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Aon 10-Q 2012 Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2012
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission file number 1-7933
Aon plc (Exact Name of Registrant as Specified in Its Charter)
+44 20 7623 5500 (Registrant’s Telephone Number,
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES x NO o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO x
Number of Class A Ordinary Shares of Aon plc, $0.01 nominal value, outstanding as of April 2, 2012: 326,415,020
Part I Financial Information ITEM 1. FINANCIAL STATEMENTS
Aon plc Condensed Consolidated Statements of Income (Unaudited)
See accompanying notes to the Condensed Consolidated Financial Statements (unaudited).
Aon plc Condensed Consolidated Statements of Comprehensive Income (Unaudited)
See accompanying notes to the Condensed Consolidated Financial Statements (unaudited).
Aon plc Condensed Consolidated Statements of Financial Position
See accompanying notes to the Condensed Consolidated Financial Statements (unaudited).
Aon plc Condensed Consolidated Statement of Stockholders’ Equity (Unaudited)
See accompanying notes to the Condensed Consolidated Financial Statements (unaudited).
Aon plc Condensed Consolidated Statements of Cash Flows (Unaudited)
See accompanying notes to the Condensed Consolidated Financial Statements (unaudited).
Notes to the Condensed Consolidated Financial Statements (Unaudited)
1. Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The Condensed Consolidated Financial Statements include the accounts of Aon plc and all controlled subsidiaries (“Aon” or the “Company”). All material intercompany accounts and transactions have been eliminated. The Condensed Consolidated Financial Statements include, in the opinion of management, all adjustments (consisting of normal recurring adjustments and reclassifications) necessary to present fairly the Company’s consolidated financial position, results of operations and cash flows for all periods presented.
Certain information and footnote disclosures normally included in the financial statements prepared in accordance with U.S. GAAP have been condensed or omitted. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. The results for the three months ended March 31, 2012 are not necessarily indicative of operating results that may be expected for the full year ending December 31, 2012.
Company Redomestication
On April 2, 2012, the Company completed the reorganization of the corporate structure of the group of companies controlled by its predecessor, Aon Corporation, as holding company of the Aon group, pursuant to which Aon Corporation merged with one of its indirect, wholly-owned subsidiaries and Aon plc became the publicly-held parent company of the Aon group. This transaction is referred to as the Redomestication. In the Redomestication, each issued and outstanding share of Aon Corporation common stock held by stockholders of Aon Corporation was converted into the right to receive one Class A Ordinary Share, nominal value $0.01 per share, of Aon plc. Likewise, equity incentive and compensation plans were assumed by Aon plc and amended to provide that those plans will now provide for the award and issuance of Aon plc Class A Ordinary Shares on a one-for-one basis. Shares of treasury stock of Aon Corporation were cancelled in the Redomestication. Any references to “Aon”, “the Company”, “us”, or “we,” or any similar references relating to periods before the Redomestication shall be construed as references to Aon Corporation, being the previous parent company of the Aon group.
Reclassification
Certain amounts in prior year’s Condensed Consolidated Financial Statements and related notes have been reclassified to conform to the 2012 presentation. In prior periods, remeasurement gains and losses from foreign currency transactions and related derivative instruments were recognized in Other general expenses in the Condensed Consolidated Statements of Income. These gains and losses are now included in Other income in the Condensed Consolidated Statements of Income and are disclosed in Note 4 to these Condensed Consolidated Financial Statements. The Company believes this provides greater clarity into the income generated from operations.
Use of Estimates
The preparation of the accompanying Condensed Consolidated Financial Statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on management’s best estimates and judgments, which management believes to be reasonable based on facts and circumstances. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment. Aon adjusts such estimates and assumptions when facts and circumstances dictate. Illiquid credit markets, volatile equity markets, and foreign currency movements have combined to increase the uncertainty inherent in such estimates and assumptions. As future events and their effects cannot be determined with definitive precision, actual results could differ significantly from these estimates. Future changes in estimates resulting from continuing changes in the economic environment will be reflected in the financial statements in future periods.
