(2) The Company anticipates subletting this location and relocating to an 8,000 square foot facility on or about May 1, 1998.
The Company's revenues are derived principally from (i) outsourcing services and (ii) software and software services. Revenues from outsourcing services are derived from policy administration services, claims administration services and IT services. Revenues from software and software services are derived from contracts that grant customers a license to use the Company's software products and contracts that provide for installation, customization, enhancement, conversion and maintenance services. Other revenues principally represent hardware sold in connection with software installations.
Revenues from outsourcing services are recognized as services are rendered. The Company is typically paid a percentage of premiums for policy administration services, a percentage of premiums or claims paid for claims administration services and a percentage of premiums subject to a minimum fee for IT services. Outsourcing services contracts generally are for terms of two to five years. Due to the ongoing nature of these services and the length of the terms of the service contracts, outsourcing services generate recurring revenues. Initial installations of software systems generally include a one-time license fee and a contract for the installation and customization of the system to meet the customer's specifications, which the Company bills at an hourly rate. Amounts charged for the initial license and the installation and customization of systems are recognized as revenue during the installation period in proportion to the hours expended for installation compared to the total hours projected for installation. In other instances, revenues are recognized based on performance milestones specified in the contract. The Company recognizes the annual fee charged for maintenance of the customer's system as revenue as hours are expended over the maintenance contract period. Revenues from computer hardware and equipment sales, included in other revenues, are recognized when the Company receives notification that the equipment has been shipped by the manufacturer and title has passed to the customer. Changes in estimates of percentage of completion or losses, if any, associated with outsourcing or software services are recognized in the period in which they are determined. Unearned revenues consist of billings to customers in advance of revenues recognized on such services. Unbilled receivables consist of revenues recognized in advance of billings due to timing differences related to billing schedules specified in contracts.
The Company incurs research and development costs that relate primarily to the development of new products and major enhancements to existing services and products. Research and development costs are comprised primarily of salaries. The Company expenses or capitalizes, as appropriate, these research and
development costs in accordance with Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed." All research and development costs incurred prior to the time management believes a project has reached "technological feasibility" are expensed. Software production costs incurred subsequent to reaching technological feasibility are capitalized, if material, and reported at the lower of unamortized cost or net realizable value. Capitalized costs are amortized over the expected service life of the related software, generally five to seven years, using the straight-line method. The cost and related accumulated amortization of projects are written off as they become fully amortized.
Prior to the Company's initial public offering, Millers Mutual, the Company and the other subsidiaries of Millers Mutual were parties to a Consolidated Federal Income Tax Allocation Agreement, effective as of January 1, 1994 (as amended, the "Tax Allocation Agreement"). Under the Tax Allocation Agreement, Millers Mutual was required to pay the Company an amount equal to any decrease in the income taxes otherwise payable by the Millers Mutual consolidated tax group attributable to any net losses of the Company. Conversely, the Tax Allocation Agreement required the Company to pay to Millers Mutual the amount of any income taxes that the Company would have paid if it had not been included in the Millers Mutual consolidated tax group. Effective August 23, 1997, the Tax Allocation Agreement was terminated as it applied to the Company. The agreement to terminate the Company's participation in the Tax Allocation Agreement provides that the Company will indemnify the other members of the Millers Mutual consolidated tax group for any of the group's income taxes and related expenses attributable to the Company, and Millers Mutual will indemnify the Company for any income taxes and related expenses attributable to any members of the consolidated tax group other than the Company.
Purchase of SDS. On March 12, 1997 the Company acquired SDS for $18.0 million. The results of operations of SDS since March 12, 1997 are included in the results of operations of the Company.
The following table sets forth, with respect to the Company and for the periods indicated, the percentage of total revenues represented by certain revenue, expense and income items:
(1) The Company was incorporated April 28, 1995 and commenced operations July 1, 1995.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 1997 AND 1996 ON A HISTORICAL BASIS
Revenues. The Company's total revenues were $56.6 million for the year ended December 31, 1997 compared to $13.7 million for the year ended December 31, 1996, an increase of $42.9 million or 313%. This increase is attributable primarily to (i) the SDS Acquisition and (ii) revenues from three significant outsourcing contracts entered into in mid-1996 under which the Company performed outsourcing services during all of 1997. These three contracts included a claims administration agreement with HOW and a policy administration agreement and a claims administration agreement with Blanch whereby services are provided to Clarendon. See "Business -- Customers."
Selling, General and Administrative Expenses. Selling, general and administrative expenses, including management fees paid to shareholder, were $10.0 million for the year ended December 31, 1997 compared to $3.1 million for the year ended December 31, 1996, an increase of $6.9 million or 223%. This increase was
Research and Development. Research and development expense was $1.2 million for the year ended December 31, 1997, net of capitalized research and development costs of $819,000. This expense was comprised primarily of personnel, equipment and occupancy costs related to software development. Prior to the SDS Acquisition, the Company did not incur any significant research and development expenses.
Other Income. Other income for the year ended December 31, 1997 includes a $1.6 million gain on the sale of AQS. Interest income, attributable primarily to short-term investments purchased with unused proceeds from the Company's initial public offering, was $681,000 for the year ended December 31, 1997. During 1996 the Company did not have investments that earned interest income. Interest expense, attributable primarily to the NationsBank Facility, was approximately $348,000 for the year ended December 31, 1997. The Company did not have any interest-bearing debt during 1996.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $3.1 million for the year ended December 31, 1996 compared to $600,000 for the period from inception through December 31, 1995, an increase of $2.5 million or 417%. This increase is attributable primarily to the Company conducting twelve months of operations in 1996 compared to approximately six months in 1995.
The Company believes that cash generated from operations and its net proceeds from the offering of Common Stock anticipated to close during the second quarter of 1998 will satisfy the Company's anticipated working capital requirements for at least one year. See "Business -- Recent Events." The Company, however, may require substantial additional funds for potential acquisitions and expansion. In the normal course of business, the Company evaluates acquisitions of businesses, products and technologies that complement the Company's business. The Company has no present commitments or understandings with respect to any such transaction. The Company, however, may acquire businesses, products or technologies in the future.
The Company believes that the computer equipment and software used and sold by the Company will function properly with respect to dates in the Year 2000 and thereafter. The Company is in the process of communicating with its significant suppliers and customers to determine the extent to which interfaces with such entities are vulnerable to Year 2000 issues and the extent to which any products purchased by or from such entities are vulnerable to Year 2000 issues. The Company presently believes that the Year 2000 issues will not require the Company to incur any material costs or pose significant operational problems for the Company directly or as a result of any Year 2000 issues of suppliers or customers. The Company believes that Year 2000 issues of its customers or potential customers provide opportunities to the Company to market its products and services as a solution to such Year 2000 issues.
The following table sets forth, for the periods indicated, the percentage of net sales represented by the indicated items:
(2) Represents $3.0 million of purchased research and development expenses relating to the SDS Acquisition.
(4) Primarily attributable to the gain on sale of AQS of $1.6 million.
The Company has experienced in the past and will experience in the future quarterly variations in net revenues and net income. Thus, operating results for any particular quarter are not necessarily indicative of results for any future period. Factors that have affected quarterly operating results include the introduction of new or enhanced services and products by the Company or its competitors, customer acceptance or rejection of new services and products, product development expenses, the timing of significant orders, the timing of large scale catastrophes, the volume of usage of the Company's services and products, competitive conditions in its industry, general economic conditions and the level of selling and administrative expenses.