The Company, through its data centers located in Blythewood, South Carolina, Oslo, Norway and North Ryde, Australia, utilizes 21 mid-range and mainframe computers. All computers are owned or held under short-term leases. In total, these computers have over 16,000 megabytes of memory and are capable of processing almost 1,400 million instructions per second. The Company is currently utilizing 75% to 85% of this capacity.
Initial license revenues for 1996 increased $3.1 million compared to 1995 due principally to an increase in domestic life and financial solutions initial licensing activity of $5.9 million (includes a decrease in divested health services of $0.4 million). This increase was offset by a decrease of $2.7 million in domestic property and casualty initial licensing. However, initial license charges for 1995 included a $4.0 million non-recurring source code license agreement with a cross-industry vendor and $4.8 million related to joint marketing and distribution arrangements with NCR Corporation. These revenues were replaced, in part, by a large license of the Company's Series II and S3+ products executed during the fourth quarter of 1996 for $6.2 million. (All references to Series III have been changed to S3+)
Initial license charges include right-to-use licenses of $8.2, $4.6, and $5.6 million for 1997, 1996 and 1995, respectively. The right-to-use licenses represent acquisitions by certain customers of perpetual rights in conjunction with renewals of MESA by these customers, or in conjunction with the initial license of a product. Initial license charges also include termination charges (related to the buyout of monthly license charges) of $0.4, $1.7 and $3.5 million for 1997, 1996 and 1995, respectively.
18.3% ($2.1 million). These increases are related to increased licensing activity. Domestic property and casualty monthly license charges remained relatively unchanged.
Monthly license charges for 1996 increased $3.7 million compared to 1995. This increase is principally related to an increase of $3.0 million in licensing activity in the international segment due to the acquisitions of Co-Cam in August 1996 and micado in October 1995. Domestic life and financial solutions monthly license charges increased $1.2 million (includes a decrease in divested health services of $0.5 million).
The Company believes that the operational and financial characteristics of its information services businesses differs substantially from its other business. During 1997, the Company disposed of its remaining property and casualty information services business (see Discontinued Operations). The Company is continuing to evaluate its life information services business.
Computer and communications expenses for 1997 increased 9.2% compared to 1996, principally as a result of increased communications, data circuit and maintenance costs associated with the growth of the Company's domestic and international outsourcing operations.
Computer and communications expenses for 1996 increased 16.1% compared to 1995, principally due to the effect of licensing expense related to the Company's long-term license and maintenance agreement (entered into in March 1995) to acquire rights to certain operating systems management software products for use in the Company's worldwide data center operations, and the effect of lease expense associated with leases entered into as part of the Company's restructuring of its data processing facilities.
Information services and data acquisition costs for 1997 increased 9.6% compared to 1996, principally due to an increase in the volume of expenses for attending physician statements related to the provision of life insurance information services.
Information services and data acquisition costs for 1996 remained relatively unchanged compared to 1995.
Depreciation and amortization of property, equipment and capitalized software costs for 1997 increased 20.1% compared to 1996. This increase is due principally to higher amortization expense resulting from the release of the latest version of CyberLife client/server life insurance software in October 1997. In addition, depreciation expense increased due to the Company's increased investment in network and PC hardware.
Other costs and expenses for 1996 increased 30.8% compared to 1995. Fees related to the use of consultants and independent contractors increased, principally the result of training costs in new technologies and the satisfaction of staffing needs for certain development and services activities. These increases were offset by an increase in amounts capitalized principally related to the increased use of outside resources in the continued enhancement and development of the Company's S3+ property and casualty insurance software and CyberLife life insurance software as well as other ongoing development projects, and decreased costs associated with the reduction of certain assigned risk pools serviced by the Company's BPO business.
Selling, general and administrative expenses for 1996 increased 15.2% compared to 1995, almost entirely due to the Company's investment in its international sales force and administrative infrastructure.
Amortization of goodwill and other intangibles for 1996 increased 12.0% compared to 1995, principally due to the result of amortization of intangible assets related to the October 1995 acquisition of micado.
