AON CORP – 10-K – Management’s Discussion and Analysis of Financial Condition and Results of Operations.
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EXECUTIVE SUMMARY OF 2011 FINANCIAL RESULTS
The challenging global economic environment continues to provide headwinds for our business. This results in pricing pressures across our Risk Solutions and HR Solutions operating segments. We continue to operate in a soft insurance pricing market. As property and casualty rates continue to moderate, the level of exposure units, or volume, appears to be stabilizing. Exposure units have been negatively impacted by the global economy, which places pressure on our business in three primary ways:
º • º declining insurable risks due to decreasing asset values, including property values, payroll, number of active employees, and corporate revenues, º • º client cost-driven behavior, where clients are actively looking to reduce spending in order to meet budget reductions, and increase risk retention, as a result of prioritizing their total spending, and º • º sector specific weakness, including financial services, construction, private equity, and mergers and acquisitions, all of which have been particularly impacted by the current economic downturn.
Our revenue for 2011 increased as a result of acquisitions, including Hewitt in
We focus on three key metrics that we communicate to shareholders: grow organically, expand margins, and increase earnings per share. The following is our measure of performance against these three metrics for 2011:
º • º Organic revenue growth, as defined under the caption "Review of Consolidated Results - General" below, was 2% in 2011, demonstrating continued improvement compared to the prior year's flat organic revenue. º • º Adjusted operating margin, as defined under the caption "Review of Consolidated Results - General" below, was 15.8% for Aon overall, 19.9% for the Risk Solutions segment, and 13.0% for the HR Solutions segment. Adjusted operating margins declined across the Risk Solutions segment, the HR Solutions segment and for the Company overall. º • º Adjusted diluted earnings per share from continuing operations attributable to Aon stockholders, as defined under the caption "Review of Consolidated Results - General" below, was$3.29 per share in 2011, an increase from$3.12 per share, or 5%, in 2010, demonstrating solid operational performance and effective capital management despite a difficult business environment.
Additionally, the following is a summary of our 2011 financial results:
º • º Revenue increased$2.8 billion , or 33%, to$11.3 billion due primarily to an increase from acquisitions, primarily Hewitt inOctober 2010 andGlenrand MIB Limited ("Glenrand") in 2011, net of dispositions, 2% organic revenue growth and a 2% favorable impact from foreign currency exchange rates. Organic revenue growth was 2% in the Risk Solutions segment and flat in the HR Solutions segment. º • º Operating expenses increased$2.4 billion from the prior year to$9.7 billion , primarily as a result of the inclusion of expenses from the Hewitt and Glenrand acquisitions, including higher intangible asset amortization expense,$18 million of non-cash charges related to the write-off of accounts receivable primarily from prior years, and unfavorable foreign currency translation offset by a$59 million decline in restructuring charges and realization of benefits from 40
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restructuring initiatives. In addition, 2010 included a$49 million expense related to the 2010 non-cash U.S. defined benefit pension plan resulting from an adjustment to the market-related value of plan assets and a$9 million expense related to the anti-bribery and compliance charge. º • º Our consolidated operating margin from continuing operations for the year on a U.S. generally accepted accounting principles ("GAAP") basis was 14.2% in 2011, essentially flat when compared to 2010. º • º Net income from continuing operations attributable to Aon stockholders increased$242 million , or 33%, from$733 million in 2010 to$975 million in 2011, primarily related to the inclusion of Hewitt.
REVIEW OF CONSOLIDATED RESULTS
General
In our discussion of operating results, we sometimes refer to supplemental information derived from consolidated financial information specifically related to organic revenue growth, adjusted operating margin, adjusted diluted earnings per share, and the impact of foreign exchange rates on operating results.
Organic Revenue
We use supplemental information related to organic revenue to help us and our investors evaluate business growth from existing operations. Organic revenue excludes the impact of foreign exchange rate changes, acquisitions, divestitures, transfers between business units, fiduciary investment income, reimbursable expenses, and unusual items. Supplemental information related to organic growth represents a measure not in accordance with U.S. GAAP, and should be viewed in addition to, not instead of, our Consolidated Financial Statements. Industry peers provide similar supplemental information about their revenue performance, although they may not make identical adjustments. Reconciliation of this non-GAAP measure, organic revenue growth percentages to the reported Commissions, fees and other revenue growth percentages, has been provided in the "Review by Segment" caption, below.
Adjusted Operating Margins
We use adjusted operating margin as a measure of core operating performance of our Risk Solutions and HR Solutions segments. Adjusted operating margin excludes the impact of restructuring charges, the legacy receivables write-off, Hewitt related integration costs, and transaction costs related to the proxy statement filed in connection with our potential relocation of our headquarters to
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Financial Statements. A reconciliation of this non-GAAP measure to the reported operating margin is as follows (in millions):
Total Risk HR Year Ended December 31, 2011 Aon (1) Solutions Solutions Revenue - U.S. GAAP $ 11,287 $ 6,817 $ 4,501 Operating income - U.S. GAAP $ 1,606 $ 1,314 $ 448 Restructuring charges 113 24 89 Legacy receivables write-off 18 18 - Transaction related costs -UK reincorporation 3 - - Hewitt related costs 47 - 47 Operating income - as adjusted $ 1,787 $ 1,356 $ 584 Operating margins - U.S. GAAP 14.2% 19.3% 10.0% Operating margins - as adjusted 15.8% 19.9% 13.0% º 1) º Includes unallocated expenses and the elimination of intersegment revenue.
