Our principal executive offices are located at 6100 4th Avenue South, Seattle, Washington. We purchased the building in August 2018 and occupy 91,437 square feet. We also occupy 1,600 square feet of office space in Vancouver, British Columbia pursuant to a lease that expires in March 2022.
(1) For more information about how we calculate total pets enrolled, total subscription pets enrolled, monthly average revenue per pet, lifetime value of a pet, average pet acquisition cost and average monthly retention, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Key Operating Metrics.”
We operate in two business segments: subscription business and other business. We generate revenue in our subscription business segment primarily from subscription fees for our medical insurance, which we market to consumers. Fees are paid at the beginning of each subscription period, which automatically renews on a monthly basis. We generate revenue in our other business segment writing policies on behalf of third parties, where we do not undertake the marketing, and have more of a business-to-business relationship. Our other business segment consists of companies or organizations that choose to provide medical insurance for cats and dogs as a benefit to their employees or members, and contracts include multiple pets. The policies in our other business segment may be materially different from our subscription business. Our ultimate goal is to build the Trupanion brand by continuing to offer the highest value proposition in the industry and maintain strong alignment with the veterinary community. We believe our activities in our other business segment benefit the overall market for pet medical insurance by expanding upon product options and distribution models within other market niches.
We generate leads for our subscription business through both third-party referrals and direct-to-consumer acquisition channels, which we then convert into members through our website and contact center. Veterinary practices represent our largest referral source. We engage our Territory Partners to have face-to-face visits with veterinarians and their staff. Territory Partners are dedicated to cultivating direct veterinary relationships and building awareness of the benefits of our subscription to veterinarians and their clients. Veterinarians then educate pet owners, who visit our website or call our contact center to learn more about, and potentially enroll in, Trupanion. We pay Territory Partners fees based on activity in their regions. We also receive a significant number of new leads from existing members adding pets and referring their friends and family members. Our direct-to-consumer acquisition channels serve as important resources for pet owner education and drive new member leads and conversion. We continuously evaluate the effectiveness of our member acquisition channels and marketing initiatives based upon their return on investment, which we measure by comparing the ratio of the lifetime value of a pet generated through each specific channel or initiative to the related acquisition cost.
Total pets enrolled. Total pets enrolled reflects the number of subscription pets or pets enrolled in one of the insurance products offered in our other business segment at the end of each period presented. We monitor total pets enrolled because it provides an indication of the growth of our consolidated business.
Lifetime value of a pet. Lifetime value of a pet (LVP) is a business operating metric that we believe reflects the lifetime value we might expect from a new subscription pet enrollment. We calculate LVP based on gross profit from our subscription business segment for the 12 months prior to the period end date excluding stock-based compensation expense related to cost of revenue from our subscription business segment, sign-up fee revenue and the change in deferred revenue between periods, multiplied by the implied average subscriber life in months. Implied average subscriber life in months is calculated as the quotient obtained by dividing one by one minus the average monthly retention rate. We monitor LVP to assess how much lifetime value we might expect from new pets over their implied average subscriber life in months and to evaluate the amount of sales and marketing expenses we may want to incur to attract new subscription pet enrollments, based on our targeted internal rate of return.
Average monthly retention. Average monthly retention is measured as the monthly retention rate of enrolled subscription pets for each applicable period averaged over the 12 months prior to the period end date. As such, our average monthly retention rate as of December 31, 2018 is an average of each month’s retention from January 1, 2018 through December 31, 2018. We calculate monthly retention as the number of pets that remain after subtracting all pets that cancel during a month, including pets that enroll and cancel within that month, divided by the total pets enrolled at the beginning of that month. We monitor average monthly retention because it provides a measure of member satisfaction and allows us to calculate the implied average subscriber life in months.
The following tables reflect the reconciliation of net acquisition cost to sales and marketing expense (in thousands):
Our operating expenses are classified into three categories: technology and development, general and administrative, and sales and marketing. For each category, the largest component is personnel costs, which include salaries, employee benefit costs, bonuses and stock-based compensation expense.
General and administrative expenses consist primarily of personnel costs and related expenses for our finance, actuarial, human resources, regulatory, legal and general management functions, as well as facilities and professional services.
