Arthur J. Gallagher & Co. (AJG) 2006 Q1 法說會逐字稿

Good morning, ladies and gentlemen.

Welcome to the Arthur J. Gallagher & Co first quarter 2006 earnings conference call. [OPERATOR INSTRUCTIONS] It is important to note that some of the comments made by Arthur J. Gallagher & Co. today may constitute forward-looking statements within the meaning of the securities law and are subject to certain factors and risks described in its filings with the Securities and Exchange Commission which may cause actual results to differ materially.

It is now my pleasure to hand the floor over to your host, J Patrick Gallagher Jr., President and CEO of Arthur J. Gallagher & Co. Sir, the floor is yours.

Thank you, Toni.

Good morning, everyone.

Welcome to our first quarter 2006 earnings conference call and webcast.

Thanks for joining us just a few days earlier than normal.

I know we're at a bit of an earlier hour, but I think as all of you on the call know that the RIMS, Risk and Insurance Management Society, convention is next week and a number of us here will be out of the office all week long.

This morning I am joined by Doug Howell, our Chief Financial Officer, John Rosengren, our General Counsel, as well as the heads of our business units.

I would like to add some color to the press release that we put out yesterday afternoon on the quarter.

Then Doug will make some comments and we'll go to questions and answers.

Obviously you've noticed the jump in our tax rate and the impact that oil prices are having on our Syn/fuel operations.

Doug is going to address this more in detail in a moment.

I want to concentrate my discussion on our insurance operations.

Remember as we approached this quarter we had to prepare the entire brokerage team for a new world.

That's the world of transparency.

From last May 18th through last December of '05, we worked very hard to totally change the way our business was conducted, a change after over 75 years in business.

Many people wondered what the impact of full disclosure would be.

Would the clients be satisfied, would they agree to our compensation, would they understand the value proposition.

In addition to the loss of contingents, there was some worry that clients would push our margins down.

As we start this conference call, let me be sure you understand just exactly how proud I am of the team and the results that we generated for the quarter.

Remember, we're competing in the middle market day in and day out, and we're not always competing against our larger publicly traded competitors, but rather against smaller, local and sometimes regional competitors who are darn good, tough competitors, and they have not had to change a thing.

They keep their contingents and they don't have to worry about transparency.

With that competition we're now well into our May and in some instance June and July renewals and it's really, really been good news.

The business is strong, the value of the team and our willingness to be transparent are actually helping our sales efforts.

Lost business has actually improved in the quarter.

So as I said, I am proud of these efforts and I'm proud of the professionals that I work with because I think once again we've shown that we can adapt, we can change and get ourself poised for growth.

If you peel back what I call some of the noise, or the in's and out's of the quarter, you will see we really did have a decent start to the year.

Our Brokerage segment, excluding contingents and excluding reserves for the state regulatory activity in '05, did about 17 million in pre-tax versus about 10 million pre-tax in '05.

This is a 72% increase year-over-year.

Now I understand that it is a smaller quarter, so the percentages are skewed, and I understand that we had a $2.4 million sale of the book to business, but even if you took that sale out, the pre-tax profit in the Brokerage segment was up 46%.

Expanding our Brokerage margin in the first quarter is always tough because of the seasonality, the fact that our first quarter has lower revenues.

New hires that we brought on in '05 are pre-tax accretive and slightly margin dilutive, but they are producing really well.

Brokerage and Risk Management combined pre-tax, excluding the contingents and the reserves, was up 19% for the quarter.

Again, new business was strong, our retention is good and expense control, I think, is clearly evident with margin expansion in particular in the Brokerage segment.

As you all know, our Brokerage segment is made up of three divisions, our Brokerage Services Retail Division, Specialty Marketing International, which is our wholesaling, reinsurance, London based wholesaling reinsurance as well, as well as our International Retail Operations, and Gallagher Benefit Services.

Let me just take a moment to run through each of those.

Let me start with the retail operation.

As I've said for a number of quarters, this operation is clearly running on what we call around here the soft market play book.

Headcount through '05 and into the first quarter of '06 was very tightly controlled.

We are continuing to recruit production talent.

But when we recruit that talent we expect producers to be accretive very quickly.

As I did say already, our new producers are now accretive to pre-tax.

Expense control in a soft market play book is also incredibly important.

