conduct their business operations primarily in leased office space. At December 31, 1998, the Company had numerous leases for its branch offices and subsidiaries throughout the states in which it operates. In addition, it owns several properties which in aggregate are not material to its business taken as a whole.
On February 23, 1998, the Company entered into an Agreement Containing Consent Order (the "Consent Order") with the Federal Trade Commission (the "FTC") in connection with the acquisition of Commonwealth and Transnation. The Consent Order required that the Company divest the rights, title and interest held by the Company prior to consummation of the acquisition, or the rights, title and interest held by Reliance Group Holdings, Inc. prior to consummation of the acquisition, in and to all title plants serving each of 12 localities named in the Consent Order. Seven of such localities were in Florida, three were in Michigan, and one each was in Washington, D.C. and St. Louis, Missouri. The Consent Order further required that the Company divest all user or access agreements pertaining to each divested title plant. As of February 26, 1999, the Company had completed the divestiture of all of the aforementioned title plants in accordance with the Consent Order. Pursuant to the terms of the Consent Order, the Company may not acquire, without prior notice to the FTC, any interest in a title plant in any of the named localities for a period of 10 years following the date of the Consent Order.
The following discussion includes, in addition to actual results of operations, information on pro forma results of operations that assumes the Commonwealth and Transnation acquisition was effective for the entire years of 1998, 1997 and 1996. The Company reported improved operating earnings in 1998 as well as in 1997 and 1996. The Company's primary business is the insurance of titles to real property, which is greatly influenced by the real estate economy. During the three year period from 1996 to 1998, the Company benefited from the execution of three distinct aspects of its business strategy. Operations were expanded through the acquisition of title insurance agents and underwriters, expenses were tightly monitored and controlled, and claims experience improved due to quality control efforts and an improved claims environment. During 1998, the Company also benefited from the acquisition of Commonwealth and Transnation and the strong national real estate economy.
In addition to the premiums and related fees, the Company earns investment income from its portfolio of fixed-maturity securities. Investment income includes dividends and interest as well as realized capital gains or losses on the portfolio. The Company regularly reexamines its portfolio strategies in light of changing earnings or tax situations. In the fourth quarter of 1996 the Company shifted its investment strategy, eliminating its investment in equity securities, and moved the majority of its investment portfolio into fixed-maturity securities. The repositioning of the portfolio eliminated the exposure of the regulated surplus of the Company's insurance subsidiaries to market fluctuations inherent in equity portfolios. Additionally, the commensurate increase in fixed-maturity securities increased the level of more stable, predictable interest income earned.
In the fourth quarter of 1996, the Company made a change from reporting policy and contract claims on a discounted basis to an undiscounted basis. In addition, during the fourth quarter of 1996 the Company changed its estimate of the ultimate net cost of all reported and unreported losses incurred through September 30, 1996 to reflect favorable experience. Under the Company's reserving methodology, the provision for losses on policies issued in each year is based on historical experience determined over a period of years. As a result, the very high incidence of losses on policies issued in the 1980s had the effect of pushing up the rate at which losses were provided in the 1990s. The early 1990s were also affected by a high volume of residential refinance business which time has proven is experiencing a lower incidence of losses.
Both the change in reserve estimate and the change from discounting to not discounting reserves were contemplated by the Company as a result of the shift in the business that now reflects a higher amount of refinance transactions and an increase in frequency of housing resales. See Note 2 to the Consolidated Financial Statements for a description of the effect of these changes on the Company's operations.
The most significant components of other expenses are rent for office space, outside costs of title production, travel, communications and taxes levied by states on premiums.
Historically, residential real estate activity has been generally slower in the winter, when fewer families move, buy or sell homes, with increased volumes in the spring and summer. Residential refinancing activity is generally more uniform throughout the seasons, subject to interest rate stability. The Company typically reports its lowest revenues in the first quarter, with revenues increasing into the second quarter and through the third quarter. The fourth quarter customarily may be as strong as the third quarter, depending on the level of activity in the commercial real estate market.
