- ----------- (1) The loss ratio represents Membership benefit costs as a percentage of Membership premiums. The product cost ratio represents product costs as a percentage of product sales. The expense ratio represents the total of commissions, general and administrative expenses and premium taxes as a percentage of Membership premiums and product sales. These ratios do not measure total profitability because they do not take into account all revenues and expenses.
Of the shares of Company common stock issued in the TPN merger, 125,000 shares were placed in escrow pending the resolution of certain possible and specified contingencies, including contingencies relating to pending or threatened litigation against TPN at the time of the Merger.
Membership Premiums and Membership Benefit Costs The Company's principal revenues are derived from Membership premiums, most of which are collected on a monthly basis. Memberships are generally guaranteed renewable and non-cancelable except for fraud, non-payment of Membership premiums or upon written request by the member.
Membership benefit costs vary depending on the type of Membership. Closed panel plans provide the Membership benefits through a designated provider attorney with whom the Company has arranged for the services to be provided in a particular geographic area. Provider attorneys receive a fixed monthly payment for each member in their service area and are responsible for providing the Membership benefits without additional remuneration. The fixed cost aspect of closed panel plans provides significant advantages to the Company in managing its claims risk. Under closed panel plans, the Company has the ability to more effectively monitor the quality of legal services provided and, due to the volume of claims that may be directed to particular provider attorney law firms, has access to larger, more diversified law firms. At December 31, 1998, approximately 94% of the Company's Memberships were closed panel plans compared to 91% at December 31, 1997.
Membership benefit costs relating to open panel Memberships, which constituted approximately 6% of Memberships in force at December 31, 1998, are based on the usual, reasonable and customary fee for providing the required services. Such costs are generally paid on a current basis, as most costs are certain in amount and require only limited investigation. The Company maintains a reserve for estimated incurred but not reported open panel Membership benefit costs as well as costs which are in the payment process. These reserves are reviewed annually by an independent actuary as necessary in conjunction with the preparation and filing of financial statements and other reports with various state insurance regulatory authorities. Underwriting risks associated with the open panel Memberships are managed primarily through contractual benefit limitations and, as a result, underwriting decisions are not necessarily based on individual Membership purchases.
Product sales and product costs Product sales consist primarily of the sale of personal and home care products, jewelry, books, audiocassettes and videotapes focusing on personal achievement. Other products and services include digital satellite television subscriptions, Internet access and web sites, long distance and travel services provided by business partners. The Company has certain alliances with business partners, whereby sales associates buy or sell products or services provided by such business partners and in return, the Company receives commissions on the sales of such goods and services and compensates the selling associates with a commission. Revenues from these transactions are included in Product sales in the Statement of Income.
Product costs consist primarily of the commissions paid to selling associates together with the actual cost paid to acquire such goods and services. Costs to purchase products and deliver services are included in Product costs in the Statement of Income
Prior to January 1997 the Company advanced commissions at the time of sale of all new Memberships. In January 1997, the Company implemented a policy whereby the associate receives only earned commissions on the first three sales unless the associate has successfully completed the new training program that was implemented at the same time. For all sales beginning with the fourth Membership or all sales made by an associate successfully completing the new training program, the Company currently advances commissions at the time of sale of a new Membership. The amount of cash potentially advanced upon the sale of a new Membership, prior to the recoupment of any charge-backs (described below), represents an amount equal to up to three years commission earnings. Although the average number of marketing associates receiving an advance commission payment on a new Membership is 11, the overall initial advance may be paid to more than twenty different individuals, each at a different level within the overall commission structure. This commission advance immediately increases an associate's account with the Company and represents prepaid commissions on active Memberships.
Should a Membership lapse before the advances have been recovered for each commission level, the Company immediately generates a "charge-back" to the applicable sales associate to recapture 50% of any unearned advance. This charge-back is immediately deducted from any future advances that would otherwise be payable to the associate for additional new Memberships. The Company historically has been able to immediately recover the majority of such charge-backs. Any remaining unrecovered advance on a Membership that has lapsed represents a receivable from the associate and is reflected as commission advances and is categorized as current or non-current based on the expected recovery period. Additionally, even though a commission advance may have been fully recovered on a particular Membership, no additional commission earnings from any Membership will be paid to an associate until all previous advances on all Memberships, both active and lapsed, have been recovered. During 1998, 22% of all associates submitting new Memberships accounted for 75% of all such new Memberships produced thereby further enhancing the recovery of commission advances.
