We operate in two business segments: subscription business and other business. We generate revenue in our subscription business segment primarily from subscription fees for our medical insurance, which we market to consumers. Fees are paid at the beginning of each subscription period, which automatically renews on a monthly basis. We generate revenue in our other business segment by writing policies on behalf of third parties. We do not undertake the marketing efforts for these policies and have a business-to-business relationship with these third parties. Our other business segment also includes revenue from companies or organizations that choose to offer medical insurance for cats and dogs as a benefit to their employees or members, and contracts include multiple pets. The products in our other business segment may be materially different from our subscription business. Our ultimate goal is to build the Trupanion brand by continuing to offer the highest value proposition in the industry and maintain strong alignment with the veterinary community. We believe our activities in our other business segment benefit the overall market for pet medical insurance by expanding upon product options and distribution models within other market niches.
We generate leads for our subscription business through both third-party referrals and direct-to-consumer acquisition channels, which we then convert into members through our website and contact center. Veterinary hospitals represent our largest referral source. We engage our Territory Partners to have face-to-face visits with veterinarians and their staff. Territory Partners are dedicated to cultivating direct veterinary relationships and building awareness of the benefits of high quality medical insurance to veterinarians and their clients. Veterinarians then educate pet owners, who visit our website or call our contact center to learn more about, and potentially enroll in, Trupanion. We also receive a significant number of new leads from existing members adding pets and referring their friends and family members. Our direct-to-consumer acquisition channels serve as important resources for pet owner education and drive new member leads and conversion. We monitor average pet acquisition cost to evaluate the efficiency of our sales and marketing programs in acquiring new members and measure effectiveness based on our desired return on investment.
Monthly average revenue per pet. Monthly average revenue per pet is calculated as amounts billed in a given period for subscriptions divided by the total number of subscription pet months in the period. Total subscription pet months in a period represents the sum of all subscription pets enrolled for each month during the period. We monitor monthly average revenue per pet because it is an indicator of the per pet unit economics of our subscription business.
Average monthly retention. Average monthly retention is measured as the monthly retention rate of enrolled subscription pets for each applicable period averaged over the 12 months prior to the period end date. As such, our average monthly retention rate as of December 31, 2019 is an average of each month’s retention from January 1, 2019 through December 31, 2019. We calculate monthly retention as the number of pets that remain after subtracting all pets that cancel during a month, including pets that enroll and cancel within that month, divided by the total pets enrolled at the beginning of that month. We monitor average monthly retention because it provides a measure of member satisfaction and allows us to calculate the implied average subscriber life in months.
Year ended December 31, 2019 compared to year ended December 31, 2018. Cost of revenue for our subscription business segment was $262.1 million, or 82% of revenue, for the year ended December 31, 2019, compared to $216.0 million, or 82%, of revenue for the year ended December 31, 2018. This $46.1 million increase in subscription cost of revenue was primarily the result of a 15% increase in subscription pets enrolled and an increase of 6% in veterinary invoice expense per pet due to increases in the cost and utilization of veterinary care. Cost of revenue for our other business segment increased by $20.3 million, or 55%, to $56.9 million for the year ended December 31, 2019, primarily due to the increase in enrolled pets in this segment.
Year ended December 31, 2019 compared to year ended December 31, 2018. The change in our effective tax rate from 2018 to 2019 was primarily caused by an increase in our net deferred tax liability resulting from an increase in the effective state tax rate.
The following table summarizes our cash flows for the periods indicated (in thousands):
Our primary sources of liquidity are cash provided by operations and available borrowings on our line of credit. In June 2018, we increased the borrowing capacity on our line of credit from $30.0 million to $50.0 million. In addition, we completed the June 2018 follow-on public offering, raising aggregate net proceeds of $65.7 million, primarily to fund the purchase of our home office building in August 2018. Our primary requirements for liquidity are paying veterinary invoices, funding operations and capital requirements, investing in new member acquisition, investing in enhancements to our member experience, and servicing debt.
Net cash used in investing activities for the year ended December 31, 2019 was primarily related to the net purchase of investments to increase our statutory capital. As of December 31, 2019, we had $74.0 million in short-term and long-term investments in our insurance entities, APIC and WICL Segregated Account AX. These investments are held to satisfy statutory requirements and we anticipate that we will need to maintain greater amounts of risk-based capital if our pet enrollments continue to grow. Net cash used in investing activities decreased by $53.4 million for the year over year, primarily related to the $55.0 million cash portion of the building acquisition in August 2018.
