The Company's corporate offices are located at 400 Sawgrass Corporate Parkway, Sunrise, Florida. The Company leases approximately 24,980 square feet in a two-story office building for a ten year term, expiring December 31, 2005. The Company currently pays rent of approximately $33,000 per month, including sales tax and maintenance charges. The Company also leases office space for a regional sales and administrative office in Texas, under a lease with a remaining term of three years.
* DIRECT COSTS ARE PRESENTED AS A PERCENTAGE OF THE RELATED REVENUES. - -------------------------------------------------------------------------------
The 1996 warranty acquisition cost ratio of 35% is slightly lower than the 1995 ratio, which approximated 36%. 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. In addition, the increasing proportion of renewal warranty contracts reduces the acquisition cost ratio, as renewal contract acquisition costs are generally lower than acquisition costs for first year contract sales. 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.
E&O related revenue for 1996, totaling $964,000, was 23% lower than the 1995 revenue of $1,253,000. The decrease 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.
In 1996, the Company reported approximately $677,000 in the "Unusual Items" caption in its consolidated statements of operations, related to several infrequently occurring events that occurred in 1996. Specifically, in the third quarter of 1996, the Company terminated its Agency Agreement and Administration Agreement with New Hampshire Insurance Company ("NHIC"), as it determined that it no longer desired to carry the program previously negotiated with NHIC. As part of the termination arrangement, the Company has paid approximately $260,000 to NHIC, and has also agreed to indemnify NHIC for all claims incurred under contracts issued during the time the agreements were in effect by paying for all claims on covered components which may be reported under such contracts, as if the arrangement with NHIC had not taken place. To the extent that claims have been paid or reported on these contracts, such amounts have been included in the "Direct costs" caption in the Company's consolidated statements of operations, and any related accrual for unpaid amounts is included in the "Accounts payable" caption in the consolidated balance sheets. In addition, effective September 15, 1996, in conjunction with its plans for future organization and growth, the Company terminated an employment contract with one of its officers, and has agreed to pay the former officer severance and related benefits totaling approximately $157,000 through the month of July 1997. In the fourth quarter of 1996, in connection with the Company's plan to improve the operating results of its Corporate Owned Regions, the employment of three regional managers of the Company's Corporate Owned Regions was terminated, and the California office was closed. In connection with these changes, the Company agreed to pay amounts totaling approximately $260,000 for severance, related benefits and rents on the California office. Charges for these items are included in the accompanying consolidated statements of operations under the caption "Unusual Items".
Investment income approximated $636,000 in 1996, a decrease of approximately 53% from the 1995 level of $1,367,000. 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 1995, decreasing interest rates caused the Company's investments in debt securities to generate significant income, especially on its trading securities portfolio, which has been included in the Company's consolidated statement of operations. In 1996 this trend slowed, reducing the amount of income recognized. Also, in mid-1996, the Company transferred a portion of its trading portfolio to available for sale, which changed the presentation of market value adjustments from a statement of operations impact to a balance sheet impact. This transfer was made to maximize earnings potential and to consolidate investment balances for one of the Company's regulated subsidiaries. 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 1996 was a benefit of 35%, as compared to a provision of 38.4% on income from continuing operations in 1995.
As a result of the losses generated in 1996, and by the 1995 ANIC judgment, the 1994 work-force reduction and termination of its UK operations, combined with the 1993 losses generated by the Company's discontinued reinsurance operations, the Company has recognized significant income tax benefits since 1993. A portion of the Company's 1993 and 1994 pre-tax losses was carried back for income tax purposes, to offset taxable income earned in the prior three years, generating tax refunds for the Company. The remaining pre-tax losses give rise to significant deferred tax benefits, which will be recognized in future years, as the temporary book to tax differences which create the deferred tax benefits become deductible for tax purposes. The total deferred tax benefit which is expected to be realized in future years approximates $9.5 million at December 31, 1996. Based upon management's estimates of future taxable income and of the positive and negative evidence regarding the likelihood of ultimate recognition of this benefit, it has been determined that no valuation allowance is necessary. This determination was based on the Company's taxable earnings history, exclusive of non-recurring charges, and the period anticipated for full recognition, assuming the Company maintains its current level of taxable income, exclusive of the charges incurred for its discontinued operations, the restructuring charges reported in 1994 and 1996, and certain other non-recurring items. The Company is currently undergoing an examination by the Internal Revenue Service of its tax returns for the years of 1993, 1994 and 1995, which could result in the proposal of significant adjustments to its taxes in those years. The Company believes that the returns as originally filed are correct in all material respects.
