The Company owns an office building and adjacent real estate in Richmond, Virginia which it uses for its corporate headquarters. This property consists of approximately 128,000 square feet of office space and a parking deck. The Company's title insurance subsidiaries
On February 27, 1998, the Company acquired all of the issued and outstanding shares of capital stock of Commonwealth and Transnation from Reliance Insurance Company, a subsidiary of Reliance Group Holdings, Inc. The assets and liabilities of Commonwealth and Transnation have been revalued to their respective fair market values. The financial statements of the Company reflect the combined operations of the Company, including Commonwealth and Transnation, from the closing date of the acquisition.
The Company's operating revenues, consisting of premiums, title search, escrow and other fees, are dependent on overall levels of real estate activity, which are influenced by a number of factors including interest rates and the general state of the economy. In addition, the Company's revenues are affected by the Company's sales and marketing efforts and its strategic decisions based on the rate structure and claims environment in particular markets.
The Company's profit margins are affected by several factors, including the volume of real estate activity, policy amount and the nature of real estate transactions. Volume is an important determinant of profitability because the Company, like any other title insurance company, has a significant level of fixed costs arising from personnel, occupancy costs and maintenance of title plants. Because premiums are based on the face amount of the policy, larger policies generate higher premiums although expenses of issuance do not necessarily increase in proportion to policy size. Cancellations affect profitability because costs incurred both in opening and in processing orders typically are not offset by fees. Commercial transactions tend to be more profitable than residential transactions.
For a discussion of pending legal proceedings for the periods covered by this discussion of the Company's financial condition and results of operation, see "Item 3 - Legal Proceedings."
The Company reported net income of $93.0 million or $5.05 per share on a diluted basis for 1998 compared to $26.2 million or $2.84 per share on a diluted basis in 1997 and $36.5 million or $4.01 per share on a diluted basis in 1996. Exclusive of assimilation costs associated with the Commonwealth and Transnation acquisition, net income was $100.5 million or $5.46 per share on a diluted basis in 1998. The 1996 earnings were favorably impacted by capital gains resulting from a shift in the Company's investment portfolio from equities to fixed-income securities as discussed under "Investment Income." Net operating income (which excludes realized investment gains) was $91.2 million, $26.3 million and $21.3 million for the years ended 1998, 1997 and 1996, respectively.
Operating revenues reported for 1998 were $1.80 billion compared to $622.8 million in 1997 and $557.8 million in 1996. On a pro forma basis, operating revenues in 1998 were $1.94 billion compared to $1.49 billion in 1997 and $1.34 billion in 1996. In addition to the inclusion of Commonwealth and Transnation revenues in 1998, the increase is the result of increased volumes in residential and commercial resale and refinancing transactions, reflecting the continuing favorable interest rate environment and the general health of the national real estate markets.
Operating Expenses. The Company's expense ratio was 87.6% in 1998 compared to 90.1% in 1997 and 91.0% in 1996. The improvement in the expense ratio reflects increased operating leverage resulting from the Company's growth in revenues, and the continuing focus on expense management.
Assimilation Costs. Assimilation costs on a pre-tax basis of approximately $11.5 million were incurred in 1998 in connection with the acquisition of Commonwealth and Transnation. No such costs were incurred in 1997 or 1996.
General, Administrative and Other Expenses. The most significant components of other expenses are outside costs of title production, rent for office space, travel, communications and taxes levied by states on premiums.
The Company pays U.S. federal and state income taxes based on laws in the jurisdictions in which it operates. The effective tax rates reflected in the income statement for 1998, 1997 and 1996 differ from the U.S. federal statutory rate principally due to non-taxable interest, dividend deductions, travel and entertainment and company-owned life insurance.
At December 31, 1998 the Company had recorded gross deferred tax assets of $96.6 million related primarily to policy and contract claims and employee benefit plans. Substantially all of this deferred tax asset balance could be realized in the future through the reversal of existing temporary taxable differences. Accordingly, it is more likely than not that the income tax benefits will be realized for all of the temporary deductible differences existing at December 31, 1998, therefore no valuation allowance has been established.
