The Company leases its principal offices located in South San Francisco, California, which are used as the Company's headquarters and as the primary operations center for GPIC, PMSIS, Fastrac, and Pinnacle Data. In addition the Company leases space in Concord, California, which is used by Pinnacle Data primarily for making manual flood zone determinations. The Company leases space in Springfield, Ohio, which is used by Fastrac with respect to its motor vehicle insurance tracking and outsourcing operations. The Company leases space in Chantilly, Virginia and Warwick, Rhode Island, which is used as the primary operations centers of PinTax. The Company leases space in Tucson, Arizona, which is used by Pinnacle Data, PinTax and Fastrac. The Company also leases other sales and service offices.
The following table sets forth certain historical selected consolidated financial data of the Company which has been derived from the audited consolidated statements of the Company for and as of the end of each of the years ended December 31, 1994, 1995, 1996, 1997 and 1998.
National and its wholly-owned Subsidiaries provide specialized information services through technology, tracking services, outsourcing services and related insurance products to financial institutions located throughout the United States and in Canada. National and its Subsidiaries are referred to in this Report collectively as the "Company". Utilizing sophisticated computer applications, the Company has developed special-purpose, proprietary software and database systems which provide information services on an outsourced, remote computer or manual access basis, enabling the customers of the Company to:
- determine if residential or commercial real estate is located inside or outside a federally-designated Special Flood Hazard Area ("SFHA"), with respect to real estate which is collateral for loans being financed or serviced by customers of the Company or for other purposes (the "Flood Zone Determination Services");
- obtain real estate tax data from various local, county and state taxing authorities nationwide with respect to real estate which is collateral for loans being financed or serviced by the customers of the Company, facilitate the payment to such taxing authorities by mortgage lenders and mortgage loan servicing companies from certain escrowed funds collected for real estate taxes from their borrowers with monthly loan payments for real estate taxes to such taxing authorities, and inform mortgage lenders and mortgage servicing companies whether the real estate taxes on property securing real estate loans have been paid and perform certain tasks of the Company's customers on an outsourced basis (the "Real Estate Tax Services");
- monitor the insurance coverage on collateral securing motor vehicle and other consumer loans and leases (the "Motor Vehicle Insurance Tracking and Outsourcing Services"); and
- monitor the insurance coverage on collateral securing residential mortgages (predominantly one-to-four unit family dwellings), to a lesser extent, commercial mortgages, disburse insurance premiums collected from borrowers with monthly loan payments for insurance coverage on behalf of mortgage lenders and mortgage servicing companies and perform certain tasks of the Company's customers on an outsourced basis (collectively, the "Hazard Insurance Tracking and Outsourcing Services").
When the Hazard Insurance Tracking and Outsourcing Services indicate that hazard insurance coverage on the collateral securing the loan has lapsed, the customer may contract with the Company to provide specialized, fire, allied peril or physical damage insurance (generally referred to as "lender-placed" insurance, formerly referred to by the Company as "force-place" insurance), that generally insures the improvements or personal property on the collateral security. The Company provides this lender-placed insurance through its wholly-owned subsidiary Great Pacific Insurance Company, in 48 states and the District of Columbia and through nonaffiliated insurance companies in the remainder of the United States. The Company also provides flood insurance, for which the risk is assumed by an agency of the U. S. Government under the National Flood Insurance Program ("NFIP"). In addition, the Company provides fire and allied perils insurance with respect to properties on which financial institutions are in the process of or have foreclosed, and physical damage insurance on motor vehicles. Great Pacific Insurance Company is rated "A" ("Excellent") by A.M. Best Company, a nationally recognized insurance statistical and rating service.
