filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
EXECUTIVE SUMMARY OF 2018 FINANCIAL RESULTS
Aon is a leading global professional services firm providing a broad range of risk, retirement, and health solutions underpinned by proprietary data and analytics. Management is leading a set of initiatives designed to strengthen Aon and unite the firm with one portfolio of capability enabled by proprietary data and analytics and one operating model to deliver additional insight, connectivity, and efficiency.
Financial Results
In the first quarter of 2018, Aon adopted new accounting guidance related to the treatment of revenue from contracts with customers that was applied prospectively on the U.S. GAAP financial statements and therefore comparable periods have not been restated. Refer to Note 2 “Summary of Significant Accounting Principles and Practices” for further information surrounding the quantitative and qualitative impacts of adopting the new accounting guidance.
The following is a summary of our 2018 financial results from continuing operations on a reported basis:
| • | Revenue increased $772 million, or 8%, to $10,770 million in 2018 compared to 2017, reflecting 5% organic revenue growth, a 2% increase related to acquisitions, net of divestitures, and a 1% favorable impact from translating prior year period results at current period foreign exchange rates (“foreign currency translation”). Organic revenue growth for the year was driven by growth across every major revenue line, with particular strength in Reinsurance Solutions, Commercial Risk Solutions, and Health Solutions. |
| • | Operating expenses increased $293 million, or 3%, to $9,226 million in 2018 compared to 2017 due primarily to a $172 million increase in expenses related to acquisitions, net of divestitures, a $75 million increase in expense related to legacy litigation, $71 million of accelerated amortization related to tradenames, a $59 million unfavorable impact from foreign currency translation, a $14 million increase in expense to support GDPR compliance, and an increase in expense associated with 5% organic revenue growth, partially offset by a $204 million net decrease in impairment charges, $195 million of incremental savings related to restructuring and other operational improvement initiatives, and a $28 million decrease in regulatory and compliance costs. |
| • | Operating margin increased to 14.3% in 2018 from 10.7% in 2017, including an increase of 90 basis points resulting from adoption of the new revenue recognition standard in 2018. The underlying increase in operating margin from the prior year is primarily driven by organic revenue growth of 5% and strong core operational improvement, partially offset by an increase in operating expenses, described above. |
| • | Due to the factors set forth above, net income from continuing operations was $1,100 million in 2018, an increase of $665 million, or 153%, from 2017. |
| • | Diluted earnings per share from continuing operations was $4.29 per share during the twelve months of 2018 compared to $1.53 per share for the prior year period, including an increase of $0.32 per share resulting from the adoption of the new revenue recognition standard. |
| • | Cash flow provided by operating activities was $1,686 million in 2018, an increase of $1,017 million, or 152%, from $669 million in 2017. The prior year included $940 million of cash tax payments related to the sale of the Divested Business. Strong operational improvement and working capital improvements in both receivables and payables contributed to year-over-year growth, partially offset by $145 million of incremental cash restructuring charges and $80 million of accelerated pension contributions. |
We focus on four key non-GAAP metrics that we communicate to shareholders: organic revenue growth, adjusted operating margins, adjusted diluted earnings per share, and free cash flow. These non-GAAP metrics should be viewed in addition to, not instead of, our Consolidated Financial Statements and Notes thereto (the “Financial Statements”). The following is our measure of performance against these four metrics from continuing operations for 2018:
| • | Organic revenue growth, a non-GAAP measure defined under the caption “Review of Consolidated Results — Organic Revenue Growth,” was 5% in 2018, compared to 4% organic growth in the prior year. Organic revenue growth was driven by growth across every major revenue line, with particular strength in Reinsurance Solutions, Commercial Risk Solutions, and Health Solutions. |
| • | Adjusted operating margin, a non-GAAP measure defined under the caption “Review of Consolidated Results — Adjusted Operating Margin,” was 25.0% in 2018, compared to 22.8% in the prior year. The increase in adjusted |
operating margin primarily reflects organic revenue growth of 5%, core operational improvement, and $195 million of savings related to restructuring and other operational improvement initiatives.
| • | Adjusted diluted earnings per share from continuing operations, a non-GAAP measure defined under the caption “Review of Consolidated Results — Adjusted Diluted Earnings per Share,” was $8.16 per share in 2018, an increase of $1.69 per share, or 26%, from $6.47 per share in 2017. The increase demonstrates strong operational performance and effective capital management, highlighted by $1.4 billion of share repurchase during 2018, partially offset by a higher adjusted effective tax rate. |
| • | Free cash flow, a non-GAAP measure defined under the caption “Review of Consolidated Results — Free Cash Flow,” was $1,446 million in 2018, an increase of $960 million, or 198%, from $486 million in 2017, driven by an increase of $1,017 million in cash flow in operations, partially offset by a $57 million increase in capital expenditures, including investments in our operating model. |
REVIEW OF CONSOLIDATED RESULTS
Summary of Results
In the first quarter of 2018, Aon adopted new accounting guidance related to the treatment of revenue from contracts with customers that was applied prospectively on the U.S. GAAP financial statements and therefore comparable periods have not been restated. Refer to Note 2 “Summary of Significant Accounting Principles and Practices” for further information surrounding the quantitative and qualitative impacts of adopting the new accounting guidance.
Our consolidated results are as follow:
| Years ended December 31 | ||||||||||||
| (millions) | 2018 | 2017 | 2016 | |||||||||
| Revenue | ||||||||||||
| Total revenue | $ | 10,770 | $ | 9,998 | $ | 9,409 | ||||||
| Expenses | ||||||||||||
| Compensation and benefits | 6,103 | 6,003 | 5,514 | |||||||||
| Information technology | 484 | 419 | 386 | |||||||||
| Premises | 370 | 348 | 343 | |||||||||
| Depreciation of fixed assets | 176 | 187 | 162 | |||||||||
| Amortization and impairment of intangible assets | 593 | 704 | 157 | |||||||||
| Other general expenses | 1,500 | 1,272 | 1,036 | |||||||||
| Total operating expenses | 9,226 | 8,933 | 7,598 | |||||||||
| Operating income | 1,544 | 1,065 | 1,811 | |||||||||
| Interest income | 5 | 27 | 9 | |||||||||
| Interest expense | (278 | ) | (282 | ) | (282 | ) | ||||||
| Other income (expense) | (25 | ) | (125 | ) | (137 | ) | ||||||
| Income from continuing operations before income taxes | 1,246 | 685 | 1,401 | |||||||||
| Income taxes | 146 | 250 | 148 | |||||||||
| Net income from continuing operations | 1,100 | 435 | 1,253 | |||||||||
| Net income from discontinued operations | 74 | 828 | 177 | |||||||||
| Net income | 1,174 | 1,263 | 1,430 | |||||||||
| Less: Net income attributable to noncontrolling interests | 40 | 37 | 34 | |||||||||
| Net income attributable to Aon shareholders | $ | 1,134 | $ | 1,226 | $ | 1,396 |
Consolidated Results for 2018 Compared to 2017
Revenue
Total revenue increased $772 million, or 8%, to $10,770 million in 2018, compared to $9,998 million in 2017. The increase was driven by 5% organic revenue growth, a 2% increase related to acquisitions, net of divestitures, and a 1% favorable impact
from foreign currency translation. Organic revenue growth for the year was driven by growth across every major revenue line, with particular strength in Reinsurance Solutions, Commercial Risk Solutions, and Health Solutions.
Commercial Risk Solutions revenue increased $483 million, or 12%, to $4,652 million in 2018, compared to $4,169 million in 2017. Organic revenue growth was 6% in 2018 driven by growth across every major geography, with particular strength in U.S. Retail driven by record new business generation and strong management of the renewal book portfolio. Results also include double-digit growth in both cyber solutions and transaction liability, two specific areas of investment to support increasing client demand.
Reinsurance Solutions revenue increased $134 million, or 9%, to $1,563 million in 2018, compared to $1,429 million in 2017. Organic revenue growth was 7% in 2018 driven by net new business generation in treaty and strong growth in facultative placements, partially offset by a modest decline in capital markets transactions given the prior year period benefited from record catastrophe bond issuance during the mid-year renewal season.
Retirement Solutions revenue increased $110 million, or 6%, to $1,865 million in 2018, compared to $1,755 million in 2017. Organic revenue growth was 2% in 2018 driven by solid growth in core actuarial retirement and in the talent practice, as well as modest growth in investment consulting.
Health Solutions revenue increased $81 million, or 5%, to $1,596 million in 2018, compared to $1,515 million in 2017. Organic revenue growth was 5% in 2018 driven primarily by strong growth in health & benefits brokerage, in both the Americas and internationally, and in the health care exchange business driven by new client wins in both the active and retiree exchanges.
Data & Analytic Services revenue decreased $35 million, or 3%, to $1,105 million in 2018, compared to $1,140 million in 2017. Organic revenue growth was 3% in 2018 driven by strong growth globally across Affinity.