The Company, as of December 31, 1995, provided for $20.1 million in estimated litigation costs arising from proceedings to which the Company was a party. The costs provided included, but were not limited to, legal fees paid or anticipated to be paid and other costs related to the Company's claims and defenses for those matters.
In connection with the October 1995 acquisition of micado, the Company expensed $14.5 million relating to purchased research and development. This amount was determined based on the estimated replacement cost related to the acquired technology for which technological feasibility has not been established and no alternative future use existed.
During the fourth quarter of 1995, the Company recorded charges aggregating $6.7 million to write-off or write-down, as appropriate, the carrying values of certain identifiable intangible assets and goodwill related to prior business acquisitions ($5.2 million) and computer software ($1.5 million).
1997 operating income increased 12.3% ($9.0 million) compared to 1996. Domestic property and casualty operating income increased 9.6%, domestic life and financial solutions operating income increased 44.6% and international operating income increased 31.8%. The increase in operating income is primarily related to increases in licensing and professional services revenues.
Operating income, after the effects of the litigation settlement, litigation recovery and credit to impairment and restructuring expense, was $73.2 million for the year ended December 31, 1996. In May 1996, the Company recorded a $9.4 million pre-tax gain for the recovery of legal expenses following the resolution of the CSAA matter. At year end 1996, the Company also recorded a $6.0 million pre-tax charge following the judgment in the SLD matter.
Excluding special charges and credits, operating income for 1997 was $82.2 million compared to $69.5 million for 1996 and $72.1 million for 1995. Operating income, as a percentage of total revenues, excluding the effects of the special charges described above, was 14.1% for 1997, 14.2% for 1996 and 16.9% for 1995.
A significant portion of both the Company's revenues and its operating income is derived from initial licensing charges received as part of the Company's software licensing activities. Because a substantial portion of these revenues are recorded at the time systems are licensed, there can be significant fluctuations from quarter-to-quarter and year-to-year in the revenues and operating income derived from licensing activities. This is attributable principally to the timing of customers' decisions to enter into license agreements with the Company, which the Company is unable to control.
During 1996, the Company made large cash expenditures related to the October 1995 acquisition of micado ($6.4 million), the repurchase of 759,512 of the 1,519,024 shares of common stock held by GAP Coinvestment Partners and General Atlantic Investors 14 L.P. ($38.0 million) in March 1996 and the repurchase of 645,500 shares of the Company's outstanding common stock on the open market ($35.6 million) under its share repurchase authorization in March 1996. Consequently, the Company maintained a higher level of debt and a lower level of investable funds during 1996, resulting in an increase in interest expense of $1.7 million and a decrease in investment income of $0.4 million.
Income from operations of the discontinued property and casualty information services segment (before taxes) for 1997 decreased 66.0% compared to 1996, due primarily to the segment operating for only a portion of 1997.
In August 1997, the Company completed the sale of substantially all of the assets of its property and casualty information services business for cash proceeds of $2.9 million. The Company retained the working capital of this business (approximately $14.3 million). This transaction produced a non-recurring gain of $1.7 million. Also, during the third quarter of 1997, the Company abandoned a related business. As a result, the Company recorded a non-recurring charge of $1.8 million, principally related to capitalized software.
In October 1997, the American Institute of Certified Public Accountants issued Statement of Position 97-2, "Software Revenue Recognition" ("SOP 97-2"). SOP 97-2 provides guidance on applying generally accepted accounting principles in recognizing revenue on software transactions, and is effective for transactions entered into in fiscal years beginning after December 31, 1997. The adoption of SOP 97-2 is not expected to have a material impact on the Company's financial statements.
The Company's current ratio (current assets divided by current liabilities) stood at 2.2 at December 31, 1997, which management believes is sufficient when combined with the available credit facilities to provide for day-to-day operating needs and the flexibility to take advantage of investment opportunities. The Company has available (net of amounts outstanding at December 31, 1997) $163 million under its five year $200 million credit facility, should management choose debt financing for any of the Company's operating, investing or financing activities. Also, the Company has available an uncommitted $15.0 million operating line of credit with which it may choose to fund temporary operating cash needs.
