Good morning, and welcome to Arthur J. Gallagher's special conference call to discuss the company's adoption of the new revenue recognition accounting standard, ASC Topic 606. Participants have been placed on a listen-only mode. Your lines will be open for questions and answers following an initial presentation. Today's call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during the conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. These forward-looking statements are subject to certain risks and uncertainties discussed on this call or described in the Company's reports filed with the SEC. Actual results may differ materially from those discussed today, and the Company undertakes no obligation to update these statements.
In addition, for reconciliations of the non-GAAP measures discussed on this call, as well as other information regarding these measures, please refer to the most recent earnings release and the other materials in the investor relations section of the company's website. Gentlemen, you may begin.
Thank you, Melissa, and welcome everybody. This is Ray Iardella, Gallagher's Investor Relations leader, and with me today is Doug Howell, Gallagher's CFO, and a handful of our folks from our accounting department. I'd like to thank you for being with us on our special call this morning to discuss the new revenue recognition accounting standard called ASC Topic 606, which we will simply call new GAAP throughout today's call. This morning, I'll take you through the investor supplement posted on our website, offer a few comments, then Doug will go deeper into new GAAP versus old GAAP. That should take about 15 minutes. Then we will open up the line for questions. Please note we will only be taking questions regarding the new revenue recognition accounting standard during Q&A. Okay. First, the supplement we have on our investor website.
We will reference that a lot today, so please have it handy. This document follows a similar format we have been providing for 10 years. Let me walk through it, because there are some differences. First, pages one and two. Our typical non-GAAP measure disclaimers and legal caveats. Page three, this is a new summary page showing old GAAP versus new GAAP on a reported basis. Page four, another new summary page. This shows old versus new on an adjusted basis. Pages five to nine is a progression of the brokerage segment from old to new. Page five is old GAAP as previously reported. Page six are the differences between old and new, or the impact of ASC 606. Page seven is new GAAP. Page eight are non-GAAP adjustments, the same we reported last year. Then page nine is new GAAP on an adjusted basis.
pages 10 to 14 follow the same progression, but just for the risk management segment. Finally, pages 15 and 16 show old GAAP versus new GAAP for our corporate segment. We've also color-coded the information to help you with the progression from old GAAP to new. Brown is old GAAP, green is new GAAP, blue is the difference between old and new, yellow is adjusted new, and finally, purple is adjusted old. Two other comments. First, we are adopting the new accounting standard using the full retrospective method. This means we will no longer report our financial results on an old GAAP basis. Beginning with our first quarter 2018 results, which we will release in a couple of weeks, we will only report on a new GAAP basis. Second, I do want to go back to the last few sentences in the first paragraph on page two.
Highlighted in bold is something you should think about. Because we are restating the past, we have the luxury of hindsight. Accordingly, it stands to reason that our 2017 new GAAP results will have better estimates than our 2018 and later financial statements. Estimates don't change cash flow, but they do change GAAP results. If you have your supplement in hand, I'll turn it over to Doug.
Thanks, Ray, and good morning, everyone. Thanks for being on today's call. Before I plunge in, I'd like to give special thanks to Gallagher's accounting, IT, and tax teams for their hard work and dedication over the last two years to implement this new accounting standard. All right. Let's start on page three of the supplement. As Ray said, that's the summary page on a reported basis. Here are the big picture takeaways that you'll see on that page. First, on a reported basis, new GAAP does not dramatically change our annual EBITAC nor annual EPS with our brokerage or risk management segments. It does have an impact on the corporate segment, but that's due to the tax reform adjustment that we made in the fourth quarter, and I'll discuss that in a few minutes.
Second, you'll see that new GAAP does have a dramatic impact on the quarterly seasonality in our brokerage and corporate segments, but you don't see that seasonal impact on the risk management segment. Third, new GAAP does require us to gross up some revenues and expense reimbursements in our risk management segment that we previously reported on a net basis. Finally, throughout all of this, like Ray said, please keep in mind that none of this change in accounting impacts cash flows, and we know that cash is king. Let's flip to page four. That's, again, just another summary page, but this time, it's on an adjusted basis. You'll see again that new GAAP versus old GAAP impacts in the blue section are the same for the brokerage and risk management segments that you saw on a reported basis back on page three.
