Company Renewal Rate and Membership Persistency Rate Case Scenario Part A: Renewal Rate The company argues that the membership persistency rate is around

Company Renewal Rate and Membership Persistency Rate Case Scenario Part A: Renewal Rate

The company argues that the membership persistency rate is around 75%. Using the information provided in the case, estimate the membership renewal rate. Explain how you arrived at your estimate.

[Similar logic can be used to estimate membership renewal rates of companies like Netflix, Amazon, etc.]

Part B:

It turns out that investors can convert income statement and balance sheets using the SEC Method (to considerable degree of accuracy), based on the existing income statement and balance sheet provided by the firm.

Find out what would have been total expense and pre-tax income of Year 1998, had the firm been using the SEC Method, as suggested by the critics. Explain your logic.

(This will be an easy problem if you have a good sense of accounting logic). Pre-Paid Legal Services, Inc.
Pre-Paid Legal plans are designed to help middle-income Americans have affordable access to quality legal
assistance.
— Pre-Paid Legal Services Corporate Vision
Harland C. Stonecipher founded the Pre-Paid Legal Services, Inc. (PPLS) in 1972 after an
expensive encounter with lawyers stemming from an automobile accident. PPLS sold legal expense
insurance that provided for partial payment of legal fees in connection with the defense of certain
civil and criminal actions. The company went public in 1979 and grew rapidly throughout the 1980s
as an increasing number of Americans subscribed to legal service insurance (see Exhibit 1). In 1998
the company had membership revenues of $110 million, earnings of $30.2 million, and end–of-year
book equity of $101.1 million. In May 1999 it began trading on the New York Stock Exchange and in
August 1999 its market capitalization reached $738 million, an increase of 101% over the previous
year.
Despite its strong financial performance, opinions about the future of Pre-Paid Legal Services
(PPLS) varied widely among U.S. equity analysts in the period late-1997 to mid-1999. The company
was highly recommended by a number of analysts, but there was also persistent short selling of the
stock.1 Short sellers’ primary concern about the company was outlined in a Fortune article in late 1997.
The business publication alleged that the company was using an inappropriate method of accounting
for sales commissions. As a result of this uncertainty, the company’s stock price fluctuated widely
from a high of $40.50 to a low of $13.50 between late 1997 and mid-1999 (see Exhibit 2).
Business Description2
PPLS offered its customers (termed members) a wide range of legal insurance. The most popular
plan, The Family Plan, accounted for 94% of all memberships in 1998. This plan provided
reimbursement for a broad range of legal expenses incurred by members and their spouses, including
will and testament preparation, document review and letter writing, and some of the legal costs
associated with employment-related trial defense, traffic violations, and Internal Revenue Service audits. 3 The Family
Plan specified limits on the number of hours of attorney time that a member was
entitled to receive for many of these services. It also provided a 25% discount on attorney rates for the
purchase of any legal services over and above those provided under the insurance contract.
PPLS’s membership premiums in 1998 averaged $19.08 per month (or $229 per year). Premiums
were typically paid on a monthly basis either by automatic charges to the member’s credit card or
through employee payroll deductions. The premiums were generally guaranteed renewable and noncancelable
except for fraud, nonpayment of premiums, or upon written request by a member. The
annual membership persistency rate in 1998 was high; approximately 75% of members at the
beginning of the year and new members during the year continued to be enrolled in the program at
the end of the year. At March 31 1999, PPLS had 648,475 active members, and membership had been
increasing at about 40% per year.
PPLS marketed its memberships through a multi-level program that encouraged buyers to
become salespeople. Members that sought to become sales associates paid the company a fee,
typically $65, to cover the cost of training materials, training meetings, and home office support
services. Registered sales associates sold the company’s services to their friends and business
associates. The most successful even recruited and developed their own sales force. In 1998 PPLS
generated 76% of its annual sales from the roughly 150,000 members registered as sales associates.
The remaining 24% of sales were generated through arrangements with insurance and service
companies with established sales forces, such as CNA and Primerica Financial Services.
Sales associates were compensated on a commission basis (see Exhibit 3). Prior to 1995, associates
that signed-up a new member received a commission of 70% of the first year premium, and a 16%
commission for subsequent year renewals. First year commissions were paid in advance whereas
