The Company's insurance subsidiaries are subject to a high degree of regulation from various state insurance administrators. Such regulation governs (among other things): investment policies; financial reporting; capital adequacy; terms of policies; and the ability of the Company's subsidiaries to pay dividends and management fees to the Company. In addition, NPS's activities in selling prearranged funeral contracts are highly regulated in the states in which NPS does business. These regulatory aspects and future changes therein could materially affect the Company's financial condition and results of operations. See "Business - Regulatory Factors."
Net investment income increased $4.4 million, or 72%, from $6.2 million in the year ended December 31, 1997 to $10.6 million in the year ended December 31, 1998. This increase was attributable to a higher level of invested assets (primarily resulting from the Woodmen Block and the World Block). Invested assets increased by 11% in 1998 compared to 1997. There was a larger increase in investment income due to the addition of the Woodmen Block late in 1997.
Net realized gains decreased $730,000, or 27%, from $2.7 million in the year ended December 31, 1997 to $1.9 million in the year ended December 31, 1998. Gains were recognized in the year ended December 31, 1998, on sales of invested assets. However, these gains were partially offset by losses of approximately $1.0 million realized on the sale of certain investments whose market values declined significantly due to announcements of operating and financial difficulties of the issuers of these investments.
Surrenders increased from the year ended December 31, 1997 to the year ended December 31, 1998 by $3.1 million. This increase in surrenders was offset by a corresponding change in the increase in future policy benefits. Surrenders generally have little impact on current year operations due to the fact that surrender benefits are fully reserved and as surrender benefits are paid the reserve for future policy benefits is reduced by a corresponding amount. The more significant effect on operations occurs in future years when the Company loses future investment earnings on the business surrendered.
Taxes, licenses, and fees increased $166,000, or 21%, from $782,000 in the year ended December 31, 1997 to $948,000 in the year ended December 31, 1998, due primarily to fees associated with the routine regulatory examination of the Company's insurance company subsidiaries which commenced in March 1998, additional fees associated with the Lincoln acquisition as well as increased taxes due to an increase in collected premiums.
The increase in the change in deferred acquisition costs of $2.9 million from $1.4 million for the year ended December 31, 1997, to $4.3 million for the year ended December 31, 1998, was due to the capitalization of the costs of acquiring new business at a higher rate than the amortization of such costs due to a higher volume of new policies issued.
Comparison of the Years Ended December 31, 1997 and December 31, 1996. Premium income increased $4.7 million, or 14%, from $33.3 million in 1996 to $38.0 million in 1997 due to an increase in the amount of new business written. The increase in new business written was primarily the result of increases in prearranged funeral contracts sold by NPS. Such sales increased due to an expansion of NPS's sales force. In addition, during 1997, the Company and NPS agreed to retroactively increase premiums charged on certain policies issued by the Company. Such additional premiums included in revenues for the year ended December 31, 1997 were $339,828.
Benefits incurred increased $6.4 million, or 26%, from $24.8 million in 1996 to $31.2 million in 1997 primarily due to an overall increase in business in-force and interest credited to policyholder accounts related to the acquisition of the Woodmen Block.
Other expenses remained relatively unchanged from 1996 to 1997; however, this was a result of three offsetting factors: (i) policy administration and general expenses increased $1.2 million as a result of the acquisition of the Woodmen Block, (ii) general and administrative expenses decreased due to the initiation of a cost sharing agreement between the Company and NPS, whereby NPS reimbursed the Company $2.7 million for a portion of its general and administrative expenses attributable to NPS's business (the $2.7 million was based on costs incurred by the Company in 1997 for the direct benefit of NPS); and (iii) commissions increased $1.2 million due to higher sales levels. The Company and NPS are affiliated companies. NPS was formed earlier than the Company and, as such, NPS assisted in the development of the Company. As the companies grew, and with the anticipation of the addition of outside shareholders, a more formal relationship among the entities became advisable, which resulted in the development of the cost sharing arrangement. See Note 11 to the consolidated financial statements of the Company.
The Company's insurance subsidiaries are restricted by state insurance laws as to the amount of dividends that they may pay to the Company without prior notice to, or in some cases prior approval from, their respective state insurance departments. These restrictions on dividend distributions are based on statutory capital and surplus and operating earnings. Statutory surplus and statutory operating results are determined according to statutes adopted by each state in which the subsidiaries do business. Statutory surplus bears no direct relationship to equity as determined under generally accepted accounting principles.
The Company's cash requirements for 1999 and in the future will depend upon mortality experience, acquisitions, timing of expansion plans and capital expenditures. Pursuant to its initial public offering in November 1998, the Company issued 520,000 shares of common stock and realized net proceeds of $2.6 million. The Company believes that interest earned on the net proceeds and anticipated revenue from operations should be adequate for the Company's working capital requirements of its existing business over the next twelve months. In the event that the Company's plans or assumptions change, or if its requirements to meet unanticipated changes in business conditions prove to be insufficient to fund operations, the Company could be required to seek additional financing prior to that time.
Deferred policy acquisition costs increased approximately $4.3 million from $12.6 million at December 31, 1997 to $16.9 million at December 31,1998, due to increases in new policies issued and in-force.
Fixed assets increased approximately $550,000 from $650,000 at December 31, 1997 to $1.2 million at December 31, 1998, due to expenditures for furniture and equipment due to the expansion of the Company's operations and ongoing development and modifications to the Company's software system. Cost of policies acquired increased approximately $584,000 from $3.2 million at December 31, 1997 to $3.8 million at December 31, 1998, due to the acquisition of World Block offset by the amortization of costs.
Goodwill increased approximately $640,000 from $773,000 at December 31, 1997 to $1.4 million at December 31, 1998, due to the Lincoln acquisition and other asset acquisitions.
During 1998 and 1996, the Company paid surrender benefits to NPS or the Trust of approximately $2.0 million and $5.0 million, respectively. Upon surrender, NPS purchased new policies for the same insureds using a portion of the surrendered funds. NPS has committed to the Company to pay all future premiums due on the blocks of policies that were reissued.
The Company expects its internal systems to be Year 2000 compliant and believes that the worst case scenario would result from vendors or other third parties failing to achieve Year 2000 compliance. Due to the general uncertainty inherent in the Year 2000 problem, the Company cannot predict whether the consequence of Year 2000 failures will have a material adverse effect on the Company's business, financial condition or results of operations. However, based on the Company's assessment of its internal systems, communications with significant vendors and other third parties, the Company does not expect Year 2000 problems to result in a material adverse effect on the Company's financial position, results of operations or cash flows.
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general purpose financial statements. SFAS No. 130 states that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income is defined as the total of net income and all other non-owner changes in equity. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Restatement of financial statements for earlier periods provided for comparative purposes is required. SFAS No. 130 had no impact on the financial condition or results of operations of the Company, but required changes in the Company's disclosure and presentation requirements. The principal change was the disclosure of the components of total comprehensive income within the Consolidated Statements of Shareholders' Equity.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designed as part of a hedge transaction, and if it is, the type of hedge transaction. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company is assessing the impact that the adoption of SFAS No. 133 will have on its consolidated financial statements, but does not expect such implementation to have a material adverse effect on its financial position, results of operations or cash flows.