Investment in pet acquisition. We have made and plan to continue to make significant investments to grow our member base. Our net acquisition cost and the number of new members we enroll depends on a number of factors, including the amount we elect to invest in sales and marketing activities in any particular period in the aggregate and by channel, the frequency of existing members adding a pet or referring their friends or family, effectiveness of our sales execution and marketing initiatives, changes in costs of media, the mix of our sales and marketing expenditures and the competitive environment. Our average pet acquisition cost has in the past significantly varied, and in the future may significantly vary, from period to period based upon specific marketing initiatives and the actual or expected relationship to LVP and estimated rates of return on pet acquisition spend. We also regularly test new member acquisition channels and marketing initiatives, which may be more expensive than our traditional marketing channels and may increase our average acquisition costs. We continually assess our sales and marketing activities by monitoring the ratio of LVP to PAC and the return on PAC spend both on a detailed level by acquisition channel and in the aggregate.
Timing of initiatives. Over time we plan to implement new initiatives to improve our member experience, make modifications to our subscription plan and find other ways to maintain a strong value proposition for our members. These initiatives will sometimes be accompanied by price adjustments, in order to compensate for an increase in benefits received by our members. The implementation of such initiatives may not always coincide with the timing of price adjustments, resulting in fluctuations in revenue and gross profit in our subscription business segment.
Comparison of the years ended December 31, 2018, 2017, and 2016
Year ended December 31, 2018 compared to year ended December 31, 2017. Total revenue increased by $61.3 million to $304.0 million for the year ended December 31, 2018, or 25%. Revenue from our subscription business segment increased by $45.4 million to $263.7 million for the year ended December 31, 2018, or 21%. This increase in subscription business revenue was primarily due to a 16% increase in total subscription pets enrolled as of December 31, 2018 compared to December 31, 2017, and increased average revenue per pet of 4% for the same period. Increases in pricing were due to the increased cost and utilization of veterinary care. Revenue from our other business segment increased $15.9 million to $40.2 million for the year ended December 31, 2018, or 65%, due to an increase in enrolled pets in this segment.
Year ended December 31, 2017 compared to year ended December 31, 2016. Cost of revenue for our subscription business segment was $176.9 million, or 81% of revenue, for the year ended December 31, 2017, compared to $141.3 million, or 82% of revenue, for the year ended December 31, 2016. This $35.6 million increase in subscription cost of revenue was primarily the result of a 15% increase in subscription pets enrolled, resulting in a 25% increase in veterinary invoice expense and related internal processing costs. As a percentage of revenue, these costs decreased to 71% for the year ended December 31, 2017 from 72% for the year ended December 31, 2016, due to the increase in monthly average revenue per pet outpacing the cost of veterinary care for certain subcategories as we more accurately priced those subcategories. Cost of revenue for our other business segment increased $9.1 million to $22.7 million for the year ended December 31, 2017, due to an increase in enrolled pets in this segment.
Year ended December 31, 2018 compared to year ended December 31, 2017. Technology and development expenses decreased $0.5 million, or 5%, to $9.2 million for the year ended December 31, 2018. This decrease was partially due to a $0.1 million decrease in amortization expense and a $0.1 million decrease in infrastructure-related costs compared to the same period in the prior year. In addition, more resources were dedicated to capital projects, resulting in a higher proportion of costs being capitalized in 2018.
Year ended December 31, 2018 compared to year ended December 31, 2017. General and administrative expenses increased $1.4 million, or 8%, to $18.2 million for the year ended December 31, 2018. This increase was primarily due to increases of compensation expense by $1.0 million and professional service fees by $0.6 million, partially offset by lower expenses as a result of owning our corporate headquarters building. General and administrative expenses decreased from 7% to 6% as a percentage of revenue for the year ended December 31, 2018, as we experienced scale in our support functions.
Year ended December 31, 2017 compared to year ended December 31, 2016. Sales and marketing expenses increased $3.9 million, or 25%, to $19.1 million for the year ended December 31, 2017. PAC increased 24% from December 31, 2016, to $152 for the year ended December 31, 2017, as a result of $1.8 million in additional testing of new marketing initiatives. Additionally, compensation and related expenses increased by $2.0 million due to a 21% increase in headcount in the year ended December 31, 2017.
Year ended December 31, 2017 compared to year ended December 31, 2016. Total other (income) expense, net improved by $0.9 million due to a $1.0 million gain related to the sale of our equity method investment in the second quarter of 2017.
The Tax Act makes additional significant changes to the Code, such as, (1) imposing a mandatory one-time tax on accumulated earnings of foreign subsidiaries and transitioning U.S. international taxation from a worldwide tax system to a territorial system with base erosion rules; (2) imposing changes on the utilization of net operating losses; (3) other general changes to the taxation of corporations, including changes to cost recovery rules, changes to the deductibility of interest expense, and elimination of the performance-based compensation exception for executive compensation. The overall impact of the Tax Act on our future results of operations is uncertain at this time. We intend to continue to reinvest all of our foreign earnings indefinitely outside of the U.S.
