THE INFORMATION IN THIS PROSPECTUS SUPPLEMENT IS NOT COMPLETE AND MAY BE
CHANGED. WE MAY NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED
WITH THE SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PROSPECTUS
SUPPLEMENT IS NOT AN OFFER TO SELL THESE SECURITIES NOR A SOLICITATION OF AN
OFFER TO BUY THESE SECURITIES IN ANY STATE WHERE THE OFFER OR SALE IS NOT
PERMITTED.
Filed Pursuant to Rule 424(a)
under the Securities Act of 1933
Registration No. 333-101111
SUBJECT TO COMPLETION, DATED JANUARY 24, 2003
PRELIMINARY PROSPECTUS SUPPLEMENT
(TO PRELIMINARY PROSPECTUS DATED JANUARY 24, 2003)
5,000,000 SHARES
[COBALT LOGO]
COMMON STOCK
This prospectus supplement relates to the offering by Wisconsin United for
Health Foundation, Inc., which we refer to as the "Foundation," of 5,000,000
shares of our common stock. We will not receive any proceeds from the sale of
shares by the Foundation. As of January 21, 2003, the Foundation owned
approximately 75% of our common stock and will own approximately 63% of our
common stock after the offering.
Our common stock is listed on the New York Stock Exchange under the symbol
"CBZ." The last reported sale price of our common stock on January 22, 2003 was
$14.40 per share.
INVESTING IN OUR COMMON STOCK INVOLVES RISKS. BEFORE BUYING ANY SHARES, YOU
SHOULD READ THE DISCUSSION OF MATERIAL RISKS OF INVESTING IN OUR COMMON STOCK IN
"RISK FACTORS," BEGINNING ON PAGE S-7 OF THIS PROSPECTUS SUPPLEMENT.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS SUPPLEMENT OR THE ACCOMPANYING
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<Table>
<Caption>
PER SHARE TOTAL
--------- --------
Public offering price....................................... $ $
Underwriting discounts and commissions...................... $ $
Proceeds to the Foundation, before expenses................. $ $
</Table>
The Foundation has granted the underwriters a 30-day option to purchase up
to an additional 750,000 shares of our common stock to cover over-allotments at
the public offering price per share less the underwriting discounts and
commissions.
The underwriters are offering the shares of our common stock as described
in "Underwriting." Delivery of the shares will be made on or about ,
2003.
JOINT BOOK-RUNNING MANAGERS
UBS WARBURG SALOMON SMITH BARNEY
---------------------
CIBC WORLD MARKETS ROBERT W. BAIRD & CO.
, 2003
TABLE OF CONTENTS
<Table>
PROSPECTUS SUPPLEMENT
Summary..................................................... S-1
Risk Factors................................................ S-7
Use of Proceeds............................................. S-19
Price Range of Common Stock................................. S-19
Capitalization.............................................. S-20
Background of the Company................................... S-21
Selected Consolidated Financial and Operating Data.......... S-22
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. S-25
Business.................................................... S-43
Management.................................................. S-53
Agreements With the Foundation.............................. S-56
Stock Ownership of Management and the Foundation............ S-63
Articles of Incorporation and Bylaws........................ S-65
Underwriting................................................ S-69
Legal Matters............................................... S-70
Consolidated Financial Statements........................... F-1
PROSPECTUS
Forward-Looking Statements.................................. 2
Cobalt Corporation.......................................... 3
Risk Factors................................................ 3
Use of Proceeds............................................. 3
Selling Shareholder......................................... 4
Price Range of Common Stock................................. 5
Dividend Policy............................................. 5
Plan of Distribution........................................ 6
Legal Matters............................................... 7
Experts..................................................... 7
Information Incorporated by Reference....................... 7
Where You Can Find More Information......................... 8
</Table>
Unless the context otherwise requires, references in this prospectus
supplement to "we," "us," "our" or "ours" refer collectively to Cobalt
Corporation and its subsidiaries. Unless otherwise stated, the information
contained in this prospectus supplement assumes the underwriters do not exercise
the over-allotment option.
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS OTHER THAN THOSE CONTAINED OR INCORPORATED BY REFERENCE IN THIS
PROSPECTUS SUPPLEMENT AND THE ACCOMPANYING PROSPECTUS AND, IF GIVEN OR MADE,
SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED. THIS PROSPECTUS SUPPLEMENT AND THE ACCOMPANYING PROSPECTUS DO NOT
CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY
SECURITIES IN ANY JURISDICTION IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL.
NEITHER THE DELIVERY OF THIS PROSPECTUS SUPPLEMENT AND THE ACCOMPANYING
PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE
ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME
AFTER THE DATE OF SUCH INFORMATION.
-i-
SUMMARY
This summary highlights information contained elsewhere or incorporated by
reference in this prospectus supplement and the accompanying prospectus. Because
this is a summary, it is not complete and does not contain all of the
information that may be important to you. For a more complete understanding of
us and this offering of our common stock, we encourage you to read carefully
this prospectus supplement and the accompanying prospectus in their entirety, as
well as the other documents to which we have referred you.
COBALT CORPORATION
OVERVIEW
Based on market share reports prepared by the Office of the Commissioner of
Insurance of the State of Wisconsin for 2001, 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(R) and Blue Shield(R) 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.
Our Blue Cross & Blue Shield United of Wisconsin subsidiary, which we refer
to as "BCBSUW," provides underwritten products, including preferred provider
organizations ("PPO") and indemnity options, as well as self-funded,
administrative services only programs. Our Compcare Health Services Insurance
Corporation health maintenance organization ("HMO"), which we refer to as
"CompcareBlue," operates the oldest HMO in Wisconsin.
We offer one of the largest provider networks in Wisconsin. We believe that
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, as
demonstrated by the fact that:
- the majority of the hospitals in our networks have received accreditation
by the Joint Commission on Accreditation of Health Care Organizations, an
organization nationally recognized for its rigorous standards with
respect to patient safety and quality initiatives;
- our network includes 89% of the board certified primary care physicians
in our service areas, which exceeds the national average of 82%, based on
the National Committee for Quality Assurance, or "NCQA," Quality Compass
2002(R); and
- as of September 30, 2002, 87% of our managed care membership was insured
through subsidiaries of ours which the NCQA's independent accreditation
process has determined have met the quality parameters established by the
NCQA.
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
S-1
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 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:
- 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 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.
- 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 approximately 80% of our revenues and
approximately 68% of our pre-tax operating income in the nine months
ended September 30, 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, between March 1, 2002 and December 31, 2002 we
reduced ownership of our former affiliate American Medical Security
Group, Inc., which we refer to as "AMSG," a small group and individual
health insurer, from approximately 45% to approximately 11% of AMSG's
outstanding common stock, raising net cash proceeds of approximately
$73.9 million and relieving us of our capital requirement relating to
AMSG. We have since sold all of our remaining shares of AMSG common
stock, raising an additional $18.7 million in cash proceeds.
- 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. On
November 15, 2002, we announced the consolidation of our claims and
customer service departments in Wisconsin, allowing us to close two
offices and realize significant estimated cost savings in 2003 and future
years.
S-2
- 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 and managed
care providers in Wisconsin. On December 31, 2002, we acquired Claim
Management Services, Inc., a Wisconsin-based third party administrator
for self-funded employee benefit plans. See "-- Recent Developments."
RECENT DEVELOPMENTS
On December 1, 2002, Stephen E. Bablitch succeeded Thomas R. Hefty as
Chairman and CEO, and Michael E. Bernstein became our President and Chief
Operating Officer. This completed the succession plan announced at our annual
meeting on May 29, 2002. Mr. Hefty will serve in a consulting capacity as
Chairman Emeritus until January 31, 2003 at which time he will retire.
On December 31, 2002, we completed the acquisition of Claim Management
Services, Inc., a third party administrator for self-funded employee benefit
plans based in Green Bay, Wisconsin. Claim Management Services administers
benefit plans for approximately 214,000 medical members and 164,000 dental
members throughout the United States and offers a line of products complementary
to our insured medical and dental products.
On January 3, 2003, we completed our divestiture of our common stock
holdings in AMSG. The sale of our remaining 1,382,077 shares was executed
through a brokered transaction. Net proceeds from the sale were $18.7 million.
On January 23, 2003, we reaffirmed previously issued guidance of $1.15 per
share for 2002 and $0.33 for the fourth quarter of 2002. Our 2002 earnings
benefited from the utilization of net operating loss carryforwards which are
expected to be substantially exhausted as of year-end. The expected $0.33
earnings per share for the fourth quarter is after the following previously
disclosed one-time adjustments:
- Severance costs and related expenses of $2.5 million for the
consolidation of claims and customer service operations.
- Expenses of $1.2 million incurred in 2002 for an offering of our common
stock that was not completed prior to year end.
Previous guidance did not take into account these two one-time adjustments.
On January 23, 2003, we also revised guidance for 2003, stating that we
expect earnings to be $1.00 per share, the high end of the range previously
disclosed. Our 2003 results are not expected to benefit significantly from net
operating loss carryforwards and, therefore, guidance reflects a full tax rate.
The foregoing earnings estimates are forward-looking statements which we
intend to be covered by the safe harbor provisions contained in the Private
Securities Litigation Reform Act of 1995. These estimates are not guarantees of
future performance, and we caution investors that they involve risks and
uncertainties. In making these estimates, we have assumed, among other things,
that we will continue to implement successfully our strategy of improving our
core operations, particularly by reducing loss and expense ratios. If this or
any of our other assumptions is incorrect, we may not attain our earnings
estimates. Other risks that could prevent us from attaining these estimates are
described under "Risk Factors," and we urge investors to consider those risks
carefully. We undertake no obligation to update these estimates for any reason
after the date of this prospectus.
CORPORATE INFORMATION
Our principal executive offices are located at 401 West Michigan Street,
Milwaukee, Wisconsin 53203, and our telephone number is (414) 226-6900.
S-3
THE OFFERING
Common stock offered by
Wisconsin United For Health
Foundation, Inc. ............. 5,000,000 shares
Common stock to be outstanding
after this offering........... 41,802,210 shares
Common stock to be owned by
the Foundation after this
offering and percentage
ownership of our outstanding
common stock.................. 26,313,390 shares, or approximately 63%
(25,563,390 shares, or approximately 61%,
assuming full exercise of the underwriters'
over-allotment option)
New York Stock Exchange
Symbol........................ CBZ
Use of proceeds............... We will receive no proceeds from this offering.
Risk factors.................. Investing in our common stock involves
significant risks. See "Risk Factors."
We calculated the number of our outstanding shares based upon the number of
shares outstanding as of January 22, 2003. We exclude from this number a total
of 4,444,731 shares issuable upon exercise of options granted by us under our
equity incentive plan as of such date at a weighted average exercise price of
$9.79 per share, of which 1,735,331 shares at a weighted average exercise price
of $7.54 per share were exercisable as of that date. We have also excluded from
the number of outstanding shares a total of 7,949,904 shares owned by BCBSUW and
treated as treasury shares.
The Foundation has agreed to sell an additional 750,000 shares if the
underwriters exercise in full their over-allotment option, which we describe in
"Underwriting." Unless the context otherwise requires, the information presented
in this prospectus supplement assumes that this option will not be exercised.
S-4
SUMMARY CONSOLIDATED FINANCIAL AND OPERATING DATA
We were formed in March 2001 as the successor to substantially all of the
operations of BCBSUW and United Wisconsin Services, Inc., which we refer to as
"UWS." Under accounting principles generally accepted in the United States, our
financial statements reflect the business and assets of BCBSUW, without UWS, for
periods through March 31, 2001, and the combined businesses of BCBSUW and UWS
for periods after that date. This presentation limits the comparability of the
financial and operating data set forth below. See "Background of the Company"
and "Selected Consolidated Financial and Operating Data" for more information.
<Table>
<Caption>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
------------------------------------------------------ ----------------------------
1997 1998 1999 2000 2001 2001 2002
-------- -------- -------- -------- ---------- ----------- --------------
STATEMENT OF OPERATIONS DATA(1): (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
Revenues:
Premiums........................... $345,903 $361,965 $418,949 $538,080 $1,255,391 $ 886,631 $1,021,832
Government contract fees........... 23,333 31,667 52,259 70,305 117,192 88,827 85,155
Other.............................. 20,606 25,302 25,970 24,715 40,655 30,073 35,993
-------- -------- -------- -------- ---------- ---------- ----------
Total health services
revenue..................... 389,842 418,934 497,178 633,100 1,413,238 1,005,531 1,142,980
Investment results(2).............. 18,347 13,501 18,510 9,583 12,482 9,020 11,263
-------- -------- -------- -------- ---------- ---------- ----------
Total revenues.............. 408,189 432,435 515,688 642,683 1,425,720 1,014,551 1,154,243
Expenses:
Medical and other benefits......... 297,979 297,885 376,814 497,822 1,119,218 793,913 876,971
Selling, general, administrative
and other........................ 119,036 133,153 158,187 176,878 303,208 219,115 238,461
Other(3)........................... 215 115 744 922 5,697 3,672 359
-------- -------- -------- -------- ---------- ---------- ----------
Total expenses.............. 417,230 431,153 535,745 675,622 1,428,123 1,016,700 1,115,791
Operating income (loss) from
continuing operations.............. (9,041) 1,282 (20,057) (32,939) (2,403) (2,149) 38,452
Gain (loss) from investment in
affiliates, net of tax(4).......... 6,857 3,991 (22,690) (6,526) (22,724) 388 15,320
-------- -------- -------- -------- ---------- ---------- ----------
Pretax income (loss) from continuing
operations......................... (2,184) 5,273 (42,747) (39,465) (25,127) (1,761) 53,772
Income tax expense (benefit)......... (2,785) (78) -- 548 (1,871) 193 3,878
-------- -------- -------- -------- ---------- ---------- ----------
Income (loss) from continuing
operations......................... $ 601 $ 5,351 $(42,747) $(40,013) $ (23,256) $ (1,954) $ 49,894
======== ======== ======== ======== ========== ========== ==========
Diluted earnings (loss) per share
from continuing operations(5)(6)... $ 0.02 $ 0.17 $ (1.37) $ (1.28) $ (0.61) $ (0.05) $ 1.19
Total diluted earnings (loss) per
share(5)(6)........................ 0.02 0.17 (1.37) (1.28) (0.58) (0.04) 1.40
OPERATING STATISTICS(1):
BCBSUW insured medical loss
ratio(7)........................... N/A N/A 90.5% 93.5% 85.7% 85.7% 84.6%
UWS insured medical loss ratio(8).... N/A N/A 99.1% 95.2% 94.4% 94.8% 89.5%
Total consolidated loss ratio(9)..... 86.1% 82.3% 89.9% 92.5% 89.2% 89.5% 85.8%
Net income (loss) margin(10)......... 0.1% 1.2% (8.3)% (6.2)% (1.6)% (0.2)% 4.3%
</Table>
<Table>
<Caption>
AS OF SEPTEMBER 30, 2002
--------------------------
(UNAUDITED, IN THOUSANDS)
BALANCE SHEET DATA:
Cash and investments(11)....................................................................... $422,988
Total assets................................................................................... 846,804
Long-term debt, including current portion...................................................... 28,000
Total shareholders' equity..................................................................... 285,264
</Table>
- ---------------
(1) Prior to March 31, 2001, data reflect only the operations of BCBSUW,
accounting for UWS and AMSG as investments in affiliates.
(2) Includes realized investment gains and losses, interest and dividends,
excluding investments in affiliates.
(3) Includes interest and amortization of goodwill.
(4) Includes UWS (prior to March 31, 2001) and AMSG.
S-5
(5) When we report a net loss, potentially dilutive securities are not included
in the calculation of earnings per share because their inclusion would have
an antidilutive effect.
(6) The 31,313,390 shares of our common stock issued to the Foundation in the
Combination were used to calculate earnings per share for all periods prior
to March 31, 2001.
(7) Includes only the BCBSUW insured medical business.
(8) Includes only the CompcareBlue, Valley and Unity insured medical business.
(9) Includes all insured products (medical, dental, disability, etc.). UWS is
included in all periods subsequent to March 31, 2001. Prior to March 31,
2001, the ratio is based on BCBSUW only.
(10) Represents net income (loss) from continuing operations as a percentage of
total revenues.
(11) Excludes investments in affiliates.
S-6
RISK FACTORS
An investment in our common stock involves risk. You should carefully
consider the risks we describe below before deciding to invest in 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 this prospectus supplement and the accompanying
prospectus, including our consolidated financial statements beginning on page
F-1.
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 the results of their 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. We have
substantially completed all aspects of our action plan. 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, BCBSUW and CompcareBlue, including capital requirements based on
risk-based capital. Our right to 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 and are currently based on the Health
Organization Risk-Based Capital calculations prescribed by the NAIC. Liquidity
standards are measured as the number of months of claims and administrative
expenses available in cash and invested assets.
The Association's standards outline three monitoring levels:
- "Early Warning," which requires a capital level of 375% and two months of
liquidity;
- "Concern Level," which requires a capital level of 300% and 1.5 months of
liquidity; and
- "Licensure Minimum," which requires a capital level of 200% and one month
of liquidity.
The Association has termination rights if our Blue Cross and Blue Shield
branded licensees' capital falls below the Licensure Minimum level. Cobalt,
BCBSUW and CompcareBlue have fallen below two of these 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. See "Business -- Blue Cross and Blue Shield Licenses." BCBSUW became
S-7
subject to Early Warning monitoring in April of 2000 and to Concern Level
monitoring in August of 2000. CompcareBlue became subject to Concern Level
monitoring in April 2000. Cobalt became subject to Concern Level monitoring in
February of 2001. Throughout 2000, 2001 and 2002, all of our Blue Cross and Blue
Shield licensees maintained risk-based capital in excess of the Licensure
Minimum level.
During 2002, Cobalt executed on its capital plan, which has improved the
capital levels of CompcareBlue, Cobalt and BCBSUW and the liquidity levels of
CompcareBlue and BCBSUW. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Management's Plan." Based on this
improvement, we currently expect all three companies to exceed monitoring
thresholds at December 31, 2002, and we plan to petition the Association to
remove us from its PPRMP during 2003.
During the period in which BCBSUW was below the Concern Level monitoring
threshold, it was required to maintain an escrow account for the benefit of
other plans to which BCBSUW is a creditor under the BlueCard program. As of
September 30, 2002, BCBSUW's capital exceeded the Concern Level monitoring
threshold. Based on our improved capital position, the Association released the
funds from escrow during the fourth quarter of 2002.
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:
- failure to meet capital and liquidity requirements of the Association;
- violation of the ownership limitations contained in our Amended and
Restated Articles of Incorporation and described below;
- termination of the voting trust and divestiture agreement before the
Foundation's ownership of our common stock falls to less than 5%;
- 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;
- failure by the Foundation to divest its shares of our common stock by the
deadlines specified by the voting trust and divestiture agreement;
- a determination by the Association that fewer than 80% of our directors
are independent; and
- failure to brand medical and dental business as required by the
Association.
S-8
Our Amended and Restated Articles of Incorporation include ownership
limitations required by the Association. Under these ownership limitations:
- no institutional owner may beneficially own 10% or more of the combined
voting power of all of our outstanding securities;
- no non-institutional owner may beneficially own 5% or more of the
combined voting power of all of our outstanding securities; and
- no person may own 20% or more of all of our outstanding equity securities
(regardless of voting power).
Although we believe that these limitations are enforceable under Wisconsin 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 nine months 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
losses in the future, we could have difficulty satisfying certain minimum
capital levels imposed by the OCI or the Association and our stock price would
decline. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Statutory Capital." 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 was completed prior to 2003. No state
or federal regulatory body has expressed concern to us over our divestiture of
unprofitable business. 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:
- failure to obtain new customers and failure to retain or voluntarily
terminating existing customers;
- premium increases and benefit changes;
S-9
- reduction in our provider network;
- our exit from business lines or markets;
- reductions in work force by existing customers; and
- 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:
- an increase in the cost of health care services and supplies, including
pharmaceuticals;
- higher than expected utilization of health care services by our insured
members;
- periodic renegotiation of contracts with hospitals, physicians and other
providers;
- the occurrence of catastrophes or epidemics;
- changes in the demographics of our members and medical trends affecting
them;
- new mandated benefits or other regulatory changes that increase our
costs; and
- 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.
S-10
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. Our
largest five providers, in terms of claims paid and incurred from January
through September 2002, are Aurora Healthcare, University Healthcare, Inc.,
Luther/Midelfort, Columbia St. Mary's and Covenant Healthcare. These top five
providers collectively accounted for 40.2% of our total claims paid and incurred
during that period. 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. Our provider
contracts typically provide for automatic term renewals unless either party
notifies the other of its intention not to renew within 90 days prior to the
expiration of the contract's term. 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, our United Government Services subsidiary serves as a fiscal
intermediary for the Medicare program. If legislation intended to increase
competition for government contracts for processing claims for the Medicare
program is adopted, it could affect our ability to compete effectively for
Medicare contracts.
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 agents and brokers are typically not exclusively
dedicated to one company and market health care products of our competitors. In
addition, we face
S-11
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:
- adversely affecting our ability to market our products and services;
- requiring us to change our products and services; or
- 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 adverse consequences which
include:
- inadequate information on which to base pricing and underwriting
decisions;
- the loss of existing customers;
- difficulty in attracting new customers;
- customer and provider disputes;
- regulatory problems; or
- increases in administrative expenses.
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
approximately 30% of our insured medical members are located in the Milwaukee
metropolitan area. Therefore, our business may be more 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. We are not dependent
on a small number of major contracts.
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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," which is the 6th highest rating out of 16
categories). A.M. Best ratings evaluate an insurer's financial strength and
ability to pay claims. A.M. Best ratings are not recommendations to buy, sell or
hold securities. 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," which is the 4th highest rating out of 16
categories) to B++ ("Very Good," which is the 5th highest rating out of 16
categories) in June 2001, we arranged with a reinsurer to use its insurance
company, which had an A+ ("Superior," which is the 2nd highest rating out of 16
categories) 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%.
We intend to continue to write workers' compensation insurance, but 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 to customers that
require the "A" rating for their workers' compensation coverage.
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:
- damage to our reputation in various markets;
- increased difficulty in selling our products and services;
- loss of a license to act as an insurer or HMO or to otherwise provide a
service;
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- loss of the right to participate in various federal programs, including
the Medicare supplement programs; or
- 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:
- legislation that holds insurance companies, HMOs or managed care
companies liable for adverse consequences of medical decisions;
- limitations on premium levels;
- increases in minimum capital, reserves and other financial viability
requirements;
- impositions of fines or other penalties for the failure to promptly pay
claims;
- prohibitions or limitations on provider financial incentives and provider
risk-sharing arrangements;
- imposition of more stringent standards of review of our coverage
determinations;
- new benefit mandates; and
- 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 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"). We will be
required to implement the Transactions requirements in October 2003. As both a
health plan and a health clearinghouse, we must be in compliance with the
Privacy regulations by April 2003. There is no implementation deadline for the
Security regulations at this time because no final Security regulations have
been issued. The law is
S-14
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:
- disputes over coverage or claims adjudication;
- vicarious liability for medical malpractice claims;
- disputes with our providers or agents over compensation and termination
of contracts;
- 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;
- customer audits of our compliance with our plan obligations; and
- disputes with taxing authorities regarding our tax liabilities.
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 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 limited in the amount of dividends that may be paid to us without the
approval of the OCI. "See Business -- Insurance Regulations." 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.
S-15
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 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. The approximately 75% of our
outstanding shares owned by the Foundation are exempt from these limitations;
however, 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. Therefore, even if the
provisions of our Amended and Restated Articles of Incorporation and Bylaws
described above were amended, repealed or held to be unenforceable, any person
wishing to acquire control of us or of any substantial portion of our
outstanding shares, with or without the approval of our board of directors or
shareholders, would first be required to obtain the approval of the OCI.
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:
- restrict our future growth, both internally and through acquisitions;
- inhibit our ability to invest in technology and other products and
services that we may need;
- adversely affect our ability to compete in the markets we serve; and
- restrict the availability of capital for our subsidiaries.