renewal commissions were paid as premiums were received. For example, if a new member signed
up at a premium of $229 per year, the associate responsible for the sale received a first year
commission of $160 (0.70*$229) at sign-up. If the member renewed in subsequent years, the sales
associate received a monthly commission of $3.04 (0.16*$19).
After 1995 PPLS modified its commission formula to a flat 25% commission for both initial year
and subsequent renewal memberships. To retain and attract sales associates, PPLS advanced the
sales associate three years of commission on every new membership sold. If a membership lapsed
before the advances had been recovered, PPLS deducted 50% of any unearned advances from future
commissions to the relevant associate. For example, if a new member signed up at a premium of $229,
the associate received a commission advance of $171.75 (25%*3*$229). If one year later the member
cancelled the policy, PPLS sought to recover $57.25, equal to 50% of the second and third year
commissions (50% of $229*2*0.25).
PPLS had historically offered two forms of legal services, each with very different implications for
managing legal claim costs. The first form of service, termed open panel, allowed members to use
their own attorney to provide legal services available under their policy. Member’s attorneys were
reimbursed for their services using a payment schedule that reflected “usual, reasonable and
customary fees” for a particular service and geographic area.
The second form of service, closed panel memberships, required members to access legal services
through a network of independent attorneys that were under contract with PPLS. These provider
attorneys were paid a fixed monthly fee on a per capita basis to provide services to plan members
living within the state in which the attorney was licensed to practice. PPLS contracted with one large,
highly rated legal firm in each of its 36 major markets. Provider attorneys are typically rated ‘AV’ by
Martindale-Hubbell, its highest rating. They were selected after a detailed review by PPLS
management.
Average costs of membership benefits in 1998 were 33% of membership premiums and
management reported that these costs were expected to remain at around 35% in the future.
Financial Performance
PPLS reported record financial performance in period 1997 and 1998 (see Exhibit 4 for summary
financial data and Exhibit 5 for 1998 financial statements and excerpted footnotes.). Membership
revenues during this period grew by an average of 59% per year, net income grew by 71% per year,
and operating cash flows grew 500% per year. The firm’s financial performance for the first six
months of 1999 continued to be impressive. Membership revenues grew by 20%, earnings by 54%,
and operating cash flows by 138% (from $2.4 million to $5.7 million).
As a result of the company’s growth performance, a number of equity analysts that followed the
stock recommended it to their clients. For example, David Strasser of Salomon Brothers issued strong
buy recommendations for PPLS in August 1997 and commented on the stock as follows:
We reiterate our Strong Buy recommendation on the shares of Pre-Paid Legal Services, Inc.
… We have recently increased our one-year price to $34 from $26. We did this for several
reasons. First, the company continues to demonstrate consistent earnings growth, in line with
Wall Street estimates, which gives us greater visibility of our projected 36% growth rate. … We
are also encouraged by the company’s ability to generate positive operating cash flow while
still growing revenues 53%. This positive cash flow is indicative of the seasoned membership
base that generates cash in spite of the company’s policy of paying commission advances to its
associates for new sales. We continue to believe that the company will announce an alliance
with a major insurance company to sell the company’s products. This would essentially
double the size of the company’s productive sales force and increase overall visibility of the
prepaid legal product.4
Accounting Dispute
Despite its strong financial performance, in late 1997 PPLS was a target of short selling. On
November 24, 1997, Fortune published an article titled “Will Pre-Paid Keep Growing?” The article
cited short seller Robert Olstein of Olstein’s Financial Alert Fund, who explained that his concern
arose because “PPLS’s accounting for commissions is unrealistic and not in accordance with
economic reality.“5 The Fortune article noted that:
Rather than record the commissions as an instant hit to earnings, Pre-Paid spreads them out
over a three-year period. Such deferrals, the shorts argue, make today’s earnings growth look
stronger than it really is. In the first half of this year, for example, if the company had
swallowed commissions when they were paid, it would have shown little if any earnings
growth—certainly not a level of growth to justify the stock’s trading at nearly 40 times
earnings.
Plus, trouble could emerge if the company’s cancellation rate on its policies increases and it