The Company, CNA and Sphere Drake are engaged in settlement discussions with respect to the reinsurance treaty. Although terms are not finalized, it is possible that the Company could pay a substantial portion of the Collateral Account to CNA under the currently proposed settlement agreement. As a result of the settlement negotiations, the Company has recorded a loss provision of $2.5 million for the guaranty in its consolidated statements of operations for 1996. Should the Merger fail to be consummated, the potential settlement agreement will be null and void, and the Company will continue to be contingently liable for the entire $5 million under the conditions described in the preceding paragraph. In such event, the Company will attempt to negotiate a settlement but there can be no assurance that it will be successful in such efforts.
As a result of the settlement negotiations, the Company has recorded a loss provision of $2.5 million for the guarantee, which is reflected in the discontinued operations caption in the accompanying 1996 consolidated statement of operations, and the offsetting reserve is reflected as a reserve against the restricted cash balance in the accompanying 1996 consolidated balance sheet. In its role under this program, the Company bore reinsurance risk through its reinsurance subsidiary. With the change in carriers to CNA, in 1993, the Company removed itself from any risk bearing position in connection with the claims reported under its E&O program, and currently no longer operates in this capacity. The 1995 amount included in the discontinued operations caption was the Acceleration judgment, which was also related to this prior E&O program.
Home warranty revenue, totaling $37,181,000 and representing 84% of total operating revenue for 1995, decreased 4% from the 1994 figure of $38,911,000, or 74% of total operating revenue, due primarily to declines in home warranty contract sales. The decrease in contract sales is primarily due to the loss of membership. 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. There have been no major pricing changes which would have significantly affected warranty revenue.
The 1995 warranty acquisition cost ratio of 36% is slightly lower than the 1994 ratio, which approximated 38%. 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.
Membership and other related revenue of $6,258,000 in 1995 was 45%, lower than 1994 revenue of $11,755,000, which is primarily related to the changing mix of the membership base. A large portion of the Company's membership no longer participates in the Company's E&O program and is exempted from paying the associated marketing/placement fees. Further impacting the membership results is the 6% decline in the Company's membership base from the prior year level. These factors have caused continuing decreases in related revenue and earnings in 1995, and reflect the continuing effects of the change in Company's E&O carriers. As a result of this change and the related increased competitive pressures within the E&O market, the Company has been unable to retain some of its Members as participants in its current E&O program. Additionally, attraction of new full members is more difficult, due to premium quotes which are not competitive for certain brokers and also due to declinations by the Company's primary insurance carrier of certain other brokers.
Throughout 1995, the Company continued to focus on attracting new members and retaining existing members who have either been declined coverage by CNA or who have obtained their E&O coverage through another entity, as participants in the Company's warranty and Consumer Reach programs. A new membership program targeted at brokers desiring to use the Company's warranty was introduced in mid-1995. This strategy has somewhat reduced the negative impact of the loss of members on other revenues, evidenced by the 1995 fourth quarter improvements in first year warranty contract sales, as compared to prior quarters.
Direct expense of the membership operations approximated 70% of related revenue for 1995 and 62% of related revenue for 1994. The disproportionate cost ratio is related primarily to the results of the CORs, which were particularly impacted by the membership declines, especially in the states of California and Texas. 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.
E&O related revenue for 1995, totaling $1,253,000 was 50% lower than the 1994 revenue of $2,528,000. 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.