S-16
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% 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.
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 December
31, 2002, the average daily trading volume of our common stock was 48,800 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." For instance, by March
23, 2004, the Foundation must sell approximately 10.5 million shares of our
common stock. 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
S-17
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:
- quarterly variations in operating results;
- changes in financial estimates and recommendations by securities
analysts;
- operating and stock price performance of other companies that investors
may deem comparable;
- press releases or publicity relating to us or our competitors or relating
to trends in our markets;
- acquisitions and financings in our industry; and
- sales of stock by insiders.
S-18
USE OF PROCEEDS
We will not receive any proceeds from the sale of shares of our common
stock by the Foundation in this offering.
PRICE RANGE OF COMMON STOCK
Our common stock is traded on the New York Stock Exchange under the symbol
"CBZ." The following table sets forth the per share high and low sale prices for
our common stock as reported on the New York Stock Exchange for the periods
presented. No cash dividends were paid during any of these periods. Prior to
March 31, 2001, we were named United Wisconsin Services, Inc., and our common
stock traded on the New York Stock Exchange under the symbol "UWZ." You can read
more about the Combination and our history under "Background of the Company."
<Table>
<Caption>
HIGH LOW
------ ------
2001:
First Quarter.......................................... $ 7.99 $ 3.38
Second Quarter......................................... 8.00 4.90
Third Quarter.......................................... 9.05 4.37
Fourth Quarter......................................... 7.00 3.99
2002:
First Quarter.......................................... $ 9.05 $ 5.33
Second Quarter......................................... 23.45 8.65
Third Quarter.......................................... 23.40 14.11
Fourth Quarter......................................... 18.70 12.15
2003:
First Quarter (through January 22, 2003)............... $14.80 $13.80
</Table>
As of January 20, 2003, there were 194 shareholders of record of our common
stock. Based on information obtained from our transfer agent and from
participants in security position listings and otherwise, we have reason to
believe there are more than 1,700 beneficial owners of shares of our common
stock.
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CAPITALIZATION
The following table sets forth our capitalization as of September 30, 2002.
You should read this information in conjunction with our consolidated financial
statements beginning on page F-1, including the notes to our consolidated
financial statements.
<Table>
<Caption>
SEPTEMBER 30, 2002
------------------
(IN THOUSANDS)
Current portion of long-term debt........................... $ 3,000
Long-term debt, excluding current portion................... 25,000
--------
Total............................................. 28,000
--------
Shareholders' equity:
Common stock, no par value; 75,000,000 shares authorized;
41,503,869 shares issued and outstanding(1)............ 259,309
Accumulated earnings...................................... 18,291
Accumulated other comprehensive loss...................... 7,664
--------
Total shareholders' equity.................................. 285,264
--------
Total capitalization........................................ $313,264
========
</Table>
- ---------------
(1) Excludes 3,874,712 shares issuable upon exercise of options granted by us
under our equity incentive plan at a weighted average exercise price of
$8.92 per share, of which 1,622,987 shares at a weighted average exercise
price of $8.17 per share were exercisable.
S-20
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:
- BCBSUW converted its form from a non-stock service insurance corporation
to a stock insurance corporation;
- BCBSUW issued all of its outstanding stock to the Foundation, a
charitable organization formed for the purpose of receiving the stock of
BCBSUW;
- 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
- 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, as of December 31, 2002, the Foundation owned approximately
75% 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 and incorporated
by reference into this prospectus supplement and the accompanying 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."
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."
S-21
SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
We derived the following selected consolidated financial and operating data
from our consolidated financial statements. You should read these data in
conjunction with our consolidated financial statements, the related notes
thereto, "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and other financial information included and incorporated
by reference in this prospectus supplement and the accompanying prospectus.
The following selected consolidated financial balance sheet data as of
December 31, 2000 and 2001 and selected consolidated financial statement of
operations data for the three years ended December 31, 2001 are derived from our
consolidated financial statements, which are included and incorporated by
reference in this prospectus supplement and the accompanying prospectus and have
been audited by Ernst & Young LLP, our independent auditors. The selected
consolidated financial balance sheet data as of December 31, 1999 and 1998 and
selected consolidated financial statement of operations data for the two years
ended December 31, 1998 are derived from audited consolidated financial
statements not included in this prospectus supplement or the accompanying
prospectus. The selected consolidated financial balance sheet data as of
December 31, 1997 are derived from unaudited financial statements.
The financial data as of September 30, 2002 and for the nine-month periods
ended September 30, 2002 and 2001 are derived from unaudited consolidated
financial statements. The unaudited consolidated financial statements include
all adjustments, consisting of normal recurring accruals, which we consider
necessary for a fair presentation of the financial position and the results of
operations for these periods. Operating results for the nine-month periods ended
September 30, 2002 and 2001 are not necessarily indicative of the results that
may be expected for the entire years ending December 31, 2002 and 2001.
For financial reporting purposes, the Combination is treated as a reverse
purchase transaction, whereby BCBSUW becomes the acquirer and reporting entity.
Therefore, the accompanying selected consolidated financial data present the
combined balance sheet data of both BCBSUW and UWS as of December 31, 2001 and
September 30, 2002, including purchase accounting adjustments for the
Combination. The selected consolidated balance sheet data presented prior to
March 31, 2001 represents only the accounts of BCBSUW, accounting for BCBSUW's
investment in UWS and AMSG as investments in affiliates. The selected
consolidated statement of operations data for the year ended December 31, 2001,
report the operations of BCBSUW and post-combination UWS, with BCBSUW's
investment in AMSG continuing to be accounted for as an investment in affiliate.
For the nine-month period ended September 30, 2001 and each of the four years
ended December 31, 2000, the selected consolidated statement of operations data
represent only the operating results of BCBSUW, accounting for BCBSUW's
investment in UWS and AMSG as investments in affiliates.
S-22
<Table>
<Caption>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
------------------------------------------------------------------- -------------------------
1997 1998 1999 2000 2001 2001 2002
----------- ----------- ----------- ----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
STATEMENT OF OPERATIONS DATA(1):
Revenues:
Premiums...................... $ 345,903 $ 361,965 $ 418,949 $ 538,080 $ 1,255,391 $ 886,631 $ 1,021,832
Government contract fees...... 23,333 31,667 52,259 70,305 117,192 88,827 85,155
Other......................... 20,606 25,302 25,970 24,715 40,655 30,073 35,993
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total health services
revenue................. 389,842 418,934 497,178 633,100 1,413,238 1,005,531 1,142,980
Investment results(2)......... 18,347 13,501 18,510 9,583 12,482 9,020 11,263
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total revenues.......... 408,189 432,435 515,688 642,683 1,425,720 1,014,551 1,154,243
Expenses:
Medical and other benefits.... 297,979 297,885 376,814 497,822 1,119,218 793,913 876,971
Selling, general,
administrative and other.... 119,036 133,153 158,187 176,878 303,208 219,115 238,461
Interest...................... 215 115 553 300 561 441 359
Amortization of goodwill...... -- -- 191 622 5,136 3,231 --
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total expenses.......... 417,230 431,153 535,745 675,622 1,428,123 1,016,700 1,115,791
Operating income (loss) from
continuing operations......... (9,041) 1,282 (20,057) (32,939) (2,403) (2,149) 38,452
Gain (loss) from investment in
affiliates, net of tax:
Investment in UWS(3).......... 6,857 6,858 (12,711) (7,604) 434 434 --
Investment in AMSG and
other....................... -- (2,867) (9,979) 1,078 (23,158) (46) 15,320
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total gain (loss) from
investment in
affiliates, net....... 6,857 3,991 (22,690) (6,526) (22,724) 388 15,320
----------- ----------- ----------- ----------- ----------- ----------- -----------
Pretax income (loss) from
continuing operations......... (2,184) 5,273 (42,747) (39,465) (25,127) (1,761) 53,772
Income tax expense (benefit).... (2,785) (78) -- 548 (1,871) 193 3,878
----------- ----------- ----------- ----------- ----------- ----------- -----------
Income (loss) from continuing
operations.................... 601 5,351 (42,747) (40,013) (23,256) (1,954) 49,894
Income from discontinued
operations.................... -- -- -- -- 951 499 8,938
----------- ----------- ----------- ----------- ----------- ----------- -----------
Net income (loss)............... $ 601 $ 5,351 $ (42,747) $ (40,013) $ (22,305) $ (1,455) $ 58,832
=========== =========== =========== =========== =========== =========== ===========
Diluted earnings (loss) per
share(4)(5):
Continuing operations......... $ 0.02 $ 0.17 $ (1.37) $ (1.28) $ (0.61) $ (0.05) $ 1.19
Discontinued operations....... -- -- -- -- 0.03 0.01 0.21
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total diluted earnings
(loss) per share...... $ 0.02 $ 0.17 $ (1.37) $ (1.28) $ (0.58) $ (0.04) $ 1.40
=========== =========== =========== =========== =========== =========== ===========
Weighted average shares
outstanding:
Diluted(4)(5)........... 31,313,390 31,313,390 31,313,390 31,313,390 38,434,459 37,722,313 42,091,041
OPERATING STATISTICS(1):
BCBSUW insured medical loss
ratio(6)...................... N/A N/A 90.5% 93.5% 85.7% 85.7% 84.6%
UWS insured medical loss
ratio(7)...................... N/A N/A 99.1% 95.2% 94.4% 94.8% 89.5%
Total consolidated loss
ratio(8)...................... 86.1% 82.3% 89.9% 92.5% 89.2% 89.5% 85.8%
Net income (loss) margin(9)..... 0.1% 1.2% (8.3)% (6.2)% (1.6)% (0.2)% 4.3%
</Table>
<Table>
<Caption>
AS OF DECEMBER 31, AS OF SEPTEMBER 30,
------------------------------------------------------- -------------------
1997 1998 1999 2000 2001 2002
----------- -------- -------- -------- -------- -------------------
(UNAUDITED) (IN THOUSANDS) (UNAUDITED)
BALANCE SHEET DATA(1):
Cash and investments(10).......................... $104,261 $109,447 $ 57,383 $ 45,678 $243,368 $422,988
Note receivable from affiliate(11)................ 70,000 70,000 70,000 70,000 -- --
Total assets...................................... 392,699 443,186 381,400 394,205 727,322 846,804
Long-term debt, including current portion......... -- -- -- -- 7,500 28,000
Total shareholders' equity........................ 245,857 250,991 200,109 168,943 208,222 285,264
</Table>
- ---------------
(1) Prior to March 31, 2001, data reflect only the operations of BCBSUW,
accounting for UWS and AMSG as investments in affiliates.
S-23
(2) Includes realized investment gains and losses, interest and dividends,
excluding investments in affiliates.
(3) Subsequent to March 31, 2001, UWS operations are consolidated with BCBSUW.
(4) When we report a net loss, potentially dilutive securities are not included
in the calculation of earnings per share because their inclusion would have
an antidilutive effect.
(5) The 31,313,390 shares of our common stock issued to the Foundation in the
Combination were used to calculate earnings per share for all periods prior
to March 31, 2001.
(6) Includes only the BCBSUW insured medical business.
(7) Includes only the CompcareBlue, Valley and Unity insured medical business.
(8) Includes all insured products (medical, dental, disability, etc.) UWS is
included in all periods subsequent to March 31, 2001. Prior to March 31,
2001, the ratio is based on BCBSUW only.
(9) Represents net income (loss) from continuing operations as a percentage of
total revenues.
(10) Excludes investments in affiliates.
(11) The note receivable from affiliate was satisfied in full effective October
1, 2002, and was eliminated in consolidation as of March 31, 2001.
S-24
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 which begin on page F-1 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. See the information set forth under the caption
"Forward-Looking Statements" in the accompanying prospectus.
OVERVIEW
Based on the OCI's market share reports for 2001, 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:
- 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 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 unprofitable self-funded membership.
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 $11 million. Additionally, during
2002 we reduced our investment in AMSG common stock from 45% of the shares
outstanding to approximately 11%, raising net cash proceeds of approximately
$73.9 million and resulting in a pre-tax gain of approximately $11 million,
while relieving us of our statutory capital requirement relating to AMSG. On
January 3, 2003, we sold our remaining shares of AMSG common stock for net cash
proceeds of $18.7 million and a pre-tax gain of approximately $0.3 million.
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 nine months 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,
S-25
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 our net
operating loss carryforwards during the fourth quarter of 2002. At such time, we
will begin accruing income tax expense at the statutory rate of approximately
40%.
CAPITATED AND OTHER SERVICE ARRANGEMENTS
CompcareBlue, Valley and Unity utilize capitation and risk-sharing programs
with certain physician groups and hospitals to manage the cost of health care
provided to members. BCBSUW has not employed capitation or risk sharing
arrangements to any significant extent. Capitation is an arrangement whereby we
pay medical providers a set fee per member per month in exchange for providing
health care services.
As of December 31, 1999 and 2000 and for the years then ended, medical and
other benefits expense in the Consolidated Statements of Operations and medical
and other benefits payable in the Consolidated Balance Sheets do not include any
significant amounts relating to capitated arrangements as these periods were
prior to the Combination. For the year ended December 31, 2001, medical and
other benefits expense included $94.3 million relating to capitated medical and
dental arrangements, representing 8% of the total medical and other benefits
expense, and medical and other benefits payable at December 31, 2001 included
$4.3 million relating to capitated arrangements. For the nine months ended
September 30, 2002, medical and other benefits expense included $94.1 million
relating to capitated medical and dental arrangements, representing 11% of total
medical and other benefits expense, and medical and other benefits payable at
September 30, 2002 included $1.3 million relating to capitated arrangements.
Approximately 50% of the insured medical benefits provided by CompcareBlue,
Valley and Unity were provided under capitated arrangements in 1999. In 2000,
this number decreased to 28%, and in 2001 this number decreased to 14%. For
BCBSUW insured medical business no significant benefits were provided under
capitated arrangements during 1999 through 2002.
Costs associated with providing risk-sharing arrangements represented less
than 1% of total medical and other benefits expense for all periods presented
and for the nine months ended September 30, 2002.
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.
<Table>
<Caption>
AS OF DECEMBER 31, AS OF SEPTEMBER 30,
----------------------------- ---------------------
1999 2000 2001 2001 2002
------- ------- --------- --------- ---------
Membership at end of period:
Insured medical products........................ 221,266 255,289 530,480 540,324 460,901
Self-funded medical products.................... 218,873 184,819 131,671 130,449 135,238
Self-funded dental products..................... 79,926 50,785 37,975 37,199 35,000
Specialty managed care products and services.... 151,471 145,955 592,566 593,967 556,982
------- ------- --------- --------- ---------
Total membership............................. 671,536 636,848 1,292,692 1,301,939 1,188,121
======= ======= ========= ========= =========
</Table>
S-26
<Table>
<Caption>
NINE MONTHS ENDED
YEARS ENDED DECEMBER 31, SEPTEMBER 30,
-------------------------------- -----------------------
1999 2000 2001 2001(1) 2002
-------- -------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT RATIOS)
Revenue:
Insured medical products................... $392,583 $510,638 $1,150,420 $ 814,253 $ 922,658
Self-funded products....................... 25,970 24,716 28,067 21,136 22,957
Specialty managed care products and
services................................ 27,774 29,922 142,009 97,624 137,266
Government services........................ 52,259 70,305 117,192 88,827 85,155
Other operations(2)........................ (1,408) (2,481) (24,450) (16,309) (25,056)
-------- -------- ---------- ---------- ----------
Total health services revenue........... 497,178 633,100 1,413,238 1,005,531 1,142,980
Investment results......................... 18,510 9,583 12,482 9,020 11,263
-------- -------- ---------- ---------- ----------
Total................................... $515,688 $642,683 $1,425,720 $1,014,551 $1,154,243
======== ======== ========== ========== ==========
Health services revenue (as a percentage of
the total):
Insured medical products................... 79.0% 80.7% 81.4% 81.0% 80.7%
Self-funded products....................... 5.2 3.9 2.0 2.1 2.0
Specialty managed care products and
services................................ 5.6 4.7 10.0 9.7 12.0
Government services........................ 10.5 11.1 8.3 8.8 7.5
Other operations(2)........................ (0.3) (0.4) (1.7) (1.6) (2.2)
-------- -------- ---------- ---------- ----------
Total................................... 100.0% 100.0% 100.0% 100.0% 100.0%
======== ======== ========== ========== ==========
Insured medical product ratios:
Loss ratio(3).............................. 90.5% 93.5% 90.7% 91.0% 87.2%
Selling, general, administrative and other
expense ratio(4)........................ 14.3% 12.0% 9.6% 9.6% 11.0%
</Table>
- ---------------
(1) Excludes UWS operating results for the three months ended March 31, 2001.
(2) Consists primarily of intracompany eliminations.
(3) Insured medical benefit as a percentage of insured medical product revenue.
(4) 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 NINE MONTHS ENDED SEPTEMBER 30, 2002 WITH NINE MONTHS
ENDED SEPTEMBER 30, 2001
TOTAL REVENUES
For the nine months ended September 30, 2002, total revenues increased
13.8% to $1,154.2 million, compared to $1,014.6 million for the nine months
ended September 30, 2001. This increase was due primarily to the Combination and
resultant addition of the UWS business. Premium rate increases on continuing
insured medical products business were another factor contributing to the
increase.
Insured Medical Products
For the nine months ended September 30, 2002, insured medical revenue
increased 13.3% to $922.7 million from $814.3 million for the nine months ended
September 30, 2001. The number of insured medical members as of September 30,
2002 decreased to 460,901 from 540,324 as of September 30, 2001. The increase in
premium revenue
S-27
for the nine months ended September 30, 2002 is primarily due to the Combination
and resultant addition of the UWS business.
Self-Funded Products
For the nine months ended September 30, 2002, self-funded administrative
fees increased 9.0% to $23.0 million from $21.1 million for the nine months
ended September 30, 2001. Self-funded membership increased slightly from 167,648
as of September 30, 2001 to 170,238 as of September 30, 2002. The significant
increase in administrative fees is primarily attributable to increased volume in
the BlueCard program. Under the BlueCard program, the Company does not maintain
membership but receives an administrative fee and percentage of discounts for
members from other Blue Plans that access medical care in Wisconsin.
Specialty Managed Care Products and Services
For the nine months ended September 30, 2002, specialty managed care
products and services revenue increased 40.7% to $137.3 million from $97.6
million for the nine months ended September 30, 2001 due primarily to the
Combination and resultant addition of the UWS business.
Government Services
Government services revenue for the nine months ended September 30, 2002
decreased 4.1% to $85.2 million from $88.8 million for the nine months ended
September 30, 2001. In the third quarter of 2001, United Government Services
incurred a one-time reimbursable expense of $1.7 million. Since United
Government Services is a cost reimbursed Medicare contractor, decreases in its
expenses will result in corresponding decreases in revenue.
INVESTMENT RESULTS
Net investment results include investment income and realized gains
(losses) on the sale of investments. Net investment results for the nine months
ended September 30, 2002 increased 25.6% to $11.3 million from $9.0 million for
the nine months ended September 30, 2001. Included in the net investment results
for the nine months ended September 30, 2002 are $0.9 million in realized
investment losses recorded in the third quarter of 2002 relating to market value
declines determined to be other-than-temporary. The increase in net investment
results for the nine months ended September 30, 2002 is primarily due to an
increase in invested assets resulting from several factors, including the
addition of the UWS invested assets at the Combination, proceeds from the sale
of AMSG shares during the first nine months of 2002 and proceeds from the sale
of Innovative Resource Group, LLC during the first quarter of 2002. Partially
offsetting the increase in investment income from invested assets was the
elimination of BCBSUW investment income related to intracompany financing
arrangements with UWS, subsequent to March 31, 2001, due to the Combination and
a decrease in interest rates on new investment purchases. Average annual
investment yields, excluding net realized gains, investment income from
affiliates and other interest income, were 4.8% for the nine months ended
September 30, 2002, and 6.0% for the nine months ended September 30, 2001.
EXPENSE RATIOS
Loss Ratio
For the nine months ended September 30, 2002, the insured medical products
loss ratio was 87.2% compared with 91.0% for the nine months ended September 30,
2001. The continued improvement in the insured medical products loss ratio is
primarily due to improvement in the loss ratio for HMO business attributable to
premium rate increases in 2002, which also resulted in the cancellation 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.
S-28
The insured medical products SGA expense ratio for the nine months ended
September 30, 2002 was 11.0% compared with 9.6% for the nine months ended
September 30, 2001. The increase in the SGA expense ratio for the nine month
period ending September 30, 2002 resulted primarily from a decrease in revenue
from cancellation of unprofitable business that was not matched by a decrease in
staff due to efforts to maintain service levels.
The combined loss and expense ratio for specialty managed care products and
services for the nine months ended September 30, 2002 improved to 96.7% from
97.7% for the nine months ended September 30, 2001. The improvement for the nine
month period ended September 30, 2002 is due to the Combination and resultant
addition of the UWS specialty managed care products and services business,
particularly the service related products such as subrogation, hospital bill
audit and electronic claims services, which have run at a lower overall
operating expense ratio than the combined loss and expense ratio for the
specialty insurance lines.
The expense ratio for government services for the nine months ended
September 30, 2002 improved to 98.5% from 99.4% for the nine months ended
September 30, 2001. The improved expense ratio is primarily a result of
increased funding on an existing subcontract for Medicaid claim processing
services. The increased funding resulted from a contract extension that became
effective January 1, 2002.
The expense ratio for self-funded products for the nine months ended
September 30, 2002 improved to 90.3% from 115.8% for the nine months ended
September 30, 2001. The improved expense ratio is primarily the result of an
increase in the volume of business serviced under the BlueCard program. Under
this program, the Company does not maintain membership but receives an
administrative fee and percentage of discounts for members from other Blue Plans
that access services in Wisconsin. Costs associated with servicing this business
are significantly lower than the costs associated with servicing other
self-funded accounts. In addition, increases in administrative fees on existing
self-funded business have also contributed to the improvement in the expense
ratio.
SGA expenses recorded at the corporate holding company for the nine months
ended September 30, 2002 include an accrual for a $1.0 million contribution due
to the Foundation on February 1, 2003. In addition, SGA expenses for the nine
months ended September 30, 2002 were offset by a favorable vendor settlement of
$3.8 million recorded during the first quarter.
OTHER EXPENSES
As a result of the adoption of Statement of Financial Accounting Standards
("SFAS") No. 142 on January 1, 2002, there was no goodwill amortization recorded
for the nine months ended September 30, 2002. This compares with goodwill
amortization of $3.2 million recorded for the nine months ended September 30,
2001. The reduction in goodwill between December 31, 2001 and September 30, 2002
reflects adjustments to the tax related goodwill recorded from the Combination.
These adjustments relate to the recognition of a valuation allowance on the net
deferred income tax asset that was previously recorded by UWS. The goodwill was
adjusted downward during the nine months ended September 30, 2002 by $0.8
million to reflect changes in temporary differences on the related net deferred
tax asset.
INCOME (LOSS) FROM INVESTMENT IN AFFILIATES
For the nine months ended September 30, 2002, the income (loss) from
investment in affiliates improved to a gain of $15.3 million compared to $0.4
million for the nine months ended September 31, 2001. The results for the nine
months ended September 30, 2002 are primarily comprised of the Company's equity
in AMSG net income of $3.9 million combined with a net gain of $9.8 million on
the sale of 4.4 million shares of AMSG stock during the first two quarters. In
addition, the Company recognized income of $1.6 million in the second quarter of
2002, which relates primarily to its proportionate share of tax benefit recorded
by Family Health Systems, Inc., a 50% owned affiliate, due to a change in tax
laws regarding the carry-back of net operating losses. The results for the nine
months ended September 30, 2001 are comprised primarily of BCBSUW's equity in
UWS income for the three month period ended March 31, 2001 (prior to the
Combination) of $0.4 million, offset by equity in an insignificant year-to-date
loss for AMSG. The decrease in the investment in affiliates, net balance between
September 30, 2002 and December 31, 2001 on the accompanying balance sheets
results from the reclassification of the Company's investment in AMSG, which is
no longer reported under the equity method of accounting due to the Company's
ownership percentage in
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AMSG decreasing below 20%. Effective with the June 2002 balance sheet, the
investment in AMSG is reported as an available-for-sale investment at fair
market value.