Compensation and Benefits
Compensation and benefits increased $100 million, or 2%, in 2018 compared to 2017. The increase was primarily driven by a $145 million increase in expenses related to acquisitions, net of divestitures, a $50 million unfavorable impact from foreign currency translation, and an increase in expense associated with 5% organic revenue growth, partially offset by a $184 million decrease in restructuring costs, $182 million of incremental savings related to restructuring and other operational improvement initiatives, and a $51 million decrease related to the adoption of the new revenue recognition standard in 2018.
Information Technology
Information technology, which represents costs associated with supporting and maintaining our infrastructure, increased $65 million, or 16%, in 2018 compared to 2017. The increase was primarily driven by a $16 million increase in expenses related to acquisitions, net of divestitures, a $14 million increase in restructuring costs, an increase in expense associated with 5% organic revenue growth, and investments supporting long-term growth initiatives, partially offset by $1 million of incremental savings related to restructuring and other operational improvement initiatives.
Premises
Premises, which represents the cost of occupying offices in various locations throughout the world, increased $22 million, or 6%, in 2018 compared to 2017. The increase was primarily driven by a $20 million increase in restructuring costs, and a $10 million increase in expenses related to acquisitions, net of divestitures, partially offset by $16 million of incremental savings related to restructuring and other operational improvement initiatives.
Depreciation of Fixed Assets
Depreciation of fixed assets primarily relates to software, leasehold improvements, furniture, fixtures and equipment, computer equipment, buildings, and automobiles. Depreciation of fixed assets decreased $11 million, or 6%, in 2018 compared to 2017. The decrease was primarily driven by a $13 million decrease in restructuring costs, partially offset by a $4 million increase related to acquisitions, net of divestitures.
Amortization and Impairment of Intangible Assets
Amortization and impairment of intangibles primarily relates to finite-lived tradenames and customer-related, contract-based, and technology assets. Amortization and impairment of intangibles decreased $111 million, or 16%, in 2018 compared to 2017. The decrease was primarily driven by a net $204 million decrease in impairment charges, partially offset by a $71 million increase in accelerated amortization related to tradenames.
Other General Expenses
Other general expenses increased $228 million, or 18%, in 2018 compared to 2017. The increase was primarily driven by a $151 million increase in restructuring costs, a $75 million increase in legacy litigation, an $11 million increase in expense to support GDPR regulatory compliance, and an increase in expense associated with 5% organic revenue growth, partially offset by a $28 million decrease in costs related to regulatory and compliance matters.
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 was $5 million in 2018, a decrease of $22 million, or 81%, from 2017, due primarily to additional income earned on the balance of cash proceeds from the Divested Business in the prior year period.
Interest Expense
Interest expense, which represents the cost of our debt obligations, was $278 million in 2018, a decrease of $4 million, or 1%, from 2017. This decrease was driven primarily by the maturity of higher interest rate term debt in Q1 2018 partially offset by interest on a higher average commercial paper outstanding compared to the prior year.
Other Income (Expense)
Other expense decreased $100 million, or 80%, to $25 million in 2018 compared to 2017. Other expense in 2018 includes, among other things, $49 million of losses on certain financial instruments and $6 million in net losses on the disposition of businesses, partially offset by a $25 million favorable impact of exchange rates on the remeasurement of assets and liabilities in non-functional currencies and $4 million of equity earnings. Other expense in 2017 includes $86 million of pension and other post-retirement expense, a $37 million unfavorable impact of exchange rates on the remeasurement of assets and liabilities in non-functional currencies, and $16 million in net losses on the disposition of businesses, partially offset by $12 million in equity earnings.
Income From Continuing Operations before Income Taxes
Due to factors discussed above, income from continuing operations before income taxes was $1,246 million in 2018, an 82% increase from $685 million in 2017.
Income Taxes From Continuing Operations
The effective tax rate on net income from continuing operations was 11.7% in 2018 and 36.5% in 2017. The primary drivers of the 2018 tax rate include the following:
| • | The geographical distribution of income including restructuring charges, legacy litigation, and the impairment of certain assets and liabilities previously classified as held for sale as well as the post-enactment date impacts of the Tax Reform Act. |
| • | Certain discrete items including the tax benefit associated with the sale of certain assets and liabilities previously classified as held for sale and the impact of share-based payments offset by the net tax expense from finalizing the impact of the enactment of the Tax Reform Act and changes in valuation allowances. |
The 2017 tax rate reflects changes in the geographical distribution of income including restructuring charges and the impairment and amortization of tradenames, the impact of share-based payments, and the provisional estimate of the enactment date impact of the Tax Reform Act.
Income from Discontinued Operations, Net of Tax
Net income from discontinued operations decreased $754 million to $74 million compared to 2017 due to the execution of the sale of the Divested Business on May 2, 2017.
Net Income Attributable to Aon Shareholders
Net income attributable to Aon shareholders decreased to $1,134 million, or $4.59 per diluted share, in 2018, compared to $1,226 million, or $4.70 per diluted share, in 2017.
Consolidated Results for 2017 Compared to 2016
Revenue
Total revenue increased by 6%, or $589 million, to $9,998 million in 2017, compared to $9,409 million in 2016. The increase was driven by 4% organic revenue growth and a 2% increase related to acquisitions, net of divestitures. Organic revenue growth for the year was driven by growth across every major revenue line, with particular strength in Reinsurance Solutions, Health Solutions, and Data & Analytic Services.
Commercial Risk Solutions revenue increased $240 million, or 6%, to $4,169 million in 2017, compared to $3,929 million in 2016. Organic revenue growth was 2% in 2017 driven by growth across nearly every geography, with particular strength in U.S. Retail driven by record new business generation and strong management of the renewal book portfolio.
Reinsurance Solutions revenue increased $68 million, or 5%, to $1,429 million in 2017, compared to $1,361 million in 2016. Organic revenue growth was 6% in 2017 driven by growth across all major product lines, highlighted by continued net new business generation in the treaty portfolio, growth in facultative placements, and strong growth in capital markets.
Retirement Solutions revenue increased $48 million, or 3%, to $1,755 million in 2017, compared to $1,707 million in 2016. Organic revenue growth was 3% in 2017 driven by double-digit growth in investment consulting, primarily for delegated investment management, as well as solid growth in the Talent, Rewards, and Performance practice.
Health Solutions revenue increased $145 million, or 11%, to $1,515 million in 2017, compared to $1,370 million in 2016. Organic revenue growth was 7% in 2017 driven primarily by strong growth in health & benefits brokerage, in both the Americas and internationally.
Data & Analytic Services revenue increased $90 million, or 9%, to $1,140 million in 2017, compared to $1,050 million in 2016. Organic revenue growth was 6% in 2017 driven by strong growth across Affinity, with particular strength in the U.S.
Compensation and Benefits
Compensation and benefits increased $489 million in 2017, or 9%, compared to 2016. The increase was primarily driven by $299 million of restructuring charges, a $154 million increase in expenses related to acquisitions, net of divestitures, and an increase in expense associated with 4% organic revenue growth, partially offset by $104 million of savings related to restructuring and other operational improvement initiatives and a $92 million decrease in expenses related to certain pension settlements.
Information Technology
Information technology, which represents costs associated with supporting and maintaining our infrastructure, increased $33 million in 2017, or 9%, compared to 2016. The increase was primarily driven by $33 million of restructuring costs, a $7 million increase in expenses related to acquisitions, net of divestitures, as well as investments in growth, partially offset by $37 million of savings related to restructuring and other operational improvement initiatives.
Premises
Premises, which represents the cost of occupying offices in various locations throughout the world, increased $5 million in 2017, or 1%, compared to 2016. The increase was primarily driven by an $11 million increase in expenses related to acquisitions, net of divestitures, and $8 million of restructuring costs, partially offset by $3 million of savings related to restructuring and other operational improvement initiatives.
Depreciation of Fixed Assets
Depreciation of fixed assets primarily relates to software, leasehold improvements, furniture, fixtures and equipment, computer equipment, buildings, and automobiles. Depreciation of fixed assets increased $25 million in 2017, or 15%, compared to 2016. The increase was primarily driven by $26 million of restructuring costs and a $14 million increase in expenses associated with acquisitions, net of divestitures, partially offset by $1 million of savings related to restructuring and other operational improvement initiatives as well as a decrease as we continue to optimize our real estate and information technology portfolio.
Amortization and Impairment of Intangible Assets
Amortization and impairment of intangibles primarily relates to finite-lived tradenames and customer-related, contract-based, and technology assets. Amortization and impairment of intangibles increased $547 million for the year, or 348%, compared to 2016. The increase was primarily driven by a $380 million non-cash impairment charge to the indefinite lived tradenames associated with the Divested Business, $143 million of accelerated amortization related to tradenames, and an increase associated with recent acquisitions, net of divestitures.