TPN distributors receive commissions from the sale of personal and home care products, personal development products, communication services and satellite subscription sales. These commissions are paid to the distributor actually making the sale as well as other distributors in his organization. Commissions on goods and services are not advanced and have averaged approximately 32% of the product sales price. These commissions are paid at the time of sale and subject to recovery only in the event of returned goods or refunds.
Membership Persistency One of the major factors affecting the Company's profitability and cash flow is Membership persistency, which represents the ability of the Company to retain a Membership, and therefore receive premiums, once it has been written. The Company monitors its overall Membership persistency rate, as well as the persistency rates with respect to Memberships sold by individual associates and agents and persistency rates with respect to Membership sales by geographic region and payment method. The Company's Membership persistency rate measures the number of Memberships in force at the end of a year as a percentage of the total of (i) Memberships in force at the beginning of such year, plus (ii) new Memberships sold during such year. From 1981 through the year ended December 31, 1998, the Company's annual Membership persistency rates, using the foregoing method, have averaged approximately 75%. The annual Membership persistency rates were 73.8%, 73.6% and 73.9% for 1998, 1997 and 1996, respectively. The Company's overall Membership persistency rate varies based on, among other factors, the relative age of total Memberships in force. The Company's overall Membership persistency rate could be lower when the Memberships in force include a higher proportion of newer Memberships. During the last three years, the Company has experienced significant increases in new Membership sales and, as a result, the percentage of newer Memberships in its total Memberships in force has increased. Unless offset by other factors, this increase could result in a decline in the Company's overall Membership persistency rate as determined by the formula described above, but does not necessarily indicate that the new Memberships written are less persistent, only that the ratio of new Memberships to total Memberships is higher than it averaged during the 1981 through 1998 period. The Company's financial condition and results of operations may be materially adversely affected if the persistency rates of existing and new Memberships are materially lower than the Company's historical experience.
Operating Ratios Three principal operating measures monitored by the Company in addition to Membership persistency are the loss ratio, product cost ratio and the expense ratio. The loss ratio represents Membership benefit costs as a percentage of Membership premiums. The product cost ratio represents product costs as a percentage of product sales. The expense ratio represents the total of commissions, general and administrative expenses and premium taxes as a percentage of Membership premiums and product sales. The Company strives to maintain these ratios as low as possible. These ratios do not measure total profitability because they do not take into account all revenues and expenses.
Income Tax Matters-Net Operating Losses At December 31, 1998, the Company had net operating loss carryforwards ("NOLs") for Federal regular and alternative minimum tax purposes of approximately $3.0 million and $2.6 million, respectively, expiring in 2011 and 2012. In addition, the Company had general business and rehabilitation tax credit carryforwards of approximately $307,000 expiring primarily in 1999 to 2001, and an alternative minimum tax ("AMT") credit carryforward of $366,000 that does not expire. No valuation allowance has been established for these deferred tax assets as the Company believes it is more likely than not that the tax benefits of such deferred tax assets will be realized. The Company generated taxable income for the year ended December 31, 1998 of $11.5 million and utilized NOLs originally generated in 1986 through 1995 in their entirety and $2.3 million of the $2.8 million NOL originally generated in 1996. Tax expense for 1998 was reduced during the fourth quarter of 1998 through a reduction in a previously established valuation allowance to reflect this utilization of deferred tax benefits. Additionally, the Company has NOLs in the amount of $5.7 million representing the NOLs of TPN as of the acquisition date. A valuation allowance has been established for these NOLs as the Company does not believe it is more likely than not that the tax benefits of these carryforwards will be realized due to utilization restrictions imposed by Section 382 discussed below.
Associate Services The Company derives revenues from services provided to its marketing sales force, principally from a one-time enrollment fee of approximately $65 from each new sales associate and the sale of marketing supplies and promotional materials to associates on an ongoing basis. In January 1997, the Company implemented a training program ("Fast Start") that allows an associate who successfully completes the program to advance through the various commission levels at a faster rate. Associates participating in this program pay a one-time fee of $249 instead of the $65 fee. The increased fee covers the additional training and materials used in the training program. The Company enrolled 75,737 new sales associates during 1998 compared to 58,121 during 1997 and 69,789 during 1996, resulting in significant increases in associate services revenues and costs. The Company's direct costs of providing materials and services to associates are reflected as costs of associate services and direct marketing. Amounts collected from sales associates are intended primarily to offset the Company's direct and indirect costs incurred in recruiting, monitoring and providing materials to sales associates and are not intended to generate material profits from such activities.
