Brown & Brown - 10-Q quarterly report FY

 

 

 

 

 

 

 

 

(Exact name of Registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (386) 252-9601

 

 

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 12-2 of the Exchange Act. (Check one):

 

 

 

The number of shares of the Registrant’s common stock, $.10 par value, outstanding as of October 30, 2006 was 139,966,544.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Brown & Brown, Inc., a Florida corporation, and its subsidiaries (collectively, Brown & Brown or the “Company”) is a diversified insurance agency, brokerage, and services organization that markets and sells to its customers insurance products and services, primarily in the property and casualty area. Brown & Brown’s business is divided into four reportable segments: the Retail Division, which provides a broad range of insurance products and services to commercial, public entity, professional and individual customers; the National Programs Division, which is comprised of two units - Professional Programs, which provides professional liability and related package products for certain professionals delivered through nationwide networks of independent agents, and Special Programs, which markets targeted products and services designated for specific industries, trade groups, governmental entities and market niches; the Brokerage Division, which markets and sells excess and surplus commercial and personal lines insurance, and reinsurance, primarily through independent agents and brokers; and the Services Division, which provides insurance-related services, including third-party administration, consulting for the workers’ compensation and managed healthcare services, and Medicare set-aside services and programs.

 

 

The accompanying unaudited, condensed, consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“United States”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. These unaudited, condensed, consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

 

 

Basic net income per share is computed by dividing net income available to shareholders by the weighted average number of shares outstanding for the period. Basic net income per share excludes dilution. Diluted net income per share reflects the potential dilution that could occur if stock options or other contracts to issue common stock were exercised or converted to common stock.

 

The following table sets forth the computation of basic net income per share and diluted net income per share:

 

 

All share and per share amounts in the consolidated financial statements have been restated to give effect to the two-for-one common stock split effected by Brown & Brown on November 28, 2005. The stock split was effected as a stock dividend.

 

 

 

 

 

 

Under APB No. 25, no compensation expense was recognized for either stock options issued under the Company’s stock compensation plans or for stock purchased under the Company’s 1990 Employee Stock Purchase Plan (“ESPP”). The pro forma effects on net income and earnings per share for stock options and ESPP awards were instead disclosed in a footnote to the financial statements. Compensation expense was previously recognized for awards of non-vested stock, based upon the market value of the common stock on the date of award, on a straight-line basis over the requisite service period with the effect of forfeitures recognized as they occurred.

 

The following table represents the pro forma information for the three and nine months ended September 30, 2005 (as previously disclosed) under the Company’s stock compensation plans had compensation cost for the stock options and common stock purchased under the ESPP been determined based on the fair value at the grant-date consistent with the method prescribed by SFAS No. 123R:

 

 

The Company has adopted SFAS 123R using the modified-prospective transition method. Under this transition method, compensation cost recognized in the three and nine months ended September 30, 2006 includes:

 

 

 

Results for prior periods have not been restated.

 

Upon adoption of SFAS 123R, the Company continued to use the Black-Scholes valuation model for valuing all stock options and shares granted under the ESPP. Compensation for non-vested stock awards is measured at fair value on the grant-date based upon the number of shares expected to vest. Compensation cost for all awards will be recognized in earnings, net of estimated forfeitures, on a straight-line basis over the requisite service period. The cumulative effect of changing from recognizing compensation expense for non-vested stock awards as forfeitures occurred to recognizing compensation expense for non-vested awards net of estimated forfeitures was not material.

 

The adoption of SFAS 123R had the following effect on the Company for the three and nine months ended September 30, 2006:

 

 

In addition, prior to the adoption of SFAS 123R, the Company presented tax benefits resulting from the exercise of stock options as operating cash flows in the statement of cash flows. SFAS 123R requires that tax benefits associated with share-based payments be classified under financing activities in the statement of cash flows. Since no stock option shares were exercised that gave rise to excess tax deductions during the three or nine months ended September 30, 2006, there is no effect of the adoption of SFAS 123R on the cash flow statement for the three or nine months ended September 30, 2006.

 

See Note 5 for additional information regarding the Company’s stock-based compensation plans and the assumptions used to calculate the fair value of stock-based awards.

