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TOWERS WATSON & CO. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Executive Overview General We are a global consulting firm focusing on providing human capital and financial consulting services. At Towers Watson, we bring together professionals from around the world - experts in their areas of specialty - to deliver the perspectives that give organizations a clear path forward. We do this by working with clients to develop solutions in the areas of employee benefits, risk and capital management, and talent and rewards. We help our clients enhance business performance by improving their ability to attract, retain and motivate qualified employees. We focus on delivering consulting services that help organizations anticipate, identify and capitalize on emerging opportunities in human capital management. We also provide independent financial advice regarding all aspects of life insurance and general insurance, as well as investment advice to help our clients develop disciplined and efficient strategies to meet their investment goals. We operate the largest private Medicare exchange in the United States. Through this exchange, we help our clients move to a more sustainable economic model by capping and controlling the costs associated with retiree healthcare benefits. As leading economies worldwide become more service-oriented, human resources and financial management have become increasingly important to companies and other organizations. The heightened competition for skilled employees, unprecedented changes in workforce demographics, regulatory changes related to compensation and retiree benefits, and rising employee-related costs have increased the importance of effective human capital management. Insurance and investment decisions have become increasingly complex and important in the face of changing economies and dynamic financial markets. Towers Watson helps its clients address these issues by combining expertise in human capital and financial management with consulting and technology solutions, to improve the design and implementation of various human resources and financial programs, including compensation, retirement, health care, and insurance and investment plans. The human capital and financial consulting services industries, although highly fragmented, are highly competitive. It is composed of major human capital consulting firms, specialty firms, consulting arms of accounting firms and information technology consulting firms. In the short term, our revenue is driven by many factors, including the general state of the global economy and the resulting level of discretionary spending, the continuing regulatory compliance requirements of our clients, changes in investment markets, the ability of our consultants to attract new clients and provide additional services to existing clients, the impact of new regulations in the legal and accounting fields, and the impact of our ongoing cost-saving initiatives. In the long term, we expect that our financial results will depend in large part upon how well we succeed in deepening our existing client relationships through thought leadership and a focus on developing cross-business solutions, actively pursuing new clients in our target markets, cross selling and making strategic acquisitions. We believe that the highly fragmented industry in which we operate offers us growth opportunities, because we provide a unique business combination of benefits and human capital consulting, as well as risk and capital management and strategic technology solutions. Segments We provide services in four business segments: Benefits, Risk and Financial Services, Talent and Rewards, and Exchange Solutions. Benefits Segment. The Benefits segment is our largest and most established segment. This segment has grown through business combinations as well as strong organic growth. It helps clients create and manage cost-effective benefits programs that help them attract, retain and motivate a talented workforce. The Benefits segment provides benefits consulting and administration services through four lines of business: • Retirement; • Health and Group Benefits; • Technology and Administration Solutions; and • International Consulting. Retirement supports organizations worldwide in designing, managing, administering and communicating all types of retirement plans. Health and Group Benefits provides advice on the strategy, design, financing, delivery, ongoing plan management and communication of health and group benefit programs. Through our Technology and Administration Solutions line of business, 31-------------------------------------------------------------------------------- Table of Contents we deliver cost-effective benefit outsourcing solutions. The International Consulting Group provides expertise in dealing with international human capital management and related benefits and compensation advice for corporate headquarters and their subsidiaries. A significant portion of the revenue in this segment is from recurring work, driven in large part by the heavily regulated nature of employee benefits plans and our clients' annual needs for these services. For the fiscal year ended June 30, 2014, the Benefits segment contributed 59% of our segment revenue. For the same period, approximately 44% of the Benefits segment's revenue originates from outside the United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations. Risk and Financial Services Segment. Within the Risk and Financial Services segment, our second largest segment, we have two lines of business: • Risk Consulting and Software ("RCS"); and • Investment. The Risk and Financial Services segment, exclusive of our Reinsurance and Property and Casualty Insurance Brokerage business ("Brokerage"), which was sold in November 2013, accounted for 19% of our total segment revenue for the fiscal year ended June 30, 2014. Approximately 73% of the segment's revenue originates from outside the United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations. The segment has a strong base of recurring revenue, driven by long-term client relationships in retainer investment consulting assignments, software solutions, consulting services on financial reporting, and actuarial opinions on property/casualty loss reserves. Some of these relationships have been in place for more than 20 years. A portion of the revenue is related to project work, which is more heavily dependent on the overall level of discretionary spending by clients. This work is favorably influenced by strong client relationships, particularly related to mergers and acquisitions consulting. Major revenue growth drivers include changes in regulations, the level of merger and acquisition activity in the insurance industry, and growth in pension and other asset pools. In the first quarter of fiscal year 2014, we entered into an agreement to sell our Brokerage business to JLT and we closed the transaction in our second quarter. We have reclassified the operating results of Brokerage as discontinued operations in our consolidated statements of operations for fiscal years 2014, 2013, and 2012. Talent and Rewards Segment. Our third largest segment, Talent and Rewards, is focused on three lines of business: • Executive Compensation; • Rewards, Talent and Communication; and • Data, Surveys and Technology. The Talent and Rewards segment accounted for approximately 17% of our total segment revenue for the fiscal year ended June 30, 2014. Few of the segment's projects have a recurring element. As a result, this segment is most sensitive to changes in discretionary spending due to cyclical economic fluctuations. Approximately 47% of the segment's revenue originates from outside the United States and is thus subject to translation exposure resulting from foreign exchange rate fluctuations. Revenue for Talent and Rewards consulting has increasing seasonality, with a meaningful amount of heightened activity in the second half of the calendar year during the annual compensation, benefits and survey cycles. Major revenue growth drivers in this group include demand for workforce productivity improvements and labor cost reductions, focus on high performance culture, globalization of the workforce, changes in regulations and benefits programs, merger and acquisition activity, the demand for universal metrics related to workforce engagement and the opportunity to leverage technology to manage annual talent management and reward processes. Exchange Solutions Segment. Our fourth largest segment, Exchange Solutions, has two lines of business: • Retiree & Access Exchanges; and • Liazon. We established our fourth segment, Exchange Solutions, when we acquired Extend Health on May 29, 2012. The Exchange Solutions segment accounted for approximately 5% of our total segment revenue for the fiscal year ended June 30, 2014. In November 2013, the segment was expanded through the acquisition of Liazon Corporation, a leader in developing and delivering private benefit exchanges for active employees. Our OneExchange Retiree solution enables employers to transition their retirees to individual, defined contribution health plans at an annual cost that the employer controls - versus group-based, defined benefit health plans, which have uncertain annual costs. By moving to a defined contribution approach, our clients can provide their retirees with the same or better health care benefits at a lower overall cost. The Liazon solution complements our existing OneExchange Active offering by helping organizations of all sizes deliver self- and fully-insured benefits to employees in new and cost-effective ways. Most Retiree & Access revenue comes from the commissions we receive from insurance carriers for enrolling individuals into their health plans. This revenue generally increases as the number of enrolled members grows. Revenues for Liazon are derived from a 32-------------------------------------------------------------------------------- Table of Contents combination of monthly administration fees and carrier commissions and overrides. Exchange Solutions experiences seasonality due to the timing of the commissions we receive from our carriers and the costs incurred to enroll members. Most of our revenue is recognized ratably over the term of the policy, whereas the costs are incurred during our corporate clients' open enrollment period, typically in our fiscal year first and second quarters. We hire additional seasonal staff to supplement our full-time service center associates, and we expect to incur higher costs during our client's busiest enrollment periods. On January 23, 2014, Towers Watson announced plans to expand the Exchange Solutions segment by combining operations and associates primarily from portions of the TAS North America line of business with the Retiree & Access Exchanges and Liazon lines of business to better align their respective strategic goals. The restructuring took effect on July 1, 2014. We are still evaluating the impact of this restructuring to our operating segments and the related disclosures. Financial Statement Overview Towers Watson's fiscal year ends June 30. Shown below are Towers Watson's top five geographies based on percentage of consolidated revenue. For the year ended June 30, 2014, the information provided excludes the Brokerage business. Fiscal Year Geographic Region 2014 2013 2012 United States 53 % 53 % 48 % United Kingdom 20 22 23 Canada 6 6 6 Germany 5 4 5 Netherlands 2 2 3 We derive the majority of our revenue from fees for consulting services. Approximately 60% of these arrangements are billed at standard hourly rates and expense reimbursement, which we refer to as time and expense basis. The remaining 40% of these arrangements are billed on a fixed-fee basis. Clients are typically invoiced on a monthly basis with revenue generally recognized as services are performed. No single client accounted for more than 1% of our consolidated revenues for any of our most recent three fiscal years. Our most significant expense is compensation to associates, which typically comprises approximately 70% of total costs of providing services. We compensate our directors, executive officers and other select associates with incentive non-cash stock-based compensation awards which generally vest equally over three years. We use a graded vesting expense methodology that assumes the equity awards are issued to participants in equal amounts of shares that vest over one year, two years and three years, giving the effect of more expense in the first year than the second and third. Our equity awards are settled in Towers Watson Class A common stock. Salaries and employee benefits are comprised of wages paid to associates, related taxes, severance, benefit expenses such as pension, medical and insurance costs, and fiscal year-end incentive bonuses. Professional and subcontracted services represent fees paid to external service providers for employment, marketing and other services. For the three most recent fiscal years, approximately 30% to 40% of the professional and subcontracted services were directly incurred on behalf of clients and were reimbursed by them, with such reimbursements being included in revenue. For the fiscal year ended June 30, 2014 for Towers Watson, approximately 35% of professional and subcontracted services represent these reimbursable services. Occupancy includes expenses for rent and utilities. General and administrative expenses include legal, marketing, supplies, telephone and networking costs to operate office locations as well as insurance, including premiums on excess insurance and losses on professional liability claims, non-client-reimbursed travel by associates, publications and professional development. This line item also includes miscellaneous expenses, including gains and losses on foreign currency transactions. Depreciation and amortization includes the depreciation of fixed assets and amortization of intangible assets and internally-developed software. 