2. Accounting Principles and Practices
Changes in Accounting Principles
Goodwill Impairment
In September 2011, the Financial Accounting Standards Board (“FASB”) issued final guidance on goodwill impairment that gives an entity the option to perform a qualitative assessment that may eliminate the requirement to perform the annual two-step test. The current two-step test requires an entity to assess goodwill for impairment by quantitatively comparing the fair value of a reporting unit
with its carrying amount, including goodwill (Step 1). If the reporting unit’s fair value is less than its carrying amount, Step 2 of the test must be performed to measure the amount of goodwill impairment, if any. The recently issued guidance gives an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity concludes that this is the case, it must perform the two-step test. Otherwise, the two-step test is not required. The Company early adopted this guidance in the fourth quarter 2011. The adoption of this guidance did not have a material impact on the Company’s financial statements.
Comprehensive Income
In June 2011, the FASB issued guidance that updates principles related to the presentation of comprehensive income. The revised guidance requires companies to present the components of net income and other comprehensive income either as one continuous statement or as two consecutive statements and eliminates the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The guidance, which must be applied retroactively, is effective for Aon beginning in the first quarter of 2012. The adoption of this guidance affects only the presentation of these Condensed Consolidated Financial Statements, and has no effect on the financial condition, results of operations or cash flows of the Company.
Fair Value Measurement
In May 2011, the FASB issued guidance that clarifies the application of existing fair value measurements and disclosures, and changes certain principles or requirements for fair value measurements and disclosures. The additional required disclosures include quantitative information, sensitivity discussion, and description of the valuation process, as well as increased disclosure of unobservable inputs that are significant to the fair value measurement and transfers between Level 1 and Level 2. The guidance is effective for Aon beginning in the first quarter 2012. The adoption of this guidance did not have a material impact on the Company’s financial statements.
3. Cash and Cash Equivalents and Short-Term Investments
Cash and cash equivalents include cash balances and all highly liquid investments with initial maturities of three months or less. Short-term investments include certificates of deposit, money market funds and highly liquid debt instruments purchased with initial maturities in excess of three months but less than one year and are carried at amortized cost, which approximates fair value.
The Company was required to hold £77 million of operating funds in the U.K., which were included in Short-term investments. These operating funds, when translated to U.S, dollars, were $123 million and $120 million at March 31, 2012 and December 31, 2011, respectively. Cash and cash equivalents included restricted balances of $90 million and $71 million at March 31, 2012 and December 31, 2011, respectively. The increase in restricted cash balances from December 31, 2011 is primarily due to increased requirements to hold cash and cash equivalents as collateral in Europe.
4. Other Income
Other income consists of the following (in millions):
5. Acquisitions and Dispositions
Acquisitions
During the three months ended March 31, 2012, the Company completed the acquisition of two businesses in the Risk Solutions segment. During the three months ended March 31, 2011, the Company completed the acquisition of one business in the Risk Solutions segment.
The following table includes the aggregate consideration transferred and the preliminary value of intangible assets recorded as a result of the Company’s acquisitions.
The results of operations of these acquisitions are included in the Condensed Consolidated Financial Statements as of the acquisition date. The results of operations of the Company would not have been materially different if these acquisitions had been reported from the beginning of the period.
Dispositions
During the three months ended March 31, 2012, the Company completed the sale of one business in the HR Solutions segment. No gain or loss was recognized on this sale. During the three months ended March 31, 2011, the Company did not complete any dispositions.
6. Goodwill and Other Intangible Assets
The change in the carrying amount of goodwill by operating segment for the three months ended March 31, 2012 is as follows (in millions):
(1) Effective January 1, 2012, the Health and Benefits Consulting business was transferred from the HR Solutions segment to the Risk Solutions segment.
Other intangible assets by asset class are as follows (in millions):
Amortization expense from intangible assets with finite lives was $104 million and $91 million for the three months ended March 31, 2012 and 2011, respectively.