So I am pleased to see that our retail margin improved 3% year-over-year in the quarter.

Our specialty marketing operation is also off to a good start.

You will remember that our London operation has struggled for a couple of years.

This quarter saw a marked improvement over the same period in '05.

And it looks to me like all of '06 will produce a much better result.

Risk Placement Services, that is our wholesaling operation, which we started from scratch in 1997, is now one of the largest and fastest growing wholesalers in the marketplace.

I might also reemphasize Risk Placement Services not for sale.

First quarter saw an 11% jump in revenues and a 28% jump in pre-tax profits, even with all lines other than catastrophe property softening.

Gallagher Benefit Services, our benefits consulting arm, is also off to a good start.

We're up 12% in revenue and 12% in pre-tax profit for the quarter.

Clients continue to struggle, as we do, with the ever escalating costs and complexities of our benefits plans.

Now let me move to Gallagher Bassett, our Risk Management Segment.

A very exciting part of GB's growth story is our international growth.

Growth in Australia over the first quarter of last year gave us a 33% lift in revenues for the quarter.

Domestically we also had a strong quarter.

Revenue in the quarter was impacted by smaller audit revenues this year than we received in '05 and by some E&O claims that we paid.

But adjusting for that Gallagher Bassett's margin and revenue would have been just a few points higher.

I am comfortable with the start of GB and I do believe that we're on track for 2006.

There is five other specific areas that I want to touch on and then I will turn it over to Doug.

The first is the property/casualty market.

Clearly property, especially in catastrophe exposed areas, is seeing the beginning of what would be known as a classic hard market.

Capacity is shrinking, pricing is going up, and availability for the coverage, in particular later this year, if we don't see some additional entrants it may dry up entirely.

We all need to remember we're standing right now on the verge of the next hurricane season.

Last season the hurricanes, you will remember the catastrophe modeling that was done in the industry fell way, way short of what the actual losses were.

So we know that the July 1st catastrophe treaty renewals are going to be very, very difficult.

Outside the catastrophe market, the market is flat to down.

Very much in line, I think, with what we saw in the fourth quarter.

So if our coastal offices can place their clients property coverage, they should get a lift.

And we're seeing some of that.

All the other offices in the Company will probably see more softening, because we believe that carriers are going to reallocate their capacity to other parts of the country.

Number two, I mentioned already the selling in a transparent world.

I can't emphasize enough what a difference this is.

But it is interesting that we're finding that clients really like the disclosure.

We're competing in the middle market by making absolutely certain that our clients know we represent them and it is working.

So it doesn't surprise me that client retention has improved.

What I am really pleased with is new business has been maintained and clients are enjoying the disclosure.

Number three, our merger and acquisition activity has remained good.

To date we've closed two deals.

The pipeline does look good for '06.

But remember, everything we do in the acquisition world is based on a good cultural fit.

We're not out just trying to buy properties.

The fit has to be there before we'll move forward.

Fourthly, we're continuing to invest in our reinsurance brokerage opportunities.

Here again our London team is getting some real momentum.

We're seeing some real traction there and we're getting a good return on those investments.

The reinsurance team globally I think is beginning to see more opportunities and opportunities to work together.

We see the Gallagher rebrand becoming much more well recognized and we think we'll be able to develop a force in the years ahead.

One of the things I think we're good at as a Company is starting businesses and building them.

Fifth, speaking of the years ahead, I believe that the life blood of any growing Company has to be its young people.

As we speak, our preparations right now are under way for 175 interns throughout Gallagher this summer.

This will be the largest class by far in the 40 plus year history of this program.

It is always exciting to have these young people with us in the summer.

In addition, we've mentioned in the past our career launch program, which is our eighteen-month online training program which now has 91 people in it.

All in all I believe it is a good start to the year.

I am proud of the team in the field.

It is a competitive marketplace.

They are producing.

New business is strong.

Client retention is good.

We're diligently focused on controlling expenses and we look forward really to the rest of 2006.

We're really focused on building the best business we can in the insurance and risk management industry.

Doug?

Thanks, Pat, and good morning, everyone.

As Pat said, we're pleased with the growth in our pre-tax earnings in our operating units.

And we continue to see improvement in our core operations.

Today I have five comments.

