at various locations which could result in higher costs or hinder our ability to operate our business. See “Business - Government regulation.”
14 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Risks related to our common shares
The price of our common shares may fluctuate substantially, which could negatively affect the holders of our common shares.
The price of our common shares may fluctuate substantially due to the following factors: (1) fluctuations in the price of the shares of the small number of public companies in the insurance brokerage business, (2) announcements of acquisitions as part of our growth strategy, (3) additions or departures of key personnel, (4) announcements of legal proceedings or regulatory matters and (5) the general volatility in the stock market. The market price of our common shares could also fluctuate substantially if we fail to meet or exceed securities analysts’ expectations of our financial results or if there is a change in financial estimates or securities analysts’ recommendations. From the beginning of 2002 to March 3, 2004, the price of our common shares on the TSX has ranged from a low of C$15.50 to a high of C$29.00, and on the NYSE has ranged from a low of $11.45 to a high of $17.90.
In addition, the stock market has experienced volatility that has affected the market prices of equity securities of many companies, and that has often been unrelated to the operating performance of these companies. A number of other factors, many of which are beyond our control, could also cause the market price of our common shares to fluctuate substantially.
Significant fluctuation in the market price of our common shares could result in securities class action claims against us.
Significant price and value fluctuations have occurred with respect to the securities of insurance and insurance-related companies. Our common share price is likely to be volatile in the future. In the past, following periods of downward volatility in the market price of a company’s securities, class action litigation has often been pursued against the respective company. If similar litigation was pursued against us, it could result in substantial costs and a diversion of our management’s attention and resources.
Our largest shareholder may substantially influence certain actions requiring shareholders approval.
As of December 31, 2003, Fairfax owned or controlled 26% of our common shares. Fairfax also owns or controls $35 million of subordinated convertible notes, which it can convert at any time into our common shares at C$17.00 per share. If Fairfax converts the notes it would hold 32% of our common shares. Under our by-laws and articles of incorporation, Fairfax has the ability to substantially influence certain actions requiring shareholder approval, including:
•
electing members of our board of directors;
•
adopting amendments to our articles and by-laws; and
•
approving a merger or consolidation, liquidation or sale of all or substantially all of our assets.
Fairfax may have different interests than you have and therefore may make decisions that are adverse to your interests.
We are incorporated in Ontario, Canada, and, as a result, it may not be possible for shareholders to enforce civil liability provisions of the securities laws of the United States.
We are organized under the laws of Ontario, Canada and some of our assets are located outside the United States. As a result, it may not be possible for the holders of our common shares to enforce against us in United States courts judgments based on the civil liability provisions of the securities laws of the United States. In addition, there is doubt as to whether the courts of Canada would recognize or enforce judgments of United States courts obtained against us or our directors or officers based on the civil liability provisions of the securities laws of the United States or any state or hear actions brought in Canada against us or those persons based on those laws.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 15
Item 2.
Item 2. Properties
We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from Mack and Parker, one of our subsidiaries. This facility, totaling approximately 3,500 square feet, contains corporate, finance, administration, sales and customer support functions. The lease on the premises expires on October 1, 2011. In addition, our brokerages lease office space in the locations in which they operate, none of which is material. In total, we hold 158 leases covering approximately 720,000 square feet with a total annual base rent for all of these locations of approximately $10 million.
We believe that our facilities are well maintained and in good condition and are adequate for our current needs. We expect that suitable additional space will be available as required.
Item 3.
Item 3. Legal Proceedings
In the normal course of business, we are involved in various claims and legal proceedings relating to insurance placed by us and other contractual matters. Our management does not believe that any such pending or threatened proceedings will have a material adverse effect on our consolidated financial position or future results of operations.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter ended December 31, 2003.
16 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity and Related Shareholder Matters
In connection with our initial public offering in the United States, our common shares became listed on the New York Stock Exchange (NYSE) on June 18, 2002 under the symbol HBG. Our common shares are also listed and posted for trading on the Toronto Stock Exchange (TSX) in Canada under the symbol HBG. The following table sets forth the high and low sales prices per share for our common shares on the NYSE and TSX:
On December 31 2003, the closing price of our common shares on the NYSE was $16.76 and on the TSX the closing sale price was C$21.90. The exchange rate in effect at December 31, 2003 was C$1.00 per $0.7738. As of March 3, 2004, there were 30,299,170 of our common shares issued and outstanding. As of the close of business March 3, 2004, we had approximately 280 holders of record of our common shares.
We have no formal dividend policy other than the board of directors considers the payment of dividends as quarterly financial information becomes available. In the future, dividends will be paid at the discretion of our board of directors depending on our financial position and capital requirements, general business conditions, contractual restrictions and other factors. Dividends paid after December 31, 2002 have been, and dividends, if any, that may be declared in the future, will be declared in U.S. dollars instead of Canadian dollars.
Item 6.
Item 6.
Selected Financial Data
We were formed in November 1998 through the merger of 11 independent insurance brokerages into a new company. The merger was accounted for using the pooling-of-interests method.
Our results for the five year period ended December 31, 2003 reflect the acquisition of brokerages that occurred in each respective period. These acquisitions were accounted for using the purchase method. Thus, results of acquisitions are only included from the date of acquisition forward. Accordingly, the results in each period are not directly comparable.
Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP and U.S. GAAP as it relates to us, see note 18 to our audited consolidated financial statements included elsewhere in this Form 10-K.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 17
(1)
Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars at the exchange rate in effect at September 30, 2001 of C$1.00 = $0.6338.
18 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
(2)
As discussed in note 2, “Summary of significant accounting policies,” of the notes to the audited consolidated financial statements, we adopted Canadian Institute of Chartered Accountants (CICA) Section 3062 on January 1, 2002. Upon adoption of CICA Section 3062, goodwill is no longer amortized. The following table illustrates the effect that CICA Section 3062 would have had on net earnings and per share information under Canadian GAAP for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 had goodwill not been amortized:
(3)
We commenced payment of dividends in the second quarter of 2000.
(4)
We adopted Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 (SFAS No. 142) on January 1, 2002. Upon adoption of SFAS No. 142 goodwill is no longer amortized. The following table illustrates the effect that SFAS No. 142 would have had on net earnings and per share information under U.S. GAAP for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 had goodwill not been amortized:
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 19
(1)
Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars using the exchange rate in effect at September 30, 2001 of C$1.00 = $0.6338.
(2)
Includes long-term debt and capital leases (including current portion), bank debt and subordinated convertible notes.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report. Certain information contained in “Management’s discussion and analysis of financial condition and results of operations” are forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements because of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the heading “Risk Factors”. Reference to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (U.S. GAAP) and to the extent that they effect us are described in Note 18 to our audited consolidated financial statements.
Overview
Hub is a leading North American insurance brokerage that has grown rapidly since its formation in 1998 through mergers, acquisitions and organic growth. We provide a broad array of property and casualty, life and health, employee benefits, investment and risk management products and services through offices located in the United States and Canada. We are pursuing a growth strategy that includes expansion of our geographic footprint across the United States and deeper penetration of the insurance brokerage market in both the United States and Canada. Both acquisitions and internal growth are core components of our strategic plan for revenue expansion.
We anticipate that increases in revenue, higher revenue per employee, expense control and more advantageous commission arrangements with insurance firms will be instrumental in margin expansion efforts.
20 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
As of December 31, 2003, our operations included 10 regional “hub” brokerages - five in the United States and five in Canada - and more than 150 offices staffed by approximately 2,500 people. Our strategic plan calls for the addition of approximately 10 additional U.S. hubs to extend our geographic footprint. Brokerages large enough to be considered hubs will generally have annual revenue in excess of $10 million. In addition to larger, “hub” acquisitions by the parent corporation, each regional hub is tasked with pursuing smaller, fold-in acquisitions that either expand its geographic penetration or add new specialization or expertise to the regional operation.
We generally acquire larger, “hub” brokerages, for a combination of cash and stock. Although there are variations in the purchase terms for each hub, our goal is to pay 30% - 70% of the “hub” purchase price in our common stock, while setting escrow periods of up to 10 years for the sellers to hold these shares. We believe the use of escrowed stock in major acquisitions creates increased alignment of interests between senior managers and the public shareholders of the corporation. We have paid all cash for the acquisition of certain brokerages, and may pay an all cash purchase price for brokerages in the future. As of December 31, 2003, senior managers of the company and its hubs owned approximately 4,129,000 shares, or 12.5% of shares outstanding, while all employees as a group held approximately 9,176,000 shares, or 27.8% of total shares outstanding.
During the three years ended December 31, 2003, we acquired 24 brokerages in the United States and another 9 brokerages in Canada, adding a combined $156.5 million to our revenue as of the dates of acquisition. Of these acquisitions, 4 were regional hubs, all based in the United States. United States revenue has grown to 62% of our total in 2003 from 21% in 2000, reflecting primarily acquisition growth but also organic growth and our strategic plan to use acquisitions to expand across the United States. Organic growth is similar to the same-store-sales calculation used by retailers. It includes revenue growth from units included in our financial statements for at least 12 months. Because we apply the purchase method of accounting for acquisitions, acquired brokerages’ financial results are included only from the date of acquisition.
We acquired brokerages with aggregate annual revenue of $8.1 million in 2003, down from approximately $59.6 million of acquired revenue in 2002. The slower pace of acquisitions in 2003 resulted from a number of factors, including competition for brokerages by banks and other buyers willing to acquire insurance brokers at higher valuations than we and most industry peers have been willing to pay.
Our management believes pricing discipline is a key to successful acquisition efforts and did not complete potential acquisitions that did not meet our pricing criteria. During 2003, for example, we considered an acquisition of a large brokerage firm in Chicago, but decided against the potential transaction as a result of our due diligence process. This process led to diversion of a significant amount of management’s time, which weighed against other acquisition efforts. We still continue to have a goal of acquiring an average of 2 hub operations per year, increasing our base of U.S. hubs to 15 from the current six. Acquisitions will be driven by opportunity, pricing and fit, however, not by a rigid timetable.
Our revenue base is diversified across a large number of insurance products and services, including:
Commercial insurance
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 21
Personal insurance
Commercial lines have increased as a percentage of our total revenue, increasing to 77% in 2003 from 18% in 2001, largely as a result of our more rapid expansion in the United States, where middle market companies and other commercial clients are the primary source of revenue. In 2003, commercial lines constituted 89% of U.S. revenue and 58% of Canadian revenue. In British Columbia (Canada), we are the largest broker of government underwritten auto insurance, a personal line. In addition, Canada’s public health care system eliminates a significant portion of the demand for employer-provided health insurance, a major commercial product line for us in the United States.
We employ a number of distribution channels to deliver products and services to clients. Among the distribution channels we employ are:
•
Retail sales and service centers that target middle-market companies, providing a broad range of property and casualty insurance, life and health insurance, risk management and financial services;
•
Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago, and in Saint John, New Brunswick and Chilliwack, British Columbia;
•
Wholesale life and financial services centers, known as managing general agents, provide life and financial products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal and Toronto;
•
Wholesale property and casualty insurance centers provide products, international risk solutions, captive management programs and specialty lines to independent brokers and corporations in North America and globally from offices in New York, Toronto, Montreal and Vancouver.
In addition, we are a member of the Worldwide Broker Network, a consortium of international brokerages which we can access to service U.S. or Canadian clients who require insurance internationally.