INCOME (LOSS) FROM DISCONTINUED OPERATIONS
Income from discontinued operations for the nine months ended September 30,
2002 consisted of the first quarter net operating loss of Innovative Resource
Group of $0.7 million and an after-tax realized gain on the sale of Innovative
Resource Group to APS Healthcare Bethesda, Inc. on March 29, 2002 in the amount
of $9.6 million, including a tax-related adjustment recorded during the third
quarter of 2002.
NET INCOME (LOSS)
For the nine months ended September 30, 2002, net income improved to a gain
of $58.8 million compared to a net loss of $1.5 million for the same period in
2001. The enhanced operating results reflect improvement of $40.6 million in
operating income from continuing operations, improvement of $14.9 million in
income from investment in affiliates and improvement of $8.4 million in income
from discontinued operations, offset by a $3.7 million increase in income taxes.
The improvement in operating income from continuing operations primarily
reflects improvement in the insured medical products loss ratio (resulting from
exiting the Medicare+Choice program, cancellations of unprofitable business and
premium rate increases), increased volume in the BlueCard program and the $3.8
million favorable vendor settlement recorded as a reduction to SGA expenses,
offset by the $1.0 million contribution to the Foundation. The improvement in
income from investment in affiliates reflects year-to-date net realized gains of
$9.8 million on the sale of AMSG shares during both the first and second
quarters of 2002, along with the $1.6 million in income related to FHS and
improved 2002 operating results at AMSG. The income from discontinued operations
primarily reflects the net realized gain of $9.6 million on the sale of IRG.
As of September 30, 2002, we had federal net operating loss carry-forwards
of approximately $74 million available to offset future taxable income. We have
been able to reduce income tax expense through utilization of certain net
operating loss carryforwards. After certain of these net operating loss
carry-forwards are fully utilized, our effective tax rate will increase. For the
nine months ended September 30, 2002, we recorded current tax expense of $7.6
million and a deferred tax benefit of $3.7 million. We recorded current and
deferred income tax expense in the amount of $0.2 million for the nine months
ended September 30, 2001.
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.
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
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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.
INVESTMENT RESULTS
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.
At December 31, 2001, lower than investment grade bonds represented 0.4% of
our investment portfolio.
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
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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
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 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 $65.6 million of
goodwill recorded in 2001 for the Combination as a result of purchase
accounting, which until the effective date of SFAS 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.
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INCOME TAXES
We recorded an income tax benefit of $1.9 million in 2001 compared to tax
expense of $0.5 million in 2000. The tax benefit recorded in 2001 was greater
than a benefit calculated at the federal statutory income tax rate due primarily
to the reversal of an accrual during 2001 in the amount of $1.5 million that was
no longer deemed necessary. This accrual had been established by United
Wisconsin Services, Inc. prior to the Combination to cover estimated income tax
exposures for the 1987 to 1994 tax years. Based on an analysis of tax
liabilities performed at the end of 2001, management determined that the $1.5
million accrual was redundant with our full valuation allowance against net
deferred tax assets, and the accrual was reversed into income.
The income tax expense recorded in 2000 was greater than a tax benefit
calculated at the federal statutory rate for 2000 due primarily to the recording
of a valuation allowance of $14.9 million on net deferred tax assets during
2000. The valuation allowance was recorded because management could not conclude
that it was "more likely than not" that tax benefits from the 2000 loss would be
realized due to a history of prior losses at BCBSUW.
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
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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.
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.
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.
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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.
INCOME TAXES
We recorded income tax expense of $0.5 million in 2000. No income tax
expense or benefit was recorded in 1999. The difference between the zero income
tax expense/benefit recorded in 1999 and an income tax benefit calculated at the
federal statutory rate was due primarily to the recording of a valuation
allowance of $18.6 million on net deferred tax assets. The valuation allowance
was recorded because management could not conclude that it was "more likely than
not" that such tax benefits would be realized due to a history of losses at
BCBSUW. The $18.6 million valuation allowance provision recorded in 1999
included $8.6 million to offset a benefit claimed on the 1998 income tax return
relating to the write-off of certain intangible assets granted for income tax
purposes at the time that BCBSUW initially became subject to income tax. This
write-off was taken as a deduction on the 1998 federal income tax return but no
book benefit was recorded in that year because the tax write-off was not
contemplated prior to completion of our 1998 financial statements. During 1999
this benefit was recorded as part of the estimate to actual tax return
reconciliation, and an offsetting expense was recorded in the same amount as
part of the 1999 valuation allowance provision. This accounting treatment did
not impact 1998 or 1999 income.
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 the nine months ended September 30, 2001. This
reflects improved operating results in all four of our 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.
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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 2.0%, 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 April 30, 2003.
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. We have pledged the stock of our BCBSUW and
CompcareBlue subsidiaries as collateral for this credit facility. 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 August 15, 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 throughout 2000, 2001 and
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 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,
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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.
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.
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 continued 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, as discussed below:
- 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.
- 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 reduced our investment in AMSG to approximately 11% as of
December 31, 2002, raising approximately $73.9 million in net cash
proceeds at BCBSUW. On January 3, 2003, we sold our remaining shares of
AMSG common stock for net cash proceeds of $18.7 million.
- 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 $22.8 million. As noted
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above, the remaining intracompany obligation between Cobalt and BCBSUW was
satisfied through the contribution of CompcareBlue to BCBSUW.
- 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 cancellation of unprofitable
business and implementation of necessary premium increases for the
remaining business. We achieved our projected core earnings for the first
nine months of 2002, including progress toward obtaining breakeven
results for CompcareBlue by the end of 2002.
In conjunction with the execution of our capital plan, we agreed with the
OCI that we would not enter into certain intercompany transactions, including
loans, guarantees, reinsurance arrangements, and other operational and financial
arrangements, and not to enter into any new reinsurance agreements with third
parties, and our insurance subsidiaries were prohibited from paying any
dividends, without the approval of the OCI. We also agreed to adhere to certain
practices in conducting and accounting for affiliate transactions, notably
involving the lending practices previously described. 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. As a
result of the substantial completion of our capital plan and the improved
financial condition and financial performance of Cobalt, the OCI acknowledged in
January 2003 that the heightened oversight previously agreed upon (as referenced
above) would no longer apply, and we agreed to continue certain practices in
accounting for affiliate transactions and in providing financial information to
the OCI.
Our insurance subsidiaries are currently in compliance with the capital
requirements calculated as required by the OCI. Non-compliance with minimum
capital and liquidity requirements 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, 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
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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 reliability 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 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
Medical and other benefits payables consist primarily of loss reserves
established under a complex estimation process utilizing company-specific,
industry-wide and general economic information and data. The estimation process
also involves continuous monitoring and evaluation of the submission,
adjudication and payment cycles of claims. We develop an estimate of ultimate
claims based upon historical experience and other available information as well
as assumptions about emerging trends, which vary by class of business.
Significant assumptions used in the estimation process include trends in loss
costs and changes in member demographics, utilization, provider contract terms
and reimbursement strategies, frequency and severity of claims incurred, known
and adjudicated claims, changes in the timing of the reporting of losses, and
expected costs to settle unpaid claims.
Due to the numerous factors influencing this liability, we develop a series
of estimates based upon generally accepted actuarial projection methodologies
using various scenarios with respect to claim submission and payment patterns
and cost trends. Our policy is to record our best estimate of medical and other
benefits payable that adequately provides for future payments of claims incurred
but not paid. Deviations (positive or negative) between actual experience and
estimates used to establish the liability are recorded in the period of claim
payment. We
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continually monitor the reasonableness of the assumptions and judgments used in
prior estimates by comparison with actual claim patterns and considers this
information in future estimates.
The loss reserve at December 31, 2000 and 1999 exceeded actual claims paid
in the subsequent period by $10.6 million and $7.8 million, respectively. The
loss reserve at December 31, 1998 was less than actual claims paid in the
subsequent period by $1.1 million.
The unfavorable experience compared to the recorded loss reserve at
December 31, 1998 was primarily due to our conversion to a new claim
adjudication system initiated in 1998. During the conversion process, our
ability to process claims and identify emerging trends on a timely basis
deteriorated. As a result, less complete data was available to project incurred
claim levels and longer lags existed between the dates that claims were
incurred, adjudicated and paid causing our estimate to be deficient.
The favorable development of $7.8 million of December 31, 1999 loss
reserves was the result of changes in the historical claim submission and
payment patterns that occurred subsequent to the initiation of the system
conversion. Key factors in the determination of loss reserves include the
average time lag between claim submission, adjudication, and payment. These lags
increased significantly during and immediately following the system conversion
and gradually decreased in 1999, approaching pre-conversion levels by year-end
1999. The December 31, 1999 loss reserve overestimated the anticipated claim
payment lag times during the last several months of 1999, resulting in favorable
development in the subsequent year.
The $10.6 million favorable development of the December 31, 2000 loss
reserve was primarily due to two blocks of business. In November 2000, UWS
acquired a 56,000 member block of business from a financially troubled HMO.
There was no reliable history of the claim submission patterns or ultimate
incurred claim levels for this block of business. The loss reserve estimate for
this block of business made at the effective date of the Combination ultimately
proved to be greater than needed. Also during 2000, we underwrote a
Medicare+Choice line of business covering 14,000 enrollees. Over the course of
2000, the claim experience of this block of business deteriorated rapidly to the
point that a premium deficiency reserve was recorded, and we made plans to exit
this line of business. The December 31, 2000 loss reserve estimate contemplated
continued deterioration during the latter part of 2000 consistent with that
earlier in the year. The deterioration actually experienced was less severe than
indicated by the trends of early 2000, leading to a redundancy of the December
31, 2000 loss reserve.
Medical and other benefits paid can also be significantly impacted by the
outcomes from court decisions, interpretations by regulatory authorities and
legislative changes involving healthcare matters. As a result, amounts
ultimately paid by us may differ from initial estimates that did not consider
such outcomes.
LITIGATION
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 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.
TAX MATTERS
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
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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.
The Tax Reform Act of 1986 made all Blue Cross organizations taxable as of
January 1, 1987 and included certain tax benefits designed to ease the burden of
becoming a taxable entity. These benefits included opening reserve adjustments
and asset basis step-ups to fair market value. The net result of these benefits
was that our 1987 income tax return reported a net operating loss that was
carried back to 1984 and then carried forward. Certain issues with respect to
net operating loss carryforwards and other matters were raised in the federal
audit of our 1984 through 1986 tax returns. To resolve these issues, we executed
a formal Closing Agreement with the IRS on April 27, 1993, and we subsequently
filed amended federal income tax returns for 1987 through 1992 consistent with
the provisions of the Closing Agreement.
Our amended federal income tax return for 1987 was reviewed in a subsequent
IRS audit in which certain benefits agreed to by the IRS in the Closing
Agreement were challenged by the Field Service Branch of the IRS. We believe
that the Closing Agreement is binding on both us and the IRS, and that the IRS
has no right to attempt to void this agreement. Based on a review by our tax
advisors and legal counsel, we believe that the government's challenge of the
Closing Agreement is groundless and without merit. We are currently litigating
this matter and expect to prevail. The litigation primarily involves a question
of law as to whether the Closing Agreement is binding, rather than matters
involving interpretation of the Internal Revenue Code or tax regulations. The
litigation is pending in the United States Court of Federal Claims. BCBSUW and
the government have filed cross-motions for partial summary judgment on the
Closing Agreement issue. The briefing with respect to those motions concluded in
June 2002, and the parties are awaiting the court's decision on the motions.
The IRS' challenge of the Closing Agreement resulted in proposed income tax
deficiencies, and we paid approximately $11.6 million as a deposit to close the
1987 to 1992 tax years to further assessment of tax. We were not required to
make this payment, and characterize it as a deposit or advance and fully expect
that it will be returned upon resolution of the dispute.
The status of this matter, the accounting treatment and the timing of
return of our deposit are reviewed on a periodic basis with our tax advisors,
legal counsel and independent auditors. We will not be able to completely close
any tax year that is impacted by the 1987 loss carry-back or carry-forward until
the litigation is resolved.
The IRS has challenged the tax basis reported in our federal income tax
return relating to the sale of UWS common stock by BCBSUW in 1995. The proposed
adjustment would increase our gain for income tax purposes by approximately $5
million. No income tax liability has been accrued for this matter at December
31, 2001 because of large net operating loss carryforwards and our full
valuation allowance. An income tax accrual may be required for this matter in
the future, should the valuation allowance be reversed.
We believe that our income tax reserves as of December 31, 2001 as well as
the existence of net operating loss carryforwards and a full valuation allowance
against net deferred tax assets appropriately account for all proposed audit
adjustments, and that there are no reasonably possible amounts due in excess of
amounts accrued, other than the matter discussed in the preceding paragraph. We
also believe that all amounts on deposit with the IRS will be returned.
In addition, the IRS has proposed adjustments to all of our tax years from
1987 forward claiming that deductions for the write-off of certain intangible
assets on hand as of January 1, 1987 are not allowable. This is a national issue
of the IRS and is currently being litigated by another Blue Plan. This issue may
prevent us from closing tax years even after the above litigation with the IRS
is settled. The benefits of this deduction have not been recorded in the
financial statements. Should this issue be resolved in our favor, either
individually or as to Blue Plans generally, a benefit will be recorded. The
financial statements also do not reflect the potential tax benefits that could
result from a $192 million deduction taken on our 2001 federal income tax return
relating to the transfer of the stock of BCBSUW to the Foundation on March 23,
2001. The IRS recently revoked favorable private letter rulings issued to other
Blue Cross Plans in similar situations, and additional guidance is expected from
the IRS. We are awaiting additional developments and guidance in this area
before considering recording an income tax benefit from this gain contingency.
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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.
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BUSINESS
OVERVIEW
Based on the OCI's market share reports for 2001, 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 one of the largest provider networks in Wisconsin. We believe that
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, as
demonstrated by the fact that:
- the majority of the hospitals in our networks have received accreditation
by the Joint Commission on Accreditation of Health Care Organizations, an
organization nationally recognized for its rigorous standards with
respect to patient safety and quality initiatives;
- our network includes 89% of the board certified primary care physicians
in our service areas, which exceeds the national average of 82%, based on
the National Committee for Quality Assurance, or "NCQA," Quality Compass
2002(R); and
- as of September 30, 2002, 87% of our managed care membership was insured
through subsidiaries of ours which the NCQA's independent accreditation
process has determined to have met the quality parameters established by
the NCQA.
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 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:
- 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,
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the number of 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.
- 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 approximately 80% of our revenues and
approximately 68% of our pre-tax operating income in the nine months
ended September 30, 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, between March 1, 2002 and December 31, 2002 we
reduced ownership of our former affiliate AMSG from approximately 45% to
approximately 11% of AMSG's outstanding common stock, raising net cash
proceeds of approximately $73.9 million and relieving us of our capital
requirement relating to AMSG. We have since sold all of our remaining
shares of AMSG common stock, raising an additional $18.7 million in cash
proceeds.
- 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. On
November 15, 2002, we announced the consolidation of our claims and
customer service departments in Wisconsin, allowing us to close two
offices and realize significant estimated cost savings in 2003 and future
years.
- 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 and managed
care providers in Wisconsin. On December 31, 2002, we acquired Claim
Management Services, Inc., a Wisconsin-based third party administrator
for self-funded employee benefit plans. See "Summary -- Recent
Developments."
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 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
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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):
<Table>
<Caption>
PRODUCT OFFERINGS INSURED MEMBERS SELF-FUNDED 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
======= =======
</Table>
- ---------------
(1) Does not include member equivalents relating to individuals who access
medical care under the BlueCard programs.
SPECIALTY MANAGED CARE PRODUCTS AND SERVICES
We believe we are one of the largest providers 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 September 30, 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 September 30, 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 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
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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 has
considered 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 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, based on the
national reputation of Mayo Health Systems, 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
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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 50% of the medical benefits provided by CompcareBlue, Valley
and Unity were provided under capitated arrangements in 1999. In 2000, this
number decreased to 28%, and in 2001 this number decreased to 17%. Through the
first nine months of 2002, this number increased to 18%, primarily as a result
of a decline in CompcareBlue's membership.
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.
Valley and Midelfort have entered into an extension of their arrangement
through December 31, 2005. The extension grants Midelfort a similar option to
repurchase the capital stock of Valley and eliminates profit sharing between the
parties.
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.
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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 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 letters 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 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
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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:
- failure to meet capital and liquidity requirements of the Association;
- violation of the ownership limitations contained in our Amended and
Restated Articles of Incorporation;
- termination of the voting trust and divestiture agreement before the
Foundation's ownership of our common stock falls to less than 5%;
- 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;
- failure by the Foundation to divest its shares of our common stock by the
deadlines specified by the voting trust and divestiture agreement;
- a determination by the Association that fewer than 80% of our directors
are independent; and
- failure to brand medical and dental business as required by the
Association.
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 $22.3 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 Association
regarding our transactions with other Blue Cross plans. We expect the
Association to terminate the PPRMP requirements during 2003 after our reported
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.
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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"). We will be
required to implement the Transactions requirements in October 2003. As both a
health plan and a health clearinghouse, we must be in compliance with the
Privacy regulations by April 2003. There is no implementation deadline for the
Security regulations at this time because no final Security regulations have
been 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.
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.
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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.
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.
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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 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 would have
a material adverse effect on us.
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MANAGEMENT
The following table sets forth certain information with respect to each of
our executive officers and directors.
As of December 31, 2002, our executive officers and directors are as
follows:
<Table>
<Caption>
NAME AGE TITLE
- ---- --- -----
Stephen E. Bablitch................. 48 Chairman and Chief Executive Officer, Director
Michael E. Bernstein................ 42 President and Chief Operating Officer
Gail L. Hanson...................... 47 Senior Vice President, Treasurer and Chief Financial Officer
Penny J. Siewert.................... 45 Senior Vice President of Individual and Specialty Risk
Timothy F. Cullen................... 58 Senior Vice President of Corporate & Public Affairs
Richard A. Abdoo.................... 58 Director
Barry K. Allen...................... 54 Director
James L. Forbes..................... 70 Director
Michael S. Joyce.................... 60 Director
D. Keith Ness, M.D. ................ 54 Director
William C. Rupp, M.D. .............. 56 Director
Janet D. Steiger.................... 63 Director
Kenneth M. Viste, Jr., M.D. ........ 61 Director
</Table>
We refer to UWS prior to September 25, 1998 as our "predecessor."
Stephen E. Bablitch is our Chairman and Chief Executive Officer. Mr.
Bablitch joined our predecessor in 1996 as General Counsel, Vice President and
Secretary. He was elected our Senior Vice President in May of 2001, our
President in May of 2002 and became our Chairman and Chief Executive Officer and
a director in December of 2002. He has served in various capacities with our and
our predecessor's subsidiaries since 1996. Mr. Bablitch has been Senior Vice
President of BCBSUW since December of 2000. He has also been General Counsel and
Secretary of BCBSUW since 1996. Prior to being elected Senior Vice President of
BCBSUW, Mr. Bablitch served as its Vice President. Prior to joining our
predecessor and BCBSUW, Mr. Bablitch was an attorney with Dewitt, Ross and
Stevens, Madison, Wisconsin from 1991 to 1996.
Michael E. Bernstein is our President and Chief Operating Officer. Mr.
Bernstein was elected a Senior Vice President in February of 2000, Executive
Vice President in May of 2002 and President and Chief Operating Officer in
December of 2002. He was elected President of CompcareBlue in July of 2001. He
has served in various capacities with our subsidiaries since 2000. Mr. Bernstein
was elected Senior Vice President of BCBSUW in March of 2000. Prior to joining
us and BCBSUW, Mr. Bernstein served as Executive Vice President for the
University of Wisconsin Medical Foundation in Madison, Wisconsin from 1998
through 1999. From 1996 to 1998, Mr. Bernstein was Senior Vice President at
University Health Care, Inc., Madison, Wisconsin.
Gail L. Hanson is our Senior Vice President, Treasurer and Chief Financial
Officer. Ms. Hanson was Treasurer of our predecessor since 1987 and has been our
Treasurer since our formation in 1998. She was elected a Vice President of our
predecessor in 1996. Ms. Hanson was named our Chief Financial Officer effective
August 1, 1999. She was elected Senior Vice President in May of 2001. Ms. Hanson
has also served in various capacities with our and our predecessor's
subsidiaries since 1984. Ms. Hanson has been Senior Vice President of BCBSUW
since December of 2000 and Treasurer since 1987. Ms. Hanson had been Vice
President of BCBSUW since 1996, Chief Financial Officer since 1999 and Assistant
Vice President since 1987, having joined BCBSUW in 1984 as the Controller of
UWIC.
Penny J. Siewert is our Senior Vice President of Individual & Specialty
Risk. Ms. Siewert was elected Vice President of Regional Services of our
predecessor in 1995 and Senior Vice President in May of 2001. She has served in
various capacities with our and our predecessor's subsidiaries since 1994. Ms.
Siewert joined BCBSUW in 1977 and has served it in various capacities. Ms.
Siewert was elected Vice President of Operations for BCBSUW in 1990,
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Vice President of Special Markets in 1992, Vice President of Regional Services
in 1995 and Senior Vice President in March of 1999.
Timothy F. Cullen is our Senior Vice President of Corporate & Public
Affairs. Mr. Cullen was elected a Vice President in May of 2001. He was elected
president and chief operating officer of the government programs division of
BCBSUW in 1991, and he has been employed as chairman of United Government
Services since January of 1999. Mr. Cullen has served in various capacities with
our and our predecessor's subsidiaries since 1988. Prior to joining us and
BCBSUW, he was secretary of health and social services for the State of
Wisconsin from 1987 to 1988. From 1974 to 1986, Mr. Cullen was employed by the
State of Wisconsin as a state senator and served three terms as senate majority
leader.
Richard A. Abdoo has been a director since 1998, and a director of our
predecessor from 1991 through 1998. He has served as President and Chief
Executive Officer of Wisconsin Energy Corporation, a diversified energy services
holding company, since May 1991, and as Chairman of the Board and Chief
Executive Officer of Wisconsin Electric Power Company, a utility company, since
1990. Mr. Abdoo has been a director of Wisconsin Energy Corporation since 1988
and a director of Wisconsin Electric Power Company since 1989. He is also a
director of Marshall & Ilsley Corporation, a bank holding company; Sensient
Technologies Corporation, an ingredient manufacturer; and AK Steel Holding
Corporation, a steel manufacturer.
Barry K. Allen has been a director since 2000. Mr. Allen has served as
Executive Vice President and Chief Human Resources Officer of Qwest
Communications International, Inc., a telecommunications company, since
September 2002. From August 2000 to September 2002, he was President of Allen
Enterprises, LLC, a private equity investment and management company.
Previously, Mr. Allen has served as President of Ameritech Corporation, a
telecommunications company, from October 1999 to 2000; Executive Vice President
of Ameritech from 1997 to 1999; and Senior Vice President of Ameritech from 1995
to 1997. He is also a director of Harley-Davidson Inc.; Fiduciary Management,
Inc., an investment advisory firm; First Business Bank-Milwaukee; and CMGI,
Inc., an internet operating and development company.
James L. Forbes has been a director since 1998. Mr. Forbes has also served
as a director of our predecessor from 1991 through 1998 and as a director of
BCBSUW from 1974 to 2001. He has served as Chairman of Badger Meter, Inc., a
manufacturer of products using flow measurement technology, since 1999, as a
director of Badger Meter, Inc. since 1981 and as Chief Executive Officer of
Badger Meter, Inc. from 1987 to April 2002. Mr. Forbes is a director of Sensient
Technologies Corporation, an ingredient manufacturer, and Journal
Communications, Inc.