TPN's revenues were primarily comprised of receipts for goods and services provided by TPN to their distributors and other customers. Distributors were required to purchase a distributor kit that included training materials and business support literature. TPN distributors were required to meet certain sales production levels to be eligible to receive commissions and many distributors elected to purchase products through an automatic monthly bank or credit card draft. These practices, which resulted in enhanced product sales, have been discontinued in February 1999.
As of December 31, 1998, substantially all of the Company's investments were in investment grade (rated Baa or higher) fixed-maturity investments, interest-bearing money market accounts and a collateralized repurchase agreement. The Company does not hold any investments classified as trading account assets or derivative financial instruments.
The table above illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at December 31, 1998 would reduce the estimated fair value of the Company's fixed-maturity investments by approximately $1.8 million at that date.
Year 2000 Issues The Company has conducted a comprehensive review of its systems, including both information technology (e.g. computer databases) and non-information technology systems (e.g. building utilities) that use date data, to identify the systems that could be affected by the "Year 2000" issue and has developed a plan to resolve the issue. The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's affected programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a major system failure or miscalculations.
Testing and conversion of system applications commenced during 1993 and was substantially completed during 1998. Testing of the Company's information technology systems (as modified for Year 2000 issues) with system dates set beyond January 1, 2000 successfully occurred in February 1999. Costs incurred through the end of 1998 have been immaterial and expensed as incurred and the remaining total cost of the Company's remediation efforts is expected to be less than $50,000, substantially all of which will be incurred on further testing during the remainder of 1999. Any additional Year 2000 costs will continue to be funded out of cash flow from operations. A significant portion of the Company's Year 2000 remediation plan has been and will continue to be accomplished by the Company's internal programming staff and while such efforts will continue on Year 2000 programming, these costs are not likely to be incremental costs to the Corporation, but rather will represent the redeployment of existing information technology resources. Although concentration on Year 2000 compliance has delayed other programming projects, such delays have not had and are not expected to have a material adverse impact on the Company's financial condition or results of operations.
Comparison of 1998 to 1997 The Company reported net income applicable to common shares of $30.2 million, or $1.26 per diluted common share, for 1998, up 72% from net income applicable to common shares of $17.5 million, or $.74 per diluted common share, for 1997. The increase in the net income applicable to common shares for 1998 is primarily the result of increases in Membership premiums for 1998 as compared to 1997.
Membership premiums totaled $110.0 million during 1998 compared to $76.7 million for 1997, an increase of 43%. Membership premiums and their impact on total revenues in any period are determined directly by the number of active Memberships in force during any such period. The active Memberships in force are determined by both the number of new Memberships sold in any period together with the persistency, or renewal rate, of existing Memberships. New Membership sales increased 38% during 1998 to 391,827 from 283,723 during 1997. At December 31, 1998, there were 603,017 active Memberships in force compared to 425,381 at December 31, 1997, an increase of 42%. Additionally, the average annual premium per Membership has increased from $225 for all Memberships in force at December 31, 1997 to $229 for all Memberships in force at December 31, 1998, a 2% increase, as a result of a higher portion of active Memberships containing the additional pre-trial hours benefit at an additional cost to the member together with increased sales of the Business Owners' Legal Solutions plan.
General and administrative expenses during 1998 and 1997 were $21.9 million and $20.3 million, respectively, and represented 14% and 15% of total revenues for such years. Although the total amount of general and administrative expenses increased approximately $1.6 million during 1998, these expenses, as a percent of total revenues, decreased 1%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of total revenues should continue as a result of certain economies of scale pertaining to the Company's operating leverage.