The estimated future amortization for intangible assets as of March 31, 2012 is as follows (in millions):
7. Restructuring
Aon Hewitt Restructuring Plan
On October 14, 2010, Aon announced a global restructuring plan (“Aon Hewitt Plan”) in connection with the acquisition of Hewitt Associates, Inc. The Aon Hewitt Plan is intended to streamline operations across the combined Aon Hewitt organization and includes an estimated 1,500 to 1,800 job eliminations. The Company expects these restructuring activities and related expenses to impact continuing operations into 2013. The Aon Hewitt Plan is expected to result in cumulative costs of approximately $325 million through the end of the plan, consisting of approximately $180 million in employee termination costs and approximately $145 million in real estate realization costs.
From the inception of the Aon Hewitt Plan through March 31, 2012, approximately 1,186 jobs have been eliminated and total expenses of $169 million have been incurred. The Company recorded $12 million and $23 million of restructuring and related charges in the three months ended March 31, 2012 and 2011, respectively. Charges related to the restructuring are included in Compensation and benefits and Other general expenses in the accompanying Condensed Consolidated Statements of Income.
The following summarizes restructuring and related costs by type that have been incurred and are estimated to be incurred through the end of the restructuring initiative related to the Aon Hewitt Plan (in millions):
(1) Actual costs, when incurred, may vary due to changes in the assumptions built into this plan. Significant assumptions that may change when plans are finalized and implemented include, but are not limited to, changes in severance calculations, changes in the assumptions underlying sublease loss calculations due to changing market conditions, and changes in the overall analysis that might cause the Company to add or cancel component initiatives.
(2) Other costs associated with restructuring initiatives, including moving costs and consulting and legal fees, are recognized when incurred.
Effective January 1, 2012, the Health and Benefits Consulting business was transferred from the HR Solutions segment to the Risk Solutions segment. Restructuring costs associated with the Health and Benefits Consulting business are reflected in the Risk Solutions segment, including $41 million that was reclassified from the HR Solutions segment to the Risk Solutions segment for 2011. During the first quarter 2011, $23 million in restructuring expenses were recorded, $14 million of which related to the Health and Benefits Consulting business. The following summarizes the restructuring and related expenses, by segment, that have been incurred and are estimated to be incurred through the end of the restructuring initiative related to the Aon Hewitt Plan (in millions):
Aon Benfield Restructuring Plan
The Company announced a global restructuring plan (“Aon Benfield Plan”) in conjunction with its acquisition of Benfield in 2008. The Aon Benfield Plan was intended to integrate and streamline operations across the combined Aon Benfield organization. The Aon Benfield Plan included 810 job eliminations. Additionally, duplicate space and assets was abandoned. The Company incurred all remaining costs for the Aon Benfield Plan in the first quarter 2012.
The Company recorded $8 million and $7 million of restructuring and related charges in the three months ended March 31, 2012 and 2011, respectively. All costs associated with the Aon Benfield Plan are included in the Risk Solutions segment. Charges related to the restructuring are included in Compensation and benefits and Other general expenses in the accompanying Condensed Consolidated Statements of Income.
The following summarizes the restructuring and related costs by type that have been incurred through the end of the restructuring initiative related to the Aon Benfield Plan in the first quarter 2012 (in millions):
As of March 31, 2012, the Company’s liabilities for its restructuring plans are as follows (in millions):
8. Investments
The Company earns income on cash balances and investments, as well as on premium trust balances that Aon maintains for premiums collected from insureds but not yet remitted to insurance companies, and funds held under the terms of certain outsourcing agreements to pay certain obligations on behalf of clients. Premium trust asset balances and a corresponding liability are included in Fiduciary assets and Fiduciary liabilities in the accompanying Condensed Consolidated Statements of Financial Position.
The Company’s interest-bearing assets and other investments are included in the following categories in the Condensed Consolidated Statements of Financial Position (in millions):
(1) Fiduciary assets includes funds held on behalf of clients but does not include fiduciary receivables.
The Company’s investments are as follows (in millions):
(2) The reduction in equity method investments is primarily due to sales and redemptions.