Michael S. Joyce has been a director since 2001. Mr. Joyce served as a
director of BCBSUW from 1996 through 2001. He has served as President and Chief
Executive Officer of the Foundation for Community and Faith-Centered Enterprise,
a charitable foundation, since October 2001. He also served as President and
Chief Executive Officer of Americans for Community and Faith-Centered Enterprise
from June 2001 to October 2001 and as President and Chief Executive Officer of
the Lynde and Harry Bradley Foundation, a charitable foundation, from 1986 to
2001.
D. Keith Ness, M.D. has been a director since 2001. Dr. Ness served as a
director of BCBSUW from 1998 through 2001. He has been a practicing family
physician since 1978. Dr. Ness has served as director, President and interim
Chief Executive Officer of Community Physician's Network, a group of primary
care physicians, since 1998 and as Medical Director of Heritage Manor Nursing
Home since 1996.
William C. Rupp, M.D. has been a director since 1998. Dr. Rupp served as a
director of our predecessor from 1997 through 1998. He has served as President
and CEO of Immanuel St. Joseph's Health System in Mankato, Minnesota since 2002,
and has been a practicing physician in oncology since 1982. Dr. Rupp served as
President and Chief Executive Officer of Luther/Midelfort Mayo Health System, a
network of community-based healthcare providers in West-Central Wisconsin, from
1994 through 2001, and as President of Midelfort Clinic from 1991 through 2001.
Janet D. Steiger has been a director since 2001. Ms. Steiger served as a
director of BCBSUW from 1998 through 2001. She was a member of the United States
Federal Trade Commission from 1989 to 1997; and served as Chair of the Federal
Trade Commission from 1989 to 1995.
S-54
Kenneth M. Viste, Jr., M.D. has been a director since 2001. Dr. Viste
served as a director of BCBSUW from 1992 through 2001. He has been a practicing
physician in neurology since 1974. He is Principal of Lakeside Neurocare,
Limited, an independent medical office. Dr. Viste has been a director of the
Physical Rehabilitation Unit of Mercy Medical Center, Oshkosh, Wisconsin, since
1974, and of the Physical Rehabilitation Unit of St. Agnes Hospital, Fond du
Lac, Wisconsin, since 1983. Dr. Viste has also served as a Clinical Professor of
Neurology at the University of Wisconsin Medical School since 1995.
Officers are elected to serve, subject to the discretion of the Board of
Directors, until their successors are appointed. There are no family
relationships among any of our directors and/or executive officers. The business
address of each of the executive officers is 401 West Michigan Street,
Milwaukee, Wisconsin 53203.
S-55
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:
- 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;
- 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;
- 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;
- 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
- 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
S-56
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:
- 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.
- 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.
- 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.
- 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.
- 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:
- make any change or addition to or repeal our Amended and Restated
Articles of Incorporation or Bylaws;
- nominate any candidate to fill any vacancy on our board of directors;
- call any special meeting of our shareholders;
- make any shareholder proposal pursuant to Section 2.14 of the Bylaws; or
- 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:
- 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;
- 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;
- 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;
- make any shareholder proposal for submission at an annual meeting of our
shareholders;
S-57
- nominate any candidate to our board of directors; or
- 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 74.9% of the outstanding
shares of our common stock entitled to vote would ordinarily exceed the
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:
- the Foundation makes a good faith and reasonable determination that
compliance with the divestiture deadlines would have a material adverse
effect on the Foundation;
- 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
S-58
- 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.
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:
- 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
- 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.
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.
S-59
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:
- we previously registered shares of our common stock at the request of the
Foundation at any time during the immediately preceding 120-day period;
- 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;
- 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;
- 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
- 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.
S-60
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
- 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,
- the consummation of a private placement transaction by the Foundation
resulting in gross sale proceeds to the Foundation of at least $10
million, or
- 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,
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.
S-61
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:
- 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;
- 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
- 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.
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. We filed such a registration
statement on November 8, 2002. The filing of the registration statement itself
did 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, such as the offering of shares by the Foundation pursuant to this
prospectus supplement, 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.
S-62
STOCK OWNERSHIP OF MANAGEMENT AND THE FOUNDATION
The following tables set forth as of December 31, 2002 information
regarding the beneficial ownership of our common stock by our directors and
certain executives, by our directors and executive officers as a group and by
the Foundation. The Foundation is the only shareholder we know to own 5% or more
of our outstanding shares of common stock. The information set forth below has
been furnished to us by the respective named shareholders.
Beneficial ownership is determined in accordance with Securities and
Exchange Commission rules. In general, these rules attribute beneficial
ownership of securities to persons who possess sole or shared voting power
and/or investment power with respect to those securities and includes, among
other things, securities that an individual has the right to acquire within 60
days. Unless otherwise indicated, the shareholders identified in the following
tables have sole voting and investment power with respect to all shares shown as
beneficially owned by them. Percentage ownership calculations for any individual
listed below are based on 41,644,584 shares of our common stock outstanding as
of December 31, 2002 plus all shares of our common stock which the individual
may acquire beneficial ownership of pursuant to stock options that are
exercisable or that will become exercisable within 60 days of December 31, 2002.
OWNERSHIP BY MANAGEMENT
<Table>
<Caption>
NUMBER OF SHARES
BENEFICIALLY PERCENT
NAME OF BENEFICIAL OWNER OWNED(1) OWNED
- ------------------------ ---------------- -------
Stephen E. Bablitch(2)(3)(4)................................ 273,056 *
Michael E. Bernstein(3)(4).................................. 38,204 *
Gail L. Hanson(3)(4)........................................ 165,610 *
Penny J. Siewert(2)(3)(4)................................... 242,886 *
Timothy F. Cullen(2)(3)(4).................................. 189,435 *
Richard A. Abdoo............................................ 8,426 *
Barry K. Allen.............................................. 14,000 *
James L. Forbes............................................. 8,126 *
Michael S. Joyce(2)......................................... 40,100 *
D. Keith Ness, M.D. ........................................ 2,000 *
William C. Rupp, M.D. ...................................... 5,000 *
Janet D. Steiger............................................ 2,000 *
Kenneth M. Viste, Jr., M.D. ................................ 3,000 *
All directors and executive officers as a group (19
persons)(1)(2)(3)(4)...................................... 1,045,302 2.45%
</Table>
- ---------------
* Less than one percent.
(1) Includes the following number of shares that may be acquired upon the
exercise of options within 60 days of December 31, 2002: Ms. Siewert,
233,073; Mr. Bablitch, 266,291; Mr. Bernstein, 26,250; Mr. Cullen, 183,864;
Ms. Hanson, 159,500; Mr. Abdoo, 6,626; Mr. Forbes, 6,626; Mr. Allen, 4,000;
Mr. Joyce, 2,000; Mr. Ness, 2,000; Mr. Rupp, 2,000; Ms. Steiger, 2,000; Mr.
Viste, 2,000; and all directors and executive officers as a group, 994,480.
(2) Includes the following shares owned jointly with such person's spouse, with
respect to which such person shares voting power and dispositive power: Mr.
Bablitch, 4,000. Also includes the following shares owned separately by such
person's spouse and/or child, with respect to which such person shares
voting power and dispositive power: Mr. Cullen, 250; Ms. Siewert, 3,000; and
Mr. Joyce, 200.
(3) Includes the following shares held under our 401(k) plan, as to which such
person has dispositive power: Mr. Bablitch, 2,765; Mr. Bernstein, 1,954; Mr.
Cullen, 3,241; Ms. Hanson, 3,173; Ms. Siewert, 5,463; and all directors and
executive officers as a group, 20,305.
S-63
(4) Does not include the following shares of restricted stock granted on January
2, 2003: Mr. Bablitch, 31,000; Mr. Bernstein, 31,000; Ms. Hanson, 12,000;
Mr. Cullen, 9,000; and Ms. Siewert, 6,000.
OWNERSHIP BY THE FOUNDATION
The following table sets forth information regarding the beneficial
ownership of our common stock by the Foundation as of January 21, 2003 and as
adjusted to give effect to the sale of shares offered hereby.
<Table>
<Caption>
SHARES OF COMMON SHARES OF COMMON
STOCK BENEFICIALLY STOCK BENEFICIALLY
OWNED PRIOR TO OWNED AFTER
THIS OFFERING NUMBER OF THIS OFFERING
--------------------- SHARES BEING --------------------
NAME AND ADDRESS NUMBER PERCENT OFFERED NUMBER PERCENT
- ---------------- ---------- ------- ------------ ---------- -------
Wisconsin United for Health Foundation, Inc. 31,313,390(1) 75% 5,000,000 26,313,390 63%
10 East Doty Street
Madison, WI 53703
</Table>
- ---------------
(1) Based on the Schedule 13D filed by the Foundation with us pursuant to the
Securities Exchange Act of 1934, as amended.
In addition, the Foundation has granted to the underwriters an option to
purchase up to 750,000 additional shares of common stock to cover
over-allotments, if any, incurred in connection with this offering. If the
option is exercised in full, then the Foundation will own 25,563,390 shares, or
approximately 61.4% of our outstanding common stock based on the number of
shares outstanding on December 31, 2002. See "Background of the Company" and
"Agreements With the Foundation" for a description of other material
transactions between us and the Foundation.
S-64
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 supplement. 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:
- is not a "major participant" (as defined below);
- has not been nominated to be a director at the initiative of a major
participant;
- 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
- 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:
- the Foundation, or any other person, in the judgment of an independent
board majority, that succeeds to the Foundation's position;
- a person that owns shares of our common stock in excess of the ownership
limitations described below;
- 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;
- 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
- a person that is an affiliate or associate of a major participant.
S-65
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
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:
- no institutional owner may beneficially own 10% or more of the combined
voting power of all of our outstanding securities;
S-66
- no non-institutional owner may beneficially own 5% or more of the
combined voting power of all of our outstanding securities; and
- 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:
- in which a person has a direct or indirect ownership interest;
- which a person has a right or option to purchase;
- which a person has the right to vote;
- 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
- 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).
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:
- the number, qualifications, limitations on liability and removal of
directors;
- the inability of shareholders to act by written consent;
S-67
- special shareholder meetings;
- the ownership limitations;
- amendments to the Bylaws;
- the prohibition on cumulative voting; and
- the right to amend the Articles.
The supermajority votes described above will not be necessary if any of the
following applies:
- we no longer have any license agreements with the Association;
- 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;
- 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
- 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.
S-68
UNDERWRITING
UBS Warburg LLC and Salomon Smith Barney Inc. are acting as joint
book-running managers and, together with CIBC World Markets Corp. and Robert W.
Baird & Co. Incorporated, are acting as representatives of the underwriters
named below. We, the Foundation and the underwriters have entered into an
underwriting agreement concerning the shares being offered. Subject to certain
conditions, each underwriter has severally agreed to purchase the number of
shares indicated in the following table.
<Table>
<Caption>
UNDERWRITERS NUMBER OF SHARES
- ------------ ----------------
UBS Warburg LLC.............................................
Salomon Smith Barney Inc. ..................................
CIBC World Markets Corp. ...................................
Robert W. Baird & Co. Incorporated..........................
---------
Total.................................................. 5,000,000
=========
</Table>
If the underwriters sell more shares than the total number set forth in the
table above, then the underwriters have a 30-day option to buy up to an
additional 750,000 shares from the Foundation at the public offering price less
the underwriting discounts and commissions, to cover these sales. If any shares
are purchased under this option, then the underwriters will severally purchase
shares in approximately the same proportion as set forth in the table above.
The following table provides information regarding the amount of the
discount to be paid to the underwriters by the Foundation. These amounts are
shown assuming both no exercise and full exercise of the underwriters' option to
purchase up to 750,000 additional shares.
<Table>
<Caption>
PAID BY THE FOUNDATION
---------------------------------
NO EXERCISE OF FULL EXERCISE OF
OVER-ALLOTMENT OVER-ALLOTMENT
OPTION OPTION
-------------- ----------------
Per share................................................... $ $
Total....................................................... $ $
</Table>
We estimate that the total expenses of this offering payable by us will be
approximately $450,000.
Shares sold by the underwriters to the public will initially be offered at
the public offering price set forth on the cover of this prospectus supplement.
Any shares sold by the underwriters to securities dealers may be sold at a
discount of up to $ per share from the public offering price. Any of these
securities dealers may resell any shares purchased from the underwriters to
other brokers or dealers at a discount of up to $ per share from the public
offering price. If all the shares are not sold at the public offering price, the
representatives may change the offering price and the other selling terms.
In connection with this offering, certain of the underwriters or securities
dealers may distribute prospectuses electronically.
We have agreed with the underwriters not to offer, sell, contract to sell,
hedge or otherwise dispose of, directly or indirectly, any of our common stock
or securities convertible into or exchangeable for shares of common stock during
the period from the date of this prospectus supplement continuing through and
including the date 90 days after the date of this prospectus supplement, without
the prior written consent of UBS Warburg LLC. Each of our executive officers,
our directors and the Foundation have also agreed to these restrictions.
In connection with this offering, Salomon Smith Barney, on behalf of the
underwriters, may purchase and sell shares of our common stock in the open
market. These transactions may include stabilizing transactions, short sales and
purchases to cover positions created by short sales. Stabilizing transactions
consist of bids or purchases made for the purpose of preventing or retarding a
decline in the market price of our common stock while this offering is in
progress. These transactions may also include short sales and purchases to cover
positions created by short sales. Short sales involve the sale by the
underwriters of a greater number of shares than they are required to purchase in
this offering. Short sales may be either "covered short sales" or "naked short
sales." Covered short sales are sales made in an amount not greater than the
underwriters' over-allotment option to purchase additional shares in this
offering. The
S-69
underwriters may close out any covered short position by either exercising their
over-allotment option or purchasing shares in the open market. In determining
the source of shares to close out the covered short position, the underwriters
will consider, among other things, the price of shares available for purchase in
the open market as compared to the price at which they may purchase shares
through the over-allotment option. Naked short sales are sales in excess of the
over-allotment option. The underwriters must close out any naked short position
by purchasing shares in the open market. A naked short position is more likely
to be created if the underwriters are concerned there may be downward pressure
on the price of shares in the open market after pricing that could adversely
affect investors who purchase our common stock in this offering.
The underwriters also may impose a penalty bid. This occurs when a
particular underwriter repays to the underwriters a portion of the underwriting
discount received by it because Salomon Smith Barney, on behalf of the
underwriters, has repurchased shares sold by or for the account of that
underwriter in stabilizing or short covering transactions.
These activities by the underwriters may stabilize, maintain or otherwise
affect the market price of our common stock. As a result, the price of our
common stock may be higher than the price that otherwise might exist in the open
market. If these activities are commenced, they may be discontinued by the
underwriters at any time. These transactions may be effected on the New York
Stock Exchange or otherwise.
We and the Foundation have agreed to indemnify the several underwriters
against some liabilities, including liabilities under the Securities Act of
1933, and to contribute to payments that the underwriters may be required to
make in respect thereof.
Robert W. Baird & Co. Incorporated, one of the underwriters in this
offering, has been retained by the Foundation to provide financial advisory
services and will be entitled, upon completion of this offering, to a fee equal
to 1.25% of the net proceeds of the offering to be received by the Foundation up
to $100 million, as well as reimbursement of expenses. To the extent that this
and subsequent public offerings or other "realization events" produce proceeds
to the Foundation in excess of $100 million (on a cumulative basis) during the
term of its agreement with the Foundation, Robert W. Baird & Co. Incorporated
will be entitled to an aggregate fee of 1.25% of the first $100 million of net
proceeds, 1% of the second $100 million and 0.75% of the net proceeds in excess
of $200 million. The National Association of Securities Dealers, Inc. has deemed
this fee to be underwriting compensation in connection with this offering.
LEGAL MATTERS
The validity of our common stock offered by this prospectus supplement and
the accompanying prospectus will be passed upon for us by Foley & Lardner,
Milwaukee, Wisconsin. Dewey Ballantine LLP is counsel to the underwriters in
connection with this offering.
S-70
COBALT CORPORATION
INDEX TO FINANCIAL STATEMENTS
<Table>
<Caption>
PAGE
----
CONSOLIDATED FINANCIAL STATEMENTS:
Report of Independent Auditors.............................. F-2
Consolidated Balance Sheets at December 31, 2001 and 2000... F-3
Consolidated Statements of Operations for the years ended
December 31, 2001, 2000 and 1999.......................... F-4
Consolidated Statements of Changes in Shareholders' Equity
and Comprehensive Income (Loss) for the years ended
December 31, 2001, 2000 and 1999.......................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2001, 2000 and 1999.......................... F-6
Notes to Consolidated Financial Statements.................. F-7
</Table>
F-1
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Cobalt Corporation
We have audited the accompanying consolidated balance sheets of Cobalt
Corporation (the "Company") as of December 31, 2001 and 2000, and the related
consolidated statements of operations, changes in shareholders' equity and
comprehensive income (loss) and cash flows for each of the three years in the
period ended December 31, 2001. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audits to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of the Company at
December 31, 2001 and 2000, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended December 31,
2001, in conformity with accounting principles generally accepted in the United
States.
/s/ Ernst & Young LLP
Milwaukee, Wisconsin
March 26, 2002,
except for Note 20, as to which the date is
March 29, 2002
F-2
COBALT CORPORATION
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31,
-------------------
2001 2000
-------- --------
(IN THOUSANDS)
ASSETS
Current assets:
Cash and cash equivalents................................. $ 51,669 $ 1,305
Investments -- available-for-sale, at fair value.......... 180,692 44,373
Due from affiliates....................................... 5,091 12,896
Premium receivables....................................... 33,486 3,325
Due from clinics and providers............................ 11,922 7,063
Other receivables......................................... 49,138 28,127
Prepaid expenses and other current assets................. 30,150 18,385
-------- --------
Total current assets........................................ 362,148 115,474
Noncurrent assets:
Investments -- held-to-maturity, at amortized cost........ 11,007 --
Investment in affiliates, net............................. 79,466 105,609
Property and equipment, net............................... 31,411 25,139
Goodwill, net............................................. 92,066 8,020
Note receivable from affiliate............................ -- 70,000
Prepaid pension........................................... 53,837 36,471
Deferred income taxes..................................... 29,385 19,067
Other noncurrent assets................................... 48,685 14,425
Assets from discontinued operations......................... 19,317 --
-------- --------
Total assets................................................ $727,322 $394,205
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Medical and other benefits payable........................ $220,038 $104,415
Advance premiums.......................................... 88,495 40,745
Due to affiliates......................................... 59 910
Payables and accrued expenses............................. 49,582 29,597
Short-term debt........................................... 12,369 --
Other current liabilities................................. 29,521 5,162
-------- --------
Total current liabilities................................... 400,064 180,829
Noncurrent liabilities:
Other benefits payable.................................... 47,282 --
Deferred income taxes..................................... 29,259 20,699
Postretirement benefits other than pension................ 18,005 12,722
Long-term debt............................................ 4,500 --
Other noncurrent liabilities.............................. 14,921 11,012
Liabilities from discontinued operations.................... 5,069 --
-------- --------
Total liabilities........................................... 519,100 225,262
Shareholders' equity:
Preferred stock (no par value, 1,000,000 shares
authorized)............................................ -- --
Common stock (See Note 19)................................ 249,566 --
Retained earnings (deficit)............................... (41,979) 170,907
Accumulated other comprehensive income (loss)............. 635 (1,964)
-------- --------
Total shareholders' equity.................................. 208,222 168,943
-------- --------
Total liabilities and shareholders' equity.................. $727,322 $394,205
======== ========
</Table>
See accompanying Notes to the Consolidated Financial Statements
F-3
COBALT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-----------------------------------
2001 2000 1999
----------- --------- ---------
(IN THOUSANDS, EXCEPT SHARE DATA)
Revenues:
Premium................................................... $1,255,391 $538,080 $418,949
Government services....................................... 117,192 70,305 52,259
Other..................................................... 40,655 24,715 25,970
---------- -------- --------
Total health services revenue.......................... 1,143,238 633,100 497,178
Investment results........................................ 12,482 9,583 18,510
---------- -------- --------
Total revenues......................................... 1,425,720 642,683 515,688
Expenses:
Medical and other benefits................................ 1,119,218 497,822 376,814
Selling, general, administrative and other................ 303,208 176,878 158,187
Interest.................................................. 561 300 553
Amortization of goodwill.................................. 5,136 622 191
---------- -------- --------
Total expenses......................................... 1,428,123 675,622 535,745
---------- -------- --------
Operating loss from continuing operations................... (2,403) (32,939) (20,057)
Loss from investment in affiliates, net of tax.............. (22,724) (6,526) (22,690)
---------- -------- --------
Pretax loss from continuing operations...................... (25,127) (39,465) (42,747)
Income tax expense (benefit)................................ (1,871) 548 --
---------- -------- --------
Loss from continuing operations............................. (23,256) (40,013) (42,747)
Income from discontinued operations, net of tax............. 951 -- --
---------- -------- --------
Net loss.................................................... $ (22,305) $(40,013) $(42,747)
========== ======== ========
Weighted average common shares.............................. 38,434,459
Diluted weighted average common shares...................... 38,434,459
Earnings (loss) per common share:
Basic EPS from continuing operations...................... $ (0.61)
Basic EPS from discontinued operations.................... 0.03
----------
Total basic EPS........................................ $ (0.58)
==========
Diluted EPS from continuing operations.................... $ (0.61)
Diluted EPS from discontinued operations.................. 0.03
----------
Total diluted EPS...................................... $ (0.58)
==========
</Table>
See accompanying Notes to the Consolidated Financial Statements
F-4
COBALT CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY AND
COMPREHENSIVE INCOME (LOSS)
<Table>
<Caption>
ACCUMULATED
COMMON RETAINED OTHER TOTAL
SHARES COMMON EARNINGS COMPREHENSIVE SHAREHOLDERS'
OUTSTANDING STOCK (DEFICIT) INCOME (LOSS) EQUITY
----------- -------- --------- ------------- -------------
(IN THOUSANDS, EXCEPT SHARE DATA)
Balance at December 31, 1998............... -- $ -- $ 246,083 $ 4,908 $250,991
Comprehensive loss:
Net loss.............................. -- -- (42,747) -- (42,747)
Change in unrealized gains/losses on
investments, net of tax............. -- -- -- (11,114) (11,114)
--------
Comprehensive loss.................. (53,861)
Change in ownership of affiliates..... -- -- 2,979 -- 2,979
---------- -------- --------- -------- --------
Balance at December 31, 1999............... -- -- 206,315 (6,206) 200,109
Comprehensive loss:
Net loss.............................. -- -- (40,013) -- (40,013)
Change in unrealized gains/losses on
investments, net of tax............. -- -- -- 4,242 4,242
--------
Comprehensive loss.................. (35,771)
Change in ownership of affiliates..... -- -- 4,605 -- 4,605
---------- -------- --------- -------- --------
Balance at December 31, 2000............... -- -- 170,907 (1,964) 168,943
Comprehensive loss:
Net loss.............................. -- -- (22,305) -- (22,305)
Change in unrealized gains/losses on
investments, net of tax............. -- -- -- 2,599 2,599
--------
Comprehensive loss.................. (19,706)
Capitalization of Wisconsin United for
Health Foundation, Inc................ 31,313,390 192,577 (192,577) -- --
Issuance of common
stock -- acquisition.................. 9,096,303 55,938 -- -- 55,938
Issuance of common stock -- options
exercised............................. 11,250 51 -- -- 51
Issuance of common stock -- 401(k)....... 172,100 1,000 -- -- 1,000
Change in ownership of affiliates........ -- -- 1,402 -- 1,402
Conversion of SAR's to options........... -- -- 594 -- 594
---------- -------- --------- -------- --------
Balance at December 31, 2001............... 40,593,043 $249,566 $ (41,979) $ 635 $208,222
========== ======== ========= ======== ========
</Table>
See accompanying Notes to the Consolidated Financial Statements
F-5
COBALT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
------------------------------
2001 2000 1999
-------- -------- --------
(IN THOUSANDS)
OPERATING ACTIVITIES
Net loss from continuing operations....................... $(23,256) $(40,013) $(42,747)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization.......................... 16,840 8,669 8,709
Premium deficiency reserve-Medicare+Choice............. (3,617) 3,617 --
Write-off of deferred acquisition
costs-Medicare+Choice................................. -- 2,434 --
Impairment of data warehouse software asset............ -- -- 2,398
Loss from investment in affiliates, net of tax......... 22,724 6,526 22,690
Realized investment (gains) losses, net................ (845) 509 (8,014)
Deferred income taxes.................................. 358 548 --
Changes in operating accounts, net of discontinued
operations, acquisitions and conversion/combination
related activity:
Premium receivables.................................. 14,051 (509) (218)
Other receivables.................................... (1,522) (5,943) (229)
Due from clinics and providers....................... 5,302 (610) (1,692)
Medical and other benefits payable................... 1,888 25,162 (6,160)
Advance premiums..................................... (2,229) 9,598 5,244
Due to/from affiliates, net.......................... (9,494) (1,612) (5,643)
Other, net........................................... (9,065) (76) (8,686)
-------- -------- --------
Net cash provided by (used in) continuing
operations...................................... 11,135 8,300 (34,348)
INVESTING ACTIVITIES
Acquisitions and Combination activity..................... 48,843 (1,013) (12,214)
Proceeds from sale of investment in affiliate............. -- -- --
Proceeds from sale of discontinued operations............. -- -- --
Purchases of available-for-sale investments............... (155,701) (8,553) (73,537)
Purchases of held-to-maturity investments................. (1,488) -- --
Proceeds from maturity of held-to maturity investments.... 325 655 5
Proceeds from sale and maturity of available-for-sale
investments............................................ 146,418 26,261 125,624
Additions to property and equipment, net.................. (5,631) (8,116) (3,488)
-------- -------- --------
Net cash provided by investing activities......... 32,766 9,234 36,390
FINANCING ACTIVITIES
Proceeds from issuance of common stock.................... 1,030
Net (repayments) borrowings of debt....................... 5,463 (11,175) (2,440)
-------- -------- --------
Net cash provided by (used in) financing
activities...................................... 6,493 (11,175) (2,440)
DISCONTINUED OPERATIONS
Cash flows from discontinued operations................... (30) -- --
-------- -------- --------
Net cash used in discontinued operations.......... (30) -- --
Cash and cash equivalents:
Increase (decrease) during year........................ 50,364 6,359 (398)
Balance at beginning of year........................... 1,305 (5,054) (4,656)
-------- -------- --------
Balance at end of year............................... $ 51,669 $ 1,305 $ (5,054)
======== ======== ========
</Table>
See accompanying Notes to the Consolidated Financial Statements
F-6
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION, ACCOUNTING FOR CONVERSION AND COMBINATION, AND BASIS OF
PRESENTATION
Cobalt Corporation ("Cobalt" or the "Company") (formerly known as United
Wisconsin Services, Inc. ("UWS")) was created as a result of the Combination of
UWS and Blue Cross & Blue Shield United of Wisconsin ("BCBSUW") on March 23,
2001 (the "Combination"). On that date, BCBSUW converted from a service
insurance corporation to a shareholder owned corporation. Upon conversion,
BCBSUW became a wholly-owned subsidiary of UWS through a combination of the two
companies. At the time of the conversion and combination, BCBSUW owned
approximately 46.6% of UWS' outstanding common stock. In exchange for the
ownership of BCBSUW, Cobalt issued 31,313,390 shares of newly issued Company
common stock to the Wisconsin United for Health Foundation, Inc. (the
"Foundation"). The Foundation was established for the sole purpose of benefiting
public health in Wisconsin from its earnings in the investment in Cobalt.