Because we have a diverse mix of products, services, insurer relationships and distribution channels, revenue and profitability levels are not usually highly susceptible to major changes as a result of a single product or service. (An exception occurred in 2003. See “US Results” on page 25.) However, general economic trends can influence both overall insurance rates - and commissions - and availability or costs of individual types of coverage.
During the 1990s, for example, insurance rates were generally considered low, or “soft,” as insurance companies sought to maximize the flow of premium dollars that they could invest profitability in a rising stock market and in other investments. Beginning in 2000, as return on investment began to shrink, insurance rates began to rise, or “harden,” a pace that accelerated rapidly after the terrorist attack of September 11, 2001. During the past two years, premium rates have remained firm for most types of coverage, rising 10% to 15% per year in many cases. During 2003, the Canadian market remained firm, but the U.S. market experienced some softening of premium rates for property and casualty coverage. Rates for liability, health and other types of coverage continued to experience increases however. Looking toward 2004, we anticipate some continued softening in the U.S. market and the beginning of softening in the Canadian market as the year progresses.
For us, as for other brokers, rising rates can present both positive and negative effects. Rising premiums usually yield stronger commission levels, if the insurance buyer maintains its coverage levels. However, many insurance buyers will respond to rising rates by reducing total coverage, often by raising deductibles, reducing limits of coverage, or by leaving some risks uninsured. In addition, a weak economic environment often leads to lower sales and employee headcounts at client companies, leading in turn to reduced demand for employee benefits, liability and other types of coverage tied to business activity levels. Our ability to achieve organic revenue growth is not solely dependent on
22 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
rising or declining rates, but results from a more complex mixture of general economic growth, access to coverage from insurers and marketing/sales expertise.
Our strategic plan has traditionally included a highly decentralized structure that offered a large degree of autonomy to each regional “hub” operation. We have sought to acquire strong businesses and retain the services and commitment of the management teams that built those businesses successfully. Decentralization has been a core component of this growth plan. As the company continues to grow, however, it is likely that added investment will be made to coordinate more functions from the head office, enhancing the potential for cross-selling, international coordination, marketing efficiency, total expense management and financial controls.
Because we are a service organization, compensation and other personnel costs make up the largest component of total expenses - 70% in 2003. Property and equipment are comprised primarily of furniture, computer systems and office equipment. Therefore, Hub’s capital resources, including external borrowings, internally generated cash flow and issuance of common shares, are targeted primarily toward acquisitions.
Results of Operations
Year ended December 31, 2003 compared to year ended December 31, 2002
We achieved growth in revenue and profitability in 2003. Although the pace of acquisitions did not match that of 2002, we benefited from strong organic growth rates in most hubs, contributions from brokerages acquired in 2002 and the currency exchange benefits of a strengthening Canadian dollar. Overall, our management believes the company made strong progress on several fronts in 2003, including increased penetration of the commercial middle market in British Columbia, expansion of the professional liability practice in Chicago and growth of the wholesale brokerage business in New York and Toronto.
As a result of these and other factors, we reported a 30% revenue increase to $286.4 million in 2003, while net earnings increased 24% to $36.5 million. Diluted earnings per share increased 8% to $1.14 from $1.06. The slower rate of growth in diluted earnings per share as compared to growth in revenue and net earnings reflected a larger number of average shares outstanding, resulting from both our U.S. IPO in June 2002 and the use of common shares in both acquisitions and compensation programs.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 23
The table below shows a breakdown of our revenue by segment and type for 2003 including organic growth for 2003:
(in thousands of U.S. dollars, except percentages)
Of the $66.4 million in new revenue we reported, $40.0 million, or 60% reflected growth through acquisition, while $26.4 million, or 40% resulted from organic growth. By comparison, acquired units added $46.1 million, or 70% of 2002’s sales growth, while organic growth contributed $19.9 million, or 30% of our revenue increases. Organic growth figures for both revenue and earnings include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2003, the rise of the Canadian dollar versus the U.S. dollar contributed 5 percentage points of our 12% organic growth rate in revenue.
Commission income, which usually ranges from 5% to 20% of the premium charged by insurers, provides approximately 91% of our revenue base. In addition to these “core” commissions, the company derives revenue from:
•
Volume overrides - additional compensation paid by insurance companies to brokerages on the basis of the overall volume of business a brokerage places with the insurance company.
•
Contingent commissions - additional compensation based on the profit an insurance company makes on the book of business a brokerage places with the insurance company.
•
Other income - comprised of fees and interest income, including income earned while we hold client premiums on behalf of insurance companies.
Volume overrides and contingent commissions are typically paid in the first or second quarter, based on prior-year performance. The sharp increase in contingent commissions and volume overrides in 2003 reflected increased profitability of business placed by us at higher premium rates and increased concentrations of some placements among a group of selected insurers.
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2003 and 2002 results included a number of factors that can complicate any efforts at
24 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
direct comparisons. The following chart shows the net earnings and diluted per-share impacts that several of these factors had over the past two years. They are shown here as an added disclosure to increase investor understanding.
As shown above, we benefited from both a stronger Canadian dollar and the receipt of life insurance proceeds in 2003, while 2002 results were strengthened by the sale of two insurance subsidiaries. The impact of foreign exchange on 2002 earnings was insignificant. In addition, 2003 included a full year’s amortization of non-cash stock based compensation, versus 2002 which included only six months of amortization. Excluding the effects of these items, net income would have increased 37% in 2003, versus 24% under Canadian GAPP, and diluted earnings per share would have increased 18% in 2003, versus 8% under Canadian GAAP.
Changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada and do not use derivatives to manage our Canadian pre-tax income, foreign exchange fluctuations will continue to impact our results. We have highlighted the impact of these changes because currency translation effects can lead to reported results that are less meaningful than local-currency results as an indicator of underlying operations. This year the strength of the Canadian dollar versus the U.S. dollar had a positive impact on our results. A decline would have a negative effect. See “Market Risk”.
U.S. Results
U.S. revenue grew 32% to $177.2 million, or 62% of revenue, in 2003, due to both organic growth and the contributions of operations acquired in 2002. Acquisitions added $38.7 million to revenue - 90% of the increase - while organic growth provided $4.4 million, or 10% of revenue growth. Our U.S. operations posted an organic growth rate of 3% in 2003, an 81% decrease from 16% in 2002. Core commission income increased 2%, while contingent commissions and volume overrides grew 37%.
During 2003 we experienced an unusual timing issue at a single hub that provides lender-placed auto insurance coverage for financial institutions. Lender-placed coverage is primarily collision coverage on automobiles financed through a financial institution. This is a high-volume business that is generally very profitable for us. However, in the third quarter of 2003, two financial institutions adjusted their credit policies, leading to cancellation of several quarters’ worth of policies in a single quarter resulting in 2003 revenue being reduced by approximately $4.3 million. Excluding the impact of this product line, U.S. organic growth was 9% in 2003.
During 2003, U.S. insurance premium rates remained strong - or hard - for most product lines, although rates for property coverage showed only modest increases as the year progressed. Hard insurance pricing in 2002 contributed strongly to a significant increase in contingent profitability income from insurers in 2003, as these insurers benefited from the near-term impact of higher rates implemented in 2002. Our management believes contingent commissions are likely to rise or decline only marginally in 2004 versus 2003 levels, reflecting a relative moderation in the pace of rate increases.
In the United States, our brokerages benefited from new business generation, additional revenue from businesses acquired during 2002 and moderate premium rate increases. While higher premium rates on most product lines
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 25
added nominally to total premium amounts, client response to higher rates often included a reduction in total coverage, increasing deductibles and other cost-savings techniques. In addition, the relative weakness in the U.S. economy led to declines in sales levels and staff headcount at many of our clients. Many products, including employee benefits and product liability coverage, are linked closely to the level of business activity at our clients. A weak economy reduces total risk, total coverage and total premiums for these clients.
As a result, our management believes an economic recovery that adds jobs and revenue at our client could make a meaningful contribution to organic growth in 2004. In addition, stronger revenue and earnings of our clients could lead these clients to reinstate coverages or lower deductibles, which also would have a beneficial impact on total premiums and commissions.
Canadian Results
Canadian revenue grew 27% to $109.2 million, or 38% of consolidated revenue, in 2003, primarily as a result of a strengthening of the Canadian dollar against the U.S. dollar as well as organic growth. Canadian brokerages posted organic growth of 26%, of which 14 percentage points reflected a stronger Canadian dollar. Acquisitions added only $1.3 million, or 6%, of the revenue increase, reflecting a slower pace of fold-in acquisitions in Canada than in the United States. Apart from foreign currency gains, in Canada, our brokerages benefited from strong organic growth and a sustained pace of increases in insurance premium rates. Canadian rate trends have trailed those of the United States, leading to expectations that Canadian premium rates will continue to be firm for much of 2004, with some softening as the year progresses. Because Canadian revenue includes a lower percentage of commercial business and more personal lines, any acceleration in economic growth that adds to payrolls is not expected to have as strong a benefit in Canada as in the United States. The strong rate of organic growth in Canada reflected both increased market penetration and continued strength in premium rates. Our strong relationships with and access to insurers in Canada proved to be an important competitive advantage in 2003, leading to increased sales to clients who were unable to obtain coverage from other sources. As was the case in the United States, Canadian operations benefited strongly from an increase in contingent commissions and volume overrides, which grew 37% in 2003, versus a decline of 12% in 2002.
Compensation Expense
The majority of our expenses are related to compensation, which increased 35% in 2003 to $161.1 million. As a percentage of revenue, compensation increased to 56% from 54% in 2002, due in large part to an increase in non-cash stock based compensation. Total compensation includes both cash based salaries and benefits and non-cash stock based compensation. Cash-based compensation grew 32% to $156.3 million in 2003, while non-cash stock based compensation increased 341% to $4.8 million.
We have undertaken a number of initiatives to reduce or maintain compensation expense. During 2002, members of the executive management group agreed to accept 50% of their earned bonuses in the form of stock options, rather than cash. At the close of 2003, we obtained agreement from managers to restructure the company’s management bonus agreement. Under the new agreement the non-cash stock option component of the annual bonus was eliminated in exchange for restricted share units to be issued in the first quarter of 2004. In addition, whereas the management bonus agreement was previously contractual in nature, the restructured plan is no longer contractual and may be subject to change as we deem necessary. Management has estimated that approximately $16.9 million of restricted share units will be issued in connection with the modifications. The amount of restricted share units to be issued was based upon a multiple of the previous two years average bonus. The restricted share units will all vest in full on January 1, 2011 subject to continued employment. Although the impact of this change is
26 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
expected to be earnings-neutral in 2004, the long-term effect is to reduce compensation costs as a percentage of revenue.
In addition to cash compensation, we have employed non-cash compensation tools such as stock options, restricted shares and restricted share units for senior employees. In response to investor interest in the true impact of these costs, we began recognizing the expense of non-cash stock based compensation during 2002. We recognized $4.8 million of expense for the full year in 2003, including both stock options and restricted share units, versus $1.1 million of expense for two quarters of 2002. Options vest evenly over three years and expire in seven years from issuance. Shares derived from the options are held in escrow for a period of five years from the date the options are granted, subject to early release in certain circumstances. Restricted share units vest over periods ranging from 48 months to 95 months. Our policy is to expense the fair value of non-cash stock based compensation to employees over the period in which entitlement to the compensation vests. The amount of expense recognized in each quarter related to stock options will vary with respect to exercise and forfeiture of options.