The Company's insurance products include lender-placed insurance policies which have stated terms of either up to ninety (90) days ("short-term policies") or six (6) months to one (1) year ("longer-term policies"), most of which are longer-term policies. Premiums for longer-term policies are recorded as revenues when earned. The Company's lender-placed and flood insurance policies are canceled at a relatively high rate because they generally remain in effect only until financial institutions receive proof that borrowers have obtained their own insurance. At the time the lender-placed policies are issued, a reserve is established to provide for return of premiums for anticipated cancellations, which has the effect of decreasing net premiums written and earned premiums. Since 1993, the reserve has been established at approximately 64% to 68% of gross premiums written. Premiums are written directly by GPIC or by third party insurance companies in certain states where GPIC is not licensed or where its products are not approved. The following table
The Company did not cede any losses to reinsurers in 1996, 1997 or 1998 for non-flood insurance losses. The Company seeks to limit its exposure with respect to any failure by a reinsurer to fulfill its obligations by evaluating the financial condition and rating of members of its reinsurance pool (the Company's policy is to purchase reinsurance with U.S. insurers rated in the "A" categories by A.M. Best Company) at the time of such purchase and by diversifying the reinsurance pool.
Loss and loss adjustment expenses ("LAE") represent losses paid related to insurance underwritten or reinsured by GPIC, adjusted for changes in reserves for losses that are in the course of settlement and losses that have been incurred but not yet reported. Commissions paid to nonaffiliates represent amounts paid to third party agents and brokers, and other producers related to sales of the Company's services and products. Personnel expenses represent salaries, wages, sales commissions and bonuses paid to Company employees and related employee benefits. All other expenses primarily consist of occupancy costs, including office rent and utilities, insurance expenses, equipment maintenance and depreciation, amortization of acquisition costs, sales and marketing expenses, professional services and expenses related to the delivery of products and services such as postage and printing.
The Company's effective income tax rate was 18%, 31%, and 22% for 1996, 1997, and 1998, respectively. See Note 8 of Notes to Consolidated Financial Statements.
National may adjust rates to reflect current trends. Assuming a constant rate of billings in 1999 as compared to 1998, revenue recognized from new tax service contracts would be approximately 35% to 40% lower and National's consolidated revenues would be approximately 5% lower.
Commissions paid to nonaffiliates increased from $1.8 million (9.6% of premiums earned) in 1997 to $3.0 million (19.4% of premiums earned) in 1998, an increase of $1.2 million or 64.1%. The percentage of commissions paid to net premiums earned varies depending upon customer and agent/broker mix. The increase in commission expense, both in amount and as a percentage of net premiums earned, is due to larger percentage of GPIC's commissions being paid to non-affiliated insurance agents and brokers.
Personnel expenses increased from $23.1 million in 1997 to $31.5 million in 1998, an increase of $8.4 million or 36.0%. The increase was a result of (i) personnel expenses of PinTax, which was acquired in September 1997; (ii) an increase in the volume of flood zone determination services and motor vehicles being tracked; and (iii) an increase in hiring of corporate and operations personnel to facilitate growth in the Company's customer base. Personnel expenses as a percent of total revenue increased from 43.6% in 1997 to 47.3% in 1998.
All other expenses increased from $16.9 million in 1997 to $23.0 million in 1998, an increase of $6.1 million or 36.1%. The increase was partially a result of general, administrative and operating expenses of PinTax, which was acquired in September 1997 and the increase in general, administrative and operating costs of the Company's other subsidiaries resulting from growth in the Company's customer base and the costs to implement new customers.
Loss and LAE was $4.0 million in 1996 (29.5% of net premiums earned) and $6.5 million in 1997 (34.0% of net premiums earned), an increase of $2.5 million, or 62.0%. The increase was primarily due to an increase in the number and average size of claims. The average loss per new claim reported increased from $5,513 in 1996 to $7,693 in 1997. The number of new claims increased from 726 reported in 1996 to 843 reported in 1997.
Commissions paid to nonaffiliates decreased from $2.0 million (14.4% of premiums earned) in 1996 to $1.8 million (9.6% of premiums earned) in 1997, a decrease of $117,000, or 6.0%. The reduction in commissions paid to nonaffiliates was a result of relatively higher growth in net written and earned premiums from clients, which did not earn commissions on the Company's insurance products.
As a result of the above factors, income before provision for income taxes increased from $1.6 million in 1996 to $4.7 million in 1997, an increase of $3.1 million, or 202%.