The Combination was accounted for as a purchase by BCBSUW of the remaining
9,096,303 shares of UWS that it did not already own at a market price of $6.15
per share on the closing date. In accordance with accounting principles
generally accepted in the United States ("GAAP"), goodwill was recorded
representing the excess of the market price over the adjusted book value of UWS
for the 53.4% of UWS that BCBSUW did not already own. Total goodwill recorded by
Cobalt as a result of the Combination amounted to $65,577,000, of which
$21,651,000 related to the recognition of a valuation allowance on the net
deferred income tax assets recorded by UWS prior to the Combination.
For financial reporting purposes, the Combination is treated as a reverse
purchase transaction, whereby BCBSUW becomes the acquirer and reporting entity
for public company reporting. Therefore, the accompanying audited consolidated
financial statements present the Company's financial position as of December 31,
2001, reflecting the purchase accounting adjustments for the Combination and
include the accounts of both UWS and BCBSUW. The financial position of the
Company presented in the December 31, 2000 balance sheet represents only the
accounts of BCBSUW, which includes BCBSUW's 46.6% investment in UWS and 44%
investment in American Medical Security Group, Inc. ("AMSG") (see Note 6). The
consolidated statements of operations, cash flows, and changes in stockholders'
equity and comprehensive income (loss) for the year ended December 31, 2001,
reflect 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 consolidated financial statements include the operations
of BCBSUW, its wholly-owned subsidiary, United Government intermediary services,
LLC ("UGS") and BCBSUW's investment in UWS and AMSG. For purposes of calculating
earnings per common share ("EPS") of the Company, the 7,949,904 shares of Cobalt
common stock owned by BCBSUW is accounted for as if it were treasury stock.
The consolidated financial statements subsequent to the Combination include
the accounts of the Company's majority owned insurance subsidiaries (BCBSUW,
Compcare Health Services Insurance Corporation ("Compcare"), Unity Health Plans
Insurance Corporation ("Unity"), Valley Health Plan, Inc. ("Valley"), United
Wisconsin Insurance Company ("UWIC"), and United Heartland Life Insurance
Company ("UHLIC")) and other non-insurance subsidiaries (UGS, Meridian Resource
Company, LLC ("MRC"), Comprehensive Receivables Group, Inc. ("CRG"), United
Wisconsin Proservices, Inc. ("Proservices"), United Heartland, Inc. ("UHI") and
C.C. Holdings, LLC ("CC Holdings")) as continuing operations. All intracompany
balances as of and transactions have been eliminated in consolidation.
The Company offers full coverage, co-payment, preferred provider
organization ("PPO") and health maintenance organization ("HMO") products to
groups, along with Medicare supplement and interim coverage options to
individuals. The Company's subsidiary, BCBSUW, is the only health insurer in the
state operating full-service regional sales and customer service centers.
Through UGS, the Company is a government contractor and processes Medicare
claims for providers in all 50 states and is currently the largest Part A
Medicare processor in the nation. The Company is also a leading provider of
managed health care services and employee benefit products, HMO products,
dental, life, disability and workers' compensation products, managed care
consulting, electronic claim submission services and receivables management
services.
F-7
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Included are the pro forma (unaudited) consolidated statements of
operations of the Company for the years ended December 31, 2001 and 2000,
presented as if the Combination had occurred at the beginning of each year
presented. Pro forma basic and diluted EPS calculations are based on the pro
forma weighted average of the Company's outstanding common stock during the
period presented.
PRO FORMA (UNAUDITED) STATEMENTS OF OPERATIONS
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
----------------------------------
2001 2000
-------------- --------------
(IN THOUSANDS, EXCEPT SHARE DATA)
Revenues:
Health services revenue:
Premium................................................ $1,472,238 $1,283,237
Government services.................................... 117,192 70,305
Other.................................................. 45,290 41,778
Investment results........................................ 13,901 12,208
---------- ----------
Total revenues.................................... 1,648,621 1,407,528
Expenses:
Medical and other benefits................................ 1,311,185 1,188,525
Selling, general, administrative and other................ 331,615 279,478
Interest.................................................. 744 1,306
Amortization of goodwill.................................. 6,470 5,464
---------- ----------
Total expenses.................................... 1,650,014 1,474,773
---------- ----------
Operating loss from continuing operations................... (1,393) (67,245)
Income (loss) from investment in affiliates, net of tax..... (23,158) 766
---------- ----------
Pretax loss from continuing operations...................... (24,551) (66,479)
Income tax benefit.......................................... (1,574) (677)
---------- ----------
Loss from continuing operations............................. $ (22,977) $ (65,802)
Income from discontinued operations, net of tax............. 1,122 1,578
---------- ----------
Net loss.................................................... $ (21,855) $ (64,224)
========== ==========
Weighted average common shares.............................. 40,453,690 40,412,393
Diluted weighted average common shares...................... 40,453,690 40,412,393
Earnings (loss) per common share
Diluted EPS from continuing operations............ $ (0.56) $ (1.63)
Diluted EPS from discontinued operations.......... 0.02 0.04
---------- ----------
Total Diluted EPS........................................... $ (0.54) $ (1.59)
========== ==========
</Table>
2. MANAGEMENT'S PLAN
During the three years in the period ended December 31, 2001, the Company
incurred operating losses from continuing operations aggregating $55.4 million.
Included in these losses are $27.8 million related to the Company's
participation in the Medicare+Choice line of business, which the Company exited
effective January 1, 2002. Prior to the Combination, UWS and its subsidiaries
incurred additional operating losses from continuing operations aggregating
$77.8 million for the first quarter of 2001 and the two years ended December 31,
2000. These losses
F-8
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
largely relate to the HMO business in southeast Wisconsin. Significant actions
were taken during 2001 to cancel unprofitable HMO business. Also contributing to
the combined aggregate losses were $8.7 million of expenses relating to the
Combination. On a pro forma basis, Cobalt's operating loss from continuing
operations for 2001 was $1.4 million (see Note 1). Despite these recent
operating losses and the implementation of changes in statutory accounting
("Codification") effective January 1, 2001, the Company complied with minimum
capital and liquidity requirements of the Office of the Commissioner of
Insurance of the State of Wisconsin ("OCI") and the BlueCross BlueShield
Association ("BCA"), during 2001, 2000 and 1999. The Company maintained
compliance, in part, by contributing regulated and non-regulated subsidiaries to
regulated entities and by collateralizing certain intra-company debt obligations
with the common stock of affiliated entities. OCI requested and management
submitted a specific plan of action to continue to exceed the minimum capital
requirements of the OCI and the BCA during 2002 (see Note 15).
The outstanding common stock of Compcare, Unity, Valley and UHI currently
provide the collateral for approximately $92 million borrowed by Cobalt from
BCBSUW and UWIC. These intra-company balances have been eliminated in the
accompanying December 31, 2001 consolidated balance sheet. However, the
intra-company balances continue to be an obligation of Cobalt to BCBSUW ($70
million) and UWIC ($22 million) in the statutory-basis financial statements of
BCBSUW and UWIC. Cobalt is obligated to repay BCBSUW by January 2, 2003 and UWIC
by October 1, 2002. Transfer of the pledged collateral to BCBSUW and UWIC will
satisfy the legal obligations, but would not assist BCBSUW in complying with
minimum capital and liquidity requirements, since the minimum capital
calculations for investments in subsidiaries require a greater discount than for
cash, marketable securities or affiliated receivables. However, settlement of
these obligations in cash will assist compliance with minimum capital and
liquidity requirements.
At December 31, 2001, all of the Company's subsidiaries are accounted for
in the BCBSUW or Compcare capital calculations as a result of contribution or
collateralization.
In order to assure the Company's regulated insurance subsidiaries continue
to satisfy minimum capital and liquidity requirements, the OCI requested,
management developed and the Cobalt board of directors approved a capital plan
to improve the Company's position relative to minimum capital and liquidity
requirements. The capital plan, which management has provided to and discussed
with the OCI and BCA, includes the following action steps to maintain required
capital and liquidity levels during 2002:
- Sell certain non-regulated subsidiaries owned by the Company for cash
and/or notes prior to October 1, 2002.
- 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.
- Obtain debt financing at the Company's corporate holding company from one
or more institutional lenders to fund holding company liquidity needs
including the repayment of the collateralized intra-company debt
obligations between the holding company and its regulated subsidiaries.
- Achieve the Company's 2002 projected core earnings, which anticipate
breakeven operating results for Compcare 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 Compcare's significant change in
profitability to occur as a result of efforts in the fourth quarter of
2001 to cancel unprofitable business and implement necessary premium
increases for the remaining business.
- Adhere to certain practices in conducting and accounting for affiliated
transactions, notably involving the lending practices previously
described. The Company will not use uncollateralized non-operating
intra-company balances in complying with minimum capital and liquidity
requirements. The Company has reflected the revised practices in the
December 31, 2001 regulated subsidiary statutory-basis financial
statements filed with the OCI and other regulatory agencies.
F-9
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- Satisfy the $70 million debt obligation to BCBSUW by December 31, 2002,
either with cash obtained through external financing or by transferring
the stock of Compcare to BCBSUW or a combination thereof.
- Satisfy the $22 million debt obligation to UWIC by September 30, 2002,
either with cash obtained through external financing or by transferring
the stock of Unity, Valley and UHI to UWIC.
The Company expects to remain in compliance with minimum capital and
liquidity requirements of the OCI and the BCA throughout 2002 by substantially
completing the capital plan described above or transactions with an equivalent
impact on the Company's position relative to minimum capital and liquidity
requirements. Non-compliance with minimum capital and liquidity requirements may
subject the Company to various regulatory actions by the OCI and BCA, including
rehabilitation, revocation of the Company's license to sell insurance products
in Wisconsin and revocation of the Company's license to operate as a Blue
Cross/Blue Shield franchisee.
3. SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
The Company actively manages its cash and cash equivalents position to
maintain optimal asset levels. Cash and cash equivalents include operating cash
and short-term investments with original maturities of three months or less.
These amounts are recorded at cost, which approximates fair value.
INVESTMENTS
Investments are classified as either held-to-maturity or
available-for-sale. Investments that the Company has the intent and ability to
hold to maturity are designated as held-to-maturity and are stated at amortized
cost. All other investments are classified as available-for-sale and are stated
at estimated fair value based on quoted market prices. The net unrealized gain
or loss on investment securities classified as available-for-sale, net of
deferred income taxes, is included in accumulated other comprehensive income
(loss) in shareholders' equity. Realized gains and losses from the sale of
available-for-sale debt and equity securities are calculated using the first-in,
first-out basis.
Investments in affiliates in which the Company does not have control, but
has the ability to exercise significant influence over operating and financial
policies are accounted for by the equity method. The Company's investments in
AMSG common stock and pre-combination UWS common stock (see Note 6) are
accounted for on the equity method.
Investments in debt and equity securities, as well as investment in
affiliates, are reviewed periodically by Company management to determine whether
there is any impairment in the historical cost of the investment 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 the Company's consolidated statement of operations. Effective December
31, 2001, the Company recorded a reduction in the carrying value of its
investment in AMSG (see Note 6).
PREMIUM RECEIVABLES
Premium receivables are stated at net realizable value, net of allowances
for uncollectible amounts of $2,371,000 and $227,000 at December 31, 2001 and
2000, respectively, based upon historical collection trends and management's
best estimate of the ultimate collectibility.
DUE FROM CLINICS AND PROVIDERS
Amounts due from clinics and providers are stated at net realizable value,
net of allowances for uncollectible amounts of $9,124,000 and $846,000 at
December 31, 2001 and 2000, respectively, based upon management's best estimate
of the ultimate collectibility.
F-10
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
OTHER RECEIVABLES
Other receivables are stated at net realizable value, net of allowances for
uncollectible amounts of $3,715,000 and $4,061,000 at December 31, 2001 and
2000, respectively, based upon management's best estimate of the ultimate
collectibility.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method over the estimated
useful lives of the related assets, which is 3 years for computer equipment and
software, 5 to 10 years for furniture and other equipment, 30 years for land
improvements and 10 to 40 years for buildings and building improvements. Any
gain or loss realized upon retirement or disposal is reflected in selling,
general, administrative and other expenses in the Company's consolidated
statement of operations. On an on-going basis, the Company reviews events or
changes in circumstances that may indicate that the carrying value of an asset
may not be recoverable.
GOODWILL
Goodwill represents the excess of the market value over the adjusted book
value for the additional UWS shares purchased by BCBSUW on March 23, 2001 (see
Note 1), along with the excess of cost over the fair value of other businesses
acquired. Goodwill was amortized on a straight-line basis over a weighted
average period of approximately 16 years. Amortization of goodwill was
$5,136,000, $622,000 and $191,000 for the years ended December 31, 2001, 2000
and 1999, respectively. Accumulated amortization was $7,455,000 and $813,000 at
December 31, 2001 and 2000, respectively.
The Company reviews goodwill for impairment annually or sooner if events or
changes in circumstances occur, which may affect the estimated useful life or
the recoverability of the remaining balance of goodwill. At December 31, 2001,
the Company's management believed that no material impairment of goodwill
existed.
DEFERRED ACQUISITION COSTS
Certain costs of acquiring new insurance policies for workers' compensation
and certain individual health products have been deferred. Deferred acquisition
costs of $9,488,000 and $6,930,000 at December 31, 2001 and 2000, respectively,
are included in other noncurrent assets and are being amortized over the
estimated premium-paying periods of the related policies. Acquisition costs of
$4,467,000, $2,661,000 and $2,946,000 were capitalized in 2001, 2000 and 1999,
respectively. Deferred acquisition costs of $3,384,000, $2,289,000 and
$2,092,000 were amortized during 2001, 2000 and 1999, respectively.
In addition to the amortization above during 2000, the Company wrote-off
$2,434,000 of deferred acquisition costs associated with the Medicare+Choice
line-of-business.
MEDICAL AND OTHER BENEFITS
The Company contracts with various health care providers for the provision
of certain medical care services to its members and generally compensates those
providers on a fee-for-service basis or pursuant to certain risk-sharing
arrangements. Medical and other benefits expense also consists of capitation
expenses, health and disability benefit claims and life insurance benefits. In
addition to actual benefits paid, medical and other benefits expense includes
the change in estimates of reported and unreported claims and accrued capitation
fees and adjustments, which are unpaid as of the balance sheet date. The
estimates of reported and unreported claims and accrued capitation fees and
adjustments, which are unpaid as of the balance sheet date, are based on
historical payment patterns using standard actuarial techniques. Processing
costs are accrued as operating expenses based on an estimate of the costs
necessary to process these claims.
F-11
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company's year-end claim liabilities are substantially satisfied
through claim payments in the subsequent year. Any adjustments to prior period
estimates are reflected in the current period. Capitation represents fixed
payments on a per member per month basis to participating physicians, dentists,
other medical specialists and hospital systems as compensation for providing
comprehensive health or dental care services. In addition, certain subsidiaries
have risk-sharing, stop-loss, and bonus arrangements with certain providers.
Estimated settlements relating to these arrangements are developed based on
historical payment patterns using standard actuarial techniques. The portion of
medical and other benefits payable pertaining to long-term disability, workers'
compensation and certain life insurance products, which is estimated to be paid
more than one year from the balance sheet date, is included as other benefits
payable on the accompanying consolidated balance sheets.
PREMIUM DEFICIENCY RESERVES
Premium deficiency reserves ("PDR") are recognized when it is probable that
the future costs associated with a group of existing contracts will exceed the
anticipated future premiums on those contracts. For purposes of determining
whether a premium deficiency exists, contracts are grouped in a manner
consistent with the Company's method of acquiring, servicing and measuring
profitability of such contracts. The Company calculates expected PDR based on
budgeted revenues and applicable expenses excluding investment income.
As a result of management's assessment of the profitability of its
Medicare+Choice line of business, during the third quarter of 2000 the Company
recorded a provision for probable future losses (premium deficiency). At
December 31, 2000, $3,617,000 is included in medical and other benefits payable
as a PDR for this line of business. As of December 31, 2001, there was no PDR
needed as a result of the Company exiting this business effective January 1,
2002. The provision for probable future losses is calculated based on a
comparison of anticipated premiums to health care related costs, including
estimated payments for providers, commissions and the cost of collecting
premiums and processing claims. Inadequate compensation from the Centers for
Medicare and Medicaid Services and increased medical benefits contributed to the
requirement for a provision for future losses.
POSTRETIREMENT/POSTEMPLOYMENT BENEFITS
Pension costs are accrued and are funded based on the minimum contribution
requirements of the Employee Retirement Income Security Act of 1974. The
actuarial cost method used is the projected unit credit method. The Company also
provides certain health and life insurance benefits to retired employees.
The Company accrues disability related postemployment benefits when it
becomes probable that such benefits will be paid and when sufficient information
exists to make reasonable estimates of the amounts to be paid.
REVENUE RECOGNITION
Health services premiums are recognized as revenue in the period in which
enrollees are entitled to care. Managed care consulting revenues are generally
recognized when services are rendered. Case management revenues are recognized
when services are billed. Receivables management revenues are recognized when
cash is received.
As a fiscal intermediary for Medicare, the Company is reimbursed for
administrative costs incurred in providing this service. In addition, the
Company also administers various uninsured programs sponsored by the federal and
state government (including State of Wisconsin Medicaid as a subcontractor) and
private corporations, for which the Company receives administrative fees. These
revenues are recognized as the services are performed.
Retrospective premium adjustments are recognized for certain groups for
which actual claims experience differs from that which was anticipated when the
related premium rates were established. Financial arrangements vary based upon
the group and line of insurance involved. The amount of premium that was subject
to retrospective premium adjustments in 2001, 2000 and 1999, was $14,365,000,
$16,441,000 and $35,179,000, respectively.
F-12
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
INCOME TAXES
Deferred tax assets and liabilities are recognized for the estimated future
tax consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and tax credit carryforwards. Deferred tax assets and liabilities are
measured using tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date. A valuation
allowance is recorded on deferred tax assets when management determines that it
would be "more likely than not" that the tax benefit of the federal and state
net operating loss ("NOL") carryovers would not be realized prior to their
expiration.
SELF-FUNDED BUSINESS
Administrative expenses include costs associated with maintenance of
membership records, claim processing and payment, coordination of benefits,
billing/cash collection and other services on self-funded business. The Company
is reimbursed for claims paid and a fee is received for the administrative costs
associated with providing these services. Benefits paid on self-funded programs
were $561,194,000, $522,566,000 and $527,987,000 in 2001, 2000 and 1999,
respectively, are excluded from the accompanying statements of operations.
Administrative fees received related to these programs totaled $28,067,000,
$24,716,000 and $25,970,000 in 2001, 2000 and 1999, respectively, and are
included in other revenue in the accompanying consolidated statements of
operations.
EARNINGS PER SHARE
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
---------------------------------
2001 2000 1999
----------- -------- --------
Numerator (in thousands):
Loss from continuing operations........................... $ (23,256) $(40,013) $(42,747)
Income from discontinued operations....................... 951 -- --
----------- -------- --------
Net loss............................................... $ (22,305) $(40,013) $(42,747)
=========== ======== ========
Denominator:
Denominator for basic EPS -- weighted average shares...... 38,434,459
Effect of dilutive securities -- employee stock options... --
-----------
Denominator for diluted EPS............................ 38,434,459
===========
Earnings (loss) per common share:
Basic & diluted from continuing operations................ $ (0.61)
Basic & diluted from discontinued operations.............. 0.03
-----------
Total basic & diluted.................................. $ (0.58)
===========
</Table>
Basic EPS excludes dilution and is computed by dividing income available to
common shareholders by the weighted average number of common shares outstanding
during the period. Diluted EPS reflects the potential dilution that could occur
if all stock options were exercised and converted into common stock. When the
Company reports a net loss, stock options are not included in the calculation of
EPS because their inclusion would have an antidilutive effect. EPS for the year
ended December 31, 2001 was calculated based on 38,434,459 weighted average
shares outstanding, which assumes that the 31,313,390 of newly issued shares to
the Foundation were outstanding for the entire three months ended March 31,
2001. EPS was not presented for the years ended December 31, 2000 and 1999
because the Company was a service insurance corporation.
F-13
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
USE OF ESTIMATES
The accompanying consolidated financial statements have been prepared in
accordance with GAAP, which requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued FASB
Statement #142, "Goodwill and Other Intangibles". Under this statement, the
Company must review the goodwill recorded on its balance sheet and the impact of
the statement on the carrying value of its investment in AMSG for impairment
based on a two-step process described in the statement. The first step is a
screen for potential impairment, while the second step measures the amount of
impairment, if any, based on fair value. In addition, the statement requires the
discontinuance of goodwill amortization upon adoption (January 1, 2002).
