UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
_______________________
Date of Report
(Date of earliest
event reported): November 8, 2002
Cobalt Corporation
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(Exact name of registrant as specified in its charter)
Wisconsin 1-14177 39-1931212
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(State or other (Commission File (IRS Employer
jurisdiction of Number) Identification No.)
incorporation)
401 West Michigan Street
Milwaukee, Wisconsin 53202
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(Address of principal executive offices including zip code)
(414) 226-6900
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(Registrant's telephone number)
Item 5. Other Events and Regulation FD Disclosure.
On November 8, 2002, the Registrant filed a Registration Statement on Form
S-3 (the "Registration Statement"), relating to (a) 500,000 shares of its common
stock which it may offer and sell from time to time and (b) 6,500,000 shares of
its common stock which Wisconsin United for Health Foundation, Inc. (the
"Foundation") may offer and sell from time to time. The information set forth
below is "incorporated by reference" into the prospectus contained in the
Registration Statement (the "Prospectus") and should be read in conjunction with
the other information contained in or incorporated by reference into the
Prospectus. This information is substantially similar to certain of the
information contained in a Registration Statement on Form S-3 (Reg. No.
333-90866) filed by the Registrant on June 20, 2002 and withdrawn on August 8,
2002, with such updates as the Registrant has deemed necessary.
RISK FACTORS
An investment in our common stock involves risk. You should carefully
consider the risks we describe below before deciding to invest our common stock.
The market price of our common stock could decline due to any of these risks, in
which case you could lose all or part of your investment. In assessing these
risks, you should also refer to the other information included and incorporated
by reference in the Prospectus, including our consolidated financial statements.
Our insurance subsidiaries are subject to minimum capital requirements. Our
failure to meet these requirements could subject us to regulatory actions or
result in the termination of our Blue Cross and Blue Shield License Agreements.
Our insurance subsidiaries are subject to minimum capital requirements
imposed under the laws of the State of Wisconsin. These laws include minimum
capital requirements calculated under a State of Wisconsin prescribed compulsory
and security surplus computation, which establishes minimum capital based upon a
percentage of underwritten premiums, with the applicable percentage determined
by line of business. Wisconsin insurance laws also include minimum capital
requirements based on the Risk Based Capital for Insurers Model Act adopted by
the National Association of Insurance Commissioners, or "NAIC," and require our
insurance subsidiaries to report their results of risk-based capital
calculations to the state insurance departments and the NAIC. Any failure by one
of our insurance subsidiaries to meet the minimum capital requirements imposed
under Wisconsin law will subject it to corrective action, including requiring
the adoption of a comprehensive financial plan, examination and the issuance of
a corrective order by the Office of the Commissioner of Insurance of the State
of Wisconsin, which we refer to as the "OCI," revocation of its license to sell
insurance products in Wisconsin, or placing the subsidiary under state
regulatory control. See "Business -- Regulation -- Capital Requirements."
At the request of the OCI, we prepared a plan of action in early 2002 for
strengthening the capital position of our insurance subsidiaries. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Management's Plan." Our insurance subsidiaries are currently in
compliance with the minimum capital requirements imposed under Wisconsin law,
calculated as required by the OCI.
In addition, the Blue Cross Blue Shield Association, which we refer to as
the "Association," imposes certain financial and service performance standards
on Cobalt, our Blue Cross & Blue Shield United of Wisconsin subsidiary, which we
refer to as "BCBSUW," and our Compcare Health Services Insurance Corporation
health maintenance organization ("HMO"), which we refer to as "CompcareBlue,"
including capital requirements based on risk-based capital. Our right to
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use the Blue Cross and Blue Shield names and service marks in our service area
is derived from a license agreement we have with the Association. The
Association's capital requirements are generally more stringent than those
imposed under Wisconsin law. The Association has termination rights if our Blue
Cross and Blue Shield branded licensees' capital falls below the lowest of three
capital thresholds established by the Association. Cobalt, BCBSUW and
CompcareBlue have fallen below two of these capital thresholds. As a result, the
Association has included Cobalt, BCBSUW and CompcareBlue in its Plan Performance
Response Monitoring Process, or "PPRMP," which entails a variety of financial
monitoring and reporting and asset escrow requirements, among other measures.
Currently, all of our Blue Cross and Blue Shield licensees maintain risk-based
capital in excess of the lowest of the three risk-based capital levels
established by the Association. See "Business -- Blue Cross and Blue Shield
Licenses."
Any new minimum capital requirements adopted in the future by the
Association or by the OCI may require us to increase our capital levels, which
we may not be able to do.
Our Blue Cross and Blue Shield license agreements could terminate upon the
occurrence of events specified in the license agreements, and termination would
significantly harm our business.
Under license agreements with the Association, we have the right to use
the Blue Cross and Blue Shield names and service marks in our Blue Cross and
Blue Shield service area and to participate in the BlueCard Program. We believe
that our exclusive right to use the Blue Cross and Blue Shield names and service
marks provides us with an important marketing advantage in our service area.
Loss of these licenses would significantly harm our ability to compete in our
markets and subject us to a significant monetary penalty to the Association.
The Association could terminate our license agreements if we do not
satisfy its financial and service performance requirements or if other events
described in the license agreements, some of which are outside of our control,
occur. These events include, but are not limited to:
o failure to meet capital and liquidity requirements of the
Association;
o violation of the ownership limitations contained in our Amended and
Restated Articles of Incorporation;
o termination of the voting trust and divestiture agreement before the
Foundation's ownership of our common stock falls to less than 5%;
o the acquisition of our company without the prior consent of a
majority of the other disinterested licensees of the Association and
a majority of the then current weighted vote of the other
disinterested licensees of the Association;
o failure by the Foundation to divest its shares of our common stock
by the deadlines specified by the voting trust and divestiture
agreement;
o a determination by the Association that fewer than 80% of our
directors are independent; and
o failure to brand medical and dental business as required by the
Association.
Our Amended and Restated Articles of Incorporation include ownership limitations
required by the Association. Although we believe that these limitations are
enforceable under Wisconsin
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law for a corporation like ours, we are not aware of any case in which a court
has specifically addressed this issue. If one of our shareholders violates the
ownership limitations and disputes their enforceability and a court does not
enforce the provisions of our Amended and Restated Articles of Incorporation, we
could lose our licenses to use the Blue Cross and Blue Shield names and service
marks.
We may not be able to maintain profitability, and our quarterly operating
results may fluctuate significantly.
Although we reported net income in the first three quarters of 2002, we
experienced net losses in each of the years ended December 31, 1999, 2000 and
2001. During this time period, we experienced operational difficulties that led
to these losses and corresponding decreases in our capital. In an effort to
remedy these difficulties, we have devoted significant resources to improving
our core operations while divesting non-core assets. Nevertheless, we cannot
assure you that we will be able to achieve sustained profitability. If we incur
additional losses, we could have difficulty satisfying our obligations to the
OCI or implementing our related action plan. In addition, our relationship with
the Association could be adversely affected and our stock price would decline.
Moreover, our quarterly results of operations could fluctuate significantly due
to a variety of factors, including steps we are taking to enhance our core
operations such as exiting unprofitable businesses, as well as from inherent
aspects of our business, such as the need to make current estimates of future
claims. These fluctuations could adversely affect the price or liquidity of our
common stock.
Our results of operations will be adversely affected if we are unable to
increase premiums to offset increases in our health care costs.
Health care costs in recent years have generally increased substantially
year-over-year, and we expect that they will continue to do so in the future.
Our results of operations depend on our ability to increase premiums to offset
increases in our health care costs. Although we attempt to base the premiums we
charge on our estimate of future health care costs, we may not be able to charge
adequate premiums as a result of competition, government regulations and other
factors. Our results of operations could be adversely affected if we are unable
to set premium rates at appropriate levels or adjust premium rates in the event
our health care costs increase.
An ongoing reduction in the number of subscribers to our health care programs
may reduce our revenue and profitability.
Overall membership in our health benefits plans has decreased
substantially recently, in large part due to our efforts to eliminate
unprofitable business. This intentional reduction in membership will be complete
by the end of 2002. An ongoing reduction in the number of subscribers to our
health care programs could adversely affect our financial position, results of
operations and cash flows. Factors that could contribute to the loss of
membership include:
o failure to obtain new customers and failure to retain or voluntarily
terminating existing customers;
o premium increases and benefit changes;
o reduction in our provider network;
o our exit from business lines or markets;
o reductions in work force by existing customers; and
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o negative publicity or news coverage about us or other managed care
companies.
Our results of operations may be adversely affected if we are unable to
accurately estimate and control future health care costs.
Most of the premium revenue we receive is based upon rates set before we
deliver services. As a result, our ability to price contracts profitably largely
depends on our ability to accurately estimate and then control future health
care costs. Factors that may cause health care costs to exceed our estimates
include:
o an increase in the cost of health care services and supplies,
including pharmaceuticals;
o higher than expected utilization of health care services by our
insured members;
o periodic renegotiation of contracts with hospitals, physicians and
other providers;
o the occurrence of catastrophes or epidemics;
o changes in the demographics of our members and medical trends
affecting them;
o new mandated benefits or other regulatory changes that increase our
costs; and
o other unforeseen occurrences.
In addition to actual benefits paid, our medical and other benefits
expense for any period includes our estimate of reported and unreported claims
and related expenses for the period. The reserves we establish for these
expenses are based upon assumptions concerning a number of factors, including
trends in health care costs, our underwriting criteria, enrollment in our plans,
expenses, general economic conditions and other factors. Actual experience will
likely differ from assumed experience, and to the extent the actual claims
experience is less favorable than estimated based on our underlying assumptions,
our incurred losses would increase and future earnings could be adversely
affected.
Our medical, workers' compensation, and other benefit expenses include
estimates of expenses incurred but not yet reported to us, or "IBNR." We
estimate our IBNR expenses based on a number of factors, including prior claims
experience, maturity of markets, complexity of products and stability of
provider networks.
We make adjustments, if necessary, to benefit expenses in the period
during which the actual claim costs are ultimately determined or when criteria
used to estimate IBNR change. We utilize the services of independent actuaries
to calculate and review the adequacy of our benefit liabilities, in addition to
using internal resources. We cannot be sure that our IBNR estimates are adequate
or that adjustments to such IBNR estimates will not harm our results of
operations. Further, our inability to accurately estimate IBNR may also affect
our ability to take timely corrective actions, further exacerbating the negative
impact on our results.
Although we maintain reinsurance to protect us against severe or
catastrophic medical claims, we cannot assure you that such reinsurance coverage
will be adequate or available in the future or that the cost of such reinsurance
will not limit our ability to obtain it.
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Our profitability will decline if we are unable to maintain our relationships
with certain significant provider groups or if we are unable to enter into
agreements with additional providers on favorable terms.
Our Unity Health Plans Insurance Corporation, or "Unity" and Valley Health
Plan, Inc., or "Valley" HMOs rely in large part on three separate health care
provider systems for the provision of health care services to their members. If
one or more of our relationships with these systems were to be terminated, we
would be adversely affected. See "Business -- Our Provider Network."
Our profitability depends upon our ability to contract on cost-effective
terms with hospitals, physicians and other health care providers. If we fail to
obtain health care provider contracts, or renew those we have, on favorable
terms, we may lose some of our members or incur higher medical costs. In
addition, our inability to contract with providers, or the inability of
providers to provide adequate care, could significantly harm us.
Competition in our industry may decrease our profitability.
We operate in a highly competitive environment which may affect our
ability to maintain or increase our membership or premium rates or to contract
with providers on attractive terms. We face competition from other managed care
companies, hospitals, health care facilities and other health care providers,
some of which have substantially greater financial and other resources than we
have.
We believe there are no significant impediments facing potential
competitors who wish to enter the markets we serve. As a result, the entry of
new competitors into our markets can occur relatively easily, which affords our
customers significant flexibility in moving to other managed care providers and
which creates alternatives for participants in our provider networks. Our
managed care operations may encounter competition from companies with broader or
narrower geographical markets, each of which could provide a competitor with
specific competitive advantages, such as greater cost control, lower prices or
greater market share. Our financial condition or results of operations may be
adversely affected by significantly lower premiums by any major competitor or by
any other limitation on our ability to maintain or increase our membership or
premium levels.
In certain markets, we compete with organizations which have a substantial
market share. In other markets, competing health plans may be owned by
providers. Portions of the Wisconsin market are dominated by a relatively small
number of provider-owned health plans, with a large influence on the markets in
which we compete. Organizations with sizable market share or provider-owned
plans may be able to obtain favorable financial arrangements from health care
providers that are not available to us. Without such arrangements, we may not be
able to compete effectively in such markets.
In addition, legislation is currently pending in Congress that is intended
to increase competition for government contracts for processing claims for the
Medicare program. Our United Government Services subsidiary serves as a fiscal
intermediary for the Medicare program. If this legislation is adopted, our
ability to compete effectively for Medicare contracts may suffer.
Our business is dependent in part on the service of non-exclusive independent
agents and brokers who may refer their business to our competitors.
We depend in part on the services of independent agents and brokers in the
marketing of health care plans, particularly to individual and small employer
group members. Independent
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agents and brokers are typically not exclusively dedicated to one company and
market health care products of our competitors. In addition, we face intense
competition for the services and allegiance of independent agents and brokers.
These persons may choose to direct business to other managed care companies or
may direct less desirable sales prospects to us.
The health benefits industry is subject to negative publicity, which can
adversely affect our profitability.
The health benefits industry is subject to negative publicity. Negative
publicity may result in increased regulation and legislative review of industry
practices, which may further increase our costs of doing business and adversely
affect our profitability by:
o adversely affecting our ability to market our products and services;
o requiring us to change our products and services; or
o increasing the regulatory burdens under which we operate.
In addition, as long as we use the Blue Cross and Blue Shield names and
marks in marketing our health benefits products and services, any negative
publicity concerning the Association or other Association licensees may
adversely affect us and the sale of our health benefits products and services.
Failure to properly maintain the integrity of our proprietary information and
information systems could result in the loss of customers or decrease in our
profitability.
Our business depends in part on our ability to maintain, or access through
outsourcing arrangements with third parties, information systems and to ensure
the continued integrity of our proprietary information. Moreover, the
collection, dissemination and use of patient data is the subject of national and
state legislation. If we do not maintain or access effective and efficient
information systems, then we could experience:
o inadequate information on which to base pricing and underwriting
decisions;
o the loss of existing customers;
o difficulty in attracting new customers;
o customer and provider disputes;
o regulatory problems;
o increases in administrative expenses; or
o other adverse consequences.
We use third party service providers for claims processing and enrollment
functions, and therefore have only limited control over data management
associated with these functions.
Health care developments or an economic downturn in Wisconsin may harm our
results.
We conduct business primarily within the State of Wisconsin, and a large
proportion of our membership is in the Milwaukee metropolitan area. Therefore,
our business may be more
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sensitive to local or state conditions, such as pricing dynamics, health care
developments or general economic conditions, than organizations servicing
larger, more diverse markets. For example, national competitors can subsidize
losses in the Wisconsin market with profits from other markets in which they
operate. We may be competitively disadvantaged, or otherwise harmed, by our
Wisconsin focus.
Our investment portfolio is subject to varying economic and market conditions,
as well as regulation.
We depend on our investment portfolio as a source of liquidity to pay
medical claims and fund other expenses. Returns on our investment portfolio also
have historically contributed significantly to our net income. Our investment
portfolio consists primarily of fixed maturity securities, short-term
investments and indexed mutual funds. The market value of our investments varies
from time to time depending on factors relating specifically to the issuers of
the securities as well as to more general factors such as prevailing interest
rates and economic and market conditions. Fluctuations in the market value of
our investment portfolio could adversely affect our liquidity. These
fluctuations could also reduce our investment return or result in losses when we
sell investments to fund our cash needs, which could adversely affect our
overall profitability.
Our regulated subsidiaries are subject to state laws and regulations that
require diversification of their investment portfolios and limit the amount of
investments in certain investment categories. While we have adopted an
investment policy intended to facilitate compliance with statutory and
regulatory requirements, our failure to comply with these laws and regulations
might cause investments exceeding regulatory limitations to be treated as
non-admitted assets for purposes of measuring statutory surplus and risk-based
capital, and, in some instances, require the sale of those investments.
A downgrade in our subsidiaries' ratings may adversely affect our business,
financial condition and results of operations.
In February 2002, A.M. Best downgraded its rating of our insurance
subsidiaries to B+ "Very Good." The A.M. Best rating principally impacts our
ability to underwrite workers' compensation business. When the rating of United
Wisconsin Insurance Company, which underwrites our workers' compensation
product, was downgraded from A-- "Excellent" to B++ "Very Good" in June 2001, we
arranged with a reinsurer to use its insurance company, which had an A+
"Superior" rating by A.M. Best, to serve as underwriter for customers that
required the higher rating for their workers' compensation coverage. In exchange
for the use of the reinsurer's license, we were required to increase the portion
of the workers compensation business ceded to the underwriter from 20% to 35%.
