Aon is a British company based in London that is active in the insurance and risk management industries.
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 1-7933
Aon Corporation(Exact Name of Registrant as Specified in Its Charter)
DELAWARE
36-3051915
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
200 E. RANDOLPH STREET, CHICAGO, ILLINOIS
60601
(Address of Principal Executive Offices)
(Zip Code)
(312) 381-1000(Registrant’s Telephone Number,Including Area Code)
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 o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). YES o NO x
Number of shares of common stock outstanding:
No. Outstanding
Class
as of 6-30-06
$1.00 par value Common
314,470,643
Part 1
Financial Information
Aon Corporation
Condensed Consolidated Statements of Financial Position
As of
(millions)
June. 30, 2006
Dec. 31, 2005
(Unaudited)
(Reclassed-Note 11)
ASSETS
Investments
Fixed maturities at fair value
$
2,802
2,820
Equity securities at fair value
48
40
Short-term investments
4,136
3,907
Other investments
400
495
Total investments
7,386
7,262
Cash
425
476
Receivables
Risk and insurance brokerage services and consulting
9,427
8,072
Other receivables
1,143
1,218
Total receivables
10,570
9,290
Deferred Policy Acquisition Costs
538
523
Goodwill
4,390
4,170
Other Intangible Assets
136
111
Property and Equipment, net
507
505
Assets Held For Sale
3,998
3,783
Other Assets
2,153
1,698
TOTAL ASSETS
30,103
27,818
LIABILITIES AND STOCKHOLDERS’ EQUITY
Insurance Premiums Payable
10,976
Policy Liabilities
Future policy benefits
1,731
1,671
Policy and contract claims
1,619
1,648
Unearned and advance premiums and contract fees
498
474
Other policyholder funds
23
21
Total Policy Liabilities
3,871
3,814
General Liabilities
General expenses
1,504
1,631
Short-term borrowings
7
Notes payable
2,082
2,105
Pension, post-employment and post-retirement liabilities
1,646
1,497
Liabilities held for sale
3,356
3,145
Other liabilities
1,255
889
TOTAL LIABILITIES
24,711
22,515
Stockholders’ Equity
Common stock - $1 par value
347
344
Paid-in additional capital
2,436
2,349
Accumulated other comprehensive loss
(1,059
)
(1,155
Retained earnings
4,843
4,573
Less - Treasury stock at cost
(1,175
(808
TOTAL STOCKHOLDERS’ EQUITY
5,392
5,303
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
See the accompanying notes to the condensed consolidated financial statements.
2
Condensed Consolidated Statements of Income
Second Quarter Ended
Six Months Ended
(millions except per share data)
June 30,2006
June. 30,2005
Revenue
Brokerage commissions and fees
1,657
1,610
3,277
3,236
Premiums and other
522
482
1,041
957
Investment income
86
56
177
133
Total revenue
2,265
2,148
4,495
4,326
Expenses
Compensation and benefits
1,136
1,081
2,237
2,167
Other general expenses
471
946
910
Benefits to policyholders
292
258
581
520
Depreciation and amortization
55
59
110
121
Interest expense
34
31
65
Provision for New York and other state settlements
1
3
Total expenses
1,989
1,902
3,941
3,786
Income from continuing operations before provision for income tax and accounting change
276
246
554
540
Provision for income tax
95
53
192
159
Income from continuing operations before accounting change
181
193
362
381
Discontinued operations
Income from discontinued operations
20
43
47
62
8
45
19
52
Income (loss) from discontinued operations
12
(2
28
10
Income before accounting change
191
390
391
Cumulative effect of a change in accounting principle, net of tax
—
Net income
Preferred stock dividends
(1
Net income available for common stockholders
Basic net income (loss) per share
Income from continuing operations
0.56
0.60
1.13
1.18
0.04
(0.01
0.09
0.03
Cumulative effect of a change in accounting principle
0.59
1.22
1.21
Diluted net income (loss) per share
0.53
0.58
1.05
0.08
0.57
1.16
Cash dividends per share paid on common stock
0.15
0.30
Diluted average common and common equivalent shares outstanding
344.8
338.5
347.5
337.8
Aon CorporationCondensed Consolidated Statements of Cash Flows(Unaudited)
June 30,
2006
2005
Cash Flows from Operating Activities:
Adjustments to reconcile net income to cash provided by operating activities
Gain from disposal of operations
Depreciation and amortization of property, equipment and software
93
105
Amortization of stock awards
78
36
Amortization of intangible assets
25
Valuation changes on investments, income on disposals and net bond amortization
(11
(6
Income taxes
(69
(51
Pension expense in excess of cash paid to major defined benefit plans
Cash paid for 2005 restructuring plan in excess of expense
(34
Change in funds held on behalf of brokerage and consulting clients
300
200
Changes in insurance underwriting assets and liabilities:
Operating receivables
(19
Other assets including prepaid premiums
30
(54
Deferred policy acquisition costs
(70
(22
Policy liabilities
259
154
(25
Changes in other assets and liabilities:
(137
(194
Other assets and liabilities - net
(23
(95
Cash Provided by Operating Activities
892
550
Cash Flows from Investing Activities:
Sale of investments
Fixed maturities
Maturities
122
119
Calls and prepayments
108
104
Sales
891
887
Equity securities
5
18
9
Purchase of investments
(1,219
(1,544
(9
(13
Short-term investments - net
(176
185
Acquisition of subsidiaries
(108
(52
Proceeds from sale of operations
Property and equipment and other - net
(71
Cash Used by Investing Activities
(432
(342
Cash Flows from Financing Activities:
Issuance of common stock
46
Treasury stock transactions - net
(424
Issuance of short-term borrowings - net
14
Issuance of long-term debt
304
Repayment of long-term debt
(430
(580
Cash dividends to stockholders
(96
(97
Cash Used by Financing Activities
(509
(341
Effect of Exchange Rate Changes on Cash
(2)
(18
Decrease in Cash
(151
Cash at Beginning of Period
570
Cash at End of Period
419
See the accompanying notes to condensed consolidated financial statements.
4
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. Statement of Accounting Principles
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles and include all normal recurring adjustments which Aon Corporation (“Aon”) considers necessary for a fair presentation. Operating results for the three and six months ended June 30, 2006 are not necessarily indicative of results that may be expected for the year ending December 31, 2006.
Refer to the consolidated financial statements and notes in the Annual Report on Form 10-K for the year ended December 31, 2005 for additional details of Aon’s financial position, as well as a description of Aon’s accounting policies, which have been continued without material change, except as described in Note 4.
Certain amounts in the 2005 condensed consolidated financial statements and footnotes related to discontinued operations have been reclassified to conform to their 2006 presentation.
2. Endurance Warrants and Common Stock Investment
In 2001, Aon invested $227 million in the common stock of Endurance Specialty Holdings, Ltd. (“Endurance”), a Bermuda-based insurance and reinsurance company. Aon sold virtually all of its common stock investment in Endurance in 2004. In conjunction with the initial common stock investment, Aon also received 4.1 million stock purchase warrants, which allowed Aon to purchase additional Endurance common stock through December 2011. These warrants met the definition of a derivative, which required them to be recorded in the financial statements at fair value, with changes in fair value recognized in earnings on a current basis. With the assistance of an independent third party, Aon valued the warrants on a quarterly basis using the Black-Scholes valuation methodology. The warrants had a fair value of approximately $73 million, $90 million and $95 million as of March 31, 2006, December 31, 2005 and June 30, 2005, respectively. The change in the fair value of the warrants was a decrease of $17 million for the six months ended June 30, 2006, a decrease of $1 million for the three months ended June 30, 2005, and in increase of $15 million for the six months ended June 30, 2005. The change in fair value is included in investment income in the Corporate and Other segment. On March 31, 2006, Aon contributed all of the Endurance warrants to its U.K. pension plans. See Note 12 for further information.
3. Accounting and Disclosure Changes
Derivatives and Hedging
In March 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 155, Accounting for Certain Hybrid Financial Instruments—an amendment of Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Statement No. 155 permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133. Additionally, Statement No. 155 requires a company to evaluate interests in securitized financial assets to identify those interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Statement No. 155 amends Statement No. 140 by eliminating the prohibition of a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Aon adopted Statement No. 155, effective January 1, 2006. The impact of adopting Statement No. 155 did not have a material impact on the Company.
Off-Balance Sheet ActivityIn March 2006, the FASB issued Statement No. 156, Accounting for Servicing of Financial Assets—an amendment of Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,with respect to the accounting for separately recognized servicing assets and liabilities. Statement No. 156 requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations, including a transfer of the servicer’s financial assets that meets the requirements for sale accounting. Aon has two arrangements accounted for under Statement No. 140 that will be covered under Statement No. 156: investments held in Private Equity Partnerships Structures I, LLC (“PEPS I”) and the premium financing activities of Aon’s subsidiary, Cananwill. Statement No. 156 is effective for the first fiscal year beginning after September 30, 2006. The Company does not expect a material impact upon adoption of this statement.
Income TaxesIn July 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement of a tax position taken or expected to be taken in a company’s tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, Aon will be required to adopt FIN 48 in first quarter 2007. Aon is currently evaluating the impact that the adoption of FIN 48 will have, if any, on its consolidated financial statements and notes thereto.
4. Share-Based Payments
Prior to 2006, Aon followed Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees, and related Interpretations in accounting for its stock-based compensation plans. Under APB No. 25, no compensation expense was recognized for stock options when the exercise price of the options equaled the market price of the stock at the date of grant. Compensation expense was recognized on a straight-line basis for stock awards based on the vesting period and the market price at the date of the award.
6
On January 1, 2006, Aon adopted FASB Statement No. 123 (revised 2004), Share-Based Payment (“Statement No. 123(R)”), which requires the measurement and recognition of compensation expense for all share-based payments to employees, including grants of employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair values. Statement No. 123(R) supercedes the Company’s previous accounting under APB No. 25 for periods beginning in 2006.
Aon adopted Statement No. 123(R) using the modified prospective transition method. The Company’s condensed consolidated financial statements as of and for the three and six months ended June 30, 2006 reflect the impact of Statement No. 123(R). In accordance with the modified prospective transition method, the Company’s condensed consolidated financial statements for prior periods have not been restated to reflect the impact of Statement No. 123(R).
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Aon’s condensed consolidated statements of income for the three and six months ended June 30, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of Statement No. 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of Statement No. 123(R). As stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Statement No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In Aon’s pro forma information required under Statement No. 123 for the periods prior to 2006, Aon accounted for forfeitures on restricted stock units as they occurred, but estimated forfeitures on stock options.
Upon adoption of Statement No. 123(R), Aon also changed its method of valuation for stock options granted beginning in 2006 to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model, which was previously used for Aon’s pro forma information required under Statement No. 123. Lattice-based option valuation models utilize a range of assumptions over the expected term of the options. Expected volatilities are based on the average of the historical volatility of Aon’s stock price and the implied volatility of traded options on Aon’s stock. Aon uses historical data to estimate option exercise and employee termination within the valuation model, stratifying between officers and non-officers. The expected dividend yield assumption is based on the company’s history and expected future dividend rate. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
The weighted-average estimated fair value of employee stock options granted during the six months ended June 30, 2006 was $11.08 per share for officers, which represents options granted in the first quarter. No options were granted to officers in the second quarter of 2006. The weighted average estimated value of options granted during the three and six months ended June 30, 2006 was $9.96 and $10.78 per share, respectively, for non-officers. The following weighted average assumptions were used to estimate fair value:
Three months endedJune 30, 2006
Six months endedJune 30, 2006
Non-officers
Officers
Other
Weighted average volatility
28.5
%
30.5
28.5% – 30.5
Expected dividend yield
2.3
Risk-free rate
4.7
4.4% – 4.7
The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding and is a derived output of the lattice-binomial model. The expected life of option grants made during the three and six months ended June 30, 2006 derived from the lattice-binomial model were 5 years for officers and 6 years for all others.