In total, as of December 31, 2003, we had issued and outstanding approximately 1.5 million stock options at a weighted average exercise price of $15.64. Our closing share price on the New York Stock Exchange was $16.76 on December 31, 2003.
Selling, Occupancy and Administration Expense
Selling, occupancy and administration expense increased 26% to $56.6 million in 2003. As a percentage of revenue, selling, occupancy and administration expense declined slightly to 19.8%, versus 20.4% in 2002.
Depreciation
Depreciation declined slightly to 2.2% of revenue in 2003 from 2.5% in 2002. The lower relative impact reflected control of capital expenditures while revenue grew. This number is not particularly important, as our business is not driven by capital expenditures.
Interest Expense
Interest expense decreased 29% to $5.2 million from $7.3 million in 2002. This decline reflected in large part the application of $80 million in proceeds for the 2002 IPO to pay down debt. In addition, interest expense was reduced by the benefits of performance-based forgiveness of interest payments due under a loan agreement with an insurer and an interest rate swap during the third and fourth quarters of 2003. The interest rate swap effectively converted $65 million of fixed interest rate senior notes into floating rate instruments, reducing interest expense on the senior notes by $0.8 million in 2003.
Intangible Asset Amortization
In January 2004, we adopted a corporate marketing and positioning strategy to build awareness of the Hub brand across all of our markets and to encourage greater coordination and collegial identity among our employees. As part of this corporate consolidation and identity development program, we have reassigned a number of key executives to new or expanded areas of responsibility and determined that future marketing and communications will be conducted under the Hub International name, rather than the traditional corporate names of acquired brokerages. As a result, in the first quarter of 2004 certain of our subsidiaries changed their names and as a result, we will recognize a non-cash impairment expense of approximately $2.6 million before tax related to trademarks.
Gain on Put Option Liability
In addition to the issuance of stock options, we issued put options to a number of individuals as part of the sale of their brokerages to us. These put options allowed the former owners to require us to repurchase our shares issued to them when we acquired their brokerages. We negotiated the cancellation of put options with one group of former owners during 2002 and negotiated the cancellation of all remaining put options during 2003.
Provision for Income Tax Expense
Our effective tax rate increased in 2003 to 34% from 33%. The difference in tax rates was affected most directly by non-taxable items in both 2003 and 2002. Approximately $2.6 million of 2002 earnings - resulting from the sale of
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 27
two subsidiaries, Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively, “Old Lyme”) - were non-taxable, while $1 million of 2003 earnings - resulting from life insurance proceeds - were non-taxable. Absent these two items, the tax rates were unchanged at approximately 34.7% in both years. Based on existing operations, management anticipates that our effective tax rate will likely be in the range of 36% - 39% in 2004.
Net Earnings and Earnings Per Share
Our net earnings increased 24% to $36.5 million in 2003, primarily as a result of growth in revenue. As a percentage of revenue, net earnings declined approximately 0.6 percentage points to 12.8% in 2003 from 13.4% in 2002. Diluted earnings per share increased at a somewhat slower rate than net earnings - 8% to $1.14, due primarily to a larger number of shares outstanding.
Our use of shares as a core component of our acquisition proceeds and as a form of executive compensation has led to significant increases in the number of shares outstanding over the past few years. In addition, we issued 6.9 million common shares in our June 2002 U.S. IPO and listing on the New York Stock Exchange. The weighted average number of diluted shares outstanding increased from 20.1 million in 2001 to 30.2 million in 2002 and 33.8 million in 2003. The impact of new acquisitions on the level of weighted average diluted shares outstanding in 2004 will be determined by both the size of acquisitions and their timing within the coming year.
As shown in the table on page 25, net earnings increased $2.6 million or $0.09 per diluted share, in 2002 on the sale of two insurance subsidiaries and decreased $1.1 million or $0.04 per diluted share due to non-cash stock based compensation. In 2003, diluted earnings per share increased $0.03 per diluted share from life insurance proceeds and another $0.06 per diluted share from foreign exchange rates and net earnings decreased $4.8 million or $0.14 per diluted share due to non-cash stock based compensation. Excluding these effects our diluted earnings per share would have increased from $1.01 in 2002 to $1.19 in 2003 on a comparable basis.
Year ended December 31, 2002 compared to year ended December 31, 2001
Revenue
We increased total revenue by $65.9 million, or 43%, to $219.9 million in 2002 from $154.0 million in 2001. Of this increase, $46.1 million or 70% was attributable to acquisitions, primarily from the acquisitions of Kaye, Burnham and
28 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Flanagan in 2001, and $19.9 million or 30% was attributable to organic growth. Commission income increased by $57.9 million, or 40%, to $200.9 million in 2002, from $143.1 million in 2001. Excluding the effect of acquisitions, commission income increased by $18.7 million, or 13%, due to organic growth, including the continued firming of insurance premium rates. In 2002, revenue from contingent commissions and volume overrides increased by $5.6 million, or 94%, to $11.5 million from $5.9 million in 2001. Excluding the effects of acquisitions of $4.2 million, contingent commissions and volume overrides increased by $1.4 million or 23% as compared with the prior year. This increase resulted primarily from contingent commissions earned in the third and fourth quarters of 2002 from Fairfax related to premium volume placed with Old Lyme. In 2002, other income, which includes fees and interest income, increased by $2.5 million, or 49%, to $7.5 million from $5.0 million in 2001. Excluding the effects of acquisitions of $2.7 million, other income decreased by $0.2 million.
U.S. Results
Total revenue from U.S. Operations increased by $58.7 million, or 78%, to $134.1 million in 2002 from $75.4 million in 2001. Excluding the effect of acquisitions, total revenue increased $11.9 million, or 16%, primarily due to increases in commission income. Commission income increased by $49.5 million, or 70%, to $120.7 million in 2002 from $71.2 million in 2001. Excluding the effect of acquisitions, commission income increased $9.6 million, or 14% due to organic growth and higher premium rates. Revenue from contingent commissions and volume overrides increased by $6.1 million, or 360%, to $7.8 million in 2002 from $1.7 million in 2001. Excluding the effect of acquisitions of $4.2 million, contingent commissions and volume overrides increased by $1.9 million, or 111%, as compared with the prior year. Of this increase, $1.2 million was attributable to contingent commissions earned in the third and fourth quarters of 2002 from Fairfax, as previously discussed, and the remainder was the result of enhanced relationships established with other insurance companies. Other income, which includes fees and interest income, increased by $3.1 million, or 122%, to $5.6 million in 2002 from $2.5 million in 2001. Excluding the effect of acquisitions of $2.7 million, other income increased $0.4 million, or 14% from 2001. This increase is due to an increase in income earned related to the financing of client premiums partially offset by lower interest income as a result of a decrease in interest rates compared with the prior year.
Canadian Results
Total revenue from Canadian Operations increased by $7.2 million, or 9%, to $85.8 million in 2002 from $78.6 million in 2001. Excluding the effect of net dispositions of $0.7 million, total revenue increased by $8.0 million or 10%. This increase was due to increases in commission income. Commission income increased by $8.3 million, or 12%, to $80.2 million in 2002 from $71.9 million in 2001. Excluding the effect of net dispositions of $0.7 million, commission income increased by $9.1 million, or 13%, the result of organic growth and higher premium rates. Contingent commissions and volume overrides decreased by $0.5 million, or 12%, to $3.7 million in 2002 from $4.2 million in 2001. This decrease was primarily attributable to deteriorating loss ratios on business placed with insurance companies during 2001. Other income, which includes fees and interest income, decreased by $0.6 million, or 24%, to $1.9 million in 2002 from $2.5 million in 2001. This decrease was attributable primarily to lower interest rates in 2002 compared with 2001.
Compensation Expense
Compensation expense in 2002 increased by $30.7 million, or 35%, to $118.7 million from $88.0 million in 2001. Compensation expense as a percentage of total revenue decreased 3% to 54% from 57% in 2001. This proportional decrease resulted largely from revenue growth as certain fixed compensation expense remained constant, and from a decrease in the accrual of executive management profitability bonuses (approximately $4.7 million or 2.1% of revenue) associated with the granting of stock options. In 2002 we changed our executive management bonus plan to require that 50% of earned bonuses be paid with stock option awards.
Selling, Occupancy and Administration Expense
Selling, occupancy and administration expenses increased by $9.6 million, or 27%, to $44.9 million in 2002 from $35.3 million in 2001. As a percentage of total revenue, selling, occupancy and administration expenses decreased to 20% in 2002 from 23% in 2001. This decrease was due to efforts to ensure that certain fixed costs remained constant while revenue grew.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 29
Depreciation
Depreciation expenses increased by $1.6 million, or 39%, to $5.5 million in 2002 from $3.9 million in 2001. Depreciation expenses remained unchanged as a percentage of total revenue at 3% in both 2002 and 2001.
Interest Expense
Interest expense decreased by $0.1 million, or 2%, to $7.3 million in 2002 from $7.4 million in 2001. In June 2002, we repaid $122.5 million of our total outstanding long-term debt and subordinated convertible debentures with proceeds from the sale of Old Lyme and our U.S. initial public offering. This reduction in debt decreased interest expense in the third and fourth quarter of 2002 by approximately $1.5 million per quarter compared to 2001.
Goodwill and Other Intangible Asset Amortization
Intangible asset amortization decreased by $3.2 million, or 66%, to $1.7 million in 2002 from $4.9 million in 2001. This decrease is attributable to the elimination of goodwill amortization, effective January 1, 2002, in accordance with The Canadian Institute of Chartered Accountants Accounting Standards Board Handbook Section 3062, “Goodwill and Other Intangible Assets.”
Gain on Disposal of Investment Held for Sale, Property, Equipment and Investments
These gains have increased by $2.5 million, or 1449%, to $2.7 million in 2002 from $0.2 million in 2001. Included in 2002 is a $2.6 million, non-taxable gain on the sale of Old Lyme. This gain increased basic and diluted earnings per share by $0.11 and $0.09, respectively. As part of our acquisition of Kaye in 2001, we acquired Old Lyme, with the intent to sell the operation and have since sold it to a subsidiary of Fairfax at a purchase price equivalent to its U.S. GAAP book value as of December 31, 2001 of approximately $43.5 million. The sale of Old Lyme was completed on May 30, 2002. As of December 31, 2002, Fairfax owned 27% of our common shares. Prior to the sale, we recorded Old Lyme as an investment available for sale, and accordingly, its results of operations are not included in our consolidated earnings.
Gain on Put Option Liability
The gain on put option liability of $0.2 million in 2002, as compared to $0.7 million in 2001, reflect changes in the fair value of put options granted by us. We issued put options as consideration for certain businesses acquired in the second and third quarters of 2001. The related put option liability is classified as long-term debt at fair value until such time as the options are exercised or expire. Factors affecting the fair market value of the put option are the stock price, stock volatility, and interest rates.
Non-cash Stock Option Compensation
Non-cash stock option compensation of $1.1 million in 2002 reflects the impact of approximately 1.3 million stock options granted in June of 2002. The options were granted with an exercise price of $15.67 per share (fair market value at date of grant) and vest evenly over three years. The options expire in seven years. Our policy is to expense the fair value of stock options granted to employees over the period in which entitlement to the compensation vests. Non-cash stock option compensation was 0.5% of total revenue for 2002.
Provision for Income Tax Expense
Income taxes in 2002 and 2001 amounted to $14.3 million and $5.3 million, respectively, resulting in an effective tax rate of 33% and 34% in 2002 and 2001, respectively. This decrease in effective tax rate was primarily the result of the non-taxable gain of $2.6 million on the sale of Old Lyme.