33-------------------------------------------------------------------------------- Table of Contents Transaction and integration expenses include fees and charges associated with the Merger and with our other acquisitions. Transaction and integration expenses principally consist of investment banker fees, regulatory filing expenses, integration consultants, as well as legal, accounting, marketing, and information technology integration expenses. Critical Accounting Policies and Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates. The areas that we believe are critical accounting policies include revenue recognition, valuation of billed and unbilled receivables from clients, discretionary compensation, income taxes, pension assumptions, incurred but not reported claims, and goodwill and intangible assets. The critical accounting policies discussed below involve making difficult, subjective or complex accounting estimates that could have a material effect on our financial condition and results of operations. These critical accounting policies require us to make assumptions about matters that are highly uncertain at the time of the estimate or assumption. Different estimates that we could have used, or changes in estimates that are reasonably likely to occur, may have a material effect on our financial condition and results of operations. Revenue Recognition We recognize revenue when it is earned and realized or realizable as demonstrated by persuasive evidence of an arrangement with a client, a fixed or determinable price, services have been rendered or products delivered or available for use, and collectability is reasonably assured. The majority of our revenue consists of fees earned from providing consulting services. We recognize revenue from these consulting engagements when hours are worked, either on a time-and-expense basis or on a fixed-fee basis, depending on the terms and conditions defined at the inception of an engagement with a client. We have engagement letters with our clients that specify the terms and conditions upon which the engagements are based. These terms and conditions can only be changed upon agreement by both parties. Individual associates' billing rates are principally based on a multiple of salary and compensation costs. Revenue for fixed-fee arrangements is based upon the proportional performance method. We typically have three types of fixed-fee arrangements: annual recurring projects, projects of a short duration, and non-recurring system projects. Annual recurring projects and the projects of short duration are typically straightforward and highly predictable in nature. As a result, the project manager and financial staff are able to identify, as the project status is reviewed and bills are prepared monthly, the occasions when cost overruns could lead to the recording of a loss accrual. We have non-recurring system projects that are longer in duration and subject to more changes in scope as the project progresses. We evaluate at least quarterly, and more often as needed, project managers' estimates-to-complete to assure that the projects' current statuses are accounted for properly. Certain software contracts generally provide that if the client terminates a contract, we are entitled to payment for services performed through termination. Revenue recognition for fixed-fee engagements is affected by a number of factors that change the estimated amount of work required to complete the project such as changes in scope, the staffing on the engagement and/or the level of client participation. The periodic engagement evaluations require us to make judgments and estimates regarding the overall profitability and stage of project completion that, in turn, affect how we recognize revenue. We recognize a loss on an engagement when estimated revenue to be received for that engagement is less than the total estimated costs associated with the engagement. Losses are recognized in the period in which the loss becomes probable and the amount of the loss is reasonably estimable. We have experienced certain costs in excess of estimates from time to time. Management believes it is rare, however, for these excess costs to result in overall project losses. We have developed various software programs and technologies that we provide to clients in connection with consulting services. In most instances, such software is hosted and maintained by us and ownership of the technology and rights to the related code remain with us. We defer costs for software developed to be utilized in providing services to a client, but for which the client does not have the contractual right to take possession, during the implementation stage. We recognize these deferred costs from the go live date, signaling the end of the implementation stage, until the end of the initial term of the contract with the client. We determined that the system implementation and customized ongoing administrative services are one combined service. Revenue is recognized over the service period, after the go live date, in proportion to the services performed. As a result, we do not recognize revenue during the implementation phase of an engagement. 34-------------------------------------------------------------------------------- Table of Contents We deliver software under arrangements with clients that take possession of our software. The maintenance associated with the initial software fees is a fixed percentage which enables us to determine the stand-alone value of the delivered software separate from the maintenance. We recognize the initial software fees as software is delivered to the client and we recognize the maintenance ratably over the contract period based on each element's relative fair value. For software arrangements in which initial fees are received in connection with mandatory maintenance for the initial software license to remain active, we determined that the initial maintenance period is substantive. Therefore, we recognize the fees for the initial license and maintenance bundle ratably over the initial contract term, which is generally one year. Each subsequent renewal fee is recognized ratably over the contractually stated renewal period. We collect, analyze and compile data in the form of surveys for our clients who have the option of participating in the survey. The surveys are published online via a web tool which provides simplistic functionality. We have determined that the web tool is inconsequential to the overall arrangement. We record the survey revenue when the results are delivered online and made available to our clients that have a contractual right to the data. If the data is updated more frequently than annually, we recognize the survey revenue ratably over the contractually stated period. Prior to the sale of our reinsurance brokerage business in November 2013 (see Note 2 for further discussion), in our capacity as a reinsurance broker, we collected premiums from our reinsurance clients and, after deducting our brokerage commissions, we remitted the premiums to the respective reinsurance underwriters on behalf of our reinsurance clients. In general, compensation for reinsurance brokerage services was earned on a commission basis. Commissions were calculated as a percentage of a reinsurance premium as stipulated in the reinsurance contracts with our clients and reinsurers. We recognized brokerage services revenue on the later of the contract's inception or billing date as fees became known or as our services were provided for premium processing. In addition, we held cash needed to settle amounts due reinsurers or our reinsurance clients, net of any commissions due to us, pending remittance to the ultimate recipient. We were permitted to invest these funds in high quality liquid instruments. As an insurance exchange, we generate revenue from commission paid to us by insurance carriers for health insurance policies issued through our enrollment services. Under our contracts with insurance carriers, once an application has been accepted by an insurance carrier and a policy has been issued, we will receive commission payments from the policy effective date until the end of the annual policy period as long as the policy is not cancelled by the insured or the carrier. We defer upfront fees and recognize revenue ratably from the policy effective date over the policy period, generally one year. The commission fee per policy placed with a carrier could vary by whether the insured was previously a Medicare participant and whether the policy is in its first or subsequent year. Due to the uncertainty of the commission fee per policy, we do not recognize revenue until the policy is accepted by the carrier, the policy is effective and a communication is received from the carrier of the fee per insured. As the commission fee is cancellable on a pro rata basis related to the underlying insurance policy which we are not party to, we recognize the commission fee ratably over the policy period. Our carrier contracts entitle us to receive commission fees per policy for the life of the policy unless limited by legislation or cancelled by the carrier or insured. As a result, the majority of the revenue is recurring in nature and grows in direct proportion to the number of new policies added each year. Revenue recognized in excess of billings is recorded as unbilled accounts receivable. Cash collections in excess of revenue recognized are recorded as deferred revenue until the revenue recognition criteria are met. Client reimbursable expenses, including those relating to travel, other out-of-pocket expenses and any third-party costs, are included in revenue, and an equivalent amount of reimbursable expenses are included in professional and subcontracted services as a cost of revenue. Valuation of Billed and Unbilled Receivables from Clients We maintain allowances for doubtful accounts to reflect estimated losses resulting from the clients' failure to pay for the services after the services have been rendered, including allowances when customer disputes may exist. The related provision is recorded as a reduction to revenue. Our allowance policy is based on the aging of the billed and unbilled client receivables and has been developed based on the write-off history. Facts and circumstances such as the average length of time the receivables are past due, general market conditions, current economic trends and our clients' ability to pay may cause fluctuations in our valuation of billed and unbilled receivables. Discretionary Compensation Our compensation program includes a discretionary bonus that is determined by management and has historically been paid once per fiscal year in the form of cash and/or deferred stock units after our annual operating results are finalized. An estimated annual bonus amount is initially developed at the beginning of each fiscal year in conjunction with our budgeting process. Estimated annual operating performance is reviewed quarterly and the discretionary annual bonus amount is then adjusted, if necessary, by management to reflect changes in the forecast of pre-bonus profitability for the year. 35-------------------------------------------------------------------------------- Table of Contents Income Taxes We account for income taxes in accordance with Accounting Standards Codification ("ASC") 740, Income Taxes, which prescribes the use of the asset and liability approach to the recognition of deferred tax assets and liabilities related to the expected future tax consequences of events that have been recognized in our financial statements or income tax returns. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established, when necessary, to reduce deferred tax assets when it is more likely than not that a portion or all of a given deferred tax asset will not be realized. In accordance with ASC 740, income tax expense includes (i) deferred tax expense, which generally represents the net change in the deferred tax asset or liability balance during the year plus any change in valuation allowances and (ii) current tax expense, which represents the amount of tax currently payable to or receivable from a taxing authority plus amounts accrued for expected tax contingencies (including both tax and interest). ASC 740 prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those positions to be recognized in the financial statements. We continually review tax laws, regulations and related guidance in order to properly record any uncertain tax positions. We adjust these reserves in light of changing facts and circumstances, such as the outcome of tax audits. Variable Interest Entities In connection with the pooled investment fund solutions we provide, we may enter into arrangements that need to be examined to determine whether they fall under the variable interest entity (VIE) accounting guidance. Management needs to exercise significant judgment to determine if these entities are VIEs and, if so, whether such VIE relationships require the Company to consolidate these entities. This process involves management's understanding of the arrangements to determine whether the entity is considered a VIE under the accounting guidance. This evaluation of whether the entity is considered a VIE under the accounting guidance involves judging whether the various structures qualify as investment companies under the deferred provisions of ASC 810-10-65-2 (the "Deferral") in applying the guidance in the VIE subsections of the Deferral. We use a variety of complex estimating processes that may consider both qualitative and quantitative factors, and may involve the use of assumptions (where necessary) about the business environment in which an entity operates; the VIE's purpose and design, including the risks the VIE was designed to create and pass through to its variable interest holders; the VIE's capital structure; the terms between the VIE and its variable interest holders and other parties involved with the VIE (and when necessary, to determine who is most closely associated with the VIE); identification of related-party relationships and de-facto agency relationships; which variable interest holder has the power to direct the activities of the VIE that most significantly impact the VIE's economic performance; analysis and calculation of its expected losses and its expected residual returns in determining which variable interest holder has the obligation to absorb losses or the right to receive benefits from the VIE that could potentially be significant to the VIE. The quantitative processes involve estimating the expected future cash flows and performance of the entity, analyzing the variability in those cash flows, and allocating the losses and returns among the identified parties having variable interests. Where an entity is determined to be a VIE, our interests are compared to those of the other parties involved with the VIE to identify the party that is the primary beneficiary, and thus should consolidate the entity. In addition to the areas of judgment mentioned above, a significant amount of judgment is exercised in interpreting the provisions of the accounting guidance and applying them to our specific transactions. Management reassesses its initial evaluation of whether an entity is a VIE when certain reconsideration events occur. Management reassesses its determination of whether it is the primary beneficiary of a VIE on an ongoing basis based on current facts and circumstances. Incurred But Not Reported (IBNR) Claims We accrue for IBNR professional liability claims that are probable and estimable. We use actuarial assumptions to estimate and record a liability for IBNR professional liability claims. Our estimated IBNR liability is based on long-term trends and averages, and considers a number of factors, including changes in claim reporting patterns, claim settlement patterns, judicial decisions, and legislation and economic decisions. Our estimated IBNR liability does not include actuarial projections for the effect of claims data for large cases due to the insufficiency of actuarial experience with such cases. Our estimated IBNR liability will fluctuate if claims experience changes over time. As of June 30, 2014, we had a $173.8 million IBNR liability, net of estimated IBNR recoverable receivables of our captive insurance companies. This net liability decreased from $174.3 million as of June 30, 2013. To the extent our captive insurance companies, PCIC and SMIC, expect losses to be covered by a third party, they record a receivable for the amount expected to be recovered. This receivable is classified in other current or other noncurrent assets in our consolidated balance sheet. Pension Assumptions Towers Watson sponsors both qualified and non-qualified defined benefit pension plans and other post-retirement benefit plan ("OPEB") plans in North America and Europe. As of June 30, 2014, these funded and unfunded plans represented 98 percent of Towers Watson's pension and OPEB obligations and are disclosed herein. Towers Watson also sponsors funded and unfunded 36-------------------------------------------------------------------------------- Table of Contents defined benefit pension plans in certain other countries, representing an additional $98.0 million in projected benefit obligations, $73.3 million in assets and a net liability of $24.8 million. North America United States - Beginning January 1, 2012, all associates, including named executive officers, accrue qualified and non-qualified benefits under a new stable value pension design. Prior to this date, associates hired prior to December 31, 2010 earned benefits under their legacy plan formulas, which were frozen on December 31, 2011. The non-qualified plan is unfunded. Retiree medical benefits provided under our U.S. postretirement benefit plans were closed to new hires effective January 1, 2011. Life insurance benefits under the same plans were frozen with respect to service, eligibility and amounts as of January 1, 2012 for active associates. Canada - Effective on January 1, 2011, associates hired on or after January 1, 2011 and effective on January 1, 2012 associates hired prior to January 1, 2011, accrue qualified and non-qualified benefits based on a career average benefit formula. Additionally, participants can choose to make voluntary contributions to purchase enhancements to their pension. Prior to the January 1, 2011, associates earned benefits under their legacy plan formulas. The non-qualified plans in North America provide for the additional pension benefits that would be covered under the qualified plan in the respective country were it not for statutory maximums. The non-qualified plans are unfunded. Europe United Kingdom - For associates previously participating under the legacy Watson Wyatt defined benefit plan, benefits accrue based on the number of years of service and the associate's average compensation during the associate's term of service since January 2008 (prior to this date, benefits accrued under a different formula). Benefit accruals earned under the legacy Towers Perrin defined benefit plan were frozen on March 31, 2008, and the plan predominantly provides lump sum benefits. All associates not earning benefits under the legacy Watson Wyatt defined benefit component of the plan accrue benefits under a defined contribution component. Germany - Effective January 1, 2011, all new associates participate in a defined contribution plan. Associates hired prior to this date continue to participate in various defined contribution and defined benefit arrangements according to legacy plan formulas. The legacy defined benefit plans are primarily account-based, with some long-service associates continuing to accrue benefits according to grandfathered final-average-pay formulas. Netherlands - Benefits under the Netherlands plan used to accrue on a final pay basis on earnings up to a maximum amount each year. The benefit accrual under the final pay plan stopped at December 31, 2010. The accrued benefits will receive conditional indexation each year. The determination of Towers Watson's obligations and annual expense under the plans is based on a number of assumptions that, given the longevity of the plans, are long-term in focus. A change in one or a combination of these assumptions could have a material impact on Towers Watson's pension benefit obligation and related cost. Any difference between actual and assumed results is amortized into Towers Watson's pension cost over the average remaining service period of participating associates. Towers Watson considers several factors prior to the start of each fiscal year when determining the appropriate annual assumptions, including economic forecasts, relevant benchmarks, historical trends, portfolio composition and peer company comparisons. Funding is based on actuarially determined contributions and is limited to amounts that are currently deductible for tax purposes. Since funding calculations are based on different measurements than those used for accounting purposes, pension contributions are not equal to net periodic pension cost. The assumptions used to determine net periodic benefit cost for the fiscal years ended June 30, 2014, 2013 and 2012 were as follows: Year Ended June 30, 2014 2013 2012 North North North America Europe America Europe America Europe Discount rate 5.32 % 4.41 % 4.86 % 4.80 % 5.79 % 5.59 % Expected long-term rate of return on assets 7.67 % 5.77 % 8.11 % 6.07 % 8.14 % 6.78 % Rate of increase in compensation levels 4.36 % 3.93 % 4.35 % 3.93 % 3.82 % 3.93 % 37-------------------------------------------------------------------------------- Table of Contents The following table presents the assumptions used in the valuation to determine the projected benefit obligation for the fiscal years ended June 30, 2014 and 2013: June 30, 2014 June 30, 2013 North North America Europe America Europe Discount rate 4.86 % 3.99 % 5.32 % 4.41 % Rate of increase in compensation levels 3.98 % 3.00 % 4.36 % 3.93 % Towers Watson's discount rate assumptions were determined by matching expected future pension benefit payments with current AA corporate bond yields from the respective countries for the same periods. In the United States, specific bonds were selected to match plan cash flows. In Canada, yields were taken from a corporate bond yield curve. In Europe, the discount rate was set based on yields on European AA corporate bonds at the measurement date. The U.K. is based on the yields on U.K. AA corporate bonds, while Germany and the Netherlands are based on yields on European AA corporate bonds. The expected rates of return assumptions for North America and Europe were supported by an analysis performed by Towers Watson of the weighted-average yield expected to be achieved with the anticipated makeup of investments. The following information illustrates the sensitivity to a change in certain assumptions for the North American pension plans for fiscal year 2014: Effect on FY 2014 Pre-Tax Pension Change in Assumption Expense 25 basis point decrease in discount rate + $ 9.0 million 25 basis point increase in discount rate - $ 8.7 million 25 basis point decrease in expected return on assets + $ 7.0 million 25 basis point increase in expected return on assets - $ 7.0 million The following information illustrates the sensitivity to a change in certain assumptions for the European pension plans for fiscal year 2014: Effect on FY 2014 Pre-Tax Pension Change in Assumption Expense 25 basis point decrease in discount rate + $ 4.7 million 25 basis point increase in discount rate - $ 4.8 million 25 basis point decrease in expected return on assets + $ 2.3 million 25 basis point increase in expected return on assets - $ 2.3 million The above sensitivities reflect the impact of changing one assumption at a time. Economic factors and conditions often affect multiple assumptions simultaneously and the effects of changes in key assumptions are not necessarily linear. The differences in the discount rate and compensation level assumption used for the North American and European plans above can be attributed to the differing interest rate environments associated with the currencies and economies to which the plans are subject. The differences in the expected return on assets are primarily driven by the respective asset allocation in each plan, coupled with the return expectations for assets in the respective currencies. Goodwill and Intangible Assets In applying the acquisition method of accounting for business combinations, amounts assigned to identifiable assets and liabilities acquired were based on estimated fair values as of the date of acquisition, with the remainder recorded as goodwill. Intangible assets are initially valued at fair value using generally accepted valuation methods appropriate for the type of intangible asset. Intangible assets with definite lives are amortized over their estimated useful lives and are reviewed