| Summary of Significant Accounting Policies | 1. Summary of
Significant Accounting Policies Terms Used in Notes to
Consolidated Financial Statements ASU FASB GAAP IRC IRS Topic 606 2014-09, Underwriting
enterprises VIE Nature of
Operations Arthur J.
Gallagher & Co. and its subsidiaries, collectively
referred to herein as we, our, us or the company, provide insurance
brokerage, consulting and third party claims settlement and
administration services to both domestic and international entities
through three reportable operating segments. Our brokers, agents
and administrators act as intermediaries between underwriting
enterprises and our clients. Our brokerage segment
operations provide brokerage and consulting services to companies
and entities of all types, including commercial, not-for-profit, not-for-profit, Chem-Mod LLC’s We do not assume
underwriting risk on a net basis, other than with respect to de
minimis amounts necessary to provide minimum or regulatory capital
to organize captives, pools, specialized underwriters or
risk-retention groups. Rather, capital necessary for events of loss
coverages is provided by underwriting enterprises. Investment income and other
revenues are generated from our premium financing operations and
our investment portfolio, which includes our invested cash and
restricted cash we hold on behalf of our clients, as well as clean
energy investments. We are headquartered in
Rolling Meadows, Illinois, have operations in 35 countries and
offer client-service capabilities in more than 150 countries
globally through a network of correspondent insurance brokers and
consultants. Basis of
Presentation The accompanying
consolidated financial statements include our accounts and all of
our majority-owned subsidiaries (50% or greater ownership).
Substantially all of our investments in partially owned entities in
which our ownership is less than 50% are accounted for using the
equity method based on the legal form of our ownership interest and
the applicable ownership percentage of the entity. However, in
situations where a less than 50%-owned investment has been
determined to be a VIE and we are deemed to be the primary
beneficiary in accordance with the variable interest model of
consolidation, we will consolidate the investment into our
consolidated financial statements. For partially owned entities
accounted for using the equity method, our share of the net
earnings of these entities is included in consolidated net
earnings. All material intercompany accounts and transactions have
been eliminated in consolidation. In the preparation of our
consolidated financial statements as of December 31, 2018,
management evaluated all material subsequent events or transactions
that occurred after the balance sheet date through the date on
which the financial statements were issued for potential
recognition in our consolidated financial statements and/or
disclosure in the notes therein.
Use of
Estimates The preparation of our
consolidated financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the
amounts reported in the financial statements and accompanying
notes. These accounting principles require us to make estimates and
assumptions that affect the reported amounts of assets and
liabilities and revenues and expenses, and the disclosure of
contingent assets and liabilities at the date of our consolidated
financial statements. We are also required to make certain
judgments and estimates that affect the disclosed and recorded
amounts of revenues and expenses related to the impact of the
adoption of and accounting under Topic 606. We periodically
evaluate our estimates and assumptions, including those relating to
the valuation of goodwill and other intangible assets, investments
(including our IRC Section 45 investments), income taxes,
revenue recognition, deferred costs, stock-based compensation,
claims handling obligations, retirement plans, litigation and
contingencies. We base our estimates on historical experience and
various assumptions that we believe to be reasonable based on
specific circumstances. Such estimates and assumptions could change
in the future as more information becomes known, which could impact
the amounts reported and disclosed herein. Revenue
Recognition Our revenues are derived
from commissions and fees as primarily specified in a written
contract, or unwritten business understanding, with our clients or
underwriting enterprises. We also recognize investment income over
time from our invested assets and invested assets we hold on behalf
of our clients or underwriting enterprises. BROKERAGE
SEGMENT
Our brokerage
segment generates revenues by:
(i)
Identifying, negotiating and placing all forms of insurance or
reinsurance coverage, as well as providing risk-shifting,
risk-sharing and risk-mitigation consulting services, principally
related to property/casualty, life, health, welfare and disability
insurance. We also provide these services through, or in
conjunction with, other unrelated agents and brokers, consultants
and management advisors.
(ii)
Acting as an agent or broker for multiple underwriting
enterprises by providing services such as sales, marketing,
selecting, negotiating, underwriting, servicing and placing
insurance coverage on their behalf.