Significant expenditures planned for 1998, excluding any possible business acquisitions and stock repurchases, are as follows: acquisition of data processing and communications equipment, support software, buildings, building improvements and office furniture, fixtures and equipment and costs relating to the internal development of software systems.
Currently, the Company's business is focused principally within the global property and casualty and life insurance and financial solutions industries. Significant changes in the regulatory or market environment of these industries could impact demand for the Company's software products and services. Additionally, there is increasing competition for the Company's products and services, and there can be no assurance that the Company's current products and services will remain competitive, or that the Company's development efforts will produce products with the cost and performance characteristics necessary to remain competitive. Furthermore, the market for the Company's products and services is characterized by rapid changes in technology. The Company's success will depend on the level of market acceptance of the Company's products, technologies and enhancements, and its ability to introduce such products, technologies and enhancements to the market on a timely and cost effective basis, and maintain a labor force sufficiently skilled to compete in the current environment.
A significant portion of both the Company's revenue and its operating income is derived from initial licensing charges received as part of the Company's software licensing activities. Because a substantial portion of these revenues is recorded at the time new systems are licensed, there can be significant fluctuations from period to period in the revenues and operating income derived from licensing activities. This is attributable principally to the timing of customers' decisions to enter into license agreements with the Company, which the Company is unable to control. The Company believes that current and potential customers' decisions to enter into license agreements with the Company may be significantly affected by strategies to make their existing information systems capable of handling the year 2000, however, at this time the Company is unable to predict what the future impact, if any, will be.
Many existing computer programs were designed to use only two digits to identify a year in date fields. If not corrected, these applications could fail or produce erroneous results when working with dates in the Year 2000 and beyond. This Year 2000 issue may potentially affect the Company in four areas: its product offerings, its services offerings, third-party products used internally, and its suppliers. The Company's various business units have been responsible for the assessment, remediation, validation and implementation of Year 2000 corrective actions.
The application code of the Company's primary product offerings, S3+, Series II, INSURE/90 , POINT , CyberLife and CYBERTEK CK/4 products, were either initially designed or have been updated in their currently available releases to be capable of processing and storing date data with dates in both the twentieth (1900's) and twenty-first (2000's) centuries. The Company is currently conducting an inventory and verifying the Year 2000 readiness of the third-party products with which these Company applications are designed to operate in order to validate that no unanticipated Year 2000 issues exist. In addition, the Company also is in the process of conducting an inventory and assessing other Company and third-party products previously licensed by the Company to customers to determine if any renovation efforts may be required in relation to these products.
In its services offerings, the Company has assessed and commenced Year 2000 remediation of the applications used in processing the data of its Information Technology Outsourcing ("ITO") and BPO services customers. Some of these remediation efforts are complete and some are still in various stages of coding, testing or implementation. The Company intends to complete these Year 2000 remediation efforts and required testing, in a Year 2000 test environment, prior to the need for these services to process data involving dates in the twenty-first century.
The primary third-party products used by the Company for its internal operation include its data center hardware and software, internal financial systems, and network and PC hardware and software. The Company's Blythewood data center has completed its hardware and operating software inventory assessments and has substantially completed the remediation efforts of updating these hardware and software assets for the Year 2000 requirements. The Company's Australian and European data centers also have completed their inventory assessment and are implementing the hardware and operating software enhancements required for Year 2000 remediation.
Finally, the primary suppliers upon whom the Company's services are dependent are electric utility and telephone companies who provide services to the Company's various offices and data centers. If these services are interrupted for a prolonged period due to the suppliers' Year 2000 problems, it will disrupt the Company's ability to provide its services to customers, notwithstanding the backup battery and diesel power supplies available for the data center locations.
As discussed above, the Company has not yet fully completed its Year 2000 evaluations or its remediation efforts. If such remediation efforts are not completed on a timely basis, Year 2000 issues could have a material impact on the Company's operations and financial results. However, based upon the Company's experience to date, at this time, it is not anticipated that the completion of remaining Year 2000 remediation efforts will have an adverse material effect upon the Company's financial position or results of operations.