 

 

 

The Company uses the Black-Scholes option-pricing model to estimate the fair value of stock options on the grant-date under SFAS 123R, which is the same valuation technique previously used for pro forma disclosures under SFAS 123. The Company did not grant any options during the three or nine months ended September 30, 2006, but did grant 12,000 shares during the nine months ended September 30, 2005. The Company used the following weighted average assumptions for all options granted during the nine months ended September 30, 2005:

 

 

The risk-free interest rate is based upon the US Treasury yield curve on the date of grant with a remaining term approximating the expected term of the option granted. The expected term of the options granted is derived from historical data; employees are divided into two groups based upon expected exercise behavior and are considered separately for valuation purposes. The expected volatility is based upon the historical volatility of the Company’s common stock over the period of time equivalent to the expected term of the options granted. The dividend yield is based upon the Company’s best estimate of future dividend yield.

 

A summary of stock option activity for the nine-month period ended September 30, 2006 is as follows:

 

 

The weighted average grant-date fair value of stock options granted during the nine-months ended September 30, 2005 was $8.51. The total intrinsic value of options exercised, determined as of the date of exercise, during the nine months ended September 30, 2006 and 2005 was $818,000 and $850,000, respectively. Aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted market price of the Company’s stock for in-the-money stock options at September 30, 2006.

 

 

The Company uses a path-depended lattice model to estimate the fair value of PSP grants on the grant-date under SFAS 123R. A summary of PSP activity for the nine months ended September 30, 2006 is as follows:

 

 

The weighted average grant-date fair value of PSP grants for the nine months ended September 30, 2006 and 2005 was $18.48 and $14.33, respectively. The total fair value of PSP grants that vested during each of the nine months ended September 30, 2006 and 2005 was $351,000 and $-0-, respectively.

 

 

 

 

As of September 30, 2006, there was approximately $20.9 million of unrecognized compensation expense related to all non-vested share-based compensation arrangements granted under the Company’s stock compensation plans. That expense is expected to be recognized over a weighted-average period of 10.1 years.

 

 

 

For the nine months ended September 30, 2006, Brown & Brown acquired the assets and assumed certain liabilities of 30 entities. The aggregate purchase price of these acquisitions was $153,584,000, including $139,100,000 of net cash payments, the issuance of $3,582,000 in notes payable and the assumption of $10,902,000 of liabilities. Substantially all of these acquisitions were acquired primarily to expand Brown & Brown’s core businesses and to attract and obtain high-quality individuals. Acquisition purchase prices are based primarily on a multiple of average annual operating profits earned over a one- to three-year period within a minimum and maximum price range. The initial asset allocation of an acquisition is based on the minimum purchase price, and any subsequent earn-out payment is allocated to goodwill.

 

All of these acquisitions have been accounted for as business combinations and are as follows:

 

 

 

The results of operations for the acquisitions completed during 2006 have been combined with those of the Company since their respective acquisitions dates. If the acquisitions had occurred as of January 1, 2005, the Company’s results of operations would be as shown in the following table:

 

 

These pro forma results are not necessarily indicative of the actual results of operations that would have occurred had the acquisitions actually been made at the beginning of the respective periods.

 

Additional consideration paid to sellers as a result of purchase price “earn-out” provisions are recorded as adjustments to intangible assets when the contingencies are settled. The net additional consideration paid by the Company in 2006 as a result of these adjustments totaled $46,305,000, of which $46,340,000 was allocated to goodwill. Of the $46,305,000 net additional consideration paid, $12,692,000 was paid in cash, $32,656,000 was issued in notes payable and $957,000 was assumed as net liabilities. As of September 30, 2006, the maximum future contingency payments related to acquisitions totaled $170,377,000.

 

 

Goodwill is subject to at least an annual assessment for impairment by applying a fair value-based test. Brown & Brown completed its most recent annual assessment as of November 30, 2005 and identified no impairment as a result of the evaluation.

 

The changes in goodwill for the nine months ended September 30, 2006 are as follows:

 

 

 

 

Amortizable intangible assets at September 30, 2006 and December 31, 2005 consisted of the following:

 

 

Amortization expense for other amortizable intangible assets for the years ending December 31, 2006, 2007, 2008, 2009 and 2010 is estimated to be $36,542,000, $37,640,000, $36,747,000, $36,278,000, and $35,621,000, respectively.

