We design, market, and administer compensation and benefit programs for companies supplementing and securing employee benefits and provide executive compensation and related consulting services to U.S. corporations, banks, and healthcare organizations. We generally compete with regional firms while we market our products and services nationwide. A majority of our revenues result from commissions paid by insurance companies that underwrite the insurance policies used to finance our clients' benefit programs. Most of our clients' benefit programs are financed by business-owned life insurance and other financial products. We pay commissions to employee and independent consultants based upon a percentage of our commission revenue. We work closely with clients to design customized products that meet the specific organizational needs of the client and with insurance companies to develop unique policy features and competitive pricing.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Securities and Exchange Commission ("SEC") has defined a company's most critical accounting policies as those that are most important to the portrayal of its financial condition and the results of operations, and which require us to make difficult and subjective judgements, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the following as our critical accounting policies and judgements. Although we believe that our estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions and conditions.
o commissions paid by insurance companies issuing the policies underlying our clients' benefit programs; o program design and administrative service fees paid by our clients; o executive compensation and benefit and related consulting fees; and o fees for legislative liaison and related advisory services.
Our commission revenue is normally recurring, is typically paid annually and usually extends for a period of ten years or more after the sale. Commissions are paid by insurance companies and vary by policy and by program and typically represent a percentage of the premium or the cash surrender value of the insurance policies underlying the program.
First Year Commission Revenue and Related Fees. First year commission revenue and related fees are derived from two principal sources: (a) the commission we earn when the client first purchases the policies, which revenue is recognized at the time the application is substantially completed, the client is contractually committed to purchase the insurance policies and the premiums are paid, by the client, to the insurance company; and (b) fees for the services related to the enrollment and initial administration of the benefit programs and underlying policies.
Year 1 100% Year 2 and 3 50% Year 4 25% Year 5 and beyond 0%
Renewal Commission Revenue and Related Fees. Renewal commission revenue is the commission we earn on the policies underlying the benefit programs we have sold in prior years. Renewal revenue is recognized on the date that the renewal premium is due or paid by the client to the insurance company depending on the type of policy. In the case of single pay policies, renewal revenue is recognized on the date of the renewal and calculated based on a percentage of the asset value or based on a percentage of the original premium paid.
We are required to assess potential impairments of long-lived assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for Impairment of Long-Lived Assets, if events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. In assessing the recoverability of goodwill, in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, and the net present value of future cash flows from policies inforce, we must make assumptions regarding estimated future cash flows, mortality, lapse, and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, we may be required to record impairment charges.
Commission expense. Commission and fee expense was $88.3 million, or 27.1% of total revenue, for the year ended December 31, 2003, versus $90.0 million, or 32.3% of total revenue, for the year ended December 31, 2002. The reduction in commission expense as a percentage of revenue reflects an increase in the percentage of revenue generated from employee consultants. Additionally, a higher percentage of 2003 revenue was renewal revenues (48.6)% as compared to 2002 (41.1)%. Generally, renewal revenues have a lower commission rate than first year revenues. We do not pay commission, or any other related expenses, on the revenue associated with the carrier incentive contracts.
General and administrative expense. General and administrative expense for the year ended December 31, 2003 was $159.3 million, or 48.9% of total revenue, compared to $140.6 million, or 50.5% of total revenue, for the year ended December 31, 2002. General and administrative expenses increased for the year ended December 31, 2003 from the prior year as a result of a full year of expense from the 2002 acquisitions, such as LongMiller and Federal Policy Group and the hiring of Andersen Human Capital Practice partners and employees, included for the entire year of 2003. General and administrative expense for the year ended December 31, 2003 included approximately $2.6 million in charges, primarily related to severance costs and lease terminations in our Executive Benefits Practice and Healthcare Group and approximately $1.3 million relating to the corporate re-branding effort as a result of our name change. A non-cash charge of $345 thousand was incurred in the first quarter of 2003 related to stock compensation expense. General and administrative expenses increase as we add more employee consultants as opposed to independent consultants.