The Company generally receives payment for products and services before disbursing funds for related direct expenses. Fees from Members and from sales of home warranty contracts are received before related marketing commissions are paid out and before claims are made under home warranty contracts. As a result of increases in home warranty production in 1996 as compared to 1995, cash collected on warranty contracts in 1996 was approximately $4,623,000 higher than 1995. In 1996, membership and related revenues and cash flows were negatively affected by the decrease in members and in the related fees generated by the Company's membership, and the Company continued to provide its Affiliates with various discounted membership options. The Company expects that cash flow generated from its warranty and other operations, in combination with the cost saving measures implemented, will be sufficient to meet its normal operating needs on an ongoing basis. However, should the merger fail to be consummated by July 1, 1997, Cross Country will be entitled to take action to collect on its judgment. In the event the judgment creditor proceeds to execute on its judgment, it is likely that the Company will be without adequate resources to pay the full amount due to Cross Country, as holder of the judgment, which would become immediately due and payable. In such event, the Company would be forced to seek alternatives to paying the remaining unpaid balance of the judgment. No other alternatives are presently being considered.
remittances. In 1996, the Company used $3,513,000 in investing activities, as compared to $2,207,000 in 1995, primarily due to the transfer of investments previously noted, offset by decreases in purchases of property and equipment. Net cash provided by financing activities totaled $3,000 in 1996, as compared to cash used in financing activities of $2,005,000 in the comparable 1995 period. The 1995 financing activities reflect the collateral fund contributions related to the Sphere Drake reinsurance recoverable.
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 million by December 1999 toward the ultimate settlement of the transferred losses and expenses. The agreements with CNA impose certain restrictive covenants until the $5 million CNA obligation is satisfied, including 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. The Company is currently in default with the terms of this agreement, as it has failed to achieve the minimum premium volume quotas as defined in the agreements, and the Company could be required by CNA to make a payment against its obligation to the Holdback Fund in the amount of approximately $200,000. However, the Company and CNA have entered into an amendment to the Holdback Agreement which would delete the premium volume quotas and release the Company from its current obligation to pay the remaining $3.1 million. Following the effective date of this amendment, the Company's obligation will be limited to the payment of 50% of actual commissions to CNA. The proposed amendment becomes effective if the Merger is consummated prior to July 1, 1997, and the dispute with Sphere Drake (as described below) is settled within 14 days of the consummation of the Merger.
Consolidated Statements of Operations - Years Ended December 31, 1996, 1995 and 1994 23
To the Board of Directors of Homeowners Group, Inc. Sunrise, Florida:
We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a resonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1996 and 1995 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles.
1. THE COMPANY - ------------------------------------------------------------------------------- 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, 1996, the Company had entered into agreements with Affiliates for territories encompassing 35 states and the District of Columbia. In 1996, the Company marketed directly in California, Florida, except Northwest Florida which territory has been granted to an Affiliate, Colorado, Hawaii, Idaho, Indiana, Iowa, Nebraska, North Dakota, Pennsylvania, South Dakota, Oregon, and Washington, ('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. Under management agreements executed in 1995, the Company continued in 1996 to manage the operations and administration of the Kansas, Missouri, Oklahoma, Arizona and New Mexico territories.
In October 1991, the Company acquired an 80% interest in a British subsidiary which began marketing home warranty contracts in the United Kingdom in February 1992. The home warranty contract program and other insurance products offered by this subsidiary were completely underwritten by Lloyd's of London, thereby eliminating any underwriting risk to the Company. In the third quarter of 1994, the Company ceased funding the UK operation, effectively closing down the subsidiary. Accordingly, there was no foreign operations activity in 1995. See further discussion of this transaction in Note 9.
As warranty production increases, the Company's required reserve and surplus levels increase, which reduces the cash available to the Company to fund its operations. During 1996 the fees generated by the Company's membership continued to decline, and the Company continued to provide its Affiliates with various discounted membership options to maintain competitiveness in the marketplace. As a result of these factors, the Company's cash flow from membership operations has been significantly impacted. The Company expects that cash flow generated from its warranty and other operations, in combination with the cost saving measures implemented, will be sufficient to meet its normal operating needs on an ongoing basis. However, should the merger fail to be consummated by July 1, 1997, Cross Country will be entitled to take action to collect on its judgment. In the event the judgment creditor proceeds to execute on its judgment, it is likely that the Company will be without adequate resources to pay the full amount due to Cross Country, as holder of the judgment, which would become immediately due and payable. In such event, the Company would be forced to seek alternatives to paying the remaining unpaid balance of the judgment. No other alternatives are presently being considered.