9. Debt
The Company uses the proceeds from the commercial paper market from time to time in order to meet short term working capital needs. At March 31, 2012, the Company had no commercial paper outstanding as compared to $50 million in commercial paper outstanding at December 31, 2011. The weighted average commercial paper outstanding for the three months ended March 31, 2012 was $20.9 million. The weighted average interest rate of the commercial paper for the same period was 0.47%.
On March 20, 2012, the Company entered into a $400 million five year credit agreement (“Revolving Credit Agreement”). Borrowings under the Revolving Credit Agreement will bear interest, at the Company’s option, at a rate equal to either (a) the rate for eurodollar deposits as reflected on the applicable Reuters LIBOR01 page for the interest period relevant to such borrowing (“Eurodollar Rate”), plus the applicable margin or (b) the highest of (i) the rate of interest publicly announced by Citibank as its prime rate, (ii) the federal funds effective rate from time to time plus 0.5% and (iii) the one month Eurodollar rate plus 1.0%, in each case plus the applicable margin. The applicable margin for borrowings under the Revolving Credit Agreement may change depending on achievement of certain public debt ratings. The Revolving Credit Agreement has a maturity date of March 20, 2017 and contains covenants with respect to the ratio of consolidated adjusted EBITDA to consolidated interest expense (which may not be less than 4.00 to 1.00) and the ratio of consolidated funded debt to consolidated adjusted EBITDA (which may not be more than the lower of (a) 3.25 to 1.00 or (b) the greater of (i) 3.00 to 1.00 or (ii) the lowest ratio of consolidated funded debt to consolidated adjusted EBITDA then set forth in certain of Aon’s other credit facilities), as well as other customary covenants, undertakings and events of default. In conjunction with the Company entering into the Revolving Credit Agreement, the prior revolving credit agreement dated December 4, 2009 was terminated. There were no borrowings on the Revolving Credit Agreement at March 31, 2012. On April 2, 2012, in connection with the Redomestication, Aon plc became party to the Revolving Credit Agreement and guaranteed the obligations of Aon Corporation thereunder. The Company was in compliance with all debt covenants at March 31, 2012.
10. Stockholders’ Equity
Common Stock
In January 2010, the Company’s Board of Directors authorized a share repurchase program under which up to $2 billion of common stock may be repurchased (“2010 Share Repurchase Program”). Shares may be repurchased through the open market or in privately negotiated transactions, including structured repurchase programs, from time to time, based on prevailing market conditions, and will be funded from available capital. Any repurchased shares will be available for employee stock plans and for other corporate purposes.
During the first quarter of 2012, the Company repurchased 2.1 million shares at an average price per share of $48.32 for a total cost of $100 million. During the first quarter 2011, the Company repurchased 6.8 million shares at an average price per share of $51.29 for a total cost of $350 million under the 2010 Share Repurchase Program as well as a previous program that was completed in the first quarter 2011. Since the inception of the 2010 Share Repurchase Program, the Company has repurchased a total of 18.2 million shares
for an aggregate cost of $913 million. As of March 31, 2012, the Company was authorized to purchase up to $1.1 billion of additional shares under the 2010 Share Repurchase Program.
As a result of the Redomestication, the 2010 Share Repurchase Program, which related to common stock of Aon Corporation, was no longer of effect. In April 2012, the Company’s Board of Directors authorized a share repurchase program under which up to $5 billion of Class A ordinary shares may be repurchased (“2012 Share Repurchase Program”). Under this 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.
During the three months ended March 31, 2012 the Company reissued 3.7 million shares of treasury stock for employee benefit programs, including 1.0 million shares related to stock option exercises, and 0.3 million shares in connection with employee stock purchase plans. In the three months ended March 31, 2011, Aon reissued 4.5 million shares of treasury stock for employee benefit programs, including 2.0 million shares related to stock option exercises and 0.1 million shares in connection with employee stock purchase plans. In addition, in the three months ended March 31, 2011, the Company issued 0.4 million shares of common stock in relation to the exercise of options issued to former holders of Hewitt options as part of the Hewitt acquisition.