for impairment if indicators of impairment arise. Intangible assets with indefinite lives are tested for impairment annually as of April 1, and whenever indicators of impairment exist. The fair value of the intangible assets is compared with their carrying value and an impairment loss would be recognized for the amount by which the carrying amount exceeds the fair value. Goodwill is tested for impairment annually as of April 1, and whenever indicators of impairment exist. Goodwill is tested at the reporting unit level which is one level below our operating segments. The Company had ten reporting units on April 1, 2014. During fiscal 2014, the Company performed Step 1 of the two-step impairment test for all reporting units in order to update the estimated fair value for all reporting units. All reporting units' estimated fair values were substantially in excess of the carrying 38-------------------------------------------------------------------------------- Table of Contents values, with the exception of the Liazon reporting unit which was only recently acquired. Liazon's fair value exceeded its carrying value, but had a passing margin of approximately 11%. To perform the test, we used Level 3 valuation techniques to estimate the fair value of a reporting unit that fall under income or market approaches. Under the discounted cash flow method, an income approach, the business enterprise value is determined by discounting to present value the terminal value which is calculated using debt-free after-tax cash flows for a finite period of years. Key estimates in this approach were internal financial projection estimates prepared by management, business risk, and expected rate of return on capital. The guideline company method, a market approach, develops valuation multiples by comparing our reporting units to similar publicly traded companies. Key estimates and selection of valuation multiples rely on the selection of similar companies, obtaining estimates of forecasted revenue and EBITDA estimates for the similar companies and selection of valuation multiples as they apply to the reporting unit characteristics. Under the similar transactions method, a market approach, actual transaction prices and operating data from companies deemed reasonably similar to the reporting units is used to develop valuation multiples as an indication of how much a knowledgeable investor in the marketplace would be willing to pay for the business units. If the Company was required to perform Step 2, we would determine the implied fair value of the reporting unit used in Step 1 to all the assets and liabilities of that reporting unit (including any recognized or unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. Then the implied fair value of goodwill would be compared to the carrying amount of goodwill to determine if goodwill is impaired. For the fiscal year ended June 30, 2014, we did not record any impairment losses of goodwill or intangibles. 39-------------------------------------------------------------------------------- Table of Contents Results of Operations The table below sets forth our consolidated statements of operations and data as a percentage of revenue for the periods indicated. Consolidated Statements of Operations (Thousands of U.S. dollars) Fiscal Year Ended June 30, 2014 2013 2012 Revenue $ 3,481,912 100 % $ 3,432,515 100 % $ 3,257,898 100 % Costs of providing services: Salaries and employee benefits 2,106,431 60 % 2,085,188 61 % 1,978,653 61 % Professional and subcontracted services 249,775 7 % 267,715 8 % 283,783 9 % Occupancy 137,883 4 % 139,942 4 % 136,557 4 % General and administrative expenses 317,448 9 % 303,472 9 % 259,064 8 % Depreciation and amortization 174,818 5 % 173,040 5 % 150,006 5 % Transaction and integration expenses 1,049 - % 30,753 1 % 86,130 3 % 2,987,404 86 % 3,000,110 87 % 2,894,193 89 % Income from operations 494,508 14 % 432,405 13 % 363,705 11 % (Loss) / income from affiliates - - (56 ) - 262 - Interest income 2,803 - 2,400 - 3,860 - Interest expense (9,031 ) - (12,676 ) - (9,156 ) - Other non-operating income 10,226 - 6,928 - 11,350 - Income before income taxes 498,506 14 % 429,001 12 % 370,021 11 % Provision for income taxes 138,249 4 % 136,991 4 % 132,443 4 % INCOME FROM CONTINUING OPERATIONS 360,257 10 % 292,010 9 % 237,578 7 % Income from discontinued operations, net of income tax of $39,202, $15,561, $13,313, respectively 6,057 - % 23,642 1 % 22,898 1 % NET INCOME BEFORE NON-CONTROLLING INTERESTS 366,314 11 % 315,652 9 % 260,476 8 % Net income / (loss) attributable to non-controlling interests 7,014 - % (3,160 ) - % 263 - % NET INCOME (attributable to common stockholders) $ 359,300 10 % $ 318,812 9 % 260,213 8 % Results of Operations for the Fiscal Year Ended June 30, 2014 Compared to Fiscal Year Ended June 30, 2013 Revenue The following discussion of the results of operations for the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013 reflects our Brokerage discontinued operations presentation in this current year filing. Revenue for the fiscal year ended June 30, 2014 was $3.5 billion, an increase of $0.05 million, or 1%, compared to $3.4 billion for the fiscal year ended June 30, 2013. On an organic basis, which excludes the effects of acquisitions and currency, revenue increased 1% for the fiscal year ended June 30, 2014 compared to the fiscal year ended June 30, 2013. Our Exchange Solutions segment contributed 5% to our total revenue in fiscal year 2014. During fiscal year 2014 we continued to assist companies with de-risking activities related to bulk-lump sum projects. We further enhanced our client development group outside the U.S. to better align our organization with our multi-national and global clients, and expanded our global footprint into rapidly developing markets such as South Africa, India and Russia. The average exchange rate used to translate our revenues earned in British pounds sterling increased to 1.6364 for fiscal year 2014 from 1.5686 for fiscal year 2013, and the average exchange rate used to translate our revenues earned in Euros increased to 1.3592 for fiscal year 2014 from 1.2941 for fiscal year 2013. Constant currency is calculated by translating prior year 40-------------------------------------------------------------------------------- Table of Contents revenue at the current year average exchange rate. Segment results are presented both on a reported basis and on a constant currency basis. Line of business results are presented only on a constant currency basis. A comparison of segment revenue for the fiscal year ended June 30, 2014, as compared to the fiscal year ended June 30, 2013, is as follows: • Benefits revenue decreased $14.8 million, or 1%, and was $1.98 billion for fiscal year 2014 compared to $1.99 billion for fiscal year 2013. On a constant currency basis, Benefits revenue decreased 1%. Our Retirement business revenue, which makes up the majority of the segment, decreased 3%. While we continue to perform bulk lump sum projects, we have not had, and did not expect to have, the level of project work and revenue that we attained in fiscal year 2013. Our Health and Group Benefits business increased 1%. Our Technology and Administration Solutions business experienced 7% revenue growth due to new client work. The revenues in this line of business are recognized from the go-live date. The revenue growth in fiscal 2014 was primarily a result of new client wins in fiscal 2013. We have also experienced an increase in implementation projects in fiscal 2014. Our International business revenue declined 1%. • Risk and Financial Services revenue was $638.4 million for fiscal year 2014 compared to $645.3 million for fiscal year 2013, a 1% decrease. Risk and Financial Services revenue decreased 2% on a constant currency basis. The results associated with the operations of our Brokerage business have been classified as discontinued operations in fiscal years 2014 and 2013. The Risk and Financial Services segment revenue decline was primarily from a 6% decrease in our Risk Consulting and Software business revenue across all regions, particularly in Asia Pacific and EMEA. In fiscal year 2013, we began restructuring efforts, as there was low client demand for discretionary projects. The restructuring was completed in fiscal year 2014. While we experienced a decrease in consulting revenue, our property and casualty software revenue continued to be strong. Our Investment business experienced 5% revenue growth, across all regions, due to increased project work and performance fees. • Talent and Rewards revenue was $582.7 million for fiscal year 2014 compared to $573.3 million for fiscal year 2013, a 2% increase on an as reported and constant currency basis. Data, Surveys and Technology business revenue increased 9%, as demand for human resources software implementations and employee surveys drove revenue growth across all regions. Rewards, Talent and Communication revenue, which is primarily project-oriented, decreased 4%. We experienced softness in this line of business in the Americas and EMEA regions this fiscal year. Additionally, our results were impacted as our communications consultants were redeployed to support Exchange Solutions product development and sales. Our Executive Compensation business experienced a 2% increase in revenue, primarily in the Americas, where demand remained solid. We anticipate modest revenue growth for our Talent and Rewards segment from several of our practice areas, including Data, Surveys and Technology. In June 2014, we released three Software-as-a Service HR technology solutions. We are seeing a higher usage of HR service center technology as organizations look to improve their employees' experience without increasing costs. • Exchange Solutions revenue increased $75.1 million, and was $170.0 million, for fiscal year 2014 compared to $94.9 million for fiscal year 2013. As our newest segment, Exchange Solutions contributed 5% to the Company's total revenue for fiscal year 2014. In the second quarter of the fiscal year 2014, we acquired Liazon to round out our portfolio of exchange offerings by adding fully-insured healthcare options and enhancing the ancillary benefit programs to the OneExchange platform. As of June 30, 2014, we had approximately 670,000 enrolled retirees/employees, which equates to approximately 730,000 covered lives, in OneExchange. Salaries and Employee Benefits Salaries and employee benefits was $2.11 billion for fiscal year 2014 compared to $2.09 billion for fiscal year 2013, an increase of $21.2 million, or 1%. We experienced a $64.0 million increase in salaries, wage related taxes and fringe benefits for fiscal year 2014. The increase was driven by our adding personnel in high growth areas of our business coupled with our rationalizing in other business areas which resulted in increased severance costs. Our discretionary annual bonus is based on pre-bonus profitability, and fluctuates based on our operating results. As a result, our bonus expense for fiscal year 2014 decreased by $24.8 million compared to fiscal year 2013. Our pension expense decreased $15.3 million. The decrease in our pension expense was due to increases in discount rates and favorable investment returns. As a percentage of revenue, salaries and employee benefits was 60% for fiscal year 2014 compared to 61% for fiscal year 2013. Professional and Subcontracted Services Professional and subcontracted services for fiscal year 2014 was $249.8 million, compared to $267.7 million for fiscal year 2013, a decrease of $17.9 million, or 6.7%. Our external service provider fees decreased by $15.7 million compared to fiscal year 2013. We contracted with these service providers to supplement our day-to-day operations. In fiscal year 2014, our telecommunication, video conferencing, and internet services were managed by our in-house information technology department, and these expenses are classified in general and administrative expenses. Our pass-through expenses, which are generally reimbursable under our contracts, decreased by $2.3 million. As a percentage of revenue, professional and subcontracted services decreased to 7% for fiscal year 2014 from 8% for fiscal year 2013. 