The executive and administrative offices of the Company and its subsidiaries are located at 321 East Main Street, Ada, Oklahoma. These offices, containing approximately 40,000 square feet of office space, are owned by the Company. Additionally, the Company completed construction during 1999, of a new facility containing approximately 17,000 square feet of office and warehouse and shipping space. The Company now has three buildings located on its property located approximately five miles from the Company's executive and administrative offices. The Company previously completed construction of its Customer Care facility during 1998 that contains approximately 10,000 square feet of office and call center space. The Customer Care is adjacent to the material distribution center constructed during 1997 containing 8,600 square feet that is now used for general office space. The Company currently fully utilizes these existing facilities and has begun construction of a new home office complex in Ada located approximately five miles from its current location. The new home office will be constructed on nearly 100 acres given to the Company by the City of Ada. Scheduled completion of the estimated $30 million four-building complex, which will include a sales associate Hall of Fame and six-story tower, is February, 2003.
In addition to the property described above that is owned by the Company, the Company opened an additional Customer Care facility in Antlers, Oklahoma during March 2000, in building space provided at no cost to the Company. This facility contains approximately 50 Customer Care representatives with the option of adding another 50 to 100 representatives in the next two years.
Prior to 2000, the Company "pooled" the activity of this "D status" group of former associates and accounted for the group and evaluated the collectibility of their commission advance receivables as if it were a single associate rather than on an associate by associate basis. The Company determined that it would change its methodology in 2000 such that the Company now evaluates the collectibility of "D status" commission advance receivables on an individual associate basis as it does the advances to its active associates. The cumulative effect of this change on prior years is reflected separately and resulted in a reduction of income (net of applicable income taxes of $2.2 million), of approximately $4.1 million ($.18 per basic and diluted share). The effect of the change on fiscal 2000 was a reduction in income (net of applicable income taxes of $1.6 million) of approximately $3.1 million ($.14 per basic and diluted share).
Membership benefit costs relating to non-Provider Memberships ("open panel" Memberships or Memberships in states where a provider law firm is not in place), which constituted less than 2% of Memberships in force at December 31, 2000, are based on the usual, reasonable and customary fee for providing the required services. Such costs are generally paid on a current basis, as most costs are certain in amount and require only limited investigation. The Company maintains a reserve for estimated incurred but not reported open panel Membership benefit costs as well as costs which are in the payment process. These reserves are reviewed annually by an independent actuary as necessary in conjunction with the preparation and filing of financial statements and other reports with various state insurance regulatory authorities. Underwriting risks associated with the open panel Memberships are managed primarily through contractual benefit limitations and, as a result, underwriting decisions are not necessarily based on individual Membership purchases.
Commission Expense Beginning with new Memberships written after March 1, 1995, the Company implemented a level commission schedule which results in the Company incurring commission expense related to the sale of its legal expense plans on a basis consistent with the recognition of the premiums generated by the sale of such Memberships. Prior to March 1, 1995, the Company's commission program resulted in recognizing commission expense of approximately 70% of Membership premiums during the first year of the Membership and approximately 16% in all subsequent years. The level commission structure results in the Company incurring commission expense at the rate of approximately 25% - 27% per year for all Membership years.
Although the Company advances its sales associates up to three years commission when a membership is sold, the average commission advance paid to its sales associates as a group is actually less than 3 years because some associates choose to receive less than a 3-year advance and the Company pays less than a 3-year advance on some of its specialty products. Also, any residual commissions due an associate (defined as commission on an individual membership after the advance has been earned) is retained to reduce any remaining commission advance receivables prior to being paid to that sales associate. The average commission advance in 2000, 1999 and 1998 was 2.31, 2.43 and 2.50 years respectively.
The Company assesses, at the end of each quarter, on an associate-by-associate basis, the recoverability of each associate's commission advance receivable by estimating the associate's future commissions to be earned on active Memberships. Each active Membership is assumed to lapse in accordance with the Company's estimated future lapse rate, which is based on the Company's actual historical Membership retention experience as applied to each active Membership's year of origin. The lapse rate is based on a 20-year history of Membership retention rates, which is updated quarterly to reflect actual experience. The Company also closely reviews current data for any trends that would affect the historical lapse rate. The sum of all expected future commissions to be earned for each associate is then compared to that associate's commission advance receivable balance. An allowance for unrecoverable commission advance receivables is recorded when expected future commissions to be earned on active Memberships (aggregated on an associate-by-associate basis) are less than the commission advance receivable balance. Adjustments to the reserve are immediately recorded in income. If an associate with an outstanding commission advance receivable has no active Memberships, the advance is written off. Refer to "Measures of Member Retention - Expected Economic Life" for a description of the method used by the Company to estimate future commission earnings.