Membership premiums totaled $76.7 million during 1997 compared to $50.6 million for 1996, an increase of 52%. Membership premiums and their impact on total revenues in any period are determined directly by the number of active Memberships in force during any such period. The active Memberships in force are determined by both the number of new Memberships sold in any period together with the persistency, or renewal rate, of existing Memberships. New Membership sales increased 46% during 1997 to 283,723 from 194,483 during 1996. At December 31, 1997, there were 425,381 active Memberships in force compared to 294,151 at December 31, 1996. Additionally, the average annual premium per Membership has increased from $216 for all Memberships in force at December 31, 1996 to $225 for all Memberships in force at December 31, 1997, a 4.0% increase, as a result of a higher portion of active Memberships containing the additional pre-trial hours benefit at an additional cost to the member together with increased sales of the Business Owners' Legal Solutions Plan.
Associate services revenue increased 115% from $5.6 million for 1996 to $12.1 million during 1997 primarily as a result of Fast Start that resulted in the Company receiving training fees of approximately $5.7 million during 1997. The $5.7 million in training fees was comprised of $184 from each of approximately 28,900 new sales associates who elected to participate in Fast Start and training fees of $25 from each of approximately 14,500 existing associates who participated in the program. New associates enrolled during 1997 were 58,121 compared to 69,789 for 1996, a decrease of 17%. The Company believes that the decline in new associate enrollment during 1997 is primarily attributable to the increased costs associated with the Fast Start program. However, while the number of new associates decreased during 1997, the number of new Memberships sold, at least partially as a result of the Fast Start program, increased significantly. Future revenues from associate services will depend primarily on the number of new associates enrolled and the number who choose to participate in the Company's training program, but the Company expects that such revenues will continue to be largely offset by the direct and indirect cost to the Company of training bonuses paid, providing associate services and other direct marketing expenses.
Primarily as a result of the increase in Membership premiums, total revenues increased to $133.4 million for 1997 from $85.6 million during 1996, an increase of 56%.
Product costs increased more than $6.4 million, or 31%, during 1997 to $27.0 million from $20.6 million for 1996 in conjunction with the 55% increase in product sales. Product costs as a percentage of product sales were 66% for 1997 compared to 78% during 1996.
General and administrative expenses during 1997 and 1996 were $20.3 million and $15.2 million, respectively, and represented 15% and 18% of total revenues for such years. Although the total amount of general and administrative expenses increased approximately $5.2 million during 1997, these expenses, as a percent of total revenues, decreased 3%. This trend of gradual increases in the total dollar amount of these expenses but decreases when expressed as a percentage of total revenues should continue as a result of certain economies of scale pertaining to the Company's operating leverage.
Due to property and equipment additions during 1997 of $3.6 million, depreciation increased from $533,000 for 1996 to $2.0 million for 1997.
Provision for income taxes increased significantly during 1997 to $12.4 million compared to $5.9 million for 1996, which represented an increase from 36.3% of income before income taxes during 1996 to 41.4% of income before income taxes for 1997. In 1997 TPN established a valuation allowance of $1.9 million for the portion of its deferred tax asset that TPN believed more likely than not would not be realized because it was unlikely that it would generate sufficient taxable income to realize the benefits from its deferred tax benefits.
General Consolidated net cash provided by operating activities was $9.9 million and $14.5 million for 1998 and 1997, respectively, compared to net cash used in operating activities of $911,000 for 1996. Cash provided by operating activities decreased $4.6 million during 1998 compared to 1997 primarily due to the $12.7 million increase in net income and an increase of $1.3 million in prepaid product commissions which was offset by the $11.1 million decrease in accounts payable and accrued expenses, the $5.2 million increase in commission advances, the $1.2 million decrease in the provision for deferred income taxes and $1.6 million decrease in deferred revenue.
Due to the UFL acquisition previously discussed and the resulting requirement for $20.7 million as cash consideration to Pioneer, the Company liquidated a substantial portion of its investments previously classified as held-to-maturity. Although the Company previously had demonstrated its intent and capability to hold such investments until their scheduled maturities, the conversion of such investments to cash as part of the UFL transaction prior to their scheduled maturities resulted in all remaining investments of the Company, including the $25 million investment portfolio of UFL, being classified as available-for-sale investments. In addition to capital expenditures of $4.9 million during 1998, the Company has continued to move larger portions of its cash and cash equivalents into longer-term investments resulting in net cash used in investing activities of $31.4 million.
