expected to continue to account for a significant majority of the Company's outsourcing revenues in the near future.
Federal residential flood insurance rates are set by FEMA and are the same for all flood insurance carriers. Consequently, policyholder retention is typically dependent upon the quality of customer service being offered. Higher retention or renewal rates provide more consistent recurring revenues. Flood insurance carriers often utilize independent agents to sell their product. Competing flood insurance carriers offering more attractive commissions to such agents pose a significant risk for declines in business.
Management services from Parent have historically been charged to the Company under a management agreement with BIG for common costs that are incurred by BIG and allocated to its affiliated companies. These common costs include human resources, legal, corporate planning and communications, cash management, certain executive management and rent. Allocation of the management services is based on employee head counts and estimates of time incurred, which management believes to be a reasonable basis of allocation.
The following table sets forth for the periods indicated certain selected operating results of the Company as a percentage of total revenues:
personnel costs due to additions to staff, (iii) increased services provided to BIG due to the growth in the volume of BIG's insurance business and (iv) the Company assuming responsibility for claims costs for independent adjusters and appraisers that were previously borne by BIG. These increases were partially offset by a decrease in the lease cost of fixed assets that were purchased by the Company from BIG on April 1, 1998. Prior to April 1, 1998, the depreciation for such equipment, which totaled $282,015 and $762,260 during 1998 and 1997, respectively, was charged to the Company under an arrangement similar to an operating lease and is included in cost of outsourcing services. Such costs are now included in depreciation and amortization.
Cost of Flood Zone Determination Services. Cost of flood zone determination services increased $6.4 million, or 133.7%, to $11.1 million in 1998 from $4.8 million in 1997. The increase in cost of flood zone determinations was primarily attributable to the inclusion of the consolidated expenses of both Geotrac and BHDS for 1998 as compared with the expenses of BHDS only for 1997. As a percentage of flood zone determination services revenue, the decrease in cost of flood zone determination services resulted primarily from a reduction during 1998 of approximately $822,000 in insurance costs due to the Company terminating its insurance policy associated with its life or loan program effective June 1, 1998. Consequently, from such date forward, the Company deferred a portion of each life of loan fee received in order to account for its obligation to perform future flood zone redeterminations.
Selling, General and Administrative Expense. Selling, general and administrative expenses increased $5.4 million, or 176.9%, to $8.4 million in 1998 from $3.0 million in 1997. The increase is primarily related to additional wages and related benefits associated with adding executive management, accounting, sales and marketing and other administrative staff during 1998 to support the Company's expanded operations, as well as the inclusion of the consolidated expenses of both Geotrac and BHDS for 1998 as compared with the expenses of BHDS only for 1997.
related to its flood and homeowners insurance programs. In addition, during 1997, the Company provided claims administration services on a cost reimbursement basis for most of BIG's other lines of business, excluding flood and homeowners. During 1996, the Company provided only information technology services to its affiliated companies on a cost reimbursement basis.
Cost of Outsourcing Services. Cost of outsourcing services increased $18.1 million, or 464.4%, to $22.0 million in 1997 from $3.9 million in 1996. The increase was primarily the result of the transfer of various policy and claims administration units from BIG to the Company, as well as upward pressure on salaries resulting from continued competition for qualified employees.
Selling, General and Administrative Expense. Selling, general and administrative expenses increased $1.9 million, or 169.9%, to $3.0 million in 1997 from $1.1 million in 1996. The increase was primarily related to additional wages and related benefits associated with adding executive management, accounting, sales and marketing and other administrative staff during 1997 to support the Company's expanded operations.
Depreciation and Amortization Expense. Depreciation and amortization expense increased $375,000, or 121.1%, to $684,000 in 1997 from $309,000 in 1996 primarily as a result of upgrading existing data processing equipment.
Provision for Income Taxes. The Company's effective income tax rates were 38.3% and 39.1% in 1997 and 1996, respectively. Income before provision for income taxes for 1997, excluding the equity in earnings of Old Geotrac, resulted in an effective income tax rate of 39.7%. The equity in earnings in Old Geotrac are presented net of tax.