Insurance operations UFL retained its existing life insurance business as a part of the Company's 1998 acquisition of UFL. The life insurance operations of UFL generated approximately $1 million in life insurance premiums and has continued to provide claims processing for the coinsured Medicare supplement and health care policies and receive full cost reimbursement for such services from the coinsurer. UFL markets primarily to individuals, age 65 and over, in New Mexico, Oklahoma and Texas.
Product sales and product costs Product sales consist primarily of the sale of personal and home care products, jewelry, books, audiocassettes and videotapes focusing on personal achievement. Other products and services include digital satellite television subscriptions, Internet access and web sites, long distance and travel services provided by business partners. The Company has certain alliances with business partners, whereby sales associates buy products or services provided by such business partners and in return, the Company receives commissions on the sales of such goods and services.
Product costs consist primarily of the actual cost paid to acquire such goods and services. Costs to purchase products and deliver services are included in Product costs.
As of December 31, 2000, substantially all of the Company's investments were in investment grade (rated Baa or higher) fixed-maturity investments and interest-bearing money market accounts. The Company does not hold any investments classified as trading account assets or derivative financial instruments.
Membership Persistency The Company's Membership Persistency rate measures the number of Memberships in force at the end of a year as a percentage of the total of (i) Memberships in force at the beginning of such year, plus (ii) new Memberships sold during such year. From 1981 through the year ended December 31, 2000, the Company's annual Membership Persistency rates, using the foregoing method, have averaged approximately 74.5%. The annual Membership Persistency rates were 71.1%, 73.4% and 73.8% for 2000, 1999 and 1998, respectively. The Company's overall Membership Persistency rate varies based on, among other factors, the relative age of total Memberships in force. The Company's overall Membership Persistency rate could become lower when the Memberships in force include a higher proportion of newer Memberships. During the last three years, the Company has experienced significant increases in new Membership sales and, as a result, the percentage of newer Memberships in its total Memberships in force has increased. Unless offset by other factors, this increase could result in a decline in the Company's overall Membership Persistency rate as determined by the formula described above, but does not necessarily indicate that the new Memberships written are less persistent, only that the ratio of new Memberships to total Memberships is higher than it averaged during the 1981 through 2000 period. The Company's financial condition and results of operations may be materially adversely affected if the persistency rates of existing and new Memberships become materially lower than the Company's historical experience.
Expected Economic Life Since the Company's Membership Persistency, as defined above, is influenced by the relative age of total Memberships in force, it will be influenced by changes in new member enrollment rates. There are other measures of retention that are independent of these variations in past enrollment rates. One such measure is the Expected Economic Life of a new member. This is the average number of years that a new member is expected to continue to renew, computed based on observed historical data. The following chart sets forth as of December 31, 2000 the Company's overall membership retention rates under the expected economic life method based on our actual experience over the last 20 years: (For example, 53.37% of members were still paying 1-year after those members purchased a membership. Of those 53.37% who were still paying 1-year after purchasing a membership, 69.27% were still paying 2-years after purchasing a membership. Thus, 2-years after purchasing a membership, 36.97% (53.37% * 69.27%) remain as paying members, etc.)
Using these data, the Expected Economic Life of a new member is computed to be 3.57 years. Note that this number is based on more than 20 years of historical Membership retention data, unlike Membership Persistency which is computed from and determined by the most recent one year period only. The Expected Economic Life of a new member may be useful for estimating the expected future stream of revenues from a large pool of new members. This membership retention data is used by the Company to estimate recoverability of commission advance receivables provided to associates. The fact that the Expected Economic Life of a new member is greater than the maximum commission advance of 3.0 years is important to ensure the collectibility of commission advance receivables.
Expected Remaining Economic Life Since the Company's experience is that the retention rate of a given generation of new members improves with time since first enrollment, the Expected Remaining Economic Life of a member also increases with time since first enrollment. For example, while the Expected Economic Life of a new member just enrolled is 3.57 years, the Expected Remaining Economic Life of a member that has already renewed for one year is about 5.2 years. Since the actual population of members in force at year end is a distribution of ages from zero to over 20 years, the Expected Remaining Economic Life of the entire population at large exceeds 3.57 years per member. As of December 31, 2000, based on the historical data described above, the current Expected Remaining Economic Life of the actual population is approximately 6.52 years
Product sales declined 83% during 2000 to $1.0 million from $5.9 million in 1999 primarily due to the concentration on Membership sales as opposed to the sale of goods and services following the TPN acquisition. Product sales are expected to be immaterial in 2001 and future periods as the Company no longer encourages product sales.