Although management believes that based on its review of the impact of adopting
this standard, no significant impairment charge is expected related to goodwill
recorded on its balance sheet or the carrying value of its investment in AMSG,
this analysis has not yet been completed. In addition, discontinuance of
goodwill amortization, excluding its investment in AMSG, is estimated to reduce
expense on the Company's consolidated statement of operations by approximately
$7.6 million annually in future years.
The following table illustrates net income (loss) and net income (loss) per
share adjusted to exclude the effects of goodwill amortization, as if the
Company had been following the accounting method described in FASB Statement
#142:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
------------------------------
2001 2000 1999
-------- -------- --------
(IN THOUSANDS, EXCEPT SHARE
AND PER SHARE DATA)
Reported net loss........................................... $(22,305) $(40,013) $(42,747)
Add back: Goodwill amortization, net of tax................. 5,136 622 191
-------- -------- --------
Adjusted net loss........................................... $(17,169) $(39,391) $(42,556)
======== ======== ========
Basic earnings (loss) per common share:
Reported net loss......................................... $ (0.58)
Goodwill amortization, net of tax......................... 0.13
--------
Adjusted net loss......................................... $ (0.45)
========
Diluted earnings (loss) per common share:
Reported net loss......................................... $ (0.58)
Goodwill amortization, net of tax......................... 0.13
--------
Adjusted net loss......................................... $ (0.45)
========
</Table>
In August 2001, the FASB issued FASB Statement #144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". This statement, effective for the
Company on January 1, 2002, amends existing guidance relating to the accounting
and reporting of impairments or disposals of long-lived assets. Management
believes that based on its review of the impact of adopting this standard, there
is no significant impact on the carrying values of existing long-lived assets as
of December 31, 2001. In addition, this statement modifies existing guidance
governing the accounting for dispositions of company assets as discontinued
operations in the statement of operations.
F-14
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
RECLASSIFICATIONS
Certain reclassifications have been made to the consolidated financial
statements for 2000 and 1999 to conform to the 2001 presentation and to report
discontinued operations (see Note 20).
4. MEDICAL AND OTHER BENEFITS PAYABLE
A summary of the activity for medical and other benefits payable net of
reinsurance for 2001, 2000 and 1999 is as follows:
<Table>
<Caption>
2001 2000 1999
---------- -------- -------
(IN THOUSANDS)
Net medical and other benefits payable at beginning of
year...................................................... $ 104,415 $ 75,637 $81,798
Net medical and other benefits payable assumed from UWS
through the Combination................................... 141,617 -- --
Incurred related to:
Current year.............................................. 1,129,768 505,597 375,750
Prior years............................................... 10,550) (7,775) 1,064
---------- -------- -------
Total incurred.............................................. 1,119,218 497,822 376,814
Paid related to:
Current year.............................................. 943,887 411,973 310,553
Prior years............................................... 183,037 57,071 72,422
---------- -------- -------
Total paid.................................................. 1,126,924 469,044 382,975
---------- -------- -------
Net medical and other benefits payable at end of year....... $ 238,326 $104,415 $75,637
========== ======== =======
</Table>
The net medical and other benefits payable above excludes reinsured
reserves of $28,994,000 as of December 31, 2001, of which $23,284,000 was
assumed from UWS through the Combination. Reinsured reserves are classified as
assets on the balance sheet. There were no reinsured reserve balances as of
December 31, 2000 and 1999. Incurred and paid claims for 2001, related to prior
years, include claims incurred prior to 2001 for BCBSUW and claims incurred
prior to March 31, 2001 for the former UWS companies. A portion of the reserves
for disability claims have been discounted on a tabular basis using the 1987 CDT
Table at 7% and 6.5% and waiver of premium claims have been discounted on a
tabular basis using the 1970 Intercompany Group Life Valuation Table at 7%. The
December 31, 2001 loss reserves include $12,667,000 of such discounted reserves.
The amount of discount for case reserves is $4,446,000 at December 31, 2001.
The Company uses paid claims and completion factors based on historical
payment patterns to estimate incurred claims. Changes in payment patterns and
claims trends can result in changes to prior years' claims estimates.
F-15
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. INVESTMENTS
Investment results consist of the following:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------
2001 2000 1999
------- ------ -------
(IN THOUSANDS)
Interest on fixed maturities................................ $ 8,514 $2,729 $ 4,171
Dividends on equity securities.............................. 474 775 697
Realized gains.............................................. 2,990 638 10,393
Realized losses............................................. (2,145) (1,147) (2,379)
Interest on cash equivalents and other investment income.... 1,628 100 78
------- ------ -------
Gross investment results.................................... 11,461 3,095 12,960
Investment expenses......................................... (879) (229) (245)
Interest income from affiliates............................. 1,273 5,494 4,804
Other investment income..................................... 627 1,223 991
------- ------ -------
$12,482 $9,583 $18,510
======= ====== =======
</Table>
Proceeds from sales of equity securities during 2001, 2000 and 1999 were
$10,571,000, $6,134,000 and $43,096,000, respectively. Proceeds from sales of
fixed maturities classified as available-for-sale during 2001, 2000 and 1999,
excluding maturities, were $133,193,000, $19,652,000 and $82,529,000,
respectively.
Unrealized gains (losses) are computed as the difference between estimated
fair value and amortized cost for fixed maturities classified as
available-for-sale or cost for equity securities. A summary of the net change in
unrealized gains/losses, less deferred income taxes, which is included in
accumulated other comprehensive income (loss), is as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------
2001 2000 1999
------ ------ --------
(IN THOUSANDS)
Fixed maturities............................................ $ (11) $1,577 $ (3,392)
Equity securities........................................... (250) (716) (3,990)
Deferred income tax benefit (expense)....................... (77) (302) 2,878
Unrealized gain (losses) of affiliates...................... 2,937 3,683 (6,610)
------ ------ --------
$2,599 $4,242 $(11,114)
====== ====== ========
</Table>
F-16
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The amortized cost, gross unrealized gains (losses) and estimated fair
values of investments are as follows:
<Table>
<Caption>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUES
--------- ---------- ---------- -----------
(IN THOUSANDS)
At December 31, 2001:
Available-for-sale:
Fixed maturity:
U.S. Treasury securities..................... $ 23,088 $ 193 $ (394) $ 22,887
State and municipal securities............... 100 2 -- 102
Foreign securities........................... 7,336 135 (151) 7,320
Corporate debt securities.................... 84,857 1,373 (771) 85,459
Mortgage-backed securities................... 51,818 426 (818) 51,426
-------- ------ ------- --------
167,199 2,129 (2,134) 167,194
Equity securities:
Mutual funds-fixed income.................... 9,839 31 -- 9,870
Common and preferred stock................... 3,760 11 (143) 3,628
-------- ------ ------- --------
13,599 42 (143) 13,498
-------- ------ ------- --------
180,798 2,171 (2,277) 180,692
Held-to-maturity:
U.S. Treasury securities....................... 11,007 392 (2) 11,397
-------- ------ ------- --------
$191,805 $2,563 $(2,279) $192,089
======== ====== ======= ========
</Table>
<Table>
<Caption>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUES
--------- ---------- ---------- -----------
(IN THOUSANDS)
At December 31, 2000:
Available-for-sale:
Fixed maturity:
U.S. Treasury securities..................... $ 5,188 $105 $ -- $ 5,293
Foreign government securities................ 2,655 9 (25) 2,639
Corporate debt securities.................... 11,321 84 (395) 11,010
Mortgage-backed securities................... 10,788 230 (2) 11,016
------- ---- ----- -------
29,952 428 (422) 29,958
Equity securities:
Mutual funds-fixed income.................... 6,269 60 (2) 6,327
Common and preferred stock................... 7,997 119 (28) 8,088
------- ---- ----- -------
14,266 179 (30) 14,415
------- ---- ----- -------
$44,218 $607 $(452) $44,373
======= ==== ===== =======
</Table>
F-17
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The amortized cost and estimated fair values of debt securities at December
31, 2001, by contractual maturity, are shown below. Expected maturities may
differ from contractual maturities because borrowers may have the right to call
or prepay obligations.
<Table>
<Caption>
AMORTIZED ESTIMATED
COST FAIR VALUES
--------- -----------
(IN THOUSANDS)
Available-for-sale:
Due in one year or less................................... $ 1,383 $ 1,443
Due after one through five years.......................... 49,881 50,431
Due after five through ten years.......................... 42,375 42,184
Due after ten years....................................... 21,742 21,710
-------- --------
115,381 115,768
Mortgage-backed securities................................ 51,818 51,426
-------- --------
$167,199 $167,194
======== ========
Held-to-maturity:
Due in one year or less................................... $ 4,734 $ 4,851
Due after one through five years.......................... 6,273 6,546
-------- --------
$ 11,007 $ 11,397
======== ========
</Table>
At December 31, 2001, approximately $17,000,000 of invested assets, which
are classified as available-for-sale, are maintained under an escrow agreement
with the BCA and the insurance subsidiaries had debt securities on deposit with
various state insurance departments with carrying values of approximately
$10,834,000, which are classified as investments held-to-maturity on the
consolidated balance sheets.
The Company participates in securities lending programs whereby blocks of
securities, which are returnable to the Company on short-term notice and are
included in investments, are loaned to third parties, primarily major brokerage
firms. The Company requires a minimum of 102% of the fair value of the loaned
securities to be separately maintained as collateral for the loans. Securities
with a cost or amortized cost of $11,269,000 and $3,782,000 and estimated fair
value of $11,409,000 and $3,866,000 were on loan under the programs at December
31, 2001 and 2000, respectively.
6. INVESTMENT IN AFFILIATES
Investment in affiliates for 2001 consists of the Company's investment in
AMSG, a leading provider of small group PPO products and life products.
Investment in affiliates for 2000 and 1999 consisted of the Company's investment
in both AMSG and UWS.
INVESTMENT IN AMSG
The Company owned 6,309,525 shares, which represented approximately 45% and
44% of total AMSG shares outstanding at December 31, 2001 and 2000,
respectively. The Company's recorded investment in AMSG was $78,554,000 and
$97,788,000 at December 31, 2001 and 2000, respectively.
At December 31, 2001, the market value of AMSG stock was $12.45 per share.
Under equity accounting, the Company's portion of AMSG's income (losses) were
$1,919,000, $1,078,000 and $(9,979,000) in 2001, 2000 and 1999, respectively.
Included in gain (loss) from investment in affiliates in the Company's
consolidated statement of operations for the year ended December 31, 2001, is a
loss of $25,163,000 relating to a writedown of the Company's investment in AMSG
to market value 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 of the Company in December, 2001.
F-18
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
AMSG repurchased 367,262, 1,261,870 and 1,121,500 shares of its outstanding
common stock, at cost, aggregating $2,216,000, $8,292,000 and $7,488,000 in
2001, 2000 and 1999, respectively. The impact of this repurchase on the
Company's investment in the net assets of affiliates is reported on the change
in ownership of affiliates line of the Company's Consolidated Statements of
Changes in Shareholder's Equity and Comprehensive Income (Loss). AMSG's
repurchase of common stock increased the Company's ownership in AMSG by
approximately 1%, 3% and 3% in 2001, 2000 and 1999, respectively.
Summarized financial information for AMSG is as follows:
CONDENSED AMSG CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31,
-------------------
2001 2000
-------- --------
(IN THOUSANDS)
Total assets................................................ $473,015 $471,923
======== ========
Total liabilities........................................... $243,615 $250,746
Shareholders' equity........................................ 229,400 221,177
-------- --------
Total liabilities and shareholders' equity................ $473,015 $471,923
======== ========
</Table>
Included in AMSG's total assets were $103,934,000 and $107,562,000 of
goodwill and other intangible assets as of December 31, 2001 and 2000,
respectively.
CONDENSED AMSG CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------------
2001 2000 1999
-------- -------- ----------
(IN THOUSANDS)
Health services revenues:
Premium revenue........................................... $838,672 $951,071 $1,056,107
Other revenue............................................. 21,285 20,112 22,361
Investment results.......................................... 16,664 18,682 18,912
-------- -------- ----------
Total revenues.............................................. 876,621 989,865 1,097,380
Expenses:
Medical and other benefits................................ 601,942 724,613 860,473
Selling, general and administrative....................... 257,742 251,767 268,059
Interest.................................................. 2,877 3,584 3,564
Amortization of goodwill and intangibles.................. 3,628 3,785 4,273
-------- -------- ----------
Total expenses.............................................. 866,189 983,749 1,136,369
Pretax income (loss)........................................ 10,432 6,116 (38,989)
Income tax expense (benefit)................................ 6,257 3,447 (13,043)
-------- -------- ----------
Net income (loss)........................................... $ 4,175 $ 2,669 $ (25,946)
======== ======== ==========
</Table>
The accounting policies of AMSG are consistent with those of the Company.
F-19
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
INVESTMENT IN UWS
The Company owned approximately 47% of the total UWS shares outstanding as
of December 31, 2000 and prior to the Combination (see Note 1).
Summarized financial information for UWS is as follows:
CONDENSED UWS CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
DECEMBER 31,
2000
--------------
(IN THOUSANDS)
Current assets.............................................. $251,230
Noncurrent assets........................................... 98,745
Assets from discontinued operations......................... 15,851
--------
Total assets.............................................. $365,826
========
Current liabilities......................................... $226,183
Noncurrent liabilities...................................... 118,078
Liabilities from discontinued operations.................... 4,792
Shareholders' equity........................................ 16,773
--------
Total liabilities and shareholders' equity................ $365,826
========
</Table>
CONDENSED UWS CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
THREE MONTH YEARS ENDED
PERIOD ENDED DECEMBER 31,
MARCH 31, -------------------
2001 2000 1999
------------ -------- --------
(IN THOUSANDS)
Revenues:
Health services revenues:
Premium revenue........................................... $219,164 $753,095 $651,938
Other revenue............................................. 5,961 21,638 14,439
Investment results.......................................... 2,757 8,119 11,289
-------- -------- --------
Total revenues.............................................. 227,882 782,852 677,666
-------- -------- --------
Expenses:
Medical and other benefits................................ 194,207 697,871 622,986
Selling, general, administrative and other................ 29,810 107,945 98,839
Interest.................................................. 1,521 6,500 5,293
Amortization of goodwill.................................. 190 470 565
-------- -------- --------
Total expenses.............................................. 225,728 812,786 727,683
-------- -------- --------
Operating loss from continuing operations................... 2,154 (29,934) (50,017)
Loss from investment in affiliate, net of tax............... -- (312) --
-------- -------- --------
Pretax loss................................................. 2,154 (30,246) (50,017)
Income tax benefit.......................................... 1,395 (12,037) (19,181)
-------- -------- --------
Loss from continuing operations............................. 759 (18,209) (30,836)
Income from discontinued operations, net of tax............. 171 1,781 1,832
-------- -------- --------
Net loss.................................................... $ 930 $(16,428) $(29,004)
======== ======== ========
</Table>
F-20
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. PROVIDER ARRANGEMENTS
The Company is a party to certain provider arrangements in conjunction with
Unity and Valley, which include profit-sharing payments to certain providers and
repurchase provisions. Management believes that control of Unity and Valley is
not temporary because exercise of the repurchase options is not probable. Any
repurchase would not provide a substantial economic benefit to the option
holders and would require regulatory approval pursuant to change of control
regulations.
Under the terms of the Valley purchase and sale agreement, as amended, the
seller retained an option to repurchase all of the capital stock of Valley as of
December 31, 2002, at a price equal to Valley's net assets plus $400,000.
Pursuant to the terms of the Unity purchase agreements, as amended, the
sellers retained options to repurchase the net assets of the acquired companies
as of December 31, 2004. These agreements provide for an extension through
December 31, 2009. One seller has the option to repurchase a portion of Unity's
business for $500,000 plus the proportionate share of the net worth of such
business less any unpaid amount of the maximum annual performance bonuses. The
maximum annual performance bonuses are limited to $650,000 in total, in which
$125,000 has been accrued for during 2001. The other seller has the option to
repurchase the remainder of the Unity business (as well as the legal entity) at
a price equal to the net assets of such business.
Total revenues subject to repurchase options, pursuant to the various
acquisition agreements, were $191,605,000 for 2001. Profit sharing expenses
related to these provider arrangements is calculated based on the profitability
of the respective HMO subsidiary and totaled $402,000 in 2001. Net income
subject to repurchase options, pursuant to those provider arrangements, totaled
$4,188,000 for 2001. Total assets and total net assets subject to repurchase
options were $66,905,000 and $24,224,000, respectively, at December 31, 2001.
The Company had no business subject to repurchase options for the periods prior
to 2001.
8. PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation and
are summarized as follows:
<Table>
<Caption>
DECEMBER 31,
-------------------
2001 2000
-------- --------
(IN THOUSANDS)
Land and land improvements.................................. $ 1,316 $ 909
Building and building improvements.......................... 11,351 7,056
Computer equipment and software............................. 48,875 33,802
Furniture and other equipment............................... 21,646 19,309
-------- --------
83,188 61,076
Less accumulated depreciation............................... (51,777) (35,937)
-------- --------
$ 31,411 $ 25,139
======== ========
</Table>
Depreciation expense related to property and equipment totaled $9,800,000,
$6,278,000 and $6,791,000 in 2001, 2000 and 1999, respectively.
During 1999, the Company recorded a non-cash pre-tax charge of $2,398,000
to reduce the carrying amount of certain computer software costs. This charge is
included in selling, general, administrative and other expense in the
accompanying consolidated statements of operations and is allocated between the
insured and self-funded segments. These costs were associated with the data
warehouse that had been written off by the Company where the carrying value
exceeded the value of the functionality.
F-21
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. REINSURANCE
Certain premiums and benefits are assumed from and ceded to other insurance
companies under various reinsurance agreements. The ceded reinsurance agreements
provide the Company with increased capacity to write larger risks and maintain
its exposure to loss within its capital resources. The ceding company is
contingently liable on reinsurance ceded in the event that the reinsurers do not
meet their contractual obligations.
Amounts assumed from and ceded to other insurance companies are summarized
as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-------------------------
2001 2000 1999
------- ------ ------
(IN THOUSANDS)
Reinsurance assumed:
Insurance premiums........................................ $20,438 $3,497 $1,843
Medical and other benefits................................ 13,889 2,543 2,173
Reinsurance ceded:
Insurance premiums........................................ $17,649 $ 429 $ 233
Medical and other benefits................................ 12,933 116 272
</Table>
Reinsurance contracts are accounted for in a manner consistent with the
underlying business.
The Company has reinsurance recoverable amounts outstanding of $35,506,000
and $112,000 as of December 31, 2001 and 2000, respectively. These balances are
included in other current and other noncurrent assets based on the expected
settlements.
The Company employs quota share and excess of loss reinsurance with third
party reinsurers as follows:
<Table>
<Caption>
QUOTA SHARE CEDING PERCENTAGE
- ----------- -----------------
Workers' Compensation:
Wisconsin....................................... 20% pre July 1, 2001, 35% effective July 1, 2001
Illinois........................................ 60%
</Table>
<Table>
<Caption>
EXCESS OF LOSS RETENTION
- -------------- ---------
Workers' Compensation......................... $250,000
Life.......................................... 75,000
Long-term disability.......................... 75,000 on claims incurred prior to October 1, 2001
3,500 monthly benefit on claims incurred after
October 1, 2001
Medical:
Valley...................................... 150,000
Unity....................................... 225,000
Compcare.................................... 300,000
BCBSUW...................................... 500,000
</Table>
10. DEBT
The Company has a bank line-of-credit ("LOC"), which permits aggregate
borrowings among certain subsidiaries, excluding the corporate holding company
and Compcare, up to $20,000,000. The LOC has an adjustable rate with interest
payments due monthly. The Company pledged 2,000,000 shares of AMSG common stock
as collateral for this LOC. The outstanding LOC balance was $7,850,000 and $0 as
of December 31, 2001 and 2000, respectively. The interest expense on the LOC was
$560,000, $300,000 and $553,000 in 2001, 2000 and 1999,
F-22
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
respectively. The weighted average interest rate on the LOC was 3.90% and 8.10%
in 2001 and 2000, respectively. In addition, on December 31, 2001, the Company
originated a term business note ("term note") for the corporate holding company
with a commercial bank for $7,500,000. The term note had an adjustable rate of
interest with payment of principal and interest due February 15, 2002. The term
note has been extended and renegotiated, with payment of principal and interest
due in quarterly installments beginning June 30, 2002 and ending June 30, 2003.
Interest is calculated at a rate equal to the London Interbank Offered Rate plus
1.5%, adjusted monthly. The current portion of the term note totaling $4,500,000
has been classified in short-term debt on the accompanying consolidated balance
sheet as of December 31, 2001. The remaining $3,000,000 balance is classified in
other noncurrent liabilities.
11. RELATED-PARTY TRANSACTIONS
As of September 11, 1998, UWS entered into a $70,000,000 note obligation
due to BCBSUW in connection with the spin-off in 1998 of AMSG's managed care
companies and specialty business. UWS pledged the common stock of Compcare as
collateral for the note obligation. Interest is 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. The terms and extension of the note are subject to approval by the OCI.
As a result of the Combination, this intra-company note and related accrued
interest is eliminated in the accompanying consolidated balance sheet as of
December 31, 2001. As of December 31, 2000, this note is classified in other
noncurrent assets. Interest income received totaled $5,494,000 and $4,804,000 in
2000 and 1999, respectively. Interest income of $1,339,000 received prior to
Combination in 2001 is included in the accompanying consolidated statement of
operations. Interest income subsequent to March 31, 2001 has been eliminated in
the consolidated statement of operations.
The Company has an agreement with United Wisconsin Life Insurance Company
("UWLIC"), a subsidiary of AMSG, whereby UWLIC underwrites certain life and
disability products on behalf of UHLIC, a wholly-owned subsidiary of the
Company. The Company assumes 100% of the premium revenues on these products from
UWLIC. The assumed premium revenue approximated $15,065,000 in 2001.
The Company and Health Care Service Corporation (the parent corporation of
BlueCross BlueShield of Illinois) each own a 50% interest in United Heartland of
Illinois, Inc. ("UHIL"). Premium receivable related to UHIL is reported in Due
from Affiliates.
12. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. Separate state income tax returns are filed by each subsidiary, except
IRG, MRC, UGS and CC Holdings, which are limited liability corporations and
considered disregarded entities for tax purposes.
The Company had net federal income tax receivables of $10,314,000 and
$11,576,000 at December 31, 2001 and 2000, respectively, included in prepaid
expenses and other current assets. Included in these amounts is a payment of
$11,576,000 made by the Company to the Internal Revenue Service ("IRS") relating
to pending audit adjustments for ongoing examinations. This payment was made to
close the 1987 through 1992 tax years to further assessment of tax. The Company
anticipates full recovery of the prepayment upon resolution of the disputed
adjustments.
The Company's federal income tax years 1984, 1986 through 2001 (excluding
1990) were open at December 31, 2001.
The Company has federal NOL carryforwards totaling $140,969,000 which
expire in the years 2011 through 2020, and alternative minimum tax ("AMT") NOL
carryforwards totaling $119,938,000. The Company has state net
F-23
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
business loss carryforwards totaling $254,879,000 at December 31, 2001, which
expire in the years 2002 through 2015. The Company had federal and state income
tax payments (refunds) net of $368,000, ($194,000) and ($275,000) in 2001 2000
and 1999, respectively. The Company's federal income tax returns are routinely
audited by the IRS. In management's opinion, adequate tax liabilities have been
established for all open audit years.