Any future downgrade of the rating of our subsidiaries, should one occur, or our
inability to access an "A" rated underwriter on acceptable terms, could
negatively impact our ability to underwrite workers' compensation business.
We conduct business in a heavily regulated industry, and changes in regulations
or violations of regulations could significantly harm us.
Our business is heavily regulated on federal, state and local levels as we
discuss under "Business -- Regulation." For example, we need to obtain and
maintain regulatory approvals to market many of our products. Delays in
obtaining or failure to obtain or maintain these approvals could significantly
harm us.
We are also subject to various governmental reviews, audits and
investigations designed to monitor our compliance with applicable rules and
regulations. Any adverse investigation, audit results or sanctions could result
in:
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o damage to our reputation in various markets;
o increased difficulty in selling our products and services;
o loss of a license to act as an insurer or HMO or to otherwise
provide a service;
o loss of the right to participate in various federal programs,
including the Medicare supplement programs; or
o imposition of fines, penalties and other sanctions.
Legislation or other regulatory reform that increases the regulatory
requirements imposed on us may significantly harm our business or results of
operations in the future. Legislative or regulatory changes that could
significantly harm us and our subsidiaries include:
o legislation that holds insurance companies, HMOs or managed care
companies liable for adverse consequences of medical decisions;
o limitations on premium levels;
o increases in minimum capital, reserves and other financial viability
requirements;
o impositions of fines or other penalties for the failure to promptly
pay claims;
o prohibitions or limitations on provider financial incentives and
provider risk-sharing arrangements;
o imposition of more stringent standards of review of our coverage
determinations;
o new benefit mandates; and
o limitations on the ability to manage care and utilization due to
"any willing provider" and direct access laws that limit or
eliminate product features that encourage members to seek services
from contracted providers or through referral by a primary care
provider.
For example, the next session of Congress could see renewed efforts to
pass some form of patient protection legislation, commonly known as Patients'
Bill of Rights legislation, which may incorporate some of the provisions
described above. We cannot predict the impact of this legislation, if adopted,
on our business.
A portion of our revenues relate to Medicare supplement programs. Changes
in these programs, particularly changes affecting enrollment or changes in
premium payment or reimbursement levels, could significantly harm our business
and decrease our profitability.
As a Medicare fiscal intermediary, our United Government Services subsidiary is
subject to complex regulations. If it fails to comply with these regulations, it
may be exposed to criminal sanctions and significant civil penalties.
Our United Government Services subsidiary serves as a fiscal intermediary
for the Medicare program. The laws and regulations governing fiscal
intermediaries for the Medicare program are complex and subject to
interpretation and can expose a fiscal intermediary to penalties for
non-compliance. Fiscal intermediaries may be subject to criminal fines, civil
penalties or other sanctions as a result of periodic audits or reviews. Other
companies in this business have recently
9
been subject to significant fines and censures for non-compliance. While we
believe that we are in compliance in all material respects with the regulations
governing fiscal intermediaries, we cannot assure you of this.
Costs of compliance with privacy laws could adversely affect our business and
results of operations.
The Health Insurance Portability and Accountability Act of 1996 ("HIPAA")
includes administrative provisions imposing significant new requirements
relating to maintaining the privacy of medical information ("Privacy"),
establishing uniform health care provider and employer identifiers, requiring
use of standardized transaction formats ("Transactions") and seeking protections
for confidentiality and security of patient data ("Security"). While the
implementation deadlines for Privacy and Transactions will occur in 2003, there
is no implementation deadline for Security at this time because there have been
no final Security regulations issued. The law is far-reaching and complex, and
proper interpretation and practice under the law continue to evolve.
Consequently, our efforts to measure, monitor and adjust our business practices
to comply with HIPAA are ongoing. Compliance with HIPAA could require us to make
significant changes to our operations and failure to comply could subject us to
civil and criminal penalties. The costs of complying with HIPAA are likely to be
substantial.
We are subject to litigation, including litigation based on new or evolving
legal theories, that could significantly affect our results of operations.
Due to the nature of our business, we are subject to a variety of legal
actions relating to our business operations, including:
o disputes over coverage or claims adjudication;
o vicarious liability for medical malpractice claims;
o disputes with our providers or agents over compensation and
termination of contracts;
o disputes related to our non-risk business, including actions
alleging breach of fiduciary duties, claim administration errors or
other violations of federal or state laws; and
o customer audits of our compliance with our plan obligations.
In addition, plaintiffs continue to bring new types of legal claims
against managed care companies. Recent court decisions and legislative activity
increase our exposure to these types of claims. In some cases, plaintiffs may
seek class action status and substantial economic, non-economic or punitive
damages. The loss of even one of these claims, if it resulted in a significant
damage award, could have a significant adverse effect on our financial condition
or results of operations. This risk of potential liability may make reasonable
settlements of claims more difficult to obtain. We cannot determine with any
certainty what new theories of recovery may evolve or what their impact may be
on the managed care industry in general or on us in particular. We believe we
have made adequate reserves in our financial statements against all litigation
known to us, but we cannot be certain our estimates of probable outcomes of such
litigation will prove to be accurate.
We currently have, and expect to maintain, liability insurance coverage
for some of the potential legal liabilities we may incur. Potential liabilities
that we incur may not, however, be covered by insurance, our insurers may
dispute coverage, our insurers may be unable to meet
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their obligations or the amount of our insurance coverage may be inadequate. We
cannot assure you that we will be able to obtain insurance coverage in the
future, or that insurance will continue to be available on a cost effective
basis, if at all.
We are also subject to other types of claims and potential claims, which
could have a material adverse effect on our financial condition and results of
operations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Liquidity and Capital Resources" and "Business --
Management Information Systems."
As a holding company, we are dependent on dividends from our subsidiaries.
We are a holding company whose assets consist largely of the outstanding
shares of common stock of our subsidiaries. As a holding company, we depend on
dividends from our insurance company subsidiaries. Our insurance subsidiaries
are currently prohibited from paying dividends to us without the approval of the
OCI. Our ability to pay our shareholders dividends in the future and meet our
obligations, including paying operating expenses and debt service on our
outstanding and future indebtedness, will depend upon the receipt of dividends
from our subsidiaries. An inability of our subsidiaries to pay dividends in the
future in an amount sufficient for us to meet our financial obligations may
materially adversely affect our business, financial condition and results of
operations.
Provisions in our Amended and Restated Articles of Incorporation and Bylaws and
Wisconsin law may prevent us from being sold to a third party, and may limit or
eliminate increases in stock price based on "takeover" speculation.
Our Amended and Restated Articles of Incorporation and Bylaws include
provisions required by the Association for its for-profit licensees, which the
Association designed to protect the independence of its for-profit licensees
from any single shareholder. These provisions include the following:
o ownership limitations that prohibit institutional investors from
owning 10% or more of the voting power of our outstanding securities
and prohibit other investors from owning 5% or more of the voting
power of our outstanding securities; and
o initially, at least 80% of our directors must be independent
directors who are not affiliated or associated with the Foundation
or any shareholder that owns our shares in excess of the ownership
limits.
These provisions may make it more difficult for a third party to acquire
us in a transaction that our board of directors has not negotiated or approved
but in which our shareholders may receive a premium for their shares. Also,
these provisions can deter a party from acquiring a significant ownership
position in us prior to submitting an offer to our board of directors, and, as a
result, our common stock may trade at lower prices relative to other companies
that do not have similar ownership limitations in their charter documents.
In addition, Wisconsin insurance law prohibits any person from acquiring
control of us, and thus indirect control of our insurance subsidiaries, without
the prior approval of the OCI. Any purchaser of 10% or more of the voting
securities of a corporation is presumed to have acquired control of the
corporation unless the OCI determines otherwise.
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Registration rights of the Foundation and the oversight of the OCI may inhibit
our ability to raise funds through equity offerings.
We may desire the flexibility to raise funds quickly by selling our common
stock in the equity markets for general corporate purposes or to take advantage
of acquisition and other investment opportunities that may arise in the future.
The Registration Rights Agreement that we entered into with the Foundation in
the Combination (which we describe in "Background of the Company") could limit
or make more difficult our ability to raise funds through equity offerings.
In addition, under the OCI order issued in connection with the
Combination, we are required to obtain the approval of the OCI prior to any
issuance of our common stock. This approval is required until the OCI determines
that its oversight is no longer necessary to protect the Foundation against
improper dilution of its equity interest.
Our failure to raise additional equity capital when required could:
o restrict our future growth, both internally and through
acquisitions;
o inhibit our ability to invest in technology and other products and
services that we may need;
o adversely affect our ability to compete in the markets we serve; and
o restrict the availability of capital for our subsidiaries.
Our directors are generally able to control the outcome of matters, other than
change of control proposals, that are submitted to our shareholders for a vote
as long as the Foundation beneficially owns a substantial percentage of the
outstanding shares of our common stock.
The Foundation beneficially owns approximately 75.4% of the outstanding
shares of our common stock. The Foundation has placed all of its shares in a
voting trust for a trustee to vote and dispose of under the terms of the Voting
Trust and Divestiture Agreement.
The trustee of the voting trust must, as a general matter, vote all of the
Foundation's shares held in the voting trust as directed by a majority of our
independent directors and a majority of all of our directors on all proposals or
matters that may come before our shareholders, except for matters relating to
proposed combination and sale transactions if our shareholders will not own a
majority of the shares of the resulting company. Thus, except for votes relating
to business combination or sale transactions, so long as the Foundation
beneficially owns a number of shares sufficient to control the outcome of a
shareholder vote and more than 20% of our outstanding shares, our board of
directors will be able to control the outcome of most matters brought before our
shareholders for a vote. In addition, so long as the Foundation beneficially
owns more than 20% of our outstanding shares, any amendment to the Articles of
Incorporation or Bylaws requires approval by the OCI.
In any election of directors, the trustee of the voting trust must vote
the Foundation's shares in favor of each nominee approved by a majority of our
directors who are deemed to be "independent" under the Association's standards
and a majority of all of our directors. As a result, our directors will likely
be able to ensure their re-election and designate their successors for as long
as the Foundation owns a substantial number of shares of our common stock.
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We will not be able to sell or merge without the approval of the Foundation as
long as the Foundation beneficially owns 50% or more of the outstanding shares
of our common stock.
Any acquisition of Cobalt will require the approval of our board of
directors and the holders of a majority of the shares of our common stock. As
long as the Foundation beneficially owns more than 50% of our common stock, it
will be able, by itself, to block any such proposed transaction even if our
board of directors and other shareholders would otherwise favor the transaction.
In addition, for so long as the Foundation beneficially owns at least 20% of our
outstanding shares, we must consult with the Foundation prior to soliciting, or
upon receiving, a business combination proposal which, if consummated, would
result in our then existing shareholders owning less than a majority of the
outstanding shares of the resulting company. The Foundation is expected to vote
its shares of our common stock on proposed merger and sale transactions based
upon its best interests. The interests of the Foundation in a merger or sale
transaction may be different from the interests of other shareholders.
Trading volume for our common stock has been limited, and significant sales of
our common stock by the Foundation, or the expectation of these sales, could
cause our stock price to fall.
From the completion of the Combination on March 23, 2001 through November
5, 2002, the average daily trading volume of our common stock was 48,709 shares
per day. Given the limited trading volume of our common stock, significant sales
of our common stock by the Foundation, or the expectation of these sales, could
cause our stock price to fall.
The Foundation is obligated to reduce its ownership of our common stock to
certain levels by specified dates, as described in "Agreements with the
Foundation -- Certain Agreements Executed in Connection with the Combination
- --Voting Trust and Divestiture Agreement." If the Foundation fails to meet its
divestiture requirements, we are entitled to arrange for the sale of the
Foundation's shares. The Foundation has the right to require us to periodically
file registration statements covering sales of stock by the Foundation, as
described under "Agreements with the Foundation -- Certain Agreements Executed
in Connection with the Combination -- Registration Rights Agreement."
Our stock and the stocks of other companies in the health care industry are
subject to stock price and trading volume volatility.
From time to time, the stock price and the number of shares traded of
companies in the health care industry experience periods of significant
volatility. Company-specific issues and developments generally in the health
care industry and in the regulatory environment may cause this volatility. Our
stock price may fluctuate in response to a number of events and factors,
including:
o quarterly variations in operating results;
o changes in financial estimates and recommendations by securities
analysts;
o operating and stock price performance of other companies that
investors may deem comparable;
o press releases or publicity relating to us or our competitors or
relating to trends in our markets;
o acquisitions and financings in our industry; and
o sales of stock by insiders.
13
BACKGROUND OF THE COMPANY
Cobalt Corporation was formed in March 2001 and is the successor to
substantially all of the operations of (i) Blue Cross & Blue Shield United of
Wisconsin, which we refer to as "BCBSUW," and (ii) United Wisconsin Services,
Inc., which was a publicly traded subsidiary of BCBSUW listed on the New York
Stock Exchange under the symbol "UWZ" and which we refer to as "UWS."
BCBSUW was formed in 1939 as a non-stock, not-for-profit service insurance
corporation, and since that time has operated as a health insurer licensed by
the Association to make exclusive use of the Association's names and service
marks in Wisconsin. In 1991, in order to gain increased access to capital
markets, BCBSUW contributed certain of its managed health care operations
(including its HMO operations) to UWS, its wholly-owned for-profit subsidiary.
Through public stock offerings completed in 1991, 1994 and 1995, BCBSUW reduced
its ownership of UWS stock to approximately 49% by February 1995.
In March 2001, the operations of BCBSUW and UWS were combined in a series
of transactions that we refer to as the "Combination." In these transactions,
BCBSUW converted from a non-profit to a shareholder-owned business,
contemporaneous with an exchange agreement approved by the Association and the
OCI. Under the exchange agreement:
o BCBSUW converted its form from a non-stock service insurance
corporation to a stock insurance corporation;
o BCBSUW issued all of its outstanding stock to the Foundation, a
charitable organization formed for the purpose of receiving the
stock of BCBSUW;
o the Foundation transferred all of the stock of BCBSUW to UWS (making
BCBSUW a wholly-owned subsidiary of UWS), in exchange for 31,313,390
shares of our newly issued common stock; and
o the combined entity changed its name to "Cobalt Corporation."
As a result of the Combination, BCBSUW is now one of our wholly-owned
subsidiaries, and the Foundation now owns approximately 75.4% of our outstanding
common stock.
As required under accounting principles generally accepted in the United
States, we accounted for the Combination as a purchase by BCBSUW of the shares
of UWS common stock which it did not own before the Combination. As a result,
the financial statements and related information contained in this prospectus
reflect the business and assets of BCBSUW (rather than UWS) before March 31,
2001, and the combined businesses of BCBSUW and UWS after that date.
In connection with the Combination, the Association rules required the
Foundation to deposit all of its shares of our common stock into a voting trust
and to sell its shares within prescribed time periods. Accordingly, we, the
Foundation and Marshall & Ilsley Trust Company, as trustee, have entered into a
Voting Trust and Divestiture Agreement, which is summarized under "Agreements
With Foundation -- Certain Agreements Executed in Connection with the
Combination -- Voting Trust and Divestiture Agreement."
14
We also entered into a Registration Rights Agreement with the Foundation
in connection with the Combination. Under the Registration Rights Agreement, we
agreed, subject to various terms and conditions, to register with the Securities
and Exchange Commission the Foundation's shares of our common stock for sale to
the public over a period of time, and the Foundation has granted us the right to
buy shares of our common stock from the Foundation in some cases. The
Registration Rights Agreement is summarized in more detail under "Agreements
With Foundation -- Certain Agreements Executed in Connection with the
Combination -- Registration Rights Agreement."
15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following presents our management's discussion and analysis of our
financial condition and results of operations as of the dates and for the
periods indicated. You should read this discussion in conjunction with our
consolidated financial statements and notes thereto and the information set
forth under the caption "Risk Factors." This discussion contains forward-looking
statements that involve risks and uncertainties. Actual results could differ
significantly from those anticipated in these forward-looking statements.
Overview
We are the leading managed care company in Wisconsin, offering a portfolio
of managed care and insurance products to employers, individuals and government
entities. We have an exclusive license to utilize the Blue Cross and Blue Shield
names and service marks in the State of Wisconsin, giving us a unique position
in that geographic market. As of September 30, 2002, we serviced 596,139 lives
in our health insurance operations and 338,825 lives in our dental insurance
programs.
During 1999 and 2000, we experienced large operating losses. These losses
were due primarily to our Medicare+Choice line of business and the self-funded
business. Additionally, UWS reported losses arising from its federal employee
contracts and a conversion of certain of its provider arrangements from
capitation to a fee for service model. In addition, during this period we
experienced difficulties in implementing new information systems, which impaired
our ability to identify trends indicating increasing medical costs, leading to
writing unprofitable contracts. These factors led to increased medical loss
ratios and resulting losses. In addition, the resulting adverse effect on our
capital position led to discussions with the OCI and the Association regarding
our plans for capital improvement.