The following tables contain selected quarterly financial information for the years ended December 31, 2018 and 2017. The unaudited quarterly information has been prepared on a basis consistent with the audited consolidated financial statements and includes all adjustments that we consider necessary for a fair presentation of the information shown. These quarterly operating results for any fiscal quarter are not necessarily indicative of the operating results for any full fiscal year or future period.
Cash provided by operating activities was $9.7 million for the year ended December 31, 2017 compared to cash used in operating activities of $5.0 million for the year ended December 31, 2016. The increase in cash provided by operating activities of $4.7 million was primarily due to the $4.1 million decrease in operating loss, drive by higher revenue and decreased operating expenses as a percentage of revenue as we increased scale in our technology and general and administrative departments.
Cash provided by financing activities was $71.2 million and $5.1 million for the years ended December 31, 2018 and 2017, respectively. The increase of $65.3 million was primarily due to net proceeds of $65.7 million received from the June 2018 follow-on public offering.
We enter into long-term contractual obligations and commitments in the normal course of business, primarily debt obligations and non-cancellable vendor service agreements. For enforceable and legally binding contracts, our contractual cash obligations as of December 31, 2018 are set forth below (in thousands):
The reserve for our subscription business represents our estimate of the future amount we will pay for veterinary invoices that are dated as of, or prior to, our balance sheet date. The reserve also includes our estimate of related internal processing costs. To determine the accrual, we make assumptions based on our historical experience, including the number of veterinary invoices we expect to receive, the average cost of those veterinary invoices, the length of time between the date of the veterinary invoice and the date we receive it, and our expected cost to process and administer the payments. As of each balance sheet date, we reevaluate our reserve and may adjust the estimate for new information.
For the year ended December 31, 2018, we paid $10.1 million for veterinary invoices dated on or before December 31, 2017, including related processing costs. Our reserve estimate for these expenses was $11.1 million as of December 31, 2017. As of December 31, 2018, we reevaluated the remaining reserve for those periods prior to December 31, 2017 and recorded an adjustment to our income statement to increase it by $0.4 million. As of December 31, 2018, our reserve was $13.9 million, consisting of $12.5 million for the amount we expect to pay in the future for veterinary invoices dated between January 1, 2018 and December 31, 2018, inclusive of related processing costs, and a reserve of $1.3 million for periods prior to 2018.
Similarly, for the years ended December 31, 2017 and 2016, we adjusted our reserve for prior periods, reducing it by $0.1 million and increasing it by $0.8 million, respectively. These adjustments were recorded in our income statement for each respective year.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 14, 2019 expressed an unqualified opinion thereon.
The Company considers any cash account that is contractually restricted to withdrawal or use to be restricted cash. The Company is party to a financing agreement requiring a restricted cash balance. As of December 31, 2018, the Company was in compliance with all requirements.
Deferred revenue consists of subscription fees received or billed in advance of the subscription services within the Company's subscription business, and the unexpired term of premiums related to the Company's unaffiliated general agents within the other business segment.
Technology and development expenses primarily consist of personnel costs and related expenses for the Company's technology staff, which includes information technology development and infrastructure support and third-party services, as well as depreciation of hardware and capitalized software.
Other income was $1.3 million for the year ended December 31, 2018. Interest income of $0.9 million, $0.2 million, and $0.1 million was recorded in other income for the years ended December 31, 2018, 2017, and 2016, respectively. Other income in the year ended December 31, 2017 included a gain of $1.0 million from the sale of the Company's equity method investment.
Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a tax rate change is recognized in the period that includes the enactment date. Valuation allowances are provided for when it is considered more likely than not that deferred tax assets will not be realized.
For the Company’s Canadian business, all plans are written by Omega and the risk is assumed by the Company through a fronting and reinsurance agreement. Premiums are recognized and earned pro rata over the terms of the related customer contracts. Revenue recognized from the agreement in 2018, 2017, and 2016 was $57.4 million, $47.1 million and $36.5 million, respectively, and deferred revenue relating to this arrangement at December 31, 2018 and 2017 was $2.1 million and $1.8 million, respectively. Reinsurance revenue was 19% of total revenue in 2018, 2017, and 2016. Cash designated for the purpose of paying claims related to this reinsurance agreement was $3.9 million and $2.8 million at December 31, 2018 and 2017, respectively. In addition, as required by the Office of the Superintendent of Financial institutions regulations related to the Company’s reinsurance agreement with Omega, the Company is required to fund a Canadian Trust account with the greater of CAD $2.0 million or 115% of unearned Canadian premium plus 15% of outstanding Canadian claims, including all incurred but not reported claims. As of December 31, 2018, the account balance was CAD $3.5 million and the Company was in compliance with all requirements.