Adjusted Diluted Earnings per Share from Continuing Operations
We also use adjusted diluted earnings per share from continuing operations as a measure of Aon's core operating performance. Adjusted diluted earnings per share excludes the impact of restructuring charges, the legacy receivables write-off, Hewitt related integration costs, and transaction costs related to the
As Year Ended December 31, 2011 U.S. GAAP Adjustments Adjusted Operating Income $ 1,606 $ 181 $ 1,787 Interest income 18 - 18 Interest expense (245 ) - (245 ) Other income 5 19 24 Income from continuing operations before income taxes 1,384 200 1,584 Income taxes 378 54 432 Income from continuing operations 1,006 146 1,152 Less: Net income attributable to noncontrolling interests 31 - 31 Income from continuing operations attributable to Aon stockholders $ 975 $ 146 $ 1,121 Diluted earnings per share from continuing operations $ 2.86 $ 0.43 $ 3.29 Weighted average common shares outstanding - diluted 340.9 340.9 340.9
Impact of Foreign Exchange Rate Fluctuations
Because we conduct business in more than 120 countries, foreign exchange rate fluctuations have a significant impact on our business. In comparison to the U.S. dollar, foreign exchange rate movements may be significant and may distort period-to-period comparisons of changes in revenue or pretax income. Therefore, to give financial statement users more meaningful information about our
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operations, we have provided a discussion of the impact of foreign currency exchange rates on our financial results. The methodology used to calculate this impact isolates the impact of the change in currencies between periods by translating last year's revenue, expenses and net income at this year's foreign exchange rates.
Summary of Results
The consolidated results of continuing operations are as follows (in millions): Years ended December 31, 2011 2010 2009 Revenue: Commissions, fees and other $ 11,235 $ 8,457 $ 7,521 Fiduciary investment income 52 55 74 Total revenue 11,287 8,512 7,595 Expenses: Compensation and benefits 6,567 5,097 4,597 Other general expenses 3,114 2,189 1,977 Total operating expenses 9,681 7,286 6,574 Operating income 1,606 1,226 1,021 Interest income 18 15 16 Interest expense (245 ) (182 ) (122 ) Other income 5 - 34
Income from continuing operations before income taxes 1,384 1,059 949 Income taxes
378 300 268 Income from continuing operations 1,006 759 681 Income (loss) from discontinued operations, after-tax 4 (27 ) 111 Net income 1,010 732 792
Less: Net income attributable to noncontrolling interests 31 26 45
Net income attributable to Aon stockholders $ 979 $ 706 $ 747
Consolidated Results for 2011 Compared to 2010
Revenue
Revenue increased by
Compensation and Benefits
Compensation and benefits increased
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partially offset by the realization of benefits from restructuring initiatives. In addition, 2010 included a
Other General Expenses
Other general expenses increased by
Interest Income
Interest income represents income earned on operating cash balances and other income-producing investments. It does not include interest earned on funds held on behalf of clients. Interest income increased
Interest Expense
Interest expense, which represents the cost of our worldwide debt obligations, increased
Other Income
Other income of
Income from Continuing Operations before Income Taxes
Income from continuing operations before income taxes was
Income Taxes
The effective tax rate on income from continuing operations was 27.3% in 2011 and 28.4% in 2010. The 2011 rate reflects the release of a valuation allowance relating to foreign tax credits offset partially by net unfavorable deferred tax adjustments in non-US jurisdictions including the impact of a
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Income from Continuing Operations
Income from continuing operations increased to
Discontinued Operations
In 2011, after-tax income from discontinued operations of
Consolidated Results for 2010 Compared to 2009
Revenue
Revenue increased by
Compensation and Benefits
Compensation and benefits increased
Other General Expenses
Other general expenses increased by
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costs. These increased costs were partially offset by lower restructuring charges, restructuring savings, operational expense management, and Benfield integration costs in 2009.
Interest Income
Interest income represents income earned on operating cash balances and other income-producing investments. It does not include interest earned on funds held on behalf of clients. Interest income decreased
Interest Expense
Interest expense, which represents the cost of our worldwide debt obligations, increased
Other Income
There was no Other income in 2010 versus
Income from Continuing Operations before Income Taxes
Income from continuing operations before income taxes was
Income Taxes
The effective tax rate on income from continuing operations was 28.4% in 2010 and 28.2% in 2009. The 2010 rate reflects the impact of the Hewitt acquisition in the fourth quarter, a favorable U.S. pension expense adjustment, which had a tax rate of 40%, and deferred tax adjustments. The 2009 tax rate was negatively impacted by a non-cash deferred tax expense on the U.S. pension curtailment gain, which had a tax rate of 40%. The underlying tax rate for continuing operations was 28.5% in 2010 and is estimated to be approximately 30% for 2011, reflecting changes in geographical mix of income following the Hewitt acquisition.
Income from Continuing Operations
Income from continuing operations increased to
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Discontinued Operations
In 2010, an after-tax loss from discontinued operations of
Restructuring Initiatives
Aon Hewitt Restructuring Plan
On
As of
The following summarizes the restructuring and related costs, by type, that have been incurred and are estimated to be incurred through the end of the restructuring initiative related to the Aon Hewitt Plan (in millions):
Estimated Total Cost for Restructuring 2010 2011 Plan (1) Workforce reduction $ 49 $ 64 $ 180 Lease consolidation 3 32 95 Asset impairments - 7 47 Other costs associated with restructuring (2) - 2 3 Total restructuring and related expenses $ 52 $ 105 $ 325 º (1) º Actual costs, when incurred, will vary due to changes in the assumptions built into this plan. Significant assumptions that may change when plans are finalized and implemented include, but are not limited to, changes in severance calculations, changes in the assumptions underlying sublease loss calculations due to changing market conditions, and changes in the overall analysis that might cause the Company to add or cancel component initiatives. º (2) º Other costs associated with restructuring initiatives, including moving costs and consulting and legal fees, are recognized when incurred. 47
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The following summarizes the restructuring and related expenses by segment that have been incurred and are estimated to be incurred through the end of the restructuring initiative related to the Aon Hewitt Plan (in millions):
Estimated Total Cost for Restructuring 2010 2011 Plan HR Solutions $ 52 $ 90 $ 297 Risk Solutions - 15 28 Total restructuring and related expenses $ 52 $ 105 $ 325
The restructuring plan, before any potential reinvestment of savings, is expected to deliver approximately
Aon Benfield Restructuring Plan
We announced a global restructuring plan ("Aon Benfield Plan") in conjunction with our 2008 acquisition of Benfield. The restructuring plan is intended to integrate and streamline operations across the combined
As of
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The following is a summary of the restructuring and related expenses by type that have been incurred and are estimated to be incurred through the end of the restructuring initiative related to the Aon Benfield Plan (in millions):
Estimated Purchase Total Cost for Price Total to Restructuring Allocation 2009 2010 2011 Date Period (1) Workforce reduction $ 32 $ 38 $ 15 $ 33 $ 118 $ 125 Lease consolidation 20 14 7 (15 ) 26 26 Asset impairments - 2 2 - 4 4 Other costs associated with restructuring (2) 1 1 2 1 5 5 Total restructuring and related expenses $ 53 $ 55 $ 26 $ 19 $ 153 $ 160 º (1) º Actual costs, when incurred, will vary due to changes in the assumptions built into this plan. Significant assumptions that may change when plans are finalized and implemented include, but are not limited to, changes in severance calculations, changes in the assumptions underlying sublease loss calculations due to changing market conditions, and changes in the overall analysis that might cause us to add or cancel component initiatives. º (2) º Other costs associated with restructuring initiatives, including moving costs and consulting and legal fees, are recognized when incurred.