An affiliate of Cross Country purchased, for approximately $2.75 million, the $5.2 million judgment obtained by Acceleration (the "Judgment"). The purchase price of the judgment reflected a $1.4 million payment previously made by the Company. The Cross Country affiliate also agreed, under certain conditions, to take no action to collect on the Judgment before January 31, 1997.
On February 10, 1997, the Company entered into a second amendment to the merger agreement with Cross Country, which extended the anticipated closing date to the earlier of July 1, 1997 or termination of the merger agreement. The Company also entered into an amendment to the agreement with the affiliate of Cross Country which holds the Judgment, extending the date through which the Cross Country affiliate agreed, under certain conditions, to take no action to collect on the Judgment until the earlier of July 1, 1997 or termination of the merger agreement. The Company guaranteed the obligation of HMS and pledged the shares of HMS and another subsidiary to secure such guarantee. HMS and the subsidiary granted security interests in their assets as part of the First Amendment to the Merger Agreement.
Management anticipates that the Merger will be approved by the majority of its stockholders at the special meeting to vote on the Merger, and that the various issues related to the judgment held by the Cross Country affiliate will be resolved by the consummation of the Merger.
In the second and third quarters of 1993, the E&O program experienced significant losses. Effective December 1, 1993, Continental Casualty Company, ("CNA") replaced POMG as the reinsurer of the E&O policies issued through November 30, 1993 to the Company's Members by certain subsidiaries of American International Group, Inc. ("AIG"). This transaction took place through a novation of previous reinsurance agreements in effect. For policies issued from December 1, 1993 forward, CNA became the insurer, and the Company began marketing CNA policies to its Members through Victor O. Schinnerer and Company, Inc. ("Schinnerer"), CNA's exclusive program and underwriting manager. Pursuant to the agreement with CNA, the Company discontinued POMG's operations. The Company, through its HOMS Insurance Agency, Inc. ("HOMS") subsidiary acts solely in the capacity of an insurance broker. Under the terms of the agreements, the Company receives a fixed percentage of the E&O premiums collected as a commission. The Company pays a portion of these commissions to the Affiliates generating the premium volume. In February 1994, the Company, CNA and AIG entered into definitive agreements, effective as of December 1, 1993, setting forth the terms described above.
The Company is further obligated to pay CNA $5,000,000 (the 'CNA Obligation') over a period originally estimated to be three years and subsequently revised to be five years, toward the ultimate settlement of the transferred losses and expenses. CNA is maintaining 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.
In connection with the transfer of the net assets of POMG to CNA and the assumption by CNA of the obligations of POMG under certain Realtor's errors and omissions policies, the Company guaranteed the performance by Sphere Drake Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5,000,000 reinsurance treaty purchased by POMG to protect it from losses in excess of a predetermined amount. Under the terms of the Company's guaranty, CNA, as the transferee of the reinsurance treaty, bears any credit risk under the treaty, including, but not limited to, any risk that Sphere Drake becomes insolvent, is adjudicated as a bankrupt or has liquidation or similar proceedings commenced against it. The reinsurance treaty represents amounts recoverable from a third party insurance company under the reinsurance treaty purchased by POMG. This guarantee is secured by $3,000,000 cash collateral posted by the Company. This amount is reported as restricted cash in the accompanying consolidated balance sheet. The Company has agreed, if necessary, to pay an additional $2,000,000, related to the guarantee, out of future commissions. On April 10,
1996, CNA issued a Notice of Arbitration to the reinsurer with respect to its refusal to honor the reinsurance treaty. The Company, CNA and Sphere Drake are engaged in settlement discussion with respect to the reinsurance treaty. Although terms are not finalized, it is possible that the Company could pay a substantial portion of the Collateral Account to CNA under the currently proposed settlement agreement. The potential settlement agreement is contingent upon the closing of the Merger. Should the Merger fail to be consummated, the potential settlement agreement will not be consummated and the Company and Sphere Drake will either continue arbitration or seek some other resolution of this issue. If the Merger is not consummated, the Company will continue to be contingently liable for the entire $5 million under the conditions described in the preceding paragraph. As a result of the settlement negotiations, the Company has recorded a loss provision of $2.5 million for the guarantee, which is included in the Discontinued Operations caption in the accompanying 1996 consolidated statements of operations. The restricted cash amount is presented net of the $2.5 million reserve in the 1996 consolidated balance sheets.