The weighted-average estimated value of employee stock options granted during the three and six months ended June 30, 2005 were $4.81 and $5.13, respectively, using the Black-Scholes model with the following weighted-average assumptions:
Three months endedJune 30, 2005
Six months endedJune 30, 2005
Expected volatility
28.0
28.0 – 30.0
Risk free interest rate
3.8
3.8 – 4.1
Expected dividends
2.5
2.5 – 2.6
Expected term (in years) (1)
1.0
(1) Represents number of years from vesting date.
The following table summarizes stock-based compensation expense related to all share-based payments recognized in the condensed consolidated statements of income in compensation and benefits.
Three months endedJune 30,
Six months endedJune 30,
Stock options
13
Employee stock purchase plan
Restricted stock units
33
15
66
Stock-based compensation expense included in compensation and benefits
81
Tax benefit
Stock-based compensation expense, net of tax
26
Impact on net income per share:
Basic
0.16
0.07
Diluted
The following table summarizes stock option activity for the six months ended June 30, 2006 and 2005.
Weighted
Average
Remaining
Exercise
Contractual
(shares in thousands)
Shares
Price
Life (in years)
Beginning outstanding
35,712
29
34,188
Granted
2,780
39
2,783
Exercised
(3,460
(271
Forfeited and expired
(62
(993
Outstanding at June 30
34,970
6.06
35,707
6.53
Exercisable at June 30
19,552
32
20,961
The aggregate intrinsic value represents the total pretax intrinsic value, based on options with an exercise price less than the Company’s closing stock price of $34.82 as of June 30, 2006, which would have been received by the option holders had those option holders exercised their options as of that date. The aggregate intrinsic value of options outstanding and exercisable as of June 30, 2006 was $229 million and $96 million, respectively.
The aggregate intrinsic value of options exercised during the three and six months ended June 30, 2006 were $12 million and $41 million, respectively, and for the three and six months ended June 30, 2005 were $1 million and $1 million, respectively.
A summary of the status of Aon’s non-vested stock awards is as follows:
Six months ended June 30,
Fair Value
Intrinsic Value
Non-vested as of beginning of period
11,785
24
8,784
3,026
38
3,188
22
Vested
(1,406
(764
Forfeited
(273
27
(204
Non-vested as of end of period
13,132
11,004
Unamortized deferred compensation expense, which includes both options and awards, amounted to $376 million as of June 30, 2006, with a remaining weighted-average amortization period of approximately 4.2 years.
Cash received from the exercise of stock options was $95 million and $5 million through June 30, 2006 and 2005, respectively.
In late 2005, Aon announced a $1 billion share repurchase program. During 2006, a majority, but not all, of option exercises and award vestings were satisfied through the reissuance of treasury shares.
The following table illustrates pro forma net income and pro forma earnings per share as if Aon had applied the fair value recognition provision of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation in 2005.
Net income, as reported
Add:
Stock-based compensation expense included in reported net income, net of tax
Deduct:
Stock-based compensation expense determined under fair value based method for all awards and options, net of tax
(29
Pro forma net income
188
385
Net income per share:
As reported
Pro forma
1.19
1.14
5. Income Per Share
Income per share is calculated as follows:
Basic net income:
Income from continuing operations, before accounting change
Income (loss) from discontinued operations, net of tax
Net income for basic per share calculation
Diluted net income:
Interest expense on convertible debt securities, net of tax
Net income for diluted per share calculation
195
394
393
Basic shares outstanding
320
322
321
Effect of convertible debt securities
Common stock equivalents
11
Diluted potential common shares
345
339
348
338
Basic net income (loss) per share:
Diluted net income (loss) per share:
Certain common stock equivalents related to options were not included in the computation of diluted net income per share because those options’ exercise price was greater than the average market price of the common shares. The number of options excluded from the quarterly calculation was 5 million and 24 million at June 30, 2006 and 2005, respectively. For six months ended June 30, 2006 and 2005, the number of options excluded was 4 million and 25 million, respectively.
6. Comprehensive Income
The components of comprehensive income, net of tax, for the three and six month ended June 30, 2006 and 2005 are as follows:
Net derivative gains (losses)
(16
Net unrealized investment gains (losses)
(12
(43
Net foreign exchange gains (losses)
106
(84
131
(186
Comprehensive income
295
130
487
The components of accumulated other comprehensive loss, net of tax, are as follows:
December 31,2005
Net derivative losses
(3
Net unrealized investment gains
Net foreign exchange translation
(119
Net additional minimum pension liability
(1,077
7. Business Segments
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting, and Insurance Underwriting. A fourth segment, Corporate and Other, when aggregated with the operating segments and after the elimination of intersegment revenues, totals to the amounts in the accompanying condensed consolidated financial statements.
The Risk and Insurance Brokerage Services segment consists primarily of Aon’s retail and reinsurance brokerage operations, as well as related insurance services, including underwriting management, captive insurance company management services, and premium financing. The Consulting segment provides a full range of human capital management services delivered predominantly to corporate clientele utilizing seven major practices: employee benefits, human resource outsourcing, compensation, management consulting, communications, strategic human resource consulting and financial advisory and litigation consulting services. The Insurance Underwriting segment provides specialty insurance products including supplemental accident, health and life insurance coverages and select property and casualty insurance products. Corporate and Other segment revenue consists primarily of investment income from equity, fixed-maturity and short-term investments that are assets primarily of the insurance underwriting
subsidiaries that exceed policyholders liabilities and which may include non-income producing equities, and income and losses on disposals of securities not otherwise included in the operating segments. Corporate and Other segment general expenses include administrative and certain information technology costs.
The accounting policies of the operating segments are the same as those described in this Form 10-Q and Aon’s Annual Report on Form 10-K for the year ended December 31, 2005, except that the disaggregated financial results have been prepared using a management approach, which is consistent with the basis and manner in which Aon senior management internally disaggregates financial information for the purpose of making internal operating decisions. Aon evaluates performance based on stand-alone operating segment income before income taxes and generally accounts for intersegment revenue as if the revenue were to third parties, that is, considered by management to be at current market prices.
Revenues are generally attributed to geographic areas based on the location of the resources producing the revenues. Intercompany revenues and expenses are eliminated in computing consolidated revenues and income before tax.
Revenue from continuing operations for Aon’s segments is as follows:
Risk and Insurance Brokerage Services
1,395
1,334
2,788
2,686
Consulting
309
315
617
624
Insurance Underwriting
556
511
1,107
1,016
Corporate and Other
Intersegment revenues
(15
(32
(30
Total
Aon’s operating segments’ geographic revenue and income before income tax is as follows:
Risk and Insurance
Insurance
Three months ended June 30:
Brokerage Services
Underwriting
United States
528
493
175
183
399
361
United Kingdom
243
266
54
Continent of Europe
303
289
41
Rest of World
286
37
75
70
Income before income tax
220
208
79
63
Six months ended June 30:
1,034
922
340
357
788
712
464
497
103
100
97
725
747
101
71
565
73
148
137
469
448
135
117
Selected information for Aon’s Corporate and Other segment follows:
Revenue:
Income (loss) from change in fair value of Endurance warrants
(17
Income from other investments
17
Limited partnership investments
Net loss on disposals and related expenses:
Impairment write-downs
(4
(7
Expenses:
16
64
57
118
Loss before income tax
(46
(103
(80
8. Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over the fair market value of net assets acquired. Goodwill is allocated to various reporting units, which are either operating segments or one reporting level below the operating segments. Goodwill is not amortized but is subject to impairment testing at least annually. When a business entity is sold, goodwill is allocated to the disposed entity based on the fair value of that entity compared to the fair value of the reporting unit in which it is included.
The changes in the net carrying amount of goodwill by operating segment for the six months ended June 30, 2006 are as follows:
Risk and
Brokerage
Services
Balance as of December 31, 2005
3,764
378
Goodwill acquired
Goodwill related to disposals
Foreign currency revaluation
Balance as of June 30, 2006
3,982
380
· “Customer Related and Contract Based” include client lists as well as non-compete covenants;
· “Present Value of Future Profits” represent the future profits of purchased books of business of the insurance underwriting subsidiaries; and
· “Marketing, Technology and Other” are all other purchased intangibles not included in the preceding categories.
Other intangible assets by asset class are as follows:
Customer
Present Value
Marketing,
Related and
of Future
Technology
Contract Based
Profits
and Other
As of June 30, 2006
Gross carrying amount
219
217
459
Accumulated amortization
187
116
323
Net carrying amount
As of December 31, 2005
406
74
Amortization expense for intangible assets for the years ended December 31, 2006, 2007, 2008, 2009 and 2010 is estimated to be $51 million, $28 million, $22 million, $21 million and $17 million, respectively.
9. Restructuring Charges
2005 Restructuring Plan
In 2005, the Company commenced restructuring initiatives that are expected to be completed in 2007 and result in cumulative pretax charges totaling approximately $300 million, including workforce reductions, lease consolidation costs, asset impairments and other expenses necessary to implement the restructuring initiatives. Costs related to the restructuring are included in compensation and benefits, other general expenses and depreciation and amortization in the accompanying condensed consolidated statements of income.
The following is a summary of second quarter and six months 2006, as well as inception to date restructuring and related expenses by type incurred and the estimated total to be incurred through the end of the restructuring initiative:
Second quarter2006
Six months2006
Inceptionto date
EstimatedTotal
Workforce reduction
Lease consolidation
Asset impairments
Other related expenses
Total restructuring and related expenses
210
The following is a summary of restructuring and related expenses incurred and estimated to be incurred, by segment, through the end of the restructuring initiative:
186
The following table sets forth the activity related to the 2005 restructuring plan liabilities:
Balance at January 1, 2005
Expensed in 2005
141
Cash payments in 2005
Balance at December 31, 2005
Expensed in 2006
Credit to expense in 2006
Change in estimated liability
(85
Balance at June 30, 2006
83
Restructuring Charges – Prior Years
In 1996 and 1997, Aon recorded restructuring liabilities as a result of the acquisition of Alexander and Alexander Services, Inc. (A&A) and Bain Hogg. During the second quarter and six months 2006, Aon made payments of $1 million and $3 million, respectively, for these liabilities. The remaining liability of $24 million is primarily for lease abandonments and is being paid out over several years, as planned.
Aon’s unpaid liabilities are included in general expense liabilities in the condensed consolidated statements of financial position.
10. Capital Stock
During the first six months of 2006, Aon issued 2,287,000 new shares of common stock for employee benefit plans and 238,000 shares in connection with the employee stock purchase plan. In addition, Aon reissued 2,531,000 shares of treasury stock for employee benefit programs.
In November 2005, Aon announced that its Board of Directors had authorized the repurchase of up to $1 billion of Aon’s common stock. Shares may be repurchased through the open market or in privately negotiated transactions from time to time, based on prevailing market conditions and will be funded from available capital. Any repurchased shares will be available for use in connection with employee stock plans and for other corporate purposes. The Company repurchased approximately 5.6 million shares at a cost of $221 million in second quarter 2006. For the first six months of 2006, approximately 11.8 million shares were repurchased at a cost of $468 million.
