Home warranty revenue, totaling $40,136,000 and representing 88% of total operating revenue for 1996, increased 8% from the 1995 figure of $37,181,000, or 83% of total operating revenue, due primarily to increases in home warranty contract sales. The increase in contract sales is due to additional membership and to a strong residential real estate market. Due to the Company's warranty revenue recognition method, which recognizes contract revenue over the one year term of the contract, warranty revenue for any period of time is also impacted by production in the eleven months immediately preceding that period. There have been no major pricing changes which would have significantly affected warranty revenue.
Direct expenses of the warranty product, which consist primarily of claims expense and acquisition costs, as a percentage of related operating revenue, increased to 80% in 1996 from 79% in 1995, primarily due to a 2% increase in average claim severity and a 6% increase in warranty claim frequency. Claim frequency experienced in 1996 returned to the unusually high frequency experienced in 1994, as a result of the severe weather patterns experienced across the country during 1996. Through December, 1996 the winter season has been extremely severe, resulting in negative experience in the last quarter of the year. This trend has continued into the first quarter of 1997, and has had a continued negative impact on the Company's cash position and its results of operations.
The amount of general and administrative ("G&A") expenses of the home warranty operation, which primarily include allocated fixed costs, increased slightly from the prior year period due primarily to increases in overhead costs related to the pending sale of the Company.
Membership and other related revenue of $4,331,000 in 1996 was 31% lower than 1995 revenue of $6,258,000, which is primarily related to the continued change in mix of the Company's membership base. As in the prior year, the portion of the Company's membership which no longer participates in the Company's E&O program and which pays the associated marketing/placement fees has continued to decline. These factors have caused continuing decreases in related revenue and earnings in 1996, a continuing reflection of the effects of the change in the Company's E&O carrier. As a result of this change, and due to continued increased competitive pressures within the E&O market, the Company has continued to experience declines in Members as participants in its current E&O program. Additionally, attraction of new full members continues to be difficult, due to premium quotes which are not competitive for certain brokers.
Throughout 1996, the Company has also continued to focus on attracting new members and retaining as participants in the warranty program former members who are not covered by CNA. This strategy has somewhat reduced the negative impact of the loss of members through increases in warranty production.
Direct expense of the membership operations approximated 75% of related revenue for 1996 and 70% of related revenue for 1995. The disproportionate cost ratio is related primarily to certain fixed costs, which do not decline with decreases in revenues, and to the results of the CORs, which were particularly impacted by the Full E&O membership declines, especially in the states of California and Texas. Also impacting the direct cost ratio is the effect of continued promotional discounting of some of the Company's membership programs, a step the Company has taken to retain some of its top producing members.
As with the home warranty operations, G&A expenses of the Company's membership and other operations increased from 1995 totals, again related to increases in general overhead costs related to the pending acquisition.
Direct expenses of the E&O operations increased from $648,000, or 52% of revenue in 1995 to $657,000 or 68% of revenue in 1996. Under the current E&O program, the Company has agreed to pay a portion of the commission it receives on the E&O premiums collected to the Affiliates generating the premium volume. There are also certain fixed costs related to the Company's risk management programs which result in the cost ratio being disproportionate.
Other expenses include interest expense of approximately $351,000, related primarily to the CNA obligation, losses from the Company's share of investment in an Internet access provider joint venture of approximately $220,000, and a loss on disposal of fixed assets of approximately $120,000. In 1995, the Company formed a partnership through which it planned to offer services as an Internet access provider to its members. Due to continued losses, and lower than anticipated sales, in December 1996, the Company stopped funding the partnership, and plans to sell its partnership interest or otherwise dissolve the partnership agreement. The losses on fixed asset disposals resulted from the Company's change in corporate office locations, at which time the Company disposed of certain office furniture and equipment, for which it received only nominal proceeds. In 1995, other expense included interest on the CNA obligation of approximately $275,000 and losses incurred by the Internet access provider joint venture of approximately $80,000.
In connection with the transfer of the net assets of POMG to CNA and the assumption by CNA of the obligations of POMG under certain Realtor's errors and omissions policies, the Company guaranteed the performance by Sphere Drake Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5 million reinsurance treaty purchased by POMG to protect it from losses in excess of a predetermined amount. Under the terms of the Company's guaranty, CNA, as the transferee of the reinsurance treaty, bears any credit risk under the treaty, including, but not limited to, any risk that Sphere Drake becomes insolvent, is adjudicated as a bankrupt or has liquidation or similar proceedings commenced against it. The Company placed $3 million into a collateral account to secure its guarantee (the "Collateral Account"), and has also agreed, if necessary, to pay the additional $2 million related to the guarantee from future commissions. On April 10, 1996, CNA issued a Notice of Arbitration to the reinsurer with respect to its refusal to honor the reinsurance treaty.
