The amount of general and administrative ("G&A") expenses of the home warranty operation, which primarily include allocated fixed costs, decreased significantly from the prior year period, and as a percentage of related revenue. The 1995 expenses were positively impacted by the work-force reduction that took place in September 1994.
Investment income approximated $1,367,000 in 1995, an increase of approximately 1000% from the 1994 level of $120,000. Unrealized holding gains/losses on trading securities are included in the Company's earnings for the period, and unrealized gains/losses on securities available for sale are reported as a separate component of stockholders' equity. In 1994, rising interest rates caused the Company's investments in debt securities to generate significant unrealized holding losses, especially on its trading securities portfolio, which have been included in the Company's consolidated income statement. In 1995, this trend reversed, and the Company recognized significant income. Investment income is generated primarily from the securities currently invested by the Company's regulated home warranty subsidiaries, as well as from additional investment of funds generated through the sales of warranty products. Funds generated through the other operations of the Company's business are generally invested in highly liquid overnight investments, and therefore earn a minimal amount of interest over the course of a year.
Home warranty revenue, totaling $38,911,000 and representing 74% of total operating revenue for 1994, increased 22% over the 1993 figure of $31,954,000, or 62% of total operating revenue, due primarily to growth in home warranty contract sales, which outpaced growth in other revenue sources. Due to the Company's warranty revenue recognition method, which recognizes contract revenue over the one year term of the contract, warranty revenue for any period of time is also impacted by production in the eleven months immediately preceding that period. Management believes that much of this improvement can be attributed to a sales and marketing strategy focused on educating Members about the value of the home warranty. Improvements in the percentage of Members selling the Company's warranty, from 19.4% in December 1993 to 22% in December 1994, indicate the success of this strategy. The improvement in home warranty contract sales is also partially attributable to the new SellerTrack program introduced in 1993, which targets the home seller directly. Upon enrollment in the Consumer Reach program, Members are notified that participation in this program requires that they use the Company's warranty product exclusively. Management periodically reviews the warranty revenue recognition rates, and the current review did not result in any revisions, as the current rates did not differ significantly from current claims experience. There have been no major pricing changes which would have significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims expense and acquisition costs, as a percentage of related operating revenue, decreased to 83% in 1994 from 84% in 1993, primarily due to a 7% decrease in average claim severity, offset by a 4% increase in warranty claim frequency. Claim frequency experienced in 1994 was negatively impacted by the unusually severe weather patterns experienced across the country throughout the first eight months of 1994 and appears to be consistent with industry trends. Through December, 1994 the winter season
The 1994 warranty acquisition cost ratio of 38% is slightly higher than the 1993 ratio, which approximated 37%. As the volume of contract sales shifts between geographic regions, the Company's overall acquisition cost ratio changes, since the Company's acquisition costs vary in different locations. The acquisition cost ratio is expected to remain relatively stable at its current level, assuming that the warranty product mix and geographic distribution do not change significantly. Management, at this time, does not expect such a change to occur.
The amount of general and administrative ("G&A") expenses of the home warranty operation, which primarily include allocated fixed costs, decreased slightly from the prior year period, and as a percentage of related revenue. Management has focused on controlling costs Company-wide. In addition, the 1994 fourth quarter expenses have been positively impacted by the work-force reduction that took place in September 1994. Approximately $470,000 of the expense incurred in this restructuring was allocated to the warranty product.
Direct expense of the membership operations approximated 63% of related revenue for 1994 and 55% of related revenue for 1993, declining only 22% from 1993, despite the 32% decline in revenue. The disproportionate cost ratio is related primarily to the expenses of the Consumer Reach program, certain phases of which are still in the development stage and are not yet generating adequate revenue to offset the expenses incurred. Also impacting the direct cost ratio is the effect of promotional discounting of some of the Company's membership programs, a step the Company has taken to ease the membership transition and retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership and other operations decreased from 1993 totals, due to management's focus on controlling costs Company-wide. Also, the 1994 fourth quarter expenses have been positively impacted by the work-force reduction that took place in September 1994. Approximately $414,000 of the workforce restructuring charge was allocated to membership and other operations, while the full amount of the UK write-off was included in this classification.