 

 

Long-term debt at September 30, 2006 and December 31, 2005 consisted of the following:

 

In July 2004, Brown & Brown completed a private placement of $200.0 million of unsecured senior notes (the “Notes”). The $200.0 million Notes are divided into two series: Series A, for $100.0 million due in 2011 and bearing interest at 5.57% per year; and Series B, for $100.0 million due in 2014 and bearing interest at 6.08% per year. The closing on the Series B Notes occurred on July 15, 2004. The closing on the Series A Notes occurred on September 15, 2004. Brown & Brown has used the proceeds from the Notes for general corporate purposes, including acquisitions and repayment of existing debt. As of September 30, 2006 and December 31, 2005 there was an outstanding balance of $200.0 million on the Notes.

 

In September 2003, Brown & Brown established an unsecured revolving credit facility with a national banking institution that provided for available borrowings of up to $75.0 million, with a maturity date of October 2008, bearing an interest rate based upon the 30-, 60- or 90-day London InterBank Offered Rate (“LIBOR”) plus 0.625% to 1.625%, depending upon the Company’s quarterly ratio of funded debt to earnings before interest, taxes, depreciation, amortization and non-cash stock-based compensation. A commitment fee of 0.175% to 0.375% per annum is assessed on the unused balance. The 90-day LIBOR was 5.37% and 4.53% as of September 30, 2006 and December 31, 2005, respectively. There was $40.0 million borrowed against this facility at September 30, 2006.

 

In January 2001, Brown & Brown entered into a $90.0 million unsecured seven-year term loan agreement with a national banking institution, bearing an interest rate based upon the 30-, 60- or 90-day LIBOR plus 0.50% to 1.00%, depending upon Brown & Brown’s quarterly ratio of funded debt to earnings before interest, taxes, depreciation, amortization and non-cash stock grant compensation. The 90-day LIBOR was 5.37% and 4.53% as of September 30, 2006 and December 31, 2005, respectively. The loan was fully funded on January 3, 2001 and as of September 30, 2006 had an outstanding balance of $16,072,000. This loan is to be repaid in equal quarterly installments of $3,200,000 through December 2007.

 

All three of these credit agreements require Brown & Brown to maintain certain financial ratios and comply with certain other covenants. Brown & Brown was in compliance with all such covenants as of September 30, 2006 and December 31, 2005.

 

 

To hedge the risk of increasing interest rates from January 2, 2002 through the remaining six years of its seven-year $90 million term loan, Brown & Brown entered into an interest rate exchange (“swap”) agreement that effectively converted the floating rate LIBOR-based interest payments to fixed interest rate payments at 4.53%. This agreement did not affect the required 0.50% to 1.00% credit risk spread portion of the term loan. In accordance with SFAS No. 133, as amended, the fair value of the interest rate swap of approximately $52,000, net of related income taxes of approximately $31,000, was recorded in other assets as of September 30, 2006, and $36,000, net of related income taxes of approximately $22,000, was recorded in other asset as of December 31, 2005; with the related change in fair value reflected as other comprehensive income. Brown & Brown has designated and assessed the derivative as a highly effective cash flow hedge.

 

Acquisition notes payable represent debt incurred to former owners of certain insurance operations acquired by Brown & Brown. These notes and future contingent payments are payable in monthly, quarterly and annual installments through April 2011, including interest in the range from 0% to 8.05%.

 

 

Brown & Brown’s significant non-cash investing and financing activities are summarized as follows:

 

 

 

The components of comprehensive income, net of related income tax effects, are as follows:

 

 

 

 

As previously disclosed, Brown & Brown, Inc. is one of more than ten insurance intermediaries named together with a number of insurance companies as defendants in putative class action lawsuits purporting to be brought on behalf of policyholders. Brown & Brown, Inc. initially became a defendant in certain of those actions in October and December of 2004. In February 2005, the Judicial Panel on Multi-District Litigation consolidated these

 

 

 

Since the New York State Attorney General filed the lawsuit referenced above against Marsh & McLennan in October 2004, governmental agencies in a number of states have looked or are looking into issues related to compensation practices in the insurance industry, and the Company continues to actively receive and respond to written and oral requests for information and/or subpoenas seeking information related to this topic. To date, requests for information and/or subpoenas have been received from governmental agencies such as attorneys general or departments of insurance in the following states: Arkansas (Department of Insurance), Arizona (Department of Insurance), California (Department of Insurance), Connecticut (Office of Attorney General), Florida (Office of Attorney General, Department of Financial Services, and Office of Insurance Regulation), Illinois (Office of Attorney General), Nevada (Department of Business & Industry, Division of Insurance), New Hampshire (Department of Insurance), New Jersey (Department of Banking and Insurance), New York (Office of Attorney General), North Carolina (Department of Insurance and Department of Justice), Oklahoma (Department of Insurance), Pennsylvania (Department of Insurance), South Carolina (Department of Insurance), Texas (Department of Insurance), Vermont (Department of Banking, Insurance, Securities & Healthcare Administration), Virginia (State Corporation Commission, Bureau of Insurance, Agent Regulation & Administration Division), Washington (Office of Insurance Commissioner) and West Virginia (Office of Attorney General). Agencies in Arizona, Virginia and Washington have concluded their respective investigations of subsidiaries of Brown & Brown, Inc. based in those states with no further action as to these entities.