Net cash provided by financing activities decreased $1.1 million during 1998 to $2.4 million from $3.5 million for 1997 as a result of $1.5 million used to reacquire treasury stock and only offset by $500,000 increase in capital lease obligations. In 1996, the Company had net cash provided by financing activities of $5.0 million, primarily as a result of exercise proceeds of stock options and stock issuances of $4.9 million.
The Company generally advances significant commissions at the time a Membership is sold. During 1998, the Company advanced commissions of $51.4 million on new Membership sales compared to $38.1 million for 1997. Since approximately 92% of Membership premiums are collected on a monthly basis, a significant cash flow deficit is created at the time a Membership is sold. This deficit is reduced as monthly premiums are remitted and no additional commissions are paid on the Membership until all previous commission advances have been fully recovered. Commission advances were subsequently reduced by commission earnings of $23.0 million and $14.9 million for 1998 and 1997, respectively. The Company has recorded an allowance of $4.0 million to provide for estimated uncollectible commission advances which includes an increase in the allowance of $250,000 during 1998.
The Company believes that it has significant ability to finance expected future growth in Membership sales based on its existing amount of cash and cash equivalents and unpledged investments at December 31, 1998 of $47.2 million.
Consolidated Financial Statements - --------------------------------- Consolidated Balance Sheets - December 31, 1998 and 1997 Consolidated Statements of Income - For the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Comprehensive Income - For the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Cash Flows - For the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Changes In Stockholders' Equity - For the years ended December 31, 1998, 1997 and 1996 Notes to Consolidated Financial Statements
Consolidated Financial Statement Schedule - ----------------------------------------- Schedule II. Consolidated Valuation and Qualifying Accounts - For the years ended December 31, 1998, 1997 and 1996 (All other schedules have been omitted since the required information is not applicable or because the information is included in the consolidated financial statements or the notes thereon.)
We have audited the accompanying consolidated balance sheets of Pre-Paid Legal Services, Inc. and subsidiaries (the "Company") as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed at Item 8 herein. These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. The consolidated financial statements give retroactive effect to the merger of the Company and TPN, Inc. d.b.a. The People's Network ("TPN"), which has been accounted for as a pooling of interests as described in Note 2 to the consolidated financial statements. We did not audit the balance sheet of TPN as of December 31, 1997, or the related statements of income, changes in stockholders' equity, and cash flows of TPN for the years ended December 31, 1997 and 1996, which statements reflect total assets constituting 13% of the related consolidated financial statement total, and total revenues constituting 31% of the related consolidated financial statement totals for each of the years ended December 31, 1997 and 1996. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included for TPN for 1997 and 1996, is based solely on the reports of such other auditors.
In our opinion, based on our audits and the reports of the other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of Pre-Paid Legal Services, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, based on our audits and (as to the amounts included for TPN) the reports of other auditors, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
To the Board of Directors of TPN, Inc. dba The People's Network:
We have audited the balance sheet of TPN, Inc. dba The People's Network (a Texas corporation) ("TPN"), as of December 31,1997, and the related statements of operations, shareholders' deficit and cash flows for the year then ended, prior to the restatement (and, therefore, are not presented herein) for the merger of Pre-Paid Legal Services, Inc. ("Pre-Paid") with TPN on October 2, 1998, which has been accounted for as a pooling of interests as described in Notes 1 and 2 to the Pre-Paid consolidated financial statements. These financial statements are the responsibility of TPN's management. Our responsibility is to express an opinion on these financial statements based on our audit.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of TPN, Inc. d.b.a. The Peoples Network as of December 31, 1997, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles.