can’t somehow recover the commissions it has already paid. Pre-Paid shrugs this off, arguing
that its historic cancellation rate is a manageable 24%. And, Harp (PPLS’s CEO) boasts, “I can
predict this business more precisely than anybody you want to mention.”
Maybe so, but the company’s own figures, disclosed in SEC filings, show that the rate is on
an upward trend. The fillings also state that Pre-Paid’s cancellation rate will rise if newly
written policies make up a greater portion of its business, and the company warns (deep in its
10-K annual report) that it experienced a “significant increase” in sales of new contracts last
year. Unless this shift is offset by “other factors,” the 10-K says, financial performance could
be severely hurt. In other words, Olstein contends, Pre-Paid may face a big write-off at some
point.
Management Response
PPLS argued that its policy of accounting for commissions resulted in a commission expense that
was more consistent with the collection of the premiums generated by the sale of such contracts.
Exhibit 6 shows management’s discussion of commissions and membership persistency in the firm’s
10-K statement. In addition, between October 1998 and June 1999 management acquired 1,384,440 of
the firm’s shares on the open market at an average price of $28 per share. 6
Nonetheless, concern over the company’s accounting persisted. In late June 1999, short sales were
6.5% of outstanding shares, more than four times the level of typical companies. 7 The company’s
stock traded at $26.63, well off its yearly high of $39.25 and the all-time high of $40.50.
Rick Nelson, an analyst at Furman Selz, summed up the market sentiment this way: “insiders feel
they’ve got a company that’s trading well off its high where the operating fundamentals are going
gangbusters. But the shorts have caught on the notion that from a cash flow standpoint, the company
just can’t handle the growth, and that their business model itself will come back to haunt them.” 8
The above estimates were developed by The National Resources Center for Consumer LegaServices
(NRC) and reported by PPLS in its 1998 10-K Report. NRC estimates included free member plans
sponsored by labor unions, the American Association for Retired Persons, the National Education
Association and military services, as well as employer-paid plans. PPLS estimated that 10% of the
total legal insurance market was covered by plans comparable to those provided by PPLS. The other
major companies servicing this market were Hyatt Legal Services, ARAG Group, LawPhone,
National Legal Plan, and the Signature Group. The NRC estimated that in 1997 the market share of
these firms (and PPLS) was 79%. The market share of PPLS alone was estimated at 15%.
Note 1 – Nature of Operations and Summary of Significant Accounting Policies
Estimates
The preparation of financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
Commissions
Effective March 1, 1995, the Company implemented a level membership commission
schedule of approximately 25% of annual premium revenue for all Membership years. This
commission schedule results in the Company incurring commission expense related to the sale of its
legal expense plans on a basis consistent with the collection of the premiums generated by the sale
of such Memberships. The Company currently advances the equivalent of three years of
commissions on new Membership sales. In January 1997, the Company implemented a new policy
whereby associates receive only earned commissions on the first three Memberships submitted
unless the associate successfully completes a training program which includes an intensive one-day
training seminar, produces three Memberships and recruits one associate within 15 business days
from their training date. Prior to March 1, 1995, first year commissions payable on the sale of a
Membership, and earned in the first Membership year, were approximately 70% of annual
Membership premiums while renewal commissions (payable as earned after the first Membership
year) were approximately 16% of annual premiums.
Revenue Recognition
Membership premiums are recognized in income when due in accordance with Membership
terms which generally require the holder of the Membership to remit premiums on a monthly basis.
Memberships are canceled for nonpayment of premium after ninety days. Premiums due but not
collected at the end of an accounting period are recorded as accrued Membership income; a provision
for uncollectible premiums, if any, is recorded currently. Revenues from Associates’ training program
fees and sales of marketing supplies are recognized as income when cash is received. Revenues for
product sales are recognized when products are shipped or services provided.
Commission Advances
Commission advances represent the unearned portion of commissions advanced to
Associates on sales of Memberships. Commissions are earned as premiums are collected, usually on a
monthly basis. The Company reduces Commission advances as premiums are paid and
commissions earned. Unearned commission advances on lapsed Memberships are recovered
through collection of premiums on an associate’s active Memberships. At December 31, 1998 and