To address these issues, we developed a plan to improve our core business
while divesting non-core businesses and assets. In our core business, we focused
on:
o discontinuing unprofitable business lines;
o repricing or terminating unprofitable customer contracts;
o improving underwriting techniques and pricing products appropriately
to reflect underlying cost trends;
o negotiating improved terms in our provider contracts; and
o bolstering management in key areas, including the Milwaukee market.
In implementing this plan, we exited the Medicare+Choice line of business
as of January 1, 2002 and elected to not renew certain unprofitable customer
contracts. We have also strengthened our senior actuarial and underwriting
staff, adopted more stringent underwriting standards and applied these standards
to achieve better pricing for new contracts, as well as those contracts up for
renewal. In addition, we have negotiated more favorable provider contracts and
have improved our product mix by increasing enrollment in our Medicare
supplement business and reducing self-funded membership.
16
We have divested certain non-core assets. We sold our behavioral health
and medical management subsidiary, Innovative Resource Group, for $27 million,
resulting in a pre-tax gain of approximately $10 million. Additionally, during
2002 we have reduced our investment in AMSG common stock from 45% of the shares
outstanding to approximately 13%, raising net proceeds of approximately $71.5
million and resulting in a pre-tax gain of approximately $11 million, while
relieving us of a significant portion of our statutory capital requirement
relating to AMSG.
Through this strategy, we have improved our core operations. Although
resulting in decreased membership and premium revenue for BCBSUW and our HMOs,
our strategy has substantially improved loss ratios and overall profitability.
Our net income from continuing operations improved to $49.9 million for the
first three quarters of 2002 from net losses of $42.7 million in 1999, $40.0
million in 2000 and $23.3 million in 2001. By 2001, we were experiencing
significant improvement in our core operations, although we nonetheless recorded
a substantial net loss, principally due to a $25.2 million writedown of our
minority investment in AMSG. We intend to continue our strategy of focusing on
our core business and seeking ways to divest additional non-core assets and
unprofitable business.
For financial reporting purposes, we have been able to reduce income tax
expense through utilization of net operating loss carryforwards. As a result of
our recent profitability, including gains on the sale of Innovative Resource
Group and common stock of AMSG, we anticipate that we will exhaust, sometime
between December 31, 2002 and March 31, 2003, those of our net operating loss
carryforwards that may, under applicable accounting guidelines, be used to
benefit our operating results. At such time, we will begin accruing income tax
expense at the statutory rate of 40%.
Summary of Membership, Revenue and Ratios
In the discussion to follow, the number of "members" is equivalent to the
number of persons covered by contracts in force. Member equivalents relating to
individuals who access medical care under the BlueCard program are not
included.
As of December 31,
------------------
1999 2000 2001
---- ---- ----
Membership at end of period:
Insured medical products................. 221,266 255,289 530,480
Self-funded medical products............. 218,873 184,819 131,671
Self-funded dental products............ 79,926 50,785 37,975
Specialty managed care products and
services................................. 151,471 145,955 592,566
------- ------- ---------
Total membership................... 671,536 636,848 1,292,692
======= ======= =========
17
Years Ended December 31,
------------------------
1999 2000 2001
---- ---- ----
(In thousands, except ratios)
Revenue:
Insured medical products........................ $392,583 $510,638 $1,150,420
Self-funded products............................ 25,970 24,716 28,067
Specialty managed care products and services.... 27,774 29,922 142,009
Government services ............................ 52,259 70,305 117,192
Other operations(1)............................. (1,408) (2,481) (24,450)
-------- -------- ----------
Total health services revenue.............. 497,178 633,100 1,413,238
Investment results.............................. 18,510 9,583 12,482
-------- -------- ----------
Total...................................... $515,688 $642,683 $1,425,720
======== ======== ==========
Health services revenue (as a percentage of the total:
Insured medical products........................ 79.0% 80.7% 81.4%
Self-funded products............................ 5.2 3.9 2.0
Specialty managed care products and services.... 5.6 4.7 10.0
Government services............................. 10.5 11.1 8.3
Other operations(1)............................. (0.3) (0.4) (1.7)
===== ===== =====
Total...................................... 100.0% 100.0% 100.0%
===== ===== =====
Years Ended December 31,
------------------------
1999 2000 2001
---- ---- ----
Insured medical product ratios:
Loss ratio(2)................................... 90.5% 93.5% 90.7%
Selling, general, administrative and other
expense ratio(3).............................. 14.3% 12.0% 9.6%
__________
(1) Consists primarily of intracompany eliminations.
(2) Insured medical benefit as a percentage of insured medical product revenue.
(3) Insured selling, general, administrative and other expenses as a percentage
of insured medical product revenues.
Results of Operations
All financial data in the Results of Operations section are gross numbers
and, therefore, are not net of intracompany eliminations.
Comparison of Results of Fiscal Year 2001 with Fiscal Year 2000
The results for 2001 include the operations of the combined UWS and BCBSUW
entities effective March 31, 2001 with AMSG continuing to be accounted for using
the equity method. Prior to March 31, 2001, the results include the operations
of BCBSUW and its investment in UWS and AMSG accounted for using the equity
method. The comparison between 2001 and 2000 is largely explained by the
addition of UWS results for the last three quarters of 2001 following the
Combination.
18
Total Revenues
Total revenues in 2001 increased 121.8% to $1,425.7 million from $642.7
million in 2000. The increase in 2001 is due primarily to the Combination and
the resultant addition of the UWS business. UWS contributed $686.8 million in
revenue in 2001 or 106.9% of the total 121.8% increase for the year. Other
factors contributing toward the increase in 2001 include premium rate increases
on the insured medical product business, the re-pricing of self-funded products
and new government fee based contracts.
Insured Medical Products
Insured medical revenue in 2001 increased 125.3% to $1,150.4 million from
$510.6 million in 2000. The increase in 2001 is primarily due to the Combination
and the resultant addition of UWS business.
The addition of UWS premiums resulted in an increase to premium revenue
for 2001 of $574.4 million or 112.5% of the total 125.3% increase. The number of
insured medical members in 2001 increased 107.8% to 530,480 from 255,289 in
2000. The total membership increase of 275,191 reflects a decrease of 18,474
members in BCBSUW insured medical membership, offset by the addition of 293,665
members from the UWS insured medical business.
Self-Funded Products
Self-funded administrative fees in 2001 increased 13.8% to $28.1 million
from $24.7 million in 2000. The increase in 2001 results from an increase of
approximately 60% in the administrative fee per member per month due to the
targeted re-pricing of self-funded business in order to eliminate unprofitable
business. The pricing increases were offset by a reduction of 30.2% in non-HMO
self-funded membership to 164,415 as of 2001 from 235,604 as of 2000.
Specialty Managed Care Products and Services
Specialty managed care products and services revenue in 2001 increased
374.9% to $142.0 million from $29.9 million in 2000. The increase in 2001
primarily resulted from the addition of $113.4 million in revenues from the UWS
specialty business, which includes life, accidental death and dismemberment,
dental, disability, workers' compensation products, along with electronic claim
submission, cost containment and receivables management services. The number of
specialty managed care members in 2001 increased to 592,566 from 145,955 in
2000. The total increase in membership of 446,611 reflects a decrease of 13,981
members in BCBSUW insured dental membership, offset by the addition of 460,592
members from the UWS specialty risk business.
Government Services
Government services revenue in 2001 increased 66.7% to $117.2 million from
$70.3 million in 2000. The increase from 2000 to 2001 is attributable to
significant growth in the volume of Medicare claims processed, due to being
awarded additional government contracts. Effective December 1, 2000, United
Government Services became the Medicare Part A Intermediary for certain
additional states and U.S. territories. In addition, also effective December 1,
2000, United Government Services became the Regional Home Health Intermediary
for certain additional states and U.S. territories.
19
Investment Results
Net investment results include investment income and realized gains
(losses) on the sale of investments, which include cash equivalents, bonds,
stocks and other invested assets. Net investment results in 2001 increased 30.2%
to $12.5 million from $9.6 million in 2000. The addition of UWS increased 2001
investment results by $8.0 million. However, offsetting this increase was the
elimination of BCBSUW investment income related to intra-company financing
arrangements with UWS, subsequent to March 31, 2001, due to the Combination.
This intra-company investment income amounted to $5.5 million in 2000, as
compared to $1.3 million in 2001, based on the amount recorded through March 31,
2001. Average annual investment yields, excluding net realized gains,
intra-company investment income and other interest income were 5.8% and 7.0% for
2001 and 2000, respectively.
Average invested assets in 2001 increased 254.3% to $166.5 million from
$47.0 million in 2000. The improvement in 2001 is primarily the result of the
acquisition of UWS at the end of the first quarter of 2001, which increased our
invested assets by $200.9 million as of December 31, 2001.
Net investment gains (losses) are realized in the normal investment
process in response to market opportunities. Realized gains were $0.8 million in
2001 compared to realized losses of $0.5 million in 2000.
Expense Ratios
Loss Ratio
The insured medical products loss ratio for 2001 (which consists of the
BCBSUW insured medical business for the full twelve months, and the HMO business
after March 31, 2001) was 90.7%, compared with 93.5% for 2000 (which includes
only the BCBSUW business). The decrease in the medical loss ratio in 2001 is
primarily the result of pricing increases and other cost control measures
instituted in response to higher than anticipated medical utilization and cost
trends. In addition, the higher loss ratio for 2000 also reflects the effect of
a premium deficiency reserve of $3.6 million recorded during the second half of
2000 on the Medicare+Choice business. The premium deficiency reserve amount
recorded as of December 31, 2000 represented estimated losses throughout 2001.
The remainder of the premium deficiency reserve was reversed in 2001, as a
result of our exiting the business effective January 1, 2002.
The BCBSUW medical loss ratio for 2001 (excluding HMO business) was 85.7%,
compared with 93.5% for 2000. This improvement is partially attributable to a
reduction in the medical loss ratio in the Medicare+Choice business from 127.3%
in 2000 to 94.8% in 2001, on comparable revenues. The loss ratio for 2001 for
the HMO business was 94.4%, compared with 95.2% in 2000. The slight improvement
is the result of our re-pricing efforts and reduction of unprofitable business.
Selling, General, Administrative and Other Expense Ratio
For our insurance subsidiaries, the selling, general, administrative and
other ("SGA") expense ratio includes commissions, administrative expenses,
premium taxes and other assessments and claim interest expense. For
non-insurance subsidiaries, SGA includes operating expenses only. The insured
medical products SGA expense ratio for 2001 was 9.6%, compared with 12.0% for
2000. The improved SGA expense ratio in 2001 is the result of additional expense
20
control measures instituted, combined with a higher premium base in 2001 due to
pricing increases. In addition, the insured medical products SGA ratio in 2000
includes the effect of a $2.4 million write-off of deferred acquisition costs
related to the Medicare Risk business.
The self-funded products expense ratio for 2001 improved to 113.9% from
144.7% in 2000. This improvement is due to continued efforts to eliminate
unprofitable business through price increases.
The specialty managed care products and services combined loss and expense
ratio in 2001 improved to 98.0% compared with 100.0% for 2000. The 2000 ratio
includes only the BCBSUW dental business, whereas the 2001 ratio includes both
BCBSUW dental and the UWS specialty managed care products and services business.
The UWS specialty business includes cost containment services and electronic
claims services, which typically run at a lower overall operating expense ratio,
thus improving the combined ratio.
The expense ratio for government services in 2001 and 2000 remained
constant at 99.3%.
Other Expenses
We have a bank line of credit, in which certain subsidiaries, excluding
the corporate holding company, can participate. The line of credit permits
aggregate borrowings up to $20.0 million, with company specific maximums for the
participating companies. Interest expense related to the bank line of credit in
2001 and 2000 was $0.6 million and $0.3 million, respectively.
Goodwill amortization totaling $5.1 million and $0.6 million was recorded
for 2001 and 2000, respectively. Of the total $5.1 million of goodwill
amortization recorded for 2001, $3.3 million relates to $68.6 million of
goodwill recorded in 2001 for the Combination as a result of purchase
accounting, which until the effective date of Financial Accounting Standards
Board No. 142 was being amortized on a straight-line basis over a period of 15
years. In addition, the 2001 amortization expense includes amortization related
to the 1999 purchase by BCBSUW of 1.4 million additional shares of UWS stock,
which has been amortized on a straight-line basis over a period of 15 years.
Amortization expense for 2000 included amortization related to the purchase by
BCBSUW of the 1.4 million additional shares of UWS stock discussed above. In
addition, goodwill amortization has been recorded for various past acquisitions
of subsidiaries and additional insurance business.
Loss from Investment in Affiliates
The loss from investment in affiliates increased to $22.7 million in 2001
from $6.5 million in 2000. The $22.7 million loss in 2001 is comprised of our
pro rata share of AMSG's net income of $2.0 million for 2001, BCBSUW's share of
UWS income of $0.4 million for the first quarter of 2001, and other affiliate
net income of $0.1 million, offset by a $25.2 million writedown of the
investment in AMSG to the fair value of AMSG's common stock quoted on the New
York Stock Exchange as of December 31, 2001. This writedown was deemed
appropriate based on management's decision to no longer classify the investment
in AMSG as a strategic long-term asset. The 2000 loss from investment in
affiliates of $6.5 million is comprised of a $7.6 million loss related to UWS,
offset by a $1.1 million equity share in the net income of AMSG.
21
Income from Discontinued Operations
Income from discontinued operations for 2001 of $1.0 million includes
Innovative Resource Group's net operating results for the nine months ended
December 31, 2001.
Net Loss
Consolidated net results improved in 2001 to a loss of $22.3 million
compared to a loss of $40.0 million in 2000. The $22.3 million net loss in 2001
was the combination of an operating loss of $2.4 million and a loss from
investment in affiliates of $22.7 million as discussed above, offset by an
income tax benefit of $2.0 million and an after-tax gain on discontinued
operations of $1.0 million. The improved 2001 operating results reflect
improvement in the insured loss and SGA ratios, increases in administrative fees
on the self-funded business and continued growth in government contract business
over the prior year.
As of December 31, 2001, we had federal net operating loss carry-forwards
of approximately $141.0 million available to offset future taxable income. A
full valuation allowance has been established against net deferred tax assets.
We had a current income tax benefit of $2.2 million in 2001 in conjunction with
the formation of Cobalt compared to no current income tax expense or benefit in
2000. We recorded an immaterial deferred tax benefit in 2001 and a deferred tax
expense of $0.5 million in 2000, which related to a valuation allowance from a
prior period.
Comparison of Results of Fiscal Year 2000 with Fiscal Year 1999
Results for 2000 and 1999 include the operations of BCBSUW and its
investment in UWS and AMSG accounted for using the equity method.
Total Revenues
Total revenues in 2000 increased 24.6% to $642.7 million from $515.7
million in 1999. The increase in 2000 resulted primarily from increased
membership and premium rate increases on the medical insurance business and new
government contracts.
Insured Medical Products
Insured medical revenue in 2000 increased 30.1% to $510.6 million from
$392.6 million in 1999. The increased premium is due to the number of insured
medical members in 2000 increasing 15.4% to 255,289 from 221,266 in 1999,
combined with increases in per member per month premium due to premium rate
increases.
Self-Funded Products
Self-funded administrative fees in 2000 decreased 5.0% to $24.7 million
from $26.0 million in 1999. The decrease in self-funded administrative fees in
2000 primarily resulted from a 21.1% decrease in self-funded membership from
298,799 in 1999 to 235,604 in 2000. The decrease in membership was offset by an
increase of 20.7% in the average self-funded administrative fee per member per
month. The decrease in revenue and membership is due to aggressive pricing on
targeted group contracts and subsequent loss of unprofitable business.
22
Specialty Managed Care Products and Services
Specialty managed care products and services revenue in 2000 increased
7.6% to $29.9 million from $27.8 million in 1999. The number of specialty
managed care members in 2000 decreased 3.6% to 145,955 from 151,471 in 1999. The
slight decrease in membership was offset by premium rate increases, resulting in
an overall increase in revenues.
Government Services
Government services revenue in 2000 increased 34.4% to $70.3 million from
$52.3 million in 1999. The increase from 1999 to 2000 is largely attributed to
becoming the Medicare Part A Intermediary for the states of Virginia and West
Virginia as of September 1, 1999.
Investment Results
Net investment results in 2000 decreased 48.1% to $9.6 million from $18.5
million in 1999, primarily due to a decrease in average invested assets, as
discussed below. Average annual investment yields, excluding net realized gains,
intra-company investment income and other interest income were 7.0% and 6.1% for
2000 and 1999, respectively.
Average invested assets in 2000 decreased 37.9% to $47.0 million from
$75.7 million in 1999. The decrease in average invested assets during 2000 is a
result of cash requirements necessary to fund operating losses.