Although the Company cannot accurately determine the amounts attributable thereto, the Company has been affected by inflation through increased costs of employee compensation and other operating expenses. To the extent permitted by the marketplace for the Company's products and services, the Company attempts to recover increases in costs by periodically increasing prices. Additionally, most of the Company's license agreements and long-term services agreements provide for annual increases in charges. ____________________________________________________
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Policy Management Systems Corporation and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
The Company's revenues are generated primarily by licensing to customers standardized insurance software systems and providing automation and administrative support and information services to the global insurance and financial services industries.
The Company provides professional support services, including systems implementation and integration assistance, consulting and educational services, which are available under services agreements and charged for separately. These services are generally provided under time and material contracts and in some circumstances under fixed price arrangements. Under fixed price contracts, revenue is recognized on the basis of the estimated percentage of completion of service provided using the cost-to-cost method. Changes in estimates to complete and losses, if any, are recognized in the period in which they are determined.
The Company does from time to time enter into certain joint development arrangements. Although these arrangements are varied, the Company principally will undertake custom development of a product or enhancement and typically retain all marketing rights and titles to such development. The Company does, however, have certain joint marketing arrangements. Joint development arrangements are generally provided for under fixed price agreements and in some circumstances on a time and material basis. The Company recognizes revenue on the same basis as professional support services; however, where technological feasibility has already been established, the Company will capitalize the portion of development costs which exceed customer funding provided under the joint development arrangement.
The Company also offers information and outsourcing services ranging from making available software licensed from the Company on a remote processing basis from the Company's data centers, to complete systems management, processing, administrative support and automated information services, through the Company's nationwide telecommunications network using the Company's data base products. Outsourcing services are typically provided under contracts having terms from three to ten years. Generally, agreements to provide information services have terms from one to five years, and in some cases month-to-month. Revenues from substantially all outsourcing and information services are recognized at the time the service is performed and losses, if any, are recognized in the period in which they are determined.
Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Assets to be Disposed Of" ("FAS 121"), requires impairment losses to be recorded on long-lived assets used in operations when indicators of impairment are present and the expected future cash flows of those assets are less than the assets' carrying amount. FAS 121 also addresses the accounting for long-lived assets that are expected to be sold or discarded. The Company adopted FAS 121 on January 1, 1996.
Identifiable intangible assets and goodwill are recorded and amortized over their estimated economic lives or periods of future benefit. The lives established for these assets are a composite of many factors which are subject to change because of the nature of the Company's operations. This is particularly true for goodwill which reflects value attributable to the going-concern nature of acquired businesses, the stability of their operations, market presence and reputation. Accordingly, the Company evaluates the continued appropriateness of these lives and recoverability of the carrying value of such assets based upon the latest available economic factors and circumstances. The Company evaluates the recoverability of all long-lived assets, including specific intangible assets and goodwill, based upon a comparison of estimated future cash flows from the related operations with the then corresponding carrying values of those assets. Impairment of value, if any, is recognized in the period in which it is determined. A rate considered to be commensurate with the risk involved is used to discount the cash flows for any recognized impairment.
The Company amortizes goodwill over an estimated life of 15 years for goodwill related to information and computer services company acquisitions and 10 years for goodwill related to software company acquisitions. The Company believes these lives appropriately reflect the current economic circumstances for such businesses and the related period of future benefit. Longer lives will be used for future business acquisitions only where independent third party studies support such lives.
In accordance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed," certain costs incurred in the internal development of computer software which is to be licensed to customers, and costs of purchased computer software, consisting primarily of software acquired through business acquisitions, are capitalized and amortized over the estimated useful life, generally 3 to 5 years, at the greater of the amount computed using (i) the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues of that product or (ii) the straight-line method. Costs which are capitalized as part of internally developed software primarily include direct and indirect costs associated with payroll, computer time and allocable depreciation and other direct allocable costs, among others. Product enhancements are improvements to an existing product that are intended to extend the life or significantly improve the marketability of the original product. Costs incurred for product enhancement are charged to expense as research and development until technological feasibility of the enhancement has been established. Upon release of the enhanced product, the unamortized value of the original product is added to the capitalized cost of the enhancement and amortized using the estimated life of the enhancement. All costs incurred prior to the establishment of technological feasibility have been expensed as research and development costs during the periods in which they were incurred and amounted to $0.6, $0.2 and $0.9 million for the years ended December 31, 1997, 1996 and 1995, respectively. The Company also recorded a write-off of $14.5 million representing purchased research and development costs during 1995 (see Note 2). The amount by which unamortized software costs exceeds the net realizable value, if any, is recognized in the period it is determined.
