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Hub Intl 10-K 2005
e10vk
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
     
[X]
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934.
 
For the fiscal year ended December 31, 2004
Or
 
[  ]
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934.
Commission File Number 1-31310
HUB INTERNATIONAL LIMITED
(Exact name of Registrant as specified in its charter)
     
Canada
  36-4412416
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
 
55 East Jackson Boulevard, Chicago, IL
  60604
(Address of principal executive offices)   (Zip Code)
Registrant’s telephone number, including area code:
(877) 402-6601
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
     
Title of Each Class   Name of Each Exchange on Which Registered
     
Common Shares, no par value
  New York Stock Exchange
Toronto Stock Exchange
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, and (2) has been subject to such filing requirements for the past 90 days. Yes x          No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x          No o
The aggregate market value of the voting stock held by non-affiliates of the registrant (i.e., other than directors, officers, or holders of more than 5% of the registrant’s common stock although such exclusion is not intended, nor shall it be deemed, to be an admission that such persons are affiliates of the registrant) computed by reference to the closing sales price on the New York Stock Exchange on June 30, 2004 was $386,770,406.
The number of shares of the registrant’s common stock, issued and outstanding as of March 1, 2005 was 30,584,013.
Documents Incorporated by Reference
Those sections or portions of the registrant’s definitive proxy statement filed or to be filed with the Securities and Exchange Commission pursuant to Regulation 14A (the “2005 Proxy Statement”) involving the election of directors and other matters at the annual and special meeting of shareholders of the registrant to be held on May 11, 2005, are incorporated by reference in Part III of this report.
 
 


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Reference in this Annual Report on Form 10-K to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. We publish our consolidated financial statements in U.S. dollars. All reference in this report to “dollars” or “$” refer to U.S. dollars and all reference to “Canadian dollars” and “C$” refer to Canadian dollars, unless otherwise noted. Except as otherwise indicated, all financial statements and financial data contained in this Annual Report on Form 10-K have been prepared in accordance with generally accepted accounting principles in Canada, or Canadian GAAP, which differs in certain respects from generally accepted accounting principles in the United States of America, or U.S. GAAP. Please see note 19 to our audited consolidated financial statements for a description of the material differences between Canadian GAAP and U.S. GAAP.
Information Concerning Forward-Looking Statements
This Form 10-K includes, and from time to time management may make, forward-looking statements which reflect our current views with respect to future events and financial performance. These forward-looking statements relate, among other things, to our plans and objectives for future operations. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other factors include, but are not limited to, risks associated with:
implementing our business strategies;
 
identifying and consummating acquisitions;
 
successfully integrating acquired businesses;
 
attaining greater market share;
 
the resolution of regulatory issues and litigation, including those related to compensation arrangements with insurance companies;
 
the possibility that the receipt of contingent compensation from insurance companies could be prohibited;
 
developing and implementing effective information technology systems;
 
recruiting and retaining qualified employees;
 
fluctuations in the demand for insurance products;
 
fluctuations in the premiums charged by insurance companies (with corresponding fluctuations in our premium-based revenue);
 
fluctuations in foreign currency exchange rates;
 
any loss of services of key executive officers;
 
industry consolidation;
 
increased competition in the industry;
 
the actual costs of resolution of contingent liabilities; and
 
the passage of new federal, state or provincial legislation subjecting our business to increased regulation in the jurisdictions in which we operate.
The words “believe,” “anticipate,” “project,” “expect,” “intend,” “will likely result” or “will continue” and similar expressions identify forward-looking statements. We caution readers not to place undue reliance on these forward-looking statements, which speak only as of their dates.
Except as otherwise required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
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PART I
Item 1. Business
Overview
We are a leading North American insurance brokerage providing a broad array of property and casualty, life and health, employee benefits, investment and risk management products and services. We focus primarily on middle-market commercial accounts in the United States and Canada, which we serve through our approximately 3,300 employees in nearly 200 offices, using a variety of retail and wholesale distribution channels. We define the middle market as those clients with 20 to 1,500 employees, which typically generate annual commissions and fees ranging from $2,500 to $250,000. Since our company was formed in 1998 through the merger of 11 Canadian insurance brokerages, we have acquired an additional 101 brokerages and have established a strong presence in the northeastern, midwestern and western United States and in the Canadian provinces of Ontario, Quebec and British Columbia. Through a combination of acquiring quality brokerages with proven track records and organic growth, we have grown our revenue from $38.7 million in 1998 to $360.9 million in 2004, with 79% of the increase being attributable to acquisitions.
We operate through an organizational structure comprised of our head office, larger regional brokerages that we call “hub” brokerages and smaller brokerages that we call “fold-ins.” Our head office oversees the acquisition of hub brokerages, coordinates selling and marketing efforts, identifies cross-selling opportunities among our brokerages, negotiates significant contracts with insurers and handles certain general administrative functions. We have 14 regional “hub” brokerages, nine operating in the United States and five in Canada. Each hub brokerage has a significant market presence in a geographic region of the United States or Canada. Each hub provides insurance brokerage services and is responsible for integrating the fold-in acquisitions in its region.
We have traditionally operated our hub brokerages in a decentralized manner so that they may more effectively address their local market conditions. A hub brokerage is responsible for not only the development of its own business, but also the identification of fold-ins that can be acquired by and integrated into the operations of the hub brokerage. This process allows each hub brokerage an opportunity to strengthen its regional market presence by acquiring new or complementary products and services and management talent and improve profit margins through the reduction or elimination of redundant administrative functions, premises and systems. Our structure enables our hub brokerages to more effectively and quickly meet the changing needs of our clients in various markets, while benefiting from the operating efficiencies and leverage of a large brokerage. In 2004 we began investing more in the coordination of additional functions from our head office to enhance cross-selling, international collaboration, marketing efficiencies, total expense management and financial control initiatives.
Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are made available free of charge through the Investor Relations section of our Internet website (http://www.hubinternational.com) as soon as practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.
Our products and services
We offer commercial and specialized insurance products and services to businesses, personal insurance products and services to individuals and program products to affinity groups and associations. We offer three categories of commercial products and services: property and casualty products, employee benefits and risk management services. We offer two categories of personal products and services: property and casualty products and life, health and financial products and services. Our program products involve the development, in collaboration with insurance companies, of baskets of insurance products for members of affinity groups or associations, such as lawyers’ associations, medical associations and other professional groups. Our specialized risk products cover diverse exposures such as environmental, professional liability and directors’ and officers’ liability.
Our business is comprised of two geographic segments, the United States and Canada. The mix of products and services we offer in the United States differs from those we offer in Canada. Our product mix in the United States is comprised of more commercial line products and services as compared with more personal line products and services in Canada. In the United States in 2004, 89% of our commission income was generated from the sale of
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commercial lines and 11% from personal lines. In Canada in 2004, 60% of our commission income was generated from the sale of commercial lines and 40% from personal lines.
The chart below lists a selection of our commercial and personal insurance products and services.
Commercial insurance
         
Property and casualty   Employee benefits   Risk management services
         
•   Business property
•   Auto and trucking fleets
•   Technology
•   Intellectual property
•   Natural disaster
•   Workers’ compensation
•   Liability
•   Surety bonds
•   Business income
•   Accounts receivable
•   Environmental risks
  •   Group life and health
•   Employment issues
•   Human resources
•   Retirement plans
•   Contract review
  •   Claims management
•   Risk finance structuring
•   Exposure evaluation
•   Coverage analysis
•   Contract review
Personal insurance
     
Property and casualty   Life, health and financial
     
•   Home
•   Personal property
•   Auto and recreational vehicles
•   Travel accident and trip cancellation
  •   Disability
•   Life
•   Investments
•   Financial planning
Strategy
Our primary goals are to further develop our position as a leading North American insurance brokerage and to generate significant sustained shareholder value. We plan to achieve these objectives by executing the following strategies:
Focus on middle-market commercial accounts. We focus our sales efforts on middle-market companies. We believe that the insurance and risk management needs of these companies are underserved because many of the brokers that target them have limited capital resources and lack the breadth of products and services that we are able to offer due to our scale and strong insurer relationships. We primarily target commercial accounts because they generally generate higher profit margins than personal accounts. Commercial accounts also provide us with the opportunity to sell personal insurance products and employee benefits to the employees of those businesses.
Grow organically. We intend to increase profitability per customer and attract new clients by leveraging our existing infrastructure to sell a broad range of products and services through the efficient use of a variety of distribution channels, effectively and efficiently identify and target profitable client segments by employing technology to capitalize on our extensive customer databases, and maximize cross-selling opportunities among our brokerages.
Grow through selected acquisitions. The introduction of new brokerages through acquisitions is a fundamental component of our strategy. We have acquired an additional 101 brokerages since our formation in 1998. We acquire brokerages to grow our revenue, complement and supplement our existing products and services and add experienced management. In addition, acquisitions of larger brokerages allow us to further expand our hub platform and geographic footprint. We believe that we are well positioned to compete for quality brokerages and that our proven success in consolidating brokerages in the past will make us attractive to regional brokerages seeking to join with and share in the resources of a larger North American brokerage.
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Standardize procedures to increase operating efficiency and reduce costs. We strive to implement the best operating and sales practices of our brokerages across our company. We provide centralized marketing support to our brokers for many specialized risk programs and group home and auto plans and we integrate promotional programs, internet technology, procurement and risk management across our brokerage offices. Our brokerages share certain systems, such as accounting and payroll processing, which reduce redundancies and increase operating efficiencies. In addition, we continue to implement a comprehensive quality control program and a standardized approach to our sales and marketing efforts across our brokerages.
Recruit, train and retain qualified personnel. We have formalized our recruiting and training program to continue to build and sustain a sales and service team with a wide variety of experience and capabilities. We recruit directly from college campuses and other industries and provide new employees with effective training and attractive compensation packages. In addition, we are developing a company-wide sales culture by promoting the techniques and results of our most successful producers through regular newsletters, sales meetings, sales tracking, awards, recognition programs and training. We have implemented Hub Academy which is a formal program designed to provide educational and training opportunities to our employees who want to advance their professional skill sets. Programs such as the new producer training program are designed to groom selected candidates to be successful producers within our company. Participants spend several weeks learning about the insurance industry, our company, quality standards, products and services and leading sales techniques from our leading producers, members of management, representatives of insurance companies and other members of the industry.
Competitive advantages
We believe the following competitive advantages will enable us to achieve our objectives:
Decentralized hub approach. Our decentralized hub approach allows us to react to regional market conditions while still centrally managing the growth and profitability of our business with consistent standards. Our geographic diversity allows us to balance our revenue stream across markets and better insulates us from regional adverse developments. Our hub structure provides us with a ready platform, capable of reacting quickly to smaller brokerage acquisition opportunities, and to assimilate fold-ins once acquired.
Broad array of products and services offered through multiple distribution channels. We offer a broad array of products and services, which allows us to maintain and maximize existing client relationships and attract new clients. We offer these insurance products and services through four distribution channels: retail, wholesale property and casualty, wholesale life and financial, and call-centers. Our diversity provides us with the flexibility to determine not only the most appropriate products and services, but also the distribution channels to employ for particular market segments.
Benefits of scale. Our scale, geographic reach and operational diversity relative to smaller local brokerages, provides insurers with greater incentives to work with us. Enhanced insurer relationships often result in mutual cost savings, increased volume overrides and contingent commissions, favorable commission rates, collaborative marketing arrangements and product design, exclusive distribution rights for certain territories and products, and, in some cases, expanded authority to price and approve insurance policies on behalf of insurance companies. We strive to leverage the strength of our relationship with insurers to enhance the range of insurance products that we are able to offer to our clients. Recent legal proceedings have challenged the appropriateness of revenue sharing arrangements between insurance companies and brokerages, including contingent profit and volume override arrangements. We disagree with the underlying premise that such arrangements conflict with our duty to our clients. Our success is dependant upon our ability to provide consumers with the appropriate combination of product, service and price in an extremely competitive environment, where most insurers offer such arrangements to numerous independent brokers who are competing for the same clients. The natural forces of supply and demand in a competitive market dictate that we provide clients with their most favorable options under all of the circumstances. Additionally, a critical mass of volume allows insurers to offer products for specific insurance needs that are attractive to consumers from the perspective of both terms and price. Accordingly, we have chosen, rather than to disband them, to fully disclose the nature of such arrangements to our clients through written materials and access to information on our internet website. Our scale also makes us attractive to smaller brokerages as a potential acquiror.
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Committed and experienced management. Most of the senior managers of our brokerages have over 20 years of experience in the industry, extensive contacts in the insurance brokerage industry, and participate in prominent industry associations, brokerage networks and insurance company brokerage councils. Most of management also has significant shareholdings in our company. A significant number of the shares held by management are subject to transfer restrictions, in some cases for up to ten years. In addition, designated key employees in each brokerage are rewarded for their contribution to our success through a bonus program that recognizes brokerage and over-all company performance in excess of specified targets. We believe that these strategies encourage loyalty and align the interests of management of our brokerages with our corporate goals and the interests of our shareholders, combining to create a powerful incentive to maximize financial results.
Our operations
We were created in November 1998 when 11 Canadian brokerages merged to form Hub. Significant events that have occurred since our formation in the last five years include:
January 1999 — Fairfax Financial Holdings Limited (Fairfax) purchased 5.4 million common shares of Hub for $34.2 million cash.
 
January 1999 — We completed a financing whereby we issued a total of 2,838,080 common shares, on a private placement basis, at a price of $8.60 per common share or approximately $24.4 million in the aggregate. Fairfax purchased, through certain of its wholly-owned subsidiaries, 1,185,184 of the common shares.
 
February 1999 — We completed a public offering in Canada of 865,624 common shares at a price of $8.60 per share for total proceeds of approximately $7.4 million and listed our common shares on the Toronto Stock Exchange (TSX).
 
During 1999 — We acquired 44 brokerages in Canada and completed our first acquisition in the United States, Mack and Parker, Inc. now known as Hub International of Illinois Limited (HUB Illinois).
 
During 2000 — We acquired 18 brokerages in Canada and the United States including C.J. McCarthy Insurance Agency, Inc, now known as Hub International of New England, Limited. (HUB New England).
 
During 2001 — We acquired 16 brokerages in Canada and the United States including J.P. Flanagan Corporation now a part of HUB Illinois, Kaye Group Inc. now known as Hub International Group Northeast Inc., including its subsidiary Kaye Insurance Associates, Inc. now known as Hub International Northeast Limited (HUB Northeast) and Burnham Insurance Group, Inc. now known as Hub International Midwest Limited (HUB Midwest).
 
June 2002 — We completed an initial public offering in the United States of 6,900,000 common shares, at a price of $14.00 per share. Total net proceeds from the offering after deducting total expenses were approximately $88.1 million.
 
During 2002 — We acquired 8 brokerages in the United States and Canada including Hooper, Hayes and Associates, Inc., now known as. Hub International of California Inc. and Fifth Third Insurance Services, Inc., which we have renamed Hub International of Indiana Limited (HUB Midwest).
 
During 2003 — We acquired 9 brokerages in the United States and in Canada with total annualized revenue of $8.0 million.
 
During 2004 — We acquired 7 brokerages in the United States and in Canada, including Talbot Financial Corporation and Bush Cotton Scott LLC, with total annualized revenue of $115.4 million.
Our operations are currently conducted from principal offices located in Albuquerque, Chicago, New York, Los Angeles, Boston, Battle Creek, Seattle, Toronto, Vancouver and Montreal.
Acquisition process
Our senior management is responsible for identifying and negotiating the acquisition of hub brokerages that are strategically suited to our growth strategy. Typically we are familiar with the owners and management of the
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acquisition target well before we initiate discussions. Most of the hub brokerages we acquire are owner operated. We perform extensive due diligence on potential targets and we determine what the budget of the acquired brokerage, including payroll and other adjustments, will be prior to completing the acquisition.
We anticipate that we will selectively acquire more hub brokerages in geographic regions where we currently have a limited presence, most notably the southeastern United States. Each new hub will be characterized by the following attributes:
an experienced and talented management team prepared to make a long-term commitment to executing our strategic business plan;
 
the ability to identify, acquire and seamlessly integrate smaller brokerages (fold-ins) in its region;
 
specialization in certain products or services that may be beneficial to or complement our other brokerages; and
 
a demonstrated record of organic growth and profitability, operating at, or capable of achieving in the near term, minimum financial performance targets.
We expect that future acquisitions will be financed with available cash, the issuance of common shares, the proceeds of other financings, or a combination of the foregoing.
The retention of existing management at the hub brokerages we acquire is important to the successful integration and subsequent operation of acquired brokerages. We have in the past encouraged, and may continue in the future to encourage, existing management to stay with the acquired hub brokerage by using our common shares to pay a large portion of the acquisition price. The shares the owner/ management receive typically are subject to transfer restrictions varying from three to ten years in duration. We also utilize our equity incentive plan to grant options to acquire our shares, restricted shares and restricted share units (in lieu of cash compensation or in consideration of non-competition covenants) which have vesting, exercise and transfer restrictions that are designed to encourage the long-term commitment of management to our company.
Distribution channels
We utilize retail, wholesale and call-center distribution channels, and have the ability to employ these distribution channels for specific market segments. Our brokerages use one or a combination of the following different distribution channels:
Retail sales and service centers that target middle-market companies provide a broad range of property and casualty insurance, life and health insurance, risk management and financial services from traditional office locations leased by our brokerages in local communities;
 
Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago and Chilliwack, British Columbia;
 
Wholesale life and financial services centers, known as managing general agents, provide life, financial and investment products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal, Toronto, San Francisco, Albuquerque and Mechanicsburg, PA; and
 