Net investment gains (losses) are realized in the normal investment
process in response to market opportunities. Realized losses were $0.5 million
in 2000 compared to realized gains of $8.0 million in 1999. BCBSUW received
interest income of $5.5 million and $4.8 million in 2000 and 1999, respectively,
on a $70.0 million note from UWS.
Expense Ratios
Loss Ratio
The insured medical products loss ratio for 2000 was 93.5% compared with
90.5% for 1999. The increase in the medical loss ratio in 2000 is primarily the
result of greater than anticipated medical utilization and cost trends. The loss
ratio on the Medicare+Choice business deteriorated to 127.3% in 2000 from 116.5%
in 1999, on revenues of $66.8 million and $21.1 million, respectively.
Selling, General, Administrative and Other Expense Ratio
The insured medical products SGA expense ratio for 2000 improved to 12.0%
compared with 14.3% for 1999. The improvement in 2000 reflects the effect of
expense controls instituted, combined with a higher premium base due to
membership and premium rate increases, offset in part by a $2.4 million
write-off of deferred acquisition costs related to the Medicare+Choice business.
The self-funded products expense ratio for 2000 improved to 144.7% from
166.9% in 1999. This improvement is due to price increases on targeted group
contracts, which resulted in the loss of unprofitable business.
23
The specialty managed care products and services combined loss and expense
ratio in 2000 improved to 100.0% from 108.3% in 1999. The expense ratio for
government services in 2000 was 99.3% compared to 98.4% in 1999, which reflects
a change in the overall average government reimbursement level due to changes in
the mix of business related to additional government business acquired in 2000.
Other Expenses
Interest expense related to the bank line of credit in 2000 and 1999 was
$0.3 million and $0.6 million, respectively.
In 1999, BCBSUW purchased 1.4 million additional shares of UWS stock. The
excess of cost over the fair value of net assets acquired has been recorded as
goodwill and was amortized on a straight-line basis over a period of 15 years.
Amortization expense was $0.6 million and $0.2 million for 2000 and 1999,
respectively.
Loss from Investment in Affiliates
The loss from investment in affiliates decreased to $6.5 million in 2000
from $22.7 million in 1999. The loss in 2000 is comprised of a loss of $7.6
million from UWS, offset by a gain of $1.1 million from AMSG. For 1999, the
affiliate results recorded by us include losses of $12.7 million from UWS and
$10.0 million from AMSG.
Net Loss
Consolidated net results improved in 2000 to a loss of $40.0 million
compared to a loss of $42.7 million in 1999. The poor results in 2000 resulted
primarily from the combination of a $32.9 million operating loss and a $6.5
million loss from investment in affiliates, net of tax. The $32.9 million
operating loss is due to a $20.6 million loss before income taxes on insured
business, which experienced greater than anticipated medical utilization and
cost trends, combined with a $10.7 million loss before income taxes on
self-funded business. In addition, the 2000 results include the effect of $3.3
million in transaction expenses in preparation for the Combination. Partially
offsetting these losses was $1.2 million in income before income taxes on
government contracts. The 1999 loss was also attributable to greater than
anticipated utilization on the insured business and losses on the self-funded
business.
Because of operating losses, BCBSUW did not have current income tax
expense or benefit in 2000 or 1999. BCBSUW had deferred tax expense of $0.5
million in 2000, which relates to a valuation allowance from a prior period.
There was no deferred tax benefit in 1999.
Liquidity and Capital Resources
Our sources of cash flow consist primarily of health services revenues and
investment income. The primary uses of cash include medical and other benefit
payments, as well as operating expense payments. Positive cash flows are
invested pending future payments of medical and other benefits and other
operating expenses. Our investment policies are designed to maximize yield,
preserve principal and provide liquidity to meet anticipated payment
obligations.
Our operating cash flow improved during the nine months ended September
30, 2002 in comparison with the nine months ended September 30, 2001. Cash
provided by continuing operations improved to $33.1 million from $0.1 million in
cash used in continuing operations for
24
the nine months ended September 30, 2001. This reflects improved operating
results in all four of the Company's reportable business segments, an increase
in the advance premium balance and improved cash collections related to balances
due from clinics and providers and other receivables. Cash provided by investing
activities for the nine months ended September 30, 2002 includes proceeds of
$71.5 million from the sale of 4.6 million shares of AMSG common stock and $17.0
million in cash proceeds received from the sale of Innovative Resource Group.
The majority of the strong positive cash inflows during the nine months ended
September 30, 2002 were used to purchase available-for-sale securities.
To meet periodic cash flow requirements, we make borrowings under our bank
line of credit. The line of credit is with a commercial bank and has an interest
rate equal to the London Interbank Offered Rate, or "LIBOR," plus 1.5%, adjusted
monthly with interest payments due monthly. The line of credit permits aggregate
borrowings among certain subsidiaries, excluding the corporate holding company,
up to $20.0 million. At September 30, 2002, the outstanding balance on this line
of credit was $0.4 million. The line of credit terminates, and all borrowings
then outstanding are due, on December 31, 2002.
We have a three year M&I revolving credit facility, which provides up to
$30.0 million of available credit to us with the availability declining by $5.0
million after one year and an additional $10.0 million after two years. The M&I
revolver bears interest at a rate of LIBOR plus 1.50% to 2.50% depending on the
timing and amount of borrowings. Our outstanding balance on the M&I revolver was
$28.0 million as of September 30, 2002.
In addition, we had a term note with a commercial bank for $7.5 million
originated on December 31, 2001, which was repaid in full on September 9, 2002.
The term note had a rate of interest equal to LIBOR plus 1.5%, with payment of
principal and interest due in quarterly installments beginning June 30, 2002 and
ending June 30, 2003.
Interest expense on the bank line of credit, M&I revolver and the term
note discussed above totaled $0.1 million for the three months ended September
30, 2002 and $0.2 million for the three months ended September 30, 2001.
Interest expense totaled $0.4 million for the nine months ended September 30,
2002 and 2001.
The Association requires BCBSUW and CompcareBlue to maintain a prescribed
liquidity ratio of certain liquid assets to average monthly expenses, as
defined, in accordance with licensure requirements of the Association. BCBSUW
and CompcareBlue maintained these required levels as of September 30, 2002.
Our investment portfolio consists primarily of investment-grade bonds,
bond-related mutual funds and government securities and has a limited exposure
to equity securities. At September 30, 2002, $309.4 million or 86.0% of our
total investment portfolio was invested in bonds, bond-related mutual funds and
government securities. The bond portfolio had an average quality rating by
Moody's Investor Service of "Aa3" at September 30, 2002. At September 30, 2002,
$347.1 million or 93.4% of our total investment portfolio was classified as
available-for-sale. The market value of the total investment portfolio was
greater than amortized cost by $13.6 million at September 30, 2002.
At December 31, 2001, $188.1 million or 98.1% of our total investment
portfolio was invested in bonds, bond-related mutual funds and government
securities compared with $30.0 million or 67.5% at December 31, 2000. The bond
portfolio had an average quality rating by Moody's Investor Service of "Aa3" at
December 31, 2001 and December 31, 2000. At
25
December 31, 2001, $180.7 million or 94.3% of our total investment portfolio was
classified as available-for-sale compared with $44.4 million or 100.0% as of
December 31, 2000. The market value of the total investment portfolio was
greater than amortized cost by $0.3 million and $0.2 million at December 31,
2001 and December 31, 2000, respectively.
Unrealized gains and losses on bonds classified as available-for-sale are
included as a component of surplus, net of applicable deferred taxes. We have no
investments in mortgage loans, non-publicly traded securities (except for
investments related to our affiliates) or real estate held for investment.
We have an outstanding line of credit in the amount of $15.0 million
available to Health Professionals of Wisconsin, Inc., an affiliate of University
Healthcare, Inc., which is a key provider for Unity. The balance was $3.0
million as of September 30, 2002. Interest on the line of credit is calculated
using the prime rate.
We have a note receivable from APS Healthcare Bethesda, Inc. for $10.0
million originated on March 29, 2002 related to the sale of Innovative Resource
Group. The note bears an interest rate of prime plus 3.5% and has a term of
three years.
As of September 11, 1998, UWS entered into a $70 million note obligation
due to BCBSUW in connection with the spin-off in 1998 of AMSG's managed care
companies and specialty business. We pledged the common stock of our
CompcareBlue subsidiary as collateral for the note obligation. Interest was
payable quarterly at a rate equal to 9.75% and 8.06% as of December 31, 2001 and
2000, respectively. The original maturity date of the principal balance was
extended from April 30, 2001 to January 1, 2002. The maturity date was
subsequently extended to February 15, 2002 at an interest rate of 7.38%. The
note was amended and the maturity date was extended to January 2, 2003 at an
interest rate of 7.38% on February 14, 2002. Effective with the Combination, the
principal amount of this note, together with all related interest expenses, are
eliminated in consolidation. On October 25, 2002, we received approval from the
OCI which allowed us to extinguish our obligations under the terms of the note
obligation by surrendering the common stock of our CompcareBlue subsidiary to
BCBSUW in full satisfaction of all debt obligations under the note. The stock of
CompcareBlue was surrendered, and all obligations under the note were satisfied,
effective October 1, 2002.
In 2001, we entered into an engagement letter with an investment bank to
provide advisory services in connection with potential financial transactions.
We terminated this relationship in March 2002. The engagement letter provided
that we pay a fee in respect of a transaction effected within twelve months of
termination (or later if an agreement regarding the transaction was entered into
within twelve months after termination) equal to the greater of $3.5 million or
a percentage of the transaction value (as defined). This fee obligation could be
claimed to extend to one or more of our asset dispositions effected in 2002, to
any offering of our common stock or other securities and to subsequent
transactions. No such claim has been made, and we would dispute any claim,
should one be made.
Under the OCI order issued in connection with the Combination, we are
required to obtain the approval of the OCI prior to any issuance of our common
stock. This approval is required until the OCI determines that its oversight is
no longer necessary to protect the Foundation against improper dilution of its
equity interest.
26
Statutory Capital
We are required to maintain certain levels of statutory capital and
surplus under the NAIC Risk Based Capital requirements. Wisconsin insurers are
also subject to compulsory and security surplus requirements based upon a
percentage of underwritten premiums, with the applicable percentage determined
by line of business. In addition to statutory capital requirements, we, BCBSUW
and CompcareBlue are required to maintain certain capital levels as determined
by the Association.
Management's Plan
Operating losses incurred during 1999 through 2001 reduced the statutory
surplus of our insurance subsidiaries. Despite these operating losses and the
implementation of changes in statutory accounting effective January 1, 2001, we
complied with minimum capital and liquidity requirements of the OCI and the
Association during 1999, 2000 and 2001. We maintained compliance, in part, by
contributing regulated and non-regulated subsidiaries to regulated entities and
by collateralizing certain intracompany debt obligations with the common stock
of affiliated entities. Following a review by the OCI of these intracompany
transactions, we agreed with the OCI as to how these transactions should be
treated for surplus and capital calculations. In addition, at the request of the
OCI, we prepared a plan of action to satisfy these intracompany obligations and
strengthen our capital to assure that our insurance subsidiaries continue to
satisfy the minimum capital and liquidity requirements of the OCI and the
Association.
The outstanding common stock of CompcareBlue provided the collateral for
approximately $70 million borrowed by us from BCBSUW. This intracompany balance
has been eliminated in our consolidated balance sheets. However, the
intracompany balance continues to be an obligation of us to BCBSUW ($70 million)
in the statutory-basis financial statements of BCBSUW as of September 30, 2002.
In October 2002, we received approval from the OCI and satisfied the $70 million
obligation due BCBSUW from Cobalt. The debt obligation under the note was
satisfied in full through the transfer of all of the common stock of
CompcareBlue.
Management provided to and discussed the capital plan with the OCI and the
Association. With our transfer of CompcareBlue to satisfy fully the debt
obligations under the $70.0 million note due BCBSUW, we have substantially
completed all aspects of the capital plan discussed below:
o Sell certain non-regulated subsidiaries owned by us for cash and/or
notes prior to October 1, 2002. On March 29, 2002, we sold our
behavioral health and medical management subsidiary, Innovative
Resource Group, LLC, for $27 million, of which $17 million was
received in cash.
o Reduce BCBSUW's investment in AMSG common stock from 45% of the
shares outstanding to less than 20% through public or private
offerings during 2002. We have reduced our investment in AMSG to
13.2% as of September 30, 2002, raising approximately $71.5 million
in net proceeds at BCBSUW.
o Obtain debt financing at our corporate holding company from one or
more institutional lenders to fund holding company liquidity needs
including the repayment of the collateralized intracompany debt
obligations between the holding company and its regulated
subsidiaries. We have obtained a $30 million revolving credit
facility. During the third quarter of 2002, we repaid our
intracompany obligation to UWIC of
27
$22.8 million. As noted above, the remaining intracompany obligation
between Cobalt and BCBSUW was satisfied through the contribution of
CompcareBlue to BCBSUW.
o Achieve our 2002 projected core earnings, which anticipate breakeven
operating results for CompcareBlue for the year ending December 31,
2002 as compared to an operating loss of $32.5 million for the year
ended December 31, 2001. Management expects CompcareBlue's
significant change in profitability to occur as a result of efforts
to cancel unprofitable business and implement necessary premium
increases for the remaining business. We achieved our projected core
earnings for the first three quarters of 2002, including progress
toward obtaining breakeven results for CompcareBlue by the end of
2002.
In addition, we have agreed with the OCI that we will not enter into
certain intercompany transactions, including loans, guarantees, reinsurance
arrangements, and other operational and financial arrangements, and our
insurance subsidiaries are prohibited from paying any dividends, without the
approval of the OCI. We have also agreed to adhere to certain practices in
conducting and accounting for affiliate transactions, notably involving the
lending practices previously described. We will not use uncollateralized,
non-operating intercompany balances in complying with minimum capital and
liquidity requirements. We have reflected the revised practices in the December
31, 2001 regulated subsidiary statutory-basis financial statements filed with
the OCI and other regulatory agencies. We have also agreed not to enter into any
new reinsurance arrangements with third parties without the approval of the OCI.
Our insurance subsidiaries are currently in compliance with the capital
requirements calculated as required by the OCI. We expect our insurance
subsidiaries to maintain compliance throughout 2002 by substantially completing
the capital plan described above or transactions with an equivalent impact on
our position relative to minimum capital and liquidity requirements.
Non-compliance with minimum capital and liquidity requirements or any of the
requirements described above may subject us to various regulatory actions by the
OCI, including, among others, revocation of our licenses to sell insurance
products in Wisconsin and placing us under state regulatory control. See
"Business -- Regulation -- Capital Requirements." In addition, the Association
has termination rights if our subsidiary licensees' capital falls below the
lowest licensure minimum capital levels established by the Association. See
"Business -- Blue Cross and Blue Shield Licenses."
Inflation
Health care costs have been rising and are expected to continue to rise at
a rate that exceeds the consumer price index. Our cost control measures,
risk-sharing incentive arrangements with medical care providers, and premium
rate increases are designed to reduce the adverse effect of medical cost
inflation on our operations. In addition, we utilize our ability to apply
appropriate underwriting criteria in selecting groups and individuals and in
controlling the utilization of health care services. However, we cannot assure
you that these efforts will fully offset the impact of inflation or that premium
revenue increases will equal or exceed increasing health care costs.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets,
28
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our estimates, including
those related to allowances for doubtful accounts, deferred tax assets,
impairment of equity method investments, goodwill impairment, medical and other
benefits payables, and litigation and tax contingencies. We base our estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
Allowance for Doubtful Accounts
A significant portion of our receivable balances result from balances due
from small and large employers, individuals, and providers of medical services.
We maintain allowances for doubtful accounts for estimated losses resulting from
the inability of our customers to make required payments or retroactivity in
reporting membership cancellations. If the financial condition of our customers
were to deteriorate or if significant employee turnover were to occur among
insured employers, resulting in an impairment of their ability to make payments,
additional allowances may be required.
Deferred Tax Assets
We have net deferred tax assets, and since March 23, 2001, the date of the
combination of UWS and BCBSUW, have recorded a full valuation allowance against
the net deferred tax assets. This valuation allowance was established after we
analyzed prior operating losses, estimated future taxable income, and feasible
tax planning strategies. Based on this analysis, management determined that we
could not conclude that realization of the net deferred tax assets was more
likely than not. In the event that a pattern of subsequent profitable operations
and other factors cause us to change our conclusion regarding realizability of
the net deferred tax assets, we would reduce the valuation allowance.
Impairment of Investments
Investments in debt and equity securities, as well as investment in
affiliates, are reviewed periodically by our management to determine whether any
declines in the market value of individual securities are deemed other than
temporary. Any impairments deemed other than temporary are recorded as a
reduction of the historical cost of the respective investment and as a realized
loss in our consolidated statement of operations.