Participating Securities
Unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid, are participating securities and are included in computing basic and diluted earnings per share using the two class method. Certain of Aon’s restricted stock units allow the holder to receive a non-forfeitable dividend equivalent.
Income from continuing operations, income from discontinued operations and net income, attributable to participating securities, were as follows (in millions):
Weighted average shares outstanding are as follows (in millions):
(1) Includes 4.9 million and 5.7 million of participating securities for the three months ended March 31, 2012 and 2011, respectively.
Certain common stock equivalents, primarily related to stock options, were not included in the computation of diluted net income per share because their inclusion would have been antidilutive. The number of shares excluded from the calculation was 1 million and 1 million for the three months ended March 31, 2012 and 2011, respectively.
Accumulated Other Comprehensive Loss
The components of Accumulated other comprehensive loss, net of related tax, are as follows (in millions):
11. Employee Benefits
The following table provides the components of the net periodic benefit cost for Aon’s U.S. pension plans, along with the most significant international defined benefit pension plans, which are located in the U.K., the Netherlands, and Canada (in millions):
Based on current assumptions, during 2012, the Company plans to contribute $237 million and $304 million to its U.S. and most significant international defined benefit pension plans, respectively. During the first quarter 2012, contributions of $18 million have been made to the Company’s U.S. defined benefit pension plans and $105 million have been made to its most significant international defined benefit pension plans.
12. Stock Compensation Plans
The following table summarizes share-based compensation expense recognized in the Condensed Consolidated Statements of Income in Compensation and benefits (in millions):
Stock Awards
A summary of the status of the Company’s RSUs is as follows (shares in thousands):
(1) Represents per share weighted average fair value of award at date of grant
Information as of March 31, 2012 regarding the Company’s PSAs granted during the three months ended March 31, 2012 and the years ended December 31, 2011 and 2010, respectively (shares in thousands, dollars in millions):
(1) Represents per share weighted average fair value of award at date of grant.
Stock Options
In connection with its incentive compensation plans, the Company did not grant any options in the first quarter of 2012. During the first quarter of 2011, the Company granted 80,000 stock options at a weighted average exercise price $53 per share.
The weighted average assumptions, the weighted average expected life and estimated fair value of employee stock options are summarized as follows:
A summary of the status of Aon’s stock options and related information is as follows (shares in thousands):
The weighted average remaining contractual life of outstanding options was 3.1 years and 3.8 years at March 31, 2012 and 2011, respectively.
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 $49.06 as of March 31, 2012, which would have been received by the option holders had those option holders exercised their options as of that date. At March 31, 2012, the aggregate intrinsic value of options outstanding was $144 million, of which $137 million was exercisable.
Other information related to the Company’s stock options is as follows (in millions):
Unamortized deferred compensation expense, which includes both options and awards, amounted to $297 million as of March 31, 2012, with a remaining weighted-average amortization period of approximately 1.9 years.
13. Derivatives and Hedging
The Company is exposed to certain market risks, including changes in foreign currency exchange rates and interest rates. To manage the risk related to these exposures, the Company enters into various derivative instruments that reduce these market risks by creating offsetting exposures. The Company does not enter into derivative instruments for trading or speculative purposes.
Foreign Exchange Risk Management
The Company and its subsidiaries are exposed to foreign exchange risk when they receive revenues, pay expenses, or enter into intercompany loans denominated in a currency that differs from their functional currency. The Company uses foreign exchange derivatives, typically forward contracts, options and cross currency swaps, to reduce its overall exposure to the effects of currency fluctuations on cash flows. These exposures are hedged, on average, for less than two years; however, in limited instances, the Company has hedged certain exposures up to five years in the future.
The Company also uses foreign exchange derivatives, typically forward contracts and options, to hedge its net investments in foreign operations for up to two years in the future.
The Company also uses foreign exchange derivatives, typically forward contracts and options, to manage the currency exposure of the Company’s global liquidity profile for one year in the future. These derivatives are not accounted for as hedges, and changes in fair value are recorded each period in Other general expenses in the Condensed Consolidated Statements of Income.