 

As previously disclosed in our public filings, offices of the Company are party to contingent commission agreements with certain insurance companies, including agreements providing for potential payment of revenue-sharing commissions by insurance companies based primarily on the overall profitability of the aggregate business written with that insurance company, and/or additional factors such as retention ratios and overall volume of business that an office or offices place with the insurance company. Additionally, to a lesser extent, some offices of the Company are party to override commission agreements with certain insurance companies, and these agreements provide for commission rates in excess of standard commission rates to be applied to specific lines of business, such as group health business, based primarily on the overall volume of such business that the office or offices in question place with the insurance company. The Company has not chosen to discontinue receiving contingent commissions or override commissions.

 

As previously disclosed, a committee comprised of independent members of the Board of Directors of Brown & Brown, Inc. (the “Special Review Committee”) determined that maintenance of a derivative suit was not in the best interests of the Company, following an investigation in response to a December 2004 demand letter from counsel purporting to represent a current shareholder of Brown & Brown, Inc. (the “Demand Letter”). The Demand Letter sought the commencement of a derivative suit by Brown & Brown, Inc. against the Board of Directors and current and former officers and directors of Brown & Brown, Inc. for alleged breaches of fiduciary duty related to the Company’s participation in contingent commission agreements. The Special Review Committee’s conclusions were communicated to the purported shareholder’s counsel and there has been limited communication since then. There can be no assurance that the purported shareholder will not further pursue his allegations or that any pursuit of any such allegations would not have a material adverse effect on the Company.

 

In response to the foregoing events, the Company also, on its own volition, engaged outside counsel to conduct a limited internal inquiry into certain sales and marketing practices of the Company, with special emphasis on the effects of contingent commission agreements on the placement of insurance products by the Company for its clients. The internal inquiry resulted in several recommendations being made in January 2006 regarding disclosure of compensation, premium finance charges, interface between the Company’s retail and wholesale units, fee-based compensation and direct incentives from insurance companies. The Company has been evaluating these recommendations and has adopted or is in the process of adopting these recommendations. As a result of that inquiry, and in the process of preparing responses to some of the governmental agency inquiries referenced above, management of the Company became aware of a limited number of specific, unrelated instances of questionable conduct. These matters have been addressed and resolved, or are in the process of being addressed and resolved, on a case-by-case basis, and thus far the amounts involved in resolving such matters have not been, either individually or in the aggregate, material. However, there can be no assurance that the ultimate cost and ramifications of resolving these matters will not have a material adverse effect on the Company.

 

Some of the other insurance intermediaries and insurance companies that have been subject to governmental investigations and/or lawsuits arising out of these matters have chosen to settle some such matters. Such settlements have involved the payment of substantial sums, as well as agreements to change business practices including, in some cases, agreements to no longer pay or accept contingent commissions. Marsh & McLennan, Aon Corporation, Arthur J. Gallagher & Co., Hilb, Rogal & Hobbs Company (“HRH”), and Willis Group Holdings Ltd. have each entered into agreements with governmental agencies, which collectively involve payments by these intermediaries to agencies and to certain of their clients totaling nearly $1 billion. With the exception of the settlement entered into by HRH, which included an agreement that HRH would discontinue acceptance of certain types of contingency compensation, these agreements provided that these insurance intermediaries would discontinue acceptance of any contingency compensation.

 

The Company cannot currently predict the impact or resolution of the Antitrust Actions, the shareholder demand or the various governmental inquiries or lawsuits and thus cannot reasonably estimate a range of possible loss, which could be material, or whether the resolution of these matters may harm the Company’s business and/or lead to a decrease in or elimination of contingent commissions and override commissions, which could have a material adverse impact on the Company’s consolidated financial condition.