41-------------------------------------------------------------------------------- Table of Contents Occupancy Occupancy expense for fiscal year 2014 was $137.9 million, compared to $139.9 million for fiscal year 2013, a decrease of $2.0 million, or 1%. The decrease in occupancy expenses relates to cost savings from the combination of duplicative office spaces. As a percentage of revenue, occupancy expense was 4% for fiscal years 2014 and 2013. General and Administrative Expenses General and administrative expenses for fiscal year 2014 was $317.4 million, compared to $303.5 million for fiscal year 2013, an increase of $13.9 million, or 5%. The increase was primarily from additional travel expenses and software maintenance costs, as well as an increase of $1.7 million in our professional liability and other claims expense due to increases in our current legal reserves and reductions in prior year IBNR reserves. The increases were partially offset by a decrease of $2.5 million in our telecommunications, video conferencing, internet and general office expenses for fiscal year 2014 compared to fiscal year 2013. These expenses were classified in professional and subcontracted services in fiscal year 2013, as we previously contracted with an external service provider for these services. As a percentage of revenue, general and administrative expenses was 9% for fiscal years 2014 and 2013. Depreciation and Amortization Depreciation and amortization expense for fiscal year 2014 was $174.8 million, compared to $173.0 million for fiscal year 2013, an increase of $1.8 million, or 1%. As a percentage of revenue, depreciation and amortization expenses was 5% for fiscal years 2014 and 2013. Transaction and Integration Expenses Transaction and integration expense for fiscal year 2014 was $1.0 million, compared to $30.8 million for fiscal year 2013, a decrease of $29.8 million. The decrease was principally due to a reduction in expenses related to information technology integration projects that were ongoing in fiscal year 2012 and completed in fiscal year 2013. As a percentage of revenue, transaction and integration expenses was 1% for fiscal year 2013. (Loss) / Income from Affiliates Loss from affiliates for fiscal year 2013 was $0.1 million. Interest Income Interest income was $2.8 million and $2.4 million for fiscal years 2014 and 2013, respectively. Interest Expense Interest expense was $9.0 million for fiscal year 2014, compared to $12.7 million for fiscal year 2013, which was in line with our outstanding principal balances during the fiscal years. Other Non-Operating Income Other non-operating income for fiscal year 2014 was $10.2 million, compared to $6.9 million for fiscal year 2013. During fiscal year 2014, we recorded $6.3 million of mark-to-market gains on investments held by a consolidated variable interest entity. The variable interest entity was subsequently deconsolidated in our third fiscal quarter. Provision for Income Taxes The provision for income taxes for fiscal year 2014 was 27.7% compared with 31.9% in fiscal year 2013. Our effective tax rate decreased by 4.2% for fiscal year 2014 as compared to fiscal year 2013, primarily due to current year income tax benefits on the release of uncertain tax positions related to lapses in statute of limitations and income tax settlements in various taxing jurisdictions, primarily the U.S. Income from Discontinued Operations, net of income tax Income from discontinued operations for fiscal year 2014 was $6.1 million, compared to $23.6 million for fiscal year 2013. The operations of our Brokerage business, formerly part of our Risk and Financial Services segment, have been classified as discontinued operations for all periods presented, as a result of our Board of Directors committing to a plan of action to sell the business in our first quarter of fiscal year 2014. During the second quarter, we closed the sale of the business to JLT. Included in income from discontinued operations for fiscal year 2014 is a pre-tax gain on the sale of $24.0 million. This gain results from the adjusted consideration of $215.1 million, offset by transaction costs of $6.4 million, accelerated stock-based compensation awards of $1.0 million, and $184.8 million in removal of Brokerage net assets, primarily goodwill and intangible assets, not transferred in the deal. The sale of our Brokerage business resulted in a significant taxable gain, since the disposal of the 42-------------------------------------------------------------------------------- Table of Contents goodwill and intangible assets associated with the business is not tax-deductible. The following selected financial information relates to the Brokerage business's operations for the years ended June 30, 2014 and 2013: Fiscal Year Ended, 2014 2013 Revenue from discontinued operations $ 63,762 $ 164,270 Income from discontinued operations before taxes 21,308 39,203 Tax expense on discontinued operations 7,522 15,561 Net income from discontinued operations 13,786 23,642 Gain from sale of discontinued operations 23,951 - Tax expense on gain from sale of discontinued operations 31,680 - Net loss from sale of discontinued operations (7,729 ) - Total net income from discontinued operations $ 6,057 $ 23,642 Net Income Attributable to Common Stockholders Net income attributable to common stockholders for the fiscal year ended June 30, 2014 was $359.3 million, an increase of $40.5 million, or 13%, compared to $318.8 million for the fiscal year ended June 30, 2013. As a percentage of revenue, net income attributable to controlling interests was 10% for fiscal year 2014, compared to 9% for fiscal year 2013. Diluted Earnings Per Share Diluted earnings per share for fiscal year 2014 was $5.06, compared to $4.46 for fiscal year 2013. Results of Operations for the Fiscal Year Ended June 30, 2013 Compared to Fiscal Year Ended June 30, 2012 The following discussion of the results of operations for the fiscal year ended June 30, 2013 compared to the fiscal year ended June 30, 2012 has been adjusted from the fiscal 2013 filing on Form 10-K to reflect our Brokerage discontinued operations presentation in this current year filing. Revenue Revenue for the fiscal year ended June 30, 2013 was $3.4 billion, an increase of $175 million, or 5%, compared to $3.3 billion for the fiscal year ended June 30, 2012. Our newest segment, Exchange Solutions, contributed 3% to our total revenue growth in fiscal year 2013 compared to 2012 due to a full fiscal year of operations in which we increased membership in the retiree exchange by more than 80%. In addition, several successes contributed to our growth in fiscal year 2013. We assisted companies with de-risking activities related to bulk lump sum projects. We enhanced our client development group outside the U.S. to better align our organization with our multi-national and global clients and expanded our global footprint into rapidly developing markets such as South Africa, India and Russia. On an organic basis, which excludes the effects of acquisitions and currency, revenue increased 4% for the fiscal year ended June 30, 2013 compared to the fiscal year ended June 30, 2012. All of our segments experienced constant currency revenue growth in fiscal year 2013 compared to 2012. The average exchange rate used to translate our revenues earned in British pounds sterling decreased to 1.5686 for fiscal year 2013 from 1.5782 for fiscal year 2012, and the average exchange rate used to translate our revenues earned in Euros increased to 1.2941 for fiscal year 2013 from 1.2757 for fiscal 2012. Constant currency is calculated by translating prior year revenue at the current year average exchange rate. Segment results are presented both on a reported basis and on a constant currency basis. Line of business results are presented only on a constant currency basis. A comparison of segment revenue for the fiscal year ended June 30, 2013, as compared to the fiscal year ended June 30, 2012, is as follows: • Benefits revenue increased $71.8 million, or 4%, and was $2.0 billion for fiscal year 2013 compared to $1.9 billion for fiscal year 2012. On a constant currency basis, Benefits revenue increased 5% due to increased project work across all lines of business. The 5% increase in our Retirement business revenue, which makes up the majority of the segment, was driven by 6% revenue growth in the Americas, primarily due to bulk lump sum projects. The 2% increase in Retirement revenue in EMEA was due to an increase in auto-enrollment project activity in the U.K. Our Technology and Administration Solutions business experienced 8% revenue growth primarily due to new client work in the U.K. 43-------------------------------------------------------------------------------- Table of Contents and Germany. The growth in EMEA was driven by new administration work, and the growth in the Americas was due in part to call center support for the bulk lump sum projects. Our International business experienced 2% revenue growth. Our Health and Group Benefits business experienced 3% growth. • Risk and Financial Services revenue was $645.3 million for fiscal year 2013 compared to $655.9 million for fiscal year 2012, a 2% decrease. Risk and Financial Services revenue was flat on a constant currency basis. The results associated with the operations of our Brokerage business have been classified as discontinued operations in fiscal years 2014, 2013 and 2012. Our lines of business experienced mixed results, with revenue growth in the Americas, while EMEA and Asia Pacific remained flat. Our Investment business had 8% constant currency revenue growth led by EMEA, due to an increase in project work and performance fees. Our Risk Consulting and Software business has two distinct offerings; software and consulting; each of which experienced different results in fiscal year 2013. Our software sales increased 11% due to our portfolio of software solutions for both life and property and casualty insurance. Our consulting services revenue, which is primarily project oriented, decreased due to tightening of discretionary spending, principally in EMEA. In addition, it appears likely that the timeline for European regulators to implement Solvency II will slip beyond 2014 and related project work may not reappear for some time. As a result, our Risk Consulting and Software business had a 4% constant currency decrease in revenue in fiscal year 2013 compared to 2012. • Talent and Rewards revenue remained consistent and was $573.3 million for fiscal year 2013 compared to $570.5 million for fiscal year 2012. We achieved organic growth in all regions and in the Executive Compensation and Data, Surveys and Technology lines of business. The 5% organic revenue growth in our Executive Compensation business was led by EMEA. This growth was due to increased regulation and governance activity demand in all regions, particularly Europe. Rewards, Talent and Communication business revenue, which is primarily project oriented, decreased 1% compared to the prior year due to tightening discretionary spending. In fiscal year 2013, there were opportunities for project work related to health care reform and other benefit changes in the Americas. We experienced 2% growth in Data, Surveys and Technology revenue due to an increase in software implementations in the Americas. • Exchange Solutions revenue increased $91.2 million, and was $94.9 million, for fiscal year 2013 compared to $3.6 million for fiscal year 2012. As our newest segment, Exchange Solutions contributed 3% to the Company's total revenue growth for fiscal year 2013 compared to fiscal year 2012. We established our fourth segment in fiscal year 2012 when we acquired Extend Health in May 2012. Our fiscal year 2012 revenue includes one month of revenue compared to a full fiscal year in 2013. In addition, Exchange Solutions segment revenue growth was due to the enrollment of new members, lower than expected attrition of members and our carrier volume incentives. During fiscal year 2013, we completed a very successful enrollment period for January 1 effective policies, during which we enrolled three times the number of new members compared to Extend Health's historical results for the past two comparable enrollment seasons. As a result of purchase accounting, we did not recognize $12 million and $3 million of deferred revenue in fiscal year 2013 and 2012, respectively, associated with cash received for commissions for policies placed prior to the acquisition, as there is no subsequent performance obligation. In fiscal year 2013, we launched OneExchange, our integrated health insurance exchange solution for active employees and retirees. Salaries and Employee Benefits Salaries and employee benefits was $2.09 billion for fiscal year 2013 compared to $1.98 billion for fiscal year 2012, an increase of $106.5 million, or 5%. This increase was driven by an increase in base salary of $73.1 million attributable to a 3% increase in headcount, our annual salary merit increases and the impact of foreign currency translation. Our EMEA and APAC operations accounted for 2% of our headcount increase as of June 30, 2013, compared to June 30, 2012. Contributing to the increase, our Exchange Solutions segment had one month of operations in fiscal year 2012 compared to a full fiscal year in 2013. Our discretionary annual bonus is based on pre-bonus profitability and fluctuates based on our operating results, and as a result, our bonus expense for fiscal year 2013 increased by $17.7 million compared to fiscal year 2012. As a result of the increase in bonus and salary, our fringe benefits expense increased $19.7 million. The $17.1 million increase in our pension expense was due to decreases in discount rates. These increases were partially offset by a $22.2 million