And, as I always remind you, we have a 21-quarter spread on our website and will file our 10-Q early next week.

First let me jump right into our tax rate in the Financial Services segment.

I am assuming that you have read or will read the detailed information in our earnings release.

Rather than reading those disclosures verbatim, let me just give you four short voice-overs that will help you as you go back through that information.

Number one, thus far in 2006 oil has reached prices leading us to estimate that there will be a 53% phase-out of section 29 tax credit.

Granted, if oil continues to increase, the phase-out percentage will ultimately be larger, but if oil prices decrease, the phase-out percentage will be less.

We just won't know for sure until the end of 2006, but we have to make an estimate when we close the books this quarter.

Number two, there has been some congressional action that might lead to some relief from this phase-out rule.

However,Congress adjourned for their recent recess before resolving the issue.

Who knows if they'll pick it up again next week when they return.

Further, with oil prices above $70 per barrel, hedging alternatives are not economical.

As we sit today, we have no relief from oil prices, there is significant uncertainty with respect to what Congress will or won't do, and hedging at these prices does not seem to make economic sense.

Number three, I am sure that you've seen by now that we booked an effective tax rate of 41%, which is 18 points higher than our 23% effective tax rate at 2005.

This increase is solely because we did not operate in the first quarter 2006 our two sinkhole facilities that generate the vast majority of tax credits.

However, please note that we can restart these facilities fairly quickly and if oil prices retreat or we get some legislative relief, we can again begin producing and thereby lower our tax rate.

Number four, you will also read that we did operate our three sinkhole facilities that generate pretax income.

You can see that at a 53% phase-out, we're slightly below our breakeven point.

Accordingly, if oil continues to be this high in the next 30 to 60 days we'll have to make a call about idling these plants for awhile.

In summary, as we sit today, our first quarter numbers reflect a full tax rate and we have significantly reduced our expected revenues from our coal ventures.

My second comment also relates to the Financial Services segment.

Our team continues to work on divesting our other investments.

We're moving along nicely in selling our home office building and hope to consummate a deal before the third quarter.

We expect that sale will generate cash and remove about 75 million of debt from our balance sheet.

However, while this will generate some free cash, don't forget that any financial statement gain would be deferred and amortized over the future lease terms.

My third comment relates to the Brokerage segment and is really a repeat of what I've been saying for quite a while.

Our brokage business is seasonal.

And now with retail contingent commissions gone, you can quickly see the seasonality in our numbers.

We've again provided information in our earnings release that gives you some insight as to what we booked for contingent commission in prior quarters.

Please consider this information when you do your quarterly estimates.

Fourth, some comments related to our cash.

During the quarter we used about 110 million to pay off the Headwaters litigation, 27 million to fund our contingent commission settlement with Illinois Attorney General and Illinois Department of Insurance, 27 million to pay dividends, about 9 million for capital expenditures and about 14 million in acquisitions and earn-outs.

Our stock buybacks were de minimus during the quarter.

My fifth and last comment relates to our efforts to rationalize our the lease office location.

Recall that in the third and fourth quarter conference calls, I explained that we have 250 leased office properties and throughout 2006 and 2007 we would be rationalizing approximately 20 to 25 of these locations.

We completed one small project in the first quarter, but truthfully the P&L impact was less than about $200,000.

Regardless, our project list is long and I would expect us to complete a couple lease rationalization projects each quarter for the next couple of years.

Okay, those are my comments.

But overall as a wrapup comments, really nice to see improvement in our core operations pretax earnings.

Back to you, Pat.

Thanks, Doug.

Toni, I think we are ready to go to questions.

[OPERATOR INSTRUCTIONS] Our first question is coming from Jon Balkind of Fox-Pitt.

Please go ahead.

Good morning, guys.

Quick question on capital and I guess it is a fairly broad question.

Can you talk a little bit more about the deal environment, Pat, and then a little bit about the dividend, what you think there given the tax rate and lower contingents?

And then what do you plan to do with the cash from the building sale?

Let me take the deal side of that first.

If you look at the statistics on deals done over the last few months, the deal flow in the industry is down slightly.

We are seeing -- we have got a number of people that we're in discussion with, a number of people that are filling out our confidential questionnaires.

So there is good interest in moving forward.

I think that some good properties have come on in the last quarter and have sold at some very high prices.