Dallas, Texas February 27, 1998, (except with respect to the merger of Pre-Paid Legal Services Inc. with TPN, Inc. as discussed in Note 2, as to which the date is September 24, 1998, the date of the definitive merger agreement)
We have audited the consolidated balance sheet of TPN, Inc. dba The Peoples Network (the Company) as of December 31, 1996, and the related statements of operations, shareholders' deficit, and cash flows for the year then ended (not presented separately herein). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards Those 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of TPN, Inc. dba The Peoples Network at December 31, 1996 and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Year Ended December 31, -------------------------------- 1998 1997 1996 -------- ---------- -------- Revenues: Membership premiums........................ $110,003 $ 76,688 $ 50,582 Product sales.............................. 27,779 41,070 26,425 Associate services......................... 17,255 12,143 5,646 Interest income............................ 2,576 1,689 1,303 Other...................................... 2,840 1,814 1,678 -------- -------- -------- 160,453 133,404 85,634 -------- -------- -------- Costs and expenses: Membership benefits........................ 36,103 25,132 16,871 Product costs.............................. 17,967 27,017 20,568 Commissions................................ 24,261 16,717 11,476 General and administrative................. 21,902 20,311 15,150 Associate services and direct marketing.... 14,738 11,431 4,544 Depreciation............................... 2,944 2,026 533 Premium taxes.............................. 1,206 866 372 -------- -------- -------- 119,121 103,500 69,514 -------- -------- --------
Basic earnings per common share.............. $ 1.29 $ .76 $ .46 ======== ======== ======== Diluted earnings per common share............ $ 1.26 $ .74 $ .44 ======== ======== ========
PRE-PAID LEGAL SERVICES, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Amounts in 000's)
Other comprehensive income (loss): Unrealized gains (losses) on investments: Unrealized holding gains (losses) arising during period............ (24) - - -------- -------- -------- Other comprehensive income.............. (24) - - -------- -------- -------- Comprehensive income.................... $ 30,186 $ 17,523 $ 10,263 ======== ======== ========
During the fourth quarter of 1998, the Company completed the acquisition of TPN, Inc. d.b.a. The People's Network ("TPN") and Universal Fidelity Life Insurance Company ("UFL"). Since its inception in late 1994, TPN had marketed personal and home care products, personal development products and services together with PRIMESTAR(R) satellite subscription television service to its members through a network marketing sales force. UFL is an Oklahoma domiciled life and accident and health insurer.
Basis of Presentation The consolidated financial statements have been prepared in accordance with generally accepted accounting principles which vary in some respects from statutory accounting principles used when reporting to state insurance regulatory authorities. Certain reclassifications have been made to conform to current year presentation. The consolidated financial statements give retroactive effect, as a result of applying the pooling of interests accounting method, to the merger with TPN, which was effective October 2, 1998. The UFL acquisition was accounted for by the purchase method of accounting for business combinations. (See Note 2)
Commissions Effective March 1, 1995, the Company implemented a level membership commission schedule of approximately 25% of annual premium revenue for all Membership years. This commission schedule results in the Company incurring commission expense related to the sale of its legal expense plans on a basis consistent with the collection of the premiums generated by the sale of such Memberships. The Company currently advances the equivalent of three years of commissions on new Membership sales. In January 1997, the Company implemented a new policy whereby associates receive only earned commissions on the first three Memberships submitted unless the associate successfully completes a training program which includes an intensive one-day training seminar, produces three Memberships and recruits one associate within 15 business days from their training date. Prior to March 1, 1995, first year commissions payable on the sale of a Membership, and earned in the first Membership year, were approximately 70% of annual Membership premiums while renewal commissions (payable as earned after the first Membership year) were approximately 16% of annual premiums.
Revenue Recognition Membership premiums are recognized in income when due in accordance with Membership terms which generally require the holder of the Membership to remit premiums on a monthly basis. Memberships are canceled for nonpayment of premium after ninety days. Premiums due but not collected at the end of an accounting period are recorded as accrued Membership income; a provision for uncollectible premiums, if any, is recorded currently. Revenues from Associates' training program fees and sales of marketing supplies are recognized as income when cash is received. Revenues for product sales are recognized when products are shipped or services provided.
Coinsurance Receivable and Accident and Health Reserves The Company has coinsured 100% of its accident and health policy liabilities pursuant to a coinsurance agreement. The amount due from coinsurer is therefore equal to the estimated accident and health reserves. The Company believes the coinsurer will be able to honor all contractual commitments under the coinsurance agreement, based on its periodic reviews of financial statements, insurance industry reports and reports filed with state insurance departments.
Commission Advances Commission advances represent the unearned portion of commissions advanced to Associates on sales of Memberships. Commissions are earned as premiums are collected, usually on a monthly basis. The Company reduces Commission advances as premiums are paid and commissions earned. Unearned commission advances on lapsed Memberships are recovered through collection of premiums on an associate's active Memberships. At December 31, 1998 and 1997, the Company had an allowance of $4.0 million and $3.7 million, respectively, to provide for estimated uncollectible balances. The Company charges interest at the prime rate on unearned commission advances relating to Memberships that canceled subsequent to the advance being made.