Other income decreased 16 % from $6.9 million to $5.8 million primarily due the implementation of SAB 101 which reduced enrollment fees recognized during the fourth quarter of 2000 by $1.4 million.
Product costs declined more than $3.4 million, or 84%, during 2000 to $675,00 from $4.2 million for 1999 in conjunction with the 83% decline in product sales. Product costs as a percentage of product sales were 66% for 2000 compared to 71% during 1999. Product costs are expected to be immaterial in 2001 and future periods as the Company no longer encourages product sales.
Other expenses increased 24% from $1.2 million to $1.4 million for 2000 primarily due to $1.7 million litigation settlements during the 4th quarter of 2000 offset by an increase in Membership lapse fee and interest income for 2000 of 41% to $4.8 million from $3.4 million for 1999. Membership lapse fees increased primarily as a result of increased commission advance receivables, which, under certain circumstances, incur a fee. Fee income on commission advance receivables was $1.8 million in 2000 and $1.0 million in 1999. At December 31, 2000 the Company reported $41.3 million in cash and investments (after utilizing more than $17.3 million to repurchase approximately 520,000 shares of its common stock) compared to $37.4 million at December 31, 1999. Depreciation and amortization decreased from $3.1 million for 1999 to $2.8 million for 2000. This decrease was primarily due to increased amortization of production costs of $425,000 during the 1999 period.
Dividends paid on outstanding preferred stock decreased to $4,000 for 2000 from $9,700 during 1999. During the second quarter of 2000, all shares of preferred stock were converted into shares of common stock or repurchased by the Company.
Comparison of 1999 to 1998 The Company reported net income applicable to common shares of $38.9 million, or $1.67 per diluted common share, for 1999, up 29% from net income applicable to common shares of $30.2 million, or $1.26 per diluted common share, for 1998. The increase in the net income applicable to common shares for 1999 is primarily the result of increases in Membership fees for 1999 as compared to 1998.
Associate services revenue increased 32% from $17.3 million for 1998 to $22.8 million during 1999 as a result of more new associates recruited and as a result of Fast Start which resulted in the Company receiving training fees of approximately $12.6 million during 1999 compared to $9.3 million during 1998. The field training program, titled Fast Start to Success ("Fast Start") is aimed at increasing the level of new Membership sales per associate. Fast Start requires a training fee of $184 per new associate and upon successful completion of the program provides for the payment of certain training bonuses. In order to be deemed successful for Fast Start purposes, the new associate must write three new Memberships and recruit three new sales associates or personally sell five Memberships within 60 days of becoming an associate. The $12.6 million and $9.3 million for 1999 and 1998, respectively, in training fees was comprised of $184 from each of approximately 68,535 new sales associates who elected to participate in Fast Start in 1999 compared to 50,622 that paid the $184 during 1998. New associates electing to participate in Fast Start increased to 74% of new associates during 1999 from 67% for 1998. Total new associates enrolled during 1999 were 92,644 compared to 75,737 for 1998, an increase of 22%. While the number of new associates increased during 1999, the number of new Memberships sold, at least partially as a result of the Fast Start program, increased even more significantly. Future revenues from associate services will depend primarily on the number of new associates enrolled and the number who choose to participate in the Company's training program, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of training (including training bonuses paid), providing associate services and other direct marketing expenses.
Other income increased $4.0 million, or 139 %, from $2.9 million for 1998 to $6.9 million for 1999 primarily due to the inclusion of income from UFL during 1999 (See Prior Year Acquisitions above) of $2.4 million and an increase in enrollment fees from $2.7 million for 1998 to $3.5 million for 2000.
Membership benefits totaled $51.8 million for 1999 compared to $36.1 million for 1998, and represented 33% of Membership fees for both 1999 and 1998. This Membership benefit ratio (Membership benefits as a percentage of Membership fees) should remain near 35% as the portion of active Memberships that provide for a capitated benefit continues to increase.
Commission expense was $36.9 million for 1999 compared to $24.0 million for 1998, and represented 23.4% and 21.8% of Membership fees for such years. Commission expense, as a percentage of Membership fees, should remain at or near 25% of Membership fees in future years based on the existing commission structure.
The Company's Membership benefit ratio, commission expense ratio, product cost ratio and the general and administrative expense ratio do not measure total profitability because they do not take into account all revenues and expenses.