So it is an interesting time in the deal world.

Every one of these, Jon, I think I've told you this before, when you look at how we do them, it is like a marriage.

It takes a long time to work with people that, in some instances, are really weighing whether they want to do an internal generational change or whether they want to sell the business.

And we want to make darn sure that the cultures fit.

From a deal flow perspective, I don't think you'll see us at the '04 or '03 level this year.

But I do think that we'll have a good merger and acquisition year.

Did that answer your first question, Jon?

Yes.

Second question, if I am not mistaken, was related to the dividend.

Yes.

Board was very confident, and as I am sure you would be aware, we do a full capital planning project with the board literally every quarter.

We take them through cash, what's going on with the cash, what our cash projections are, and we run that out over a three-year period.

As you know, the board increased our dividend at the end of the fourth quarter in January this year.

So we're very confident that there is absolutely plenty of cash flow to continue our dividend.

And in fact, I wouldn't be surprised if the board were to agree to improve or increase that depending on how, of course, '06 goes in '07.

I think the last question related to what we expect to do with the cash on the sale of the building.

Yes.

There are three things that we do with cash at Gallagher now.

I think this is Doug Howell's third year and I think the first quarter he got here we began a mantra that basically says the three things we do with cash are buy brokers, pay dividends and buy stock back.

Now of course last year there were no stock buybacks.

And in Doug's comments he went through where the cash went through the fourth quarter of last year, which was literally well over $100 million.

If you look back in time, we probably averaged stock buybacks somewhere on the order of 50 to $80 million a year.

So those are our three uses of cash depending on what our opportunities are to buy brokers.

Great.

Thanks, Pat.

Jon, one clarification on that, too, is that recall that we have $75 million of debt on the building.

Right.

The amount of cash that actually flows in on the sale of the building is more like the net book value plus whatever gain we get.

Got you.

Okay.

Thank you.

Our next question is coming from Alison Jacobowitz of Merrill Lynch.

Please go ahead.

Good morning, Alison.

Good morning.

I was wondering, I am not sure 100% how to ask it, but it is good to see the improvement in the margins ex the contingent commissions.

We've talked some in the past about your efforts to sort of replace part of them at least, or some, or something like that.

I was wondering if you could talk about your progress or what's going on or if you're seeing anything that is sort of offsetting the loss of contingent commissions?

It is really a mixed bag right now, Alison.

We do have agreements with a number of our carriers to pay us additional commission on lines of coverage that would be subject to contingents were we allowed to be in a contingent arrangement.

This, of course, has been approved by the Director of Insurance in the State of Illinois as well as our attorney general.

And it is disclosed up front to our clients.

I will tell you that in actuality getting it has been hit and miss.

In some instances the desk underwriters have not been aware of the fact we have an arrangement.

In some instances the carrier said we'll do this if your producer, again, at the desk underwriter asks for the increase.

Some of the increases are calculated nationally and then remitted to us at the home office.

But on balance, what we're seeing is we believe some replacement but not as much as we're hoping for.

Jim Gault might want to comment on that as well.

Hi, Alison.

This is Jim.

Pat is right on that we have got a number of markets that added to the policies at the underwriting desk.

But they have not internally setup the right accounting mechanisms to put it into the policies on a consistent basis.

So we're in the process of trying to track it and then go back to those markets and show them where they're short to the box.

And it will be an evolving issue throughout '06 because it is very new.

And remember that the vast majority of our competition doesn't have this issue.

It is confusing at the underwriting desk when we work with the underwriters on trying to capture this.

We don't have a specific number.

And I would be very careful, Alison, modeling much of a change this year, just because these are also commissions that are negotiable at the underwriting desk.

So we have to, also once again, train production people to make sure they get the additional commission.

It is going to be an evolving thing and we just hope that it helps us improve results over the long haul.

Pat, this is Jay Cohen.

I have got a bigger picture question on contingents and that is you still have this unlevel playing field where you and several others are not accepting them, but many other of your competitors are.

You hear that this is just an untenable situation, it can't last, but you don't see anything happening to change it.

Can you look in your crystal ball and tell us what you think could happen?

I am going to give you two scenarios, Jay.

Both of them crystal ball and as you know well my talent at predicting is very questionable.

About as good as mine.

So let me give you both scenarios.