Deferred taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. The Company records deferred tax assets related to the recognition of future tax benefits of temporary differences and net operating loss and tax credit carryforwards. To the extent that realization of such benefits is not considered more likely than not, the Company establishes a valuation allowance to reduce such assets to estimated realizable value.
Stock-Based Compensation Compensation expense is recorded with respect to stock option grants and restricted stock awards to employees using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). This method calculates compensation expense on the measurement date as the excess of the current market price of the underlying Company stock over the amount the employee is required to pay for the shares, if any. The expense is recognized over the vesting period of the grant or award. The Company has adopted the disclosure requirements of SFAS 123, "Accounting for Stock-Based Compensation," in preparing its financial statement disclosures.
The Company completed its acquisition of UFL on December 30, 1998. UFL, based in Duncan, Oklahoma, was a subsidiary of Pioneer Financial Services, Inc. ("Pioneer"), which is a subsidiary of the Conseco group of companies. The Company paid $20.7 million in cash to Pioneer in exchange for all of the outstanding capital stock of UFL. As a part of the transaction, Pioneer Life Insurance Company, a wholly-owned subsidiary of Pioneer, entered into a 100% coinsurance agreement with UFL assuming all of the assets and liabilities relating to UFL's Medicare supplement and health care business written by UFL. UFL will retain its existing life insurance business (1998 premiums were approximately $1.0 million) and will continue to provide claims processing for the coinsured Medicare supplement and health care policies and receive full cost reimbursement for such services.
Year Ended December 31, ----------------------- 1998 1997 ---------- --------- Net revenues: As reported................................ $ 160,453 $ 133,404 Pro forma.................................. 162,507 135,307
A summary of the amortized cost, unrealized gains and losses and fair values of investment securities at December 31, 1998 and 1997 follows:
A comparison of the amortized cost and fair value of the Company's available-for-sale investment securities at December 31, 1998 by maturity date follows:
The Company's investment securities are included in the accompanying consolidated balance sheets at December 31, 1998 and 1997 as follows.
The Company is required to pledge investments to various state insurance departments as a condition to obtaining authority to do business in certain states. The Company has investments pledged to state regulatory agencies as follows: December 31, --------------------- 1998 1997 --------- --------- Certificates of deposit............................ $ 1,772 $ 1,797 Obligation of state and political subdivisions..... 100 300 U. S. Government obligations....................... 1,050 675 -------- -------- Total $ 2,922 $ 2,772 ======== ========
Year Ended December 31, ------------------------------ 1998 1997 1996 -------- -------- -------- Statutory Federal income tax rate........ 34.0% 34.0% 34.0% Change in valuation allowance............ (8.2) 6.4 2.9 Tax exempt interest...................... (.1) (.2) (.2) State income taxes and other............. 1.2 1.2 (.4) -------- -------- -------- Effective income tax rate................ 26.9% 41.4% 36.3% ======== ======== ========
The Company's ability to pay dividends is dependent in part on its ability to derive dividends from its subsidiaries. The payment of dividends by PPLCI is restricted under the Oklahoma Insurance Code to available surplus funds derived from realized net profits. At December 31, 1998, PPLCI did not have funds available for payment of dividends without the approval of the Oklahoma Insurance Commissioner.
The Chairman and his wife own Stonecipher Aviation LLC ("SA"). The Company has agreed to reimburse SA for certain expenses pertaining to trips made by Company personnel for Company business purposes using aircraft owned by SA. Such reimbursement represents the pro rata portion of direct operating expenses, such as fuel, maintenance, pilot fees and landing fees, incurred in connection with such aircraft based on the relative number of flights taken for Company business purposes versus the number of other flights during the applicable period. No reimbursement is made for depreciation, capital expenditures or improvements relating to such aircraft. During 1998 and 1997, the Company paid $279,000 and $192,000, respectively, to SA as reimbursement for such transportation expenses.