Wholesale property and casualty insurance centers provide products, international risk solutions, captive management programs and specialty lines in part to our own retail brokerages, but primarily to independent brokers and corporations in North America and internationally from our locations in New York, Toronto, Montreal and Vancouver.
In addition, we are a member of the Worldwide Broker Network, a consortium of international brokerages which we can access to service clients resident in the United States and Canada who require insurance internationally.
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Competition
The insurance brokerage industry is highly competitive. We face several sources of competition including other brokerages, insurance companies, banks and other financial services companies. Brokerage consolidators have been active in the market over several years. Consolidators, often publicly traded corporations, consolidate small to medium size independent brokerages with a view to strengthening their competitive position and increasing their market share. In addition to direct competition from the insurance companies, other sources of competition exist as banks in the United States continue their efforts to diversify their financial services to include insurance brokerage services (often through the acquisition of established insurance brokerages) and as the Canadian chartered banks lobby for greater flexibility to create and market insurance products.
We compete for clients in both the United States and in Canada on the basis of reputation, client service, program and product offerings and the ability to tailor our products and risk management services to the specific needs of a client. We believe that we are in a favorable competitive position in most of the meaningful aspects of our business because of our broad array of products and services, diversity of distribution channels, industry focus and expertise, and management experience.
Like some of our competitors, we focus our sales efforts primarily on middle-market commercial accounts. We believe that the most likely source of competition for us in the United States will be other brokerages who pursue an acquisition or consolidation strategy similar to ours as well as other large regional brokerages. We believe that our primary competitors in Canada are local retail brokers and other large regional brokerages.
Government regulation
Licenses
In every state, province and territory in which we do business, the relevant brokerage is required to be licensed or to have received regulatory approval to conduct business. In addition to licensing requirements, most jurisdictions require individuals who engage in brokerage and certain insurance service activities to be licensed personally.
In one province new regulations require enhanced disclosure of contingent compensation arrangements and other relationships with insurance companies. Similar laws and regulations have been proposed in several other jurisdictions.
Our operations depend on the validity of and continued good standing under the licenses and approvals pursuant to which we operate. Licensing laws and regulations vary from jurisdiction to jurisdiction and are always subject to amendment or interpretation by regulatory authorities. Such authorities generally have the discretion to grant, renew and revoke licenses and approvals.
Privacy
The management and dissemination of information is critical to our business. We gather information from our clients to assess and address their insurance needs. We share information both internally, among our employees, and, where appropriate and permitted, between our brokerages, as well as externally, with insurers. We believe we have taken appropriate steps to safeguard our clients’ information. In both the United States and Canada comprehensive privacy laws have been introduced to protect the privacy of individuals from the undisclosed or non-consensual sharing of sensitive information for commercial purposes. As the gathering and use of information is such an integral component of our business, we must always be alert for changes in the information regulatory environment.
Employees
As of December 31, 2004, we employed 3,170 persons on a full-time basis, 2,590 of whom were employed in sales and customer service and 580 of whom were employed in corporate, finance and administration. None of our employees are represented by a labor union and we have never experienced a work stoppage. We believe our relationship with our employees is good.
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We have generally entered into agreements containing confidentiality and non-disclosure provisions with our employees and consultants who have access to our proprietary information. In addition, each member of senior management of our brokerages is subject to an employment agreement that sets out the terms of his or her employment. These agreements typically include non-solicitation and non-competition covenants, which continue for up to two years after the cessation of employment.
Risks related to our business
Regulatory investigations and class action lawsuits related to the structure of compensation paid by insurance companies to insurance brokers may result in prohibitions of contingent commissions, affiliate relationships and/or significant fines or judgments that could have a material adverse effect on our financial condition, results of operation and liquidity.
HUB Northeast and several other insurance brokers are currently the subject of an investigation being conducted by the Office of the Attorney General of the State of New York regarding contingent compensation agreements between insurance brokers and insurance companies. Several state and provincial authorities in jurisdictions in which we operate have also commenced investigations of the structure of sales commissions paid by insurance companies to insurance brokers and other relationships between insurance companies and insurance brokers. Certain of our subsidiaries have received and responded to various letters of inquiry and subpoenas from Attorneys General and/or insurance regulators of several other states, including California, Connecticut, Texas, Illinois, Delaware, Pennsylvania and New Hampshire, and the province of Quebec. We have co-operated and are co-operating with these authorities. While it is not possible to predict the outcome of any of these investigations, the cost of cooperating with these investigations is significant. Moreover, if such compensation agreements were to be restricted or no longer permitted, or if we were subject to a significant fine, our financial condition, results of operation and liquidity may be materially adversely affected.
In October 2004, we were named as a defendant in a class action lawsuit (the “Opticare case”) filed in Federal District Court in New York against 30 different insurance brokers and insurance companies. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, we were also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. In January 2005 we were named as one of several defendants in a third class action filed in Federal District Court in Illinois, containing allegations substantially similar to those in the Opticare case and the other Illinois federal class actions. None of the complaints contain any specific factual allegations against us, but rather generally assert that all of the broker defendants engaged in the types of conduct of which the New York Attorney General charged the Marsh & McLennan companies in his suit against them. On February 17, 2005 the Federal Judicial Panel on Multidistrict Litigation transferred the Opticare case as well as three other class actions in which we are not named to the District of New Jersey. We expect that the three class actions filed in Federal District Court in Illinois will also be transferred to New Jersey. We deny the allegations made in these lawsuits and intend to vigorously defend these cases.
In January, 2005 we were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through our Chicago hub and claims that an undisclosed contingent commission was received with respect to its policy. We deny this and the other allegations of the complaint and intend to vigorously defend this case.
The cost of defending against the lawsuits, and diversion of management’s attention, are significant and could have a material adverse effect on our results of operations. In addition, an adverse finding in a class action lawsuit or a similar suit could result in a significant judgment against us that could have a material adverse effect on our financial position, results of operation and liquidity. An adverse result in either a regulatory investigation or class action lawsuit could also cause a significant decline in the market price of our common shares, which could cause our shareholders to lose a significant portion of their investment in our common shares.
Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, we retained external counsel to assist us in responding to the New York Attorney General’s inquiries and, among other things, requested
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that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to our other hubs, both for internal purposes and in the course of assisting us in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes.
Additionally, regulatory investigations regarding the insurance brokerage industry could lead to the prohibition of certain relationships, such as our ownership of wholesale brokerages or the placement of business with Old Lyme Insurance Company, Ltd., which is indirectly owned primarily by our employees. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Related party transactions.” Any such prohibition could have a material adverse effect on our financial condition, results of operations and liquidity.
Insurance company contingent commissions and volume overrides are less predictable than normal commissions, which impairs our ability to forecast the amount of such revenue that we will receive and may negatively impact our operating results.
We derive a portion of our revenue from contingent commissions and volume overrides. The aggregate of these sources of revenue generally has accounted for approximately 6% of our total revenue. Contingent commissions may be paid by an insurance company based on the profit it makes on the overall volume of business that we place with it. Volume overrides and contingent commissions are typically calculated in the first or second quarter of the following year by the insurance companies and are paid once calculated. As a result of recent developments in the property and casualty insurance industry, including changes in underwriting criteria due in part to the higher numbers and dollar value of claims as compared to the premiums collected by insurance companies, we cannot predict the payment of this performance-based revenue as accurately as we have been able to in the past. Further, we have no control over the process by which insurance companies estimate their own loss reserves, which affects our ability to forecast contingent commissions. Because these contingent commissions affect our revenue, any decrease in their payment to us could adversely affect our results of operations.
If we fail to comply with regulatory requirements for insurance brokerages, we may not be able to conduct our business.
Our business is subject to legal requirements and governmental regulatory supervision in the jurisdictions in which we operate. These requirements are designed to protect our clients by establishing minimum standards of conduct and practice, particularly regarding the provision of advice and product information as well as financial criteria.
Our activities in the United States and Canada are subject to regulation and supervision by state and provincial authorities. Although the scope of regulation and form of supervision by state and provincial authorities may vary from jurisdiction to jurisdiction, insurance laws in the United States and Canada are often complex and generally grant broad discretion to supervisory authorities in adopting regulations and supervising regulated activities. This supervision generally includes the licensing of insurance brokers and agents and the regulation of the handling and investment of client funds held in a fiduciary capacity. Our ability to conduct our business in the jurisdictions in which we currently operate depends on our compliance with the rules and regulations promulgated from time to time by the regulatory authorities in each of these jurisdictions.
Our clients have the right to file complaints with the regulators about our services, and the regulators may investigate and require us to address these complaints. Our failure to satisfy the regulators that we are in compliance with their requirements or the legal requirements governing our activities can result in disciplinary action, fines, reputational damage and financial harm.
In addition, changes in legislation or regulations and actions by regulators, including changes in administration and enforcement policies, could from time to time require operational improvements or modifications at various locations which could result in higher costs or hinder our ability to operate our business. See “Business — Government regulation.”
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We may be unsuccessful in identifying and acquiring suitable acquisition candidates, which could impede our growth and ability to remain competitive in our industry.
Our strategic plan includes the regular and systematic evaluation and acquisition of insurance brokerages in new and existing markets. Since our formation in 1998, approximately 79% of our revenue growth has been attributable to acquisitions. However, we may not successfully identify suitable acquisition candidates. Prospective acquisition candidates may not become available or we may not be able to complete an acquisition once negotiations have commenced. We compete for acquisition and expansion opportunities with entities that have substantially greater resources than we do and these entities may be able to outbid us for these acquisition targets. If we fail to execute our acquisition strategy, our revenue growth is likely to suffer.
Our continued growth is partly based on our ability to successfully integrate acquired brokerages and our failure to do so may have an adverse effect on our revenue and expenses.
We may be unable to successfully integrate brokerages that we may acquire in the future. The integration of an acquisition involves a number of factors that may affect our operations. These factors include:
diversion of management’s attention;
 
difficulties in the integration of acquired operations and retention of personnel;
 
entry into unfamiliar markets;
 
unanticipated problems or legal liabilities; and
 
tax and accounting issues.
A failure to integrate acquired brokerages may be disruptive to our operations and negatively impact our revenue or increase our expenses.
Insurance brokerages that we have acquired may have liabilities that we are not aware of and may not be as profitable as we expect them to be.
Since our formation in November 1998 through the merger of 11 insurance brokerages, we have acquired an additional 101 brokerages. Although we conduct due diligence in respect of the business and operations of each of the brokerages we acquire, we may not have identified all material facts concerning these brokerages. For example, on one occasion we discovered a brokerage’s liability for unaccrued corporate taxes only after we had completed the acquisition of the brokerage. Unanticipated events or liabilities relating to these brokerages could have a material adverse effect on our financial condition. Furthermore, once we have integrated an acquired brokerage, it may not achieve levels of revenue, profitability, or productivity comparable to our existing locations, or otherwise perform as expected. Our failure to integrate one or more acquired brokerages so that they achieve our performance goals may have a material adverse effect on our results of operations and financial condition.
If we fail to obtain additional financing for acquisitions, we may be unable to expand our business.
Our acquisition strategy may require us to seek additional financing. If we are unable to obtain sufficient financing on satisfactory terms and conditions, we may not be able to maintain or increase our market share or expand our business through acquisitions. Our ability to obtain additional financing will depend upon a number of factors, many of which are beyond our control. We may not be able to obtain additional satisfactory financing because we already have debt outstanding and because we may not have sufficient cash flow to service or repay our existing or additional debt. For example, as of December 31, 2004, we had $186.8 million of total debt and our two credit facilities contain covenants that, among other things, require us to maintain certain financial ratios and restrict our ability to incur additional debt.
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We cannot accurately forecast our commission revenue because our commissions depend on premium rates charged by insurance companies, which historically have varied and are difficult to predict. Any declines in premiums may adversely impact our profitability.
In 2004, we derived approximately 91% of our revenue from commissions paid by insurance companies on the sale of their insurance products to our clients. Our revenue from commissions fluctuates with premiums charged by insurers, as commissions typically are determined as a percentage of premiums. When premiums decline, we experience downward pressure on our revenue and earnings. Historically, property and casualty premiums have been cyclical in nature and have varied widely based on market conditions. Significant reductions in premium rates occurred during the years 1988 through 2000 as a result of expanded underwriting capacity of property and casualty insurance companies and increased competition. In some cases, property and casualty insurance companies lowered commission rates. The years 2001 through 2003 saw premium rates increase. During the latter part of 2003, the Canadian market remained firm, but the U.S. market experienced some softening of premium rates for property and casualty coverage. During the first six months of 2004 Canadian and U.S. markets both softened, although rates for certain types of coverage continued to increase. During the last half of 2004, however, insurance rates began falling at a much more rapid pace than during the first six months of the year. Because we cannot determine the timing and extent of premium pricing changes, we cannot accurately forecast our commission revenue, including whether it will significantly decline. If premiums decline or commission rates are reduced, our revenue, earnings and cash flow could decline. In addition, our budgets for future acquisitions, capital expenditures, dividend payments, loan repayments and other expenditures may have to be adjusted to account for unexpected changes in revenue.
Proposed tort reform legislation in the United States, if enacted, could decrease demand for liability insurance, thereby reducing our commission revenue.
Legislation concerning tort reform is currently being considered in the United States Congress and in several states. Among the provisions being considered for inclusion in such legislation are limitations on damage awards, including punitive damages, and various restrictions applicable to class action lawsuits, including lawsuits asserting professional liability of the kind for which insurance is offered under certain policies we sell. Enactment of these or similar provisions by Congress, or by states or countries in which we sell insurance, could result in a reduction in the demand for liability insurance policies or a decrease in policy limits of such policies sold, thereby reducing our commission revenue.
A substantial portion of our total assets are represented by goodwill and other intangible assets as a result of our acquisitions and under new accounting standards, we may be required to write down the value of our goodwill and other intangible assets.
When we acquire a brokerage, virtually the entire purchase price for the acquisition is allocated to goodwill and other identifiable intangible assets. The amount of purchase price allocated to goodwill is determined by the excess of the purchase price over the net identifiable assets paid by us to acquire the brokerage.
The accounting rules require that all business combinations be accounted for in accordance with the purchase method of accounting.
For all business combinations accounted for using the purchase method annual impairment testing of goodwill and indefinite life intangible assets is required. A deterioration in our operating results may adversely affect the carrying value of our goodwill and other indefinite life intangible assets. The loss of a significant client at one of our brokerages could result in an impairment of goodwill associated with such brokerage, which would cause us to take an impairment to goodwill. Such an impairment would adversely affect our earnings.
The loss of members of our senior management or a significant number of our brokers could negatively affect our financial plans, marketing and other objectives.
The loss of or failure to attract key personnel could significantly impede our financial plans, growth, marketing and other objectives. Our success depends to a substantial extent not only on the ability and experience of our senior management but also on the individual brokers and teams that service our clients and maintain client relationships. In
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the past, we have experienced short-term disruptions to certain brokerage operations due to the early retirement of senior members of management at those brokerages. Our operations are not generally dependent on any one individual; however, the loss of Martin Hughes, our Chairman and Chief Executive Officer, could negatively impact our acquisition strategy in the United States due to his significant relationships and expertise in the insurance industry.
The insurance brokerage industry has in the past experienced intense competition for the services of leading individual brokers and brokerage teams. We believe that our future success will depend in large part on our ability to attract and retain additional highly skilled and qualified personnel and to expand, train and manage our employee base. We may not be successful in doing so because the competition for qualified personnel in our industry is intense. If we fail to recruit and retain top producers, our organic growth may be adversely affected.
Competition in our industry is intense, and if we are unable to compete effectively, we may lose market share and our business may be materially adversely affected.
The insurance brokerage business is highly competitive and we actively compete with other insurance brokerages for customers and insurance company markets, many of which have existing relationships with insurance companies or have a significant presence in niche insurance markets that may give them an advantage over us. Because relationships between insurance brokers and insurance companies or clients are often local or regional in nature, this potential competitive disadvantage is particularly pronounced. See “Business — Competition” for a further discussion of the level of competition in our industry.
We face competition in all markets in which we operate, based on product breadth, innovation, quality of service and price. We compete with a number of brokerages in the United States, who may have greater resources than we do, as well as with numerous Internet-based, specialist and regional firms in the United States and Canada. If we are unable to compete effectively against our competitors, we will suffer a loss of market share, decreased revenue and reduced operating margins.
In addition, regulatory changes in the financial services industry in the United States and Canada have permitted banks, securities firms and insurance companies to affiliate, causing rapid consolidation in the insurance industry. Some insurance companies are engaged in the direct sale of insurance, primarily to individuals, and do not pay commissions to agents and brokers on policies they sell directly. Increasing competition from insurance companies and from within the financial services industry, generally, could have a negative effect on our operations.
We do business with certain subsidiaries of our largest shareholder and if a conflict of interest were to arise it may not be resolved in our favor and could adversely affect our revenue.
As of December 31, 2004, Fairfax Financial Holdings Limited owned or controlled 26% of our common shares, 32% if Fairfax converted our convertible subordinated debentures it holds. We do business with certain subsidiaries of Fairfax which represented approximately 8% of our revenue in 2004. We expect that this percentage will decrease as we complete more acquisitions in the United States. If a conflict of interest arose between us and Fairfax or one of its subsidiaries, we cannot assure you that this conflict would be resolved in a manner that would favor us. In addition, if Fairfax were to sell our common shares that it owns, it may no longer be as interested in continuing to do business with us which could have a material adverse effect on our revenue and expenses and such a sale by Fairfax could also impact our share price.
We depend on our information processing systems. Interruption or loss of our information processing systems could have a material adverse effect on our business.
Our ability to provide administrative services depends on our capacity to store, retrieve, process and manage significant databases and expand and upgrade periodically our information processing capabilities. Interruption or loss of our information processing capabilities through loss of stored data, breakdown or malfunctioning of computer equipment and software systems, telecommunications failure, or damage caused by fire, tornadoes, lightning, electrical power outage or other disruption could have a material adverse effect on our business, financial condition and results of operations. Although we have disaster recovery procedures in place for all our hub brokerages and
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insurance to protect against such contingencies, such procedures may not be effective and any insurance or recovery procedures may not continue to be available at reasonable prices and may not address all such losses or compensate us for the possible loss of clients occurring during any period that we are unable to provide services.
Privacy legislation may impede our ability to utilize our customer database as a means to generate new sales.
We intend to utilize our extensive customer databases for marketing and sales purposes, which we believe will enhance our ability to meet our organic growth targets. However, privacy legislation, such as the Gramm-Leach-Bliley Act and the Health Insurance Portability and Accountability Act of 1996 in the United States and the Personal Information Protection and Electronic Documents Act (PIPEDA) in Canada, as well as other regulatory changes, may restrict our ability to utilize personal information that we have collected in our normal course of operations to generate new sales. If we become subject to new restrictions, or other regulatory restrictions, of which we are not aware, our ability to grow our business may be adversely affected.
The security of the databases that contain our customers’ personal information may be breached which could subject us to litigation or adverse publicity.
We depend on computer systems to store information about our customers, some of which is private. Database privacy, identity theft and related computer and internet issues are matters of growing public concern. We have installed privacy protection systems and devices on our network in an attempt to prevent unauthorized access to information in our database. However, our technology may fail to adequately secure the private information we maintain in our databases and protect it from theft or inadvertent leakage. In such circumstances, we may be held liable to our customers, which could result in litigation or adverse publicity that could have a material adverse effect on our business.
Our corporate structure and strategy of operating through decentralized brokerages may make it more difficult for us to become aware of and respond to adverse operating or financial developments at our brokerages.
We depend on timely and accurate reporting of business conditions and financial results from our brokerages to affect our business plan and determine and report our operating results. We receive end of month reports from each of our brokerages regarding their financial condition and operating results. If an adverse business or financial development occurs at one or more of our brokerages near the beginning of a month, we may not become aware of the occurrence for several weeks which could make it more difficult for us to effectively respond to that development. In addition, if one of our brokerages were to report inaccurate financial information, we might not learn of these inaccuracies for several weeks, if at all, which could adversely affect our ability to determine and report our financial results. For example, on occasion, inconsistent accounting treatment at a brokerage has not been detected until preparation of our quarterly financial statements. We have implemented enterprise reporting software that enables us to extract financial and operating data from our brokerages electronically; however, in the event of a technical or other failure we may be unable to use this software effectively to compile our financial data or to prevent inconsistent reporting of financial information.
Our profitability and liquidity may be materially adversely affected by errors and omissions.
We have extensive operations and are subject to claims and litigation in the ordinary course of business resulting from alleged errors and omissions. Errors and omissions claims can involve significant defense costs and may result in large damage awards against us. Errors and omissions could include, for example, our employees or sub-agents failing, whether negligently or intentionally, to place coverage or to notify insurance companies of claims on behalf of clients, to provide insurance companies with complete and accurate information relating to the risks being insured or to appropriately apply funds that we hold for our clients on a fiduciary basis. It is not always possible to prevent and detect errors and omissions and the precautions we take may not be effective in all cases.
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The amount of coverage limits and related deductible amounts of our errors and omissions insurance policies are established annually based upon our assessment of our errors and omissions exposure, loss experience and the availability and pricing of coverage within the marketplace. While we endeavor to purchase coverage that is appropriate to our assessment of our risk, we are unable to predict with certainty the frequency, nature or magnitude of claims for direct or consequential damages.
Our profitability and liquidity may be adversely affected if in the future our insurance coverage proves to be inadequate or unavailable or there is an increase in liabilities for which we self-insure. In addition, errors and omissions claims may harm our reputation or divert management resources away from operating our business.
Risks related to our common shares
The price of our common shares may fluctuate substantially, which could negatively affect the holders of our common shares.
The price of our common shares may fluctuate substantially due to the following factors: (1) fluctuations in the price of the shares of the small number of public companies in the insurance brokerage business, (2) announcements of acquisitions as part of our growth strategy, (3) additions or departures of key personnel, (4) writedowns of assets or operations, including writedowns for intangible assets and goodwill impairment (5) announcements of legal proceedings or regulatory matters and (6) the general volatility in the stock market. The market price of our common shares could also fluctuate substantially if we fail to meet or exceed securities analysts’ expectations of our financial results or if there is a change in financial estimates or securities analysts’ recommendations. From the beginning of 2002 to March 1, 2005, the price of our common shares on the TSX has ranged from a low of C$15.50 to a high of C$27.50, and on the NYSE has ranged from a low of $11.45 to a high of $20.02.
In addition, the stock market has experienced volatility that has affected the market prices of equity securities of many companies, and that has often been unrelated to the operating performance of these companies. A number of other factors, many of which are beyond our control, could also cause the market price of our common shares to fluctuate substantially.
Significant fluctuation in the market price of our common shares could result in securities class action claims against us.
Significant price and value fluctuations have occurred with respect to the securities of insurance and insurance-related companies. Our common share price is likely to be volatile in the future. In the past, following periods of downward volatility in the market price of a company’s securities, class action litigation has often been pursued against the respective company. If similar litigation was pursued against us, it could result in substantial costs and a diversion of our management’s attention and resources.
Our largest shareholder may substantially influence certain actions requiring shareholder approval.
As of December 31, 2004, Fairfax owned or controlled 26% of our common shares. Fairfax also owns or controls $35 million of subordinated convertible notes, which it can convert at any time into our common shares at C$17.00 per share. If Fairfax converts the notes it would hold 32% of our common shares. Under our by-laws and articles of incorporation, Fairfax has the ability to substantially influence certain actions requiring shareholder approval, including:
electing members of our board of directors;
 
adopting amendments to our articles and by-laws; and
 
approving a merger or consolidation, liquidation or sale of all or substantially all of our assets.
Fairfax may have different interests than other shareholders and therefore may make decisions that are adverse to other shareholders’ interests.
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We are incorporated in Canada, and, as a result, it may not be possible for shareholders to enforce civil liability provisions of the securities laws of the United States.
We are organized under the laws of Canada and some of our assets are located outside the United States. As a result, it may not be possible for the holders of our common shares to enforce against us in United States courts judgments based on the civil liability provisions of the securities laws of the United States. In addition, there is doubt as to whether the courts of Canada would recognize or enforce judgments of United States courts obtained against us or our directors or officers based on the civil liability provisions of the securities laws of the United States or any state or hear actions brought in Canada against us or those persons based on those laws.
Item 2. Properties
We maintain our corporate headquarters in Chicago, Illinois at premises that we sublet from HUB Illinois, one of our subsidiaries. This facility, totaling approximately 8,200 square feet, contains corporate, finance, administration, sales and customer support functions. The lease on the premises expires on October 1, 2011. In addition, our brokerages lease office space in the locations in which they operate, none of which is material. In total, we hold 198 leases covering approximately 974,000 square feet with a total annual base rent for all of these locations of approximately $12.4 million.
We believe that our facilities are well maintained and in good condition and are adequate for our current needs. We expect that suitable additional space will be available as required.
Item 3. Legal Proceedings
In April 2004, HUB Northeast, formerly known as Kaye Insurance Associates, Inc., a subsidiary of Hub, received a subpoena from the Office of the Attorney General of the State of New York seeking information regarding certain compensation agreements between insurance brokers and insurance companies. The New York Attorney General subpoenaed information on such compensation agreements from several other major insurance brokers and insurance companies as well. Such compensation agreements, also known as contingent agreements, between insurance companies and brokers are a long-standing and common practice within the insurance industry. HUB Northeast discloses such agreements on its invoices to clients and on its web site. In addition, we disclose the arrangements in our public filings. In August 2004, HUB Northeast received a second subpoena from the Office of the Attorney General of the State of New York seeking information regarding all revenue that HUB Northeast may have derived from insurance companies. In September 2004, HUB Northeast received a third subpoena from the Office of the Attorney General of the State of New York seeking information regarding any “fictitious” and “inflated” insurance quotes to which HUB Northeast may have been a party. Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, we retained external counsel to assist us in responding to the New York Attorney General’s inquiries and, among other things, requested that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to our other hubs, both for internal purposes and in the course of assisting us in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes. We continue to fully cooperate with the Attorney General’s inquiry. While it is not possible to predict the outcome of this investigation, if such compensation agreements were to be restricted or no longer permitted, our financial condition, results of operation and liquidity may be materially adversely affected.
From August 2004 through February 2005, various other subsidiaries of Hub have received and responded to letters of inquiry and subpoenas from authorities in California, Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec.
In October 2004, we were named as a defendant in a class action lawsuit (the “Opticare case”) filed in Federal District Court in New York against 30 different insurance brokers and insurance companies. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, we were
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also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. In January 2005 we were named as one of several defendants in a third class action filed in Federal District Court in Illinois, containing allegations substantially similar to those in the Opticare case and other Illinois federal class actions. None of the complaints contain any specific factual allegations against us, but rather generally assert that all of the broker defendants engaged in the types of conduct of which the New York Attorney General charged the Marsh & McLennan companies in his suit against them. On February 17, 2005 the Federal Judicial Panel on Multidistrict Litigation transferred the Opticare case as well as three other class actions in which we are not named to the District of New Jersey. We expect that the three class actions filed in Federal District Court in Illinois will also be transferred to New Jersey. We dispute the allegations made in these lawsuits and intend to vigorously defend these cases.
In January, 2005 we and our affiliates were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through our HUB Illinois and claims that an undisclosed contingent commission was received with respect to its policy. We deny this and the other allegations of the complaint and intend to vigorously defend this case.
The cost of defending against the lawsuits, and diversion of management’s attention, are significant and could have a material adverse effect on our results of operations. In addition, an adverse finding in a class action lawsuit or a similar suit could result in a significant judgment against us that could have a material adverse effect on our financial condition, results of operation and liquidity.
In the normal course of business, we are involved in various claims and legal proceedings relating to insurance placed by us and other contractual matters. Our management does not believe that any such pending or threatened proceedings will have a material adverse effect on our consolidated financial position or future results of operations.
Item 4.  Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter ended December 31, 2004.
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PART II
Item 5.  Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
In connection with our initial public offering in the United States, our common shares became listed on the New York Stock Exchange (NYSE) on June 18, 2002 under the symbol HBG. Our common shares are also listed and posted for trading on the Toronto Stock Exchange (TSX) in Canada under the symbol HBG. The following table sets forth the high and low sales prices per share for our common shares on the NYSE and TSX:
                                           
