SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to section 13 or 15 (d) of the Securities
Exchange Act of 1934 for the quarterly period ended March 31, 2003 or
--------------
[ ] Transition report pursuant to section 13 or 15 (d) of the Securities
Exchange Act of 1934 for the transition period from_____________
to___________
Commission File Number 1-9761
ARTHUR J. GALLAGHER & CO.
--------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 36-2151613
--------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Two Pierce Place, Itasca, Illinois 60143-3141
--------------------------------------------------------------------------------
(Address of principal executive offices) (Zip code)
(630) 773-3800
--------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
--------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES [X] NO [ ]
The number of outstanding shares of the registrant's Common Stock, $1.00 par
value, as of April 30, 2003 was 90,066,153
Arthur J. Gallagher & Co.
Index
Page No.
Part I. Financial Information:
Item 1. Financial Statements (Unaudited):
Consolidated Statement of Earnings for the three-month
periods ended March 31, 2003 and 2002 ................................ 3
Consolidated Balance Sheet at March 31, 2003 and
December 31, 2002 .................................................... 4
Consolidated Statement of Cash Flows for the three-month
periods ended March 31, 2003 and 2002 ................................ 5
Notes to Consolidated Financial Statements .............................. 6-17
Independent Accountant's Review Report .................................. 18
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ............................................... 19-28
Item 3. Quantitative and Qualitative Disclosure About Market Risk ............... 28-29
Item 4. Controls and Procedures ................................................. 29
Part II. Other Information:
Item 2. Changes in Securities ................................................... 30
Item 6. Exhibits and Reports on Form 8-K ........................................ 30
Signatures ...................................................................... 31
Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 ........ 32-33
- 2 -
Part I - Financial Information
Item 1. Financial Statements (Unaudited)
Arthur J. Gallagher & Co.
Consolidated Statement of Earnings
(Unaudited - in millions, except per share data)
Three-month period ended
March 31,
------------------------
2003 2002
------ ------
Commissions $168.6 $143.1
Fees 104.2 89.9
Investment income - fiduciary funds 2.0 1.9
Investment income - all other 15.3 15.7
Investment losses (25.7) (1.4)
------ ------
Gross revenues 264.4 249.2
Less brokerage (10.1) (10.2)
------ ------
Total revenues 254.3 239.0
------ ------
Compensation 157.0 131.8
Other operating 62.8 49.8
Depreciation 5.3 4.6
Amortization 2.1 1.2
Investment expenses 11.3 2.8
------ ------
Total expenses 238.5 190.2
------ ------
Earnings before income taxes 15.8 48.8
Provision for income taxes 3.9 15.1
------ ------
Net earnings $ 11.9 $ 33.7
====== ======
Basic net earnings per share $ .13 $ .39
Diluted net earnings per share .13 .37
Dividends declared per common share .18 .15
See notes to consolidated financial statements.
- 3 -
Arthur J. Gallagher & Co.
Consolidated Balance Sheet
(Unaudited - in millions)
March 31, December 31,
2003 2002
--------- ------------
Cash and cash equivalents $ 165.1 $ 152.6
Restricted cash 250.6 256.3
Trading securities 55.6 58.2
Investments - current 41.1 37.9
Premiums and fees receivable 1,213.6 1,183.7
Other current assets 78.5 84.9
-------- --------
Total current assets 1,804.5 1,773.6
Investments - long-term 142.2 168.4
Fixed assets related to consolidated investments-net 189.2 185.4
Other fixed assets - net 64.6 65.6
Deferred income taxes 102.3 102.4
Other noncurrent assets 36.2 33.1
Goodwill - net 98.5 84.2
Amortizable intangible assets - net 54.9 50.9
-------- --------
Total assets $2,492.4 $2,463.6
======== ========
Premiums payable to insurance and reinsurance companies $1,543.4 $1,488.2
Accrued compensation and other accrued liabilities 144.6 165.7
Unearned fees 23.0 19.4
Income taxes payable 2.1 11.0
Other current liabilities 20.7 17.5
Corporate related borrowings - 25.0
Consolidated investments related borrowings - current 25.5 22.8
-------- --------
Total current liabilities 1,759.3 1,749.6
Consolidated investments related borrowings -long-term 127.5 128.3
Other noncurrent liabilities 60.8 57.5
Stockholders' equity:
Common stock - issued and outstanding 89.9 million shares in 2003 and
88.5 million shares in 2002 89.9 88.5
Capital in excess of par value 123.5 92.7
Retained earnings 356.7 361.0
Unearned deferred compensation (10.8) (6.5)
Unearned restricted stock (14.5) (7.5)
-------- --------
Total stockholders' equity 544.8 528.2
-------- --------
Total liabilities and stockholders' equity $2,492.4 $2,463.6
======== ========
See notes to consolidated financial statements.
- 4 -
Arthur J. Gallagher & Co.
Consolidated Statement of Cash Flows
(Unaudited - in millions)
Three-month period ended
March 31,
------------------------
2003 2002
------- -------
Cash flows from operating activities:
Net earnings $ 11.9 $ 33.7
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Net loss on investments and other 26.5 0.5
Gain on sales of operations (2.5) (2.5)
Depreciation and amortization 9.3 6.7
Decrease (increase) in restricted cash 5.7 (37.3)
(Increase) decrease in premiums receivable (19.7) 32.8
Increase (decrease) in premiums payable 51.8 (14.5)
Decrease in trading securities - net 1.9 -
Decrease in other current assets 3.2 0.4
(Decrease) increase in accrued compensation and other accrued liabilities (22.8) 5.2
Decrease in income taxes payable (9.0) (16.3)
Tax benefit from issuance of common stock 2.1 3.9
Net change in deferred income taxes 0.2 -
Other (0.3) (1.3)
------ ------
Net cash provided by operating activities 58.3 11.3
------ ------
Cash flows from investing activities:
Purchases of marketable securities - (3.5)
Proceeds from sales of marketable securities - 3.3
Proceeds from maturities of marketable securities - 1.3
Net additions to fixed assets (9.9) (11.2)
Cash paid for acquisitions, net of cash acquired 0.3 (3.6)
Proceeds from sales of operations 2.5 2.5
Other 0.1 (6.6)
------ ------
Net cash used by investing activities (7.0) (17.8)
------ ------
Cash flows from financing activities:
Proceeds from issuance of common stock 3.4 3.9
Repurchases of common stock (5.8) -
Dividends paid (13.3) (11.1)
Borrowings on line of credit facilities 2.7 151.5
Repayments on line of credit facilities (25.0) (133.0)
Repayments of long-term debt (0.8) (0.1)
------ ------
Net cash (used) provided by financing activities (38.8) 11.2
------ ------
Net incease in cash and cash equivalents 12.5 4.7
Cash and cash equivalents at beginning of period 152.6 98.5
------ ------
Cash and cash equivalents at end of period $165.1 $103.2
====== ======
Supplemental disclosures of cash flow information:
Interest paid $ 2.4 $ 2.2
Income taxes paid 9.6 26.4
See notes to consolidated financial statements.
- 5 -
Notes To Consolidated Financial Statements (Unaudited)
1. Nature of Operations and Basis of Presentation
Arthur J. Gallagher & Co. (Gallagher) provides insurance brokerage and risk
management services to a wide variety of commercial, industrial, institutional
and governmental organizations. Commission revenue is principally generated
through the negotiation and placement of insurance for its clients. Fee revenue
is primarily generated by providing other risk management services including
claims management, information management, risk control services and appraisals
in either the property/casualty (P/C) market or human resource/employee benefit
market. Investment income and other revenue is generated from Gallagher's
investment portfolio, which includes fiduciary funds, equity securities, and tax
advantaged and other strategic investments. Gallagher is headquartered in
Itasca, Illinois, has operations in seven countries and does business in more
than 100 countries around the world through a network of correspondent brokers
and consultants.
The accompanying unaudited consolidated financial statements have been prepared
by Gallagher pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and footnote disclosures normally
included in annual financial statements have been omitted pursuant to such rules
and regulations. Gallagher believes the disclosures are adequate to make the
information presented not misleading. The unaudited consolidated financial
statements included herein are, in the opinion of management, prepared on a
basis consistent with the audited consolidated financial statements for the year
ended December 31, 2002 and include all adjustments (consisting only of normal
recurring adjustments) necessary for a fair presentation of the information set
forth. As discussed in Note 3 to the consolidated financial statements, certain
reclassifications have been made to the consolidated financial statements to
conform to the current year's presentation. The quarterly results of operations
are not necessarily indicative of results of operations for subsequent quarters
or the full year. These unaudited consolidated financial statements should be
read in conjunction with the audited consolidated financial statements and the
notes thereto included in Gallagher's Annual Report on Form 10-K for the year
ended December 31, 2002.
2. Effect of New Pronouncements
Guarantees - In November 2002, the Financial Accounting Standards Board (FASB)
issued FASB Interpretation No. 45 (Interpretation 45), "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others," which will significantly change current practice in the
accounting for, and disclosure of, guarantees. Interpretation 45 requires
certain guarantees to initially be recorded at fair value, which is different
from the current practice of recording a liability only when a loss is probable
and estimable, as those terms are defined in Statement of Financial Accounting
Standards No. 5, "Accounting for Contingencies." Interpretation 45 also requires
a guarantor to make significant new disclosures, even when the likelihood of
making any payments under the guarantee is remote, which is also a change from
general current practice.
The Interpretation's disclosure requirements are effective for all guarantees,
regardless of the initiation date, for financial statements of interim or annual
periods ending after December 15, 2002, while the initial recognition and
initial measurement provisions are applicable on a prospective basis to
guarantees issued, renewed or modified after December 31, 2002. Gallagher
implemented the disclosure requirements of Interpretation 45 in 2002, which was
presented in Gallagher's Annual Report on Form 10-K for the year ended
December 31, 2002. Gallagher evaluated one letter of credit pursuant to
Interpretation 45 during the first quarter of 2003 and the impact was
immaterial. Gallagher will evaluate all new or renewing guarantees each quarter
to determine the impact on Gallagher's consolidated financial statements. The
adoption of Interpretation 45 could have a material effect on Gallagher's
consolidated operating results and/or financial position. See Notes 4 and 10 to
the consolidated financial statements.
