Management’s Discussion and Analysis of Financial Condition and Results of Operations below presents the Company’s operating results for each of the two years in the period ended December 31, 2016, and its financial condition as of December 31, 2016. Except for the historical information contained herein, this report and other written and oral statements that the Company makes from time to time contain forward-looking statements, which involve substantial known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. See the section of this report entitled “Special Note Regarding Forward-Looking Statements.” Among the factors that could cause actual results to differ materially are those discussed in “Risks Factors” in Item 1A of this report. In addition, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in connection with the information presented in the Company’s consolidated financial statements and the related notes to its consolidated financial statements included in Part IV of this report.
We are an industry leader in the sale of individual and family medical insurance plans (“IFP”), which include short-term medical (“STM”) insurance plans and guaranteed-issue and underwritten hospital indemnity plans.
We design and structure these IFPs and supplemental products on behalf of insurance carriers and discount benefit providers. We market products to individuals through our internal distribution network and we use an external distribution network consisting of non-owned third party licensed agent call centers to market to individuals. For both our internal distribution network and our external distribution network, we administer the IFPs and supplemental products. We manage customer relations via our online member portal, which is available 24 hours a day, seven days a week. Our online enrollment process allows us to aggregate and analyze consumer data and purchasing habits to track market trends and drive product innovation.
Our scalable, proprietary, and web-based technology platform provides customers, whom we refer to as members, immediate access to the products we sell through our internal and third-party distribution channels. The health insurance products we develop are underwritten by insurance carriers, and we assume no underwriting, insurance or reimbursement risk. Members can tailor product selections to meet their personal insurance and budget needs, buy policies and print policy documents and identification cards in real-time. Our technology platform uses abbreviated online applications, some with health questionnaires, to provide an immediate accept or reject decision for products that we offer. Once an application is accepted, individuals can use our automated payment system to complete the enrollment process and obtain instant electronic access to their policy fulfillment documents, including the insurance policy, benefits schedule and identification cards. We receive credit card and Automated Clearing House (“ACH”) payments directly from members at the time of sale. Our technology platform provides scalability as we add members and on a per-policy-basis, reduces the costs associated with marketing, selling, underwriting and administering policies.
As the managing general underwriter of our IFP and supplemental products, we receive all amounts due in connection with the plans we sell on behalf of the providers of the services, third-party commissions and referral fees. We refer to these total collections as premium equivalents, which typically represent a combination of premiums, fees for discount benefit plans (a non-insurance benefit product that supplements or enhances an insurance product), our enrollment fees and referral fees. From premium equivalents, we remit risk premium to carriers and amounts earned by discount benefit plan providers, who we refer to as third-party obligors, such carriers and third-party obligors being the ultimate parties responsible for providing the insurance coverage or discount benefits to the member. Our revenues consist of the balance of the premium equivalents.
We collect premium equivalents upon the initial sale of the plan and then monthly upon each subsequent periodic payment under such plan. We receive most premium equivalents through online credit card or ACH processing. As a result, we have limited accounts receivable. We remit the risk premium to the applicable carriers and the amounts earned by third-party obligors on a monthly basis based on the respective agreements.
We also provide consumers with access to health insurance information search and comparison technology through our website, HealthPocket.com. This free website allows consumers to easily and clearly compare and rank health insurance plans available for an individual, family, or small business, empowering consumers to make health plan decisions and reduce their out-of-pocket costs. In addition, the data aggregated by HealthPocket (“HP”) is used to research consumer needs and to measure product demand to help us design and manufacture high-demand insurance products. HP’s revenue is principally derived from referral fees and marketing fees, licensing fees, limited exclusivity fees, and landing page development fees.
In 2015, we launched a direct-to-consumer insurance website that allows consumers to research health insurance trends, comparison shop, and purchase IFP under the AgileHealthInsurance® brand. AgileHealthInsurance.com (“Agile”) is one of the few internet sites dedicated to helping consumers understand the benefits of Term Health Insurance. We use the term “Term Health Insurance” to refer to health insurance products of less than one year in duration, such as STM. These IFP plans are the culmination of extensive research on health insurance needs in the PPACA era, and we believe consumers will easily be able to find affordable prices for these plans on AgileHealthInsurance.com. AgileHealthInsurance.com utilizes what we believe is a best-of-class plan comparison and online enrollment tool, to accompany these new plans. The underlying technology was developed by engineers with decades of experience working on top-tier e-Commerce websites known for their ease-of-use.