Because we adjust out the impact of tax reform, this adjusted page shows that there's no real difference between old and new GAAP for our corporate segment on an annual basis. Yes, on a quarterly basis there's seasonality, but not on an annual basis. Let's stay on page four. What are the differences between old and new GAAP? Within the brokerage segment, annually, on an annual basis, it's a lot of small numbers. Revenue change is about 40 basis points. Annual expense change is about 15 basis points. Annual EBITAC change is less than 1%, and annual EBITAC margin stays about the same. I'd call that really no change of significance whatsoever on an annual basis. However, on page four, you'll see that there's dramatic change in seasonality. You'll see that our first quarter is now our largest.
That is almost entirely due to our employee benefit operation. Most employer-provided benefit plans have a January 1 effective date. Under old GAAP, we recognized the revenue from those placements over the course of the following year as our customers paid their monthly insurance premiums to the carriers. Now, under new GAAP, we must calculate what we might get over the coming year and recognize a big chunk of it on January 1st. That estimate will change if our customers' payrolls change, but we can now do a decent job of calculating and booking that estimate in the first quarter. We have a little of the same thing in our reinsurance operation. All the rest of our retail, wholesale, program, captive, and specialty businesses really don't change that much on a quarterly or seasonal basis. Sticking still on page four but moving down to the risk management segment.
You'll see that both annual revenues and annual expenses under new GAAP are much higher than old GAAP. Very little change in EBITAC. New GAAP requires a gross-up of certain pass-through expenses. You'll see a line called reimbursements that is the same amount in the revenue section as it is in the expense section of the P&L. Under old GAAP, about 75% of those reimbursements were netted against each other. These are expenses we administer on behalf of our customers. An example would be investigative services. In some cases, the client contracts with the investigation firm, yet we manage the investigator, and we may pay the bills from a bank account owned by the client. We're not on the actual contract with the investigation company, that would not be reported as Gallagher's revenue nor Gallagher's expense.
We have other cases where Gallagher Bassett's name is on the contract. Our services are the same, in other words, we manage the investigator, and frankly, we may or may not pay the bill from our own cash accounts or from the customer's cash accounts. That doesn't matter under the new accounting because our name is on the contract. Now these arrangements are now presented gross through our P&L. In either circumstance, the substance of the service is exactly the same. There is a technical distinction. If our name is on the contract, we must report it gross. If not, we report it net. Either way, there's no impact on EBITAC, but it does gross up the P&L. As for quarterly seasonality, like I said before, unlike our brokerage segment, there is no meaningful change in our risk management segment seasonality.
Let's leave page four and jump way back to page 15 to the corporate segment. The very bottom line shows our adjusted results for our corporate segment. On an annual adjusted basis, you can see that there is no real difference between old and new GAAP. When you move up the page, looking at the adjusted line, there are significant differences between old and new GAAP on a quarterly basis for clean energy and the corporate line. No real changes for interest, M&A, home office move, litigation, et cetera. There's two reasons for this seasonality. First, for the clean energy tax credits, we effectively recognize those in proportion to pre-tax income. Because our brokerage segment under new GAAP has such a large pre-tax in the first quarter, we will recognize more tax credits earlier in the year.
It doesn't change the annual numbers, just the quarterly seasonality. Second, for permanent tax items that run through the corporate line in the corporate tax column, those also shift with the change in quarterly pre-tax earnings, that which explains the seasonality. Finally, staying on page 15 of the corporate segment, please take a look at the line called impact of tax reform. Again, that's within the corporate segment only. When we implemented new GAAP, we did end up with a positive cumulative impact to retained earnings. That in turn causes an increase in our deferred tax liability. We first established that number using a 35% federal rate for 2017 and prior. When tax reform was passed in December of 2017, that deferred tax liability is recalculated at the new federal income tax rate of 21%.
That produces a different number under new GAAP than old GAAP. You'll see that difference on the impact from tax reform line in the corporate segment. We remove that line anyway to arrive at adjusted results, so it has no impact on adjusted numbers, but it does impact the reported numbers. Before we open the line, let me answer two likely questions that might be on your mind. Let's turn back to page six, to the brokerage segment. This blue page shows all the net changes from implementing new GAAP. In the end, it's a $9 million after-tax nothing in our opinion. There is some geography shifting.
