In July 1998, the Company turned over operation of its Blythewood, South Carolina data center to Lockheed Martin. This data center has 9 mainframe and mid-range computers, which have over 5 terabytes of disk storage and are capable of processing over 1.75 billion instructions per second. The Company is currently utilizing 85% of this capacity.
The Company's data center in Oslo, Norway has one mainframe computer, which has over 2,000 megabytes of disk storage and is capable of processing over 200 million instructions per second. The Company is currently utilizing 80% of this capacity.
The results of operations in 1998 include $13.3 million of special charges. These pre-tax charges include $3.7 million related to the acquisition of The Leverage Group ("TLG") and $9.6 million for the impairment of capitalized software development costs which resulted from certain technology related issues and changes in the Company's strategy (see Note 3 of Notes to Consolidated Financial Statements).
The results of operations in 1996, 1995 and 1994 reflect special charges. The results of operations in 1996 include a net special credit of $3.4 million. This credit resulted from a pre-tax gain of $9.4 million related to the recovery of previously incurred litigation costs and a pre-tax charge of $6.0 million related to other litigation. The results of operations in 1995 include special charges of $56.4 million (after taxes $39.9 million, or $2.06 per share). These charges principally related to the restructuring of the Company's data processing facilities and information services business, litigation costs, acquisition-related charges, impairment of certain intangible assets and software associated with acquired businesses and the gain on the sale of the Company's health services business. The results of operations in 1994 reflect special charges of $67.5 million (after taxes $41.5 million or $1.99 per share). These charges principally related to the impairment of intangible assets associated with acquired businesses and discontinued acquired software products and changes in estimates associated with previously established restructuring reserves.
The Company's revenues are generated principally by licensing standardized insurance software systems and providing outsourcing and professional services to the global insurance and related financial services industries. Licensing revenues are provided for under the terms of nonexclusive and nontransferable agreements, which generally have a noncancelable minimum term of six years and provide for an initial license charge and a monthly license charge. Customers wishing to acquire perpetual rights to use the Company's software enter into additional agreements to acquire such rights. Services revenues are derived from professional support services, which include implementation and integration assistance, consulting and education services and outsourcing services.
Initial license charges include right-to-use licenses of $15.5, $10.2, and $4.6 million for 1998, 1997 and 1996, respectively. Right-to-use licenses represent the acquisition by certain customers of the right-to-use component of their remaining monthly license charge obligation, if any, plus the acquisition of a perpetual right to use the product thereafter. Since these types of licenses represent an acceleration of future revenues, they reduce future monthly license charges. Initial license charges also include contract termination fees of $4.9, $0.2 and $0 million for 1998, 1997 and 1996, respectively. Additionally, 1998 initial license charges include $4.9 million from licensing of the recently acquired TLG products and $2.2 million of license agreements with the purchaser of the discontinued life information services segment. In 1997, initial license charges include $1.8 million of initial license agreements with the purchaser of the discontinued property and casualty information services segment.
Because a significant portion of initial licensing revenues are recorded at the time new systems are licensed, there can be significant fluctuations in revenue from period to period. Set forth below is a comparison of initial license revenues by segment for 1998, 1997 and 1996:
Monthly license charges for 1998 increased $3.2 million compared to 1997. The life and financial solutions segment's monthly license charges increased 25.0% ($2.9 million) due to increased licensing activity. The property and casualty and international segments' monthly license charges remained relatively unchanged.
These increases are related to increased licensing activity. Property and casualty monthly license charges remained relatively unchanged.
Professional and outsourcing services revenues for 1998 increased $89.0 million compared to 1997, with the following increases by business segment: property and casualty up 19.1% ($35.6 million); life and financial solutions up 55.1% ($38.5 million); and international up 12.0% ($14.9 million). The increases are principally due to increases in implementation services and in the processing volumes of services provided to new and existing customers.
Furthermore, the Company believes most insurance companies were required to complete remediation of their policy administration systems by the third quarter of 1998. However, many insurance companies' information technology ("IT") departments are continuing to focus on Year 2000 remediation issues and testing of their applications, suppliers and data processing environments. This continuing level of distraction and asset allocation limits the Company's ability to accurately predict licensing and services demand over the next twelve to eighteen months.