Direct expenses of the warranty product, which consist primarily of claims expense and acquisition costs, as a percentage of related operating revenue decreased to 79% in 1995 from 83% in 1994, primarily due to a 2% decrease in average claim severity and a 1% increase in warranty claim frequency. Claim frequency experienced in 1995 returned to the 1993 levels, after the unusually high frequency experienced in 1994, as a result of the severe weather patterns experienced across the country throughout the first eight months of 1994. Through December, 1995 the winter season has been extremely severe, resulting in negative experience in the last quarter of the year. This trend has continued into the first quarter of 1996, and has had a significant negative impact on the Company's cash position and its results of operations.
As with the home warranty operations, G&A expenses of the Company's membership and other operations decreased from 1994 totals, due to the September 1994 work-force reduction, combined with the focus on controlling costs.
Direct expenses of the E&O operations increased from $512,000 in 1994 to $648,000 in 1995. Under the current E&O program, the Company has agreed to pay a portion of the commission it receives on the E&O premiums collected to the Affiliates generating the premium volume. There was no such arrangement under previous E&O programs, and, as 1994 was a transition year, the 1995 increase was anticipated. As the premium volume under the new program grows, the commission paid to the Affiliates will grow proportionately.
In early September 1994, the Company underwent an organizational restructuring, reducing its total work-force by approximately 20%. This restructuring resulted in annual cost savings of approximately $1,700,000 in 1995, through reductions in salary, benefits and payroll tax expenses, excluding the effects of any other personnel or staffing changes. The 1994 one time charge for severance pay and related benefits, totaling $1,063,000 is included in "Unusual items" in the accompanying consolidated statements of operations. Approximately $400,000 of this total relates to an agreement to terminate the employment contract between the Company and its former Chairman of the Board of Directors.
Investment income approximated $1,367,000 in 1995, an increase of approximately 1000% from the 1994 level of $120,000. Unrealized holding gains/losses on trading securities are included in the Company's earnings for the period, and unrealized gains/losses on securities available for sale are reported as a separate component of stockholders' equity. In 1994, rising interest rates caused the Company's investments in debt securities to generate significant unrealized holding losses, especially on its trading securities portfolio, which have been included in the Company's consolidated income statement. In 1995, this trend reversed, and the Company recognized significant income. Investment income is generated primarily from the securities currently invested by the Company's regulated home warranty subsidiaries, as well as from additional investment of funds
generated through the sales of warranty products. Funds generated through the other operations of the Company's business are generally invested in highly liquid overnight investments, and therefore earn a minimal amount of interest over the course of a year.
The Company's 1995 effective tax rate on income from continuing operations was 38.4%, as compared to a benefit of 11.3% on income from continuing operations in 1994.
As a result of losses generated by the current year Acceleration judgment (see Discontinued Operations below), the 1994 work-force reduction and termination of its UK operations, combined with the prior year losses generated by the Company's discontinued reinsurance operations, the Company has recognized significant income tax benefits in 1993 and 1994. A portion of the Company's 1993 and 1994 pre-tax losses was carried back for income tax purposes, to offset taxable income earned in the prior three years, generating tax refunds for the Company. The remaining pre-tax losses give rise to significant deferred tax benefits, which will be recognized in future years, as the temporary book to tax differences which create the deferred tax benefits become deductible for tax purposes. The total deferred tax benefit which is expected to be realized in future years approximates $8.2 million at December 31, 1995. Based upon management's estimates of future taxable income and of the positive and negative evidence regarding the likelihood of ultimate recognition of this benefit, it has been determined that no valuation allowance is necessary. This determination was based on the Company's taxable earnings history, exclusive of non-recurring charges, and the period anticipated for full recognition, assuming the Company maintains its current level of taxable income, exclusive of the charges incurred for its discontinued operations, the restructuring charges reported in 1994 and 1996, and certain other non-recurring items.