Net cash used in investing activities was $6.9 million in 2000 as compared to net cash provided by investing activities of $10.6 million for 1999 and net cash used in investing activities of $31.4 million for 1998. Due to the 1998 UFL acquisition and the resulting requirement for $20.7 million as cash consideration to Pioneer, the Company liquidated a substantial portion of its investments classified as held-to-maturity. Although the Company previously had demonstrated its intent and capability to hold such investments until their scheduled maturities, the conversion of such investments to cash as part of the UFL transaction prior to their scheduled maturities resulted in all remaining investments of the Company, including the $25 million investment portfolio of UFL, being classified as available-for-sale investments. In addition to capital expenditures of $5.6 million during 2000, the Company liquidated a portion of its available-for-sale investments in order to reacquire shares of the Company's common stock.
Net cash used in financing activities was $13.7 million in 2000 as compared to $26.7 million in 1999 and net cash provided by financing activities of $1.4 million for 1998. This $13.0 million change during 2000 was mainly comprised of the decrease of $12.1 million in cash used to reacquire treasury stock as compared to 1999.
The Company generally advances its associates significant commissions at the time a Membership is sold. During 2000, the Company advanced commissions of $97.5 million on new Membership sales compared to $74.8 million for 1999. Since approximately 94% of Membership fees are collected on a monthly basis, a significant cash flow deficit is created at the time a Membership is sold. This deficit is reduced as monthly Membership fees are remitted and commissions earned are retained to recover previous commission advance receivables. Commission advance receivables were subsequently reduced by earned commissions payable to associates of $48.3 million and $36.8 million for 2000 and 1999, respectively. The Company has recorded an allowance of $11.1 million to provide for estimated uncollectible commission advance receivables which includes an increase in the allowance of $6.6 million during 2000 and $550,000 during 1999.
The Company announced on April 6, 1999, a stock repurchase program authorizing management to reacquire up to 500,000 shares of the Company's common stock. The Board of Directors has increased such authorization from 500,000 shares to 2,000,000 shares during subsequent board meetings. At December 31, 2000, the Company had repurchased 1,748,209 shares under these authorizations for a total consideration of $48.3 million, an average price of $27.60 per share. The Board, at its January 16, 2001 meeting, authorized additional 250,000 shares to be repurchased. Stock repurchases will be made at prices that are considered attractive by management and at such times that management believes will not unduly impact the Company's liquidity. No time limit has been set for completion of the repurchase program. Unless the growth in the number of new Memberships written increases to the extent of consuming substantially all of the Company's cash flow from operations, it expects to continue to fund its stock repurchase program from its working capital.
Parent Company Funding and Dividends Although the Company is the operating entity in many jurisdictions, the Company's subsidiaries serve as operating companies in various states which regulate Memberships as insurance or specialized legal expense products. The most significant of these wholly owned subsidiaries are PPLCI, UFL and PPLSIF. The ability of PPLCI, UFL and PPLSIF to provide funds to the Company is subject to a number of restrictions under various insurance laws in the jurisdictions in which PPLCI, UFL and PPLSIF conduct business, including limitations on the amount of dividends and management fees that may be paid and requirements to maintain specified levels of capital and reserves. In addition PPLCI and UFL will be required to maintain its stockholders' equity at levels sufficient to satisfy various state or provincial regulatory requirements, the most restrictive of which is currently $3 million for PPLCI. Additional capital requirements of PPLCI, UFL or PPLSIF will be funded by the Company in the form of capital contributions or surplus debentures. At December 31, 2000, neither PPLCI, UFL nor PPLSIF had funds available for payment of substantial dividends without the prior approval of the respective insurance commissioners.
All statements in this report concerning Pre-Paid Legal Services, Inc. (the "Company") other than purely historical information, including but not limited to, statements relating to the Company's future plans and objectives, discussions with the staff of the SEC, expected operating results, and the assumptions on which such forward-looking statements are based, constitute "Forward-Looking Statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and are based on the Company's historical operating trends and financial condition as of December 31, 2000 and other information currently available to management. The Company cautions that the Forward-Looking Statements are subject to all the risks and uncertainties incident to its business, including but not limited to risks described below. Moreover, the Company may make acquisitions or dispositions of assets or businesses, enter into new marketing arrangements or enter into financing transactions. None of these can be predicted with certainty and, accordingly, are not taken into consideration in any of the Forward-Looking Statements made herein. For all of the foregoing reasons, actual results may vary materially from the Forward-Looking Statements. The Company assumes no obligation to update the Forward-Looking Statements to reflect events or circumstances occurring after the date of the statement.