    NYSE   TSX    
            Cash
    High   Low   High   Low   Dividends
                     
2002
                                       
 
First Quarter
                    C$21.00       C$15.50       C$0.07  
 
Second Quarter
    $16.80       $13.46       C$25.75       C$20.00       C$0.07  
 
Third Quarter
    $16.60       $12.90       C$25.25       C$20.25       C$0.07  
 
Fourth Quarter
    $18.60       $11.45       C$29.00       C$17.71       C$0.07  
2003
                                       
 
First Quarter
    $15.05       $11.55       C$23.12       C$17.34       $0.05  
 
Second Quarter
    $17.18       $13.05       C$23.27       C$19.00       $0.05  
 
Third Quarter
    $19.97       $15.50       C$27.50       C$20.95       $0.05  
 
Fourth Quarter
    $17.05       $15.00       C$22.99       C$19.40       $0.05  
2004
                                       
 
First Quarter
    $19.25       $15.94       C$25.50       C$20.42       $0.05  
 
Second Quarter
    $19.40       $17.75       C$26.90       C$24.00       $0.05  
 
Third Quarter
    $19.62       $17.37       C$25.65       C$22.20       $0.05  
 
Fourth Quarter
    $18.84       $16.00       C$23.25       C$19.00       $0.05  
2005
                                       
 
First Quarter (through March 1, 2005)
    $20.02       $17.60       C$24.91       C$21.45       $0.06  
On December 31, 2004, the closing price of our common shares on the NYSE was $18.41 and on the TSX the closing sale price was C$22.00. The exchange rate in effect at December 31, 2004 was C$1.00 per $0.8308. As of March 1, 2005, there were 30,584,013 of our common shares issued and outstanding. As of the close of business March 1, 2005, we had approximately 297 holders of record of our common shares.
We have no formal dividend policy other than the board of directors considers the payment of dividends as quarterly financial information becomes available. In the future, dividends will be paid at the discretion of our board of directors depending on our financial position and capital requirements, general business conditions, contractual restrictions and other factors. Dividends paid after December 31, 2002 have been, and dividends, if any, that may be declared in the future, will be declared in U.S. dollars instead of Canadian dollars.
We did not repurchase any of our shares in the fourth quarter of fiscal 2004.
Item 6. Selected Financial Data
We were formed in November 1998 through the merger of 11 independent insurance brokerages into a new company. The merger was accounted for using the pooling-of-interests method.
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Our results for the five year period ended December 31, 2004 reflect the acquisition of brokerages that occurred in each respective period. These acquisitions were accounted for using the purchase method. Thus, results of acquisitions are only included from the date of acquisition forward. Accordingly, the results in each period are not directly comparable.
Our historical consolidated financial statements are prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP. For a discussion of the principal differences between Canadian GAAP and U.S. GAAP as it relates to us, see note 19 to our audited consolidated financial statements included elsewhere in this Form 10-K.
                                           
    Year Ended December 31,
(in thousands of U.S. dollars,    
except per share amounts)(1)   2004   2003   2002   2001   2000
                     
Consolidated statement of earnings data:                                
Canadian GAAP
                                       
Revenue:
                                       
 
Commission income
  $ 328,961     $ 259,461     $ 200,976     $ 143,063     $ 86,410  
 
Contingent commissions and volume overrides
    21,705       18,530       11,464       5,899       4,909  
 
Other
    10,184       8,368       7,520       5,031       3,921  
                               
      360,850       286,359       219,960       153,993       95,240  
                               
Expenses:
                                       
 
Cash compensation
    199,520       156,320       118,667       88,015       54,701  
 
Selling, occupancy and administration
    73,199       56,606       44,932       35,276       21,778  
 
Depreciation
    7,266       6,244       5,492       3,940       1,885  
 
Interest expense
    7,470       5,191       7,317       7,447       1,981  
 
Intangible asset amortization
    5,520       3,208       1,671       4,940       3,260  
 
Non-cash stock based compensation
    20,890       4,801       1,089              
 
Loss on write-off of trademarks
    2,587                          
 
(Gain) loss on disposal of property, equipment and other assets
    (1,880 )     (202 )     (2,679 )     (173 )     127  
 
(Gain) on put option liability
          (160 )     (186 )     (719 )      
 
Proceeds from life insurance
          (1,000 )                  
                               
      314,572       231,008       176,303       138,726       83,732  
                               
Net earnings before income taxes
    46,278       55,351       43,657       15,267       11,508  
Provision for income tax expense
    20,034       18,842       14,256       5,262       5,370  
                               
Net earnings(2)
  $ 26,244     $ 36,509     $ 29,401     $ 10,005     $ 6,138  
                               
Earnings per share(2)
                                       
 
Basic
    $0.87       $1.22       $1.27       $0.53       $0.34  
 
Diluted
    $0.80       $1.14       $1.06       $0.50       $0.34  
Weighted average shares outstanding:
                                       
 
Basic
    30,246       29,967       23,181       19,012       18,327  
 
Diluted
    35,305       33,767       30,199       20,105       18,327  
Dividends declared per share(3)
    $0.20       $0.20       $0.18       $0.18       $0.13  
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    Year Ended December 31,
(in thousands of U.S. dollars,    
except per share amounts)(1)   2004   2003   2002   2001   2000
                     
U.S. GAAP
                                       
 
Net earnings (Canadian GAAP)
  $ 26,244     $ 36,509     $ 29,401     $ 10,005     $ 6,138  
   
Cumulative effect of change in accounting policy for put options
          335                    
   
Adjustment to put option liability
          (409 )     (814 )     (811 )      
   
Adjustment to investment held for sale
                (2,236 )     520        
   
Change in reporting currency
                      144       405  
                               
 
Net earnings (U.S. GAAP)(4)
  $ 26,244     $ 36,435     $ 26,351     $ 9,858     $ 6,543  
                               
Net earnings per share (U.S. GAAP)(4)
                                       
 
Basic
    $0.87       $1.22       $1.14       $0.52       $0.36  
 
Diluted
    $0.80       $1.14       $0.96       $0.49       $0.36  
 
(1) Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars at the exchange rate in effect at September 30, 2001 of C$1.00 = $0.6338.
 
(2) As discussed in note 2, “Summary of significant accounting policies,” of the notes to the audited consolidated financial statements, we adopted Canadian Institute of Chartered Accountants (CICA) Section 3062 on January 1, 2002. Upon adoption of CICA Section 3062, goodwill is no longer amortized. The following table illustrates the effect that CICA Section 3062 would have had on net earnings and per share information under Canadian GAAP for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 had goodwill not been amortized:
                                         
    Year Ended December 31,
(in thousands of U.S. dollars, except    
per share amounts)   2004   2003   2002   2001   2000
                     
Reported net earnings — Canadian GAAP
  $ 26,244     $ 36,509     $ 29,401     $ 10,005     $ 6,138  
Add back: Goodwill amortization
                      3,996       2,820  
                               
Net earnings adjusted for goodwill
  $ 26,244     $ 36,509     $ 29,401     $ 14,001     $ 8,958  
                               
Basic EPS — Reported
  $ 0.87     $ 1.22     $ 1.27     $ 0.53     $ 0.34  
Basic EPS — Adjusted for goodwill
  $ 0.87     $ 1.22     $ 1.27     $ 0.74     $ 0.49  
Diluted EPS — Reported
  $ 0.80     $ 1.14     $ 1.06     $ 0.50     $ 0.34  
Diluted EPS — Adjusted for goodwill
  $ 0.80     $ 1.14     $ 1.06     $ 0.70     $ 0.49  
 
(3) We commenced payment of dividends in the second quarter of 2000.
 
(4) We adopted Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 (SFAS No. 142) on January 1, 2002. Upon adoption of SFAS No. 142 goodwill is no longer amortized. The following table illustrates the effect that SFAS No. 142 would have had on net earnings and per share
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information under U.S. GAAP for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 had goodwill not been amortized:
                                         
    Year Ended December 31,
(in thousands of U.S. dollars, except    
per share amounts)   2004   2003   2002   2001   2000
                     
Reported net earnings — U.S. GAAP
  $ 26,244     $ 36,435     $ 26,351     $ 9,858     $ 6,543  
Add back: Goodwill amortization
                      4,065       2,988  
                               
Net earnings adjusted for goodwill
  $ 26,244     $ 36,435     $ 26,351     $ 13,923     $ 9,531  
                               
Basic EPS — Reported
  $ 0.87     $ 1.22     $ 1.14     $ 0.52     $ 0.36  
Basic EPS — Adjusted for goodwill
  $ 0.87     $ 1.22     $ 1.14     $ 0.73     $ 0.52  
Diluted EPS — Reported
  $ 0.80     $ 1.14     $ 0.96     $ 0.49     $ 0.36  
Diluted EPS — Adjusted for goodwill
  $ 0.80     $ 1.14     $ 0.96     $ 0.69     $ 0.52  
 
                                               
    As of December 31
     
(in thousands of U.S. dollars)(1)   2004   2003   2002   2001   2000
                     
Consolidated balance sheet data
                                       
Total assets
  $ 857,535     $ 699,288     $ 596,876     $ 502,296     $ 206,157  
Total debt(2)
  $ 186,797     $ 113,799     $ 107,038     $ 196,952     $ 34,665  
Total shareholders’ equity
  $ 381,783     $ 342,790     $ 284,274     $ 135,271     $ 112,212  
Reconciliation to U.S. GAAP:
                                       
 
Total shareholders’ equity (Canadian GAAP)
  $ 381,783     $ 342,790     $ 284,274     $ 135,271     $ 112,212  
   
Adjustment to investment held for sale
    (1,716 )     (1,716 )     (1,716 )     520        
   
Accumulated other comprehensive income:
                                       
     
Unrealized gains (losses), net of tax of $(99) — 2004, $(56) — 2003, $51 — 2002, $85 — 2001, $(122) — 2000
    157       90       (83 )     (140 )     198  
     
Cumulative translation account
                496             5,811  
     
Adjustment to put option liability
                (1,702 )     (4,898 )      
     
Executive share purchase plan loan
                (1,912 )     (2,142 )      
                               
Total shareholders’ equity (U.S. GAAP)
  $ 380,224     $ 341,164     $ 279,357     $ 128,611     $ 118,221  
                               
 
(1) Effective October 1, 2001, we adopted the U.S. dollar as our reporting currency. Our financial results for all periods prior to October 1, 2001 have been restated from Canadian dollars to U.S. dollars using the exchange rate in effect at September 30, 2001 of C$1.00 = $0.6338.
 
(2) Includes long-term debt and capital leases (including current portion), bank debt and subordinated convertible notes.
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this report. Certain information contained in “Management’s discussion and analysis of financial condition and results of operations” are forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements because of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the heading “Risk Factors”. Reference to “Hub”, “we”, “us”, “our” and the “registrant” refer to Hub International Limited and its subsidiaries, unless otherwise expressly stated. Unless otherwise indicated, all dollar amounts are expressed in, and the term “dollars” and the symbol “$” refer to, U.S. dollars. The term “Canadian dollars” and the symbol “C$” refer to Canadian dollars. Our financial statements are prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from United States generally accepted accounting principles (U.S. GAAP) and to the extent that they effect us are described in Note 19 to our audited consolidated financial statements.
Overview
Hub is a leading North American insurance brokerage that has grown rapidly since its formation in 1998 through mergers, acquisitions and organic growth. We provide a broad array of property and casualty, life and health, employee benefits, investment and risk management products and services through offices located in the United States and Canada. We are pursuing a growth strategy that includes expansion of our geographic footprint across the United States and deeper penetration of the insurance brokerage market in both the United States and Canada. Both acquisitions and internal growth are core components of our strategic plan for revenue expansion.
As of December 31, 2004, our operations included 14 regional “hub” brokerages — nine in the United States and five in Canada — and nearly 200 offices staffed by approximately 3,300 people. Our strategic plan calls for the addition of approximately 6 additional U.S. hubs to extend our geographic footprint. Brokerages large enough to be considered hubs will generally have annual revenue in excess of $10 million. In addition to larger, “hub” acquisitions by the parent corporation, each regional hub is tasked with pursuing smaller, fold-in acquisitions that either expand its geographic penetration or add new specialization or expertise to the regional operation.
We generally acquire larger, “hub” brokerages, for a combination of cash and stock. Although there are variations in the purchase terms for each hub, our goal is to pay 30%-70% of the “hub” purchase price in our common stock, while setting escrow periods of up to 10 years for the sellers to hold these shares. We believe the use of escrowed stock in major acquisitions creates increased alignment of interests between senior managers and the public shareholders of the corporation. We have paid all cash for the acquisition of certain brokerages, and may pay an all cash purchase price for brokerages in the future. As of December 31, 2004, senior managers of the company and its hubs owned approximately 2,129,000 shares, or 7% of total shares outstanding, while all employees as a group held approximately 7,075,000 shares, or 23.3% of total shares outstanding.
During the three years ended December 31, 2004, we acquired 19 brokerages in the United States and another 8 brokerages in Canada, adding combined revenue of $183.2 million from the dates of acquisition. Of these acquisitions, 7 were regional hubs, all based in the United States. United States revenue has grown to 66% of our total revenue primarily as a result of acquisitions and organic growth. Organic growth is similar to the same-store-sales calculation used by retailers. It includes revenue growth from units included in our financial statements for at least 12 months. Because we apply the purchase method of accounting for acquisitions, acquired brokerages’ financial results are included only from the date of acquisition.
We acquired brokerages with aggregate annual revenue of $115.4 million in 2004, up from approximately $8.1 million of acquired revenue in 2003.
Our management believes pricing discipline is a key to successful acquisition efforts and has chosen not to complete potential acquisitions that did not meet our pricing criteria. We have a goal of acquiring an average of 2 hub operations per year, increasing our base of U.S. hubs to 15 from the current 9. Acquisitions will be driven by opportunity, pricing and fit, however, not by a rigid timetable.
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In accordance with our strategic plan, on July 1, 2004 we purchased Talbot Financial Corporation, (“Talbot”) based in New Mexico. We purchased all of the common shares of Satellite Acquisition Corporation (“Satellite”), a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation for $90 million in cash. We will purchase Talbot management’s special shares of Satellite over the next three years, using a combination of both our restricted and unrestricted common shares. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month period ending December 31, 2004, 2005 and 2006, respectively. The contingent payments to Talbot management are a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. Based on Talbot’s financial performance for 2004, we anticipate total earnout payments in the $45-$50 million range. During the third and fourth quarter of 2004 we expensed $14.4 million of non-cash stock based compensation related to this acquisition.
Our revenue base is diversified across a large number of insurance products and services, including:
Commercial insurance
         
Property and casualty   Employee benefits   Risk management services
         
•   Business property   •   Group life and health   •   Claims management
•   Auto and trucking fleets
  •   Employment issues   •   Risk finance structuring
•   Technology
  •   Human resources   •   Exposure evaluation
•   Intellectual property
  •   Retirement plans   •   Coverage analysis
•   Natural disaster
  •   Contract review   •   Contract review
•   Workers’ compensation
       
•   Liability
       
•   Surety bonds
       
•   Business income
       
•   Accounts receivable
       
•   Environmental risks
       
Personal insurance
     
Property and casualty   Life, health and financial
     
•   Home
  •   Disability
•   Personal property
  •   Life
•   Auto and recreational vehicles
  •   Investments
•   Travel accident and trip cancellation
  •   Financial planning
Commercial lines have increased to 79% of our total revenue, largely as a result of our more rapid expansion in the United States, where middle market companies and other commercial clients are the primary source of revenue. In 2004, commercial lines constituted 89% of U.S. revenue and 60% of Canadian revenue. In British Columbia (Canada), we are the largest broker of government underwritten auto insurance, a personal line. In addition, Canada’s public health care system eliminates a significant portion of the demand for employer-provided health insurance, a major commercial product line for us in the United States.
We employ a number of distribution channels to deliver products and services to clients. Among the distribution channels we employ are:
Retail sales and service centers that target middle-market companies, providing a broad range of property and casualty insurance, life and health insurance, risk management and financial services;
 
Retail call-centers provide sales and services by telephone to individuals or members of employee groups, associations, affinity groups and specific communities. We operate call-centers in Chicago and Chilliwack, British Columbia;
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Wholesale life and financial services centers, known as managing general agents, provide life, financial and investment products and expertise to independent agents on a wholesale basis from our locations in Vancouver, Calgary, Montreal, Toronto, San Francisco, Albuquerque and Mechanicsburg, PA; and
 
Wholesale property and casualty insurance centers provide products, international risk solutions, captive management programs and specialty lines to independent brokers and corporations in North America and globally from offices in New York, Toronto, Montreal and Vancouver.
In addition, we are a member of the Worldwide Broker Network, a consortium of international brokerages which we can access to service U.S. or Canadian clients who require insurance internationally.
We have a diverse mix of products, services, insurer relationships and distribution channels, and as a result, our revenue and profitability levels are not usually highly susceptible to major changes related to a single product or service. However, general economic trends may influence overall insurance rates, commissions and availability or costs of individual types of coverage, which in turn may affect our revenue and profitability levels. Our ability to achieve organic revenue growth is not solely dependent on rising or declining rates, but results from a more complex mixture of general economic growth, access to coverage from insurers and marketing/ sales expertise.
During the 1990s, insurance rates were generally considered low, or “soft,” as insurance companies sought to maximize the flow of premium dollars that they could invest profitably in a rising stock market and in other investments. Beginning in 2000, as return on investment began to shrink, insurance rates began to rise, or “harden,” at a pace that accelerated rapidly after the terrorist attacks of September 11, 2001. During the two years after September 11, 2001, premium rates remained firm for most types of coverage, rising 10% to 15% per year in many cases. During the latter part of 2003, the Canadian market remained firm, but the U.S. market experienced some softening of premium rates for property and casualty coverage. During the first six months of 2004, Canadian and U.S. markets both softened, although rates for certain types of coverage continued to increase. During the third and fourth quarters of 2004 however, insurance rates for many types of coverage began falling at a much more rapid pace than during the first six months of the year.
For us, as for other brokers, falling rates can present both positive and negative effects. Falling premiums yield less commission income, if the insurance buyer maintains its coverage levels. However, many insurance buyers will respond to falling rates by increasing total coverage, often by lowering deductibles, increasing limits of coverage, or by adding new risks to those already insured. Although insurance rates fell during the last six months of 2004 we have not yet experienced any significant positive reactions from insurance buyers, although we expect we may in the months ahead. In addition, the economic environment could lead to higher or lower sales and employee headcounts at client companies, leading in turn to increased or reduced demand for employee benefits, liability and other types of coverage tied to business activity levels.
Our strategic plan has traditionally included a highly decentralized structure that offered a large degree of autonomy to each regional “hub” operation. We have sought to acquire strong businesses and retain the services and commitment of the management teams that built those businesses successfully. Decentralization has been a core component of this growth plan. In 2004 we began investing more in the coordination of additional functions from our head office to enhance a cross-selling, international collaboration, marketing efficiencies, total expense management and financial control initiatives.
Because we are a service organization, compensation and other personnel costs make up the largest component of total expenses — 70% in 2004. Property and equipment are comprised primarily of furniture, computer systems and office equipment. Therefore, Hub’s capital resources, including external borrowings, internally generated cash flow and issuance of common shares, are targeted primarily toward acquisitions.
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Results of Operations
Year ended December 31, 2004 compared to year ended December 31, 2003
Revenue
A significant portion of our revenue growth in 2004 was the result of brokerages acquired. During 2004, we acquired seven insurance brokerages, including Talbot, and divested of three small brokerages in Canada. Total annual revenue of these acquired brokerages was $115.4 million of which $57.8 million is included in our 2004 revenue. As a result of these acquisitions and 5% organic growth, which includes the strengthening of the Canadian dollar in 2004 compared to the U.S. dollar, we reported a 26% increase in revenue to $360.9 million in 2004.
The table below shows a breakdown of our revenue by segment and type for 2004 including organic growth for 2004:
(in thousands of U.S. dollars, except percentages)
                                                         
    Revenue           Adjustment for        
        Total Net   Total Net   (Acquisitions)   Organic   Organic
    2004   2003   Change($)   Growth(%)   and Disposals   Growth($)   Growth(%)
                             
Total
                                                       
Commission Income
  $ 328,961     $ 259,461     $ 69,500       27 %   $ (56,814 )   $ 12,686       5 %
Contingent Commissions and Volume Overrides
    21,705       18,530       3,175       17 %     (897 )     2,278       12 %
Other Income
    10,184       8,368       1,816       22 %     (1,853 )     (37 )     0 %
                                           
Total
  $ 360,850     $ 286,359     $ 74,491       26 %   $ (59,564 )   $ 14,927       5 %
                                           
U.S.
                                                       
Commission Income
  $ 216,293     $ 158,025     $ 58,268       37 %   $ (58,619 )   $ (351 )     0 %
Contingent Commissions and Volume Overrides
    14,864       13,493       1,371       10 %     (898 )     473       4 %
Other Income
    7,860       5,701       2,159       38 %     (1,909 )     250       4 %
                                           
Total
  $ 239,017     $ 177,219     $ 61,798       35 %   $ (61,426 )   $ 372       0 %
                                           
Canada
                                                       
Commission Income
  $ 112,668     $ 101,436     $ 11,232       11 %   $ 1,805     $ 13,037       13 %
Contingent Commissions and Volume Overrides
    6,841       5,037       1,804       36 %     1       1,805       36 %
Other Income
    2,324       2,667       (343 )     (13 )%     56       (287 )     (11 )%
                                           
Total
  $ 121,833     $ 109,140     $ 12,693       12 %   $ 1,862     $ 14,555       13 %
                                           
Of the $74.5 million in new revenue we reported, $59.6 million, or 80% reflected growth through acquisition, while $14.9 million, or 20% resulted from organic growth. By comparison, acquired revenue added $40.0 million, or 60% of 2003’s sales growth, while organic growth contributed $26.4 million, or 40% of our revenue increases. Organic growth figures include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2004, the rise of the Canadian dollar versus the U.S. dollar contributed three percentage points of our 5% organic growth rate in revenue.
Commission income, which usually ranges from 5% to 20% of the premium charged by insurers, provides approximately 91% of our revenue base. In addition to these “core” commissions, the company derives revenue from:
Volume overrides — additional compensation paid by insurance companies to brokerages on the basis of the overall volume of business a brokerage places with the insurance company;
 
Contingent commissions — additional compensation based on the profit an insurance company makes on the book of business a brokerage places with the insurance company; and
 
Other income — comprised primarily of premium finance fees, fees charged to clients in lieu of commissions and interest income, including income earned while we hold client premiums on behalf of insurance companies.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contingent Liabilities” for information regarding our legal proceedings.
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In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2004 and 2003 results included a number of factors that can complicate direct comparisons. To increase investor understanding, the following chart shows the net earnings and diluted earnings per share impact specific items would have had if they had not occurred over the past two years.
                   