Upon closing the acquisition of Commonwealth and Transnation on February 27, 1998, the Company incurred debt of $207.5 million under a credit facility and issued 2.2 million shares of 7% Series B Cumulative Convertible Preferred Stock. The Company estimates that servicing the debt and preferred stock will require approximately $20.0 million per year, which management expects to be funded largely from cash flow from operations. Additionally, management believes that these cash requirements will be partially offset by approximately $15.0 million of federal income tax benefits related to the tax deductibility of interest expense, amortization of intangibles and amortization of tax reserve discount. In view of the historical ability of the Company to generate strong, positive cash flows, and the strong cash position and relatively conservative capitalization structure of the Company, management believes that the Company will have sufficient liquidity and adequate capital resources to meet both its short- and long-term capital needs. In addition, the Company has a working capital line of credit in the amount of $30 million which was unused at December 31, 1998.
Year 2000 readiness is a major undertaking involving the review and modification of multiple, interacting information technology systems, including the Company's systems, equipment, facilities, services and products as well as those of third party business partners (essential suppliers, vendors, service contractors, distributors, joint venturers, creditors, borrowers, financial service organizations, etc.). Certain equipment and facilities (such as telephones, voicemail, elevators) may contain embedded chips or microcontrollers that will need to be replaced.
The Company began its formal Year 2000 compliance program in 1996. The Year 2000 Project Team was appointed to assess the Year 2000 vulnerability of the Company's significant systems, equipment, facilities, services and products. The Year 2000 Project Team is comprised of internal and external personnel. Several Company executives, including the Company's President, serve as Project Team Sponsors. The Year 2000 Project Team is separate and distinct from the Company's information and technology department. Through the Year 2000 Project Team, the Company has undertaken an internal quality assurance program to evaluate and test its significant systems, equipment, facilities, services and products. The Year 2000 Project Team is independently validating the initial assessment and recommendations made by the quality assurance program. The internal and external assessments are the basis of a full remediation and testing process. In addition to the Project Team Sponsors, the Year 2000 compliance program is subject to the independent review of a Corporate Steering Committee. Both the Project Team Sponsors and Corporate Steering Committee review the Year 2000 compliance program for its impact (and the impact of the Year 2000 issues) on all phases of the Company's business.
The Year 2000 Project Team has divided its Year 2000 compliance program into four (4) phases with estimated completion deadlines: assessment (internal fourth quarter 1998, external first quarter 1999), remediation/replacement (second quarter 1999), testing (second quarter 1999), and integration (third quarter 1999). As of December 31, 1998, the Company had assembled and engaged the Year 2000 Project Team and examined and created a budget for the remainder of the project. The Company also hired Year 2000 dedicated resources including a full time Contingency Planner, acquired and implemented mainframe remediation tools and developed a mainframe Year 2000 specific test process and environment. The Company's headquarters mainframe was upgraded and a compliant version of the operating system was installed. Headquarters facilities had been assessed and facilities related remediation plans were under development. A pilot program for testing resources and facilities in the field had been implemented, a field test lab had been designed and requisitioned and as of December 31, 1998, substantially all of the field had been inventoried.
The Company believes that it has identified all of the business systems vital to its operations and that its Year 2000 compliance program will result in the continuation of the Company's operations to and through the Year 2000 and beyond. However, the Year 2000 issue, and its resolution, is complex and multifaceted. The success of a response plan cannot be conclusively known until the Year 2000 is reached (or an earlier date to the extent that systems and equipment address Year 2000 date data prior to year 2000). Even with appropriate and diligent pursuit of a well-conceived response plan, including testing procedures, there is no certainty that any company will achieve complete success. However, the Company is diligently trying to ensure that its significant systems, equipment, facilities, services and products will not be adversely affected by the Year 2000 problem. As such, the Company has engaged a Corporate Contingency Planner to develop a contingency plan to address the worst case scenario if the Company's Year 2000 compliance program should fail to address the Year 2000. The contingency plan is currently under development.
Interest Rate Sensitivity Principal Amount by Expected Maturity Average Interest Rate (dollars in thousands)
The Company also has long-term debt of $207.5 million bearing interest at 5.49% at December 31, 1998. A .25% change in the interest rate would affect income before income taxes by approximately $0.5 million annually.
In connection with the title insurance industry in general, factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include the following: (i) the costs of producing title evidence are relatively high, whereas premium revenues are subject to regulatory and competitive restraints; (ii) real estate activity levels have historically been cyclical and are influenced by such factors as interest rates and the condition of the overall economy; (iii) the value of the Company's investment portfolio is subject to fluctuation based on similar factors; (iv) the title insurance industry may be exposed to substantial claims by large classes of claimants; (v) the industry is regulated by state laws that require the maintenance of minimum levels of capital and surplus and that restrict the amount of dividends that may be paid by the Company's insurance subsidiaries without prior regulatory approval; and (vi) the risks