On the one hand I think that regulators are a little bit befuddled.

They're uncomfortable with a bifurcated market and it is clearly bifurcated.

You have got four or five players that have had to give up entirely retail contingents.

And you have got the rest of the industry with very strong independent agent lobbies simply saying we don't need a change.

In our Illinois legislature there are a number of representatives that are insurance agents.

And in hearings in Springfield there was strong sentiments that when we go to buy a truck we don't ask our truck dealer to tell us everything he is making.

Our agents in our towns are doing just fine.

So it is really tough.

They couldn't get the legislature in Illinois to agree to the NAIC model law just for disclosure.

So fighting, if you're a regulator and you think oh, my God, how am I going to level this playing field.

You certainly are not going to do it with the thousands of independent agents around the country and, by the way, insurance carriers that truly believe their incentive programs have worked.

We're willing to fight this.

You end up then stuck in this bifurcated market.

That is one possible result.

There is another possible result.

You will notice the AIG settlement and the Zurich settlement with New York's attorney general have very strong language on what they can and cannot do as it relates to continuing to pay contingents.

Should the New York attorney general or Illinois or others decide that they're going to take insurance companies to task for paying these contingent commissions, you could see a sea change.

You could see carriers saying, look, if I am going to make a settlement, I have to make an agreement that I am not paying them, I am not paying them across the board.

So it is going to be very interesting to see which way it goes.

The Zurich settlement was a very interesting settlement.

All right.

Thanks for the answer, Pat.

Thank you.

Our next question is coming from Brian Derivio of U.S. Trust.

Please go ahead.

Good morning, Brian.

Good morning, guys.

How are you.

Two questions for you.

Pat, first where do we stand in the effort to make the Illinois State AG settlement a national settlement?

And then Doug, assuming that you will not be able to utilize any of the section 29 credits this year, could we expect to see some additional cash flows hitting you guys with the reversal of those DTA's?

Let me take the first one in terms of the effort to create a settlement across the board.

What's happening, and which is interesting, is that in many states well, let's put it this way.

In some states we've been told that the investigation is over.

They're closing their investigation and they're basically happy with how we operate.

But not actually signing on to a settlement.

Which frankly, Brian, is a good thing.

The reason for that is if we got into individual settlements with every state, there would be state by state negotiation about how we operate.

And it is better for us to have one court to go to, if you will.

That's the court -- not even a court.

It is one place to go, which is the Illinois AG and the Illinois Department of Insurance for Illinois activity to get any kind of clarification.

And we've had to do that on a number of occasions.

So there has been a very quieting out there, but not people actually signing on to the deal.

There is still activity in two or three states where we are continuing to cooperate with investigations, I won't mention those states specifically, but the general sense I have is that the states out there are respecting Illinois' work and simply saying the attorney general and the Director of Illinois have told us they have done a thorough investigation.

They have changed business practices and we're happy to have Gallagher operate that way.

Doug?

Brian, yes, the deferred tax asset will start to monetize if we don't continue to generate credits this year.

So there will be positive cash flow that come out of the reversal of that deferred tax asset.

Okay, great.

Thank you, guys.

Thank you.

Our next question is coming from Jay Gelb of Lehman Brothers.

Please go ahead.

Thanks and good morning.

I want to touch on two issues.

First, could you give us a sense of what your expectations are for the compensation and benefits ratio in Brokerage for 2006?

And if you could just clarify whether that's including the contingents or excluding when you compare that to '05.

And then second, how should we think about the effective tax rate for 2007, if, for example, the price of oil stays above $70 for all of 2007?

Are you looking at a reference point for oil that's higher than '06?

Thanks a lot.

Jay, let me answer the tax rate question.

If we don't burn, we'll be at a 41% effective tax rate in 2007 if we don't produce any tax credits.

The first part of the question related to -- .

The compensation ratio in the first quarter.

For actually the full year, I was looking for your outlook.

First of all, this is Pat.

The first quarter that comparison is excluding contingent commissions.

Right.

Then for the full year, as you know, we don't give specific guidance in the Brokerage and Risk Management segment, so I have to be a little careful.

I am pleased with the fact -- and headcount control is a very important part of the soft market play book, so I am pleased with the fact that we saw an improvement in the first quarter.

If we have nice revenue growth in the next three quarters, I expect that we'll have solid improvement.