Human Capital Practice reorganization. In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice were transferred to the Pearl Meyer & Partners practice. In addition, several partners and staff members were terminated which resulted in exiting certain activities of the Practice and creating unused leased office space in numerous cities. We recorded a charge of $7.5 million in the fourth quarter of 2003 relating to the reorganization, of which, $7.1 million remains on the consolidated balance sheet as of December 31, 2003. No similar costs were recorded in 2002.
Other income. For the years ended December 31, 2003 and 2002, we received rental income of approximately $302 thousand and $262 thousand, respectively from several subtenants.
Interest expense. Interest expense for the year ended December 31, 2003 was $24.3 million compared to $4.1 million in 2002. To finance the November 2002 acquisition of LongMiller, we borrowed approximately $87.5 million on our line of credit and issued $305 million of non-recourse insurance revenue asset-backed notes. The increased outstanding borrowings were responsible for the increase in interest expense.
Net income. Net income, for the year ended December 31, 2003 was $12.7 million, or $0.68 per diluted common share versus net income of $17.3 million after an impairment charge of $523 thousand, net of taxes, from the adoption of SFAS No. 142, or $0.99 per diluted share, for the same period last year. The diluted weighted average number of shares outstanding increased to 18.7 million shares for the year ended December 31, 2003 from 17.5 million shares for the year ended December 31, 2002.
Revenue. Total revenue for the year ended December 31, 2002 was $278.6 million compared to $236.9 million for the year ended December 31, 2001. The Banking Practice experienced strong revenue growth of 26.3% in 2002 as a result of closing numerous cases in the community banking sector and the acquisition of LongMiller in November 2002. Increases of approximately $3.0 million of first year commission and fee revenue and approximately $14.0 million of renewal revenue are attributable to the acquisition of LongMiller. Revenue growth was also strong in the Healthcare Group, which benefited from increased first year commission and fee revenue. Revenue in 2002 was positively impacted by approximately $9.5 million with the February 2002 acquisition of Federal Policy Group, which provides tax and legislative consulting services. New business revenue includes $3.2 million received pursuant to an Administrative Services Agreement and Bonus Forfeiture Agreement with an insurance carrier with which a significant amount of inforce insurance is in place (see Carrier Incentive Contracts below). Our Executive Benefits Practice ("EBP") experienced a decline in revenue from $94.2 million in 2001 to $82.8 million in 2002 as a result of economic conditions and proposed legislation related to the structure of deferred compensation plans that has caused clients to delay implementing new deferred compensation plans. These circumstances may continue in future periods and adversely affect our ability to generate future revenue in EBP.
Net income. Net income, after an impairment charge of $523 thousand (net of taxes) from the adoption of SFAS No. 142, for the year ended December 31, 2002 was $17.3 million, or $0.99 per diluted common share versus net income of $16.0 million or $1.18 per diluted share for the year ended December 31, 2001. The diluted weighted average number of shares outstanding increased to 17.5 million shares for the year ended December 31, 2002 from 13.6 million shares for the year ended December 31, 2001.
As a result of the restructuring, we expect to leverage the Pearl Meyer & Partners brand name for executive compensation consulting, eliminate confusion in the marketplace regarding our practices and their markets, and significantly lower the cost structure for the remaining Human Capital Practice. The remaining business of the Human Capital Practice consists of actuarial/retirement plan and investment advisory services. See Note 4, "Human Capital Practice" to the consolidated financial statements for further information.
On September 25, 2002, we entered into an Administrative Services Agreement and Bonus Forfeiture Agreement with an affiliate of AUSA Holding, Inc., one of our principal stockholders and insurance carrier. We received approximately $2.5 million of payments in 2003 related to this agreement. During 2002, we received $2.5 million for services rendered prior to and through September 30, 2002 and recognized a total of $3.1 million of revenue in 2002, pursuant to this agreement. Under the terms of this agreement, we expect to continue to receive approximately $2.5 million annually from the carrier for a period of 30 years, depending upon certain conditions. Of this annual amount $2.0 million is included in the cash flows securitizing the asset-backed notes issued to finance the acquisition of LongMiller, and we will not have access to this cash for general corporate purposes until the securitized notes are fully paid. This revenue, net of amounts provided for chargebacks, is being recognized on a monthly basis beginning in October 2002. The amounts received are subject to chargeback (reimbursement of a portion of amounts received) if any policies under this agreement are surrendered or exchanged. Any chargeback amounts would be deducted from the next scheduled payment.