There are SEC inquiries pending with respect to certain of our accounting practices that may have a material adverse effect on the Company if adversely determined. Both the staff of the Division of Enforcement and the staff of the Division of Corporation Finance of the Securities and Exchange Commission have made inquiries of the Company relating primarily to the Company's accounting policies for commission advance receivables from sales associates. See "Legal Proceedings". The Company continues to discuss these inquiries and issues with the SEC. While the Company believes that its accounting policies conform to generally accepted accounting principles in all material respects, there can be no assurance that the SEC will agree with the Company's position. The Company's change in accounting principle for evaluating recoverability of commission advance receivables from terminated associates has not been reviewed by the staff of the SEC and there is no assurance that they will concur with this change. If the SEC's inquiries are resolved adversely to the Company, it could have a material adverse affect on the Company's financial condition and stock price.
The business in which the Company operates is competitive. There are number of existing and potential competitors that have the ability to offer competing products that could adversely effect the Company's ability to grow. In addition, the Company may face competition from a growing number of Internet based legal sites which the potential to offer legal and related services at competitive prices. Increased competition could have a material adverse effect on the Company's financial condition and results of operations. See "Description of Business - Competition".
Consolidated Financial Statements - --------------------------------- Consolidated Balance Sheets - December 31, 2000 and 1999 Consolidated Statements of Income - For the years ended December 31, 2000, 1999 and 1998 Consolidated Statements of Comprehensive Income - For the years ended December 31, 2000, 1999 and 1998 Consolidated Statements of Cash Flows - For the years ended December 31, 2000, 1999 and 1998 Consolidated Statements of Changes In Stockholders' Equity - For the years ended December 31, 2000, 1999 and 1998 Notes to Consolidated Financial Statements
Consolidated Financial Statement Schedule - ----------------------------------------- Schedule II. Consolidated Valuation and Qualifying Accounts - For the years ended December 31, 2000, 1999 and 1998 (All other schedules have been omitted since the required information is not applicable or because the information is included in the consolidated financial statements or the notes thereon.)
We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries (the "Company") as of December 31, 2000 and 1999, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2000. Our audits also included the financial statement schedule listed in the Index at Item 8 herein. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS'EQUITY (Amounts and shares in 000's, except dividend rates and par values)
Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, as well as those of PPL Agency, Inc. (See Note 11 for additional information regarding PPL Agency, Inc.). The primary subsidiaries of the Company include Pre-Paid Legal Casualty, Inc. ("PPLCI"), Pre-Paid Legal Services, Inc. of Florida ("PPLSIF") and UFL. All significant intercompany accounts and transactions have been eliminated.
Foreign Currency Translation The financial results of the Company's Canadian operations are measured in its local currency and then translated into U.S. dollars. All balance sheet accounts have been translated using the current rate of exchange at the balance sheet date. Results of operations have been translated using the average rates prevailing throughout the year.
Revenue Recognition Membership fees are recognized in income when due in accordance with Membership terms, which generally require the holder of the Membership to remit fees on at least a monthly basis. Approximately 94% of the Company's members remit their Membership fees on a monthly basis. The Company records Membership fees received in excess of that currently due as deferred revenue and recognize such deferred amount as income when due. However, since approximately 94% of members choose to remit their Membership payments monthly (approximately 70% by automatic bank draft and credit card), such Membership fees are both "paid" and "due" within the same monthly reporting period.
Associate services revenue includes one-time non-refundable enrollment fees of $65 from each new sales associate and fees of $184 paid by associates participating in the Company's training program. The fee for the training program is recognized upon completion of the training. The enrollment fee is for sales and promotional materials, bonuses paid to individuals who recruit and sponsor the associates and enrollment services provided to the associate. Revenue from and costs of the sales and promotional materials (approximately $18) is recognized when the materials are delivered to the associates. The remaining $47 of revenues and related costs are deferred and recognized over the estimated average active service period of associates which at December 31, 2000 is estimated to be one year.
Coinsurance Receivable and Accident and Health Reserves The Company has coinsured 100% of the accident and health policy liabilities of UFL pursuant to a coinsurance agreement. The amount due from coinsurer is therefore equal to the estimated accident and health reserves. Accident and health reserves is an estimate of outstanding claims, including an actuarial estimate of claims incurred but not reported, based upon historical claims experience, modified for current trends and changes in benefit coverage, which factors could vary as claims are ultimately settled. The Company believes the coinsurer will be able to honor all contractual commitments under the coinsurance agreement, based on its periodic reviews of financial statements, insurance industry reports and reports filed with state insurance departments.