Jay, if it is helpful for you the 21 quarter spread that is out on the website, we have used the denominator which excludes contingent commission.

So you will be able to get 21 quarters of that ratio if you go out on the website.

Right.

That's very helpful.

And then just on that tax rate, Doug, what would cause you not to burn synthetic fuel in 2007?

Is there a reference price of oil we should be thinking about?

Again, what you have to think about is if we're looking at a phase-out range of $61 to $75 today, there will be some modest inflation in that number for 2007.

So maybe there is a phase-out range of 63 to 77, something like that would be kind of the phase-out range.

But we won't know what those inflation adjustments will be until April of 2007 before we get that.

That's probably not a bad guess.

Okay, that's really helpful.

Thanks a lot.

Thanks, Jay.

Thank you.

Our next question is coming from Dan Johnson of Citadel.

Please go ahead.

Good morning, Dan.

Good morning, guys.

A couple questions if you would, please.

On the Risk Management side, obviously we're seeing the significant impact of the new government, I believe it is a Workers' Comp type contract that you have going on down there.

Can you remind us what the rough business mix or excuse me, the rough geographic mix between say U.S. and international is for that segment?

Yes, it is approximately 10%, Dan, about 10% of our business and about 10% of our employees outside the borders of the United States.

That was a Workers' Compensation.

It is called Work Cover.

It is New South Wales, that's the state that Sydney is in.

And it is a portion of the market.

It is a small market share of their Work Cover program.

Maybe we can talk a little bit about what's going on then within the U.S. business.

At that sort of mix I guess the U.S. business was marginally positive on a growth rate.

And obviously over the last couple of years we've seen some very nice double digit growth that we're starting to get used to.

Is this an issue of client retention or is this an issue of claims per client or an issue of sort of dollars per I guess for sort of revenue per claim?

Dan, that is a great question.

Thanks for asking it.

I will send you the next one for the next quarter.

Honestly, I didn't know.

I know.

I mean it is a great question.

The answer to that is number one, retention at Gallagher Bassett is solid, mid to high 90's.

It is very difficult to move a large TPA account.

And the reason is that you're just so involved with them every day.

Our risk fact system is getting over 19 million hits from client inquiries a month.

That gives you an idea of how tied you are to the clients.

We have very high satisfaction scores on our satisfaction inquiries, surveys, and retention is outstanding.

The new business over the past year, as I commented, has also been strong.

So it boils down to what's going on out there?

And what is interesting is in about the last six months on Gallagher Bassett's book of business, even in a robust economy, we've seen a bit of a decrease in claim counts in claim count growth.

You say well how can that be if the economy is robust, why would Gallagher Bassett's claim counts per client be -- why would the growth in that be slowing?

To the best of our ability to understand, remember we're working with large Risk Management, self-insured accounts for the most part, and we perceive that there may actually be a benefit in these clients' loss control activities.

And part of that is something we help them with.

In essence I think it is a good thing for the clients if their claim counts go down and obviously we get paid per claim, so it is better for us if their claim counts are up.

Our claim pricing is up for the year.

And I would say we're probably on a claim pricing basis moving up about 3 to 4 to 5%.

So it is not the claim pricing.

It is not lost business.

It is activity based.

Now, the month of March, which is interesting, we've seen declines in existing book claim activity for about six or seven months.

The month of March, for the first time, we saw in our existing clients an actual growth in claim activity.

So we're still very bullish on the year.

Dan, if I could add to that, too.

Because a lot of our business is Workers' Comp business, there are some subsequent claims, actual counts to claim expected count reconciliations that go on, just like you do when you go in and you audit a Workers' Comp program on the premium side.

And if you were to levelize the audits that are going on out there, the adjustments that are going on out there, you're probably going to get a number on the U.S. side that's more 8 to 9% in terms of domestic growth.

So this claim count trend that Pat is saying is kind of coming through a little bit in some of these subsequent audits that true-up the billings and so on the phase 7%, if you adjusted for that, maybe it is closer to 9%.

Let me add to that.

What Doug is saying is in most of the Gallagher Bassett clients you estimate the claim activity for the year.

We bill that ratably one twelfth.

At the 18th month if they had 50 more claims than we expected or 50 less claim, there is a true-up.

Understood.