There have been several recent legislative proposals to change the federal tax laws with respect to business-owned life insurance. On September 17, 2003, the Senate Finance Committee approved legislation proposed by Sen. Jeff Bingaman (D-NM) that would tax the death benefits taxpayers receive from certain policies on the lives of former employees. Following an intensive lobbying effort by the insurance industry, the Finance Committee on February 2, 2004, reconsidered the business-owned life insurance provision it had previously approved and, in its place, approved legislation that generally would tax the death benefits taxpayers receive from policies on the lives of employees or former employees only in cases where the insured person had not consented to being covered or in the case of a former employee, or where the insured was not among the company's highly-compensated employees at the time of policy issuance. We believe that this most recent proposal, if enacted, would not have a material adverse effect on our revenue from the sale of business-owned life insurance policies. However, if Congress were to adopt legislation broadly limiting the tax-free payment of death benefits on such policies or otherwise adversely affecting the tax treatment of the policies, future revenue from sale of business-owned life insurance policies could materially decline.
The following analysis depicts the results of each of our operating segments on a stand-alone basis. The practices are allocated a charge to cover centralized Resource Center expenditures in the areas of human resources, marketing, and information technology.
As of January 1, 2003, we transferred the operations of Coates Kenney from Executive Benefits Practice to Human Capital Practice. As a result, segment information for the year ended December 31, 2002 has been reclassified to reflect this transfer.
First year revenue was significantly lower in the Executive Benefits Practice, reflecting the continued difficult economic and legislative environment, which most directly affects this segment of the business. First year revenue for the year ended December 31, 2003, includes approximately $785 thousand from the execution of an incentive contract with one of our insurance carriers. Renewal revenue declined from the year ended December 31, 2002, as a result of split dollar legislation and lower deferrals into executive benefit plans. Commission expense as a percentage of total revenue declined from 49.0% for the year ended December 31, 2002, to 41.8% for the year ended December 31, 2003, due to the higher percentage of sales by employee consultants who are paid on a lower commission grid. General and administrative expense for the year ended December 31, 2003, includes approximately $800 thousand of restructuring charges recorded in accordance with Statement of Financial Accounting Standards ("SFAS ") No. 146, Accounting for Costs Associated with Exit or Disposal Activities for the ongoing consolidation of the business support services and $711 thousand of charges associated with other severance agreements and lease terminations.
Total first year revenue increased 3.1% to $66.1 million for the year ended December 31, 2003 from $64.2 million for the year ended December 31, 2002. Revenue in the large bank sector of the business declined significantly from 2002 due to the sustained low interest rate environment. Increases in the community bank sector more than offset the first year revenue decrease in the large bank sector. Renewal revenue for the year ended December 31, 2003 includes $2.0 million related to the Administrative Services Agreement entered into on September 25, 2002 with an affiliate of AUSA Holding, Inc. along with $2.7 million in first year revenue from the execution of contracts with two other insurance carriers during 2003. With interest rates remaining at very low historical levels, there is some uncertainty about sustaining revenue growth due to product appeal, product capacity, and pricing concerns. Approximately $40.0 million of the increase in renewal revenue is attributable to the securitized inforce revenue stream from the acquisition of LongMiller. Commission expense for the year ended December 31, 2003 was $55.0 million, or 33.2% of revenue, compared to $45.3 million, or 39.1% of revenue, in the same period in 2002. The commission expense as a percentage of revenue continues to decrease as a result of a higher percentage of first year revenue produced by employee consultants. In addition, a larger percentage of total revenue consists of renewal revenue, which has a lower commission expense percentage. We do not pay commission expense on the revenue associated with the carrier incentive contracts. General and administrative expense for the year ended December 31, 2003, was $40.2 million, or 24.2% of revenue, compared to $30.8 million or 26.6% of revenue, for the comparable period in 2002. December 31, 2003 expenses included twelve months for LongMiller compared to one month in 2002, and operating expenses for the fourth quarter 2003 acquisition of Shoemaker and Blackwood. The lower percentage of general and administrative expenses to revenue reflects the relatively lower costs associated with the revenue stream from the LongMiller acquisition.