There are also 22.4 million shares of common stock held in treasury at June 30, 2006 which are restricted as to their reissuance.
11. Disposal of Operations
Discontinued Operations
In June 2006, Aon reached a definitive agreement to sell its warranty and credit operations, Aon Warranty Group (“AWG”), which was previously included in the Insurance Underwriting segment, to Warrior Acquisition Corp., an affiliate of Onex Corporation, for approximately $710 million. The disposition is subject to various closing conditions, including receipt of certain required regulatory approvals, and is expected to be completed in the fourth quarter of 2006. Operating results, including related Corporate and Other segment investment income, have been reclassified to discontinued operations for the quarter and six months ended June 30, 2006 and 2005.
In accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Aon has reclassified the assets and liabilities of this operation to assets held-for-sale and liabilities held-for-sale, respectively, in the June 30, 2006 and December 31, 2005 condensed consolidated statements of financial position. Goodwill has been allocated to AWG based on an estimate of its fair value compared to the fair value of the reporting unit in which it was previously included. The Company does not expect a pretax loss from the sale of AWG.
The assets and liabilities reclassified are as follows:
Balance as of
December 31,
1,946
1,802
408
407
751
663
Goodwill and other intangible assets
223
225
Property and equipment and other assets
670
686
Total Assets
2,965
2,694
General expenses and other liabilities
451
Total Liabilities
In fourth quarter 2005, Aon committed to sell a non-core Australian brokerage unit, which was previously included in the Risk and Insurance Brokerage Services segment. This operation was sold in first quarter 2006, resulting in a pretax gain of $1 million.
In fourth quarter 2005, Aon completed the sale of Swett & Crawford (“Swett”), its U.S.-based wholesale insurance brokerage unit. Previously, Swett was included in the Risk and Insurance Brokerage Services segment. The sale resulted in a pretax gain of $239 million.
A&A Discontinued Operations
Prior to its acquisition by Aon, A&A discontinued its property and casualty insurance underwriting operations in 1985, some of which were then placed into run-off, with the remainder sold in 1987. In connection with those sales, A&A provided indemnities to the purchaser for various estimated and potential liabilities, including provisions to cover future losses attributable to insurance pooling arrangements, a stop-loss reinsurance agreement and actions or omissions by various underwriting agencies previously managed by an A&A subsidiary.
As of June 30, 2006, the liabilities associated with the foregoing indemnities were included in other liabilities in the condensed consolidated statements of financial position. Such liabilities amounted to $4 million, net of reinsurance recoverables and other assets of $77 million. The insurance liabilities represent estimates of known and future claims expected to be settled over the next 20 to 30 years, principally with regards to asbestos, pollution and other health exposures. Although these liabilities represent a best estimate of the probable liabilities, adverse developments may occur given the nature of the information available and the variables inherent in the estimation processes.
The operating results of all these businesses are classified as discontinued operations, and prior year’s operating results have been reclassified to discontinued operations, as follows:
Revenues:
AWG
310
308
603
594
Swett
60
370
703
Pretax income:
Operations:
Gain (loss) on sale—other
After-tax income (loss):
Operations
Sale
12. Net Periodic Benefit Cost
The following table provides the components of the net periodic benefit cost for Aon’s U.S. plans:
Pension Benefits
Other Benefits
(millions) Three months ended June 30:
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost
Amortization of net loss
Net periodic benefit cost
(millions) Six months ended June 30:
50
(57
49
The following table provides the components of net periodic benefit costs for Aon’s material international pension plans, which are located primarily in the U.K. and The Netherlands:
107
(56
(110
(94
44
Employer Contribution
As previously disclosed in its 2005 financial statements, Aon currently expects to contribute $6 million in 2006 to its U.S. defined benefit pension plans to satisfy minimum funding requirements and $4 million to fund other postretirement benefit plans. As of June 30, 2006, contributions of $2 million have been made to the U.S. pension plans and $2 million to other postretirement benefit plans.
Aon previously disclosed in its 2005 financial statements that it expected to contribute $180 million in 2006 to its major international defined benefit pension plans. Based on current rules and assumptions, Aon now plans to contribute approximately $350 million to its major international defined pension plans during 2006. As of June 30, 2006, $264 million has been contributed. This amount includes contributions of 4.1 million Endurance warrants, valued at $73 million, $34 million of notes issued by PEPS I, and convertible preferred stock in Scandent Holdings Maturities Limited, received as part of the sale proceeds of Cambridge Integrated Services Group, valued at $58 million.
13. Other-Than-Temporary Impairments
The following table analyzes our investment positions with unrealized losses segmented by quality and period of continuous unrealized loss as of June 30, 2006.
Investment Grade
6 -12
($ in millions)
0-6 Months
Months
> 12 Months
FIXED MATURITIES
U.S. government & agencies
# of positions
61
202
Amortized Cost
Unrealized Loss
(5
(8
States & political subdivisions
Foreign government
163
569
461
99
1,129
579
477
1,159
(10
Corporate securities
328
94
559
244
504
176
924
253
532
970
(28
Mortgage & asset backed securities
231
409
178
TOTAL FIXED MATURITIES
319
665
235
1,219
974
1,276
396
2,646
996
414
2,744
(58
(98
% of Total Unrealized Loss
58
98
Non-Investment Grade
EQUITIES
0
For categorization purposes, Aon considers any rating of Baa or higher by Moody’s Investor Services or equivalent rating agency to be investment grade. Aon has no fixed maturities below investment grade with an unrealized loss.
Aon’s fixed-maturity portfolio in total had a $98 million gross unrealized loss at June 30, 2006, and is subject to interest rate, market, and credit risks. No single position had an unrealized loss greater than $6 million. With a carrying value of $2,802 million at June 30, 2006, Aon’s total fixed-maturity portfolio is approximately 99% investment grade based on market value. Fixed-maturity securities with an unrealized loss are all investment grade and have a weighted average rating of “Aa” based on amortized cost. Aon’s non-publicly-traded fixed maturity portfolio had a carrying value of $192 million, including $25 million in notes issued by PEPS I to Aon. In 2006, Aon, via its U.K. subsidiary, contributed $34 million of PEPS I notes to one of its U.K. pension plans. Valuations of these securities primarily reflect the fundamental analysis of the issuer and current market price of comparable securities.
Aon’s equity portfolio is comprised of non-redeemable preferred stocks, publicly traded common stocks and other common and preferred stocks not publicly traded. This portfolio had $2 million of unrealized losses at June 30, 2006, and is subject to interest rate, market, credit, illiquidity, concentration and operational performance risks.
Aon reviews invested assets with material unrealized losses each quarter. Please see Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates in Aon’s 2005 Annual Report on Form 10-K for further information.
14. Notes Payable
In April 2006, an indirect wholly-owned subsidiary of Aon issued CAD 375 million (US $334 million at June 30, 2006 exchange rates) of 5.05% senior unsecured debentures due in April 2011. The principal and interest on the debentures is unconditionally and irrevocably guaranteed by Aon. The net proceeds from the offering were used to repay outstanding indebtedness under the Company’s €650 million (US $818 million at June 30, 2006 exchange rates) Euro credit facility.
15. Contingencies
Aon and its subsidiaries are subject to numerous claims, tax assessments, lawsuits and proceedings that arise in the ordinary course of business. The damages claimed in these matters are or may be substantial, including, in many instances, claims for punitive, treble or extraordinary damages. Aon has purchased errors and omissions (“E&O”) insurance and other appropriate insurance to provide protection against losses that arise in such matters. Accruals for these items, and related insurance receivables, when applicable, have been provided to the extent that losses are deemed probable and are reasonably estimable. These accruals and receivables are adjusted from time to time as developments warrant.
In 2004, Aon, other insurance brokers, insurers and numerous other industry participants received subpoenas and other requests for information from the office of the Attorney General of the State of New York and from other states relating to certain practices in the insurance industry.
On March 4, 2005, Aon entered into an agreement (the “Settlement Agreement”) with the Attorney General of the State of New York, the Superintendent of Insurance of the State of New York, the Attorney General of the State of Connecticut, the Illinois Attorney General and the Director of the Division of Insurance, Illinois Department of Financial and Professional Regulation (collectively, the “State Agencies”) to resolve all the issues related to investigations conducted by the State Agencies.
As has been described in detail in Aon’s previous financial filings, the Settlement Agreement requires Aon to pay between 2005-2007 a total of $190 million into a fund (the “Fund”) to be distributed to certain Eligible Policyholder clients. The Settlement Agreement sets forth the procedures under which Aon mailed notices to its Eligible Policyholder clients and distributes the Fund to Participating Policyholder clients. In order to obtain a payment from the Fund, Participating Policyholders were required to tender a release of claims against the Company arising from acts, omissions, transactions or conduct that were the subject of the investigations.
As required by the Settlement Agreement, within 60 days of the effective date of that agreement, the Company commenced the implementation of certain business reforms, including agreeing not to accept contingent compensation as defined in the Settlement Agreement.
Purported clients have also filed civil litigation against Aon and other companies under a variety of laws and legal theories relating to broker compensation practices and other issues under investigation by New York and other states. As previously reported, a putative class action styled Daniel v. Aon (Affinity) has been pending in the Circuit Court of Cook County, Illinois since August 1999. On March 9, 2005, the Court gave preliminary approval to a nationwide class action settlement within the $40 million reserve established in the fourth quarter of 2004. The Court granted final approval to the settlement in March 2006. Parties that objected to the settlement have appealed.
Beginning in June 2004, a number of other putative class actions were filed against Aon and other companies by purported classes of clients under a variety of legal theories, including state tort, contract, fiduciary duty, antitrust and statutory theories and federal antitrust and Racketeer Influenced and Corrupt Organizations Act theories. These actions are currently pending at early stages in state court in California and in federal court in New Jersey. Aon believes it has meritorious defenses in all of these cases and intends to vigorously defend itself against these claims. The outcome of these lawsuits, and any losses or other payments that may occur as a result, cannot be predicted at this time.
Beginning in late October 2004, several putative securities class actions were filed against Aon in the U.S. District Court for the Northern District of Illinois. Also beginning in late October 2004, several putative ERISA class actions were filed against Aon in the U.S. District Court for the Northern District of Illinois. Aon believes it has meritorious defenses in all of these cases and intends to vigorously defend itself against these claims. The outcome of these lawsuits, and any losses or other payments that may occur as a result, cannot be predicted at this time.
With respect to the various class actions that have been filed, we are unable to estimate a range of possible losses, as these actions have not yet progressed to the stages where damages can be estimated.
In May 2005, the Office of the U.S. Attorney for the Southern District of New York and the Securities and Exchange Commission sent to Aon subpoenas seeking information relevant to these agencies’ industry-wide investigations of finite risk insurance. Aon is fully cooperating with these investigations. Because this is an industry-wide investigation, and there is no indication at this time that Aon will incur any liability in connection with the investigation, Aon is unable at this time to provide an estimate of any possible losses.
In February 2006, Lloyds announced that it had brought suit in London against Benfield and a subsidiary of Aon to recover alleged losses relating to these brokers’ placement of insurance for Lloyds’s New Central Fund. Lloyds alleges that its brokers did not fairly present the risk to reinsurers and thus that the brokers should be held liable for reinsurers’ failure to pay approximately ₤325 million ($593 million based on June 30, 2006 exchange rate) in claims. Aon disputes Lloyds’s allegations, believes that it has meritorious defenses and intends to vigorously defend itself against Lloyds’s claims. Because the lawsuit is at a very early stage and Aon has only recently begun to undertake its defense, Aon is unable at this time to provide an estimate of a range of possible losses.