Net Earnings
Net earnings in 2002 increased by $19.4 million, or 194%, to $29.4 million in 2002 compared with $10.0 million in 2001. Basic earnings per share increased 140% to $1.27 in 2002 compared with $0.53 per share in 2001. Diluted earnings per share increased 112% to $1.06 in 2002 from $0.50 in 2001.
30 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Cash Flow, Liquidity and Capital Resources
We improved our financial position and capacity for acquisitions in 2003 through positive cash flow from operations and a private debt offering. As a result of these factors, as of December 31, 2003, we had cash and cash equivalents of $82.1 million, an increase of 102%, from $40.6 million as of December 31, 2002. Operating activities generated $53.9 million of cash in 2003 compared to $19.1 million in 2002. The amount of cash provided by operating activities is affected by net earnings for the period, non-cash income and expenses, the collection of accounts and other receivables and the payment of accounts payable and accrued liabilities. In 2003, $20.1 million of cash was used in investing activities, primarily for the acquisitions of property and equipment and the purchase of subsidiaries compared to $8.4 million in 2002. Also in 2003, $4.6 million of cash was provided from financing activities, primarily resulting from our private debt offering, of $65.0 million, and offset by the repayment of long-term debt and capital leases, and the payment of dividends. In 2003, the effect of exchange rate changes on cash and cash equivalents was an increase of $3.1 million compared to $0.1 million in 2002. Net debt, defined as long-term debt ($78.8 million) and subordinated convertible debentures ($35.0 million) less non-trust cash (cash and cash equivalents of $82.1 million) as of December 31, 2003, was $31.7 million compared with $66.4 million as of December 31, 2002.
As a broker, we collect and hold premiums paid by clients, deduct commissions and other expenses from these payments, and hold the remainder in trust, which we remit to the insurers who provide coverage to clients. We earn interest on these funds during the time between receipt of the cash and the time the cash is paid to insurers. The cash held in trust is shown separately on our balance sheet. On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
In addition to internally generated cash, we maintain two separate credit facilities:
(1)
Revolving U.S. dollar LIBOR loan - This undrawn facility was renegotiated in December 2003 subject to completion of the definitive amended agreement. Under the new terms, the unsecured facility totals $50 million and bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR, which were 1.12% and 1.42% at December 31, 2003 and 2002, respectively. The facility is available on a revolving basis for one year and expires on December 13, 2004; however if the revolving period is not extended, we may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $NIL and $50 million at December 31, 2003 and 2002, respectively. We are in compliance with all financial covenants governing this facility as of December 31, 2003 and 2002.
(2)
Demand U.S. dollar base rate loan - We have an undrawn $9.3 million facility which expires on July 18, 2004 and bears interest at the bank’s U.S. base rate plus 50 bonus points. Borrowings under this facility are repayable on demand.
In June 2003, we completed a private placement of $65 million in principal amount of unsecured senior notes. The senior notes were issued in two series. Series A represents $10 million of 5.71% senior notes with interest due semi-annually, and principal due of $3,333 annually, June 15, 2008 through June 15, 2010. Series B represents $55 million of 6.16% senior notes with interest due semi-annually, and principal due of $11,000 annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of our revolving U.S. Dollar LIBOR Loan with the balance held for general corporate purposes, which may include future acquisitions. We incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2003, $65 million was outstanding under the senior notes. We are in compliance with all financial covenants governing the senior notes.
On July 16, 2003, we entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% and 6.16% on $10 million and $55 million, respectively, of the senior notes in order to ensure that we pay a market related interest rate on a portion of our borrowings. Under Canadian GAAP, we account for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 31
December 31, 2003, we estimate the fair value of the swap to be $2.6 million, which is not recognized in these financial statements. Accordingly, $2.6 million is the estimated amount that we would need to pay to terminate the swap as of December 31, 2003.
Also at December 31, 2003 we had outstanding a $7.5 million term loan from an insurance carrier. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) and reduces the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Credits were earned for 2003 and 2002 which reduced interest payments to zero from $750 and $229, respectively.
In addition to these primary credit sources, we ended 2003 with $6.3 million of subsidiary debt comprised of various notes payable, term loans and capital leases. We intend to repay these liabilities from internally generated cash flow, existing cash balances and/or borrowings under our credit facilities as the subsidiary debt becomes due during 2003 through 2010. Of the outstanding subsidiary debt, $0.5 million is secured by liens on certain assets of our subsidiaries.
Also at December 31, 2003, we had outstanding $35.0 million aggregate principal amount of 8.5% convertible subordinated notes due June 28, 2007 held by certain subsidiaries of Fairfax (the Fairfax notes). The Fairfax notes are convertible by the holders at any time into our common shares at C$17.00 per share. If Fairfax converted all of the Fairfax notes, Fairfax would own approximately 32% of our total outstanding common shares as of December 31, 2003, versus the 26% of outstanding shares held on that date.
At the close of 2003, our cash position included approximately $35.1 million deployed as working capital at the brokerage level and approximately $47.0 million available for acquisitions. It is impossible to define exactly how many acquisitions or how much new revenue could be acquired through the use of this cash, additional cash flow from operations and application of credit facilities, as acquisition pricing and other factors vary during the course of the year. However, we intend to use common shares as compensation for approximately 30-70% of the value of a hub acquisition, and generally have paid a multiple of 5-8 times earnings before interest, taxes, depreciation and amortization (frequently referred to as EBITDA) for acquired brokerages.
We believe that our capital resources, including existing cash, funds generated from operations and borrowings available under credit facilities, will be sufficient to satisfy the company’s financial requirements, including some strategic acquisitions, during the next twelve months. We may finance acquisitions with available cash or an existing credit facility, but may, depending on the number and size of future acquisitions, need to supplement our finance requirements with the proceeds from debt financing, the issuance of additional equity securities, or a combination of both.
Our debt to capitalization ratio (defined as debt expressed as a percentage of debt and shareholders’ equity) decreased to 25% at December 31, 2003, compared with 27% at December 31, 2002. If all lines of credit and other loan facilities were fully utilized by the company at December 31, 2003, our ratio of debt to capitalization would have been 34%, which is below the range 35% to 38% that our management believes is suitably conservative for our business model. Under our loan covenants, our debt to capitalization ratio must be maintained below the 45% level. As of December 31, 2003, we were in compliance with the financial covenants under all of our debt instruments.
32 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Contingent obligations
The table below summarizes our contractual obligations and commercial commitments as of December 31, 2003:
Acquisitions
In connection with the acquisition of Hooper Hayes and Associates, Inc., in 2002 we issued 196,000 shares (the “Retractable Shares”) that are being held in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2003, 63,000 shares have been released from escrow.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (“Flanagan”) total additional consideration of 37,500 of our common shares were earned at December 31, 2003 valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares have been recorded as “issuable shares” and included in shareholders’ equity and goodwill has been increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition we expect to issue non-cash stock based compensation in the form of 84,375 restricted share units in the first quarter of 2004. Half of these restricted share units will vest in 4 years and the balance will vest in 7 years.
In connection with other various acquisitions completed through December 31, 2003, we may be obligated to pay contingent consideration up to a maximum sum of approximately $8.2 million cash and $0.2 million in common shares based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through September, 2006 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2003, the financial statements reflect a liability to pay cash of $71 and to issue common shares valued at approximately $635 as of December 31, 2003.
Other
In connection with our executive share purchase plan, under certain circumstances, we may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4,513 and $5,077 as of December 31, 2003 and 2002 respectively, to assist in purchasing our common shares. As collateral, the employees have pledged 478,000 and 602,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $8,105 and $7,677 as of December 31, 2003 and 2002, respectively. Interest on the loans in the amount of $279, $264 and $377 for the years ended December 31, 2003, 2002 and 2001, respectively, was paid by us and is included in compensation expense. We no longer make loans to our executive officers and directors.
We have undertaken a number of initiatives to reduce and maintain compensation expense. During 2002, members of the executive management group agreed to accept 50% of their earned bonuses in the form of stock options, rather than cash. At the close of 2003, we obtained agreement from managers to restructure the company’s management bonus agreement to reduce total compensation expense over the long term. Under the new agreement the non-cash stock option component of the annual bonus was eliminated in exchange for restricted
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 33
share units to be issued in the first quarter of 2004. In addition, whereas the management bonus agreement was previously contractual in nature, the restructured plan is no longer contractual and may be subject to change as we deem necessary. Our management has estimated that approximately $16.9 million of restricted share units will be issued in connection with the modifications. The amount of restricted share units to be issued was based upon a multiple of the previous two years average bonus. The restricted share units will vest in full on July 1, 2011, subject to continued employment of the awardee. Although the impact of this change is expected to be earnings-neutral in 2004, the long-term effect is intended to be a slower rate of increase in compensation expense relative to revenue growth.
In the ordinary course of business, we are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of our management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on our consolidated financial position or results of operations.
Shareholders’ equity
Restricted share units. We committed to award, under our equity incentive plan, an aggregate of 266,000 restricted shares that would be paid for by the participants (none of whom are members of our senior management or directors) with loans either from us or from a bank (guaranteed by us). In addition, we committed to award an aggregate of 471,000 restricted share units that would be exercisable for common shares, without payment of cash consideration. On June 30, 2003, we awarded 610,000 restricted share units in satisfaction of substantially all of the above-mentioned commitments. The restricted share units vest over periods ranging from 68 months to 95 months. In the first quarter of 2004, 1,005,690 restricted share units were issued in connection with the restructure of our management bonus agreement and 84,375 restricted share units were issued in connection with the renegotiation of contingent consideration for Flanagan.
Share repurchases. For the year ended December 31, 2003, no common shares were repurchased by us, other than 6,470 common shares under the executive share purchase plan.
Shares reserved for issuance. As of December 31, 2003, 3.6 million common shares were reserved for issuance under our equity incentive plan. As of December 31, 2003, an aggregate of approximately 2.1 million stock options and restricted share units were outstanding which would reduce such shares reserved for issuance. The issuance of approximately 1,090,065 additional restricted share units in the first quarter of 2004 will also reduce such shares reserved for issuance.
Shareholders’ equity increased by $58.5 million, or 21%, to $342.8 million as of December 31, 2003 from $284.3 million as of December 31, 2002. This increase resulted from net earnings of $36.5 million, an increase in contributed surplus of $3.5 million related primarily to non-cash stock based compensation expense, $7.1 million increase due to the release of the put option liability, $0.4 million due to shares issued in conjunction with purchase of subsidiaries and other items, $1.0 million due to shares issued in conjunction with the contingent consideration payments, as well as an increase in the cumulative translation account of $18.0 million, due mainly to the strengthening of the Canadian dollar compared to the U.S. dollar in 2003. The increase in shareholders’ equity was offset by the payment of dividends of $6.1 million in 2003, and a reduction in share capital of $1.9 million as a result of a transfer from long-term assets on company funded loans to executives used to purchase company shares pursuant to our executive share purchase plan. We no longer make loans to our executive officers. This treatment is consistent with U.S. GAAP.
Market risk
Interest rate risk
We are exposed to interest rate risk in connection with our senior notes due to the interest rate swap entered into in July which converted the fixed rate interest payments on the $65 million of senior notes outstanding into floating rate payments. At December 31, 2003, we had $65 million of floating rate debt outstanding. Each 100 basis point increase in interest rates charged on the balance of our outstanding floating rate debt as of December 31, 2003 will result in approximately $0.4 million decrease in our earnings.