E&O related revenue for 1994, totaling $2,528,000 was 8% lower than the 1993 revenue of $2,742,000. The 1994 revenue includes commissions earned on the new E&O program of approximately $1,002,000 and nearly $1,443,000 of E&O reimbursement on the prior E&O program. The expense reimbursement earned in 1993 was a fixed percentage of total premiums collected, and is reported net of expenses incurred primarily in processing applications of the insured Members on behalf of the insurer. The decrease in this revenue relates to the decline in the Company's membership base, which has a corresponding effect on the premium volume of the program and, thus, the commissions earned.
Operating costs and expenses of the E&O operations increased from $2,459,000 in 1993 to $2,724,000 in 1994, including $180,000 related to the workforce reduction that took place September 1994. Under the new E&O program, the Company has agreed to pay a portion of the commission it receives on the E&O premiums collected to the Affiliates generating the premium volume. There was no such arrangement under previous E&O programs. Consequently, as the premium volume under the new program grows, the commission paid to the Affiliates will grow proportionately.
In early September 1994, the Company underwent an organizational restructuring, reducing its total work-force by approximately 20%. This restructuring is expected to result in annual cost savings of approximately $1,700,000, through reductions in salary, benefits and payroll tax expenses, excluding the effects of any other personnel or staffing changes. The one time charge for severance pay and related benefits, totaling $1,063,000 is included in "Unusual items" in the accompanying consolidated statements of income. Approximately $400,000 of this total relates to an agreement to terminate the employment contract between the Company and its former Chairman of the Board of Directors.
of fair value accounting for certain debt and equity securities that are either held for trading purposes or are available for sale. This standard requires that unrealized holding gains/losses on trading securities be included in the Company's earnings for the period, and that unrealized gains/losses on securities available for sale be reported as a separate component of stockholders' equity. In 1994, rising interest rates have caused the Company's investments in debt securities to generate significant unrealized holding losses, especially on its trading securities portfolio, which have been included in the Company's consolidated income statement, as required by the new standard. Investment income is generated primarily from the securities currently invested by the Company's regulated home warranty subsidiaries, as well as from additional investment of funds generated through the sales of warranty products. Funds generated through the other operations of the Company's business are generally invested in highly liquid overnight investments, and therefore earn a minimal amount of interest over the course of a year.
The Company's effective tax rate in 1994 was a benefit of 19.2%, as compared to a 40% provision on income from continuing operations in 1993.
In connection with the Company's discontinued reinsurance operation, the Company is obligated to pay CNA $5,000,000 over a period originally estimated to be three years. In 1994, the Company revised its estimate of the repayment term of the CNA obligation to five years, and, accordingly, adjusted the net present value of the obligation, based upon the new repayment term. In addition, the Company revised its estimate of expenses incurred relative to the reinsurance portfolio transfer, and consequently, recorded an adjustment for the additional balances due. The net effect of these two adjustments had no impact on the Company's consolidated results of operations.
In consideration for CNA's assumption of POMG's reinsurance obligations, the Company transferred POMG's net assets, excluding intercompany balances, which approximated $6,100,000 at December 31, 1993, to CNA. The Company contributed an additional $1,000,000 to POMG immediately prior to the transfer of assets, bringing the total to $7,100,000, consisting of the following:
The Company is further obligated to pay CNA $5,000,000 over a period originally estimated to be three years toward the ultimate settlement of the transferred losses and expenses. CNA will maintain a separate accounting for the POMG net assets. Additionally, a separate fund, the "Holdback Fund," has been established to accumulate the aforementioned $5,000,000 from the Company, additional funds to be contributed by Schinnerer and CNA over the same period, and investment income earned on these funds, to pay claims and expenses related to the reinsured policies in excess of the POMG net assets. If the ultimate reinsured losses and related expenses are less than the transferred net assets of POMG combined with the assets in the Holdback Fund, CNA will distribute the remaining assets among the Company, Schinnerer and itself according to a predetermined formula. However, management believes that a refund is unlikely. Until the $5,000,000 obligation is fulfilled, certain covenants will be in effect restricting the indebtedness and dividend levels of the Company.