The following table presents a reconciliation of premium equivalents to revenues for the years ended December 31, 2016 and 2015 ($ in thousands):
Plans in force. We consider a plan to be in force when we have issued a member his or her insurance policy or discount benefit plan and have collected the applicable premium payments and/or discount benefit fees. Our plans in force are an important indicator of our expected revenues, as we receive a monthly commission for up to six months for our six-month STM plans, up to eleven months for our eleven months plans, up to twelve months for our approximately twelve-month (i.e., up to 364 days) STM plans and can exceed twelve months for our hospital indemnity and discount benefit plans, provided that the policy or discount benefit plan is not cancelled. A member may be enrolled in more than one policy or discount benefit plan simultaneously. A plan becomes inactive upon notification to us of termination of the policy or discount benefit plan, when the member’s policy or discount benefit plan expires or following non-payment of premiums or discount benefit fees when due.
The following table presents a reconciliation of net income to adjusted net income and adjusted net income per share for the years ended December 31, 2016 and 2015 (in thousands, except per share data):
Core S, G & A. We define this metric as total GAAP S, G & A adjusted for stock-based compensation, severance, restructuring and other costs, and marketing leads and advertising expense. We have included Core S, G & A in this report because it is a key measure used by our management to understand and evaluate our core operating performance and trends. Other companies may calculate this measure differently than we do. Core S, G & A has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for S, G & A as reported under GAAP.
Revenues for the year ended December 31, 2016 were $184.5 million, an increase of $79.8 million, or 76.2%, compared to 2015. The increases were primarily due to the increase in the number of policies in force. Policies in force increased to 290,117 at December 31, 2016 from 195,132 at December 31, 2015. This increase represents a 48.7% year over year change. The increase in policies in force was due primarily to continued consumer demand for our affordable healthcare products outside of the ACA open enrollment period and the diversification and enhancement of our distribution system, including our e-Commerce division, AgileHealthInsurance.com.
Our third-party commissions consist of fees and commissions paid to third-party distributors for selling our products to members, which we pay monthly for existing members and on a weekly basis for new members. Generally, we expect third-party commissions, as a percentage of revenue, to begin to decrease as AgileHealthInsurance.com continues to sell a larger percentage of IFPs.
Third-party commissions for the year ended December 31, 2016 were $107.7 million, an increase of $54.0 million, or 100.6%, compared to 2015. The increases in third-party commissions were primarily due to an increase in the number of policies in force sold through non-owned distributors.
Third-party commissions represented 58.4% and 34.6% of revenues and premium equivalents, respectively, for the year ended December 31, 2016 as compared to 51.3% and 30.6% of revenues and premium equivalents for 2015. These increases were largely the result of a revenue mix shift towards non-owned call centers and away from owned call centers due to the restructuring of two of our call centers in November 2015 and increased incentives provided to several third-party distributors during the quarter. Third-party commission increases were partially off-set by lower effective commission rates for distributors with advanced commission balances.
S, G & A expense for the ended December 31, 2016 was $51.5 million. This represents an increase of $4.2 million, or 8.9% for the year ended December 31, 2016 compared to 2015.
During the last quarter of the year ended December 31, 2015, the Company committed to and communicated a plan to restructure its operations at ICE and Secured. The Company determined certain processes and cost centers of ICE and Secured to be duplicative and recognized that efficiencies could be gained by leveraging these operations with other owned call centers. The reorganization improved profitability and scalability. As of December 31, 2015, the restructuring plan was communicated to employees and substantially complete.
In connection with the restructuring, intangible assets were reviewed for impairment at December 31, 2015 and as a result of our assessment, we recorded a loss on intangibles related to distributors of $878,000. The associated loss is included in the consolidated statement of operations as S, G & A expense. See Notes 5 and 8 of the accompanying audited financial statements for further information about our intangible assets and restructuring activities.
TRA expense was $9.7 million and $361,000 for the years ended December 31, 2016 and 2015, respectively. TRA expense for 2016 of $9.7 million increased significantly over prior year due primarily to the one-time, non-cash, release of the valuation allowance against the deferred tax assets. For the year ended December 31, 2015, TRA expense was $361,000. See Note 15 of the accompanying audited financial statements for further information on the TRA agreement with the holders of HPIH Series B Membership Interests.
Other expense of $5,000 for the year ended December 31, 2016 was comprised of miscellaneous bank fees. For the year ended December 31, 2015, other income of $178,000 included a gain of $189,000 on the deconsolidation of SIL offset by $11,000 of miscellaneous bank fees. See Note 3 of the accompanying audited financial statements for further information about SIL.