In 1996, net cash provided by operating activities totaled $4,347,000, as compared to cash used in operations of $667,000 in 1995. This increase in cash is primarily due to liquidation of some of the Company's investment portfolio, relating to a transfer of investments from trading to available for sale in mid-1996, paired with increases in warranty production in 1996 as compared to the 1995 levels. In the first quarter of 1996, the Company modified its payment terms to its claims service contractors to move from 20 to 30 day terms, consistent with industry standards, which further positively impacted cash flows. Also impacting operating cash flows are various payments for claims payable, Affiliate and Member commissions and E&O premium
During 1996 the Company made principal repayments of approximately $725,000 against the CNA obligation. As of December 31, 1996, the net present value of the balance due to CNA under this obligation was $3,075,000. In addition, in connection with the transfer of the net assets of POMG to CNA and the assumption by CNA of the obligations of POMG under certain Realtor's errors and omissions policies, the Company guaranteed the performance by Sphere Drake Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5 million reinsurance treaty purchased by POMG to protect it from losses in excess of a predetermined amount. Under the terms of the Company's guaranty, CNA, as the transferee of the reinsurance treaty, bears any credit risk under the treaty, including, but not limited to, any risk that Sphere Drake becomes insolvent, is adjudicated as a bankrupt or has liquidation or similar proceedings commenced against it. The Company has agreed, if necessary, to pay an additional $2 million out of future commissions related to the guarantee. Should this occur, the repayments on the $5 million obligation will be delayed until the $2 million is paid. The Company will not be required to further reduce its collected commission by more than 50% under these agreements. On April 10, 1996, CNA issued a Notice of Arbitration to Sphere Drake, with respect to its refusal to honor the reinsurance treaty. Accordingly, the Company, CNA and Sphere Drake have engaged in settlement negotiations with respect to the reinsurance treaty. Although terms are not yet finalized, its is possible that the Company could pay a substantial portion of the Collateral Account to CNA under the terms of the currently proposed settlement agreement. As a result of the settlement negotiations between CNA and Sphere Drake, the Company has recorded a loss provision of $2.5 million for the guarantee.
In December 1991, ANIC, the insurer of the Company's E&O program through April 1991, brought suit against the Company and HMS. On December 13, 1995, a jury verdict in the amount of $5,156,022 was rendered in favor of the Plaintiff and against HMS. Under the terms of the Merger Agreement with Cross Country, Cross Country agreed to pay the balance due to ANIC under a settlement agreement, upon closing of the Merger. Pursuant to the settlement agreement, on September 4, 1996, the Company paid to ANIC the full amount of its 1995 federal income tax refund, together with interest, which totaled $1,401,485. The remaining balance due bears interest at the rate of 10% per annum from September 1, 1996 until the settlement amount is paid in full. An affiliate of Cross Country purchased the judgment from ANIC as of October 31, 1996, for approximately $2.75 million. The Cross Country affiliate agreed, under certain conditions, to take no action to collect on the judgment before January 31, 1997. In January 1997, under the Second Amendment to the Merger Agreement, the Cross Country affiliate extended the date until which it agreed to take no action to collect on the judgment to July 1, 1997. The Company has guaranteed the obligation of HMS and pledged the shares of HMS and another subsidiary of the Company to secure such guarantee. HMS and the subsidiary granted security interests in their assets as part of the First Amendment to the merger agreement. Should the merger fail to be consummated by July 1, 1997, Cross Country will be entitled to take action to collect on its judgment. In the event the judgment creditor proceeds to execute on its judgment, it is likely that the Company will be without adequate resources to pay the full amount due to Cross Country, as holder of the judgment, which would become immediately due and payable. In such event, the Company would be forced to seek alternatives to paying the remaining unpaid balance of the judgment. No other alternatives are presently being considered. The Company's efforts in 1996 to contest the
domestication of the judgment in Florida, appeal the judgment and otherwise prevent the judgment creditor from executing on its judgment have resulted in substantial fees to professionals and other advisors, which further negatively impacted the Company's liquidity during 1996.
Seventeen of the states in which the Company's subsidiaries operate regulate the home warranty business. Certain of these states require that reserves be maintained to cover future repairs for the remaining terms of warranty contracts (generally one year). As of December 31, 1996, approximately $10,800,000 of cash and investments are needed to maintain the regulated subsidiaries' required minimum reserve and surplus levels. Of this amount, approximately $1,200,000 of cash and investments are held by the regulated states to assure the Company's fulfillment of its obligations to contract holders. Increases in warranty production, as seen thus far in the first quarter of 1996, result in increases in the Company's required reserve and surplus levels in the regulated states. In addition, state regulators generally seek reserve balances in excess of the minimum standards. In certain states, withdrawal of any reserves in excess of statutory minimums requires approval from the regulatory authorities. The Company has been advised by certain authorities that such approval will not be granted. Accordingly, the Company maintained reserves of approximately $13,500,000 as of December 31, 1996. The Company is currently in compliance with all applicable surplus and reserve requirements.
The Company is continuing its efforts to upgrade its current computer and processing environments over the next two years, in an attempt to increase operational efficiency, improve management information, and allow for future growth in the Company's business. This plan is currently expected to have an incremental cost of approximately $750,000 in excess of the cost of maintaining, servicing and improving the existing system, over the life of the project. Management expects that sufficient funds will be available to cover the cost of the upgrade. If such funds are not available, this project will be deferred.