The components of federal income tax expense (benefit) are as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
-------------------------
2001 2000 1999
-------- ----- ------
(IN THOUSANDS)
Current:
Federal................................................... $(2,359) $ -- $ --
State..................................................... 130 -- --
------- ---- -----
(2,229) -- --
Deferred:
Federal................................................... 183 548 --
State..................................................... 175 -- --
------- ---- -----
358 548 --
------- ---- -----
Total..................................................... $(1,871) $548 $ --
======= ==== =====
</Table>
The differences between taxes computed at the federal statutory rate and
recorded income taxes are as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
----------------------------
2001 2000 1999
------- -------- -------
(IN THOUSANDS)
Tax applicable to operating loss at federal statutory
rate...................................................... $ (895) $(11,529) $(7,020)
Valuation allowance......................................... -- 14,877 18,608
Goodwill amortization....................................... 1,436 218 67
Use of NOL carryover from prior years....................... (1,495) -- --
State income and franchise taxes, net of federal benefit.... 198 (2,602) (1,585)
Reversal of accrued taxes................................... (1,453) -- --
Adjustments to conform to prior year tax return as filed.... 250 -- (8,600)
Meals, entertainment and dues............................... 144 158 160
Spin-off expenses........................................... 78 -- --
Other, net.................................................. (134) (574) (1,630)
------- -------- -------
$(1,871) $ 548 $ --
======= ======== =======
</Table>
Tax benefits resulting from temporary differences, including NOL's are
required to be recorded as assets to the extent that management believes it is
"more likely than not" that such tax benefits will be realized. A full valuation
allowance was recorded at the date of the Combination for the net deferred tax
assets of UWS, based upon the Company's history of losses and changes in tax
planning strategies post combination. This valuation allowance increased
goodwill by $21,651,000 at the time of the Combination. When management
determines that it is "more likely than not" that the tax benefit of the federal
and state NOL carryovers will be realized prior to their expiration, the
valuation allowance will be reduced. Any reduction of the valuation allowance
recorded at the time of the Combination will be recorded as a reduction to
goodwill. All other reductions to valuation allowances recorded by the Company
will be recorded to income upon reversal.
F-24
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Significant components of the Company's federal and state deferred tax
liabilities and assets are as follows:
<Table>
<Caption>
DECEMBER 31, 2001 DECEMBER 31, 2000
------------------- -------------------
FEDERAL STATE FEDERAL STATE
-------- -------- -------- --------
(IN THOUSANDS)
Deferred tax liabilities:
Claims-based receivables.......................... $ (2,476) $ (427) $ (700) $ (158)
Pension accrual................................... (17,950) (4,027) (12,937) (2,920)
Deferred acquisition costs........................ (2,567) (579) (2,425) (547)
Interest expense.................................. (1,555) (351) (1,555) (351)
Federal effect of state taxes..................... (1,838) -- -- --
AMSG basis difference............................. (3,202) (5,209) -- --
Prepaid expenses.................................. (3,515) (748) -- --
Other, net........................................ (1,089) (169) (308) (70)
-------- -------- -------- --------
(34,192) (11,510) (17,925) (4,046)
Deferred tax assets:
Postretirement benefits other than pensions....... 5,257 1,179 4,453 1,005
Deferred gain on sale of building................. 822 186 1,005 227
Employee benefits................................. 6,886 1,538 4,213 951
Medical and other benefits payable discounting.... 4,080 740 1,691 382
Net operating loss and other carryforwards........ 49,794 20,183 33,848 12,458
Bad debt reserve allowance........................ 2,784 626 1,797 406
Premium deficiency reserve........................ -- -- 1,266 285
AMT credit........................................ 2,963 -- 2,963 --
Advance premium discounting....................... 5,424 1,132 -- --
Other, net........................................ 2,362 478 1,372 310
Valuation allowance............................... (46,180) (14,552) (34,717) (11,985)
-------- -------- -------- --------
34,192 11,510 17,891 4,039
-------- -------- -------- --------
Net deferred tax assets (liabilities)............... $ -- $ -- $ (34) $ (7)
======== ======== ======== ========
</Table>
The federal deferred benefit arising from the deductibility of state
deferred tax is included as a component of other federal deferred taxes. The net
deferred tax assets and liabilities are included in other current or other
noncurrent assets and liabilities, as applicable.
13. GOVERNMENT CONTRACTS
The Company, through UGS, serves as a fiscal intermediary for Medicare and
various other government programs. Claims processed and administrative fees
received related to these services were as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------------------
2001 2000 1999
----------- ----------- ----------
(IN THOUSANDS)
Number of claims processed.............................. 47,140 36,320 27,740
Amount of claims paid................................... $25,255,210 $13,194,510 $9,894,850
Administrative fees received............................ $ 117,192 $ 70,305 $ 52,259
</Table>
F-25
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As a fiscal intermediary for various government programs, the Company is
subject to regulations covering allowable cost reimbursements and operating
procedures. The laws and regulations governing fiscal intermediaries are complex
and subject to interpretation. The Company believes that it is in compliance
with all applicable laws and regulations and is not aware of any pending or
threatened investigations involving allegations of potential wrongdoing. While
no such regulatory inquiries have been made, compliance with such laws and
regulations can be subject to future government review and interpretation, as
well as significant regulatory actions including fines in excess of fees
received, significant penalties and exclusions from being a government
contractor for these programs.
14. COMMITMENTS AND CONTINGENCIES
LONG-TERM CONTRACT
On October 1, 1998, the Company entered into an agreement with a service
bureau to obtain certain electronic data processing services for the Company.
The agreement had an initial term of five years, with options for two additional
one-year renewal periods which have been exercised. Expenses to this service
bureau were $13,405,000, $14,986,000 and $13,945,000 in 2001, 2000 and 1999,
respectively.
OPERATING LEASES
The Company has operating leases for office space, EDP equipment,
automobiles, software and terminal lines. Future minimum lease payments under
noncancelable operating leases with initial or remaining lease terms in excess
of one year at December 31, 2001 were $38,492,000 in total. Annually, the lease
payments are $9,094,000, $8,627,000, $7,677,000, $5,457,000, $3,448,000 and
$4,189,000 in 2002, 2003, 2004, 2005, 2006 and thereafter, respectively. Rental
expense totaled $13,835,000, $9,538,000 and $13,404,000 in 2001, 2000 and 1999,
respectively.
EXTENSION OF CREDIT
The Company has an outstanding revolving line-of-credit in the amount of
$15,000,000 available to Health Professionals of Wisconsin, Inc., which
originated in 1997. Interest is accrued based on the quarterly prime rate, with
interest payments due annually on November 1. Interest income amounted to
$308,000 and $451,000 for 2001 and 2000, respectively. The outstanding balance
as of December 31, 2001 and 2000 was $3,000,000 and $4,628,000, respectively.
LITIGATION
The Company is involved in various legal actions occurring in the normal
course of business. In the opinion of management, adequate provision has been
made for losses which may result from these actions and, accordingly, the
outcome of these proceedings is not expected to have a material adverse effect
on the consolidated financial statements.
RISKS AND UNCERTAINTIES
The Company's profitability depends in large part on accurately predicting
and effectively managing health care costs. The Company continually reviews its
premium and benefit structure to reflect its underlying claims experience and
revised actuarial data; however, several factors could adversely affect the
medical cost ratios. Certain of these factors, which include changes in health
care practices, inflation, new technologies, major epidemics, natural disasters
and malpractice litigation, are beyond any health plan's control and could
adversely affect the Company's ability to accurately predict and effectively
control health care costs. Costs in excess of those anticipated could have a
material adverse effect on the Company's results of operations.
F-26
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. SHAREHOLDERS' EQUITY
STATUTORY FINANCIAL INFORMATION (UNAUDITED)
The Company's insurance subsidiaries are required to file financial
statements with the OCI and other state insurance regulators. Such financial
statements are prepared in accordance with statutory accounting practices
("SAP") prescribed or permitted by the OCI, which differ from GAAP under which
the accompanying consolidated financial statements are prepared. Codification
promulgated by the National Association of Insurance Commissioners ("NAIC") and
adopted by the OCI, took effect on January 1, 2001. Codification impacts the
calculation of statutory surplus for the Company's insurance subsidiaries. The
impact varies by subsidiary with the most significant changes in surplus
resulting from the treatment of deferred tax assets and health care and pharmacy
rebate receivables. The 2001 statutory financial statements reflect a reduction
in statutory surplus of $21,188,000 as a result of implementation of
codification. The Company has taken certain actions including the reallocation
of capital to mitigate the impact of Codification on its insurance subsidiaries.
Significant differences between SAP and GAAP include certain valuations of
investments, calculations of discounted claim reserves, non-recognition of
certain assets (primarily health-care receivables, premium receivables greater
than 90 days, property and equipment and certain intercompany receivable
balances), and recognition of deferred income tax assets based on criteria which
vary from GAAP. While the OCI has the authority to permit insurers to deviate
from prescribed SAP, none of the Company's insurance subsidiaries subject to
oversight by the OCI have received approval to adopt any such practices.
Selected statutory information by insurance subsidiary is as follows:
<Table>
<Caption>
BCBSUW COMPCARE UNITY VALLEY UWIC UHLIC
-------- -------- ------- ------- ------- -------
(IN THOUSANDS)
Intercompany Receivables........... $ 86,701 $ -- $ -- $ -- $22,581 $ 45
Other Admitted Assets.............. 159,988 161,289 43,062 18,848 54,804 38,976
-------- -------- ------- ------- ------- -------
Total Admitted Assets.............. $246,689 $161,289 $43,062 $18,848 $77,385 $39,021
======== ======== ======= ======= ======= =======
Liabilities........................ $158,712 $100,452 $29,111 $11,084 $36,016 $29,174
======== ======== ======= ======= ======= =======
Statutory Surplus.................. $ 87,977 $ 60,837 $13,951 $ 7,764 $41,369 $ 9,847
======== ======== ======= ======= ======= =======
Statutory Net Income (Loss)........ $ (1,571) $(16,533) $ 5,522 $ 566 $ 2,336 $ (413)
======== ======== ======= ======= ======= =======
</Table>
Included in the admitted assets and statutory surplus of BCBSUW is the
$70,000,000 collateralized note obligation due from Cobalt, which is eliminated
in the accompanying financial statements. An extension of the maturity date to
January 2, 2003 of the collateralized note obligation was approved by the OCI on
February 14, 2002 (see Note 11). Pursuant to the terms of the extended note, the
Company must meet certain requirements, including the regulatory approval of all
dividends paid by the Company's insurance subsidiaries and regulatory approval
of all affiliated and material non-affiliated reinsurance agreements.
Included in the admitted assets and statutory surplus of Compcare is the
statutory surplus value of UWIC and UHLIC, which are wholly-owned subsidiaries
of Compcare.
Wisconsin insurance regulations also require the maintenance of a minimum
compulsory surplus based on a percentage of premiums written. As of December 31,
2001, all of the Company's insurance subsidiaries exceeded the regulatory
minimum compulsory surplus, calculated as prescribed by the OCI. In addition,
the Company's insurance subsidiaries are subject to risk-based capital ("RBC")
requirements promulgated by the NAIC. The RBC requirements establish minimum
levels of capital and surplus based upon the insurer's operations and investment
risk. At December 31, 2001, the Company was in compliance with these capital
surplus requirements. In addition, the Company is required to maintain certain
capital and liquidity levels in conjunction with the licensing of certain
F-27
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
products by the BCA. While exceeding the minimum standards to maintain its
license by $15,790,000 and $7,175,000, respectively, for BCBSUW and Compcare,
the Company is subject to ongoing monitoring by the BCA.
<Table>
<Caption>
BCBSUW COMPCARE UNITY VALLEY UWIC UHLIC
-------- -------- ------ ------ ------- ------
(IN THOUSANDS)
Compulsory Surplus Requirement......... $61,117 $15,911 $5,048 $2,420 $10,297 $2,172
Compulsory Surplus Excess.............. 10,968 10,001 7,224 4,557 18,401 7,676
</Table>
Dividends paid by insurance and HMO subsidiaries are limited by state
insurance regulations. As of December 31, 2001, the Company's regulated
subsidiaries are unable to pay dividends to the Company in 2002 without
regulatory approval.
16. EMPLOYEE BENEFIT PLANS
PENSION AND POSTRETIREMENT BENEFITS
The Company and certain of its subsidiaries participate in two defined
benefit pension plans. In conjunction with the Combination, the pension plan
previously named the UWSI/BCBSUW Pension Plan, a multiple employer plan
sponsored by BCBSUW and the former UWS, was amended and renamed Cobalt
Corporation Pension Plan (the "Plan"). Coincident with the Combination and the
aforementioned Plan name change, the Company assumed the assets and liabilities
of the Plan and became the sole sponsor.
Effective January 1, 1999, a portion of the assets and liabilities of the
Plan were spun-off to a new UGS Pension Plan (the "UGS Plan"). The UGS Plan
provided retirement benefits for current UGS employees and past retirees,
including benefits accrued prior to 1999, on the same basis as had been provided
under the Plan.
The Plan and the UGS Plan provide retirement benefits to covered employees
based primarily on compensation and years of service. The Company contributed
$3,514,000 to the UGS Plan in 2001. No contributions were made to any of the
plans in 2000 or 1999.
The Company also has postretirement benefit plans to provide medical,
dental, and vision benefits and life insurance for certain groups of retired
employees. Such plans were amended in 1997 to limit the Company's financial
contribution in future periods. No benefits will be provided for individuals
hired after the effective dates of these amendments.
The following financial information includes both the Plan and the UGS
Plan.
The following table summarizes the change in the pension and postretirement
benefit obligations as of December 31, 2001 and 2000:
<Table>
<Caption>
PENSION POSTRETIREMENT
------------------ -----------------
2001 2000 2001 2000
-------- ------- ------- -------
(IN THOUSANDS)
Benefit obligation at beginning of year................ $ 82,351 $76,770 $14,318 $13,176
Benefit obligation assumed from UWS through the
Combination.......................................... 22,080 -- 3,398 --
Service cost......................................... 4,751 2,393 501 284
Interest cost........................................ 6,687 5,129 1,151 890
Plan amendments...................................... -- -- 32 1,400
Actuarial (gains) losses............................. (1,376) 4,752 1,198 (509)
Company transfers.................................... -- (821) -- --
Benefits paid........................................ (6,339) (5,872) (1,313) (923)
-------- ------- ------- -------
Benefit obligation at end of year...................... $108,154 $82,351 $19,285 $14,318
======== ======= ======= =======
</Table>
F-28
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The pension and postretirement plans' assets are comprised primarily of
debt, equity and other marketable securities, including 700,000 shares of Cobalt
stock, held by the Plan, with a fair value of $4,466,000 and $2,363,000 at
December 31, 2001 and 2000, respectively. The Plan received dividends in the
amount of $35,000 related to the Cobalt stock held during 2000. No dividends
were paid to the Plan in 2001.
The following table summarizes the change in the pension and postretirement
plan assets as of December 31, 2001 and 2000:
<Table>
<Caption>
PENSION POSTRETIREMENT
------------------- ----------------
2001 2000 2001 2000
-------- -------- ------- ------
(IN THOUSANDS)
Fair value of plan assets at beginning of year......... $129,929 $122,341 $ 2,380 $3,052
Fair value of plan assets assumed from UWS through the
Combination.......................................... 39,729 -- -- --
Employer contributions............................... 3,514 -- 583 28
Actual return on plan assets......................... (13,647) 14,281 204 223
Company transfers.................................... -- (821) -- --
Benefits paid........................................ (6,339) (5,872) (1,313) (923)
-------- -------- ------- ------
Fair value of plan assets at end of year............... $153,186 $129,929 $ 1,854 $2,380
======== ======== ======= ======
</Table>
The following table provides a reconciliation of the funded status of the
plans to the prepaid pension and postretirement costs at December 31, 2001 and
2000:
<Table>
<Caption>
PENSION POSTRETIREMENT
----------------- -------------------
2001 2000 2001 2000
------- ------- -------- --------
(IN THOUSANDS)
Funded status of plan at end of year.................. $45,032 $47,578 $(17,431) $(11,938)
Unrecognized net transition asset................... (548) (1,577) -- --
Unrecognized prior service cost..................... (7,484) (5,110) (228) (920)
Unrecognized net (gain) loss........................ 16,837 (4,420) (346) 136
------- ------- -------- --------
Prepaid (accrued) at end of year...................... $53,837 $36,471 $(18,005) $(12,722)
======= ======= ======== ========
</Table>
The 2000 combined ending prepaid pension balance consists of $36,964,000
for the Plan, offset by an accrued pension liability of $493,000 for the UGS
Plan. In 2001, both plans had a prepaid pension balance.
F-29
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Weighted-average assumptions used as of December 31, 2001 and 2000, the
measurement date, in developing the projected benefit obligations are as
follows:
<Table>
<Caption>
DECEMBER 31,
------------
2001 2000
----- ----
Pension:
Discount rate............................................. 7.00% 7.00%
Rate of compensation increase............................. 4.75 4.75
Expected rate of return on Plan assets.................... 9.25 9.25
Postretirement:
Discount rate............................................. 7.00% 7.00%
Health care cost trend.................................... 10.50 5.00
Expected return on Plan:
Union plan assets...................................... 8.00% 8.00%
Non-union plan assets.................................. 5.00 5.00
</Table>
The unrecognized net asset is being amortized over the remaining estimated
service lives of participating employees at January 1, 1986: 15.4 years for
salaried employees and 16.9 years for hourly employees.
The effect of a 1% increase in the medical trend rate would be a $1,267,000
increase in the benefit obligation at December 31, 2001. The effect of a 1%
decrease in the medical trend would be a $1,175,000 decrease in the benefit
obligation at December 31, 2001.
The components of the pension credit and postretirement benefit cost, which
are included in selling, general, administrative and other expenses in 2001,
2000 and 1999 are as follows:
<Table>
<Caption>
PENSION POSTRETIREMENT
----------------------------- ----------------------
2001 2000 1999 2001 2000 1999
-------- -------- ------- ------ ----- -----
(IN THOUSANDS)
Service cost........................... $ 4,751 $ 2,393 $ 1,988 $ 501 $ 284 $ 206
Interest cost.......................... 6,687 5,129 5,175 1,152 890 737
Expected return on plan assets......... (13,956) (10,283) (9,483) (143) (184) (224)
Net amortization of transition asset... (1,264) (1,087) (1,137) -- -- --
Amortization of prior service cost..... (1,530) (1,013) (1,013) (75) (120) (182)
Amortization of unrecognized (gain)
loss................................. -- -- 4 (24) (2) (42)
-------- -------- ------- ------ ----- -----
Pension (credit) and postretirement
benefit costs for the year........... $ (5,312) $ (4,861) $(4,466) $1,411 $ 868 $ 495
======== ======== ======= ====== ===== =====
</Table>
DEFINED CONTRIBUTION AND BONUS PLANS
The Company participates in defined contribution plans whereby the employer
contributes a percentage of participants' qualifying compensation up to certain
limits, as defined by the plans. The employer match is made in Cobalt common
stock. Employee directed contributions in Cobalt common stock are limited to 30%
of their contributions exclusive of the Company match. The Company also
established various other profit-sharing and bonus programs. Expenses related to
all of these plans totaled $10,612,000, $2,337,000 and $2,128,000 in 2001, 2000
and 1999, respectively.
F-30
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STOCK-BASED COMPENSATION PLANS
Certain employees of the Company participated in a stock appreciation
rights ("SAR") plan, based upon the market value of Cobalt common stock. On
December 12, 2001, all 647,390 outstanding SAR's were converted to nonqualified
stock options of an equal number, and at an exercise price equal to the original
strike price of the SAR's. As of that date, 347,890 of the outstanding SAR's
were vested and 281,556 of the SAR's had a strike price lower than the current
market price. The Company recorded expenses of $594,000 for the year ended
December 31, 2001 for the excess of the market value over the strike price as of
the date that the SAR's were converted to options. The SAR liability outstanding
of $544,000 was reclassified to retained earnings upon conversion of the SAR's
to options. These expenses are included in selling, general, administrative and
other expenses in the accompanying consolidated statements of operations.
Prior to the Combination, the Company had no stock based compensation
programs other than the aforementioned SAR plan. As a result of the Combination,
the Company assumed the stock based compensation plan covering employees and
directors of the former UWS. This plan allows for option grants of up to
4,500,000 shares of common stock as incentive or nonqualified stock options
("NQSOs"). NQSOs vest 25% per year over a four year period.
Stock option activity for all plans as of December 31, 2001 (in thousands,
except exercise price data) is as follows:
<Table>
<Caption>
TOTAL
NUMBER OF WEIGHTED AVERAGE
NQSOS EXERCISE PRICE
--------- ----------------
Beginning balance........................................... -- --
Options assumed from UWS through Combination................ 3,606 $ 9.39
Conversion of SARS.......................................... 647 5.70
Granted..................................................... 49 6.12
Exercised................................................... (11) 4.58
Forfeited................................................... (1,018) 13.16
------
Ending balance.............................................. 3,273 $ 7.43
======
Exercisable at end of year.................................. 1,955 $ 8.71
======
</Table>
Options with respect to 1,226,000 shares were available for grant as of
December 31, 2001.
Other information regarding NQSOs outstanding and exercisable as of
December 31, 2001 (in thousands, except exercise price data) is as follows:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------- ----------------------
WEIGHTED
AVERAGE
REMAINING WEIGHTED WEIGHTED
CONTRACTUAL AVERAGE AVERAGE
NUMBER LIFE EXERCISE NUMBER EXERCISE
RANGE OF EXERCISE PRICES OUTSTANDING (IN YEARS) PRICE EXERCISABLE PRICE
- ------------------------ ----------- ------------ -------- ----------- --------
$ 4.31 - $ 5.19 1,294 9.31 $ 4.33 422 $ 4.34
5.50 - 6.00 107 10.51 5.61 24 5.54
6.15 - 6.87 29 11.31 6.27 -- --
7.19 473 8.75 7.19 365 7.19
8.50 - 9.19 424 9.10 8.53 240 8.53
9.61 - 13.42 902 6.98 11.29 861 11.27
14.04 - 16.81 44 6.91 15.72 44 15.72
</Table>
F-31
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Since the Company's employee stock options have characteristics
significantly different from those of traded options and because changes in the
subjective input assumptions can materially affect the fair value estimates, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
The Company follows Accounting Principles Board Opinion No. 25 under which
no compensation expense is recorded when the exercise price of the Company's
employee stock options equals the market price of the underlying stock on the
date of grant. The Company's pro forma information, as if options were expensed
in accordance with FASB 123, "Accounting for Stock-Based Compensation", is as
follows:
<Table>
<Caption>
YEAR ENDED
DECEMBER 31,
2001
--------------
(IN THOUSANDS,
EXCEPT PER
SHARE DATA)
Pro forma net loss.......................................... $(22,589)
Pro forma loss per common share:
Basic and diluted......................................... $ (0.59)
Assumptions:
Risk-free interest rate................................... 5.44%
Dividend yield............................................ 0.67%
Volatility factor......................................... 0.55%
Weighted average expected life............................ 6 years
</Table>
As calculated using the Black-Scholes model, the weighted average,
grant-date fair value of options granted in which the exercise price equaled the
market price on the date of the grant was $3.69 per share for 2001. The fair
value of options granted in which the exercise price was less than the market
price on the date of grant was $4.10 per share for 2001. The fair value of
options granted in which the exercise price was greater than the market price on
the date of grant was $3.36 per share for 2001.
F-32
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Selected quarterly financial data in 2001 and 2000 are as follows:
<Table>
<Caption>
QUARTER
------------------------------------------------------
FIRST SECOND THIRD FOURTH TOTAL
-------- -------- -------- -------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
2001
Continuing operations:
Total revenues........................ $186,691 $411,021 $416,839 $411,169 $1,425,720
Pretax income (loss).................. 1,284 (3,913) 868 (23,366) (25,127)
Net income (loss)..................... 1,284 (3,931) 693 (21,302) (23,256)
Diluted EPS........................... 0.04 (0.09) 0.02 (0.52) (0.61)
Discontinued operations:
Net income (loss)..................... -- 135 364 452 951
Diluted EPS........................... -- -- 0.01 0.01 0.03
Net income (loss)....................... 1,284 (3,796) 1,057 (20,850) (22,305)
Diluted EPS............................. 0.04 (0.09) 0.03 (0.51) (0.58)
2000
Total revenues.......................... $146,267 $155,424 $167,492 $173,500 $ 642,683
Pretax income (loss).................... (7,908) (8,427) (24,216) 1,086 (39,465)
Net income (loss)....................... (7,908) (8,427) (24,764) 1,086 (40,013)
</Table>
18. SEGMENT REPORTING
The Company has four reportable business segments: insured medical
products, specialty managed care products and services (previously reported as
two separate segments, specialty risk and specialty service), Government
services and self-funded products. Insured medical products include: full
coverage, copayment, preferred provider organization, Medicare supplement,
interim coverage, health maintenance organization ("HMO") and point of service
products sold primarily in Wisconsin. The specialty managed care products and
services segment includes dental, life, disability and workers' compensation
products, along with managed care consulting, electronic claim submission
services, subrogation and hospital bill audit services and receivables
management services. The specialty managed care products and services are sold
throughout the United States. The self-funded products consist of administrative
services and access to Cobalt's extensive provider networks for uninsured
contracts. Government services include processing services for Medicare
providers throughout the United States and for Medicaid in the State of
Wisconsin.