Finally the other question is related to the margins in the business, long time running around mid teens, had drifted up a couple hundred basis points and then has seemed to have come down a little bit here.

Can you just touch on that and outlook there, if you could broadly.

This is Pat.

The interesting thing there is that those of you that have been following us for a long time will remember that it wasn't too many years ago we were talking about whether or not this business could run over 10, 11, 12%.

We're very proud of the margin achievement that we have in this business.

And we've also said that we would be very happy to run this business in the middle to high teens.

So when the margin jumps to 19, I would not want you to build a model for having a 19% business going forward for the next three years. 16, 17, 18, we're real pleased in those areas.

Great.

Thanks a lot.

Thank you.

Our next question is coming from Paul Newsome of AG Edwards.

Please go ahead.

Good morning, gentlemen.

Good morning, Paul.

Hope things are well.

Just two clarification questions.

The real short one is when you reported organic growth prior to giving up contingent commissions, did organic growth include the contingent commissions?

Yes.

And then a more interesting question.

I agree with you, I think the Zurich settlement is extremely interesting.

And I was wondering if the disclosure that they are going to make their agents, including presuming yourself, give the clients, is it more or less than what you would otherwise be disclosing?

Well, Paul, that's a very important question.

Number one, it is right in line with what we're doing on every quotation.

Our assurance of voluntary compliance requires that whenever we have a bindable quote and we're doing a proposal for a client, that we show that client that bindable quote and the commission that's related to it.

The Zurich mandate really poses no issue for us and we're already doing that.

It is a major change for our competition.

It is going to be very interesting to see if their business falls off because clients say no you're not going to dictate to me how I am going to operate.

There is a lot of activity going on in the market.

It is kind of fun to watch because our people are clearly using transparency as a sales wedge.

And now you've got a major insurer, saying to their independent agency plant, you're going to be transparent as well as it relates to our quotes.

And there is a lot of push back.

It is going to be interesting to see what happens.

My understanding is that Zurich is requiring an actual separate form that the client has to sign off on.

Is it not only the level of disclosure but the form of how you're disclosing similar to what Zurich is required to do?

Are you having your clients kind of sign a form kind of thing as well?

No, we do not.

But you're giving them all the same information, obviously.

Yes.

In fact, we're very clear in our proposals exactly what the compensation is on everything we're quoting.

Excellent.

Okay.

Thank you very much.

Thank you.

Our next question is coming from Meyer Shields of Stifel Nicolaus.

Please go ahead.

Good morning.

One quick question to start with.

This quarter's press release mentions that you can collect retail contingents for three years after an acquisition?

That's correct.

That's a change from the fourth quarter press release, right?

That's correct.

What's going on behind that or underlying that?

It is very simple.

When we explained to the attorney general and the director of insurance the impact that only allowing us to collect them for one year was having on our acquisition activity, they agreed that it would be appropriate to let us do it for three years or the typical earnout period of an acquisition.

That seems like good news.

Yes, it is good news.

Historically you have talked about your efforts to expand in larger commercial account space.

Now that it looks like just about all the regulatory noise is behind us, how has the competitive market changed?

It is a great question.

And remember, by item count the preponderance of our business is in the commercial middle market and upper middle market.

But as an organization we've been in the large Risk Management business since the 60's.

So it is not a new effort afoot to somehow go out and now get into the Risk Management business.

Our offices in New York, Chicago, Houston, Miami, Los Angeles, San Francisco, in particular, have very big practices in the large Risk Management account.

From our perspective and in our experience, what happened with the regulatory noise is it created a tremendous additional number of RFP's, request for proposals.

Many of those RFP's did not have movement from one broker to another.

Or I might say we didn't pick up a huge amount of business because of that RFP activity.

What we have seen is that number one, risk managers want to be able to share with their audit committee that they have looked.

Number two, there has been more splitting of accounts, where you might have had one broker having a very large position on a large Risk Management account or being the sole broker, that is pretty much changing.

They're putting other relationships in there.

So there has been a lot of consternation.

There has been a lot of looking.

There has been some moving and we have benefited from that.

The people that we've recruited and liked that have come to us have done a good job of producing.

But there has not been a tremendous wholesale departure from the existing relationships.

Okay.

And one last question if I can.