If you add up the changes in base commissions, fees, supplementals, investment income, which is really where we report fees from our premium funding business, and then the compensation line, it adds up to a couple million bucks on a nearly $4 billion revenue segment. After reviewing tens of thousands of contracts, we had some supplementals and premium funding fees that got reclassified into base fees. We had some regular fees that got reclassified into commissions and vice versa. In the end, we had about $7 million of net revenue deferrals and about $5 million of net expense deferrals. It all washes down to next to nothing and doesn't impact cash whatsoever on those lines. In our view, the only real item worthy of mention is the contingent commission line. Let me compare and contrast old versus new GAAP in the accounting for contingent commissions.
Under old GAAP, we recognized contingent commissions when they were received, basically on a cash basis. This meant that for most all of our contracts, when we received a payment from the carrier in, say, March or April of 2017, we booked the revenue then under old GAAP, even though that was really related to how the business performed in the previous calendar year, 2016 in this example. Under new GAAP, and sticking with that same example, new GAAP required us throughout 2016 to estimate and accrue what we received in March or April of 2017. As Ray mentioned earlier, when adopting the standard, we have the luxury of hindsight. However, if we had been doing it real time over the course of 2016, our estimates would not have been so perfect.
They would've been revised and adjusted along the way as information regarding the ultimate payment we'll receive became more known to us. Going forward, our estimates are likely to be a bit more fluid. For example, on a loss ratio type contingent commission contract, we could be chugging along all year, estimating that we'll get a contingent payment in March of the following year. Say in November, a catastrophe hits and wipes it all out. In the fourth quarter, we would need to reverse the revenue we booked, effectively taking a cat related charge. Clearly, a change in our estimate for contingents will not rise to the magnitude of what a carrier might book for a cat loss, but it can move our results a penny or two as we change our estimates. We just didn't have that situation in the past under old GAAP.
On page six, you'll see slightly lower contingent commissions in 2017 on a new GAAP basis. About a third of that decrease is because we disposed of some small books of business that paid us a contingent in 2017, but that was based on 2016 performance, so that got pushed back into 2016. Another third of that difference relates to payments we received for multi-year longer tail businesses that also got pushed back to earlier years. We might get some of those again in a few years, but perhaps because of the uncertainty, it is possible that our current estimates are lower than what will ultimately develop. Finally, another third of that difference is simply because of the large cat year we had in 2017. We didn't get as many contingents here in March of 2018 that we got last year in March.
To put all this in context, across the globe, we have over 1,000 contingent commission contracts, so we had to turn over a lot of rocks and actually assign all of those cash payments that we received back into the years in which the contracts applied. The second likely question may be on page 11 in the risk management segment. You'll see fees are down by $7 million. Recall in our third quarter 2017 earnings call, we posted 10% organic growth. We highlighted that such was an aberration because we had a $4 million positive retrospective audit adjustment for one of our customers, where our fee is based on their historical payroll levels. We booked that in the third quarter 2017 under old GAAP. Under new GAAP, we must push that back into the previous years rather than when it was received.
The remaining difference of a couple million dollars on nearly $900 million of revenue is clearly a net. Those are my prepared remarks. I hope this helps you understand the new accounting, none of this changes our business nor has any impact on our cash flow, but it does change the accounting. Those are my comments. Melissa, let's open up the lines and go to questions.
Thank you. The call is now open for questions. If you have a question, please pick up your handset and press *1 on your telephone at this time. If you are on a speakerphone, please disable that function prior to pressing *1 to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing *2. Again, it's *1 for questions at this time. Our first question comes from the line of Elyse Greenspan with Wells Fargo. Please proceed with your question.
Hi, this is Weston Bloomer on for Elyse. Thank you for all the disclosures. It's all very helpful. I just have one follow-up, specifically on the reimbursements in the risk management section. I guess, does this mean that the reimbursements, do they typically remain at the same level year-over-year? Since we only have one year of data, I think that'd be helpful.
Great question. Thanks for being on the call, Weston. That can flip a lot. If our clients elect to contract directly and want us just to manage it, we'll do that for them. In the next year, if they want to join onto our collective buying agreements where we maybe get better rates, they come back onto our contract. That can pop around a little bit, but by and large, I don't see a lot of difference in 2018 versus 2017 in that line item. We'll compute everything net of it. I don't see a big difference.