(in thousands of U.S. dollars, except   Net   Diluted
per share amounts)   Earnings   EPS
         
Reported net earnings (Canadian GAAP) for the year ended December 31, 2004
  $ 26,244     $ 0.80  
 
Impact of foreign exchange
  $ (1,734 )   $ (0.05 )
 
Impact of write-off of trademarks
  $ 1,656     $ 0.05  
 
Non-cash stock based compensation — Talbot
  $ 14,388     $ 0.41  
Reported net earnings (Canadian GAAP) for the year ended December 31, 2003
  $ 36,509     $ 1.14  
 
Impact of foreign exchange
  $ (2,260 )   $ (0.07 )
 
Life insurance proceeds
  $ (1,000 )   $ (0.03 )
As shown above, we benefited less from a stronger Canadian dollar in 2004 as compared to 2003. The impact of foreign exchange on 2004 earnings generated an increase of $1.7 million as compared to an increase of $2.3 million in 2003. In 2004, we wrote off $1.7 million (after tax) of intangible assets related to trademarks as part of our corporate branding initiative and recorded $14.4 million of non-cash stock based compensation related to the Talbot acquisition.
Changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada and do not use derivatives to manage our Canadian pre-tax income, foreign exchange fluctuations will continue to impact our results. We have highlighted the impact of these changes because currency translation effects can lead to reported results that are less meaningful than local-currency results as an indicator of underlying operations. In 2004, the strength of the Canadian dollar versus the U.S. dollar had a less positive impact on our results than in 2003. Any decline in the Canadian dollar relative to the U.S. dollar would have a negative effect on our results. See “Market Risk”.
U.S. Results
U.S. revenue grew 35% to $239.0 million, or 66% of consolidated revenue in 2004. Acquisitions in 2004 added $61.4 million to revenue — 100% of the increase. Our U.S. operations posted an organic growth rate of 0% in 2004, as compared to 3% in 2003, primarily as a result of the rapid softening of premium rates for property and casualty coverage in the third and fourth quarters of 2004. Core commission income increased 37%, while contingent commissions and volume overrides grew 10%. Higher premium rates in 2003 contributed strongly to a significant increase in contingent profitability income from insurance companies in 2004.
Canadian Results
Canadian revenue grew 12% to $121.8 million, or 34% of consolidated revenue, in 2004 as compared to 2003, primarily as a result of organic growth and strengthening of the Canadian dollar against the U.S. dollar. Canadian brokerages posted organic growth of 13%, of which eight percentage points reflected a stronger Canadian dollar. Dispositions lowered revenue by $2.5 million while acquisitions added $0.6 million, for a net decrease of $1.9 million. Similar to the United States, premium rates in Canada fell significantly in the third and fourth quarters of 2004. Canadian operations benefited from an increase in contingent commissions and volume overrides, which grew 36% in 2004, versus 37% growth rate in 2003. Higher premium rates in 2003 contributed strongly to a significant increase in contingent profitability income from insurance companies in 2004.
Compensation Expense
Cash compensation expense for 2004 increased 28% to $199.5 million from $156.3 million, while non-cash stock based compensation grew 335% to $20.9 million from $4.8 million in 2003. As a percentage of revenue, cash
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compensation expense increased to 55% from 54% in 2003, primarily due to a relatively higher level of compensation costs as a percentage of revenue at Talbot.
                                         
                % of Revenue
                 
(in thousands of U.S. dollars, except percentages)   2004   2003   % Change   2004   2003
                     
Compensation Comparison
                                       
Cash compensation
  $ 199,520     $ 156,320       28 %     55 %     54 %
Non-cash stock based compensation
    20,890       4,801       335 %     6 %     2 %
                               
Total
  $ 220,410     $ 161,121       37 %     61 %     56 %
                               
Our non-cash stock based compensation includes stock options and restricted share units for senior employees as well as the amortization of $14.4 million, or $0.41 per diluted share, of non-cash stock based compensation related to the estimated earnout due to management of Talbot over the next three years. In response to investor interest in the true impact of these costs, we began recognizing the expense of non-cash stock based compensation during 2003. Options vest evenly over three years and expire in seven years from issuance. Shares derived from the options are held in escrow for a period of five years from the date the options are granted, subject to early releases in certain circumstances. Restricted share units vest over periods ranging from 48 months to 95 months. Our policy is to expense the fair value of non-cash stock based compensation to employees over the period in which entitlement to the compensation vests. The amount of expense recognized in each year related to stock options will vary with respect to exercise and forfeiture of options.
Non-cash stock based compensation for the years ended December 31, 2004, 2003 and 2002 is comprised of the following:
                           
(in thousands of U.S. dollars)   2004   2003   2002
             
Non-cash stock based compensation:
                       
 
Stock options granted June 2002
  $ 1,955     $ 1,899     $ 1,089  
 
Stock options granted February 2003
    445       410        
 
Stock based compensation granted for 2003 bonuses
    2,368       1,405        
 
Restricted share units
    1,609       1,087        
 
Other
    125              
                   
      6,502       4,801       1,089  
 
Stock based compensation related to Talbot acquisition
    14,388              
                   
    $ 20,890     $ 4,801     $ 1,089  
                   
The Company estimates the non-cash stock based compensation expense for 2005 through 2010 will be:
                                                 
    Year ended December 31,
     
(in thousands of U.S. dollars)   2005   2006   2007   2008   2009   2010
                         
Stock options granted June 2002
  $ 851     $     $     $     $     $  
Stock options granted February 2003
    366                                
Stock based compensation granted for 2003 bonuses
    2,340       2,254       2,163       2,163       2,163       2,104  
Stock based compensation regarding Talbot acquisition
    25,459       8,400       1,508                    
Restricted share units
    1,661       1,654       1,618       1,618       347       130  
Other
    112       27       9                    
                                     
    $ 30,789     $ 12,335     $ 5,298     $ 3,781     $ 2,510     $ 2,234  
                                     
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In total, as of December 31, 2004, we had issued and outstanding approximately 1.5 million stock options at a weighted average exercise price of $15.34. Our closing share price on the New York Stock Exchange was $18.41 on December 31, 2004.
Selling, Occupancy and Administration Expense
Selling, occupancy and administration expense increased 29% to $73.2 million in 2004. As a percentage of revenue, selling, occupancy and administration expense remained constant at 20% despite additional costs related to the implementation of the Sarbanes-Oxley Act of 2002 of $2.5 million and legal costs associated with various investigations regarding contingent commissions arrangements of $0.4 million.
Depreciation
Depreciation increased 16% to $7.3 million in 2004 but remained constant at 2% of revenue.
Interest Expense
Interest expense increased 44% to $7.5 million from $5.2 million in 2003. This increase reflected borrowings for the Talbot acquisition in July 2004, partially offset by the benefits of an interest rate swap in 2004. The interest rate swap effectively converted $65 million of fixed interest rate senior notes into floating rate instruments, reducing interest expense on the senior notes by $1.3 million in 2004 compared to $0.8 million in 2003.
Intangible Asset Amortization
Intangible asset amortization increased 72% to $5.5 million in 2004 as a result of the acquisition of Talbot.
Loss on Write-off of Trademarks
In January 2004, we adopted a corporate marketing and positioning strategy to build awareness of the Hub brand across all of our markets and to encourage greater coordination and collegial identity among our employees. As part of this corporate consolidation and identity development program, we have reassigned a number of key executives to new or expanded areas of responsibility and determined that future marketing and communications will be conducted under the Hub International name, rather than the traditional corporate names of acquired brokerages. As a result, in the first quarter of 2004 certain of our subsidiaries changed their names and as a result, we recognized a non-cash impairment expense of approximately $2.6 million before tax related to trademarks.
Gain/Loss on Disposal of Subsidiaries, Property, Equipment and Other Assets
2004 included gains of $1.9 million on the sale of investments and assets and shares of certain brokerages compared with a gain of $0.2 million in 2003. Approximately $1.6 million of the 2004 gain is non-taxable.
Provision for Income Tax Expense
Our effective tax rate increased to 43% in 2004 from 34% in 2003 due primarily to non-cash stock based compensation expense related to the acquisition of Talbot which is not deductible for tax purposes. Excluding the non-cash stock based compensation the effective tax rate for 2004 was 33%.
Net Earnings and Earnings Per Share
Our net earnings decreased 28% or $10.3 million to $26.2 million in 2004 due to the impact of non-cash stock based compensation, write off of trademarks and the impact of foreign exchange. Diluted earnings per share decreased $0.34 per diluted share to $0.80 in 2004.
Year ended December 31, 2003 compared to year ended December 31, 2002
Revenue
Revenue increased 30% to $286.4 million in 2003. Although the pace of acquisitions did not match that of 2002, we benefited from strong organic growth rates in most hubs, contributions from brokerages acquired in 2002 and the currency exchange benefits of a strengthening Canadian dollar.
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The table below shows a breakdown of our revenue by segment and type for the year ended December 31, 2003 including organic growth for 2003:
                                                         
    Revenue           Adjustment for        
(in thousands of U.S. dollars,       Total Net   Total Net   (Acquisitions)   Organic   Organic
except percentages)   2003   2002   Change($)   Growth(%)   and Disposals   Growth($)   Growth(%)
                             
Total
                                                       
Commission Income
  $ 259,461     $ 200,976     $ 58,485       29 %   $ (36,303 )   $ 22,182       11 %
Contingent Commissions and Volume Overrides
    18,530       11,464       7,066       62 %     (2,951 )     4,115       36 %
Other Income
    8,368       7,520       848       11 %     (749 )     99       1 %
                                           
Total
  $ 286,359     $ 219,960     $ 66,399       30 %   $ (40,003 )   $ 26,396       12 %
                                           
U.S.
                                                       
Commission Income
  $ 158,025     $ 120,741     $ 37,284       31 %   $ (35,038 )   $ 2,246       2 %
Contingent Commissions and Volume Overrides
    13,493       7,780       5,713       73 %     (2,872 )     2,841       37 %
Other Income
    5,701       5,628       73       1 %     (753 )     (680 )     (12 )%
                                           
Total
  $ 177,219     $ 134,149     $ 43,070       32 %   $ (38,663 )   $ 4,407       3 %
                                           
Canada
                                                       
Commission Income
  $ 101,436     $ 80,235     $ 21,201       26 %   $ (1,265 )   $ 19,936       25 %
Contingent Commissions and Volume Overrides
    5,037       3,684       1,353       37 %     (79 )     1,274       35 %
Other Income
    2,667       1,892       775       41 %     4       779       41 %
                                           
Total
  $ 109,140     $ 85,811     $ 23,329       27 %   $ (1,340 )   $ 21,989       26 %
                                           
Of the $66.4 million in new revenue we reported, $40.0 million, or 60% reflected growth through acquisition, while $26.4 million, or 40% resulted from organic growth. By comparison, acquired revenue added $46.1 million, or 70% of 2002’s sales growth, while organic growth contributed $19.9 million, or 30% of our revenue increases. Organic growth figures for both revenue and earnings include the impact of foreign exchange rate changes between the U.S. and Canadian dollars. In 2003, the rise of the Canadian dollar versus the U.S. dollar contributed five percentage points of our 12% organic growth rate in revenue.
Commission income, which usually ranges from 5% to 20% of the premium charged by insurers, provides approximately 91% of our revenue base. In addition to these “core” commissions, the company derives revenue from:
Volume overrides — additional compensation paid by insurance companies to brokerages on the basis of the overall volume of business a brokerage places with the insurance company.
 
Contingent commissions — additional compensation based on the profit an insurance company makes on the book of business a brokerage places with the insurance company.
 
Other income — comprised primarily of premium finance fees, fees charged to clients in lieu of commissions and interest income, including income earned while we hold client premiums on behalf of insurance companies.
The sharp increase in contingent commissions and volume overrides in 2003 reflected increased profitability of business placed by us at higher premium rates and increased concentrations of some placements among a group of selected insurers.
In addition to the variations that can result from changes in organic growth rates, acquisitions and other variables related to operations, both 2003 and 2002 results included a number of factors that can complicate direct comparisons. To increase investor understanding, the following chart shows the net earnings and diluted earnings per share impact specific items would have had if they had not occurred over the past two years.
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(In thousands of U.S. dollars,   Net   Diluted
except per share amounts)   Earnings   EPS
         
Net earnings (Canadian GAAP) for the year ended December 31, 2003
  $ 36,509     $ 1.14  
 
Impact of foreign exchange
  $ (2,260 )   $ (0.07 )
 
Life insurance proceeds
  $ (1,000 )   $ (0.03 )
 
Non-cash stock based compensation for the year ended December 31, 2002
  $ 4,801     $ 0.14  
Net earnings (Canadian GAAP)
  $ 29,401     $ 1.06  
 
Gain on sale of Old Lyme
  $ (2,613 )   $ (0.09 )
 
Non-cash stock based compensation
  $ 1,089     $ 0.04  
As shown above, we benefited from both a stronger Canadian dollar and the receipt of life insurance proceeds in 2003, while 2002 results were strengthened by the sale of two insurance subsidiaries. The impact of foreign exchange on 2002 earnings was insignificant. In addition, 2003 included a full year’s amortization of non-cash stock based compensation, versus 2002 which included only six months of amortization.
Changes in currency exchange rates are not an unusual item. Because we derive our revenue from both the United States and Canada and do not use derivatives to manage our Canadian pre-tax income, foreign exchange fluctuations will continue to impact our results. We have highlighted the impact of these changes because currency translation effects can lead to reported results that are less meaningful than local-currency results as an indicator of underlying operations. In 2003, the strength of the Canadian dollar versus the U.S. dollar had a positive impact on our results. A decline would have a negative effect. See Management’s Discussion and Analysis of Financial Condition and Results of Operations — “Market Risk.”
U.S. Results
U.S. revenue grew 32% to $177.2 million, or 62% of revenue, in 2003, due to both organic growth and the contributions of operations acquired in 2002. Acquisitions added $38.7 million to revenue — 90% of the increase — while organic growth provided $4.4 million, or 10% of revenue growth. Our U.S. operations posted an organic growth rate of 3% in 2003, an 81% decrease from 16% in 2002. Core commission income increased 2%, while contingent commissions and volume overrides grew 37%.
During 2003 we experienced an unusual timing issue at a single hub that provides lender-placed auto insurance coverage for financial institutions. Lender-placed coverage is primarily collision coverage on automobiles financed through a financial institution. This is a high-volume business that is generally very profitable for us. However, two financial institutions adjusted their credit policies in 2003, leading to cancellation of several quarters’ worth of policies in a single quarter resulting in 2003 revenue being reduced by approximately $4.3 million. Excluding the impact of this product line, U.S. organic growth was 9% in 2003.
During 2003, U.S. insurance premium rates remained strong — or hard — for most product lines, although rates for property coverage showed only modest increases as the year progressed. Hard insurance pricing in 2002 contributed strongly to a significant increase in contingent profitability income from insurers in 2003, as these insurers benefited from the near-term impact of higher rates implemented in 2002.
In the United States, our brokerages benefited from new business generation, additional revenue from businesses acquired during 2002 and moderate premium rate increases. While higher premium rates on most product lines added nominally to total premium amounts, client response to higher rates often included a reduction in total coverage, increasing deductibles and other cost-savings techniques. In addition, the relative weakness in the U.S. economy led to declines in sales levels and staff headcount at many of our clients. Many products, including employee benefits and product liability coverage, are linked closely to the level of business activity at our clients. A weak economy reduces total risk, total coverage and total premiums for these clients.
Canadian Results
Canadian revenue grew 27% to $109.2 million, or 38% of consolidated revenue, in 2003, primarily as a result of a strengthening of the Canadian dollar against the U.S. dollar as well as organic growth. Canadian brokerages posted
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organic growth of 26%, of which fourteen percentage points reflected a stronger Canadian dollar. Acquisitions added only $1.3 million, or 6%, of the revenue increase, reflecting a slower pace of fold-in acquisitions in Canada than in the United States. Apart from foreign currency gains, in Canada, our brokerages benefited from strong organic growth and a sustained pace of increases in insurance premium rates. Canadian rate trends have trailed those of the United States. Because Canadian revenue includes a lower percentage of commercial business and more personal lines, any acceleration in economic growth that adds to payrolls is not expected to have as strong a benefit in Canada as in the United States. The strong rate of organic growth in Canada reflected both increased market penetration and continued strength in premium rates. Our strong relationships with and access to insurers in Canada proved to be an important competitive advantage in 2003, leading to increased sales to clients who were unable to obtain coverage from other sources. As was the case in the United States, Canadian operations benefited strongly from an increase in contingent commissions and volume overrides, which grew 37% in 2003, versus a decline of 12% in 2002.
Compensation Expense
The majority of our expenses are related to compensation, which increased 35% in 2003 to $161.1 million. As a percentage of revenue, compensation increased to 56% from 54% in 2002, due in large part to an increase in non-cash stock based compensation. Total compensation includes both cash based salaries and benefits and non-cash stock based compensation. Cash compensation grew 32% to $156.3 million in 2003, while non-cash stock based compensation increased 341% to $4.8 million.
Compensation Comparison
                             
                % of
                Revenue
                 
(in thousands of U.S. dollars, except percentages)   2003   2002   % Change   2003   2002
                     
Cash compensation
  $ 156,320     $ 118,667     32%   54%   54%
Non-cash stock based compensation
    4,801       1,089     341%   2%   —%
                         