Other General Expenses
Other general expenses increased $236 million in 2017, or 23%, compared to 2016. The increase was primarily driven by $131 million of restructuring costs, a $71 million increase in expenses associated with acquisitions, net of divestitures, $28 million of costs related to regulatory and compliance matters, and an increase in expense associated with 4% organic revenue growth, partially offset by $20 million of savings related to restructuring and other operational improvement initiatives and a $15 million decrease in expenses related to the sale of the Divested Business in the prior year period.
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 was $27 million in 2017, an increase of $18 million, or 200%, from 2016, due primarily to additional income earned on the balance of cash proceeds from the Divested Business.
Interest Expense
Interest expense, which represents the cost of our debt obligations, was $282 million in 2017, similar to the prior year period.
Other Income (Expense)
Other expense decreased $12 million from $137 million in 2016 to $125 million in 2017. Other expense in 2017 includes, among other things, $86 million of pension and other post-retirement expense, a $37 million unfavorable impact of exchange rates on the remeasurement of assets and liabilities in non-functional currencies, and $16 million in net losses on the disposition of businesses, partially offset by $12 million in equity earnings. Other expense in 2016 includes $173 million of pension and other post-retirement expense and $14 million of losses on certain financial instruments, partially offset by $39 million in net gains on the disposition of businesses and $13 million in equity earnings.
Income From Continuing Operations before Income Taxes
Due to factors discussed above, income from continuing operations before income taxes was $685 million in 2017, a 51% decrease from $1,401 million in 2016.
Income Taxes From Continuing Operations
The effective tax rate on net income from continuing operations was 36.5% in 2017 and 10.6% in 2016. The 2017 rate reflects changes in the geographical distribution of income, the impact of share-based payments, and the provisional estimate of the impact of U.S. tax reform based on Aon's initial analysis of the Tax Cuts and Jobs Act. The 2016 rate reflects changes in the geographical distribution of income and the impact from certain pension settlements in the second and fourth quarters.
Income from Discontinued Operations, Net of Tax
On February 9, 2017, the Company entered into a Purchase Agreement with the Buyer to sell the Divested Business. The Company has retrospectively classified the results of the Divested Business as discontinued operations in the Company’s Consolidated Statements of Income for all periods presented. Income from discontinued operations, net of tax, increased $651 million to $828 million compared to 2016. This increase was primarily driven by the gain on sale of the Divested Business.
Net Income Attributable to Aon Shareholders
Net income attributable to Aon shareholders decreased to $1,226 million, or $4.70 per diluted share, in 2017, compared to $1,396 million, or $5.16 per diluted share, in 2016.
Non-GAAP Metrics
In our discussion of consolidated results, we sometimes refer to certain non-GAAP supplemental information derived from consolidated financial information specifically related to organic revenue growth, adjusted operating margin, adjusted diluted earnings per share, free cash flow, and the impact of foreign exchange rate fluctuations on operating results. This non-GAAP supplemental information should be viewed in addition to, not instead of, our Financial Statements.
Organic Revenue Growth
We use supplemental information related to organic revenue growth to help us and our investors evaluate business growth from existing operations. Organic revenue growth is a non-GAAP measure that includes the impact of intercompany activity and excludes the impact of the adoption of the new revenue recognition standard, changes in foreign exchange rates, acquisitions, divestitures, transfers between revenue lines, and fiduciary investment income. This supplemental information related to organic revenue growth represents a measure not in accordance with U.S. GAAP and should be viewed in addition to, not instead of, our
Financial Statements. Industry peers provide similar supplemental information about their revenue performance, although they may not make identical adjustments. A reconciliation of this non-GAAP measure to the reported Total revenue is as follows (in millions, except percentages):
| Twelve Months Ended | ||||||||||||||||||||||||||
| Dec 31, 2018 | Dec 31, 2017 | % Change | Revenue Recognition(1) | Less: Currency Impact (2) | Less: Fiduciary Investment Income (3) | Less: Acquisitions, Divestitures & Other | Organic Revenue Growth (4) | |||||||||||||||||||
| Commercial Risk Solutions | $ | 4,652 | $ | 4,169 | 12 | % | — | % | 1 | % | — | % | 5 | % | 6 | % | ||||||||||
| Reinsurance Solutions | 1,563 | 1,429 | 9 | (1 | ) | 2 | 1 | — | 7 | |||||||||||||||||
| Retirement Solutions | 1,865 | 1,755 | 6 | — | 1 | — | 3 | 2 | ||||||||||||||||||
| Health Solutions | 1,596 | 1,515 | 5 | (1 | ) | — | — | 1 | 5 | |||||||||||||||||
| Data & Analytic Services | 1,105 | 1,140 | (3 | ) | — | — | — | (6 | ) | 3 | ||||||||||||||||
| Elimination | (11 | ) | (10 | ) | NA | NA | NA | NA | NA | NA | ||||||||||||||||
| Total revenue | $ | 10,770 | $ | 9,998 | 8 | % | — | % | 1 | % | — | % | 2 | % | 5 | % |
| Twelve Months Ended | |||||||||||||||||||||||
| Dec 31, 2017 | Dec 31, 2016 | % Change | Less: Currency Impact (2) | Less: Fiduciary Investment Income (3) | Less: Acquisitions, Divestitures & Other | Organic Revenue Growth (4) | |||||||||||||||||
| Commercial Risk Solutions | $ | 4,169 | $ | 3,929 | 6 | % | — | % | — | % | 4 | % | 2 | % | |||||||||
| Reinsurance Solutions | 1,429 | 1,361 | 5 | — | — | (1 | ) | 6 | |||||||||||||||
| Retirement Solutions | 1,755 | 1,707 | 3 | (1 | ) | — | 1 | 3 | |||||||||||||||
| Health Solutions | 1,515 | 1,370 | 11 | — | — | 4 | 7 | ||||||||||||||||
| Data & Analytic Services | 1,140 | 1,050 | 9 | — | — | 3 | 6 | ||||||||||||||||
| Elimination | (10 | ) | (8 | ) | NA | NA | NA | NA | NA | ||||||||||||||
| Total revenue | $ | 9,998 | $ | 9,409 | 6 | % | — | % | — | % | 2 | % | 4 | % |
| (1) | Revenue Recognition represents the impact of Aon’s adoption of the new revenue recognition standard, effective for Aon in the first quarter of 2018. |
| (2) | Currency impact is determined by translating prior period's revenue at this period's foreign exchange rates. |
| (3) | Fiduciary investment income for the years ended December 31, 2018, 2017, and 2016, respectively, was $53 million, $32 million, and $22 million. |
| (4) | Organic revenue growth includes the impact of intercompany activity and excludes the impact of the adoption of the new revenue recognition standard, changes in foreign exchange rates, acquisitions, divestitures, transfers between revenue lines, and fiduciary investment income. |
Adjusted Operating Margin
We use adjusted operating margin as a non-GAAP measure of core operating performance of the Company. Adjusted operating margin excludes the impact of certain items, as listed below, because management does not believe these expenses reflect our core operating performance. This supplemental information related to adjusted operating margin represents a measure not in accordance with U.S. GAAP, and should be viewed in addition to, not instead of, our Financial Statements.
A reconciliation of this non-GAAP measure to reported operating margins is as follows (in millions, except percentage data):
| Years ended December 31 | ||||||||||||
| 2018 | 2017 | 2016 | ||||||||||
| Revenue from continuing operations | $ | 10,770 | $ | 9,998 | $ | 9,409 | ||||||
| Operating income from continuing operations - as reported | $ | 1,544 | $ | 1,065 | $ | 1,811 | ||||||
| Amortization and impairment of intangible assets(3) | 593 | 704 | 157 | |||||||||
| Restructuring | 485 | 497 | — | |||||||||
| Legacy litigation | 75 | — | — | |||||||||
| Regulatory and compliance matters | — | 28 | — | |||||||||
| Transaction costs | — | — | 15 | |||||||||
| Operating income from continuing operations - as adjusted | $ | 2,697 | $ | 2,294 | $ | 1,983 | ||||||
| Operating margin from continuing operations - as reported | 14.3 | % | 10.7 | % | 19.2 | % | ||||||
| Operating margin from continuing operations - as adjusted | 25.0 | % | 22.9 | % | 21.1 | % |
Adjusted Diluted Earnings per Share
We also use adjusted diluted earnings per share as a non-GAAP measure of our core operating performance. Adjusted diluted earnings per share excludes the items identified above, plus related income taxes because management does not believe these expenses are representative of our core earnings. This supplemental information related to adjusted diluted earnings per share represents a measure not in accordance with U.S. GAAP and should be viewed in addition to, not instead of, our Financial Statements.