34 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Exchange rate sensitivity
We report our revenue in U.S. dollars. Our Canadian operations earn revenue and incur expenses in Canadian dollars. Given our significant Canadian dollar revenue, we are sensitive to the fluctuations in the value of the Canadian dollar and are therefore exposed to foreign currency exchange risk. Foreign currency exchange risk is the potential for loss in revenue and net income as a result of a decline in the U.S. dollar value of Canadian dollar revenue due to a decline in the value of the Canadian dollar compared to the U.S. dollar.
The Canadian dollar is subject to volatility and had experienced a significant decline in its value compared to the U.S. dollar in 2001 and 2002 but has increased significantly in value throughout 2003. At December 31, 2003 and 2002 one U.S. dollar equaled $1.2924 and $1.5779 Canadian dollars, respectively. The table below summarizes the effect that a $0.01 decline or increase in the value of the Canadian dollar would have had on our revenue, net earnings and cumulative translation account for the twelve months ended December 31, 2003, 2002 and 2001.
The increasing proportion of our revenue derived from our U.S. Operations and earned in U.S. dollars has, in part, offset the potential risk of a decline in the Canadian dollar. We expect that the proportion of revenue earned in U.S. dollars will continue to increase, further mitigating our foreign currency exchange sensitivity. We have not entered into, and do not intend to enter into, foreign currency forward exchange agreements.
Goodwill and other intangible assets
Intangible assets arising from acquisitions consist of the following:
We completed our impairment testing on the balance of goodwill and intangible assets as of January 1, 2004, 2003 and 2002. Based on the testing performed, no impairment losses were incurred.
The amounts allocated to customer relationships were determined by discounting the expected future net cash flows from commissions with consideration given to remaining economic lives, renewals, and associated expenses. Non-competition covenants value were determined using an income approach with consideration given to economic benefits associated with having the covenants in place versus damages that would ensue absent the agreements; and in the case of trademarks, a cash flow royalty savings approach addressing the economic benefits of the trademarks to Hub was used. The balance of the excess purchase price is allocated to goodwill.
Customer relationships are amortized on a straight-line basis over their periods of duration, normally fifteen years. Many factors outside our control determine the persistency of our customer relationships and we cannot be sure that the value we have allocated will ultimately be realized. Non-competition covenants and trademarks are intangible assets that have an indefinite life and accordingly, are not amortized but are evaluated for impairment. When an employee leaves Hub, the non-competition covenant becomes effective and the value assigned is then amortized over the life of covenant. Prior to 2002 we amortized goodwill primarily over a period of forty years. Under the new accounting standards adopted in 2002, goodwill is not amortized and is evaluated annually for
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 35
impairment. For the past three years ended December 31, 2003, our amortization has been comprised of the following:
We estimate that our amortization charges for intangible assets from 2004 through 2008 for all acquisitions consummated to date will be:
Related party transactions
We had transactions with, and recorded revenue from, the following related parties:
As of December 31, 2003 and 2002, we had accounts receivable and accounts payable balances with the above related parties in the amounts of $3,185 and $17,999, for 2003, respectively, and $2,104 and $12,180 for 2002, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in the normal course of business. The companies above are related through common ownership by Fairfax, which owns approximately 26% of our common shares as of December 31, 2003.
As of December 31, 2003 and 2002, long-term debt related to put options of $NIL and $5,940, respectively, and subordinated convertible debentures of $35,000 at the end of both years, are due to related parties.
During 2003, 2002 and 2001, we incurred expenses related to rental of premises from related parties in the amount of $2,102, $1,691 and $1,373, respectively. At December 31, 2003 and 2002, we also had accounts receivable due from related parties in the amount of $3,530 and $3,801, respectively, of which the majority were loans to employees to enable them to purchase our common shares. Of the accounts receivable, as of December 31, 2003 and 2002, $1,918 and $2,207, respectively, were related to company loans to employees to purchase shares under our executive share purchase plan. As collateral, the employees have pledged 153,000 and 177,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $2,590 and $2,263 as of December 31, 2003 and 2002, respectively.
Off-Balance Sheet Transactions
Under Canadian GAPP, we account for the interest rate swap transaction which converted fixed rate interest payments of 5.71% and 6.16% on the senior notes of $10 million and $55 million, respectively, using the synthetic instruments method. Under this method, we report in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.6 million is not
36 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
recognized in our Canadian GAAP financial statements. Under U.S. GAAP, we have designated the swap transaction of a hedge of changes in the fair value of our fixed rate debt caused by changes in interest rates and record the swap on our U.S. GAAP balance sheet at is fair value. Changes in fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt. We have no other material off-balance sheet arrangements.
Critical Accounting Policies
Our significant accounting polices are more fully described in Note 2 to our consolidated financial statements. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts and policies, our observance of trends in the insurance industry, information provided by our clients and information provided by outside sources, as appropriate. Our critical accounting policies include the recognition of commission income, the allocation of the purchase price of an acquisition, the measurement of goodwill and other intangibles and related impairment evaluation, and the valuation of stock-based compensation. These policies are discussed below.
Recognition of Commission Income
We recognize commission income and fees as of the effective date of our client’s policy unless information is not available relating to the determination of their policy premiums, in which case we recognize commission income and fees related to that policy when that information becomes available and the revenue can be reasonably determined. We maintain an allowance for estimated policy cancellations and commission returns based upon the application of historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The allowance for estimated policy cancellations is based on our management’s judgment, and is regularly evaluated by management by taking into consideration factors such as changes in the nature and volume of policies; trends in actual and forecasted policy cancellations; and current economic conditions that may affect the likelihood of client policy changes or cancellations. If our actual policy cancellation rates are significantly different from our historical policy cancellation rates, and those changes have not been adjusted for in the allowance, our actual commission income may be significantly different from what we estimated.
Allocation of the Purchase Price of an Acquisition
The acquisition of new brokerages is a fundamental component of our strategy. When we acquire a business, the cost of the purchase is allocated to all of the assets acquired and liabilities assumed based on their fair values. Any excess of the cost of purchase over the net of the allocated amounts is recognized as goodwill. For significant acquisitions, we engage qualified third party valuators to assist us in conducting asset valuations.
The fair value of assets, including intangible assets, and liabilities may be determined using a number of valuation methods including net realizable values, market prices and discounted cash flows. 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.
Goodwill and Other Intangible Assets
Intangible assets primarily represent goodwill, associated with our acquisitions. Goodwill represents the excess of the cost of purchase of acquired businesses over the fair market value of their identifiable net assets. The fair value of our subsidiary brokerages has been increasing primarily due to recent increases in premium rates and organic growth as previously discussed which has generally increased the commission earned by us.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 37
Effective January 1, 2002, we adopted Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board Handbook Section 3062 and the U.S. Financial Accounting Standards Board SFAS No. 142, which change and conform the recognition, measurement and disclosure of “Goodwill and Other Intangible Assets” under Canadian and U.S. GAAP.
These new accounting standards require that we no longer amortize goodwill and intangible assets with indefinite useful lives. We test at least annually for impairment at the reporting unit level. We determine impairment by comparing the fair value of a reporting unit to its carrying value. The fair value of a reporting unit may be determined using a number of market valuation methods including quoted market prices, discounted cash flows and net realizable values. The use of assumptions and estimates is inherent in each of these valuation techniques. 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.
The cost of definite lived intangible assets is amortized over the estimated remaining useful life of the assets. We regularly evaluate whether events or changes in circumstances indicate that the carrying amount of intangibles, other than goodwill and intangible assets with indefinite useful lives, may warrant revision or may not be recoverable. The estimation of the useful economic lives and the selection of estimates and assumptions used in conducting impairment tests require the exercise of judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests of the assets and, as a result, significantly different results of operations.
Stock-based compensation
Stock-based compensation includes both stock options, restricted shares and restricted share units. Our accounting policy is to recognize the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
We measure the fair value of stock options at the date of grant of the award and recognize this amount as compensation expense over the vesting period of the options. An alternative accounting treatment would be to follow the intrinsic value method for accounting for stock options.
We estimate the fair value of the stock options granted using the Black-Scholes valuation model, which requires us to make assumptions in relation to the expected term of the stock option, volatility in the price of the underlying common shares, interest rates and dividend yield. The fair value model is particularly sensitive to the changes in the price and price volatility of our common shares. The assumptions used are based on our management’s judgment and the use of different judgments, estimates, and assumptions could produce significantly different results of fair value of the stock options and, as a result, significantly different results of operations.
Effects of recent accounting pronouncements
We are not aware of any new accounting pronouncements which will impact on our financial reporting.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Risk”.
38 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Item 8.
Item 8. Financial Statements and Supplementary Data
Index to consolidated financial statements
Index to notes to consolidated financial statements
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 39
Report of Independent Auditors to the Board of Directors and Shareholders of Hub International Limited:
We have audited the accompanying consolidated balance sheets of Hub International Limited and its subsidiaries as of December 31, 2003 and 2002 and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three year period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in Canada and in the United States of America. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hub International Limited and its subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2003, in accordance with accounting principles generally accepted in Canada.
As discussed in Note 2 to the financial statements, the Company changed the method of accounting for goodwill and other intangible assets in 2002.
Chicago, Illinois
February 19, 2004
40 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Hub International Limited
Consolidated Balance Sheets
As of December 31,
(in thousands of U.S. dollars)
(the accompanying notes form an integral part of the financial statements)
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 41
Hub International Limited
Consolidated Statements of Earnings
For the Years Ended December 31,
(in thousands of U.S. dollars, except per share amounts)
(the accompanying notes form an integral part of the financial statements)
42 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Hub International Limited
Consolidated Statements of Retained Earnings
For the Years Ended December 31,
(in thousands of U.S. dollars)
(the accompanying notes form an integral part of the financial statements)
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 43
Hub International Limited
Consolidated Statements of Cash Flows
For the Years Ended December 31,
(in thousands of U.S. dollars)
(the accompanying notes form an integral part of the financial statements)
44 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
HUB International Limited
Notes to Consolidated Financial Statements
For the years ended December 31, 2003, 2002 and 2001
(In thousands, except per share amounts or as otherwise indicated)
1. Nature of operations and recent significant transactions
Business operations
Hub International Limited (the “Company”) is an international insurance brokerage that provides a variety of property and casualty, life and health, employee benefits, investment and risk management products and services. The Company’s shares are listed on both the New York Stock Exchange (NYSE: HBG) and Toronto Stock Exchange (TSX: HBG).
Private Debt Offering
During the second quarter of 2003, the Company completed a private placement of $65 million unsecured senior notes (see note 8). Net proceeds on the sale of the notes were used to pay down $50 million of existing indebtedness and for general corporate purposes which may include future acquisitions.
Initial U.S. Public Offering
In June 2002, the Company completed its initial U.S. public offering (“U.S. IPO”) of 6.9 million common shares at a price of $14 per share. The cash proceeds of the offering, net of issue costs of $8.5 million, were approximately $88.1 million of which approximately $86.0 million was used to repay bank debt, long-term debt and a convertible subordinated debenture during the second quarter of 2002.