"D status" associates are those that are no longer "active" because they fail to meet the Company's established vesting requirements by selling at least three new Memberships per quarter or retaining a personal Membership. "D status" associates lose their right to any further commissions earned on Memberships previously sold at the time they are placed in "D status". As a result the Company is no longer required to pay commissions that would be otherwise payable to these terminated associates.
The Company assesses, at the end of each quarter, on an associate-by-associate basis, the recoverability of each associate's commission advance receivable by estimating the associate's future commissions to be earned on active Memberships. Each active Membership is assumed to lapse in accordance with the Company's estimated future lapse rate, which is based on the Company's actual historical Membership retention experience as applied to each active Membership's year of origin. The lapse rate is based on a 20-year history of Membership retention rates, which is updated quarterly to reflect actual experience. The Company also reviews current data for any trends that would affect the historical lapse rate. The sum of all expected future commissions to be earned for each associate is then compared to that associate's commission advance receivable balance. An allowance for unrecoverable commission advance receivables is recorded for any deficiency of expected future commissions to be earned on active Memberships (aggregated on an associate-by-associate basis). Adjustments to the reserve are immediately recorded in income. If an associate with an outstanding commission advance receivable has no active Memberships , the advance receivable is written off.
Further, the Company's analysis of the recoverability of commission advance receivables is also based on the assumption that the associate does not write any new Memberships. The Company believes that this assessment methodology is conservative since its actual experience is that many associates do continue to sell new policies and the Company, through its chargeback rights, gains an additional source to recover commission advance receivables.
Goodwill Goodwill, included in Other Assets, primarily represents the excess of acquisition costs over the value assigned to the net assets acquired in the 1998 UFL business combination and is being amortized on the straight-line method over a period of ten years. The carrying amount of goodwill is reviewed for recoverability using estimated undiscounted cash flows for the business acquired over the remaining amortization periods. Goodwill amortization for 2000 and 1999 was $83,000 in both years. Since the UFL acquisition was effective December 30, 1998, no amortization expense was charged to earnings during 1998. The unamortized goodwill balance at December 31, 2000 and 1999 is $679,000 and $747,000, respectively.
Membership Benefits Liability The Membership benefits liability represents per capita amounts due provider law firms on closed panel Memberships and claims reported but not paid and actuarially estimated claims incurred but not reported on open panel Memberships. The Company calculates the benefit liability costs on open panel Memberships based on completion factors that consider historical claims experience based on the dates that claims are incurred, reported to the Company and subsequently paid. Processing costs related to these claims are accrued based on an estimate of expenses to process such claims.
Segment Information The Company began applying the requirements of Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131") in its 1999 financial statements, the first year the Company operated in more than one segment. Operating segments are defined in the statement as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker(s) in deciding how to allocate resources and in assessing performance. SFAS No. 131 also requires disclosures about products and services, geographic areas and major customers. Required disclosures are presented in Note 17.
Codification of Statutory Accounting Principles In March 1998, the National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (the "Codification"). The Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, is effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The State of Oklahoma will require adoption of the Codification for the preparation of statutory financial statements effective January 1, 2001. The Company estimates that the adoption of the Codification will increase the statutory capital and surplus of its regulated subsidiaries as of January 1, 2001 by approximately $1.3 million.
Reclassifications Certain prior year amounts have been reclassified to conform with current year presentation.
Effective October 2, 1998, the Company issued 999,992 shares of its common stock in exchange for all of the outstanding common stock of TPN based on a conversion ratio of 345 shares of the Company's common stock for each share of TPN common stock. The merger qualified as a tax-free reorganization and was accounted for as a pooling of interests.
During 2000, the Company changed its methodology for evaluating the recoverability of its commission advance receivables from terminated or "D status" sales associates. "D status" associates are those that fail to meet the Company's established vesting requirements (i.e., associates that do not sell at least three new Memberships per quarter or do not retain a personal Membership). "D status" associates lose their right to any further commissions earned on Memberships previously sold at the time they are placed in "D status" and as a result, the Company is entitled to retain all commission earnings that would be otherwise payable to these terminated associates to recover their commission advance receivable balance. See Note 13 - Commitments and Contingencies.