Although the ultimate outcome of all matters referred to above cannot be ascertained, and liabilities in indeterminate amounts may be imposed on Aon or its subsidiaries, on the basis of present information, amounts already provided, availability of insurance coverages and legal advice received, it is the opinion of management that the disposition or ultimate determination of such claims will not have a material adverse effect on the consolidated financial position of Aon. However, it is possible that future results of operations or cash flows for any particular quarterly or annual period could be materially affected by an unfavorable resolution of these matters.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
This Management’s Discussion and Analysis is divided into six sections. First, key recent events are described that have affected or will affect our financial results during 2006. Next, we discuss our critical accounting policies with respect to the implementation of the new accounting pronouncements on share-based payments and the potential impact of the FASB’s proposed changes to pension accounting rules. We then review our consolidated results and segments with comparisons from second quarter and six months 2006 to the corresponding periods in 2005. We then cover our financial condition and liquidity along with related disclosures as well as information on our off balance sheet arrangements. The final section addresses certain factors that can influence future results.
The outline for our Management’s Discussion and Analysis is as follows:
KEY RECENT EVENTS
Sale and Strategic Analysis of Certain Businesses
Restructuring and Other Business Reorganization Initiatives
Stock Repurchase Program
U.K. Pension Contributions
CRITICAL ACCOUNTING POLICIES
Share-based Payments
Proposed Accounting Standard on Pension Accounting
REVIEW OF CONSOLIDATED RESULTS
General
Consolidated Results
REVIEW BY SEGMENT
FINANCIAL CONDITION AND LIQUIDITY
Cash Flows
Financial Condition
Short-term Borrowings and Notes Payable
Off Balance Sheet Arrangements
INFORMATION CONCERNING FORWARD-LOOKING STATEMENTS
Key Recent Events
Warranty Business
In June 2006, Aon reached a definitive agreement to sell its warranty and credit operations, Aon Warranty Group (“AWG”) which was previously included in our Insurance Underwriting segment, to Warrior Acquisition Corp., an affiliate of Onex Corporation, for approximately $710 million. The disposition is subject to various closing conditions, including receipt of certain required regulatory approvals, and is expected to be completed in the fourth quarter of 2006. The operating results of this business, including related Corporate and Other segment investment income, have been reclassified to discontinued operations for the quarter and six month periods ending June 30, 2006 and 2005 (see “Discontinued Operations”).
Aon continues to explore strategic options with respect to one of its specialty property and casualty businesses, Construction Program Group, which was not included in the AWG transaction. We are no longer writing any new business for the remainder of our specialty property and casualty businesses.
See Note 11 to the condensed consolidated financial statements, “Disposal of Operations,” for further information.
We continue to execute and refine the restructuring initiatives announced in 2005 with the purpose of maximizing our revenue potential and eliminating unnecessary costs. The identified restructuring initiatives are expected to result in cumulative pretax charges totaling approximately $300 million over a three-year period. Through June 30, 2006 we incurred $210 million of expenses relating to these efforts. The restructuring expenses are composed of workforce reductions, lease consolidations, asset impairments, and other related expenses. We expect the remaining expenses to affect our continuing operations through the end of 2007. We anticipate that these initiatives will lead to annualized pre-tax savings of at least $195 million by 2008. The cost and savings estimates may change as actual results become known and we finalize restructuring opportunities.
The 2005 Restructuring Plan is expected to result in the elimination of 2,400 job positions and space consolidation in certain locations. When offices close we recognize losses on subleases or lease buy-outs; such situations may also trigger asset impairments. The following is a summary of restructuring and related expenses by type incurred and estimated to be incurred through the end of the restructuring initiative:
Actual
Full
First
Second
Year-
Estimated (1)
Year2005
Quarter2006
to-date2006
Remainderof 2006
2007
Costs By Type:
158
69
Estimated Savings
171
(1) Our estimated costs are forward looking and should be read in connection with our risk factors in our 2005 Form 10-K. Actual costs may vary due to changes in the assumptions built into this plan. Some of the assumptions likely to change when plans are finalized and approved include changes in severance calculations, the assumptions underlying our sublease loss calculations due to changing market conditions and our overall analysis that might cause us to add or cancel component initiatives.
Year-to-date, restructuring and related expenses amounted to $52 million, which include:
· $32 million year-to-date in workforce reduction costs.
· $12 million in lease consolidation costs, reflecting leases terminated or abandoned in the U.S. and the U.K.
· $2 million of asset impairments attributable to leasehold impairment write-downs on abandoned leases.
· $6 million in other related expenses, which represent fees paid to outside parties for work related to the restructuring.
Below is a detail of the restructuring and related expense by segment:
Estimated
FirstQuarter
SecondQuarter
Inception toDate
Remainder of2006
Corporate
The following table details the restructuring and related expenses incurred in 2005 and first half of 2006 and estimated for the remainder of 2006 and 2007 by geographic region:
United
Continent
Rest of
Costs By Region:
States
Kingdom
of Europe
World
2005 (incurred)
92
1st Quarter 2006 (incurred)
2nd Quarter 2006 (incurred)
Remainder of 2006 (estimated)
2006 (estimated)
2007 (estimated)
Total incurred and remaining estimated
51
In addition to these actions, we are exploring additional initiatives that will likely be decided upon during the second half of 2006, which may result in an increase in estimated restructuring costs and related savings.
In November 2005, we announced a $1 billion stock repurchase program. Shares may be repurchased through the open market or in privately negotiated transactions from time to time, based on prevailing market conditions, and will be funded from available capital. Any repurchased common stock will be available for use in connection with employee stock plans and for other corporate purposes. Through June 30, 2006 we repurchased approximately 12.4 million shares at a cost of $493 million under the stock repurchase program.
In first quarter 2006, we contributed cash and certain financial investments valued at approximately $227 million to our U.K. pension plans. Included in the contribution were part of our holdings in PEPS I notes, investment in Endurance warrants, and our investment in Scandent Holdings Maturities Limited (“Scandent”), received as part of the sale of Cambridge Integrated Services Group, valued at $58 million. Our year-to-date Corporate and Other segment investment income includes a $17 million decrease in the fair value of the Endurance warrants prior to their contribution on March 31. The year-to-date results of our Risk and Insurance Brokerage Services segment includes a realized gain recognized on the contribution of our investment in Scandent of $35 million.
Other than as discussed below, there have been no changes in the Company’s critical accounting policies, which include restructuring, pensions, contingencies, policy liabilities, valuation of investments and intangible assets, as discussed in the Annual Report on Form 10-K filed for the year ended December 31, 2005.
On January 1, 2006, Aon adopted FASB Statement No. 123(R), which requires the measurement and recognition of compensation expense for all share-based payments to employees, including grants of employee stock options and employee stock purchases related to the Employee Stock Purchase Plan, based on estimated fair values.
Prior to the adoption of Statement No. 123(R), Aon accounted for stock-based awards to employees using the intrinsic value method in accordance with APB No. 25 as allowed under Statement No. 123. Under the intrinsic value method, no stock-based compensation expense was recognized in the condensed consolidated statements of income other than for restricted stock units, because the exercise price of Aon’s stock options granted to employees equaled the fair market value of the underlying stock at the date of grant.
Aon adopted Statement No. 123(R) using the modified prospective transition method. In accordance with the modified prospective transition method, the Company’s condensed consolidated financial statements for prior periods have not been restated to reflect the impact of Statement No. 123(R).
Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in Aon’s condensed consolidated statements of income for the three and six months ended June 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of Statement No. 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of Statement No. 123(R). Because stock-based compensation expense recognized is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Statement No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In Aon’s pro forma information required under Statement No. 123 for the periods prior to 2006, Aon accounted for forfeitures on restricted stock units as they occurred, but estimated forfeitures on stock options.
Upon adoption of Statement No. 123(R), Aon also changed its method of valuation for stock options granted beginning in 2006 to a lattice-binomial option-pricing model from the Black-Scholes option-pricing model, which was previously used for Aon’s pro forma information required under Statement No. 123. Aon’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by Aon’s stock price as well as assumptions regarding a number of variables, which include, but are not limited to, Aon’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.
Included in Aon’s second quarter and year-to-date compensation and benefits expense is $6 million and $13 million, respectively, of expense related to the amortization of stock options with no corresponding amount recorded in 2005. Included in year-to-date cumulative effect of a change in accounting principle is an after-tax positive impact of $1 million reflecting the beneficial impact of estimating forfeitures.
In March 2006, the FASB issued an Exposure Draft of Statement No. 132(R), Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R). The proposed standard would require balance sheet recognition of the funded status of defined benefit postretirement plans, including pension plans. The proposal would also require companies to measure plan assets and obligations as of the date of the year-end financial statements. If Aon had adopted this Exposure Draft as it is currently written as of December 31, 2005, the total impact from the Company’s material plans would have been to reduce the Company’s stockholders’ equity by approximately $500 million. Changes to plan assumptions (e.g. discount rates) will impact this amount.
In the discussion of operating results, we sometimes refer to supplemental information extracted from consolidated financial information which is not required to be presented in the financial statements by U.S. generally accepted accounting principles (“GAAP”).
Supplemental information related to organic revenue growth is information that management believes is an important measure to evaluate business production from existing operations. We also believe that this supplemental information is helpful to investors. Organic revenue growth excludes from reported revenue the impact of foreign exchange, acquisitions, divestitures, transfers between business units, investment income, reimbursable expenses, unusual items, and for the underwriting segment only, an adjustment between written and earned premium.
The supplemental organic revenue growth information does not affect net income or any other GAAP reported figures. It should be viewed in addition to, not in lieu of, our condensed consolidated statements of income. Industry peers provide similar supplemental information about their revenue performance, although they do not necessarily make identical adjustments.
Aon has offices in over 120 countries and sovereignties. Movement of foreign exchange rates in comparison to the U.S. dollar may be significant and will distort true period-to-period comparisons of changes in revenue or pretax income. Therefore, management has isolated the impact of the change in currencies between periods by providing percentage changes on a comparable currency basis for revenue, and has disclosed the effect on earnings per share. Reporting on this basis gives financial statement users more meaningful information about our operations.
Certain tables in the segment discussions show a reconciliation of organic revenue growth percentages to the reported revenue growth percentages for the segments and sub-segments. We separately disclose the impact of foreign currency as well as the impact from acquisitions, divestitures, and transfers of business units, which represent the most significant reconciling items. Other reconciling items are generally not significant individually, or in the aggregate, and are therefore totaled in an “all other” category. If there is a significant individual reconciling item within the “all other” category, we provide additional disclosure in a footnote.
The following table and commentary provide selected consolidated financial information.
Second quarter ended
Six months ended
Percent
Change
Total consolidated revenue
(50
(33
Income from continuing operations before provision for income tax
Pretax margin-continuing operations
12.2
11.5
12.3
12.5
Brokerage commissions and fees increased by $47 million or 3% from second quarter 2005. Year-to-date revenue increased $41 million or 1% from the comparable 2005 period. The growth in both comparable periods was primarily driven by second quarter organic revenue growth in Brokerage-Americas of 5%, mostly driven by our U.S. retail business, and growth in Affinity and Latin America.