(iii)
Providing consulting services related to health and welfare
benefits, voluntary benefits, executive benefits, compensation,
retirement planning, institutional investment and fiduciary,
actuarial, compliance, private insurance exchange, human resource
technology, communications and benefits administration.
(iv)
Providing management and administrative services to captives,
pools, risk-retention groups, healthcare exchanges, small
underwriting enterprises, such as accounting, claims and loss
processing assistance, feasibility studies, actuarial studies, data
analytics and other administrative services. The majority of our
brokerage contracts and service understandings are for a period of
one year or less. Commissions and
fees The primary source of
revenues for our brokerage services is commissions from
underwriting enterprises, based on a percentage of premiums paid by
our clients, or fees received from clients based on an agreed level
of service usually in lieu of commissions. These commissions and
fees revenues are substantially recognized at a point in time on
the effective date of the associated policies when control of the
policy transfers to the client, as well as deferring certain
revenues to reflect delivery of services over the contract
period. Commissions are fixed at
the contract effective date and generally are based on a percentage
of premiums for insurance coverage or employee head count for
employer sponsored benefit plans. Commissions depend upon a large
number of factors, including the type of risk being placed, the
particular underwriting enterprise’s demand, the expected
loss experience of the particular risk of coverage, and historical
benchmarks surrounding the level of effort necessary for us to
place and service the insurance contract. Rather than being tied to
the amount of premiums, fees are most often based on an expected
level of effort to provide our services. Whether we are paid a
commission or a fee, the vast majority of our services are
associated with the placement of an insurance (or insurance-like)
contract. Accordingly, we recognize approximately 80% of our
commission and fee revenues on the effective date of the underlying
insurance contract. The amount of revenue we recognize is based on
our costs to provide our services up and through that effective
date, including an appropriate estimate of our profit margin on a
portfolio basis (a practical expedient as defined in
Topic 606). Based on the proportion of additional services we
provide in each period after the effective date of the insurance
contract, including an appropriate estimate of our profit margin,
we recognize approximately 15% of our commission and fee revenues
in the first three months, and the remaining 5% thereafter. These
periods may be different than the underlying premium payment
patterns of the insurance contracts, but the vast majority of our
services are fully provided within one year of the insurance
contract effective date. For consulting and advisory
services, we recognize our revenue in the period in which we
provide the service or advice. For management and administrative
services, our revenue is recognized ratably over the contract
period consistent with the performance of our obligations, mostly
over an annual term.
Supplemental
revenues Certain underwriting
enterprises may pay us additional revenues for the volume of
premium placed with them and for insights into our sales pipeline,
our sales capabilities or our risk selection knowledge. These
amounts are in excess of the commission and fee revenues discussed
above, and not all business we place with underwriting enterprises
is eligible for supplemental revenues. Unlike contingent revenues,
discussed below, these revenues are primarily a fixed amount or
fixed percentage of premium of the underlying eligible insurance
contracts. For supplemental revenue contracts based on a fixed
percentage of premium, our obligation to the underwriting
enterprise is substantially completed upon the effective date of
the underlying insurance contract and revenue is fully earned at
that time. For supplemental revenue contracts based on a fixed
amount, revenue is recognized ratably over the contract period
consistent with the performance of our obligations, almost always
over an annual term. We receive these revenues on a quarterly or
annual basis. Contingent
revenues Certain underwriting
enterprises may pay us additional revenues for our sales
capabilities, our risk selection knowledge, or our administrative
efficiencies. These amounts are in excess of the commission or fee
revenues discussed above, and not all business we place with
participating underwriting enterprises is eligible for contingent
revenues. Unlike supplemental revenues, also discussed above, these
revenues are variable, generally based on growth, the loss
experience of the underlying insurance contracts, and/or our
efficiency in processing the business. We generally operate under