Change in reporting currency
The Company’s consolidated financial statements historically have been expressed in Canadian dollars. Effective October 1, 2001, the Company adopted the U.S. dollar as its reporting currency. Comparative financial information has been restated in United States (U.S.) dollars using the translation of convenience method. Accordingly, the financial results for the first nine months of the year ended December 31, 2001 and the entire year ended 2000, were converted from Canadian to U.S. dollars at the exchange rate in effect at September 30, 2001 of one Canadian dollar (C$) to 0.6338 U.S. dollar.
Sale of Old Lyme
Effective June 28, 2001, the Company acquired Kaye Group Inc. (Kaye). Kaye, primarily an insurance broker, also underwrote insurance risks through its subsidiaries Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively Old Lyme). The Company indicated prior to the effective date of the acquisition that it intended to find a purchaser for the Old Lyme operations as soon as possible after closing.
On May 30, 2002 the Company completed the sale of Old Lyme to Fairfax Inc, a related party, and recorded a non-taxable gain on the sale of $2.6 million. This gain increased 2002 annual basic earnings per share and diluted earnings per share by $0.11 and $0.09, respectively.
2. Summary of significant accounting policies
These consolidated financial statements of the Company are expressed in United States (U.S.) dollars and have been prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from U.S. GAAP and to the extent that they affect the Company, the differences are described in note 18 “Reconciliation to U.S. GAAP.” The more significant of the accounting policies are as follows:
Basis of presentation
The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All material inter-company accounts and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements to conform to the current year presentation.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 45
Estimates and assumptions
Preparation of the financial statements in conformity with Canadian GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the reported amount of revenue and expense during the reporting period. The principal estimates used in the preparation of these financial statements are the determination of the provision for cancelled policies relating to revenue renegotiation, the allocation of the purchase price on acquisitions, the valuation of reporting units when testing the recoverability of goodwill and other intangible assets, the estimation of the useful lives of definite life intangible assets, and the measurement of stock based compensation. Actual results could differ from those estimated.
Foreign currency translation
The operations of the Company’s subsidiaries outside of the U.S. are self-sustaining. The assets and liabilities of these subsidiaries as at December 31, 2003 and 2002 were translated to U.S. dollars at the year-end exchange rate. Revenue and expenses for 2003 and 2002 were translated to U.S. dollars at the average exchange rate for the period. Accordingly, the unrealized gains and losses which result from this translation are deferred and included in shareholders’ equity under the caption “Cumulative translation account.”
Revenue Recognition
Commission income and fees, (including commission income related to installment billing arrangements) are recognized as of the effective date of the policy unless information is not available relating to the determination of the client’s policy premiums, in which case commission income and fees related to that policy are recognized when that information becomes available and the revenue can be reasonably determined. Commission income is reported net of sub-broker commission expense. Commission and other adjustments are recorded when they occur and the Company maintains an allowance for estimated policy cancellations and commission returns by applying historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The Company is entitled to contingent commissions and volume overrides from insurance companies which are recorded in the earlier of the period in which amounts can be reasonably estimated or the period in which the amounts are received. Amounts related to contingent commissions and volume overrides can be reasonably estimated when information pertaining to the calculation, such as premium volumes, loss ratios and expenses, can be obtained from the insurance companies. Other revenue primarily includes investment income, policy service fees and income earned related to the financing of client premiums. Investment income is recorded when earned. Policy service fees are recorded on the effective date of the policy, at which time the service has been provided. Income earned related to the financing of client premiums is recorded when known.
Cash and cash equivalents
Cash and cash equivalents consist of cash, and highly-liquid investments having maturities of three months or less at the acquisition date.
Concentration of credit risk
The Company’s financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains cash with banks in excess of federally insured limits and is exposed to the credit risk from this concentration of cash. The Company performs ongoing credit evaluations of its customers financial condition and generally requires no collateral. No single client accounted for more than ten percent of total client premiums nor more than ten percent of revenue for the years ended December 31, 2003, 2002 and 2001, respectively.
In addition, the Company is also party to interest rate swap transactions which are subject to credit risk. Credit risk arises from the possibility that counterparties may default on their obligations to the Company. Derivative contracts generally expose the Company to credit loss if changes in market rates affect a counterparty’s position unfavorably and the counterparty defaults on payment.
46 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Trust Cash
Premiums collected (less commissions and other deductions), but not yet remitted to insurance companies, are included in trust cash. Trust cash is restricted as to use by contractual obligations and by laws in certain states and provinces in which the Company operates.
Property and equipment
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recorded based on the useful economic lives of the related assets as follows: for computer equipment on a straight-line basis from 3 to 5 years or on a 30% declining balance method; for furniture, fixtures, and office equipment on a straight-line basis from 5 to 7 years or on a 20% declining balance method. Leasehold improvements are amortized on the straight-line method over the term of the related lease. Upon sale or retirement, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is reflected in earnings. If the carrying value of property and equipment is identifiable as impaired, it is written down to its net recoverable amount.
Business combinations
Acquisitions of subsidiaries have been accounted for using the purchase method, whereby the results of acquired companies are included only from the date of acquisition. Consideration which is contingent on maintaining or achieving specified earnings levels in future periods is recognized as an additional cost of the purchase when the contingency is resolved and the additional consideration is issued or becomes issuable.
Goodwill and other intangible assets
Effective January 1, 2002, the Company adopted the Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board Handbook Section 3062, “Goodwill and Other Intangible Assets” (Section 3062) without restatement of prior periods.
Goodwill and intangible assets with indefinite useful lives are no longer amortized but are subject to impairment tests on at least an annual basis. Goodwill is allocated to reporting units and any potential goodwill impairment is identified by comparing the carrying value of a reporting unit with its fair value. If any potential impairment is indicated, it is quantified by comparing the carrying value of goodwill to its fair value, based on the fair value of the assets and liabilities of the reporting unit.
Intangible assets other than goodwill which do not have indefinite lives are amortized on a straight-line basis over their useful lives. These intangible assets are subject to an annual impairment test comparing carrying values to net recoverable amounts.
The Company completed its impairment testing on the balance of goodwill and intangible assets as of January 1, 2004, 2003 and 2002. Based on the testing performed, no impairment losses were incurred.
No goodwill amortization expense was incurred for the year ended December 31, 2003 and 2002. For the year ended December 31, 2001 the Company incurred goodwill amortization expense of $4,125 before tax and approximately $3,996 after tax ($0.20 per diluted share).
The effect of the adoption of Section 3062 on net earnings and earnings per share for the years ended December 31, 2003, 2002 and 2001 was as follows:
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 47
Interest rate swap
The Company accounts for interest rate swaps with respect to its long-term debt using the synthetic instruments method under which the net interest on the swap and associated debt is reported in earnings as if it were a single synthetic financial instrument. The fair value of the derivative is not recognized in the balance sheet.
Guarantees
In February 2003, the CICA issued an accounting guideline on the disclosure of guarantees, which broadens the definition of guarantees and requires substantially expanded disclosure. This new guideline was effective for the Company this year. As this guideline requires disclosure only, there was no impact on the consolidated statements of earnings and retained earnings and consolidated balance sheets. See note 10(b). A guarantee is a contract that contingently requires the guarantor to make payments to a third party based on (i) changes in an underlying interest rate, foreign exchange rate or other variable, including the occurrence or non-occurrence of an event, that is related to an asset, liability or equity security held by the guaranteed party, (ii) an indemnification provided to the third party with the characteristics listed above, (iii) another entity’s failure to perform under an obligating agreement, or (iv) another entity’s failure to perform related to its indebtedness.
Stock based compensation
The Company recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
Future income taxes
Income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities and their tax bases. Future income tax assets and liabilities are determined for each temporary difference based on the tax rates which are expected to be in effect when the asset or liability is settled. The benefit of loss carry forwards is recognized as an asset to the extent that it is more likely than not to be realized.
48 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Earnings per share
Basic earnings per share, excluding the dilutive effect of common share equivalents, is calculated by dividing net earnings by the weighted average number of common shares outstanding for the period. Diluted earnings per share is calculated using the treasury stock method and includes the effects of all potentially dilutive securities. Earnings per common share have been calculated as follows:
Put options
The fair value of put options issued by the Company as consideration for businesses acquired is classified as long-term debt until such time as the option is exercised or expires. Changes in the fair value of these options are recorded in earnings. As part of the negotiations of contingent consideration the former owners of certain companies acquired in 2001 agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2003 no put options are outstanding on the Company’s common shares.
3. Acquisitions
The Company’s strategic business plan includes the regular and systematic evaluation and acquisition of insurance brokerages in new and existing markets. Insurance brokerages, due to their nature, typically maintain a very low capital to earnings ratio. As a result, the Company recorded a substantial amount of goodwill and other intangible assets in connection with these acquisitions.
The Company typically pays a portion of the consideration for an acquired brokerage in cash. Consideration for the remainder of the purchase price is normally in the form of the Company’s common shares based on the fair market value of the Company’s common shares as traded on the NYSE or TSX, and is defined and calculated pursuant to the acquisition agreement.
(a)
During 2003, the Company acquired 9 insurance brokerages for total consideration of approximately $8,674, of which $8,136 was cash and the remainder of $538 in 32,000 common shares of the Company. These acquisitions were accounted for under the purchase method. The allocation of aggregate purchase prices to the fair value of the assets acquired was as follows: goodwill - $6,389, customer relationships - $1,352, non-competition covenants - $337, current assets - $4,298, capital assets - $24, current liabilities - $3,726.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 49
Of the goodwill acquired $1,367 is deductible for tax purposes. In addition the Company also recognized $1,800 of goodwill associated with contingent consideration relating to prior year acquisitions.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (“Flanagan”) total additional consideration of 37,500 of our common shares were earned at December 31, 2003 valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares have been recorded as “issuable shares” and included in shareholders’ equity and goodwill has been increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition we expect to issue non-cash stock based compensation in the form of 84,375 restricted share units in the first quarter of 2004. Half of these restricted share units will vest in 4 years and the balance will vest in 7 years.
(b)
During 2002, the Company purchased all of the issued and outstanding shares of Hooper Hayes & Associates, Inc. (Hooper Hayes), and Fifth Third Insurance Services, Inc. which was renamed Hub International of Indiana Limited (Hub Indiana), as well as outstanding shares or net assets of 6 other brokerages, all of which were acquired using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
In accordance with the purchase agreement, the former owners of Burnham Stewart Group, Inc. (Burnham), were entitled to additional consideration based upon certain acquired operations of Burnham achieving 2002 profitability targets. The additional consideration to be issued was a multiple of the final adjusted profitability as of December 31, 2002 for those operations. The total additional consideration was $22,166 of which $8,423 was cash and the remainder of $13,743 in 1,228 common shares of the Company. The Company issued the common shares in March 2003. As of December 31, 2002, the Company had accrued the cash portion of the contingent consideration and the share portion of the contingent consideration had been recorded as “issuable shares” and included in shareholders’ equity. As part of the negotiations of the contingent consideration, the former owners of Burnham agreed to relinquish their rights to put options on all of the 1,423 common shares issued as part of the 2002 acquisition, as well as on shares issued as contingent consideration in exchange for release from escrow provisions on those same common shares. The total additional consideration of $22,794 is shown as an addition to goodwill and customer relationships in the table below.
50 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2002 are summarized as follows:
Of the goodwill acquired, $30,522 is deductible for tax purposes.
(c)
During 2001, the Company purchased all of the issued and outstanding shares of Kaye, Burnham and Flanagan, as well as the outstanding shares or net assets of 13 other brokerages, all of which were acquired using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 51
The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2001 are summarized as follows:
Contingent consideration
In addition to the consideration shown above, the previous owners of certain other acquisitions are entitled to contingent consideration if certain revenue or profitability targets are met. See note 10 “Commitments and contingencies.”