A reconciliation of this non-GAAP measure to reported Diluted earnings per share is as follows (in millions, except per share data and percentages):
| Year Ended December 31, 2018 | ||||||||||||
| (millions, except per share data) | U.S. GAAP | Adjustments | Non-GAAP Adjusted | |||||||||
| Operating income from continuing operations | $ | 1,544 | $ | 1,153 | $ | 2,697 | ||||||
| Interest income | 5 | — | 5 | |||||||||
| Interest expense | (278 | ) | — | (278 | ) | |||||||
| Other income (expense) (1) | (25 | ) | 37 | 12 | ||||||||
| Income before income taxes from continuing operations | 1,246 | 1,190 | 2,436 | |||||||||
| Income taxes (2) | 146 | 233 | 379 | |||||||||
| Net income from continuing operations | 1,100 | 957 | 2,057 | |||||||||
| Net income (loss) from discontinued operations (3) | 74 | (82 | ) | (8 | ) | |||||||
| Net income | 1,174 | 875 | 2,049 | |||||||||
| Less: Net income attributable to noncontrolling interests | 40 | — | 40 | |||||||||
| Net income attributable to Aon shareholders | $ | 1,134 | $ | 875 | $ | 2,009 | ||||||
| Diluted net income (loss) per share attributable to Aon shareholders | ||||||||||||
| Continuing operations | $ | 4.29 | $ | 3.87 | $ | 8.16 | ||||||
| Discontinued operations | 0.30 | (0.33 | ) | (0.03 | ) | |||||||
| Net income | $ | 4.59 | $ | 3.54 | $ | 8.13 | ||||||
| Weighted average ordinary shares outstanding — diluted | 247.0 | — | 247.0 | |||||||||
| Effective tax rates (3) | ||||||||||||
| Continuing operations - U.S. GAAP | 11.7 | % | 15.6 | % | ||||||||
| Discontinued operations - U.S. GAAP | 15,949.3 | % | 29.7 | % |
| Year Ended December 31, 2017 | ||||||||||||
| (millions, except per share data) | U.S. GAAP | Adjustments | Non-GAAP Adjusted | |||||||||
| Operating income from continuing operations | $ | 1,065 | $ | 1,229 | $ | 2,294 | ||||||
| Interest income | 27 | — | 27 | |||||||||
| Interest expense | (282 | ) | — | (282 | ) | |||||||
| Other income (expense) (1) | (125 | ) | 128 | 3 | ||||||||
| Income before income taxes from continuing operations | 685 | 1,357 | 2,042 | |||||||||
| Income taxes (2) | 250 | 55 | 305 | |||||||||
| Net income from continuing operations | 435 | 1,302 | 1,737 | |||||||||
| Net income (loss) from discontinued operations (3) | 828 | (772 | ) | 56 | ||||||||
| Net income | 1,263 | 530 | 1,793 | |||||||||
| Less: Net income attributable to noncontrolling interests | 37 | — | 37 | |||||||||
| Net income attributable to Aon shareholders | $ | 1,226 | $ | 530 | $ | 1,756 | ||||||
| Diluted net income (loss) per share attributable to Aon shareholders | ||||||||||||
| Continuing operations | $ | 1.53 | $ | 4.99 | $ | 6.52 | ||||||
| Discontinued operations | 3.17 | (2.95 | ) | 0.22 | ||||||||
| Net income | $ | 4.70 | $ | 2.04 | $ | 6.74 | ||||||
| Weighted average ordinary shares outstanding — diluted | 260.7 | — | 260.7 | |||||||||
| Effective tax rates (3) | ||||||||||||
| Continuing operations - U.S. GAAP | 36.5 | % | 14.9 | % | ||||||||
| Discontinued operations - U.S. GAAP | 58.9 | % | 11.7 | % |
| Year Ended December 31, 2016 | ||||||||||||
| (millions, except per share data) | U.S. GAAP | Adjustments | Non-GAAP Adjusted | |||||||||
| Operating income from continuing operations | $ | 1,811 | $ | 172 | $ | 1,983 | ||||||
| Interest income | 9 | — | 9 | |||||||||
| Interest expense | (282 | ) | — | (282 | ) | |||||||
| Other income (expense) (1) | (137 | ) | 220 | 83 | ||||||||
| Income before income taxes from continuing operations | 1,401 | 392 | 1,793 | |||||||||
| Income taxes (2) | 148 | 102 | 250 | |||||||||
| Net income from continuing operations | 1,253 | 290 | 1,543 | |||||||||
| Net income from discontinued operations (3) | 177 | 94 | 271 | |||||||||
| Net income | 1,430 | 384 | 1,814 | |||||||||
| Less: Net income attributable to noncontrolling interests | 34 | — | 34 | |||||||||
| Net income attributable to Aon shareholders | $ | 1,396 | $ | 384 | $ | 1,780 | ||||||
| Diluted net income (loss) per share attributable to Aon shareholders | ||||||||||||
| Continuing operations | $ | 4.51 | $ | 1.07 | $ | 5.58 | ||||||
| Discontinued operations | 0.65 | 0.36 | 1.01 | |||||||||
| Net income | $ | 5.16 | $ | 1.43 | $ | 6.59 | ||||||
| Weighted average ordinary shares outstanding — diluted | 270.3 | — | 270.3 | |||||||||
| Effective tax rates (3) | ||||||||||||
| Continuing operations - U.S. GAAP | 10.6 | % | 13.9 | % | ||||||||
| Discontinued operations - U.S. GAAP | 34.0 | % | 30.2 | % |
| (1) | Adjusted Other income (expense) excludes Pension settlement charges of $37 million, $128 million, and $220 million, for the years ended 2018, 2017, and 2016, respectively. |
| (2) | Adjusted items are generally taxed at the estimated annual effective tax rate, except for the applicable tax impact associated with estimated Restructuring Plan expenses, legacy litigation, accelerated tradename amortization, impairment charges and non-cash pension settlement charges, which are adjusted at the related jurisdictional rates. In addition, tax expense excludes the tax impacts from the sale of certain assets and liabilities previously classified as held for sale as well as the tax adjustments recorded to finalize the 2017 accounting for the enactment date impact of the Tax Reform Act recorded pursuant to SAB 118. |
| (3) | Adjusted net income from discontinued operations excludes the gain on sale of discontinued operations of $82 million, $779 million, and $0 million for the years ended 2018, 2017, and 2016, respectively. Adjusted net income from discontinued operations excludes intangible asset amortization of $0 million, $11 million, and $120 million for the twelve months ended December 31, 2018, 2017, and 2016, respectively. The effective tax rate was further adjusted for the applicable tax impact associated with the gain on sale and intangible asset amortization, as applicable. |
Free Cash Flow
We use free cash flow, defined as cash flow provided by operations minus capital expenditures, as a non-GAAP measure of our core operating performance and cash generating capabilities of our business operations. This supplemental information related to free cash flow represents a measure not in accordance with U.S. GAAP and should be viewed in addition to, not instead of, our Financial Statements. The use of this non-GAAP measure does not imply or represent the residual cash flow for discretionary expenditures. A reconciliation of this non-GAAP measure to cash flow provided by operations is as follows (in millions):
| Years Ended December 31 | 2018 | 2017 | 2016 | |||||||||
| Cash Provided by Continuing Operating Activities | $ | 1,686 | $ | 669 | $ | 1,829 | ||||||
| Capital Expenditures Used for Continuing Operations | (240 | ) | (183 | ) | (156 | ) | ||||||
| Free Cash Flow Provided By Continuing Operations | $ | 1,446 | $ | 486 | $ | 1,673 |
Impact of Foreign Currency Exchange Rate Fluctuations
We conduct business in more than 120 countries and sovereignties and, because of this, foreign currency exchange rate fluctuations have a significant impact on our business. Foreign currency exchange rate movements may be significant and may distort true period-to-period comparisons of changes in revenue or pretax income. Therefore, to give financial statement users meaningful information about our operations, we have provided an illustration of the impact of foreign currency exchange rate fluctuations on our financial results. The methodology used to calculate this impact isolates the impact of the change in currencies between periods by translating the prior year’s revenue, expenses, and net income using the current year’s foreign currency exchange rates.
Translating prior year results at current year foreign currency exchange rates, currency fluctuations had a $0.08 favorable impact on net income per diluted share during the year ended December 31, 2018. Currency fluctuations had a $0.12 favorable impact on net income per diluted share during the year ended December 31, 2017, when 2016 results were translated at 2017 rates. Currency fluctuations had no impact on net income per diluted share during the year ended December 31, 2016, when 2015 results were translated at 2016 rates.
Translating prior year results at current year foreign currency exchange rates, currency fluctuations had a $0.09 favorable impact on adjusted net income per diluted share during the year ended December 31, 2018. Currency fluctuations had a $0.08 favorable impact on adjusted net income per diluted share during the year ended December 31, 2017, when 2016 results were translated at 2017 rates. Currency fluctuations had a $0.04 unfavorable impact on adjusted net income per diluted share during the year ended December 31, 2016, when 2015 results were translated at 2016 rates. These translations are performed for comparative purposes only and do not impact the accounting policies or practices for amounts included in the Financial Statements.