Certain amounts in the Company's 1993 and 1992 consolidated financial statements have been reclassified to reflect POMG as a discontinued operation. Losses incurred by POMG through September 30, 1993, the discontinued operations measurement date, totaled approximately $6,200,000, net of income tax benefits of $3,800,000. Additionally, the transaction resulted in a loss, including a provision for POMG operating losses during the phase out period, of approximately $9,000,000. This loss is comprised of the following:
NATURE CARRYING VALUE ------ -------------- Net assets transferred $7,100,000 Provision for losses during the phase out period 2,800,000 Discounted value of additional obligation to CNA 4,500,000 Income tax benefit (5,400,000) ---------- After-tax loss $9,000,000 ==========
Under the CNA program, underwriting is performed on an individual insured basis, whereas, AIG and all previous insurers of the Company's program performed program underwriting. As this is a significant change in philosophy, management believes that certain of its Members will benefit individually while others will not benefit, and may choose to obtain alternate E&O coverage outside of the HMS membership network.
Cash paid for income taxes is generally expected to approximate the current income tax provision in a given year. However, due to the losses incurred in 1993 and 1994, the Company has currently refundable income tax benefits approximating $1,277,000. A portion of the prior year losses, and the current year loss have generated NOL carryforwards that will be used to offset future taxable income. Despite these NOL carry forwards, the Company will be required to make estimated tax payments until certain of the losses generated for financial statement purposes become deductible for tax purposes. The Company intends to file for further refunds of taxes paid in prior years. During 1994 the Company received $2.7 million as a refund of Federal income taxes paid during 1993 and 1992, and a portion of the taxes paid in 1991. The application for refund filed by the Company in 1995, approximating $1.3 million is still pending.
In consideration for CNA's assumption of POMG's reinsurance obligations, which is more fully discussed in the BUSINESS - ERRORS & OMISSIONS INSURANCE section herein, the Company has agreed to pay CNA $5,000,000 over a period estimated to be five years from the commencement of the CNA E&O program toward the ultimate settlement of the transferred losses and expenses. The agreements with CNA impose certain restrictive covenants until the $5,000,000 CNA Obligation is satisfied. These covenants include limits on dividends and on future borrowings. The funds due to CNA are a senior obligation of the Company, secured by an interest in the common stock of the Company's HOMS subsidiary and in the Company's Member list. Through December 31, 1999, the Company and its Affiliates must provide CNA/Schinnerer with right of first refusal on E&O insurance offered to its membership. The Company forwards half of its commissions earned under the CNA E&O program to CNA, to be applied as debt repayments on the obligation until its satisfaction.
As of December 31, 1995, the net present value of the balance due to CNA under this obligation was $3,601,000. During 1995 the Company made principal repayments of approximately $329,000 against the obligation. In addition to the assets transferred to CNA, the Company has guaranteed the validity of a $5,000,000 reinsurance recoverable, one of the POMG assets transferred. This guarantee is secured by $3,000,000 cash collateral posted by the Company. The Company has agreed, if necessary, to pay an additional $2,000,000 out of future commissions related to the guarantee. Should this occur, the repayments on the $5,000,000 obligation will be delayed until the $2,000,000 is paid. The Company will not be required to further reduce its collected commission by more than 50% under these agreements. The Company has not recorded a provision for this guarantee, based upon the opinion of its special insurance counsel,
that the cover note relating to the reinsurance contract is a binding agreement, enforceable in accordance with its terms, and the objections voiced by the reinsurer do not support a material basis for it to successfully deny coverage.