Prior to the reduction of our ownership of AMSG common stock to 15% on
June 4, 2002, our investment in AMSG was accounted for under the equity method
of accounting. At December 31, 2001, we owned 6,309,525 shares of the
outstanding common stock (45% ownership) of AMSG. Our per share carrying value
as of December 31, 2001 was $16.44 based on our share of AMSG's equity. Pursuant
to current accounting principles generally accepted in the United States, we
wrote down our investment in AMSG to the current market value of such stock
($12.45 as of December 31, 2001) as a charge to operations due to our evaluation
and announcement that our holdings in AMSG no longer represented a strategic
investment and that we planned an orderly reduction of its ownership. Effective
upon the reduction of our ownership of AMSG common stock to 15%, we changed our
accounting for our investment in AMSG from the equity method to the fair value
method. Under the fair value method, our investment in
29
AMSG is recorded at market value, with any changes in market value being
recorded as an unrealized gain or loss.
Goodwill Impairment
On January 1, 2002, we adopted Statement of Financial Account Standards
No. 142, "Goodwill and Other Intangible Assets," under which we are required to
analyze recorded goodwill for possible impairment on a periodic basis. In
assessing the recoverability of our goodwill and other intangibles we must make
assumptions regarding estimated future cash flows and other factors to determine
the fair value of the respective assets. If these estimates or their related
assumptions change in the future, we may be required to record impairment
charges for these assets not previously recorded. Based on our analysis, we have
not recorded any impairment losses.
Medical and Other Benefits Payables
The amount of medical and other benefits payables (the "loss reserves") is
determined based on an estimation process that is very complex and uses
information obtained from both company specific and industry data, as well as
general economic information (e.g., medical cost index). The estimation process
requires us to continuously monitor and evaluate the life cycle of claims, on
type-of-business and nature-of-claim bases. Using data obtained from this
monitoring and assumptions about the emerging trends, we develop information
about the size of ultimate claims based on historical experience and other
available market information. The most significant assumptions, which vary by
class of business, used in the estimation process include determining the trend
in loss costs, the expected consistency in the frequency and severity of claims
incurred but not yet reported to prior year claims, changes in the timing of the
reporting of losses from the loss date to the notification date, and expected
costs to settle unpaid claims. We also monitor the reasonableness of the
judgments made in the prior year estimation process (referred to as a hindsight
analysis) and adjust current year assumptions based on the hindsight analysis.
Because the amount of the loss reserves is sensitive to assumptions, we do
not totally rely on a single estimate to determine the loss reserve. To test the
reasonableness of the best estimate generated by our loss estimation process, we
develop several estimates using generally recognized actuarial projection
methodologies that result in a range of reasonably possible loss reserve
outcomes that are used to challenge our best estimate. We will continue to
closely monitor these developments to ensure that our conclusions on the impact
are appropriate. Should other trends emerge, we would react accordingly which
could result in upward adjustments to our reserves and a corresponding charge to
earnings. Another factor that can significantly impact the loss reserve estimate
is the impact of legislative changes in health care, court resolutions and
judicial interpretations. We only factor into our assumptions actual legislative
changes, court rulings and interpretations. Therefore, the loss reserve
estimates made can be significantly impacted by future legislative actions,
rulings or interpretations.
Litigation and Tax Contingencies
We and our affiliates are involved in various legal actions occurring in
the normal course of business. In the opinion of management, we have made
adequate reserves for losses which may result from these actions. It is
possible, however, that future results of operations for any particular
quarterly or annual period could be materially affected by changes in our
assumptions related to these proceedings. As discussed in Note 14 of our audited
consolidated financial statements, as of December 31, 2001, we have accrued our
best estimate of the probable cost for
30
the resolution of these claims. This estimate has been developed in consultation
with internal and outside legal counsel that is handling our defense in these
matters and is based upon a combination of litigation and settlement strategies.
To the extent additional information arises or strategies change, it is possible
that our best estimate of its probable liability in these matters may change. We
recognize the costs of legal defense in the periods incurred. Accordingly, the
future costs of defending claims are not included in our estimated liability.
We frequently face challenges from domestic tax authorities regarding the
amount of taxes due. These challenges include questions regarding the timing and
amount of deductions and the allocation of income. In evaluating the exposure
associated with our various filing positions, we record reserves for probable
exposures when identified. Based on our evaluation of our tax positions, we
believe we have appropriately accrued for probable exposures. To the extent we
were to prevail in matters for which accruals have been established or be
required to pay amounts in excess of its reserves, our effective tax rate in a
given financial statement period may be materially impacted.
Quantitative and Qualitative Disclosures about Market Risk
Because of our investment policies, the primary market risks associated
with our portfolio are interest rate risk, credit risk and the risk related to
fluctuations in equity prices. With respect to interest rate risk, a reasonably
near-term rise in interest rates could negatively affect the fair value of our
bond portfolio. However, because we consider it unlikely that we would need or
choose to substantially liquidate our portfolio, we believe that such an
increase in interest rates would not have a material impact on future earnings
or cash flows. In addition, we are exposed to the risk of loss related to
changes in credit spreads. Credit spread risk arises from the potential that
changes in an issuer's credit rating or credit perception may affect the value
of financial instruments.
The overall goal of the investment portfolio is to support our ongoing
operations. Our philosophy is to manage assets to maximize total return over a
multiple-year time horizon, subject to appropriate levels of risk. We manage
these risks by establishing gain and loss tolerances, targeting asset-class
allocations, diversifying among asset classes and segments within various asset
classes, and using performance measurement and reporting.
We use a sensitivity model to assess the interest rate risk of our fixed
income investments. The model includes all fixed income securities and
incorporates assumptions regarding the impact of changing interest rates on
expected cash flows for certain financial assets with prepayment features, such
as callable bonds and mortgage-backed securities. Since December 31, 2001, no
significant changes have occurred in the determination of the reduction in fair
value of our modeled financial assets as a result of a hypothetical
instantaneous 100 basis point increase in market interest rates.
31
BUSINESS
Overview
We are the leading managed care company in Wisconsin, offering a broad
portfolio of managed care and insurance products to employers, individuals and
government entities. We have an exclusive license to utilize the Blue Cross and
Blue Shield service marks in Wisconsin, giving us a unique position in that
market. As of September 30, 2002, we serviced 596,139 lives in our health
insurance operations and 338,825 lives in our dental insurance programs.
BCBSUW provides underwritten products, including preferred provider
organizations (PPO) and indemnity options, as well as self-funded,
administrative services only programs. CompcareBlue operates the oldest HMO in
Wisconsin.
We offer the largest provider network in Wisconsin. All of our customers,
including HMO members, have the ability to access the leading physicians and
hospitals in their respective service areas, including Mayo Health Systems,
University Health Care and Aurora Health Care. We believe that our ability to
offer a full spectrum of products and a broad provider network to meet the needs
and objectives of a wide range of customers provides us with a competitive
advantage.
We offer a variety of specialty managed care products, including dental,
life and disability insurance. We are one of the largest providers of dental HMO
and dental indemnity coverage in Wisconsin. We also offer workers' compensation
insurance and a variety of specialty managed care services, including cost
containment, health care electronic data interchange and receivables management
services. These specialty products and services are designed to complement our
customers' employee benefit packages. We also process Medicare claims as a
Medicare Part A fiscal intermediary and a Regional Home Health intermediary for
providers in numerous states and several U.S. territories and as a national
intermediary for the Federally Qualified Health Centers in all 50 states.
We market our medical and dental products through a salaried sales force
located throughout Wisconsin, as well as through independent agents and brokers,
and directly to customers via the internet. By integrating the marketing of our
medical products, we are able to offer a broad range of product choices to
health care consumers. We sell our specialty managed care products and services
through a variety of distribution channels to employer groups and providers,
principally in Wisconsin.
Our Strategy
Over the past two years, we have taken certain steps that have resulted in
significant increases in profitability, including discontinuing unprofitable
business lines; repricing or terminating unprofitable customer contracts;
improving underwriting techniques and pricing products appropriately to reflect
underlying cost trends; negotiating improved terms in our provider contracts and
bolstering management in key areas, including in our Milwaukee market. We intend
to continue to pursue improvements in our operating results through the
implementation of the following strategies:
o Capitalize on the Strength of the Blue Cross Brand. We believe that
our right to the exclusive use of the Blue Cross and Blue Shield
brands in Wisconsin gives us a significant marketing advantage, and
we intend to continue emphasizing these brands among prospective
customers and members. According to the Association, the number of
32
members insured by plans bearing the Blue Cross and Blue Shield
brands has increased by approximately 26% nationwide since 1995. We
further intend to leverage the strength of the Blue Cross and Blue
Shield brands on a national basis by participating in the
Association's BlueCard PPO program, a network of Blue Cross and Blue
Shield plans. The BlueCard PPO program allows us to compete with
national health insurers for groups with employees outside of the
Wisconsin market and provides our members and members of other Blue
Cross and Blue Shield affiliates the opportunity to access care
while away from home.
o Focus on Core Business. We have made a strategic decision to focus
on our core Blue Cross and Blue Shield branded and HMO businesses,
where we believe significant opportunities exist for earnings
growth. These businesses together produced over 80% of our revenues
and approximately 59% of our pre-tax operating income in the quarter
ended March 31, 2002. On March 29, 2002, we sold our behavioral
health and medical management subsidiary, Innovative Resource Group,
LLC, for $27 million. In the future, we may sell other non-core
specialty businesses. In addition, since March 1, 2002 we have
reduced our ownership of our former affiliate AMSG, a small group
and individual health insurer, from approximately 45% to
approximately 13% of AMSG's outstanding common stock, raising net
proceeds of approximately $71.5 million and relieving us of a
significant portion of our capital requirement relating to AMSG.
o Expand Operating Margins and Realize Operating Efficiencies. We
intend to focus on expanding operating margins in our core
businesses by improving underwriting techniques and product design,
pricing products appropriately to reflect underlying cost trends,
discontinuing unprofitable businesses and contracts, and improving
provider arrangements. We intend to pursue additional operating
efficiencies through consolidation of administrative functions,
including combining the administrative functions of BCBSUW and
CompcareBlue as well as the administrative functions of certain of
our specialty businesses.
o Increase Market Share. We intend to focus on increasing market share
in Wisconsin through an increased emphasis on our core business, the
BlueCard PPO program and our Medicare supplement product offerings,
as well as the introduction of new products. We expect to accomplish
this by leveraging our diverse customer base by cross-selling
product offerings, and pursuing opportunistic acquisitions of health
insurers in Wisconsin.
Products and Services
Insured and Self-Funded Medical Products
We offer a wide range of insured and self-funded medical products,
including HMOs, PPOs, point of service (POS) plans, indemnity products, and
Medicare supplement products. We design our products to meet the needs and
objectives of a wide range of customers, including employers, individuals, and
government entities. Our customers either contract with us to assume
underwriting risk or self-fund underwriting risk and rely on us for network
management and administrative services. Our products vary with respect to the
level of benefits provided, the costs to be paid by employers and members,
including deductibles and copayments, and the extent to which our members'
access to providers is subject to referral or preauthorization requirements.
We provide our Blue Cross and Blue Shield branded products through BCBSUW
and our Blue Cross and Blue Shield branded HMO, CompcareBlue, which operates
primarily in the
33
Milwaukee metropolitan area. We also provide private branded products through
our HMO subsidiaries, Valley and Unity. Valley operates primarily in
northwestern Wisconsin, including the city of Eau Claire, whereas Unity operates
primarily in south central and southwestern Wisconsin, including the city of
Madison.
We also participate in the BlueCard PPO program, a national network of
Blue Cross and Blue Shield plans. The BlueCard PPO program permits members of
our Blue Cross and Blue Shield branded health plans to receive health care
services from providers in the networks of other Blue Cross and Blue Shield
plans. This allows us to compete with national health insurers for groups with
employees outside the Wisconsin market. This also allows members to access care
while away from home. Through electronic communications the "host" plan verifies
eligibility, pays the claim based on its local fee arrangement and is then
reimbursed by the "home" plan for the claim as well as an administrative fee.
Absent an agreement between two plans, the Association determines the amount of
the administrative fee. Under this arrangement, we are also able to generate
revenue from provider network management and claims repricing.
As of September 30, 2002, our health plan membership consisted of the
following (in numbers of individuals):
Insured Self-Funded
Product Offerings Members Members (1)
- ----------------- ------- -----------
HMO.............................. 159,150 4,652
PPO.............................. 161,492 84,125
POS.............................. 61,525 10,802
Indemnity........................ 19,878 35,659
Medicaid......................... 4,355 --
Medicare Supplement.............. 54,101 --
------- -------
Total Medical............... 460,901 135,238
======= =======
- ------------
(1) Does not include member equivalents relating to individuals who access
medical care under the BlueCard program.
Specialty Managed Care Products and Services
We are the largest provider of dental coverage in Wisconsin. Dental HMO
coverage is offered through CompcareBlue, and dental indemnity coverage is
offered through BCBSUW. These dental HMO and indemnity benefit products are
currently marketed under the DentalBlue(R) brand name. As of March 31, 2002 we
had approximately 304,000 insured dental members and approximately 35,000
self-funded dental members.
We offer group term life and accidental death and dismemberment coverages
as well as dependent life benefits. Short and long-term disability products
provide income replacement for an employee who becomes disabled through a
non-work related event. As of March 31, 2002, we insured approximately 116,000
disability members and 137,000 life members.
We provide worker's compensation insurance products and managed care
services to employees in Wisconsin. We also provide cost containment services,
including hospital bill audit, provider discount network repricing,
negotiations, diagnosis-related group validation, claims administration audit,
subrogation and recovery, electronic audit, collection and fraud investigation
and recovery services to assist customers in reducing their expenses and provide
more cost effective health care delivery. Additionally, we provide software and
claim submission services for Medicare, Medicaid, private insurers, third party
administrators and re-pricers. We also provide collections and receivables
management services to hospitals and other commercial
34
clients. We generally provide these specialty managed care products and services
through wholly-owned subsidiaries.
Government Services
We provide health care program administration and program safeguard
services for the Centers for Medicare & Medicaid Services, which we refer to as
"CMS." In connection with providing these services, we serve as the Medicare
Part A Intermediary and Regional Home Health Intermediary for numerous states
and territories, and serve as the national Intermediary for the Federally
Qualified Health Centers in all 50 states. In addition to providing services to
the Medicare program, we also provide claim processing and administrative
services in conjunction with the Wisconsin Medicaid program and the Health
Insurance Risk Sharing Plan.
The Association contracts with CMS to process Medicare Part A claims. We
have subcontracted with the Association to provide those services in various
states and territories. Until May 2002, that subcontract was held by BCBSUW,
which further subcontracted those services to our wholly-owned subsidiary,
United Government Services, LLC.
In May 2002, BCBSUW was granted a contract novation by CMS, enabling
BCBSUW to transfer the Medicare contract to United Government Services. We are
the first Medicare Part A processor to receive such a novation, and it is our
understanding that we received the novation based on the strength of our
compliance program. The novation provides for certain limitations on our
liability relating to acts subsequent to the novation. Also, the novation will
facilitate the transfer of the Medicare Part A processing business to another
Blue Cross and Blue Shield plan, should we determine to do so. Congress is
currently considering legislation which, if passed, would allow us to sell
United Government Services to any third party, including one that is not a Blue
Cross and Blue Shield plan, should we determine to do so. The legislation is
intended to increase competition for government contracts for processing claims
for the Medicare program. Our United Government Services subsidiary is a fiscal
intermediary for the Medicare program. Such legislation, if adopted, could
result in further competition for Medicare contracts.
Sales and Marketing
Marketing group health insurance products is generally a two-step process.
Presentations are made first to employers. Once selected by an employer, we then
directly solicit members from the employee base. During periodic "open
enrollments," when employees are permitted to change health care programs, we
use advertising and work site presentations to attract new members. Virtually
all of the group contracts are renewable annually.
Significant factors in product selection by employers and employees
include the composition of provider networks, quality of services, price, choice
and scope of benefits, and market presence. To the extent permitted by the OCI
and the federal government, we can offer an employer a wide spectrum of benefit
options, including federally qualified and non-federally qualified products. To
address rising health care costs, some employers now consider a variety of
health care options to encourage employees to use the most cost-effective form
of health care services.
We market our medical and dental products through a salaried sales force
located throughout Wisconsin, as well as through independent agents and brokers,
and directly to customers via the internet. By integrating the marketing of our
insured health and specialty managed care products and services, we are able to
offer a wide range of products and services to our customers. We sell
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our specialty managed care products and services through a variety of
distribution channels to employer groups and providers, primarily in Wisconsin.
While our traditional sales and marketing efforts have yielded significant
gains within our insured medical/self-funded and specialty businesses
individually, we believe that a more coordinated cross-selling effort could
significantly increase our market share across our business lines.