calendar year contracts, but we do not receive these revenues from
the underwriting enterprises until the following calendar year,
generally in the first and second quarters, after verification of
the performance indicators outlined in the contracts. Accordingly,
during each reporting period, we must make our best estimate of
amounts we have earned using historical averages and other factors
to project such revenues. We base our estimates each period on a
contract-by-contract Sub-brokerage Sub-brokerage revenues. Sub-brokerage sub-brokers RISK MANAGEMENT
SEGMENT Revenues for our risk
management segment are comprised of fees generally negotiated
(i) on a per-claim cost-plus Per-claim Where we operate under a
contract with our fee established on a per-claim claim-by-claim Cost-plus
fees Where we provide services
and generate revenues on a cost-plus basis, we recognize revenue
over the contract period consistent with the performance of our
obligations. Performance-based
fees Certain clients pay us
additional fee revenues for our efficiency in managing claims or on
the basis of claim outcome effectiveness. These amounts are in
excess of the fee revenues discussed above. These revenues are
variable, generally based on performance metrics set forth in the
underlying contracts. We generally operate under multi-year
contracts with fiscal year measurement periods. We do not receive
these fees, if earned, until the following year after verification
of the performance metrics outlined in the contracts. Each
period we base our estimates on a contract-by-contract
Reimbursements Reimbursements represent
amounts received from clients reimbursing us for certain
third-party costs associated with providing our claims management
services. In certain service partner relationships, we are
considered a principal because we direct the third party, control
the specified service and combine the services provided into an
integrated solution. Given this principal relationship, we are
required to recognize revenue gross and service partner vendor fees
in the operating expense in our consolidated statement of
earnings. Deferred
Costs We incur costs to provide
brokerage and risk management services. Those costs are either
(i) costs to obtain a contract or (ii) costs to fulfill
such contract, or (iii) all other costs.
(i)
Costs to obtain - we incur costs to obtain a contract with a
client. Those costs would not have been incurred if the contract
had not been obtained. Almost all of our costs to obtain are
incurred prior to, or on, the effective date of the contract and
consist primarily of incentive compensation we pay to our
production employees. Our costs to obtain are expensed as incurred
as described in Note 3 to these consolidated financial
statements.
(ii)
Costs to fulfill - we incur costs to fulfill a contract (or
anticipated contract) with a client. Those costs are incurred prior
to the effective date of the contract and relate to fulfilling our
primary placement obligations to our clients. Our costs to fulfill
prior to the effective date are capitalized and amortized on the
effective date. These fulfillment activities include collecting
underwriting information from our client, assessing their insurance
needs and negotiating their placement with one or more underwriting
enterprises. The majority of costs that we incur relate to
compensation and benefits of our client service employees. Costs
incurred during preplacement activities are expected to be
recovered in the future. If the capitalized costs are no longer
deemed to be recoverable, then they would be expensed.
(iii)
Other costs that are not costs to obtain or fulfill are
expensed as incurred. Examples include other operating costs such
as rent, utilities, management costs, overhead costs, legal and
other professional fees, technology costs, insurance related costs,
communication and advertising, and travel and entertainment.
Depreciation, amortization and change in estimated acquisition
earnout payable are expensed as incurred. Investment
income Investment income primarily
includes interest and dividend income (including interest income
from our premium financing operations), which is accrued as it is
earned. Gains on books of business sales represent one-time Earnings per
Share Basic net earnings per
share is computed by dividing net earnings by the weighted average
number of common shares outstanding during the reporting period.
Diluted net earnings per share is computed by dividing net earnings
by the weighted average number of common and common equivalent
shares outstanding during the reporting period. Common equivalent
shares include incremental shares from dilutive stock options,
which are calculated from the date of grant under the treasury
stock method using the average market price for the
period. Cash and Cash
Equivalents Short-term investments,
consisting principally of cash and money market accounts that have
average maturities of 90 days or less, are considered cash
equivalents.
