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General
The following discussion should be read in conjunction with our consolidated financial statements and notes to those consolidated financial statements, included elsewhere in this report.
We are a general insurance agency and brokerage headquartered in Daytona Beach and Tampa, Florida. Since 1993, our stated corporate objective has been to increase our net income per share by at least 15% every year. We have increased revenues from $95.6 million in 1993 (as originally stated, without giving effect to any subsequent acquisitions accounted for under the pooling-of-interests method of accounting) to $455.7 million in 2002, a compound annual growth rate of 19.0%. In the same period, we increased net income from $8.0 million (as originally stated, without giving effect to any subsequent acquisitions accounted for under the pooling-of-interests method of accounting) to $83.1 million in 2002, a compound annual growth rate of 29.7%. We have also increased net income per share 15.0% or more for ten consecutive years, excluding the effect of a one-time investment gain of $1.3 million in 1994 and favorable adjustments to our income tax reserves of $0.7 million in 1994 and $0.5 million in 1995. Since 1993, excluding the historical impact of poolings, our pre-tax margins (income before income taxes and minority interest) improved in all but one year, and in that year, the pre-tax margin was essentially flat. These improvements have resulted primarily from net new business growth (new business production offset by lost business) and continued operating efficiencies. Our revenue growth in 2002 was driven by a general increase in premium rates, stronger net new business growth and the acquisition of 32 agency entities with annualized revenues of approximately $62.0 million.
Our revenues are comprised principally of commissions paid by insurance companies, commissions and fees paid directly by customers and investment income. Commission revenues generally represent a percentage of the premium paid by the insured and are materially affected by fluctuations in both premium rate levels charged by insurance underwriters and the insureds’ underlying “insurable exposure units,” which are units that insurers use to measure or express insurance exposed to risk (such as property values, sales and payroll levels) so as to determine what premium to charge the policyholder. These premium rates are established by insurance companies based upon many factors, including reinsurance rates, none of which we control. Beginning in 1987 and continuing through 1999, revenues were adversely influenced by a consistent decline in premium rates resulting from intense competition among property and casualty insurers for market share. Among other factors, this condition of a prevailing decline in premium rates, commonly referred to as a “soft market,” generally resulted in flat to reduced commissions on renewal business. The effect of this softness in rates on our revenues was somewhat offset by our acquisitions and net new business production. As a result of increasing “loss ratios” (the comparison of incurred losses plus adjustment expense against earned premiums) of insurance companies through 1999, there was a general increase in premium rates beginning in the first quarter of 2000 and continuing through the fourth quarter of 2002. Although premium rates vary by line of business, geographical region, insurance company and specific underwriting factors, we believe this was the first time since 1987 that we operated in an environment of increased premiums for three consecutive years. While we cannot predict the timing or extent of premium pricing changes as a result of market fluctuations or their effect on our operations in the future, we believe that premium rates will continue to increase through at least 2003.
The volume of business from new and existing customers, fluctuations in insurable exposure units and changes in general economic and competitive conditions further impact our revenues. For example, stagnant rates of inflation and the general decline of economic activity in recent years have generally limited the increases in the values of insurable exposure units. Conversely, the increasing costs of litigation settlements and awards have caused some customers to seek higher levels of insurance coverage. Still, our revenues continue to grow through an intense focus on net new business growth and acquisitions. We anticipate that results of operations for 2003 will continue to be influenced by these competitive and economic conditions.
We also earn “contingent commissions,” which are revenue-sharing commissions from insurance companies based upon the volume and the growth and/or profitability of the business placed with such companies during the prior year. These commissions are primarily received in the first and second quarters of each year, and over the last three years, have averaged approximately 6.1% of the previous year’s total commissions and fees. Contingent commissions are included in our total commissions and fees in the consolidated statements of income in the year received. The term “core commissions and fees” excludes contingent commissions and represents the revenues earned directly from each specific insurance policy sold or from fee-based services rendered.