Competition and Markets Authority
The U.K.’s competition regulator, the Competition and Markets Authority (the “CMA”), conducted a market investigation into the supply and acquisition of investment consulting and fiduciary management services, including those offered by Aon and its competitors in the U.K., to assess whether any feature or combination of features in the target market prevents, restricts, or distorts competition. The CMA issued a final report on December 12, 2018. The CMA will draft a series of orders that will set out the detailed remedies, expected in first quarter of 2019, when they will be subject to further public consultation. We do not anticipate the remedies to have a significant impact on the Company’s consolidated financial position or business.
Financial Conduct Authority
The FCA is conducting a market study to assess how effectively competition is working in the wholesale insurance broker sector in the U.K. in which Aon, through its subsidiaries, participates. The FCA has indicated that the purpose of a market study is to assess the extent to which the market is working well in the interests of customers and to identify features of the market that may impact competition. Depending on the study’s findings, the FCA may require remedies in order to correct any features found
to be preventing, restricting, or distorting competition. The study is ongoing and we are unable to estimate the impact, if any, on Aon’s business at this time.
LIQUIDITY AND FINANCIAL CONDITION
Liquidity
Executive Summary
We believe that our balance sheet and strong cash flow provide us with adequate liquidity. Our primary sources of liquidity are cash flows from operations, available cash reserves, and debt capacity available under our credit facilities. Our primary uses of liquidity are operating expenses, restructuring activities, capital expenditures, acquisitions, share repurchases, pension obligations, and shareholder dividends. We believe that cash flows from operations, available credit facilities, and the capital markets will be sufficient to meet our liquidity needs, including principal and interest payments on debt obligations, capital expenditures, pension contributions, and anticipated working capital requirements, for the foreseeable future.
Cash on our balance sheet includes funds available for general corporate purposes, as well as amounts restricted as to their use. Funds held on behalf of clients in a fiduciary capacity are segregated and shown together with uncollected insurance premiums and claims in Fiduciary assets in the Consolidated Statements of Financial Position, with a corresponding amount in Fiduciary liabilities.
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 underwriters. We also collect claims or refunds from underwriters on behalf of insureds, which are then returned 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 depending on when we collect the premiums, claims, and refunds, make payments to underwriters and insureds, and collect funds from clients and make payments on their behalf, and upon the impact of foreign currency movements. Fiduciary assets, because of their nature, are generally 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 short-term investments of $3.9 billion and $3.7 billion at December 31, 2018 and 2017, respectively, and fiduciary receivables of $6.3 billion and $5.9 billion at December 31, 2018 and 2017, respectively. While we earn investment income on the fiduciary assets held in cash and investments, the cash and investments cannot be used for general corporate purposes.
We maintain multicurrency cash pools with third-party banks in which various Aon entities participate. Individual Aon entities are permitted to overdraw on their individual accounts provided the overall global balance does not fall below zero. At December 31, 2018, non-U.S. cash balances of one or more entities were negative; however, the overall balance was positive.
The following table summarizes our Fiduciary assets, non-fiduciary Cash and cash equivalents, and Short-term investments as of December 31, 2018 (in millions):
| Statement of Financial Position Classification | |||||||||||||||
| Asset Type | Cash and Cash Equivalents | Short-term Investments | Fiduciary Assets | Total | |||||||||||
| Certificates of deposit, bank deposits or time deposits | $ | 656 | $ | — | $ | 2,279 | $ | 2,935 | |||||||
| Money market funds | — | 172 | 1,587 | 1,759 | |||||||||||
| Cash and short-term investments | 656 | 172 | 3,866 | 4,694 | |||||||||||
| Fiduciary receivables | — | — | 6,300 | 6,300 | |||||||||||
| Total | $ | 656 | $ | 172 | $ | 10,166 | $ | 10,994 |
Cash and cash equivalents decreased $100 million in 2018 compared to 2017. A summary of our cash flows provided by and used for continuing operations from operating, investing, and financing activities is as follows (in millions):
| Years Ended December 31 | ||||||||
| 2018 | 2017 | |||||||
| Cash provided by operating activities - continuing operations | $ | 1,686 | $ | 669 | ||||
| Cash provided by investing activities - continuing operations | $ | 31 | $ | 2,806 | ||||
| Cash used for financing activities - continuing operations | $ | (1,699 | ) | $ | (3,265 | ) | ||
| Effect of exchange rates changes on cash and cash equivalents | $ | (118 | ) | $ | 69 |
Operating Activities
Net cash provided by operating activities for continuing operations during the twelve months ended December 31, 2018 increased $1,017 million, or 152%, from the prior year to $1,686 million. This amount represents net income reported, as adjusted for gains or losses on sales of businesses, share-based compensation expense, depreciation expense, amortization and impairments, and other non-cash income and expenses, as well as changes in working capital that relate primarily to the timing of payments of accounts payable and accrued liabilities and the collection of receivables.
Pension Contributions
Pension cash contributions were $252 million for the twelve months ended December 31, 2018, which includes our acceleration of contributions to the qualified U.S. pension plan, as compared to cash contributions of $146 million and a non-cash contribution of $80 million for the twelve months ended December 31, 2017. In 2019, we expect to contribute approximately $145 million to our pension plans, with the majority attributable to non-U.S. pension plans, which are subject to changes in foreign exchange rates.
Restructuring Plan
In 2017, we initiated a global restructuring plan (the “Restructuring Plan”) in connection with the sale of the Divested Business. The Restructuring Plan is intended to streamline operations across the organization and deliver greater efficiency, insight, and connectivity. We expect these restructuring activities and related expenses to affect continuing operations through 2019, including an estimated 4,800 to 5,400 role eliminations. In the fourth quarter of 2018, we expanded the Restructuring Plan, which resulted in additional expected costs of approximately $200 million, consisting of $150 million of cash investment and $50 million of non-cash charges. Annualized estimated savings increased $50 million as a result of the expanded program. We do not expect any further adjustments to the total estimated program costs or annualized savings through the remainder of the program, which will be completed in the fourth quarter of 2019.
We expect the Restructuring Plan to result in cumulative costs of approximately $1,225 million through the end of the plan, consisting of approximately $450 million in employee termination costs, $130 million in technology rationalization costs, $65 million in real estate consolidation costs, $50 million in non-cash asset impairments, such as expense taken on software no longer in use, and $530 million in other costs including certain separation costs associated with the sale of the Divested Business. We estimate that our annualized savings from the Restructuring Plan and other operational improvement initiatives will be approximately $500 million by the end of 2019.
The following table summarizes restructuring and separation costs by type that have been incurred through December 31, 2018 and are estimated to be incurred through the end of the Restructuring Plan (in millions). Estimated remaining costs by type may be revised in future periods as these assumptions are updated:
| Year Ended December 31, 2018 | Inception to Date | Estimated Remaining Costs | Estimated Total Cost (1) | |||||||||||||
| Workforce reduction | $ | 115 | $ | 414 | $ | 36 | $ | 450 | ||||||||
| Technology rationalization (2) | 47 | 80 | 50 | 130 | ||||||||||||
| Lease consolidation (2) | 28 | 36 | 29 | 65 | ||||||||||||
| Asset impairments | 13 | 39 | 11 | 50 | ||||||||||||
| Other costs associated with restructuring and separation (2) (3) | 282 | 413 | 117 | 530 | ||||||||||||
| Total restructuring and related expenses | $ | 485 | 982 | $ | 243 | $ | 1,225 |
| (1) | Actual costs, when incurred, may vary due to changes in the assumptions built into the Restructuring Plan. Significant assumptions that may change when plans are finalized and implemented include, but are not limited to, changes in severance calculations, changes in the assumptions underlying sublease loss calculations due to changing market conditions, and changes in the overall analysis that might cause the Company to add or cancel component initiatives. |
| (2) | Total contract termination costs incurred under the Restructuring Plan associated with Technology rationalizations, Lease consolidations, and Other costs associated with restructuring and separation, respectively, for the twelve months ended December 31, 2018 were $5 million, $25 million, and $85 million; and since inception of the Restructuring Plan, were $6 million, $33 million, and $88 million, respectively. Total estimated contract termination costs expected to be incurred under the Restructuring Plan associated with Technology rationalizations, Lease consolidations, and Other costs associated with restructuring and separation, respectively, are $15 million, $80 million, and $95 million. |
| (3) | Other costs associated with the Restructuring Plan include those to separate the Divested Business, as well as moving costs and consulting and legal fees. These costs are generally recognized when incurred. |
As of December 31, 2018, our liabilities for the Restructuring Plan were as follows (in millions):
| Restructuring Plan | ||||
| Balance at December 31, 2017 | $ | 186 | ||
| Expensed | 448 | |||
| Cash payments | (425 | ) | ||
| Foreign currency translation and other | (8 | ) | ||
| Balance at December 31, 2018 | $ | 201 |
Investing Activities
Cash flow provided by investing activities in continuing operations was $31 million during the twelve months ended December 31, 2018, a decrease of $2,775 million compared to prior year. The primary drivers of cash flow used for investing activities are acquisition of businesses, purchases of short-term investments, capital expenditures, and payments for investments. The primary drivers of cash flow provided by investing activities are sales of businesses, sales of short-term investments, and proceeds from investments. The gains and losses corresponding to cash flows provided by proceeds from investments and used for payments for investments are primarily recognized in Other income (expense) in the Consolidated Statements of Income.