Restricted
Cash In our capacity as an
insurance broker, we collect premiums from insureds and, after
deducting our commissions and/or fees, remit these premiums to
underwriting enterprises. We hold unremitted insurance premiums in
a fiduciary capacity until we disburse them, and the use of such
funds is restricted by laws in certain states and foreign
jurisdictions in which our subsidiaries operate. Various state and
foreign agencies regulate insurance brokers and provide specific
requirements that limit the type of investments that may be made
with such funds. Accordingly, we invest these funds in cash and
U.S. Treasury fund accounts. We can earn interest income on these
unremitted funds, which is included in investment income in the
accompanying consolidated statement of earnings. These unremitted
amounts are reported as restricted cash in the accompanying
consolidated balance sheet, with the related liability reported as
premiums payable to underwriting enterprises. Additionally, several
of our foreign subsidiaries are required by various foreign
agencies to meet certain liquidity and solvency requirements. We
were in compliance with these requirements at December 31,
2018. Related to our third party
administration business and in certain of our brokerage operations,
we are responsible for client claim funds that we hold in a
fiduciary capacity. We do not earn any interest income on the funds
held. These client funds have been included in restricted cash,
along with a corresponding liability in premiums payable to
underwriting enterprises in the accompanying consolidated balance
sheet. Premiums and fees
receivable Premiums and fees
receivable in the accompanying consolidated balance sheet are net
of allowances for estimated policy cancellations and doubtful
accounts. The allowance for estimated policy cancellations was
$7.8 million and $7.4 million at December 31, 2018
and 2017, respectively, which represents a reserve for future
reversals in commission and fee revenues related to the potential
cancellation of client insurance policies that were in force as of
each year end. The allowance for doubtful accounts was
$10.0 million and $13.5 million at December 31, 2018
and 2017, respectively. We establish the allowance for estimated
policy cancellations through a charge to revenues and the allowance
for doubtful accounts through a charge to operating expenses. Both
of these allowances are based on estimates and assumptions using
historical data to project future experience. Such estimates and
assumptions could change in the future as more information becomes
known which could impact the amounts reported and disclosed herein.
We periodically review the adequacy of these allowances and make
adjustments as necessary. Derivative
Instruments We are exposed to market
risks, including changes in foreign currency exchange rates and
interest rates. To manage the risk related to these exposures, we
enter into various derivative instruments that reduce these risks
by creating offsetting exposures. In the normal course of business,
we are exposed to the impact of foreign currency fluctuations that
impact our results of operations and cash flows. We utilize a
foreign currency risk management program involving foreign currency
derivatives that consist of several monthly put/call options
designed to hedge a portion of our future foreign currency
disbursements through various future payment dates. To mitigate the
counterparty credit risk we only enter into contracts with major
financial institutions based upon their credit ratings and other
factors. These derivative instrument contracts are cash flow hedges
that qualify for hedge accounting and primarily hedge against
fluctuations between changes in the GBP and Indian Rupee versus the
U.S. dollar. Changes in fair value of the derivative instruments
are reflected in other comprehensive earnings in the accompanying
consolidated balance sheet. The impact of the hedge at maturity is
recognized in the income statement as a component of investment
income, compensation and operating expenses depending on the nature
of the hedged item. We enter into various long-term debt
agreements. We use interest rate derivatives, typically swaps, to
reduce our exposure to the effects of interest rate fluctuations on
the forecasted interest rates for up to three years into the
future. These derivative instrument contracts are periodically
monitored for hedge ineffectiveness, the amount of which has not
been material to the accompanying consolidated financial
statements. We do not use derivatives for trading or speculative
purposes. Premium
Financing Seven subsidiaries of the
brokerage segment make short-term loans (generally with terms of
twelve months or less) to our clients to finance premiums. These
premium financing contracts are structured to minimize potential
bad debt expense to us. Such receivables are generally considered
delinquent after seven days of the payment due date. In normal
course, insurance policies are cancelled within one month of the
contractual payment due date if the payment remains delinquent. We
recognize interest income as it is earned over the life of the
contract using the “level-yield” method. Unearned
interest related to contracts receivable is included in the
receivable balance in the accompanying consolidated balance sheet.
The outstanding loan receivable balance was $316.2 million and
$305.5 million at December 31, 2018 and 2017,
respectively.