Consolidated Statements of Cash Flows - Years Ended December 31, 1995, 1994 and 1993 27
Consolidated Statements of Stockholders' Equity - Years Ended December 31, 1995, 1994 and 1993 28
Homeowners Group, Inc. ('HOMG') and its subsidiaries (collectively the 'Company') provide home warranty contracts, access to real estate errors and omissions liability insurance ('E&O') and other products and services primarily to residential real estate brokerage firms and agents. The Company enters into agreements with real estate brokerage firms and agents ('Members') which grant Members the right to use the products and services provided by the Company. The Company generally markets its products and services through franchise agreements whereby the third party operators ('Affiliates') have exclusive geographic territories in which to enroll real estate brokerage firms as Members. Through December 31, 1995, the Company had entered into agreements with Affiliates for territories encompassing 39 states and the District of Columbia. In 1995, the Company markets directly in California, Florida, except Northwest Florida which territory has been granted to an Affiliate, Colorado, Indiana, Iowa, Nebraska, North Dakota, South Dakota and Hawaii, ('Corporate-Owned Regions'), and is a 45% partner in a partnership which directly enrolls Members in Texas. In 1994 and part of 1995, the Company also directly enrolled Members in Maine, Massachusetts, New Hampshire and Vermont, however, in May 1995, the Company franchised this New England territory. During 1995, the Company entered into management agreements, whereby it began managing the operations and administration of the Kansas, Missouri, Oklahoma, Arizona and New Mexico territories.
Under the E&O program immediately prior to POMG's formation, the Company was originally required to provide a $7,000,000 letter of credit ('LOC') to the reinsurer which was required to be secured by US Government securities approximating $8,400,000 (cost and market). The amount of the LOC required to be posted by the Company was subject to change at the discretion of the insurer, based on contract volume and underwriting risk. In the event that funds available in the E&O program pool, together with investment income earned thereon, were insufficient to cover the claims and expenses incurred by the program, the Company's US Government securities would have been used to fund payment
In consideration for CNA's assumption of POMG's reinsurance obligations, the Company transferred POMG's net assets, excluding intercompany balances, to CNA. These net assets approximated $6,100,000 at December 31, 1993. The Company contributed an additional $1,000,000 to POMG immediately prior to the transfer of assets, bringing the total to $7,100,000, consisting of the following:
Cash and investments $25,700,000 Assumed reinsurance premiums receivable 6,000,000 Reinsurance recoverable 5,000,000 Other receivables 500,000 Accounts payable and accrued expenses (1,000,000) Reinsurance loss and loss adjustment reserve (29,100,000) ----------- Net assets $ 7,100,000 -----------
Net assets transferred $ 7,100,000 Provision for losses during the phase out period 2,800,000 Discounted value of CNA obligation 4,500,000 Income tax benefits (5,400,000) ------------ After-tax loss $ 9,000,000 ------------
Principles Of Consolidation -- The accompanying consolidated financial statements include the accounts of HOMG and all of its majority owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The Company's 45% interest in the partnership enrolling and servicing Members in Texas is accounted for by the equity method. The earnings from the partnership are included in operating revenue in the accompanying consolidated statements of income.
Accounting Estimates -- The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Revenue And Expense Recognition -- Home warranty contract revenue is recognized over the life of the contract (generally one year) in proportion to historical experience of repair costs. Direct costs incurred in acquiring the contracts are recognized in the same manner. In the third quarter of 1993, the Company refined its definition of direct acquisition costs to include certain additional expenses, such as incentive bonuses paid to the Company's Members and Affiliates, costs of personnel directly involved in acquiring the contracts, and premium taxes. Such costs have been reclassified from amounts previously reported according to this refinement. Repair costs under home warranty contracts are expensed as mechanical breakdowns are reported to and repairs are authorized by the Company. All other revenues and expenses are recognized upon delivery or receipt of the related products or services.
Investments -- The Company accounts for its investments according to Statement of Financial Accounting Standards ('SFAS') No. 115, 'Accounting for Certain Investments in Debt and Equity Securities.' This standard requires that the Company report at fair value the securities which are held for trading purposes, or which are available for sale. Unrealized holding gains and losses on trading securities are determined based upon the change in fair value and are included in investment income in the accompanying consolidated statements of income. Unrealized holding gains on securities available for sale are also determined based upon the changes in fair values, and are reported as a separate component in the stockholders equity section of the balance sheet. Gains and losses on securities are determined based upon specific identification of the securities sold. The Company does not currently have any securities which are classified as held to maturity.