1997, the Company had an allowance of $4.0 million and $3.7 million, respectively, to provide for
estimated uncollectible balances. The Company charges interest at the prime rate on unearned
commission advances relating to Memberships that canceled subsequent to the advance being made.
Membership Benefit Liability
The Membership benefit liability represents claims reported but not paid and actuarially
estimated claims incurred but not reported on open panel Memberships and per capita amounts
due provider attorneys on closed panel Memberships. The Company calculates the benefit liability
costs on open panel Memberships based on completion factors that consider historical claims
experience based on the dates that claims are incurred, reported to the Company and subsequently
paid. Processing costs related to these claims are accrued based on an estimate of expenses to process
such claims.
Life Insurance Reserves
Incurred but not reported claim estimates are actuarially estimated based on life insurance
in-force and estimated claims occurrences.
Exhibit 6 Management Discussion of Commissions and Membership Persistency, excerpted from
Management’s Discussion and Analysis of Financial Condition and Results, Pre-Paid Legal Services
10-K, December 31, 1998.
Commissions
Beginning with new Memberships written after March 1, 1995, the Company implemented a level
commission schedule which results in the Company incurring commission expense related to the sale
of its legal expense plans on a basis more consistent with the collection of the premiums generated
by the sale of such Memberships. Prior to March 1, 1995, the Company had incurred much higher
commissions (approximately 70%) during the first year of the Membership with substantially lower
commissions (approximately 16%) in all subsequent years. The level commission structure results in
the Company incurring commissions at the rate of approximately 25% per year for all Membership
years.
Prior to January 1997 the Company advanced commissions at the time of sale of all new
Memberships. In January 1997, the Company implemented a policy whereby the associate receives
only earned commissions on the first three sales unless the associate has successfully completed the
new training program that was implemented at the same time. For all sales beginning with the
fourth Membership or all sales made by an associate successfully completing the new training
program, the Company currently advances commissions at the time of sale of a new Membership.
The amount of cash potentially advanced upon the sale of a new Membership, prior to the
recoupment of any charge-backs (described below), represents an amount equal to up to three years
commission earnings. Although the average number of marketing associates receiving an advance
commission payment on a new Membership is 11, the overall initial advance may be paid to more
than twenty different individuals, each at a different level within the overall commission structure.
This commission advance immediately increases an associate’s account with the Company and
represents prepaid commissions on active Memberships.
Should a Membership lapse before the advances have been recovered for each commission level,
the Company immediately generates a “charge-back” to the applicable sales associate to recapture
50% of any unearned advance. This charge-back is immediately deducted from any future advances
that would otherwise be payable to the associate for additional new Memberships. The Company
historically has been able to immediately recover the majority of such charge-backs. Any remaining
unrecovered advance on a Membership that has lapsed represents a receivable from the associate and
is reflected as commission advances and is categorized as current or non-current based on the
expected recovery period. Additionally, even though a commission advance may have been fully
recovered on a particular Membership, no additional commission earnings from any Membership
will be paid to an associate until all previous advances on all Memberships, both active and lapsed,
have been recovered. During 1998, 22% of all associates submitting new Memberships accounted for
75% of all such new Memberships produced thereby further enhancing the recovery of
commission advances.
The Company’s commission advance policy exposes the Company to the risk of uncollectible
commission advances particularly for associates who do not receive commissions on a large
number of Memberships or who experience below average Membership persistency. The
Company closely monitors such commission advances to ensure maximum recoverability and maintains a
recoverability reserve which at December 31, 1998 and 1997, was $4.0 million and $3.7
million, respectively.
Associates also receive compensation when associates sponsored by them or other associates that
they have sponsored in their organization successfully complete the new training program
implemented by the Company on January 4, 1997. In order to successfully qualify, the new associate
going through th…
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