All costs associated with the Aon Benfield Plan are included in the Risk Solutions segment. Charges related to the restructuring are included in Compensation and benefits and Other general expenses in the Consolidated Statements of Income. These restructuring activities and related expenses were concluded in January.
The Aon Benfield Plan, before any potential reinvestment of savings, is expected to deliver cumulative cost savings of approximately
2007 Restructuring Plan
In 2007, we announced a global restructuring plan intended to create a more streamlined organization and reduce future expense growth to better serve clients (the "2007 Plan"). The 2007 Plan resulted in approximately 4,700 job eliminations and we have closed or consolidated several offices resulting in sublease losses or lease buy-outs. The total cumulative pretax charges for the 2007 Plan were
We estimate that we realized cost savings, before any reinvestment of savings, of approximately
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The following summarizes the restructuring and related expenses by type that have been incurred related to the 2007 Plan (in millions):
Total 2007 2007 2008 2009 2010 2011 Plan Workforce reduction $ 17 $ 166 $ 251 $ 72 $ (2 ) $ 504 Lease consolidation 22 38 78 15 (9 ) $ 144 Asset impairments 4 18 15 2 - $ 39 Other costs associated with restructuring (1) 3 29 13 5 - $ 50
Total restructuring and related expenses
º (1) º Other costs associated with restructuring initiatives include moving costs and consulting and legal fees.
The following summarizes the restructuring and related expenses by segment that have been incurred related to the 2007 Plan (in millions):
Total 2007 2007 2008 2009 2010 2011 Plan Risk Solutions $ 41 $ 234 $ 322 $ 84 $ (10 ) $ 671 HR Solutions 5 17 35 10 (1 ) $ 66
Total restructuring and related expenses
LIQUIDITY AND FINANCIAL CONDITION
Liquidity
Executive Summary
Our balance sheet and strong cash flow provide us with financial flexibility to create long-term value for our stockholders. Our primary sources of liquidity are cash flow from operations, available cash reserves and debt capacity available under various credit facilities. Our primary uses of liquidity are operating expenses, capital expenditures, acquisitions, share repurchases, restructuring payments, funding pension obligations and the payment of stockholder dividends.
Cash and short-term investments decreased
Our investment grade rating is important to us for a number of reasons, the most important of which is preserving our financial flexibility. If our credit ratings were downgraded to below investment grade, the interest expense on any outstanding balances on our credit facilities would increase and we could incur additional requests for pension contributions. To manage unforeseen situations, we have
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committed credit lines of approximately
Cash Flows Provided by Operating Activities
Net cash provided by operating activities in 2011 increased
Cash Flows Used For Investing Activities
Cash used for investing activities in 2011 was
Cash used for investing activities in 2010 was
Cash used for investing activities was
Cash Flows Used For Financing Activities
Cash used for financing activities during 2011 was
Cash provided by financing activities during 2010 was
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exercise of stock options and issuance of shares purchased through the employee stock purchase plan were
Cash used for financing activities in 2009 was
Cash and Investments
At
In our capacity as an insurance broker or agent, we collect premiums from insureds and, after deducting our commission, remit the premiums to the respective insurance underwriter. We also collect claims or refunds from underwriters on behalf of insureds, which are then remitted to the insureds. Unremitted insurance premiums and claims are held by us in a fiduciary capacity. In addition, some of our outsourcing agreements require us to hold funds on behalf of clients to pay obligations on their behalf. The levels of fiduciary assets and liabilities can fluctuate significantly, primarily depending on when we collect the premiums, claims and refunds, make payments to underwriters and insureds, collect funds from clients and make payments on their behalf. Fiduciary assets, because of their nature, are required to be invested in very liquid securities with highly-rated, credit-worthy financial institutions. In our Consolidated Statements of Financial Position, the amount we report for fiduciary assets and fiduciary liabilities are equal. Our fiduciary assets included cash and investments of
As disclosed in Note 15 "Fair Value Measurements and Financial Instruments" of the Notes to Consolidated Financial Statements, the majority of our short-term investments carried at fair value are money market funds. Money market funds are carried at cost as an approximation of fair value. Based on market convention, we consider cost a practical and expedient measure of fair value. These money market funds are held throughout the world with various financial institutions. We do not believe that there are any significant market liquidity issues affecting the fair value of these investments.
As of
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The following table summarizes our Fiduciary assets and non-fiduciary cash and cash equivalents and short-term investments as ofDecember 31, 2011 (in millions): Statement of Financial Position Classification Cash and Cash Short-term Fiduciary Asset Type Equivalents Investments Assets Total Certificates of deposit, bank deposits or time deposits $ 272 - $ 2,546 $ 2,818 Money market funds - 784 1,619 2,403 Highly liquid debt instruments - - 25 25 Other investments due within one year - 1 - 1 Cash and investments 272 785 4,190 5,247 Fiduciary receivables - - 6,648 6,648 Total $ 272 $ 785 $ 10,838 $ 11,895
Share Repurchase Program
In the fourth quarter of 2007, our Board of Directors increased the authorized share repurchase program to
In
For information regarding share repurchases made during the fourth quarter of 2011, see Item 5 - "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of
Shelf Registration Statement
On
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Credit Facilities
We have a three-year
For both our U.S. and Euro Facilities, the two most significant covenants require us to maintain a ratio of consolidated EBITDA (earnings before interest, taxes, depreciation and amortization), adjusted for Hewitt related transaction costs and up to
Rating Agency Ratings
The major rating agencies' ratings of our debt atFebruary 24, 2012 appear in the table below. Ratings Senior Commercial Long-term Debt Paper Outlook Standard & Poor's BBB+ A-2 Stable Moody's Investor Services Baa2 P-2 Stable Fitch, Inc. BBB+ F-2 Stable
A downgrade in the credit ratings of our senior debt and commercial paper would increase our borrowing costs, reduce or eliminate our access to capital, reduce our financial flexibility, and increase our commercial paper interest rates or possibly restrict our access to the commercial paper market altogether.