- 6 -
Consolidation of Partially-Owned Entities - In January 2003, the FASB issued
FASB Interpretation No. 46 (Interpretation 46), "Consolidation of Variable
Interest Entities." Interpretation 46 defines a variable interest entity (VIE)
as a corporation, partnership, trust, or any other legal structure used for
business purposes that either (a) does not have equity investors with voting
rights or (b) has equity investors that do not provide sufficient financial
resources for the entity to support its own activities.
Prior to Interpretation 46, a partially owned entity was only consolidated into
the investor company's consolidated financial statements if it was controlled by
the investor company through voting interests. Regardless of voting interests,
Interpretation 46 requires a VIE to be consolidated by an investor company if
that VIE's equity is less than 10% of its assets and the investor company is
subject to a majority of the risk of loss from the VIE's activities or entitled
to receive a majority of the VIE's residual returns or both. Interpretation 46
also requires disclosures about VIEs in circumstances where the investor company
is not required to consolidate but does have a significant variable interest.
The consolidation requirements of Interpretation 46 apply immediately to VIEs
created or invested in after January 31, 2003. The consolidation requirements
apply to entities created or invested in as of January 31, 2003 or earlier, in
the first fiscal year or interim period beginning after June 15, 2003. Certain
of the disclosure requirements apply in all financial statements issued after
January 31, 2003, regardless of when the VIE was established. Gallagher did not
create or invest in any new VIEs after January 31, 2003. Thus, the adoption of
Interpretation 46 did not have an impact on its consolidated financial
statements as of and for the three-month period ended March 31, 2003. However,
Gallagher has a number of investments it believes may be deemed to be VIEs.
These investments include qualified affordable housing and alternative energy
projects intended primarily to be income tax credit generators, a synthetic fuel
facility intended to produce both tax credits and pretax income, real estate
development projects intended to generate gains and venture capital investees
intended to generate equity income and realized gains. At March 31, 2003, assets
of these potential VIE investments totaled approximately $635.0 million in the
aggregate. Gallagher's maximum exposure to losses related to these investments
is $12.0 million including net book value, letters of credit, financial
guarantees and funding commitments. Management is currently evaluating the
impact Interpretation 46 will have on Gallagher's consolidated financial
statements. However, management anticipates that the adoption of Interpretation
46 will not have a material effect on Gallagher's consolidated net earnings or
stockholders' equity.
3. Reclassification of Previously Reported Financial Statements
Prior to 2003, commissions paid to sub-brokers on Gallagher's retail P/C
brokerage business were reported as other operating expenses in Gallagher's
consolidated statement of earnings. During 2003, Gallagher determined that it
would be appropriate to report these amounts as offsets to gross revenues in the
consolidated statement of earnings in order to conform to a more common industry
practice. Previously reported financial statements have been reclassified to
conform to this current year presentation and this reclassification had no
impact on the previously reported net earnings or stockholders' equity. The
impact on total revenues and expenses of this reclassification is presented in
the consolidated statement of earnings.
During the first quarter of 2003, Gallagher reviewed its historical segment
disclosures and determined that it would be appropriate to change how the
segment information is reported. Prior to 2003, Gallagher reported three
operating segments, brokerage, risk management and financial services, and a
corporate segment. For the 2003 segment disclosures, Gallagher has only reported
the three operating segments and has allocated the corporate balances to the
three operating segments. Allocations of investment income and certain expenses
are based on reasonable assumptions and estimates. Reported operating results by
segment would change if different methods were applied. Certain assets are not
individually identifiable by segment and, accordingly, have been allocated based
on formulas. Previously reported segment information has been reclassified to
conform to the current year's presentation.
In addition, certain reclassifications have been made to the prior year
consolidated financial statements in order to conform to the current year's
presentation.
- 7 -
4. Investments
Trading Securities - The following is a summary of Gallagher's trading
securities and the related outstanding letters of credit (LOCs), financial
guarantees and funding commitments.
March 31, 2003
------------------------
March 31, 2003 December 31, 2002 LOCs &
-------------------- ------------------- Financial Funding
Trading Securities (in millions): Current Long-term Current Long-term Guarantees Commitments
-------- --------- ------- --------- ---------- -----------
Managed directly $ 15.6 $ - $ 17.7 $ - $ - $ -
Managed by third parties 40.0 - 40.5 - - 6.5
-------- -------- ------- --------- --------- ----------
Total trading securities $ 55.6 $ - $ 58.2 $ - $ - $ 6.5
======== ======== ======= ========= ========= ==========
Trading Securities - Trading securities managed directly by Gallagher and by
third party managers consist primarily of common and preferred stocks and
corporate bonds. The trading securities managed by third parties are generally
structured through limited partnerships. All of the trading securities are
carried at fair value in the accompanying consolidated balance sheet, with
unrealized gains and losses included in the consolidated statement of earnings.
The fair value for these securities is primarily based on quoted market prices.
To the extent that quoted market prices are not available, fair value is
determined based on other relevant factors including dealer price quotations,
price quotations for similar instruments in different markets and pricing
models. Pricing models and their underlying assumptions impact the amount and
timing of unrealized gains and losses recognized. The use of different pricing
models or assumptions could produce different results.
The trading securities managed directly by Gallagher can generally be liquidated
in 30 days or less. The trading securities managed by third parties can
generally be liquidated between 60 and 360 days depending on the terms of the
partnership agreements.
Investments - The following is a summary of Gallagher's investments and the
related outstanding letters of credit (LOCs), financial guarantees and funding
commitments.
March 31, 2003
----------------------
March 31, 2003 December 31, 2002 LOCs &
----------------- ------------------ Financial Funding
Investments (in millions): Current Long-term Current Long-term Guarantees Commitments
------- --------- ------- --------- ---------- -----------
Asset Alliance Corporation (AAC)
related investments:
Direct and indirect investments in AAC $ 0.6 $ 46.7 $ - $ 46.7 $ 10.0 $ -
Investment guaranteed by AAC
- 9.3 - 9.1 - -
Low income housing investments:
Bridge loans 20.6 - 20.3 - - -
Partnership interests
Developer - 7.4 - 8.1 - -
- 7.6 - 7.6 - -
Shopping centers and other
commercial real estate - 6.7 - 7.3 5.0 -
Alternative energy investments:
Owned partnership interests 1.0 23.0 0.9 15.2 5.9 8.7
Partnership interest installment sales 18.9 21.9 15.0 24.3 - -
Bermuda insurance investments - 20.4 - 20.4 3.2 -
Venture capital investments:
Carrying value - 4.4 1.7 30.0 - -
Allowances for LOCs and commitments - (5.2) - (0.3) - -
------ -------- ------ ------ ------ -------
Total Investments $ 41.1 $ 142.2 $ 37.9 $168.4 $ 24.1 $ 8.7
====== ======== ====== ====== ====== =======
- 8 -
Asset Alliance Corporation (AAC) - Through various debt and common and preferred
stock holdings, Gallagher effectively owns 25% of AAC - a holding company that
generally owns 50% of 12 private investment management firms ("Firms"). At March
31, 2003, these Firms manage both domestic and international investment
portfolios totaling $3.5 billion for corporations, pension funds and
individuals. AAC has a proportional interest in the Firms' revenues which result
principally from fees and participation in investment returns from the managed
investment portfolios. Gallagher accounts for AAC using the equity method of
accounting.
Gallagher also guarantees a portion of AAC's debt. On April 15, 2003, AAC made
its regularly scheduled debt service payment thereby reducing Gallagher's
guarantee to $5.0 million. AAC is scheduled to make its final payment on the
underlying debt in June 2003 thereby releasing Gallagher's remaining guarantee.
During the fourth quarter 2002, one of the Firms, Beacon Hill Asset Management
LLC (Beacon Hill), withdrew from managing its portfolio as a result of various
legal, contractual and business issues leading AAC to write down its investment.
Gallagher recorded a $3.0 million pretax charge to reflect its proportional
loss. In the first quarter 2003, investors in Beacon Hill filed a lawsuit to
recover investment losses naming AAC as a co-defendant. Gallagher is unable to
estimate the impact, if any, this lawsuit may have on AAC and the resulting
impact on Gallagher's investment value.
Gallagher also has a $9.3 million investment in a fund that AAC guarantees as to
return and principal. Accrued interest and principal are due in December 2006.
Low Income Housing (LIH) Developments - Gallagher's investments in LIH consist
of three components:
Bridge Loans represent early-stage loans on properties that are mainly being
------------
developed to qualify for LIH tax credits. The loans are collateralized by the
land and buildings under development and carry market interest rates ranging
from 4.75% to 9.5% at March 31, 2003. The loans are generally outstanding for
12-24 months and accrue interest until the projects are refinanced by a
purchaser or syndicator. No loan has ever defaulted since Gallagher began making
these types of loans in 1996.
Partnership Interests represent Gallagher's ownership in completed and certified
---------------------
LIH developments. At March 31, 2003, Gallagher owned a limited partnership
interest in 24 LIH developments. These are generating tax benefits to Gallagher
on an ongoing basis in the form of both tax deductions for operating losses and
tax credits. These investments are generally accounted for using the effective
yield method and are carried at amortized cost. Under the effective yield
method, Gallagher recognizes the tax credits as they are allocated by the
partnerships, which are included, net of amortization of the investment, as a
component of the provision for income taxes. Gallagher has never had a loss on a
LIH project.
LIH Developer represents Gallagher's 30% ownership interest in the company that
-------------
is the developer and/or syndicator of most of Gallagher's LIH investments. The
LIH Developer generates revenues from syndication and development fees and its
equity is virtually all cash, cash producing real estate project receivables and
bridge loans. Gallagher accounts for this investment using the equity method of
accounting.
Shopping Centers & Other Commercial Real Estate - Gallagher has invested in
small land and property developments. They consist of two shopping centers each
anchored by Wal-Mart, a strip mall, a golf course under redevelopment, a loan
collateralized by investments in similar projects and three other very small
projects. None of these investments has a carrying value greater than $2.6
million. These investments are primarily limited partnership legal structures
and, as such, Gallagher uses the equity method of accounting.
As part of investing in certain commercial real estate partnerships, Gallagher
posts LOCs thereby allowing the partnership to obtain financing while the
project is being developed. At March 31, 2003, most of the $5.0 million
outstanding LOCs relates to the two parcels of land being developed for
Wal-Mart. Gallagher expects that half of the LOCs will be released in early 2004
and the other half in late 2004.