Prior to 2000, the Company "pooled" the activity of this "D status" group of former associates and accounted for the group and evaluated the collectibility of their commission advance receivables as if it were a single associate rather than on an associate by associate basis. The Company determined that it would change its methodology in 2000 such that the Company now evaluates the collectibility of "D status" commission advance receivables on an individual associate basis, as it does the commission advance receivables of its active associates. The cumulative effect of this change on prior years is reflected separately and resulted in a reduction in income (net of applicable taxes of $2.2 million) of approximately $4.1 million ($.18 per basic and diluted share). The effect of the change on fiscal 2000 resulted in a reduction of income (net of applicable income taxes of $1.6 million) of approximately $3.1 million ($.14 per basic and diluted share).
The Company believes that an evaluation of the collectibility of commission advance receivables on an associate-by-associate basis is preferable to an evaluation on a pooled basis because it results in a more refined estimate of collectibility.
The Company's investment securities are included in the accompanying consolidated balance sheets at December 31, 2000 and 1999 as follows.
The Company advances its sales associates a maximum of 3 years commission when a membership is sold. However, the average commission advance paid to sales associates as a group is actually less than 3 years because some associates choose to receive less than a 3-year advance and some of the Company's specialty products pay less than a 3-year advance. Also, any residual commissions due an associate (defined as commission on an individual membership after the advance has been earned) is retained to reduce any remaining commission advance receivables prior to being paid to that sales associate. The average commission advance in 2000, 1999 and 1998 was 2.31, 2.43 and 2.50 years respectively.
Commission advance receivable activity for years ended December 31, 2000, 1999 and 1998 is as follows:
The allowance for uncollectible commission advance receivables is adjusted to the amount of the estimated deficiency of expected future commission earnings on active memberships of associates. Any adjustment in the reserve account is recorded in the provision for estimated uncollectible Membership commission advance receivables. Commission advance receivables that do not have any related outstanding Memberships are charged to the allowance for uncollectible advance commission receivables.
A reconciliation of the statutory Federal income tax rate to the effective income tax rate is as follows:
Deferred tax liabilities and assets at December 31, 2000 and 1999 are comprised of the following:
At December 31, 2000, the Company has NOLs in the amount of $2.8 million representing remaining NOLs of TPN generated prior to the merger date. A valuation allowance has been established for the TPN NOLs, UFL's AMT credit carryforward and UFL's expenses not yet deducted for tax purposes. At December 31, 1999, the Company had established a valuation allowance for the general business and rehabilitation tax credit carryfowards and the TPN NOLS. The Company does not believe it is more likely than not that the tax benefits of these carryforwards will be realized prior to their expiration, in part due to utilization restrictions imposed by the Internal Revenue Code and anticipated continued growth. However, carryforwards of $954,000 will be utilized in the 2000 income tax returns and accordingly, were also realized for financial reporting purposes.
During 2000, 1999 and 1998, the Company's Special Preferred Stock, consisting of 7,032 shares, 391 shares and 4,766 shares, respectively, were converted into 42,661 shares of Common Stock and during 2000, 10,585 shares were redeemed for a value of $141,204. At December 31, 2000 all such shares had been converted or redeemed. Each share of the Special Preferred Stock was previously entitled to a non-cumulative annual dividend of $1.00 per share, was convertible into 3.5 shares of Common Stock and was redeemable at the option of the Company at $13.34 per share, plus all accumulated and unpaid dividends
Agency's financial position and results of operations are included in the Company's financial statements on a combined basis. Agency earned commissions, net of amounts paid directly to its agents by the underwriter, during 2000, 1999 and 1998 of $122,000, $121,000 and $119,000, respectively, through its sales of insurance products of an unaffiliated company. Agency had net income for the year ended December 31, 2000 of $11,661 and net losses for the years ended December 31, 1999 and 1998 of $18,148 and $10,694, respectively, after incurring commissions earned by the Chairman of $50,000, $49,000 and $47,000, respectively, and annual management fees paid to the Company of $36,000 for 2000, 1999 and 1998.
The Company indemnified Mr. Stonecipher for litigation expenses and settlement costs in connection with a lawsuit filed by Frank Jaques, a former director of the Company, in 1999 against Mr. Stonecipher in the District Court of Pontotoc County, Oklahoma. Mr. Jaques claimed damages relating to an agreement between Mr. Jaques and Mr. Stonecipher relating to a stock subscription agreement with the Company which Mr. Stonecipher entered into in order to obtain the approval of the Oklahoma Securities Department for the Company's original intrastate public offering in 1977. The stock subscription agreement was executed by Mr. Stonecipher for the benefit of the Company in his capacity as the Chairman and founder. The Board of Directors determined that the requirements for indemnification under the Company's Bylaws had been satisfied and that Mr. Stonecipher was entitled to such indemnification. In 2000, the Company reimbursed Mr. Stonecipher $130,370 for litigation expenses, and in 2001, the Company reimbursed him for $802 in litigation expenses and $275,000 for settlement of the case which was accrued as of December 31, 2000.