Letters of Credit
We have outstanding letters of credit ("LOCs") totaling
Adequacy of Liquidity Sources
We believe that cash flows from operations and available credit facilities will be sufficient to meet our liquidity needs, including capital expenditures, pension contributions, cash restructuring costs, and anticipated working capital requirements, for the foreseeable future. Our cash flows from operations, borrowing capacity and overall liquidity are subject to risks and uncertainties. See Item 1, "Information Concerning Forward-Looking Statements" and Item 1A, "Risk Factors."
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Contractual Obligations
Summarized in the table below are our contractual obligations and commitments as of
Payments due in 2013 - 2015 - 2017 and 2012 2014 2016 beyond Total
Short- and long-term borrowings
220 403 300 1,136 2,059 Operating Leases 473 849 679 1,203 3,204 Pension and other postretirement benefit plan (1) (2) 301 641 679 1,743 3,364 Purchase obligations (3) (4) (5) 396 350 233 157 1,136 Insurance premiums payable 10,838 - - - 10,838 $ 12,565 $ 3,320 $ 3,012 $ 6,196 $ 25,093 º (1) º Pension and other postretirement benefit plan obligations include estimates of our minimum funding requirements, pursuant to ERISA and other regulations and minimum funding requirements agreed with the trustees of ourU.K. pension plans. Additional amounts may be agreed to with, or required by, theU.K. pension plan trustees. Nonqualified pension and other postretirement benefit obligations are based on estimated future benefit payments. We may make additional discretionary contributions. º (2) º In 2007, our principalU.K subsidiary agreed with the trustees of one of theU.K. plans to contribute £9.4 million ($15 million ) per year to that pension plan for the next six years, with the amount payable increasing by approximately 5% on eachApril 1 . The trustees of the plan have certain rights to request that ourU.K. subsidiary advance an amount equal to an actuarially determined winding-up deficit. As ofDecember 31, 2011 , the estimated winding-up deficit was £390 million ($610 million ). The trustees of the plan have accepted in practice the agreed-upon schedule of contributions detailed above and have not requested the winding-up deficit be paid. º (3) º Purchase obligations are defined as agreements to purchase goods and services that are enforceable and legally binding on us, and that specifies all significant terms, including what is to be purchased, at what price and the approximate timing of the transaction. Most of our purchase obligations are related to purchases of information technology services or for claims outsourcing in theU.K. º (4) º Excludes$75 million of unfunded commitments related to an investment in a limited partnership due to our inability to reasonably estimate the period(s) when the limited partnership will request funding. º (5) º Excludes$118 million of liabilities for unrecognized tax benefits due to our inability to reasonably estimate the period(s) when cash settlements will be made.
Financial Condition
At
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Balance sheet categories that reflected large variances from last year included the following:
º • º Cash and short-term investments decreased$74 million , resulting primarily from an increase in accounts receivable of$494 million ,$399 million in cash contributions to major deferred benefit plans in excess of pension expense and capital expenditures of$241 million , offset by net income of$1.0 billion . º • º Total Receivables increased$494 million primarily related to a temporary delay in invoicing HR Solutions' customers. This increase in unbilled receivables resulted in a temporary decrease in cash collections in 2011 of approximately$300 million . We expect this temporary increase in unbilled receivables and the resulting decrease in operating cash flow to reverse and return to normalized levels in the first half of 2012. º • º Goodwill and other intangibles decreased$212 million due primarily to amortization of intangible assets, partially offset by goodwill recognized from acquisitions.
Borrowings
Total debt at
On
On
Our total debt as a percentage of total capital attributable to Aon stockholders was 35.8% and 35.3% at
Equity
Equity at
Accumulated other comprehensive loss increased
º • º a decline in net foreign currency translation adjustments of$44 million , which was attributable to the strengthening of the U.S. dollar against foreign currencies; º • º an increase of$396 million in the net underfunded position of our post-retirement benefit obligations due primarily to a decrease in the discount rate used to determine the future benefit obligation; and 56
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º •
º net derivative losses of
REVIEW BY SEGMENT
General
We serve clients through the following segments: º • º Risk Solutions acts as an advisor and insurance and reinsurance broker, helping clients manage their risks, via consultation, as well as negotiation and placement of insurance risk with insurance carriers through our global distribution network. º • º HR Solutions partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance by designing, implementing, communicating and administering a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. Risk Solutions Years ended December 31, 2011 2010 2009 Revenue $ 6,817 $ 6,423 $ 6,305 Operating income 1,314 1,194 900 Operating margin 19.3% 18.6% 14.3%
The demand for property and casualty insurance generally rises as the overall level of economic activity increases and generally falls as such activity decreases, affecting both the commissions and fees generated by our brokerage business. The economic activity that impacts property and casualty insurance is described as exposure units, and is closely correlated with employment levels, corporate revenue and asset values. During 2011 we began to see some improvement in pricing; however, we would still consider this to be a "soft market," which began in 2007. In a soft market, premium rates flatten or decrease, along with commission revenues, due to increased competition for market share among insurance carriers or increased underwriting capacity. Changes in premiums have a direct and potentially material impact on the insurance brokerage industry, as commission revenues are generally based on a percentage of the premiums paid by insureds. In 2011, pricing showed signs of stabilization and improvement in both our retail and reinsurance brokerage product lines and we expect this trend to slowly continue into 2012.
Additionally, beginning in late 2008 and continuing through 2011, we faced difficult conditions as a result of unprecedented disruptions in the global economy, the repricing of credit risk and the deterioration of the financial markets. Weak global economic conditions have reduced our customers' demand for our brokerage products, which have had a negative impact on our operational results.