Total
  $ 161,121     $ 119,756     35%   56%   54%
                         
We have undertaken a number of initiatives to reduce or maintain compensation expense. During 2002, members of the executive management group agreed to accept 50% of their earned bonuses in the form of stock options, rather than cash. At the close of 2003, we obtained agreement from managers to restructure the company’s management bonus agreement. Under the new agreement the non-cash stock option component of the annual bonus was eliminated in exchange for restricted share units to be issued in the first quarter of 2004. In addition, whereas the management bonus agreement was previously contractual in nature, the restructured plan is no longer contractual and may be subject to change as we deem necessary. Approximately $16.9 million of restricted share units were issued in connection with the modifications. The amount of restricted share units issued was based upon a multiple of the previous two years average bonus. The restricted share units will all vest in full on January 1, 2011 subject to continued employment. Although the impact of this change is expected to be earnings-neutral in 2004, the long-term effect is to reduce compensation costs as a percentage of revenue.
In addition to cash compensation, we have employed non-cash compensation tools such as stock options, restricted shares and restricted share units for senior employees. In response to investor interest in the true impact of these costs, we began recognizing the expense of non-cash stock based compensation during 2002. We recognized $4.8 million of expense for the full year in 2003, including both stock options and restricted share units, versus $1.1 million of expense for two quarters of 2002. Options vest evenly over three years and expire in seven years from issuance. Shares derived from the options are held in escrow for a period of five years from the date the options are granted, subject to early release in certain circumstances. Restricted share units vest over periods ranging from 48 months to 95 months. Our policy is to expense the fair value of non-cash stock based compensation to employees over the period in which entitlement to the compensation vests. The amount of expense recognized in each quarter related to stock options will vary with respect to exercise and forfeiture of options.
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In total, as of December 31, 2003, we had issued and outstanding approximately 1.5 million stock options at a weighted average exercise price of $15.64. Our closing share price on the New York Stock Exchange was $16.76 on December 31, 2003.
Selling, Occupancy and Administration Expense
Selling, occupancy and administration expense increased 26% to $56.6 million in 2003. As a percentage of revenue, selling, occupancy and administration expense declined slightly to 19.8%, versus 20.4% in 2002.
Depreciation
Depreciation declined slightly to 2.2% of revenue in 2003 from 2.5% in 2002. The lower relative impact reflected control of capital expenditures while revenue grew.
Interest Expense
Interest expense decreased 29% to $5.2 million from $7.3 million in 2002. This decline reflected in large part the application of $80 million in proceeds for the 2002 IPO to pay down debt. In addition, interest expense was reduced by the benefits of performance-based forgiveness of interest payments due under a loan agreement with an insurer and an interest rate swap during the third and fourth quarters of 2003. The interest rate swap effectively converted $65 million of fixed interest rate senior notes into floating rate instruments, reducing interest expense on the senior notes by $0.8 million in 2003.
Intangible Asset Amortization
Intangible asset amortization increased 92% to $3.2 million in 2003 as a result of 2003 and 2002 acquisitions.
Gain on Put Option Liability
In addition to the issuance of stock options, we issued put options to a number of individuals as part of the sale of their brokerages to us. These put options allowed the former owners to require us to repurchase our shares issued to them when we acquired their brokerages. We negotiated the cancellation of put options with one group of former owners during 2002 and negotiated the cancellation of all remaining put options during 2003.
Provision for Income Tax Expense
Our effective tax rate increased in 2003 to 34% from 33%. The difference in tax rates was affected most directly by non-taxable items in both 2003 and 2002. Approximately $2.6 million of 2002 earnings — resulting from the sale of two subsidiaries, Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively, “Old Lyme”) — were non-taxable, while $1.0 million of 2003 earnings — resulting from life insurance proceeds — were non-taxable. Absent these two items, the tax rates were unchanged at approximately 34.7% in both years.
Net Earnings and Earnings Per Share
Our net earnings increased 24% to $36.5 million in 2003, primarily as a result of growth in revenue. As a percentage of revenue, net earnings declined approximately 0.6 percentage points to 12.8% in 2003 from 13.4% in 2002. Diluted earnings per share increased at a somewhat slower rate than net earnings — 8% to $1.14 — due primarily to a larger number of shares outstanding.
Our use of shares as a core component of our acquisition proceeds and as a form of executive compensation has led to significant increases in the number of shares outstanding over the past few years. In addition, we issued 6.9 million common shares in our June 2002 U.S. IPO and listing on the New York Stock Exchange. The weighted average number of diluted shares outstanding increased from 20.1 million in 2001 to 30.2 million in 2002 and 33.8 million in 2003.
As shown in the table on page 27, net earnings increased $2.6 million or $0.09 per diluted share, in 2002 on the sale of two insurance subsidiaries and decreased $1.1 million or $0.04 per diluted share due to non-cash stock based compensation. In 2003, diluted earnings per share increased $0.03 per diluted share from life insurance proceeds and
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another $0.07 per diluted share from foreign exchange rates and net earnings decreased $4.8 million or $0.14 per diluted share due to non-cash stock based compensation.
Cash Flow, Liquidity and Capital Resources
As of December 31, 2004, we had cash and cash equivalents of $98.2 million, an increase of 20%, from $82.1 million as of December 31, 2003. Operating activities generated $57.4 million of cash in 2004 compared to $53.9 million in 2003. The amount of cash provided by operating activities is affected by net earnings for the period, non-cash income and expenses, the change in trust cash, the collection of accounts and other receivables and the payment of accounts payable and accrued liabilities. In 2004, $93.3 million of cash was used in investing activities, primarily for the purchase of subsidiaries compared to $20.1 million in 2003. Also in 2004, $48.1 million of cash was provided from financing activities, primarily resulting from long-term debt advances. In 2004, the effect of exchange rate changes on cash and cash equivalents was an increase of $4.0 million compared to $3.1 million in 2003. Net debt, defined as long-term debt ($151.8 million) and subordinated convertible debentures ($35.0 million) less non-trust cash (cash and cash equivalents of $98.2 million) as of December 31, 2004, was $88.6 million compared with $31.7 million as of December 31, 2003.
As a broker, we collect and hold premiums paid by clients, deduct commissions and other expenses from these payments, and hold the remainder in trust, which we remit to the insurers who provide coverage to clients. We earn interest on these funds during the time between receipt of the cash and the time the cash is paid to insurers. The cash held in trust is shown separately on our balance sheet under the caption “Trust Cash”. On the statement of cash flows, changes in trust cash are included as part of the change in non-cash working capital and the determination of cash provided from operating activities.
In addition to internally generated cash, we maintain two separate credit facilities:
(1) Revolving U.S. dollar LIBOR loan — This unsecured facility totals $75 million and bears interest at a floating rate of prime plus 1%, or 112.5 basis points above LIBOR. The LIBOR was 2.40% and 1.12% at December 31, 2004 and 2003, respectively. The facility is available on a revolving basis for one year and expires on April 22, 2005. However if the revolving period is not extended, we may convert the outstanding balance under the facility to a three year non-revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million and $NIL at December 31, 2004 and 2003, respectively. As of December 31, 2004 and 2003 we were in compliance with all financial covenants governing this facility.
 
(2) Demand U.S. dollar base rate loan — We have an undrawn $10.0 million facility which bears interest at the bank’s U.S. base rate, which was 5.75% and 4.50% at December 31, 2004 and 2003, respectively, plus 50 basis points. Borrowings under this facility are repayable on demand.
As of December 31, 2004, we had outstanding $65 million in principal amount of unsecured senior notes issued June 10, 2002. The senior notes were issued in two series: Series A represents $10 million aggregate principal amount of 5.71% senior notes with interest due semi-annually, and principal due of $3,333 due annually, June 15, 2008 through June 15, 2010. Series B represents $55 million aggregate principal amount of 6.16% senior notes with interest due semi-annually, and principal due of $11,000 due annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. We incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the senior notes. As of December 31, 2004 we were in compliance with all financial covenants governing the senior notes.
On July 15, 2003, we entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments of 5.71% senior notes and 6.16% senior notes in amounts of $10 million and $55 million, respectively, to a floating rate of approximately 2.0% and 2.4%, respectively. We account for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at December 31, 2004, we estimated the
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fair value of the swap to be $2.4 million, which is not recognized in our financial statements. Accordingly, $2.4 million is the estimated amount that we would need to pay to terminate the swap as of December 31, 2004.
Also at December 31, 2004 we had outstanding a $7.5 million term loan from an insurance carrier with which we place insurance. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) and reduces the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Credits earned for 2004 and 2003 reduced interest payments to zero from $750 for both years.
In addition to these primary credit sources, we ended 2004 with $14.1 million of subsidiary debt comprised of various notes payable, term loans and capital leases. We intend to repay these liabilities from internally generated cash flow, existing cash balances and/or borrowings under our credit facilities as the subsidiary debt becomes due during 2005 through 2010. Of the outstanding subsidiary debt, $8.4 million is secured by liens on certain assets of our subsidiaries.
Also at December 31, 2004, we had outstanding $35.0 million aggregate principal amount of 8.5% convertible subordinated notes due June 28, 2007 held by certain subsidiaries of Fairfax (the Fairfax notes). The Fairfax notes are convertible by the holders at any time into our common shares at C$17.00 per share. If Fairfax had converted all of the Fairfax notes, Fairfax would have owned approximately 32% of our total outstanding common shares as of December 31, 2004, versus the 26% of outstanding shares which it held on that date.
At the close of 2004, our cash position included approximately $57.1 million deployed as working capital at the brokerage level and approximately $41.1 million available for acquisitions. This amount combined with available lines of credit leaves us with a total amount of $61.1 million available for acquisitions. It is impossible to define exactly how many acquisitions or how much new revenue could be acquired through the use of this cash, additional cash flow from operations and application of credit facilities, as acquisition pricing and other factors vary during the course of the year. However, we intend to use our common shares as consideration for approximately 30%-70% of the value of a hub acquisition, and generally have paid a multiple of 5-8 times earnings before interest, taxes, depreciation and amortization (frequently referred to as EBITDA, which is not a GAAP measure) for acquired brokerages.
We believe that our capital resources, including existing cash, funds generated from operations and borrowings available under credit facilities, will be sufficient to satisfy the company’s financial requirements, including some strategic acquisitions, during the next twelve months. We may finance acquisitions with available cash or an existing credit facility, but may, depending on the number and size of future acquisitions, need to supplement our finance requirements with the proceeds from debt financing, the issuance of additional equity securities, or a combination of both.
Our debt to capitalization ratio (debt as a percentage of debt and shareholders’ equity) increased to 33% at December 31, 2004, compared with 25% at December 31, 2003. If all lines of credit and other loan facilities were fully utilized by the company at December 31, 2004, our ratio of debt to capitalization would have been 35%, which is within the range of 35% to 38% that our management believes is suitably conservative for our business model. Under our loan covenants, our debt to capitalization ratio must be less than the 45%. As of December 31, 2004, we were in compliance with the financial covenants under all of our debt instruments.
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Contractual obligations
The table below summarizes our contractual obligations and commercial commitments as of December 31, 2004:
                                             
Contractual Obligations                        
Payments due by period (in thousands of       On   Less than   1-3   4-5   After
U.S. dollars)   Total   Demand   1 Year   Years   Years   5 Years
                         
Long-term debt
  $151,329   $     $ 4,912     $ 14,899     $ 84,185     $ 47,333  
Capital lease obligations
  468           283       185              
Operating lease obligations
  76,465           15,680       26,179       19,538       15,068  
Executive share purchase plan loans
  526                       526        
                                   
Total
  $228,788   $     $ 20,875     $ 41,263     $ 104,249     $ 62,401  
                                   
Acquisitions
In connection with the acquisition of Talbot on July 1, 2004, we will purchase special shares of Satellite Acquisition Corp., (“Satellite”) owned by the management of Talbot, over the next three years, using a combination of both our restricted and unrestricted common shares. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12-month periods ending December 31, 2004, 2005 and 2006, respectively. We will record the contingent payment to Talbot management as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. In 2004, we recorded $14.4 million of non-cash stock based compensation with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004, management estimates we may be obligated to pay contingent payments of approximately $30-$35 million in our common shares, in addition to the $14.4 million of amounts accrued to date mentioned above.
In connection with the acquisition of Hooper Hayes and Associates, Inc., now known as Hub International of California Inc., in 2002 we issued 196,000 shares (the “Retractable Shares”) that were deposited in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2004, 126,000 shares have been released from escrow.
In connection with other various acquisitions completed through December 31, 2004, we may be obligated to pay contingent consideration up to a maximum sum of approximately $12.4 million in cash and $3.6 million in common shares based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through August 2007 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2004, the financial statements reflect a liability to pay cash of $0.2 million as of December 31, 2004.
Contingent liabilities
In April 2004, Hub International Northeast Limited (“HUB Northeast”), formerly known as Kaye Insurance Associates, Inc., a subsidiary of Hub, received a subpoena from the Office of the Attorney General of the State of New York seeking information regarding certain compensation agreements between insurance brokers and insurance companies. The New York Attorney General subpoenaed information on such compensation agreements from several other major insurance brokers and insurance companies as well. Such compensation agreements, also known as contingent agreements, between insurance companies and brokers are a long-standing and common practice within the insurance industry. HUB Northeast discloses such agreements on its invoices to clients and on its web site. In addition, we disclose the arrangements in our public filings. In August 2004, HUB Northeast received a second subpoena from the Office of the Attorney General of the State of New York seeking information regarding all revenue that HUB Northeast may have derived from insurance companies. In September 2004, HUB Northeast received a third subpoena from the Office of the Attorney General of the State of New York seeking information
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regarding any “fictitious” and “inflated” insurance quotes to which HUB Northeast may have been a party. We continue to fully cooperate with the Attorney General’s inquiry.
Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, we retained external counsel to assist us in responding to the New York Attorney General’s inquiries and, among other things, requested that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to our other hubs, both for internal purposes and in the course of assisting us in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes. While it is not possible to predict the outcome of this investigation, if such compensation agreements were to be restricted or no longer permitted, our financial condition, results of operations and liquidity may be materially adversely affected.
From August 2004 through February 2005, various other subsidiaries of Hub received and responded to letters of inquiry and subpoenas from authorities in California, Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec.
In October 2004, we were named as a defendant in a class action lawsuit (the “Opticare case”) filed in Federal District Court in New York against 30 different insurance brokers and insurance companies. The lawsuit alleges that the defendants used the contingent commission structure to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, we were also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. In January 2005 we were named as one of several defendants in a third class action filed in Federal District Court in Illinois, containing allegations substantially similar to those in the Opticare case and other Illinois federal class actions. None of the complaints contain any specific factual allegations against us, but rather generally assert that all of the broker defendants engaged in the types of conduct of which the New York Attorney General charged the Marsh & McLennan companies in his suit against them. On February 17, 2005 the Federal Judicial Panel on Multidistrict Litigation transferred the Opticare case as well as three other class actions in which we are not named to the District of New Jersey. We expect that the three class actions filed in Federal District Court in Illinois will also be transferred to New Jersey. We deny the allegations made in these lawsuits and intend to vigorously defend these cases.
In January, 2005 we and our affiliates were named as defendants in a class action filed in the Circuit Court of Cook County, Illinois. The named plaintiff is a Chicago law firm that obtained its professional liability insurance through Hub International of Illinois Limited (formerly Mack and Parker, Inc.) and claims that an undisclosed contingent commission was received with respect to its policy. We deny this and the other allegations of the complaint and intend to vigorously defend this case.
We did not record a liability at December 31, 2004 related to the above contingent liabilities.
In connection with our executive share purchase plan, under certain circumstances, we may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4.3 million and $4.5 million as of December 31, 2004 and 2003, respectively, to assist in purchasing our common shares. As collateral, the employees have pledged 431,000 and 478,000 common shares as of December 31, 2004 and 2003, respectively, which had a market value of $7.9 million and $8.1 million as of December 31, 2004 and 2003, respectively. Interest on the loans in the amount of $192,000, $279,000 and $264,000 for the years ended December 31, 2004, 2003 and 2002, respectively, was paid by us and is included in cash compensation expense. We no longer make loans to our executive officers and directors.
In the normal course of business, we are involved in various claims and legal proceedings relating to insurance placed by us and other contractual matters. Our management does not believe that any such pending or threatened proceedings will have a material adverse effect on our consolidated financial position or future results of operations.
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Shareholders’ equity
Restricted share units. In 2004, restricted share units totaling 977,000 were issued in connection with the restructuring of our management bonus agreement and 84,000 restricted share units were issued in connection with the renegotiation of contingent consideration for J.P. Flanagan Corporation.
Share repurchases. For the year ended December 31, 2004, no common shares were repurchased by us, other than shares equal in value to $94,000 under the executive share purchase plan.
Shares reserved for issuance. As of December 31, 2004, 3.6 million common shares were reserved for issuance under our equity incentive plan of which approximately 3.3 million stock options and restricted share units were outstanding.
Shareholders’ equity increased by $39.0 million, or 11%, to $381.8 million as of December 31, 2004 from $342.8 million as of December 31, 2003. This increase resulted from net earnings of $26.2 million, an increase in contributed surplus of $7.9 million related primarily to non-cash stock based compensation, $3.4 million due to shares issued in conjunction with acquisitions, $0.9 million due to shares issued in conjunction with the contingent consideration payments, an exercise of stock options for $0.5 million, and an increase in the cumulative translation account of $6.9 million, (due mainly to the strengthening of the Canadian dollar compared to the U.S. dollar in 2004). The increase in shareholders’ equity was offset by the declaration of dividends of $6.1 million in 2004.
Market risk
Interest rate risk
We are exposed to interest rate risk in connection with our senior notes due to the interest rate swap entered into in 2003, which converted the fixed rate interest payments on the $65 million aggregate principal amount of senior notes outstanding into floating rate payments and on our revolving U.S. dollar LIBOR loan. As a result each 100 basis point increase in interest rates charged on the balance of our outstanding floating rate debt as of December 31, 2004 will result in approximately $0.8 million decrease in our earnings.
Exchange rate sensitivity
We report our revenue in U.S. dollars. Our Canadian operations earn revenue and incur expenses in Canadian dollars. Given our significant Canadian dollar revenue, we are sensitive to the fluctuations in the value of the Canadian dollar and are therefore exposed to foreign currency exchange risk. Foreign currency exchange risk is the potential for loss in revenue and net income as a result of a decline in the U.S. dollar value of Canadian dollar revenue due to a decline in the value of the Canadian dollar compared to the U.S. dollar.
The Canadian dollar is subject to volatility. It experienced a significant decline in its value compared to the U.S. dollar in 2001 but has increased significantly in value throughout 2003 and 2004. At December 31, 2004 and 2003 one U.S. dollar equaled $1.2036 and $1.2924 Canadian dollars, respectively. The table below summarizes the effect that a $0.01 decline or increase in the value of the Canadian dollar would have had on our revenue, net earnings and cumulative translation account for the twelve months ended December 31, 2004, 2003 and 2002.
                         
(in millions of U.S. dollars, except percentages)   2004   2003   2002
             
Revenue
  +/-$ 1.6     +/-$ 1.5     +/-$ 1.3  
Net earnings
  +/-$ 0.4     +/-$ 0.2     +/-$ 0.2  
Cumulative translation account
  +/-$ 2.6     +/-$ 1.9     +/-$ 1.2  
The increasing proportion of our revenue derived from our U.S. operations and earned in U.S. dollars has, in part, offset the potential risk of a decline in the Canadian dollar. We expect that the proportion of revenue earned in U.S. dollars will continue to increase, further mitigating our foreign currency exchange sensitivity. We have not entered into, and do not intend to enter into, foreign currency forward exchange agreements.
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Goodwill and other intangible assets
Intangible assets arising from acquisitions consist of the following:
                   
(in thousands of U.S. dollars)   2004   2003
         
Customer relationships
  $ 95,982     $ 43,422  
Non-competition covenants
    4,110       2,643  
Trademarks
          2,587  
Goodwill
    394,063       323,185  
Accumulated amortization
    (28,637 )     (23,072 )
             
 
Total
  $ 465,518     $ 348,765  
             
We completed our impairment testing on the balance of goodwill and intangible assets as of January 1, 2005, 2004 and 2003. Based on the testing performed, no impairment losses were incurred.
The amounts allocated to customer relationships were determined by discounting the expected future net cash flows from commissions with consideration given to remaining economic lives, renewals, and associated expenses. The amounts allocated to non-competition covenants were determined using an income approach with consideration given to economic benefits associated with having the covenants in place versus damages that would ensue absent the agreements. In the case of trademarks, a cash flow royalty savings approach, addressing the economic benefits of the trademarks to Hub was used. The balance of the excess purchase price is allocated to goodwill.
Customer relationships are amortized on a straight-line basis over their estimated economic useful life, typically ten to fifteen years. Many factors outside our control determine the persistency of our customer relationships and we cannot be sure that the value we have allocated will ultimately be realized. Non-competition covenants are intangible assets that have an indefinite life and accordingly, are not amortized but are evaluated for impairment. When an employee leaves Hub, the non-competition covenant becomes effective and the value assigned is then amortized over the life of the covenant. During the first quarter 2004, certain of our subsidiaries initiated a plan to change their names and as a result we recognized a non-cash loss on the write-off of trademarks of $2.6 million before tax. Prior to 2003, we amortized goodwill primarily over a period of forty years. Under the new accounting standards adopted in 2003, goodwill is not amortized and is evaluated annually for impairment. For the year ended December 31, 2004, 2003 and 2002, our amortization has been comprised of the following:
                           
Year ended December 31,            
(in thousands of U.S. dollars)   2004   2003   2002
             
Customer relationships
  $ 5,344     $ 3,040     $ 1,627  
Non-competition covenants
    176       168       44  
                   
 
Total
  $ 5,520     $ 3,208     $ 1,671  
                   
We estimate that our amortization charges for intangible assets from 2005 through 2009 for all acquisitions consummated through December 31, 2004 will be:
                                           
Year ended December 31,                    
(in thousands of U.S. dollars)   2005   2006   2007   2008   2009
                     
Customer relationships
  $ 7,388     $ 7,388     $ 7,388     $ 7,388     $ 7,388  
Non-competition covenants
    180       126       70       2       1  
                               
 
Total
  $ 7,568     $ 7,514     $ 7,458     $ 7,390     $ 7,389  
                               
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Related party transactions
We had transactions with, and recorded revenue from, the following related parties:
                         
Year ended December 31,            
(in thousands of U.S. dollars)   2004   2003   2002
             
Northbridge Financial Corporation
  $ 23,378     $ 18,504     $ 12,787  
Crum & Forster Holdings, Inc. 
    682       1,259       914  
Fairfax Inc. 
    3,638       8,411       6,278  
                   
      27,698       28,174       19,979  
Old Lyme Insurance Company, Ltd (“OLIC”)
    2,113              
                   