John W. Hail, a director of the Company, served as Executive Vice President, Director and Agency Director of the Company from July 1986 through May 1988 and also served as Chairman of the Board of Directors of TVC Marketing, Inc., which was the exclusive marketing agent of the Company from April 1984 through September 1985. Pursuant to agreements between Mr. Hail and the Company entered into during the period in which Mr. Hail was an executive officer of the Company, Mr. Hail receives override commissions from renewals of certain memberships initially sold by the Company during such period. During 2000, 1999 and 1998, such override commissions on renewals totaled $89,593, $90,839 and $93,867, respectively. Mr. Hail also owns interests ranging from 12% to 100% in corporations not currently affiliated with the Company, including TVC Marketing, Inc., but which were engaged in the marketing of the Company's legal service memberships and which earn renewal commissions from memberships previously sold. These entities earned renewal commissions, net of amounts passed through as commissions to their sales agents, during 2000, 1999 and 1998 of $313,005, $301,021 and $284,344, respectively.
The Company in 1995 and 1997 also adopted stock option plans for its marketing associates whereby the associates could earn stock options based upon their production and recruiting efforts. These options were issued to qualifying associates based on production and recruiting results or for achieving a specified level within the Company's marketing structure. The exercise price for December 1995 grants was equal to the closing stock price on such date and the exercise price for July 1997 grants was $27.00 (which exceeded market). The options granted for production during July 1997 expired pursuant to their terms on July 31, 1998, and the options granted December 14, 1995 expired on December 14, 2000.
A summary of the status of the Company's total stock option activity as of December 31, 2000, 1999 and 1998 for the years ended on those dates is presented below:
The following table summarizes information about stock options exercisable at December 31, 2000:
Statement of Financial Accounting Standards No. 123, "Accounting for Stock Based Compensation," ("SFAS 123") establishes a fair value method and disclosure standards for stock-based employee compensation arrangements, such as stock purchase plans and stock options. It also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees, requiring that such transactions be accounted for based on fair value. As allowed by SFAS 123, the Company continues to follow the provisions of Accounting Principles Board Opinion No. 25 and related interpretations for its employee compensation arrangements, and discloses the pro forma effects of applying SFAS 123. Had compensation cost for the Company's employee-related stock option plans, including options granted to RVPs, been determined based on the fair value at the grant dates for awards under the Plan consistent with the method of SFAS 123, the Company's net income and earnings per share for 2000, 1999 and 1998 would have been reduced to the pro forma amounts indicated below:
The estimated fair value of options granted to employees, including RVPs, was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used: no dividend yield; risk-free interest rate of 5.15% for 2000, 6.09% for 1999 and 5.00% for 1998; expected life of 3-5 years; and expected volatility for the years ending December 31, 2000, 1999 and 1998 were 63.4%, 64.1% and 63.5%, respectively.
During 1988, the Company adopted an employee stock ownership plan. Under the plan, employees may elect to defer a portion of their compensation by making contributions to the plan. Up to seventy-five percent of the contributions made by employees may be used to purchase Company common stock. The Company, at its option, may make matching contributions to the plan, and recorded expense during 2000, 1999 and 1998 of $130,000, $86,150, and $58,027 based on annual contributions of Company stock of 5,500 shares, 2,800 shares and 1,900 shares, respectively.
First quarter... $43,647 $8,782 - $ 8,782 Second quarter.. 47,128 9,872 - 9,872 Third quarter... 48,128 9,870 - 9,870 Fourth quarter... 53,957 10,429 - 10,429
The Company derived approximately 99% and 98% of its revenues and net income from the sale of legal service plans and directly related activities during 2000 and 1999, respectively. Revenues and net income from the Company's other operating segment (life insurance, through UFL acquired in December 1998) were approximately 1% and 2% of each of the respective consolidated totals for 2000 and 1999, respectively. UFL markets term life insurance products primarily to individuals, age 65 and over, in New Mexico, Oklahoma and Texas. The following table sets forth the composition of the segments and total Company revenues, net income and identifiable assets for the years ended December 31, 2000 and 1999.
Substantially all of the Company's business is currently conducted in the United States. Revenues from the Company's Canadian legal service plan operations for 2000 and 1999 were $3.8 million and $1.0 million, respectively. The Company has no significant long-lived assets located in Canada.