Fee revenues are generated primarily by our Services Division, which provides insurance-related services, including third-party administration, consulting for the workers’ compensation and employee benefit self-insurance markets and managed healthcare services. In each of the past three years, fee revenues generated by the Services Division have averaged approximately 6.9% of our total commissions and fees.
Investment income consists primarily of interest earnings on premiums and advance premiums collected and held in a fiduciary capacity before being remitted to insurance companies. Our policy is to invest available funds in high-quality, short-term fixed income investment securities. Investment income also includes gains and losses realized from the sale of investments.
Acquisitions and the Impact of the Pooling-of-Interests Method of Accounting
During 2002, we acquired the assets and certain liabilities of 26 general insurance agencies, several books of business (customer accounts) and the outstanding stock of six general insurance agencies in transactions all accounted for under the purchase method of accounting.
In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” which requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. This change in accounting rules was the impetus for many of our acquisitions in 2001. During 2001, we acquired the following 12 agency groups in stock-for-stock transactions accounted for under the pooling-of-interests method of accounting:
- The Huval Companies
- Spencer & Associates, Inc. and SAN of East Central Florida, Inc.
- The Young Agency, Inc.
- Layne & Associates, Ltd.
- Agency of Insurance Professionals, Inc., CompVantage Insurance Agency, LLC and Agency of Indian Programs Insurance, LLC
- Finwall & Associates Insurance, Inc.
- The Connelly Insurance Group, Inc.
- The Benefit Group, Inc.
- Logan Insurance Agency, Inc. and Automobile Insurance Agency of Virginia, Inc.
- Froehlich-Paulson-Moore, Inc. and M&J Buildings, LLC
- McKinnon & Mooney, Inc.
- Raleigh, Schwarz & Powell, Inc.
We also acquired the assets of 13 general insurance agencies, several books of business (customer accounts) and the outstanding stock of two general insurance agencies in transactions accounted for under the purchase method of accounting.
During 2000, we acquired the following four agency groups in stock-for-stock transactions accounted for under the pooling-of-interests method of accounting:
- Bowers, Schumann & Welch
- The Flagship Group, Ltd.
- WMH, Inc. and Huffman & Associates, Inc.
- Mangus Insurance & Bonding, Inc.
We also acquired the assets of five general insurance agencies, several books of business and the outstanding stock of two general insurance agencies in transactions accounted for under the purchase method of accounting.
The revenues and expenses of entities that were acquired and accounted for under the purchase method of accounting are recognized only from the date of acquisition, and therefore do not impact our previously reported historical results. However, during 2001 and prior years when acquisitions could be accounted for under the pooling-of-interests method, the applicable accounting rules require that our consolidated financial statements be restated for all prior periods to include the results of operations, financial positions and cash flows of those entities acquired. Because most of the pooled entities were operated as privately held companies that paid significant year-end bonuses and compensation to their principals and owners during the periods prior to our acquisition of such entities, the combination of their lower net income results with our results diluted our historically reported profit margins, defined as income before income taxes and minority interest as a percentage of total revenues. As restated, our profit margins were 24.8% and 20.4% in 2001 and 2000, respectively. Without giving effect to any acquisitions accounted for under the pooling-of-interests method in the year of acquisition or in any prior year, our profit margins were 27.9% and 27.4% in 2001 and 2000, respectively. Our 2002 profit margin reflects a full year of operating results not affected by any pooling-of-interest restatement and is therefore the most representative of the ongoing profit margin relationship and expectations of the three years presented.
(See Notes 2 and 3 of Notes to Consolidated Financial Statements for the year ended December 31, 2002 for a description of our acquisitions.)
The following discussion and analysis regarding results of operations and liquidity and capital resources should be considered in conjunction with the accompanying consolidated financial statements and related notes.
Results of Operations for the Years Ended December 31, 2002, 2001 and 2000
Commissions and Fees
Commissions and fees increased 26% in 2002, 39% in 2001 and 12% in 2000. Core commissions and fees increased 12.1% in 2002, 11.3% in 2001 and 11.1% in 2000, which excludes commissions and fees generated from acquired operations that were accounted for under the purchase method of accounting, and divested operations. These results reflect stronger premium rate increases that began in the first quarter of 2000 and continued through 2002.