Underwriting premiums increased $40 million or 8% from second quarter 2005 and $84 million or 9% on a year-to-date basis, driven by strong growth in a supplemental health product.
Investment income increased $30 million or 54% from second quarter 2005 and $44 million or 33% on a year-to-date basis. The second quarter increase was primarily driven by higher interest rates and the year-to-date increases were driven by the $35 million gain related to our U.K. pension plan contribution, increased interest rates and the movement to longer-term, higher-yield investments. Partially offsetting the impact of these items was a decrease of $17 million in the fair value of our investment in Endurance warrants on a year-to-date basis in 2006, compared with an increase of $15 million on those warrants on a year-to-date basis in 2005.
Total expenses, including restructuring and related expenses, increased $87 million or 5% from second quarter 2005. On a year-to-date basis, total expenses, including restructuring, increased $155 million or 4%.
On a quarterly basis, compensation and benefits increased $55 million or 5% over the prior year, driven by $7 million of restructuring related expenses and $6 million of stock option expense, both with no corresponding expense in 2005, higher incentive compensation, and $7 million due to acquisitions, partially offset by restructuring savings.
On a year-to-date basis compensation and benefits increased $70 million or 3%, driven by $32 million of restructuring related expenses and $13 million of stock option expense, both with no corresponding expense in 2005, and higher incentive compensation, partially offset by restructuring savings.
Other general expenses of $471 million were consistent with 2005 on a quarterly basis and $36 million or 4% higher on a year-to-date basis. The increase on a year-to-date basis was driven by $18 million of restructuring related expenses in 2006 with no corresponding amounts in 2005 and higher legal expenses in the first quarter.
Benefits to policyholders increased $34 million or 13% on a quarterly basis and $61 million or 12% on a year-to-date basis, in line with the growth in our underwriting business.
Depreciation and amortization decreased $4 million for the quarter and $11 million or 9% for six months, primarily due to $27 million of asset impairments and write-downs throughout 2005, which reduced 2006 depreciation because of a lower property base.
Income from Continuing Operations Before Provision for Income Tax and Cumulative Effect of a Change in Accounting Principle
On a quarterly basis, income from continuing operations, before provision for income tax and the cumulative effect of a change in accounting principle, increased $30 million to $276 million in second quarter 2006, as compared to $246 million for second quarter 2005. The increase is attributable to organic revenue growth in the Risk and Insurance Brokerage Services and Insurance Underwriting segments, partially offset by restructuring expenses, stock option expense and higher incentives.
On a year-to-date basis, income from continuing operations, before provision for income tax and the cumulative effect of a change in accounting principle, increased $14 million to $554 million in 2006, as compared to $540 million for 2005. The increase is attributable to organic revenue growth in the Risk and Insurance Brokerage Services and Insurance Underwriting segments, a gain from the contribution of an investment to the U.K. pension plan, and higher investment income, partially offset by restructuring expenses, the first quarter mark-to-market adjustments of our former investment in Endurance warrants, unfavorable foreign exchange, stock option expense and higher incentives.
Income Taxes
The effective tax rate for continuing operations was 34.4% and 21.5% for the second quarters ended June 30, 2006 and 2005, respectively, and 34.7% and 29.4% for the first half 2006 and 2005, respectively. The effective tax rate for the second quarter and six months 2006 reflects the geographic distribution of earnings and lower tax rates in certain countries. The comparable rates for 2005 were impacted by favorable resolution of certain tax matters.
Income from Continuing Operations
Income from continuing operations before accounting change for second quarter 2006 and 2005 was $181 million and $193 million, respectively. Basic and diluted income per share in 2006 was $0.56 and $0.53, versus $0.60 and $0.58, respectively, in 2005. Income from continuing operations in 2006 included hedging losses of $0.01 per share and currency translation gains of $0.01 per share.
Income from continuing operations before accounting change for the first half of 2006 and 2005 was $362 million and $381 million, respectively. Basic and diluted income per share in 2006 was $1.13 and $1.05, versus $1.18 and $1.13, respectively, in 2005. Income from continuing operations included hedging and currency translation losses of $0.01 each per share in 2006.
Second quarter income from discontinued operations was $12 million in 2006 ($0.04 per both basic and diluted share) versus a loss of $2 million in 2005 (($0.01) per both basic and diluted share). For the first half of 2006 and 2005, income from discontinued operations was $28 million ($0.09 and $0.08 per basic and diluted share, respectively), and $10 million ($0.03 per both basic and diluted share). Discontinued operations principally include our Warranty business for all periods and our Swett operation in 2005. Results in 2005 were impacted by unfavorable deferred tax adjustments.
Aon classifies its businesses into three operating segments: Risk and Insurance Brokerage Services, Consulting and Insurance Underwriting (see Note 7). Aon’s operating segments are identified as those that:
· report separate financial information, and
· are evaluated regularly when we are deciding how to allocate resources and assess performance.
Revenues are attributed to geographic areas based on the location of the resources producing the revenues. Segment revenue includes investment income generated by invested assets of that segment, as well as the impact of related derivatives. Investment characteristics mirror liability characteristics of the respective segments:
· Our Risk and Insurance Brokerage Services and Consulting businesses invest funds held on behalf of clients and operating funds in short-term obligations.
· In Insurance Underwriting, policyholder claims and other types of non-interest sensitive insurance liabilities are primarily supported by intermediate to long-term fixed-maturity instruments. For this business segment, operating invested assets are approximately equal to average net policy liabilities.
· Our insurance subsidiaries also have invested assets that exceed net policy liabilities, in order to maintain solid claims paying ratings. Income from these investments is reflected in Corporate and Other segment revenues.
The following table and commentary provide selected financial information on the operating segments.
Operating segment revenue: (1) (2)
Income before income tax:
Pretax Margins:
15.8
15.6
16.8
16.7
7.4
9.2
8.6
8.8
14.2
(1) Intersegment revenues of $13 million and $15 million were included in second quarter 2006 and 2005, respectively.
(2) Intersegment revenues of $32 million and $30 million were included in six months 2006 and 2005, respectively.
The following chart reflects investment income earned by the operating segments, which is included in the foregoing results.
· Risk and Insurance Brokerage investment income increased $12 million on a quarterly and $53 million on a year-to-date basis. The increase in the quarterly income was driven by higher interest rates and the year-to-date increase was principally from the contribution of the Scandent preferred stock investment to a U.K. pension plan, which resulted in a gain of $35 million. The remaining year-to-date increase was also caused by increased investment balances and higher interest rates.
· Consulting investment income was marginally higher because of higher interest rates.
· Insurance underwriting investment income increased $3 million on a quarterly basis and $5 million on a year-to-date basis, primarily because of higher interest rates.
Aon is a leader in many sectors of the insurance industry. According to the rankings in Business Insurance, Aon is now the world’s largest insurance broker, based on pure brokerage operations.
Changes in insurance premiums have a direct and potentially material impact on the insurance brokerage industry, as commission revenues are generally based on a percentage of the premiums paid by insureds. More specifically, lower premium rates, or a “soft market,” generally result in lower commission revenues.
Risk and Insurance Brokerage Services generated approximately 62% of Aon’s total operating segment revenues for both the second quarter and first half of 2006. Revenues are generated primarily through:
· commissions and fees paid by insurance and reinsurance companies,
· fees paid by clients, and
· interest income on funds held on behalf of clients.
Our revenues vary from quarter to quarter throughout the year as a result of:
· the timing of our clients’ policy renewals,
· the net effect of new and lost business,
· the timing of services provided to our clients, and
· the income we earn on investments, which is heavily influenced by short-term interest rates.
Our risk brokerage companies operate in a highly competitive industry and compete with many retail insurance brokerage and agency firms, as well as individual brokers and agents and direct writers of insurance coverage. Specifically, this segment:
· addresses the highly specialized product development and risk management needs of commercial enterprises, professional groups, insurance companies, governments, healthcare providers, and non-profit groups, among others;
· provides affinity products for professional liability, life, disability income and personal lines for individuals, associations and businesses;
· provides reinsurance services to insurance and reinsurance companies and other risk assumption entities by acting as brokers or intermediaries on all classes of reinsurance;
· provides managing underwriting and premium finance services to independent agents and brokers as well as corporate clients; and
· provides actuarial, loss prevention and administrative services to businesses and consumers.
We review our product revenue results using the following sub-segments:
· Risk Management and Insurance Brokerage—Americas (Brokerage—Americas)encompasses our retail brokerage services, affinity products, managing general underwriting, placement and captive management services and premium finance services in North and South America, the Caribbean and Bermuda.
· Risk Management and Insurance Brokerage—International (Brokerage—International)offers similar products and services to the rest of the world not included in Brokerage—Americas.
· Reinsurance Brokerage and Related Services (Reinsurance) offers sophisticated advisory services in program design and claim recoveries that enhance the risk/return characteristics of insurance policy portfolios, improve capital utilization and evaluate and mitigate catastrophic loss exposures worldwide.
These charts detail Risk and Insurance Brokerage Services revenue by product sub-segment.
Less:
Acquisitions,
Organic
Currency
Divestitures
All
Second quarter ended June 30,
Impact
& Transfers
Growth
Brokerage—Americas
591
539
Brokerage—International
590
592
Reinsurance
214
203
1,121
991
1,207
1,252
460
443
)%
Brokerage—Americas revenue increased $52 million or 10% on a quarterly basis and $130 million or 13% on a year-to-date basis. Organic revenue in Brokerage—Americas rose 5% on both a quarterly and year-to-date basis, primarily driven by our U.S. retail business, and growth in Affinity and Latin America. Our year-to-date revenue increase was also a result of the $35 million gain related to the contribution of our investment in Scandent preferred stock to a U.K. pension plan.
Brokerage—International decreased $2 million on a quarterly basis and $45 million on a year-to-date basis. For both the quarter and six months, growth in Continental Europe, Asia and Australia was offset by weakness in the U.K. The year-to-date comparison was negatively impacted by the stronger dollar. Brokerage—International organic revenue declined 1% on a quarterly basis and was flat on a year-to-date basis reflecting changes in the model for compensation from underwriters in the U.K. and the negative impact of soft market conditions.
Reinsurance revenue increased $11 million or 5% on a quarterly and $17 million or 4% on a year-to-date basis. Reinsurance organic revenue increased 5% in the quarter and 2% on a year-to-date basis reflecting growth in the Americas and Asia driven by new business and improved pricing, partially offset by the impact of higher risk retention by clients and weaker pricing in the U.K. and European markets.
This chart details Risk and Insurance Brokerage Services revenue by geographic area.
35
· Strong organic growth in the United States and higher investment income drove the improvement in revenue for both periods. In addition, our year-to-date revenue increase was a result of the $35 million gain related to the contribution of our investment in Scandent preferred stock to a U.K. pension plan.
· The U.K. revenue decline of 9% for the quarter and 7% on a year-to-date basis reflects soft market conditions and changing price structures.
· Continent of Europe was up 5% for the quarter, reflecting an increase in organic revenue growth. The year-to-date decline was driven primarily by the negative impact of foreign exchange.
· The Rest of Word revenue was up for both periods reflecting strong organic growth in emerging markets in Latin America and Asia.
Income Before Income Tax
Second quarter pretax income increased 6% to $220 million from $208 million in 2005, driven by organic revenue growth and higher investment income, partially offset by restructuring costs.