For 2016, we recorded a benefit for income taxes of $4.8 million, reflecting an effective tax rate of (56.8%). For 2015, we recorded a benefit for income taxes of $1.9 million, reflecting an effective tax rate of 420.4%. During 2016, the effective tax rate was significantly impacted by release of the valuation allowance provided against our deferred tax assets. The deferred tax asset was a result of obligations under the tax receivable agreement. We recorded and maintained a full valuation allowance on all of deferred tax assets of HII until December 31, 2016 when there was sufficient evidence to support the reversal of all of this allowance. When we determined that we would be able to realize our remaining deferred income tax assets in the foreseeable future, a release of all of the related valuation allowance resulted in the recognition of $8.1 million of deferred tax assets at December 31, 2016. See Note 11 of the accompanying audited financial statements for further information on income taxes and the effective tax rates.
Cash used in operating activities for the year ended December 31, 2015 of $11.3 million was primarily the result of a $19.8 million increase in advanced commission loans to our distributors. The other adjustments to reconcile net income to net cash provided by operating activities were $3.0 million of depreciation and amortization of property and equipment and intangible assets, $1.3 million of income related to fair value adjustment to the contingent consideration, and $1.4 million of stock-based compensation. The primary drivers of the net change in operating assets and liabilities were an increase in accounts payable, accrued expenses and other liabilities by $6.3 million, a decrease in accounts receivable, prepaid expenses and other current assets of $930,000 and an increase in restricted cash of $2.0 million.
Our uses of cash in investing activities for the year ended December 31, 2016 of $3.1 million included cash used to fund the development of internal-use software of $3.1 million and $60,000 to purchase property and equipment.
Our primary uses of cash in investing activities for the year ended December 31, 2015 of $245,000 included cash used to fund the development of internally developed software of $1.8 million and $156,000 to purchase property and equipment, offset by the proceeds from the repayment of a loan of $1.2 million and the proceeds of matured held-to-maturity securities of $461,000.
During the year ended December 31, 2016, cash used by financing activities of $10.4 million was primarily attributable to proceeds received from borrowings under the RLOC of $7.5 million offset by repayments of the RLOC of $15.0 million, distributions to members for tax payments under the operating agreement of HPIH of $2.0 million, payments of $547,000 under contingent consideration obligations and payments on noncompete agreements of $192,000. See Note 17 of the accompanying consolidated financial statements for information on the operating agreement between HPIH and its members.
The purpose of the RLOC is to provide working capital, expand the advanced commissions program, and to help us maintain adequate liquidity. Borrowings under this facility are secured by all of our and our subsidiaries’ assets, including, but not limited to, cash, accounts receivable, and property and equipment. The stated interest rate for the RLOC is 30-day LIBOR, plus 1.95%. As of December 31, 2016, we have no outstanding balance from draws on the RLOC and $15.0 million was available to be drawn upon.
The RLOC is subject to customary covenants and restrictions which, among other things, require us to maintain minimum working capital equal to 1.50 times the outstanding balance, and require that our maximum funded debt to tangible net worth ratio shall not exceed 1.50 at any time during the term of the RLOC. The RLOC also imposes certain nonfinancial covenants on us that would require immediate payment if we, among other things, reorganize, merge, consolidate, or otherwise change ownership or business structure without the bank’s prior written consent. The RLOC is secured by a first priority security interest in substantially all of the Company’s business assets.
We evaluate goodwill, which had a carrying value of $41.1 million as of December 31, 2016, for impairment at least annually, during the third quarter of each year, or whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. To assess the realizability of goodwill, we have the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. We may elect to forgo this option and proceed to the annual two-step goodwill impairment test.
If we elect to perform the qualitative assessment and it indicates that a significant decline to fair value of a reporting unit is more likely than not, or if a reporting unit’s fair value has historically been closer to its carrying value, or we elect to forgo this qualitative assessment, we will proceed to Step 1 testing where we calculate the fair value of a reporting unit based on discounted future probability-weighted cash flows. If Step 1 indicates that the carrying value of a reporting unit is in excess of its fair value, we will proceed to Step 2 where the fair value of the reporting unit will be allocated to assets and liabilities as it would in a business combination. Impairment occurs when the carrying amount of goodwill exceeds its estimated fair value calculated in Step 2.