Consolidated Statements of Cash Flows - Years Ended December 31, 1996, 1995 and 1994 24
Consolidated Statements of Stockholders' Equity - Years Ended December 31, 1996, 1995 and 1994 25
We have audited the accompanying consolidated balance sheets of Homeowners Group, Inc. and its subsidiaries (the "Company") as of December 31, 1996 and 1995 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
The accompanying financial statements for the year ended December 31, 1996 have been prepared assuming the Company will continue as a going concern. As discussed in Notes 1, 2 and 10, the Company could be obligated to pay on an outstanding judgement. In the event the judgement creditor proceeds to execute on its judgement, it is likely the Company will be without adequate resources to pay the full amount due, which raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to this matter are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
As discussed in Note 10 to the consolidated financial statements the Company is currently undergoing an examination by the Internal Revenue Service of its tax returns for the years 1993, 1994 and 1995.
Although the Company's home warranty contracts are generally not considered to be insurance products, the Company is subject to insurance-type regulations in many of the states in which the home warranty contracts are sold. Certain of these states require that reserves be maintained to cover future repairs for the remaining terms of the warranty contracts (generally one year). As of December 31, 1996, approximately $10,800,000 of cash and securities were needed to maintain the regulated subsidiaries' minimum reserve and surplus levels. Increases in warranty production, as seen thus far in the first quarter of 1997, result in increases in the Company's required reserve and surplus levels in the regulated states. In addition, state regulators generally seek reserve balances in excess of the minimum standards. In certain states, withdrawal of any reserves in excess of statutory minimums requires approval from the regulatory authorities. The Company has been advised by certain authorities that such approval will not be granted. Accordingly, the Company maintained reserves of approximately $13,500,000 as of December 31, 1996. The Company is currently in compliance with all applicable surplus and reserve requirements.
See also Note 2, for discussion of the Company's cash collateral requirements relative to the 1993 transfer of its discontinued reinsurance operations and Note 10 for discussion of other commitments and contingencies impacting cash flow.
The Company announced on May 15, 1996 that it had entered into a definitive merger agreement (the "Merger") under which The Cross Country Group, Inc. ("Cross Country") agreed to acquire the Company for $2.35 per share in cash. The merger agreement stated that the merger was subject to a number of conditions including approval of the transaction by the Company's stockholders and regulatory authorities. The Company also announced on May 15, 1996 that it had reached an agreement to settle the judgment obtained by Acceleration National Insurance Company ("Acceleration" or "ANIC") by paying to Acceleration a reduced amount of approximately $4.4 million in cash at the closing of the merger, which Cross Country had agreed, as a condition to the merger, to satisfy.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 1. THE COMPANY (Continued) - ------------------------------------------------------------------------------- On November 7, 1996, the Company, announced that it had entered into an amendment to the merger agreement with Cross Country, which, among other things, reduced the price at which Cross Country will acquire HOMG stock to $2.06 per share in cash. The amendment also extended the anticipated closing date to no later than March 1, 1997. In addition, the amendment modified the Company's stock rights plan to permit Cross Country and its affiliates to buy an unlimited number of shares in privately negotiated transactions. This stock rights plan amendment was not effective until three business days after the information was released, provided that no other bid for the Company was received within such three day period. The three day period passed with no other bids submitted to purchase the Company.
As of the date of this filing, the Company has obtained regulatory approval for the merger in all states.
In December 1992, the Company formed its own reinsurance subsidiary, POMG Insurance Company, Ltd. ('POMG'), which acquired certain net assets from Meridian Insurance Company, Ltd. ('Meridian'), the previous reinsurer of the Company's E&O program. In December 1992, the subsidiary purchased a $5,000,000 aggregate stop loss reinsurance policy to further protect it from the risk of loss in excess of a predetermined amount on the first two E&O policy years.
The agreements with CNA impose certain restrictive covenants until the $5,000,000 CNA Obligation is satisfied. These covenants include limits on dividends and on future borrowings. The funds due to CNA are a senior obligation of the Company, secured by an interest in the common stock of the Company's HOMS subsidiary and in the Company's Member list. For a five year period ending November 30, 1999, the Company and its Affiliates must provide CNA/Schinnerer with right of first refusal on E&O insurance offered to its membership. In addition to the restrictive covenants, the Company has agreed to meet certain production quotas with respect to annual premium volume. Based on the 1996 premium volume achieved, the Company is currently in default of the terms of the agreements as modified, and could be required by CNA to make a payment against its obligation to the Holdback Fund in the amount of approximately $200,000. However, the Company and CNA have entered into an amendment to the Holdback Agreement which would delete the premium volume quotas and release the Company from its current obligation to pay the remaining $3.1 million. Following the effective date of this amendment, the Company's obligation will be limited to the payment of 50% of actual commissions to CNA. The proposed amendment becomes effective if the Merger is consummated prior to July 1, 1997, and the dispute with Sphere Drake (as described above) is settled within 14 days of the consummation of the Merger.