Six months pretax income increased 5% to $469 million from $448 million in 2005. The increase is attributable to organic revenue growth and the gain from the contribution of our Scandent preferred stock investment to the U.K. pension plan, partially offset by restructuring costs.
Aon Consulting is one of the world’s largest integrated human capital consulting organizations. This segment:
· provides a full range of human capital management services, from employee benefits to compensation consulting, and
· generated 14% of Aon’s total operating segment revenue for both the second quarter and six months 2006.
We review our revenue results using the following sub-segments:
· Consulting services, which provide consulting services in six major practice areas:
1. Employee Benefits advises clients about the structure, funding and administration of employee benefit programs which attract, retain and motivate employees. Benefits consulting includes health and welfare, retirement, executive benefits, absence management, compliance, employer commitment, investment advisory and elective benefit services.
2. Compensation focuses on designing salary, bonus, commission, stock option and other pay structures, with special expertise in the financial services and technology industries.
3. Management Consulting assists clients in process improvement and design, leadership, organization and human capital development, and change management.
4. Communications advises clients on how to communicate initiatives that support their corporate vision.
5. Strategic Human Resource Consulting advises complex global organizations on talent, change and organization effectiveness issues including assessment, selection performance management, succession planning, organization design and related people-management programs.
6. Financial Advisory and Litigation Consulting provides consulting services including white-collar and financial statement investigation, securities litigation, financial due diligence, financial valuation services and other related specialties.
· Outsourcing, which offers employment processing, performance improvement, benefits administration and other employment-related services.
Revenues in the Consulting segment are affected by changes in clients’ industries, including government regulation, as well as new products and services, the state of the economic cycle, broad trends in employee demographics and the management of large organizations.
These charts detail Consulting revenue by product sub-segment.
Consulting services
237
Outsourcing
72
475
484
142
140
· Consulting Services revenue declined 3% and 2% for the quarter and first six months, respectively, reflecting the transfer of certain small units to the Risk and Insurance Brokerage Services segment. Organic revenue growth was 1% on a quarterly and 3% on a year-to-date basis reflecting growth in compensation consulting and the recently established Financial Advisory and Litigation Consulting unit.
· Outsourcing organic revenue growth for the quarter was flat, while year-to-date rose 2% reflecting the positive impact of a U.K. acquisition, somewhat offset by lower U.S. business. AT&T, which is our largest outsourcing client, has informed us that they are terminating many services in a contract with us as of the end of 2006, though they will remain a significant client of Aon Consulting. The outsourcing contract to be terminated by AT&T accounts for approximately 30% of the outsourcing subsegment’s annual revenue.
This chart details Consulting revenue by geographic area.
For both periods:
· The U.S. revenue decline was primarily caused by reduced outsourcing business triggered by the loss of clients and the transfer out of certain small units, partially offset by Financial Advisory and Litigation Consulting revenue and increases in compensation consulting.
· United Kingdom revenue rose 4% on a quarterly basis and is up 8% on a year-to-date basis principally due to increased pension consulting work which was driven by new U.K. pension rules.
· The improvement in Rest of World for both periods reflects organic revenue growth. The decline in Continent of Europe reflects lower revenues and, on a year-to-date basis, the impact of foreign currency.
Second quarter 2006 pretax income was $23 million compared to $29 million in 2005. Pretax margins were 7.4% and 9.2% for 2006 and 2005, respectively. Six months 2006 pretax income was $53 million compared to $55 million in 2005. Pretax margins were 8.6% and 8.8% for 2006 and 2005, respectively. The year over year pretax income and margin decline was principally caused by lower revenue. Restructuring costs and investments made in the Financial Advisory and Litigation Consulting and Global Benefits practices were offset by improved cost controls in other areas of the business.
The Insurance Underwriting segment:
· provides supplemental accident, health and life insurance coverage mostly through direct distribution networks, primarily through more than 7,000 career insurance agents working for our subsidiaries. Our revenues are affected by our success in attracting and retaining these career agents;
· offers select commercial property and casualty business on a limited basis through managing general underwriters, primarily Aon-owned companies;
· has operations in the United States, Canada, Europe and Asia/Pacific and South America; and
· generated 24% of Aon’s total operating segment revenue for both the second quarter and six months of 2006.
In June 2006, we reached agreement to sell our Warranty business. This business administers extended warranty services on automobiles, electronic goods, personal computers and appliances. It also offers extended warranty and credit insurance products that are sold through retailers, automotive dealers, insurance agents and brokers, and real estate brokers. These operations have been reclassed to discontinued operations for all periods presented and are not included in the following discussion. The sale is expected to close by the end of 2006.
· Accident & Health and Life (AH&L), through which we provide an array of accident, sickness, short-term disability and other supplemental insurance products. Most of these products are primarily fixed-indemnity obligations and are not subject to escalating medical cost inflation;
· Property and Casualty, through which we provide select commercial property and casualty insurance on a limited basis.
Written premium and fees are the basis for organic revenue growth in this segment; however, reported revenues reflect earned premiums and fees.
These charts detail Insurance Underwriting revenue by product sub-segment:
All Other
Accident & health and life
499
450
Property & casualty
All Other (1)
980
890
127
126
(1) The difference between written and earned premium and fees, as a percentage change, was 0% for accident & health and life, (8)% for property & casualty, and (1)% for total revenue.
In the Accident & Health and Life business, organic revenue grew 12% for the quarter and 11% for six months, primarily driven by strong growth in a supplemental health product.
Property and Casualty decreased $4 million for the quarter due to the decision to curtail certain non-core businesses. The slight improvement on a year-to-date basis is due to an increase in the Construction Program Group, offset by reductions in all other programs.
This chart details Insurance Underwriting revenue by geographic area.
· United States revenue increased $38 million or 11% on a quarterly basis and $76 million or 11% on a year-to-date basis driven by growth in a supplemental health product.
· United Kingdom revenue was generally consistent with prior years on a quarterly and year-to-date basis.
· Continent of Europe revenue increased 9% on a quarterly basis as a result of organic revenue growth, but was consistent on a year-to-date basis, reflecting the impact of foreign currency rates on six months results.
· Rest of World revenue grew $5 million or 7% on a quarterly basis and $11 million or 8% on a year-to-date basis, reflecting improved organic revenue growth.
Second quarter pretax income rose 25% to $79 million and pretax margins rose to 14.2% from 12.3%. Six months pretax income increased 15% to $135 million and pretax margins rose from 11.5% to 12.2%. The increase in both pretax income and margins reflect improved profitability in A&H and Life and higher investment income.
Corporate and Other segment revenue consists primarily of investment income (including income or loss on investment disposals and other-than-temporary impairment losses), which is not otherwise reflected in the operating segments. This segment includes:
· invested assets and related investment income not directly required to support the risk and insurance brokerage services and consulting businesses, and
· the assets in excess of net policyholder liabilities of the insurance underwriting subsidiaries and related income.
Corporate and Other segment revenue includes changes in the valuation of Endurance warrants. Through March 31, 2006 we carried our investment in Endurance warrants at fair value and recorded changes in the fair value through the Corporate and Other segment. On March 31, 2006, the investment in Endurance warrants was contributed to our U.K. pension plans.
Private equities are principally carried at cost except where Aon has significant influence, in which case they are carried under the equity method. These investments usually do not pay dividends. Limited partnerships (LP) are accounted for under the equity method and changes in the value of the underlying LP investments flow through Corporate and Other segment revenue.
Although our portfolios are highly diversified, they still remain exposed to market, equity, and credit risk. We:
· periodically review securities with material unrealized losses and evaluate them for other-than-temporary impairments,
· analyze various risk factors and identify any specific asset impairments. If we determine there is specific asset impairment, we recognize a realized loss and adjust the cost basis of the impaired asset to its fair value, and
· review invested assets with material unrealized losses each quarter (see Note 13 for additional information regarding other-than-temporary impairments).
This chart shows the components of Corporate and Other revenue and expenses:
Income from marketable equity securities and other investments
Net loss on disposals and related expenses
Corporate segment revenue was $18 million for second quarter 2006 compared to $3 million in the second quarter of 2005. The increase was driven by higher investment balances and interest rates. Year-to-date revenue in 2006 was $15 million, compared to $30 million in 2005. The decrease in revenue reflects the change in fair value of our investment in Endurance warrants, which resulted in a gain of $15 million in 2005 and a loss of $17 million in 2006. As mentioned previously, the warrants were included in our contribution to the U.K. pension plans on March 31, 2006. The decline was partially offset by higher investment balances and interest rates.
Loss Before Income Tax
The pretax loss in the Corporate and Other segment was $46 million compared with a loss of $54 million a year ago, as higher revenue was partially offset by higher consulting fees, interest expense, and costs related to the divestiture of AWG.
The pretax loss for six months was $103 million compared to a pretax loss of $80 million a year ago, reflecting the impact of the Endurance warrants, along with higher general expenses.
FINANCIAL CONDITION & LIQUIDITY
Cash flows from operations represent the net income we earned in the reported periods adjusted for non-cash charges and changes in operating assets and liabilities.
Cash flows provided by operating activities for the six months ended June 30, 2006 and 2005 are as follows:
(millions) Six months ended June 30,
Insurance Underwriting operating cash flows (including Warranty)
290
All other operating cash flows
302
350
Cash provided by operating activities
Insurance Underwriting operating cash flows
Our insurance underwriting operations include accident & health and life and warranty, credit and property & casualty businesses. These insurance products have distinct differences in the timing of premiums earned and payment of future liabilities.
The operating cash flow from our insurance subsidiaries, which also includes related corporate items, was $290 million for 2006, an increase of $183 million compared to 2005. This increase was primarily related to organic revenue growth of 13% compared to -2% in the same period last year (including warranty and credit in both periods). This growth resulted in a significant increase in retained unearned premium reserves. For 2006, operating cash flows, analyzed by major income statement component, indicated that premium and other fees collected, net of reinsurance, were $1,761 million compared to $1,595 million in 2005. Investment and other miscellaneous income received was $107 million and $94 million in 2006 and 2005, respectively. Investment income improved in 2006 due to favorable interest rates and an increase in invested assets.
We used revenues generated from premiums, investments and other miscellaneous income to pay claims and other cash benefits, commissions, general expenses and taxes. Claims and other cash benefits paid were $741 million in 2006 versus $691 million in 2005. Commissions and general expenses paid were $714 million for 2006, compared to $767 million in 2005. Tax payments for 2006 were $123 million compared to $124 million last year.
We will invest and use operating cash flows to satisfy future benefits to policyholders and when appropriate, make them available to pay dividends to the Aon parent company. During 2006, Combined Insurance Company of America, one of our major underwriting subsidiaries, declared and paid a cash dividend of $95 million to Aon.
Generally, we invest in highly liquid and marketable investment grade securities to support policy liabilities. These invested assets are subject to insurance regulations set forth by the various governmental jurisdictions in which we operate, both domestically and internationally. The insurance regulations may restrict both the quantity and quality of various types of assets within the portfolios.
Our insurance subsidiaries’ policy liabilities are segmented among multiple accident and health and property casualty portfolios. Those portfolios have widely varying estimated durations and interest rate characteristics. Generally, our policy liabilities are not subject to interest rate volatility risk. Therefore, in many of the portfolios, asset and policy liability duration are not closely matched. Interest rate sensitive policy liabilities are generally supported by floating rate assets.
Funds held on behalf of clients
In our Risk and Insurance Brokerage Services and Consulting segments, we typically hold funds on behalf of clients as a result of:
· premiums received from clients that are in transit to insurers. These premiums held on behalf of, or due from, clients are reported as assets with a corresponding liability due to the insurer.
