The Company owns an office building and adjacent real estate in Richmond, Virginia which it uses for its corporate headquarters. This property consists of approximately 128,000 square feet of office space and a parking deck. The Company's title insurance subsidiaries conduct their business operations primarily in leased office space. As of December 31, 1999, the Company had numerous leases for its branch offices and subsidiaries throughout the states in which it operates. In addition, it owns several other 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, and the Company completed, the divestiture of certain title plants in 12 localities named in the Consent
three distinct aspects of its business strategy. In addition to the Commonwealth and Transnation acquisition, operations were expanded through the acquisition of title insurance agents, 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.
The Company's profit margins are affected by several factors, including the volume of real estate and mortgage refinance activity, policy amount and the nature of real estate transactions. Volume is an important determinant of profitability because the Company, like any other title insurance company, has a significant level of fixed costs arising from personnel, occupancy costs and maintenance of title plants. Because premiums are based on the face amount of the policy, larger policies generate higher premiums although expenses of issuance do not necessarily increase in proportion to policy size. Cancellations affect profitability because costs incurred both in opening and in processing orders typically are not offset by fees. Commercial transactions tend to be more profitable than residential transactions.
Generally, title insurance claim rates are lower than other types of insurance because title insurance policies insure against prior events affecting the quality of real estate titles, rather than
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 but is highly subject to changes in interest rates. 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 influenced by changes in the levels of refinancing activity. For additional information, see "Item 1 - Business - Cyclicality and Seasonality."
The Company reported net income of $54.3 million or $2.79 per share on a diluted basis for 1999 compared to $93.0 million or $5.05 per share on a diluted basis in 1998 and $26.2 million or $2.84 per share on a diluted basis in 1997. Exclusive of assimilation costs associated with the Commonwealth and Transnation acquisition, net income was $100.5 million or $5.46 per share on a diluted basis in 1998. Net operating income (which excludes realized investment gains and losses) was $55.3 million, $91.2 million and $26.3 million for the years ended 1999, 1998 and 1997, respectively.
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, and $55.8 million or $2.79 per share on a diluted basis in 1997. On a pro forma basis, and excluding assimilation costs, net operating income was $103.7 million and $54.9 million for the years ended 1998 and 1997, respectively.
Operating revenues reported for 1999 were $2.00 billion compared to $1.80 billion in 1998 and $622.8 million in 1997. On a pro forma basis, operating revenues in 1998 were $1.94 billion compared to $1.49 billion in 1997. In addition to the inclusion of Commonwealth and Transnation revenues in 1998, the increase in 1998 was the result of increased volumes in residential and commercial resale and refinancing transactions, reflecting the favorable interest
rate environment and the general health of the national real estate markets. During 1999 order volume in direct company offices decreased to 833,600 from 1,041,500 in 1998 as a result of the effect on the residential mortgage markets of three interest rate increases initiated by the Federal Reserve in 1999. The resulting decrease in direct revenues was offset by an increase in agency revenues, principally the result of the timing effects of the industry's typical time lag in business reported through independent agents.
Operating Expenses. The Company's expense ratio was 92.2% in 1999 compared to 87.6% in 1998 and 90.1% in 1997. The expense ratio improved in 1998 compared to 1997 reflecting increased operating leverage resulting from the growth in revenues, and the continuing focus on expense management. The increase in the expense ratio in 1999 compared to 1998 resulted from an increase in the amount of agency commissions as the mix of revenues shifted from direct operations to independent agents.
Assimilation Costs. Assimilation costs on a pre-tax basis of approximately $11.5 million were incurred in 1998 in connection with the acquisition of Commonwealth and Transnation. No such costs were incurred in 1999 or 1997.
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. As a percentage of gross title revenues, salary and related expenses were 28.1%, 29.3% and 32.2% in 1999, 1998 and 1997, respectively. In response to the lower level of orders received in direct operations, staffing levels had been decreased to 8,500 by December 1999 from a peak level of 10,700 in December 1998.
The Company pays U.S. federal and state income taxes based on laws in the jurisdictions in which it operates. The effective tax rates reflected in the income statement for 1999, 1998 and 1997 differ from the U.S. federal statutory rate principally due to non-taxable interest, dividend deductions, travel and entertainment and company-owned life insurance.
At December 31, 1999 the Company had recorded gross deferred tax assets of $112.9 million related primarily to policy and contract claims and employee benefit plans. A valuation allowance is provided for deferred tax assets if it is more likely than not these items will either expire before the Company is able to realize their benefit, or that future deductibility is uncertain.
At December 31, 1999, the Company recorded a valuation allowance of $11.5 million related to the $11.5 million deferred tax asset created by the unrealized losses associated with the Company's investment portfolio. No valuation allowance was recorded at December 31, 1998.
In prior years, the Company discussed the nature and progress of its efforts to assure mission critical systems would function properly to and beyond the Year 2000. In late 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company experienced no significant disruptions in mission critical information technology and non-information technology systems and believes those systems successfully responded to the Year 2000 date change. The Company expensed approximately
$8.3 million during 1999 and $4.8 million during 1998 in connection with remediating its systems. The Company is not aware of any material problems resulting from Year 2000 issues, either with its products, its mission critical internal systems, or the products and services of third parties whose services are critical to the operation of the Company. The Company will continue to monitor its mission critical computer applications and those of its mission critical suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly.
The following table provides information about the Company's financial instruments that are sensitive to changes in interest rates. For investment securities, the table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Actual cash flows could differ from the expected amounts.
performance or achievements expressed or implied by such forward-looking statements. Further, any such statement is specifically qualified in its entirety by the following cautionary statements.