Risk Solutions generated approximately 60% of our consolidated total revenues in 2011. Revenues are generated primarily through fees paid by clients, commissions and fees paid by insurance and reinsurance companies, and investment income on funds held on behalf of clients. Our revenues vary from quarter to quarter throughout the year as a result of the timing of our clients' policy renewals, the net effect of new and lost business, the timing of services provided to our clients, and the income we earn on investments, which is heavily influenced by short-term interest rates.
We operate in a highly competitive industry and compete with many retail insurance brokerage and agency firms, as well as with individual brokers, agents, and direct writers of insurance coverage. Specifically, we address the highly specialized product development and risk management needs of commercial enterprises, professional groups, insurance companies, governments, health care providers, and non-profit groups, among others; provide affinity products for professional liability, life, disability
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income, and personal lines for individuals, associations, and businesses; provide products and services via GRIP Solutions; provide reinsurance services to insurance and reinsurance companies and other risk assumption entities by acting as brokers or intermediaries on all classes of reinsurance; provide capital management transaction and advisory products and services, including mergers and acquisitions and other financial advisory services, capital raising, contingent capital financing, insurance-linked securitizations and derivative applications; provide managing underwriting to independent agents and brokers as well as corporate clients; provide risk consulting, actuarial, loss prevention, and administrative services to businesses and consumers; and manage captive insurance companies.
Revenue
Risk Solutions commissions, fees and other revenue were as follows (in millions): Years ended December 31 2011 2010 2009 Retail brokerage: Americas $ 2,605 $ 2,377 $ 2,249 International 2,698 2,548 2,498 Total retail brokerage 5,303 4,925 4,747 Reinsurance brokerage 1,463 1,444 1,485 Total $ 6,766 $ 6,369 $ 6,232
In 2011, commissions, fees and other revenue increased
Reconciliation of organic revenue growth to reported commissions, fees and other revenue growth for 2011 versus 2010 is as follows:
Less: Less: Acquisitions, Percent Currency Divestitures Organic Change Impact & Other Revenue Retail brokerage: Americas 10 % 1 % 6 % 3 % International 6 4 (1 ) 3 Total retail brokerage 8 3 2 3 Reinsurance brokerage 1 2 (1 ) - Total 6 % 3 % 1 % 2 %
Retail brokerage Commissions, fees and other revenue increased 8% driven by a 3% favorable impact from foreign currency exchange rates, 3% growth in organic revenue in both the
Americas Commissions, fees and other revenue increased 10% reflecting the 6% impact of acquisitions, net of dispositions, 3% organic revenue growth driven by strong growth in
International commissions, fees and other revenue improved 6% driven by a 4% impact from favorable foreign currency exchange rates and a 3% organic revenue increase reflecting growth in
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Reinsurance commissions, fees and other revenue increased 1% driven by a favorable foreign currency translation of 2% and was partially offset by a 1% decline in dispositions, net of acquisitions and other. Organic revenue was flat primarily resulting from strong growth in the capital market transactions and advisory business, partially offset by declines in global facultative placements.
Operating Income
Operating income increased
HR Solutions Years ended December 31, 2011 2010 2009 Revenue $ 4,501 $ 2,111 $ 1,267 Operating income 448 234 203 Operating margin 10.0% 11.1% 16.0%
In
Our HR Solutions segment generated approximately 40% of our consolidated total revenues in 2011 and provides a broad range of human capital services, as follows:
º • º Health and Benefits advises clients about how to structure, fund, and administer employee benefit programs that attract, retain, and motivate employees. Benefits consulting includes health and welfare, executive benefits, workforce strategies and productivity, absence management, benefits administration, data-driven health, compliance, employee commitment, investment advisory and elective benefits services. EffectiveJanuary 1, 2012 , this line of business will be included in the results of the Risk Solutions segment. º • º Retirement specializes in global actuarial services, defined contribution consulting, investment consulting, tax and ERISA consulting, and pension administration. º • º Compensation focuses on compensatory advisory/counsel including: compensation planning design, executive reward strategies, salary survey and benchmarking, market share studies and sales force effectiveness, with special expertise in the financial services and technology industries. º • ºStrategic Human Capital delivers advice to complex global organizations on talent, change and organizational effectiveness issues, including talent strategy and acquisition, executive on-boarding, performance management, leadership assessment and development, communication strategy, workforce training and change management. º • ºBenefits Administration applies our HR expertise primarily through defined benefit (pension), defined contribution (401(k)), and health and welfare administrative services. Our model replaces the resource-intensive processes once required to administer benefit plans with more efficient, effective, and less costly solutions. º • º Human Resource Business Processing Outsourcing ("HR BPO") provides market-leading solutions to manage employee data; administer benefits, payroll and other human resources processes; and 59
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record and manage talent, workforce and other core HR process transactions as well as other complementary services such as absence management, flexible spending, dependent audit and participant advocacy.
Beginning in late 2008, the disruption in the global credit markets and the deterioration of the financial markets created significant uncertainty in the marketplace. Weak economic conditions globally continued throughout 2011. The prolonged economic downturn is adversely impacting our clients' financial condition and therefore the levels of business activities in the industries and geographies where we operate. While we believe that the majority of our practices are well positioned to manage through this time, these challenges are reducing demand for some of our services and putting continued pressure on pricing of those services, which is having an adverse effect on our new business and results of operations.