On December 13, 1995, a jury verdict in the amount of $5,156,022 was rendered in favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"), a subsidiary of the Company, in the following matter: Acceleration National Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al., Defendants, in the Court of Common Pleas of Franklin County, Ohio. This amount has been accrued as an adjustment to the Company's loss from discontinued reinsurance operation, and reported net of taxes in the amount of $2,036,629 in the accompanying consolidated income statements. See also note 10 regarding contingencies and anticipated resolution of this matter.
PRINCIPLES OF CONSOLIDATION -- The accompanying consolidated financial statements include the accounts of HOMG and all of its majority owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. The Company's 45% interest in the partnership enrolling and servicing Members in Texas is accounted for by the equity method. The earnings from the partnership are included in operating revenue in the accompanying consolidated statements of operations.
REVENUE AND EXPENSE RECOGNITION -- Home warranty contract revenue is recognized over the life of the contract (generally one year) in proportion to historical experience of repair costs. Direct costs incurred in acquiring the contracts are recognized in the same manner. Direct acquisition costs include certain additional expenses, such as incentive bonuses paid to the Company's Members and Affiliates, costs of personnel directly involved in acquiring the contracts, and premium taxes. Repair costs under home warranty contracts are expensed as mechanical breakdowns are reported to and repairs are authorized by the Company. Initial and renewal membership fees and associated commission expenses are deferred upon collection of the fees and are recognized over the life of the membership period, generally one year. E&O premium commissions are recognized upon collection of the related premiums. All other revenues and expenses are recognized upon delivery or receipt of the related products or services.
PROPERTY AND EQUIPMENT -- Property and equipment is carried at cost and depreciated on the straight-line method over their estimated useful lives, which range from three to seven years. Leasehold improvements are amortized over the shorter of the lease term or the estimated useful lives of the improvements.
Debt and Equity Securities.' This standard requires that the Company report at fair value the securities which are held for trading purposes, or which are available for sale. Unrealized holding gains and losses on trading securities are determined based upon the change in fair value and are included in investment income in the accompanying consolidated statements of operations. Unrealized holding gains on securities available for sale are also determined based upon the changes in fair values, and are reported net of tax as a separate component in the stockholders equity section of the balance sheet. Gains and losses on securities are determined based upon specific identification of the securities sold. The Company does not currently have any securities which are classified as held to maturity.
FOREIGN CURRENCY TRANSLATION -- The financial statements of the Company's previous 80% owned British subsidiary are translated into US dollars in accordance with SFAS No. 52, 'Foreign Currency Translation.' Net assets of the subsidiary, whose functional currency is the British Pound Sterling, are translated at current exchange rates, while results of operations are translated at average exchange rates in effect for the year.
NET INCOME PER COMMON SHARE -- Net income per common share is based upon the weighted average number of common shares outstanding during each year. Dilutive stock options and warrants are included in the calculation of weighted average shares utilizing the Treasury Stock Method. Primary and fully diluted earnings per share are essentially the same in all years presented in the accompanying consolidated statements of operations.