Our pricing strategy is targeted to cover current and anticipated changes
in health care costs and operating costs and deliver budgeted returns on
investment. To that end, in May 2002, we transferred primary responsibility for
our underwriting department to our Chief Actuary. We believe that the active
role our actuarial staff plays in the underwriting process will allow us to grow
our business while effectively managing the financial risks associated with our
products.
Our Provider Network
BCBSUW offers one of the largest provider networks in Wisconsin and
provides a diverse selection of primary care and specialty care physicians to
meet the health care needs of our members. CompcareBlue has an extensive
provider network in southeastern Wisconsin, and is the only HMO that contracts
with all eight of the largest multi-specialty clinics in Milwaukee, including
Aurora Health Care, the largest multi-specialty provider in Wisconsin, for the
provision of health care services to its members.
A majority of Valley's medical and other benefits are provided under an
arrangement with Midelfort Clinic, Ltd. and its affiliate, Luther Hospital,
which are affiliated with Mayo Health Systems and which we believe are the
leading medical service providers in Eau Claire, Wisconsin. Unity contracts with
Community Physicians' Network, an independent physician association, and
University Health Care, Inc. University Health Care contracts on behalf of the
University of Wisconsin Hospital and Clinics, the University of Wisconsin
Medical Foundation and the University of Wisconsin School of Medicine. Community
Physicians' Network and University Health Care provide the majority of physician
services for Unity's membership throughout its 19 county service area.
All of our HMOs have received National Committee for Quality Assurance, or
"NCQA," accreditation and higher than average satisfaction scores on clinical
services. As a result of our aggressive credentialing efforts, the percentage of
our HMO practitioners who are board certified is at or above the NCQA averages.
BCBSUW contracts primarily on a discounted fee-for-service basis. In
fee-for-service arrangements, risks associated with utilization are retained by
us. However, such arrangements provide us with greater pricing flexibility and
opportunities to benefit by application of underwriting on a group-specific or
individual basis. Furthermore, fee schedule-based compensation allows us to
better target improvement in loss ratios through product development, benefit
modification and medical management. CompcareBlue, Valley and Unity manage the
cost of health care provided to members through the method of payment and
risk-sharing programs with physician groups and hospitals and through their
respective utilization management programs. The method of payment consists of a
combination of capitation, fee schedules and discounted fee-for-service
arrangements. Capitation is an arrangement whereby we pay medical providers a
set fee per member per month in exchange for providing health care services.
Approximately 28% of the medical benefits provided by CompcareBlue, Valley
and Unity were provided under capitated arrangements in 2000. In 2001, this
number decreased to 17%, and
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through the first three quarters of 2002, this number increased to 21%,
primarily as a result of a decline in CompcareBlue's membership.
Valley and Midelfort have agreed in principle on the key terms of a
three-year extension of the arrangement. The parties are in the process of
negotiating the final terms of the agreement. The extension is expected to grant
Midelfort a similar option to repurchase the capital stock of Valley and will
eliminate profit sharing between the parties.
Pursuant to the provider agreements between Unity and Community Health
Systems, LLC and University Health Care, Community Health Systems has the
option, exercisable on December 31, 2004, to repurchase its proportionate share
of Unity for the current net worth of the business being repurchased. University
Health Care has the option, also exercisable on December 31, 2004, to purchase
its share of Unity for $0.5 million plus the proportionate share of the net
worth of Unity attributable to the University Health Care business, less any
unpaid amount of a maximum performance bonus specified in the agreement.
Exercise of the repurchase option ends the agreement with respect to that party.
If both repurchase options are exercised, we would have no ongoing interest in
Unity.
Medical Management
We utilize a broad range of focused, traditional cost containment and
advanced care management processes across our various product lines, such as
case management, disease management, evidence based medical policy, return on
investment evaluation, targeted opportunities, and quality improvement programs.
Our case management philosophy is built on helping members confront a complex
care system to find the appropriate care in a timely and cost effective manner.
We believe this approach builds positive relationships with providers and
members, and helps us achieve cost savings.
Our population-based disease management programs attempt to identify
members that have or are at risk to develop high cost chronic diseases and
conditions. These members typically have high utilization of health care
services, which can result in significant costs. By identifying high risk
members and enrolling them in specialized programs involving patient education,
lifestyle modification including changes in diet and intensive care management,
we seek to improve patient satisfaction, manage medical costs and improve
medical outcomes. These programs include diabetes, congestive heart failure,
asthma, and high risk pregnancy and we plan to expand these in the future.
We outsource significant behavioral health, utilization, disease and case
management services to our former subsidiary, Innovative Resource Group, which
we sold in March 2002. Innovative Resource Group manages our local pharmacy
network, customer service and clinical programs. WellPoint Pharmacy Management
manages our pharmacy claims processing and pharmaceutical manufacturer rebates.
Management Information Services
Information systems management for our core health business is primarily
delivered under a facilities management agreement with Blue Cross Blue Shield of
South Carolina and Electronic Data Systems Corporation, or "EDS." Blue Cross and
Blue Shield of South Carolina is responsible for administering information
systems supporting our claims processing. By working with another plan in the
Blue Cross and Blue Shield system, we are able to leverage system enhancements
that support the interchange of data across Blue Cross and Blue Shield plans,
such as the coordination of provider network arrangements on a national basis.
We use EDS
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information systems primarily to support our membership enrollment database. Our
specialty businesses use a variety of internal information systems that are
specifically designed for various product lines. Our agreement with Blue Cross
Blue Shield of South Carolina is in effect until October 2005, and our agreement
with EDS is in effect until October 2003.
In 1999, and again in 2002, we received a letter from the holder of a
patent asserting that certain of our information systems, including our claims
processing systems, infringe this patent. We are reviewing the merits of this
assertion. If we are found to infringe this patent, we could be required to
discontinue the infringing activity, which could disrupt our operations, and
could be required to pay damages for past activities and pay royalties for
future use, which could be substantial. As to certain of our systems that have
been claimed to infringe the patent, we have a contractual right to
indemnification from the vendor of the systems for losses resulting from patent
infringement. However, we cannot assure you that the indemnification would be
sufficient to protect us in the event that a patent infringement claim is made
against us and is determined to be valid.
Competition
The managed care industry is highly competitive. We believe the principal
competitive features affecting our ability to retain and increase our membership
include the strength of the Blue Cross and Blue Shield brands, our ability to
offer our customers a broad continuum of insured and self-funded products and
access to a network of high quality providers. Portions of the Wisconsin market
are dominated by a small number of provider-owned health plans, with a
correspondingly large influence on the markets in which we compete. We may
experience increased competition in the future, and provider-owned health plans
can often obtain favorable financial arrangements which are not available to us.
Some of our competitors are larger, have considerably greater financial
resources and distribution capabilities and offer more diversified types of
insurance coverage than us. Our key competitors include Humana, Inc., United
Healthcare, Dean Health Plan, Physicians Plus and Wisconsin Physician Service.
Blue Cross and Blue Shield Licenses
We are a licensee of the Blue Cross Blue Shield Association. The
Association is a national trade association of Blue Cross and Blue Shield
licensees which strives to promote and preserve the integrity of the Blue Cross
and Blue Shield names and service marks as well as provide certain coordination
among plan and provider services. As a licensee of the Association, we have the
exclusive right to use the Blue Cross and Blue Shield names and service marks
for all of our products in Wisconsin.
The licenses require us to pay an annual fee to the Association equal to
total association expenses allocated to Association members based upon
enrollment and premium. Each Association licensee is an independent legal
organization and is not responsible for obligations of other Association member
organizations. We do not have the right to use the Blue Cross and Blue Shield
names and service marks outside of our Blue Cross and Blue Shield service area,
except in certain limited circumstances.
Each of BCBSUW, CompcareBlue and United Government Services is also a
licensee of the Association, by virtue of being a controlled affiliate of
Cobalt. As required by the Association, Cobalt has provided each of BCBSUW and
CompcareBlue a guarantee of their contractual and financial obligations to their
customers. We have also agreed to indemnify the Association and other Blue Cross
and Blue Shield plans against any claims asserted against such entities
resulting
38
from our activities as well as the activities of any of our Blue Cross and Blue
Shield licensed affiliates.
Our license agreements require us to pay the Association a specific amount
upon termination of the license agreements, subject to certain limited
exceptions. The amount payable upon termination of our license agreement is
equal to the product of $25 multiplied by the number of our members receiving
products or services sold or administered under the Blue Cross or Blue Shield
names or service marks, subject to reduction to the extent the payment of the
fee would cause us to fall below certain capital requirements established by the
Association.
The Association could terminate our license agreements if we do not
satisfy its financial and service performance requirements or upon the
occurrence of other events described in the license agreements, some of which
are outside of our control. Termination events include, but are not limited to:
o failure to meet capital and liquidity requirements of the
Association (which are in addition to those required by state
regulatory agencies);
o violation of the ownership limitations contained in our Amended and
Restated Articles of Incorporation;
o termination of the voting trust and divestiture agreement before the
Foundation's ownership of our common stock falls to less than 5%;
o the acquisition of our company without the prior consent of a
majority of the disinterested licensees of the Association and a
majority of the then current weighted vote of the disinterested
licensees of the Association;
o violation of the Foundation's divestiture deadlines;
o determination by the Association that fewer than 80% of our
directors are independent; and
o failure to apply the Blue Cross and Blue Shield brands to medical
and dental business.
Our Amended and Restated Articles of Incorporation and Amended and
Restated Bylaws include various provisions required by the Association for its
for-profit licensees. These provisions are designed to protect the independence
of the Association's for-profit licensees from any single stockholder and are
described under "Articles of Incorporation and Bylaws."
The Association has established three risk-based capital thresholds which
are, in order of increasing seriousness, the "Early Warning Monitoring
Threshold," the "Concern Level Monitoring Threshold" and the licensure minimum.
As of December 31, 2001, Cobalt's, BCBSUW's and CompcareBlue's capital levels
were below the "Concern Level Monitoring Threshold." Because of our financial
performance, the Association has included BCBSUW, CompcareBlue and Cobalt in its
Plan Performance Response Monitoring Process, or "PPRMP." As a result, the
Association has requested that we and those subsidiaries regularly submit
additional interim financial information to the Association. In addition, the
PPRMP monitoring process requires that BCBSUW maintain a prescribed level of
escrowed assets as a financial guarantee for our transactions with other Blue
Cross plans. As of September 30, 2002, approximately $25.2 million of BCBSUW's
invested assets were maintained in escrow for this purpose. The PPRMP monitoring
process also requires that we provide certain notices to the
39
Association regarding our transactions with other Blue Cross plans. We expect
the Association to terminate the PPRMP requirements after our capital levels
improve above the prescribed monitoring thresholds.
As of December 31, 2001, BCBSUW and CompcareBlue exceeded the minimum
standard to maintain their licenses by $15.8 million and $7.2 million,
respectively. The Association is entitled to terminate our license agreement
with the Association, including the right to use the Blue Cross and Blue Shield
names and service marks, if we fall below the licensure minimum level of
statutory capital and surplus.
Regulation
General
Government regulation of employee benefit plans, including health care
coverage, health plans and our specialty managed care products, is a changing
area of law that varies from jurisdiction to jurisdiction and generally gives
responsible administrative agencies broad discretion. To comply with these
regulations, it may be necessary for us to make changes from time to time in our
services, products, structure or operations. Additional government regulation or
future interpretation of existing regulations could increase the cost of our
compliance or otherwise affect our operations, products, profitability or
business prospects.
Federal legislation has significantly expanded regulation of group health
plans and health care coverage. The laws place restrictions on the use of
pre-existing conditions and eligibility restrictions based upon health status
and prohibit cancellation of coverage due to claims experience or health status.
Federal regulations also prohibit insurance companies from declining coverage to
small employers. Additional federal laws, which took effect in 1998, include
prohibitions against separate, lower dollar maximums for mental health benefits
and requirements relating to minimum coverage for maternity inpatient
hospitalization.
Increasingly, states are considering various health care reform measures
which, if passed, may limit our ability and our health plans' ability to control
which providers are part of their networks and hinder their ability to manage
utilization and cost effectively. "Patient Protection" laws, which became
effective in Wisconsin in late 1998, established a prudent layperson standard
for coverage of emergency room care and provided extended access to providers
who are no longer part of the plan's network. A number of other states are
considering similar legislation. In addition, the United States House of
Representatives and Senate have each passed separate versions of federal patient
protection legislation which could increase our health plans' administrative
costs and hinder their ability to manage utilization and costs effectively. We
cannot predict whether final legislation will be adopted.
HIPAA
The Health Insurance Portability and Accountability Act of 1996 ("HIPAA")
includes administrative provisions imposing significant new requirements
relating to maintaining the privacy of medical information ("Privacy"),
establishing uniform health care provider and employer identifiers, requiring
use of standardized transaction formats ("Transactions") and seeking protections
for confidentiality and security of patient data ("Security"). While the
implementation deadlines for Privacy and Transactions will occur in 2003, there
is no implementation deadline for Security at this time because there have been
no final Security regulations issued. The law is far-reaching and complex, and
proper interpretation and practice
40
under the law continue to evolve. Consequently, our efforts to measure, monitor
and adjust our business practices to comply with HIPAA are ongoing. Compliance
with HIPAA could require us to make significant changes to our operations and
failure to comply could subject us to civil and criminal penalties. The costs of
complying with HIPAA are likely to be substantial.
HMOs
Wisconsin has enacted statutes regulating the activities of HMOs. This
regulation provides for periodic financial reports from HMOs and imposes minimum
capital or reserve requirements. In addition, certain of our subsidiaries are
required by state regulatory agencies to maintain restricted cash reserves
represented by interest-bearing instruments which are held by trustees or state
regulatory agencies to ensure that adequate financial resources are maintained
or to act as a fund for insolvencies of other HMOs in the state.
As a federally qualified HMO, CompcareBlue must file periodic reports
with, and is subject to periodic review by, the Centers for Medicare and
Medicaid Services.
Our HMOs which have Medicaid contracts are subject to both federal and
state regulation regarding services to be provided to Medicaid enrollees,
payment for those services and other aspects of the Medicaid program. Medicaid
has in force and/or has proposed regulations relating to fraud and abuse,
physician incentive plans and provider referrals, which may affect our
operations.
We contract with the Office of Personnel Management ("OPM") to cover
federal employees under the Federal Employees Health Benefit Plan. These
contracts are subject to extensive regulation, including complex rules relating
to the premiums charged. OPM has the authority to retroactively audit the rates
charged and may seek premium refunds and other sanctions against health plans
participating in the program. Our health plans that currently contract, or have
contracted in past years, with OPM, are subject to such audits and have in the
past and may in the future be requested to make such refunds. Given our
participation in this federal program, and other federal health care programs,
we have implemented, and place great importance upon, an effective compliance
program.
Capital Requirements
Our insurance subsidiaries are subject to minimum capital requirements
imposed under the laws of the State of Wisconsin. These laws include minimum
capital requirements calculated under a prescribed compulsory and security
surplus computation, which establishes minimum capital based upon a percentage
of underwritten premiums, with the applicable percentage determined by the line
of business. Wisconsin insurance laws also include minimum capital requirements
based on the Risk Based Capital for Insurers Model Act adopted by the NAIC. The
formula for calculating such risk-based capital requirements, set forth in the
instructions adopted by the NAIC, is designed to take into account asset risks,
insurance risks, interest rate risks and other relevant risks with respect to
the individual insurance company's business. Under these laws, our insurance
subsidiaries must submit a report of their risk-based capital level as of the
end of each calendar year. Insurers having less capital than required by the
risk-based capital model formula will be subject to varying degrees of
regulatory action depending on the level of capital inadequacy. The regulatory
action which may be imposed on an insurer includes requiring the adopting of a
comprehensive financial plan, its examination and the issuance of a corrective
order by the state insurance department, or placing the insurer under state
regulated control.
41
At the request of the OCI, we prepared a plan of action in early 2002 for
strengthening the capital position of our insurance subsidiaries. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Management's Plan." Our insurance subsidiaries are currently in
compliance with the minimum capital requirements imposed under Wisconsin law,
calculated as required by the OCI.
In addition, the Association requires certain of our insurance
subsidiaries to meet certain risk-based capital requirements, which are
generally more stringent than those imposed under Wisconsin law. See "Business
- -- Blue Cross and Blue Shield Licenses."
Insurance Regulation
Each of our insurance subsidiaries is subject to regulation by the
department of insurance in each state in which it is licensed. Regulatory
authorities exercise extensive supervisory power over insurance companies
relating to the licensing of insurance companies; the amount of capital which
must be maintained; the approval of forms and insurance policies used; the
nature of, and limitation on, an insurance company's investments; periodic
examination of the operations of insurance companies; the form and content of
annual statements and other reports required to be filed on the financial
condition of insurance companies; and the establishment of capital requirements
for insurance companies. Our insurance company subsidiaries are required to file
periodic statutory financial statements in each jurisdiction in which they are
licensed. Additionally, such companies are examined periodically by the
insurance departments of the jurisdictions in which they are licensed to do
business.