Revenue
In 2011, Commissions, fees and other revenue of
Years ended December 31, 2011 2010 2009 Consulting services $ 2,251 $ 1,387 $ 1,075 Outsourcing 2,272 731 191 Intersegment (23 ) (8 ) - Total $ 4,500 $ 2,110 $ 1,266 Organic revenue growth was flat in 2011, as detailed in the following reconciliation: Less: Less: Acquisitions, Percent Currency Divestitures Organic Year ended December 31 Change Impact & Other Revenue Consulting services 62 % 2 % 59 % 1 % Outsourcing 211 - 211 - Intersegment N/A N/A N/A N/A Total 113 % 2 % 111 % - %
Consulting services increased
Outsourcing revenue increased
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Operating Income
Operating income was
Unallocated Income and Expense
A reconciliation of our operating income to income from continuing operations before income taxes is as follows (in millions):
Years ended December 31 2011 2010 2009 Operating income (loss): Risk Solutions $ 1,314 $ 1,194 $ 900 HR Solutions 448 234 203 Unallocated (156 ) (202 ) (82 ) Operating income 1,606 1,226 1,021 Interest income 18 15 16 Interest expense (245 ) (182 ) (122 ) Other income 5 - 34 Income from continuing operations before income taxes $ 1,384 $ 1,059 $ 949
Unallocated operating expense includes corporate governance costs not allocated to the operating segments. Net unallocated expenses declined
Interest income represents income earned on operating cash balances and other income-producing investments. It does not include interest earned on funds held on behalf of clients. Interest income increased
Interest expense, which represents the cost of our worldwide debt obligations, increased
Other income of
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Consolidated Financial Statements have been prepared in accordance with U.S. GAAP. To prepare these financial statements, we made estimates, assumptions and judgments that affect what we report as our assets and liabilities, what we disclose as contingent assets and liabilities at the date of
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the financial statements, and the reported amounts of revenues and expenses during the periods presented.
In accordance with our policies, we regularly evaluate our estimates, assumptions and judgments, including, but not limited to, those concerning revenue recognition, restructuring, pensions, goodwill and other intangible assets, contingencies, share-based payments, and income taxes, and base our estimates, assumptions, and judgments on our historical experience and on factors we believe reasonable under the circumstances. The results involve judgments about the carrying values of assets and liabilities not readily apparent from other sources. If our assumptions or conditions change, the actual results we report may differ from these estimates. We believe the following critical accounting policies affect the more significant estimates, assumptions, and judgments we used to prepare these Consolidated Financial Statements.
Revenue Recognition
Risk Solutions segment revenues include insurance commissions and fees for services rendered and investment income on funds held on behalf of clients. Revenues are recognized when they are earned and realized or realizable. The Company generally considers revenues to be earned and realized or realizable when there is persuasive evidence of an arrangement with a client, there is a fixed or determinable price, services have been rendered, and collectability is reasonably assured. For brokerage commissions, revenue is typically considered to be earned and realized or realizable at the completion of the placement process. Commission revenues are recorded net of allowances for estimated policy cancellations, which are determined based on an evaluation of historical and current cancellation data. Commissions on premiums billed directly by insurance carriers are recognized as revenue when the Company has sufficient information to conclude the amount due is determinable, which may not occur until cash is received from the insurance carrier. In instances when commissions relate to policy premiums that are billed in installments, revenue is recognized when the Company has sufficient information to determine the appropriate billing and the associated commission. Fees for services provided to clients are generally recognized ratably over the period that the services are rendered. Investment income is recognized as it is earned and realized or realizable.
HR Solutions segment revenues consist primarily of fees paid by clients for consulting advice and outsourcing contracts. Fees paid by clients for consulting services are typically charged on an hourly, project or fixed-fee basis. Revenues from time-and-materials or cost-plus arrangements are recognized as services are performed. Revenues from fixed-fee contracts are generally recognized ratably over the term of the contract. Reimbursements received for out-of-pocket expenses are recorded as a component of revenues. The Company's outsourcing contracts typically have three-to-five year terms for benefits services and five-to-ten year terms for human resources business process outsourcing ('HR BPO') services. The Company recognizes revenues as services are performed. The Company also receives implementation fees from clients either up-front or over the ongoing services period as a component of the fee per participant. Lump sum implementation fees received from a client are initially deferred and generally recognized ratably over the ongoing contract services period. If a client terminates an outsourcing services arrangement prior to the end of the contract, a loss on the contract may be recorded, if necessary, and any remaining deferred implementation revenues would then be recognized into earnings over the remaining service period through the termination date. Services provided outside the scope of the Company's outsourcing contracts are recognized on a time-and-material or fixed-fee basis.
In connection with the Company's long-term outsourcing service agreements, highly customized implementation efforts are often necessary to set up clients and their human resource or benefit programs on the Company's systems and operating processes. For outsourcing services sold separately or accounted for as a separate unit of accounting, specific, incremental and direct costs of implementation incurred prior to the services going live are generally deferred and amortized over the
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period that the related ongoing services revenue is recognized. Such costs may include internal and external costs for coding or customizing systems, costs for conversion of client data and costs to negotiate contract terms. For outsourcing services that are accounted for as a combined unit of accounting, specific, incremental and direct costs of implementation, as well as ongoing service delivery costs incurred prior to revenue recognition commencing, are deferred and amortized over the remaining contract services period. Contracts are assessed periodically to determine if they are onerous, in which case a loss is recognized in the current period. Deferred costs are assessed for recoverability on a periodic basis, to the extent the deferred cost exceeds related deferred revenue.
Restructuring Workforce reduction costs
The method used to recognize workforce reduction costs depends on whether the benefits are provided under a one-time benefit arrangement or under an ongoing benefit arrangement. We account for relevant expenses as an ongoing benefit arrangement when we have an established termination benefit policy, statutory requirements dictate the termination benefit amounts, or we have an established pattern of providing similar termination benefits. The method to estimate the amount of termination benefits is based on the benefits available to the employees being terminated.
We recognize the workforce reduction costs related to restructuring activities resulting from an ongoing benefit arrangement when we identify the specific classification (or functions) and locations of the employees being terminated and notify the employees.
We recognize the workforce reduction costs related to restructuring activities resulting from a one-time benefit arrangement when we identify the specific classification (or functions) and locations of the employees being terminated, notify the employees, and expect to terminate employees within the legally required notification period. When employees receive incentives to stay beyond the legally required notification period, we recognize the cost of their termination benefits over the remaining service period.
Lease termination costs
Where we have provided notice of cancellation pursuant to a lease agreement or abandoned space and have no intention of reoccupying it, we recognize a loss and corresponding liability. The liability reflects our best estimate of the fair value of the future cash flows associated with the lease at the date we vacate the property or sign a sublease arrangement. To determine the loss and corresponding liability, we estimate sublease income based on current market quotes for similar properties.
Useful lives on leasehold improvements or other assets associated with lease abandonments may be revised to reflect a shorter useful life than originally estimated, which results in accelerated depreciation.