The results of operations related to our ownership of the building are included in the Company’s Consolidated Statements of Operations from the date of acquisition.
The following table summarizes the Company's future rental payments to be received from non-cancellable leases in place as of December 31, 2018 (in thousands):
In February 2016, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) amending the lease presentation guidance. The ASU requires organizations that lease assets to recognize the rights and obligations created by those leases on the consolidated balance sheets. This ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within that reporting period, with early adoption permitted. The Company will adopt this guidance as of January 1, 2019 using the modified retrospective transition method, and will elect all applicable practical expedients upon the adoption. Based on the lease portfolio as of December 31, 2018, the Company does not expect the adoption of this guidance to have a material impact on its consolidated financial statements.
In June 2016, the FASB issued an ASU amending the measurement of credit losses on financial instruments. The ASU requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. This replaces the existing incurred loss impairment model with an expected loss methodology, which will result in more timely recognition of credit losses. This ASU is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2019. The Company is currently in the process of evaluating the impact the adoption of this ASU will have on its consolidated financial statements.
In August 2018, the FASB issued an ASU that eliminates certain disclosure requirements for fair value measurements, requires new disclosures regarding significant unobservable inputs used to develop Level 3 fair value measurements, and modifies certain existing disclosure requirements for Level 3 fair value measurements. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within that reporting period, with early adoption permitted. The Company is currently evaluating the impact the adoption of this ASU will have on its consolidated financial statements.
Depreciation expense related to property and equipment, inclusive of assets purchased on capital lease, was $4.3 million, $4.2 million and $3.8 million for the years ended December 31, 2018, 2017 and 2016, respectively.
Amortization expense associated with intangible assets for the year ended December 31, 2018 was $0.2 million, and is expected to be approximately $0.5 million in each of the five succeeding years.
The Company measures the fair value of restricted cash, money market funds, and foreign deposits based on quoted prices in active markets for identical assets. The fair value of the municipal bond is based on either recent trades in inactive markets or quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable market data. The estimated fair value of the Company's investment in the variable interest entity is a Level 3 measurement, and is based on market interest rates, the assessed creditworthiness of the entity, and the estimated fair value of the entity's common stock. As of December 31, 2018, the Company estimates that the purchase price approximates the fair value. Short-term investments are carried at amortized cost and the fair value is disclosed in Note 5, Investments. The fair value of these investments is determined in the same manner as for available-for-sale securities and is considered a Level 1 measurement.
The Company's other long-term assets balance included notes receivable of $3.0 million and $2.5 million as of December 31, 2018 and 2017, respectively, recorded at their estimated collectible amount. The Company estimates that the carrying value of the notes receivable approximates the fair value. The estimated fair value represents a Level 3 measurement within the fair value hierarchy, and is based on market interest rates and the assessed creditworthiness of the third party.
The following summarizes the Company's contractual commitments as of December 31, 2018 (in thousands):
(1) Consists of a revolving line of credit. Excludes interest of the greater of 4.5% or 1.25% plus the prime rate (6.75% as of December 31, 2018).
The Company had a lease agreement for its headquarters building located in Seattle, Washington until the Company purchased the building in August 2018. Minimum rent payments under operating leases are recognized on a straight-line basis over the term of the lease. Rental expense for operating leases was $1.4 million, $1.8 million and $1.2 million for the years ended December 31, 2018, 2017 and 2016, respectively.
In addition, from time to time the Company is or may become subject to various legal proceedings arising in the ordinary course of business, including proceedings against members, other entities or regulatory bodies. Estimated liabilities are recorded when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. In many instances, the Company is unable to determine whether a loss is probable or to reasonably estimate the amount of such a loss and, therefore, the potential future losses arising from a matter may exceed the amount of estimated liabilities the Company has recorded in the financial statements covering these matters. The Company reviews its estimates at least quarterly and makes adjustments to reflect negotiations, estimated settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular matter.