An executive officer (President) and director of the Company has loans from the Company made in December 1992, December 1996 and October 1998. The largest aggregate balance of these loans during the year ended December 31, 1998 was $504,000. The outstanding balance of these loans as of December 31, 1998 was $501,737. These loans bear annual interest at the rate of 3% in excess of the prime rate, adjusted on January 1 of each year, and are secured by commissions due from the Company. This individual also owns interests ranging from 10% to 67% in corporations or partnerships not affiliated with the Company but engaged in the marketing of the Company's Memberships and which earn commissions from sales of Memberships. These entities earned commissions, net of amounts passed through as commissions to their sales agents, during 1998, 1997 and 1996 of $39,000, $49,000 and $54,000, respectively.
At December 31, 1998, the Company was committed under noncancelable operating and capital leases, principally for buildings and equipment. Aggregate rental expense under all operating leases was $468,000, $379,000 and $363,000 in 1998, 1997 and 1996, respectively. Minimum rentals for operating and capital leases in succeeding years ending December 31 are: Capital Operating Year Leases Leases ---- --------- ----------- 1999 $ 521 $ 62 2000 407 10 2001 247 1 -------- ------- Total 1,175 $ 73 ======= Less: Amount representing interest................ 29 -------- Present value of net minimum capital lease payments....................................... 1,146 -------- Less: Current installments of obligations under capital leases................................. 487 -------- Obligations under capital leases, net of current installments .................................. $ 659 ========
During February 1999, a suit was filed against the Company by a building owner seeking to recover unspecified damages and attorneys' fees for an alleged breach of a lease agreement between the owner and TPN. Management has indicated its plans to vigorously contest this suit and believes that any loss resulting from the suit would not have a material impact on the Company's financial position, results of operations or cash flows in future years.
A summary of the status of the Company's Plan as of December 31, 1998, 1997 and 1996 and changes during the years ending on those dates is presented below:
The Company, effective July 3, 1995, December 14, 1995 and July 22, 1997 adopted stock option plans for its marketing associates whereby the associates could earn stock options based upon their production and recruiting efforts. These options were issued to qualifying associates at each month end from July 1995 through March 1996 and for the month of July 1997 based on the month's production and recruiting results. The options granted December 14, 1995 were issued to qualifying associates achieving a specified level within the Company's marketing structure. The exercise price is equal to the closing stock price on the last trading day of each respective month for all grants from July 1995 through March 1996, the exercise price for December 1995 grants was equal to the closing stock price on such date and the exercise price for the July 1997 grants was $27.00 (which exceeded market). The options granted from July 1995 through March 1996 expired pursuant to their terms on July 31, 1997 and the options granted for production during July 1997 expired pursuant to their terms on July 31, 1998. The options granted December 14, 1995 expire on December 14, 2000. Activity related to these plans is as follows:
In addition to those options issued pursuant to the Plan and those options issued to non-employee marketing associates in the two preceding tables, the Company has other options outstanding. All grants during 1998, 1997 and 1996 were made to Regional Vice Presidents ("RVP") (marketing employees) of the Company and marketing consultants. The exercise price is equal to the closing stock price on the day the RVP was appointed by the Company or the date the options were granted to the marketing consultant. A summary of the status of such options as of December 31, 1998, 1997 and 1996 and changes during the years ending on those dates is presented below:
The following table summarizes information about stock options other than those included in the Plan or issued to marketing associates outstanding at December 31, 1998:
Basic earnings per common share: As reported................................ $ 1.29 $ .76 $ .46 Pro forma.................................. .92 .71 .45
Diluted earnings per common share: As reported................................ $ 1.26 $ .74 $ .44 Pro forma.................................. .91 .70 .43
The estimated fair value of options granted to employees, including RVPs, was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used: no dividend yield; risk-free interest rate of 5.00% for 1998 and 1997 and 6.00% for 1996; expected life of 3-7 years; and expected volatility ranging from 30% to 64%.
Basic earnings per common share are computed by dividing net income applicable to common stockholders by the weighted average number of shares of Common Stock outstanding during the year.
The Company had taxable income for 1998 and the Company's tax expense for 1998 was reduced in the fourth quarter to reflect management's current estimate of the utilization of certain NOLs for which a valuation allowance had been previously established. Due to this reduction in tax expense, fourth quarter earnings were increased $3.5 million, or 15 cents per diluted share. Additionally, the fourth quarter of 1997 contained an adjustment related to TPN's deferred tax assets that resulted in additional tax expense of $1.9 million, or 8 cents per diluted share.