decrease in non-cash stock-based compensation primarily from the January 1, 2013 end of the service period and vesting of the restricted stock units issued to employees of Towers Perrin in the Merger. As a percentage of revenue, salaries and employee benefits was 61% for fiscal years 2013 and 2012. Professional and Subcontracted Services Professional and subcontracted services for fiscal year 2013 was $267.7 million, compared to $283.8 million for fiscal year 2012, a decrease of $16.1 million, or 6%. Our external service provider fees decreased by $17.6 million compared to fiscal year 2012. We contracted with these service providers to supplement our day-to-day operations. In fiscal year 2013, our telecommunication, video conferencing, and internet services have been managed by our in-house information technology department, and these expenses are classified in general and administrative expenses. Our pass-through expenses, which are 44-------------------------------------------------------------------------------- Table of Contents reimbursable under our contracts, increased by $1.5 million. As a percentage of revenue, professional and subcontracted services decreased to 8% for fiscal year 2013 from 9% for fiscal year 2012. Occupancy Occupancy expense for fiscal year 2013 was $139.9 million, compared to $136.6 million for fiscal year 2012, an increase of $3.3 million, or 2%. The increase was due to higher utilities, a decrease in sublease income and lower tenant improvement allowances, partially offset by a decrease in rent. As a percentage of revenue, occupancy expense was 4% for fiscal years 2013 and 2012. General and Administrative Expenses General and administrative expenses for fiscal year 2013 was $303.5 million, compared to $259.1 million for fiscal year 2012, an increase of $44.4 million, or 17%. Our professional liability and other claims expense increased $29.8 million in fiscal year 2013 compared to 2012 due to increases in our current legal reserves and reductions in prior year IBNR reserves. We also experienced an increase of $13.3 million in our telecommunications, video conferencing, internet and general office expenses for fiscal year 2013 compared to 2012. These expenses were classified in professional and subcontracted services in fiscal year 2012, as we previously contracted with an external service provider for these services. In addition, our newest segment Exchange Solutions was formed in the fourth quarter of fiscal year 2012, contributing to higher general and administrative expenses in fiscal year 2013. As a percentage of revenue, general and administrative expenses was 9% for fiscal year 2013, compared to 8% for fiscal year 2012. Depreciation and Amortization Depreciation and amortization expense for fiscal year 2013 was $173.0 million, compared to $150.0 million for fiscal year 2012, an increase of $23 million, or 15%. The increase is primarily due to the amortization of intangibles related to our acquisition of Extend Health in the fourth quarter of fiscal year 2012. In addition, we accelerated amortization for a software application that we acquired in the Merger, as management determined that its use would be primarily discontinued in the next two to three years. A portion of the increase is also attributable to increased depreciation on the computer hardware that was placed in service in fiscal years 2011 and 2012. As a percentage of revenue, depreciation and amortization expenses was 5% for fiscal years 2013 and 2012. Transaction and Integration Expenses Transaction and integration expense for fiscal year 2013 was $30.8 million, compared to $86.1 million for fiscal year 2012, a decrease of $55.3 million. The decrease was principally due to a reduction in expenses related to information technology integration projects that were ongoing in fiscal year 2012 and completed in fiscal year 2013. As a percentage of revenue, transaction and integration expenses was 1% for fiscal year 2013 and 3% for fiscal year 2012. (Loss) / Income from Affiliates Loss from affiliates for fiscal year 2013 was $0.1 million compared to income from affiliates of $0.3 million for fiscal year 2012. In the second quarter of fiscal year 2012, we purchased a majority ownership in Fifth Quadrant Actuaries and Consultants Holdings (Pty) Ltd. ("Fifth Quadrant") and began to consolidate its operations. Fifth Quadrant has historically been the primary source of income from affiliates. Interest Income Interest income was $2.4 million and $3.9 million for fiscal years 2013 and 2012, respectively. Interest Expense Interest expense was $12.7 million for fiscal year 2013, compared to $9.2 million for fiscal year 2012, which was in line with our outstanding principal balances during the fiscal years. Other Non-Operating Income Other non-operating income for fiscal year 2013 was $6.9 million, compared to $11.4 million for fiscal year 2012. In fiscal year 2012, we recorded a $2.8 million gain resulting from the fair value adjustment to our investment in Fifth Quadrant upon the purchase of a controlling interest. We acquired an additional ownership in Fifth Quadrant and consolidated our former equity investee in our results of operations beginning in the second quarter of fiscal year 2012. In fiscal year 2012, we also recorded deferred payments from divestitures. 45-------------------------------------------------------------------------------- Table of Contents Provision for Income Taxes The provision for income taxes for fiscal year 2013 was 31.9% compared with 35.8% in fiscal year 2012. Our effective tax rate decreased by 3.9% for fiscal year 2013 as compared to fiscal year 2012 primarily due to a current year income tax benefit for foreign exchange losses recognized from legal entity restructurings. Income from Discontinued Operations, net of income tax Income from discontinued operations for fiscal year 2013 was $23.6 million, compared to $22.9 million for fiscal year 2012. Net Income Attributable to Common Stockholders Net income attributable to common stockholders for the fiscal year ended June 30, 2013 was $318.8 million, an increase of $58.6 million, or 23%, compared to $260.2 million for the fiscal year ended June 30, 2012. As a percentage of revenue, net income attributable to controlling interests was 9% for fiscal year 2013, compared to 8% for fiscal year 2012. Diluted Earnings Per Share Diluted earnings per share for fiscal year 2013 was $4.46, compared to $3.59 for fiscal year 2012. Liquidity and Capital Resources Our most significant sources of liquidity are funds generated by operating activities, available cash and cash equivalents, and our credit facility. Consistent with our liquidity position, management considers various alternative strategic uses of cash reserves including acquisitions, dividends and stock buybacks, or any combination of these options. We believe that we have sufficient resources to fund operations beyond the next 12 months. The key variables that we manage in response to current and projected capital resource needs include credit facilities and short-term borrowing arrangements, working capital and our stock repurchase program. Our cash and cash equivalents at June 30, 2014 totaled $727.8 million, compared to $532.8 million at June 30, 2013. The increase in cash in fiscal 2014 was due to net cash flows from operations and proceeds from the sale of our Brokerage business, partially offset by the cash paid for the acquisition of Liazon, repurchases of common stock and purchases of long-lived assets and investments. Short-term investments at June 30, 2014 totaled $122.8 million compared to $56.6 million at June 30, 2013. These assets consist primarily of held-to-maturity investments in certificates of deposit and time deposits which have been classified as short-term. Cash and cash equivalents and short term investments include $34.8 million and $15.1 million, respectively, from the consolidated balance sheets of PCIC and SMIC, which are available for payment of professional liability and other claims reserves. Additionally we have fiduciary assets totaling $12.0 million at June 30, 2014, which is related to our health and welfare benefits administration outsourcing business. These amounts are held in a fiduciary capacity on behalf of clients and are not available for other general use by the Company. Adjusting for these items, we have a net $693.0 million of cash and $107.7 million of short-term investments that are available for our general use. Our non-U.S. operations are substantially self-sufficient for their working capital needs. As of June 30, 2014, $580.6 million of Towers Watson's total cash and cash equivalents balance of $727.8 million and $107.6 million of our $122.8 million of our total short-term investments were held outside of the United States. Should we require more capital in the U.S. than is generated by our U.S. operations, we may decide to make additional borrowings under our Senior Credit Facility, repatriate funds held in foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates or increased interest expense. We do not expect restrictions or taxes on repatriation of cash held outside the U.S. to have a material effect on the Company's overall liquidity, financial condition or results of operations. During fiscal 2014, the Company has accrued approximately $2.5 million in income tax expense with respect to the future distribution of current year earnings in our Japan, Australia, Bermuda and Philippines subsidiaries. ASC 740, Income Taxes, requires a company to recognize income tax expense when it becomes apparent that some or all of the undistributed earnings of a foreign subsidiary will be remitted in the foreseeable future. Except as noted above, we have not provided U.S. federal income taxes on undistributed foreign earnings of our foreign subsidiaries, including previously accumulated foreign earnings of our Japan, Australia, Bermuda and Philippines subsidiaries, because such earnings are considered indefinitely reinvested outside the United States. It is not practicable to estimate the U.S. federal income tax liability that might be payable if such earnings are not invested indefinitely. If future events, including material changes in estimates of cash, working capital and 46-------------------------------------------------------------------------------- Table of Contents long-term investment requirements, necessitate that these earnings be repatriated, an additional provision for U.S. income and foreign withholding taxes, net of foreign tax credits, may be necessary. Assets and liabilities associated with non-U.S. entities have been translated into U.S. dollars as of June 30, 2014, at U.S. dollar rates that fluctuate compared to historical periods. As a result, cash flows derived from changes in the consolidated balance sheets include the impact of the change in foreign exchange translation rates. Events that could change the historical cash flow dynamics discussed above include significant changes in operating results, potential future acquisitions, material changes in geographic sources of cash, unexpected adverse impacts from litigation or future pension funding during periods of severe downturn in the capital markets. Cash Flows From Operating Activities. Cash flows from operating activities were $456.1 million for fiscal year 2014 compared to cash flows from operating activities of $531.3 million for fiscal year 2013. This decrease of $75.2 million is primarily attributable to higher bonus payments made during the first quarter of fiscal year 2014 as compared to the first quarter of fiscal year 2013. The allowance for doubtful accounts decreased $4.7 million from June 30, 2013 to June 30, 2014. The number of days of accounts receivable outstanding decreased to 80 at June 30, 2014 compared to 83 at June 30, 2013. Cash Flows Used in Investing Activities. Cash flows used in investing activities for fiscal year 2014 were $268.1 million, compared to $137.8 million of cash flows used in fiscal year 2013. This increase in cash flows used in investing activities was primarily due to discrete events that occurred during fiscal year 2014; specifically the cash outflows from the acquisition of Liazon and the purchase of $109.5 million of investments by funds that we manage, which were previously consolidated (this is offset by an equal amount of cash inflows from financing activities), as well as the purchase of held-to-maturity securities that do not have a comparable amount in fiscal year 2013. The cash outflows were partially offset by the cash proceeds from the sale of our Brokerage business. Cash Flows Used in Financing Activities. Cash flows used in financing activities in fiscal year 2014 were $15.2 million, compared to cash flows used in financing activities of $326.7 million in fiscal year 2013. The decrease in cash flows used in financing activities of $311.4 million was primarily due to cash subscriptions of $109.5 million into funds that we manage, which were previously