In May 2002, the Human Capital Practice was formed by combining our existing Rewards and Performance Group with the addition of 10 partners and 74 employees from Andersen's Human Capital Practice. As of October 1, 2003, we transferred part of the
In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice (including the Rewards and Performance Group) were transferred to the Pearl Meyer & Partners Practice. We recorded a charge of approximately $7.5 million in the fourth quarter 2003 relating to the reorganization of which $7.1 million remains on the consolidated balance sheet as of December 31, 2003.
As of October 1, 2003, we transferred part of the operations of the Human Capital Practice to Pearl Meyer & Partners. As a result, all years presented have been reclassified to reflect this transfer.
Total consulting revenue increased 20.3% to $26.8 million for the year ended December 31, 2003, compared to $22.3 million for the year ended December 31, 2002. The practice continues to experience more sales activity as a result of additional engagements in its areas of expertise of corporate governance and executive compensation due, in part, to increased public scrutiny of these areas. General and administrative expense was $23.3 million for the year ended December 31, 2003, compared to $20.9 million for the year ended December 31, 2002 reflecting higher headcount.
Total consulting revenue increased 3.2% to $22.3 million for the year ended December 31, 2002, compared to $21.6 million for the year ended December 30, 2001. General and administrative expense increased to $20.9 million for the year ended December 31, 2002 from $14.2 million for the year ended December 31, 2001, due to additional depreciation for new information systems, increased compensation costs, and higher headcount than in 2001. Amortization expense for the year ended December 31, 2002 decreased compared to the year ended December 31, 2001, due to the elimination of goodwill amortization as of January 1, 2002. Operating loss of $116 thousand for the year ended December 31, 2002, decreased from $3.8 million for the year ended December 31, 2001, due to the slowing economy and the difficult consulting environment.
In addition to our tangible balance sheet assets and liabilities, we have an on-going non-securitized renewal revenue stream, estimated to be $818.4 million over the next ten years. This on-going renewal revenue stream reflects current conditions and is not necessarily indicative of the revenue that may actually be achieved in the future and we cannot assure you that commissions under these policies will be received. See "Estimated Future Gross Renewal Revenue" section in the next few pages.
The following tables represent the estimated gross renewal revenue associated with the business-owned life insurance policies owned by our clients as of December 31, 2003. The projected gross revenues are not adjusted for mortality, lapse, or other factors that may impair realization, have not been discounted to reflect their net present value, and do not reflect the commission expense we must pay to consultants when we recognize the related revenue. We cannot assure you that commissions under these policies will be received. These projected gross revenues are based on the beliefs and assumptions of management and are not necessarily indicative of the revenue that may actually be realized in the future.
The 10-year inforce revenue net of commission expense is $438.0 million and $395.5 million, for the years ended December 31, 2003 and 2002, respectively.
Human Capital Practice, Pearl Meyer & Partners, and Federal Policy Group generate fee-based revenues and do not produce inforce revenues.
For the year ended December 31, 2003, approximately $72.1 million of cash was used primarily $(66.2 million) for the net repayment of borrowings.
As of December 31, 2003, there was restricted cash of approximately $19.0 million, an increase of $4.9 million from December 31, 2002, which will be used to pay down the asset-backed notes issued to finance the acquisition of LongMiller. This cash is not available for general corporate purposes, but is solely to service securitization indebtedness incurred to finance the acquisition of LongMiller.
On December 16, 2003, we received proceeds of approximately $11.5 million from our participation in a pooled trust preferred transaction, in which we issued $12.0 million aggregate principal amount of long-term subordinated debt securities with a floating rate based on three month LIBOR plus a spread of 410 basis points (5.27% as of December 31, 2003). We used the net proceeds to pay down the term portion of our credit facility. The pooled trust preferred debt is payable in one payment due in 30 years with interest paid quarterly.
Our financial statements begin on page 37 of this Form 10-K.