The Company's primary sources of cash are from operating income and lines of credit. In 1998, the Company derived a substantial portion of its operating cash from the operating profits from Pinnacle Data, as well as the net premiums written from GPIC. The Company has reserved certain amounts of the net written premiums it received in 1998 for a variety of purposes, including reserves for return premiums, unearned premiums and loss reserves. The Company believes that its cash flow from operations, existing cash balances and lines of credit will be sufficient to meet its working capital needs for the foreseeable future.
Of the Company's cash and short-term investments, $7.6 million is held by GPIC. Insurance companies, including GPIC, are subject to laws and regulations, which restrict their ability to pay dividends to parent companies or other shareholders. Under California law, the maximum amount of dividends that GPIC may pay the Company in any twelve (12) month period without prior regulatory approval is the greater of (i) net income for the preceding calendar year, or (ii) 10% of policyholders' surplus (shareholders' equity adjusted to a statutory basis) as of the previous December 31. For the year ended December 31, 1998, GPIC had net income of $0.48 million and as of December 31, 1998, statutory policyholders' surplus of $24.2 million. For the year ended December 31, 1998, the maximum dividend permitted to be paid by GPIC to National was approximately $2.6 million. For 1999, the maximum dividend permitted to be paid by GPIC to National is approximately $2.4 million. See "Market for Registrant's Common Equity and Related Stockholder Matters" and Note 14 of Notes to Consolidated Financial Statements.
In May 1998, the Company entered into a $2 million revolving credit facility (the "Credit Facility") with its primary commercial bank. The Credit Facility replaced the Company's previous revolving credit facility dated April 2, 1997. In September 1998, the Credit Facility was increased to $4.275 million and the maturity date of the principal payment was extended to May 31, 1999. The Credit Facility calls for monthly interest payment at the rate of 0.75% per year in excess of the rate of interest, which the financial institution has
Consolidated stockholders' equity at December 31, 1998, totaled $30.4 million or $7.02 per share compared to $27.8 million or $6.73 per share at December 31, 1997.
National has entered into a Merger Agreement with The First American Financial Corporation ("FAFCO"). As a result of such Merger, National would become a wholly owned subsidiary of FAFCO. Since the announcement of the Merger in November 1998, there has been some employee attrition, and additional departures can be expected pending the consummation of the Merger. The Merger is subject to a number of conditions including, without limitation, the approval of the California Department of Insurance and the approval of the shareholders of National. There can be no assurance that all of the conditions of the Merger will be satisfied and that the Merger will be consummated. If the Merger is not consummated, the Company may be required to replace certain departed employees. The effect of the departure of such employees and the need to engage and train their replacements is currently unknown.
National has incurred costs totaling $587,000 as of December 31, 1998 in connection with the negotiation of the Merger Agreement and in preparation for the consummation of the Merger, and additional costs will be incurred prior to the consummation of the Merger. All of such costs have been deferred and reported as Other Assets on the Balance Sheet. Such costs are not reflected in the Consolidated Statements of Operations and Comprehensive Income included in this Report. If the Merger is consummated, such costs will be recorded as expense in the future financial statements of National, as a subsidiary of FAFCO. If the Merger is not consummated, such costs will be recorded as expense by National in the quarter in which the Merger transaction is abandoned. If the Merger is abandoned such costs would have a material adverse effect on the net income and earnings per share of National for the quarter and the calendar year in which the Merger is abandoned.
The Company anticipates that it may incur certain costs in 1999 in connection with various new business activities, including building its customer base, reorganizing operations and carrying on its product quality
improvement programs. The overall goal of these activities is to enhance the long-term value of the Company. The Company has begun to hire additional personnel, purchase new computer and other equipment, lease additional office space and incur other expenses in connection with these business activities. There can be no assurance that such costs will be offset by increases in revenue; and, in any event, the Company expects that any increase in revenue will lag the periods in which expenses are incurred. Furthermore, there can be no assurances that the hiring of additional personnel or the reorganizing of operations will lead to higher profitability. If such increases in expenses are not fully offset by increases in revenue, the Company's financial position and results of operations and earnings could be materially adversely affected.