Alternative Energy Investments - Gallagher has made investments in partnerships
formed to develop energy that qualifies for tax credits under Internal Revenue
Code Section 29. There are two types of such investments:
- 9 -
Owned Partnership Interests consist of (i) waste-to-energy ("Biomass")
---------------------------
partnerships which own the rights to gas emissions ("Biogas") from landfills and
the wells and infrastructure necessary to capture the Biogas and (ii) synthetic
coal ("Syn/Coal") partnerships which own equipment that processes qualified fuel
under IRS Code Section 29. Gallagher has an interest in 6 Biomass limited
partnerships and 4 Syn/Coal limited partnerships or limited liability companies
which generate tax benefits to Gallagher on an on-going basis in the form of
both tax deductions for operating losses and tax credits. These investments are
primarily accounted for using the effective yield method and are carried at
amortized cost. Under the effective yield method, Gallagher recognizes the tax
credits as they are allocated by the partnerships, which are included, net of
amortization of the investment, as a component of the provision for income
taxes.
At March 31, 2003, LOCs and financial guarantees of $5.9 million relate to the
completion of a Biogas pipeline and the reclamation of a Syn/Coal property. The
$8.7 million funding commitment relates to a new Syn/Coal project and the Biogas
pipeline discussed above.
Partnership Installment Sales represent the remaining book value and receivables
-----------------------------
from the Biomass and Syn/Coal operations that have been sold to third parties.
Gallagher accounts for these investments on the installment sale basis, which
requires that the net gains, including the amortization of the bases of the
assets sold, be recognized over time as a component of investment income.
As part of selling its interests in Biomass and Syn/Coal partnerships, Gallagher
provided indemnifications to the buyers for taxes that may arise as a result of
incorrect representations. Gallagher obtained legal, tax, and other expert
services and advice when making these representations, and in certain
circumstances, subsequently obtained private letter rulings from the IRS. At
March 31, 2003, the maximum potential amount of future payments that Gallagher
could be required to make under these indemnifications totaled approximately $84
million, net of the applicable income tax benefit. Gallagher has not recorded
any contingent liability for these potential indemnifications and believes the
likelihood of the occurrence of events that would trigger payments under these
contracts to be remote.
Bermuda Insurance Investments - These investments consist primarily of a $20
million equity investment (less than 2%) in Allied World Assurance Holdings,
Ltd. which is a Bermuda based insurance and reinsurance company founded in 2001
by American International Group, Inc., The Chubb Corporation and affiliates of
Goldman, Sachs & Co. This investment is carried at its original cost.
The remaining balance of $0.4 million is Gallagher's minority interest in a
rent-a-captive facility, formed in 1997, that Gallagher uses as a placement
facility for its insurance brokerage operations. This investment is carried at
its original cost. Gallagher has posted a $3.2 million LOC to allow the
rent-a-captive to meet minimum statutory surplus requirements. This LOC has
never been drawn upon.
Venture Capital - At March 31, 2003, Gallagher's remaining venture capital
investments consisted of various debt and equity investments in
development-stage companies and turn-arounds, none of which is individually
significant. At March 31, 2003, an allowance had been established for all LOCs,
financial guarantees and funding commitments related to these investments.
- 10 -
Consolidated Investments - Gallagher has an ownership interest in excess of 50%
in three investment enterprises: two real estate partnerships and an airplane
leasing limited liability company. One real estate partnership represents a 60%
investment in a limited partnership that owns the building that Gallagher leases
for its home office and several of its subsidiary operations. The other real
estate partnership represents an 80% investment in a limited partnership that is
developing an 11,000-acre residential community near Orlando, Florida. Gallagher
also owns 90% of an airplane leasing company that leases two cargo airplanes to
the French Postal Service. These three investments are consolidated into
Gallagher's consolidated financial statements because Gallagher's voting control
in each of these investments is greater than 50%. The following is a summary of
these consolidated investments (in millions):
March 31, 2003
-----------------------------
LOCs &
March 31, December 31, Financial Funding
2003 2002 Guarantees Commitments
------------- --------------- ------------ ---------------
Home office land and building:
Fixed assets $100.7 $ 100.4 $ - $ -
Accumulated depreciation (11.2) (10.6) - -
Non-recourse borrowings - current (0.7) (0.7) - -
Recourse borrowings - current - - - -
Non-recourse borrowings - noncurrent (74.6) (74.8) - -
Recourse borrowings - noncurrent (3.0) (3.0) - -
Net other consolidated assets and liabilities 1.1 0.7 - -
------------- --------------- ------------ ---------------
Net investment 12.3 12.0 - -
------------- --------------- ------------ ---------------
Florida residential development
Land and improvements:
Fixed assets 55.7 50.7 - -
Accumulated depreciation - - - -
Non-recourse borrowings - current (2.9) (2.9) - -
Recourse borrowings - current (19.7) (17.0) - -
Non-recourse borrowings - noncurrent (3.2) (3.3) - -
Recourse borrowings - noncurrent (12.4) (12.4) - -
Net other consolidated assets and liabilities (5.1) (2.0) 8.1 7.0
------------- --------------- ------------ ---------------
Net investment 12.4 13.1 8.1 7.0
------------- --------------- ------------ ---------------
Airplanes leased to the French Postal Service:
Fixed assets 51.8 51.8 - -
Accumulated depreciation (7.8) (6.9) - -
Non-recourse borrowings - current (2.2) (2.2) - -
Recourse borrowings - current - - - -
Non-recourse borrowings - noncurrent (34.3) (34.8) - -
Recourse borrowings - noncurrent - - - -
Net other consolidated assets and liabilities (2.7) 0.2 - -
------------- --------------- ------------ ---------------
Net investment 4.8 8.1 - -
------------- --------------- ------------ ---------------
Total consolidated investments:
Fixed assets 208.2 202.9 - -
Accumulated depreciation (19.0) (17.5) - -
Non-recourse borrowings - current (5.8) (5.8) - -
Recourse borrowings - current (19.7) (17.0) - -
Non-recourse borrowings - noncurrent (112.1) (112.9) - -
Recourse borrowings - noncurrent (15.4) (15.4) - -
Net other consolidated assets and liabilities (6.7) (1.1) 8.1 7.0
------------- --------------- ------------ ---------------
Net investment $ 29.5 $ 33.2 $8.1 $7.0
============= =============== ============ ===============
- 11 -
As shown in the above table, these consolidated investment enterprises have
borrowings related to their assets. In the case of the home office building and
the airplane leasing company, over 97% of the borrowings are collateralized
solely by the enterprises' underlying assets and are non-recourse to Gallagher's
other operations. In the case of the Florida residential development,
approximately 84% of the borrowings are recourse to Gallagher through LOCs and
written financial guarantees in the event the underlying assets are not
sufficient collateral. In addition, at March 31, 2003, with respect to the
Florida residential development, Gallagher had an $8.1 million written
guarantee, which was reduced to $2.5 million on April 27, 2003, and has verbally
committed to fund another $7.0 million of development costs.
At March 31, 2003, the maximum exposure to loss related to these investments is
as follows (in millions):
Net carrying value $ 29.5
Recourse portion of debt 35.1
LOCs, financial guarantees and funding commitments 15.1
-----
Maximum exposure $ 79.7
======
A summary of future cash payments, excluding interest, for borrowings of
Gallagher's consolidated investment enterprises follows (in millions):
Payments Due by Period
---------------------------------------------------------------------
Contractual Obligations 2003 2004 to 2005 2006 to 2007 Thereafter Total
--------------------------------------- --------------- ---------------- ---------------- ---------------- -----------------
Home office mortgage loan $ 0.5 $ 1.7 $ 2.0 $74.1 $ 78.3
Florida residential development
debt 7.8 18.0 - 12.4 38.2
Airplane leasing company debt 1.7 4.9 29.9 - 36.5
------------- ---------------- ---------------- ---------------- -----------------
Total contractual obligations $10.0 $24.6 $31.9 $86.5 $153.0
============= ================ ================ ================ =================
Impairment Reviews - Gallagher has a management investment committee that meets
10 to 12 times per year to evaluate its investments. For those investments that
are carried at fair value based on quoted market prices (principally trading
securities), the committee evaluates the source of quoted market prices. For
those investments that do not have quoted market prices, the committee
proactively looks for indicators of impairment. Factors, among others, that may
indicate that an impairment may exist, include defaults on interest and/or
principal payments, reductions or changes to dividend payments, sustained
operating losses or a trend of poor operating performance, recent refinancings
or recapitalizations, unfavorable press, untimely filing of financial
information, significant customer or revenue loss, litigation, tax audits,
losses by other companies in a similar industry, overall economic conditions,
management and expert advisor changes, and significant changes in strategy. In
addition, in cases where the ultimate value of an investment is directly
dependent on Gallagher for future financial support, the investment committee
discusses its willingness and intent to provide future funding.
If an indicator of impairment exists, Gallagher performs a process to compare
the investment's carrying value to an estimate of its fair value. To estimate
the fair value of loans, Gallagher discounts the expected future cash flows from
principal and interest payments. This requires Gallagher to exercise significant
judgment when estimating both the amount and the timing of the expected cash
flows. To estimate the fair value of common and preferred stock investments,
Gallagher looks at values established in recent recapitalizations or appraisals
conducted by third parties. In some cases, no such recapitalizations or
appraisals exist and Gallagher must perform its own valuations. This also
requires Gallagher to exercise significant judgment. Even if impairment
indicators exist, no write-down may be required if the estimated fair value is
not less than the current carrying value or the decline in value is deemed to be
temporary and Gallagher has the ability and intent to hold the investment for a
period of time sufficient for the value to recover. When Gallagher determines
that a write-down is required, it is recorded as a realized loss against current
period earnings.
- 12 -
Both the process to look for indicators of impairment and the method to compute
the amount of impairment incorporate quantitative data and qualitative criteria
including new information that can dramatically change the decision about the
valuation of an investment in a very short period of time. The determination of
whether a decline in fair value is other-than-temporary is necessarily a matter
of subjective judgment. The timing and amount of realized losses reported in
earnings could vary if management's conclusions were different.
During the first quarter 2003, Gallagher decided to withdraw virtually all
continued support for its venture capital investments, except to the limited
extent needed to realize value from the remaining assets. Without Gallagher's
support, it is doubtful that these operations will be able to execute their
business plans. Therefore, Gallagher's investments were deemed to be
other-than-temporarily impaired leading to a $25.7 million pretax charge.