How fragmented is reinsurance brokerage and what does that imply for your growth strategy there?

It is less fragmented than retail brokerage by a measure of 1,000.

There are good boutiques but primarily you have the larger five players that have a very strong position in that market.

Okay.

Thanks, Meyer.

Thanks a lot.

Thank you. [OPERATOR INSTRUCTIONS] Our next question is coming from Nik Fisken of Stephens Incorporated.

Please go ahead.

Good morning, Nick.

Good morning, everybody.

Did we pay Headwaters the 5 million a quarter payment?

We made the payment for 2005.

So all of those payments have been made.

As for the first quarter of 2006, we're still computing what amount would be due to them.

And given the certainty with respect to oil prices, that payment wouldn't go out here until for another 30 days, I don't believe.

We'll have to see how much it is because there has been a phase-out and then we'll have to see how we pay that here in the next few weeks.

And that would be for first quarter '06, correct?

Correct.

And is it safe to say that given year-to-date different variables that it is going to be less than 5 million?

Their payment is subject to the phase-out also.

Got it.

So depends on if we assume the 53% phase-out, then their payment could be reduced by 53% also.

Okay.

What price oil do we stop producing for the three facilities?

Like I said in my prepared comments is that with oil prices at this level, we're going to have to take a look at that here in the next 30 days and make a decision, because we're about at the breakeven point right now.

Is it your call or your clients call?

We do have partners that are in these facilities with us and we would want to sit down and make sure the partners are in agreement with us making that shut down decision, too.

Are you guys going to put out a press release if you decide to shut them down?

We'd have to see when that we made that decision, if it is thirty days from now we might end up doing it.

If we think it is a material change, if it is up around the press release time, again, we just do it at that time.

And the 5 million a quarter to Headwaters is based on these three facilities, is that right.

It is two of the three facilities.

Two of the three.

Okay.

Okay.

The fees that were up nicely to 347, is that a function of what Pat was just talking about in terms of you guys taking some share on the upper end of the market?

I think that it is a function of two things, Nik.

As we've become more transparent, the fee income on the brokerage side some clients have chosen to move to fees.

And then, yes, the other side of that is that we've picked up some nice accounts in the last six months.

Okay.

And then on getting back the dollars lost from contingents, you say that it was below what was anticipated.

Can you kind of gauge it for us, was it 50% below what we anticipated, what do we anticipate?

No, Nik, we haven't really given any numbers of what we anticipate because we don't want you modeling that.

So I don't want to give you -- frankly, for the quarter, I don't even have it all in yet.

I don't have those numbers.

Jim is going through 65 branches with the CFO figuring that out.

Okay.

Okay.

Thanks so much.

Thank you.

Our last question is coming from Alison Jacobowitz of Merrill Lynch.

Please go ahead.

Actually it is Jay Cohen, again.

On this large account issue, I was actually with a broker yesterday who focuses on large accounts and they were suggesting there was a decent amount of price competition among the brokers for the larger accounts.

Do you get a sense of that at all, Pat?

Yes, definitely, absolutely.

Jay, I might add that's not unusual.

This whole transparency thing, the larger risk management accounts have predominantly been handled on fees for the last ten, twelve years or more.

I go back to the 60's and Beatrice Foods.

We handled Beatrice on a fee.

That's been the normal way for accounts to be handled for years in the large risk management world.

You bet, there is competition on price with fees as well.

Great.

Thanks, Pat.

Thank you.

Thank you.

Since there are no more questions, I will now turn the floor back over to you, Mr. Gallagher.

Thank you, Toni, and thanks again, everybody, for joining us this morning.

I just make a quick comment.

As I said in my opening remarks, I am proud of our start this year.

I can't emphasize enough the change in the field in terms of how we've had to compete, what we've been through in terms of explaining to our production team why it is okay to show everything to their clients, and in spite of all that, revenues being up, margins being up, transparency now the norm throughout the organization, the fact that we're able to recruit seasoned talent, which we continue to do.

We're bringing in good, young talent as well.

I think that I feel good about the rest of 2006.

And just know that we remain extremely focused on building the best brokerage and risk management Company in the business.

Thanks for being with us this morning and have a great day.

Thank you for your participation, ladies and gentlemen.

This does conclude today's teleconference.

You may disconnect your lines at this time.

Have a wonderful day.