"Other continuing operations" include activities not directly related to
the business segments, unallocated corporate items (i.e. gain (loss) from
investment in affiliates, amortization of goodwill and unallocated overhead
expenses) and intracompany eliminations. The Company evaluates segment
performance based on profit or loss from operations before income taxes.
F-33
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Financial data from continuing operations by segment is as follows:
<Table>
<Caption>
YEARS ENDED DECEMBER 31,
--------------------------------
2001 2000 1999
---------- -------- --------
(IN THOUSANDS)
Health services revenue:
Insured medical products.................................. $1,150,420 $510,638 $392,583
Specialty managed care products and services.............. 142,009 29,922 27,774
Government services....................................... 117,192 70,305 52,259
Self-funded products...................................... 28,067 24,716 25,970
Other continuing operations............................... (24,450) (2,481) (1,408)
---------- -------- --------
Total consolidated..................................... $1,413,238 $633,100 $497,178
========== ======== ========
Investment results:
Insured medical products.................................. $ 13,641 $ 8,014 $ 15,950
Specialty managed care products and services.............. 4,701 473 1,133
Government services....................................... 752 705 375
Self-funded products...................................... 55 391 1,052
Other continuing operations............................... (6,667) -- --
---------- -------- --------
Total consolidated..................................... $ 12,482 $ 9,583 $ 18,510
========== ======== ========
Pre-tax income (loss):
Insured medical products.................................. $ 8,790 $(20,553) $ (3,665)
Specialty managed care products and services.............. 7,522 408 (1,229)
Government services....................................... 1,572 1,230 1,202
Self-funded products...................................... (3,834) (10,694) (16,365)
Other continuing operations:
Corporate holding company.............................. (13,713) -- --
Loss from investment in affiliates, net of tax......... (22,724) (6,526) (22,690)
Other.................................................. (2,740) (3,330) --
---------- -------- --------
Total consolidated................................... $ (25,127) $(39,465) $(42,747)
========== ======== ========
</Table>
Transactions with other operating segments are as follows:
<Table>
<Caption>
Health services revenue:
Insured medical products.................................. $(15,860) $(2,481) $(1,408)
Specialty managed care products and services.............. (8,590) -- --
Investment results:
Insured medical products.................................. $ (6,667) $ -- $ --
</Table>
F-34
COBALT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<Table>
<Caption>
DECEMBER 31,
-------------------
2001 2000
-------- --------
(IN THOUSANDS)
Total assets from continuing operations:
Insured medical products.................................. $521,249 $240,787
Specialty managed care products and services.............. 69,556 14,100
Government services....................................... 26,843 22,061
Self-funded products...................................... 10,891 11,648
Other continuing operations............................... 79,466 105,609
-------- --------
Total consolidated..................................... $708,005 $394,205
======== ========
</Table>
Total assets from continuing operations (excluding Government services
assets and investment in affiliate) are allocated by segment based on the
percentage of pro forma revenue for the year ended December 31, 2001 and
historical revenue for the year ended December 31, 2000. Investment in
unconsolidated affiliates is classified in other operations.
19. COMMON STOCK
The common stock of Cobalt has no par value or stated value. The
authorized, issued and outstanding shares of common stock are as follows:
<Table>
<Caption>
DECEMBER 31, 2001
-----------------
NUMBER OF SHARES:
Authorized................................................ 75,000,000
Issued (includes 7,949,904 shares owned by subsidiary, see
Note 1)................................................ 48,542,947
Outstanding............................................... 40,593,043
</Table>
20. DISCONTINUED OPERATIONS
On March 29, 2002, Cobalt sold 100% of the membership interest of its
subsidiary, IRG, for $27 million ($17 million in cash and $10 million in a
three-year note). IRG was one of Cobalt's specialty companies, which provided
behavioral health and medical management services. Accordingly, IRG is accounted
for as a discontinued operation for all periods presented. The purchase
agreement also provides for certain bonuses/penalties to be received/paid
between IRG and Cobalt based on IRG revenues generated from Cobalt in future
years. In addition, the agreement requires certain subsidiaries of Cobalt to
enter into seven-year service agreements for the provision of services by IRG.
The accompanying financial statements and related footnote disclosures have
been reclassified to report the financial position and operating results of IRG
as discontinued. There were no operations to report as discontinued for the two
years ended December 31, 2000, because IRG was not consolidated with Cobalt for
financial reporting purposes until the Combination.
21. SUBSEQUENT EVENTS
On March 22, 2002, AMSG repurchased from BCBSUW 1.4 million shares of AMSG
common stock at a price of $13 per share. The aggregate proceeds from the sale
will be invested by BCBSUW in fixed income securities. This sale of AMSG common
stock by BCBSUW reduces its ownership percentage in AMSG from 45.2% to 39.1%.
F-35
THE INFORMATION IN THIS PROSPECTUS IS NOT COMPLETE AND MAY BE CHANGED. WE MAY
NOT SELL THESE SECURITIES UNTIL THE REGISTRATION STATEMENT FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION IS EFFECTIVE. THIS PROSPECTUS IS NOT AN OFFER
TO SELL THESE SECURITIES NOR A SOLICITATION OF AN OFFER TO BUY THESE SECURITIES
IN ANY STATE WHERE THE OFFER OR SALE IS NOT PERMITTED.
SUBJECT TO COMPLETION, DATED JANUARY 24, 2003
PRELIMINARY PROSPECTUS
7,000,000 SHARES
[COBALT LOGO]
COMMON STOCK
This prospectus is part of a registration statement that we filed with the
Securities and Exchange Commission using a "shelf" registration process. Under
this shelf registration process, we may from time to time sell up to 500,000
shares of our common stock and Wisconsin United for Health Foundation, Inc.
(which we refer to as the "Foundation") may from time to time sell up to
6,500,000 shares of our common stock. This prospectus provides you with a
general description of the securities we may offer. Each time we or the
Foundation sells common stock, we will provide you with a prospectus supplement
that will contain more specific information. We may also add, update or change
in the prospectus supplement any of the information contained in this
prospectus. Please carefully read both this prospectus and any prospectus
supplement together with the additional information described below under
"Information Incorporated by Reference" and "Where You Can Find More
Information."
Our common stock is traded on the New York Stock Exchange under the symbol
"CBZ." On January 21, 2003, the closing sale price of our common stock was
$14.46 per share.
INVESTING IN OUR COMMON STOCK INVOLVES RISKS. BEFORE BUYING ANY SHARES, YOU
SHOULD READ THE DISCUSSION OF MATERIAL RISKS OF INVESTING IN OUR COMMON STOCK
INCORPORATED BY REFERENCE HEREIN OR CONTAINED IN ANY ACCOMPANYING PROSPECTUS
SUPPLEMENT. SEE "RISK FACTORS" ON PAGE 3.
Our principal executive offices are located at 401 West Michigan Street,
Milwaukee, Wisconsin 53203, and our telephone number is (414) 226-6900.
---------------------
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR PASSED UPON THE
ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
---------------------
The date of this prospectus is , 2003.
TABLE OF CONTENTS
<Table>
<Caption>
PAGE
----
Forward-Looking Statements.................................. 2
Cobalt Corporation.......................................... 3
Risk Factors................................................ 3
Use of Proceeds............................................. 3
Selling Shareholder......................................... 4
Price Range of Common Stock................................. 5
Dividend Policy............................................. 5
Plan of Distribution........................................ 6
Legal Matters............................................... 7
Experts..................................................... 7
Information Incorporated by Reference....................... 7
Where You Can Find More Information......................... 8
</Table>
---------------------
Unless the context otherwise requires, references in this prospectus to
"we," "us," "our" or "ours" refer collectively to Cobalt Corporation and its
subsidiaries.
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS OTHER THAN THOSE CONTAINED OR INCORPORATED BY REFERENCE IN THIS
PROSPECTUS OR ANY APPLICABLE PROSPECTUS SUPPLEMENT AND, IF GIVEN OR MADE, SUCH
INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY ANY SECURITIES IN ANY JURISDICTION IN WHICH SUCH
OFFER OR SOLICITATION IS UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR
ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION
THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME AFTER THE DATE
OF SUCH INFORMATION.
1
FORWARD-LOOKING STATEMENTS
This prospectus contains and incorporates by reference forward-looking
statements that involve risks and uncertainties. We intend these forward-looking
statements to be covered by the safe harbor provisions for forward-looking
statements contained in the Private Securities Litigation Reform Act of 1995,
and we are including this statement for purposes of those safe harbor
provisions. These forward-looking statements are often accompanied by words such
as "believe," "anticipate," "plan," "expect," "estimate," "intend," "seek,"
"goal," "may," "will," "could" and similar expressions. These statements
include, without limitation, statements about our plans and expectations for
improving our capital position and operating results, our market opportunities,
our growth strategies, competition, expected activities and future acquisitions
and investments and the adequacy of our available cash resources. We caution
investors that matters subject to forward-looking statements involve risks and
uncertainties, including economic, regulatory, competitive and other factors
that may affect our business. These statements are not guarantees of future
performance.
Our actual results may differ from projections or estimates due to a
variety of important factors. Our results of operations and projections of
future earnings depend in large part on accurately predicting and effectively
managing our business. A variety of factors may in the future affect our
operating results, including:
- loss of existing customer relationships and an ongoing decline in
membership;
- competition;
- changes in health care practices;
- changes in federal or state laws and regulations or their
interpretations;
- medical cost inflation;
- provider contract changes;
- new technologies;
- changes in our management;
- government-imposed surcharges;
- taxes or assessments;
- major epidemics;
- disasters; and
- numerous other factors affecting the delivery and cost of health care,
such as major health care providers' inability to maintain their
operations.
Due to these factors and risks, no assurance can be given with respect to
our future premium levels or our ability to control our future medical costs.
2
COBALT CORPORATION
Based on market share reports prepared by the Office of the Commissioner of
Insurance of the State of Wisconsin for 2001, 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(R) and Blue Shield(R) service marks in
Wisconsin, giving us a unique position in that market.
Our Blue Cross & Blue Shield United of Wisconsin subsidiary provides
underwritten products, including preferred provider organizations and indemnity
options, as well as self-funded, administrative services only programs. Our
health maintenance organizations ("HMOs") are Compcare Health Services Insurance
Corporation, which we refer to as "CompcareBlue," Valley Health Plan, Inc., and
Unity Health Plans Insurance Corporation. Our CompcareBlue subsidiary operates
the oldest HMO in Wisconsin.
We offer one of the largest provider networks in Wisconsin. We believe that
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, as
demonstrated by the fact that:
- the majority of the hospitals in our networks have received accreditation
by the Joint Commission on Accreditation of Health Care Organizations, an
organization nationally recognized for its rigorous standards with
respect to patient safety and quality initiatives;
- our network includes 89% of the board certified primary care physicians
in our service areas, which exceeds the national average of 82%, based on
the National Committee for Quality Assurance, or "NCQA," Quality Compass
2002(R); and
- as of September 30, 2002, 87% of our managed care membership was insured
through subsidiaries of ours which have met the quality parameters
established by the NCQA, which is supported through NCQA's independent
accreditation process.
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.
RISK FACTORS
Investing in our common stock involves risks. Before buying any shares, you
should read the discussion of the material risks of investing in our common
stock contained in our Current Report on Form 8-K dated November 8, 2002, as
amended by our Form 8-K/A filed on January 24, 2003, as well as in any
prospectus supplement accompanying this prospectus.
USE OF PROCEEDS
Unless otherwise stated in the applicable prospectus supplement, we intend
to use all or a portion of the net proceeds from the sale by us of common stock
offered by this prospectus and any accompanying prospectus
3
supplement for general corporate purposes. General corporate purposes may
include the repayment of outstanding indebtedness, the purchase of our common
shares, capital expenditures, mergers, acquisitions and other strategic
investments. We have not made specific allocations of the proceeds for such
purposes at this time.
We will not receive any of the proceeds from the sale of common stock by
the Foundation, if any.
SELLING SHAREHOLDER
The following table sets forth information regarding the beneficial
ownership of our common stock by the Foundation as of January 21, 2003 and as
adjusted to give effect to the sale of all of the shares which may be offered
and sold from time to time under this prospectus. Each time the Foundation sells
shares, a prospectus supplement will provide specific information about the
Foundation's beneficial ownership of our common stock before and after such
sale.
<Table>
<Caption>
SHARES OF COMMON
STOCK BENEFICIALLY
OWNED AFTER SALE OF
SHARES OF COMMON THE MAXIMUM NUMBER
STOCK BENEFICIALLY OWNED MAXIMUM OF SHARES BEING
PRIOR TO THIS OFFERING NUMBER OF OFFERED
------------------------- SHARES BEING --------------------
NAME AND ADDRESS NUMBER PERCENT OFFERED NUMBER PERCENT
- ---------------- ------------ --------- ------------ ---------- -------
Wisconsin United for Health Foundation, Inc.
10 East Doty Street, Suite 600
Madison, WI 53703.................................. 31,313,390(1) 74.9% 6,500,000 24,813,390 59.4%
</Table>
- ---------------
(1) Based on the Schedule 13D filed by the Foundation pursuant to the Securities
Exchange Act of 1934, as amended.
4
PRICE RANGE OF COMMON STOCK
Our common stock is traded on the New York Stock Exchange under the symbol
"CBZ". The following table sets forth the per share high and low sale prices for
our common stock as reported on the New York Stock Exchange for the periods
presented, along with the cash dividends paid per share for those periods. Prior
to March 31, 2001, we were named United Wisconsin Services, Inc., and our common
stock traded on the New York Stock Exchange under the symbol "UWZ."
<Table>
<Caption>
HIGH LOW
------ ------
2001:
First Quarter............................................. $ 7.99 $ 3.38
Second Quarter............................................ 8.00 4.90
Third Quarter............................................. 9.05 4.37
Fourth Quarter............................................ 6.95 3.99
2002:
First Quarter............................................. $ 9.05 $ 5.33
Second Quarter............................................ 23.45 8.65
Third Quarter............................................. 23.40 14.11
Fourth Quarter............................................ 18.70 12.15
2003:
First Quarter (through January 21, 2003).................. $14.80 $13.80
</Table>
As of January 20, 2003, there were 194 shareholders of record of our common
stock. Based on information obtained from our transfer agent and from
participants in security position listings and otherwise, we have reason to
believe there are more than 1,700 beneficial owners of shares of our common
stock.
DIVIDEND POLICY
We do not currently pay cash dividends and we do not plan to declare or pay
any dividends in the foreseeable future, but will instead retain cash for
working capital needs, for possible acquisitions, to reduce outstanding debt or
for other corporate purposes. Our ability to pay dividends to our shareholders
in the future will depend primarily upon the receipt of dividends from our
insurance subsidiaries. Currently, our insurance subsidiaries are prohibited
from paying dividends to us without the approval of the Office of the
Commissioner of Insurance of the State of Wisconsin.
5
PLAN OF DISTRIBUTION
We or the Foundation may sell the shares of common stock covered by this
prospectus through underwriters or dealers, through agents, or directly to one
or more purchasers. A prospectus supplement will describe the terms of any
offering of shares of the common stock, including:
- the name or names of the underwriters, if any;
- the purchase price of the common stock and the proceeds we will receive
from the sale;
- any over-allotment options under which underwriters may purchase
additional common stock from us or from the Foundation;
- any agency fees or underwriting discounts and other items constituting
agents' or underwriters' compensation;
- the public offering price, if applicable; and
- any discounts or concessions allowed or reallowed or paid to dealers.
If underwriters are used in a sale, they will acquire the shares of common
stock for their own account and may resell them from time to time in one or more
transactions at a fixed public offering price or at varying prices determined at
the time of sale. The obligations of the underwriters to purchase the common
stock will be subject to the conditions set forth in the applicable underwriting
agreement. We or the Foundation may offer the common stock to the public through
underwriting syndicates represented by managing underwriters or by underwriters
without a syndicate. Subject to certain conditions, the underwriters may be
obligated to purchase all of the shares of common stock offered by the
prospectus supplement. Any public offering price and any discounts or
concessions allowed or reallowed or paid to dealers may change from time to
time. We or the Foundation may use underwriters with whom we have a material
relationship. We or the Foundation will describe the nature of any such
relationship in the prospectus supplement, naming the underwriter.
We or the Foundation may sell the common stock directly or through agents
we or the Foundation may designate from time to time. We will name any agent
involved in the offering and sale of securities and we will describe any
commissions we will pay the agent in the prospectus supplement.
Unless the prospectus supplement states otherwise, our or the Foundation's
agent will act on a best-efforts basis for the period of its appointment.
We or the Foundation may provide agents and underwriters with
indemnification against certain civil liabilities, including liabilities under
the Securities Act, or contribution with respect to payments that the agents or
underwriters may make with respect to such liabilities. Agents and underwriters
may engage in transactions with, or perform services for, us or the Foundation
in the ordinary course of business.
In connection with any underwritten offering covered by a supplement to
this prospectus, the underwriters may purchase and sell shares of our common
stock in the open market. These transactions may include stabilizing
transactions, short sales and purchases to cover positions created by short
sales. Stabilizing transactions consist of bids or purchases made for the
purpose of preventing or retarding a decline in the market price of our common
stock while the offering is in progress. These transactions may also include
short sales and purchases to cover positions created by short sales. Short sales
involve the sale by the underwriter of a greater number of shares than it is
required to purchase in the offering. Short sales may be either "covered short
sales" or "naked short sales." Covered short sales are sales made in an amount
not greater than the underwriter's over-allotment option to purchase additional
shares in this offering. An underwriter may close out any covered short position
by either exercising its over-allotment option or purchasing shares in the open
market. In determining the source of shares to close out the covered short
position, an underwriter will consider, among other things, the price of shares
available for purchase in the open market as compared to the price at which it
may purchase shares through the over-allotment option. Naked short sales are
sales in excess of the over-allotment option. An underwriter must close out any
naked short position by purchasing shares in the open market. A naked short
position is more likely to be created if an underwriter is concerned there may
be downward pressure on the price of shares in the open market after pricing
that could adversely affect investors who purchase our common stock in this
offering.
6
The underwriters, if any, also may impose a penalty bid. This occurs when a
particular underwriter repays to the underwriters a portion of the underwriting
discount received by it because a managing underwriter (if there is one), on
behalf of the underwriters, has repurchased shares sold by or for the account of
that underwriter in stabilizing or short covering transactions.
These activities by underwriters may stabilize, maintain or otherwise
affect the market price of our common stock. As a result, the price of our
common stock may be higher than the price that otherwise might exist in the open
market. If these activities are commenced, they may be discontinued by the
underwriters at any time. These transactions may be effected on the New York
Stock Exchange or otherwise.
In compliance with National Association of Securities Dealers, Inc., or
"NASD," guidelines, the maximum consideration or discount to be received by any
NASD member or independent broker dealer may not exceed 8% of the aggregate
amount of the securities offered pursuant to this prospectus and any applicable
prospectus supplement.
Robert W. Baird & Co. Incorporated, one of the underwriters in this
offering, has been retained by the Foundation to provide financial advisory
services and will be entitled, upon completion of this offering, to a fee equal
to 1.25% of the net proceeds of the offering to be received by the Foundation up
to $100 million, as well as reimbursement of expenses. To the extent that this
and subsequent public offerings or other "realization events" produce proceeds
to the Foundation in excess of $100 million (on a cumulative basis) during the
term of its agreement with the Foundation, Robert W. Baird & Co. Incorporated
will be entitled to an aggregate fee of 1.25% of the first $100 million of net
proceeds, 1% of the second $100 million and 0.75% of the net proceeds in excess
of $200 million. The National Association of Securities Dealers, Inc. has deemed
this fee to be underwriting compensation in connection with this offering.
LEGAL MATTERS
The validity of our common stock offered by this prospectus will be passed
upon for us by Foley & Lardner, Milwaukee, Wisconsin.
EXPERTS
Ernst & Young LLP, independent auditors, have audited our consolidated
financial statements for the year ended December 31, 2001 included in our Form
8-K/A filed on January 24, 2003 amending our Current Report on Form 8-K dated
November 8, 2002, as set forth in their report, which is incorporated by
reference in this prospectus and elsewhere in the registration statement. Our
financial statements are incorporated by reference in reliance on Ernst & Young
LLP's report, given on their authority as experts in accounting and auditing.
INFORMATION INCORPORATED BY REFERENCE
We are "incorporating by reference" specified documents that we file with
the SEC, which means:
- incorporated documents are considered part of this prospectus;
- we are disclosing important information to you by referring you to those
documents; and
- information we file with the SEC will automatically update and supersede
information contained in this prospectus.
We incorporate by reference the documents listed below and any future
filings we make with the SEC under Sections 13(a), 13(c), 14 or 15(d) of the
Securities Exchange Act of 1934 after the date of this prospectus and before the
end of the offering of our common stock:
- Our Annual Report on Form 10-K for the year ended December 31, 2001, as
amended by our Form 10-K/A filed April 18, 2002;
- Our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2002,
June 30, 2002 and September 30, 2002;
7
- Our Current Report on Form 8-K dated March 19, 2002; our Current Report
on Form 8-K dated March 29, 2002, as amended by our Form 8-K/A filed on
May 28, 2002; our Current Report on Form 8-K dated July 9, 2002; our
Current Report on Form 8-K dated November 8, 2002, as amended by our Form
8-K/A filed on January 24, 2003; our Current Report on Form 8-K dated
November 15, 2002; our Current Report on Form 8-K dated December 31,
2002; and our Current Report on Form 8-K dated January 23, 2003; and
- The description of our common stock contained in our Registration
Statement on Form 10, filed with the SEC on May 29, 1998, as amended,
including any amendment or report filed for the purpose of updating such
information.
You may request a copy of any of these filings, including exhibits, at no
cost by writing to or calling Cobalt Corporation, Attn: Corporate Secretary, 401
West Michigan Street, Milwaukee, Wisconsin 53202, phone number (414) 226-6900.
WHERE YOU CAN FIND MORE INFORMATION
We file annual, quarterly and current reports, proxy statements, and other
information with the SEC. We have also filed a registration statement on Form
S-3, including exhibits, under the Securities Act of 1933 with respect to the
common stock offered by this prospectus. This prospectus is a part of the
registration statement, but does not contain all of the information included in
the registration statement or the exhibits. You may read and copy the
registration statement and any other document that we file at the SEC's public
reference rooms at 450 Fifth Street, N.W., Washington D.C., and at regional SEC
offices in New York, New York and Chicago, Illinois. You can call the SEC at
1-800-SEC-0330 for further information on the operation of the public reference
rooms. You can also find our public filings with the SEC on the Internet at a
web site maintained by the SEC located at http://www.sec.gov. Our common stock
is listed on the New York Stock Exchange and reports, proxy statements and other
information concerning us can be inspected at the New York Stock Exchange
located at 11 Wall Street, New York, New York 10005.
8
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5,000,000 SHARES
[COBALT LOGO]
COMMON STOCK
---------------------
PRELIMINARY PROSPECTUS SUPPLEMENT
, 2003
---------------------
JOINT BOOK-RUNNING MANAGERS
UBS WARBURG SALOMON SMITH BARNEY
---------------------
CIBC WORLD MARKETS ROBERT W. BAIRD & CO.
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