Income Taxes -- Income taxes are provided in accordance with SFAS No. 109, 'Accounting for Income Taxes.' Under this standard, deferred tax assets and liabilities represent the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in the financial statements.
Foreign Currency Translation -- The financial statements of the Company's British subsidiary are translated into US dollars in accordance with SFAS No. 52, 'Foreign Currency Translation.' Net assets of the subsidiary, whose functional currency is the British Pound Sterling, are translated at current exchange rates, while results of operations are translated at average exchange rates in effect for the year.
Net Income Per Common Share -- Net income per common share is based upon the weighted average number of common shares outstanding during each year. Dilutive stock options and warrants are included in the calculation of weighted average shares utilizing the Treasury Stock Method. Primary and fully diluted earnings per share are essentially the same in all years presented in the accompanying consolidated statements of income. The inclusion of common stock equivalents in the 1993 computation of weighted average shares has a dilutive effect on the per share amount of income from continuing operations, but an antidilutive effect on the per share amounts from discontinued operations and on the net loss. In this circumstance, in accordance with Accounting Principles Board ('APB') Opinion No. 30, the common stock equivalents are recognized for all computations even though they have an antidilutive effect on one of the per share amounts. The antidilution is insignificant, and does not change the per share amounts.
Franchising Fee Revenue -- The Company records franchising fee revenue in accordance with SFAS No. 45, 'Accounting for Franchise Fee Revenue.' Under this standard, franchising revenue is recorded when all material services or conditions related to the sale are complete, substantially all of the initial services of the franchisor required by the franchise agreement are complete, and no other material conditions or obligations related to the determination of substantial performance exist.
The 1994 and 1993 general and administrative expenses incurred by the Company's previous 80% owned British subsidiary approximated $777,000 and $882,000, respectively, and are included in the accompanying 1994 and 1993 consolidated statements of income. Operating revenue generated by the subsidiary in 1994 and 1993 approximated $16,000 and $13,000, respectively. During the third quarter of 1994, the Company ceased funding this operation, effectively closing down the subsidiary. See further discussion of this transaction at Note 9.
Non-current securities available for sale, consisting primarily of debt securities, at fair value 1,834,981 4,078,966 ----------- ----------- Total carrying value of investments $12,896,954 $12,340,881 ----------- -----------
Information with respect to unrealized holding gains and losses, as of December 31, 1995:
unrealized holding gains and losses from sales of securities available for sales totaled $1,744 and $143,774, respectively, for the year ended December 31, 1994. Gains and losses on securities are determined based upon specific identification of the securities sold.
Contractual maturities of securities classified as available for sale as of December 31, 1995 are as follows:
AMORTIZED MARKET COST VALUE ---- ----- Due in one year or less $1,793,879 $1,811,624 Due after one year through five years 1,664,062 1,705,892 Due after five years 113,672 129,089 ---------- ---------- Total securities classified as available for sale $3,571,613 $3,646,605 ---------- ----------
At December 31, 1995, municipal bonds and cash deposits in the amount of $1.2 million were held by various state regulatory agencies to assure performance of the Company's obligations under home warranty contracts.
Income (loss) from continuing operations before income taxes consists of the following for the years ended December 31:
The provision (benefit) for income taxes consists of the following for the years ended December 31:
1995 1994 1993 ---- ---- ---- Continuing Operations: Current: Federal $501,776 $(1,678,495) $2,566,527 State 53,000 19,031 234,000 ----------- ----------- ----------- Total 554,776 (1,659,464) 2,800,527 Deferred (1,682,776) 1,461,460 (672,000) ----------- ----------- ----------- Total provision (benefit) on income from continuing operations (1,128,000) (198,004) 2,128,527
Realization of the deferred tax asset is dependent on generating sufficient taxable income during the carryforward periods. Although realization is not assured, management believes it is more likely than not that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term, if estimates of future taxable income during the carryforward period are reduced.