 

 

The Company is involved in numerous pending or threatened proceedings by or against Brown & Brown, Inc. or one or more of its subsidiaries that arise in the ordinary course of business. The damages that may be claimed against the Company in these various proceedings are substantial, including in many instances claims for punitive or extraordinary damages. Some of these claims and lawsuits have been resolved, others are in the process of being resolved, and others are still in the investigation or discovery phase. The Company will continue to respond appropriately to these claims and lawsuits, and to vigorously protect its interests.

 

 

 

Brown & Brown’s business is divided into four reportable segments: the Retail Division, which provides a broad range of insurance products and services to commercial, governmental, professional and individual customers; the National Programs Division, which is comprised of two units - Professional Programs, which provides professional liability and related package products for certain professionals delivered through nationwide networks of independent agents, and Special Programs, which markets targeted products and services designated for specific industries, trade groups, governmental entities, and market niches; the Brokerage Division, which markets and sells excess and surplus commercial and personal lines insurance, and reinsurance, primarily through independent agents and brokers; and the Services Division, which provides insurance-related services, including third-party administration, consulting for the workers’ compensation and employee benefit self-insurance markets, and managed healthcare services. Brown & Brown conducts all of its operations within the United States of America.

 

Summarized financial information concerning Brown & Brown’s reportable segments for the nine months ended September 30, 2006 and 2005 is shown in the following table. The “Other” column includes any income and expenses not allocated to reportable segments and corporate-related items, including the inter-company interest expense charge to the reporting segment.

 

 

 

 

THE FOLLOWING DISCUSSION UPDATES THE MD&A CONTAINED IN THE COMPANY’S 2005 ANNUAL REPORT ON FORM 10-K, AND THE TWO DISCUSSIONS SHOULD BE READ TOGETHER.

 

 

We are a general insurance and brokerage agency that commenced business in 1939 and are headquartered in Daytona Beach and Tampa, Florida. We market and sell to our customers insurance products and services, primarily in the property, casualty and the employee benefits markets. As an agent and broker, we do not assume underwriting risks. Instead, we provide our customers with quality insurance contracts, as well as other targeted, customized risk management products and services.

 

Our commissions and fees revenue are comprised of commissions paid by insurance companies and fees paid directly by customers. Commission revenues generally represent a percentage of the premium paid by the insured and are materially affected by fluctuations in both premium rate levels charged by insurance companies and the insureds’ underlying “insurable exposure units,” which are units that insurance companies use to measure or express insurance exposed to risk (such as property values, sales and payroll levels) so as to determine what premium to charge the insured. These premium rates are established by insurance companies based upon many factors, including reinsurance rates, none of which we control. Beginning in 1986 and continuing through 1999, commission revenues were adversely influenced by a consistent decline in premium rates resulting from intense competition among property and casualty insurance companies for market share. Among other factors, this condition of a prevailing decline in premium rates, commonly referred to as a “soft market,” generally resulted in flat to reduced commissions on renewal business. The effect of this softness in rates on our commission revenues was somewhat offset by our acquisitions and net new business production. As a result of increasing “loss ratios” (the comparison of incurred losses plus adjustment expenses against earned premiums) of insurance companies through 1999, there was a general increase in premium rates beginning in the first quarter of 2000 and continuing into 2003. During 2003, the increases in premium rates began to moderate, and in certain lines of insurance, premium rates decreased. In 2004, as general premium rates continued to moderate, the insurance industry experienced the worst hurricane season since 1992 when Hurricane Andrew hit south Florida. The insured losses from the 2004 hurricane season were absorbed relatively easily by the insurance industry and the general insurance premium rates continued to soften during 2005. During the third quarter of 2005, the insurance industry experienced the worst hurricane season ever recorded. Primarily as a result of these hurricanes, including Hurricanes Katrina, Rita and Wilma, the total insured losses are estimated to be in excess of $50 billion. As a result of the 2005 insured losses, there is upward pressure on the insurance premium rates on coastal property, primarily in the southeastern part of the United States. In other parts of the country, premium rates continue to be generally “soft”.

 

We also earn “contingent commissions,” which are profit-sharing commissions based primarily on underwriting results, but may also reflect considerations for volume, growth and/or retention. These commissions are primarily received in the first and second quarters of each year, based on underwriting results and other aforementioned considerations for the prior year(s), and, over the last three years, have averaged approximately 6.0% of the previous year’s total commissions and fees revenue. Contingent commissions are included in our total commissions and fees in the Consolidated Statements of Income in the year received. The term “core commissions and fees” excludes contingent commissions and therefore represents the revenues earned directly from specific insurance policies sold, and specific fee-based services rendered.