Investment Income
Investment income decreased to $2.9 million in 2002, compared with $3.7 million in 2001 and $4.9 million in 2000. The decrease in 2002 was primarily a result of the substantially lower investments yields earned during the year even though our available investment cash balances increased as a result of the $149.4 million net proceeds raised in our March 2002 follow-on common stock offering. The decrease in 2001 was primarily a result of lower available investment cash balances due to the higher level of acquisition activity, although declining investment yields also contributed to reduced income. Investment income also included gains of approximately $0.1 million in 2002, $0.3 million in 2001 and $0.2 million in 2000 realized from the sale of investments in various equity securities and partnership interests.
Other Income
Other income consists primarily of gains and losses from the sale and disposition of assets. In 2002, gains of $0.7 million were recognized from the sale of customer accounts. Gains from the sale of customer accounts were $0.8 million in 2001 and $0.1 million in 2000.
Employee Compensation and Benefits
Employee compensation and benefits increased approximately 20% in 2002, 25% in 2001 and 14% in 2000, primarily as a result of acquisitions and an increase in commissions paid to new and existing employees. Employee compensation and benefits as a percentage of total revenues was 49% in 2002, 51% in 2001 and 56% in 2000. The percentages were higher in 2001 and 2000 due to higher compensation and year-end bonuses paid to the principals and owners of pooled entities prior to the dates of acquisition. We had approximately 3,384 full-time employees at December 31, 2002, compared with approximately 3,000 at December 31, 2001 and approximately 2,140 at December 31, 2000.
Other Operating Expenses
Other operating expenses increased 17% in 2002, 28% in 2001, and 6% in 2000. However, other operating expenses as a percentage of total revenues decreased to 15% in 2002 from 16% in 2001 and 17% in 2000. However, the continuing decline in other operating expenses, expressed as a percentage of total revenues, is attributable to the effective cost containment measures brought about by an initiative designed to identify areas of excess expense, and to the fact that, in an increasing premium rate environment, certain significant other operating expenses such as office rent, office supplies and telephone costs, increase at a slower rate than commission and fee revenues increase during the same period.
Depreciation
Depreciation increased 11% in 2002, 6% in 2001 and 5% in 2000. These increases were primarily due to the purchase of new computer equipment and the depreciation associated with acquired assets.
Amortization
Amortization expense decreased $1.8 million, or 11%, in 2002, primarily due to the elimination of goodwill amortization in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” but offset by the increased amortization of identifiable intangible assets from new acquisitions consummated in 2002 and late 2001. Amortization expense increased $6.6 million, or 72%, in 2001, and $0.9 million, or 11%, in 2000 due to the additional amortization of intangibles as a result of new acquisitions. (See Notes 1, 2, 3, and 4 of Notes to Consolidated Financial Statements for the year ended December 31, 2002 for additional analysis of amortization expense.)
Interest Expense
Interest expense decreased $1.0 million, or 18%, in 2002, as a result of reduced outstanding debt. In 2001, interest expense increased $4.4 million, or 350%, over 2000, primarily as a result of a $90 million term loan obtained in January 2001 to acquire the insurance agency business-related assets of Riedman Corporation. Effective January 2, 2002, we entered into an interest rate swap agreement to lock in an effective fixed interest rate of 4.53% for the remaining six years of the term loan, excluding our “credit risk spread” (additional interest paid to offset risk of default) between 0.5% and 1.0%. The decrease in 2000 was the result of reduced outstanding debt.
Non-Cash Stock Grant Compensation
Non-cash stock grant compensation expense represents the expense required to be recorded under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” relating to our stock performance plan, which is more fully described in note 11 of the notes to our consolidated financial statements.
The annual cost of this stock performance plan increases only when our average stock price over a 20-trading-day period increases by increments of 20% or more from the price at the time of the original grant, or when more shares are granted and the stock price increases.