consolidated (this is offset by an equal amount of cash outflows from investing activities) that does not have a comparable amount in fiscal year 2013. Additionally, we utilized our Senior Credit Facility less during fiscal year 2014 than in the prior fiscal year, and had lower net repayments of borrowings during fiscal year 2014 as compared to fiscal year 2013. During fiscal year 2014, the average outstanding balance on our Senior Credit Facility was $9.3 million, and the largest outstanding balance at any point in time was $57.5 million. Capital Commitments Capital expenditures were $64.8 million for fiscal year 2014. Additionally, during fiscal year 2014, we spent $56.0 million for internally-developed capitalized software for external use by our clients. Dividends During May 2014, our board of directors approved the payment of a quarterly cash dividend in the amount of $0.14 per share which was paid in July 2014. Total dividends paid in fiscal year 2014 and in fiscal year 2013 were $21.1 million and $48.2 million, respectively. The amount in fiscal years 2014 and 2013 includes $1.6 million and $1.3 million, respectively, of dividends paid by our consolidated, majority-owned subsidiary, Fifth Quadrant, to its third-party shareholders. Off-Balance Sheet Arrangements and Contractual Obligations Remaining payments by fiscal year due as of June 30, 2014 Contractual Cash Less than More Than Obligations (in thousands) Total 1 Year 1-3 Years 3-5 Years 5 Years Term loan $ 225,000 $ 25,000 $ 200,000 $ - $ - Lease commitments 565,557 109,926 180,499 127,996 147,136 $ 790,557 $ 134,926 $ 380,499 $ 127,996 $ 147,136 Operating Leases. We lease office space under operating lease agreements with terms typically averaging 10 years. We have determined that there is not a large concentration of leases that will expire in any one fiscal year. Consequently, management anticipates that any increase in future rent expense on leases will be mainly market driven. While the future operating lease 47-------------------------------------------------------------------------------- Table of Contents payments presented above are not recognized on our balance sheet, we do have certain assets and liabilities related to these leases in the form of deferred rent accruals and intangible assets and liabilities. The intangible assets and liabilities were recognized for the difference between the contractual cash obligations shown above and the estimated market rates at the time of certain past acquisitions. The resulting intangibles will amortize to rent expense but do not impact the amounts shown above since there is no change to our contractual cash obligations. Pension Contribution. The table above does not include contributions for pension plans. Contributions to our qualified pension plans for fiscal year 2015 are projected to be $88.4 million. Additionally, the Company expects to pay $57.8 million in benefits directly to participants for fiscal 2015. Uncertain Tax Positions. The table above does not include liabilities for uncertain tax positions under ASC 740, Income Taxes. The settlement period for the $32.4 million liability, which excludes interest and penalties, cannot be reasonably estimated since it depends on the timing and possible outcomes of tax examinations with various tax authorities. Contingent Consideration from Acquisitions. The table above does not include liabilities for contingent consideration for our EMB acquisition in fiscal year 2011 and our DaVinci acquisition in fiscal year 2013. As of June 30, 2014, we still expect to pay out £2.4 million per year for fiscal years 2015 and 2016 related to the EMB contingent consideration provisions in our agreements and subject to performance requirements on behalf of the sellers. Related to the DaVinci acquisition, we expect to pay out approximately $125 thousand per year for fiscal year 2015 through fiscal year 2017. Indebtedness Towers Watson Senior Credit Facility On November 7, 2011, Towers Watson and certain subsidiaries entered into a five-year, $500 million revolving credit facility, which amount may be increased by an aggregate amount of $250 million, subject to the satisfaction of customary terms and conditions, with a syndicate of banks (the "Senior Credit Facility"). Borrowings under the Senior Credit Facility bear interest at a spread to either LIBOR or the Prime Rate. During fiscal 2014 and 2013, the weighted-average interest rate on the Senior Credit Facility was 1.93% and 1.49%, respectively. We are charged a quarterly commitment fee, currently 0.175% of the Senior Credit Facility, which varies with our financial leverage and is paid on the unused portion of the Senior Credit Facility. Obligations under the Senior Credit Facility are guaranteed by Towers Watson and all of its domestic subsidiaries (other than our captive insurance companies). The Senior Credit Facility contains customary representations and warranties and affirmative and negative covenants. The Senior Credit Facility requires Towers Watson to maintain certain financial covenants that include a minimum Consolidated Interest Coverage Ratio and a maximum Consolidated Leverage Ratio (which terms in each case are defined in the Senior Credit Facility). In addition, the Senior Credit Facility contains restrictions on the ability of Towers Watson to, among other things, incur additional indebtedness; pay dividends; make distributions; create liens on assets; make acquisitions; dispose of property; engage in sale-leaseback transactions; engage in mergers or consolidations, liquidations and dissolutions; engage in certain transactions with affiliates; and make changes in lines of businesses. As of June 30, 2014, we were in compliance with our covenants. As of June 30, 2014, Towers Watson had no borrowings outstanding under the Senior Credit Facility. Letters of Credit under the Senior Credit Facility As of June 30, 2014, Towers Watson had standby letters of credit totaling $21.4 million associated with our captive insurance companies in the event that we fail to meet our financial obligations. Additionally, Towers Watson had $1.0 million of standby letters of credit covering various other existing or potential business obligations. The aforementioned letters of credit are issued under the Senior Credit Facility, and therefore reduce the amount that can be borrowed under the Senior Credit Facility by the outstanding amount of these standby letters of credit. Additional Borrowings, Letters of Credit and Guarantees not part of the Senior Credit Facility Towers Watson Consultoria Ltda. (Brazil) has a bilateral credit facility with a major bank totaling Brazilian Real (BRL) 4.5 million (U.S. $2.0 million). BRL 2.0 million of the credit facility is committed to an overdraft facility and as of June 30, 2014, there were no borrowings outstanding under this facility. BRL 2.5 million of the credit facility is committed to lease guarantees. Towers Watson has also provided a $5 million Australian dollar-denominated letter of credit (U.S. $4.7 million) to an Australian governmental agency as required by local regulations. The estimated fair market value of this letter of credit is immaterial because it has never been used, and we believe that the likelihood of future usage is remote. 48-------------------------------------------------------------------------------- Table of Contents Towers Watson also has $5.6 million of the credit facility committed to lease guarantees of letters of guarantee from major banks in support of office leases and performance under existing or prospective contracts. Term Loan Agreement Due June 2017 On June 1, 2012, the Company entered into a five-year $250 million amortizing Term Loan with a consortium of banks. The interest rate on the term loan is based on the Company's choice of one, three or six month LIBOR plus a spread of 1.25% to 1.75%, or alternatively the bank base rate plus 0.25% to 0.75%. The spread to each index is dependent on the Company's consolidated leverage ratio. The weighted-average interest rate elected on the Term Loan during fiscal 2014 and 2013 was 1.42% and 1.46%, respectively. The Term Loan amortizes at a rate of $6.25 million per quarter, beginning in September 2013, with a final maturity of June 1, 2017. The Company has the right to prepay a portion or all of the outstanding Term Loan balance on any interest payment date without penalty. This agreement contains substantially the same terms and conditions as our existing Senior Credit Facility dated November 7, 2011, including guarantees from all of the domestic subsidiaries of Towers Watson (other than PCIC and SMIC). The Company entered into the Term Loan as part of the financing of our acquisition of Extend Health (see Note 2). Non-U.S. GAAP Measures In order to assist readers of our financial statements in understanding the core operating results that the Company's management uses to evaluate the business and for financial planning, we present the following non-U.S. GAAP measures: (1) Adjusted EBITDA, (2) Adjusted Diluted Earnings Per Share from continuing operations, and (3) Adjusted income from continuing operations (attributable to common stockholders). The Company believes these measures are relevant and provide useful information widely used by analysts, investors and other interested parties in our industry to provide a baseline for evaluating and comparing our operating results. These non-U.S. GAAP measures are not defined in the same manner by all companies and may not be comparable to other similarly titled measures of other companies. Non-U.S. GAAP measures should be considered in addition to, and not as a substitute for, the information contained within our financial statements. Adjusted EBITDA We consider Adjusted EBITDA to be an important financial measure, which is used to internally evaluate and assess our core operations, to benchmark our operating results against our competitors, and to evaluate and measure our performance based compensation plans. Since the Merger in January 2010, we have incurred significant acquisition-related expenses related to our merger and integration activities necessary to combine Watson Wyatt and Towers Perrin. These acquisition-related expenses include transaction and integration costs, severance costs, non-cash charges for amortization of intangible assets and merger-related stock-based compensation costs from the issuance of merger-related restricted shares. Included in our transaction and integration costs are integration consultant fees and legal, accounting, marketing and information technology integration expenses. Adjusted EBITDA excludes the impact of these acquisition-related expenses and is important in illustrating what our operating results would have been had these expenses not been incurred. Adjusted EBITDA is defined as Net income (attributable to common stockholders) adjusted for discontinued operations, net of tax, provision for income taxes, interest, net, depreciation and amortization, transaction and integration expenses, stock-based compensation, and other non-operating income excluding income from variable interest entity. 49-------------------------------------------------------------------------------- Table of Contents A reconciliation of Adjusted EBITDA to Net income (attributable to common stockholders) is as follows: Year Ended June 30, 2014 2013 2012 (in thousands) NET INCOME (attributable to common stockholders) $ 359,300 $ 318,812 $ 260,213 Less: Income from discontinued operations, net of tax 6,057 23,642 22,898 Income from continuing operations (attributable to common stockholders) 353,243 295,170 237,315 Provision for income taxes 138,249 136,991 132,443 Interest, net 6,228 10,276 5,296 Depreciation and amortization 174,818 173,040 150,006 Transaction and integration expenses 1,049 30,753 86,130 Stock-based compensation (a) - 8,931 27,925 Change in accounting method for pension - - 2,963 Extend Health stock-based compensation - - 931 Other non-operating income (b) (3,929 ) (6,872 ) (11,612 ) Adjusted EBITDA $ 669,658 $ 648,289 $ 631,397 (a) Stock-based compensation is included in salary and employee benefits expense and relates to Towers Watson Restricted Class A shares held by our current associates which were awarded to them in connection with the Merger in 2010 and Extend Health stock options held by our current associates which were assumed by the Company in connection with the acquisition. (b) Other non-operating income includes income from affiliates and other non-operating income excluding income from variable interest entity of $6.3 million for the year ended June 30, 2014. Adjusted diluted earnings per share and Adjusted Income from continuing operations (attributable to common stockholders) Adjusted diluted earnings per share is another measure which excludes the impact of acquisition related expenses that is used to internally evaluate and assess our core operations and to benchmark our operating results against our competitors. Adjusted diluted earnings per share is defined as Adjusted Income from continuing operations divided by the weighted average shares of common stock, diluted. Adjusted Income from continuing operations is defined as Net income (attributable to common stockholders) adjusted for discontinued operations, net of tax, and adjusted for certain tax-effected merger and acquisition related items of transaction and integration expenses, non-cash stock-based compensation, and amortization of intangible assets. This measure is used solely for the purpose of calculating Adjusted diluted earnings per share. 