    $ 29,811     $ 28,174     $ 19,979  
                   
As of December 31, 2004 and 2003, we had accounts receivable and accounts payable balances with the above related parties in the amounts of $4.6 million and $17.8 million for 2004, respectively, and $3.2 million and $18.0 million for 2003, respectively. All revenue and related accounts receivable and accounts payable are the result of transactions in the normal course of business. The companies listed above except for OLIC, are related through common ownership by Fairfax Financial Holdings Limited (Fairfax), which owns approximately 26% of our common shares as of December 31, 2004. During the second quarter of 2004, Fairfax sold OLIC to Old Lyme Insurance Group, Ltd, a company owned primarily by a group of Hub employees, including Bruce Guthart, our Chief Operating Officer and a director of Hub, and Michael Sabanos, Chief Financial Officer of HUB Northeast. We continue to place insurance with OLIC. The compensation that Hub earns from the business placed with OLIC and the fees it earns from managing OLIC are substantially the same as if Fairfax continued to own the company.
As of December 31, 2004 and December 31, 2003, subordinated convertible debentures of $35 million were held by certain subsidiaries of Fairfax.
During 2004, 2003 and 2002, we incurred expenses related to rental of premises from related parties in the amount of $2.4 million, $2.1 million and $1.7 million respectively. At December 31, 2004 and 2003, we also had accounts receivable due from related parties in the amount of $2.6 million and $3.5 million respectively, of which the majority were loans to employees to enable them to purchase our common shares. Of these accounts receivable, as of December 31, 2004 and 2003, $1.8 million and $1.9 million respectively, were related to Company loans to employees to purchase shares under our executive share purchase plan. As collateral, the employees have pledged 143,000 and 153,000 common shares as of December 31, 2004 and 2003, respectively, which have a market value of $2.6 million for both December 31, 2004 and 2003, respectively.
Off-Balance Sheet Transactions
Under Canadian GAAP, we use the synthetic instruments method to account for the interest rate swap transaction — which converted fixed rate interest payments of 5.71% and 6.16% on the senior notes of $10 million and $55 million, respectively to a floating rate of approximately 2.00% and 2.40% for 2004 and 2003, respectively. Under this method, we report in earnings the net interest expense on the swap and associated debt as if it were a single, synthetic, financial instrument. The fair value of the swap, estimated at $2.4 million is not recognized in our Canadian GAAP financial statements. Under U.S. GAAP, we have designated the swap transaction as a hedge of changes in the fair value of our fixed rate debt caused by changes in interest rates and record the swap on our U.S. GAAP balance sheet at its fair value. Changes in the fair value of the swap are reported in earnings. Changes in the fair value of the debt being hedged which are attributable to changes in interest rates are recognized in earnings by adjustment of the carrying amount of the debt. We have no other material off-balance sheet arrangements.
Critical Accounting Policies and Estimates
Our significant accounting polices are more fully described in Note 2 to our audited consolidated financial statements. Certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and require the application of significant judgment by our management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, our management uses its judgment to
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determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical experience, terms of existing contracts and policies, our observance of trends in the insurance industry, information provided by our clients and information provided by outside sources, as appropriate. Our critical accounting policies include the recognition of commission income, the allocation of the purchase price of an acquisition, the measurement of goodwill and other intangibles and related impairment evaluation, and the valuation of stock-based compensation. These policies are discussed below.
Recognition of Commission Income
We recognize commission income and fees as of the effective date of our client’s policy unless information is not available relating to the determination of their policy premiums, in which case we recognize commission income and fees related to that policy when that information becomes available and the revenue can be reasonably determined. We maintain an allowance for estimated policy cancellations and commission returns based upon the application of historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The allowance for estimated policy cancellations is based on our management’s judgment, and is regularly evaluated by management by taking into consideration factors such as changes in the nature and volume of policies; trends in actual and forecasted policy cancellations; and current economic conditions that may affect the likelihood of client policy changes or cancellations. If our actual policy cancellation rates are significantly different from our historical policy cancellation rates, and those changes have not been adjusted for in the allowance, our actual commission income may be significantly different from what we estimated.
Allocation of the Purchase Price of an Acquisition
The acquisition of new brokerages is a fundamental component of our strategy. When we acquire a business, the cost of the purchase is allocated to all of the assets acquired and liabilities assumed based on their fair values. Any excess of the cost of purchase over the net of the allocated amounts is recognized as goodwill. For significant acquisitions, we engage qualified third party valuators to assist us in conducting asset valuations.
The fair value of assets, including intangible assets, and liabilities may be determined using a number of valuation methods including net realizable values, market prices and discounted cash flows. The use of assumptions and estimates is inherent in each of these valuation methods. Valuation methods and their underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates, or assumptions could produce different allocations of the purchase price and, as a result, different results of operations.
For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, we account for such payment as an expense. Where such compensation is stock based, our accounting policy for stock based compensation is followed. The fair value of such compensation is a significant estimate. The use of different estimates could produce results that are significantly different than our results of operations.
Goodwill and Other Intangible Assets
Intangible assets primarily represent goodwill, associated with our acquisitions. Goodwill represents the excess of the cost of purchase of acquired businesses over the fair market value of their identifiable net assets.
We do not amortize goodwill and intangible assets with indefinite useful lives. We do, however, test these assets at least annually for impairment at the reporting unit level. We determine impairment by comparing the fair value of a reporting unit to its carrying value. The fair value of a reporting unit may be determined using a number of market valuation methods including quoted market prices, discounted cash flows and net realizable values. The use of assumptions and estimates is inherent in each of these valuation techniques. The valuation method and the underlying assumptions and estimates are based on management’s judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests and, as a result, significantly different results of operations.
The cost of definite lived intangible assets is amortized over the estimated remaining useful life of the assets. We regularly evaluate whether events or changes in circumstances indicate that the carrying amount of intangibles, other
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than goodwill and intangible assets with indefinite useful lives, may warrant revision or may not be recoverable. The estimation of the useful economic lives and the selection of estimates and assumptions used in conducting impairment tests require the exercise of judgment. The use of different judgments, estimates and assumptions could produce different results in the application of the impairment tests of the assets and, as a result, significantly different results of operations.
Stock based compensation
Stock based compensation includes both stock options, restricted shares and restricted share units. Our accounting policy is to recognize the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
We measure the fair value of stock options at the date of grant of the award and recognize this amount as compensation expense over the vesting period of the options.
We estimate the fair value of the stock options granted using the Black-Scholes valuation model, which requires us to make assumptions in relation to the expected term of the stock option, volatility in the price of the underlying common shares, interest rates and dividend yield. The fair value model is particularly sensitive to the changes in the price and price volatility of our common shares. The assumptions used are based on our management’s judgment and the use of different judgments, estimates, and assumptions could produce significantly different results of fair value of the stock options and, as a result, significantly different results of operations.
Effects of recent accounting pronouncements
The Canadian Accounting Standards Board has issued two new accounting standards that will affect the Company in 2007. These new standards align Canadian GAAP to U.S. GAAP. Accordingly, information currently presented in our “Reconciliation to U.S. GAAP” note will be incorporated into our financial statements and these GAAP differences will be eliminated.
Financial Instruments — Recognition and Measurement
New Section 3855 will affect our reporting of our interest rate swap whereby the swap will be recorded on our balance sheet at its fair value. Currently, the fair value of the swap is not recognized on our balance sheet.
Comprehensive Income
New Section 1530 establishes standards for the reporting and display of comprehensive income. Unrealized gains and losses on debt and equity securities as well as foreign currency translation adjustments will be included in comprehensive income. Currently, we do not record these unrealized gains and losses and foreign currency translation adjustments are recorded in equity through the cumulative translation account.
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risk”.
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Item 8.    Financial Statements and Supplementary Data
Index to consolidated financial statements
         
    Page
     
    44  
    45  
    46  
    47  
    48  
    49  
    50  
Index to notes to consolidated financial statements
                 
Footnote   Description   Page
         
   1     Nature of operations and recent significant transactions     50  
   2     Summary of significant accounting policies     51  
   3     Commitments and contingencies     53  
   4     Acquisitions     55  
   5     Accounts and other receivables     59  
   6     Intangible assets     59  
   7     Property and equipment     61  
   8     Accounts payable and accrued liabilities     61  
   9     Debt     61  
  10     Defined Contribution Plan     63  
  11     Shareholders’ equity     63  
  12     Equity Incentive Plan     65  
  13     Earnings per share     67  
  14     Fair value of financial instruments     67  
  15     Income taxes     67  
  16     Interest and income taxes paid     69  
  17     Segmented information     69  
  18     Related party transactions     71  
  19     Reconciliation to U.S. GAAP     71  
  20     Quarterly data     76  
  21     Subsequent events     76  
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Report of Independent Registered Public Accounting Firm to the Board of Directors and Shareholders of Hub International Limited:
We have audited the accompanying consolidated balance sheets of Hub International Limited (the “Company”) as at December 31, 2004 and 2003 and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three-year period ended December 31, 2004. We have also audited the effectiveness of the Company’s internal control over financial reporting as at December 31, 2004, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and management’s assessment thereof included in Management’s Annual Report on Internal Control over Financial Reporting appearing under Item 8. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
We conducted our audits of the Company’s financial statements in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. A financial statement audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We conducted our audit of the effectiveness of the Company’s internal control over financial reporting and management’s assessment thereof in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as at December 31, 2004 and 2003 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004 in accordance with Canadian generally accepted accounting principles. Also, in our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as at December 31, 2004 is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the COSO. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as at December 31, 2004 based on criteria established in Internal Control — Integrated Framework issued by the COSO.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
(-s- PricewaterhouseCoopers LLP)
Chicago, Illinois
March 7, 2005
Management’s Annual Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over Hub’s financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the U.S. Securities Exchange Act of 1934).
Management has used the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) to evaluate the effectiveness of Hub’s internal control over financial reporting.
Management has assessed the effectiveness of Hub’s internal control over financial reporting as at December 31, 2004, and has concluded that such internal control over financial reporting was effective. Based on management’s assessment, there were no material weaknesses in Hub’s internal control over financial reporting as at December 31, 2004.
PricewaterhouseCoopers LLP, who has audited the Company’s consolidated financial statements for the year ended December 31, 2004, has also audited management’s assessment of the effectiveness of Hub’s internal control over financial reporting as at December 31, 2004 as stated in their report which appears in Item 8 of this Annual Report on Form 10-K.
     
-s- Martin P. Hughes
  -s- Dennis J. Pauls
Martin P. Hughes
  Dennis J. Pauls
Chairman and Chief Executive Officer
  Vice President and Chief Financial Officer
March 7, 2005
  March 7, 2005
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    45 


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Hub International Limited
Consolidated Balance Sheets
As of December 31,
(in thousands of U.S. dollars)
                 
    2004   2003
         
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 98,204     $ 82,052  
Trust cash
    71,718       54,534  
Accounts and other receivables
    162,841       163,728  
Income taxes receivable
    6,208       6,768  
Future income taxes
    3,901       2,776  
Prepaid expenses
    5,835       4,449  
             
Total current assets
    348,707       314,307  
Goodwill
    376,676       305,862  
Other intangible assets
    88,842       42,903  
Property and equipment
    27,907       24,181  
Future income taxes
    4,368       5,232  
Other assets
    11,035       6,803  
             
Total assets
  $ 857,535     $ 699,288  
             
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable and accrued liabilities
  $ 271,843     $ 226,168  
Income taxes payable
    2,273       3,804  
Future income taxes
    34       24  
Current portion long-term debt and capital leases
    5,195       3,362  
             
Total current liabilities
    279,345       233,358  
Long-term debt and capital leases
    146,602       75,437  
Subordinated convertible debentures
    35,000       35,000  
Future income taxes
    14,805       12,703  
             
Total liabilities
    475,752       356,498  
             
Commitments and Contingencies
               
Shareholders’ equity
               
Share capital
    259,617       254,845  
Issuable shares
          721  
Contributed surplus
    12,681       4,806  
Cumulative translation account
    26,983       20,062  
Retained earnings
    82,502       62,356  
             
Total shareholders’ equity
    381,783       342,790  
             
Total liabilities and shareholders’ equity
  $ 857,535     $ 699,288  
             
(the accompanying notes form an integral part of the financial statements)
  46   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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Hub International Limited
Consolidated Statements of Earnings
For the Years Ended December 31,
(in thousands of U.S. dollars, except per share amounts)
                           
    2004   2003   2002
             
Revenue
                       
 
Commission income
  $ 328,961     $ 259,461     $ 200,976  
 
Contingent commissions and volume overrides
    21,705       18,530       11,464  
 
Other
    10,184       8,368       7,520  
                   
      360,850       286,359       219,960  
                   
Expenses
                       
 
Cash compensation
    199,520       156,320       118,667  
 
Selling, occupancy and administration
    73,199       56,606       44,932  
 
Depreciation
    7,266       6,244       5,492  
 
Interest expense
    7,470       5,191       7,317  
 
Intangible asset amortization
    5,520       3,208       1,671  
 
Non-cash stock based compensation
    20,890       4,801       1,089  
 
Loss on write-off of trademarks
    2,587              
 
Gain on disposal of subsidiaries, property, equipment and other assets
    (1,880 )     (202 )     (2,679 )
 
Gain on put option liability
          (160 )     (186 )
 
Proceeds from life insurance
          (1,000 )      
                   
      314,572       231,008       176,303  
                   
Net earnings before income taxes
    46,278       55,351       43,657  
                   
Provision for income tax expense
                       
 
Current
    19,904       16,922       12,851  
 
Future
    130       1,920       1,405  
                   
      20,034       18,842       14,256  
                   
Net earnings
  $ 26,244     $ 36,509     $ 29,401  
                   
Earnings per share
                       
 
Basic
    $0.87       $1.22       $1.27  
 
Diluted
    $0.80       $1.14       $1.06  
Weighted average shares outstanding — Basic (000’s)
    30,246       29,967       23,181  
Weighted average shares outstanding — Diluted (000’s)
    35,305       33,767       30,199  
(the accompanying notes form an integral part of the financial statements)
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    47 


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Hub International Limited
Consolidated Statements of Retained Earnings
For the Years Ended December 31,
(in thousands of U.S. dollars)
                         
    2004   2003   2002
             
Retained earnings — Beginning of year
  $ 62,356     $ 31,915     $ 6,995  
Net earnings
    26,244       36,509       29,401  
Dividends
    (6,098 )     (6,068 )     (4,481 )
                   
Retained earnings — End of year
  $ 82,502     $ 62,356     $ 31,915  
                   
(the accompanying notes form an integral part of the financial statements)
  48   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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Hub International Limited
Consolidated Statements of Cash Flows
For the Years Ended December 31,
(in thousands of U.S. dollars)
                           
    2004   2003   2002
             
OPERATING ACTIVITIES
                       
Net earnings
  $ 26,244     $ 36,509     $ 29,401  
Items not affecting working capital
                       
 
Amortization and depreciation
    12,786       9,452       7,163  
 
Gain on disposal of subsidiaries, property, equipment and other assets
    (1,880 )     (202 )     (2,679 )
 
Non-cash stock based compensation
    20,890       4,801       1,089  
 
Loss on write-off of trademarks
    2,587              
 
Gain on put option liability
          (160 )     (186 )
 
Future income taxes
    130       1,920       1,405  
Non-cash working capital items
                       
 
Trust cash
    (3,351 )     (886 )     (3,222 )
 
Accounts and other receivables
    15,672       (4,067 )     (26,665 )
 
Prepaid expenses
    (1,303 )     (2,616 )     1,287  
 
Accounts payable and accrued liabilities
    (12,285 )     13,431       11,673  
 
Other assets
    512       (2,062 )      
 
Income taxes
    (2,646 )     (2,184 )     (202 )
                   
Net cash flows from operating activities
    57,356       53,936       19,064  
                   
INVESTING ACTIVITIES
                       
Property and equipment — purchases
    (7,293 )     (6,125 )     (4,469 )
Property and equipment — proceeds on sale
    159       69       6  
Purchase of subsidiaries, net of cash received
    (94,307 )     (14,881 )     (50,813 )
Sale of subsidiaries
    7,454       1,098       2,623  
Proceeds from investment held for sale
                43,521  
Other assets
    687       (307 )     684  
                   
Net cash flows used for investing activities
    (93,300 )     (20,146 )     (8,448 )
                   
FINANCING ACTIVITIES
                       
Long-term debt — advances
    65,000       65,000       51,175  
Long-term debt and capital leases — repayments
    (11,326 )     (54,540 )     (50,094 )
Proceeds from sale of executive purchase plan shares
    497       222        
Dividends paid
    (6,098 )     (6,068 )     (4,481 )
Share capital — issued for cash, net of issue costs
          (61 )     88,147  
Bank debt
                (55,000 )
Subordinated convertible debenture — repayment
                (26,800 )
                   
Net cash flows from financing activities
    48,073       4,553       2,947  
                   
Effect of exchange rate changes on cash and cash equivalents
    4,023       3,067       100  
                   
Change in cash and cash equivalents
    16,152       41,410       13,663  
Cash and cash equivalents — Beginning of year
    82,052       40,642       26,979  
                   
Cash and cash equivalents — End of year
  $ 98,204     $ 82,052     $ 40,642  
                   
(the accompanying notes form an integral part of the financial statements)
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    49 


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Hub International Limited
Notes to Consolidated Financial Statements
For the years ended December 31, 2004, 2003 and 2002
(In thousands of U.S. dollars, except per share amounts or as otherwise indicated)
1.  Nature of operations and recent significant transactions
Business operations
Hub International Limited (the “Company”) is an international insurance brokerage that provides a variety of property and casualty, life and health, employee benefits, investment and risk management products and services. The Company’s shares are listed on both the New York Stock Exchange (NYSE: HBG) and Toronto Stock Exchange (TSX: HBG).
Talbot
During 2004, the Company purchased Talbot Financial Corporation (“Talbot”) as described below, which was accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of Talbot are included in the Company’s consolidated results from the date of acquisition.
The Company purchased Talbot which is based in New Mexico on July 1, 2004, in accordance with the following terms: The Company purchased all of the common shares of Satellite Acquisition Corporation (“Satellite”), a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company will purchase special shares of Satellite owned by the management of Talbot, over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. For 2004 the Company recorded $14.4 million of non-cash stock based compensation relating to the Talbot acquisition with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004 the Company anticipates total earnout payments in the $45-$50 million range.
Bank Facility
On April 23, 2004 the Company renegotiated an existing unsecured loan facility increasing the funds available from $65 million to $75 million (see note 9). $65 million of this facility was drawn and used for the acquisition of Talbot.
Private Debt Offering
During the second quarter of 2003, the Company completed a private placement of $65 million unsecured senior notes (see note 9). Net proceeds on the sale of the notes were used to pay down $50 million of existing indebtedness and for general corporate purposes including acquisitions.
Initial U.S. Public Offering
In June 2002, the Company completed its initial U.S. public offering (“U.S. IPO”) of 6.9 million common shares at a price of $14 per share. The cash proceeds of the offering, net of issue costs of $8.5 million, were approximately $88.1 million of which approximately $86.0 million was used to repay bank debt, long-term debt and a convertible subordinated debenture during the second quarter of 2002.
Sale of Old Lyme
Effective June 28, 2001, the Company acquired Kaye Group Inc., now known as Hub International Group Northeast Inc., including its subsidiary Kaye Insurance Associates, Inc. now known as Hub International Northeast Limited (“HUB Northeast”). HUB Northeast, primarily an insurance broker, also underwrote insurance risks through its subsidiaries Old Lyme Insurance Company of Rhode Island Inc. and Old Lyme Insurance Company, Ltd. (collectively Old Lyme). The Company indicated prior to the effective date of the HUB Northeast acquisition that it intended to find a purchaser for the Old Lyme operations as soon as possible after closing.
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On May 30, 2002 the Company completed the sale of Old Lyme to Fairfax Inc, a related party, and recorded a non-taxable gain on the sale of $2.6 million. This gain increased 2002 annual basic earnings per share and diluted earnings per share by $0.11 and $0.09, respectively. Fairfax subsequently sold Old Lyme Insurance Company, Ltd. to a related party. See note 18 “Related Party Transactions.”
2.  Summary of significant accounting policies
These consolidated financial statements of the Company are expressed in United States (U.S.) dollars and have been prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP). These principles differ in certain respects from U.S. GAAP and to the extent that they affect the Company, the differences are described in note 19 “Reconciliation to U.S. GAAP.” The more significant of the accounting policies are as follows:
Basis of presentation
The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All material inter-company accounts and transactions have been eliminated. Certain reclassifications have been made to prior years’ financial statements to conform to the current year presentation.
Estimates and assumptions
Preparation of the financial statements in conformity with Canadian and U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and the reported amount of revenue and expense during the reporting period. The principal estimates used in the preparation of these financial statements are the determination of the provision for cancelled policies relating to revenue recognition, allowance for doubtful accounts, the allocation of the purchase price on acquisitions, the valuation of reporting units when testing the recoverability of goodwill and other intangible assets, the estimation of the useful lives of definite life intangible assets, and the measurement of non-cash stock based compensation. Actual results could differ from those estimated.
Foreign currency translation
The operations of the Company’s subsidiaries outside of the U.S. are self-sustaining. The assets and liabilities of these subsidiaries as at December 31, 2004 and 2003 were translated to U.S. dollars at the year-end exchange rate. Revenue and expenses for 2004, 2003 and 2002 were translated to U.S. dollars at the average exchange rate. Accordingly, the unrealized gains and losses which result from this translation are deferred and included in shareholders’ equity under the caption “Cumulative translation account.”
Revenue Recognition
Commission income and fees, (including commission income related to installment billing arrangements) are recognized as of the effective date of the policy unless information is not available relating to the determination of the client’s policy premiums, in which case commission income and fees related to that policy are recognized when that information becomes available and the revenue can be reasonably determined. Commission income is reported net of sub-broker commission expense. Commission and other adjustments are recorded when they occur and the Company maintains an allowance for estimated policy cancellations and commission returns by applying historical policy cancellation and commission return rates to the current year revenue, adjusted for any known deviations. The Company is entitled to contingent commissions and volume overrides from insurance companies which are recorded in the earlier of the period in which amounts can be reasonably estimated or the period in which the amounts are received. Amounts related to contingent commissions and volume overrides can be reasonably estimated when information pertaining to the calculation, such as premium volumes, loss ratios and expenses, can be obtained from the insurance companies. Other revenue primarily includes investment income, policy service fees and income earned related to the financing of client premiums. Investment income is recorded when earned. Policy service fees are recorded on the effective date of the policy, at which time the service has been provided. Income earned related to the financing of client premiums is recorded when known.
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Cash and cash equivalents
Cash and cash equivalents consist of cash, and highly-liquid investments having maturities of three months or less at the acquisition date.
Concentration of credit risk
The Company’s financial instruments that are exposed to concentration of credit risk consist primarily of cash and cash equivalents and accounts receivable. The Company maintains cash with banks in excess of federally insured limits and is exposed to the credit risk from this concentration of cash. The Company performs ongoing credit evaluations of its customers’ financial condition and generally requires no collateral. No single client accounted for more than ten percent of total client premiums or more than ten percent of revenue for the years ended December 31, 2004, 2003 and 2002, respectively.
In addition, the Company is also party to interest rate swap transactions which are subject to credit risk. Credit risk arises from the possibility that counterparties may default on their obligations to the Company. Derivative contracts generally expose the Company to credit loss if changes in market rates affect a counterparty’s position unfavorably and the counterparty defaults on payment.
Trust cash
Premiums collected (less commissions and other deductions), but not yet remitted to insurance companies, are included in trust cash. Trust cash is restricted as to use by contractual obligations and by laws in certain states and provinces in which the Company operates.
Property and equipment
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recorded based on the estimated useful economic lives of the related assets as follows: for computer equipment on a straight-line basis from 3 to 5 years or on a 30% declining balance method; for furniture, fixtures, and office equipment on a straight-line basis from 5 to 7 years or on a 20% declining balance method. Leasehold improvements are amortized on the straight-line method over the term of the related lease. Upon sale or retirement, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is reflected in earnings. If the carrying value of property and equipment is identified as impaired, it is written down to its fair value.
Business combinations
Acquisitions of subsidiaries have been accounted for using the purchase method, whereby the results of acquired companies are included only from the date of acquisition. Consideration which is contingent on maintaining or achieving specified earnings levels in future periods is recognized as an additional cost of the purchase when the contingency is resolved and the additional consideration is issued or becomes issuable. For acquisitions where part of the consideration paid has the character of compensation rather than purchase price, we account for such payment as an expense. Where such compensation is stock based, our accounting policy for stock based compensation is followed.
Goodwill and other intangible assets
Effective January 1, 2002, the Company adopted the Canadian Institute of Chartered Accountants (CICA) Accounting Standards Board Handbook Section 3062, “Goodwill and Other Intangible Assets” (Section 3062) without restatement of prior periods.
Goodwill and intangible assets with indefinite useful lives are not amortized but are subject to impairment tests on at least an annual basis. Goodwill is allocated to reporting units and any potential goodwill impairment is identified by comparing the carrying value of a reporting unit with its fair value. If any potential impairment is indicated, it is quantified by comparing the carrying value of goodwill to its fair value, based on the fair value of the assets and liabilities of the reporting unit.
The Company completed its impairment testing on the balance of goodwill and indefinite lived intangible assets as of January 1, 2005, 2004 and 2003. Based on the testing performed, no impairment losses were incurred.
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Intangible assets other than goodwill which do not have indefinite lives are amortized on a straight-line basis over their useful lives. These intangible assets are subject to an impairment test comparing carrying values to net recoverable amounts. If the carrying value of intangible assets is identified as impaired, it is written down to its fair value.
Interest rate swap
The Company accounts for interest rate swaps with respect to its long-term debt using the synthetic instruments method under which the net interest on the swap and associated debt is reported in earnings as if it were a single synthetic financial instrument. The fair value of the derivative is not recognized in the balance sheet.
Stock based compensation
The Company recognizes the fair value of stock based compensation as an expense over the period in which entitlement to the compensation vests.
Future income taxes
Income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities and their tax bases. Future income tax assets and liabilities are determined for each temporary difference based on the tax rates which are expected to be in effect when the asset or liability is settled. The benefit of loss carry forwards is recognized as an asset to the extent that it is more likely than not to be realized.
Put options
The fair value of put options issued by the Company as consideration for businesses acquired is classified as long-term debt until such time as the option is exercised or expires. Changes in the fair value of these options are recorded in earnings. As part of the negotiations of contingent consideration the former owners of certain companies acquired in 2001 agreed to relinquish their rights to put options on 730,000 common shares at December 31, 2003 and on 1,423,000 common shares at December 31, 2002. Accordingly at December 31, 2004 and 2003 no put options were outstanding on the Company’s common shares.
3.    Commitments and contingencies
(a) In April 2004, Hub International Northeast Limited (“HUB Northeast”), formerly known as Kaye Insurance Associates, Inc., a subsidiary of Hub, received a subpoena from the Office of the Attorney General of the State of New York seeking information regarding certain compensation agreements between insurance brokers and insurance companies. The New York Attorney General subpoenaed information on such compensation agreements from several other major insurance brokers and insurance companies as well. Such compensation agreements, also known as contingent agreements, between insurance companies and brokers are a long-standing and common practice within the insurance industry. HUB Northeast discloses such agreements on its invoices to clients and on its web site. In addition, the Company discloses the arrangements in public filings. In August 2004, HUB Northeast received a second subpoena from the Office of the Attorney General of the State of New York seeking information regarding all revenue that HUB Northeast may have derived from insurance companies. In September 2004, HUB Northeast received a third subpoena from the Office of the Attorney General of the State of New York seeking information regarding any “fictitious” and “inflated” insurance quotes to which HUB Northeast may have been a party.
  Promptly after HUB Northeast’s receipt of the first New York Attorney General’s subpoena, the Company retained external counsel to assist in responding to the New York Attorney General’s inquiries and, among other things, requested that such external counsel conduct a thorough investigation of HUB Northeast to determine whether any current or former employee engaged in the practice of falsifying or inflating insurance quotes. Such investigation of HUB Northeast is substantially complete. Subsequently, outside counsel’s investigation was expanded to other hubs, both for internal purposes and in the course of assisting it in responding to the inquiries of other regulatory authorities. To date, management is unaware of any incidents of falsifying or inflating insurance quotes. While it is not possible to predict the outcome of this investigation, if
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    53 