We enter into long-term contractual obligations and commitments in the normal course of business, primarily debt obligations and non-cancellable vendor service agreements. For enforceable and legally binding contracts, our contractual cash obligations as of December 31, 2019 are set forth below (in thousands):
(1) Consists of our revolving line of credit. Excludes interest of the greater of 4.5% or 0.75% plus the prime rate (5.50% at December 31, 2019).
We use the paid loss development method (chain-ladder method) to estimate reserves for veterinary invoices for our subscription and for the majority of our other business segment. Paid loss development factors are estimated based on historical paid loss triangles. The reserve represents our estimate of the future amount we will pay for veterinary invoices that are dated as of, or prior to, our balance sheet date. The reserve also includes our estimate of related internal processing costs. To determine the accrual, we make assumptions based on our historical experience, including the number of veterinary invoices we expect to receive, the average cost of those veterinary invoices, the length of time between the date of the veterinary invoice and the date we receive it, and our expected cost to process and administer the payments. As of each balance sheet date, we reevaluate our reserve and may adjust the estimate for new information.
Compensation expense related to stock-based transactions, including employee and non-employee stock option awards, restricted stock awards, and restricted stock units, is measured and recognized in the financial statements based on fair value. The fair value of stock options is estimated on the measurement date using the Black-Scholes option-pricing model that requires management to apply judgment and make estimates, including:
Expected term for awards granted to employees -We have based our expected term for awards issued to employees on the simplified method, as permitted by the SEC Staff Accounting Bulletin Topic 14, Share-Based Payment;
Stock-based compensation expense for stock options, restricted stock awards, and restricted stock units is recognized on a straight-line basis over the requisite service period, which is generally the vesting period of the respective award. We recognize forfeitures when they occur.
We have audited the accompanying consolidated balance sheets of Trupanion, Inc. (the Company) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive loss, changes in stockholders' equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and the financial statement schedule listed in the Index at Item 15(a) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We evaluated the design and tested the operating effectiveness of controls over the reserve for veterinary invoices process, including controls over the completeness and accuracy of the data used in management’s actuarial projections and the review and approval processes that management has in place for the methods and assumptions used by management’s actuaries in estimating the reserves.
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts and related disclosures. Actual results could differ from such estimates.
Receivables are comprised of trade receivables and other miscellaneous receivables. Accounts and other receivables are carried at their estimated collectible amounts. Accounts receivable balance is primarily related to the Company’s other business segment where the Company generates revenue from underwriting policies through unaffiliated general agents. These policies are typically annual policies, with monthly payment terms through the end of the twelve-month period. The Company had $50.0 million and $27.6 million accounts receivable associated with underwriting these policies as of December 31, 2019 and 2018, respectively.
The Company evaluates whether declines in the fair value of its investments below book value are other-than-temporary. This evaluation includes the Company's ability and intent to hold the security until an expected recovery occurs, the severity and duration of the unrealized loss, as well as all available information relevant to the collectability of the security, including past events, current conditions, and reasonable and supportable forecasts, when developing estimates of cash flows expected to be collected.
Level 1 - Quoted prices in active markets for identical assets or liabilities
Acquired finite-lived intangibles are amortized on a straight-line basis over the estimated useful lives of the assets. Indefinite-lived intangible assets are not amortized. The Company reviews these assets for impairment at least annually or if indicators of potential impairment exist.
Other income, net, was $1.6 million, $1.3 million, and $1.2 million, including interest income of $1.7 million, $0.9 million, and $0.2 million for the years ended December 31, 2019, 2018, and 2017, respectively. Other income in the year ended December 31, 2017 included a gain of $1.0 million from the sale of the Company's equity method investment.
Advertising costs are expensed as incurred, with the exception of television advertisements, which are expensed the first time each advertisement is aired. Advertising costs amounted to $7.8 million, $6.3 million and $4.9 million, in the years ended December 31, 2019, 2018 and 2017, respectively.
The Company’s consolidated financial statements are reported in U.S. dollars. Assets and liabilities denominated in foreign currencies were translated to U.S. dollars, the reporting currency, at the exchange rates in effect on the balance sheet date. Revenue and expenses denominated in foreign currencies were translated to U.S. dollars using a weighted-average rate for the relevant reporting period. Cumulative translation adjustments of $0.4 million, $0.7 million, and $0.1 million were recorded in accumulated other comprehensive loss as of December 31, 2019, 2018, and 2017, respectively.