· claims due to clients that are in transit from insurers. Claims held by, or due to us and which are due to clients, are also shown as both assets and liabilities.
These funds held on behalf of clients are generally invested in interest bearing trust accounts and can fluctuate significantly depending on when we collect cash from our clients and when premiums are remitted to the insurance carriers.
The operating cash flow from our Risk and Insurance Brokerage Services and Consulting segments, as well as related corporate items, was $302 million in 2006 compared to $243 million in 2005. These amounts exclude the change in funds held on behalf of clients as described above. The operating cash flows depend on the timing of receipts and payments related to revenues, incentive compensation, other operating expenses and income taxes. Comparing 2006 to 2005, the net increase in cash from our Risk and Insurance Brokerage Services and Consulting segments and related corporate items of $59 million was primarily influenced by organic revenue growth and a movement to non-cash incentives year over year.
Aon uses the excess cash generated by our brokerage and consulting businesses as well as dividends received from our insurance company subsidiaries to meet its liquidity needs, which consist of servicing its debt, paying dividends to its stockholders and repurchasing outstanding shares.
42
Investing and Financing Activities
We used the consolidated cash flow from operations (net of funds held on behalf of clients) for:
· investing activities of $432 million. The cash flows used by investing activities included purchases of investments, net of sales, of $273 million; acquisitions of subsidiaries, net of divestitures, of $88 million, and capital expenditures, net of disposals, of $71 million.
· financing needs of $509 million. Financing uses primarily included cash dividends paid to shareholders of $96 million, debt repayments, net of issuances, of $35 million and net treasury share activity of $424 million.
Since year-end 2005, total assets increased $2.3 billion to $30.1 billion.
Total investments at June 30, 2006 were $7.4 billion, an increase of $124 million from December 31, 2005. The change is due to an increase in short-term investments held on behalf of clients, offset by a decrease in other investments, which primarily represents the contribution of our Endurance warrants and investment in Scandent preferred stock to our U.K. pension plan. Fixed maturities decreased $18 million during the first six months of 2006 to $2,802 million. Approximately 94% of Aon’s investment portfolio at quarter end was in short-term investments and fixed maturities, with 99% of our fixed maturities rated investment grade.
Amount Shown
in Statement
Percentage
of Financial
of Total
Position
Fixed maturities—available for sale:
US government and agencies
States and political subdivisions
Debt securities of foreign governments not classified as loans
1,180
914
Public utilities
67
Mortgage-backed and asset-backed securities
365
Total Fixed Maturities
Equity securities—available for sale:
Common stocks
Non-redeemable preferred stocks
Total Equity Securities
Policy loans
Other long-term investments
PEPS I Preferred Stock
205
Total Other Long Term Investments
342
Total Other Investments
TOTAL INVESTMENTS
Total receivables increased $1.3 billion in the first six months of 2006 primarily the result of the timing of cash receipts and the impact of foreign exchange rates. Insurance premiums payable increased $1.5 billion over the same period. This increase primarily reflects the timing of cash payments, client demand for risk programs and the effect of foreign exchange rates.
Other assets increased $455 million from December 31, 2005. Other assets are comprised principally of prepaid premiums related to reinsurance, prepaid pension assets, current and deferred income taxes. The increase is principally caused by higher prepaid pension assets.
Policy liabilities increased $57 million, driven by an increase in future policy benefits.
Borrowings
Total debt at June 30, 2006 was $2,103 million, a decrease of $9 million from December 31, 2005.
At June 30, 2006, we had a $600 million unused U.S. bank credit facility, which expires in February 2010, to support commercial paper and other short-term borrowings. The facility allows us to issue up to $150 million in letters of credit.
We also have several foreign credit facilities available. At June 30, 2006, we had available to us:
· a five-year €650 million ($818 million) multi-currency facility of which $221 million was outstanding at June 30, 2006. See Note 8 to the consolidated financial statements in our 2005 Form 10-K for further discussion of both the U.S. and Euro facilities;
· a £37.5 million ($68 million) facility and a 364-day 10 million Canadian dollar ($9 million) facility. The pound sterling facility was recently renewed. This facility now contains the same financial covenants and expiration date as the Euro facility. The Canadian facility expires in September 2006; and
· a €20 million ($25 million) open-ended facility.
The major rating agencies’ ratings of our debt at August 1, 2006 appear in the table below.
Senior long-term debt
Commercial paper
Rating
Outlook
Standard & Poor’s
BBB+
Positive
A-2
Moody’s Investor Services
Baa2
P-2
Fitch, Inc.
Stable
F-2
During 2006, Moody’s Investors Services changed its outlook on Aon to positive from stable, citing Aon’s healthy net income over the past several years, recent improvement in adjusted brokerage operating margins, steady underwriting performance, as well as progress in implementing more transparent pricing practices.
A downgrade in the credit ratings of our senior debt and commercial paper would:
· increase our borrowing costs and reduce our financial flexibility. Our 6.20% notes due 2007 ($250 million of which are outstanding with a current interest rate of 6.95%) expressly provide for interest rate increases in the case of certain ratings downgrades.
· increase our commercial paper interest rates or may restrict our access to the commercial paper market altogether. Although we have committed backup lines we cannot ensure that our financial position will not be hurt if we can no longer access the commercial paper market.
In addition, intercompany notes between Aon Parent and certain of our accident & health and life insurance companies will become payable within 30 days if Aon’s credit rating on its senior long-term debt falls below investment grade.
Stockholders’ equity increased $89 million from the fourth quarter 2005 to $5.4 billion. The change was driven primarily by $391 million of net income and an increase in foreign exchange gains, principally offset by $468 million of net treasury stock repurchases.
Accumulated other comprehensive loss decreased $96 million since December 31, 2005. Net unrealized investment gains decreased by $43 million over year-end 2005. Net foreign exchange translation increased by $131 million because of the strengthening of the U.S. dollar against certain foreign currencies as compared to the prior year-end.
Our total debt as a percentage of total capital was 28.1% at June 30, 2006. This is compared to our total debt as a percentage of total capital of 28.5% at year-end 2005.
We record various contractual obligations as liabilities in our consolidated financial statements. Other items, such as certain purchase commitments and other executory contracts, are not recognized as liabilities in our consolidated financial statements, but we are required to disclose them.
Aon and its subsidiaries have issued letters of credit to cover contingent payments for taxes and other business obligations to third parties. We accrue amounts in our consolidated financial statements for these letters of credit to the extent they are probable and estimable.
Following the guidance of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilitiesand other relevant accounting guidance, we use special purpose entities and qualifying special purpose entities (“QSPE’s”), also known as special purpose vehicles, in some of our operations.
Premium Financing
Certain of our U.S., U.K., Canadian and Australian subsidiaries originate short-term loans (generally with terms of 12 months or less) to businesses to finance their insurance premium obligations, and then sell these premium finance agreements in securitization transactions that meet the criteria for sale accounting under Statement No. 140. These sales involve special purpose entities (“SPEs”), which are considered qualified special purpose entities (“QSPEs”) according to Statement No. 140 and multi-seller, non-qualified bank commercial paper conduit SPEs (“Bank SPEs”) that are variable interest entities according to FIN 46. Statement No. 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates (Aon’s subsidiaries).
We have analyzed qualitative and quantitative factors related to our subsidiaries’ interests in the Bank SPEs and have determined that these subsidiaries are not the sponsors of the Bank SPEs. Additionally, independent third parties:
· have made substantial equity investments in the Bank SPEs
· have voting control of the Bank SPEs
· generally have the risks and rewards of ownership of the assets of the Bank SPEs.
Thus, we have concluded that non-consolidation of the Bank SPEs remains appropriate in accordance with FIN 46 given that our subsidiaries do not have significant variable interests.
Through the securitization agreements we, or one of our QSPEs, sell undivided interests in specified premium finance agreements to the Bank SPEs. The aggregate amount advanced on premium finance agreements sold to the Bank SPEs at any one time is limited by the securitization agreements to $1.8 billion. The Bank SPEs had advanced $1.5 billion and $1.8 billion, at June 30, 2006 and December 31, 2005, respectively. Additional advances are available as additional eligible premium finance agreements are sold to the Bank SPEs and collections (administered by Aon) on previously sold agreements reduce available advances.
We record at fair value our retained interest in the sold premium finance agreements, and report it in insurance brokerage and consulting services receivables in the condensed consolidated statements of financial position. We also retain servicing rights for sold agreements and earn servicing fee income over the servicing period. The servicing fees are included in the gain/loss calculation. At June 30, 2006 and 2005, the fair value of the servicing rights approximates the estimated costs to service the receivables and accordingly, we have not recorded any servicing assets or liabilities related to this servicing activity.
We estimate fair value by discounting estimated future cash flows from the servicing rights and servicing costs using:
· discount rates that approximate current market rates
· expected future prepayment rates.
The Bank SPEs bear the credit risks on the receivables, subject to limited recourse in the form of credit loss reserves, which we formerly guaranteed. During 2005, we eliminated the percentage guarantee for all facilities, replacing it with other collateral enhancements.
All but the Australian facility require Aon to maintain consolidated net worth, as defined, of at least $2.5 billion, and:
· consolidated EBITDA (earnings before interest, taxes, depreciation and amortization) to consolidated net interest of at least 4 to 1
· consolidated indebtedness to consolidated EBITDA of no more than 3 to 1.
We intend to renew the conduit facilities when they expire. If there were adverse bank, regulatory, tax or accounting rule changes, our access to the conduit facilities and special purpose vehicles would be restricted. These special purpose vehicles are not included in our consolidated financial statements, following the appropriate accounting standards.
PEPS I
On December 31, 2001, we sold the vast majority of our LP portfolio, valued at $450 million, to PEPS I, a QSPE. The common stock interest in PEPS I is held by a limited liability company, owned by one of our subsidiaries (49%) and by a charitable trust, which we do not control, established for victims of the September 11th attacks (51%).
PEPS I sold approximately $171 million of investment grade fixed-maturity securities to unaffiliated third parties. It then paid our insurance underwriting subsidiaries the $171 million in cash and issued them an additional $279 million in fixed-maturity and preferred stock securities.
Standard & Poor’s Ratings Services rated the fixed-maturity securities our subsidiaries received from PEPS I as investment grade. As part of this transaction, the insurance companies had been required to purchase from PEPS I additional fixed-maturity securities in an amount equal to the unfunded LP commitments as they are requested. These fixed-maturity securities are rated below investment grade. Beginning in July 2004, Aon Parent assumed this responsibility. Commitments of $1 million were funded in 2006. As of June 30, 2006, the unfunded commitments amounted to $47 million. These commitments have specific expiration dates and the general partners may decide not to draw on these commitments. The assets, liabilities and operations of PEPS I are not included in our condensed consolidated financial statements.
In previous years Aon has recognized other than temporary impairment writedowns of $59 million, equal to the original cost of one tranche. The preferred stock interest represents a beneficial interest in securitized limited partnership investments. The fair value of the private preferred stock interests depends on the value of the limited partnership investments held by PEPS I. These preferred stock interests have an unrealized investment gain as of June 30, 2006. Management assesses other-than-temporary declines in the fair value below cost using a financial model that considers the:
· value of the underlying limited partnership investments of PEPS I and
· nature and timing of the cash flows from the underlying limited partnership investments of PEPS I.