During 2001, after the first vesting condition for most of the previously granted performance stock was satisfied as a result of increases in our 20-trading-day average stock price, we granted additional shares of performance stock. With the awards granted in 2001 and the increase in our stock price since the grant date, the expense for the stock performance plan increased to $3.8 million in 2002, from $2.0 million in 2001 and $0.5 million in 2000. Additionally, in 2002, $0.7 million was expensed due to the accelerated vesting of some performance stock shares as a result of the deaths of two employees.
Since the first vesting condition for the performance stock grants issued in 2001 was satisfied in 2002 by reaching a 20-trading-day average stock price of $35.00, we intend to issue another set of performance stock grants in 2003 at a grant price per share of $35.00. There will be no expense relating to this set of performance stock grants until the 20-trading-day average performance stock grant price exceeds the $35.00 stock price by an increment of 20%.
Income Taxes
The effective tax rate on income from operations was 36.6% in 2002, 38.5% in 2001 and 37.3% in 2000. The lower effective tax in 2002 was primarily a result of the reduction of the general effective tax rate to 38.0% and the impact of a $1 million contribution which generated a $1 million state income tax credit. It is estimated that the effective tax rate on an ongoing basis will be 38.0%.
Results of Operations – Segment Information
As discussed in note 16 of the notes to our consolidated financial statements, we operate in four business segments: the Retail, National Programs, Services and Brokerage Divisions.
The Retail Division is our insurance agency business that provides a broad range of insurance products and services to commercial, governmental, professional and individual customers. More than 97% of the Retail Division’s revenues are commission-based. As a majority of our operating expenses do not change as premiums fluctuate, we believe that a majority of any fluctuation in commissions received by us will be reflected in our pre-tax income. The Retail Division’s revenues accounted for 75% to 78% of our total consolidated commissions and fees over the last three years. The Retail Division’s total revenues in 2002 increased $60.9 million to $348.5 million, a 21.2% increase over 2001. Of this increase, approximately $38.0 million related to commissions and fees from acquisitions accounted for under the purchase method of accounting that had no comparable revenues in 2001. The remaining increase is primarily due to net new business growth and rising premium rates during 2002. Income before income taxes and minority interest in 2002 increased $26.9 million to $78.9 million, a 51.8% increase over 2001. This increase is due to acquired revenues, increases in premium rates and improved cost structure related to these entities acquired during 2001 under the pooling-of-interest method of accounting. Total revenues in 2001 increased $88.0 million to $287.6 million, a 44.1% increase over 2000. This increase is primarily due to net new business growth and rising premium rates during 2001. Income before income taxes and minority interest in 2001 increased $21.9 million to $52.0 million, a 72.7% increase over 2000. This increase is due to acquired revenues, net new business growth, and rising premium rates.
The National Programs Division is comprised of two units: Professional Programs, which provides professional liability and related package products for certain professionals delivered through nationwide networks of independent agents; and Special Programs, which markets targeted products and services designated for specific industries, trade groups and market niches. Similar to the Retail Division, essentially all of the National Programs Division’s revenues are commission-based. Total revenues in 2002 increased $14.8 million to $58.6 million, a 33.7% increase over 2001, of which $7.9 million was related to net new business growth. The remaining increase in total revenues of $6.9 million was from acquired agencies, of which $3.3 million related to only two months of revenues from CalSurance Associates acquired as of November 1, 2002, whose revenues are primarily program related. In 2002, the underwriting company on our professional medical program decided not to renew their contract effective March, 2003, and therefore we are actively seeking a replacement carrier. Revenues from this professional medical program in 2002 were approximately $2.3 million, and without a replacement carrier, the 2003 revenues are expected to be less than $0.5 million. Income before income taxes and minority interest in 2002 increased $8.4 million to $26.2 million, a 46.8% increase over 2001, of which the majority of the increase related to the internally generated revenues. Total revenues in 2001 increased $7.0 million to $43.8 million, an 18.9% increase over 2000, of which $2.4 million was related to net new business growth. All of this net new business growth was related to our Special Programs Division, but was partially offset by the loss of approximately $3.4 million of auto industry-related programs that were terminated. Revenues related to our Professional Programs Division were essentially flat for 2001; however, prior to 2001, we experienced at least three years of annual revenue declines of 10% to 20% in this business. Income before income taxes and minority interest in 2001 increased $2.9 million to $17.9 million, a 19.6% increase over 2000, due primarily to net increases in revenues.