Due to the nature of investments, they are subject to risk and therefore,
Gallagher cannot give assurance that there will not be further impairments in
the future should conditions change.
5. Business Combinations
During the three-month period ended March 31, 2003, Gallagher acquired
substantially all the net assets of the following insurance brokerage firms in
exchange for its common stock using the purchase accounting method for recording
business combinations (in millions except share data):
Common Recorded
Name and Effective Date of Shares Common Cash Escrow Purchase Contingent
Acquisitions Issued Share Value Paid Deposited Price Payable
--------------------------------- ---------- ------------- -------- ----------- ------------ ------------
(000s)
W. E. Kingsley Co. (KEWC)
January 1, 2003 101 $ 2.7 $ - $ 0.3 $ 3.0 $ -
McRory & Company (MRC)
January 1, 2003 54 1.4 - 0.2 1.6 -
Harman & McRory (HMRC)
January 1, 2003 49 1.3 - 0.1 1.4 -
Benefits Planning & Insurance
Agency, Inc. (BPI)
February 28, 2003 577 12.7 - 1.4 14.1 8.5
---------- ------------- -------- ----------- ------------ ------------
781 $18.1 $ - $ 2.0 $ 20.1 $ 8.5
========== ============= ======== =========== ============ ============
Common shares exchanged in connection with these acquisitions were valued at
closing market prices as of the effective date of the respective acquisition.
Escrow deposits that are returned to Gallagher as a result of purchase price
adjustment provisions are recorded as downward adjustments to goodwill when the
escrows are settled. The contingent payable that is disclosed in the foregoing
table represents the maximum amount of additional consideration that could be
paid per the purchase agreement. This contingent obligation is primarily based
upon future earnings of the acquired entity and is not included in the purchase
price that was recorded for this acquisition at the date of acquisition. Future
payments made under this arrangement will be recorded as upward adjustments to
goodwill when the contingencies are settled.
- 13 -
The following is a summary of the estimated fair values of the assets acquired
at the date of each acquisition based on preliminary purchase price allocations
(in millions):
KEWC MRC HMRC BPI Total
-------- ------- -------- -------- -----------
$ 3.1 $ 1.0 $ 0.5 $ 0.1 $ 4.7
Current assets
Fixed assets 0.1 - - - 0.1
Goodwill 1.2 1.1 1.0 11.8 15.1
Expiration lists 0.9 0.3 0.2 2.1 3.5
Non-compete agreements 0.4 0.1 0.1 1.0 1.6
-------- ------- -------- -------- -----------
Total assets acquired 5.7 2.5 1.8 15.0 25.0
Current liabilities 2.7 0.9 0.4 0.9 4.9
-------- ------- -------- -------- -----------
Total liabilities assumed 2.7 0.9 0.4 0.9 4.9
-------- ------- -------- -------- -----------
Total net assets acquired $ 3.0 $ 1.6 $ 1.4 $14.1 $ 20.1
======== ======= ======== ======== ===========
These acquisitions allow Gallagher to expand into desirable geographic
locations, further extend its presence in the retail and wholesale insurance
brokerage services industry and increase the volume of general services
currently provided. The excess of the purchase price over the estimated fair
value of the tangible net assets acquired at the acquisition date was allocated
within the Brokerage segment to goodwill, expiration lists and non-compete
agreements in the amounts of $15.1 million, $3.5 million and $1.6 million,
respectively. Purchase price allocations are preliminarily established at the
time of the acquisition and are subsequently reviewed within the first year of
operations to determine the necessity for allocation adjustments. Expiration
lists and non-compete agreements related to these acquisitions are currently
being amortized on a straight-line basis over a weighted average useful life of
15 years and 6 years, respectively. The $3.5 million of expiration lists and
$1.6 million of non-compete agreements related to the 2003 acquisitions are not
expected to be deductible for income tax purposes.
Gallagher's consolidated financial statements for the three-month period ended
March 31, 2003 include the operations of these companies from the date of their
respective acquisition. The following is a summary of the unaudited pro forma
historical results, as if these purchase acquisitions had been acquired at
January 1, 2002 (in millions, except per share data):
Three-month period ended
March 31,
-----------------------------
2003 2002
-------------- --------------
Total revenues $ 255.4 $ 251.9
Net earnings 11.9 33.6
Basic net earnings per share .13 .39
Diluted net earnings per share .13 .37
The unaudited pro forma results above have been prepared for comparative
purposes only and do not purport to be indicative of the results of operations
which actually would have resulted had the acquisitions occurred at January 1,
2002, nor is it necessarily indicative of future operating results.
- 14 -
6. Earnings Per Share
The following table sets forth the computation of basic and diluted net earnings
per share (in millions, except per share data):
Three-month period ended
March 31,
------------------------
2003 2002
---------- ---------
Net earnings $ 11.9 $ 33.7
======== ========
Weighted average number of common shares outstanding 88.8 85.4
Dilutive effect of stock options using the treasury stock method 3.5 5.2
-------- --------
Weighted average number of common and common equivalent
shares outstanding 92.3 90.6
======== ========
Basic net earnings per share $ .13 $ .39
Diluted net earnings per share .13 .37
Options to purchase 2.7 million and 0.1 million shares of common stock were
outstanding at March 31, 2003 and 2002, respectively, but were not included in
the computation of the dilutive effect of stock options for the three-month
period then ended. These options were excluded from the computation because the
options' exercise prices were greater than the average market price of the
common shares during the respective period and, therefore, would be antidilutive
to earnings per share under the treasury stock method.
7. Stock Option-Based Compensation
At March 31, 2003, Gallagher has four stock-based employee compensation plans,
which are described more fully in Note 10 to the consolidated financial
statements included in Gallagher's Annual Report on Form 10-K for the year ended
December 31, 2002. Gallagher primarily grants stock options for a fixed number
of shares to employees, with an exercise price equal to the fair value of the
underlying shares at the date of grant. Gallagher accounts for stock option
grants under the recognition and measurement principles of Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations and, accordingly, recognizes no compensation expense for these
stock options granted to employees. The following table illustrates the effect
on net earnings and net earnings per share if Gallagher had applied the fair
value recognition provisions of Statement of Financial Accounting Standards
Board No. 123 (SFAS 123), "Accounting for Stock-Based Compensation," to stock
option-based employee compensation (in millions, except per share data):
Three-month period ended
March 31,
------------------------
2003 2002
------- ------
Net earnings, as reported $ 11.9 $ 33.7
Deduct: Total stock option-based employee compensation
expense determined under fair value based method for
all awards, net of related tax effects (1.1) (0.9)
----- -----
Pro forma net earnings $ 10.8 $ 32.8
===== =====
Basic net earnings per share - pro forma $ .12 $ .38
Diluted net earnings per share - pro forma .12 .36
As presented in the table above, had Gallagher applied the fair value
recognition provisions of SFAS 123, diluted net earnings per share as reported
for both three-month periods ended March 31, 2003 and 2002 would have been
reduced by $.01. The pro forma disclosures above only include the effect of
options granted subsequent to January 1, 1995. Accordingly, the effects of
applying the SFAS 123 pro forma disclosures to future periods may not be
indicative of future effects.
- 15 -
8. Deferred Compensation
Gallagher has a Deferred Equity Participation Plan, which is a non-qualified
plan that provides for distributions to certain key executives of Gallagher upon
their normal retirement. Under the provisions of the plan, Gallagher contributes
shares of its common stock, in an amount approved by Gallagher's Board of
Directors, to a rabbi trust on behalf of the executives participating in the
plan. Distributions under the plan may not normally be made until the
participant reaches age 62 and are subject to forfeiture in the event of
voluntary termination of employment prior to age 62. All distributions from the
plan are made in the form of Gallagher's common stock.
Effective on March 31, 2003 and 2002, Gallagher contributed $4.4 million and
$4.0 million, respectively, to the plan through the issuance of 169,000 and
122,000 shares, respectively, of Gallagher's common stock. The Gallagher common
stock that is issued under the plan to the rabbi trust is valued at historical
cost (fair market value at the date of grant) and the unearned deferred
compensation obligation is classified as an equity instrument. The unearned
deferred compensation balance is shown as a reduction of stockholders' equity in
the accompanying consolidated balance sheet and is being amortized to
compensation expense ratably over the vesting period of the participants. Future
changes in the fair value of the Gallagher common stock that is owed to the
participants does not have any impact on Gallagher's consolidated financial
statements. During the three-month periods ended March 31, 2003 and 2002, $0.2
million and $0.1 million, respectively, was charged to compensation expense
related to this plan.
9. Restricted Stock Awards
Gallagher has an incentive compensation plan for several of its key executives
and management personnel. The compensation under this plan is determined by a
formula applied to the pretax profitability of certain operating divisions and
may include an equity award as part of such incentive compensation.
Effective on March 31, 2003 and 2002, Gallagher contributed 275,000 and 274,000
shares, respectively, of its common stock to the plan, with an aggregate fair
value of $7.2 million and $9.0 million, respectively, as of those dates. Also,
effective on March 31, 2003, Gallagher granted restricted stock awards of 27,000
shares in the aggregate of its common stock to its Chief Executive Officer and
one other Corporate Officer, with an aggregate fair value of $0.7 million as of
that date. Also, effective on March 31, 2002, Gallagher granted, to its Chief
Executive Officer, a restricted stock award of 32,000 shares of Gallagher common
stock with an aggregate fair value of $1.0 million as of that date. All of the
2003 restricted stock awards vest over a two-year period at the rate of 50% per
year beginning on March 31, 2004. All of the 2002 restricted stock awards vest
over a three-year period at the rate of 33 1/3% per year beginning on March 31,
2003. Gallagher accounts for restricted stock at historical cost, which equals
its fair market value at the date of grant. When restricted shares are issued,
an unearned restricted stock obligation is recorded as a reduction of
stockholders' equity, which will be ratably charged to compensation expense over
the vesting period of the participants. During the three-month period ended
March 31, 2003, $0.8 million was charged to compensation expense related to the
2002 awards. There were no amounts charged to compensation expense related to
the 2003 awards in the first quarter of 2003. In addition, there were no amounts
charged to compensation expense related to this incentive compensation plan in
the first quarter of 2002.