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  such compensation agreements were to be restricted or no longer permitted, the Company’s financial condition, results of operations and liquidity may be materially adversely affected.
 
  From August 2004 through February 2005, various other subsidiaries of the Company received and responded to letters of inquiry and subpoenas from authorities in Connecticut, Texas, Illinois, Delaware, Pennsylvania, New Hampshire and Quebec.
 
  In October 2004, the Company was joined as a defendant in a class action lawsuit (the “Opticare case”) against 30 different insurance brokers and insurance companies. The lawsuit was originally filed in August 2004 in the U.S. District Court for the Southern District of New York by OptiCare Health Systems Inc., a client of a Marsh & McLennan subsidiary. It now names the ten largest U.S. insurance brokers and four of the largest commercial insurers. The amended complaint alleges that the defendants used the contingent commission structure of placement service agreements in a conspiracy to deprive policyholders of “independent and unbiased brokerage services, as well as free and open competition in the market for insurance.” In December, 2004, the Company was also named as one of multiple defendants in two identical class actions filed in Federal District Court in Illinois, with allegations substantially similar to those in the Opticare case. None of the complaints contain any specific factual allegations against the Company. The Company disputes the allegations of these complaints and intends to vigorously defend against the suits. However, a finding that the contingent commission structure conflicts with an insurance broker’s duty to its clients as well as the cost of defending against the lawsuit and the diversion of management’s attention could have a material adverse effect on the Company’s financial condition, results of operations and liquidity. See note 21 “Subsequent events”
 
  The Company has not recorded a liability at December 31, 2004 related to these matters.
(b) In connection with the acquisition of Talbot on July 1, 2004, the Company will purchase special shares of Satellite owned by the management of Talbot over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. During 2004, the Company recorded $14.4 million of non-cash stock based compensation with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004, management estimates the Company may be obligated to pay contingent payments of approximately $30-$35 million in common shares of the Company in addition to the $14.4 million of amounts accrued to date mentioned above.
  In connection with the acquisition of Hooper Hayes and Associates, Inc., now known as Hub International California, Inc., in 2002 the Company issued 196,000 shares (the “Retractable Shares”) that were deposited in escrow subject to release over a period of three years upon the satisfaction of certain performance targets. As of December 31, 2004, 126,000 shares have been released from escrow.
 
  In connection with other various acquisitions completed through December 31, 2004, the Company may be obligated to pay contingent consideration up to a maximum sum of approximately $12.4 million in cash and $3.6 million in common shares of the Company based upon the acquired brokerages achieving certain targets. The contingent payments are payable on various dates through August, 2007 according to the terms and conditions of each purchase agreement. Any additional consideration will be recorded as an adjustment to goodwill once the contingency is resolved. In connection with contingent consideration earned as at December 31, 2004, the financial statements reflect a liability to pay cash of $0.2 million.
(c) In connection with the Company’s executive share purchase plan, under certain circumstances, the Company may be obligated to purchase loans for officers, directors and employees from a Canadian chartered bank totaling $4,287 and $4,513 as of December 31, 2004 and 2003 respectively, to assist in purchasing common shares of the Company. The Company no longer makes loans to its executive officers and directors. As collateral, the employees have pledged 431,000 and 478,000 common shares as of December 31, 2004 and 2003, respectively, which have a market value of $7,885 and $8,105 as of December 31, 2004 and 2003,
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respectively. Interest on the loans in the amount of $192, $279 and $264 for the years ended December 31, 2004, 2003 and 2002, respectively, was paid by the Company and is included in cash compensation expense.
 
(d) The Company is committed under lease agreements for office premises and computer equipment. At December 31, 2004, aggregate minimum rental commitments (net of expected sub-lease receipts) under operating leases are as follows:
         
2005
  $ 15,680  
2006
    14,257  
2007
    11,922  
2008
    10,322  
2009
    9,216  
2010 and thereafter
    15,068  
       
    $ 76,465  
       
  Rent expense for the year ended December 31, 2004, 2003, and 2002 amounted to $14,242, $11,503 and $9,684, respectively, net of sublease rental income of $1,536, $1,282 and $737, respectively.
(e) In the ordinary course of business, the Company and its subsidiaries are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on the consolidated financial position or results of operations of the Company.
4.  Acquisitions and dispositions
The Company’s strategic business plan includes the regular and systematic evaluation and acquisition of insurance brokerages in new and existing markets. Insurance brokerages, due to their nature, typically maintain a very low capital to earnings ratio. As a result, the Company records a substantial amount of goodwill and other intangible assets in connection with acquisitions.
The Company typically pays a portion of the consideration for an acquired brokerage in cash. Consideration for the remainder of the purchase price is normally in the form of the Company’s common shares based on the fair market value of the Company’s common shares as traded on the NYSE or TSX, and is defined and calculated pursuant to the acquisition agreement.
(a) During 2004, the Company purchased Talbot, (as described below), all of the issued and outstanding membership interests of Bush, Cotton and Scott, LLC. located in the State of Washington, as well as the assets of five other insurance brokerages, all of which were accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
  The Company purchased Talbot which is based in New Mexico on July 1, 2004, in accordance with the following terms: The Company purchased all of the common shares of Satellite, a corporation formed by senior management at Talbot. In turn, Satellite purchased 100% of Talbot from Safeco Corporation. The Company will purchase special shares of Satellite owned by the management of Talbot over the next three years, using a combination of both restricted and unrestricted common shares of the Company. Payments will be made on September 1, 2005, March 31, 2006 and March 31, 2007 based upon Talbot’s earnings for the 12 month periods ending December 31, 2004, 2005 and 2006, respectively. The contingent payment to Talbot management will be recorded by the Company as a charge to earnings in the form of non-cash stock based compensation expense over the period in which the payments are earned. For 2004 the Company recorded $14,388 of non-cash stock based compensation relating to the Talbot acquisition with an offsetting credit to accounts payable and accrued liabilities for the same amount. Based on Talbot’s financial performance for 2004 the Company anticipates total earnout payments in the $45-$50 million range.
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    55 


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The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2004 are summarized below:
                                 
        Bush, Cotton        
    Talbot   & Scott   Other   Total
                 
    July 1, 2004   April 1, 2004   Various    
Acquisition Date
                               
Current assets
  $ 49,639     $ 4,702     $ 358     $ 54,699  
Current liabilities
    (41,261 )     (4,803 )     (146 )     (46,210 )
Property, equipment and other assets
    8,316       96       95       8,507  
Long-term debt and capital leases
    (16,129 )     (2,826 )           (18,955 )
                         
Net assets (liabilities) at fair value
  $ 565     $ (2,831 )   $ 307     $ (1,959 )
                         
Consideration
                               
Cash
  $ 93,946     $ 11,966     $ 10,798     $ 116,710  
Payable
                1,447       1,447  
Common shares (at market value)
          2,800       533       3,333  
                         
    $ 93,946     $ 14,766     $ 12,778     $ 121,490  
                         
Goodwill
  $ 48,649     $ 9,932     $ 10,722     $ 69,303  
Customer relationships
    44,163       6,891       1,641       52,695  
Non-competition covenants
    569       774       108       1,451  
                         
    $ 93,381     $ 17,597     $ 12,471     $ 123,449  
                         
Number of shares issued as consideration (000’s)
          152       29       181  
                         
Of the goodwill acquired $67,792 is deductible for tax purposes. Goodwill included under “Other” above, in the amount of $3,051 is associated with contingent consideration relating to prior period acquisitions.
During 2004, the Company sold assets and shares of certain insurance brokerages for $9,166 resulting in a gain of $2,086. Annual revenue for 2003 of these brokerages was approximately $7,400.
(b) During 2003, the Company acquired nine brokerages, all of which were accounted for using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
  56   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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The allocation of the purchase price, including goodwill and other identifiable assets, and the cost of the acquired brokerages in 2003 are summarized below:
         
    Total
     
    Various
Acquisition Date
       
Current assets
  $ 4,298  
Current liabilities
    (3,726 )
Property, equipment and other assets
    24  
       
Net assets at fair value
  $ 596  
       
Consideration
       
Cash
  $ 8,136  
Common shares (at market value)
    538  
       
    $ 8,674  
       
Goodwill
  $ 6,389  
Customer relationships
    1,352  
Non-competition covenants
    337  
       
    $ 8,078  
       
Number of shares issued as consideration (000’s)
    32  
       
Of the goodwill acquired $1,367 is deductible for tax purposes. In addition, the Company also recognized $1,800 of goodwill associated with contingent consideration relating to prior year acquisitions.
As part of the negotiations of the contingent consideration for J.P. Flanagan Corporation (“Flanagan”), a brokerage purchased in 2001, total additional consideration of 37,500 of the Company’s common shares were earned at December 31, 2003 valued at approximately $635, based on the closing price of the shares at December 31, 2003 on the NYSE. The common shares were recorded as “issuable shares” and included in shareholders’ equity and goodwill has been increased by the same amount at December 31, 2003. Also as part of the negotiations the former owner agreed to relinquish his rights to put options on the 730,000 shares previously issued as well as on shares issued as contingent consideration. In addition the Company issued non-cash stock based compensation in the form of 84,375 restricted share units in 2004 valued at $1.4 million. 69,375 of these restricted share units have been canceled. 15,000 remain outstanding, vesting 50% January 1, 2008 and 50% January 1, 2010.
(c) During 2002, the Company purchased all of the issued and outstanding shares of Hooper Hayes & Associates, Inc., now known as Hub International of California Inc., and Fifth Third Insurance Services, Inc. which was renamed Hub International of Indiana Limited (HUB Midwest), as well as outstanding shares or net assets of 6 other brokerages, all of which were acquired using the purchase method of accounting.
  In accordance with the purchase agreement dated July 1, 2001, the former owners of Burnham Stewart Group, Inc. (“Burnham”), now known as HUB Midwest were entitled to additional consideration based upon certain acquired operations of Burnham achieving 2002 profitability targets. The additional consideration to be issued was a multiple of the final adjusted profitability as of December 31, 2002 for those operations. The total additional consideration was $22,166 of which $8,423 was cash and the remainder of $13,743 in 1,228 common shares of the Company. The Company issued the common shares in March 2003. As of December 31, 2002, the Company had accrued the cash portion of the contingent consideration and the share portion of the contingent consideration had been recorded as “issuable shares” and included in shareholders’ equity. As part of the negotiations of the contingent consideration, the former owners of Burnham agreed to relinquish their rights to put options on all of the 1,423 common shares issued as part of the 2002 acquisition, as well as on shares issued as contingent consideration in exchange for release from escrow provisions on those same common shares. The total additional consideration of $22,794 is shown as an addition to goodwill and customer relationships in the table below.
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    57 


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The allocation of the purchase price, including goodwill and other identifiable intangible assets, and the cost of the acquired brokerages in 2002 are summarized as follows:
                                         
            Burnham        
    Hooper       Contingent        
    Hayes   Hub Indiana   Consideration   Other   Total
                     
    Nov. 1, 2002   Dec. 31, 2002   Dec. 31, 2002   Various    
Acquisition Date
                                       
Working capital
  $ (1,141 )   $ (289 )   $ (628 )   $ 1,180     $ (878 )
Property, equipment and other assets
    69       1,312             108       1,489  
                               
Net assets (liabilities) at fair value
  $ (1,072 )   $ 1,023     $ (628 )   $ 1,288     $ 611  
                               
Consideration
                                       
Cash
  $ 1,514     $ 37,250     $     $ 12,899     $ 51,663  
Debt
          122       8,423       2,365       10,910  
Contingently issuable shares
                13,743             13,743  
Common shares (at market value)
    7,115                   344       7,459  
                               
    $ 8,629     $ 37,372     $ 22,166     $ 15,608     $ 83,775  
                               
Goodwill
  $ 6,209     $ 24,622     $ 21,096     $ 10,704     $ 62,631  
Customer relationships
    3,265       11,727       1,698       3,384       20,074  
Non-competition covenants
    227                   232       459  
                               
    $ 9,701     $ 36,349     $ 22,794     $ 14,320     $ 83,164  
                               
Number of shares issued as consideration (000’s)
    449                   24       473  
                               
Number of shares issued as contingently issuable consideration (000’s)
                1,228             1,228  
                               
Of the goodwill acquired, $30,522 is deductible for tax purposes.
Contingent consideration
In addition to the consideration shown above, the previous owners of certain acquisitions are entitled to contingent consideration if certain revenue or profitability targets are met. See note 3 “Commitments and contingencies.”
  58   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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5.    Accounts and other receivables
Accounts and other receivables consist of the following:
                 
    December 31,
     
    2004   2003
         
Client premiums receivable
  $ 128,345     $ 138,494  
Commissions receivable
    31,565       22,228  
Less: Allowance for doubtful accounts
    (1,436 )     (1,086 )
Less: Allowance for policy cancellations
    (1,876 )     (1,343 )
             
      156,598       158,293  
Other receivables
    6,243       5,435  
             
    $ 162,841     $ 163,728  
             
Allowance for doubtful accounts:
                         
    2004   2003   2002
             
Balance, January 1
  $ 1,086     $ 714     $ 815  
Charged to net earnings before income taxes
    664       1,057       233  
Deductions of amounts previously charged to the provision
    (1,251 )     (810 )     (335 )
Acquired through acquisitions
    937       125       1  
                   
Balance, December 31
  $ 1,436     $ 1,086     $ 714  
                   
Losses relating to the non-collection of client premium receivables, may be mitigated by cancellation of the underlying insurance policy.
6.    Intangible assets
As of December 31, 2004 and 2003 the gross carrying amount and accumulated amortization of intangible assets other than goodwill were as follows:
                                                   
    As of December 31, 2004   As of December 31, 2003
         
    Gross       Gross    
    Carrying   Accumulated       Carrying   Accumulated    
    Amount   Amortization   Total   Amount   Amortization   Total
                         
Definite life intangible assets:
                                               
 
Customer relationships
  $ 95,982     $ 10,802     $ 85,180     $ 43,422     $ 5,480     $ 37,942  
 
Non-competition covenants
    791       448       343       476       269       207  
 
Trademarks
                      2,587             2,587  
                                     
      96,773       11,250       85,523       46,485       5,749       40,736  
                                     
Indefinite life intangible assets:
                                               
 
Non-competition covenants
    3,319             3,319       2,167             2,167  
                                     
Total
  $ 100,092     $ 11,250     $ 88,842     $ 48,652     $ 5,749     $ 42,903  
                                     
During the first quarter 2004 the Company adopted a strategic plan to make use of the “Hub” brand throughout the Company. Certain of the Company’s subsidiaries have decided to change their names and as a result the Company
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    59 


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recognized a non-cash loss on the write-off of trademarks during the first quarter 2004 of $2,587, before income taxes.
Additions during 2004 and 2003 were as follows:
                   
    2004   2003
         
Definite life intangible assets:
               
 
Customer relationships
  $ 52,695     $ 1,602  
 
Non-competition covenants
          206  
             
      52,695       1,808  
Indefinite life intangible assets:
               
 
Non-competition covenants
    1,451       136  
             
Total
  $ 54,146     $ 1,944  
             
The Company is unable to estimate the useful life of certain non-competition covenants. These indefinite life intangible assets will be reviewed annually for impairment. Once a non-competition covenant is triggered, following the employee leaving the Company, the Company’s policy is to amortize the related intangible asset over the period of the remaining contractual obligation.
The changes in the carrying amount of goodwill for the years ended December 31, 2004 and 2003, are as follows:
                         
    Operations   Operations    
    in Canada   in U.S.   Total
             
Balance as of December 31, 2002
  $ 75,386     $ 206,326     $ 281,712  
Goodwill acquired during 2003
    535       7,654       8,189  
Goodwill disposed during 2003
    (478 )     (197 )     (675 )
Cumulative translation adjustment
    16,636             16,636  
                   
Balance as of December 31, 2003
    92,079       213,783       305,862  
Goodwill acquired during 2004
    1,005       68,298       69,303  
Goodwill disposed during 2004
    (4,604 )     (727 )     (5,331 )
Cumulative translation adjustment
    6,842             6,842  
                   
Balance as of December 31, 2004
  $ 95,322     $ 281,354     $ 376,676  
                   
For the years ended December 31, 2004, 2003 and 2002, amortization has been comprised of the following:
                         
    2004   2003   2002
             
Customer relationships
  $ 5,344     $ 3,040     $ 1,627  
Non-competition covenants
    176       168       44  
                   
Total
  $ 5,520     $ 3,208     $ 1,671  
                   
The Company estimates the amortization charges for 2005 through 2009 for all acquisitions consummated through December 31, 2004 will be:
                                         
Year ended December 31,   2005   2006   2007   2008   2009
                     
Customer relationships
  $ 7,388     $ 7,388     $ 7,388     $ 7,388     $ 7,388  
Non-competition covenants
    180       126       70       2       1  
                               
Total
  $ 7,568     $ 7,514     $ 7,458     $ 7,390     $ 7,389  
                               
  60   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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7.    Property and equipment
                                                 
    2004   2003
         
        Accumulated   Net Book       Accumulated   Net Book
    Cost   Depreciation   Value   Cost   Depreciation   Value
                         
Leasehold improvements
  $ 12,496     $ 4,937     $ 7,559     $ 10,522     $ 3,419     $ 7,103  
Office equipment
    18,959       10,268       8,691       15,416       8,357       7,059  
Computer equipment
    29,250       17,593       11,657       24,998       14,979       10,019  
                                     
    $ 60,705     $ 32,798     $ 27,907     $ 50,936     $ 26,755     $ 24,181  
                                     
Included in computer equipment is computer software with a net book value of $6,331 and $5,137 at December 31, 2004 and 2003, respectively. Depreciation expense of $1,906, $1,538 and $1,087 was charged against these assets for the years ended December 31, 2004, 2003 and 2002, respectively.
During 2004 and 2003, property and equipment were acquired at an aggregate cost of $7,293 and $8,272, respectively, of which $NIL and $2,147, respectively, were acquired by means of capital leases and other financing.
The cost above reflects certain property and equipment held under capital leases of which the remaining liability at December 31, 2004 and 2003 was $468 and $650, respectively.
8.    Accounts payable and accrued liabilities
Accounts payable and accrued liabilities consist of the following:
                 
    December 31,
     
    2004   2003
         
Insurance premiums payable
  $ 198,901     $ 176,211  
Other accounts payable and accrued liabilities
    58,554       49,957  
Stock based compensation related to Talbot acquisition
    14,388        
             
    $ 271,843     $ 226,168  
             
9.    Debt
                 
    December 31,
     
    2004   2003
         
Series A Senior Notes, with interest at 5.71%(1)
  $ 10,000     $ 10,000  
Series B Senior Notes, with interest at 6.16%(1)
    55,000       55,000  
Revolving U.S. Dollar LIBOR loan(2)
    65,000        
Term loan, interest only at 10%, due February 2007(3)
    7,500       7,500  
Term loan, variable interest, due December 2007
    3,500        
Various other unsecured notes payable and debt(4)
    10,329       5,649  
Capital leases(4)
    468       650  
             
Long-term debt and capital leases
    151,797       78,799  
Less current portion
    (5,195 )     (3,362 )
             
    $ 146,602     $ 75,437  
             
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    61 


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Future repayments of long-term debt and capital leases are as follows:
         
For the Year Ending December 31,
       
2005
  $ 5,195  
2006
    4,479  
2007
    10,605  
2008
    69,426  
2009
    14,759  
2010 and thereafter
    47,333  
       
    $ 151,797  
       
 
(1)  Senior Notes — As at December 31, 2004 the Company has outstanding $65 million aggregate principal amount of unsecured senior notes issued June 10, 2002. The senior notes were issued in two series: Series A represents $10 million aggregate principal amount of 5.71% senior notes with interest due semi-annually, and principal of $3,333 due annually, June 15, 2008 through June 15, 2010 and Series B represents $55 million aggregate principal amount of 6.16% senior notes with interest due semi-annually, and principal of $11,000 due annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of the Company’s revolving U.S. Dollar LIBOR Loan with the balance for general corporate purposes and acquisitions. The Company incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2004, $65 million was outstanding under these senior notes, and the Company was in compliance with all financial covenants.
 