Depreciation and amortization expense on property and equipment for the years ended December 31, 1996, 1995 and 1994 approximated $959,000, $602,000 and $749,000, respectively, and is included in general and administrative expenses in the accompanying consolidated statements of operations. In 1996, in connection with the Company's
Information with respect to unrealized holding gains and losses and securities classified as available for sale, as of December 31, 1996 and 1995 is as follows:
GROSS AMORTIZED UNREALIZED HOLDING FAIR COST GAINS LOSSES VALUE ---------- ---------- -------- ---------- Money markets $ 221,560 $ - $ - $ 221,560 US Gov't obligations 6,331,527 69,185 5,567 6,395,145 Corporate bonds 403,122 6,308 1,659 407,771 Municipal bonds 895,000 5,173 - 900,173 ---------- ---------- -------- ---------- Total $7,851,209 $ 80,666 $7,226 $7,924,649 ========== ========== ======== ========== Money markets $ 651,014 $ - $ - $ 651,014 US Gov't obligations 1,051,167 37,555 - 1,088,722 Corporate bonds 961,462 50,958 1,464 1,010,956 Municipal bonds 895,000 913 - 895,913 ---------- ---------- -------- ---------- Total $3,558,643 $ 89,426 $1,464 $3,646,605 ========== ========== ======== ==========
GROSS AMORTIZED UNREALIZED HOLDING FAIR COST GAINS LOSSES VALUE ---------- ---------- -------- ---------- Mutual funds $4,423,627 $ 54,336 $155,564 $4,322,399 Partnership holding 570,070 34,756 - 604,826 ---------- ---------- -------- ---------- Total $4,993,697 $ 89,092 $155,564 $4,927,225 ========== ========== ======== ========== Mutual funds $8,419,962 $ 234,985 $ 22,404 $8,632,543 Partnership holding 550,000 67,806 - 617,806 ---------- ---------- -------- ---------- Total $8,969,962 $ 302,791 $ 22,404 $9,250,349 ========== ========== ======== ========== Mutual funds $8,011,093 $ - $371,509 $7,639,584 Partnership holding 550,000 51,825 - 604,825 ---------- ---------- -------- ---------- $8,561,093 $ 51,825 $371,509 $8,244,409 ========== ========== ======== ==========
Contractual maturities of securities classified as available for sale as of December 31, 1996 are as follows:
1996 1995 1994 ---- ---- ---- Domestic ($1,597,002) $2,207,689 $18,735 Foreign - - (760,957) ----------- ---------- ---------- Total ($1,597,002) $2,207,689 ($742,222) ------------ ---------- ----------
1996 1995 1994 ---- ---- ---- Continuing Operations: Current: Federal ($70,000) $501,776 ($1,678,495) State (130,125) 53,000 19,031 ---------- ------- ---------- Total (200,125) 554,776 (1,659,464) Deferred (358,566) 292,323 1,575,345 ---------- -------- ---------- Total provision (benefit) on income from continuing operations (558,691) 847,099 (84,119) Discontinued Operation: Tax benefit from loss on operation of discontinued reinsurance segment (940,750) (1,940,211) - ---------- ----------- ---------- Total provision (benefit) for income taxes ($1,499,441) ($1,093,112) ($84,119) =========== ============ ==========
The Company historically has provided deferred income taxes primarily on deferred home warranty contract revenues and acquisition costs, which are recognized for tax purposes before recognition in the financial statements. The Company also provides deferred income taxes on deferred marketing fee revenue and expenses under the annually funded E&O
programs. The major portion of these benefits reverse within one year. The components of the net deferred income tax assets are as follows:
Less current portion 1,191,601 (1,537,257) ----------- ----------- Long term debt, net of current portion $2,940,711 $2,591,929 ========== ==========
Estimated aggregate annual maturities of long term debt are as follows:
Estimated annual repayments of the CNA obligation are based on anticipated premium volume. In 1995 and 1994, the Company revised its estimate of the net present value of the CNA obligation, based upon the actual payments remitted in each year, and in 1994, to reflect an estimated repayment term of five years, as opposed to the original estimate of three years. This change in estimate resulted in an increase in the discount on the obligation, which will be amortized to interest expense over the life of the obligation. The funds due to CNA, which are recorded at net present value, are a senior obligation of the Company, secured by an interest in the common stock of the Company's HOMS subsidiary and in the Company's Member list.
In 1996, the Company reported approximately $677,000 in the "Unusual Items" caption in its consolidated statements of operations, related to several infrequently occurring events that occurred in 1996. Specifically, in the third quarter of 1996, the Company terminated its Agency Agreement and Administration contract with New Hampshire Insurance Company ("NHIC"), as it determined that it no longer desired to carry the program previously negotiated with NHIC. As part of the termination arrangement, the Company has paid approximately $260,000 to NHIC, and has also agreed to indemnify NHIC for all claims incurred under contracts issued during the time the agreements were in effect by paying for all claims on covered components which may be reported under such contracts, as if the arrangement with NHIC had not taken place. To the extent that claims have been paid or reported on these contracts, such amounts have been included in the "Direct costs" caption in the Company's consolidated statements of operations, and any related accrual for unpaid amounts is included in the "Accounts payable" caption in the consolidated balance sheets. In addition, effective September 15, 1996, in conjunction with its plans for future organization and growth, the Company terminated an employment contract with one of its officers, and has agreed to pay the former officer severance and related benefits totaling approximately $157,000 through the month of July 1997. In the fourth quarter of 1996, in connection with the Company's plan to improve the operating results of its Corporate Owned Regions, the employment of three regional managers of the Company's Corporate Owned Regions was terminated, and the California office was closed. In connection with these changes, the Company agreed to pay amounts totaling approximately $190,000 for severance and related benefits and $70,000 for rent on the California office. Charges for these items are included in the accompanying consolidated statements of operations under the caption "Unusual Items". At December 31, 1996, approximately $283,000 of the charges for unusual items remained accrued and unpaid. There were no adjustments to the liability other than to reflect payments made under the terms of the agreements.