10. Commitments, Contingencies and Financial Guarantees
Gallagher generally operates in leased premises. Certain office space leases
have options permitting renewals for additional periods. For minimum aggregate
rental commitments at December 31, 2002, see Note 15 to the consolidated
financial statements included in Gallagher's Annual Report on Form 10-K for the
year ended December 31, 2002.
As more fully described in Note 4 to the consolidated financial statements, at
March 31, 2003, Gallagher had LOCs, financial guarantees and funding commitments
related to its trading securities, investments and consolidated investments.
At March 31, 2003, Gallagher had LOCs, financial guarantees and funding
commitments totaling $7.3 million (net of recorded liabilities of $3.2 million)
related to its brokerage and risk management services operations as more fully
described in Note 15 to the consolidated financial statements included in
Gallagher's Annual Report on Form 10-K for the year ended December 31, 2002.
- 16 -
Gallagher is engaged in various legal actions incident to the nature of its
business. Management is of the opinion that none of the litigation will have a
material effect on Gallagher's consolidated financial position or operating
results. Gallagher's financial services subsidiary is party to a lawsuit
relating to its investment in the synthetic fuel industry which, if determined
adversely to the subsidiary on substantially all claims and for a substantial
amount of the damages asserted, could have a material adverse effect on
Gallagher. However, Gallagher believes that the plaintiff's claims lack merit.
The subsidiary is vigorously defending such claims and has asserted
counterclaims against the plaintiff.
11. Segment Information
Gallagher has identified three operating segments: Brokerage, Risk Management
and Financial Services. The Brokerage segment represents three operating
divisions: Retail Brokerage Services, Wholesale Brokerage Services and Gallagher
Benefit Services The Brokerage segment, for commission or fee compensation,
places commercial property-casualty and employee benefit-related insurance on
behalf of its customers. The Risk Management segment provides P/C and health
claim third-party administration, loss control and risk management consulting
and insurance property appraisals. Third-party administration is principally the
management and processing of claims for self-insurance programs of Gallagher's
clients or clients of other brokers. The Financial Services segment is
responsible for managing Gallagher's diversified investment portfolio to
maximize long-term after-tax returns. Allocations of investment income and
certain expenses are based on reasonable assumptions and estimates. Reported
operating results by segment would change if different methods were applied.
Financial information relating to Gallagher's segments is as follows (in
millions):
Three-month period ended
March 31,
------------------------
2003 2002
------------ -----------
Brokerage
Total revenues $ 188.0 $ 154.7
========= ==========
Earnings before income taxes $ 26.8 $ 25.7
========= ==========
Identifiable assets at March 31, 2003 and 2002 $ 1,773.8 $ 1,521.0
========= ==========
Risk Management
Total revenues $ 76.7 $ 70.0
========= ==========
Earnings before income taxes $ 10.7 $ 11.6
========= ==========
Identifiable assets at March 31, 2003 and 2002 $ 84.5 $ 72.3
========= ==========
Financial Services
Total revenues $ (10.4) $ 14.3
========= ==========
Earnings (loss) before income taxes $ (21.7) $ 11.5
========= ==========
Identifiable assets at March 31, 2003 and 2002 $ 634.1 $ 579.3
========= ==========
- 17 -
Review by Independent Auditors
The consolidated financial statements at March 31, 2003 and for the three-month
periods ended March 31, 2003 and 2002 have been reviewed, prior to filing, by
Ernst & Young LLP, Gallagher's independent auditors, and their report is
included herein.
Independent Accountants' Review Report
Board of Directors and Stockholders
Arthur J. Gallagher & Co.
We have reviewed the accompanying consolidated balance sheet of Arthur J.
Gallagher & Co. as of March 31, 2003 and the related consolidated statement of
earnings for the three-month periods ended March 31, 2003 and 2002, and the
consolidated statement of cash flows for the three-month periods ended March 31,
2003 and 2002. These financial statements are the responsibility of Gallagher's
management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data, and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States,
which will be performed for the full year with the objective of expressing an
opinion regarding the financial statements taken as a whole. Accordingly, we do
not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to the accompanying consolidated financial statements referred to above
for them to be in conformity with accounting principles generally accepted in
the United States.
/s/ Ernst & Young LLP
------------------------------------
Ernst & Young LLP
Chicago, Illinois
May 15, 2003
- 18 -
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Introduction
The following discussion and analysis should be read in conjunction with
Gallagher's consolidated financial statements and the related notes thereto that
are included elsewhere in this quarterly report.
Gallagher provides insurance brokerage and risk management services to a wide
variety of commercial, industrial, institutional and governmental organizations.
Commission revenue is primarily generated through the negotiation and placement
of insurance for its clients. Fee revenue is primarily generated by providing
other risk management services including claims management, information
management, risk control services and appraisals in either the P/C market or
human resource/employee benefits market. Investment income and other revenue is
generated from Gallagher's investment portfolio, which includes fiduciary funds,
equity securities, and tax advantaged and other strategic investments. Gallagher
is headquartered in Itasca, Illinois, has operations in seven countries and does
business in more than 100 countries around the world through a network of
correspondent brokers and consultants.
Insurance Market Overview
During the period from 1986 to 2000, heavy competition for market share among
P/C insurance carriers resulted in low premium rates. This "soft market" (i.e.,
low premium rates) generally resulted in flat or reduced renewal commissions.
During this soft market, natural catastrophes and other losses resulted in
billions of dollars in underwriting losses to the insurance market. Substantial
mergers, both domestically and internationally, resulted in fewer insurance
companies. Increased property replacement costs and increasingly large
litigation awards caused some clients to seek higher levels of insurance
coverage. These factors would generally have the effect of generating higher
premiums to clients and higher commissions to Gallagher. In spite of these
forces, there were opposing factors including favorable equity markets,
increased underwriting capital causing heavy competition for market share and
improved economies of scale following consolidations, all of which tended to
lower premium rates. The net result was that P/C premium rates remained low
through 1999. Years of underwriting losses coupled with the downward turn in
equity markets and interest rates for the past three years have placed insurers
in the situation of having to replenish depleted reserves. In order to restore
reserves, many carriers began to increase premium rates in 2000 and continued to
do so throughout 2001 and 2002 and into 2003, particularly after the events
described below.
The insurance industry was jolted by the tragic terrorist attacks that occurred
on September 11, 2001. The devastation caused by those events resulted in the
largest insurance loss ever. Along with this historic loss, larger than
anticipated loss experience across most risks, the stock market's steep decline,
lower interest rates and diminished risk capacity have led to the unprecedented
acceleration of premium rate increases. A higher premium rate environment is
referred to as a "hard market" and generally results in increased commission
revenues. Fluctuations in premiums charged by insurance companies have a direct
and potentially material impact on the insurance brokerage industry. Commission
revenues are generally based on a percentage of the premiums paid by insureds
and normally follow premium levels. Thus, a hard market will generally
contribute positively to Gallagher's operating results. Since September 11th,
the increased premium rates charged by insurance companies have had a positive
impact on Gallagher's 2002 and 2003 operating results. Although management
believes this hard market will continue during 2003, the longevity of the hard
market and its future effect on Gallagher's operations is difficult to predict.
While the rate of increase in premiums in the P/C marketplace has slowed,
certain types of coverages, such as directors and officers and medical
malpractice liability, continue to have a high rate of increase.
In a period of rising insurance costs, there is resistance among certain "risk"
buyers (Gallagher's clients) to pay increased premiums and the higher
commissions generated by these premiums. Such resistance is causing some buyers
to raise their deductibles and/or reduce the overall amount of insurance
coverage they purchase. In addition, some buyers are switching to negotiated fee
in lieu of commission arrangements with Gallagher for placing their risk. Other
buyers are moving toward the alternative insurance market, which could have a
favorable effect on Gallagher's Risk Management Services segment. These factors
tend to reduce commission revenue to Gallagher. Gallagher anticipates that new
sales and renewal increases in the areas of risk management, claims management,
captive insurance and self-insurance services will continue to be a major
- 19 -
factor in Gallagher's fee revenue growth during 2003. Though inflation tends to
increase the levels of insured values and risk exposures, premium rates charged
by insurance companies have had a greater impact on Gallagher's revenues than
inflation.
Critical Accounting Policies
Gallagher's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States (GAAP), which
require management to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and accompanying notes.
Gallagher believes the following significant accounting policies may involve a
higher degree of judgment and complexity. See Note 1 to the consolidated
financial statements included in Gallagher's Annual Report on Form 10-K for the
year ended December 31, 2002 for other significant accounting policies.
Revenue Recognition
Commission revenues are recognized at the latter of the billing or the effective
date of the related insurance policies, net of an allowance for estimated policy
cancellations. Commission revenues related to installment premiums are
recognized periodically as billed. Contingent commissions and commissions on
premiums directly billed by insurance companies, are recognized as revenue when
the data necessary to reasonably determine such amounts has been obtained by
Gallagher. Typically, these types of commission revenues cannot be reasonably
determined until the cash or the related policy detail is received by Gallagher
from the insurance company. A contingent commission is a commission paid by an
insurance company that is based on the overall profit and/or volume of the
business placed with that insurance company. Commissions on premiums billed
directly by insurance companies relate to a large number of small premium
transactions, whereby the billing and policy issuance process is controlled
entirely by the insurance company. The income effects of subsequent premium
adjustments are recorded when the adjustments become known.
Fee revenues generated from the Brokerage segment primarily relate to fees
negotiated in lieu of commissions, which are recognized in the same manner as
commission revenues. Fee revenues generated from the Risk Management segment
relate to third party claims administration, loss control and other risk
management consulting services, which are provided over a period of time,
typically one year. These fee revenues are recognized ratably as the services
are rendered. The income effects of subsequent fee adjustments are recorded when
the adjustments become known.
Premiums and fees receivable in the consolidated balance sheet are net of
allowances for estimated policy cancellations and doubtful accounts. The
allowance for estimated policy cancellations is established through a charge to
revenues, while the allowance for doubtful accounts is established through a
charge to other operating expenses. Both of these allowances are based on
estimates and assumptions using historical data to project future experience.
Gallagher periodically reviews the adequacy of these allowances and makes
adjustments as necessary. The use of different estimates or assumptions could
produce different results.
Fair Value of Investments
Trading Securities - Trading securities managed directly by Gallagher and by
third party managers consist primarily of common and preferred stocks and
corporate bonds. The trading securities managed by third parties are generally
structured through limited partnerships. All of the trading securities are
carried at fair value in the accompanying consolidated balance sheet, with
unrealized gains and losses included in the consolidated statement of earnings.