Short-term Investments
Short-term investments decreased $357 million at December 31, 2018 as compared to December 31, 2017. As disclosed in Note 16 “Fair Value Measurements and Financial Instruments” of the Financial Statements contained in Part II, Item 8 of this report, the majority of our investments carried at fair value are money market funds. These money market funds are held throughout the world with various financial institutions. We are not aware of any market liquidity issues that would materially impact the fair value of these investments.
Acquisitions and Dispositions of Businesses
During 2018, the Company completed the acquisition of eight businesses for consideration of $58 million, net of cash acquired, and completed the disposition of four business for a net cash outflow of $10 million.
During 2017, the Company completed the acquisition of seventeen businesses for consideration of $1,029 million, net of cash acquired, and the sale of nine businesses for $4,246 million.
Capital Expenditures
The Company’s additions to fixed assets, including capitalized software, which amounted to $240 million in 2018 and $183 million in 2017, primarily related to computer equipment purchases, the refurbishing and modernizing of office facilities, and software development costs.
Financing Activities
Cash flow used for financing activities in continuing operations during the twelve months ended December 31, 2018 was $1,699 million, an increase of $1,566 million compared to prior year. The primary drivers of cash flow used for financing activities are share repurchases, issuances of debt, net of repayments, dividends paid to shareholders, issuances of shares for employee benefit plans, transactions with noncontrolling interests, and other financing activities.
Share Repurchase Program
Aon has a share repurchase program authorized by the Company’s Board of Directors. The Repurchase Program was established in April 2012 with $5.0 billion in authorized repurchases, and was increased by $5.0 billion in authorized repurchases in each of November 2014 and February 2017, for a total of $15.0 billion in repurchase authorizations.
The following table summarizes the Company’s Share Repurchase activity (in millions, except per share data):
| Twelve months ended December 31 | ||||||||
| 2018 | 2017 (1) | |||||||
| Shares repurchased | 10.0 | 18.0 | ||||||
| Average price per share | $ | 143.94 | $ | 133.67 | ||||
| Costs recorded to retained earnings | ||||||||
| Total repurchase cost | $ | 1,447 | $ | 2,403 | ||||
| Additional associated costs | 7 | 12 | ||||||
| Total costs recorded to retained earnings | $ | 1,454 | $ | 2,415 |
| (1) | Included in the 18.0 million shares repurchased during the twelve months ended December 31, 2017 were 0.1 million shares that did not settle until January 2018. These shares were settled at an average price per share of $134.41 and total cost of $15.9 million. |
At December 31, 2018, the remaining authorized amount for share repurchase under the Repurchase Program was approximately $4.0 billion. Under the Repurchase Program, the Company has repurchased a total of 118.3 million shares for an aggregate cost of approximately $11.0 billion.
Borrowings
Total debt at December 31, 2018 was $6.2 billion, an increase of $278 million compared to December 31, 2017. Commercial paper activity during the years ended December 31, 2018 and 2017 is as follows (in millions):
| Twelve months ended December 31 | |||||||
| 2018 | 2017 | ||||||
| Total issuances(1) | $ | 5,400 | $ | 1,648 | |||
| Total repayments | (5,118 | ) | (1,997 | ) | |||
| Net issuances | $ | 282 | $ | (349 | ) |
(1) The proceeds of the commercial paper issuances were used primarily for short-term working capital needs.
On December 3, 2018, Aon Corporation issued $350 million 4.50% Senior Notes due December 2028. The Company used the proceeds for general corporate purposes.
On March 8, 2018 the Company’s CAD 375 million ($291 million at March 8, 2018 Exchange Rates) 4.76% Senior Notes due March 2018 issued by a Canadian subsidiary of Aon Corporation matured and was repaid in full.
Other Liquidity Matters
Distributable Reserves
As a company incorporated in England and Wales, we are required under U.K. law to have available “distributable reserves” to make share repurchases or pay dividends to shareholders. Distributable reserves may be created through the earnings of the U.K. parent company and, among other methods, through a reduction in share capital approved by the courts of England and Wales. Distributable reserves are not linked to a U.S. GAAP reported amount (e.g., retained earnings). As of December 31, 2018 and 2017, we had distributable reserves in excess of $2.2 billion and $1.2 billion, respectively. We believe that we will have sufficient distributable reserves to fund shareholder dividends and make share repurchases for the foreseeable future.
Credit Facilities
We expect cash generated by operations for 2018 to be sufficient to service our debt and contractual obligations, finance capital expenditures, continue purchases of shares under the Repurchase Program, and continue to pay dividends to our shareholders. Although cash from operations is expected to be sufficient to service these activities, we have the ability to access the commercial paper markets or borrow under our credit facilities to accommodate any timing differences in cash flows. Additionally, under current market conditions, we believe that we could access capital markets to obtain debt financing for longer-term funding, if needed.
As of December 31, 2018, we had two primary committed credit facilities outstanding: our $900 million multi-currency U.S. credit facility expiring in February 2021 (the “2021 Facility”) and our $400 million multi-currency U.S. credit facility expiring in October 2022 (the “2022 Facility”). On February 2, 2019, we extended the 2021 Facility by one year, and it will now expire in February 2022.
Each of these facilities includes customary representations, warranties, and covenants, including financial covenants that require us to maintain specified ratios of adjusted consolidated earnings before interest, taxes, depreciation, and amortization (“EBITDA”) to consolidated interest expense and consolidated debt to adjusted consolidated EBITDA, in each case, tested quarterly. At December 31, 2018, we did not have borrowings under either the 2021 Facility or the 2022 Facility, and we were in compliance with all other covenants contained therein during the twelve months ended December 31, 2018.
Shelf Registration Statement
On September 25, 2018, we filed a shelf registration statement with the SEC, registering the offer and sale from time to time of an indeterminate amount of, among other securities, debt securities, preference shares, Class A Ordinary Shares, and convertible securities. Our ability to access the market as a source of liquidity is dependent on investor demand, market conditions, and other factors.
Rating Agency Ratings
The major rating agencies’ ratings of our debt at February 19, 2019 appear in the table below.
| Ratings | |||||
| Senior Long-term Debt | Commercial Paper | Outlook | |||
| Standard & Poor’s | A- | 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 could increase our borrowing costs, reduce or eliminate our access to debt capital, reduce our financial flexibility, or restrict our access to the commercial paper market altogether, and/or impact future pension contribution requirements.
Guarantees in Connection with the Sale of the Divested Business
In connection with the sale of the Divested Business, we guaranteed future operating lease commitments related to certain facilities assumed by the Buyer. We are obligated to perform under the guarantees if the Divested Business defaults on the leases at any time during the remainder of the lease agreements, which expire on various dates through 2024. As of December 31, 2018, the undiscounted maximum potential future payments under the lease guarantee were $85 million, with an estimated fair value of $17 million. No cash payments were made in connection to the lease commitments during the year ended December 31, 2018.
Additionally, we are subject to performance guarantee requirements under certain client arrangements that were assumed by the Buyer. Should the Divested Business fail to perform as required by the terms of the arrangements, we would be required to fulfill the remaining contract terms, which expire on various dates through 2023. As of December 31, 2018, the undiscounted maximum potential future payments under the performance guarantees were $188 million, with an estimated fair value of $1 million. No cash payments were made in connection to the performance guarantees during the year ended December 31, 2018.
Letters of Credit and Other Guarantees
We have entered into a number of arrangements whereby our performance on certain obligations is guaranteed by a third party through the issuance of a letter of credit (“LOCs”). We had total LOCs outstanding of approximately $83 million at December 31, 2018, compared to $96 million at December 31, 2017. These LOCs cover the beneficiaries related to certain of our U.S. and Canadian non-qualified pension plan schemes and secure deductible retentions for our own workers’ compensation program. We also have obtained LOCs to cover contingent payments for taxes and other business obligations to third parties, and other guarantees for miscellaneous purposes at our international subsidiaries.
The Company has certain contractual contingent guarantees for premium payments owed by clients to certain insurance companies. The maximum exposure with respect to such contractual contingent guarantees was approximately $103 million at December 31, 2018, compared to $95 million at December 31, 2017.