We actively market insurance products to Medicare eligible individuals.
Medicare supplement (or Medigap) policies are regulated by the OCI and are the
subject of increasing regulation at the state level, as well as additional
legislation at the federal level. We continue to monitor and alter procedures to
comply with new laws and regulations. During 2001, we were subject to regulation
by the Centers for Medicare & Medicaid Services by virtue of our participation
in the Medicare+Choice program. We exited this program effective January 1,
2002.
Under Wisconsin law, insurance companies must provide the OCI with advance
notice of any dividend that is more than 15% larger than any dividend for the
corresponding period of the previous year. In addition, the OCI may disapprove
any "extraordinary" dividend, defined as any dividend which, together with other
dividends paid by an insurance company in the prior twelve months, exceeds the
lesser of: (i) 10% of statutory capital and surplus as of the preceding December
31; (ii) with respect to a life insurer, net income less realized gains for the
calendar year preceding the date of the dividend; or (iii) with respect to a
non-life insurer, the greater of (A)(ii) above or (B) the aggregate net income
less realized gains for the three calendar years preceding the date of the
dividend less distributions made within the first two of those three years. Our
insurance subsidiaries are currently not allowed to pay dividends to us without
the prior approval of the OCI.
Insurance Holding Company Regulations
We are a holding company that conducts all of our business through our
subsidiaries and are subject to insurance holding company laws and regulations.
Such insurance holding company laws and regulations generally require
registration with the department of insurance of the holding company's
domiciliary state and the filing of certain reports describing capital
structure, ownership, financial condition, certain intercompany transactions and
general business operations. Various notice and reporting requirements generally
apply to transactions between
42
companies within an insurance holding company system, depending on the size and
nature of the transactions. Certain state insurance holding company laws and
regulations require prior regulatory approval or, in certain circumstances,
prior notice, of certain material intercompany transfers of assets as well as
certain transactions between the regulated companies, their parent holding
companies and affiliates, and acquisitions.
Under Wisconsin law, acquisition of control of us, and thereby indirect
control of our insurance subsidiaries, requires the prior approval of the OCI.
"Control" is defined as the direct or indirect power to direct or cause the
direction of the management and policies of a person. Any purchaser of 10% or
more of the voting securities of a corporation is presumed to have acquired
control of the corporation and its subsidiaries unless the OCI, upon
application, determines otherwise.
ERISA
The provision of goods and services to or through certain types of
employee health benefit plans is subject to ERISA. ERISA is a complex set of
laws and regulations that are subject to periodic interpretation by the federal
courts and the United States Department of Labor. ERISA places certain controls
on how our business units may do business with employers covered by ERISA,
particularly employers that maintain self-funded plans. The Department of Labor
is charged with the enforcement of ERISA and has promulgated new regulations
which will expand the claim review process. Given that the current state
insurance law governing health insurers contains stringent claim appeal process
requirements, we do not anticipate that the rules will significantly impact our
operations. There have been continued attempts to limit ERISA's preemptive
effect on state laws through proposed state and federal legislation, regulations
and litigation. If such limitations were to be imposed, they might increase our
liability exposure relating to employee health benefits offered by our health
plans and specialty businesses and may permit greater state regulation of other
aspects of those businesses' operations.
Trademarks
Blue Cross and Blue Shield are federally registered service marks of the
Association. Compcare(R) is a federally registered service mark of Cobalt. We
have filed for and maintain various other service marks and trade names at the
federal level and in Wisconsin. Although we consider our registered service
marks, trademarks and trade names important in the operation of our business,
our business is not dependent on any individual service mark, trademark or trade
name owned by us. CompcareBlue and BCBSUW use the Blue Cross and Blue Shield
service marks in their businesses, pursuant to a license agreement with the
Association as our controlled affiliates. Termination of this license may have a
material adverse effect on us.
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AGREEMENTS WITH THE FOUNDATION
Certain Agreements Executed in Connection with the Combination
In connection with the Combination, we entered into a Voting Trust and
Divestiture Agreement and a Registration Rights Agreement, which are summarized
below.
Voting Trust and Divestiture Agreement
Purpose
The Association agreed to continue to grant us licenses to use the Blue
Cross and Blue Shield names and service marks following completion of the
Combination only if the Foundation agreed to deposit all of its shares of our
common stock in a voting trust and sell those shares within prescribed time
periods. The Association designed this condition to preserve our independence
from the Foundation. The Voting Trust and Divestiture Agreement summarized below
also incorporates the conditions imposed by the OCI's order approving the
conversion of BCBSUW.
Deposit of Shares
The Foundation deposited into a voting trust all of the shares of our
common stock it received in the Combination. The terms of the voting trust
significantly limit the Foundation's voting rights, and the trustee of the
voting trust will vote those shares in the manner described below. In addition,
the Foundation may dispose of those shares only in a manner that would not
violate the ownership requirements contained in our Amended and Restated
Articles of Incorporation and any other agreement to which the Foundation will
be a party.
Withdrawal of Shares
As described below, the Foundation must sell its shares of our common
stock within prescribed periods of time. In order to sell these shares, the
Foundation will need to withdraw shares from the voting trust from time to time.
In order to ensure that the Foundation is selling shares in a permitted manner,
the Foundation may withdraw shares from the voting trust only in order to sell
such shares and then only if:
o we register the shares in the name of the purchaser before the
Foundation withdraws them from the voting trust, so that the
Foundation may not keep ownership of those shares;
o the Foundation does not sell the shares to an affiliate of the
Foundation, so that the Foundation may not keep indirect ownership
of those shares;
o the Foundation does not sell the shares to a person or entity that
already owns shares of our common stock in excess of the ownership
limits contained in our Amended and Restated Articles of
Incorporation, so that the ownership limits are not violated;
o the sale would not result in a person or entity owning shares of our
common stock in excess of the ownership limits contained in our
Amended and Restated Articles of Incorporation, so that the
ownership limits are not violated; and
44
o the Voting Trust and Divestiture Agreement, the Registration Rights
Agreement and our Amended and Restated Articles of Incorporation and
Bylaws permit the sale.
Voting of Shares Held in Voting Trust
In general, in order to maintain our independence from the Foundation, the
trustee of the voting trust will vote the shares of our common stock owned by
the Foundation as directed by our directors, except that the Foundation will
decide how to vote these shares on a merger or similar business combination
proposal which would result in our then existing shareholders owning less than
50.1% of the resulting company, or which would result in any person or entity
who owned 50.1% or less of our common stock owning more than 50.1% of the voting
securities of the resulting entity. Specifically, the trustee of the voting
trust will vote all of the Foundation's shares of our common stock in the voting
trust in the following manner:
o If the matter is the election of our directors, the trustee will
vote the shares in favor of each nominee whose nomination has been
approved by (i) a majority of the members of our board of directors
who were not nominated at the initiative of the Foundation or of a
person or entity owning shares of our common stock in excess of the
ownership limits contained in our Amended and Restated Articles of
Incorporation (such directors being called "Independent Directors"),
and (ii) a majority of our entire board of directors.
o The trustee will vote against the removal of any of our directors,
and against any change to our Amended and Restated Articles of
Incorporation or Bylaws, unless (i) a majority of the Independent
Directors, and (ii) a majority of our entire board of directors,
initiates or consents to such removal or amendment action.
o In the event that director seats are eligible for public shareholder
representation, the trustee will be directed to vote its shares in
the same proportion and for the same candidates voted for by the
non-Foundation holders or our common stock. This provision will
expire at such time as the Foundation owns less than 20% of the
outstanding shares of our common stock.
o The trustee will vote as directed by the board of directors of the
Foundation on any proposed business combination transaction that if
consummated would result in (1) the then existing holders of our
common stock, including the Foundation, owning less than 50.1% of
the outstanding voting securities of the resulting entity, or (2)
any person or entity who, prior to the proposed transaction, owned
less than 50.1% of our outstanding common stock owning 50.1% or more
of the outstanding voting securities of the resulting entity.
o The trustee will vote in accordance with the recommendation of our
board of directors on any action requiring prior approval of our
board of directors as a prerequisite to becoming effective.
In addition, unless a majority of the Independent Directors and a majority
of our entire board of directors initiates or consents to such action, neither
the Foundation nor the trustee of the voting trust may:
o make any change or addition to or repeal our Amended and Restated
Articles of Incorporation or Bylaws;
o nominate any candidate to fill any vacancy on our board of
directors;
45
o call any special meeting of our shareholders;
o make any shareholder proposal pursuant to Section 2.14 of the
Bylaws; or
o take any action that would be inconsistent with the voting
requirements contained in the Voting Trust and Divestiture
Agreement.
Standstill
As the largest holder of our common stock, the Foundation would ordinarily
enjoy the benefits of control typically held by majority shareholders. However,
in order to maintain our independence from the Foundation, as required by the
Association, the Foundation has agreed not to take actions that a shareholder of
a corporation ordinarily could take in its capacity as a shareholder.
Specifically, the Voting Trust and Divestiture Agreement provides that the
Foundation may not:
o individually, or as part of a group, acquire the right to vote or
dispose of any shares of our common stock or options to purchase
shares of our stock other than those shares issued to it in the
Combination, unless it receives the shares in a stock split or other
similar transaction;
o enter into any agreement with any person or entity to sell shares of
our common stock, except in accordance with the Voting Trust and
Divestiture Agreement and the Registration Rights Agreement;
o sell any of its shares of our common stock to a person or entity if
the person or entity already owns, or would own as a result of the
sale transaction and any transactions related to the sale, our
common stock in excess of the ownership limit for the person or
entity included in our Amended and Restated Articles of
Incorporation;
o make any shareholder proposal for submission at an annual meeting of
our shareholders;
o nominate any candidate to our board of directors; or
o appoint any individual to fill a vacancy on our board of directors.
Observation Rights
For so long as the Foundation beneficially owns at least 20% of the
outstanding shares of our common stock, the Foundation, through an authorized
representative, will have a limited right to attend and observe all meetings and
executive sessions of our board of directors. However, the authorized
representative of the Foundation will not observe any portion of a meeting
during which privileged communications between the board of directors and its
attorneys occur.
Divestiture Requirements
The Association requires its for-profit licensees to have limitations on
the ownership of their stock in order to maintain independence from the control
of any single shareholder or group of shareholders. The Foundation's ownership
(prior to completion of this offering) of approximately 75.4% of the outstanding
shares of our common stock entitled to vote would ordinarily exceed the
46
ownership limitations established by the Association. The Association has agreed
to waive the ownership limitations for the Foundation provided that the
Foundation satisfies a number of conditions, including selling the shares of our
common stock that it owns in the manner and within the time periods described
below.
One-Year Divestiture Deadline
The Foundation was required to sell shares of our common stock so that it
beneficially owned less than 80% of the outstanding common stock within one year
following completion of the Combination. Because the Foundation owned
approximately 77.5% of our outstanding shares entitled to vote immediately after
the Combination, it was not necessary for any sales to be effected during this
period.
Three-Year Divestiture Deadline
In addition to meeting the one-year divestiture deadline, the Foundation
must sell sufficient shares of our common stock so that it beneficially owns
less than 50% of the outstanding shares of our common stock by March 23, 2004.
This three-year period is extended day for day, up to a maximum of 365 days, for
each day that we are not required to file a registration statement (i) in
response to an actual demand registration under the Registration Rights
Agreement because we had recently effected a registration of our common stock or
(ii) as the result of the pendency of any blackout period under the Registration
Rights Agreement.
Five-Year Divestiture Deadline
In addition to meeting the one-year divestiture deadline and the
three-year divestiture deadline, the Foundation must sell sufficient shares of
our common stock so that it beneficially owns less than 20% of the outstanding
shares of our common stock by March 23, 2006. This five-year period is extended
day for day, up to a maximum of 730 days, for each day that we are not required
to file a registration statement (i) in response to an actual demand
registration under the Registration Rights Agreement because we had recently
effected a registration of our common stock or (ii) as the result of the
pendency of any blackout period under the Registration Rights Agreement.
Extension of Divestiture Deadlines
In the event that the Foundation does not meet the divestiture deadlines,
it may be able to obtain an extension if it receives Association approval.
Specifically, we must extend the divestiture deadlines if:
o the Foundation makes a good faith and reasonable determination that
compliance with the divestiture deadlines would have a material
adverse effect on the Foundation;
o the Foundation advises us of its determination and the reasons for
the determination and makes a reasonable request for an extension of
the pending divestiture deadline; and
o we received written confirmation from the Association that the
Foundation's request for an extension of the divestiture deadline
would not cause a violation of the license agreement between us and
the Association.
47
Similarly, we can extend the divestiture deadline for the Foundation
without a prior request by the Foundation. Any such extension is subject to
prior approval of the Association. Specifically, we may extend the divestiture
deadlines if we make a good faith determination that compliance with the
divestiture deadlines would have a material adverse effect on us or any of our
shareholders, other than the Foundation, and if we receive written confirmation
from the Association that the extension of the divestiture deadline requested by
us would not cause a violation of the license agreement between us and the
Association.
Failure to Meet Divestiture Deadlines
It is possible that the Foundation will not be able to meet the
divestiture deadlines. If the Foundation fails to meet a divestiture deadline,
and the divestiture deadline has not been extended, we will arrange for the sale
of those shares of our common stock that the agreement required the Foundation
to sell and will pay the proceeds received in the sale to the Foundation, after
deducting the expenses incurred by us. The sale of these shares would likely
require registration with the SEC, which may take considerable time to complete.
The Foundation will pay the expenses of the sale. Until sold, the trustee of the
voting trust will vote those shares of our common stock as described above under
"-- Voting of Shares Held in Voting Trust."
Dividends
We currently do not plan to declare and pay any dividends on the
outstanding shares of our common stock in the future. However, if we do declare
and pay dividends, the Foundation will be entitled to receive any such cash
dividends paid on the shares of our common stock held in the voting trust, after
the trustee deducts its fees and expenses. Any stock dividends paid on the
shares of our common stock held in the voting trust will be subject to the
voting trust as if originally deposited in the voting trust.
Termination of Voting Trust and Divestiture Agreement
The Voting Trust and Divestiture Agreement will terminate once the trustee
receives notice from us and the Foundation that the Foundation beneficially owns
less than 5% of the outstanding shares of our common stock. At that point, the
restrictions and deadlines in the Voting Trust and Divestiture Agreement will no
longer apply, and the Foundation will have satisfied the divestiture deadlines.
Otherwise, the Voting Trust is irrevocable.
Acquisition Proposals
The Voting Trust and Divestiture Agreement provides that the Foundation
may not solicit or encourage inquiries or proposals with respect to, or provide
any confidential information to or have any discussions, meetings, or
communications with a person relating to, a merger, tender offer, or other
business combination involving us. However, the Foundation may:
o have discussions with the counter-party to a business combination
transaction after our board of directors submits the transaction to
our shareholders for approval; and
o have discussions with any person or entity concerning the sale of
our common stock as permitted by the Voting Trust and Divestiture
Agreement and the Registration Rights Agreement.
48
In addition, under the Voting Trust and Divestiture Agreement, for so long
as the Foundation beneficially owns at least 20% of the outstanding shares of
our common stock, we must consult with the Foundation before soliciting, or upon
receiving, a business combination proposal in which our then existing
shareholders including the Foundation will own less than a majority of the
outstanding shares of the resulting entity.
Registration Rights Agreement
Purpose
The Registration Rights Agreement gives the Foundation the right to
require us to register with the Securities and Exchange Commission the
Foundation's shares of our common stock for sale so that the Foundation may
satisfy the divestiture deadlines contained in the Voting Trust and Divestiture
Agreement without having to rely on private or other nonregistered sales. As
discussed below, the Registration Rights Agreement will also give us the option
to purchase shares of our common stock from the Foundation.
Demand Registration Rights
Under federal securities laws, every offer and sale of securities must be
either registered with the Securities and Exchange Commission under the
Securities Act of 1933, as amended, or exempt from registration. The
Registration Rights Agreement gives the Foundation the right to demand that we
effect a registration with the Securities and Exchange Commission of some or all
of the shares of our common stock beneficially owned by the Foundation. The
Foundation is entitled to one demand registration per calendar year for as long
as the Foundation beneficially owns shares of our common stock, provided that we
do not have to effect a demand registration if we have effected a demand
registration within the preceding 120 days, even if that 120-day period extends
into a prior calendar year. However, our obligations to effect a demand
registration will be subject to the limitations described below.
Purchase Option
If the Foundation requests a demand registration, we will have the option
to purchase any or all of the shares of our common stock of which the Foundation
requests registration before we must take any action. We will not have the
option to purchase less than all of the shares if the market value of the shares
that we elect not to purchase is less than $30 million. The purchase price per
share for the shares we elect to purchase will be the average closing sale price
per share of our common stock on the New York Stock Exchange during the ten
consecutive trading days ending on the second trading day immediately preceding
the date the Foundation requests the demand registration. If we do not exercise
this option in full, we must file a registration statement for the remaining
shares, subject to the exceptions described below.