The fair value for these securities is primarily based on quoted market prices.
To the extent that quoted market prices are not available, fair value is
determined based on other relevant factors including dealer price quotations,
price quotations for similar instruments in different markets and pricing
models. Pricing models and their underlying assumptions impact the amount and
timing of unrealized gains and losses recognized. The use of different pricing
models or assumptions could produce different results.
Other Investments - For those investments that do not have quoted market prices,
Gallagher proactively looks for indicators of impairment. Factors, among others,
that may indicate that an impairment may exist include defaults on interest
and/or principal payments, reductions or changes to dividend payments, sustained
operating losses or a trend of poor operating performance, recent refinancings
or recapitalizations, unfavorable press, untimely filing of financial
information, significant customer or revenue loss, litigation, tax audits,
losses by other companies in a similar industry, overall economic conditions,
management and expert advisor changes, and significant changes in strategy. In
addition, in cases where the ultimate value of an investment is directly
- 20 -
dependent on Gallagher for future financial support, Gallagher will assess its
willingness and intent to provide future funding.
If an indicator of impairment exists, Gallagher performs a process to compare
the investment's carrying value to an estimate of its fair value. To estimate
the fair value of loans, Gallagher discounts the expected future cash flows from
principal and interest payments. This requires Gallagher to exercise significant
judgment when estimating both the amount and the timing of the expected cash
flows. To estimate the fair value of common and preferred stock investments,
Gallagher looks at values established in recent recapitalizations or appraisals
conducted by third parties. In some cases, no such recapitalizations or
appraisals exist and Gallagher must perform its own valuations. This also
requires Gallagher to exercise significant judgment. Even if impairment
indicators exist, no write down may be required if the estimated fair value is
not less than the current carrying value or the decline in value is deemed to be
temporary and Gallagher has the ability and intent to hold the investment for a
period of time sufficient for the value to recover. When Gallagher determines
that a write-down is required, it is recorded as a realized loss against current
period earnings.
Both the process to look for indicators of impairment and the method to compute
the amount of impairment incorporate quantitative data and qualitative criteria
including new information that can dramatically change the decision about the
valuation of an investment in a very short period of time. The determination of
whether a decline in fair value is other-than-temporary is necessarily a matter
of subjective judgment. The timing and amount of realized losses reported in
earnings could vary if management's conclusions were different.
Due to the nature of investments, they are subject to risk and therefore,
Gallagher cannot give assurance that there will not be further impairments in
the future should conditions change.
Intangible Assets
Intangible assets consist of the excess of cost over the value of net tangible
assets of acquired businesses, expiration lists and non-compete agreements.
Expiration lists and non-compete agreements are amortized using the
straight-line method over their estimated useful lives (5 to 15 years for
expiration lists and 5 to 6 years for non-compete agreements). Allocation of
intangible assets between goodwill, expiration lists and non-compete agreements
and the determination of estimated useful lives are based on valuations
Gallagher receives from qualified independent appraisers. The calculations of
these amounts are based on estimates and assumptions using historical and pro
forma data and recognized valuation methods. The use of different estimates or
assumptions could produce different results.
Goodwill is not amortized, but is subject to periodic reviews for impairment (at
least annually or more frequently if impairment indicators arise). Gallagher
reviews goodwill and other intangible assets for impairment periodically and
whenever events or changes in business circumstances indicate that the carrying
value of the assets may not be recoverable. Under those circumstances, if the
fair value were less than the carrying amount of the asset, a loss would be
recognized for the difference. The determinations of impairment indicators and
fair value are based on estimates and assumptions related to the amount and
timing of future cash flows and future interest rates. The use of different
estimates or assumptions could produce different results.
Effect of New Pronouncements
See Note 2 to the consolidated financial statements for a discussion on the
effects of new pronouncements.
Reclassification of Previously Reported Financial Statements
See Note 3 to the consolidated financial statements for a discussion on the
reclassification of previously reported financial statements.
2003 Acquisitions
See Note 5 to the consolidated financial statements for a discussion on the 2003
acquisitions.
- 21 -
Results of Operations
Brokerage
The Brokerage segment represents three operating divisions: Retail Brokerage
Services, Wholesale Brokerage Services and Gallagher Benefit Services The
Brokerage segment, for commission or fee compensation, places commercial
property-casualty and employee benefit-related insurance on behalf of its
customers. Financial information relating to Gallagher's Brokerage segment is as
follows (in millions):
Three-month period ended
March 31,
----------------------------- Percent
2003 2002 change
-------------- -------------- --------------
Commissions $ 168.6 $ 143.1 18%
Fees 27.7 20.1 38%
Investment income - fiduciary 1.8 1.7 6%
-------------- --------------
Gross revenues 198.1 164.9 20%
Less brokerage (10.1) (10.2) (1%)
-------------- --------------
Total revenues 188.0 154.7 22%
-------------- --------------
Compensation 114.7 94.0 22%
Other operating 41.4 31.2 33%
Depreciation 3.0 2.6 15%
Amortization 2.1 1.2 75%
-------------- --------------
Total expenses 161.2 129.0 25%
-------------- --------------
Earnings before income taxes 26.8 25.7 4%
Provision for income taxes 6.7 8.0 (16%)
-------------- --------------
Net earnings $ 20.1 $ 17.7 14%
============== ==============
Growth - revenues 22% 20%
Organic growth in commissions and fees 15% 14%
Growth - pretax earnings 4% 11%
Compensation expense ratio 58% 57%
Other operating expense ratio 21% 19%
Effective tax rate 25% 31%
Pretax margin 14% 16%
Identifiable assets at March 31, 2003 and 2002 $ 1,773.8 $ 1,521.0
============== ==============
The increase in commissions in 2003 was principally due to new business
production, renewal rate increases and an increase in contingent commissions,
all of which aggregated to $50.9 million and were partially offset by lost
business of $27.0 million. The increase in fees in 2003 resulted from new
business production and renewal rate increases of approximately $7.3 million,
which was partially offset by lost business of $2.7 million. Also contributing
to the increase in commissions and fees in 2003 were revenues associated with
the acquisitions accounted for as purchases that were made in the last 12
months. The organic growth in commission and fee revenues in 2003 was 15%
compared to 14% in 2002. Organic growth represents the increase in revenues
before the impact of the 2003 and 2002 acquisitions accounted for as purchases.
Investment income - fiduciary, which represents interest income earned on cash
and restricted funds, was relatively unchanged in 2003 compared to 2002. While
the amount of invested cash has increased, rates of return are at historical
lows placing downward pressure on the returns that Gallagher is able to earn.
The increase in compensation expense in 2003 was higher than usual and is
primarily due to an increase in employee headcount in the period from March 31,
2002 to March 31, 2003, salary increases, increases in
- 22 -
incentive compensation linked to Gallagher's overall operating results, a
corresponding increase in employee benefit expenses, and increases in pension
and medical insurance costs in 2003. The increase in employee headcount relates
to the hiring of additional production and support staff to generate the recent
and future new business growth and the addition of employees associated with the
acquisitions accounted for as purchases that were made in the last 12 months.
Compensation as a percentage of commission and fee revenues increased to 58% in
the first quarter of 2003 from 57%. These percentages are higher-than-normal
primarily due to the investments made in new personnel during the past 24 months
as it takes time for the commission and fee revenues generated from the new
production personnel to cover their fixed costs and to contribute favorably to
pretax earnings.
The increase in other operating expenses in 2003 over 2002 was due primarily to
an increase in fees for professional services, costs associated with leased
office space and office expansion and business insurance costs. Also
contributing were increases in travel and entertainment costs, due primarily to
new business development from new producers.
The increase in depreciation expense was due primarily to the purchases of
furniture, equipment and leasehold improvements related to office expansions and
moves made during the last twelve months. Also contributing to the increase in
depreciation expense in 2003 was the depreciation expense associated with the
acquisitions accounted for as purchases that were made in the last 12 months.
The increase in amortization was due primarily to amortization expense
associated with acquisitions accounted for as purchases that were made in the
last 12 months. Expiration lists and non-compete agreements are amortized using
the straight-line method over their estimated useful lives (5 to 15 years for
expiration lists and 5 to 6 years for non-compete agreements).
The overall effective income tax rate was 25% for the first quarter of 2003
compared to 31% for the first quarter of 2002. These rates reflect the effect of
tax credits generated by investments in limited partnerships that operate low
income housing and alternative energy projects, which are partially offset by
state and foreign taxes. The decrease in the effective income tax rate in 2003
is due to a synthetic fuel transaction that was consummated in the first quarter
2003. Gallagher expects that the additional tax credits generated from this
transaction will keep the effective tax rate in the mid-20% range for 2003.
- 23 -
Risk Management
The Risk Management segment provides P/C and health claim third-party
administration, loss control and risk management consulting and insurance
property appraisals. Third-party administration is principally the management
and processing of claims for self-insurance programs of Gallagher's clients or
clients of other brokers. Financial information relating to Gallagher's Risk
Management segment is as follows (in millions):
Three-month period ended
March 31,
----------------------------- Percent
2003 2002 change
-------------- -------------- --------------
Fees $ 76.5 $ 69.8 10%
Investment income - fiduciary 0.2 0.2 0%
-------------- --------------
Total revenues 76.7 70.0 9%
-------------- --------------
Compensation 42.3 37.8 12%
Other operating 21.4 18.6 15%
Depreciation 2.3 2.0 15%
-------------- --------------
Total expenses 66.0 58.4 13%
-------------- --------------
Earnings before income taxes 10.7 11.6 (9%)
Provision for income taxes 2.6 3.6 (28%)
-------------- --------------
Net earnings $ 8.1 $ 8.0 1%
============== ==============
Growth - revenues 9% 7%
Organic growth in fees 10% 7%
Growth - pretax earnings (9%) 26%
Compensation expense ratio 55% 54%
Other operating expense ratio 28% 27%
Effective tax rate 25% 31%
Pretax margin 14% 17%
Identifiable assets at March 31, 2003 and 2002 $ 84.5 $ 72.3
============== ==============
The increase in fees in 2003 was due primarily to new business production of
approximately $12.6 million, renewal rate increases and favorable retention
rates on existing business partially offset by lost business of $7.5 million.