During September 1994, the Company recorded unusual charges totaling $1,787,355. These charges represent expenses related to a reduction in the Company's workforce and the closing of its UK operations.
The Company is currently undergoing an examination by the Internal Revenue Service of its tax returns for the years 1993, 1994 and 1995, which could result in the proposal of significant adjustments to its taxes in those years. The Company believes that the returns as originally filed are correct in all material respects.
The Company is subject to various lawsuits and claims arising in the normal course of business. In the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations.
On December 13, 1995, a jury verdict in the amount of $5,156,022 was rendered in favor of the Plaintiff and against Homeowners Marketing Services, Inc. ("HMS"), a subsidiary of the Company, in the following matter: Acceleration National Insurance Company, Plaintiff, vs. Homeowners Marketing Services, Inc., et al., Defendants, in the Court of Common Pleas of Franklin County, Ohio. The causes of action included breach of contract, unjust enrichment, and negligent misrepresentation. Under the Acceleration program, the Company bore reinsurance risk through the letters of credit that it was required to post as collateral to be drawn upon in the event that the assets in the reinsurance pool, together with investment income earned thereon were insufficient to cover the claims and related expenses incurred. With the change in carriers to CNA in 1993, the Company removed itself from any risk bearing position in connection with the claims reported under its E&O program, and currently no longer operates in this capacity. Accordingly, the judgment amount was reported in discontinued operations in the accompanying consolidated statements of operations.
Under the terms of the Merger Agreement, Cross Country agreed to pay the balance due to Acceleration National Insurance Company ("ANIC") under a settlement agreement, upon closing of the Merger. Pursuant to the settlement agreement, on September 4, 1996, the Company paid to ANIC the full amount of its 1994 federal income tax refund, together with interest, which totaled $1,401,485. The remaining balance due bears interest at the rate of 10% per annum from September 1, 1996 until the settlement amount is paid in full. An affiliate of Cross Country purchased the judgment from ANIC as of October 31, 1996, for approximately $2.75 million. The Cross Country affiliate agreed, under certain conditions, to take no action to collect on the judgment before January 31, 1997. In January 1997, under a second amendment to the merger agreement, the Cross Country affiliate extended the date until which it agreed to take no action to collect on the judgment to July 1, 1997, or failure to consummate the merger. The Company guaranteed the obligation of HMS and pledged the shares of HMS and another subsidiary of the Company to secure such guarantee. HMS and the subsidiary granted security interests in their assets as part of the First Amendment to the Merger Agreement.In the event the judgment creditor proceeds to execute on its judgment, it is likely that the Company will be without adequate resources to pay the full amount due to Cross Country, as holder of the judgment, which would become immediately due and payable. In such event, the Company would be forced to seek alternatives to paying the remaining unpaid balance of the judgment. No other alternatives are presently being considered. The judgment, which accrues interest at the rate of 10% per annum, is recorded in discontinued operations in the accompanying consolidated statements of operations, and is separately stated in the accompanying consolidated balance sheets.
The Company also entered into an engagement agreement with a director, to provide legal services to the Company for a one year period. The agreement calls for a minimum payment of a non-refundable $100,000 retainer.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 10. COMMITMENTS AND CONTINGENCIES (Continued) - ------------------------------------------------------------------------------- In connection with the transfer of the net assets of POMG to CNA and the assumption by CNA of the obligations of POMG under certain Realtor's errors and omissions policies, the Company guaranteed the performance by Sphere Drake Insurance, PLC ("Sphere Drake"), a third party reinsurance company, under a $5,000,000 reinsurance treaty purchased by POMG to protect it from losses in excess of a predetermined amount. Under the terms of the Company's guaranty, CNA, as the transferee of the reinsurance treaty, bears any credit risk under the treaty, including, but not limited to, any risk that Sphere Drake becomes insolvent, is adjudicated as a bankrupt or has liquidation or similar proceedings commenced against it. This guarantee is secured by $3,000,000 cash collateral posted by the Company. This amount is reported as restricted cash in the accompanying consolidated balance sheet. The Company has agreed, if necessary, to pay an additional $2,000,000, related to the guarantee, out of future commissions. On April 10, 1996, CNA issued a Notice of Arbitration to the reinsurer with respect to its refusal to honor the reinsurance treaty. The Company, CNA and Sphere Drake are engaged in settlement discussions with respect to the reinsurance treaty. Although terms are not finalized, it is possible that the Company could pay a substantial portion of the Collateral Account to CNA under the currently proposed settlement agreement. As a result of the settlement negotiations, the Company has recorded a loss provision of $2.5 million for the guaranty in its consolidated statements of operations for 1996. Should the Merger fail to be consummated, the potential settlement agreement will be null and void, and the Company will continue to be contingently liable for the entire $5 million under the conditions described in the preceding paragraph. In such event, the Company will attempt to negotiate a settlement but there can be no assurance that it will be successful in such efforts. As a result of the settlement negotiations, the Company has recorded a loss provision of $2.5 million against the guarantee, which is included in the Discontinued Operations caption in the accompanying 1996 consolidated statements of operations. The restricted cash amount is presented net of the $2.5 million reserve in the 1996 consolidated balance sheets. See also Note 2.