 

Fee revenues are generated primarily by our Services Division, which provides insurance-related services, including third-party administration and consulting for the self-funded workers’ compensation markets and Medicare set-aside services and programs.

 

Investment income consists primarily of interest earnings on premiums and advance premiums collected and held in a fiduciary capacity before being remitted to insurance companies. Our policy is to invest available funds in high-quality, short-term fixed income investment securities. Investment income also includes gains and losses realized from the sale of investments.

 

 

Our Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We continually evaluate our estimates, which are based on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for our judgments about the carrying values of our assets and liabilities, which values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

The more critical accounting and reporting policies include our accounting for revenue recognition, business acquisitions and purchase price allocations, intangible assets impairments, reserves for litigation and derivative interests. In particular, the accounting for these areas requires significant judgments to be made by management. Different assumptions in the application of these policies could result in material changes in our consolidated financial position or consolidated results of operations. Refer to Note 1 in the “Notes to Consolidated Financial Statements” in our 2005 Annual Report on Form 10-K on file with the Securities and Exchange Commission for details regarding all of our critical and significant accounting policies.

 

 

 

All share and per share information has been restated to give effect to a two-for-one common stock split that became effective November 28, 2005. That split was effected as a stock dividend.

 

 

The following discussion and analysis regarding results of operations, and liquidity and capital resources should be considered in conjunction with the accompanying Condensed Consolidated Financial Statements and related Notes.

 

 

 

Financial information relating to our Condensed Consolidated Financial Results for the three and nine months ended September 30, 2006 and 2005 is as follows (in thousands, except percentages):

 

 

 

 

Net income for the third quarter of 2006 was $40.3 million, or $0.29 per diluted share, compared with net income in the third quarter of 2005 of $34.8 million, or $0.25 per diluted share, a 16.0% increase on a per-share basis. Net income for the nine months ended September 30, 2006 was $134.7 million or $0.96 per diluted share, compared with net income for the comparable period in 2005 of $114.8 million, or $0.82 per diluted share, a 17.1 % increase on a per-share basis.

 

 

Commissions and fees, including contingent commissions, for the third quarter of 2006 increased $20.1 million, or 10.7%, over the same period in 2005. Contingent commissions for the third quarter of 2006 decreased $0.5 million over the third quarter of 2005, to $2.1 million. Core commissions and fees are our commissions and fees, less (i) contingent commissions and (ii) divested business (commissions and fees generated from offices, books of business or niches sold or terminated). Core commissions and fees revenue for the third quarter of 2006 increased $21.2 million, of which approximately $11.5 million represents core commissions and fees from agencies acquired since the third quarter of 2005. After divested business of $0.6 million, the remaining $9.7 million represents net new business production, which reflects a 5.2% internal growth rate for core commissions and fees. Commissions and fees for the nine months ended September 30, 2006 increased $72.4 million, or 12.5%, over the same period in 2005. For the nine months ended September 30, 2006, contingent commissions increased $5.8 million over the comparable period in 2005. Core commissions and fees revenue for the first nine months of 2006 increased $68.2 million, of which approximately $43.6 million of the total increase represents core commissions and fees from agencies acquired since the comparable period in 2005. After divested business of $1.6 million, the remaining $24.6 million represents net new business production, which reflects a 4.5% internal growth rate for core commissions and fees.

 

 

Investment income for the three months ended September 30, 2006 increased $1.4 million, or 80.2%, over the same period in 2005. Investment income for the nine months ended September 30, 2006 increased $4.1 million, or 96.1%, over the same period in 2005. These increases in investment income were primarily due to higher investment yield rates.

 

 

Other income for the three months ended September 30, 2006 decreased $0.2 million, or 54.5%, over the same period in 2005. Other income for the nine months ended September 30, 2006 decreased $2.1 million, or 66.3%, over the same period in 2005. Other income consists primarily of gains and losses from the sale and disposition of assets. The majority of the gain for the nine months ended September 30, 2005 was the result of the completion of the one year earn-out from the sale of our medical services operation in Louisiana in June 2004.