Fixed
Assets We carry fixed assets at
cost, less accumulated depreciation, in the accompanying
consolidated balance sheet. We periodically review long-lived
assets for impairment 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, we would recognize
a loss for the difference. Depreciation for fixed assets is
computed using the straight-line method over the following
estimated useful lives:
Useful
Life
Office equipment Three to ten
years
Furniture and
fixtures Three to ten
years
Computer
equipment Three to five
years
Building Fifteen to forty
years
Software Three to five
years
Refined fuel
plants Ten years
Leasehold
improvements Shorter of the lease term
or useful life of the asset Intangible
Assets Intangible assets represent
the excess of cost over the estimated fair value of net tangible
assets of acquired businesses. Our primary intangible assets are
classified as either goodwill, expiration lists, non-compete non-compete non-compete non-compete We review all of our
intangible assets for impairment periodically (at least annually
for goodwill) and whenever events or changes in business
circumstances indicate that the carrying value of the assets may
not be recoverable. We perform such impairment reviews at the
division (i.e., reporting unit) level with respect to goodwill and
at the business unit level for amortizable intangible assets. In
reviewing intangible assets, if the fair value were less than the
carrying amount of the respective (or underlying) asset, an
indicator of impairment would exist and further analysis would be
required to determine whether or not a loss would need to be
charged against current period earnings as a component of
amortization expense. Based on the results of impairment reviews in
2018, 2017 and 2016, we wrote off $10.6 million,
$6.2 million and $1.8 million, respectively, of
amortizable intangible assets primarily related to prior year
acquisitions of our brokerage segment, which is included in
amortization expense in the accompanying consolidated statement of
earnings. 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. Such
estimates and assumptions could change in the future as more
information becomes known which could impact the amounts reported
and disclosed herein. Income
Taxes Our tax rate reflects the
statutory tax rates applicable to our taxable earnings and tax
planning in the various jurisdictions in which we operate.
Significant judgment is required in determining the annual
effective tax rate and in evaluating uncertain tax positions. We
report a liability for unrecognized tax benefits resulting from
uncertain tax positions taken or expected to be taken in our tax
return. We evaluate our tax positions using a two-step Uncertain tax positions are
measured based upon the facts and circumstances that exist at each
reporting period and involve significant management judgment.
Subsequent changes in judgment based upon new information may lead
to changes in recognition, derecognition and measurement.
Adjustments may result, for example, upon resolution of an issue
with the taxing authorities, or expiration of a statute of
limitations barring an assessment for an issue. We recognize
interest and penalties, if any, related to unrecognized tax
benefits in our provision for income taxes.
Tax law requires certain
items to be included in our tax returns at different times than
such items are reflected in the financial statements. As a result,
the annual tax expense reflected in our consolidated statements of
earnings is different than that reported in our tax returns. Some
of these differences are permanent, such as expenses that are not
deductible in our tax returns, and some differences are temporary
and reverse over time, such as depreciation expense and
amortization expense deductible for income tax purposes. Temporary
differences create deferred tax assets and liabilities. Deferred
tax liabilities generally represent tax expense recognized in the
financial statements for which a tax payment has been deferred, or
expense which has been deducted in the tax return but has not yet
been recognized in the financial statements. Deferred tax assets
generally represent items that can be used as a tax deduction or
credit in tax returns in future years for which a benefit has
already been recorded in the financial statements. We establish or adjust
valuation allowances for deferred tax assets when we estimate that
it is more likely than not that future taxable income will be
insufficient to fully use a deduction or credit in a specific
jurisdiction. In assessing the need for the recognition of a
valuation allowance for deferred tax assets, we consider whether it
is more likely than not that some portion, or all, of the deferred
tax assets will not be realized and adjust the valuation allowance
accordingly. We evaluate all significant available positive and
negative evidence as part of our analysis. Negative evidence
includes the existence of losses in recent years. Positive evidence
includes the forecast of future taxable income by jurisdiction,
tax-planning Fair Value of Financial
Instruments Fair value accounting
establishes a framework for measuring fair value, which is defined
as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market
participants at the measurement date (i.e., an exit price). This
framework includes a fair value hierarchy that prioritizes the
inputs to the valuation technique used to measure fair
value. The classification of a
financial instrument within the valuation hierarchy is based upon
the transparency of inputs to the valuation of an asset or
liability on the measurement date. The three levels of the
hierarchy in order of priority of inputs to the valuation technique
are defined as follows:
•
Level 1 - Valuations are based on unadjusted quoted prices in
active markets for identical financial instruments;
•
Level 2 - Valuations are based on quoted market prices, other
than quoted prices included in Level 1, in markets that are
not active or on inputs that are observable either directly or
indirectly for the full term of the financial instrument;
and
•
Level 3 - Valuations are based on pricing or valuation
techniques that require inputs that are both unobservable and
significant to the overall fair value measurement of the financial
instrument. Such inputs may reflect management’s own
assumptions about the assumptions a market participant would use in
pricing the financial instrument. The level in the fair value
hierarchy within which the fair value measurement is classified is
determined based on the lowest level input that is significant to
the fair value measure in its entirety. The carrying amounts of
financial assets and liabilities reported in the accompanying
consolidated balance sheet for cash and cash equivalents,
restricted cash, premiums and fees receivable, other current
assets, premiums payable to underwriting enterprises, accrued
compensation and other accrued liabilities and deferred
revenue-current, at December 31, 2018 and 2017, approximate
fair value because of the short-term duration of these instruments.