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.
INVESTMENTS -- The Company accounts for its investments according to Statement of Financial Accounting Standards ('SFAS') No. 115, 'Accounting for Certain Investments in
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.
DISCONTINUED OPERATIONS -- The Company reviews the liabilities recorded in association with its 1993 discontinued reinsurance operations annually, and adjusts the balances as necessary. In 1995 and 1994, the Company revised its estimate of the net present value of the CNA obligation, based upon the actual payments remitted during each year, and in 1994, to reflect an estimated repayment term of five years, as opposed to the original estimated term 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. Further, in both years, the Company revised its estimate of expenses incurred relative to the reinsurance portfolio transfer, and 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 1996, this evaluation did not result in any adjustment.
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.
STOCK-BASED COMPENSATION -- SFAS No. 123 'Accounting for Stock-Based Compensation', encourages, but does not require companies to record compensation cost for stock-based employees and non-employee members of the Board compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation to employees and non-employee members of the Board using the intrinsic value method as prescribed by Accounting Principles Board Opinion ("APB") No. 25, 'Accounting for Stock Issued to Employees', and related interpretations. Accordingly, compensation cost for stock options issued to employees and non-employee members of the Board are measured as the excess, if any, of the fair value of the Company's stock at the date of grant over the amount an employee or non-employee member of the Board must pay for the stock.
RECLASSIFICATIONS -- Certain amounts in the accompanying 1995 and 1994 consolidated financial statements have been reclassified from amounts previously reported to conform to the current presentation.
The 1994 general and administrative expenses incurred by the Company's previous 80% owned British subsidiary approximated $777,000, and are included in the accompanying 1994 consolidated statements of operations. Operating revenue generated by the subsidiary in 1994 approximated $16,000. 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 10.
Property and equipment consists of the following at December 31: 1996 1995 ---- ---- Office furnishings and equipment $1,130,428 $1,497,939 Leasehold improvements 529,600 713,970 Computer equipment and software 4,608,420 3,985,487 Automobiles 47,533 47,533 Assets held under capital lease 1,204,804 499,032 ---------- ---------- Total 7,520,785 6,743,961 Accumulated depreciation and amortization (3,117,755) (3,162,068) ----------- ----------- Property & equipment--net $4,403,030 $3,581,893 =========== ===========
change in corporate office locations, the Company disposed of office furniture and equipment having a net book value of approximately $120,000, for which it received only nominal proceeds. A charge for the net book value of the disposed assets is included in other income (expense) in the accompanying consolidated statements of operations.
1996 1995 ---- ---- Trading securities, at fair value $4,927,225 $9,250,349 Current securities available for sale, at fair value 507,050 1,811,624
Non-current securities available for sale, consisting primarily of debt securities, at fair value 7,417,599 1,834,981 ----------- ----------- Total carrying value of investments $12,851,874 $12,896,954 =========== ===========
Information with respect to unrealized holding gains and losses and trading securities, as of December 31, 1996 and 1995 is as follows:
Gross realized gains and losses from sales of securities available for sale totaled $19,717 and $5,497, respectively for the year ended December 31, 1996. Gross realized gains from sales of securities available for sale totaled $106,139 for the year ended December 31, 1995. Gross 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.
AMORTIZED FAIR COST VALUE --------- ---------- Due in one year or less $508,262 $507,050 Due after one year through five years 7,112,926 7,187,353 Due after five years 230,021 230,246 ---------- ---------- Total securities classified as available for sale $7,851,209 $7,924,649 ========== ==========
At December 31, 1996, treasury bonds, 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.