The local currencies of the Company's foreign subsidiaries have been determined to be their functional currencies. Assets and liabilities of foreign subsidiaries are translated into United States dollars at current exchange rates and resulting translation adjustments are included as a separate component of stockholders' equity. Revenue and expense accounts of these operations are translated at average exchange rates prevailing during the year. Transaction gains and losses, which were not material, are included in the results of operations of the period in which they occur.
In June 1997, Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("FAS 131"), was issued. FAS 131 is designed to improve the information provided in financial statements about the different types of business activities in which the enterprise engages and economic environments in which the enterprise operates, and is effective for fiscal years beginning after December 15, 1997, with earlier application encouraged. The Company adopted FAS 131 at December 31, 1997 and has included the appropriate disclosures in Note 12.
In early 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 provides guidance on accounting for the costs of computer software developed or obtained for internal use, and is effective for fiscal years beginning after December 31, 1998, with earlier application encouraged. The adoption of SOP 98-1 is not expected to have a material effect on the Company's financial statements.
Certain prior year amounts have been reclassified or restated to conform to current year presentation. See also Note 12.
The total costs of the acquisition were determined, and assigned to the net assets acquired, as follows:
Depreciation and amortization charged to expense was $27.6, $23.7, and $28.1 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Amortization charged to expense was $10.6, $10.4 and $9.3 million for the years ended December 31, 1997, 1996 and 1995, respectively. Goodwill and other intangible assets with an aggregate carrying value of $5.2 million were written off as part of impairment and restructuring charges recorded during the year ended December 31, 1995 (see Note 11).
On March 27, 1995, the Company entered into a long-term license and maintenance agreement in order to acquire rights to certain operating system management software products for use in the Company's worldwide data center operations. The agreement, which has an initial term of ten years, may be renewed and extended for an additional period of five years, subject to mutual agreement and other modifications. Minimum contract payments by the Company over the initial ten-year term aggregate $33.0 million payable in specified annual installments which escalate over the ten-year period. In addition to minimum contract payments, the Company will pay an annual supplemental revenue fee, subject to certain provisions in the agreement, equal to a specified annual percentage of the Company's applicable prior year annual gross revenues, less the specified annual installment for such period. Minimum contract payments will be expensed on a straight-line basis over the initial ten-year term. Annual supplemental revenue fees, if any, will be accrued in the period in which determined. The agreement provisions for the supplemental revenue fee were not met for 1996, and the Company made no supplemental payment in 1997 for the 1996 period.
During 1997, the Company entered into two five year renewable lease and maintenance agreements to lease certain data processing equipment for use in its worldwide data center operations. Minimum lease payments over the initial terms of the agreements aggregate $8.6 million payable in specified monthly installments. At the end of the term of each agreement, the Company has the option to purchase the leased equipment at fair market value, upgrade the equipment with the latest technology, or discontinue each lease.
The Company occupies leased facilities under various operating leases expiring through 2014. The leases for certain facilities contain options for renewal and provide for escalation of annual rentals based upon increases in the lessors' operating costs. Rent expense under leases for facilities was $10.0, $7.7 and $7.1 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Future minimum lease obligations under noncancelable operating leases are stated below and include payments over 17 years aggregating $3.4 million related to a leasehold planned for future abandonment, net of subleases (in thousands):
A reconciliation of the difference between the actual income tax provision and the expected provision, computed using the applicable statutory rate, is as follows:
No provision has been made for federal income taxes on unremitted earnings of certain of the Company's foreign subsidiaries (approximately $28 million at December 31, 1997) since the Company plans to permanently reinvest all such earnings. However, if such earnings were remitted, there would be additional federal income tax expense of $2.3 million.