The Services Division provides insurance-related services, including third-party administration, consulting for the workers’ compensation and employee benefit self-insurance markets, and managed healthcare services. Unlike our other segments, more than 90% of the Services Division’s revenues are fees, which are not significantly affected by fluctuations in general insurance premiums. The Services Division’s total revenues in 2002 increased $3.6 million to $28.6 million, a 14.5% increase over 2001. Of this increase, $2.8 million was the result of net new business growth and the remaining $0.8 million was acquired. Income before income taxes and minority interest in 2002 increased $0.3 million to $4.3 million, an 8.7% increase over 2001, primarily due to strong net new business growth. The Services Division’s total revenues in 2001 increased $3.3 million to $25.0 million, a 15.4% increase over 2000. Of this increase, $2.2 million was the result of net new business growth and the remaining portion was acquired. Income before income taxes and minority interest in 2001 increased $0.9 million to $4.0 million, a 29.3% increase over 2000, primarily due to strong net new business growth.
The Brokerage Division markets and sells excess and surplus commercial insurance and reinsurance, primarily through independent agents and brokers. Similar to our Retail and National Programs Divisions, essentially all of the Brokerage Division’s revenues are commission-based. Total Brokerage Division revenues in 2002 increased $12.1 million to $24.3 million, a 98.8% increase over 2001. Of this increase, $4.6 million related to commissions and fees from acquisitions accounted for under the purchase method of accounting that had no comparable revenue in 2001. The remaining increase is primarily due to net new business growth. As a result of the Brokerage Division’s strong net new business growth, income before income taxes and minority interest in 2002 increased $2.8 million to $6.9 million, a 67.9% increase over 2001. Total Brokerage Division revenues in 2001 increased $4.2 million to $12.2 million, a 53.1% increase over 2000, due entirely to net new business growth. Income before income taxes and minority interest in 2001 increased $1.4 million to $4.1 million, a 51.5% increase over 2000, again due to net new business growth.
Quarterly Operating Results
The following table sets forth our quarterly results for 2002 and 2001.
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2002 |
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Total revenues | $ | 111,035 | $ | 114,903 | $ | 110,657 | $ | 119,147 | |||||
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Income before income taxes and minority interest | 33,711 | 35,690 | 33,396 | 31,867 | |||||||||
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Net income | 20,162 | 21,401 | 20,178 | 21,381 | |||||||||
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Net income per share: |
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$ | 0.31 | $ | 0.31 | $ | 0.30 | $ | 0.31 | ||||||
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Diluted | 0.31 | 0.31 | 0.29 | 0.31 | |||||||||
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2001 |
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Total revenues | $ | 89,410 | $ | 89,933 | $ | 89,809 | $ | 95,877 | |||||
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Income before income taxes and minority interest | 21,753 | 21,229 | 21,623 | 25,873 | |||||||||
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Net income | 12,876 | 12,420 | 13,402 | 15,215 | |||||||||
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Net income per share: | |||||||||||||
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Basic | $ | 0.21 | $ | 0.20 | $ | 0.21 | $ | 0.24 | |||||
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Diluted | 0.20 | 0.20 | 0.21 | 0.24 | |||||||||
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Liquidity and Capital Resources
Our cash and cash equivalents of $91.2 million at December 31, 2002 reflects an increase of $75.2 million from our December 31, 2001 balance of $16.0 million. During 2002, $93.3 million of cash was provided from operating activities and $149.4 million was raised from selling 5,000,000 shares of additional common stock in a follow-on stock offering in March 2002. From those funds, $120.9 million was used for acquisitions, $23.7 million was used to repay long-term debt, $13.4 million was used to pay dividends and $7.3 million was used for additions to fixed assets.