4.
Accounts and other receivables
Accounts and other receivables consist of the following:
52 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Allowance for doubtful accounts:
Losses relating to the non-collection of client premium receivables, may be mitigated by cancellation of the underlying insurance policy.
5. Intangible assets
As of December 31, 2003 and 2002 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
Additions during 2003 and 2002 were as follows:
The Company is unable to estimate the useful life of certain non-competition covenants. These indefinite life intangible assets will be reviewed annually for impairment. Once a non-competition covenant is triggered, following the employee leaving the Company, the Company’s policy is to amortize the related intangible asset over the period of the remaining contractual obligation.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 53
The changes in the carrying amount of goodwill for the years ended December 31, 2003 and 2002, are as follows:
For the years ended December 31, 2003, 2002 and 2001, amortization has been comprised of the following:
The Company estimates the amortization charges for 2004 through 2008 for all acquisitions consummated to date will be:
6. Property and equipment
Included in computer equipment is computer software with a net book value of $5,137 and $2,641 at December 31, 2003 and 2002, respectively. Depreciation expense of $1,538, $1,087 and $621 was charged against these assets for the years ended December 31, 2003, 2002 and 2001, respectively.
During 2003 and 2002, property and equipment were acquired at an aggregate cost of $8,272 and $4,494, respectively, of which $2,147 and $25, respectively, were acquired by means of capital leases and other financing.
54 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
The cost above reflects certain property and equipment held under capital leases of which the remaining liability at December 31, 2003 and 2002 was $650 and $993, respectively.
7. Accounts payable and accrued liabilities
Accounts payable and accrued liabilities consist of the following:
8. Debt
Future repayments of long-term debt and capital leases are as follows:
(1)
Senior Notes - In June 2003, the Company, completed a private placement of $65 million in principal amount of unsecured senior notes. The senior notes were issued in two series. Series A represents $10 million of 5.71% senior notes with interest due semi-annually, and principal of $3,333 due annually, June 15, 2008 through June 15, 2010. Series B represents $55 million of 6.16% senior notes with interest due semi-annually, and principal of $11,000 due annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of the Company’s revolving U.S. Dollar LIBOR Loan with the balance held for general corporate purposes, which may include future acquisitions. The Company incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2003, $65 million was outstanding under these senior notes. The Company is in compliance with all financial covenants governing these notes.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 55
On July 16, 2003, the Company entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% and 6.16% on $10 million and $55 million, respectively, of the senior notes in order to ensure that the Company pays a market related interest rate on a portion of its borrowings. As at December 31, 2003, the Company estimated the fair value of the swap to be $2.6 million, which is not recognized in these financial statements. Accordingly, $2.6 million is the estimated amount that the Company would need to pay to terminate the swap as of December 31, 2003.
(2)
Revolving U.S. dollar LIBOR loan - This undrawn facility was renegotiated in December 2003, subject to completion of the definitive amended agreement. Under the new terms, the unsecured facility totals $50 million, bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR, which were 1.12% and 1.42% at December 31, 2003 and 2002, respectively. The facility is available on a revolving basis for one year and expires on December 13, 2004; however if the revolving period is not extended, the Company may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $NIL and $50 million at December 31, 2003 and 2002, respectively. The Company was in compliance with all financial covenants governing this facility as of December 31, 2003 and 2002.
(3)
Put Options - as discussed in note 3(a), the former owner of Flanagan has relinquished his right to put options on 730,000 commons shares of the Company. Accordingly, an amount of $5,940, previously classified as long-term debt, has been reclassed as share capital (see note 11).
(4)
This term loan is from an insurance carrier. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) which reduces the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Under this incentive arrangement, both the annual interest payments as well as the principal payment can be reduced to zero. Credits were earned for 2003 and 2002 which reduced interest payments to zero from $750 and $229, respectively.
(5)
Certain property and equipment have been pledged as collateral in amounts not less than the outstanding balance of the loan at December 31, 2003 and December 31, 2002, respectively.
Demand U.S. dollar base rate loan
The Company has an undrawn $9.3 million facility which expires on July 18, 2004 and bears interest at the bank’s U.S. base rate plus 50 basis points. Borrowings on the facility are repayable on demand.
Subordinated convertible debentures
In connection with the acquisition of Kaye on June 28, 2001, the Company issued $35 million aggregate principal amount, 8.5% convertible subordinated debentures (the Fairfax notes) due June 28, 2007 to certain subsidiaries of Fairfax Financial Holdings Limited (Fairfax). The Fairfax notes are convertible by the holders at any time into the Company’s common shares at C$17.00 per share. Beginning June 28, 2006, the Company may require conversion of the Fairfax notes into common shares at C$17.00 per share if, at any time, the weighted average closing price of the Company’s common shares on the TSX for twenty consecutive trading days equals or exceeds C$19.00 per share. If converted, Fairfax would have owned approximately 32% of the Company’s outstanding common shares as of December 31, 2003.
9. Defined Contribution Plan
Substantially all officers and employees of the Company in the United States are entitled to participate in a qualified retirement savings plan (defined contribution plan). The cost to the Company was $1,781, $1,425, and $648 for 2003, 2002 and 2001 respectively. Subsequent to year-end a defined contribution plan was put in place for Canadian employees.
56 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
10. Commitments and contingencies
(a)
The Company is committed under lease agreements for office premises and computer equipment. At December 31, 2003, aggregate minimum rental commitments (net of expected sub-lease receipts) under operating leases are as follows:
Rent expense for the year ended December 31, 2003, 2002, and 2001 amounted to $11,503, $9,684 and $7,665 respectively, net of sublease rental income of $1,282, $737 and $620 respectively.
(b)
In connection with the Company’s executive share purchase plan, under certain circumstances, the Company may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4,513 and $5,077 as of December 31, 2003 and 2002 respectively, to assist in purchasing common shares of the Company. The Company no longer makes loans to its executive officers and directors. As collateral, the employees have pledged 478,000 and 602,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $8,105 and $7,677 as of December 31, 2003 and 2002, respectively. Interest on the loans in the amount of $279, $264 and $377 for the years ended December 31, 2003, 2002 and 2001, respectively, was paid by the Company and is included in compensation expense.
(c)
On December 24, 2003 executive management profitability bonuses were restructured. Under the new agreement, the stock option component of the annual bonus was eliminated in exchange for restricted share units to be issued in the first quarter of 2004. Management has estimated that approximately $16.9 million of restricted share units will be issued. These restricted share units will all vest on January 1, 2011 subject to continued employment. Hub’s policy is to expense the fair value of non-cash stock based compensation evenly over the period they are earned. Non-cash stock based compensation expense related to the 2003 bonuses was $1,405 and is included in non-cash stock based compensation.
(d)
In connection with the acquisition of Hooper Hayes and Associates, Inc., in 2002 the Company issued 196,000 shares (the “Retractable Shares”) that are being held in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2003, 63,000 shares have been released from escrow.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (“Flanagan”) total additional consideration of 37,500 of our common shares were earned at December 31, 2003 valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares have been recorded as “issuable shares” and included in shareholders’ equity and goodwill has been increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition we expect to issue non-cash stock based compensation in the form of 84,375 restricted share units in the first quarter of 2004. Half of these restricted share units will vest in 4 years and the balance will vest in 7 years.
In connection with other various acquisitions completed through December 31, 2003, the Company may be obligated to pay contingent consideration up to a maximum sum of approximately $8.2 million cash and $0.2 million in common shares based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through September, 2006 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2003, the
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 57
financial statements reflect a liability to pay cash of $71 and to issue common shares valued at approximately $635 as of December 31, 2003.
(e)
In the ordinary course of business, the Company and its subsidiaries are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on the consolidated financial position or results of operations of the Company.
11. Shareholders’ equity
Share capital
At December 31, 2003 and 2002, there were an unlimited number of non-voting, preferred shares authorized, issuable in series on such terms and conditions as set by the Board of Directors, of which no shares were issued. At December 31, 2003 and 2002, there were an unlimited number of common shares authorized, of which 30,143 and 29,025 were issued and outstanding as at December 31, 2003 and December 31, 2002 respectively.
58 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Issuable shares
Contributed surplus
Cumulative translation account
12. Equity Incentive Plan
On February 28, 2003, the Company issued options exercisable for 267,000 common shares at an exercise price of $13.79 per share, the U.S. dollar equivalent of the closing sales price of the Company’s common shares on the TSX on that date. The maximum option term is seven years, and the options vest as to one-third per year over three years of continuous employment. The number of common shares that may be issued under the Equity Incentive Plan is limited to 3,631,820 common shares.
A summary of the stock option activity and related information for the years ended December 31, 2003 and 2002 consists of the following (no stock options were issued prior to 2002):
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 59
The following table summarizes information about the stock options outstanding at December 31, 2003 and 2002:
The fair value of the stock options granted in 2003 was approximately $1.2 million (weighted average exercise price was $13.79 per share). The aggregate fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions for the options issued in 2003:
Non-cash stock based compensation related to stock options of $2,309 and $1,089 for the year ended December 31, 2003 and 2002, respectively, was expensed with offsetting credits to contributed surplus.
Shares derived from the options are held in escrow and subject to transfer restrictions for the period of five years from the date the options are granted, subject to early release in certain circumstances.
On June 30, 2003, the Company awarded 605,000 restricted share units to employees of the Company. The restricted share units are exercisable for common shares without payment of cash consideration and vest over periods ranging from 68 months to 95 months. In addition, in December 2003, the Company agreed to award approximately $16.9 million of restricted share units in connection with the restructure of executive management profitability bonuses - see note 10(c).
Non-cash stock based compensation for the year ended December 31, 2003 and 2002 is comprised of the following:
13. Fair value of financial instruments
The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts and other receivables, accounts payable and accrued liabilities at December 31, 2003 and 2002, approximate fair value because of the short -term nature of these instruments. The carrying value of the Company’s variable rate debt at December 31, 2003 and 2002, of $385 and $50,587 respectively, approximates fair market value.
In connection with the acquisition of Kaye in 2001, the Company issued 8.5% subordinated convertible debentures due June 28, 2007 with a carrying amount and aggregate principal of $35 million. These debentures remain
60 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
outstanding at December 31, 2003. The Company believes it is not practicable to estimate the fair value of its subordinated convertible debentures due to the conversion features.
The carrying values of long-term debt approximate fair values.
14. Income taxes
Income taxes for 2003, 2002 and 2001, amounted to $18.9 million, $14.3 million and $5.3 million, respectively, resulting in an effective tax rate of 34%, 33% and 34% in 2003, 2002, and 2001, respectively.
The provision for income tax expense differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 36.62%, 38.62% and 41.7% in 2003, 2002 and 2001, respectively, as follows:
The components of the future tax assets and liabilities at December 31, 2003 and 2002, were as follows:
The Company has net operating loss carryforwards of $13,970 at December 31, 2003 that expire 2008 through 2010 resulting in a future tax asset of $2,724. In addition, the Company has state net operating loss carryforwards in the U.S. of approximately $3,610 which expire 2019 through 2023 resulting in a future tax asset of $171. Such net operating losses are currently available to offset certain future state and local taxable income.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 61
15. Interest and income taxes paid
Interest and income taxes paid for the years ending December 31 were:
16. Segmented information
The Company is an international insurance brokerage, which provides a variety of property, casualty, life and health, employee benefits, investment and risk management products and services. In addition to its Corporate Operations, the Company has identified two operating segments within its insurance brokerage business: Canadian Operations and U.S. Operations. Corporate Operations consist primarily of investment income, unallocated administrative costs, interest expense and the income tax expense or benefit which is not allocated to the Company’s operating segments. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends.