Interest Rate Risk Management
The Company holds variable-rate short-term brokerage and other operating deposits. The Company uses interest rate derivatives, typically swaps, to reduce its exposure to the effects of interest rate fluctuations on the forecasted interest receipts from these deposits for up to two years in the future.
Certain derivatives also give rise to credit risks from the possible non-performance by counterparties. The credit risk is generally limited to the fair value of those contracts that are favorable to the Company. The Company has limited its credit risk by using International Swaps and Derivatives Association (“ISDA”) master agreements, collateral and credit support arrangements, entering into non-exchange-traded derivatives with highly-rated major financial institutions and by using exchange-traded instruments. The Company monitors the credit-worthiness of, and exposure to, its counterparties. As of March 31, 2012, all net derivative positions were free of credit risk contingent features. In addition, the Company did not receive or pledge collateral for any derivatives as of March 31, 2012.
The notional and fair values of derivative instruments are as follows (in millions):
(1) Included within Other assets (2) Included within Other liabilities
The amounts of derivative gains (losses) recognized in the Condensed Consolidated Financial Statements for the three months ended March 31, 2012 and 2011 are as follows (in millions):
(1) Included within Fiduciary investment income and Interest expense (2) Included within Other general expenses and Interest expense
(1) Relates to fixed rate debt (2) Included in Interest expense
It is estimated that approximately $20 million of pretax losses currently included within Accumulated other comprehensive loss will be reclassified into earnings in the next twelve months.
The amount of gain (loss) recognized in income on the ineffective portion of derivatives for the three months ended March 31, 2012 and 2011 was not material.
The Company recognized a gain of $5 million and a loss of $1 million during the three months ended March 31, 2012 and 2011, respectively, related to foreign exchange derivatives not designated or qualifying as hedges. These amounts were recorded in Other general expenses in the Condensed Consolidated Statements of Income.
14. Fair Value and Financial Instruments
Accounting standards establish a three tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:
· Level 1 — observable inputs such as quoted prices for identical assets in active markets; · Level 2 — inputs other than quoted prices for identical assets in active markets, that are observable either directly or indirectly; and · Level 3 — unobservable inputs in which there is little or no market data which requires the use of valuation techniques and the development of assumptions.
The following methods and assumptions are used to estimate the fair values of the Company’s financial instruments:
Money market funds and highly liquid debt securities are carried at cost and amortized cost, respectively, as an approximation of fair value. Based on market convention, the Company considers cost a practical and expedient measure of fair value.
Cash, cash equivalents, and highly liquid debt instruments consist of cash and institutional short-term investment funds. The Company independently reviews the short-term investment funds to obtain reasonable assurance the fund net asset value is $1 per share.
Equity investments consist of domestic and international equity securities and exchange traded equity derivatives valued using the closing stock price on a national securities exchange. Over the counter equity derivatives are valued using observable inputs such as underlying prices of the equity security and volatility. The Company independently reviews the listing of Level 1 equity securities in the portfolio and agrees the closing stock prices to a national securities exchange, and on a sample basis, independently verifies the observable inputs for Level 2 equity derivatives and securities.
Fixed income investments consist of certain categories of bonds and derivatives. Corporate, government, and agency bonds are valued by pricing vendors who estimate fair value using recently executed transactions and proprietary models based on observable inputs, such as interest rate spreads, yield curves and credit risk. Asset-backed securities are valued by pricing vendors who estimate fair value using discounted cash flow models utilizing observable inputs based on trade and quote activity of securities with similar features. Fixed income derivatives are valued by pricing vendors using observable inputs such as interest rates and yield curves. The Company obtains a detailed understanding of the models, inputs, and assumptions used in developing prices provided by its vendors. This understanding includes extensive discussions with valuation resources at the vendor. During these discussions, the Company uses a fair value measurement questionnaire, which is part of the Company’s internal controls over financial reporting, to obtain the information necessary to assert the model, inputs and assumptions used comply with U.S. GAAP, including disclosure requirements. The Company also obtains observable inputs from the pricing vendor and independently verifies the observable inputs, as well as assesses assumptions used for reasonableness based on relevant market conditions and internal Company guidelines. If an assumption is deemed unreasonable, based on the Company’s guidelines, it is then reviewed by a member of management and the fair value estimate provided by the vendor is adjusted, if deemed appropriate. These adjustments do not occur frequently and have not historically been material to the fair value estimates used in the Condensed Consolidated Financial Statements.