Off-Balance Sheet Arrangements
Apart from commitments, guarantees, and contingencies, as disclosed herein and Note 17 “Claims, Lawsuits, and Other Contingencies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this report, the Company had no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, results of operations, or liquidity. Our cash flows from operations, borrowing availability, and overall liquidity are subject to risks and uncertainties. See “Information Concerning Forward-Looking Statements” below.
Contractual Obligations
Summarized in the table below are our contractual obligations and commitments as of December 31, 2018. Payments by year due are estimated as follows (in millions):
| Payments due by | |||||||||||||||||||
| 2019 | 2020-2021 | 2022-2023 | After 2023 | Total | |||||||||||||||
| Principal payments on debt | $ | 251 | $ | 1,000 | $ | — | $ | 5,095 | $ | 6,346 | |||||||||
| Interest payments on debt | 275 | 514 | 467 | 2,220 | 3,476 | ||||||||||||||
| Operating leases | 303 | 474 | 330 | 472 | 1,579 | ||||||||||||||
| Pension and other postretirement benefit plans | 150 | 270 | 298 | 314 | 1,032 | ||||||||||||||
| Purchase obligations | 179 | 132 | 24 | 5 | 340 | ||||||||||||||
| Total | $ | 1,158 | $ | 2,390 | $ | 1,119 | $ | 8,106 | $ | 12,773 |
Pension and other postretirement benefit plan obligations include estimates of our minimum funding requirements pursuant to the Employee Retirement Income Security Act and other regulations, as well as minimum funding requirements agreed with the trustees of our U.K. pension plans. Additional amounts may be agreed to with, or required by, the U.K. pension plan trustees. Nonqualified pension and other postretirement benefit obligations are based on estimated future benefit payments. We may make additional discretionary contributions.
In 2017, our principal U.K. subsidiary agreed with the trustees of one of the U.K. plans to contribute £44 million ($59 million at December 31, 2017 exchange rates) through 2019 which is estimated to bring the plan to 100% funded basis. Contributions were based on the 2016 valuation and no further contributions are forecasted after 2019. The trustees of the plan have certain rights to request that our U.K. subsidiary advance an amount equal to an actuarially determined winding-up deficit. As of December 31, 2018, the estimated winding-up deficit was £84 million ($106 million at December 31, 2018 exchange rates). 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.
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 the goods to be purchased or services to be rendered, the price at which the goods or services are to be rendered, and the timing of the transactions. Most of our purchase obligations are related to purchases of information technology services or other service contracts. Purchase obligations exclude $279 million of liabilities for uncertain tax positions due to our inability to reasonably estimate the period(s) when potential cash settlements will be made.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Financial Statements have been prepared in accordance with U.S. GAAP. To prepare these financial statements, we make 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 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 restructuring, revenue recognition, 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 use to prepare these Financial Statements.
Revenue Recognition
The Company recognizes revenue when control of the promised services is transferred to the customer in the amount that best reflects the consideration to which the Company expects to be entitled in exchange for those services. For arrangements where control is transferred over time, an input or output method is applied that represents a faithful depiction of the progress towards completion of the performance obligation. For arrangements that include variable consideration, the Company assesses whether any amounts should be constrained. For arrangements that include multiple performance obligations, the Company allocates consideration based on their relative fair values.
Costs incurred by the Company in obtaining a contract are capitalized and amortized on a systematic basis that is consistent with the transfer of control of the services to which the asset relates, considering anticipated renewals when applicable. Certain contract related costs, including pre-placement brokerage costs, are capitalized as a cost to fulfill and are amortized on a systematic basis consistent with the transfer of control of the services to which the asset relates, which is generally less than one year.
Commercial Risk Solutions includes retail brokerage, cyber solutions, global risk consulting, and captives. Revenue primarily includes insurance commissions and fees for services rendered. Revenue is predominantly recognized at a point in time upon the effective date of the underlying policy, or for a limited number of arrangements, over the term of the arrangement using output measures to depict the transfer of control of the services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those services. For arrangements recognized over time, various output measures, including units transferred and time elapsed, are utilized to provide a faithful depiction of the progress towards completion of the performance obligation. Revenue is recorded net of allowances for estimated policy cancellations, which are determined based on an evaluation of historical and current cancellation data. Commissions and fees for brokerage services may be invoiced near the effective date of the underlying policy or over the term of the arrangement in installments during the policy period.
Reinsurance Solutions includes treaty and facultative reinsurance brokerage and capital markets. Revenue primarily includes reinsurance commissions and fees for services rendered. Revenue is predominantly recognized at a point in time upon the effective date of the underlying policy (or policies), or for a limited number of arrangements, over the term of the arrangement using output measures to depict the transfer of control of the services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those services. For arrangements recognized over time, various output measures, including units delivered and time elapsed, are utilized to provide a faithful depiction of the progress towards completion of the performance obligation. Commissions and fees for brokerage services may be invoiced at the inception of the reinsurance period for certain reinsurance brokerage, or more commonly, over the term of the arrangement in installments based on deposit or minimum premiums for most treaty reinsurance arrangements.
Retirement Solutions includes core retirement, investment consulting, and talent, rewards & performance. Revenue consists primarily of fees paid by customers for consulting services, such as risk management strategies, health and benefits, and human capital consulting services. Revenue recognized for these arrangements is predominantly recognized over the term of the arrangement using input or output measures to depict the transfer of control of the services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those services, or for certain arrangements, at a point in time upon completion of the services. For consulting arrangements recognized over time, revenue will be recognized based on a measure of progress that depicts the transfer of control of the services to the customer, utilizing an appropriate input or output measure to provide a reasonable assessment of the progress towards completion of the performance obligation including units delivered or time elapsed. Fees paid by customers for consulting services are typically charged on an hourly, project or fixed-fee basis, and revenue for these arrangements is typically recognized based on time incurred, days elapsed, or reports delivered. Revenue from time-and-materials or cost-plus arrangements are recognized as services are performed using input or output measures to provide a reasonable assessment of the progress towards completion of the performance obligation including hours worked, and revenue for these arrangements is typically recognized based on time and materials incurred. Reimbursements received for out-of-pocket expenses are recorded as a component of revenue. Payment terms vary but are typically over the contract term in installments.
Health Solutions includes health and benefits brokerage and health care exchanges. Revenue primarily includes insurance commissions and fees for services rendered. For brokerage commissions, revenue is predominantly recognized at the effective date of the underlying policy (or policies), or for a limited number of arrangements, over the term of the arrangement to depict the transfer of control of the services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those services using input or output measures, including units delivered or time elapsed, to provide a faithful depiction of the progress towards completion of the performance obligation. Revenue from health care exchange arrangements are typically recognized upon successful enrollment of participants, net of a reserve for estimated cancellations. Commissions and fees for brokerage services may be invoiced at the effective date of the underlying policy or over the term of the arrangement in installments during the policy period. Payment terms for other services vary but are typically over the contract term in installments.
Data & Analytic Services includes Affinity, Aon InPoint, and ReView. Revenue consists primarily of fees for services rendered and is generally recognized over the term of the arrangement to depict the transfer of control of the services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those services. Payment terms vary but are typically over the contract term in installments. For Data & Analytic Services arrangements recognized over time, revenue will be recognized based on a measure of progress that depicts the transfer of control of the services to the customer, utilizing an appropriate input or output measure to provide a faithful depiction of the progress towards completion of the performance obligation, including units delivered or time elapsed. Input and output measures utilized vary based on the arrangement but typically include reports provided or days elapsed.
Restructuring
Workforce reduction costs
The method used to account for workforce reduction costs depends on whether the costs result from an ongoing severance plan or are one-time costs. We account for relevant expenses as severance costs when we have an established severance policy, statutory requirements dictate the severance amounts, or we have an established pattern of paying by a specific formula. We recognize these costs when the likelihood of future settlement is probable and the amount of the related benefit is reasonably estimable, or on a straight-line basis over the remaining service period, if applicable.
We estimate our one-time workforce reduction costs related to exit and disposal activities not resulting from an ongoing severance plan based on the benefits available to the employees being terminated. We recognize these costs when we identify the specific classification (or functions) and locations of the employees being terminated, notify the employees who might be included in the termination, and expect to terminate employees within the legally required notification period. When employees are receiving incentives to stay beyond the legally required notification period, we record the cost of their severance over the remaining service period.
Lease consolidation 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. The loss reflects our best estimate of the net present value of the future cash flows associated with the lease at the date we provide notice of cancellation in accordance with contractual terms, vacate the property, or sign a sublease arrangement. To determine the loss, we estimate sublease income based on current market quotes for similar properties. When we finalize definitive agreements with the sublessee, we adjust our sublease losses for actual outcomes.