The organic growth in fee revenues in 2003 was 10% compared to 7% in 2002.
Investment income - fiduciary, which represents interest income earned on cash
and restricted funds, was unchanged in 2003 compared to 2002. While the amount
of invested cash has increased, rates of return are at historical lows placing
downward pressure on the returns that Gallagher is able to earn. The increase in
compensation expense in 2003 was due to an increase in employee headcount in the
period from March 31, 2002 to March 31, 2003, salary increases, a corresponding
increase in employee benefit expenses, and increases in pension and medical
insurance costs in 2003.
The increase in other operating expenses in 2003 over 2002 was due primarily to
an increase in fees for professional services, costs associated with leased
office space and office expansion and business insurance costs.
The increase in depreciation expense is due primarily to the purchases of
furniture, equipment and leasehold improvements related to office expansions and
moves made during the last 12 months.
- 24 -
Financial Services
The Financial Services segment is responsible for managing Gallagher's
diversified investment portfolio to maximize long-term after-tax returns.
Financial information relating to Gallagher's Financial Services segment is as
follows (in millions):
Three-month period ended
March 31,
------------------------ Percent
2003 2002 change
------ ------ -------
Investment income:
Cash and cash equivalents $ 0.6 $ 0.9 (33%)
Trading securities (0.2) 1.5 (113%)
AAC related investments 0.8 1.1 (27%)
Low income housing investments 0.3 0.7 (57%)
Shopping centers & other commercial real estate (0.6) - NMF
Alternative energy investments 9.9 5.7 74%
Venture capital (0.4) (0.2) (100%)
Consolidated investments 2.9 2.0 45%
Other 2.0 4.0 (50%)
------ ------
Total investment income 15.3 15.7 (3%)
Investment losses (25.7) (1.4) NMF
------ ------
Total revenues (10.4) 14.3 (173%)
------ ------
Total expenses 11.3 2.8 304%
------ ------
Earnings (loss) before income taxes (21.7) 11.5 (289%)
Provision (benefit) for income taxes (5.4) 3.5 (254%)
------ ------
Net earnings (loss) $(16.3) $ 8.0 (304%)
====== ======
Identifiable assets at March 31, 2003 and 2002 $634.1 $579.3
====== ======
Investment income from cash and cash equivalents can vary from
quarter-to-quarter as a result of the timing of excess cash flow.
The decrease in investment income from trading securities in 2003 was primarily
due to a sharp decline in the equity markets during the first quarter of 2003
and to the reclassification of Gallagher's marketable securities portfolio from
available for sale to trading in the third quarter of 2002. Effective
September 30, 2002, Gallagher reclassified its marketable securities portfolio
from available for sale to trading. As a result of this reclassification,
changes in unrealized gains and losses on this portfolio are recorded in
investment income in the consolidated statement of earnings. Prior to
September 30, 2002, changes in unrealized gains and losses on this portfolio
were recorded in stockholders' equity as accumulated other comprehensive
earnings or losses.
Investment income from AAC related investments, low income housing investments,
commercial real estate and venture capital investments were relatively unchanged
in 2003 compared to 2002.
The increase in investment income from alternative energy investments in 2003
was due to the sale of Gallagher's interests in limited partnerships that
operate synthetic fuel facilities. Gallagher recognizes installment gains based
on qualified fuel production generated by these facilities. In the first quarter
of 2003, production at these facilities, which ultimately determines the amount
of the gains realized, was approximately equal to the expected annualized rate
of production. Also contributing to the year-over-year increase was the
short-term shut down of production in the first quarter of 2002 as the movable
equipment was relocated to permanent sites to accommodate the delivery of
synthetic fuel to the end user.
- 25 -
The increase in investment income from consolidated investments in 2003 was due
to the acquisition of the airplane leasing company in the second quarter of
2002. On May 31, 2002, a 90% owned subsidiary of Gallagher acquired the net
assets of a leasing company that leases two cargo airplanes to the French Postal
Service.
Other income primarily represents gains from book-of-business dispositions (one
each in 2003 and 2002).
In the first quarter 2003, Gallagher decided to exit from its investments in
venture capital, development stage enterprises and turn-arounds and recorded a
pretax charge of $25.7 million to reduce the carrying values of these
investments to their estimated realizable value. Gallagher does not intend to
make new investments in these investment classes.
Total expenses of this segment include compensation, interest, professional
fees, operating expenses of the alternative energy investments, expenses of the
real estate partnerships and depreciation. The increase in 2003 was due
primarily to an increase in professional fees associated with investment
transactions and operating expenses of the alternative energy investments. In
addition, first quarter 2002 expenses were unusually low due to the timing of
incentive compensation and professional fees that were incurred in the second
quarter of 2002.
Financial Condition and Liquidity
Cash Provided by Operations - The insurance brokerage industry is not capital
intensive. The capital used to fund Gallagher's investment portfolio has been
primarily generated from the excess cash provided by its operations, and tax
savings generated from tax advantaged investments. Cash provided by operating
activities was $58.3 million and $11.3 million for the three-month periods ended
March 31, 2003 and 2002, respectively. Because of the variability related to the
timing of premiums and fees receivable and premiums payable, net cash flows
provided by operations vary substantially from quarter-to-quarter and
year-to-year. Funds restricted as to Gallagher's use, primarily premiums held as
fiduciary funds, have not been included in determining Gallagher's overall
liquidity. Currently, Gallagher believes it has sufficient capital to meet its
cash flow needs. However, in the event that Gallagher needs capital to fund its
operations and investing requirements, it would use borrowings under its
line-of-credit agreement to meet its short-term needs and would consider other
alternatives for its long-term needs. Such alternatives would include raising
capital through public markets or restructuring its operations in the event that
cash flows from operations are reduced dramatically due to lost business.
However, Gallagher has historically been profitable and cash flows from
operations and short-term borrowings under its line-of-credit agreements have
been sufficient to fund Gallagher's operating, investment and capital
expenditure needs. Gallagher expects this favorable cash flow trend to continue
in the foreseeable future.
Borrowings - Gallagher has a $150.0 million line-of-credit agreement it uses to
post LOCs and from time-to-time borrows to supplement operating cash flows. At
March 31, 2003, $50.7 million was used primarily for investment related LOCs
discussed in Notes 4 and 10 to the consolidated financial statements and $99.3
million remains available for potential borrowings through September 10, 2003.
There were no borrowings outstanding under the line-of-credit agreement at March
31, 2003. Facility fees are .10% on the used and unused portions, the interest
rate is based on the prime commercial rate or LIBOR plus .40% and terms include
various covenants based on net worth and expenditure levels. Gallagher was in
compliance with these covenants at March 31, 2003. Gallagher does not expect
difficulties in obtaining a new line-of-credit facility by September 10, 2003.
Consolidated Investment Related Borrowings - As more fully described in Note 4
to the consolidated financial statements, at March 31, 2003, the accompanying
balance sheet includes $153.0 million of borrowings related to Gallagher's
consolidated investment enterprises of which $35.1 million is recourse to
Gallagher's other operations.
Off-Balance Sheet Debt - Gallagher's unconsolidated investment portfolio
includes investments in enterprises where Gallagher's ownership is between 3%
and 50%. As a result, these investments are accounted for using either the lower
of amortized cost/cost or fair value, or the equity method, whichever is
appropriate depending on the legal form of Gallagher's ownership interest and
the applicable percentage of the entity owned. As such, the balance sheets of
these investees are not consolidated in Gallagher's consolidated balance sheets
at March 31, 2003 and December 31, 2002. The March 31, 2003 and December 31,
2002 balance sheets of several of these unconsolidated investments contain
outstanding debt, which is not required to be included in Gallagher's
consolidated balance sheets.
- 26 -
In certain cases, Gallagher guarantees a portion of the enterprises' debt. Based
on the ownership structure of these investments, management believes that
Gallagher's exposure to losses related to these investments is limited to the
combination of its net carrying value, funding commitments, letters of credit
and financial guarantees. In the event that certain of these enterprises were to
default on their debt obligations and Gallagher's net carrying value became
impaired, the amount to be written-off could have a material effect on
Gallagher's consolidated operating results and/or financial position. See Notes
4 and 10 to the consolidated financial statements.
Dividends - Through the first three months of 2003, Gallagher paid $13.3 million
in cash dividends on its common stock. Gallagher's dividend policy is determined
by the Board of Directors. Quarterly dividends are declared after considering
Gallagher's available cash from earnings and its anticipated cash needs. On
April 15, 2003, Gallagher paid a first quarter dividend of $.18 per share to
shareholders of record at March 31, 2003, a 20% increase over the first quarter
dividend per share in 2002.
Capital Expenditures - Net capital expenditures were $9.9 million and $11.2
million for each of the three-month periods ended March 31, 2003 and 2002,
respectively. These amounts include net capital expenditures of the two
previously discussed real estate partnerships of $5.5 million in 2003 and $2.7
million in 2002, the majority of which are related to the Florida residential
development project. In 2003, exclusive of the net capital expenditures related
to those two real estate partnerships, Gallagher expects total expenditures for
capital improvements to be approximately $30.0 million. Capital expenditures by
Gallagher are related primarily to office moves and expansions and updating
computer systems and equipment.
Common Stock Repurchases - Gallagher has a common stock repurchase plan that has
been approved by the Board of Directors. Under the provisions of the repurchase
plan, Gallagher is authorized to repurchase approximately 4.3 million additional
shares through June 30, 2003. Under the plan, Gallagher repurchased 239,000
shares at a cost of $5.8 million in the first three months of 2003. There were
no repurchases made in the first three months of 2002. Repurchased shares are
held for reissuance in connection with its equity compensation and stock option
plans. Gallagher is under no commitment or obligation to repurchase any
particular amount of common stock and at its discretion may suspend the
repurchase plan at any time.
Contractual Obligations and Commitments
In addition to obligations and commitments related to Gallagher's investing
activities discussed above, at March 31, 2003, Gallagher has posted LOCs of $5.2
million and $5.3 million related to self insurance deductibles and client self
insurance deductibles, respectively. Gallagher has a recorded liability of $3.2
million related to its self insurance deductibles and has collateral on the
client's self insurance deductibles valued at $12.5 million. See Note 15 to the
consolidated financial statements included in Gallagher's Annual Report on Form
10-K for the year ended December 31, 2002.