The Company's reserve for the subscription business segment increased $2.8 million from $11.1 million at December 31, 2017 to $13.9 million at December 31, 2018. This change was comprised of $191.1 million in expense recorded during the period less $187.5 million in payments of veterinary invoices. This $191.1 million in veterinary invoice expense incurred included an increase of $0.4 million to the reserves relating to prior years, which was the result of ongoing analysis of recent payment trends. The Company's adjustments to prior year reserves were a reduction of $0.1 million and an increase of $0.8 million as a result of analysis of payment trends in the years ended December 31, 2017 and 2016, respectively.
The Company’s reserve for the other business segment increased $0.5 million from $1.7 million at December 31, 2017 to $2.2 million at December 31, 2018. This change was comprised of $23.5 million in expense recorded during the period less $23.0 million in payments of veterinary invoices. This $23.5 million in veterinary invoice expense incurred included a reduction of $0.3 million to the reserves relating to prior years, which was the result of ongoing analysis of recent payment trends. The Company's adjustments to decrease prior year reserves were $0.2 million and $0.1 million as a result of analysis of payment trends in each of the years ended December 31, 2017 and 2016, respectively.
In the following tables, amounts are by year the veterinary invoice relates to, referred to as the year of occurrence. Amounts in these tables are presented on a constant currency basis to remove the impact of changes in the foreign currency exchange rate. The cumulative amounts paid as of the end of each year are revalued using the currency exchange rate as of December 31, 2018. Information for years 2015 through 2017 is provided as required supplementary information.
Borrowings on the revolving line of credit were limited to the lesser of $50.0 million or the total amount of cash and securities held by the Company's insurance subsidiaries (American Pet Insurance Company and Wyndham Insurance Company (SAC) Limited Segregated Account AX) as of December 31, 2018 and 2017. As of December 31, 2018, available borrowing capacity on the line of credit was $36.6 million, with an outstanding balance of $0.4 million for ancillary services and letters of credit, and borrowings under the facility of $13.0 million, recorded net of financing fees of $0.1 million.
Stock-based compensation expense includes stock options, restricted stock awards, and restricted stock units granted to employees and non-employees and has been reported in the Company’s consolidated statements of operations depending on the function performed by the employee or non-employee. Stock-based compensation expense recognized in each category of the consolidated statement of operations for the years ended December 31, 2018, 2017 and 2016 was as follows (in thousands):
As of December 31, 2018, stock options outstanding and stock options exercisable had a weighted average remaining contractual life of 5.6 years and 5.0 years, respectively.
The weighted-average grant date fair value per share and the fair value of options vested were as follows for the years ended December 31, 2018, 2017, and 2016:
The purchase price was allocated to the following assets based on estimates of their relative fair value (in thousands):
Substantially all of the Company’s long-lived assets were located in the United States as of December 31, 2018 and 2017.
As of December 31, 2018, the Company’s insurance subsidiary in New York maintained $56.2 million of statutory capital and surplus which was above the required amount of $53.4 million of statutory capital and surplus to avoid additional regulatory oversight. The increase in statutory capital and surplus as of December 31, 2018 was due to the Company having sufficient history for its average historical loss and loss adjustment expense ratio to be used in the risk-based capital calculation. In prior periods, this calculation used industry average ratios due to having less than ten years of historical data.
The components of income tax (benefit) expense were as follows (in thousands):
A valuation allowance is required to reduce the deferred tax assets reported if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. After consideration of all the evidence, both positive and negative, the Company has recorded a full valuation allowance against its U.S. Federal deferred tax assets as of December 31, 2018 and 2017 because the Company’s management has determined that it is more likely than not that these assets will not be fully realized.
The Tax Act implemented a new tax on foreign subsidiary income referred to as the Global Intangible Low-Taxed Income (“GILTI”). The Company is recording GILTI on a current basis and not booking deferred taxes related to GILTI.
The Company is open to examination by the U.S. federal tax jurisdiction for the years ended December 31, 2015 through 2018. The Company is also open to examination for 2007 and forward with respect to net operating loss carryforwards generated and carried forward from those years in the United States. The Company is open to examination by the Canada Revenue Agency for the years ended December 31, 2014 through 2018 for all corporate tax matters, and open for the years ended December 31, 2011 through 2018 for transactions with non-arm’s length non-Canadian residents.
The following table contains quarterly financial data for the years ended December 31, 2018 and 2017 (in thousands, except per share data). The unaudited quarterly information has been prepared on a basis consistent with the audited consolidated financial statements and includes all adjustments that the Company considers necessary for a fair presentation of the information shown. The operating results for any fiscal quarter are not necessarily indicative of the operating results for a full fiscal year or any future period and there can be no assurances that any trend reflected in such results will continue in the future.