Our cash and cash equivalents of $16.0 million at December 31, 2001 reflects a decrease of $21.0 million from our December 31, 2000 balance of $37.0 million. During 2001, $69.9 million of cash was provided from operating activities and $90.1 million was received from long-term debt financing. From this borrowing and existing cash balances, $131.0 million was used for acquisitions, $33.3 million was used to repay long-term debt, $9.7 million was used to pay dividends and $11.0 million was used for additions to fixed assets.
Our cash and cash equivalents of $37.0 million at December 31, 2000 reflects an increase of $2.3 million from the December 31, 1999 balance of $34.7 million. During 2000, $42.3 million of cash was provided from operating activities and $0.5 million was received from long-term debt financing. From this financing and existing cash balances, $17.7 million was used for acquisitions, $5.5 million was used for purchases of our stock, $4.5 million was used to repay long-term debt, $7.5 million was used to pay dividends and $5.6 million was used for additions to fixed assets.
Our ratio of current assets to current liabilities (the “current ratio”) was 1.12 and 0.78 at December 31, 2002 and 2001, respectively. The increase in the current ratio in 2002 is primarily attributable to the follow-on stock offering of 5,000,000 shares of common stock which yielded net proceeds of $149.4 million.
As of December 31, 2002, our contractual cash obligations were as follows:
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Contractual Cash Obligations |
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Long-term debt | $ | 84,853 | $ | 27,279 | $ | 30,607 | $ | 26,455 | $ | 512 | ||||||
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Capital lease obligations | 66 | 55 | 11 | – | – | |||||||||||
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Other long-term liabilities | 5,604 | 2,181 | 870 | 1,230 | 1,323 | |||||||||||
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Operating leases | 49,774 | 15,052 | 20,699 | 9,032 | 4,991 | |||||||||||
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Maximum future acquisition contingency payments |
35,957 | 23,321 | 12,636 | – | – | |||||||||||
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Total Contractual Cash Obligations |
$ | 176,254 | $ | 67,888 | $ | 64,823 | $ | 36,717 | $ | 6,826 | ||||||
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In January 2001, we entered into a $90 million seven-year term loan agreement with SunTrust Banks, Inc. Borrowings under this facility bear interest based upon the 30-, 60- or 90-day London InterBank Offering Rate (“LIBOR”) plus a credit risk spread ranging from 0.50% to 1.00%, depending upon our quarterly ratio of funded debt to earnings before interest, taxes, depreciation and amortization. Ninety-day LIBOR was 1.38% as of December 31, 2002. The loan was fully funded on January 3, 2001 and a balance of $64.3 million remained outstanding as of December 31, 2002. This loan is to be repaid in equal quarterly principal installments of $3.2 million through December 2007. Effective January 2, 2002, we entered into an interest rate swap agreement with SunTrust Banks, Inc. to lock in an effective fixed interest rate of 4.53% for the remaining six years of the term loan, excluding our credit risk spread of between 0.50% and 1.00%.
We also had a revolving credit facility with a national banking institution that provided for available borrowings of up to $50 million, with a maturity date of October 2002, bearing an interest rate based upon the 30-, 60- or 90-day LIBOR plus 0.45% to 1.00%, depending upon our quarterly ratio of funded debt to earnings before interest, taxes, depreciation and amortization. A commitment fee of 0.15% to 0.25% per annum was assessed on the unused balance. The 90-day LIBOR was 1.88% as of December 31, 2001. There were no borrowings against this facility at December 31, 2001 and the facility was not renewed upon its maturity date in October 2002.
We continue to maintain our credit agreement with Continental Casualty Company (CNA) under which $1.0 million (the maximum amount available for borrowing) was outstanding at December 31, 2002. The interest rate on this credit agreement is equal to the prime rate (4.25% at December 31, 2002), plus 1%. The available amount will be paid in full August 2003.