Information Concerning Forward-Looking Statements
This quarterly report contains forward-looking statements within the meaning of
that term in the Private Securities Litigation Reform Act of 1995 (the "Act")
found at Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, as amended (the "Exchange Act"). Additional
written or oral forward-looking statements may be made by Gallagher from time to
time in information provided to the Securities and Exchange Commission (SEC),
press releases, its website, or otherwise. Statements contained in this report
that are not historical facts are forward-looking statements made pursuant to
the safe harbor provisions of the Act. Forward-looking statements may include,
but are not limited to, discussions concerning revenues, expenses, earnings,
cash flow, capital structure, financial losses, as well as market and industry
conditions, premium rates, financial markets, interest rates, foreign exchange
rates, contingencies and matters relating to Gallagher's operations and income
taxes. In addition, when used in this report, the words "anticipates,"
"believes," "should," "estimates," "expects," "intends," "plans" and variations
thereof and similar expressions are intended to identify forward-looking
statements. Such forward-looking statements are based on available current
market and industry material, experts' reports and opinions and long-term
trends, as well as management's expectations concerning future events impacting
Gallagher.
- 27 -
Forward-looking statements made by or on behalf of Gallagher are subject to
risks and uncertainties, including but not limited to the following: Gallagher's
commission revenues are highly dependent on premiums charged by insurers, which
are subject to fluctuation; lower interest rates reduce Gallagher's income
earned on invested funds; the alternative insurance market continues to grow
which could unfavorably impact commission and favorably impact fee revenue;
Gallagher's revenues vary significantly from period to period as a result of the
timing of policy inception dates and the net effect of new and lost business
production; the general level of economic activity can have a substantial impact
on Gallagher's renewal business; Gallagher's operating results, returns on
investments and financial position may be adversely impacted by exposure to
various market risks such as interest rate, equity pricing, foreign exchange
rates and the competitive environment, and changes in income tax laws.
Gallagher's ability to grow has been enhanced through acquisitions, which may or
may not be available on acceptable terms in the future and which, if
consummated, may or may not be advantageous to Gallagher. Accordingly, actual
results may differ materially from those set forth in the forward-looking
statements.
Readers are cautioned not to place undue reliance on any forward-looking
statements contained in this report, which speak only as of the date set forth
on the signature page hereto. Gallagher undertakes no obligation to publicly
release the result of any revisions to these forward-looking statements that may
be made to reflect events or circumstances after such date or to reflect the
occurrence of anticipated or unanticipated events.
Item 3. Quantitative and Qualitative Disclosure About Market Risk
Gallagher is exposed to various market risks in its day to day operations.
Market risk is the potential loss arising from adverse changes in market rates
and prices, such as interest and foreign currency exchange rates and equity
prices. Gallagher does not enter into derivatives or other similar financial
instruments for trading or speculative purposes. The following analyses present
the hypothetical loss in fair value of the financial instruments held by
Gallagher at March 31, 2003 that are sensitive to changes in interest rates and
equity prices. The range of changes in interest rates used in the analyses
reflects Gallagher's view of changes that are reasonably possible over a
one-year period. This discussion of market risks related to Gallagher's
consolidated balance sheet includes estimates of future economic environments
caused by changes in market risks. The effect of actual changes in these risk
factors may differ materially from Gallagher's estimates. In the ordinary course
of business, Gallagher also faces risks that are either nonfinancial or
unquantifiable, including credit risk and legal risk. These risks are not
included in the following analyses.
Gallagher has a comprehensive and diversified investment portfolio. Gallagher's
invested assets are held as cash and cash equivalents and trading securities.
Accordingly, these assets are subject to various market risk exposures such as
interest rate risk and equity price risk.
The fair value of Gallagher's cash and cash equivalents investment portfolio at
March 31, 2003 approximated its carrying value due to its short-term duration.
Market risk was estimated as the potential decrease in fair value resulting from
a hypothetical one percentage point increase in interest rates for the
instruments contained in the cash and cash equivalents investment portfolio. The
resulting fair values were not materially different from the carrying values at
March 31, 2003.
At March 31, 2003, the fair value of Gallagher's trading securities portfolio
was $55.6 million. This portfolio is managed internally and externally by
several independent fund managers.
The fair value of Gallagher's trading securities portfolio managed internally
was $15.6 million at March 31, 2003. The overall objective of the trading
securities portfolio is to provide Gallagher with a stable after-tax yield. This
unhedged portfolio consists primarily of dividend-yielding preferred stocks that
are more sensitive to interest rate risk than to equity pricing risk. The
estimated potential loss in fair value resulting from a hypothetical
one-percentage point increase in short-term interest rates would be
approximately $1.7 million at March 31, 2003.
The fair value of Gallagher's trading securities portfolio managed externally
was $40.0 million at March 31, 2003. This portfolio is also subject to equity
pricing risk. However, these investments are actively managed in order to
minimize Gallagher's exposure to equity pricing risk. The objective of this
portfolio is to maximize the overall return to Gallagher, while minimizing the
downward price risk in order to preserve the investments' underlying principal
balances. The external managers may use hedge strategies such as "selling short"
equity
- 28 -
securities in order to mitigate the effects of changes in equity prices
thereby attempting to make any such fluctuations immaterial. Accordingly,
hypothetical changes in equity prices would not cause the resulting fair value
to be materially different from the carrying value for this portfolio at March
31, 2003. While several of these fund managers hedge parts of their investment
strategies, equity pricing risk cannot be completely eliminated.
Gallagher has other investments that have valuations that are indirectly
influenced by equity market and general economic conditions that can change
rapidly. In addition, some investments require direct and active financial and
operational support from Gallagher. A future material adverse effect may result
from changes in market conditions or if Gallagher elects to withdraw financial
or operational support.
At March 31, 2003, Gallagher had no borrowings outstanding under its
line-of-credit agreement. However, in the event that Gallagher does have
borrowings outstanding, the fair value of these borrowings would likely
approximate their carrying value due to their short-term duration and variable
interest rates. The market risk would be estimated as the potential increase in
the fair value resulting from a hypothetical one-percentage point decrease in
Gallagher's weighted average short-term borrowing rate at March 31, 2003 and the
resulting fair values would not be materially different from its carrying value.
Gallagher is subject to foreign currency exchange rate risk primarily from its
United Kingdom based subsidiaries that incur expenses denominated in British
pounds while receiving a substantial portion of their revenues in U.S. dollars.
Gallagher does not hedge this foreign currency exchange rate risk. Foreign
currency gains (losses) related to this market risk are recorded in earnings
before income taxes as they are incurred. Assuming a hypothetical adverse change
of 10% in the average foreign currency exchange rate for 2003 (a weakening of
the U.S. dollar), earnings before income taxes would decrease by approximately
$1.7 million. Gallagher is also subject to foreign currency exchange rate risk
associated with the translation of its foreign subsidiaries into U.S. dollars.
However, it is management's opinion that this foreign currency exchange risk is
not material to Gallagher's consolidated operating results or financial
position. Gallagher manages the balance sheet of its foreign subsidiaries such
that foreign liabilities are matched with equal foreign assets thereby
maintaining a "balanced book" which minimizes the effects of currency
fluctuations.
Item 4. Controls and Procedures
Within the 90-day period prior to filing this report, Gallagher management
carried out an evaluation, under the supervision and with the participation of
Gallagher's Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"),
of the effectiveness of Gallagher's disclosure controls and procedures pursuant
to Exchange Act Rule 13a-14. Based on this evaluation, the CEO and CFO have
concluded that Gallagher's disclosure controls and procedures were effective as
of the date of such evaluation.
There have been no significant changes in Gallagher's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date of Gallagher's evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
- 29 -
Part II- Other Information
Item 2. Changes in Securities
Effective on March 31, 2003, Gallagher contributed 275,000 shares of its common
stock to an incentive plan, with an aggregate fair value of $7.2 million as of
that date. Also, effective on March 31, 2003, Gallagher granted restricted stock
awards of 27,000 shares in the aggregate of its common stock to its Chief
Executive Officer and one other Corporate Officer, with an aggregate fair value
of $0.7 million as of that date. These 2003 restricted stock awards vest over a
two-year period at the rate of 50% per year beginning on March 31, 2004.
Effective on March 31, 2003, Gallagher contributed $4.4 million to the Deferred
Equity Participation Plan through the issuance of 169,000 shares of Gallagher
common stock. Distributions under the plan normally may not be made until the
participant retires after reaching age 62 and are subject to forfeiture in the
event of voluntary termination of employment prior to age 62. All distributions
from the plan are made in the form of Gallagher's common stock.
Exemption from registration is provided under Section 4(2) of the Securities Act
of 1933, as amended, regarding transactions by an issuer not involving any
public offering.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
15.1 Letter of awareness from Ernst & Young LLP concerning unaudited
interim financial information.
99.1 Certification of CEO Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
99.2 Certification of CFO Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
(b) Reports on Form 8-K
No Reports on Form 8-K were filed during the three-month period ended
March 31, 2003.
- 30 -
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 the 15th day of May,
2003.
Arthur J. Gallagher & Co.
/s/ Douglas K. Howell
--------------------------------------------------
Douglas K. Howell
Vice President and Chief Financial Officer
(principal financial officer and duly
authorized officer)
- 31 -
Arthur J. Gallagher & Co.
Certifications Pursuant to
Section 302 of
The Sarbanes-Oxley Act of 2002
Certification
I, J. Patrick Gallagher, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Arthur J. Gallagher &
Co.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a.) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b.) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c.) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a.) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b.) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 15, 2003
/s/ J. Patrick Gallagher, Jr.
----------------------------------------
J. Patrick Gallagher, Jr.
President and Chief Executive Officer
(principal executive officer)
- 32 -
Arthur J. Gallagher & Co.
Certifications Pursuant to
Section 302 of
The Sarbanes-Oxley Act of 2002 (Continued)
Certification
I, Douglas K. Howell, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Arthur J. Gallagher &
Co.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a.) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b.) Evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c.) Presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a.) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b.) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: May 15, 2003
/s/ Douglas K. Howell
----------------------------------------------
Douglas K. Howell
Vice President and Chief Financial Officer
(principal financial officer)
- 33 -
Arthur J. Gallagher & Co.
Exhibit Index
15.1 Letter of awareness from Ernst & Young LLP concerning unaudited interim
financial information.
99.1 Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
- 34 -