Tax benefits resulting from the 1993 operations of the Company's discontinued reinsurance subsidiary have been carried back to the prior three years for refunds of taxes paid in those years. The remaining tax benefits from the 1993 losses generated by the discontinued operation and the 1994 unusual charges will be carried forward for realization in future years. Based upon management's analysis of the positive and negative evidence regarding the likelihood of realization of this asset, a valuation allowance was deemed to be unnecessary.
1996 1995 ---------- ---------- Deferred home warranty revenue $6,686,461 $6,414,575 Deferred home warranty acquisition costs (2,309,536) (2,238,425) Litigation accrual 1,460,634 2,036,628 Deferred member fee revenue 312,457 487,601 Deferred member fee commissions (124,077) (191,052) Current portion of provision for loss on disposal of reinsurance operation 273,213 493,750 Miscellaneous 37,450 (106,157) ---------- ---------- Current portion of deferred income tax asset 6,336,602 6,896,920 Non-current portion of provision for loss on disposal of reinsurance operation 884,060 991,855 Provision for reinsurance recoverable 940,750 - NOL tax carryforward 1,528,737 342,292 Capitalized software (812,597) (659,554) AMT credit 699,015 699,015 ---------- ---------- Total deferred income tax asset $9,576,567 $8,270,528 ========== ==========
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. In reaching this determination, management reviewed the Company's historical performance, and projections of future results, should the Company's performance continue at the current level, exclusive of non-recurring events and transactions. These projections provided positive evidence of future probable realization of the full tax asset within the prescribed carryforward time frame. The projected realization also considered the negative impact of charges which could result from adverse resolution of certain outstanding contingencies; most notably the Company's guarantee to CNA of a $5 million reinsurance recoverable, related to the transfer of the POMG net assets. Negative evidence reviewed consisted of several non-recurring charges incurred by the Company over the past three years. As each of these charges was deemed to be unusual in nature, each of them different from the other, and there was no expectation of future recurrences of such items, the positive evidence was determined to outweigh the negative evidence.
The provision (benefit) for income taxes on income from continuing operations included in the accompanying consolidated statements of operations differs from the provision (benefit) computed using the statutory federal income tax rate (34%), due to the effects of the following items:
1996 1995 ---- ---- Net present value of obligation to CNA, discounted at 6% $3,075,397 $3,601,513 Obligations under capital leases 966,637 319,166 Other notes payable, due in monthly installments of $3,472 plus interest 90,278 208,507 ------ ------- Total 4,132,312 4,129,186
In connection with the CNA program, the Company is obligated to pay CNA $5 million. The Company makes payments against this obligation through reductions in the commission it earns on the premiums generated under the program (see Note 2). Accordingly, the Company has agreed to meet certain premium volume quotas (the "Quotas"), on an annualized basis, which will ensure that the obligation is paid in full over the term of the agreement, with scheduled minimum repayments. If, on an annualized basis, premium volume falls below the Quotas, a cash payment equal to 5% of the difference between actual premium volume and the Quotas must be made to CNA to be applied against the obligation to CNA. Additionally, there are specified minimum premium volume levels (the "Levels") which must be attained. If E&O premiums fall below the Levels, CNA may review the program, give the Company an opportunity to address the issue and then, at its option, may stop the program and take ownership of the Company's expiration list, and the Company may still be required to make a cash payment equal to 5% of the difference in the actual premium volume and the Quotas, to be applied against the obligation to CNA. As a result of the Company's failure in 1995 to meet the minimum Levels, in March 1996, the Company and CNA amended the agreement, waiving the minimum Levels. In
addition, the Quotas were modified to $17 million in 1995, $18 million in 1996, and $20 million for each year thereafter. The agreement to market CNA insurance exclusively to its membership was extended through December 31, 1999. As of December 31, 1996, the balance due CNA totaled approximately $3.1 million. The Company is currently in default, as it has failed to achieve the minimum Quotas, and the Company could be required by CNA to make a payment against its obligation to the Holdback Fund in the amount of approximately $200,000. However, the Company and CNA have entered into a further amendment to the Holdback Agreement which would delete the Quotas and the Levels, and release the Company from its current obligation to pay the remaining $3.1 million. Following the effective date of this amendment, the Company's obligation will be limited to payment of 50% of actual commissions to CNA. The proposed amendment becomes effective if the Merger is consummated prior to July 1, 1997, and the dispute with Sphere Drake (See Note 2) is settled within 14 days of the consummation of the Merger.
