Pursuant to Rule 12b-2 and SEC Release No. 33-8876, a smaller reporting company transitioning to the larger reporting company system, is not required to satisfy a larger reporting company's reporting requirements until the first quarterly report on Form 10-Q for the following fiscal year. Under the disclosure requirements for a smaller reporting company, this information is not required to be provided.
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, 2017, and its financial condition as of December 31, 2017. 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 “Risk 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.
For a detailed description of our business, refer to "Overview" included in Part I, Item 1 "Business" or Note 1 of the accompanying consolidated financial statements.
The following table presents the number of policies in force by product type as of December 31, 2017 and 2016:
Our revenues primarily consist of commissions and fees earned for health insurance policies and supplemental products issued to members, referral fees, and fees for discount benefit plans paid by members as a direct result of our enrollment services, brokerage services or referral sales. Revenues reported by the Company are net of risk premiums remitted to insurance carriers and fees paid for discount benefit plans.
Revenues for the year ended December 31, 2017 were $250.5 million, an increase of $66.0 million, or 35.7%, compared to 2016. The increases were primarily due to a 29.6% year over year growth, in the number of policies in force, to 376,056 at December 31, 2017 from 290,117 at December 31, 2016. The increase in revenues was driven by an increase in policies in force, favorable commission margins, and improved discount benefit plan offerings.
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. Third-party commissions, as a percentage of revenue, will vary based on the mix of sales between AgileHealthInsurance.com and our third-party distributors.
Third-party commissions for the year ended December 31, 2017 were $145.3 million, an increase of $37.6 million, or 35.0%, compared to 2016. The increases in third-party commissions were primarily due to an increase in the number of policies in force sold through third-party independent distributors.
Third-party commissions represented 58.0% and 36.7% of revenues and premium equivalents, respectively, for the year ended December 31, 2017, as compared to 58.4% and 34.6% of revenues and premium equivalents for 2016. These changes were largely the result of increased incentives provided to several third-party distributors during the year. Third-party commission increases were partially off-set by lower effective commission rates for distributors with advanced commission balances.
SG&A expense represented 25.7% and 16.3% of revenues and premium equivalents, respectively, for the year ended December 31, 2017 compared to 27.9% and 16.5% of revenues and premium equivalents, respectively, for 2016.
The decrease in SG&A expenses as a percentage of revenues for the year ended December 31, 2017 compared to the same period 2016 was primarily attributable to increasing revenues from growth in policies-in-force and efficiencies gained from our scalable technology platform.
On December 22, 2017, prior to the end of the Company’s fiscal year, the President of the United States signed into law H.R. 1, referred to as the “Tax Act.” The Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 118 (“SAB 118”) on December 22, 2017. SAB 118 provides up to a one-year measurement period from a registrant’s reporting period that includes the Tax Act’s enactment date to allow the registrant sufficient time to obtain, prepare and analyze information to complete the accounting required under ASC 740.
The reduction of the U.S. federal tax rate from 35% to 21% resulted in tax expense of $12.6 million due to the re-measurement of our deferred tax assets. The reduction of the federal tax rate also resulted in a one-time increase to income of $11.8 million due to the reduction of the Tax Receivable Agreement ("TRA") liability. The overall net impact impact of these amounts reduced earnings by $775,000. The reduction in the tax rate will also impact the company’s tax expense in future periods beginning in 2018.
For 2017, we recorded a provision for income tax expense of $16.8 million, reflecting an effective tax rate of 38.8%. For 2016, we recorded a benefit for income taxes of $4.8 million, reflecting an effective tax rate of (56.8)%. During 2016, the effective tax rate was significantly impacted by release of the valuation allowance provided against much of our deferred tax assets. The deferred tax asset is a result of obligations under the TRA. We recorded and maintained a full valuation allowance on all of the related deferred tax assets of HIIQ until December 31, 2016 when there was sufficient evidence to support a partial reversal. The reversal of the valuation allowance resulted in the recognition of $8.1 million of deferred tax assets at December 31, 2016. See Note 9 of the accompanying audited financial statements for further information on income taxes and the effective tax rates.
Net income attributable to HIIQ for 2017 and 2016 included HIIQ’s share of its consolidated entities’ net income and loss. See Note 12 of the accompanying consolidated financial statements for further discussion on the TRA with the holders of HPIH Series B Membership Interests.
On July 17, 2017, the Company, through HPIH, entered into a Credit Agreement (the “Credit Agreement”) among HPIH, and certain of its affiliates as guarantors, and SunTrust Bank, as lender (the “Lender”). The Credit Agreement provides for a $30.0 million revolving credit facility (the “Credit Facility”) pursuant to which the Lender has agreed to make revolving loans and issue letters of credit. The Credit Facility will be used for general corporate purposes, including funding of ongoing working capital needs, capital expenditures, and permitted acquisitions. The Credit Facility also provides HPIH with the right to request additional incremental term loans thereunder up to an aggregate additional amount of $20.0 million, subject to the satisfaction of certain additional conditions provided therein.