For the Company’s Canadian business, all plans are written by Omega and the risk is assumed by the Company through a fronting and reinsurance agreement. Premiums are recognized and earned pro rata over the terms of the related customer contracts. Revenue recognized from the agreement in 2019, 2018, and 2017 was $67.5 million, $57.4 million and $47.1 million, respectively, and deferred revenue relating to this arrangement at December 31, 2019 and 2018 was $2.7 million and $2.1 million, respectively. Reinsurance revenue was 18% of total revenue in 2019 and was 19% in 2018 and 2017. Cash designated for the purpose of paying claims related to this reinsurance agreement was $4.6 million and $3.9 million at December 31, 2019 and 2018, respectively. In addition, as required by the Office of the Superintendent of Financial institutions regulations related to the Company’s reinsurance agreement with Omega, the Company is required to fund a Canadian Trust account with the greater of CAD $2.0 million or 115% of unearned Canadian premium plus 15% of outstanding Canadian claims, including all incurred but not reported claims. As of December 31, 2019, the account balance was CAD $4.3 million and the Company was in compliance with all requirements.
The Company adopted Accounting Standards Update (ASU) No. 2016-02 Leases (Topic 842), as amended, using the modified retrospective approach under which the transition provisions were applied as of January 1, 2019. In addition, the Company elected the “package of practical expedients” under the transition guidance within the new standard to not reassess prior conclusions about lease identification, lease classification, and initial direct costs for existing lease contracts. The Company also elected the practical expedient to not separate lease and non-lease components, if any, for all lease contracts.
Upon adoption of this standard, the Company recorded approximately $0.1 million right-of-use assets and lease liabilities for operating leases. They were classified as other long-term assets and other liabilities on the Company's consolidated balance sheets. The standard did not have a material impact on the Company's consolidated statements of operations, stockholders' equity, or cash flows.
Depreciation expense related to property and equipment was $4.7 million, $4.3 million and $4.2 million for the years ended December 31, 2019, 2018 and 2017, respectively.
In August 2018, the Company purchased a real property that houses the company headquarters located at 6100 Fourth Avenue South, Seattle, Washington. The real estate acquisition was determined to be an asset acquisition, with the purchase price allocated based on relative fair value of the assets acquired. Additionally, acquisition-related expenses were capitalized as part of the purchase price. The purchase price was $65.2 million, consisting of $55.0 million in cash, 303,030 shares of common stock with an estimated fair value of $9.6 million, and transaction costs totaling $0.6 million. The issued shares are subject to a lock-up period that continues to and includes June 25, 2020. The fair value of the issued shares was estimated as of the closing date for the real estate acquisition using the Black-Scholes option pricing model and the following assumptions:
The Company assessed fair value on the date of the acquisition based on Level 3 inputs within the fair value framework, which included estimated cash flow projections that utilized appropriate discount rates, capitalization rates, renewal probability and available market information, which included market rental rates and market rent growth rates. Estimates of future cash flows were based on a number of factors including historical operating results, known and anticipated trends, and market and economic conditions.
The lease-related intangible assets relate to in-place lease agreements associated with the building acquisition in August 2018 and have a remaining weighted-average useful life of 3.4 years. Patents, trademarks, and other intangible assets have a remaining weighted-average useful life of 9.9 years.
Amortization expense associated with intangible assets was $0.9 million and $0.2 million for the years ended December 31, 2019 and 2018, respectively. There was no amortization expense associated with intangible assets in 2017.
The amortized cost, gross unrealized holding gains and losses, and fair value of long-term and short-term investments by major security type and class of security were as follows as of December 31, 2019 and 2018 (in thousands):
In September 2018, the Company acquired a non-controlling equity interest in a joint venture, whereby it has committed to licensing certain intellectual property and contributing up to $2.2 million AUD upon the achievement of specific operational milestones over a period of at least four years from the agreement execution date. As of December 31, 2019, the Company has contributed $0.5 million AUD. This equity investment is accounted for using the equity method and is classified in other long-term assets on the Company's consolidated balance sheet. The Company's share of income and losses from this equity method investment is included in gain (loss) from investment in joint venture on its consolidated statement of operations. Also included in this line item are income and expenses associated with administrative services provided to the joint venture.
The Company purchased $4.0 million and $3.0 million in preferred stock in the variable interest entity for the year ended December 31, 2019 and 2018, respectively. The preferred stock investment is accounted for as an available-for-sale debt security, and measured at fair value at each balance sheet date. The estimated fair value of the preferred stock investment is a Level 3 measurement, and is based on certain unobservable inputs such as the value of the underlying enterprise, volatility, time to liquidity, and market interest rates. An increase or decrease in any of these unobservable inputs would result in a change in the fair value measurement. Fair value was $7.6 million and $3.0 million as of December 31, 2019 and 2018, respectively. The Company recognized a $0.6 million unrealized gain in other comprehensive income (loss) for the year ended December 31, 2019.