In early September 1994, the Company underwent an organizational restructuring, reducing its total work force by approximately 20%, or 40 employees, including clerical staff, supervisors, managers and executives. This restructuring is expected to result in annual cost savings of approximately $1,700,000, through reductions in salary, benefits and payroll tax expenses. The charge, consisting of payroll, related taxes and benefits of the terminated employees, and included in the `Unusual items' caption in the accompanying consolidated statements of operations, totaled approximately $1,063,000. Approximately $400,000 of this total related to an agreement to terminate the employment contract between the Company and its former Chairman of the Board of Directors. The plan to terminate employees was approved and carried out prior to September 30, 1994. The benefit arrangement awarded to the terminated employees was within the Company policy, or according to employment contracts with certain employees. As of December 31, 1994, approximately $923,000 had been paid against the liability, and $140,000 remained accrued and unpaid. There were no adjustments to the liability other than to reflect payments to terminated employees.
The Company, in the third quarter of 1994 ceased funding HGC. One time charges for severance pay of $80,000, the balance due under the subsidiary's lease agreements and other obligations of $371,000 and write-off of the subsidiary's net assets of $273,000, for a total of approximately $724,000, is included in the 'Unusual items' caption in the accompanying consolidated statements of operations. In 1995, the Company
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 9. UNUSUAL ITEMS (Continued) - -------------------------------------------------------------------------------
liquidated the subsidiary and negotiated reduced payments in full settlement of the balances owed, resulting in payment of approximately $175,000. The remaining accrued balance of $276,000 was reversed, and reflected in net income in the year ended December 31, 1995.
The Company currently rents office space in Sunrise, Florida, under a lease which expires on December 31, 2005. The lease requires annual increases of 3% of the base rent per square foot through the end of the lease term plus actual maintenance expenses and property tax increases. The Company also leases office space in one of the Corporate-Owned Regions for a remaining term of three years. Future minimum annual rental payments approximate $353,241 in 1997, $347,481 in 1998, $345,191 in 1999, $330,316 in 2000, $311,306 in 2001, and $1,702,347 thereafter. Rental expense for 1996, 1995 and 1994 approximated $593,000, $563,000 and $601,000, respectively, and is included in general and administrative expenses in the accompanying consolidated statements of operations.
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 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. In March, 1997, this suit was settled for $110,000, the charge for which is reflected in other income (expense) in the accompanying consolidated statements of operations.
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:
At December 31, 1995 $2.00 435,700 216,700 161,300 =========== ======== ======== =======
The Company applies APB No. 25 and related interpretations in accounting for its stock option plan to employees and non-employee members of the Board as described in Note 3. Accordingly, no compensation expense has been recognized in the year ended December 31, 1996 related to this plan. Had compensation costs for the Company's stock option plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS 123, 'Accounting for Stock-Based Compensation,' the Company's pro forma net loss for 1995 would have been $2,660,340. Pro forma primary and fully diluted loss per share for 1995 would have been $0.48. There were no options granted in 1996. The weighted average fair value of options granted during 1995 was estimated at $2.38, based upon the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions; no dividend yield, expected volatility of 47.7%, tax free interest rate of 5.78% and expected lives of five years.
In the fourth quarter of 1996, the Company recorded unusual charges for certain employee contract terminations and for its California office closing, in the approximate amount of $260,000. Also, in the fourth quarter, the Company charged to expense the balance due from its 50% Internet access provider joint venture in the amount of $150,000, and accrued $110,000 related to a lawsuit settlement with a former franchisee. The fourth quarter 1996 loss from discontinued operation consists of a provision of $2,500,000, related to the Sphere Drake reinsurance recoverable, for which the Company has guaranteed to CNA the validity of the reinsurance treaty. See also Note 10.