Estimated annual repayments of the CNA obligation are based on anticipated premium volume. In 1995 and 1994, the Company revised its estimate of the net present value of the CNA obligation, based upon the actual payments remitted, and in 1994, to reflect an estimated repayment term of five years, as opposed to the original estimate of three years. This change in estimate resulted in an increase in the discount on the obligation, which will be amortized to interest expense over the life of the obligation. The funds due to CNA, which are recorded at net present value, are a senior obligation of the Company, secured by an interest in the common stock of the Company's HOMS subsidiary and in the Company's Member list.
total related to an agreement to terminate the employment contract between the Company and its former Chairman of the Board of Directors.
10. Commitments And Contingencies - -------------------------------------------------------------------------------- The Company is subject to various lawsuits and claims arising in the normal course of business. In the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations.
On December 16, 1995, a jury verdict in the amount of $5,156,022 was rendered in favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"), a subsidiary of the Company, in the following matter: Acceleration National Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al., Defendants, in the Court of Common Pleas of Franklin County, Ohio. HMS has filed an appeal of the judgment. Post judgment proceedings have been initiated in Florida and elsewhere, including discovery in aid of execution. Although such actions were initially stayed in Florida, on March 13, 1996, the Circuit Court for Broward County, Florida, dismissed an action by HMS which contested the domestication of the judgment in Florida, and no stay is presently in effect. In the event the judgment creditor proceeds to execute on its judgment, such actions would have a material adverse effect on the business of HMS, and could have a material adverse effect on the liquidity of the Company. The judgment, which accrues interest at the rate of 10% per annum, is recorded in other expense in the accompanying consolidated statements of income, and in accrued and other expenses in the accompanying consolidated balance sheets.
In February 1996, a lawsuit was filed against the Company in the Court of Common Pleas of Bucks County, Pennsylvania, by the former franchisee of the Pennsylvania territory, alleging breach of contact, fraud and misrepresentation, and is seeking damages in the amount of $50,000, trebled, reimbursement of costs and attorney's fees, and an injunction to prevent the Company from terminating the franchise agreement. The Company believes this suit is without merit, and has filed a motion to transfer the case to Florida and a motion to dismiss the case. No accrual for this matter has been reflected in the accompanying consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- 11. Stock Options, Warrants And Purchase Rights - --------------------------------------------------------------------------------
The Company adopted stock option plans in 1988 authorizing issuance of up to 600,000 shares of common stock to officers and other employees. Of the authorized shares, 300,000 may be issued as 'incentive stock options' within the meaning of Section 422 of the Internal Revenue Code, and 300,000 may be issued as non-qualified options. The options issued through 1992 generally become exercisable two years after the date of grant and expire no later than ten years after the date of grant. The options issued in 1993 generally become exercisable over a five year period, beginning on the date of grant. Information with respect to options under the above plans follows:
OPTION PRICE AVAILABLE STOCK OPTIONS PER SHARE OUTSTANDING EXERCISABLE FOR GRANT - --------------------------------------------------------------------------------
In 1988, the Company issued five-year stock purchase warrants for 100,000 shares to outside directors and 150,000 shares to the underwriters of the initial public offering. All 250,000 warrants expired in 1993; none had been exercised. In 1991, the Company issued similar warrants for 25,000 shares to an outside director. These warrants are for $10.80 per share and are exercisable at any time until April 11, 1996.
In December 1994, the Company repriced all outstanding options to $2.00 per share, with the exception of the options granted to the current Chairman and the former Chairman of the Board of Directors and the Chief Financial Officer. The options granted to the Chief Financial Officer were repriced to $3.00 per share. The options granted to the former Chairman have been canceled effective January 1995. Upon such cancellation, 100,000 options were granted to the current Chairman of the Board, at $3.00 per share. In December 1995, all of the options granted to the Chief Financial Officer were repriced to $2.00 per share. Also in December 1995, 140,000 options granted to the Chairman from 1988 through 1992 were canceled, and replaced by a new grant of 140,000 options, exercisable for a ten year period at $2.00 per share.
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- 1995 (In thousands except per share amounts) Operating revenue $10,835 $11,218 $11,540 $10,961 Income from operations before income taxes 514 676 245 (4,471) Net income (loss) 316 415 142 (2,779) Per share data: Net income (loss) $0.06 $0.07 $0.03 ($0.50)