The Company believes that system evaluations and decision processes are also being affected by uncertainties related to the Internet. The emergence of the Internet as a viable insurance distribution channel is causing a re-evaluation of the traditional methods of distribution for insurance products. The Company also believes that in order for insurance companies to capitalize on this new distribution method they will be required to redesign their business models and related support systems. The issues raised by the emergence of the Internet and related technology requirements will be distracting and confusing for many insurance companies and complicate the process of transitioning the insurance industry to client/server architecture. Therefore, customer uncertainty as to their Internet and client/server business strategies may extend sales cycles for large enterprise systems.
Employee compensation and benefits for 1998 increased 23.3% compared to 1997. The net increase results principally from higher salaries and related costs associated with the growth in professional services staffing being somewhat offset by the transfer of certain employee costs to computer and communication expenses as a result of the Company's data center outsourcing agreement with Lockheed Martin Corporation ("Lockheed Martin"). Had these employee costs not been transferred, 1998 employee compensation and benefits would have increased 25% by comparison to last year. Compensation and benefits increased 22.8% ($14.2 million) internationally and 23.6% ($36.4 million) domestically.
Employee compensation and benefits for 1997 increased 31.6% compared to 1996 principally as a result of the increased salaries and related costs associated with the growth in staffing in all business units. Compensation and benefits increased 31.2% ($14.9 million) internationally and 31.8% ($37.2 million) domestically.
Computer and communications expenses for 1997 increased 15.6% compared to 1996, principally as a result of increased communications, data circuit and maintenance costs associated with the growth of the Company's domestic and international outsourcing operations.
Depreciation and amortization of property, equipment and capitalized software costs for 1997 increased 19.6% compared to 1996. This increase is due principally to higher amortization expense resulting from the release of version 9702 of CyberLife client/server life insurance software in October 1997. In addition, depreciation expense increased due to the Company's increased investment in network and PC hardware.
Other operating costs and expenses for 1998 decreased 12.8% compared to 1997 principally due to lower consultant, contract loss and bad debt expense, partially offset by increased facility costs and decreased amounts of capitalized software development costs.
Selling, general and administrative expenses for 1997 increased 39.0% compared to 1996, principally from the Company's investment in its international sales force and administrative infrastructure.
1997 operating income increased 13.8% compared to 1996. Increases in segment operating income were: property and casualty up 10.8%, life and financial solutions up 47.1% and international up 28.3%. The increase in operating income is primarily related to increases in licensing and professional services revenues.
Investment income for 1998 was relatively unchanged compared to 1997. Interest expense decreased 27.5% for 1998 compared to 1997, principally due to lower levels of borrowed funds under the Company's credit facility and the capitalization of interest on construction in progress.
For additional information on the discontinued operations, see Note 13 of Notes to Consolidated Financial Statements.
In February 1998, the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 provides guidance on accounting for the costs of computer software developed or obtained for internal use, and is effective for fiscal years beginning after December 31, 1998, with earlier adoption encouraged. The Company adopted SOP 98-1 at January 1, 1998. The adoption did not have a material effect on the Company's financial statements.
In June 1998, Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133") was issued, effective for fiscal years beginning after June 15, 1999, with earlier adoption encouraged. SFAS 133 requires companies to record derivative instruments on the balance sheet as assets and liabilities, measured at fair value. Gain or losses resulting from changes in the values of those derivatives are accounted for depending on the use of the derivative. The Company does not enter into derivative instruments except occasionally to hedge the foreign currency exchange and interest rate risk of specific projected transactions. The Company was not holding any derivative instruments at December 31, 1998 and 1997.
The Company's operating results and financial condition may be impacted by a number of factors, including, but not limited to, the following, any of which could cause actual results to vary materially from current and historical results or the Company's anticipated future results.