Fair value concepts of severance arrangements and lease losses
Accounting guidance requires that the liabilities recorded related to our restructuring activities be measured at fair value.
Where material, we discount the lease loss calculations to arrive at their present value. Most workforce reductions happen over a short span of time and therefore no discounting is necessary. However, we may discount the termination benefit arrangement when we terminate employees who will provide no future service and we pay their severance over an extended period. The discount reflects our incremental borrowing rate, which matches the lifetime of the liability. Significant changes in the discount rate selected or the estimations of sublease income in the case of leases could impact the amounts recorded.
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Other associated costs with restructuring activities
We recognize other costs associated with restructuring activities as they are incurred, including moving costs and consulting and legal fees.
Pensions
We sponsor defined benefit pension plans throughout the world. Our most significant plans are located in the U.S., the
Significant changes to pension plans
Our U.S.,
Recognition of gains and losses and prior service
We defer the recognition of gains and losses that arise from events such as changes in the discount rate and actuarial assumptions, actual demographic experience and plan asset performance.
Unrecognized gains and losses are amortized as a component of periodic pension expense based on the average expected future service of active employees for our plans in
As of
The following table discloses our combined experience loss, the number of years over which we are amortizing the experience loss, and the estimated 2012 amortization of loss by country (amounts in millions):
The U.S. U.K. Netherlands Canada Combined experience loss $ 1,480 $ 1,763 $ 191 $ 154 Amortization period (in years) 27 31 12 23 Estimated 2012 amortization of loss $ 43 $ 43 $ 12 $ 5
The unrecognized prior service cost at
For the U.S. pension plans we use a market-related valuation of assets approach to determine the expected return on assets, which is a component of net periodic benefit cost recognized in the Consolidated Statements of Income. This approach recognizes 20% of any gains or losses in the current
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year's value of market-related assets, with the remaining 80% spread over the next four years. As this approach recognizes gains or losses over a five-year period, the future value of assets and therefore, our net periodic benefit cost will be impacted as previously deferred gains or losses are recorded. As of
Our plans in the
Rate of return on plan assets and asset allocation
The following table summarizes the expected long-term rate of return on plan assets for future pension expense and the related target asset mix:
The U.S. U.K. Netherlands Canada Expected return (in total) 8.8 % 6.3 % 5.2 % 6.8 % Target equity (1) 70.0 % 43.0 % 35.0 % 60.0 % Target fixed income 30.0 % 57.0 % 65.0 % 40.0 % Expected return on equities (1) 10.3 % 8.7 % 8.0 % 8.5 % Expected return on fixed income 6.3 % 4.9 % 4.0 % 4.5 % º (1) º Includes investments in infrastructure, real estate, limited partnerships and hedge funds.
In determining the expected rate of return for the plan assets, we analyzed investment community forecasts and current market conditions to develop expected returns for each of the asset classes used by the plans. In particular, we surveyed multiple third party financial institutions and consultants to obtain long-term expected returns on each asset class, considered historical performance data by asset class over long periods, and weighted the expected returns for each asset class by target asset allocations of the plans.
The U.S. pension plan asset allocation is based on approved allocations following adopted investment guidelines. The actual asset allocation at
The investment policy for each
Impact of changing economic assumptions
Changes in the discount rate and expected return on assets can have a material impact on pension obligations and pension expense.
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Holding all other assumptions constant, the following table reflects what a one hundred basis point increase and decrease in our estimated liability discount rate would have on our estimated 2012 pension expense (in millions):
Change in discount rate Increase (decrease) in expense Increase Decrease U.S. plans $ (2 ) $ 1 U.K. plans (24 ) 16 The Netherlands plan (11 ) 12 Canada plans (1 ) 1 Holding other assumptions constant, the following table reflects what a one hundred basis point increase and decrease in our estimated long-term rate of return on plan assets would have on our estimated 2012 pension expense (in millions): Change in long-term rate of return on plan assets Increase (decrease) in expense Increase Decrease U.S. plans $ (14 ) $ 14 U.K. plans (43 ) 43 The Netherlands plan (6 ) 6 Canada plans (3 ) 3
Estimated future contributions
We estimate contributions of approximately
Goodwill and Other Intangible Assets
Goodwill represents the excess of cost over the fair market value of the net assets acquired. We classify our intangible assets acquired as either trademarks, customer relationships, technology, non-compete agreements, or other purchased intangibles.
Goodwill is not amortized, but rather tested for impairment at least annually in the fourth quarter. In
We perform impairment reviews at the reporting unit level. A reporting unit is an operating segment or one level below an operating segment (referred to as a "component"). A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and segment management regularly reviews the operating results of that component. An operating segment shall be deemed to be a reporting unit if all of its components
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are similar, if none of its components is a reporting unit, or if the segment comprises only a single component.
The goodwill impairment test is initially a qualitative analysis to determine if it is "more likely than not" that the fair value of each reporting unit exceeds the carrying value, including goodwill, of the corresponding reporting unit. If the "more likely than not" threshold is not met, then the goodwill impairment test becomes a two step analysis. Step One requires the fair value of each reporting unit to be compared to its book value. Management must apply judgment in determining the estimated fair value of the reporting units. If the fair value of a reporting unit is determined to be greater than the carrying value of the reporting unit, goodwill and trademarks are deemed not to be impaired and no further testing is necessary. If the fair value of a reporting unit is less than the carrying value, we perform Step Two. Step Two uses the calculated fair value of the reporting unit to perform a hypothetical purchase price allocation to the fair value of the assets and liabilities of the reporting unit. The difference between the fair value of the reporting unit calculated in Step One and the fair value of the underlying assets and liabilities of the reporting unit is the implied fair value of the reporting unit's goodwill. A charge is recorded in the financial statements if the carrying value of the reporting unit's goodwill is greater than its implied fair value.
In determining the fair value of our reporting units, we use a discounted cash flow ("DCF") model based on our most current forecasts. We discount the related cash flow forecasts using the weighted-average cost of capital method at the date of evaluation. Preparation of forecasts and selection of the discount rate for use in the DCF model involve significant judgments, and changes in these estimates could affect the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period. We also use market multiples which are obtained from quoted prices of comparable companies to corroborate our DCF model results. The combined estimated fair value of our reporting units from our DCF model often results in a premium over our market capitalization, commonly referred to as a control premium. We believe the implied control premium determined by our impairment analysis is reasonable based upon historic data of premiums paid on actual transactions within our industry. Based on tests performed in both 2011 and 2010, there was no indication of goodwill impairment, and no further testing was required.