Okay. On the margin within those reimbursements, is there a different overall target margin under the new method? Is that something that you're able to disclose more around earnings or I guess any color around that would be helpful.
Yeah, it depends on the nature of the service and our level of effort. That would be something. The better way of determining the margin on that is really the workforce that we have to deploy into managing those relationships and making sure that we get a margin on that. The actual flow of the expenses through our books, if we're deploying an adjuster and just processing a fee, we're not going to mark that up 17 points like we have on our base. If we've got a team of people that have expertise that augment and supplement that pass-through revenue, we'll want to make sure that we get our fair margin on that labor, which would run through our compensation line.
Okay, great. Thanks for the disclosures. I'll jump back in the queue if I have any more questions. Thank you.
Thanks, Weston.
Thank you. Our next question comes from the line of Robert Glasspiegel with Janney Montgomery Scott. Please proceed with your question.
Good morning. Quick question on the change is largely cosmetic and doesn't affect cash flow or economics of the business. Is there anything you're going to do differently in the future to make the accounting less volatile in response? Would you change your view on that reimbursement stuff with contracts so it wouldn't flow through the numbers on the margin? Or is there anything that you might do to manage through it differently?
Yeah. Thanks, Bob, and good morning. One of the things we've said for years is that we were indifferent between supplementals and contingents. Whatever provided us the greatest economic value for our services that we provide, we'll take it either way. I still believe that's the case. Now, we just have to estimate contingents and book them current rather than waiting until they come in. As for the reimbursements, I don't think it really changes the complexion of our numbers. I think that the world's smart enough to see through those numbers. You see a lot of other large companies that have these lines in there. I think if we compute our margin without them, I hope that the street will look through to see what our real margins are of running our business versus just being a bill processor or a deployer of resources.
We actually think it brings good value to our clients to jump onto our negotiated programs. I think our clients see value in that. That actually could grow in the future as more. I think that we pay about $10 billion of insurance claims. I think that we pay about maybe $2 billion or $3 billion of costs that go directly to the file. If we can provide value-added services for those fees that our clients would probably actually try to increase the reimbursements line because I think it brings better value to our customers.
You're going to report both reported margins and adjusted margins with the reimbursements not in the revenues and expenses?
Yeah, good point.
We should track it ex the reimbursements, is what you're saying.
Yeah. We did that on page three and four.
Good
on pages there. Yeah, I believe it. We took a look at a lot of other companies when we did this, that's what they're doing. It really makes sense. If it's just a pass-through, we shouldn't be saddled with margin on that.
One last question. The base on 2017 got knocked back $0.07, which is trivial, 2%. Is there anything in the nature of that $0.07 or whatever adjustments that flows through 2018? Does it come back at an accelerated rate, or are we just 2% behind the eight ball as a starting point?
Well, I think there's two things that I pointed out in 2017. We already highlighted on the Risk Management segment that we had that retrospective audit that came in in the third quarter. I think the fact that really the new news here on this call that's not accounting is that because of the large CATs, we are seeing about $3 million or $4 million lesser contingent commissions on those programs that would have come through in our first quarter 2018 earnings. That's what gets knocked back. The other things like the divestiture of the business-
That'll correct, right? Because 2018 is going to be on 2018's profitability rather than-
Correct
2017 now.
Yep.
You should have a favorable comparison on that piece to the extent that CATs.
You're a good accountant, Bob. That's right.
That piece comes back.
Right
theoretically if the industry profitability is not materially different.
That's right.
Okay. Thank you, Doug.
Yeah, thanks, Bob. Thanks for being on the call.
Thank you. Ladies and gentlemen, as a reminder, if you'd like to ask a question, please press *1 on your telephone keypad. Our next question comes from the line of Paul Newsome with Sandler O'Neill. Please proceed with your question.