See Note 4 to these consolidated financial statements for the
fair values related to the establishment of intangible assets and
the establishment and adjustment of earnout payables. See
Note 8 to these consolidated financial statements for the fair
values related to borrowings outstanding at December 31, 2018
and 2017 under our debt agreements. See Note 13 to these
consolidated financial statements for the fair values related to
investments at December 31, 2018 and 2017 under our defined
benefit pension plan. Litigation We are the defendant in
various legal actions related to claims, lawsuits and proceedings
incident to the nature of our business. We record liabilities for
loss contingencies, including legal costs (such as fees and
expenses of external lawyers and other service providers) to be
incurred, when it is probable that a liability has been incurred on
or before the balance sheet date and the amount of the liability
can be reasonably estimated. We do not discount such contingent
liabilities. To the extent recovery of such losses and legal costs
is probable under our insurance programs, we record estimated
recoveries concurrently with the losses recognized. Significant
management judgment is required to estimate the amounts of such
contingent liabilities and the related insurance recoveries. In
order to assess our potential liability, we analyze our litigation
exposure based on available information, including consultation
with outside counsel handling the defense of these matters. As
these liabilities are uncertain by their nature, the recorded
amounts may change due to a variety of different factors, including
new developments in, or changes in approach, such as changing the
settlement strategy as applicable to each matter.
Retention bonus
arrangements In connection with the
hiring and retention of both new talent and experienced personnel,
including our senior management, brokers and other key personnel,
we have entered into various agreements with key employees setting
up the conditions for the cash payment of certain retention
bonuses. These bonuses are an incentive for these employees to
remain with the company, for a fixed period of time, to allow us to
capitalize on their knowledge and experience. We have various forms
of retention bonus arrangements; some are paid up front and some
are paid at the end of the term, but all are contingent upon
successfully completing a minimum period of employment. A retention
bonus that is paid to an employee upfront that is contingent on a
certain minimum period of employment, will be initially classified
as a prepaid asset and amortized to compensation expense as the
future services are rendered over the duration of the stay period.
A retention bonus that is paid to an employee at the end of the
term that is contingent on a certain minimum period of employment,
will be accrued as a liability through compensation expense as the
future services are rendered over the duration of the stay period.
If an employee leaves prior to the required time frame to earn the
retention bonus outright, then all or any portion that is
ultimately unearned or refundable, and recovered by the company if
prepaid, is forfeited and reversed through compensation
expense. Stock-Based
Compensation We have several employee
equity-settled and cash-settled share-based compensation plans.
Equity-settled share-based payments to employees include grants of
stock options, performance stock units and restricted stock units
and are measured based on estimated grant date fair value. We have
elected to use the Black-Scholes option pricing model to determine
the fair value of stock options on the dates of grant. Performance
stock units are measured on the probable outcome of the performance
conditions applicable to each grant. Restricted stock units are
measured based on the fair market values of the underlying stock on
the dates of grant. Shares are issued on the vesting dates net of
the minimum statutory tax withholding requirements, as applicable,
to be paid by us on behalf of our employees. As a result, the
actual number of shares issued will be fewer than the actual number
of performance stock units and restricted stock units outstanding.
Furthermore, we record the liability for withholding amounts to be
paid by us as a reduction to additional paid-in Cash-settled share-based
payments to employees include awards under our Performance Unit
Program and stock appreciation rights. The fair value of t |