The most significant assumptions used in these analyses are those made in estimating future cash flows. In estimating future cash flows, the income approach uses a discounted debt-free cash flow analysis to measure fair value by estimating the present value of future economic benefits. To perform the discounted debt-free cash flow analysis, we develop a pro forma analysis of the reporting unit to estimate future available debt-free cash flow and discounting estimated debt-free cash flow by an estimated industry weighted average cost of capital based on the same comparable companies used in the market approach. Per FASB guidance, the weighted average cost of capital is based on inputs (e.g., capital structure, risk, etc.) from a market participant’s perspective and not necessarily from the reporting unit’s perspective.
Future cash flow is projected based on assumptions for our economic growth, industry expansion, future operations and the discount rate, all of which require significant judgments by management.
The allowance for sales returns represents management’s best estimate of probable returns of policies sold. This estimates is based on a rolling 12 month average of returns tracked by month of service and month of return. A blended historical and current “Open Enrollment” factor is included within the analysis to account for increased returns related to seasonal sales spikes during the open enrollment period. In an effort to identify adverse trends for sales returns and chargebacks, we perform ongoing reviews of returns.
Currently, we do not believe that we have a significant amount of risk relative to the allowance for advanced commissions. As a measure of sensitivity, a 10% change in the allowance would have a $45,000 effect on pre-tax earnings.
Deferred tax asset and amounts due to member pursuant to the TRA agreement
We evaluate quarterly the positive and negative evidence regarding the expected realization of net deferred tax assets. The carrying value of our net deferred tax assets is based on our assessment as to whether it is more likely than not that we will generate sufficient future taxable income to realize these deferred tax assets. We had recorded a valuation allowance against all of the deferred tax assets of HII as of December 31, 2015. We maintained a full valuation allowance on all of deferred tax assets of HII until December 31, 2016 when there was sufficient evidence to support the reversal of all of the eligible allowance.
When we determined that we would be able to realize our remaining deferred income tax assets in the foreseeable future, a release of all of the related eligible valuation allowance resulted in the recognition of $8.1 million of deferred tax assets at December 31, 2016 and a reduction of income tax expense of $8.1 million. The release of the valuation allowance resulted in the recognition of a $9.1 million tax receivable agreement obligation and $9.1 million in TRA expense which is in TRA expense in the consolidated statements of operations.
Expense for stock-based compensation is recognized based upon estimated grant date fair value and is amortized over the service period of the awards using the accelerated method. We offer awards which vest based on service conditions, performance conditions or market conditions. For grants of SARs and stock options, we apply the Black-Scholes option-pricing model, Monte Carlo Simulation, or a lattice model, depending on the vesting conditions, in determining the fair value of share-based payments to employees.
These models incorporate various assumptions, including expected volatility and expected term. Through November of 2015, expected stock price volatilities were estimated using implied volatilities of comparable publicly-traded companies, given our limited trading history. As of December 2015, volatility is calculated using the Company’s trading history. The expected term of awards granted is based on the Company’s best estimate and the use of the simplified method for “plain vanilla” awards under GAAP, where applicable. Accruals of compensation cost for an award with a performance condition shall be based on the probable outcome of that performance condition. Therefore, compensation cost shall be accrued if it is probable that the performance condition will be achieved and shall not be accrued if it is not probable that the performance condition will be achieved. Such judgements can significantly impact the timing and amount of expense recognized.
Significant judgment is required to determine both probability and the estimated amount. We review these provisions at least quarterly and adjust these provisions accordingly to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and updated information.
On February 1, 2017, we came to mutual agreement with HCC to terminate the terms of our carrier contract with HCC. We no longer sell HCC products through any of our distribution channels. We do not expect this contract termination to have a material impact on our Company’s total revenues because we have added additional world-class carriers in 2016 with market leading expertise and products. See Note 19 of the accompanying consolidated financial statements for further details.
The Company is subject to legal proceedings, claims, and liabilities that arise in the ordinary course of business. Regardless of the outcome, litigation can have an adverse impact on us because of defense and settlement costs, diversion of management resources and other factors. The Company accrues losses associated with legal claims when such losses are probable and reasonably estimable. If the Company determines that a loss is probable and cannot estimate a specific amount for that loss, but can estimate a range of loss, the best estimate within the range is accrued. If no amount within the range is a better estimate than any other, the minimum amount of the range is accrued. Estimates are adjusted as additional information becomes available or circumstances change. Legal defense costs associated with loss contingencies are expensed in the period incurred.