62 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2003, 2002 and 2001 is as follows:
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 63
17. Related party transactions
The Company had transactions with, and recorded revenue from, the following related parties:
As of December 31, 2003 and 2002, the Company had accounts receivable and accounts payable balances with the above related parties in the amounts of $3,185 and $17,999, for 2003, respectively, and $2,104 and $12,180 for 2002, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in
64 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
the normal course of business. The companies above are related through common ownership by Fairfax, which owns approximately 26% of the Company’s common shares as of December 31, 2003.
As of December 31, 2003 and 2002, long-term debt related to put options of $NIL and $5,940, respectively, and subordinated convertible debentures of $35,000 at the end of both years, are due to related parties.
During 2003, 2002 and 2001, the Company incurred expenses related to rental of premises from related parties in the amount of $2,102, $1,691 and $1,373, respectively. At December 31, 2003 and 2002, the Company also had accounts receivable due from related parties in the amount of $3,530 and $3,801, respectively, of which the majority were loans to employees to enable them to purchase shares of the Company. Of these accounts receivable, as of December 31, 2003 and 2002, $1,918 and $2,207, respectively, were related to Company loans to employees to purchase shares under the executive share purchase plan. As collateral, the employees have pledged 153,000 and 177,000 common shares as of December 31, 2003 and 2002, respectively, which have a market value of $2,590 and $2,263 as of December 31, 2003 and 2002, respectively.
18. Reconciliation to U.S. GAAP
The consolidated financial statements have been prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP.
Net earnings and comprehensive income
The table below presents the differences between Canadian and U.S. GAAP affecting net earnings and comprehensive income for the years ending December 31, 2003, 2002 and 2001.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 65
Shareholders’ equity
The table below sets out the differences between Canadian GAAP and U.S. GAAP that affect shareholders’ equity at December 31, 2003 and 2002:
Notes:
(1)
Under Canadian GAAP, Old Lyme was recorded as an investment held for sale at its cost, which was equivalent to its fair value, of $40,938 on June 28, 2001. No further adjustments were made to the carrying value of the investment until Old Lyme was sold on May 30, 2002, when the Company recorded a gain of $2,613, equal to the difference between the sale proceeds (which were agreed to be its net asset value under U.S. GAAP as of December 31, 2001 plus interest at 4% per annum from December 31, 2001 until closing) and its carrying value. Interest on debt financing the purchase of Old Lyme was charged to income as it accrued.
Under U.S. GAAP, Old Lyme was recorded as an investment held for sale at its fair value of $40,938. Between acquisition and completion of the sale the carrying value of the investment was adjusted for increases in fair value due to changes in its U.S. GAAP net asset value and interest accretion. Such adjustments were reflected as changes in goodwill arising on the Kaye acquisition. Interest on debt financing the purchase of Old Lyme was debited to the carrying value of the investment and did not impact earnings. The difference between the carrying value of the investment as of the date of completion of the sale and the sale proceeds was reflected as an adjustment to goodwill arising on the Kaye acquisition and accordingly no gain or loss was recorded in income.
The impact of the above noted Canadian and U.S. GAAP differences on earnings were as follows:
(2)
Under U.S. GAAP, historical financial statements are translated using a different exchange rate, which: for assets and liabilities is the exchange rate at the balance sheet date; for the income statement is the average exchange rate for the period; and for the share capital accounts is the historical exchange rate.
The aggregate impact of these differences has been presented in the reconciliation of shareholders’ equity for Canadian to U.S. GAAP under the caption “cumulative translation account.”
(3)
Under Canadian GAAP, the fair value of the put options (determined using the Black-Scholes model) issued in connection with certain 2001 acquisitions was allocated to equity instruments on the balance sheet. The balance of the purchase price was allocated to debt. Changes in the value of the put options in periods subsequent to the acquisition date are included in earnings. Under U.S. GAAP prior to July 1, 2003, the fair value of the share consideration and the attached put options was initially recorded in equity and the redemption value of the shares to which the put options are attached was reclassified as mezzanine equity
66 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
outside of shareholders’ equity as a result of the put options granted on those shares to certain of the selling shareholders. On July 1, 2003, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement requires that an issuer classify financial instruments meeting certain criteria as liabilities (or assets in some circumstances) rather than equity. As a result of the adoption of this new standard, the Company changed its accounting policy with respect to the financial instruments issued in connection with certain 2001 acquisitions. Effective July 1, 2003, the Company remeasured the fair value of the put options (using the Black-Scholes model) and classified this amount as liability. Amounts previously classified as mezzanine equity were reclassified as shareholders’ equity. The difference between the estimated fair value of the put options as at July 1, 2003 and May 31, 2001 was reported as a cumulative adjustment to net earnings under U.S. GAAP. Comparative financial statements were not restated. Under U.S. GAAP, changes in the estimated fair value of the put options are included in earnings.
Also under U.S. GAAP, the fair value of the put options at the date of issuance was also recorded as a debit and credit to shareholders’ equity, representing an unearned compensation expense, as the put options require the selling shareholders to remain employed by the Company in order to be able to exercise the put options. Compensation expense is being recognized using the straight-line method over the period from the issue date to the exercise date.
As part of the negotiations of contingent consideration the former owners of certain 2001 acquisitions agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2003 no put options were outstanding on our common shares.
(4)
The condensed consolidated statements of earnings and cash flows for the years ended December 31, 2003, 2002 and 2001 and the condensed consolidated balance sheets as at December 31, 2003 and 2002, under U.S. GAAP are as follows:
(5)
Under U.S. GAAP, comprehensive income is measured in accordance with SFAS No. 130, Reporting Comprehensive Income. This standard defines comprehensive income as all changes in equity other than those resulting from investments by owners and distributions to owners and includes the change in unrealized gains (losses) on debt and equity securities and foreign currency translation adjustments. Under Canadian GAAP unrealized gains and losses (arising from a temporary decline in value) on equity securities are not recorded and foreign currency translation adjustments are presented as movements in the cumulative translation account. Certain disclosures required by SFAS 115, Accounting for Certain Investments in Debt and Equity Securities,
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 67
have not been included as such disclosures related to the Company’s investments in debt and equity securities are immaterial to the overall financial statement presentation.
(6)
Under Canadian GAAP, the Company accounts for the interest rate swap transaction which converted fixed rate interest payments of 5.71% and 6.16% on the Senior Notes of $10 million and $55 million, respectively, using the synthetic instruments method. Under this method, the Company reports in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.6 million, is not recognized in the Company’s Canadian GAAP financial statements. Under U.S. GAAP, the Company has designated the swap transaction of a hedge of changes in the fair value of its fixed rate debt caused by changes in interest rates. Under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, the Company records the swap on its U.S. GAAP balance sheet at its fair value. Changes in fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt.
Effects of New Accounting Pronouncements
The Company is not aware of any new accounting pronouncements which will impact on its financial reporting.
19. Quarterly Data (unaudited)
20. Subsequent event
In the first quarter of 2004 certain of the Company’s subsidiaries changed their names and as a result, the Company will recognize a non-cash impairment expense of approximately $2.6 million before tax related to trademarks.
68 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Under SEC rules, we are required to maintain disclosure controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Our chief executive officer and chief financial officer conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) and 15d-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act) as of December 31, 2003 (the Evaluation Date). Based on that evaluation, our chief executive officer and chief financial officer concluded that as of the Evaluation Date, our disclosure controls and procedures were effective in timely alerting them to material information relating to us required to be disclosed in our reports filed or submitted under the Exchange Act. In addition, there have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in the design or operation of our internal control over financial reporting or in other factors that could significantly affect our internal control over financial reporting during the fourth quarter of 2003. Notwithstanding the foregoing, there can be no assurance that our disclosure controls and procedures will detect or uncover all failures within our company to disclose all material information otherwise required to be set forth in our periodic reports.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information regarding directors, nominees for directors and executive officers is included under the caption entitled “Election of Directors” and “Management” in the 2004 Proxy Statement and is incorporated herein by reference.
Item 11.
Item 11.
Executive Compensation
Information regarding executive compensation of directors and executive officers is included in the 2004 Proxy Statement under the caption entitled “Executive Compensation and Related Information” and is incorporated herein by reference.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management
Information regarding beneficial ownership of the common shares by certain beneficial owners and by management is included under the caption entitled “Security Ownership of Management and Certain Beneficial Holders” in the 2004 Proxy Statement and is incorporated herein by reference.
Item 13.
Item 13.
Certain Relationships and Related Transactions
Information regarding certain relationships and related transactions is included under the caption entitled “Certain Relationships and Related Transactions” in the 2004 Proxy Statement and is incorporated herein by reference.
Item 14.
Item 14.
Principal Accountant Fees and Services
Information regarding principal accountant fees and services is included under the caption entitled “Principal Accountant Fees and Services” in the 2004 Proxy Statement and is incorporated herein by reference.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 69
PART IV
Item 15.
Item 15.
Exhibits, Financial Statements Schedules and Reports on Form 8-K
(a)(1) Financial Statements
Reference is made to the information set forth in Part II, Item 8 of this report, which information is incorporated herein by reference.
(a)(2) Exhibits
The exhibits to this report are listed in (c) below. Each exhibit listed therein which constitutes a management contract or compensatory plan or arrangement is identified with the symbol (*).
(b) Reports on Form 8-K
We filed a Current Report on Form 8-K on October 30, 2003 to furnish a press release under Item 9 and Item 12 announcing the Company’s third quarter 2003 financial results.
(c) Exhibits
70 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003

Incorporated herein by reference to the registrant’s Registration Statement on Form S-1 (No. 333-84734), as filed with the Securities and Exchange Commission (the “Commission”) on March 22, 2002.
*
Management contract or compensatory plan or arrangement.
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 71
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 15, 2004.
Hub International Limited
Martin P. Hughes
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on March 15, 2004.
SIGNATURE
TITLE
/s/ MARTIN P. HUGHES
Martin P. Hughes
Chairman of the Board and Chief Executive Officer (Principal Executive Officer)
/s/ DENNIS J. PAULS
Dennis J. Pauls
Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
/s/ RICHARD A. GULLIVER
Richard A. Gulliver
President, Director
/s/ R. CRAIG BARTON
R. Craig Barton
President, Canadian Operations, Director
/s/ BRUCE GUTHART
Bruce Guthart
Chief Operating Officer and President, U.S. Operations, Director
/s/ JEAN MARTIN
Jean Martin
Director, Vice President
/s/ ANTHONY GRIFFITHS
Anthony Griffiths
Director
/s/ BRADLEY MARTIN
Bradley Martin
Director
/s/ PAUL MURRAY
Paul Murray
Director
/s/ FRANK WILKINSON
Frank Wilkinson
Director
72 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003
EXHIBIT INDEX
ANNUAL REPORT December 31, 2003 HUB INTERNATIONAL LIMITED 73

Incorporated herein by reference to the registrant’s Registration Statement on Form S-1 (No. 333-84734), as filed with the Securities and Exchange Commission (the “Commission”) on March 22, 2002.
*
Management contract or compensatory plan or arrangement.
74 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2003