OPTION PRICE AVAILABLE STOCK OPTIONS PER SHARE OUTSTANDING EXERCISABLE FOR GRANT - ------------------------------------------------------------------------------- At December 31, 1993 4.00 - 9.75 558,550 206,050 38,450
Granted 2.00 80,000 (80,000) Became exercisable 5.75 75,900 Canceled 4.00 - 9.75 (156,250) (43,650) 156,250 ----------- -------- -------- -------
Granted 2.00 240,000 (240,000) Became exercisable 2.00 203,000 Canceled 2.00 - 3.00 (286,600) (224,600) 286,600 ----------- -------- -------- -------
Became exercisable 2.00 30,500 Canceled 2.00 (1,900) (500) 1,900 ----------- -------- -------- -------
At December 31, 1996 $2.00 433,800 246,700 163,200 =========== ======== ======== =======
The following table summarizes information about stock options outstanding as of December 31, 1996:
In 1991, the Company issued five-year stock purchase warrants for 25,000 shares to an outside director. These warrants were for $10.80 per share, expired April 11, 1996; none had been exercised. In 1990, the Company declared a dividend of one right for each share of common stock outstanding as of November 12, 1990. The rights will be distributed and become immediately exercisable upon the earlier of 10 days following a public announcement that a person or group of affiliated persons has acquired the rights to acquire beneficial ownership of 20% or more of the Company's outstanding shares or 10 days following the commencement of a tender offer or exchange offer that would result in a person or affiliated group beneficially owning 30% or more of the outstanding shares. Each right permits the holder to acquire one share of common stock for a price of $30 per share. The rights may be redeemed by the Company at any time prior to the tenth day after the acquisition of 20% of the outstanding shares or the announcement of an offer for 30% of the outstanding shares. Upon the occurrence of certain events after the rights become exercisable, each right
would, subject to certain adjustments and alternatives, entitle the holder to purchase common stock of the Company or the acquiring entity having a market value of twice the $30 exercise price of the right (except that acquiring persons would not be able to exercise the rights).
In connection with the amendment to the definitive merger agreement with Cross Country, the Company's stock rights plan was modified to permit Cross Country and its affiliates to buy an unlimited number of shares in privately negotiated transactions. This stock rights plan amendment was not effective until three business days after the information was released, or November 7, 1996, provided that no other bid for the Company was received within such three day period. The three day period passed with no other bids submitted to purchase the Company.
In December 1994, the Company repriced all outstanding options to $2.00 per share, with the exception of the options granted to the current Chairman and the former Chairman of the Board of Directors and the Chief Financial Officer. The options granted to the Chief Financial Officer were repriced to $3.00 per share. The options granted to the former Chairman were canceled effective January 1995. Upon such cancellation, 100,000 options were granted to the current Chairman of the Board, at $3.00 per share. In December 1995, all of the options granted to the Chief Financial Officer were repriced to $2.00 per share. Also in December 1995, 140,000 options granted to the Chairman from 1988 through 1992 were canceled, and replaced by a new grant of 140,000 options, exercisable for a ten year period at $2.00 per share.
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- ------- ------- (In thousands except per share amounts)
Operating revenue $10,415 $11,575 $12,054 $11,387 Loss from continuing operations before income taxes (360) (25) (140) (1,072) Net (loss) from continuing operations (230) (13) (97) (699) Loss from discontinued operation -- -- -- (1,559) Net loss ($230) ($13) ($97) ($2,258) Per share data: Net income (loss) from continuing operations ($0.04) $0.00 ($0.02) ($0.13) Loss from discontinued operation -- -- -- (0.28) Net loss ($0.04) ($0.00) ($0.02) ($0.41)