Fair value concepts of one-time workforce reduction costs and lease losses
Accounting guidance requires that our exit and disposal accruals reflect the fair value of the liability. Where material, we discount the lease loss calculations to arrive at their net present value. Most workforce reductions happen over a short span of time, so no discounting is necessary.
For the remaining lease term, we decrease the liability for payments and increase the liability for accretion of the discount, if material. 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.
Asset impairments
Asset impairments relate to fixed assets and are accounted for in the period when they become known. Furthermore, we record impairments by reducing the book value to the net present value of future cash flows (in situations where the asset had an identifiable cash flow stream) or accelerating the depreciation to reflect the revised useful life. Asset impairments are included in Depreciation of fixed assets in the Consolidated Statements of Income.
Other associated costs of exit and disposal activities
We recognize other costs associated with exit and disposal activities as they are incurred, including separation costs, 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 U.K., the Netherlands, and Canada, which are closed to new entrants. We have ceased crediting future benefits relating to salary and services for our U.S., U.K., Netherlands, and Canadian plans to the extent statutorily permitted.
The service cost component of net periodic benefit cost is reported in Compensation and benefits and all other components are reported in Other income (expense). We used a full-yield curve approach in the estimation of the service and interest cost
components of net periodic pension and postretirement benefit cost for our major pension and other postretirement benefit plans; this was obtained by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows.
Recognition of gains and losses and prior service
Certain changes in the value of the obligation and in the value of plan assets, which may occur due to various factors such as changes in the discount rate and actuarial assumptions, actual demographic experience, and/or plan asset performance are not immediately recognized in net income. Such changes are recognized in Other comprehensive income and are amortized into net income as part of the net periodic benefit cost.
Unrecognized gains and losses that have been deferred in Other comprehensive income, as previously described, are amortized into expense as a component of periodic pension expense based on the average life expectancy of the U.S., U.K., Netherlands, and Canada plan members. We amortize any prior service expense or credits that arise as a result of plan changes over a period consistent with the amortization of gains and losses.
As of December 31, 2018, our pension plans have deferred losses that have not yet been recognized through income in the Consolidated Financial Statements. We amortize unrecognized actuarial losses outside of a corridor, which is defined as 10% of the greater of market-related value of plan assets or projected benefit obligation. To the extent not offset by future gains, incremental amortization as calculated above will continue to affect future pension expense similarly until fully amortized.
The following table discloses our unrecognized actuarial gains and losses, the number of years over which we are amortizing the experience loss, and the estimated 2019 amortization of loss by country (millions, except amortization period):
| U.K. | U.S. | Other | |||||||||
| Unrecognized actuarial gains and losses | $ | 1,136 | $ | 1,708 | $ | 433 | |||||
| Amortization period | 8 - 28 | 7 - 23 | 13 - 40 | ||||||||
| Estimated 2019 amortization of loss | $ | 30 | $ | 55 | $ | 12 |
The unrecognized prior service cost (credit) at December 31, 2018 was $3 million, $30 million, and $(7) million for the U.S., U.K. and other plans, respectively.
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 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 December 31, 2018, the market-related value of assets was $2.0 billion. We do not use the market-related valuation approach to determine the funded status of the U.S. plans recorded in the Consolidated Statements of Financial Position. Instead, we record and present the funded status in the Consolidated Statements of Financial Position based on the fair value of the plan assets. As of December 31, 2018, the fair value of plan assets was $1.8 billion.
Our non-U.S. plans use fair value to determine expected return on assets.
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 as of December 31, 2018:
| U.K. | U.S. | Other | |||
| Expected return | 3.64% | 7.05% | 2.50 - 4.10% |
In determining the expected rate of return for the plan assets, we analyze 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 investment policy for U.K. and other non-U.S. pension plans is generally determined by the plans’ trustees. Because there are several pension plans maintained in the U.K. and other non-U.S. categories, our target allocation presents a range of the target allocation of each plan. Target allocations are subject to change.
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.
Holding all other assumptions constant, the following table reflects what a 25 basis point (“bps”) increase and decrease in our estimated discount rate would have on our projected benefit obligation at December 31, 2018 (in millions):
| Increase (decrease) in projected benefit obligation (1) | 25 bps Change in Discount Rate | ||||||
| Increase | Decrease | ||||||
| U.K. plans | $ | (158 | ) | $ | 168 | ||
| U.S. plans | (80 | ) | 84 | ||||
| Other plans | (70 | ) | 79 |
| (1) | Increases to the projected benefit obligation reflect increases to our pension obligations, while decreases in the projected benefit obligation are recoveries toward fully-funded status. A change in the discount rate has an inverse relationship to the projected benefit obligation. |
Holding all other assumptions constant, the following table reflects what a 25 bps increase and decrease in our discount rate would have on our estimated 2019 pension expense (in millions):
| 25 bps Change in Discount Rate | |||||||
| Increase (decrease) in expense | Increase | Decrease | |||||
| U.K. plans | $ | (2 | ) | $ | 1 | ||
| U.S. plans | 1 | (1 | ) | ||||
| Other plans | (1 | ) | 1 |
Holding all other assumptions constant, the following table reflects what a 25 bps increase and decrease in our long-term rate of return on plan assets would have on our estimated 2019 pension expense (in millions):
| 25 bps Change in Long-Term Rate of Return on Plan Assets | |||||||
| Increase (decrease) in expense | Increase | Decrease | |||||
| U.K. plans | $ | (13 | ) | $ | 13 | ||
| U.S. plans | (5 | ) | 5 | ||||
| Other plans | (2 | ) | 2 |
Estimated future contributions
We estimate cash contributions of approximately $145 million to our pension plans in 2019 as compared with cash contributions of $252 million in 2018, which includes our acceleration of contributions to the qualified U.S. pension plan.
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 tradenames, customer-related and contract-based, or technology and other.
Goodwill is not amortized, but rather tested for impairment at least annually in the fourth quarter. We test more frequently if there are indicators of impairment or whenever business circumstances suggest that the carrying value of goodwill may not be recoverable. These indicators may include a sustained significant decline in our share price and market capitalization, a decline in our expected future cash flows, or a significant adverse change in legal factors or in the business climate, among others. No events occurred during 2018 that indicate the existence of an impairment with respect to our reported goodwill.
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 are similar, if none of its components are a reporting unit, or if the segment comprises only a single component.
When evaluating these assets for impairment, we may first perform a qualitative assessment to determine whether it is more likely than not that a reporting unit is impaired. If we do not perform a qualitative assessment, or if we determine that it is not more likely than not that the fair value of the reporting unit exceeds its carrying amount, then the goodwill impairment test becomes a two-step analysis. Step 1 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 is 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 2. Step 2 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 1 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 2018 and 2017, 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 December 31, 2018. If we are required to record impairment charges in the future, they could materially impact our results of operations.
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 or more future events occur or fail to occur. Under U.S. GAAP, we are required to establish reserves for loss contingencies when the loss 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 and amounts due are probable of collection.
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.
Restricted Share Units
Restricted share units (“RSUs”) are service-based awards for which we recognize the associated compensation cost on a straight-line basis over the requisite service period. We estimate the fair value of the awards based on the market price of the underlying share on the date of grant, reduced by the present value of estimated dividends foregone during the vesting period where applicable.
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 share on the date of grant, reduced by the present value of estimated dividends foregone during the vesting period.
Compensation expense is recognized over the performance period. 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 plan is the Leadership Performance Plan (“LPP”), which has a three-year performance period. 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. The 2016 to 2018 performance period ended on December 31, 2018, the 2015 to 2017 performance period ended on December 31, 2017 and the 2014 to 2016 performance period ended on December 31, 2016. The LPP currently has two open performance periods: 2017 to 2019 and 2018 to 2020. A 10% upward adjustment in our estimated performance achievement percentage for both open performance periods would have increased our 2018 expense by approximately $2.1 million, while a 10% downward adjustment would have decreased our expense by approximately $6.0 million.
Income Taxes
We earn income in numerous countries and this income is subject to the laws of taxing jurisdictions within those countries.
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. In this assessment, 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 base the carrying values of liabilities and assets for income taxes currently payable and receivable 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.
Income Tax Accounting Implications of the Tax Cuts and Jobs Act
On December 22, 2017, the Tax Reform Act was enacted into law and the new legislation contained several key tax provisions that impacted the Company. In December 2017, the SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), which allowed registrants to record provisional amounts during a measurement period not to extend beyond one year of the enactment date. Since the Tax Reform Act was passed late in the fourth quarter of 2017 and ongoing guidance and accounting interpretation was expected, certain items were considered provisional in the Company’s financial statements for 2017 due to the forthcoming guidance and ongoing analysis of year-end data and tax positions. In the fourth quarter of 2018, the Company completed its analysis in accordance with SAB 118. See Note 11 “Income Taxes” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this report for additional information and a detailed description of the impact of completing the accounting for 2017.
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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