Both of our credit agreements require us to maintain certain financial ratios and comply with certain other covenants. We were in compliance with all such covenants as of December 31, 2002.
Neither Brown & Brown nor its subsidiaries have ever incurred off-balance sheet obligations through the use of, or investment in, off-balance sheet derivative financial instruments or structured finance or special purpose entities organized as corporations, partnerships or limited liability companies or trusts.
We believe that our existing cash, cash equivalents, short-term investment portfolio and funds generated from operations will be sufficient to satisfy our normal liquidity needs through at least the end of 2003. Additionally, we believe that funds generated from future operations will be sufficient to satisfy our normal liquidity needs, including the required annual principal payments on our long-term debt.
In December 2001, a universal "shelf" registration statement that we filed with the Securities and Exchange Commission covering the public offering and sale, from time to time, of up to an aggregate of $250 million of debt and/or equity securities, was declared effective. The net proceeds from the sale of securities registered under the shelf registration statement would be used to fund acquisitions and for general corporate purposes, including capital expenditures, and to meet working capital needs. The common stock follow-on offering of 5,000,000 shares in March 2002 was made pursuant to the shelf registration statement.
Critical Accounting Policies
Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our estimates, which are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe that, of our significant accounting policies (see “Note 1 – Significant Accounting Policies” of Notes to Consolidated Financial Statements for the year ended December 31, 2002), the following critical accounting policies may involve a higher degree of judgment and complexity.
Revenue Recognition
Commission revenue is recognized as of the effective date of the insurance policy or the date the customer is billed, whichever is later. At that date, the earnings process has been completed, and we can reliably estimate the impact of policy cancellations for refunds and establish reserves accordingly. Management determines the policy cancellation reserve based upon historical cancellation experience adjusted by known circumstances. Subsequent commission adjustments are recognized upon notification from the insurance companies. Contingent commissions from insurance companies are recognized when determinable, which is when such commissions are received. Fee revenues are recognized as the services are rendered.
Business Acquisitions and Purchase Price Allocations
We have significant intangible assets acquired through business acquisitions consisting of purchased customer accounts, noncompete agreements, and the excess of costs over the fair value of identifiable net assets acquired (goodwill). The determination of estimated useful lives and the allocation of the purchase price to the intangible assets requires significant judgment and affects the amount of future amortization and possible impairment charges.
In accordance with SFAS No. 141, “Business Combinations,” all of our business combinations initiated after June 30, 2001 have been accounted for using the purchase method. In connection with these acquisitions, the Company records the estimated value of the net tangible assets purchased and the value of the identifiable intangible assets purchased, which typically consist of purchased customer accounts and noncompete agreements. Purchased customer accounts includes the physical records and files obtained from acquired businesses that contain information on insurance policies, customers and other information that is essential to policy renewals, and primarily represents the present value of the underlying cash flows expected to be received over the estimated future renewal periods of those purchased customer policies. The valuation of purchased customer accounts involves significant estimates and assumptions such as cancellation frequency, expenses and discount rates. If any of these assumptions change, it could affect the carrying value of purchased customer accounts. Noncompete agreements are valued based on the terms of the agreements. Purchased customer accounts and noncompete agreements are being amortized on a straight-line basis over the related estimated lives and contract periods, which range from five to 20 years. The excess of the purchase price of an acquisition over the fair value of the identifiable tangible and intangible assets is assigned to goodwill and is not amortized in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,”(SFAS No. 142).
Intangible Assets Impairment
Effective January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which requires that goodwill be subject to at least an annual assessment for impairment by applying a fair-value based test. Other intangible assets will be amortized over their useful lives and will be subject to a lower of cost or market impairment testing.
SFAS No. 142 requires us to compare the fair value of each reporting unit with its carrying value to determine if there is potential impairment of goodwill. If the fair value of the reporting unit is less than its carrying value, an impairment loss would be recorded to the extent that the fair value of the goodwill within the reporting unit is less than its carrying value. Fair value is estimated based on multiples of revenues, earnings before interest, income taxes, depreciation and amortization (EBITDA) and discounted cash flows.