No Obligation to Effect Demand Registrations Under Certain Circumstances
If the Foundation requests a demand registration and we do not elect to
exercise our demand purchase option, we will still not be required to file a
registration statement for the shares the Foundation desires to sell if:
o we previously registered shares of our common stock at the request
of the Foundation at any time during the immediately preceding
120-day period;
49
o we previously registered shares of our common stock at the request
of the Foundation at any time during the calendar year in which the
Foundation made a demand;
o we previously effected a registration of shares of our common stock
for sale by us during the preceding 120 days, other than shares
registered pursuant to acquisitions or dividend reinvestment or
similar employee plans;
o the amount of our common stock that the Foundation seeks to register
has a market value of less than $30 million, unless the shares are
all of the remaining shares of our common stock the Foundation owns;
or
o we determine in good faith that a demand registration would
materially interfere with a previously announced business
combination transaction in which we intend to issue shares of our
common stock, or would result in the premature disclosure of any
pending development involving us, in which case the agreement does
not require us to file a demand registration for a 120-day period.
Piggy-back Registration Rights
In addition to granting the Foundation the right to demand registration of
its sales of shares, the Registration Rights Agreement also permits the
Foundation to "piggy-back" on any registrations we make. Specifically, the
Registration Rights Agreement provides that whenever we propose to file a
registration statement for a public offering of shares of our common stock, the
Foundation will have the right (i) to have any or all of the shares of our
common stock that it beneficially owns included among the securities we will
register, and (ii) until it beneficially owns less than 50% of the issued and
outstanding shares of our common stock, to have any or all of its shares of our
common stock included among the securities we will register so that the
Foundation is entitled to receive up to 50% of the proceeds from the offering.
If the lead managing underwriter for an offering for which the Foundation
requests piggy-back registration rights determines that marketing or other
factors require a limitation on the number of shares of our common stock the
parties can sell in the offering, then we will have priority over the Foundation
unless the Foundation beneficially owns more than 50% of the issued and
outstanding shares of our common stock at the time of the offering and has
elected to exercise its right, as described above, to sell shares sufficient to
receive up to 50% of the proceeds.
Continuing Option to Purchase the Foundation Shares
In addition to the demand purchase option described above, beginning on
the date of the earliest of
o the consummation of a demand registration or an offering pursuant to
a piggy-back request which results in gross sale proceeds to the
Foundation of at least $10 million,
o the consummation of a private placement transaction by the
Foundation resulting in gross sale proceeds to the Foundation of at
least $10 million, or
o the purchase by us of our common stock in a private placement
resulting in gross sale proceeds to the Foundation of at least $10
million,
50
we may purchase from the Foundation any or all of the shares of our common stock
beneficially owned by the Foundation at a price equal to (i) the average closing
sale price of our common stock on the New York Stock Exchange over a 10-day
period ending on the date notice of exercise is given (or, if greater, the
10-day period ending on the 45th day before the date notice of exercise is
given), or (ii) the sale price received in a private placement if the Foundation
has not yet exercised its demand or piggy-back registration rights. If we
purchase shares of our common stock from the Foundation pursuant to this option,
we must hold the shares for 45 days before reselling them in a public or private
transaction.
Holdback
It is possible that the Foundation may desire to sell its shares of our
common stock at a time when we are planning to sell additional shares for our
own benefit. In such a case, the Foundation may not sell any shares of our
common stock that it beneficially owns for a 90-day period following its receipt
of notice from us that we have filed a registration statement if the
Foundation's sale of our common stock would adversely affect our offering, or if
the lead managing underwriter, in the case of an underwritten offering, advises
us that the Foundation's sale of our common stock would adversely affect our
offering.
Similarly, it is possible that we may desire to sell shares of our common
stock for our own benefit at a time when the Foundation desires to make a demand
registration. In such a case, we may not file a registration statement for our
common stock or securities convertible into our common stock during the 30-day
period commencing on the effective date of a registration statement filed on
behalf of the Foundation under a demand registration.
Registration Expenses
We will pay all registration expenses in connection with a demand
registration or a piggy-back registration by the Foundation except for the
Foundation's legal fees and any underwriting discounts or commissions or
transfer taxes.
Rule 144
The Registration Rights Agreement provides that the Foundation may not
sell any shares of our common stock that it beneficially owns pursuant to Rule
144 under the Securities Act of 1933, as amended, until the Foundation has sold
at least $50 million of our common stock to purchasers that are not affiliates
of the Foundation. Thereafter, the Foundation may sell shares of our common
stock that it owns pursuant to Rule 144 if:
o the intended sale would not be to a person or entity that already
owns shares of our common stock in excess of the ownership limit for
that person or entity contained in our Amended and Restated Articles
of Incorporation;
o the intended sale would not cause a person or entity to own shares
of our common stock in excess of the ownership limits for that
person or entity contained in our Amended and Restated Articles of
Incorporation; and
o the intended sale would not otherwise violate the Registration
Rights Agreement, the Voting Trust and Divestiture Agreement and our
Amended and Restated Articles of Incorporation or Bylaws.
51
Under Rule 144, the amount of stock that a party can sell in any
three-month period is limited, and the party can sell the stock only in
specified unsolicited broker transactions or transactions with a market maker.
Private Sales
If the Foundation desires to sell any or all of its shares of our common
stock in a private sale transaction to qualified investors, we will have the
right of first refusal to purchase the shares of our common stock from the
Foundation upon the same terms and conditions as the Foundation proposes to sell
the shares in the private sale.
Other
In connection with obtaining the approval of the OCI to the Combination,
we have agreed to contribute a total of $2 million cash to the Foundation.
Pursuant to an agreement with the Foundation, this amount must be contributed by
February 1, 2003. Of this amount, an aggregate of $1 million has been
contributed during 2001 and 2002. The Foundation may demand any portion of the
remaining $1 million obligation at any time.
Pursuant to a letter agreement between us and the Foundation dated
November 1, 2002, we have agreed to file a "shelf" registration statement on
Form S-3 with the Securities and Exchange Commission registering 6,500,000 of
the shares of our common stock owned by the Foundation, as well as 500,000
shares of our common stock which we may issue from time to time. The filing of
the registration statement itself will not constitute a "demand" under the
Registration Rights Agreement.
Each time the Foundation wishes to sell a portion of those shares, it must
notify us and we must promptly prepare and file an appropriate supplement to the
prospectus or post-effective amendment to the registration statement. We refer
to any such sale by the Foundation as a "Takedown." The Foundation may not
request another Takedown until at least 90 days have elapsed since the earlier
of (x) the 60th day after the filing of the necessary prospectus supplement or
the effective date of the necessary post-effective amendment (or, if no
prospectus supplement or post-effective amendment is filed, the 60th day after
our receipt of notice of the Takedown from the Foundation) or (y) such time as
all of the shares of our common stock covered by such Takedown have been sold.
If any Takedown by the Foundation is to be effected as an underwritten
offering, it will generally be treated as a demand under the Registration Rights
Agreement. Any Takedown by the Foundation not effected as an underwritten
offering will be treated as a private placement for purposes of the Registration
Rights Agreement, except that we will not have any purchase options (as
described above under "Private Sales") with respect to such shares unless the
contemplated sale price is less than 75% of the closing price per share of our
common stock on the New York Stock Exchange on the date immediately prior to the
date such sale is agreed to in writing by the Foundation. If we decide to issue
shares covered by the registration statement in an underwritten offering, we
must notify the Foundation, which may then exercise "piggy-back" rights under
the Registration Rights Agreement.
52
ARTICLES OF INCORPORATION AND BYLAWS
Our Amended and Restated Articles of Incorporation ("Articles") and our
Amended and Restated Bylaws ("Bylaws") contain certain provisions regarding the
required composition of our board of directors and ownership of our common stock
that investors should understand when considering an investment in our common
stock. We have set forth below a short summary of some of those provisions, and
a short description of how completion of the offering will affect the board
composition requirements. In the following summary, the term "person" includes
any individual or entity.
Qualification of Directors
General
Our board of directors is currently comprised of nine members, which is
the maximum number of board positions authorized by our Articles and our Bylaws.
The current directors, taken as a group and each individually, satisfy specific
board composition and individual criteria imposed by the Association and OCI as
a result of the Combination. Certain of these standards are based solely upon
the amount of issued and outstanding common stock beneficially owned by the
Foundation, and will terminate when the Foundation's holdings decrease below
20%. Due to this correlation to the Foundation's holdings of our common stock,
an increase in outstanding shares, sales of shares by the Foundation, or a
combination of both could potentially affect the required composition of our
board of directors.
Independent Directors
Our Articles provide that no one will be able to become one of our
directors unless (i) he or she is an "Independent Director" (as defined below),
or (ii) immediately after he or she becomes a director, at least a specified
percentage of our directors would be Independent Directors. Currently, at least
78.75% of our directors are required to qualify as Independent Directors. This
means that there can be a maximum of one non-Independent Director as of the date
of this prospectus. The percentage of directors that must be Independent
Directors will decrease as the Foundation's stock ownership decreases, according
to a formula described below. A person will qualify as an "Independent Director"
if he or she:
o is not a "major participant" (as defined below);
o has not been nominated to be a director at the initiative of a major
participant;
o has not announced a commitment to a proposal made by a major
participant that has not been approved by an "independent board
majority" (as defined below); and
o has not been determined by an independent board majority to have
been subject to any relationship or arrangement which those
directors deem to be likely to interfere with his or her exercise of
independent judgment.
As used above, an "independent board majority" means a group of directors
consisting of a majority of all Independent Directors AND a majority of all
directors. A "major participant" means:
53
o the Foundation, or any other person, in the judgment of an
independent board majority, that succeeds to the Foundation's
position;
o a person that owns shares of our common stock in excess of the
ownership limitations described below;
o a person that has filed proxy materials with the Securities and
Exchange Commission supporting a candidate for election to the board
of directors in opposition to candidates approved by an independent
board majority;
o a person that has taken actions deemed by an independent board
majority to indicate that such person will seek to become a major
participant; or
o a person that is an affiliate or associate of a major participant.
If, however, an independent board majority has given prior approval to an
acquisition of our common stock by a person and that acquisition would otherwise
have caused that person to become a major participant, the acquiring person will
nevertheless not be a major participant so long as the person (i) makes no
subsequent acquisition of our common stock not approved by an independent board
majority, and (ii) takes no other action that would make that person a major
participant, without the prior approval of an independent board majority. The
Foundation will always be a major participant.
The board of directors composition specified by our Articles will change
as the Foundation's ownership of our common stock decreases. For each 1%
reduction in the percentage of our outstanding common stock owned by the
Foundation below 80%, the percentage of board seats that must be occupied by
Independent Directors will be reduced by one-half of 1%. For example, when the
Foundation's holdings have been reduced to 50% of our outstanding common stock,
the Amended and Restated Articles of Incorporation will require that at least
65% of the directors be Independent Directors. However, the Independent
Directors will always be required to comprise a majority of the board.
Independent Public Shareholder Representation
As part of the Combination, OCI imposed certain board composition
requirements in an effort to reflect "independent public shareholder
representation," which relates to the number of shares owned by the investing
public apart from the Foundation. For those positions on our board of directors
which are not required to satisfy the definition of Independent Director, an
individual nominated and elected to such a position must satisfy different
"independent public shareholder representative" criteria set forth in our
Bylaws. Based upon the current independent board majority percentage, only one
board position must satisfy OCI's "independent public shareholder
representative" criteria. Three current board members, Messrs. Richard Abdoo,
Barry Allen, and Dr. William Rupp, each satisfy this test.
Qualified Candidates
Our Amended and Restated Bylaws provide that shareholders will elect
directors by a plurality vote and that shareholders may only elect "qualified
candidates" to the board of directors. A qualified candidate is an individual
nominated by an independent board majority or properly nominated pursuant to the
procedures set forth in our Amended and Restated Bylaws, and, in either event,
who is not disqualified by virtue of being a "non-independent candidate" for
54
whom there is no board seat available because of the requirement that at least a
specified percentage (between 50.01% and 80%) of the directors be Independent
Directors. A "non-independent candidate" is a candidate who would not qualify as
an "Independent Director," as described above.
If there are more qualified candidates in any election of directors than
available board seats, then the independent candidates receiving the greatest
number of votes will win the seats reserved for Independent Directors, and the
remaining candidate(s) who satisfy certain eligibility requirements imposed
under Section 3.04 of our Amended and Restated Bylaws (whether independent or
non-independent candidates) receiving the greatest number of votes will win any
seat(s) available for non-Independent Directors. (However, under the terms of
the voting trust and divestiture agreement with the Foundation, the trustee of
the voting trust is required, in an election involving board seats not reserved
for Independent Directors, to vote the Foundation's shares in proportion to the
votes cast by shareholders other than the Foundation. See "Agreements With the
Foundation -- Voting Trust and Divestiture Agreement -- Voting of Shares Held in
Voting Trust.")
Limitations on Common Stock Ownership
General
Our Articles contain the following ownership limitations required by the
Association for its for-profit licensees. These limitations are imposed to
protect the licensee's independence from any single shareholder or concerted
group of shareholders. Under these ownership limitations:
o no institutional owner may beneficially own 10% or more of the
combined voting power of all of our outstanding securities;
o no non-institutional owner may beneficially own 5% or more of the
combined voting power of all of our outstanding securities; and
o no person may own 20% or more of all of our outstanding equity
securities (regardless of voting power).
Our Articles define "beneficial ownership" to include securities:
o in which a person has a direct or indirect ownership interest;
o which a person has a right or option to purchase;
o which a person has the right to vote;
o with respect to which a person would be required to file a Schedule
13D or 13G under the Securities Exchange Act of 1934, as amended; or
o which are owned by any affiliate or associate of the person, or by
anyone else with which the person has any agreement or
understanding.
Our Articles also include a number of exceptions to the definition of
beneficial ownership (for example, a pledgee of stock or one in possession of a
revocable proxy is not a beneficial owner).
55
Violation of Limitation on Ownership
Except as set forth below, if any person beneficially owns our securities
in excess of the ownership limits, then (i) the person will not receive any
rights to the excess shares, and (ii) the excess shares will immediately be
deemed to be transferred to a "share escrow agent" appointed by us to sell the
excess shares. However, a person's beneficial ownership will not violate the
ownership limits if the person's excess shares do not exceed the lesser of 1% of
the voting power of the capital stock or 1% of the ownership interest of us, and
the person disposes of the excess shares within fifteen days of becoming aware
of the ownership of excess shares.
Exceptions to Ownership Limits
The ownership limits described above do not apply to shares received by
the Foundation in the Combination, or any shares acquired by the Foundation as a
result of a subsequent stock dividend, stock split, conversion or similar
distribution. However, the ownership limits will apply to shares transferred by
the Foundation or the voting trust to any other person.
Change in Ownership Limits
In addition, an independent board majority together with the holders of
75% or more of the outstanding shares of our common stock may change the
ownership limits, without regard to the terms of the license agreement, by
amending the Articles as described below.
Control Share Voting Restrictions
Our Articles provide that shares of our common stock owned by the
Foundation or the trustee are not subject to the voting power restrictions
provided by Section 180.1150(2) of Wisconsin law, which would otherwise limit
the voting power of our shares owned by the Foundation and the trustee that
exceed 20% of the voting power in the election of directors to 10% of the full
voting power of such excess shares.
Amendments to Amended and Restated Articles of Incorporation
Our Articles provide that the approval of an independent board majority
and of the holders of 75% or more of the outstanding shares of common stock will
be required in order to amend various sections of the Articles, including the
sections dealing with:
o the number, qualifications, limitations on liability and removal of
directors;
o the inability of shareholders to act by written consent;
o special shareholder meetings;
o the ownership limitations;
o amendments to the Bylaws;
o the prohibition on cumulative voting; and
o the right to amend the Articles.
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The supermajority votes described above will not be necessary if any of the
following applies:
o we no longer have any license agreements with the Association;
o the amendment in question is an amendment to the ownership
limitation and transfer restriction provisions of the Articles which
has been proposed in order to conform to a change in the terms of
any Association license agreement;
o the amendment in question is any other amendment to the ownership
limitation and transfer restriction provisions that is required or
permitted by the Association, whether or not it constitutes a change
to any license agreement; or
o the amendment in question is an amendment to the ownership
limitation and transfer restriction provisions which has been
approved by an independent board majority in connection with a
proposal to acquire all our outstanding capital stock.
For so long as the Foundation owns at least 20% of the outstanding shares of our
common stock, any amendment of the Articles will be subject to the prior review
and approval of the OCI.
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Item 7. Financial Statements and Exhibits.
(a) Not applicable.
(b) Not applicable.
(c) Exhibits.
None.
58
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
COBALT CORPORATION
Date: November 8, 2002 By:/s/ Gail L. Hanson
-----------------------------
Gail L. Hanson
Chief Financial Officer