This report contains certain statements related to future results, or states our intentions, beliefs and expectations or predictions for the future which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from either historical or anticipated results depending on a variety of factors. Potential factors that could impact results include: general economic conditions in different countries in which we do business around the world, changes in global equity and fixed income markets that could affect the return on invested assets, fluctuations in exchange and interest rates that could influence revenue and expense, rating agency actions that could affect our ability to borrow funds, funding of our various pension plans, changes in the competitive environment, our ability to implement restructuring initiatives and other initiatives intended to yield cost savings, our ability to execute the stock repurchase program, our ability to consummate the pending sale of the Aon Warranty Group, changes in commercial property and casualty markets and commercial premium rates that could impact revenues, changes in revenues and earnings due to the elimination of contingent commissions, other uncertainties surrounding a new compensation model, the impact of investigations brought by state attorneys general, state insurance regulators, federal prosecutors and federal regulators, the impact of class actions and individual lawsuits including client class actions, securities class actions, derivative actions and ERISA class actions, the cost of resolution of other contingent liabilities and loss contingencies, and the difference in ultimate paid claims in our underwriting companies from actuarial estimates.
We are exposed to potential fluctuations in earnings, cash flows and the fair value of certain of our assets and liabilities due to changes in interest rates, foreign exchange rates and equity prices. In order to manage the risk arising from these exposures, we enter into a variety of derivative instruments. Aon does not enter into derivatives or financial instruments for trading purposes.
We are subject to foreign exchange rate risk associated with translating financial statements of our foreign subsidiaries into U.S. dollars. Our primary exposures are to the British pound, the Euro, the Canadian dollar, and the Australian dollar. We use over-the-counter (“OTC”) options and forward contracts to reduce the affect of foreign currency fluctuations on the translation of the financial statements of our foreign operations.
Additionally, some of our foreign brokerage subsidiaries receive revenues in currencies that differ from their functional currencies. Our U.K. subsidiary earns a portion of its revenue in U.S. dollars but the majority of its expenses are incurred in pounds sterling. Our policy is to convert into pounds sterling a sufficient amount of U.S. dollar revenue to fund the subsidiary’s pound sterling expenses using OTC options and forward exchange contracts. At June 30, 2006, we hedged approximately 70% of our U.K. subsidiaries’ expected U.S. dollar transaction exposure for the next twelve months. We do not generally hedge exposures beyond three years.
The translated value of revenue and expense from our international brokerage and underwriting operations are subject to fluctuations in foreign exchange rates. Second quarter 2006 diluted earnings per share were positively impacted by $0.01 related to translation gains. We incurred currency hedging losses of $0.01.
We also use forward contracts to offset foreign exchange risk associated with foreign denominated inter-company notes.
The nature of the income of our businesses is affected by changes in international and domestic short-term interest rates. We monitor our net exposure to short-term interest rates and, as appropriate, hedge our exposure by entering into interest rate swap agreements and use exchange-traded futures and options to limit our net exposure. A decrease in global short-term interest rates adversely affects Aon’s income. This activity primarily relates to brokerage funds held on behalf of clients in the U.S. and U.K.
Interest rate swaps and caps are used to limit exposure to changes in interest rates related to interest rate guarantees provided by a subsidiary of Aon to certain unaffiliated entities.
Our underwriting companies’ fixed income investment portfolios are subject to credit risk. The reduction of a fixed income security’s credit rating will adversely affect the price of the security. The credit quality of Aon’s fixed income portfolio is high. The portfolio maintains an “Aa” average credit rating. The fixed maturity portfolio credit profile is monitored daily and evaluated regularly.
The valuation of our marketable equity security portfolio is subject to equity price risk. We sell futures contracts and purchase options to reduce the price volatility of our equity securities portfolio and equity securities we own indirectly through limited partnership investments.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures. Based on Aon management’s evaluation (with the participation of the chief executive officer and chief financial officer), as of the end of the period covered by this report, Aon’s chief executive officer and chief financial officer have concluded that the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15(d) —15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by Aon in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
Changes in internal control over financial reporting. During 2005, the Company commenced a review and subsequent project to replace or upgrade certain core financial systems. The implementation of a suite of software began in first quarter 2006 and is expected to be executed in phases throughout 2006 and 2007. The implementation is intended, among other things, to enhance the Company’s internal controls over financial reporting. Other than the changes above, no other changes in Aon’s internal control over financial reporting occurred during second quarter 2006 that have materially affected, or are reasonably likely to materially affect, Aon’s internal control over financial reporting.
Review by Independent Registered Public Accounting Firm
The condensed consolidated financial statements at June 30, 2006, and for the three and six months then ended, have been reviewed, prior to filing, by Ernst & Young LLP, Aon’s independent registered public accounting firm, and their report is included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and StockholdersAon Corporation
We have reviewed the condensed consolidated statement of financial position of Aon Corporation (the Company) as of June 30, 2006, and the related condensed consolidated statements of income for the three-month and six-month periods ended June 30, 2006 and 2005 and the condensed statements of cash flows for the six month periods ended June 30, 2006 and 2005. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial position of Aon Corporation as of December 31, 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated March 7, 2006 we expressed an unqualified opinion on those consolidated financial statements. In 2006, as discussed in Note 11, the Company reclassified assets and liabilities that become held-for-sale, resulting in a revision of the December 31, 2005 consolidated statement of financial position. We have not audited the revised statement of financial position reflecting the reclassification of these assets and liabilities.
Chicago, IllinoisAugust 8, 2006
OTHER INFORMATION
ITEM 1.
LEGAL PROCEEDINGS
See Note 15 (Contingencies) to the condensed consolidated financial statements.
ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
(a) None.
(b) None.
(c) Issuer Purchases of Equity Securities.
The following information relates to the repurchase of equity securities by Aon or any affiliated purchaser during any month within the second quarter of 2006:
Period
Total Number ofShares Purchased
Average PricePaid per Share (1)
Total Number ofShares Purchasedas Part of PubliclyAnnounced Plansor Programs
Maximum DollarValue of Sharesthat May Yet BePurchased Underthe Plans orPrograms (1)
4/1/06 – 4/30/06
2,934,300
41.32
607,150,003
5/1/06 – 5/31/06
2,131,200
38.39
525,332,455
6/1/06 – 6/30/06
551,500
33.68
506,759,184
5,617,000
39.46
(1) Does not include commissions paid to repurchase shares.
On November 3, 2005, the Company announced that its Board of Directors had authorized the repurchase of up to $1 billion of Aon’s common stock. Shares may be repurchased through the open market or in privately negotiated transactions. Through June 30, 2006, the Company has repurchased 12,447,000 shares of common stock at an average price (excluding commissions) of $39.63 per share for an aggregate purchase price of $493 million since inception of the stock repurchase program, and the remaining authorized amount for stock repurchases under this program is $507 million, with no termination date.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a)
The Annual Meeting of Stockholders of the Registrant was held on May 19, 2006 (the “Annual Meeting”).
(b)
Not applicable
(c)
Certain matters voted upon at the Annual Meeting and the votes cast with respect to such matters are as follows:
(i)
Election of Directors
Name
For
Withheld
Patrick G. Ryan
285,852,399
6,701,830
Gregory C. Case
287,611,842
4,942,387
Edgar D. Jannotta
284,854,627
7,699,602
Jan Kalff
289,929,661
2,624,568
Lester B. Knight
279,959,350
12,594,879
J. Michael Losh
276,170,779
16,383,450
R. Eden Martin
286,639,853
5,914,376
Andrew J. McKenna
277,069,959
15,484,270
Robert S. Morrison
279,933,443
12,620,786
Richard B. Myers
288,683,429
3,870,800
Richard C. Notebaert
279,535,066
13,019,163
John W. Rogers, Jr.
287,049,232
5,504,997
Gloria Santona
289,985,413
2,568,816
Dr. Carolyn Y. Woo
289,822,941
2,731,288
(ii) Ratification of appointment of Ernst & Young LLP as Aon’s independent registered public accounting firm for the 2006 fiscal year.
Against
Abstain
287,055,155
3,296,553
2,202,519
(iii) Approval of material terms of the performance goals under, and amendment to, the Senior Officer Incentive Compensation Plan.
277,253,590
12,688,037
2,612,601
(iv) Approval of material terms of the performance goals under, and amendment to, the Aon Stock Incentive Plan.
158,358,869
131,653,627
2,541,732
ITEM 5.
On June 30, 2006, Aon Corporation (the “Company”) and Warrior Acquisition Corp., an affiliate of Onex Corporation (“Onex”), entered into a purchase agreement (the “Agreement”) pursuant to which Onex has agreed to acquire Aon Warranty Group and its worldwide operations for $710 million in cash, subject to adjustment based upon a comparison of the net worth (excluding goodwill) of Aon Warranty Group at the closing with a target level of net worth calculated to be $420,011,470 as of December 31, 2005. The payment of the purchase price by Onex is guaranteed by Onex Partners II, L.P.
The Agreement contains customary representations and warranties. The closing of the transactions contemplated by the Agreement is subject to receipt of specified regulatory approvals and various other conditions, including the maintenance of current ratings from A.M. Best Company with respect to certain insurance companies within Aon Warranty Group.
The foregoing summary is qualified in its entirety by reference to the Agreement, which is incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on July 3, 2006 and the Limited Guarantee of Onex Partners II, L.P., a copy of which is filed as Exhibit 2.2 to this report and is incorporated herein by reference.
ITEM 6.
EXHIBITS
Exhibits – The exhibits filed with this report are listed on the attached Exhibit Index.
SIGNATURE
Pursuant to the requirements 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.
(Registrant)
August 9, 2006
/s/ David P. Bolger
DAVID P. BOLGER
EXECUTIVE VICE PRESIDENT,
CHIEF FINANCIAL OFFICER, AND
CHIEF ADMINISTRATIVE OFFICER
(Principal Financial and Accounting Officer)
Aon CORPORATION
Exhibit NumberIn Regulation S-K
Item 601 Exhibit Table
2.1
Purchase Agreement dated as of June 30, 2006 by and between Aon Corporation and Warrior Acquisition Corp. – incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on July 3, 2006.
2.2
Limited Guarantee of Onex Partners II, L.P. dated June 30, 2006 with respect to the Purchase Agreement dated June 30, 2006 between Aon Corporation and Warrior Acquisition Corp.
4.1
Indenture dated as of April 12, 2006 among Aon Finance N.S.1, ULC, Aon Corporation and Computershare Trust Company of Canada – incorporated by reference to Exhibit 4.1 to the Current Report on Form 8-K filed on April 18, 2006
10.1
Amendment No. 2 to Employment Agreement between Aon Corporation and Michael D. O’Halleran.
10.2
Aon Corporation Non-Employee Directors’ Deferred Stock Unit Plan.
10.3
Second Amendment to the Aon Corporation Outside Directors Stock Award and Retirement Plan.
10.4
Senior Officer Incentive Compensation Plan, as amended – incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed on May 24, 2006.
10.5
Aon Stock Incentive Plan, as amended – incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K filed on May 24, 2006.
Statements regarding Computation of Ratios
(a) Statement regarding Computation of Ratio of Earnings to Fixed Charges.
(b) Statement regarding Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends.
Letter re: Unaudited Interim Financial Information
31.1
Certification of CEO
31.2
Certification of CFO
32.1
Certification of CEO Pursuant to section 1350 of Title 18 of the United States Code
32.2
Certification of CFO Pursuant to section 1350 of Title 18 of the United States Code