Pooled funds consist of various equity, fixed income, commodity, and real estate mutual fund type investment vehicles. Pooled investment funds fair value is estimated based on the proportionate share ownership in the underlying net assets of the investment, which is based on the fair value of the underlying securities that trade on a national securities exchange. Where possible, the Company independently reviews the listing securities in the portfolio and agrees the closing stock prices to a national securities exchange. The Company gains an understanding of the investment guidelines and valuation policies of the fund and holds extensive discussions regarding fund performance with pooled fund managers. The Company obtains audited fund manager financial statements, when available. If the pooled fund is designed to replicate a publicly traded index, the Company compares the performance of the fund to the index to assess the reasonableness of the fair value measurement.
Alternative investments consist of limited partnerships, private equity and hedge funds. Alternative investment fair value is generally estimated based on the proportionate share ownership in the underlying net assets of the investment as determined by the general partner or investment manager. The valuations are based on various factors depending on investment strategy, proprietary models, and specific financial data or projections. The Company obtains audited fund manager financial statements, when available. The Company obtains a detailed understanding of the models, inputs and assumptions used in developing prices provided by the investment managers (or appropriate party). During these discussions with the investment managers, the Company uses a fair value measurement questionnaire, which is part of the Company’s internal controls over financial reporting, to obtain the information necessary to assert the model, inputs and assumptions used comply with U.S. GAAP, including disclosure requirements. The Company also obtains observable inputs from the investment manager and independently verifies the observable inputs, as well as assesses assumptions used for reasonableness based on relevant market conditions and internal Company guidelines. If an assumption is deemed unreasonable, based on the Company’s guidelines, it is then reviewed by a member of management and the fair value estimate provided by the vendor is adjusted, if deemed appropriate. These adjustments do not occur frequently and have not historically been material to the fair value estimates in the Condensed Consolidated Financial Statements.
Derivatives are carried at fair value, based upon industry standard valuation techniques that use, where possible, current market-based or independently sourced pricing inputs, such as interest rates, currency exchange rates, or implied volatilities.
Annuity contracts consist of insurance group annuity contracts purchased to match the pension benefit payment stream owed to certain selected plan participant demographics within a few major United Kingdom defined benefit plans. Annuity contracts are valued using a discounted cash flow model utilizing assumptions such as discount rate, mortality, and inflation. The Company independently verifies the observable inputs.
Real estate and REITs consist of publicly traded REITs and direct real estate investments. Level 1 REITs are valued using the closing stock price on a national securities exchange. The Level 3 values are based on the proportionate share of ownership in the underlying net asset value as determined by the investment manager. The Company independently reviews the listing of Level 1 REIT securities in the portfolio and agrees the closing stock prices to a national securities exchange. The Company gains an understanding of the investment guidelines and valuation policies of the Level 3 real estate funds and discusses performance with the fund managers. The Company obtains audited fund manager financial statements, when available. See the description of “Alternative Investments” for further detail on valuation procedures surrounding Level 3 REITs.
Guarantees are carried at fair value, which is based on discounted estimated cash flows using published historical cumulative default rates and discount rates commensurate with the underlying exposure.
Debt is carried at outstanding principal balance, less any unamortized discount or premium. Fair value is based on quoted market prices or estimates using discounted cash flow analyses based on current borrowing rates for similar types of borrowing arrangements.
The following tables present the categorization of the Company’s assets and liabilities that are measured at fair value on a recurring basis at March 31, 2012 and December 31, 2011 (in millions):
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