Currently, the Company's business is focused principally within the global property and casualty and life and financial solutions industries. Significant changes in the regulatory or market environment of these industries could impact demand for the Company's software products and services. Additionally, there is increasing competition for the Company's products and services, and there can be no assurance that the Company's current products and services will remain competitive, or that the Company's development efforts will produce products with the cost and performance characteristics necessary to remain competitive. Furthermore, the market for the Company's products and services is characterized by rapid changes in technology and the emergence of the Internet as a viable insurance distribution channel. The Company's success will depend on the level of market acceptance of the Company's products, technologies and enhancements, and its ability to introduce such products, technologies and enhancements to the market on a timely and cost effective basis, and maintain a labor force sufficiently skilled to compete in the current environment.
Because of the foregoing factors, as well as other factors affecting the Company's operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.
Beginning in the fourth quarter of 1997, the Company initiated consolidation of its Year 2000 activities under a centralized Year 2000 Project Office. Prior to that, individual business units were responsible for the assessment, remediation, validation and implementation of Year 2000 corrective actions.
There following seven phases are included in the Company's Year 2000 project:
Planning. Educating the organization on Year 2000 issues and concerns, the readiness efforts necessary, and preparing for the next phase of the Year 2000 readiness project. Inventory. Cataloguing all organizational components, including products, external or internal interfaces, hardware and software that may require remediation and testing to adequately address Year 2000 concerns. Triage. Prioritizing and categorizing all products, equipment, interfaces, data, and facilities identified during the Inventory phase. Emphasis is placed on the identification of: all mission critical components, those that are least important, and those that fall in the middle Assessment. Identifying remediation requirements for each component in order of business risk prioritization determined during Triage. Remediation. Repairing, replacing, or retiring components based on the work identified during the Assessment phase. Unit tests on repaired applications are also included in this phase. Testing. Testing components that were repaired. Such tests include both system tests and integrated tests in test environments with machine dates advanced to reflect dates in the years 1999 and 2000. Implementation. Migrating systems, applications, and hardware to production environments, installation of replacement systems and the retirement of designated components, as well as finalizing, documenting and taking care of residual activities. This phase also includes the compilation and retention of supporting documentation that conforms to prescribed corporate standards.
All phases are currently scheduled to be completed during the third quarter of 1999.
The Year 2000 issue may potentially affect the Company in four areas: its product offerings, its service offerings, its internal systems, and its suppliers and trading partners.
Based on current inventories, the Company is also in the process of contacting critical, third party dependencies to determine whether remediation efforts or alternative measures to handle Year 2000 impacts are necessary.
customers after December 31, 1999. Live customer data is currently being processed on these remediated applications in a production environment. Based upon customer preference, additional testing is scheduled during 1999 in a Year 2000 environment. This testing is designed to confirm that no unanticipated problems will occur due to third party products with which the Company's applications are designed to operate.
The Company's products are designed to be used with and require use of third-party products, such as operating systems and compilers. Also, customers often modify the Company's products to suit their unique requirements. If these third parties experience Year 2000 failures of their products, or if customers experience system failures as a result of their modifications or for other reasons, the Company could become involved in disputes or litigation related to the cause of such system failures.
In addition, the failure to correct material Year 2000 problems could result in an interruption in, or a failure of, certain normal business activities or operations and litigation. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the Year 2000 problem, resulting in part from the uncertainty of the Year 2000 readiness of third-party suppliers and the Company's customers and prospective customers, the Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on the Company's results of operations, liquidity or financial condition. The Year 2000 Project is expected to significantly reduce the Company's level of uncertainty about the Year 2000 problem and, in particular, about the Year 2000 compliance and readiness of its mission critical suppliers and trading partners. The Company believes that, with the implementation of new business systems and completion of the Project as scheduled, the possibility of significant interruptions of normal operations should be reduced.
The Company continues to develop contingency plans to minimize the effect of such disruptions.
The Company is currently evaluating methods to address the issues involved with the introduction of the euro, including the conversion of its products in the relevant markets and impacts on the processes for preparing taxation and accounting records.
Although the Company cannot accurately determine the amounts attributable thereto, the Company has been affected by inflation through increased costs of employee compensation and other operating expenses. To the extent permitted by the marketplace for the Company's products and services, the Company attempts to recover increases in