50-------------------------------------------------------------------------------- Table of Contents A reconciliation of Adjusted diluted earnings per share to Net income (attributable to common stockholders) is as follows: Year Ended June 30, 2014 2013 2012 (In thousands, except share and per share amounts) NET INCOME (attributable to common stockholders) $ 359,300 $ 318,812 $ 260,213 Less: Income from discontinued operations, net of tax 6,057 23,642 22,898 Income from continuing operations (attributable to common stockholders) 353,243 295,170 237,315 Adjusted for certain acquisition related items (c), (d): Amortization of intangible assets 54,354 52,387 41,192 Transaction and integration expenses including severance 758 20,933 54,110 Stock-based compensation (e) - 6,079 18,505 Change in accounting method for pension - - 1,859 Gain on investment in Fifth Quadrant - - (1,779 ) Gain on investment in Extend Health - - (727 ) Release of acquisition related liability - - (601 ) Other merger-related tax items - - (698 ) Extend Health stock-based compensation - - 615 Adjusted income from continuing operations (attributable to common stockholders) $ 408,355 $ 374,569 $ 349,791 Weighted average shares of common stock - diluted (000) 70,955 71,555 72,542 Diluted earnings per share, as reported from continuing operations $ 4.98 $ 4.13 $ 3.27 Adjusted for certain acquisition-related items: Amortization of intangible assets 0.77 0.73 0.57 Transaction and integration expenses including severance 0.01 0.29 0.74 Stock-based compensation - 0.08 0.26 Change in accounting method for pension - - 0.03 Gain on investment in Fifth Quadrant - - (0.03 ) Gain on investment in Extend Health - - (0.01 ) Release of acquisition related liability - - (0.01 ) Other merger-related tax items - - (0.01 ) Extend Health stock-based compensation - - 0.01 Adjusted diluted earnings per share from continuing operations $ 5.76 $ 5.23 $ 4.82 (c) The adjustments to net income attributable to common stockholders and diluted earnings per share of certain acquisition-related items are net of tax. In calculating the net of tax amounts, all adjustments were tax effected at the applicable effective tax rate (ETR) for the period, which was 27.7% for the year ended June 30, 2014 and 31.9% for the year ended June 30, 2013. 51-------------------------------------------------------------------------------- Table of Contents (d)In fiscal 2012, there were significant variances between the interim period ETR and the applicable ETR for each merger-related item. In calculating the net of tax amounts for the year ended June 30, 2012, the ETRs applied were as follows: Year Ended 2012 Amortization of intangible assets 35.40 % Transaction and integration expenses including severance 37.20 % Stock-based compensation 33.70 % Change in accounting method for pension 37.30 % Gain on investment in Fifth Quadrant 28.00 % Gain on investment in Extend Health 39.90 % Release of acquisition related liability 39.90 % Extend Health stock-based compensation 34.00 % Included in other merger-related tax items in 2012 is a $0.7 million benefit resulting from tax restructurings in Canada, Brazil, Mexico, Belgium, Sweden, Ireland and France. All merger-related tax items are included in the consolidated statement of operations under provision for income taxes for 2012. (e) Stock-based compensation relates to shares of Restricted Class A common stock held by our current associates which were awarded to them as former Towers Perrin employees in connection with the Merger. Risk Management As a part of our risk management program, we purchase customary commercial insurance policies, including commercial general liability and claims-made professional liability insurance. Our professional liability insurance currently includes a self-insured retention of $1 million per claim, together with a self-insured retention of $10 million aggregate, above the $1 million self-insured retention, and covers professional liability claims against us, including the cost of defending such claims. For the policy period beginning July 1, 2011 certain changes were made to our professional liability insurance program. These changes remain in-force for the annual policy periods beginning July 1, 2011 and ending July 1, 2015. Our professional liability insurance includes a self-insured retention of $1 million per claim. Towers Watson also retains a $10 million aggregate self-insured retention above the $1 million self-insured retention per claim, including the cost of defending such claims. Stone Mountain Insurance Company ("SMIC") provides us with $40 million of coverage per claim and in the aggregate, above these retentions, including the cost of defending such claims. SMIC secured $25 million of reinsurance from unaffiliated reinsurance companies in excess of the $15 million SMIC retained layer. Excess insurance attaching above the SMIC coverage is provided by various unaffiliated commercial insurance companies. Because of the $1 million self-insured retention per claim and the additional $10 million aggregate self-insured retention above, and because SMIC is wholly-owned by us, our primary errors and omissions risk is borne by Towers Watson and the subsidiary SMIC. We reserve for contingent liabilities based on ASC 450, Contingencies, when it is determined that a liability, inclusive of defense costs, is probable and reasonably estimable. The contingent liabilities recorded are primarily developed actuarially. Before the Merger, Watson Wyatt and Towers Perrin each obtained substantial professional liability insurance from an affiliated captive insurance company, Professional Consultants Insurance Company ("PCIC"). A limit of $50 million per claim and in the aggregate was provided by PCIC subject to a $1 million per claim self-insured retention. PCIC secured reinsurance of $25 million attaching above the $25 million PCIC retained layer. In addition, both legacy companies carried excess insurance from unaffiliated commercial insurance companies above the self-insured retention and the coverage provided by PCIC. Our ownership interest in PCIC is 72.86%. As a consequence, PCIC's results of operations are consolidated into our results of operations. PCIC ceased issuing insurance policies effective July 1, 2010 and at that time entered into a run-off mode of operation. Our shareholder agreements with PCIC could require additional payments to PCIC if development of claims significantly exceeds prior expectations. We provide for the self-insured retention where specific estimated losses and loss expenses for known claims are considered probable and reasonably estimable. Although we maintain professional liability insurance coverage, this insurance does not cover claims made after expiration of our current policies of insurance. Generally accepted accounting principles require that we record a liability for incurred but not reported ("IBNR") professional liability claims if they are probable and reasonably estimable, and for which we have not yet contracted for insurance coverage. We use actuarial assumptions to estimate and record our IBNR liability. As of June 30, 2014, we had a $173.8 million IBNR liability, net of estimated IBNR recoverable 52-------------------------------------------------------------------------------- Table of Contents receivables of our captive insurance companies. This net liability decreased from $174.3 million as of June 30, 2013. To the extent our captive insurance companies, PCIC and SMIC, expect losses to be covered by a third party, they record a receivable for the amount expected to be recovered. This receivable is classified in other current or other noncurrent assets in our consolidated balance sheet. Insurance market conditions for us and our industry have varied in recent years, but the long-term trend has been increasing premium cost. Although the market for professional liability insurance is presently reasonably accessible, trends toward higher self-insured retentions, constraints on aggregate excess coverage for this class of professional liability risk and financial difficulties which have, over the past few years, been faced by several longstanding E&O carriers, are anticipated to recur periodically, and to be reflected in our future annual insurance renewals. As a result, we will continue to assess our ability to secure future insurance coverage, and we cannot assure that such coverage will continue to be available in the event of adverse claims experience, adverse loss trends, market capacity constraints or other factors. In light of increasing litigation worldwide, including litigation against professionals, we have a policy that all client relationships be documented by engagement letters containing specific risk mitigation clauses that were not included in all historical client agreements. Certain contractual provisions designed to mitigate risk may not be legally enforceable in litigation involving breaches of fiduciary duty or certain other alleged errors or omissions, or in certain jurisdictions. We may incur significant legal expenses in defending against litigation. Recent Accounting Pronouncements Not yet adopted On June 7, 2013, the FASB issued ASU 2013-8, "Financial Services - Investment Companies (Topic 946): Amendments to the Scope, Measurement, and Disclosure Requirements," which amends the criteria an entity would need to meet to qualify as an investment company under ASC 946. The ASU (1) introduces new disclosure requirements that apply to all investment companies and (2) amends the measurement criteria for certain interests in other investment companies. The ASU also amends the requirements in ASC 810 related to qualifying for the "investment-company deferral" in ASU 2010-10 as well as the requirements in ASC 820 related to qualifying for the "net asset value practical expedient" in ASU 2009-12. We manage certain funds that are considered variable interest entities and for which our management fee is considered a variable interest. These funds qualify for the "investment-company deferral" in ASU 2010-10 and therefore are subject to the consolidation guidance prior to the issuance of ASU 2009-17. The ASU is effective for interim and annual periods that begin after December 15, 2013, and early adoption is prohibited. The Company is currently evaluating whether these funds will continue to qualify for the "investment-company deferral" based on the amended investment company criteria proscribed by ASU 2013-8. On May 28, 2014, the FASB and IASB issued their final standard on revenue from contracts with customers. The standard, issued as ASU 2014-09 by the FASB, outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The ASU applies to all contracts with customers except those that are within the scope of other topics in the FASB Accounting Standards Codification. Compared with current U.S. GAAP, the ASU also requires significantly expanded disclosures about revenue recognition. The ASU is effective for interim and annual reporting periods that begin after December 15, 2016 and early adoption is prohibited. The Company is currently evaluating the impact of adopting this provision. On June 19, 2014, the FASB issued ASU 2014-12, Accounting for Share-Based Payments When the Terms of an Award Provide a Performance Target Could Be Achieved After the Requisite Service Period. The update is intended to resolve the diverse accounting treatment of these types of awards in practice. The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. A reporting entity should apply existing guidance in "Compensation - Stock Compensation (Topic 718)" as it relates to awards with performance conditions that affect vesting to account for such awards. As such, the performance target should not be reflected in estimating the grant-date fair value of the award. Compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. If the performance target becomes probable of being achieved before the end of the requisite service period, the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The ASU is effective for interim and annual reporting periods that begin after December 15, 2015. The Company does not expect the adoption of this pronouncement to have an impact on our financial statements as this guidance mirrors our existing policy for such share-based awards. 53-------------------------------------------------------------------------------- Table of Contents |