  On July 15, 2003, the Company entered into an interest rate swap agreement. The effect of the swap is to convert the fixed rate interest payments on the 5.71% senior notes and 6.16% senior notes in amounts of $10 million and $55 million, respectively, to a floating rate of approximately 2.00% and 2.40% for 2004 and 2003, respectively. The Company accounts for the swap transaction using the synthetic instruments method under which the net interest expense on the swap and associated debt is reported in earnings as if it were a single, synthetic, financial instrument. As at December 31, 2004, the Company estimated the fair value of the swap to be $2.4 million, which is not recognized in these financial statements. Accordingly, $2.4 million is the estimated amount that the Company would need to pay to terminate the swap as of December 31, 2004.
 
(2)  Revolving U.S. dollar LIBOR loan — This unsecured facility totals $75 million, bears interest at a floating rate of prime plus 1% or 112.5 basis points above LIBOR. LIBOR was 2.40% and 1.12% at December 31, 2004 and 2003, respectively. The facility is available on a revolving basis for one year and expires on April 22, 2005. However, if the revolving period is not extended, the Company may convert the outstanding balance under the facility to a three year non- revolving term loan repayable at the end of three years with an interest rate of 137.5 basis points above the Canadian dollar interest swap rate. An annual commitment fee of 20 basis points is assessed on the unused balance. Borrowings under this facility totaled $65 million and $NIL at December 31, 2004 and 2003, respectively. As of December 31, 2004, the Company was in compliance with all financial covenants governing this facility.
 
(3)  This term loan is from an insurance carrier. The terms of the loan provide for an incentive arrangement whereby a credit can be earned that will reduce annual interest payments under the loan (based on target premiums placed with the carrier) which reduces the principal repayment due in February 2007 (based on both target premiums placed with the carrier as well as the loss ratio on premiums placed with the carrier). Under this incentive arrangement, both the annual interest payments as well as the principal payment can be reduced to zero. Credits were earned for 2004 and 2003 which reduced interest payments to zero from $750, for both years.
 
(4)  Certain property and equipment have been pledged as collateral in amounts not less than the outstanding balance of the loan at December 31, 2004 and 2003, respectively.
  62   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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Demand U.S. dollar base rate loan
The Company has an undrawn $10.0 million facility which bears interest at the bank’s U.S. rate which was 5.75% and 4.50% at December 31, 2004 and 2003, respectively, plus 50 basis points. Borrowings on the facility are repayable on demand.
Subordinated convertible debentures
In connection with the acquisition of HUB Northeast on June 28, 2001, the Company issued $35 million aggregate principal amount, 8.5% convertible subordinated debentures (the Fairfax notes) due June 28, 2007 to certain subsidiaries of Fairfax Financial Holdings Limited (Fairfax). The Fairfax notes are convertible by the holders at any time into the Company’s common shares at C$17.00 per share. Beginning June 28, 2006, the Company may require conversion of the Fairfax notes into common shares at C$17.00 per share if, at any time, the weighted average closing price of the Company’s common shares on the TSX for twenty consecutive trading days equals or exceeds C$19.00 per share. If converted, Fairfax would have owned approximately 32% of the Company’s outstanding common shares as of December 31, 2004.
10. Defined contribution plan
Substantially all officers and employees of the Company in the United States are entitled to participate in a qualified retirement savings plan (defined contribution plan). The cost to the Company was $2,397, $1,781 and $1,425 for 2004, 2003 and 2002, respectively. In 2004 a defined contribution plan was put in place for Canadian employees. The cost to the Company was $362 for 2004.
11. Shareholders’ equity
Share capital
At December 31, 2004, 2003 and 2002 there were an unlimited number of non-voting, preferred shares authorized, issuable in series on such terms and conditions as set by the Board of Directors, of which no shares were issued. At December 31, 2004, 2003 and 2002 there were an unlimited number of common shares authorized, of which 30,411, 30,143 and 29,025 were issued and outstanding as at December 31, 2004, 2003 and 2002, respectively.
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    63 


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    Common Shares
    Outstanding
     
    (000’s)   Amount
         
Balance, December 31, 2001
    21,656     $ 125,506  
Issued — U.S. IPO
    6,900       90,616  
Issued for executive stock purchase plan (net of repurchases)
    (4 )     (152 )
Release of put option liability
          11,768  
Purchase of subsidiaries
    473       7,459  
             
Balance, December 31, 2002
    29,025       235,197  
Purchase of subsidiaries
    32       538  
Repurchases of executive share purchase plan shares
    (7 )     (66 )
Share issue costs, net of future tax asset
          (61 )
Shares issued for contingent consideration
    1,246       14,041  
Cancellation of shares
    (8 )     (91 )
Restricted share units released
    7       112  
Stock options exercised
    1       14  
Reclassification of executive share purchase plan loans
    (153 )     (1,918 )
Release of put option liability
          7,079  
             
Balance, December 31, 2003
    30,143       254,845  
Shares issued
    181       3,337  
Executive share purchase plan share loan cancellations, net of repurchases
    1       33  
Shares issued for contingent consideration
    53       904  
Cancellation of shares
    (2 )     (26 )
Stock options exercised
    33       497  
Restricted share units released
    2       27  
             
Balance, December 31, 2004
    30,411     $ 259,617  
             
Issuable shares
                 
    Common Shares
     
    (000’s)   Amount
         
Balance, December 31, 2001
        $  
Issuable for contingent consideration
    1,228       13,743  
             
Balance, December 31, 2002
    1,228       13,743  
Issued
    (1,228 )     (13,743 )
Issuable for contingent consideration
    43       721  
             
Balance, December 31, 2003
    43       721  
Issued
    (43 )     (721 )
             
Balance, December 31, 2004
        $  
             
Contributed surplus
                         
    2004   2003   2002
             
Balance at December 31
  $ 4,806     $ 1,234     $  
Non-cash stock based compensation
    7,755       3,284       1,082  
Other
    120       288       152  
                   
Balance at December 31
  $ 12,681     $ 4,806     $ 1,234  
                   
  64   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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Cumulative translation account
                         
    2004   2003   2002
             
Balance at December 31
  $ 20,062     $ 2,185     $ 2,770  
Translation of self-sustaining foreign operations
    6,981       19,553       (269 )
Translation of debt financing of self-sustaining foreign operations
    (60 )     (1,676 )     (316 )
                   
Balance at December 31
  $ 26,983     $ 20,062     $ 2,185  
                   
12. Equity Incentive Plan
No options were issued in 2004. On February 28, 2003, the Company issued options exercisable for 267,000 common shares at an exercise price of $13.79 per share, the U.S. dollar equivalent of the closing sales price of the Company’s common shares on the TSX on that date. The maximum option term is seven years, and the options vest at one-third per year over three years of continuous employment. The number of common shares that may be issued under the Equity Incentive Plan is limited to 3,631,820 common shares.
A summary of the stock option activity and related information for the years ended December 31, 2004, 2003 and 2002 consists of the following:
                 
    Number   Weighted-Average
    (000’s)   Exercise Price
         
Balance, December 31, 2001
        $  
Granted
    1,270     $ 15.67  
Exercised
        $  
Forfeited
        $  
             
Balance, December 31, 2002
    1,270     $ 15.67  
Granted
    268     $ 13.79  
Exercised
    (1 )   $ 15.67  
Forfeited
    (39 )   $ 15.67  
             
Balance, December 31, 2003
    1,498     $ 15.64  
Exercised
    (33 )   $ 15.06  
Forfeited
    (9 )   $ 15.29  
             
Balance, December 31, 2004
    1,456     $ 15.34  
             
The following table summarizes information about the stock options outstanding at December 31, 2004, 2003 and 2002:
                                                 
    2004   2003
         
    Number   Weighted-Average   Number   Number   Weighted-Average   Number
    Outstanding   Remaining   Exercisable   Outstanding   Remaining   Exercisable
Exercise Price   (000’s)   Contractual Life   (000’s)   (000’s)   Contractual Life   (000’s)
                         
$15.67
    1,201       4.42 years       812       1,230       5.43 years       417  
$13.79
    255       5.16 years       96       268       6.08 years       6  
                                     
      1,456       4.55 years       908       1,498       5.55 years       423  
                                     
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    65 


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    2002
     
    Number   Weighted-Average   Number
    Outstanding   Remaining   Exercisable
Exercise Price   (000’s)   Contractual Life   (000’s)
             
$15.67
    1,270       6.45 years        
$13.79
                   
                   
      1,270       6.45 years        
                   
There were no stock options issued in 2004. The fair value of the stock options granted in 2003 was approximately $1.2 million (weighted average exercise price was $13.79 per share). The aggregate fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions for the options issued in 2003 and 2002:
                 
    2003   2002
         
Dividend yield
    2.00%       1.15%  
Expected volatility
    40.1%       30.0%  
Risk free interest rate
    2.90%       4.14%  
Expected life
    5  years       5  years  
Non-cash stock based compensation related to stock options of $2,400, $2,309 and $1,089 for the year ended December 31, 2004, 2003 and 2002, respectively, was expensed with offsetting credits to contributed surplus. The Company recognizes the fair value of non-cash stock based compensation as an expense over the period in which entitlement to the compensation vests.
Shares derived from the options are held in escrow and subject to transfer restrictions for a period of five years from the date the options are granted, subject to early release in certain circumstances.
In 2004, restricted share units totaling 977,000 were issued in connection with the restructuring of the Company management bonus agreement and 84,000 restricted share units were issued in connection with the renegotiation of contingent consideration for Flanagan. The fair value of the restricted share units awarded in 2004 was approximately $16.1 million ($16.50 per share). In addition 45,000 restricted share units were awarded to certain employees valued at approximately $0.8 million ($17.06 per share) in 2004.
On June 30, 2003, the Company awarded 605,000 restricted share units to employees of the Company. The restricted share units are exercisable for common shares without payment of cash consideration and vest over periods ranging from 68 months to 95 months. No restricted share units were awarded in 2002.
Non-cash stock based compensation for the year ended December 31, 2004, 2003 and 2002 is comprised of the following:
                           
    2004   2003   2002
             
Non-cash stock based compensation:
                       
 
Stock options granted June 2002
  $ 1,955     $ 1,899     $ 1,089  
 
Stock options granted February 2003
    445       410        
 
Stock based compensation granted for 2003 bonuses
    2,368       1,405        
 
Restricted share units
    1,609       1,087        
 
Other
    125              
                   
      6,502       4,801       1,089  
 
Stock based compensation related to Talbot acquisition
    14,388              
                   
    $ 20,890     $ 4,801     $ 1,089  
                   
  66   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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13. Earnings per share
Basic earnings per share, excluding the dilutive effect of common share equivalents, is calculated by dividing net earnings by the weighted average number of common shares outstanding for the period. Diluted earnings per share is calculated using the treasury stock method and includes the effects of all potentially dilutive securities. Earnings per common share have been calculated as follows:
                           
    2004   2003   2002
             
Net earnings (numerator)
  $ 26,244     $ 36,509     $ 29,401  
Effect of dilutive securities:
                       
 
Interest on 8.5% subordinated convertible debentures (net of income tax)
    1,900       1,886       2,520  
 
Dividends in lieu on restricted share units (net of income tax)
    95       111        
                   
Net earnings plus assumed conversions (numerator)
  $ 28,239     $ 38,506     $ 31,921  
                   
Weighted average shares outstanding — Basic (denominator)
    30,246       29,967       23,181  
Effect of dilutive securities:
                       
 
8.5% subordinated convertible debentures
    2,705       3,210       4,513  
 
Stock options
    1,294       147        
 
Restricted share units
    687       299        
 
Talbot earnout shares
    303              
 
Retractable shares
    70       133       49  
 
Issuable shares
          11       307  
 
Put options
                2,149  
                   
Weighted average shares outstanding — Diluted (denominator)
    35,305       33,767       30,199  
                   
Earnings per common share:
                       
 
Basic
  $ 0.87     $ 1.22     $ 1.27  
 
Diluted
  $ 0.80     $ 1.14     $ 1.06  
14. Fair value of financial instruments
The carrying amounts of the Company’s financial assets and liabilities, including cash and cash equivalents, accounts and other receivables, accounts payable and accrued liabilities at December 31, 2004 and 2003, approximate fair value because of the short-term nature of these instruments. The carrying value of the Company’s variable rate debt at December 31, 2004 and 2003, of $68,723 and $385, respectively, approximates fair market value.
In connection with the acquisition of HUB Northeast in 2001, the Company issued 8.5% subordinated convertible debentures due June 28, 2007 with a carrying amount and aggregate principal of $35 million. These debentures remain outstanding at December 31, 2004. The Company believes it is not practicable to estimate the fair value of its subordinated convertible debentures due to the conversion features.
15. Income taxes
Income taxes for 2004, 2003 and 2002, amounted to $20.0 million, $18.8 million and $14.3 million, respectively, resulting in an effective tax rate of 43%, 34% and 33% in 2004, 2003, and 2002, respectively.
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    67 


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The provision for income tax expense differs from the result that would have been obtained by applying the combined Canadian statutory federal and provincial income tax rate of 36.12%, 36.62% and 38.62% in 2004, 2003 and 2002, respectively, as follows:
                         
    2004   2003   2002
             
Provision for tax at statutory rates
  $ 16,716     $ 20,270     $ 16,852  
Non-deductible stock based compensation expense
    6,044              
Income earned outside of Canada
    (1,689 )     (1,688 )     (2,036 )
Non-taxable life insurance proceeds
          (366 )      
Non-taxable gain on sale of Old Lyme
                (1,009 )
Other
    (1,037 )     626       449  
                   
Provision for tax
  $ 20,034     $ 18,842     $ 14,256  
                   
The components of the future tax assets (liabilities) at December 31, 2004 and 2003, were as follows:
                   
    2004   2003
         
Future income tax assets
               
 
Current
  $ 3,901     $ 2,776  
 
Long-term
    4,368       5,232  
             
 
Total future income tax assets
    8,269       8,008  
             
Future income tax (liabilities)
               
 
Current
    (34 )     (24 )
 
Long-term
    (14,805 )     (12,703 )
             
 
Total future income tax liabilities
    (14,839 )     (12,727 )
             
 
Net future income tax liabilities
  $ (6,570 )   $ (4,719 )
             
                 
    2004   2003
         
Non-deductible book reserves
  $ 3,768     $ 2,211  
Non-cash stock based compensation
    3,268       1,633  
Net operating loss carryforwards
    3,217       2,895  
IPO costs
    1,434       2,003  
Goodwill and other intangible asset amortization
    (10,876 )     (9,504 )
Unrealized foreign currency gains on long-term debt
    (3,895 )     (1,744 )
Other accrual adjustments
    (1,517 )     (1,373 )
Property and equipment depreciation
    (1,379 )     (1,335 )
Other
    376       495  
Valuation allowance for future tax assets
    (966 )      
             
Net future income tax liabilities
  $ (6,570 )   $ (4,719 )
             
The Company has net operating loss carryforwards of $16,606 at December 31, 2004 that expire 2008 through 2011 resulting in a future tax asset of $2,637. In addition, the Company has state net operating loss carryforwards in the U.S. of approximately $12,221 which expire 2019 through 2024 resulting in a future tax asset of $580 before valuation allowance. Such net operating losses are currently available to offset certain future state and local taxable income. A valuation allowance in the amount of $409 has been established related to certain U.S. state net operating loss carryforwards. In addition, a valuation allowance of $557 has been established related to certain non-deductible book reserves in the U.S. The Company does not believe that these losses and reserves will be realized.
  68   HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2004


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16. Interest and income taxes paid
Interest and income taxes paid for the years ending December 31, 2004, 2003 and 2002 were:
                         
    2004   2003   2002
             
Interest paid
  $ 6,936     $ 5,731     $ 7,714  
Income taxes paid
  $ 21,806     $ 21,007     $ 13,124  
17. Segmented information
The Company is an international insurance brokerage, which provides a variety of property, casualty, life and health, employee benefits, investment and risk management products and services. In addition to its Corporate Operations, the Company has identified two operating segments within its insurance brokerage business: Canadian Operations and U.S. Operations. Corporate Operations consist primarily of investment income, unallocated administrative costs, interest expense and the income tax expense or benefit which is not allocated to the Company’s operating segments. The elimination of intra-segment revenue relates to intra-company interest charges, management fees and dividends.
Geographic revenue is determined based upon the functional currency of the various subsidiaries. Financial information by operating and geographic segment for 2004, 2003 and 2002 is as follows:
                                                 
    2004   2003
         
    Canada   U.S.   Consolidated   Canada   U.S.   Consolidated
                         
Revenue
                                               
Brokerage
  $ 121,752     $ 239,243     $ 360,995     $ 109,238     $ 177,487     $ 286,725  
Corporate
    22,448       9,424       31,872       20,331       1,803       22,134  
Elimination of intra-segment revenue
    (22,367 )     (9,650 )     (32,017 )     (20,429 )     (2,071 )     (22,500 )
                                     
    $ 121,833     $ 239,017     $ 360,850     $ 109,140     $ 177,219     $ 286,359  
                                     
Net earnings (loss) before income taxes
                                               
Brokerage
  $ 24,704     $ 40,096     $ 64,800     $ 17,600     $ 43,105     $ 60,705  
Corporate
    (9,163 )     (9,359 )     (18,522 )     6,771       (12,125 )     (5,354 )
                                     
    $ 15,541     $ 30,737     $ 46,278     $ 24,371     $ 30,980     $ 55,351  
                                     
Income tax expense (benefit) — current
                                               
Brokerage
  $ 8,772     $ 15,699     $ 24,471     $ 7,020     $ 14,302     $ 21,322  
Corporate
    (712 )     (3,855 )     (4,567 )     209       (4,609 )     (4,400 )
                                     
    $ 8,060     $ 11,844     $ 19,904     $ 7,229     $ 9,693     $ 16,922  
                                     
Income tax expense (benefit) — future
                                               
Brokerage
  $ (252 )   $ 1,103     $ 851     $ (355 )   $ 2,876     $ 2,521  
Corporate
    (688 )     (33 )     (721 )     (883 )     282       (601 )
                                     
    $ (940 )   $ 1,070     $ 130     $ (1,238 )   $ 3,158     $ 1,920  
                                     
Net earnings (loss)
                                               
Brokerage
  $ 16,184     $ 23,294     $ 39,478     $ 10,935     $ 25,927     $ 36,862  
Corporate
    (7,763 )     (5,471 )     (13,234 )     7,445       (7,798 )     (353 )
                                     
    $ 8,421     $ 17,823     $ 26,244     $ 18,380     $ 18,129     $ 36,509  
                                     
ANNUAL REPORT December 31, 2004 HUB INTERNATIONAL LIMITED    69 


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    2004   2003
         
    Canada   U.S.   Consolidated   Canada   U.S.   Consolidated
                         
Identifiable assets
                                               
Brokerage
  $ 172,445     $ 624,171     $ 796,616     $ 176,653     $ 442,517     $ 619,170  
Corporate
    52,339       8,580       60,919       65,316       16,117       81,433  
                                     
    $ 224,784     $ 632,751     $ 857,535     $ 241,969     $ 458,634     $ 700,603  
                                     
Amortization of intangible assets
  $ 110     $ 5,410     $ 5,520     $ 75     $ 3,133     $ 3,208  
Additions to property and equipment
  $ 2,802     $ 8,373     $ 11,175     $ 2,942     $ 5,185     $ 8,127  
Depreciation
  $ 2,542     $ 4,724     $ 7,266     $ 2,350     $ 3,894     $ 6,244  
Interest income
  $ 984     $ 966     $ 1,950     $ 914     $ 735     $ 1,649  
Interest expense
  $ 6,680     $ 790     $ 7,470     $ 4,752     $ 439     $ 5,191  
                         
    2002
     
    Canada   U.S.   Consolidated
             
Revenue
                       
Brokerage
  $ 85,761     $ 134,249     $ 220,010  
Corporate
    19,758       54,183       73,941  
Elimination of intra-segment revenue
    (19,708 )     (54,283 )     (73,991 )
                   
    $ 85,811     $ 134,149     $ 219,960  
                   
Net earnings (loss) before income taxes
                       
Brokerage
  $ 10,688     $ 38,229     $ 48,917  
Corporate
    8,879       (14,139 )     (5,260 )
                   
    $ 19,567     $ 24,090     $ 43,657  
                   
Income tax expense (benefit) — current
                       
Brokerage
  $ 4,472     $ 11,871