| HUB INTERNATIONAL LTD Item 1A Risk Factors 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 volume overrides and 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 |
| The insurance industry in general, and certain of our hubs, have been the subject of scrutiny by various regulatory bodies, including state attorneys general and the departments of insurance for various states, with respect to certain contingent commission arrangements between insurance companies and brokers |
| As previously reported, our subsidiary HUB Northeast (formerly known as Kaye Insurance Associates, Inc |
| ), received three subpoenas from the Office of the Attorney General of the State of New York seeking information regarding certain contingent agreements and other business practices |
| Since August 2004, 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 |
| To date, management is unaware of any incidents of falsifying or inflating insurance quotes or other illegal practices |
| State attorneys general and insurance departments continue their investigations of various industry practices |
| We continue to review our practices in light of these investigations and resulting charges brought against other brokers |
| We have fully cooperated with the attorney general and department of insurance inquiries |
| While it is not possible to predict the outcome of these investigations, if contingent compensation agreements were to be restricted or no longer permitted, our financial condition, results of operation and liquidity may be materially adversely affected |
| We were first named as a defendant in a federal class action lawsuit in October, 2004 |
| 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 |
| ” A number of substantially similar federal class actions were filed against us and many other defendants |
| On February 17, 2005, the Federal Judicial Panel on Multidistrict Litigation transferred these and other class actions in which we were not named to the District of New Jersey |
| In August 2005 and February 2006, amended complaints were filed in the consolidated federal court proceedings pending in New Jersey and styled In re Insurance Brokerage Antitrust Litigation |
| Certain of our subsidiaries have been named as additional defendants |
| The case has now been divided into two cases, one for employee benefits and the other for commercial insurance |
| A handful of allegations specifically pertaining to Hub have been added, but remain vague |
| The judge in these actions has permitted limited discovery to take place, which is continuing |
| 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 the ANNUAL REPORT December 31, 2005 HUB INTERNATIONAL LIMITED 9 _________________________________________________________________ [40]Table of Contents Chicago office of what is now HUB Midwest and claims that we received an undisclosed contingent commission with respect to its policy |
| We dispute the allegations of this lawsuit and are vigorously defending this case |
| The cost of defending against these lawsuits or others which may be filed, 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 regulatory investigation or a class action or similar lawsuit could result in a significant judgment or imposition of liability against us that could have a material adverse effect on our financial condition, results of operation and liquidity |
| As of December 31, 2005, we have not recorded a liability related to these matters |
| 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 which could have a material adverse effect on our consolidated financial position or future results of operations |
| Additionally, regulatory investigations regarding the insurance brokerage industry could lead to 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 accounted for approximately 9prca of our total revenue in 2005 |
| 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 and a series of natural disasters, 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 the amount paid 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, provincial and territorial authorities |
| Although the scope of regulation and form of supervision by these 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 |
| 10 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2005 _________________________________________________________________ [41]Table of Contents 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 |
| ” 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 79prca 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 and ability to remain competitive in our industry are 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 |
| 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, 2005, we had dlra175dtta3 million of total debt and our two credit ANNUAL REPORT December 31, 2005 HUB INTERNATIONAL LIMITED 11 _________________________________________________________________ [42]Table of Contents facilities contain covenants that, among other things, require us to maintain certain financial ratios and restrict our ability to incur additional debt |
| 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 2005, we derived approximately 88prca 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 |
| The years 2001 through 2003 saw premium rates increase |
| During the latter part of 2003, the Canadian market remained firm, but the US market experienced some softening of premium rates for property and casualty coverage |
| During the first six months of 2004 Canadian and US 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 |
| In 2005, in both Canada and the US we saw average declines in premiums in the range of three to five percent |
| 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 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 fair market value of identifiable net assets we acquire |
| Accounting rules require that we conduct an annual impairment testing of goodwill and indefinite life intangible assets |
| A deterioration in our operating results, including the loss of a significant client or clients at one of our brokerages, could result in an impairment of goodwill and other indefinite life intangible assets associated with such brokerage, which would cause us to take an impairment to goodwill and other indefinite life intangible assets |
| Such an impairment could adversely affect our earnings |
| 12 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2005 _________________________________________________________________ [43]Table of Contents The loss of members of our senior management or a significant number of our brokers could negatively affect our financial plans, growth, 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 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, 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 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, 2005, Fairfax Financial Holdings Limited owned or controlled 26prca of our common shares, or 31prca if Fairfax was to convert our subordinated convertible debentures it holds |
| We do business with certain subsidiaries of Fairfax which represented approximately 7prca of our revenue in 2005 |
| 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 be assured 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 negatively impact our share price |
| ANNUAL REPORT December 31, 2005 HUB INTERNATIONAL LIMITED 13 _________________________________________________________________ [44]Table of Contents 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 certain disaster recovery procedures in place and 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 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 implement and monitor 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 |
| 14 HUB INTERNATIONAL LIMITED ANNUAL REPORT December 31, 2005 _________________________________________________________________ [45]Table of Contents 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 |
| 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 a variety of factors, including the following: (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) write-downs of assets or operations, including write-downs 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 |
| Any downward pressure on the price of our shares could be exacerbated by a lack of demand for our shares at the time |
| From the beginning of 2004 to March 1, 2006, the price of our common shares on the TSX has ranged from a low of Cdlra19dtta00 to a high of Cdlra32dtta80 and on the NYSE has ranged from a low of dlra15dtta94 to a high of dlra28dtta70 |
| In addition, the stock market has experienced volatility that has affected the market prices of equity securities of many companies, which 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 |
| 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 were 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, 2005, Fairfax owned or controlled 26prca of our common shares |
| Fairfax also owns or controls dlra35 million of subordinated convertible debentures, which it can convert at any time into our common shares at Cdlra17dtta00 per share |
| If Fairfax converts the debentures it would hold 31prca of our common shares |
| Under our by-laws ANNUAL REPORT December 31, 2005 HUB INTERNATIONAL LIMITED 15 _________________________________________________________________ [46]Table of Contents 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 |
| 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 |
| 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 |