The Credit Facility matures on July 17, 2020 (the “Termination Date”) and borrowings under the Credit Agreement can either be, at HPIH’s election: (i) at the Base Rate (which is the highest of the prime rate, the federal funds rate plus 0.50%, the one-month LIBOR index rate plus 1.00%, and zero) plus a spread ranging from 0.75% to 1.25% or (ii) at Adjusted LIBOR (as defined in the Credit Agreement) plus a spread ranging from 1.75% to 2.25%. The applicable spread is dependent upon HPIH’s Consolidated Total Leverage Ratio (as defined in the Credit Agreement). Interest accrued on each Base Rate Loan (as defined in the Credit Agreement) is payable in arrears on the last day of each calendar quarter and on the Termination Date. Interest accrued on each Eurodollar Loan (as defined in the Credit Agreement) is payable on the last day of the applicable interest period, or every three months, whichever comes sooner, and on the Termination Date.
The Credit Agreement contains customary covenants including, but not limited to, (i) a minimum interest coverage ratio and a maximum Consolidated Total Leverage Ratio and (ii) limitations on incurrence of debt, investments, liens on assets, certain sale and leaseback transactions, transactions with affiliates, mergers, consolidations and sales of assets. The Credit Agreement also includes customary events of default, conditions, representations and warranties, and indemnification provisions.
As of December 31, 2017, we had no outstanding balance from draws on the Credit Facility and $30.0 million was available to be drawn upon. Concurrent with the execution of the above Credit Agreement, the Company terminated its previous revolving line of credit established on December 15, 2014. As of December 31, 2016 we had no outstanding balance from draws on the previous revolving line of credit.
Cash provided by operating activities for the year ended December 31, 2016 of $18.0 million was primarily the result of consolidated net income, before noncontrolling interests, of $13.1 million. Adjustments to reconcile net income to net cash provided by operating activities consisted of $3.2 million of depreciation and amortization, and $3.8 million of stock-based compensation. The primary drivers of the net change in operating assets and liabilities were a $12.5 million increase in advanced commissions to our distributors, an increase in accounts payable, accrued expenses and other liabilities by $12.0 million, and an increase in due to member of $9.2 million. These were offset by an increase in restricted cash of $4.0 million and a decrease in accounts receivable, prepaid expenses and other current assets of $1.1 million. The increase in advanced commissions was the result of increased sales by our third-party distributors, driven by continued demand for our affordable healthcare products. The $9.2 million increase in due to member was the impact of recording the corresponding TRA liability associated with the release of the valuation allowance against our deferred tax assets.
Our uses of cash in investing activities for the year ended December 31, 2016 of included cash used to fund the development of internal-use software of $3.1 million and $61,000 to purchase property and equipment.
During the year ended December 31, 2017, cash used in financing activities of $11.3 million was primarily attributable to distributions made to members for tax payments under the operating agreement with HPIH for $5.5 million, and share repurchases of class A common stock for $4.9 million. Common stock withheld in treasury from the vesting of restricted shares accounted for $842,000. See Note 14 of the accompanying consolidated financial statements for information on the operating agreement between HPIH and its members.
During the year ended December 31, 2016, cash used in financing activities of $10.4 million was primarily attributable to proceeds received from borrowings under the revolving line of credit of $7.5 million offset by repayments on the line 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.
We evaluate goodwill, which had a carrying value of $41.1 million as of December 31, 2017, for impairment at least annually, during the fourth 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.
The allowance for sales returns represents management’s best estimate of probable returns of policies sold. This estimate is based on a rolling 12 month average of returns tracked by month of service and month of return. In an effort to identify adverse trends for sales returns and chargebacks, we perform ongoing reviews of returns. In the prior year, management applied an "open enrollment" factor to the model, however review of actual returns compared to those estimated in 2016 resulted in revisions to the model such that this factor was deemed unnecessary. Revision of these assumptions resulted in a overall lower allowance as a percentage of sales.
As of December 31, 2017 and 2016, our allowance accounts were $471,000 and $695,000, respectively. As a measure of sensitivity, a 1% change in the allowance calculation would have a $90,000 and $313,000 net effect on pre-tax earnings, respectively.
As of December 31, 2017 and 2016, our allowance accounts were $180,000 and $454,000, respectively. There were no receivable balances written off in 2017 or 2016.
When we determined that we would be able to realize certain 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 2016 consolidated statement of income. In 2017, due to the impact of the change in corporate tax rate related to the Tax Act, we recognized an increase of $11.8 million in the tax receivable agreement obligation, and a corresponding increase to non-operating TRA income of $11.8 million. Income tax expense increased by $12.5 million while the deferred tax asset, net decreased by $12.9 million.
The resulting compensation expense is recognized over the requisite service period. The requisite service period is the period during which an employee is required to provide service in exchange for an award, which often is the vesting period. Compensation expense is recognized only for those awards expected to vest. In accordance with GAAP, compensation expense is not recognized for awards with performance vesting conditions until it is deemed probable that the underlying performance events will occur. All stock-based compensation expense is classified within SG&A expense in the consolidated statements of income.
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. For detailed discussion surrounding legal and other contingencies, see Note 12 in the accompanying consolidated financial statements.
Financial statements and exhibits filed under this item are listed in the index appearing in Part IV, Item 15 of this report.