Prior to July 1, 1995, eligible employees were covered under the Policy Management Systems Corporation Profit Sharing Plan and Trust. The Company's contributions to this Plan were determined by the Board of Directors of the Company. Employees made no contributions to this Plan. The Company made no contributions to the Plan for 1995 and on July 1, 1995, all accounts of all participants in this Plan were merged into the Company's 401(k) Retirement Savings Plan.
In May 1995, the Company established a stock ownership plan through which eligible employees of the Company and its participating affiliates may acquire shares of the Company's common stock through regular payroll deductions. Participants may make after-tax contributions in multiples of $5.00, with a minimum deduction per pay period of $10.00 and a maximum deduction per pay period of the lesser of $900.00 or 10% of regular salary. The Company makes a matching contribution equal to 15% of participants contributions. Participants who withdraw shares acquired under the Plan within two years of the date of purchase are ineligible to make further contributions to purchase shares under the Plan for twelve months after such withdrawal.
Options granted under all plans except the 1993 Plan have exercise prices at 100% of market value at date of grant and generally become exercisable either at the rate of 20%, 25% or 33 1/3% per year (cumulative) beginning one year from date of grant.
Participants in the 1993 Plan have exercise rights as a percentage of market value at date of grant as follows: 1993 - 105%; 1994 - 104%; 1995 - 103%; 1996 - 102%; 1997 - 101%; and 1998 - 100%. Options granted under the Plan in 1993 become exercisable as follows: 25% on January 1, 1995; 25% on January 1, 1997; and 50% on January 1, 1999. For individuals who were or may be selected to participate in the Plan, and for additional options which were or may be granted to participants due to promotions, the number of options granted and what percentage becomes exercisable on the above dates are determined according to formulas described in the Plan.
During the second quarter of 1997, the property and casualty segment executed a license agreement covering a package of several of the Company's information access and electronic commerce software products for $1.8 million with Insurance Information Exchange L.L.C., the purchaser of the discontinued property and casualty information services.
As part of a 1983 business acquisition, the Company acquired a billing and collection system (CABILS), which was originally utilized in specialty processing or the processing of assigned risk business for the Company's customers (principally those customers acquired in the business acquisition) and, later, evolved into the basis for a portion of the Company's full property and casualty total policy management processing for voluntary as well as assigned risk business. During 1995, several of the Company's customers of this business opted to either move some or all states served by them to LAD servicing carriers or to not renew their agreements for these services for other reasons. In addition, the Texas Plan implemented rate increases and a mandatory takeout plan which had the effect of further decreasing the number of policies served by the Company. During 1995, the Company decided to migrate its property and casualty total policy management processing to its S3+ technology, replacing the software acquired in 1983. Based on a detailed business assessment performed by the Company, the anticipated cash flows for this business for the period until the S3+ migration was completed did not support the carrying value of the software and related goodwill associated with this business. As a result, the Company recorded, at October 1, 1995, impairment charges of $2.8 million to write-off the carrying value of the software ($0.4 million) and related goodwill ($2.4 million).
The Company determined that a development and design tool used in the development of certain of its property and casualty software no longer provided significant service potential to the Company's development efforts. As the Company's license for the tool is non-transferable, the Company recorded an impairment charge at October 1, 1995 of $1.1 million to write-off the remaining carrying value of this software.
1. Property and casualty enterprise software and services (generally referred to as the "domestic property and casualty business"). This segment provides software products, product support, professional services and outsourcing primarily to the US property and casualty insurance market.
2. Life and financial solutions enterprise software and services (generally referred to as the "domestic life and financial solutions business"). This segment provides software products, product support, professional services and outsourcing primarily to the US life insurance and financial services markets. In 1995, this segment included the Company's health services unit which was sold in June 1995.
4. Property and casualty information services. This segment provided information services, principally motor vehicle records and claims histories, to US property and casualty insurers. This segment was sold in August 1997.
5. Life information services. This segment provides information services, principally physician reports and medical histories, to US life insurers.
In accordance with the provisions of Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Company has adjusted all prior period financial information to reflect these revised classifications.