GPIC is required to maintain reserves to cover its estimated ultimate liability for loss and loss adjustment expenses with respect to reported losses and incurred but not reported claims. These reserves are estimates of what GPIC expects the ultimate settlement and administration of claims will cost, and are based on known facts and circumstances, predictions of future events, estimates of future trends in claims severity and other variable, subjective factors. No assurances can be given that such estimates will be adequate to cover actual losses incurred by GPIC. Any significant changes in GPIC's estimate of ultimate losses on reported claims may materially adversely affect the results of GPIC's operations in the period reported. GPIC has in the past experienced adverse developments in its loss reserves. GPIC's loss and loss adjustment expense reserves are reviewed on an annual basis by unaffiliated actuaries. GPIC's most recent actuarial review of such reserves as
Traditional insurance companies underwrite risks individually or by class, following an in-depth analysis of such risks. Although GPIC applies underwriting techniques to a small portion of insured risks, the immediate coverage required by purchasers of lender-placed insurance and REO Insurance generally requires GPIC to write specialized insurance within predesignated limits and geographic areas, at a flat rate, without the application of traditional underwriting criteria to individual risks. Accordingly, GPIC may be insuring individual risks that it might not have insured had it applied traditional analysis to such risks. In addition, GPIC may not have adequate spread of risk in a particular geographic area. See "Business -- Insurance Operations -- Underwriting."
The markets for the Company's information services are highly competitive and characterized by rapidly changing technology. The Company believes that its future success will depend, in part, on its ability to identify, develop, install and support new services in a timely fashion, and on market acceptance of such services. No assurance can be given that the introduction of new technologies will enable the Company to gain market share, realize cost savings or increase revenues.
Commencing in 1996 the Company initiated a program to address the Year 2000 compliance problem through normal planned enhancements of existing systems, development of new applications, and upgrades to operating systems and databases already covered by maintenance agreements. With respect to the Company's major information technology systems, all operating systems, database engines and tools, and all software applications are Year 2000 compliant and, with respect to the vast majority of them, Company testing thereof to assure compliance is complete. Testing of all such systems was completed in 1998, however, some retesting may occur in 1999 for validation purposes.
Certain of the taxing authorities across the United States provide real estate tax information in electronic format to PinTax, which tax information PinTax uses in performing real estate tax services. There can be no assurance that such taxing authorities will be Year 2000 compliant. If taxing authorities suffer any serious systems failures, they may be unable to provide tax information to PinTax in electronic format. In such case, PinTax may experience difficulty in accessing such information and would likely incur additional expenses in obtaining such tax information, if such information could be obtained. In certain cases, such information may be unavailable until such systems failures are corrected, which, depending on the duration of any such failure, could severely adversely affect the ability of PinTax to provide real estate tax services with respect to such affected jurisdictions. PinTax has attempted to survey its clients and the taxing authorities from which PinTax receives electronic data to determine their respective Year 2000 compliance status. Many such clients and taxing authorities have failed to respond to such survey and PinTax is attempting to follow-up to determine such status. While there can be no assurance that such non-responding clients and taxing authorities are Year 2000 complaint, PinTax does not believe that such failure to respond should be interpreted as a lack of Year 2000 compliance. Nevertheless, PinTax is in the process of developing contingency plans to handle problems that arise as a result of taxing authorities and clients experiencing Year 2000 related failures. There can be no assurance, however, that all contingencies can be identified or that a successful plan related thereto can be developed and implemented.
Since 1996 the Company has incurred approximately $140,000 in costs related directly to Year 2000 compliance and expects to expend an approximately $50,000 more before December 31, 1999 in connection with achieving Year 2000 compliance. Such costs will be paid for from cash from operations. The accounting treatment of costs incurred solely in connection with Year 2000 compliance will be treated as period costs and will be expensed as incurred.
functional after December 31, 1999. Nevertheless, if such remote locations were adversely affected by public utilities failures as well, the Company would be severely adversely affected during the continuation of any such failures. The Company intends to consider additional contingency plans during the first half of 1999.