 

 

Employee compensation and benefits for the third quarter of 2006 increased $6.8 million, or 7.2%, over the same period in 2005. Employee compensation and benefits for the nine months ended September 30, 2006 increased $26.2 million, or 9.4%, over the same period in 2005. These increases are primarily related to the addition of new employees from acquisitions completed since October 1, 2005 and increased compensation that resulted from higher commissions and fees revenue. Employee compensation and benefits as a percentage of total revenue decreased to 47.6% for the third quarter of 2006, from 49.3% for the third quarter of 2005. For the nine months ended September 30, 2006, employee compensation and benefits as a percentage of total revenue decreased to 45.9%, from 47.3% for the same period in 2005. These improved ratios for the three and nine month periods were the result of the continued assimilation of the acquisitions completed in 2005 and 2006 into our standard compensation program.

 

 

Non-cash stock-based compensation for the three and nine months ended September 30, 2006 increased approximately $0.2 million, or 22.9%, and $2.2 million, or 95.0%, respectively. As more fully described in Notes 4 and 5 of the Condensed Consolidated Financial Statements, the increase was due to the implementation of SFAS No. 123R. The majority of the increased cost primarily relates to the expensing of the 15% discount granted to participants under our 1990 Employee Stock Purchase Plan.

 

 

Other operating expenses for the third quarter of 2006 increased $3.9 million, or 15.1%, over the same period in 2005. For the nine months ended September 30, 2006, other operating expenses increased $11.8 million, or 15.0%, over the same period in 2005. These increases are primarily the result of acquisitions completed since the fourth quarter of 2005 that had no comparable results in the same period of 2005. Other operating expenses as a percentage of revenues for the third quarter of 2006 increased to 13.9%, compared with 13.4% for the same period in 2005. For the nine months ended September 30, 2006, other operating expenses as a percentage of revenues increased to 13.7%, compared with 13.4% for the same period in 2005. The slight increase during the nine months ended September 30, 2006 was due to a general increase in travel and entertainment expenses in 2006, and the fact that in 2005 there was a $1.0 million reversal for an accrual for the revoked Florida Communications Tax.

 

 

Amortization expense for the third quarter of 2006 increased $0.6 million, or 7.5%, over the third quarter of 2005. For the nine months ended September 30, 2006, amortization expense increased $2.7 million, or 11.2%, over the same period in 2005. These increases are primarily due to acquisitions completed since October 1, 2005.

 

 

Depreciation expense for the third quarter of 2006 increased $0.4 million, or 15.1%, over the third quarter of 2005. For the nine months ended September 30, 2006, depreciation expense increased $0.9 million, or 11.7%, over the same period in 2005. These increases are due to capital expenditures and fixed assets purchased in acquisitions completed since October 1, 2005.

 

 

Interest expense for the third quarter of 2006 decreased $0.4 million, or 11.2%, over the same period in 2005. For the nine months ended September 30, 2006, interest expense decreased $0.8 million, or 7.4%, over the same period in 2005.

 

 

As discussed in Note 13 of the Notes to Condensed Consolidated Financial Statements, we operate in four reportable segments: the Retail, National Programs, Brokerage and Services Divisions. On a divisional basis, increases in amortization, depreciation and interest expenses are the result of new acquisitions within that division in a particular year. Likewise, other income in each division primarily reflects net gains on sales of customer accounts and fixed assets. In evaluating the operational efficiency of a division, management places greater emphasis on the net internal growth rate of core commissions and fees revenue, the gradual improvement of the ratio of employee compensation and benefits to total revenues, and the gradual improvement of the ratio of other operating expenses to total revenues.

 

Our core commissions and fees internal growth rates for the three months ended September 30, 2006 by divisional units are as follows (in thousands, except percentages):

 

 

 

The reconciliation of the above internal growth schedule to the total Commissions and Fees included in the Condensed Consolidated Statements of Income for the three months ended September 30, 2006 and 2005 is as follows (in thousands, except percentages):

 

 

Our core commissions and fees internal growth rates for the nine months ended September 30, 2006 by divisional units are as follows (in thousands, except percentages): 

 

 

The reconciliation of the above internal growth schedule to the total Commissions and Fees included in the Condensed Consolidated Statements of Income for the nine months ended September 30, 2006 and 2005 is as follows (in thousands, except percentages):

 

 

 

 

 

The Retail Division provides a broad range of insurance products and services to commercial, public entity, professional and individual customers. Financial information relating to our Retail Division is as follows (in thousands, except percentages):