Good morning. Thanks, guys, for the call. Obviously, a lot of hard work. With respect to the re-estimates of contingents, I just want to make sure I've got this right. Is it essentially we're in a situation where as we go quarter to quarter to quarter, first, second, third, fourth, the volatility of those contingents will increase because most of the contracts, I assume, are January 1st? Is that-
Well, interesting. Yeah, let me see. Again, thanks for being on the call, Paul. It's actually an interesting thing. There's actually substantial volatility in our contingents under old GAAP. We used to have a big chunk of them in the first quarter of every year, and those things could pop around a lot, right? The Street, I think, is accustomed to volatility in contingent. Accruing them over time probably will reduce the volatility, except if they're large loss or property-exposed contingents. We could be thinking we're having a great year, and unfortunately, our calendar here in the U.S. kind of syncs up with the hurricane season. The last big blowers can come through in September and October.
We could be thinking we're making a couple, three million bucks on a program, and then we get hit with a loss in November, and we'd have to show you, guys, "This is our base commissions and fees. This is what happened. We did have a reversal related to the catastrophes that just hit." Again, the magnitude of that on our numbers, think about what we just went through this last year in 2017, and I told you basically there's probably $3 million or $4 million less of contingents that we're going to get as a result of that. It's not like a carrier that might have hundreds of million dollars worth of loss. As a percentage of our revenues, our EPS, it will be a little blippy, but I don't know if it'll be volatile.
Okay. Thank you. Appreciate it.
Sure, Paul. Thanks.
Thank you. Our next question comes from the line of Phil Stefano with Deutsche Bank. Please proceed with your question.
Yeah. Thanks, and good morning. I guess a follow-up on the contingent commissions. Ray had pointed out that that one paragraph on page two or three about the benefit of hindsight and probably being a little smoother. I guess, when I look at the brokerage contingent commissions for 2017, first quarter is a bit higher than second through fourth quarter, and I was wondering if there was anything different in that that wouldn't have caused it to be a bit more smoother through the year.
Great question. One thing about some of our contingent commissions that are based on volume, not on loss ratio, you would expect the accruals to more closely relate to the volumes of our direct commission. In this case, our benefit business has substantially more earnings in the first quarter, it stands to reason any of their overrides would have a slightly higher pattern of emergence in the first quarter also. While it's not necessarily straight line, it will have more of a correlation to the direct commission and fee line that we're seeing. Good question, good observation, and thanks for bringing it up.
I guess the follow-on would be the supplementals is the same rationale because we see the same patterning with first quarter a bit higher?
Yeah, exactly. Sorry, I should have said that. Yep.
No. No worries. Perfect. That's all I have. Thank you.
All right. Thanks, Phil. Melissa, do we have any other questions coming in we can sit for a second and see?
No. There are no other questions at this time. However, it is star one if you do have a question. We'll pause a moment to allow for any others. We have another question from Scott Heleniak with RBC Capital Markets. Please proceed with your question.
Hi, thanks. I just had a quick question regarding the corporate segment. Would you expect a similar pattern, seasonality-wise, that you saw in 2017 versus 2018? I was wondering if you could comment on what kind of seasonality you might expect to see in that segment.
We tried not to provide too much forward-looking on our 2018 results. I think that the corporate segment, once you build your models, build the corporate segment to more closely track with your core brokerage and risk management earnings. You'll get to a pretty close number.
Okay.
I would expect to provide some guidance regarding that point on our earnings call here in about three weeks. To do it, I was hoping to be ready for you today on being able to provide our typical guidance for the corporate segment, with tax reform, I just want to make sure we've got everything nailed down. I apologize for not being able to give you our typical guidance, but you'll have it here in another couple of weeks.
That's fair enough. Okay. Appreciate it. Thank you.
All right. Thanks. I think that might be it for today, Melissa. Is that right?
That's right. There's no other questions.
All right. Let me make a couple closing comments. First and foremost, again back to the team at Gallagher that did this. This is a lot of work for us. I think there's hundreds of thousands of policies, over 1,000 contingent commission and supplemental agreement. We are a large organization with quite a diverse reach, and they did a terrific job on it. It's taken a lot of work. It doesn't change our business, doesn't change our cash flow. Hopefully, it does a better job of putting us consistent with other industries that you may follow if you're a generalist. All in all, we still think our cash flows are terrific, and brokerage is a good business and this is a lot of accounting that we had to navigate. Thanks for everybody following along.
Good luck in updating your models, and we'll talk to you here in about 3 weeks on our earnings call. Thanks, everyone.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.