The Company recognizes transfers between levels of the fair value hierarchy on the date of the event or change in circumstances that caused the transfer. There were no transfers between levels for the year ended December 31, 2019 and 2018.
The following summarizes the Company's contractual commitments as of December 31, 2019 (in thousands):
(1) Consists of a revolving line of credit. Excludes interest of the greater of 4.5% or 0.75% plus the prime rate (5.50% as of December 31, 2019).
In addition, from time to time the Company is or may become subject to various legal proceedings arising in the ordinary course of business, including proceedings against members, other entities or regulatory bodies. Estimated liabilities are recorded when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. At this time, the Company does not believe any such matters to be material individually or in the aggregate. These views are subject to change following the outcome of future events or the results of future developments.
The following table summarizes the development of veterinary invoice expense, on a constant currency basis, for the Company's subscription business segment by year of occurrence (in thousands, except for cumulative number of veterinary invoices data):
Borrowings on the revolving line of credit were limited to the lesser of $50.0 million or the total amount of cash and securities held by the Company's insurance subsidiaries (American Pet Insurance Company and Wyndham Insurance Company (SAC) Limited Segregated Account AX), less amounts outstanding relating to other ancillary services and letters of credit. As of December 31, 2019, available borrowing capacity on the line of credit was $23.3 million, with an outstanding balance of $0.5 million for ancillary services and letters of credit, and borrowings under the facility of $26.2 million, recorded net of financing fees of $0.1 million.
The grant date fair value of stock option awards are estimated on the date of grant using the Black-Scholes option-pricing model. The Company did not grant any stock options during the years ended December 31, 2019 and 2018. For the year ended December 31, 2017, valuation assumptions are presented in the following table:
The Company leases certain office space and equipment from third parties and recognizes lease expense on a straight-line basis over the lease term. Leases with an initial term of 12 months or less are not recorded on its consolidated balance sheets. Minimum rent payments under operating leases are recognized on a straight-line basis over the term of the lease. Rental expense for operating leases was $0.4 million, $1.4 million and $1.8 million for the years ended December 31, 2019, 2018 and 2017, respectively.
The Company also leases a portion of its building acquired in August 2018 to third parties and records related rental income within general and administrative expense in the consolidated statements of operations. These leases have remaining initial lease terms of 2 years to 8 years, some of which give the tenants options to renew the leases for up to an additional 10 years, and options to terminate the leases after 3 years of the initial lease terms, with early termination fees required. The Company recorded rental income of $2.2 million and $0.9 million for the years ended December 31, 2019 and December 31, 2018, respectively.
The following table summarizes the Company's future rental payments to be received from non-cancellable leases in place as of December 31, 2019 (in thousands):
The statutory net income for 2019, 2018 and 2017 and statutory capital and surplus at December 31, 2019, 2018 and 2017, for the Company’s insurance subsidiary in New York were as follows (in thousands):
The components of income tax expense (benefit) were as follows (in thousands):
A valuation allowance is required to reduce the deferred tax assets reported if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. After consideration of all the evidence, both positive and negative, the Company has recorded a full valuation allowance against its U.S. Federal deferred tax assets as of December 31, 2019 and 2018 because the Company’s management has determined that it is more likely than not that these assets will not be fully realized.
The Company is open to examination by the U.S. federal tax jurisdiction for the years ended December 31, 2016 through 2019. The Company is also open to examination for 2007 and forward with respect to net operating loss carryforwards generated and carried forward from those years in the United States. The Company is open to examination by the Canada Revenue Agency for the years ended December 31, 2015 through 2019 for all corporate tax matters, and open for the years ended December 31, 2012 through 2019 for transactions with non-arm’s length non-Canadian residents.
The Tax Act implemented a new tax on foreign subsidiary income. The Company books Global Intangible Low-Taxed Income ("GILTI") on a current basis and does not book deferred taxes related to GILTI.
The following table contains quarterly financial data for the years ended December 31, 2019 and 2018 (in thousands, except per share data). The unaudited quarterly information has been prepared on a basis consistent with the audited consolidated financial statements and includes all adjustments that the Company considers necessary for a fair presentation of the information shown. The operating results for any fiscal quarter are not necessarily indicative of the operating results for a full fiscal year or any future period and there can be no assurances that any trend reflected in such results will continue in the future.