In 1998, the typical seasonality of the title insurance business was somewhat tempered by the high level of refinancing activity, which may not continue through 1999.
Comparison of Years Ended December 31, 1998, December 31, 1997 and December 31, 1996
On a pro forma basis and excluding assimilation costs net income would have been $105.7 million or $5.22 per share on a diluted basis in 1998, $55.8 million or $2.79 per share on a diluted basis in 1997 and $41.3 million or $2.48 per share on a diluted basis in 1996. On a pro forma basis, and excluding assimilation costs, net operating income was $103.7 million, $54.9 million and $33.4 million for the years ended 1998, 1997 and 1996, respectively.
respectively. The improvement in 1998 was principally due to the addition of earnings from the investments acquired in the Commonwealth and Transnation transaction. The 1996 results included capital gains associated with the Company's change in investment strategy where it sold its equity portfolio and began investing principally in fixed-maturity securities.
Salaries and Employee Benefits. Personnel-related expenses are a significant portion of total operating expenses in the title insurance industry. These expenses require intensive management through changing real estate cycles. The level of these expenses is directly related to business volumes which increased in 1998 over 1997 and in 1997 over 1996. As a percentage of gross title revenues, salary and related expenses were 29.3%, 32.2% and 33.0% in 1998, 1997 and 1996, respectively.
Agents' Commissions. Commissions paid to title insurance agents are the largest single expense incurred by the Company. The commission rate varies by geographic area in which the commission was earned. Commissions as a percentage of agency revenue were 77.6% in 1998, 75.0% in 1997 and 74.2% in 1996.
Provision for Policy and Contract Claims. The Company's claims experience has shown improvement in recent years. The loss ratio (the provision for policy and contract claims as a percentage of operating revenues) was 5.2%, 5.4% and 5.2% in 1998, 1997 and 1996, respectively. As previously discussed, the Company changed its method of reporting policy and contract claims in the fourth quarter of 1996. Claims paid as a percentage of operating revenues were 2.8%, 4.4% and 4.8% in 1998, 1997 and 1996, respectively.
Cash provided by operating activities for the years ended December 31, 1998, 1997 and 1996 was $165.1 million, $18.8 million and $33.2 million, respectively. As of December 31, 1998, the Company held cash and invested cash of $174.0 million and fixed-maturity securities of $774.9 million.
Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the change in the century. If not corrected, many date-sensitive applications could fail or create erroneous results by or in the year 2000. The Company understands the importance of having systems and equipment operational through the year 2000 and beyond and is committed to addressing these challenges while continuing to fulfill its business obligations to its clients and business partners.
Although the Company has developed a Year 2000 compliance program, there is no guarantee that the systems of other companies, upon which the Company's systems rely, will be properly converted in a timely manner or will not have an adverse effect on the Company's systems. Thus, the Company has surveyed and continues to monitor its important business partners to analyze and report any Year 2000-related issues that might impact the Company. The Company considers the Year 2000 readiness of its business partners as an important factor in its business dealings and relationships. Of course, notwithstanding the Company's efforts or results, the actions or omissions of third parties beyond the Company's knowledge or control may adversely affect its ability to function unaffected to and through the Year 2000, including the possibility of lost revenues or lawsuits by third parties.
Realizing the importance of Year 2000 readiness, the Company has allocated approximately $14.1 million in the aggregate from its general operating funds to the Year 2000 issue. Although significant, this amount is not material to the Company's operational budget. An approximate allocation of the budgeted amount is $4.0 million for assessment, $5.0 million for remediation/replacement, $2.5 million for testing, $1.3 million for integration, and $1.3 million for contingencies. Through December 31, 1998, approximately $4.8 million has been spent in the assessment, remediation and testing phases. Since the Year 2000 Project Team is separate from the Company's information and technology department and the amount allocated to the Year 2000 issue is specifically allocated for that purpose, the allocation has not resulted in the delay of any other non-Year 2000 related information and technology projects.
cash flows and related weighted-average interest rates by expected maturity dates. Actual cash flows could differ from the expected amounts.
and uncertainties associated with the Year 2000 readiness of third parties with whom the Company does business.