We review intangible assets that are being amortized for impairment whenever events or changes in circumstance indicate that their carrying amount may not be recoverable. There were no indications that the carrying values of amortizable intangible assets were impaired as of
Contingencies
We define a contingency as an existing condition that involves a degree of uncertainty as to a possible gain or loss that will ultimately be resolved when one ore more future events occur or fail to occur. Under U.S. GAAP, we are required to establish reserves for loss contingencies when it is probable and we can reasonably estimate its financial impact. We are required to assess the likelihood of material adverse judgments or outcomes as well as potential ranges or probability of losses. We determine the amount of reserves required, if any, for contingencies after carefully analyzing each individual item. The required reserves may change due to new developments in each issue. We do not recognize gain contingencies until the contingency is resolved.
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Share-based Payments
Share-based compensation expense is measured based on the estimated grant date fair value and recognized over the requisite service period for awards that we ultimately expect to vest. We estimate forfeitures at the time of grant based on our actual experience to date and revise our estimates, if necessary, in subsequent periods if actual forfeitures differ from those estimates.
Stock Option accounting
We generally use a lattice-binomial option-pricing model to value stock options granted. Lattice-based option valuation models use a range of assumptions over the expected term of the options, and estimate expected volatilities based on the average of the historical volatility of our stock price and the implied volatility of traded options on our stock.
In terms of the assumptions used in the lattice-based model, we: º • º use historical data to estimate option exercise and employee terminations within the valuation model. We stratify employees between those receiving Leadership Performance Plan ("LPP") options, Special Stock Plan options, and all other option grants. We believe that this stratification better represents prospective stock option exercise patterns, º • º base the expected dividend yield assumption on our current dividend rate, and º • º base the risk-free rate for the contractual life of the option on the U.S. Treasury yield curve in effect at the time of grant.
The expected life of employee stock options represents the weighted-average period stock options are expected to remain outstanding, which is a derived output of the lattice-binomial model.
Restricted stock units
Restricted stock units ("RSUs") are service-based awards for which we recognize the associated compensation cost on a straight-line basis over the service period. We estimate the fair value of the awards based on the market price of the underlying stock on the date of grant.
Performance share awards
Performance share awards ("PSAs") are performance-based awards for which vesting is dependent on the achievement of certain objectives. Such objectives may be made on a personal, group or company level. We estimate the fair value of the awards based on the market price of the underlying stock on the date of grant, reduced by the present value of estimated dividends foregone during the vesting period.
PSAs may immediately vest at the end of the performance period or may have an additional service period. Compensation cost is recognized over the performance or additional service period, whichever is longer. The number of shares issued on the vesting date will vary depending on the actual performance objectives achieved. We make assessments of future performance using subjective estimates, such as long-term plans. As a result, changes in the underlying assumptions could have a material impact on the compensation expense recognized.
The largest performance-based share-based payment award plan is the LPP, which has a three-year performance period. The 2009 to 2011 performance period ended on
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As the percent of expected performance increases or decreases, the potential change in expense can go from 0% to 200% of the targeted total expense.
Income Taxes
We earn income in numerous foreign countries and this income is subject to the laws of taxing jurisdictions within those countries, as well as U.S. federal and state tax laws. The estimated effective tax rate for the year is applied to our quarterly operating results. In the event that there is a significant unusual or discrete item recognized, or expected to be recognized, in our quarterly operating results, the tax attributable to that item would be separately calculated and recorded at the same time as the unusual or discrete item, such as the resolution of prior-year tax matters.
The carrying values of deferred income tax assets and liabilities reflect the application of our income tax accounting policies, and are based on management's assumptions and estimates about future operating results and levels of taxable income, and judgments regarding the interpretation of the provisions of current accounting principles.
Deferred tax assets are reduced by valuation allowances if, based on the consideration of all available evidence, it is more likely than not that some portion of the deferred tax asset will not be realized. Significant weight is given to evidence that can be objectively verified.
We assess carryforwards and tax credits for realization as a reduction of future taxable income by using a 'more likely than not' determination. We have not recognized a U.S. deferred tax liability for undistributed earnings of certain foreign subsidiaries of our continuing operations to the extent they are considered permanently reinvested. Distributions may be subject to additional U.S. income taxes if we either distribute these earnings, or we are deemed to have distributed these earnings, according to the Internal Revenue Code, and could materially affect our future effective tax rate.
We base the carrying values of liabilities for income taxes currently payable on management's interpretation of applicable tax laws, and incorporate management's assumptions and judgments about using tax planning strategies in various taxing jurisdictions. Using different estimates, assumptions and judgments in accounting for income taxes, especially those that deploy tax planning strategies, may result in materially different carrying values of income tax assets and liabilities and changes in our results of operations.
We operate in many foreign jurisdictions where tax laws relating to our businesses are not well developed. In such jurisdictions, we obtain professional guidance, when available, and consider existing industry practices before using tax planning strategies and meeting our tax obligations. Tax returns are routinely subject to audit in most jurisdictions, and tax liabilities are frequently finalized through negotiations. In addition, several factors could increase the future level of uncertainty over our tax liabilities, including the following:
º • º the portion of our overall operations conducted in foreign tax jurisdictions has been increasing, and we anticipate this trend will continue, º • º to deploy tax planning strategies and conduct foreign operations efficiently, our subsidiaries frequently enter into transactions with affiliates, which are generally subject to complex tax regulations and are frequently reviewed by tax authorities, º • º tax laws, regulations, agreements and treaties change frequently, requiring us to modify existing tax strategies to conform to such changes, and º • º the proposed move of the corporate headquarters toLondon . 69
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NEW ACCOUNTING PRONOUNCEMENTS
Note 2 "Summary of Significant Accounting Principles and Practices" of the Notes to Consolidated Financial Statements contains a summary of our significant accounting policies, including a discussion of recently issued accounting pronouncements and their impact or future potential impact on our financial results, if determinable.
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