Management assesses the recoverability of our goodwill, identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The following factors, if present, may trigger an impairment review: (i) significant underperformance relative to expected historical or projected future operating results; (ii) significant negative industry or economic trends; (iii) significant decline in our stock price for a sustained period; and (iv) market capitalization relative to net book value. If the recoverability of these assets is unlikely because of the existence of one or more of the above-mentioned factors, an impairment analysis is performed using a projected discount cash flow method. Management must make assumptions regarding estimated future cash flows and other factors to determine the fair value of these respective assets. If these estimates or related assumptions change in the future, we may be required to record an impairment charge. We completed our most recent evaluation of impairment for goodwill as of November 30, 2002 and identified no impairment as a result of the evaluation.
Reserves for Litigation
We are subject to numerous litigation claims that arise in the ordinary course of business. In accordance with SFAS No. 5, “Accounting for Contingencies,” if it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss is estimable, an accrual for the costs to resolve these claims is recorded in accrued expenses in the accompanying balance sheets. Professional fees related to these claims are included in Other Operating Expenses in the accompanying Consolidated Statements of Income. Management, with the assistance of outside counsel, determines whether it is probable that a liability has been incurred and estimates the amount of loss after analysis of each individual issue. New developments or changes in settlement strategy in dealing with these matters may significantly affect the required reserves and impact our net income.
Derivative Instruments
We entered into one derivative financial instrument, an interest rate exchange agreement, or “swap” to manage the exposure to fluctuations in interest rates on our $90 million variable rate debt. As of December 31, 2002, we maintained this swap agreement whereby Brown & Brown pays a fixed rate on the notional amount to a bank and the bank pays us a variable rate on the notional amount equal to a base LIBOR rate. We have assessed this derivative as a highly effective cash flow hedge, and accordingly, changes in the fair market value of the swap are reflected in other comprehensive income. The fair market value of this instrument is determined by quotes obtained from the related counter parties in combination with a valuation model utilizing discounted cash flows. The valuation of these derivative instruments is a significant estimate that is largely affected by changes in interest rates. If interest rates significantly increase or decrease, the value of these instruments will significantly change resulting in an impact on our net income.
New Accounting Pronouncements
In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” (SFAS No. 145). This Statement rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishment of Debt,” and an amendment of that Statement, SFAS No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.” This Statement also rescinds SFAS No. 44, “Accounting for Intangible Assets of Motor Carriers.” This Statement amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. This Statement will be effective for the year ended December 31, 2003 and for transactions entered into after May 15, 2002. The adoption of SFAS No. 145 will not have a material impact on our financial position or results of operations.
In June 2002, the Financial Accounting Standards Board issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” (SFAS No. 146). This Statement nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” Under Issue 94-3, a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of SFAS No. 146 will not have a material impact on our financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (SFAS No. 148). This Statement amends SFAS No. 123 (same title) and provides an alternative method of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements in both annual and interim financial statements related to the methods of accounting for stock-based employee compensation and the effect of the method on reported results. This Statement also prohibits the use of the prospective method of transition, as outlined in SFAS No. 123, when beginning to expense stock options and change to the fair value-based method in fiscal years beginning after December 15, 2003. As required, we adopted the disclosure requirements of SFAS No. 148 on December 31, 2002.
In November 2002, the FASB issued Financial Accounting Standards Board Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45), which requires the guarantor to recognize a liability for the fair value of the obligation at the inception of the guarantee. The adoption of FIN 45 will not have a material impact on our financial position or results of operations.
In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities,” which, clarified the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is applicable immediately for variable interest entities created after January 31, 2003. The provisions of FIN 46 are applicable for variable interest entities created prior to January 31, 2003 no later than July 1, 2003. The adoption of FIN 46 will not have an impact on our financial position or results of operations.
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