At December 31, 1997 and 1998 amounts due from BIG totaled $8.8 million and $5.8 million, respectively. At the same dates, amounts due to BIG (including income tax payable to BIG), totaled $5.1 million and $1.7 million, respectively. In addition, at December 31, 1998, notes payable to BIG totaled $8.1 million. All intercompany balances were subsequently repaid either from a portion of the proceeds received by the Company in the initial public offering or from funds received from BIG from proceeds made available to BIG by a subsidiary of the selling shareholder in the offering. The Company maintained a zero balance account arrangement with BIG through June, 1998. As a result of this funding arrangement, the Company has a negative cash balance for financial reporting purposes at December 31, 1997 representing checks that have been issued but that have not yet been presented to the bank for payment. This arrangement was discontinued in June, 1998.
Information concerning the Company's (1) state of readiness, (2) cost of addressing Year 2000 issues, (3) risk of Year 2000 issues, and (4) contingency plans is provided below. The discussion is divided into two parts: the first addresses the Company's outsourcing operations, and the second addresses the Company's flood zone determination operations.
include overtime hours, temporary employees, additional space, paper forms in replacement of computer-generated forms, blank paper stock, physical file space, additional copiers and fax machines, additional equipment, greater support for data reconciliation and cash reconciliation processes in the absence of computer-generated production data, and greater use of fiche and fiche readers.
For IT hardware systems, the Project Plan addresses the Year 2000 Problem with respect to: IBM AS/400 processors and tape drives; production servers; communication servers; development servers; wide area network and network infrastructure hardware; modems; printers; tape drives; desktop personal computers; and fax servers. For IT software systems, the Plan addresses the Year 2000 Problem with respect to: network operating systems; software development packages and third-party vendor software packages; in-house developed software packages; GeoCompass(R), the Company's flood zone determination electronic ordering and delivery package; and GMaS internal production routing.
The Company has reviewed and validated the Year 2000 compliance of the IBM AS/400 business system used in its flood zone determination operations. This process involved reviewing all internally developed application code, modules, databases, and reports for correct date handling, changing all date fields to handle the four digit century format, and upgrading the operating system to the Year 2000 compliant version. The Company's internally developed GeoCompass(R) and GMaS software packages have also been assessed for Year 2000 readiness. Updated versions of such software that are Year 2000 compliant are expected to be put into service during the second quarter of 1999. Of the Company's flood zone determination network operating systems, the Company has determined that certain versions are not Year 2000 compliant. These versions are expected to be upgraded in the second quarter of 1999 The Company is in the process of having its other flood zone determination hardware and software components validated for Year 2000 compliance by the vendors that supply those products.
Testing methodology of existing internal systems includes the identification of programs and Year 2000 critical dates for date rollover testing. An initial test was completed in February, 1999 of a mirrored production environment. This environment tested AS/400 applications, communication and data transfer systems, electronically generated faxes and data files, LAN and WAN connections, and production flow within the Company. All tests will be documented, errors corrected and retested before verification can be signed-off.
The Company estimates that, to date, it has spent approximately $150,000 in time and materials (computing costs, network and telephone support, office supplies, programming support and project coordination) in executing its Project Plan with respect to its flood zone determination operations. The Company anticipates that it will cost an additional $100,000 to address the Year 2000 Problem with respect to these operations. Nearly all costs, whether incurred or to be incurred, are internal to the Company. The Company does not anticipate the total replacement of any core system. In the event an outside vendor's software is targeted for replacement, the Company may incur additional costs relating to acquisition of
The most reasonably likely worst case scenario for the Company's flood zone determination operations is the possibility that the Company will be unable to electronically exchange data with its clients. Such circumstances would require the Company to revert to manually exchanging requests for searches and remitting completed determinations to clients. This increase in manual operations would likely result in significant increases in the cost of clerical support (temporary employees), data entry (overtime wages), paper supplies, fax machines and telephone customer service support (overtime wages). Moreover, the inability to electronically exchange data with certain clients could result in a material loss of revenue.
The following financial statements of the Company and its independent certified public accountants' report are set forth on pages 34 through 59 of this report: