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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997
/ / TRANSITION REPORT PURSUANT TO SECTION 13(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ______________
COMMISSION FILE NUMBER: 1-12718
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FOUNDATION HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 95-4288333
(State or other jurisdiction of (I.R.S. Employer identification
incorporation or organization) No.)
21600 OXNARD STREET, WOODLAND HILLS, CA 91367
(Address of principal executive offices) (Zip Codes)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (818) 676-6978
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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Class A Common Stock, $.001 par value New York Stock Exchange, Inc.
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes (x) No ( )
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. (x)
The aggregate market value of the voting stock held by non-affiliates of the
registrant at March 16, 1998 was $3,061,505,816 (which represents 106,719,157
shares of Class A Common Stock held by such non-affiliates multiplied by
$28.6875, the closing price of such stock on the New York Stock Exchange on
March 16, 1998).
The number of shares outstanding of the registrant's Class A Common Stock as
of March 16, 1998 was 111,308,582 (excluding 3,194,374 shares held as treasury
stock), and 10,297,642 shares of the registrant's Class B Common Stock were
outstanding as of such date.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates information by reference from the
registrant's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the close of the year ended December
31, 1997.
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FOUNDATION HEALTH SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
PAGE NO.
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PART I
Item 1. Business............................................................................ 1
Item 2. Properties.......................................................................... 17
Item 3. Legal Proceedings................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders Other Information............... 19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............... 30
Item 6. Selected Financial Data............................................................. 32
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations........................................................................ 33
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.......................... 44
Item 8. Financial Statements and Supplementary Data......................................... 46
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure........................................................................ 83
PART III
Item 10. Directors and Executive Officers of the Registrant.................................. 83
Item 11. Executive Compensation.............................................................. 83
Item 12. Security Ownership of Certain Beneficial Owners and Management...................... 83
Item 13. Certain Relationships and Related Transactions...................................... 83
PART IV
Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K.................. 83
PART I
ITEM 1. BUSINESS
Foundation Health Systems, Inc. (the "Company" or "FHS") is an integrated
managed care organization which administers the delivery of managed health care
services. The Company's health maintenance organizations ("HMOs"), insured
preferred provider organizations ("PPOs") and government contracts subsidiaries
provide health benefits to 6.2 million individuals in 21 states through group,
individual, Medicare risk, Medicaid and CHAMPUS programs. The Company's
subsidiaries also offer managed health care products related to behavioral
health, dental, vision and prescription drugs, and offer managed health care
product coordination for multi-region employers and administrative services for
medical groups and self-funded benefits programs. Over the past several years,
the Company has developed a diversified product line and has achieved geographic
expansion throughout the United States. The Company operates and conducts its
HMO and other businesses through its wholly and majority owned subsidiaries.
The current operations of the Company are the result of the April 1, 1997
merger transaction (the "FHS Combination") involving Health Systems
International, Inc. ("HSI") and Foundation Health Corporation ("FHC"). Pursuant
to the Agreement and Plan of Merger (the "Merger Agreement") that evidenced the
FHS Combination, FH Acquisition Corp., a wholly owned subsidiary of HSI, merged
with and into FHC and FHC survived as a wholly owned subsidiary of HSI, which
changed its name to "Foundation Health Systems, Inc." and thereby became the
Company. Under the Merger Agreement, FHC stockholders received 1.3 shares of the
Company's Class A Common Stock for every share of FHC common stock held. The
shares of the Company's Class A Common Stock issued to FHC's stockholders in the
FHS Combination constituted approximately 61% of the outstanding stock of the
Company after the FHS Combination and the shares held by the Company's
stockholders prior to the FHS Combination (i.e., the prior stockholders of HSI)
constituted approximately 39% of the outstanding stock of the Company after the
FHS Combination.
The FHS Combination was accounted for as a pooling of interests for
accounting and financial reporting purposes. The pooling of interests method of
accounting is intended to present, as a single interest, two or more common
stockholder interests which were previously independent and assumes that the
combining companies have been merged from inception. Consequently, in this
Annual Report on Form 10-K, the Company's consolidated financial statements have
been prepared and/or restated as though HSI and FHC always had been combined on
a calendar year basis.
The Company currently operates in the managed health care industry segment,
and in 1997 the Company operated in five different Divisions within such
segment, including three regional Health Plan Divisions and two additional
Specialty Divisions. Such Divisions encompass the following three primary lines
of business in which the Company continues to operate: (i) health plan
operations (through the three regional Health Plan Divisions described below);
(ii) government contracts (through the Government Operations Division described
below); and (iii) specialty services (through the Specialty Services Division
described below). As set forth below, the Company has discontinued its
risk-based operations in the Workers' Compensation segment.
The Company is one of the largest managed health care companies in the
United States, with more than 4.3 million full-risk and administrative services
only ("ASO") members through its Health Plan Divisions. The Company provides a
comprehensive range of health care services through HMOs organized into three
Health Plan Divisions located in the following geographic regions: the
California Division (encompassing only the state of California), the Eastern
Division (Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and
West Virginia) and the Western Division (Arizona, Colorado, Idaho, Louisiana,
New Mexico, Oklahoma, Oregon, Texas, Utah and Washington). The Company also
operates PPO networks providing access to health care services to over 4 million
individuals in 37 states and owns six health and life insurance companies
licensed to sell insurance in 38 states and the District of Columbia.
1
The Company's HMOs market traditional HMO products to employer groups and
Medicare and Medicaid products directly to employer groups and individuals.
Health care services that are provided to the Company's commercial and
individual members include primary and specialty physician care, hospital care,
laboratory and radiology services, prescription drugs, dental and vision care,
skilled nursing care, physical therapy and mental health. The Company's HMO
service networks include approximately 43,000 primary care physicians and 74,000
specialists.
In addition to the Company's HMO and PPO operations in its three regional
Health Plan Divisions, the Company conducted business in 1997 through the
following two Specialty Divisions.
The Company's Government Operations Division oversees the provision of
contractual services to federal government programs such as the Civilian Health
and Medical Program of the Uniformed Services ("CHAMPUS"). The Company receives
revenues for administrative and management services and, under most of its
contracts, also accepts financial responsibility for a portion of the health
care costs.
The Company's Specialty Services Division oversees the provision of
supplemental programs to enrollees in the Company's HMOs, as well as to members
whose basic medical coverage is provided by non-FHS companies, including vision
coverage, dental coverage, managed behavioral health programs, and a
prescription drug program. The Specialty Services Division consists both of
operations in which the Company assumes underwriting risk in return for premium
revenue, and operations in which the Company provides administrative services
only, including certain of the behavioral health and pharmacy benefits
management programs. Such Division also provides certain bill review and third
party administrative services as described elsewhere in this Annual Report.
Finally, the Company's Workers' Compensation segment consists of operations
in which the Company assumes workers' compensation claims risk in return for
premium revenue, and certain non-risk operations including providing access to
managed care networks, utilization review services and third party
administrative services. As noted below in the section of this Annual Report on
Form 10-K entitled "Discontinued Operations and Anticipated Divestitures," the
Company has recently determined to discontinue its risk-based workers'
compensation operations and to transfer its non-risk workers' compensation
services to its Speciality Services Division.
The Company utilizes sophisticated medical management systems to reduce
excess utilization of health care services. The Company continues to develop a
new generation medical management system which utilizes clinical protocols and
triage procedures to direct members to the most appropriate provider. The
Company believes that this new system, which it calls "Fourth Generation Medical
Management" (the "4-G System"), has the potential to represent a major advance
in applying sophisticated information systems to the practice of medicine. The
Smithsonian Institution has added the 4-G System to its Permanent Research
Collection of Information Technology Innovation at the National Museum of
American History, and the 4-G System was also a finalist for the 1997
Computerworld Smithsonian Award in Medicine.
The Company continues to evaluate the profitability realized or likely to be
realized by its existing businesses and operations, and the opportunities to
expand its businesses in profitable markets. In this connection, the Company is
reviewing from a strategic standpoint which of its businesses or operations
should be divested, and has targeted the Northeastern United States for
expansion due to the relatively low penetration of managed health care in the
region and such region's relatively higher average premiums as compared to the
Company's California and western regions. Consistent with this Northeast
expansion strategy, in 1997 the Company acquired Advantage Health, the trade
name for a group of managed health care companies headquartered in Pittsburgh,
with operations in West Virginia, Ohio and western Pennsylvania; Physicians
Health Services, Inc. ("PHS"), a group of managed health care companies
headquartered in Connecticut; and FOHP, Inc. ("FOHP"), a group of managed health
care companies located in Neptune, New Jersey. In 1997 the Company also acquired
PACC Health Plans, Inc. and PACC HMO, Inc. (collectively, "PACC"), a group of
managed care companies operating in Washington and Oregon.
2
The Company was incorporated in 1990. Prior to the FHS Combination, the
Company was the successor to the business conducted by Health Net, now the
Company's HMO subsidiary in California, which became a subsidiary of the Company
in 1992, and HMO and PPO networks operated by QualMed, Inc. ("QualMed"), which
combined with the Company in 1994 to create HSI. FHC was incorporated in
Delaware in 1984. After the FHS Combination, the executive offices of the
Company remained at 21600 Oxnard Street, Woodland Hills, CA 91367. Except as the
context otherwise requires, the term the "Company" refers to FHS and its
subsidiaries.
HEALTH PLAN DIVISIONS
HMO AND PPO OPERATIONS. The Company's HMOs offer members a comprehensive
range of health care services, including ambulatory and outpatient physician
care, hospital care, pharmacy services, eye care, behavioral health and
ancillary diagnostic and therapeutic services. The Company offers a full
spectrum of managed health care products.
The integrated health care programs offered by the Company's HMOs include
products offered through both traditional Network Model HMOs (in which the HMOs
contract with individual physicians, physician groups and independent or
individual practice associations ("IPAs")) and IPA Model HMOs (in which the HMOs
contract with one or more IPAs that in turn subcontract with individual
physicians to provide HMO patient services) which offer quality care, cost
containment and comprehensive coverage; a matrix package which allows employees
to select their desired coverage from alternatives that have interchangeable
outpatient and inpatient co-payment levels; point-of-service programs which
offer a multi-tier design that provides both conventional HMO and indemnity-like
(in-network and out-of-network) tiers; a PPO-like tier which allows members to
self-refer to the network physician of their choice; and a managed indemnity
plan, which is provided for employees who reside outside of their HMO service
areas. The Company's PPO subsidiaries consist of networks of health care
providers which offer their services to health care third party payors, such as
insurers and self-funded employers.
The Company's strategy is to offer a wide range of managed health care
products and services to employers to assist them in containing health care
costs. The pricing of the products offered is designed to provide incentives to
both employers and employees to select and enroll in the products with greater
managed health care and cost containment elements. In general, the Company's HMO
subsidiaries provide comprehensive health care coverage for a fixed fee or
premium that does not vary with the extent or frequency of medical services
actually received by the member. PPO enrollees choose their medical care from
among the various contracting providers or choose a non-contracting provider and
are reimbursed on a traditional indemnity plan basis after reaching an annual
deductible. The Company assumes both underwriting and administrative expense
risk in return for the premium revenue it receives from its HMO and PPO
products. The HMOs and PPOs have contractual relationships with health care
providers for the delivery of health care to the Company's enrollees. While a
majority of the Company's members are covered by conventional HMO products, the
Company is continuing to expand its other product lines, thereby enabling it to
offer flexibility to an employer and to tailor its products to an employer's
particular needs.
As of December 31, 1997, the Company owned and operated HMOs and PPOs in
three regional Health Plan Divisions of the United States: The California
Division, the Western Division (Arizona, Colorado, Idaho, Louisiana, New Mexico,
Oklahoma, Oregon, Texas, Utah and Washington) and the Eastern Division
(Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and West
Virginia). The following table contains certain information relating to
commercial HMO and PPO members,
3
Medicare members and employer groups under contract as of December 31, 1997 in
each region in which the Company operates (excluding point-of-service):
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
---------- --------- ---------
Commercial HMO and PPO Members............................. 1,658,234 760,641 948,850
Medicare Members (risk only)............................... 153,485 72,559 85,937
Medicaid Members........................................... 294,591 53,982 94,470
In addition, the following sets forth certain data regarding the Company's
employer groups in its commercial managed care operations of its Health Plan
Divisions:
Number of Employer Groups........................................... 68,793
Largest Employer Group as % of enrollment........................... 4.9%
10 largest Employer Groups as % of enrollment....................... 15.6%
% of Members in Employer Groups with fewer
than 50 Eligible Members.......................................... 11.0%
CALIFORNIA DIVISION. The California market is characterized by a
concentrated population. In early 1998, the Company merged the operations of two
of its California HMO subsidiaries, Health Net and Foundation Health, a
California Health Plan. The resulting HMO, Health Net, is believed by the
Company to be the second-largest HMO in the state of California in terms of
membership. The Company's commercial HMO membership in California as of December
31, 1997 was 1,658,234 which represented a decrease of 1% during 1997. The
Company's Medicare risk membership in California as of December 31, 1997 was
153,485 which represented an increase of 10% during 1997. The Company's Medicaid
membership in California as of December 31, 1997 was 294,591 members.
EASTERN DIVISION. The Eastern Division currently includes Company
operations in Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and
West Virginia. During 1997 the Company acquired Advantage Health, the trade name
for a group of managed health care companies headquartered in Pittsburgh, with
operations in Ohio, Pennsylvania and West Virginia; PHS, a group of managed
health care companies headquartered in Connecticut with operations in
Connecticut, New Jersey and New York; and FOHP, a group of managed health care
companies now headquartered in Neptune, New Jersey with operations in New
Jersey.
The Company believes its Pennsylvania HMO and PPO operations make it the
fourth largest HMO managed care provider in terms of membership in the
Commonwealth of Pennsylvania. The Company's commercial HMO membership in
Pennsylvania was 67,215 as of December 31, 1997 which represented an increase of
59% during 1997. The Company's Medicare risk membership in Pennsylvania was
15,070 as of December 31, 1997 which represented an increase of 10% during 1997.
The Company believes its Connecticut HMO and PPO operations make it the
largest HMO managed care provider in terms of membership in the state of
Connecticut. The Company's commercial HMO membership in Connecticut was 339,307
as of December 31, 1997 (including approximately 180,000 members from its
year-end acquisition of PHS. The Company's commercial HMO membership in
Connecticut at the end of 1996 was 129,047. The Company's Medicare risk
membership in Connecticut was 26,229 as of December 31, 1997 and the Company's
Medicaid membership in Connecticut was 47,175 as of December 31, 1997.
The Company believes its New Jersey HMO and PPO operations make it the
fourth-largest HMO managed care provider in terms of membership in the state of
New Jersey. The Company's commercial HMO membership in New Jersey was 299,021
(including approximately 68,000 PHS members) as of
4
December 31, 1997. The Company's Medicare risk membership in New Jersey was
13,383 as of December 31, 1997 and the Company's Medicaid membership in New
Jersey was 21,442 as of December 31, 1997.
The Company believes its Florida HMO and PPO operations make it the
eighth-largest HMO managed care provider in terms of membership in the state of
Florida. The Company's commercial HMO membership in Florida was 93,714 as of
December 31, 1997 which represented an increase of 37% during 1997. The
Company's Medicare risk membership in Florida was 23,900 as of December 31, 1997
which represented a decrease of 6% during 1997. The Company's Medicaid
membership in Florida was 23,274 as of December 31, 1997, an 11% increase in
1997.
In New York, the Company's operations resulted from the acquisition of PHS.
The Company now has approximately 149,000 members in New York. The Company's HMO
and PPO operations in West Virginia and Ohio at this time are much smaller in
scope than its operations in the other states making up the Eastern Division.
WESTERN DIVISION. The Western Division currently includes Health Plan
operations in Arizona, Colorado, Idaho, Louisiana, New Mexico, Oklahoma, Oregon,
Texas, Utah and Washington. The Western Division also oversees the Company's six
health and life insurance companies licensed to sell insurance in 38 states and
the District of Columbia.
The Company's Washington HMO services Seattle and Spokane and also services
a limited number of residents who reside in the state of Idaho. The Company's
Oregon HMO services Portland and its vicinity. During 1997, the Company acquired
PACC, a Portland-based HMO with operations in Oregon and Washington. Portland,
Seattle and Spokane have experienced population growth rates greater than the
national average over the last several years. In addition, an increasing
percentage of the population in each of these areas has enrolled in HMOs in the
last several years. In Washington and Oregon, the Company believes that it ranks
sixth and fifth, respectively, with respect to total membership; the Company
believes that it ranks first in Washington and third in Oregon with respect to
the size of its primary care physician and specialist networks. The Company's
commercial HMO and PPO membership in Oregon was 163,406 (including 108,000 prior
PACC members) as of December 31, 1997. At year end 1996 the Company had 50,809
commercial members in Oregon. The Company's commercial HMO and PPO membership in
Washington was 94,937 as of December 31, 1997 which represented a decrease of 1%
during 1997. The Company's Medicare risk membership in Washington was 3,194 as
of December 31, 1997 which represented an increase of 14% during 1997. The
Company's Medicaid membership in Washington was 25,076 as of December 31, 1997
which represented an increase of 56% during 1997.
The Western Division also services the southwest region of the United
States, with operations in Arizona, Colorado, Louisiana, New Mexico, Oklahoma,
Texas and Utah. The Company's employer groups in the southwest consist
predominantly of companies with fewer than 50 employees, except for Arizona, in
which the Company's operations are dominated by large employer groups. During
1997, the Company merged its two Colorado HMOs, QualMed Plans for Health of
Colorado, Inc. and Foundation Health, A Colorado Health Plan, Inc. The Company
believes that the resulting HMO is the fourth largest HMO in Colorado as
measured by total membership. The Company's commercial HMO membership in
Colorado (including both the QualMed and Foundation plans) was 76,255 as of
December 31, 1997 which represented an increase of 5% during 1997. The Company's
Medicare membership in Colorado was 12,272 as of December 31, 1997 which
represented an increase of 6% during 1997. In New Mexico, the Company believes
that its ranks fourth, as measured by total membership and the size of its
provider network. The Company's commercial HMO membership in New Mexico was
34,130 as of December 31, 1997 which represented a decrease of 11% during 1997.
The Company's Medicare risk membership in New Mexico was 2,310 as of December
31, 1997 which represented an increase of 12% during 1997.
In Arizona, the Company believes that its commercial managed care operations
rank it first as measured by total membership and second as measured by the size
of its provider network. The Company's commercial HMO membership in Arizona was
304,653 as of December 31, 1997. The Company's
5
Medicare risk membership in Arizona was 47,455 as of December 31, 1997 which
represented an increase of 10% during 1997.
Collectively, the Company's commercial HMO membership in Texas, Oklahoma,
Louisiana and Utah was 43,279 as of December 31, 1997. The Company's Medicaid
risk membership in these states was 24,714 as of December 31, 1997, a 26%
decrease in 1997. As noted below in the section of this Annual Report on Form
10-K entitled "Discontinued Operations and Anticipated Divestitures," the
Company is presently reviewing possible exit strategies for its HMO operations
in Texas, Oklahoma and Louisiana.
MEDICARE RISK. The Company expanded its Medicare risk business in 1997
through the addition of 49,419 Medicare risk enrollees and, as of December 31,
1997, the Company's Medicare risk plans had a combined membership of
approximately 309,333. The Company expects its Medicare risk business to
continue to increase in the future.
The Company offers its Medicare risk products directly to individuals and to
employer groups. To enroll in a Company Medicare risk plan covered persons must
be eligible for Medicare. Health care services normally covered by Medicare are
provided or arranged for by the Company, in conjunction with a broad range of
preventive health care services. The federal Health Care Financing
Administration ("HCFA") pays to the Company for each enrolled member a monthly
fee based, in part, upon the "Adjusted Average Per Capita Cost," as determined
by HCFA's analysis of fee-for-service costs related to beneficiary demographics.
Depending on plan design and other factors, the Company may charge a member a
premium or prepaid charge.
The Company's California Medicare risk product, Seniority Plus, was licensed
and certified to operate in 36 California counties as of December 31, 1997. The
Company's other HMOs are licensed and certified to offer Medicare risk plans in
8 counties in Colorado, 5 counties in New Mexico, 6 counties in Washington, 6
counties in Pennsylvania, 18 counties in Oregon, 8 counties in Connecticut, 6
counties in Arizona, 3 counties in Florida and 41 counties in New York and New
Jersey.
MEDICAID PRODUCTS. As of December 31, 1997, the Company had an aggregate of
approximately 443,043 Medicaid members, principally in California. To enroll in
these Medicaid products, an individual must be eligible for Medicaid benefits
under the appropriate state regulatory requirements. These HMOs offer, in
addition to standard Medicaid coverage, certain additional services including
dental and vision benefits. The applicable state agency pays the Company's HMOs
a monthly fee for each Medicaid member enrolled on a percentage of
fee-for-service costs. The Company has Medicaid members and operations in
California, Connecticut, Florida, New Jersey, New York, Oklahoma, Oregon, Texas
and Washington.
ADMINISTRATIVE SERVICES ONLY BUSINESS. The Company also provides third
party administrative services to large employer groups throughout its service
areas. Under these arrangements, the Company provides claims processing,
customer service, medical management and other administrative services without
assuming the risk for medical costs. The Company is generally compensated for
these services on a fixed per member per month basis.
INDEMNITY INSURANCE PRODUCTS. The Company offers indemnity products as part
of multiple option products in various markets. These products are offered by
the Company's six health and life insurance subsidiaries which are licensed to
sell insurance in 38 states and the District of Columbia. Through these
subsidiaries, the Company also offers HMO members certain auxiliary non-health
products such as group life, accidental death and disability and short-term
disability insurance, in conjunction with its managed care products.
Although the Western Division oversees the Company's health and life
insurance operations, such operations' products are provided throughout all of
the Company's service areas. The following table contains certain information
relating to such health and life insurance companies' insured PPO, point of
6
service ("POS"), indemnity, group life and disability products as of December
31, 1997 in each of the three Health Plan Divisions in which the Company
operates:
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
----------- --------- -----------
Insured PPO Members.......................................... 32,530 78,349 6,770
Point of Service Members..................................... 90,864 30,786 0
Indemnity Members............................................ 9,277 9,855 0
Group Life Members........................................... 80,876 70,594 811
Disability Product Members................................... 442 12,997 0
SPECIALTY SERVICES DIVISION
The Company's Specialty Services Division offers behavioral health, dental,
vision, and pharmaceutical products and services as well as managed care
products related to bill review, administration and cost containment for
hospitals, health plans and other entities.
DENTAL AND VISION. Through DentiCare of California, Inc. ("DentiCare"), the
Company operates a dental HMO in California, Hawaii and Oklahoma and dental
administrative services in California and Colorado, serving approximately
633,000 enrollees as of December 31, 1997. This enrollment includes 206,000
enrollees who are beneficiaries under Medicaid dental programs, 142,000
enrollees who are also enrollees of affiliated Health Plan companies, 41,000
enrollees who are beneficiaries of Hawaii's Medicaid program and 23,000
enrollees who are beneficiaries under Medicaid contracts held by non-affiliated
third parties. DentiCare is also a participant in California's Healthy Families
Program, with initial beneficiary enrollment and service delivery commencing in
July 1998. Acquired by the Company in 1991, DentiCare has grown from total
revenues in 1992 of $24 million to $49 million for the year ended December 31,
1997.
Operating on administrative and information system platforms in common with
DentiCare is Foundation Health Vision Services, Inc., d.b.a. AVP Vision Services
("AVP"). AVP operates in four states and provides at-risk and administrative
services under various programs that result in the delivery of vision benefits
to over 675,000 enrollees. Total revenues from AVP operations for the year ended
December 31, 1997 exceeded $14 million. Since its acquisition by the Company in
1992, AVP has grown from 30,000 covered enrollees to 415,000 enrollees in
full-risk products and 262,000 enrollees covered under administrative services
contracts as of December 31, 1997.
Both DentiCare and AVP are licensed in California under the Knox-Keene
Health Care Service Plan Act of 1975, as amended (the "Knox-Keene Act") as
Specialized Health Care Service Plans, and compete with other HMOs, traditional
insurance companies, self-funded plans, PPOs and discounted fee-for-service
plans. The two companies share a common strategy to maximize the value and
quality of managed dental and vision care services while appropriately balancing
financial risk assumption among providers, enrollees and other entities to
achieve the effective and efficient use of available resources.
BEHAVIORAL HEALTH. The Company's subsidiaries organized under Managed
Health Network ("MHN") and Foundation Health PsychCare Services, Inc. ("FHPS"),
each licensed in California under the Knox-Keene Act as Specialized Health Care
Service Plans, offer managed behavioral health, employee assistance programs
("EAP") and substance abuse programs. MHN and FHPS, directly and through
Specialty Division affiliates, offer these programs on an insured and
self-funded basis to employers, governmental entities and other payors in
various states.
These products and services were provided to over 7.5 million individuals in
the year ended December 31, 1997, with approximately 2.96 million individuals
under risk-based programs, approximately 1.1 million individuals under
self-funded programs and approximately 3.47 million individuals under EAP
programs.
7
The Company expects to effect the corporate merger of FHPS and MHN in 1998,
pending regulatory approvals.
MHN provides managed behavioral health programs to employers, governmental
agencies and public entitlement programs, such as CHAMPUS and Medicaid. Employer
group sizes range from Fortune 100 to mid-sized companies with 200 employees.
MHN's strategy is to continue its market share achievement in the Fortune 500,
health plan and CHAMPUS markets through a combination of direct and consultant/
broker sales. MHN intends to achieve additional market share by capitalizing on
competitor consolidation, remaining CHAMPUS procurement opportunities and the
growing state and county Medicaid behavioral carve-outs, funded on either a risk
or ASO basis.
PHARMACY BENEFIT MANAGEMENT. The Company has developed a significant,
free-standing capability to manage drug benefit quality and cost through its
pharmacy benefit management ("PBM") subsidiary, Integrated Pharmaceutical
Services, Inc. ("IPS"). Through its formulary programs, its national network of
contract pharmacies and its discount-rebate contracts with drug manufacturers,
IPS provides PBM services to over 13 million individuals enrolled in various
contracted health benefit and insurance programs. By linking utilization data
with formulary and rebate contracts with manufacturers, IPS strives to effect
the equivalent of significant bulk purchase discounts for its customers and
their enrollees. IPS has maintained pharmacy cost trends at 10% for the past two
calendar years for the Company's California health plan while pharmacy trends
for the state and the nation were significantly higher.
The management of IPS believes there currently exist significant growth
opportunities for PBMs that excel at flattening the drug cost trend for managed
care organizations and employer groups. The components of excellence are
knowledge-based programs such as turn key clinical intervention programs and
successfully leveraging pharmacy buying power. These are the strengths upon
which IPS is attempting to build.
BILL REVIEW SERVICES. The Company also provides third party administration
and bill review services with respect to workers's compensation claims primarily
to self-insured employers, and operates a medical review and cost-containment
business for the workers' compensation industry primarily within California.
These operations were previously part of the Company's Workers' Compensation
Division, the risk-based operations of which division the Company has recently
determined to discontinue.
GOVERNMENT OPERATIONS DIVISION
CHAMPUS. The Company's wholly-owned subsidiary, Foundation Health Federal
Services, Inc. ("Federal Services"), administers large, multi-year managed care
federal contracts for the United States Department of Defense (the "DoD").
Federal Services currently administers health care contracts for DoD's
TRICARE program covering 1.9 million eligible individuals under the Civilian
Health and Medical Program of the Uniformed Services ("CHAMPUS"). Through the
federal government's TRICARE program, Federal Services provides CHAMPUS families
with improved access to primary health care, lower out-of-pocket expenses and
fewer claims forms. Federal Services currently administers three TRICARE
contracts for five regions that cover the following states:
- Region 11: Washington, Oregon and part of Idaho
- Region 6: Texas, Arkansas, Oklahoma and part of Louisiana
- Regions 9, 10 & 12: California, Hawaii, Alaska and part of Arizona
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Region 11 contract increased by 9% to 113,748 while the
total estimated number of eligible beneficiaries decreased by 2% to 237,488.
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Region 6 contract increased by 28% to 266,899 while the
8
total estimated number of eligible beneficiaries decreased by 1% to 626,267.
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Regions 9, 10 and 12 contract increased by 45% to
332,103 while the total estimated number of eligible beneficiaries increased by
7% to 759,472 due to the addition of Alaska to the contract.
Under the TRICARE contracts, Federal Services shares health care cost risk
with the DoD for both gains and losses. Federal Services subcontracts to
affiliated and unrelated third parties for the administration and health care
risk of parts of these contracts. If all option periods are exercised by the DoD
and no extensions of the performance period are made, health care delivery ends
on February 29, 2000 for the Region 11 contract, on October 31, 2000 for the
Region 6 contract and on March 31, 2001 for the Regions 9, 10 and 12 contract.
Federal Services expects to compete for the rebid of all of these contracts.
Federal Services protested to the U.S. General Accounting Office (the "GAO")
concerning the awards of TRICARE contracts for Region 1 (northeast states) and
for Regions 2 and 5 (mid-Atlantic and mid-west states) to competitors of Federal
Services. The GAO sustained the protests and recommended that the DoD conduct
another round of competition for these contracts. The DoD filed petitions for
reconsideration of the protest decision by the GAO and the GAO is currently
considering those petitions. If the petitions are denied and the protest
decisions are upheld, Federal Services expects to compete again for these
contracts.
MEDICARE AND MEDICAID. As described earlier in this Annual Report on Form
10-K, the Company also contracts with federal and state governments to provide
managed Medicare and Medicaid health care programs. As of December 31, 1997, the
total number of Medicare risk enrollees in the Company's Medicare HMO operations
exceeded 309,000 members. As of December 31, 1997, the total number of Medicaid
risk enrollees in the Company's Medicaid HMO operations exceeded 443,000
members.
During 1997, Federal Services administered contracts with the states of
Massachusetts, New Jersey, Georgia, Maryland and Maine to enroll Medicaid
eligible individuals in managed care programs within such states. Federal
Services is not at risk for the provision of any health care services under
these contracts. The contract with the state of Maine expired on December 31,
1997. Federal Services entered into an agreement with MAXIMUS, Inc., effective
December 24, 1997, to sell the contracts for Massachusetts, New Jersey, Georgia
and Maryland. Federal Services is presently in discussions with these four
states to transfer these contracts to MAXIMUS, Inc.
WORKERS' COMPENSATION SEGMENT
The Company's Workers' Compensation segment applies the Company's managed
care concepts, such as use of specialized preferred provider networks and health
care utilization review, to the operations of its workers' compensation
subsidiaries. The Company's workers' compensation insurance companies consist of
the following entities: California Compensation Insurance Company, a specialty
workers' compensation carrier writing business primarily in California; Business
Insurance Company, a national workers' compensation specialty carrier;
Commercial Compensation Insurance Company, licensed to write multiple lines of
business in approximately 47 states; and Combined Benefits Insurance Company,
writing single source workers' compensation and group health insurance primarily
in California. As noted below in the section of this Annual Report on Form 10-K
entitled "Discontinued Operations and Anticipated Divestitures," the Company has
recently determined to discontinue its risk-based workers' compensation
operations.
PROVIDER RELATIONSHIPS AND RESPONSIBILITIES
PHYSICIAN RELATIONSHIPS. Upon enrollment in most of the Company's HMO
plans, each member selects a participating physician group ("PPG") or primary
care physician from the HMO's provider panel. The primary care physicians and
PPGs assume overall responsibility for the care of members. Medical care
provided directly by such physicians includes the treatment of illnesses not
requiring referral, as well as physical examinations, routine immunizations,
maternity and child care and other preventive health
9
services. The primary care physicians and PPGs are responsible for making
referrals (approved by the HMO's or PPG's medical director) to specialists and
hospitals. Certain Company HMOs offer enrollees "open panels" under which
members may access any physician in the network without first consulting a
primary care physician.
The following table sets forth the number of primary care and specialist
physicians with whom the Company's HMOs (and certain of such HMOs' PPGs)
contracted as of December 31, 1997 in each of the three Health Plan Divisions of
the Company:
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
----------- ----------- -----------
Primary Care Physicians....................................... 11,797 9,692 22,360
Specialist Physicians......................................... 23,613 26,795 23,783
----------- ----------- -----------
Totals........................................................ 35,410 36,487 46,143
PPG and physician contracts are generally for a period of at least one year
and are automatically renewable unless terminated, with certain requirements for
maintenance of good professional standing and compliance with the Company's
quality, utilization and administrative procedures. In California and Arizona,
PPGs or primary care physicians generally receive a monthly "capitation" fee for
every member served. The capitation fee represents payment in full for all
medical and ancillary services specified in the provider agreements. The
non-physician component of all hospital services is covered by a combination of
capitation and/or per diem charges. In such capitated arrangements, in cases
where the capitated provider cannot provide the health care services needed,
such providers generally contract with specialists and other ancillary service
providers to furnish the requisite services pursuant to capitation agreements or
negotiated fee schedules with specialists. Many of the Company's HMOs outside
California and Arizona reimburse physicians according to a discounted
fee-for-service schedule, although several HMOs have commenced capitation
arrangements with certain providers and provider groups in their market areas.
HOSPITAL RELATIONSHIPS. The Company's HMOs arrange for hospital care
primarily through contracts with selected hospitals in their service areas. Such
hospital contracts generally provide for multi-year terms, with limited annual
reimbursement increases, and provide for payments on a variety of bases,
including capitation, per diem rates, case rates and discounted fee-for-service
schedules.
Covered inpatient hospital care for a member is comprehensive; it includes
the services of physicians, nurses and other hospital personnel, room and board,
intensive care, laboratory and x-ray services, diagnostic imaging and generally
all other services normally provided by acute-care hospitals. HMO or PPG nurses
and medical directors are actively involved in discharge planning and case
management, which often involves the coordination of community support services,
including visiting nurses, physical therapy, durable medical equipment and home
intravenous therapy.
The Company owns and operates a 128-bed hospital located in Los Angeles,
California, the East Los Angeles Doctors Hospital, and a 200-bed hospital
located in Gardena, California, the Memorial Hospital of Gardena. As noted below
in the section of this Annual Report on Form 10-K entitled "Discontinued
Operations and Anticipated Divestitures," the Company is reviewing the
feasibility of divesting direct ownership of these hospitals.
COST CONTAINMENT. In most HMO plan designs, the primary care physician or
PPG is responsible for authorizing all needed medical care except for emergency
medical services. By coordinating care through such physicians in cases where
reimbursement includes risk-sharing arrangements, the Company believes that
inappropriate use of medical resources is reduced and efficiencies are achieved.
To limit possible abuse in utilization of hospital services in non-emergency
situations, a certification process precedes the inpatient admission of each
member, followed by continuing review during the
10
member's hospital stay. In addition to reviewing the appropriateness of hospital
admissions and continued hospital stay, the Company plays an active role in
evaluating alternative means of providing care to members and encourages the use
of outpatient care, when appropriate, to reduce the cost that would otherwise be
associated with an inpatient admission.
QUALITY ASSURANCE. Quality assurance is a continuing priority for the
Company. Most of the Company's HMOs have a quality assurance plan administered
by a committee comprised of medical directors and primary care and specialist
physicians. The committees' responsibilities include periodic review of medical
records, development and implementation of standards of care based on current
medical literature and community standards, and the collection of data relating
to results of treatment. All of the Company's HMOs also have a subscriber
grievance procedure and/or a member satisfaction program designed to respond
promptly to member grievances. Aspects of such member service programs take
place both within the PPGs and within the Company's HMOs. Set forth under the
heading "National Committee for Quality Assurance" below is information
regarding certain quality assurance accreditations received by the Company's
subsidiaries.
MANAGEMENT INFORMATION SYSTEMS
Effective information technology systems are critical to the Company's
operation. The Company's information technology systems include several computer
systems, each utilizing a combination of packaged and customized software and a
network of on-line terminals. The information technology systems gather and
store data on the Company's members and physician and hospital providers. The
systems contain all of the Company's necessary membership and claims-processing
capabilities as well as marketing and medical utilization programs. These
systems provide the Company with an integrated and efficient system of billing,
reporting, member services and claims processing and the ability to examine
member encounter information for the optimization of clinical outcomes.
In 1995, the Company embarked on a multi-year project to develop and install
a new information system designed to facilitate the seamless management of
patients throughout the entire health care continuum. This "Fourth Generation
Medical Management" project (the "4-G System") upon implementation would include
regional data repositories containing clinical and demographic data about each
of the Company's health plan members, which data serves as the basis for
enhanced clinical decision making. Physicians, hospitals and the Company's case
managers would have access to expert systems and an ever-expanding library of
clinical protocols which help in optimizing the diagnosis and treatment
decisions for each health plan member.
The Comprehensive Member Support Center ("Member Support Center"), located
in the Philadelphia area, is a sophisticated telecommunications center staffed
by experienced nurses that is the Company's initial application of the 4-G
System. Each Member Support Center nurse has access to member-specific health
information. In addition, expert clinical algorithms, developed by physicians at
leading hospitals and academic medical centers, guide nurse interactions with
members. As calls from members come into the center, the nurse can retrieve
detailed member and provider information and use the expert algorithms to guide
members to the most appropriate level of care for their condition. Outbound
activities of the call center includes clinical reminder calls to members and
consultive support for self-care protocols and educational materials. Whenever a
member accesses the center, his or her primary care physician receives a
follow-up report by fax, ensuring continuity of care.
When first introduced, the Member Support Center served only members in the
Philadelphia plan. Today, the Member Support Center serves more than three
million FHS members in 13 states. In 1998, it is anticipated that the members of
PHS and the Company's Arizona plan will be added to the center. The clinical
nurses at the center today are handling approximately 1,300 phone calls each day
from the Company's members. They interact with members 24 hours a day, seven
days a week, to help ensure that members have access to the right provider in
the right setting--no matter where they are in the United
11
States. The Company is contemplating the creation of regional centers similar to
the Member Support Center which it believes will further strengthen the
connection between members and the Company.
The Company believes the Member Support Center is the most sophisticated
telecommunications system in the managed care industry today. The Company sees
it as a critical competitive advantage, especially in the Northeastern United
States where FHS offers "open access" health plans.
The Company also recognizes that the arrival of the Year 2000 poses a
challenge to the ability of computer systems to recognize the date change from
1999 to 2000 (the "Year 2000 Issue") and has begun to assess and modify its
computer applications and business processes to provide for their continued
functionality given the Year 2000 Issue. The Year 2000 Issue is the result of
computer programs being written using two digits rather than four to define the
applicable year. Any of the Company's computer programs (both external and
internal) that have time sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or material miscalculations causing disruptions of operations, including, among
other things, the inability to process transactions, prepare invoices or engage
in normal business activities.
The costs of the Company's Year 2000 Issue projects and the timetable in
which the Company plans to complete the Year 2000 Issue compliance requirements
are set forth elsewhere in this Annual Report on Form 10-K and are based on
estimates derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors.
DISCONTINUED OPERATIONS AND ANTICIPATED DIVESTITURES
The Company revised its strategy of maintaining a presence in the workers'
compensation insurance business as a result of various adverse developments
arising in 1997 in the workers' compensation insurance business, primarily
related to the workers' compensation claims environment in California. As
discussed elsewhere in this Annual Report on Form 10-K, such adverse
developments caused the Company's workers' compensation reserves to be
inadequate which required the Company to strengthen such reserves at the end of
1997. These developments also led the Company to adopt a plan to completely
discontinue this segment of its business, through divestiture of its workers'
compensation risk-assuming insurance subsidiaries. The Company is presently
conducting the sale of these businesses.
The Company is presently reviewing a possible plan to exit its HMO
operations in the states of Texas, Louisiana and Oklahoma due to inadequate
returns on invested capital. The Company is presently reviewing an exit strategy
for such states' businesses (including potential sale transactions). In December
1997 the Company also entered into a sale agreement to divest its
non-operational HMO license in Alabama to an unaffiliated third party.
The Company has decided to review the possibility of divesting its direct
ownership of two Southern California hospitals, a 128-bed hospital located in
Los Angeles, California, the East Los Angeles Doctors Hospital, and a 200-bed
hospital located in Gardena, California, the Memorial Hospital of Gardena.
Direct ownership of these two hospitals is not consistent with the Company's
business philosophy to manage health care through contracts with independent
providers of medical services. The Company is presently responding to inquiries
of parties which have expressed an interest in purchasing these hospitals.
12
The Company is also analyzing the strategic fit of its Denticare managed
dental operations with the ongoing operations and operating strategy of the
Company and, in this connection, whether a sale of such operations could be
completed consistent with the Company's interests.
In addition, effective June 30, 1997, the Company divested its United
Kingdom operations.
As set forth elsewhere in this Annual Report on Form 10-K, the Company
continues to evaluate the profitability realized or likely to be realized by its
existing businesses and operations, and is reviewing from a strategic standpoint
which of such businesses or operations should be divested.
ADDITIONAL INFORMATION CONCERNING THE COMPANY'S BUSINESS
MARKETING AND SALES. Marketing for group Health Plan business is a two-step
process in which the Company first markets to employer groups and then provides
information directly to employees once the employer has selected a Company HMO.
The Company typically uses its internal sales staff to serve the large employer
groups while independent brokers work with the Company's internal sales staff to
develop business with smaller employer groups. Once selected by an employer, the
Company solicits enrollees from the employee base directly. In 1997, the Company
marketed its programs and services primarily through its direct sales staff and
independent brokers, agents and consultants. During "open enrollment" periods
when employees are permitted to change health care programs, the Company uses
direct mail, work day and health fair presentations, telemarketing, and outdoor,
print, radio and television advertisements to attract new enrollees. The
Company's sales efforts are supported by its marketing division which includes
research and product development, corporate communications, public relations and
marketing services.
Premiums for each employer group are generally contracted for on a yearly
basis, payable monthly. Numerous factors are considered by the Company in fixing
its monthly premiums, including employer group needs and anticipated health-care
utilization rates as forecasted by the Company's management based on the
demographic composition of, and the Company's prior experience in, its service
areas. Premiums are also affected by applicable regulations that prohibit
experience rating of group accounts (i.e., setting the premium for the group
based on its past use of health care services) and by state regulations
governing the manner in which premiums are structured.
The Company believes that the importance of the ultimate health care
consumer (or member) in the health care product purchasing process is likely to
increase in the future. Accordingly, the Company intends to focus its marketing
strategies on the development of distinct brand identities and innovative
product service offerings that will appeal to potential Health Plan members.
COMPETITION. HMOs operate in a highly competitive environment in an
industry currently subject to significant changes from business consolidations,
new strategic alliances, legislative reform and market pressures brought about
by a better informed and better organized customer base. The Company's HMOs face
substantial competition from for-profit and nonprofit HMOs, PPOs, self-funded
plans (including self-insured employers and union trust funds), Blue Cross/Blue
Shield plans and traditional indemnity insurance carriers, some of which have
substantially larger enrollments and greater financial resources than the
Company. The Company believes that the principal competitive features affecting
its ability to retain and increase membership include the range and prices of
benefit plans offered, provider network, quality of service, responsiveness to
user demands, financial stability, comprehensiveness of coverage, diversity of
product offerings and market presence and reputation. The relative importance of
each of these features and key competitors vary by market. The Company believes
that it competes effectively with respect to all of these factors.
Kaiser Foundation Health Plan ("Kaiser") is the largest HMO in California
and in the United States and the Company's principal competitor in the
California HMO industry. In addition to Kaiser, the Company's other HMO
competitors include PacifiCare of California (which recently purchased FHP
Health Plan), California Care (Blue Cross) and CIGNA Healthplans of California,
Inc. In addition, there
13
are a number of other types of competitors including self-directed plans,
traditional indemnity insurance plans and other managed care plans.
The Company competes in California for employers and members against other
HMOs, self-funded plans, traditional health insurers and a variety of PPOs. The
establishment of PPOs has been encouraged by legislation in California that
enables insurance companies to negotiate fees with health care providers and to
extend economic incentives to insureds to utilize such providers without
significant legal restrictions. However, the California Department of
Corporations (the "DOC"), which regulates all California HMOs, has interpreted
California law to prohibit California PPOs that lack an HMO license from
compensating providers on a capitated or other prepaid or periodic basis unless
those providers themselves have an HMO license. Thus, only HMOs may legally
enter into such financial arrangements with providers, while PPOs are limited to
fee-for-service arrangements.
The Company's Colorado HMO competes primarily against other HMOs including
Kaiser and PacifiCare of Colorado, as well as with a Blue Cross/Blue Shield HMO,
other commercial carriers and various hospital or physician-owned HMOs. The
Company's largest competitor in New Mexico is Presbyterian Health Plan. The
Company's New Mexico HMO also competes with Lovelace Health Plan (an HMO owned
by CIGNA Corporation) and Blue Cross/Blue Shield. The Company's largest
competitor in Arizona is Health Partners. The Company's Arizona HMO also
competes with CIGNA, PacifiCare, Aetna, and Blue Cross/Blue Shield. In Utah, the
Company competes with Intermountain Health Plan and PacifiCare, among other
companies.
The Company's Oregon HMO competes primarily against other HMOs including
Kaiser, PacifiCare of Oregon, The Good Health Plan, and a Blue Cross/Blue Shield
HMO, and with various PPOs. The Company's Washington HMO competes primarily with
Group Health Cooperative of Puget Sound, Kaiser, HealthPlus (Blue Cross), and
with commercial carriers, self-funded plans and other Blue Cross/Blue Shield
organizations.
The Company's HMOs in Connecticut compete for business with commercial
insurance carriers, Blue Cross and Blue Shield of Connecticut and more than ten
HMOs. The Company's main competitors in Pennsylvania, New York and New Jersey
are Aetna/U.S. Healthcare, Independence Blue Cross, Empire Blue Cross, Oxford
Health Plans, AmeriHealth and Keystone East. The Company's HMO operations in
Florida compete for business with Humana Medical Plan, United HealthCare, Health
Options, and Prudential HealthCare, among others.
GOVERNMENT REGULATION. The Company believes it is in compliance in all
material respects with all current state and federal regulatory requirements
applicable to the business to be conducted by its subsidiaries. Certain of these
requirements are discussed below.
FEDERAL HMO STATUTES. Under the Federal Health Maintenance Organization Act
of 1973 (the "HMO Act"), services to members must be provided substantially on a
fixed, prepaid basis without regard to the actual degree of utilization of
services. Although premiums established by an HMO may vary from account to
account through composite rate factors and special treatment of certain broad
classes of members, traditional experience rating of accounts (i.e.,
retrospective adjustments for a group account based on that group's past use of
health care services) is not permitted under the HMO Act; prospective rating
adjustments are, however, allowed. Several of the Company's HMOs are federally
qualified in certain parts of their respective service areas under the HMO Act
and are therefore subject to the requirements of such act to the extent
federally qualified products are offered and sold.
Additionally, there are a number of proposed federal laws currently before
Congress to further regulate managed health care. The Company cannot predict the
ultimate fate of any of these legislative proposals. The Company's Medicare risk
contracts are subject to regulation by HCFA. HCFA has the right to audit HMOs
operating under Medicare contracts to determine the quality of care being
rendered and the degree of compliance with HCFA's contracts and regulations.
14
CALIFORNIA HMO REGULATIONS. California HMOs such as Health Net and certain
of the Company's specialty plans are subject to state regulation, principally by
the DOC under the Knox-Keene Health Care Service Plan Act of 1975, as amended
(the "Knox-Keene Act"). Among the areas regulated by the Knox-Keene Act are: (i)
adequacy of administrative operations, (ii) the scope of benefits required to be
made available to members, (iii) manner in which premiums are structured, (iv)
procedures for review of quality assurance, (v) enrollment requirements, (vi)
composition of policy making bodies to assure that plan members have access to
representation, (vii) procedures for resolving grievances, (viii) the
interrelationship between HMOs and their health care providers, (ix) adequacy
and accessibility of the network of health care providers, (x) provider
contracts and (xi) initial and continuing financial viability. Any material
modifications to the organization or operations of Health Net are subject to
prior review and approval by the DOC. This approval process can be lengthy and
there is no certainty of approval. In addition, under the Knox-Keene Act, Health
Net and certain other Company subsidiaries must file periodic reports with, and
are subject to periodic review by, the DOC.
Currently, the California legislature is considering a number of significant
managed health care measures which could materially alter California's
regulatory environment. Among such measures are proposals to establish an
entirely new regulatory structure for managed care, in lieu of the DOC. Other
legislative proposals focus on medical care dispute resolution mechanisms,
medical malpractice liability, and plan enrollee notification about plan
provisions and coverage. The Company cannot predict the ultimate fate of any of
these legislative proposals in California.
OTHER HMO REGULATIONS. In each state in which the Company does business,
HMOs must file periodic reports with, and their operations are subject to
periodic examination by, state licensing authorities. In addition, each HMO must
meet numerous state licensing criteria and secure the approval of state
licensing authorities before implementing certain operational changes, including
the development of new product offerings and, in some states, the expansion of
service areas. To remain licensed, each HMO must continue to comply with state
laws and regulations and may from time to time be required to change services,
procedures or other aspects of its operations to comply with changes in
applicable laws and regulations. HMOs are required by state law to meet certain
minimum capital and deposit and/or reserve requirements in each state and may be
restricted from paying dividends to their parent corporations under certain
circumstances from time to time. Several states have increased minimum capital
requirements, which increases are typically phased in over a period of time.
Regulations in these and other states may be changed in the future to further
increase equity requirements. Such increases could require the Company to
contribute additional capital to its HMOs. Any adverse change in governmental
regulation or in the regulatory climate in any state could materially impact the
HMOs operating in that state. The HMO Act and state laws place various
restrictions on the ability of HMOs to price their products freely. The Company
must comply with certain provisions of certain state insurance and similar laws,
especially as it seeks ownership interests in new HMOs, PPOs and insurance
companies, or otherwise expands its geographic markets or diversifies its
product lines.
INSURANCE REGULATIONS. State departments of insurance (the "DOIs") regulate
insurance and third party administrator business conducted by certain
subsidiaries of the Company (the "Insurance Subsidiaries") pursuant to various
provisions of state insurance codes and regulations promulgated thereunder. The
Insurance Subsidiaries are subject to various capital reserve and other
financial requirements established by the DOIs. The Insurance Subsidiaries must
also file periodic reports regarding their activities regulated by the DOIs and
are subject to periodic reviews of those activities by the DOIs. The Company
must also obtain approval from or file with the DOIs for all of its group and
individual policies prior to issuing those policies. The Company does not
believe that the requirements imposed by the DOIs will have a material impact on
the ability of the Insurance Subsidiaries to conduct their business profitably.
NATIONAL COMMITTEE FOR QUALITY ASSURANCE ("NCQA"). NCQA, an independent,
non-profit organization that reviews and accredits HMOs, assesses an HMO's
quality improvement, utilization management,
15
credentialing process, commitment to members' rights and preventive health
services. HMOs that comply with NCQA's review requirements and quality standards
receive NCQA accreditation. After an NCQA review is completed, NCQA will issue
one of four designations. These are (i) accreditation for three years; (ii)
accreditation for one year; (iii) provisional accreditation for twelve to
eighteen months to correct certain problems with a follow-up review to determine
qualification for accreditation; and (iv) not accredited. Intergroup, the
Company's HMO in Arizona, has received NCQA accreditation for three years.
Health Net, PHS, Foundation Health, a Florida Health Plan, QualMed Pennsylvania,
QualMed Plans for Health of Colorado, and QualMed, a Washington Health Plan have
all received one year accreditation from NCQA. Certain of the Company's other
Health Plan subsidiaries are in the process of applying for NCQA accreditation.
SERVICE MARKS
The Company's service marks and/or trademarks include, among others: THE
ACUTE CARE ALTERNATIVE-Registered Trademark-, Alliance 2000-SM-, Alliance
1000-SM-, Asthmawise-SM-, AVP-SM-, AVP Vision Plans-SM-, BabyWell-SM-, BEING
WELL-Registered Trademark-, CARECAID-Registered Trademark-,
CMP-Registered Trademark-, COMBINED CARE-REGISTERED TRADEMARK-, COMBINED CARE
PLUS-SM-, COMMUNITY MEDICAL PLAN, INC. and design-Registered Trademark-, A CURE
FOR THE COMMON HMO-Registered Trademark-, Feetbeat Worksite Walking Program-SM-,
FIRM SOLUTIONS-Registered Trademark-, FLEX ADVANTAGE-Registered Trademark-, FLEX
NET-SM-, FOUNDATION HEALTH and design-Registered Trademark-, FOUNDATION HEALTH
GOLD-Registered Trademark-, Foundation Health Systems-SM-, GOOD HEALTH IS JUST
AROUND THE CORNER-Registered Trademark-, HANK-Registered Trademark-, HANK and
design-Registered Trademark-, HEALTH NET-Registered Trademark-, Health Net
ACCESS-SM-, Health Net Comp.24-SM-, Health Net ELECT-SM-, Health Net
INSIGHT-SM-, Health Net OPTIONS-SM-, Health Net SELECT-SM-, Health Net Seniority
Plus-SM-, Health Smart and design-SM-, Healthworks (stylized)-SM-, Heart &
Soul-SM-, IMET and design-Registered Trademark-, Indian
design-Registered Trademark-, INDIVIDUAL PREFERRRED PPO-Registered Trademark-,
InterCare-SM-, InterComp-SM-, InterFlex-SM-, Inter Mountain Employers Trust-SM-,
InterPlus-SM-, LIFE WITH DIGNITY AND HOPE-Registered Trademark-, MAKING QUALITY
HEALTH CARE AFFORDABLE-Registered Trademark-, M.D. Health Plan Personal Medical
Management-SM-, On the Road to Good Health-SM-, PHYSICIANS HEALTH
SERVICES-Registered Trademark-, Premier Medical Network-SM-, Premier Medical
Network It's Your Choice-SM-, QUALASSIST-Registered Trademark-,
QUALADMIT-Registered Trademark-, QUALCARE-Registered Trademark-, QUALCARE
PREFERRED-Registered Trademark-, QUAL-MED-Registered Trademark-, QUALMED-SM-,
QUALMED HEALTH & LIFE INSURANCE COMPANY-Registered Trademark-, QUALMED PLANS FOR
HEALTH-Registered Trademark-, Rapid Access-SM-, SENIOR
SECURITY-Registered Trademark-, SENIOR VALUE-Registered Trademark-, Someone at
Your Side-SM-, Sun/Mountain design-Registered Trademark-,The Final Piece of the
Healthcare Puzzle-SM-, VitalLine-SM-, VITALTEAM-Registered Trademark-, WELL
MANAGED CARE RIGHT FROM THE START-Registered Trademark-, WELL
REWARDS-Registered Trademark-, Well Woman-SM-, Wise Choice-SM-, WORKING WELL
TOGETHER-Registered Trademark- and Your Partner in Healthy Living-SM- and
certain designs related to the foregoing.
The Company utilizes these and other marks in connection with the marketing
and identification of products and services. The Company believes such marks are
valuable and material to its marketing efforts.
EMPLOYEES
The Company currently employs approximately 15,200 employees. Such employees
perform a variety of functions, including administrative services for employers,
providers, and members, negotiation of agreements with physician groups,
hospitals, pharmacies and other health care providers, handling claims for
payment of hospital and other services and providing data processing services.
The Company's employees are not unionized and the Company has not experienced
any work stoppage since its organization. The Company considers its relations
with its employees to be very good.
As set forth elsewhere in this Annual Report on Form 10-K, in connection
with the FHS Combination the Company adopted a significant restructuring plan
which provides for a workforce reduction, the consolidation of employee benefit
plans and the consolidation of certain office locations.
16
ITEM 2. PROPERTIES
The Company owns its offices in Pueblo, Colorado and leases office space for
its principal executive offices in Woodland Hills and its offices in Rancho
Cordova, California.
The Pueblo facility, with approximately 72,000 square feet, is subject to a
mortgage in the aggregate principal amount of approximately $1 million. The
Company is also renovating three Pueblo properties which it obtained in 1996
with approximately 188,400 aggregate square feet and intends to receive public
funds for certain of such properties' renovation from the City and County of
Pueblo in return for certain employment commitments.
The Woodland Hills facility, with approximately 300,000 square feet, is
leased pursuant to a ten year base lease expiring in 2001 on an anchor
full-service gross basis with annual rent in 1997 of approximately $8.6 million.
The Company and its subsidiaries also lease an aggregate of approximately
550,000 square feet of office space in Rancho Cordova, California. The Company's
aggregate rent obligations under these leases were approximately $9.2 million in
1997. These leases expire at various dates through July 2002.
In addition to the Company's office space in Pueblo, Woodland Hills and
Rancho Cordova, the Company and its subsidiaries lease approximately 220 sites
in 27 states, comprising roughly 2.2 million square feet of space.
The Company owns in total approximately 1.7 million square feet of space.
The Company owns approximately 535,000 aggregate square feet of space for health
care centers in California and Arizona and approximately 249,000 square feet of
space for two hospitals in Southern California. The Company also owns
approximately a dozen office buildings, in Arizona, California, Colorado and
Connecticut, which collectively encompass about 840,000 square feet of space.
Management believes that its ownership and rental costs are consistent with
those available for similar space in the applicable local area. The Company's
properties are well maintained, considered adequate and are being utilized for
their intended purposes.
ITEM 3. LEGAL PROCEEDINGS
RESTRICTED STOCK DISPUTE
Following the conversion of Health Net to a for-profit subsidiary of the
Company (the "Conversion"), a restricted stock plan (the "Restricted Stock
Plan") was adopted and restricted shares of the Company ("Restricted Shares")
were issued to certain management employees of Health Net. In February 1993, the
DOC informed Health Net that it believed the issuance of Restricted Shares of
the Company to persons who were stockholders of the Company as of the date of
the Conversion (the "Restricted Share Recipients") violated certain provisions
and terms imposed by the DOC in connection with the Conversion. In March 1993,
the DOC insisted that such restricted shares be rescinded and stated that the
DOC would take steps necessary to revoke the approval of the Conversion if the
issuance of the Restricted Shares was not rescinded (the "Conditional Revocation
Order"). In April 1993 the Restricted Share Recipients agreed to rescind all of
the Restricted Shares issued to them, under express protest to the DOC.
Subsequently, certain of the Restricted Share Recipients filed a formal protest
with the DOC requesting a hearing regarding the correctness of the decision.
On September 14, 1994, Health Net, the Company and certain of the Restricted
Share Recipients, on behalf of all the Restricted Share Recipients (the
"Petitioners"), filed a Petition for Writ of Administrative Mandamus in the
Superior Court of the County of Los Angeles (Case No. BS030426) (the "Writ
Proceeding"). The Writ Proceeding sought to overturn the Conditional Revocation
Order and to require the Commissioner of the DOC to follow procedures set forth
in the Administrative Procedures Act which would result in an administrative
hearing regarding the correctness of the Conditional Revocation Order
17
or, in the alternative, to treat the Conditional Revocation Order as a final
agency action and to have the Court order the Commissioner of the DOC to rescind
the Conditional Revocation Order.
On May 25, 1995, the Petitioners filed an amended petition expanding the
original claims and adding a new cause of action for a declaratory judgment that
would revoke the rescission of the issuance of the Restricted Shares. The DOC
and the CWF filed new demurrers to the amended petition on July 3, 1995. At a
hearing on July 28, 1995, the Court sustained the demurrers without leave to
amend. On August 7, 1995, the Petitioners filed objections to the Court's
Statement of Decision. On August 15, 1995, the Court overruled the objections of
the Petitioners to the Court's Statement of Decision. On September 8, 1995, the
Court entered an Order of Dismissal, and the Amended Petition for Writ of
Mandate and Complaint for Declaratory Relief of the Petitioners was dismissed.
On September 19, 1995, the DOC served notice of the entry of the Order of
Dismissal. On October 18, 1995, the Petitioners filed a Notice of Appeal. The
opening brief was filed on March 15, 1996, and the Respondents' briefs were
filed on or around June 13, 1996. The reply briefs to the Respondents' briefs
were timely filed on August 19, 1996 and the Court set oral arguments on the
appeal for November 13, 1996.
On November 26, 1996, the California Court of Appeals entered an order
affirming the trial court decision. During the first week of January 1997, the
Petitioners filed a petition for review asking the California Supreme Court to
consider the matter. The DOC and the CWF filed oppositions to the petition for
review on January 21, 1997 and January 23, 1997, respectively. On March 12,
1997, the California Supreme Court issued a ruling denying the petition for
review. This case is now resolved.
MEDAPHIS CORPORATION
On November 7, 1996 the Company's predecessor HSI filed a lawsuit against
Medaphis Corporation ("Medaphis") and its former Chairman and Chief Executive
Officer Randolph G. Brown, entitled HEALTH SYSTEMS INTERNATIONAL, INC. V.
MEDAPHIS CORPORATION, RANDOLPH G. BROWN AND DOES 1-50, case number BC 160414,
Superior Court of California, County of Los Angeles. The lawsuit arises out of
the acquisition of Health Data Sciences Corporation ("HDS") by Medaphis. In July
1996, HSI, the owner of 1,234,544 shares of Series F Preferred Stock of HDS,
representing over sixteen percent of the total outstanding equity of HDS, voted
its shares in favor of the acquisition of HDS by Medaphis. HSI received as the
result of the acquisition 976,771 shares of Medaphis Common Stock in exchange
for its Series F Preferred Stock. Pursuant to the Merger Agreement, the Company
succeeded to the interests of HSI in the Medaphis lawsuit, and the Company has
been substituted for HSI as plaintiff in the suit.
In its complaint, the Company alleges that Medaphis was actually a poorly
run company with sagging earnings in its core business, and had artificially
maintained its stock prices through a series of acquisitions and accounting
maneuvers which provided the illusion of growth while hiding the reality of its
weakening financial and business condition. The Company alleges that Medaphis,
Brown and other insiders deceived the Company by presenting materially false
financial statements and by failing to disclose that Medaphis would shortly
reveal a "write off" of up to $40 million in reorganization costs and would
lower its earnings estimate for the following year, thereby more than halving
the value of the Medaphis shares received by the Company. The Company alleges
that these false and misleading statements were contained in oral communications
with the Company, as well as in the registration statement and the prospectus
provided by Medaphis to all HDS shareholders in connection with the HDS
acquisition. Further, despite knowing of the Company's discussions to form a
strategic alliance of its own with HDS, Medaphis and the individual defendants
wrongfully interfered with that prospective business relationship by proposing
to acquire HDS using Medaphis stock whose market price was artificially inflated
by false and misleading statements. The Company alleges that the defendants'
actions constitute violations of both federal and state securities laws, as well
as fraud and other torts under state law. The Company is seeking either
rescission of the transaction or damages in excess of $38 million. The
defendants have denied the allegations in the complaint, and the Company is
vigorously pursuing its claims against Medaphis.
18
Recently the Company moved to disqualify the law firm representing certain
of the individual defendants. The trial court granted the Company's motion, and
the law firm and its clients have appealed such decision. In addition, the trial
court granted a stay of the case until June 4, 1998 in order to permit the law
firm to appeal. The Company intends to press for an expedited appeal. Prior to
the stay the case was in the early stages of discovery. No trial date has yet
been set.
MONACELLI VS. GEM INSURANCE COMPANY
On December 29, 1994, a lawsuit entitled MARIO AND CHRISTIAN MONACELLI V.
GEM INSURANCE COMPANY, ET AL (Case No. CV94-20715) was initiated in Maricopa
County (Arizona) Superior Court against Gem Insurance Company, a subsidiary of
the Company ("Gem"), for bad faith and misrepresentation. Plaintiffs
subsequently asserted claims in the same action against their insurance agent,
Mark Davis, for negligence and misrepresentation. The Plaintiffs' claims arose
from the rescission of their health insurance policy based on their alleged
failure to disclose an X-ray, taken one year before the Plaintiffs filled out
their insurance application, which revealed an undiagnosed mass on Mr.
Monacelli's lung. Plaintiffs incurred approximately $70,000 in medical expenses
in connection therewith. Prior to trial, the agent recanted certain portions of
his deposition testimony and admitted that the Plaintiffs had told him that Mr.
Monacelli had undergone certain tests which were not revealed on the
application. Based on this new information, Gem paid the Plaintiffs' medical
expenses with interest.
The case went to trial in April of 1997 against Gem and the agent. A jury
verdict was ultimately rendered awarding the Plaintiffs $1 million in
compensatory damages and assessing fault 97% to Gem and 3% to the agent, Mark
Davis. In addition, the jury awarded $15 million in punitive damages against
Gem. Thereafter, the plaintiffs filed a motion seeking to recover an additional
$4 million in attorneys' fees, and Gem filed post-trial motions for judgment
notwithstanding the verdict, for a new trial and for remittitur of the jury
verdict. Gem's motion for judgment notwithstanding the verdict was denied. The
court granted Gem's motion for remittitur and remitted the jury verdict to an
award of $1 million in compensatory damages and $2 million in punitive damages.
The court further ordered that if the plaintiffs did not accept the remittitur
order, Gem's motion for new trial would be granted. The plaintiffs accepted the
court's remittitur. Their motion for attorneys' fees is currently pending.
Notwithstanding the plaintiffs' acceptance of the court's remittitur, Gem plans
to appeal the verdict.
In addition, on July 15, 1997 Gem filed a complaint against Mr. Davis and
his spouse in Maricopa County (Arizona) Superior Court (Case No. CV97-13053)
asserting a claim for indemnity against Mr. Davis with respect to the Monacelli
case.
MISCELLANEOUS PROCEEDINGS
The Company and certain of its subsidiaries are also parties to various
legal proceedings, many of which involve claims for coverage encountered in the
ordinary course of its business. Based in part on advice from litigation counsel
to the Company and upon information presently available, management of the
Company is of the opinion that the final outcome of all such proceedings should
not have a material adverse effect upon the Company's results of operations or
financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the security holders of the
Company, either through solicitation of proxies or otherwise, during the fourth
quarter of the year ended December 31, 1997.
19
OTHER INFORMATION
REVOLVING CREDIT FACILITY
On July 8, 1997 the Company entered into a Credit Agreement with the banks
identified therein (the "Banks") and Bank of America National Trust and Savings
Association ("Bank of America"), in its capacity as the Administrative Agent,
pursuant to which the Company obtained an unsecured five-year $1.5 billion
revolving credit facility maturing on July 7, 2002. The Credit Agreement
replaced (i) the Company's prior Amended and Restated Credit Agreement, dated as
of April 26, 1996, with Bank of America, as agent, providing for a $700 million
unsecured revolving credit facility and (ii) FHC's prior (A) Revolving Credit
Agreement, dated as of December 5, 1994, with Citicorp USA, Inc., as agent,
providing for a $300 million unsecured revolving credit facility and (B)
Revolving Credit Agreement, dated as of December 17, 1996, with Citibank, N.A.,
as administrative agent, providing for a $200 million unsecured revolving credit
facility.
The Credit Agreement contains customary representations and warranties,
affirmative and negative covenants and events of default. Specifically, Section
7.11 of the Credit Agreement provides that the Company and its subsidiaries may,
so long as no event of default exists: (i) declare and distribute stock as a
dividend; (ii) purchase, redeem or acquire its stock, options and warrants with
the proceeds of concurrent public offerings; and (iii) declare and pay dividends
or purchase, redeem or otherwise acquire its capital stock, warrants, options or
similar rights with cash subject to certain specified limitations.
Under the Credit Agreement, as amended pursuant to a Letter Agreement dated
March 27, 1998 (the "Credit Facility Letter Agreement") with the Banks, the
Company is: (i) obligated to maintain certain covenants keyed to the Company's
financial condition and performance (including a Total Leverage Ratio and Fixed
Charge Ratio); (ii) obligations to limit liens; (iii) subject to customary
covenants, including (A) disposition of assets only in the ordinary course and
generally at fair value and (B) restrictions on acquisitions, mergers,
consolidations, loans, leases, joint ventures, contingent obligations and
certain transactions with affiliates; (iv) permitted to sell the Company's
workers' compensation insurance business, provided that the net proceeds shall
be applied towards repayment of the outstanding Loans under the Credit
Agreement; and (v) permitted to incur additional indebtedness in an aggregate
amount not to exceed $1,000,000,000 upon certain terms and conditions, including
mandatory prepayment of the outstanding Loans with a certain portion of the
proceeds from the issuance of such indebtedness, resulting in a permanent
reduction of the aggregate amount of commitments under the Credit Agreement by
the amount so prepaid. The Credit Facility Letter Agreement, a copy of which is
filed as Exhibit 10.70 to this Annual Report on Form 10-K, also provided for an
increase in the interest and facility fees under the Credit Agreement.
SHAREHOLDER RIGHTS PLAN
On May 20, 1996, the Board of Directors of the Company declared a dividend
distribution of one right (a "Right") for each outstanding share of the
Company's Class A Common Stock and Class B Common Stock (collectively, the
"Common Stock"), to stockholders of record at the close of business on July 31,
1996 (the "Record Date"). The Board of Directors of the Company also authorized
the issuance of one Right for each share of Common Stock issued after the Record
Date and prior to the earliest of the Distribution Date (as defined below), the
redemption of the Rights and the expiration of the Rights and in certain other
circumstances. Rights will attach to all Common Stock certificates representing
shares then outstanding and no separate Rights Certificates will be distributed.
Subject to certain exceptions contained in the Rights Agreement dated as of June
1, 1996 by and between the Company and Harris Trust and Savings Bank, as Rights
Agent (the "Rights Agreement"), the Rights will separate from the Common Stock
in the event any person acquires 15% or more of the outstanding Class A Common
Stock, the Board of Directors of the Company declares a holder of 10% or more to
the outstanding Class A Common Stock to be an "Adverse Person," or any person
commences a tender offer for 15% of the Class A Common Stock (each event causing
a "Distribution Date").
20
Except as set forth below and subject to adjustment as provided in the
Rights Agreement, each Right entitles its registered holder, upon the occurrence
of a Distribution Date, to purchase from the Company one one-thousandth of a
share of Series A Junior Participating Preferred Stock, at a price of $170.00
per one-thousandth share. However, in the event any person acquires 15% or more
of the outstanding Class A Common Stock, or the Board of Directors of the
Company declares a holder of 10% or more of the outstanding Class A Common Stock
to be an "Adverse Person," the Rights (subject to certain exceptions contained
in the Rights Agreement) will instead become exercisable for Class A Common
Stock having a market value at such time equal to $340.00. The Rights are
redeemable under certain circumstances at $.01 per Right and will expire, unless
earlier redeemed, on July 31, 2006.
A copy of the Rights Agreement has been filed with the Securities and
Exchange Commission as Exhibit 99.1 to the Company's Registration Statement on
Form 8-A (File No. 001-12718). In connection with its execution of the Merger
Agreement for the FHS Combination, the Company entered into Amendment No. 1 (the
"Rights Amendment") to the Rights Agreement to exempt the Merger Agreement and
related transactions from triggering the Rights. In addition, the Rights
Amendment modifies certain terms of the Rights Agreement applicable to the
determination of certain "Adverse Persons," which modifications become effective
upon consummation of the transactions provided for under the Merger Agreement.
This summary description of the Rights does not purport to be complete and is
qualified in its entirety by reference to the Rights Agreement.
THE CALIFORNIA WELLNESS FOUNDATION
Pursuant to the Amended Foundation Shareholder Agreement, dated as of
January 28, 1992 (the "CWF Shareholder Agreement"), by and among the Company,
the CWF and certain stockholders (the "HNMH Stockholders") of HN Management
Holdings, Inc. (a predecessor to the Company) ("HNMH") named therein, the CWF is
subject to various volume and manner of sale restrictions specified in the CWF
Shareholder Agreement which limit the number of shares that the CWF may dispose
of prior to December 31, 1998.
Under the relevant provisions of California law, when a corporation converts
from nonprofit to for-profit corporate status, the equivalent of the fair market
value of the nonprofit corporation must be contributed to a successor charity
that has a charitable purpose consistent with the purposes of the nonprofit
entity. The CWF was formed to be the charitable recipient of the conversion
settlement when Health Net (a subsidiary of the Company) effected a conversion
from nonprofit to for-profit status, which occurred in February 1992 (the
"Conversion"). In connection with the Conversion, Health Net issued to the CWF
promissory notes in the original principal amount of $225 million (the "CWF
Notes") and shares of Class B Common Stock (which immediately prior to the
business combination involving HNMH and QualMed, Inc. were split to become
25,684,152 shares of Class B Common Stock then held by the CWF). While such
shares are held by the CWF, they are entitled to the same economic benefit as
Class A Common Stock, but are non-voting in nature. If the CWF sells or
transfers such shares to an unrelated third party, they automatically convert to
Class A Common Stock.
In addition, the CWF Shareholder Agreement, in conjunction with the Letter
Agreement executed by the Company and the Trustees of a Trust (holding shares on
behalf of the HNMH Stockholders) on March 9, 1995 and ratified by the Company's
Board of Directors on March 16, 1995 (the "Letter Agreement") requires the CWF
to offer its shares of Class B Common Stock to the Company prior to selling such
shares to any other person. In this respect, the CWF Shareholder Agreement
permits the CWF to offer and sell up to 80% of the CWF's interest in the Class B
Common Stock (or all but 5,136,830 of such shares) to the Company prior to
December 31, 1998. The CWF Shareholder Agreement, in conjunction with the Letter
Agreement, requires the CWF to provide the Company with notice on or before
January 31 of each year setting forth the number of shares, if any, being
offered to the Company. The Company then has 45 days following receipt of such
notice to notify the CWF of its intention to purchase such number of shares.
21
On January 27, 1997, the CWF provided the Company with notice of its offer
to sell 3,852,653 shares of Class B Common Stock, provided that at the Company's
option the number of shares could be increased to not more than 5,000,000
shares. Pursuant to such offer and subsequent letter agreements (collectively,
the "1997 Notice Materials") the CWF agreed to extend until June 20, 1997 the
time by which the Company could notify the CWF of its intention to purchase or
redeem such number of shares of Class B Common Stock. Accordingly, after
appropriate notice was given and effective June 27, 1997, the Company redeemed
4,550,000 shares of Class B Common Stock from the CWF at a price of $24.469 per
share.
In addition, on June 18, 1997, the Company provided its consent under the
CWF Shareholder Agreement to permit the CWF to sell 3,000,000 shares of Class B
Common Stock to an unrelated third party. Pursuant to the 1997 Notice Materials,
the CWF also retained the right to sell the balance of the 5,000,000 shares not
redeemed by the Company (or up to 450,000 shares) to unrelated third parties.
Sales of such 450,000 shares to unrelated third parties were consummated
throughout August of 1997. On November 6, 1997, the Company also provided its
consent under the CWF Shareholder Agreement to permit the CWF to sell 1,000,000
shares of Class B Common Stock to an unrelated third party. Pursuant to the
Company's Certificate of Incorporation, such 3,000,000 shares, 450,000 shares
and 1,000,000 shares of Class B Common Stock automatically converted into shares
of Class A Common Stock in the hands of such third parties.
As a result of such transactions, the CWF now holds 10,297,642 shares of
Class B Common Stock and, as of December 31, 1997, approximately $18.8 million
in principal of the CWF Notes remained outstanding.
On February 25, 1998, the CWF notified the Company of its intention to sell
up to 8,026,000 additional shares of Class B Common Stock pursuant to the CWF
Registration Rights Agreement in an underwritten public offering. Pursuant to
the terms of the CWF Registration Rights Agreement, the Company upon receipt of
a notification under such agreement must prepare and file a registration
statement with respect to such shares with the Securities and Exchange
Commission as expeditiously as possible but in no event later than 90 days
following receipt of the notice, subject to certain exceptions. The Company is
responding to the CWF notification in accordance with the terms of the CWF
Registration Rights Agreement. Any shares of Class B Common Stock sold by CWF to
third parties will automatically convert on a one-for-one basis into shares of
Class A Common Stock.
REDEMPTION OF THE FHC PUBLIC DEBT
FHC, a subsidiary of the Company, consummated a cash tender offer on June
27, 1997 of all of its $125 million outstanding principal amount of 7 3/4%
Senior Notes due 2003 (the "FHC Notes").
The price paid for each tendered FHC Note was based on a fixed spread of 25
basis points over the reference yield of the 6 1/4% U.S. Treasury Notes due
February 15, 2003, plus accrued and unpaid interest to the applicable settlement
date. Accordingly, the reference yield was 6.365%, the reference yield plus the
fixed spread was 6.615% and the purchase price per $1,000 principal amount of
the FHC Notes was $1,054.77, plus accrued and unpaid interest.
CAUTIONARY STATEMENTS
In connection with the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995, the Company is hereby filing cautionary
statements identifying important risk factors that could cause the Company's
actual results to differ materially from those projected in forward-looking
statements of the Company made by or on behalf of the Company.
The Company wishes to caution readers that these factors, among others,
could cause the Company's actual financial or enrollment results to differ
materially from those expressed in any projected, estimated or forward-looking
statements relating to the Company. The following factors should be considered
in
22
conjunction with any discussion of operations or results by the Company or its
representatives, including any forward-looking discussion, as well as comments
contained in press releases, presentations to securities analysts or investors,
or other communications by the Company.
In making these statements, the Company is not undertaking to address or
update each factor in future filings or communications regarding the Company's
business or results, and is not undertaking to address how any of these factors
may have caused changes to discussions or information contained in previous
filings or communications. In addition, certain of these matters may have
affected the Company's past results and may affect future results.
HEALTH CARE COSTS. A large portion of the revenue received by the Company
is expended to pay the costs of health care services or supplies delivered to
its members. The total health care costs incurred by the Company are affected by
the number of individual services rendered and the cost of each service. Much of
the Company's premium revenue is set in advance of the actual delivery of
services and the related incurring of the cost, usually on a prospective annual
basis. While the Company attempts to base the premiums it charges at least in
part on its estimate of expected health care costs over the fixed premium
period, competition, regulations and other circumstances may limit the Company's
ability to fully base premiums on estimated costs. In addition, many factors may
and often do cause actual health care costs to exceed those costs estimated and
reflected in premiums. These factors may include increased utilization of
services, increased cost of individual services, catastrophes, epidemics,
seasonality, new mandated benefits or other regulatory changes and insured
population characteristics.
The managed care industry is labor intensive and its profit margin is low.
Hence, it is especially sensitive to inflation. Health care industry costs have
been rising annually at rates higher than the Consumer Price Index. Increases in
medical expenses without corresponding increases in premiums could have a
material adverse effect on the Company.
PHARMACEUTICAL COSTS. The costs of pharmaceutical products and services are
increasing faster than the costs of other medical products and services. Thus,
the Company's HMOs face ever higher pharmaceutical expenses. Though the
Specialty Services Division's managed pharmaceutical care operations endeavor to
keep pharmaceutical costs low for the Company's HMOs, there can be no assurances
that the Company will be able to do so in the face of rapidly rising prices.
Also, statutory and regulatory changes may significantly alter the Company's
ability to manage pharmaceutical costs through restricted formularies of
products available to the Company's health plan members.
MEDICAL MANAGEMENT. The Company's profitability is dependent, to a large
extent, upon its ability to accurately project and manage health care costs,
including without limitation, appropriate benefit design, utilization review and
case management programs, and its risk sharing arrangements with providers,
while providing members with quality health care. For example, high
out-of-network utilization of health care providers and services may have
significant adverse affects on the Company's ability to manage health care costs
and member utilization of health care. There can be no assurance that the
Company through its medical management programs will be able to continue to
manage medical costs sufficiently to restore and/ or maintain profitability in
all of its product lines.
MARKETING. The Company markets its products and services through both
employed sales people and independent sales agents. Although the Company has a
number of such sales employees and agents, if certain key sales employees or
agents or a large subset of such individuals were to leave the Company, its
ability to retain existing customers and members could be impaired. In addition,
certain of the Company's customers or potential customers consider rating,
accreditation or certification of the Company by various private or governmental
bodies or rating agencies necessary or important. Certain of the Company's
health plans or other business units may not have obtained or may not desire or
be able to obtain or maintain such accreditation or certification which could
adversely affect the Company's ability to obtain or retain business with such
customers.
23
The managed health care industry has recently received a significant amount
of negative publicity. Such general publicity, or any negative publicity
regarding the Company in particular, could adversely affect the Company's
ability to sell its products or services or could create regulatory problems for
the Company. Furthermore, recently, the managed care industry has experienced
significant merger and acquisition activity. Speculation or uncertainty about
the Company's future could adversely affect the ability of the Company to market
its products.
COMPETITION. The Company competes with a number of other entities in the
geographic and product markets in which it operates, some of which other
entities may have certain characteristics or capabilities which give them an
advantage in competing with the Company. The Company believes there are few
barriers to entry in these markets, so that the addition of new competitors can
occur relatively easily. Certain of the Company's customers may decide to
perform for themselves functions or services formerly provided by the Company,
which could result in a decrease in the Company's revenues. Certain of the
Company's providers may decide to market products and services to Company
customers in competition with the Company. In addition, significant merger and
acquisition activity has occurred in the industry in which the Company operates
as well as in industries which act as suppliers to the Company such as the
hospital, physician, pharmaceutical and medical device industries. This activity
may create stronger competitors and/or result in higher health care costs.
Provider service organizations may be created by health care providers to offer
competing managed care products. To the extent that there is strong competition
or that competition intensifies in any market, the Company's ability to retain
or increase customers, its revenue growth, its pricing flexibility, its control
over medical cost trends and its marketing expenses may all be adversely
affected.
PROVIDER RELATIONS. One of the significant techniques the Company uses to
manage health care costs and utilization and monitor the quality of care being
delivered is contracting with physicians, hospitals and other providers. Because
of the large number of providers with which the Company's health plans contract,
the Company currently believes it has a limited exposure to provider relations
issues. In any particular market, however, providers could refuse to contract
with the Company, demand higher payments or take other actions which could
result in higher health care costs, less desirable products for customers and
members or difficulty in meeting regulatory or accreditation requirements.
In some markets, certain providers, particularly hospitals,
physician/hospital organizations or multi-specialty physician groups, may have
significant market positions or even monopolies. Many of these providers may
compete directly with the Company. If such providers refuse to contract with the
Company or utilize their market position to negotiate favorable contracts or
place the Company at a competitive disadvantage, the Company's ability to market
products or to be profitable in those areas could be adversely affected.
ADMINISTRATION AND MANAGEMENT. The level of administrative expense is a
partial determinant of the Company's profitability. While the Company attempts
to effectively manage such expenses, increases in staff-related and other
administrative expenses may occur from time to time due to business or product
start-ups or expansions, growth or changes in business, acquisition, regulatory
requirements or other reasons. Such expense increases are not clearly
predictable and increases in administrative expenses may adversely affect
results.
The Company currently believes it has a relatively experienced, capable
management staff. Loss of certain managers or a number of such managers could
adversely affect the Company's ability to administer and manage its business.
RESTRUCTURING COSTS. In connection with the FHS Combination, the Company
adopted a restructuring plan during the quarter ended June 30, 1997, the
principal elements of which include: a workforce reduction; the consolidation of
employee benefit plans; the consolidation of facilities in geographic locations
where office space is duplicated; the consolidation of overlapping provider
networks; and the consolidation of information systems at all locations to
standardized systems. The Company anticipates the
24
plan will be substantially completed by the end of 1998. During the quarter
ended December 31, 1997, the Company adopted an additional restructuring plan
and recorded a restructuring charge related to the integration of the Company's
Eastern Division health plans in connection with its acquisition of PHS and
FOHP. Although the Company believes it is "on track" to timely complete its
restructuring plans, there can be no assurances that unforeseen difficulties in
accomplishing any one or more of the elements of the plans will substantially
delay the completion of the plans and materially adversely affect the Company's
future profitability.
MANAGEMENT INFORMATION SYSTEMS. The Company's business is significantly
dependent on effective information systems. The information gathered and
processed by the Company's management information systems assists the Company
in, among other things, pricing its services, monitoring utilization and other
cost factors, processing provider claims, billing its customers on a timely
basis and identifying accounts for collection. The Company has many different
information systems for its various businesses. The Company is in the process of
attempting to reduce the number of systems and also to upgrade and expand its
information systems capabilities. Any difficulty associated with or failure to
successfully implement such updated management information systems, or any
inability to expand processing capability in the future in accordance with its
business needs, could result in a loss of existing customers and difficulty in
attracting new customers, customer and provider disputes, regulatory problems,
increases in administrative expenses or other adverse consequences. In addition,
the Company may, from time-to-time, obtain significant portions of its
systems-related or other services or facilities from independent third parties
which may make the Company's operations vulnerable to such third parties'
failure to perform adequately.
The Company also recognizes that the arrival of the Year 2000 poses a unique
worldwide challenge to the ability of virtually all computer systems to
recognize the date change from 1999 to 2000 (the "Year 2000 Issue") and has
begun to assess and modify its computer applications and business processes to
provide for their continued functionality given the Year 2000 Issue. The Year
2000 Issue is the result of computer programs being written using two digits
rather than four to define the applicable year. Any of the Company's computer
programs (both external and internal) that have time sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000. This
could result in a system failure or material miscalculations causing disruptions
of operations, including, among other things, the inability to process
transactions, prepare invoices or engage in normal business activities.
There can be no assurance that the systems of the Company or of other
companies on which the Company's systems rely will be timely converted and/or
modified, and such failure could have a material adverse effect on the Company
and its operations. The costs of the Company's Year 2000 Issue projects and the
timetable in which the Company plans to complete the Year 2000 Issue compliance
requirements set forth elsewhere in this Annual Report on Form 10-K are based on
estimates derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. There can be no assurance that these estimates will be achieved
and actual results could differ materially from these plans and estimates.
At this time it is also unclear as to the extent of existing insurance
coverage, if any, the Company may have to cover these potential Year 2000 Issue
liabilities.
MANAGEMENT OF GROWTH. The Company has made several large acquisitions in
recent years, and has an active ongoing acquisition program. Failure to
effectively integrate acquired operations could result in increased
administrative costs or customer confusion or dissatisfaction. The Company may
also not be able to manage this growth effectively, including not being able to
continue to develop processes and systems to support its growing operations.
There can be no assurance that the Company will be able to maintain its
historical growth rate.
POTENTIAL DIVESTITURES. The Company continues to evaluate the profitability
realized or likely to be realized by its existing businesses and operations, and
is reviewing from a strategic standpoint which of its
25
businesses or operations should be divested. In this regard the Company (i) has
decided to divest its workers' compensation insurance business, (ii) is
considering divestiture of direct ownership of two southern California
hospitals, (iii) is currently reviewing plans to exit its HMO operations in the
states of Texas, Louisiana and Oklahoma and (iv) is analyzing the strategic fit
of its Denticare managed dental operations with the ongoing operations and
operating strategy of the Company. There can be no assurance that the Company
will complete any of these transactions. Further, entering into and evaluating
these transactions may entail certain risks and uncertainties in addition to
those which may result from any such change in the Company's business
operations, including but not limited to, extraordinary transaction costs,
unknown indemnification liabilities or unforeseen administrative needs, any of
which could result in reduced revenues, increased charges, post transaction
administrative costs or could otherwise have a material adverse effect on the
Company's business, financial condition or results of operations. See "Item 1.
Business--Discontinued Operations and Anticipated Divestitures."
GOVERNMENT PROGRAMS AND REGULATION. The Company's business is subject to
extensive federal and state laws and regulations, including, but not limited to,
financial requirements, licensing requirements, enrollment requirements and
periodic examinations by governmental agencies. The laws and rules governing the
Company's business and interpretations of those laws and rules are subject to
frequent change. For example, as described earlier in this Annual Report on Form
10-K, in the section entitled "California HMO Regulations," the California
legislature may in 1998 make significant changes in the laws regulating HMOs
operating in that state. Existing or future laws and rules could force the
Company to change how it does business and may restrict the Company's revenue
and/or enrollment growth and/or increase its health care and administrative
costs. In particular, the Company's HMO and insurance subsidiaries are subject
to regulations relating to cash reserves, minimum net worth, premium rates and
approval of policy language and benefits. Although such regulations have not
significantly impeded the growth of the Company's business to date, there can be
no assurance that the Company will be able to continue to obtain or maintain
required governmental approvals or licenses or that regulatory changes will not
have a material adverse effect on the Company's business. Delays in obtaining or
failure to obtain or maintain such approvals, or moratoria imposed by regulatory
authorities, could adversely affect the Company's revenue or the number of its
members, could increase costs, or could adversely affect the Company's ability
to bring new products to market as forecasted.
A significant portion of the Company's revenues relate to federal, state and
local government health care coverage programs, such as Medicare and Medicaid
programs. Such contracts carry certain risks such as higher comparative medical
costs, government regulatory and reporting requirements, the possibility of
reduced or insufficient government reimbursement in the future, and higher
marketing and advertising costs per member as the result of marketing to
individuals as opposed to groups. Such risk contracts also are generally subject
to frequent change including changes which may reduce the number of persons
enrolled or eligible, reduce the revenue received by the Company or increase the
Company's administrative or health care costs under such programs. In the event
government reimbursement were to decline from projected amounts, the Company's
failure to reduce the health care costs associated with such programs could have
a material adverse effect upon the Company's business. Changes to such
government programs in the future may also affect the Company's willingness to
participate in such programs.
The Company is also subject to various governmental audits and
investigations. Such activities could result in the loss of licensure or the
right to participate in certain programs, or the imposition of fines, penalties
and other sanctions. In addition, disclosure of any adverse investigation or
audit results or sanctions could negatively affect the Company's reputation in
various markets and make it more difficult for the Company to sell its products
and services.
The amount of government receivables represents the Company's best estimate
of government liability. The receivables are generally subject to government
audit and negotiation and the final amounts actually received may be greater or
less than the amounts recognized by the Company.
26
LOSS RESERVES. The Company's loss reserves are estimates of future costs
based on various assumptions. The accuracy of these estimates may be affected by
external forces such as changes in the rate of inflation, the regulatory
environment, the judicious administration of claims, medical costs and other
factors. Included in the loss reserves are estimates for incurred but not
reported ("IBNR") claims which are established for unreported claims and adverse
loss developments relating to current and prior years. Estimates are continually
monitored and reviewed and, as settlements are made or estimates adjusted,
differences are reflected in current operations. Such estimates are subject to
the impact of changes in the regulatory environment and economic conditions.
Given the inherent variability of such estimates, the actual liability could
differ significantly from the amounts provided. Moreover, if the assumptions on
which the estimates are based prove to be incorrect and reserves are inadequate
to cover the Company's actual experience, the Company's profitability could be
adversely affected.
LITIGATION AND INSURANCE. The Company is subject to a variety of legal
actions to which any corporation may be subject, including employment and
employment discrimination-related suits, employee benefit claims, breach of
contract actions, tort claims, shareholder suits, including for securities
fraud, and intellectual property related litigation. In addition, because of the
nature of its business, the Company incurs and likely will continue to incur
potential liability for claims related to its business, such as failure to pay
for or provide health care, poor outcomes for care delivered or arranged,
provider disputes, including disputes over withheld compensation and claims
related to self-funded business. In some cases, substantial non-economic or
punitive damages may be sought. While the Company currently has insurance
coverage for some of these potential liabilities, others may not be covered by
insurance, the insurers may dispute coverage or the amount of insurance may not
be enough to cover the damages awarded. In addition, certain types of damages,
such as punitive damages, may not be covered by insurance and insurance coverage
for all or certain forms of liability may become unavailable or prohibitively
expensive in the future.
STOCK MARKET. Recently, the market prices of the securities of certain of
the publicly-held companies in the industry in which the Company operates have
shown volatility and sensitivity in response to many factors, including public
communications regarding managed care, legislative or regulatory actions, health
care cost trends, pricing trends, competition, earning or membership reports of
particular industry participants, and acquisition activity. There can be no
assurances regarding the level of stability of the Company's share price at any
time or the impact of these or any other factors on the share price.
RECENT DEVELOPMENTS
FOUNDATION HEALTH CORPORATION. Effective April 1, 1997, the Company was
formed pursuant to the FHS Combination involving HSI and FHC. Pursuant to the
FHS Combination, FHC merged into a newly created subsidiary of HSI and each
outstanding share of FHC capital stock was converted into 1.3 shares of HSI's
Class A Common Stock. As part of the FHS Combination HSI remained as the
ultimate parent company and changed its name to "Foundation Health Systems,
Inc." The FHS Combination was tax-free and accounted for as a pooling of
interests.
The Merger Agreement governing the FHS Combination also provided for, among
other things, amendment of the Company's By-Laws to effect certain changes to
the governance provisions of the Company following the FHS Combination,
including provisions related to the structure of the Company's Board of
Directors and the committees of the Company's Board of Directors.
ADVANTAGE HEALTH. On April 1, 1997 the Company completed the acquisition of
Advantage Health, the trade name for a group of managed health care companies
based in Pittsburgh, PA for $12.5 million in cash. Advantage Health has
approximately 35,000 full-risk members. In 1996 Advantage Health recorded
revenues of approximately $56 million, with about ninety percent (90%) from
health plan operations. The Company purchased Advantage Health from St. Francis
Health System, which has a short-term option to reacquire a twenty percent (20%)
interest in Advantage Health for $2.5 million. Advantage Health remains a party
to long-term provider agreements with the St. Francis Health System.
27
PACC. On October 22, 1997 the Company completed its acquisition of PACC HMO
and PACC Health Plans, each an Oregon non-profit corporation (collectively,
"PACC") pursuant to an Agreement and Plan of Reorganization, dated as of March
20, 1997 and effective on April 9, 1997 (the "Reorganization Agreement"), among
the Company, QualMed Health Plan, Inc., an Oregon corporation and an indirect
wholly-owned subsidiary of the Company ("QMO"), and PACC.
As part of such transaction and as provided for in the Reorganization
Agreement, PACC organized Northwest Health Foundation (the "PACC Foundation") as
an Oregon nonprofit public benefit corporation which received the net
acquisition consideration proceeds. The PACC Foundation also assumed certain of
PACC's obligations under the Reorganization Agreement (including indemnification
obligations) at closing. Although the total purchase price for PACC was $68
million, under the Reorganization Agreement the Company received an
approximately $10.1 million credit for certain physician payment obligations of
PACC it assumed, and was permitted to transfer to the PACC Foundation an
aggregate of $14.3 million in investments previously owned by PACC. As a result,
the Company paid the PACC Foundation a net purchase price of approximately $43.7
million.
The transaction was structured as a merger of PACC into QMO, with QMO as the
surviving corporation which was renamed QualMed Plans for Health of Oregon, Inc.
The merger was immediately preceded by an acquisition and assumption by QualMed
Washington Health Plan, Inc. (a Washington corporation and indirect wholly-owned
subsidiary of the Company) of various contracts of PACC relating to PACC's
health care service contractor business in the state of Washington and the
acquisition and assumption by QualMed Health & Life Insurance Company (an
insurance company domesticated under the laws of the state of Colorado and an
indirect wholly-owned subsidiary of the Company) of various contracts of PACC
relating to PACC's health maintenance organization business in the state of
Washington.
Immediately prior to its acquisition by the Company, PACC (based in
Clackamas, Oregon) had health plan operations in Oregon and Washington, with
approximately 116,000 medical members (approximately 108,000 of which were
located in the Portland, Oregon area). Approximately 67,000 of such members were
in PACC HMO (a commercial health maintenance organization), with the balance in
PACC Health Plans (primarily a preferred provider organization).
FIRST OPTION HEALTH PLAN. On April 30, 1997, the Company purchased
convertible debentures (the "FOHP Debentures") of FOHP, Inc., a New Jersey
corporation ("FOHP"), in the aggregate principal amount of approximately $51.7
million. The FOHP Debentures were convertible into up to 71 percent of the
fully-diluted equity of FOHP at the Company's discretion, and the Company so
converted the FOHP Debentures effective December 1, 1997. Additionally,
effective December 8, 1997, the Company purchased additional convertible
debentures of FOHP in the aggregate principal amount of approximately $29
million. The Company immediately converted approximately $18.9 million of these
additional convertible debentures of FOHP into 92,804,003 shares of Common Stock
of FOHP. As a result, the Company now owns approximately 98% of the outstanding
shares of FOHP common stock. The remaining approximately $10 million of
convertible debentures of FOHP owned by the Company may be converted into
fully-diluted equity of FOHP at the Company's election. Upon the conversion of
all of the convertible debentures of FOHP into fully-diluted equity of FOHP, the
Company will own approximately 99.99% of the total outstanding equity of FOHP.
Effective December 31, 1997, the Company purchased nonconvertible debentures
in the amount of $24 million from FOHP. The debentures mature on December 31,
2002. The debentures were issued to the Company in consideration for additional
capital contributions made by the Company pursuant to the Amended and Restated
Securities Purchase Agreement, dated February 10, 1997, and as amended March 13,
1997, among the Company, FOHP, and First Option Health Plan of New Jersey, Inc.
("FOHP-NJ"), a wholly-owned subsidiary of FOHP (collectively, the "Definitive
Agreements"). Pursuant to the Definitive Agreements, at any time during the 1999
calendar year, the Company may acquire any
28
remaining shares of FOHP not owned by the Company pursuant to a tender offer,
merger, combination or other business combination transaction for consideration
(to be paid in cash or stock of the Company) equal to the value of such FOHP
stock based on appraiser determinations.
FOHP (headquartered in Neptune, New Jersey) is owned by physicians,
hospitals and other health care providers and is the sole shareholder of
FOHP-NJ, a New Jersey corporation. FOHP-NJ is a managed health care company
providing commercial products for businesses and individuals, along with
Medicare, Medicaid and workers' compensation programs. FOHP-NJ currently has
more than 250,000 members in New Jersey enrolled in its commercial, Medicare,
Medicaid and PPO programs.
The Company also provides a variety of management services to FOHP,
including provider contracting, utilization review and quality assurance and
employee relations, sales and marketing and strategic planning. The Company
receives monthly management fees from FOHP for such services in an amount equal
to two percent of FOHP's premium revenue. The Company, at its option, may also
provide information systems and claims processing services to FOHP.
Approximately $1,700,000 of the $51.7 million principal amount of the original
FOHP Debentures reflected fees paid to the Company by FOHP for such management
services provided by the Company prior to the closing of the sale of the FOHP
Debentures; such principal amount was immediately converted into FOHP common
stock.
PHYSICIANS HEALTH SERVICES, INC. On December 31, 1997, the Company
completed its acquisition of Physicians Health Services, Inc. ("PHS"), a
449,000-member health plan with operations in the New York metropolitan area,
including northern New Jersey, and throughout the state of Connecticut. The
Company paid approximately $265 million for the approximately nine million PHS
shares then outstanding and caused PHS to cash-out approximately $6 million in
PHS employee stock options as part of the acquisition. The Company funded the
acquisition with cash on hand and existing bank credit lines.
In addition, PHS is a joint venture partner with The Guardian Life Insurance
Company of America ("Guardian") to market the "Healthcare Solutions" health
insurance products in the New York City metropolitan area. The Guardian and the
Company have indicated that they intend to work cooperatively under the current
joint venture agreements and to build and expand Healthcare Solutions products
in the tri-state area.
COMMERCIAL COMPENSATION INSURANCE COMPANY. On May 14, 1997 Business
Insurance Group, Inc. ("BIG"), a subsidiary of the Company, acquired the
Christiania General Insurance Corporation of New York, now known as Commercial
Compensation Insurance Company ("CCIC"). CCIC was purchased by BIG to more
effectively compete in the workers' compensation and group accident and health
markets outside of California. CCIC is currently licensed in 46 states with 26
workers' compensation licenses and 26 group accident and health licenses.
GEM INSURANCE COMPANY. Gem Insurance Company ("Gem"), a subsidiary of the
Company, had previously reached definitive agreement prior to the end of the
second quarter of 1997 regarding a reinsurance transaction with The Centennial
Life Insurance Company ("Centennial"). Pursuant to this agreement, Centennial
was to reinsure, administer and manage Gem's accident and health, life and
annuity policies in exchange for a reinsurance premium. The transaction was not
ultimately consummated due to the unanticipated failure to satisfy certain
closing conditions including the failure to receive certain regulatory
approvals. Gem established a reserve in the amount of $57.5 million for the
estimated premium deficiency related to these policies.
Since October of 1997, Gem has implemented a restructuring plan to reduce
operating losses and its in force insurance risk. In 1997 the majority of Gem's
losses were related to business in Utah and Nevada, and Gem initiated a
withdrawal from the Nevada insurance markets on September 20, 1997, and began
restructuring Utah insurance products in the fourth quarter of 1997 (which
restructuring was completed on March 11, 1998). Commission rates were also
reduced to market-level rates in all states and general agents were terminated
in Nevada and Utah.
29
Gem is currently reviewing its restructuring alternatives with the
Departments of Insurance in the other states in which it operates. These
alternatives include a potential restructuring of the business or withdrawal.
Gem is currently licensed in nine states with business in seven of such states.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The following table sets forth the high and low sales prices of the
Company's Class A Common Stock, par value $.001 per share (the "Class A Common
Stock") on The New York Stock Exchange, Inc. ("NYSE") since January 2, 1995.
HIGH LOW
------- -------
Calendar Quarter - 1995
First Quarter................................................................ 33 7/8 24 7/8
Second Quarter............................................................... 34 1/8 25
Third Quarter................................................................ 30 3/8 27 7/8
Fourth Quarter............................................................... 34 1/4 29 1/4
Calendar Quarter - 1996
First Quarter................................................................ 37 1/8 30 3/8
Second Quarter............................................................... 37 1/8 26 7/8
Third Quarter................................................................ 28 7/8 19 3/8
Fourth Quarter............................................................... 29 1/8 22 5/8
Calendar Quarter - 1997
First Quarter................................................................ 30 3/4 23 1/8
Second Quarter............................................................... 33 24 1/4
Third Quarter................................................................ 33 15/16 29 11/16
Fourth Quarter............................................................... 33 3/8 22 1/16
Calendar Quarter - 1998
First Quarter (through March 16, 1998)....................................... 29 1/16 22 1/4
On March 16, 1998, the last reported sales price per share of the Class A
Common Stock was $28 11/16 per share.
DIVIDENDS
No dividends have been paid by the Company during the preceding two fiscal
years. The Company has no present intention of paying any dividends on its
Common Stock.
The Company is a holding company and, therefore, its ability to pay
dividends depends on distributions received from its subsidiaries, which are
subject to regulatory net worth requirements and certain additional state
regulations which may restrict the declaration of dividends by HMOs, insurance
companies and licensed managed health care plans. The payment of any dividend is
at the discretion of the Company's Board of Directors and depends upon the
Company's earnings, financial position, capital requirements and such other
factors as the Company's Board of Directors deems relevant.
Under the Credit Agreement entered into on July 8, 1997 with Bank of America
as agent, the Company cannot declare or pay cash dividends to its stockholders
or purchase, redeem or otherwise acquire shares of its capital stock or
warrants, rights or options to acquire such shares for cash except to the extent
permitted under such Credit Agreement as described elsewhere in this Annual
Report on Form 10-K.
30
HOLDERS
As of March 24, 1998, there were approximately 2,000 holders of record and
an additional approximately 25,500 beneficial holders of Class A Common Stock.
The California Wellness Foundation (the "CWF") is the only holder of record of
the Company's Class B Common Stock, par value $.001 per share (the "Class B
Common Stock") which constitutes approximately 8.5% of the Company's aggregate
equity. Under the Restated Certificate, shares of the Company's Class B Common
Stock have the same economic benefits as shares of the Company's Class A Common
Stock, but are non-voting. Upon the sale or other transfer of shares of Class B
Common Stock by the CWF to an unrelated third party, such shares automatically
convert into Class A Common Stock.
31
ITEM 6. SELECTED FINANCIAL DATA
FOUNDATION HEALTH SYSTEMS, INC.
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31
------------------------------------------------------
1997 1996 1995 1994 1993
---------- --------- --------- --------- ---------
Revenues
Health plan premiums................................ $5,829,444 $5,395,125 $4,557,214 $3,863,965 $3,196,112
Government contracts................................ 949,168 908,730 279,380 209,980 860,498
Specialty services.................................. 342,107 316,993 210,533 139,853 111,626
Investment and other income......................... 114,300 88,392 66,510 51,698 42,151
---------- --------- --------- --------- ---------
7,235,019 6,709,240 5,113,637 4,265,496 4,210,387
---------- --------- --------- --------- ---------
Expenses
Health plan services................................ 4,912,532 4,598,074 3,643,463 3,091,890 2,562,650
Government health care services..................... 711,757 706,076 174,040 147,629 688,800
Specialty services.................................. 290,319 289,744 182,380 121,299 101,391
Selling, general and administrative................. 851,826 859,996 657,275 536,209 531,558
Amortization and depreciation....................... 98,353 112,916 89,356 66,741 55,832
Interest............................................ 63,555 45,372 33,463 23,081 26,643
Merger, restructuring, and other costs.............. 338,425 44,108 20,164 125,379 29,725
Gem costs........................................... 57,500
---------- --------- --------- --------- ---------
7,324,267 6,656,286 4,800,141 4,112,228 3,996,599
---------- --------- --------- --------- ---------
Income (loss) from continuing operations before income
taxes and minority interest......................... (89,248) 52,954 313,496 153,268 213,788
Income tax provision (benefit)........................ (21,418) 14,124 124,345 70,169 98,399
Minority interest..................................... 7,275
---------- --------- --------- --------- ---------
Income (loss) from continuing operations.............. (67,830) 38,830 189,151 83,099 108,114
Discontinued operations:
Income (loss) from operations, net of tax........... (30,409) 25,084 3,028 18,434 6,218
Gain (loss) on disposition, net of tax.............. (88,845) 20,317
---------- --------- --------- --------- ---------
Net income (loss)..................................... $ (187,084) $ 84,231 $ 192,179 $ 101,533 $ 114,332
---------- --------- --------- --------- ---------
---------- --------- --------- --------- ---------
Basic earnings (loss) per share
Continuing operations............................. $ (0.55) $ 0.31 $ 1.54 $ 0.73 $ 0.96
Discontinued operations........................... (0.25) 0.20 0.02 0.16 0.06
Discontinued operations gain (loss) on
disposition..................................... (0.72) 0.16
---------- --------- --------- --------- ---------
Net............................................... $ (1.52) $ 0.67 $ 1.56 $ 0.89 $ 1.02
---------- --------- --------- --------- ---------
---------- --------- --------- --------- ---------
Diluted earnings (loss) per share
Continuing operations............................. $ (0.55) $ 0.31 $ 1.53 $ 0.72 $ 0.95
Discontinued operations........................... (0.25) 0.20 0.02 0.16 0.05
Discontinued operations gain (loss) on
disposition..................................... (0.72) 0.16
---------- --------- --------- --------- ---------
Net............................................... $ (1.52) $ 0.67 $ 1.55 $ 0.88 $ 1.00
---------- --------- --------- --------- ---------
---------- --------- --------- --------- ---------
Weighted average common and common stock equivalent
shares outstanding:
Basic............................................... 123,333 124,453 122,741 113,723 112,294
Diluted............................................. 123,821 124,966 123,674 115,658 113,879
Balance Sheet Data
Cash & cash equivalents and investments............. $1,125,246 $1,137,133 $ 885,974 $ 872,244 $ 840,185
Total assets........................................ 4,076,350 3,423,776 2,733,765 2,218,506 1,775,475
Notes payable and capital leases--noncurrent........ 1,308,979 791,618 547,522 301,356 360,687
Stockholders' equity................................ 895,974 1,183,411 1,068,255 877,466 522,622
32
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Foundation Health Systems, Inc. (the "Company") is an integrated managed
care organization which administers the delivery of managed health care
services. Through its subsidiaries, the Company offers group, individual,
Medicaid and Medicare health maintenance organization ("HMO") and preferred
provider organization ("PPO") plans; government sponsored managed care plans;
and managed care products related to bill review, administration and
cost-containment, behavioral health, dental, vision and pharmaceutical products
and services.
CONSOLIDATED OPERATING RESULTS
REVENUES
The Company's revenues grew by $525.8 million or 7.8% for the year ended
December 31, 1997 as compared to the same period in 1996. Growth in revenues for
the year was due to slightly higher health plan premiums for the Company's
commercial membership and membership growth in Medicaid contracts in California,
commercial membership growth on the east coast, and the partial year impact of
acquisitions that occurred in the second and fourth quarters of 1997. Higher
investment and other income includes gains on sale of the Company's investments
in FPA Medical Management, Inc. ("FPA"), interest received on notes and rental
income on real estate from FPA that resulted from the sale of the Company's
physician practice management operations during 1996 to FPA, a gain on the
redemption of notes receivable by FPA held by the Company, and a gain on the
sale of certain Medicaid contracts. Revenues for the year ended December 31,
1996 increased by $1,595.6 million or 31.2% as compared to the same period in
1995. Revenue increases in 1996 were due to the full year impact of new
acquisitions in Connecticut and Pennsylvania and the partial year impact of the
Mental Health Network ("MHN') acquisition, commercial and Medicare risk
membership growth in California, new CHAMPUS government contracts and higher
cash and investment balances resulting in increased investment and other income.
The overall medical care ratio ("MCR") (medical costs as a percentage of
revenue) for the year ended December 31, 1997 was 83.1% compared to 84.5% for
the year ended December 31, 1996. The decline is due primarily to higher medical
costs and loss contracts that negatively impacted the MCR in 1996 as well as
favorable reserve development in 1997 in certain of the Company's health plans
as well as improved health care and subcontractor performance on certain
government contracts. The 1997 reduction in MCR was offset slightly by
escalating health care costs including higher pharmacy costs coupled with a
relatively flat premium environment, particularly in the California market and
throughout the Company's health plans. The overall MCR for the year ended
December 31, 1996 was 84.5% as compared to 79.3% during the same period in 1995.
The increase in the MCR was due to the aforementioned higher medical costs and
loss contracts that were charged in 1996 as well as due to continued pricing
pressures throughout the Company's health plans and an increase in pharmacy
costs.
SELLING, GENERAL, AND ADMINISTRATIVE COSTS
The Company's selling, general and administrative ("SG&A") expenses
decreased by $8.2 million or 1.0% for the year ended December 31, 1997 as
compared to the same period in 1996, and increased by $202.7 million or 30.8%
for the year ended December 31, 1996 as compared to the same period in 1995. The
administrative expense ratio (SG&A as a percentage of health plan and government
contracts revenue) decreased to 12.6% for the year ended December 31, 1997 from
13.6% for the year ended December 31, 1996. The administrative expense ratio was
flat at 13.6% for the year ended December 31, 1996 as compared to the the year
ended December 31, 1995. Favorable expense reductions occurred for the year
ended December 31, 1997 as a percentage of revenues due to the Company's ongoing
efforts to aggressively control its SG&A expenses and synergy savings associated
with the integration of HSI and FHC after the FHS Combination. This was offset
partially by additional SG&A expenses associated with
33
the new acquisitions during 1997. While SG&A expenses increased by $202.7
million during 1996 as a result of new acquisitions, additional administrative
expenses associated with CHAMPUS government contracts, and general growth in the
commercial business, SG&A as a percentage of total revenue was essentially flat
for the year ended 1996 as compared to 1995.
AMORTIZATION AND DEPRECIATION
Amortization and depreciation expense declined by $14.6 million for the year
ended December 31, 1997 as compared to the same period in 1996 due to certain
intangible assets becoming fully amortized by the end of 1996, fixed assets
becoming fully depreciated in early 1997 in the California division and fixed
asset write-offs primarily associated with the Company's restructuring plans
discussed below. Amortization and depreciation expense increased by $23.6
million for the year ended December 31, 1996 as compared to the same period in
1995 primarily due to higher levels of fixed asset expenditures and goodwill
amortization as a result of acquisitions.
INTEREST EXPENSE
Interest expense increased by $18.2 million and $11.9 million during 1997
and 1996, respectively, as compared to the same periods during the prior year.
The increase in interest expense during both years was due to higher debt levels
associated with the Company's revolving lines of credit partially offset by
lower interest rates.
MERGER, RESTRUCTURING AND OTHER COSTS AND GEM COSTS
Restructuring costs of $149.4 million, $27.4 million and $12.2 million were
recorded for the years ended December 31, 1997, 1996 and 1995, respectively. The
1997 charge was primarily the result of a restructuring plan adopted in
connection with the FHS Combination, and included costs related to severance and
benefits, provider network consolidation, asset impairments and real estate
lease terminations. Of the $149.4 million, $61.7 million resulted in cash
payments as of December 31, 1997, with $45.2 million expected in future cash
payments. The 1996 restructuring costs included severance, asset impairments and
lease termination costs and required cash outlays of approximately $7.3 million.
The 1995 restructuring costs represented severance payments.
Merger costs totaling $70.4 million were recorded in 1997 and included
transaction, consulting, debt consolidation and other merger costs directly
related to the FHS Combination. Merger costs of $8.0 million related to the
terminated merger between HSI and Wellpoint Health Network were recorded in
1995.
Other costs totaling $118.6 million, including the write-off of various
receivables, litigation and loss contract accruals were recorded during 1997.
Additionally, during 1996, $16.7 million of other costs related to loss contract
accruals and consulting were recorded. The Company also established a premium
deficiency reserve of $57.5 million related to its Gem Insurance Company during
1997.
See Note 14, "Merger, Restructuring and Other Costs and Gem Costs", to the
consolidated financial statements for further information.
INCOME TAX PROVISION AND BENEFIT
The tax benefit on losses from continuing operations for the year ended
December 31, 1997 of 24.0% differs from the tax provision rate of 26.7% on
income from continuing operations for the year ended 1996 due primarily to
nondeductible merger transaction costs associated with the FHS Combination
during 1997 and a reduction in tax exempt interest income.
The reduced tax provision rate of 26.7% in 1996 relative to the 1995 rate of
39.7% was primarily a result of tax benefits associated with net operating loss
carryforwards of acquired subsidiaries, increased research and development
credits, elimination of a duplicate tax for undistributed income between an
34
acquired subsidiary and its former parent, increased proportion of tax-exempt
income as a percentage of pre-tax income, and a settlement of an IRS
examination.
LINE OF BUSINESS REPORTING
The Company currently operates in the managed health care segment. The
managed health care segment's continuing operations are in three primary lines
of business (i) health plan operations; (ii) government contracts; and (iii)
specialty services. Discontinued operations include the worker's compensation
insurance and physician practice management ("Medical Practices") segments.
CONTINUING OPERATIONS
HEALTH PLANS
Revenues generated by the Company's health plan operations increased $434.3
million or 8.1% for the year ended December 31, 1997 compared to the same period
in 1996 and $837.9 million or 18.4% for the period ended December 31, 1996
compared to the same period in 1995. The increase in revenues for the year ended
December 31, 1997 as compared to the same period in 1996 is primarily due to
enrollment increases in the Medicaid lines of business and enrollment and
premium increases in the Medicare lines of business in California, commercial
enrollment increases in Connecticut and Arizona, and the partial year impact of
the acquisitions of Advantage Health in Pennsylvania, FOHP, Inc. ("FOHP") in New
Jersey, and PACC HMO and PACC Health Plans (collectively, "PACC") in Oregon. The
increase in revenues for the year ended December 31, 1996 as compared to the
same period in 1995 is due to acquisitions in the Northeast, including M.D.
Health Plan operating in Connecticut and Greater Atlantic Health Plan of
Pennsylvania, and increased Medicare risk and Medicaid enrollment in California.
Health care costs increased by 6.8% for the year ended December 31, 1997 as
compared to the same period in 1996. In the California market, health care costs
increased as a result of higher pharmacy costs for both the commercial and
Medicare lines of business, percentage of premium provider contracting
arrangements, increased hospital utilization in the Medicare line of business,
and increased enrollment in the Medicaid line of business. While health care
costs increased during 1997, the health plans' MCR declined to 84.3% for the
year ended December 31, 1997 from 85.2% for the comparable period in 1996
primarily due to higher medical costs in 1996 and favorable loss reserve
development in certain health plan operations during 1997. The health plans' MCR
increased to 85.2% in 1996 as compared to 79.9% for the same period in 1995.
Continued downward pressure on pricing, coupled with increased pharmacy costs
and utilization contributed to the overall health plan MCR.
GOVERNMENT CONTRACTS
Government contracts revenue increased by $40.4 million or 4.4% for the year
ended December 31, 1997, compared to the same period in 1996 as a result of the
California/Hawaii CHAMPUS contract being active for only 9 months in 1996
compared to a full year in 1997. Revenues increased $629.4 million for the year
ended December 31, 1996 or 225% compared to the same period in 1995. The
increase was due to the California/Hawaii CHAMPUS contract which began in April
1996 as well as the full year impact of the Washington/Oregon and Region 6
CHAMPUS contracts (Texas, Arkansas, Oklahoma and Louisiana) which began health
care delivery on March 1, 1995 and November 1, 1995, respectively.
Government health care costs as a percentage of government contract revenue
decreased from 77.7% in 1996 to 75.0% in 1997 as a result of improved health
care and subcontractor performance on the California/Hawaii and
Washington/Oregon CHAMPUS contracts, and the favorable impact of change order
revenue and cost development in 1997. Cost percentages for the year 1996
compared to 1995 increased to 77.7% primarily due to the recognition of
implementation revenue in 1995 for the Washington/Oregon, Region 6 and
California/Hawaii CHAMPUS contracts, which did not have associated health care
costs.
35
SPECIALTY SERVICES
The Company's specialty services subsidiaries offer behavioral health,
dental, vision, and pharmaceutical products and services as well as managed care
products related to bill review, administration and cost containment for
hospitals, health plans and other entities. Revenues generated by the Company's
specialty services operations for 1997 increased by $25.1 million or 7.9% as
compared to the same period in 1996 primarily due to the impact of a full year's
revenue from MHN which was acquired in March 1996. The increase in revenue was
offset somewhat by the sale of certain ancillary health care service operations
in 1996 and reduced revenue from various ASO operations. Revenues for 1996 as
compared to 1995 increased due to the acquisition of MHN in March 1996 as well
as growth in ASO, bill review and other services.
The Company expects continued pressure from employer groups to maintain
modest increases in premiums for behavioral health, dental and vision products.
Specialty services costs have decreased as a percentage of specialty services
revenue to 84.9% for 1997 as compared to 91.4% in 1996. The decrease is due to
the adverse reserve development recognized in the fourth quarter of 1996 which
resulted in a higher MCR during 1996 as well as the favorable benefit of the MHN
acquisition. Specialty services costs as a percentage of revenue increased to
91.4% in 1996 from 86.6% in 1995 due to the aforementioned adverse reserve
development recognized in 1996.
DISCONTINUED OPERATIONS
WORKERS' COMPENSATION INSURANCE BUSINESS
The Company revised its strategy of maintaining a presence in the workers'
compensation insurance business as a result of various adverse developments
arising in 1997 in the workers' compensation insurance business, primarily
related to the workers' compensation claims environment in California. As
discussed elsewhere in this Annual Report on Form 10-K, such adverse
developments caused the Company to strengthen its workers' compensation reserves
at the end of 1997. These developments also led the Company to adopt a plan to
completely discontinue this segment of its business, through divestiture of its
workers' compensation risk-assuming insurance subsidiaries. The Company is
presently conducting the sale of these businesses.
The Company's workers compensation insurance companies consist of the
following: California Compensation Insurance Company, a specialty workers'
compensation carrier writing business primarily in California; Business
Insurance Company, a national workers' compensation specialty carrier;
Commercial Compensation Insurance Company, and Combined Benefits Insurance
Company, writing single source workers' compensation and employee group health
insurance primarily in California.
The workers' compensation companies entered into a quota share reinsurance
agreement ("Quota Share Treaty") with General Reinsurance Corporation ("Gen Re")
effective July 1, 1996 and also entered into an aggregate excess of loss
reinsurance agreement ("Aggregate Treaty") with Gen Re effective January 1,
1997.
Under the Quota Share Treaty, the Company ceded 30% of its net premiums
earned, losses and allocated loss adjustment expenses incurred to Gen Re from
July 1, 1996 to December 31, 1996 and ceded 7.5% of its net retained business
from January 1, 1997 to June 30, 1997. The Quota Share Treaty contains a
provisional ceding commission, which adjusts based on actual reported loss
experience on the subject business. The Company stopped ceding under the quota
share treaty effective July 1, 1997.
The Aggregate Treaty was entered into at a premium cost of $32 million, in
exchange for $37.3 million of reinsurance coverage for the first six months of
1997. Effective July 1, 1997 a second six-month Aggregate Treaty was entered
into with Gen Re at a cost of $61.5 million, in exchange for $75 million of
reinsurance coverage. For the twelve months ended December 31, 1997, a total of
$93.5 million of
36
premiums were ceded to Gen Re for aggregate excess of loss reinsurance
protection, and the Company ceded $112.3 million of ceded losses incurred for
the year.
Workers' compensation revenue of $560.9 million increased 8.1% in 1997 as
compared to 1996. The increase in revenue is due to an increase in gross premium
revenues, investment income and capital gains, offset by the cost of the
Aggregate Excess Treaty.
Net premiums earned increased by 6.3% in 1997 as compared to 1996 due
primarily to national expansion of workers' compensation in states outside
California, offset by reduced premium writings in California. Premiums earned on
policies issued in California continue to be negatively affected by price
competition since the start of competitive rating on January 1, 1995.
Revenue of $518.7 million in 1996 increased by $101.6 million or 24.4% as
compared to 1995. The increase in revenue was due primarily to an increase in
premium revenues.
Net investment income for 1997 increased $3.9 million or 11.3%. The
increased investment income is due to an increase in assets available for
investment, from higher operational cash flow and capital surplus contributions
of $120 million in mid-1996 to the insurance operations to support premium
writings.
Net investment income of $34.3 million in 1996 increased $9.9 million or
40.6% compared to 1995. The increase in investment income is due to an increase
in assets available for investment from operational cash flow and capital
contributions.
Realized capital gains of $7.2 million in 1997 were an increase of $6.6
million from 1996. This increase was due to reductions in long term interest
rates in the bond market, primarily for tax-exempt bonds, provided an
opportunity to sell securities and realize gains in the fourth quarter of 1997.
The primary ratios used to measure underwriting performance of the workers'
compensation companies are the loss and loss adjustment expense ratio, the
underwriting expense ratio, and the policyholder dividend ratio, which when
added together constitute the combined ratio. These ratios are calculated as a
percentage of net premiums earned.
The following sets forth the workers' compensation companies underwriting
experience as measured by its combined ratio and its components for the twelve
months ended December 31, 1997, 1996 and 1995.
1997 1996 1995
--------- --------- ---------
Loss and Loss Adjustment Expense..................................... 86.6% 79.4% 62.8%
Underwriting Expense................................................. 32.1 23.6 23.5
Policyholder Dividends............................................... .2 (1.1) 1.4
--------- --------- ---------
COMBINED RATIO....................................................... 118.9% 101.9% 87.7%
--------- --------- ---------
--------- --------- ---------
The loss and loss adjustment expense ratio increased to 86.6% in 1997 as
compared to 79.4% in 1996. The increase in 1997 is primarily due to an increase
in the estimates for accident year 1996 and prior loss and loss adjustment
expenses incurred, which estimates were increased by $75.2 million in 1997. The
cause of the increase in the accident year 1996 and prior estimates was due to
changes to the California permanent disability rating schedules in April 1997
which adversely affected average claim severity in California. The change to the
permanent disability rating schedules had a negative affect on the entire
California workers' compensation industry. In addition, a court ruling in late
1996 expanded the presumption of the treating physician related to workers'
compensation workplace injuries in determining the disability of the injured
worker. The impact of this court ruling also increased claim severity. The
increase to accident year 1996 and prior loss estimates represented 14.7% of net
premiums earned for 1997. The effect of the accounting of the Aggregate Treaty
reduced the loss and loss adjustment expense ratio by 5.2%, due to more ceded
losses incurred than ceded premiums earned.
37
The underwriting expense ratio increased by 8.5% in 1997 as compared to
1996. The increase in the ratio is primarily due to the accounting for the
Aggregate Treaty, which does not have an underwriting expense provision as part
of the agreement. Also, under the Quota Share Treaty, the ceding of the
Company's net retained business was substantially less in 1997 than in 1996. As
such, ceded commission in 1996 under the Quota Share Treaty has a positive
effect on the underwriting expense ratio, and a lower beneficial impact on the
ratio in 1997. The pro-forma impact to the underwriting expense ratio without
accounting for the Aggregate and Quota Share Treaties would have been 24.9% in
1997 compared to 24.0% in 1996.
The loss and loss adjustment expense ratio increased 166 basis points in
1996 as compared to 1995. In 1995, this ratio was favorably impacted by a $26.5
million reduction to accident year 1994 and prior loss and loss adjustment
expense estimates. In 1996, the comparable amount of development for accident
years 1995 and prior was an increase to the losses and loss adjustment expense
incurred of $20.1 million.
The loss from discontinued operations for the segment was $30.4 million in
1997 as compared to income of $22.2 in 1996. The loss in 1997 was primarily due
to the strengthening of reserves in the amount of $75.2 million in the fourth
quarter of 1997. In addition, the Company recorded an estimate of the loss to be
incurred when the workers' compensation insurance operations are sold of
approximately $99.0 million, net of tax.
PHYSICIAN PRACTICE MANAGEMENT BUSINESS
On June 28, 1996 the Company executed a Stock and Note Purchase Agreement
with FPA for the purchase by FPA of the Company's Medical Practices. The
transaction was consummated in November 1996 and the Company recognized a net of
tax gain on sale of $20.3 million, net of $17.6 million of taxes, in 1996. In
1997, the Company recognized an additional $10.1 million gain on the sale, net
of $2.8 million of taxes, as a result of the final settlement of certain
contractual provisions. The income and loss on discontinued operations, net of
taxes, for the Medical Practices was $2.9 million during 1996 and $48.9 million
during 1995. The results in both years were primarily due to insufficient
patient volume being served by the Medical Practices. In 1996, the loss was
reduced by a gain of $10.8 million related to the sale of various independent
practice associations.
The following table presents financial information reflecting the Company's
continuing operations for its primary lines of business:
38
FOUNDATION HEALTH SYSTEMS, INC.
LINE OF BUSINESS FINANCIAL INFORMATION
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED
YEAR ENDED DECEMBER 31, 1997 DECEMBER 31, 1996
-------------------------------------- -------------------------
PERCENT PERCENT PERCENT
AMOUNT OR OF TOTAL INCREASE AMOUNT OR OF TOTAL
PERCENT REVENUE (DECREASE) PERCENT REVENUE
------------ ----------- ----------- ------------ -----------
Revenues
Health plan premiums............................... $ 5,829,444 80.6% 8.1% $ 5,395,125 80.5%
Government contracts............................... 949,168 13.1 4.4 908,730 13.5
Specialty services................................. 342,107 4.7 7.9 316,993 4.7
Investment and other income........................ 114,300 1.6 29.3 88,392 1.3
------------ ----- ------------ -----
7,235,019 100.0 7.8 6,709,240 100.0
------------ ----- ------------ -----
Expenses
Health plan services............................... 4,912,532 67.9 6.8 4,598,074 68.5
Government health care services.................... 711,757 9.9 0.8 706,076 10.5
Specialty services................................. 290,319 4.0 0.2 289,744 4.3
Selling, general and administrative
("SG&A")......................................... 851,826 11.8 (1.0) 859,996 12.8
Amortization and depreciation...................... 98,353 1.4 (12.9) 112,916 1.7
Interest........................................... 63,555 0.9 40.1 45,372 0.7
Merger, restructuring and other costs.............. 338,425 4.7 -- 44,108 0.7
Gem costs.......................................... 57,500 0.8 -- --
------------ ----- ------------ -----
7,324,267 101.2 10.0 6,656,286 99.2
------------ ----- ------------ -----
Income (loss) from continuing operations before
income taxes....................................... (89,248) (1.2) (268.5) 52,954 0.8
Income tax provision (benefit)....................... (21,418) (0.3) (251.6) 14,124 0.2
------------ ----- ------------ -----
Income (loss) from continuing operations............. $ (67,830) (0.9)% (274.7 ) $ 38,830 0.6 %
------------ ----- ------------ -----
------------ ----- ------------ -----
Basic earnings (loss) per share...................... $ (0.55) $ 0.31
Diluted earnings (loss) per share.................... (0.55) 0.31
Weighted average common and common stock equivalent
shares outstanding:
Basic.............................................. 123,333 124,453
Diluted............................................ 123,821 124,966
Operating ratios:
Overall medical care ratio......................... 83.1% 84.5%
Health plan medical care ratio..................... 84.3 85.2
Government contracts medical care ratio............ 75.0 77.7
Specialty services medical care ratio.............. 84.9 91.4
SG&A as a percent of health plan and government
contracts revenues............................... 12.6 13.6
Effective tax rate (benefit)--continuing
operations....................................... (24.0) 26.7
39
FOUNDATION HEALTH SYSTEMS, INC.
LINE OF BUSINESS FINANCIAL INFORMATION
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
YEAR ENDED DECEMBER 31, 1996 1995
---------------------------------------- -------------------------
PERCENT PERCENT PERCENT
AMOUNT OR OF TOTAL INCREASE AMOUNT OR OF TOTAL
PERCENT REVENUE (DECREASE) PERCENT REVENUE
------------ ----------- ------------- ------------ -----------
Revenues
Health plan premiums............................... $ 5,395,125 80.5% 18.4% $ 4,557,214 89.1%
Government contracts............................... 908,730 13.5 225.3 279,380 5.5
Specialty services................................. 316,993 4.7 50.6 210,533 4.1
Investment and other income........................ 88,392 1.3 32.9 66,510 1.3
------------ ----- ------------ -----
6,709,240 100.0 31.2 5,113,637 100.0
------------ ----- ------------ -----
Expenses
Health plan services............................... 4,598,074 68.5 26.2 3,643,463 71.2
Government health care services.................... 706,076 10.5 305.7 174,040 3.4
Specialty services................................. 289,744 4.3 58.9 182,380 3.6
Selling, general and administrative
("SG&A")......................................... 859,996 12.8 30.8 657,275 12.9
Amortization and depreciation...................... 112,916 1.7 26.4 89,356 1.7
Interest........................................... 45,372 0.7 35.6 33,463 0.7
Merger, restructuring and other costs.............. 44,108 0.7 -- 20,164 0.4
Gem costs.......................................... -- -- --
------------ ----- ------------ -----
6,656,286 99.2 38.7 4,800,141 93.9
------------ ----- ------------ -----
Income from continuing operations before income
taxes.............................................. 52,954 0.8 (83.1) 313,496 6.1
Income tax provision................................. 14,124 0.2 (88.6) 124,345 2.4
------------ ----- ------------ -----
Income from continuing operations.................... $ 38,830 0.6% (79.5) $ 189,151 3.7 %
------------ ----- ------------ -----
------------ ----- ------------ -----
Basic earnings per share............................. $ 0.31 $ 1.54
Diluted earnings per share........................... 0.31 1.53
Weighted average common and common stock equivalent
shares outstanding:
Basic.............................................. 124,453 122,741
Diluted............................................ 124,966 123,674
Operating ratios:
Overall medical care ratio......................... 84.5% 79.3%
Health plan medical care ratio..................... 85.2 79.9
Government contracts medical care ratio............ 77.7 62.3
Specialty services medical care ratio.............. 91.4 86.6
SG&A as a percent of health plans and government
contracts revenues............................... 13.6 13.6
Effective tax rate--continuing operations.......... 26.7 39.7
40
FOUNDATION HEALTH SYSTEMS, INC.
LINE OF BUSINESS FINANCIAL INFORMATION
(IN THOUSANDS)
DECEMBER 31,
1997
-------------------------- DECEMBER 31,
PERCENT 1996
INCREASE ---------------
ENROLLMENT (DECREASE) ENROLLMENT
------------- ----------- ---------------
Health Plan
Commercial............................................................... 3,522 27.0% 2,774
Medicare risk............................................................ 308 30.0 237
Medicaid................................................................. 442 40.3 315
----- ----- -----
4,272 28.4 3,326
----- ----- -----
Government
CHAMPUS PPO and indemnity................................................ 1,090 5.3 1,035
CHAMPUS HMO.............................................................. 801 47.5 543
----- ----- -----
1,891 19.8 1,578
----- ----- -----
ASO 48 (85.2) 324
----- ----- -----
Combined................................................................. 6,211 18.8 5,228
----- ----- -----
----- ----- -----
LIQUDITY AND CAPITAL RESOURCES
Certain of the Company's subsidiaries must comply with minimum capital and
surplus requirements under applicable state laws and regulations, and must have
adequate reserves for claims. Certain subsidiaries must maintain ratios of
current assets to current liabilities of 1:1 pursuant to certain government
contracts. The Company believes it is in compliance with these contractual and
regulatory requirements in all material respects.
The Company believes that cash from operations, existing working capital,
lines of credit, and funds from planned divestitures of business are adequate to
fund existing obligations, introduce new products and services, and continue to
develop health care-related businesses. The Company regularly evaluates cash
requirements for current operations and commitments, and for capital
acquisitions and other strategic transactions. The Company may elect to raise
additional funds for these purposes, either through additional debt or equity,
the sale of investment securities or otherwise, as appropriate.
Government health care receivables are best estimates of payments that are
ultimately collectible. Since these amounts are subject to government audit and
negotiation, amounts ultimately collected may vary from current estimates.
For the year ended December 31, 1997, cash used from operating activities
was $125.9 million compared to $6.7 million in the prior year. This was due
primarily to payments for merger, restructuring and other costs associated with
the FHS Combination, as well as Gem costs. This was partially offset by
fluctuations in operating assets and liabilities primarily caused by timing
differences in the payment of accounts payables and other liabilities, reserves
for claims and other settlements, and deferred taxes at each respective year
end. Net cash used by investing activities was $134.8 million during 1997 as
compared to $184.8 million during 1996. This decrease during 1997 was due to
higher net redemptions of investments available for sale, an early payment
related to the FPA note receivable, offset by the cost of the acquisitions of
FOHP, Physician Health Services, Inc. ("PHS"), PACC, Advantage Health and
Christiania General Insurance Corporation. Net cash generated from financing
activities was $332.1 million in 1997 as
41
compared to $348.8 million during the same period in 1996. The increase in 1997
was due primarily to additional draws under the revolving line of credit of
$566.2 million that was used primarily to finance the new acquisitions, offset
by the repurchase of stock from the California Wellness Foundation of $111
million and the repayment of Senior Notes of $125 million.
The Company has a $1.5 billion credit facility (the "Credit Facility"), with
Bank of America as Administrative Agent for the Lenders thereto, which was
amended pursuant to a Letter Agreement dated March 27, 1998 with the Lenders
(the "Credit Facility Letter Agreement"). All previous revolving credit
facilities were terminated and rolled into the Credit Facility on July 8, 1997.
At the election of the Company, and subject to customary covenants, loans are
initiated on a bid or committed basis and carry interest at offshore or domestic
rates, at the applicable LIBOR Rate plus margin or the bank reference rate.
Actual rates on borrowings under the Credit Facility vary, based on competitive
bids and the Company's unsecured credit rating at the time of the borrowing.
Under the Credit Facility Letter Agreement, the margins used in setting the
facility fee and borrowing rates under the Credit Facility were increased.
Accordingly, the Company will incur an increase in the "all in" margin of 0.05%
based on its debt rating as of December 31, 1997 under the terms of the Credit
Facility. Any decrease in such rating would result in an increase in such
margin. The Credit Facility is available for five years, until July 2002, but it
may be extended under certain circumstances for two additional years. (See,
OTHER INFORMATION--REVOLVING CREDIT FACILITY contained in this report for
further information concerning the Revolving Credit Facility)
On June 27, 1997 the Company consummated a cash tender offer to repurchase
all of its $125 million outstanding principal amount of 7 3/4% Senior Notes due
2003. The purchase price per $1,000 principal amount of notes was $1,054.77.
During the quarter ended June 30, 1997, the Company sold 4,076,087 shares of
common stock of FPA that it had received as consideration in its sale of the
Medical Practices. The proceeds from the sale of stock were approximately $79
million, or an average of $19.45 per share. In addition, as of June 30, 1997 FPA
prepaid approximately $98.7 million due on a promissory note received as
consideration in the Company's sale of its Medical Practices.
On June 27, 1997, the Company redeemed 4,550,000 shares of Class B Common
Stock from The California Wellness Foundation ("the CWF") at a price of $24.47
per share. The Company provided its consent to permit the CWF to sell 3,000,000
shares of Class B Common Stock to an unrelated third party in June of 1997 and
to sell 450,000 shares of Class B Common Stock to unrelated third parties
throughout August of 1997. On November 6, 1997, the Company also provided its
consent to permit the CWF to sell 1,000,000 shares of Class B Common Stock to an
unrelated third party. Pursuant to the Company's Certificate of Incorporation,
such 3,000,000 shares, 450,000 shares and 1,000,000 shares of Class B Common
Stock automatically converted into shares of Class A Common Stock in the hands
of such third parties.
The Company's subsidiaries must comply with certain minimum capital
requirements under applicable state laws and regulations. The long-term portion
of principal and interest payments under the CWF Notes issued to the Company in
connection with the Health Net conversion is subordinated to Health Net meeting
tangible equity requirements under applicable California statutes and
regulations. As of December 31, 1997, the Company's subsidiaries were in
compliance with minimum capital requirements.
IMPACT OF INFLATION AND OTHER ELEMENTS
The managed health care industry is labor intensive and its profit margin is
low; hence, it is especially sensitive to inflation. Increases in medical
expenses or contracted medical rates without corresponding increases in premiums
could have a material adverse effect on the Company.
42
Various federal and state legislative initiatives regarding the health care
industry have been proposed during recent legislative sessions, and health care
reform and similar issues continue to be in the forefront of social and
political discussion. If health care reform or similar legislation is enacted,
such legislation could impact the Company. Management cannot at this time
predict whether any such initiative will be enacted and, if enacted, the impact
on the financial condition or results of operations of the Company.
The Company's ability to expand its business is dependent, in part, on
competitive premium pricing and its ability to secure cost-effective contracts
with providers. Achieving these objectives is becoming increasingly difficult
due to the competitive environment. In addition, the Company's profitability is
dependent, in part, on its ability to maintain effective control over health
care costs while providing members with quality care. Factors such as health
care reform, integration of acquired companies, regulatory changes, utilization,
new technologies, hospital costs, major epidemics and numerous other external
influences may affect the Company's operating results. Accordingly, past
financial performance is not necessarily a reliable indicator of future
performance, and investors should not use historical records to anticipate
results or future period trends.
The Company's HMO and insurance subsidiaries are required to maintain
reserves to cover their estimated ultimate liability for expenses with respect
to reported and unreported claims incurred. These reserves are estimates of
future payments based on various assumptions. Establishment of appropriate
reserves is an inherently uncertain process, and there can be no certainty that
currently established reserves will prove adequate in light of subsequent actual
experience, which in the past has resulted and in the future could result in
loss reserves being too high or too low. The accuracy of these estimates may be
affected by external forces such as changes in the rate of inflation, the
regulatory environment, the judicial administration of claims, medical costs and
other factors. Future loss development or governmental regulators could require
reserves for prior periods to be increased, which would adversely impact
earnings in future periods. In light of present facts and current legal
interpretations, management believes that adequate provisions have been made for
claims and loss reserves.
Reference is also made to the disclosures contained under the heading
"Cautionary Statements" included elsewhere in this Annual Report or Form 10-K,
which could cause the Company's actual results to differ from those projected in
forward looking statements of the Company made on behalf of the Company. In
addition, certain of these factors may have affected the Company's past results
and may affect future results.
YEAR 2000
The Company recognizes that the arrival of the Year 2000 requires computer
systems to be able to recognize the date change from 1999 to 2000 and, like
other companies, is assessing and modifying its computer applications and
business processes to provide for their continued functionality.
The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs that have time sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, prepare invoices or
engage in normal business activities.
The Year 2000 effort for the Company has the highest priority of technology
projects. The project has dedicated resources with multiple teams to address
unique systems environment. Uniform project management techniques are in place
with overall oversight responsibility residing with the Company's Chief
Technology Officer. Emphasis has been placed on business unit involvement and
the use of internal staff enhanced by external specialists. Selected systems
will be retired with the business functions being converted to Year 2000
compliant systems. A number of the Company's systems include packaged software
from large vendors that the Company is closely monitoring to ensure that these
systems are Year 2000 compliant. The Company believes that vendors will make
timely updates available to ensure that all
43
remaining purchased software is Year 2000 compliant. The remaining systems'
compliance with Year 2000 will be addressed by internal technical staff.
The Company has initiated formal communications with others with whom it
does significant business to determine their Year 2000 issues. There can be no
assurances that the systems of other companies on which the Company's systems
rely will be timely converted, or that the failure to convert by another company
would not have a material adverse effect on the Company.
The Company does not anticipate that the related overall costs to resolve
these potential Year 2000 problems will be material to any single year. The
total current cost estimate for the Year 2000 project is between $13 and $17
million, of which approximately $2 million has been incurred to date. These
costs are expensed as incurred.
However, notwithstanding the foregoing, the costs of the project and the
timetable in which the Company plans to complete the Year 2000 compliance
requirements are based on estimates derived utilizing numerous assumptions of
future events including the continued availability of certain resources, third
party modification plans and other factors. There can therefore be no assurance
that these estimates will be achieved and actual results could differ materially
from these estimates.
At this time it is unclear as to the extent of existing insurance coverage,
if any, the Company may have to cover potential year 2000 liabilities. The
Company is currently analyzing the obtainment of such coverage.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
CONTINUING OPERATIONS
The Company is exposed to interest rate and market risk primarily due to its
investing and borrowing activities. Market risk generally represents the risk of
loss that may result from the potential change in the value of a financial
instrument as a result of fluctuations in interest rates and in equity prices.
Interest rate risk is a consequence of maintaining fixed income investments. The
Company is exposed to interest rate risks arising from changes in the level or
volatility of interest rates, prepayment speeds and/or the shape and slope of
the yield curve. In addition, the Company is 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 Company has several bond portfolios to fund reserves. The Company
attempts to manage the interest rate risks related to its investment portfolios
by actively managing the asset/liability duration of its investment portfolios.
The overall goal of the investment portfolios is to support the ongoing
operations of the Company's business units. The Company's philosophy is to
actively manage assets to maximize total return over a multiple-year time
horizon, subject to appropriate levels of risk. Each business unit will have
additional requirements with respect to liquidity, current income and
contribution to surplus. The Company manages these risks by setting risk
tolerances, targeting asset-class allocations, diversifying among assets and
asset characteristics, and using performance measurement and reporting.
The Company uses a value-at-risk model to assess the market risk of its
investments. The estimation of potential losses that could arise from changes in
market conditions is typically accomplished through the use of statistical
models which seek to predict risk of loss based on historical price and
volatility patterns. The Company's measured value at risk for its investments
from continuing operations, using a 95% confidence level, was approximately $5.2
million at December 31, 1997.
The Company's calculated value-at-risk exposure represents an estimate of
reasonably possible net losses that could be recognized on its investment
portfolios assuming hypothetical movements in future market rates and are not
necessarily indicative of actual results which may occur. It does not represent
the maximum possible loss nor any expected loss that may occur, since actual
future gains and losses will differ
44
from those estimated, based upon actual fluctuations in market rates, operating
exposures, and the timing thereof, and changes in the Company's investment
portfolios during the year.
The Company, however, believes that any loss incurred would be offset by the
effects of interest rate movements on the respective liabilities, since these
liabilities are affected by many of the same factors that affect asset
performance; that is, economic activity, inflation and interest rates, as well
as regional and industry factors.
In addition, the Company has some interest rate market risk due to its
borrowings. Notes payable, capital leases and other financing arrangements total
$1,309 million and the related average interest rate is 6.09% (which interest
rate is subject to change pursuant to the terms of the credit agreement). See a
description of the credit facility under "Liquidity and Capital Resources." The
table below presents the expected cash flows of market risk sensitive
instruments at December 31, 1997. These cash flows include both expected
principal and interest payments consistent with the terms of the outstanding
debt as of December 31, 1997.
YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 BEYOND TOTAL
--------- --------- ---------- --------- ------------ --------- ------------
(DOLLARS IN THOUSANDS)
Long-term Borrowings
Fixed Rate..................... $ 4,329 $ 4,329 $ 24,288 $ 2,540 $ 2,715 $ 10,859 $ 49,060
Floating Rate.................. 75,900 75,900 75,900 75,900 1,340,900 0 1,644,500
--------- --------- ---------- --------- ------------ --------- ------------
Total............................ $ 80,229 $ 80,229 $ 100,188 $ 78,440 $ 1,343,615 $ 10,859 $ 1,693,560
--------- --------- ---------- --------- ------------ --------- ------------
--------- --------- ---------- --------- ------------ --------- ------------
DISCONTINUED OPERATIONS
The Company announced that it plans to sell its workers compensation
insurance businesses which represent a separate segment of business. Therefore
the results of these businesses have been reported as discontinued operations.
The Company's measured value-at-risk of its investments from discontinued
operations, a 95 percent confidence level at December 31, 1997, was
approximately $9.2 million, out of a total market value of investments of $625
million.
The discontinued operations businesses do not have any significant interest
rate risk due to debt.
45
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF THE AUDIT COMMITTEE
OF THE BOARD OF DIRECTORS
OF FOUNDATION HEALTH SYSTEM, INC.
The Board of Directors of the Company addresses its oversight responsibility for
the consolidated financial statements through its Audit Committee (the
"Committee"). The Committee currently consists of Gov. George Deukmejian, Thomas
T. Farley, Earl B. Fowler (Chairman) and Richard J. Stegemeier, each of whom is
an independent outside director.
In fulfilling its responsibilities in 1997, the Committee reviewed the overall
scope of the independent auditors' audit plan and reviewed the independent
auditors' non-audit services to the Company. The Committee also exercised
oversight responsibilities over various financial and regulatory matters.
The Committee's meetings are designed to facilitate open communication between
the independent auditors and Committee members. To ensure auditor independence,
the Committee meets privately with the independent auditors providing for full
and free access to the Committee.
Earl B. Fowler, Chairman
Audit Committee
March 30, 1998
46
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Foundation Health Systems, Inc.
Woodland Hills, California
We have audited the accompanying consolidated balance sheets of Foundation
Health Systems, Inc. and subsidiaries (the "Company") as of December 31, 1997
and 1996, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1997. Our audits also included the financial statement schedule of Condensed
Financial Information listed in the Index at Item 14(a)(2). These financial
statements and financial statement schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on the
financial statements and financial statement schedule based on our audits. The
consolidated financial statements and financial statement schedule give
retroactive effect to the merger of Health Systems International, Inc. and
Foundation Health Corporation, which has been accounted for as a pooling of
interests as discussed in Note 1 to the consolidated financial statements. As
described in Note 1 to the consolidated financial statements, the financial
statements of Foundation Health Corporation were restated to conform to the
calendar year end of Foundation Health Systems, Inc. as of December 31, 1997 and
1996 and for each of the three years in the period ended December 31, 1997.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit 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, such consolidated financial statements present fairly, in
all material respects, the financial position of Foundation Health Systems, Inc.
and subsidiaries at December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1997 in conformity with generally accepted accounting principles.
Also, in our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Los Angeles, California
March 27, 1998
47
FOUNDATION HEALTH SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS)
DECEMBER 31,
--------------------------
1997 1996
------------ ------------
ASSETS
Current assets
Cash and cash equivalents.......................................................... $ 559,360 $ 487,938
Investments--available for sale.................................................... 553,001 634,978
Premium receivables, net of allowance for doubtful accounts of $22.9 million and
$18.2 million at December 31, 1997 and 1996...................................... 224,383 150,782
Amounts receivable under government contracts...................................... 272,060 221,787
Deferred taxes..................................................................... 213,695 96,486
Reinsurance and other receivables.................................................. 130,875 74,169
Other assets....................................................................... 188,606 161,904
Net assets of discontinued operations.............................................. 267,713 381,572
------------ ------------
Total current assets................................................................. 2,409,693 2,209,616
Investments--held to maturity...................................................... 12,885 14,217
Property and equipment, net........................................................ 427,149 304,748
Goodwill and other intangible assets, net.......................................... 1,044,727 704,951
Other assets....................................................................... 181,896 190,244
------------ ------------
Total Assets......................................................................... $ 4,076,350 $3,423,776
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Reserves for claims and other settlements.......................................... $ 967,815 $ 798,980
Unearned premiums.................................................................. 244,340 177,048
Notes payable and capital leases................................................... 3,593 85,476
Amounts payable under government contracts......................................... 78,441 44,323
Accounts payable and other liabilities............................................. 470,483 324,355
------------ ------------
Total current liabilities............................................................ 1,764,672 1,430,182
Notes payable and capital leases................................................... 1,308,979 791,618
Other liabilities.................................................................. 106,725 18,565
------------ ------------
Total liabilities.................................................................... 3,180,376 2,240,365
------------ ------------
Commitments and contingencies (Note 12)
Stockholders' equity
Preferred stock, $.001 par value, 10,000 shares authorized, none issued and
outstanding......................................................................
Class A common stock, $.001 par value, 350,000 shares authorized, 114,449 and
109,179 shares issued and outstanding at December 31, 1997 and 1996.............. 114 109
Class B non-voting convertible common stock, $.001 par value, 30,000 shares
authorized, 10,298 and 19,298 shares issued and outstanding at December 31, 1997
and 1996......................................................................... 10 19
Additional paid in capital......................................................... 628,611 721,482
Treasury Class A common stock, 3,194 shares and 3,324 shares at December 31, 1997
and 1996......................................................................... (95,831) (98,878)
Retained earnings.................................................................. 370,394 557,478
Unrealized investment gains (losses), net of taxes................................. (7,324) 3,201
------------ ------------
Total stockholders' equity........................................................... 895,974 1,183,411
------------ ------------
Total Liabilities and Stockholders' Equity........................................... $ 4,076,350 $3,423,776
------------ ------------
------------ ------------
See accompanying notes to consolidated financial statements
48
FOUNDATION HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
------------ ------------ ------------
Revenues
Health plan premiums.................................................. $ 5,829,444 $ 5,395,125 $ 4,557,214
Government contracts.................................................. 949,168 908,730 279,380
Specialty services.................................................... 342,107 316,993 210,533
Investment and other income........................................... 114,300 88,392 66,510
------------ ------------ ------------
7,235,019 6,709,240 5,113,637
------------ ------------ ------------
Expenses
Health plan services.................................................. 4,912,532 4,598,074 3,643,463
Government health care services....................................... 711,757 706,076 174,040
Specialty services.................................................... 290,319 289,744 182,380
Selling, general and administrative................................... 851,826 859,996 657,275
Amortization and depreciation......................................... 98,353 112,916 89,356
Interest.............................................................. 63,555 45,372 33,463
Merger, restructuring and other costs................................. 338,425 44,108 20,164
Gem costs............................................................. 57,500
------------ ------------ ------------
7,324,267 6,656,286 4,800,141
------------ ------------ ------------
Income (loss) from continuing operations before income taxes............ (89,248) 52,954 313,496
Income tax provision (benefit).......................................... (21,418) 14,124 124,345
------------ ------------ ------------
Income (loss) from continuing operations................................ (67,830) 38,830 189,151
Discontinued operations:
Income (loss) from operations, net of tax............................. (30,409) 25,084 3,028
Gain (loss) on disposition, net of tax................................ (88,845) 20,317
------------ ------------ ------------
Net income (loss)....................................................... $ (187,084) $ 84,231 $ 192,179
------------ ------------ ------------
------------ ------------ ------------
Basic earnings (loss) per share
Continuing operations................................................. $ (0.55) $ 0.31 $ 1.54
Discontinued operations............................................... (0.25) 0.20 0.02
Discontinued operations gain (loss) on disposition.................... (0.72) 0.16
------------ ------------ ------------
Net................................................................... $ (1.52) $ 0.67 $ 1.56
------------ ------------ ------------
------------ ------------ ------------
Diluted earnings (loss) per share
Continuing operations................................................. $ (0.55) $ 0.31 $ 1.53
Discontinued operations............................................... (0.25) 0.20 0.02
Discontinued operations gain (loss) on disposition.................... (0.72) 0.16
------------ ------------ ------------
Net................................................................... $ (1.52) $ 0.67 $ 1.55
------------ ------------ ------------
------------ ------------ ------------
Weighted average common and common stock equivalent shares outstanding:
Basic................................................................. 123,333 124,453 122,741
Diluted............................................................... 123,821 124,966 123,674
See accompanying notes to consolidated financial statements
49
FOUNDATION HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
COMMON STOCK
-----------------------------------
COMMON STOCK
CLASS A CLASS B ADDITIONAL HELD IN TREASURY
---------------------- -------------------------- PAID-IN ----------------------
SHARES AMOUNT SHARES AMOUNT CAPITAL SHARES AMOUNT
--------- ----------- ----------- ------------- ----------- ----------- ---------
Balance at January 1, 1995.............. 99,617 $ 100 25,684 $ 26 $ 614,696 (2,797) $ (54,670)
Issuance of common stock-net............ 41 1,203
Exercise of stock options including
related tax benefit................... 1,711 1 22,312
Employee stock purchase plan............ 99 2,039
Purchase of treasury stock.............. (1,296) (35,849)
Retirement of treasury stock............ (3,963) (4) (54,958) 3,963 87,472
Advance to repurchase Class A shares....
Unrealized gain on investments available
for sale..............................
Net income..............................
--------- ----- ----------- --- ----------- ----------- ---------
Balance at December 31, 1995............ 97,505 97 25,684 26 585,292 (130) (3,047)
Issuance of common stock-net............ 1,468 3 4,386
Exercise of stock options including
related tax benefit................... 1,216 1 29,546
Employee stock purchase plan............ 121 2,576
Employee profit sharing plan............ 166 4,558
Sale of common stock.................... 9,581 10 (6,386) (7) 95,828
Purchase of treasury stock.............. (4,072) (105,419)
Retirement of treasury stock............ (878) (2) (704) 878 9,588
Unrealized loss on investments available
for sale..............................
Net income..............................
--------- ----- ----------- --- ----------- ----------- ---------
Balance at December 31, 1996............ 109,179 109 19,298 19 721,482 (3,324) (98,878)
Redemption of common stock.............. (4,550) (4) (111,330)
Retirement of treasury stock............ (130) (3,047) 130 3,047
Exercise of stock options including
related tax benefit................... 842 19,310
Conversion of Class B to Class A........ 4,450 5 (4,450) (5)
Employee stock purchase plan............ 108 2,196
Unrealized loss on investments available
for sale..............................
Net loss................................
--------- ----- ----------- --- ----------- ----------- ---------
Balance at December 31, 1997............ 114,449 $ 114 10,298 $ 10 $ 628,611 (3,194) $ (95,831)
--------- ----- ----------- --- ----------- ----------- ---------
--------- ----- ----------- --- ----------- ----------- ---------
UNREALIZED
INVESTMENT
GAINS AND
(LOSSES),
RETAINED NET OF TAXES
EARNINGS AND OTHER TOTAL
--------- ------------ ----------
Balance at January 1, 1995.............. $ 338,790 $ (21,476) $ 877,466
Issuance of common stock-net............ 1,203
Exercise of stock options including
related tax benefit................... 22,313
Employee stock purchase plan............ 2,039
Purchase of treasury stock.............. (35,849)
Retirement of treasury stock............ (32,510)
Advance to repurchase Class A shares.... (16,330) (16,330)
Unrealized gain on investments available
for sale.............................. 25,233 25,233
Net income.............................. 192,179 192,179
--------- ------------ ----------
Balance at December 31, 1995............ 498,459 (12,573) 1,068,254
Issuance of common stock-net............ 4,389
Exercise of stock options including
related tax benefit................... 29,547
Employee stock purchase plan............ 2,576
Employee profit sharing plan............ 4,558
Sale of common stock.................... 95,831
Purchase of treasury stock.............. (105,419)
Retirement of treasury stock............ (25,212) 16,330
Unrealized loss on investments available
for sale.............................. (556) (556)
Net income.............................. 84,231 84,231
--------- ------------ ----------
Balance at December 31, 1996............ 557,478 3,201 1,183,411
Redemption of common stock.............. (111,334)
Retirement of treasury stock............
Exercise of stock options including
related tax benefit................... 19,310
Conversion of Class B to Class A........
Employee stock purchase plan............ 2,196
Unrealized loss on investments available
for sale.............................. (10,525) (10,525)
Net loss................................ (187,084) (187,084)
--------- ------------ ----------
Balance at December 31, 1997............ $ 370,394 $ (7,324) $ 895,974
--------- ------------ ----------
--------- ------------ ----------
See accompanying notes to consolidated financial statements
50
FOUNDATION HEALTH SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
-------------------------------
1997 1996 1995
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).............................................................. $(187,084) $ 84,231 $ 192,179
Adjustments to reconcile net income (loss) to net cash provided (used) by
operating activities:
Amortization and depreciation................................................ 98,353 112,916 89,356
Loss on disposal of United Kingdom Operations................................ 12,676
Loss on early redemption of Senior Notes..................................... 9,586
Write-down of fixed assets................................................... 8,456 14,963
Amortization of bond discounts............................................... 628 1,124 609
Gain on sale of investments available for sale............................... (4,610) (2,173) (1,200)
Gain on note receivable early redemption..................................... (3,079)
Other changes in net assets of discontinued operations....................... (5,395) (78,589) (94,835)
(Gain) loss on disposition of discontinued operations........................ 88,845 (20,317) 3,028
(Income) loss from discontinued operations................................... 30,409 (25,084)
Change in assets and liabilities, net of effects from acquisition of
businesses:
Premium receivable and unearned subscriber premiums.......................... 3,105 35,941 76
Other assets................................................................. (112,302) (239,013) (94,521)
Amounts receivable/payable under government contracts........................ (16,155) (101,711) (42,840)
Reserves for claims and other settlements.................................... (55,450) 165,695 16,905
Accounts payable and accrued liabilities..................................... 6,145 45,351 (17,340)
--------- --------- ---------
Net cash provided (used) from operating activities............................... (125,872) (6,666) 51,417
CASH FLOWS FROM INVESTING ACTIVITIES:
Sale or maturity of investments available for sale............................. 597,691 441,550 810,526
Purchases of investments available for sale.................................... (406,818) (513,734) (883,534)
Maturity of investments held to maturity....................................... 3,591 7,613 24,008
Purchases of investments held to maturity...................................... (2,274) (7,835) (9,288)
Purchases of property and equipment............................................ (131,669) (95,751) (85,719)
Proceeds from note receivables................................................. 93,011 825
Investment in other companies.................................................. (21,949)
Other.......................................................................... 5,316 (17,562) (8,413)
Acquisition of businesses, net of cash acquired................................ (293,625) 108 (150,460)
--------- --------- ---------
Net cash used for investing activities........................................... (134,777) (184,786) (324,829)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and employee stock purchases........... 21,506 31,756 22,570
Proceeds from sale of stock.................................................... 95,828
Proceeds from issuance of notes payable and other financing arrangements....... 566,240 331,576 370,000
Repayment of debt and other non-current liabilities............................ (144,341) (4,939) (162,551)
Advances to repurchase shares of Class A common stock.......................... (16,330)
Stock repurchase............................................................... (111,334) (105,418) (35,849)
--------- --------- ---------
Net cash provided by financing activities........................................ 332,071 348,803 177,840
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents............................. 71,422 157,351 (95,572)
Cash and cash equivalents, beginning of year..................................... 487,938 330,587 426,159
--------- --------- ---------
Cash and cash equivalents, end of year........................................... $ 559,360 $ 487,938 $ 330,587
--------- --------- ---------
--------- --------- ---------
SUPPLEMENTAL CASH FLOWS DISCLOSURE :
Cash paid during the year for:
Interest....................................................................... $ 56,056 $ 43,337 $ 32,501
Income taxes................................................................... (3,534) 65,698 65,259
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Capital lease obligations...................................................... $ 3,993 $ 401
Notes and stocks received on sale of Medical Practices......................... 201,118
Transfer of investment as consideration for PACC acquisition................... 14,310
Conversion of FOHP convertible debentures to equity............................ 70,654
Transfer of investments from held to maturity to available for sale............ $ 2,913
Issuance of notes and assumption of liabilities as consideration in acquisition
of GHH....................................................................... 28,200
Profit sharing plan shares issued.............................................. 4,558
ACQUISITION OF BUSINESSES:
Fair value of assets acquired.................................................. $ 849,487 $ 23,650 $ 300,604
Liabilities assumed............................................................ 438,448 12,903 105,787
Issuance of common stock....................................................... 6,631
--------- --------- ---------
Cash paid for acquisitions..................................................... 411,039 4,116 194,817
Less cash acquired for acquisitions............................................ 117,414 4,224 44,357
--------- --------- ---------
Net cash paid in acquisitions.................................................. $ 293,625 $ (108) $ 150,460
--------- --------- ---------
--------- --------- ---------
See accompanying notes to consolidated financial statements
51
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--DESCRIPTION OF BUSINESS
The current operations of Foundation Health Systems, Inc. (the "Company" or
"FHS") are a result of the April 1, 1997 merger transaction (the "FHS
Combination") involving Health Systems International, Inc. ("HSI") and
Foundation Health Corporation ("FHC"). Pursuant to the FHS Combination, FH
Acquisition Corp., a wholly owned subsidiary of HSI ("Merger Sub"), merged with
and into FHC and FHC survived as a wholly-owned subsidiary of HSI, which changed
its name to "Foundation Health Systems, Inc." and thereby became the Company.
Pursuant to the Agreement and Plan of Merger (the "Merger Agreement") that
evidenced the FHS Combination, FHC stockholders received 1.3 shares of the
Company's Class A Common Stock for every share of FHC common stock held,
resulting in the issuance of approximately 76.7 million shares of the Company's
Class A Common Stock to FHC stockholders. The shares of the Company's Class A
Common Stock issued to FHC's stockholders in the FHS Combination constituted
approximately 61% of the outstanding stock of the Company after the FHS
Combination and the shares held by the Company's stockholders prior to the FHS
Combination (i.e. the prior stockholders of HSI) constituted approximately 39%
of the outstanding stock of the Company after the FHS Combination.
The FHS Combination was accounted for as a pooling of interests for
accounting and financial reporting purposes. The pooling of interests method of
accounting is intended to present, as a single interest, two or more common
stockholder interests which were previously independent and assumes that the
combining companies have been merged from inception. Consequently, the Company's
consolidated financial statements have been prepared and/or restated as though
HSI and FHC always had been combined. Although prior to the FHS Combination FHC
reported on a fiscal year ended June 30 basis, the consolidated financial
statements have been restated to reflect the Company's calendar year basis.
CONTINUING OPERATIONS
The Company is an integrated managed care organization which administers the
delivery of managed health care services. Continuing operations consist of three
separate lines of business: health plans, government contracts and specialty
services. Through its subsidiaries, the Company offers group, individual,
Medicaid and Medicare health maintenance organization ("HMO") and preferred
provider organization ("PPO") plans; government sponsored managed care plans;
and managed care products related to administration and cost-containment,
behavioral health, dental, vision and pharmaceutical products and other
services.
The Company's health plans provide a wide range of managed health care
services throughout the United States with more than 4.3 million at-risk and
administrative services only members. The Company provides a comprehensive range
of health care services through HMOs organized into three operational divisions
located in the following geographic regions: the California Division which
includes Health Net, a California health maintenance organization, the Eastern
Division (Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and
West Virginia) and the Western Division (Arizona, Colorado, Idaho, Louisiana,
New Mexico, Oklahoma, Oregon, Texas, Utah and Washington). The Company's
commercial HMO subsidiaries contract to provide medical care services to a
defined, enrolled population for a predetermined, prepaid monthly fee for group,
Medicaid, individual and Medicare HMO plans throughout their respective service
areas. All of the HMOs are state licensed and some are also federally qualified.
The Company also operates PPO networks which provide access to health care
services and owns six health and life insurance companies licensed to sell
insurance throughout the United States.
52
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1--DESCRIPTION OF BUSINESS (CONTINUED)
The Company's wholly-owned subsidiary, Foundation Health Federal Services,
Inc. ("Federal Services"), administers large, multi-year managed care government
contracts. Federal Services subcontracts to affiliated and unrelated third
parties the administration and health care risk of parts of these contracts.
Federal Services currently administers health care programs covering 1.9 million
eligible individuals under the Civilian Health and Medical Program of the
Uniformed Services ("CHAMPUS"). Through the Federal Government's TRICARE
program, Federal Services provides CHAMPUS families with improved access to
primary health care, lower out-of-pocket expenses and fewer claims forms.
Federal Services currently administers three TRICARE contracts in five regions
that cover the following states:
- Region 6: Texas, Arkansas, Oklahoma and Louisiana
- Regions 9, 10 & 12: California, Hawaii, Alaska and portions of Arizona
- Region 11: Washington, Oregon and portions of Idaho
The Company's specialty services subsidiaries offer behavioral health,
dental, vision, and pharmaceutical products and services as well as managed care
products related to bill review, administration and cost containment for
hospitals, health plans and other entities.
DISCONTINUED OPERATIONS
WORKERS' COMPENSATION INSURANCE SEGMENT--The Company revised its strategy of
maintaining a presence in the workers' compensation insurance business and
adopted a plan to discontinue this segment of its business through divestiture
of its workers' compensation insurance subsidiaries. The Company is currently in
negotiation for the sale of the business. As a result, the Company is reporting
its workers' compensation insurance segment as discontinued operations in the
consolidated financial statements (see Note 15).
The workers' compensation insurance companies consist of the following:
California Compensation Insurance Company, a specialty workers' compensation
carrier writing business primarily in California; Business Insurance Company, a
national workers' compensation specialty carrier; Commercial Compensation
Insurance Company (f/k/a Christiania General Insurance Corporation); and
Combined Benefits Insurance Company, writing single source workers' compensation
and employee health insurance primarily in California.
PHYSICIAN PRACTICE MANAGEMENT SEGMENT--On June 28, 1996 the Company executed
a Stock and Note Purchase Agreement with FPA Medical Management, Inc. ("FPA"), a
national health care management services organization, for the purchase by FPA
of the Company's physician practice management subsidiary and affiliated
physician-owned medical practices (collectively, the "Medical Practices"). The
transaction was consummated in November 1996. The consolidated financial
statements report this segment as discontinued operations (see Note 15).
RESTATEMENT FOR FHS COMBINATION
As previously stated, the Company's consolidated financial statements have
been prepared and/or restated as though HSI and FHC always had been combined.
The following summary reflects the adjustments required to change FHC from a
June 30 fiscal year end to the Company's calendar year end.
53
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 1--DESCRIPTION OF BUSINESS (CONTINUED)
The separate and combined results of the Company and FHC for the two years
and period prior to the consummation of the FHS Combination are as follows (in
thousands):
QUARTER ENDED YEAR ENDED DECEMBER 31,
MARCH 31, -----------------------------
1997 1996 1995
------------- ------------- -------------
(UNAUDITED)
REVENUE
HSI total revenues and investment income as previously
reported............................................ $ 850,404 $ 3,242,858 $ 2,765,222
FHC June 30 fiscal year basis......................... 1,044,740 3,407,628 2,459,423
Net adjustments to reflect FHC on a calendar year
basis............................................... -- 560,028 299,762
Adjustments to reflect workers' compensation insurance
subsidiaries as discontinued operations............. (125,125) (501,274) (410,770)
------------- ------------- -------------
Combined.............................................. $ 1,770,019 $ 6,709,240 $ 5,113,637
------------- ------------- -------------
------------- ------------- -------------
NET INCOME
HSI as previously reported............................ $ 24,572 $ 73,592 $ 89,592
FHC June 30 fiscal year basis......................... 33,909 148,282 6,010
Net adjustments to reflect FHC on a calendar year
basis............................................... -- (137,643) 96,577
------------- ------------- -------------
Combined.............................................. $ 58,481 $ 84,231 $ 192,179
------------- ------------- -------------
------------- ------------- -------------
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned and majority-owned subsidiaries. All significant
intercompany transactions have been eliminated in consolidation except for
transactions between the Company's continuing operations subsidiaries and the
discontinued operations segments discussed in Note 15. The accompanying
consolidated financial statements have been restated for the FHS Combination
accounted for as a pooling of interests as discussed in Note 1.
REVENUE RECOGNITION
Commercial premium revenue includes HMO and PPO premiums from employer
groups and individuals and from Medicare recipients who have purchased
supplemental benefit coverage, which premiums are based on a predetermined
prepaid fee, Medicaid revenues based on multi-year contracts to provide care to
Medicaid recipients, and revenue under Medicare risk contracts to provide care
to enrolled Medicare recipients. Revenue is recognized in the month in which the
related enrollees are entitled to health care services. Premiums collected in
advance are recorded as unearned premiums.
Revenue under government contracts is recognized in the month in which the
eligible beneficiaries are entitled to health care services. Government
contracts also contain cost and performance incentive provisions which adjust
the contract price based on actual performance, and revenue under contracts is
subject to price adjustments attributable to inflation and other factors. The
effects of these adjustments are recognized on a monthly basis. Amounts
receivable under government contracts are comprised primarily of estimated
amounts receivable under these cost and performance incentive provisions, price
adjustments, and change orders for services not originally specified in the
contracts.
54
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Specialty services revenue is recognized in the month in which the
administrative services are performed or the period that coverage for services
is provided.
HEALTH CARE EXPENSES
The cost of health care services is recognized in the period in which it is
provided and includes an estimate of the cost of services which have been
incurred but not yet reported. Such costs include payments to primary care
physicians, specialists, hospitals, outpatient care facilities and the costs
associated with managing the extent of such care. The estimate for reserves for
claims and other settlements is based on actuarial projections of hospital and
other costs using historical studies of claims paid. Estimates are continually
monitored and reviewed and, as settlements are made or estimates adjusted,
differences are reflected in current operations. Such estimates are subject to
the impact of changes in the regulatory environment and economic conditions.
Given the inherent variability of such estimates, the actual liability could
differ significantly from the amounts provided. While the ultimate amount of
claims and losses paid are dependent on future developments, management is of
the opinion that the reserves for claims and other settlements are adequate to
cover such claims and losses. These liabilities are reduced by estimated amounts
recoverable from third parties for subrogation.
The Company generally contracts in California and Arizona with various
medical groups to provide professional care to certain of its members on a
capitation or fixed per member per month fee basis. Capitation contracts
generally include a provision for stop-loss and non-capitated services for which
the Company is liable. Professional capitated contracts also generally contain
provisions for shared risk, whereby the Company and the medical groups share in
the variance between actual hospital costs and predetermined goals.
Additionally, the Company contracts with certain hospitals to provide hospital
care to enrolled members on a capitation basis. The HMOs also contract with
hospitals, physicians and other providers of health care, pursuant to discounted
fee-for-service arrangements and hospital per diems under which providers bill
the HMOs for each individual service provided to enrollees.
CASH AND CASH EQUIVALENTS
Cash equivalents include all highly liquid investments with a maturity of
three months or less when purchased.
The Company and its consolidated subsidiaries are required to set aside
certain funds for restricted purposes pursuant to regulatory requirements. As of
December 31, 1997 and 1996, cash and cash equivalent balances of $37.9 million
and $5.5 million, respectively, are restricted and included in other noncurrent
assets.
INVESTMENTS
The Company classifies certain debt investments held by trustees or agencies
pursuant to state regulatory requirements as held to maturity based on the
Company's ability and intent to hold these investments to maturity. Such
investments are presented at amortized cost. All other investments are
classified as available for sale and are reported at fair value based on quoted
market prices, with unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders' equity, net of income tax
effects. The cost of investments sold is determined in accordance with the
specific identification method and realized gains and losses are included in
investment income.
55
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Restricted investments totaled $14.6 million and $14.2 million at December
31, 1997 and 1996. In addition, $20.3 million in investments are restricted in
connection with the California Wellness Foundation (the "CWF") note payable at
December 31, 1997 and 1996 (see Note 6).
PROPERTY AND EQUIPMENT
Property and equipment are stated at historical cost less accumulated
depreciation. Depreciation is computed using the straight-line method over the
lesser of estimated useful lives of the various classes of assets or the lease
term. Lives of the assets range from 3 to 40 years.
Expenditures for maintenance and repairs are expensed as incurred. Major
improvements which increase the estimated useful life of an asset are
capitalized. Upon the sale or retirement of assets, recorded cost and related
accumulated depreciation are removed from the accounts, and any gain or loss on
disposal is reflected in operations.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets consist primarily of goodwill and other
intangible assets which arise as a result of various business acquisitions.
Other intangible assets consist of the value of employer group contracts and
provider networks. Goodwill and other intangible assets are amortized using the
methods listed below over appropriate periods not exceeding 40 years. Fully
amortized goodwill and other intangible assets and related accumulated
amortization are removed from the accounts. The Company evaluates the carrying
value of its goodwill and other intangible assets periodically based on fair
values or undiscounted operating cash flows whenever significant events or
changes occur which might impair recovery of recorded costs, and it writes down
recorded costs of the assets to fair value when recorded costs, prior to
impairment, are higher.
Goodwill and other intangible assets consisted of the following at December
31, 1997 (in thousands):
ACCUMULATED AMORTIZATION
COST AMORTIZATION NET BALANCE PERIOD
------------ ------------ ------------ -------------
Goodwill................................................ $ 1,026,992 $ 78,339 $ 948,653 27-40 years
Provider network........................................ 20,686 4,864 15,822 5-20 years
Employer group contracts................................ 120,089 62,380 57,709 11 years
Other................................................... 69,070 46,527 22,543 4-15 years
------------ ------------ ------------
Total................................................... $ 1,236,837 $ 192,110 $ 1,044,727
------------ ------------ ------------
------------ ------------ ------------
Goodwill and other intangible assets consisted of the following at December
31, 1996 (in thousands):
ACCUMULATED AMORTIZATION
COST AMORTIZATION NET BALANCE PERIOD
---------- ------------ ----------- -------------
Goodwill................................................... $ 652,088 $ 62,316 $ 589,772 27-40 years
Provider network........................................... 25,035 3,761 21,274 5-20 years
Employer group contracts................................... 122,140 53,467 68,673 11 years
Other...................................................... 68,194 42,962 25,232 4-15 years
---------- ------------ -----------
Total...................................................... $ 867,457 $ 162,506 $ 704,951
---------- ------------ -----------
---------- ------------ -----------
Amortization expense on goodwill and other intangible assets was $40.3
million, $45.2 million and $33.1 million for the years ended December 31, 1997,
1996 and 1995, respectively.
56
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations
of credit risk consist primarily of cash equivalents, investments and premium
receivables. All cash equivalents and investments are managed within established
guidelines which limit the amounts which may be invested with one issuer.
Concentrations of credit risk with respect to premium receivables are limited
due to the large number of payers comprising the Company's customer base. The
Company's ten largest employer groups accounted for 36.2% and 29.9% of
receivables and 16.3% and 16.8% of premium revenue as of December 31, 1997 and
1996, respectively, and for the years then ended.
EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share", which
requires changes in current earnings per share ("EPS") reporting requirements.
The Company adopted SFAS No. 128 in the fourth quarter of 1997 and restated all
prior period EPS data presented in the accompanying financial statements. Basic
EPS excludes dilution and reflects income divided by the weighted average shares
of common stock outstanding during the periods presented. Diluted EPS is based
upon the weighted average shares of common stock and dilutive common stock
equivalents (stock options) outstanding during the periods presented; no
adjustment to income is required. Common stock equivalents arising from dilutive
stock options are computed using the treasury stock method.
Options to purchase an aggregate of 6.6 million, 4.1 million and 1.3 million
shares of common stock during 1997, 1996 and 1995, respectively, were not
included in the computation of diluted EPS because the options' exercise price
was greater than the average market price of the common stock. These options
expire through December 2007.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts of cash equivalents, investments available
for sale and notes payable approximate their carrying amounts in the financial
statements and have been determined by the Company using available market
information and appropriate valuation methodologies. The carrying amount of cash
equivalents approximate fair value due to the short maturity of those
instruments. The fair values of investments are estimated based on quoted market
prices and dealer quotes for similar investments. The fair value of notes
payable is estimated based on the quoted market prices for the same or similar
issues or on the current rates offered to the Company for debt with the same
remaining maturities. Considerable judgment is required to develop estimates of
fair value. Accordingly, the estimates are not necessarily indicative of the
amounts the Company could have realized in a current market exchange. The use of
different market assumptions and/or estimation methodologies may have a material
effect on the estimated fair value amounts.
57
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The fair value estimates are based on pertinent information available to
management as of December 31, 1997 and 1996. Although management is not aware of
any factors that would significantly affect the estimated fair value amounts,
such amounts have not been comprehensively revalued for purposes of these
financial statements since that date, and therefore, current estimates of fair
value may differ significantly.
STOCK-BASED COMPENSATION
During 1995, the Financial Accounting Standards Board issued SFAS No. 123,
"Accounting for Stock-Based Compensation". The Company has chosen to continue
accounting for stock-based compensation under the intrinsic value method
prescribed in Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees." Under the intrinsic value method, compensation cost for
stock options is measured at the date of grant as the excess, if any, of the
quoted market price of the Company's stock over the exercise price of the option
(see Note 7).
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
During 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income", which requires that an enterprise report, by
major components and as a single total, the change in its net assets during the
period from nonowner sources; SFAS No. 131 "Disclosures About Segments of an
Enterprise and Related Information", which establishes annual and interim
reporting standards for an enterprise's business segments and related
disclosures about its products, services, geographic areas, and major customers;
and SFAS No. 132 "Employers Disclosures About Pensions and Other Postretirement
Benefits", which revises and standardizes pension and other benefit plan
disclosures. Adoption of these statements will not impact the Company's
consolidated financial position, results of operations or cash flows. These
statements are effective for fiscal years beginning after December 15, 1997.
NOTE 3--ACQUISITIONS
The following summarizes acquisitions and strategic investments by the
Company for the three years ended December 31, 1997:
1997
ADVANTAGE HEALTH--On April 1, 1997 the Company completed the acquisition of
Advantage Health, a group of managed health care companies based in Pittsburgh,
Pennsylvania, for $12.5 million in cash. The acquisition has been recorded using
purchase accounting and the excess of the purchase price over the fair value of
the assets acquired was recorded as goodwill. The goodwill, in the amount of
$19.7 million, is being amortized on a straight line basis over 35 years.
Advantage Health has approximately 35,000 full-risk members in Pennsylvania,
Ohio and West Virginia. The Company purchased Advantage Health from St. Francis
Health System, which has an option to re-acquire a 20 percent interest in
Advantage Health for $2.5 million. Advantage Health remains a party to long-term
provider agreements with the St. Francis Health System.
PACC--On October 22, 1997, effective October 1, 1997, the Company completed
the acquisitions of PACC HMO and PACC Health Plans (collectively, "PACC"), which
are managed health care companies based near Portland, Oregon, for a net
purchase price of approximately $43.7 million in cash. The acquisition has been
recorded using purchase accounting and the excess of the purchase price over the
fair value of the assets acquired was recorded as goodwill. The goodwill, in the
amount of $32.2 million, is
58
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 3--ACQUISITIONS (CONTINUED)
being amortized on a straight-line basis over 40 years. PACC is a 116,000 member
health plan with operations in Oregon and Washington.
FOHP--On April 30, 1997 the Company made a $51.7 million investment in FOHP,
Inc. ("FOHP"). FOHP was owned by physicians, hospitals and other health care
providers and was the sole shareholder of First Option Health Plan of New
Jersey, Inc. ("FOHP-NJ"), a managed health care company. The Company's initial
investment was in the form of FOHP debentures convertible into up to 71 percent
of FOHP's outstanding equity at the Company's discretion. As of December 1, 1997
the Company converted these initial FOHP debentures into 71 percent of FOHP's
equity. Additionally, effective December 8, 1997 FOHP issued an additional $29.0
million of convertible debentures to the Company which immediately converted
approximately $18.9 million of these debentures into an additional 27 percent of
FOHP's outstanding equity increasing FHS' equity holding in FOHP to
approximately 98 percent. Goodwill of $107.7 million was recorded as a result of
these transactions. On December 31, 1997 the Company purchased nonconvertible
debentures in the amount of $24 million from FOHP. FOHP currently has more than
250,000 members in New Jersey enrolled in its commercial, Medicare, Medicaid and
PPO programs.
PHYSICIANS HEALTH SERVICES--On December 31, 1997 the Company completed the
acquisition of Physicians Health Services, Inc. ("PHS"), a group of managed
health care companies based in Shelton Connecticut. The Company paid
approximately $265 million for the approximately nine million PHS shares then
outstanding and caused PHS to cash-out approximately $6 million in PHS employee
stock options as part of the acquisition. The acquisition has been recorded
using purchase accounting and the excess of the purchase price over the fair
value of the assets acquired was recorded as goodwill. The goodwill, in the
amount of $218.9 million, is being amortized on a straight-line basis over 40
years. PHS is a 449,000 member health plan with operations in the New York
metropolitan area, including northern New Jersey, and throughout the state of
Connecticut.
CHRISTIANIA GENERAL INSURANCE CORPORATION--On May 14, 1997 the Business
Insurance Group, Inc., a subsidiary of the Company, acquired the Christiania
General Insurance Corporation of New York ("CGIC") for $12.7 million in cash.
The acquisition has been recorded using purchase accounting and the excess of
the purchase price over the fair value of the assets acquired was recorded as
goodwill. The goodwill, in the amount of $5.2 million, is being amortized on a
straight-line basis over 20 years. As discussed in Note 1, the workers'
compensation segment is reported as discontinued operations and includes CGIC.
The following table reflects unaudited pro forma combined results of
operations of the Company and Advantage Health, PACC, FOHP, PHS, and CGIC on the
basis that the acquisitions had taken place at the beginning of each year ended
December 31 (in thousands, except per share data):
1997 1996
---------- ----------
Total revenues.................................... $8,373,830 $7,593,247
Loss from continuing operations................... (176,589) (1,890)
Net income (loss)................................. (295,746) 45,570
Basic and diluted earnings (loss) per share:
Continuing operations........................... (1.43) (.02)
Net............................................. (2.39) .37
59
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 3--ACQUISITIONS (CONTINUED)
1996
MANAGED HEALTH NETWORK--In March 1996 the Company issued stock for Managed
Health Network, Inc. and its subsidiaries (collectively "MHN"), a privately held
company providing employee assistance and managed behavioral health programs to
more than 2.7 million covered lives through its subsidiaries, in a pooling of
interests transaction valued at approximately $45 million.
1995
MDEC--On March 15, 1995 the Company acquired all of the outstanding stock of
M.D. Enterprises of Connecticut, Inc. ("MDEC"), and its wholly-owned subsidiary,
M.D. Health Plan, an HMO operating in Connecticut, for $100.5 million. The
goodwill, in the amount of $89.1 million and employer group contracts in the
amount of $8.0 million, is being amortized on a straight-line basis over 35 and
11 years, respectively.
HDS--In 1995, the Company acquired shares of preferred stock of Health Data
Sciences Corporation ("HDS"), representing a minority equity interest in HDS,
for an aggregate purchase price of approximately $21.9 million. In July 1996,
HDS was acquired by Medaphis Corporation ("Medaphis") and the Company's
preferred stock in HDS was converted into 976,771 shares of Medaphis common
stock. Since the acquisition of HDS by Medaphis the value of Medaphis common
stock has substantially declined, and the Company has therefore reflected an
unrealized loss of $15.6 million related to its investment in Medaphis common
stock. In connection with the decline the Company filed a lawsuit against
Medaphis in 1996 claiming, among other things, that misleading financial
performance information was given to the Company prior to the acquisition. The
complaint seeks rescission of the transaction or damages in excess of $38.0
million. As of December 31, 1997, the litigation is ongoing.
GHH--On December 1, 1995, the Company acquired the outstanding stock of G.
H. Holdings ("GHH") and certain of its for-profit subsidiaries, including
Greater Atlantic Health Services (now known as QualMed Plans for Health), an HMO
operating in Pennsylvania and New Jersey, for $126.5 million in cash and notes
(the "GHH Transaction"). The acquisition has been accounted using purchase
accounting and the excess of the purchase price over the fair value of assets
acquired in the amount of $88.4 million was recorded as goodwill. Goodwill is
being amortized on a straight-line basis over 35 years. The Company subsequently
divested certain of GHH's subsidiaries.
BICO--In February 1995, California Compensation Insurance Company acquired
Business Insurance Company ("BICO"), a national workers' compensation specialty
carrier, for $13.2 million in cash. The acquisition has been recorded using
purchase accounting and no goodwill was recorded as a result of this
transaction.
60
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4--INVESTMENTS
As of December 31, 1997, the amortized cost, gross unrealized holding gains
and losses and fair value of the Company's investments were as follows (in
thousands):
AVAILABLE FOR SALE HELD TO MATURITY
--------------------------------------------- ---------------------------------------------
GROSS GROSS GROSS GROSS
UNREALIZED UNREALIZED UNREALIZED UNREALIZED
AMORTIZED HOLDING HOLDING FAIR AMORTIZED HOLDING HOLDING FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
--------- --------- --------- --------- --------- --------- --------- ---------
Asset backed
securities............. $ 122,313 $ 901 $ (1,537) $ 121,677
U.S. government and
agencies............... 88,468 808 (269) 89,007 $ 9,675 $ 69 $ (4) $ 9,740
Obligations of states and
other political
subdivisions........... 184,399 1,742 (144) 185,997
Corporate debt
securities............. 73,521 704 (122) 74,103
Securities held by
depository............. 20,912 20,912
Other securities......... 74,118 2,918 (15,731) 61,305 3,210 3,210
--------- --------- --------- --------- --------- --------- --------- ---------
$ 563,731 $ 7,073 $(17,803) $ 553,001 $ 12,885 $ 69 $ (4) $ 12,950
--------- --------- --------- --------- --------- --------- --------- ---------
--------- --------- --------- --------- --------- --------- --------- ---------
As of December 31, 1996, the amortized cost, gross unrealized holding gains
and losses and fair value of the Company's investments were as follows (in
thousands):
AVAILABLE FOR SALE HELD TO MATURITY
--------------------------------------------- ---------------------------------------------
GROSS GROSS GROSS GROSS
UNREALIZED UNREALIZED UNREALIZED UNREALIZED
AMORTIZED HOLDING HOLDING FAIR AMORTIZED HOLDING HOLDING FAIR
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
--------- --------- --------- --------- --------- --------- --------- ---------
Asset backed
securities............. $ 187,204 $ 498 $ (972) $ 186,730
U.S. government and
agencies............... 100,989 121 (911) 100,199 $ 11,806 $ 31 $ (25) $ 11,812
Obligations of states and
other political
subdivisions........... 100,825 339 (287) 100,877
Corporate debt
securities............. 94,732 473 (1,321) 93,884
Securities held by
depository............. 25,019 25,019
Other securities......... 123,785 16,218 (11,734) 128,269 2,411 2,411
--------- --------- --------- --------- --------- --- --- ---------
$ 632,554 $ 17,649 $(15,225) $ 634,978 $ 14,217 $ 31 $ (25) $ 14,223
--------- --------- --------- --------- --------- --- --- ---------
--------- --------- --------- --------- --------- --- --- ---------
61
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4--INVESTMENTS (CONTINUED)
At December 31, 1997, the contractual maturities of the Company's
investments were as follows (in thousands):
ESTIMATED
COST FAIR VALUE
-------- ----------
AVAILABLE FOR SALE:
Due in one year or less......................... $173,550 $ 173,854
Due after one year through five years........... 137,126 138,462
Due after five years through ten years.......... 75,999 77,180
Due after ten years............................. 26,800 26,755
-------- ----------
413,475 416,251
Asset-backed securities......................... 122,313 121,677
Equity securities............................... 27,943 15,073
-------- ----------
Total available for sale.......................... $563,731 $ 553,001
-------- ----------
-------- ----------
HELD TO MATURITY
Due in one year or less......................... $ 6,951 $ 6,952
Due after one year through five years........... 5,934 5,999
-------- ----------
Total held to maturity............................ $ 12,885 $ 12,951
-------- ----------
-------- ----------
Proceeds from sales and maturities of investments available for sale during
1997 were $605.3 million, resulting in realized gains and losses of $4.7 million
and $75 thousand, respectively.
Proceeds from the sales and maturities of investments available for sale
during 1996 were $441.6 million resulting in gross realized gains and losses of
$2.5 million and $300 thousand, respectively.
The Company's regulated subsidiaries are required to keep investments on
deposit in various states where they are licensed. At December 31, 1997, $34.9
million in securities are restricted to satisfy various state regulatory and
licensing requirements.
NOTE 5--PROPERTY AND EQUIPMENT
Property and equipment comprised the following at December 31 (in
thousands):
1997 1996
---------- ----------
Land.............................................. $ 28,302 $ 20,694
Construction in progress.......................... 19,472 12,066
Buildings and improvements........................ 159,571 114,353
Furniture, equipment and software................. 526,781 395,528
---------- ----------
734,126 542,641
Less--accumulated depreciation.................... 306,977 237,893
---------- ----------
$ 427,149 $ 304,748
---------- ----------
---------- ----------
62
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5--PROPERTY AND EQUIPMENT (CONTINUED)
Depreciation expense on property and equipment was $58.1 million, $67.7
million and $56.3 million for the years ended December 31, 1997, 1996 and 1995.
NOTE 6--NOTES PAYABLE, CAPITAL LEASES AND OTHER FINANCING ARRANGEMENTS
Notes payable, capital leases and other financing arrangements comprised the
following at December 31 (in thousands):
1997 1996
---------- --------
Revolving credit facility, variable interest at
LIBOR plus .35% at December 31, 1997,
unsecured....................................... $1,265,000
Senior Notes due June 1, 2003, interest at 7.75%,
unsecured, repaid June 1997 (see note 14)....... $124,673
Revolving credit facility, variable interest at
5.95% at December 31, 1996, unsecured........... 319,000
Revolving credit facility, variable interest at
6.40% at December 31, 1996, unsecured........... 380,000
GHH note payable, due December 2000, interest at
7.95%, unsecured................................ 22,500 22,500
CWF note payable, due quarterly with a balloon
payment due 2006, variable interest of 2.5%
above 3 year Treasury Bill rate, 10.3% at
December 31, 1997 and 1996, secured by
substantially all of the assets of Health Net... 18,754 19,331
Capital leases and other notes payable............ 6,318 11,590
---------- --------
Total notes payable and capital leases............ 1,312,572 877,094
Less notes payable and capital leases-current
portion......................................... 3,593 85,476
---------- --------
Notes payable and capital leases-noncurrent
portion......................................... $1,308,979 $791,618
---------- --------
---------- --------
REVOLVING CREDIT FACILITY
The Company's Credit Facility, as amended, provides for an unsecured
five-year $1.5 billion revolving credit facility which replaced (i) the
Company's prior $700 million unsecured revolving credit facility with Bank of
America, as agent, and (ii) FHC's prior $300 million unsecured revolving credit
facility with Citicorp USA, Inc., as agent, and $200 million unsecured revolving
credit facility with Citibank, N.A., as administrative agent. The facility is
available to the Company and its subsidiaries for general corporate purposes,
including permitted acquisitions.
Bank of America is the administrative agent and co-lead bank with Citibank
N.A. for the other participating banks named in the Credit Agreement. At the
election of the Company, and subject to customary covenants, loans are initiated
on a bid or committed basis and carry interest at offshore or domestic rates,
but subject to the applicable LIBOR Rate plus margin or a base rate (which is
the higher of .50% above the Federal Funds Rate or the Bank of America
"reference rate"). Actual rates on borrowings under the facility vary based on
competitive bidding and the Company's unsecured debt rating at the time of the
borrowing. The facility is available for five years, until July 2002, but may be
extended, under certain circumstances, for two additional years until July 2004.
63
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 6--NOTES PAYABLE, CAPITAL LEASES AND OTHER FINANCING ARRANGEMENTS
(CONTINUED)
The weighted average annual interest rate on the Company's notes payable and
capital leases was approximately 6.24%, 6.39% and 7.44% for the years ended
December 31, 1997, 1996 and 1995.
Scheduled principal repayments on notes payable, capital leases and other
financing arrangements for the next five years are as follows (in thousands):
1998............................................................ $ 3,593
1999............................................................ 2,199
2000............................................................ 24,368
2001............................................................ 1,088
2002............................................................ 1,265,958
Thereafter...................................................... 15,366
-----------
Total notes payable and capital leases........................ $ 1,312,572
-----------
-----------
NOTE 7--STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS
The Company has various stock option plans which cover certain employees,
officers and non-employee directors, and employee stock purchase plans under
which nearly all full-time employees of the Company are eligible to participate.
These plans have been approved by the stockholders.
Under the 1989, 1990, 1991, 1992, 1993 and 1997 employee stock option plans
and the non-employee director stock option plan, the Company grants options at
prices at or above the market value of the stock on the date of grant. The
options carry a maximum term of 10 years and in general vest ratably over 3
years, 5 years or over the 3rd, 4th and 5th anniversaries of the date of grant.
The Company has reserved a total of 24.9 million shares of its Class A Common
Stock for issuance under the stock option plans. The Company anticipates all
future option grants will be made under the 1997 stock option plan.
Under the 1990, 1993 and 1997 employee stock purchase plans, the Company
provides employees with the opportunity to purchase stock through payroll
deductions. Eligible employees may purchase up to $25,000 in fair market value
annually of the Company's Class A Common Stock at 85% of the lower of the market
price on either the first or last day of each offering period, except under the
1990 plan which specifies a purchase price at 85% of the market price on the
date of purchase. The Company has reserved a total of 650 thousand shares of its
Class A Common Stock for issuance under the 1997 plan. The 1990 and 1993 plans
were terminated effective September 1997 and November 1997, respectively.
64
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS (CONTINUED)
Stock option activity and weighted average exercise prices for the years
ended December 31 is presented below:
1997 1996 1995
-------------------- ----------------------- ------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
---------- ------- ------------- ------- ------------ ---------
Outstanding at January 1.......................... 7,051,940 $27.75 6,519,232 $24.44 7,355,064 $ 20.59
Granted........................................... 3,912,040 32.18 2,338,031 32.50 1,624,856 25.69
Exercised......................................... (830,021) 22.66 (1,237,312) 19.52 (1,998,009) 11.33
Canceled.......................................... (497,128) 28.61 (568,011) 27.32 (462,679) 24.18
---------- ------------- ------------
Outstanding at December 31........................ 9,636,831 $29.94 7,051,940 $27.75 6,519,232 $ 24.44
---------- ------------- ------------
---------- ------------- ------------
Exerciseable at December 31....................... 5,116,533 4,640,576 3,282,878
---------- ------------- ------------
---------- ------------- ------------
Under the 1990, 1993 and 1997 employee stock purchase plans, the Company
sold 100 thousand, 117 thousand and 88 thousand shares of its stock to employees
in 1997, 1996 and 1995, respectively.
The following table summarizes the weighted average exercise price and
weighted average remaining contractual life for significant option groups
outstanding at December 31, 1997:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------- -------------------------
WEIGHTED AVERAGE WEIGHTED WEIGHTED
RANGE OF NUMBER OF REMAINING AVERAGE NUMBER OF AVERAGE
EXERCISE PRICES OPTIONS CONTRACTUAL LIFE EXERCISE PRICE OPTIONS EXERCISE PRICE
- --------------- --------- ---------------- -------------- --------- --------------
$ 3.21 - $27.75 2,531,599 5.98 years $21.72 2,054,136 $21.07
27.88 - 32.25 1,935,638 6.72 years 29.65 1,555,364 29.62
32.50 - 32.50 3,622,500 9.68 years 32.50 0.00
32.69 - 52.81 1,547,094 7.63 years 37.77 1,507,033 37.87
--------- ---------
$ 3.21 - $52.81 9,636,831 7.78 years $29.94 5,116,533 $28.62
--------- ---------
--------- ---------
The weighted average fair value for options granted during 1997, 1996 and
1995 was $9.95, $10.46 and $12.86, respectively. The weighted-average fair value
for employee purchase rights during 1997, 1996 and 1995 was $5.68, $6.21 and
$6.70, respectively. The fair values were estimated using the Black-Sholes
option-pricing model. The following weighted average assumptions were used in
the fair value calculation for 1997, 1996 and 1995, respectively: (i) risk-free
interest rate of 5.71%, 6.23% and 7.70% for option grants and 5.66%, 5.79% and
7.13% for employee purchase rights; (ii) expected option lives of 3.7 years, 2.7
years and 3.1 years and expected employee purchase right lives of 2.1 months,
3.3 months, and 3.3 months; (iii) expected volatility for both options and
employee purchase rights of 30.0%, 37.6% and 37.2%; and (iv) no expected
dividend yield for either options or employee purchase rights.
The Company applies APB Opinion 25 and related Interpretations in accounting
for its plans. Accordingly, no compensation cost has been recognized for its
stock option or employee stock purchase plans. Had compensation cost for the
Company's plans been determined based on the fair value at the grant dates of
options and employee purchase rights consistent with the method of SFAS No. 123,
the
65
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS (CONTINUED)
Company's net income and earnings per share would have been reduced to the pro
forma amounts indicated below for the years ended December 31 (in thousands,
except per share data):
1997 1996 1995
---------- -------- --------
Net income (loss)................................. As reported $ (187,084) $ 84,231 $192,179
Pro forma (193,638) 69,226 187,591
Basic earnings (loss) per share................... As reported (1.52) 0.67 1.56
Pro forma (1.57) 0.56 1.53
Diluted earnings (loss) per share................. As reported (1.52) 0.67 1.55
Pro forma (1.56) 0.55 1.52
As fair value criteria was not applied to option grants and employee
purchase rights prior to 1995, and additional awards in future years are
anticipated, the effects on net income and earnings per share in this pro forma
disclosure may not be indicative of future amounts.
NOTE 8--CAPITAL STOCK
The Company has two classes of Common Stock. The Company's Class B Common
Stock has the same economic benefits as the Company's Class A Common Stock but
is non-voting. Upon the sale or transfer of shares of Class B Common Stock by
the CWF to an unrelated third party, such shares automatically convert into
Class A Common Stock. The CWF is the only holder of record of the Company's
Class B Common Stock.
PUBLIC OFFERING
On May 15, 1996, the Company completed a public offering in which the
Company sold 3,194,374 shares of Class A Common Stock and the CWF sold 6,386,510
shares of Class A Common Stock (constituting 6,386,510 shares of Class B Common
Stock which automatically converted into shares of Class A Common Stock upon the
sale) for a per share purchase price to the public of $30.00 (the "Offering").
The net proceeds received by the Company from the sale of the 3,194,374 shares
of Class A Common Stock were approximately $92.4 million after deducting
underwriting discounts and commissions and estimated expenses of the Offering
payable by the Company. The Company used its net proceeds from the Offering to
repurchase 3,194,374 shares of Class A Common Stock held pursuant to the
Associate Trust Agreement from certain Class A Stockholders. The Company
repurchased these shares of Class A Common Stock from the Class A Stockholders
at $30.00 per share less transaction costs associated with the Offering,
amounting to $1.08 per share. All of these 3,194,374 shares of Class A Common
Stock repurchased are currently held in treasury. The Company did not receive
any of the proceeds from the sale of shares of Class A Common Stock in the
Offering by the CWF.
On June 27, 1997, the Company redeemed 4,550,000 shares of Class B Common
Stock from the CWF at a price of $24.47 per share. The Company provided its
consent to permit the CWF to sell 3,000,000 shares of Class B Common Stock to an
unrelated third party in June of 1997 and to sell 450,000 shares of Class B
Common Stock to unrelated third parties throughout August of 1997. On November
6, 1997, the Company also provided its consent to permit the CWF to sell
1,000,000 shares of Class B Common Stock to an unrelated third party. Pursuant
to the Company's Certificate of Incorporation, such 3,000,000 shares,
66
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 8--CAPITAL STOCK (CONTINUED)
450,000 shares and 1,000,000 shares of Class B Common Stock automatically
converted into shares of Class A Common Stock in the hands of such third
parties.
As a result of such transactions, the CWF now holds 10,297,642 shares of
Class B Common Stock at December 31, 1997.
SHAREHOLDER RIGHTS PLAN
On May 20, 1996, the Board of Directors of the Company declared a dividend
distribution of one right (a "Right") for each outstanding share of the
Company's Class A Common Stock and Class B Common Stock (collectively, the
"Common Stock"), to stockholders of record at the close of business on July 31,
1996 (the "Record Date"). The Board of Directors of the Company also authorized
the issuance of one Right for each share of Common Stock issued after the Record
Date and prior to the earliest of the Distribution Date (as defined below), the
redemption of the Rights, and the expiration of the Rights and in certain other
circumstances Rights will attach to all Common Stock certificates representing
shares then outstanding and no separate Rights Certificates will be distributed.
The Rights will separate from the Common Stock in the event any person acquires
15% or more of the outstanding Class A Common Stock, the Board of Directors of
the Company declares a holder of 10% or more of the outstanding Class A Common
Stock to be an "Adverse Person," or any person commences a tender offer for 15%
of the Class A Common Stock (each event causing a "Distribution Date").
Except as set forth below and subject to adjustment as provided in the
Rights Agreement, each Right entitles its registered holder, upon the occurrence
of a Distribution Date, to purchase from the Company one one-thousandth of a
share of Series A Junior Participating Preferred Stock, at a price of $170.00
per one-thousandth share. However, in the event any person acquires 15% or more
of the outstanding Class A Common Stock, or the Board of Directors of the
Company declares a holder of 10% or more of the outstanding Class A Common Stock
to be an "Adverse Person," the Rights (subject to certain exceptions contained
in the Rights Agreement) will instead become exercisable for Class A Common
Stock having a market value at such time equal to $340.00. The Rights are
redeemable under certain circumstances at $.01 per Right and will expire, unless
earlier redeemed, on July 31, 2006.
In connection with the FHS Combination, the Company entered into Amendment
No. 1 to the Rights Agreement to exempt the FHS Combination and related
transactions from triggering the Rights. In addition, the amendment modified
certain terms of the Rights Agreement applicable to the determination of certain
"Adverse Persons," which modifications became effective upon consummation of the
FHS Combination.
NOTE 9--EMPLOYEE BENEFIT PLANS
DEFINED CONTRIBUTION RETIREMENT PLANS
The Company and certain subsidiaries sponsor defined contribution retirement
plans intended to qualify under Sections 401(a) and 401(k) of the Internal
Revenue Code of 1986, as amended (the "Code"). Participation in the plans is
available to substantially all employees who meet certain eligibility
requirements and elect to participate. Employees may contribute up to the
maximum limits allowed by Section 401(k) of the Code, with Company contributions
based on matching or other formulas. The Company's expense under the plans
totaled $4.2 million, $5.1 million and $4.5 million for the years ended December
31, 1997, 1996 and 1995, respectively.
67
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9--EMPLOYEE BENEFIT PLANS (CONTINUED)
DEFINED BENEFIT RETIREMENT PLANS
In 1995 the Company adopted two unfunded non-qualified defined benefit
pension plans, a Supplemental Executive Retirement Plan and a Directors'
Retirement Plan (collectively, the "FHC SERPs"). In 1996 the Company adopted two
additional unfunded non-qualified defined benefit pension plans, a Supplemental
Executive Retirement Plan and a Directors' Retirement Plan (collectively, the
"HSI SERPs"). These plans cover key executives, as selected by the Board of
Directors, and non-employee directors. Benefits under the plans are based on
years of service and level of compensation.
As part of the FHS Combination, the FHC SERPs were frozen in April 1997 at
which time each participant became 100% vested in their benefits under the plans
which are equal to 90% of the actuarial equivalent of the participant's
retirement benefit as of December 31, 1996. All benefits under the FHC SERPs
were paid out either in cash, or as a rollover to the deferred compensation
plan.
The following table sets forth the funded status of the FHC SERPs and HSI
SERPs and the amounts recognized in the Company's consolidated financial
statements at December 31:
1997 1996
--------- ---------
(IN THOUSANDS)
Actuarial present value of:
Vested benefit obligation.............................................. $ 4,702 $ 10,591
Nonvested benefit obligation........................................... 885 4,654
--------- ---------
Accumulated benefit obligation........................................... $ 5,587 $ 15,245
--------- ---------
--------- ---------
Projected benefit obligation............................................. $ 8,078 $ 21,912
Plan assets at fair value................................................ -- --
--------- ---------
Projected benefit obligation in excess of plan assets.................... 8,078 21,912
Unrecognized net (gain) loss............................................. 316 (7,294)
Unrecognized prior service cost.......................................... (4,248) (4,503)
Unrecognized net transition obligation................................... (3,506)
Additional liability..................................................... 1,441 8,636
--------- ---------
Pension liability........................................................ $ 5,587 $ 15,245
--------- ---------
--------- ---------
Net pension costs included the following components for the years ended
December 31:
1997 1996 1995
--------- --------- ---------
(IN THOUSANDS)
Service cost.................................................... $ 1,331 $ 2,150 $ 1,183
Interest cost on projected benefit obligation................... 820 1,283 321
Net amortization and deferral................................... 533 1,000 264
Plan termination expense--FHC SERP.............................. 12,074
--------- --------- ---------
$ 14,758 $ 4,433 $ 1,768
--------- --------- ---------
--------- --------- ---------
68
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9--EMPLOYEE BENEFIT PLANS (CONTINUED)
The projected benefit obligation and net pension cost were determined using
discount rates of 7.50%, 7.88% and 8% for 1997, 1996 and 1995, respectively and
an assumed rate of compensation increase of 4%, 5% and 4% for 1997, 1996 and
1995, respectively.
DEFERRED COMPENSATION PLANS
Under the Company's deferred compensation plan certain members of
management, highly compensated employees and non-employee Board members may
defer payment of up to 90% of their compensation. As part of the FHS
Combination, the plan was frozen in May 1997 at which time each participant's
account was credited with three times the 1996 Company match (or a lesser amount
for certain prior participants) and each participant became 100% vested in all
such contributions. The current provisions with respect to the form and timing
of payments under the plan remain unchanged. At December 31, 1997 and 1996, the
liability under the plan amounted to $29.3 million and $19.9 million. The
Company's expense under the plan totaled $7.8 million, $3.7 million and $3.1
million for the years ended December 31, 1997, 1996, and 1995.
POST-RETIREMENT HEALTH AND LIFE PLANS
Certain subsidiaries of the Company sponsor post-retirement defined benefit
health care plans that provide post-retirement medical benefits to key
executives, employees and dependents who meet certain eligibility requirements.
Under these plans, the Company pays a percentage of the costs of medical, dental
and vision benefits during retirement. The plans include certain cost-sharing
features such as deductibles, coinsurance and maximum annual benefit amounts
which vary based principally on years of credited service. The accumulated
post-retirement benefit obligation under the plans was $6.3 million and $5.2
million at December 31, 1997 and 1996 respectively. The net periodic
post-retirement cost was $1.3 million, $828 thousand and $798 thousand for the
years ended December 31, 1997, 1996 and 1995 respectively.
The weighted-average annual assumed rate of increase in the per capita cost
of covered benefits (i.e. health care cost trend rate) is 7.25% for 1997, and is
assumed to decrease gradually to 4.5% for 2007 and remain at that level
thereafter. The impact of increasing the assumed health care cost trend rate by
1 percentage point would not have a significant effect on the accumulated
post-retirement benefit obligation or the aggregate of the service and interest
cost components of the net periodic post-retirement benefit cost for the year
ended December 31, 1997.
PERFORMANCE-BASED ANNUAL BONUS PLAN
In 1997, the Company had a Performance-Based Annual Bonus Plan that
qualified under Section 162(m) of the Code (the "Prior 162(m) Plan"). Under the
Prior 162(m) Plan, if the Company achieved $62.5 million in consolidated income
from operations before taxes, certain executives were potentially eligible to
receive cash bonuses from a pool of 2.5% of such consolidated operating income
based on the executives' salaries in relation to the pool. Amounts payable to
such executives from such pool were subject to downward adjustment by the
Company's Compensation and Stock Option Committee of the Board of Directors. The
$62.5 million performance goal for the Prior 162(m) Plan was not met for 1997.
The Company's Stockholders adopted a new Performance-Based Annual Bonus Plan
that qualifies under Section 162(m) of the Code which became effective on
January 1, 1998 and replaced the Prior 162(m) Plan.
69
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9--EMPLOYEE BENEFIT PLANS (CONTINUED)
EMPLOYEE STOCK PURCHASE PLANS
The Company sponsors employee stock purchase plans available to
substantially all employees who meet certain eligibility requirements and elect
to participate (see Note 7).
NOTE 10--INCOME TAXES
Significant components of the provision (benefit) for income taxes are as
follows for the years ended December 31:
1997 1996 1995
---------- --------- ----------
(IN THOUSANDS)
Current:
Federal.................................................. $ (12,894) $ 13,687 $ 80,115
State.................................................... 3,183 2,593 19,092
---------- --------- ----------
Total current.............................................. (9,711) 16,280 99,207
---------- --------- ----------
Deferred:
Federal.................................................. (57,150) 7,420 14,854
State.................................................... (5,478) 1,123 1,364
---------- --------- ----------
Total deferred............................................. (62,628) 8,543 16,218
---------- --------- ----------
Total provision (benefit) for income taxes................. $ (72,339) $ 24,823 $ 115,425
---------- --------- ----------
---------- --------- ----------
Income tax expense (benefit) is included in the financial statements as
follows for the years ended December 31:
1997 1996 1995
---------- --------- ----------
(IN THOUSANDS)
Continuing operations...................................... $ (21,418) $ 14,124 $ 124,345
Discontinued operations.................................... (50,921) 10,699 (8,920)
---------- --------- ----------
Total provision (benefit) for income taxes................. $ (72,339) $ 24,823 $ 115,425
---------- --------- ----------
---------- --------- ----------
70
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 10--INCOME TAXES (CONTINUED)
A reconciliation of the statutory federal income tax rate and the effective
income tax rate on income from continuing operations is as follows for the years
ended December 31:
1997 1996 1995
------------ ------------ ------------
Statutory federal income tax rate................................ (35)% 35% 35%
State and local taxes, net of federal income tax effect.......... (3) 3 6
Tax exempt interest income....................................... (2) (3) (1)
Goodwill amortization............................................ 6 6 1
Valuation allowance adjustment................................... (2) (5) 0
Merger transaction costs......................................... 8 0 0
Pooling transactions............................................. 0 (4) 0
IRS settlement................................................... 0 (4) 0
Other, net....................................................... 4 (1) (1)
-- -- --
Effective income tax rate...................................... (24)% 27% 40%
-- -- --
-- -- --
Significant components of the Company's deferred tax assets and liabilities
as of December 31 are as follows:
1997 1996
---------- ---------
(IN THOUSANDS)
CURRENT DEFERRED TAX ASSETS:
Accrued liabilities.................................................. $ 70,547 $ 50,995
Accrued compensation and benefits.................................... 28,150 22,582
Restructuring reserves............................................... 30,057 317
Net operating loss carryforwards..................................... 140,862 11,178
Other, net........................................................... 1,524 12,689
---------- ---------
Net deferred tax assets before valuation allowance................... 271,140 97,761
Valuation allowance.................................................. (57,445) (1,275)
---------- ---------
Total deferred tax assets............................................ $ 213,695 $ 96,486
---------- ---------
---------- ---------
NONCURRENT DEFERRED TAX LIABILITIES:
Depreciable and amortizable property................................. $ 66,608 $ 6,106
Other, net........................................................... 839 3,345
---------- ---------
Total deferred tax liabilities....................................... $ 67,447 $ 9,451
---------- ---------
---------- ---------
As of December 31, 1997, the Company had federal net operating loss
carryforwards of approximately $324 million from continuing operations, of which
$126 million may be subject to carryover limitations under Section 382 of the
Code. A valuation allowance has been provided to account for the potential
limitations associated with utilization of net operating loss carryforwards. The
net operating loss carryforwards expire between 2006 and 2012.
The valuation allowance increase of $56.2 million is due to the acquisition
of a subsidiary for which the future realizability of such subsidiary's deferred
tax assets, primarily related to net operating loss carryforwards, is uncertain.
71
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 11--REGULATORY REQUIREMENTS
All of the Company's health plans as well as its insurance subsidiaries are
required to periodically file financial statements with regulatory agencies in
accordance with statutory accounting and reporting practices. Under the
California Knox-Keene Health Care Service Plan Act of 1975, as amended,
California plans must comply with certain minimum capital or tangible net equity
requirements. The Company's non-California health plans, as well as its health
and life insurance companies, must comply with their respective state's minimum
regulatory net worth requirements generally under the regulation of the
respective state's department of insurance.
The regulatory net worth of the Company's health plans exceeded the minimum
aggregate requirement by approximately $243 million and $368 million at December
31, 1997 and 1996, respectively. Under certain government contracts. Federal
Services is required to maintain a current ratio of 1:1 and certain HMO
subsidiaries are required to maintain a current ratio of 1:1 under Medicaid
contracts.
As a result of the above requirements and certain other regulatory
requirements, certain subsidiaries are subject to restrictions on their ability
to make dividend payments, loans or other transfers of cash to the Company. Such
restrictions, unless amended or waived, limit the use of any cash generated by
these subsidiaries to pay obligations of the Company. As of December 31, 1997,
restricted assets of these subsidiaries totaled approximately $52.5 million.
NOTE 12--COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
The Company is involved in various legal proceedings, which are routine in
its business. In the opinion of management, based upon current facts and
circumstances known by the Company, the resolution of these matters should not
have a material adverse effect on the financial position or results of
operations of the Company.
OPERATING LEASES
The Company leases administrative and medical office space under various
operating leases. Certain medical office space is subleased to participating
medical groups doing business with the Company. Certain leases contain renewal
options and rent escalation clauses.
In 1995, the Company entered into a $60 million tax retention operating
lease with NationsBank of Texas, N.A., as Administrative Agent for the Lenders
who are parties thereto, and First Security Bank of Utah, N.A., as Owner
Trustee, (the "TROL Agreement") for the construction of health care centers and
corporate facilities. Under the TROL Agreement, rental payments commence upon
completion of construction, with a guarantee of 87% to the lessor of the
residual value of properties leased at the end of the lease term. After the
initial five year noncancelable lease term, the lease may be extended by
agreement of the parties or the Company must purchase or arrange for sale of the
leased properties. The Company has committed to a guaranteed residual value of
$30.8 million under this agreement.
72
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--COMMITMENTS AND CONTINGENCIES (CONTINUED)
Future minimum lease commitments for noncancelable operating leases at
December 31, 1997 are as follows (in thousands):
1998...................................................... $ 46,477
1999...................................................... 42,083
2000...................................................... 38,614
2001...................................................... 35,552
2002...................................................... 13,535
Thereafter................................................ 7,695
---------
Total minimum lease commitments........................... $ 183,956
---------
---------
Rent expense totaled $48.7 million, $46.8 million and $39.3 million in 1997,
1996 and 1995, respectively.
NOTE 13--RELATED PARTIES
Two current directors of the Company and one prior director are partners in
law firms which received legal fees totaling $1.1 million, $1.0 million, and
$1.9 million in 1997, 1996, and 1995, respectively. An officer of a contracted
hospital was also a member of the Company's Board of Directors until April 1,
1997. Medical costs paid to the provider totaled $67.1 million, $58.7 million,
and $55.3 million in 1997, 1996, and 1995, respectively. Such contracted
hospital is also an employer group of the Company. The Company received annual
premium revenues of $1.2 million in 1997, $3.4 million in 1996 and $3.0 million
in 1995. Certain stockholders and prior directors of the Company are officers of
consulting firms which received approximately $132 thousand in 1997, $1.3
million in 1996 and $140 thousand in 1995, pursuant to consulting agreements to
pay for certain consulting services provided to the Company.
In 1995, the Company advanced an aggregate sum of approximately $16.3
million to three of its former executive officers and directors in connection
with the future repurchase of shares of the Company's Class A Common Stock held
by such individuals. This repurchase agreement was entered into in connection
with certain severance agreements between the Company and each such individual
in connection with his or her termination of employment. Such advances were
non-interest bearing and were secured by a pledge of shares of Class A Common
Stock, which shares were ultimately repurchased by the Company in January 1996.
During the first quarter of 1996, the Company repurchased 303,879 shares of
its Class A Common Stock from certain current and former management employees of
the Company and HN Management Holdings, Inc., a predecessor to the Company. The
repurchased shares were held pursuant to the Amended and Restated Health Net
Associate Trust Agreement dated as of May 1, 1994 on behalf of certain founding
stockholders of the Company at the date of the conversion of Health Net to
for-profit status. The repurchased shares, having an aggregate value of $9.6
million, were immediately canceled and netted against Class A Common Stock,
additional paid-in-capital, and retained earnings.
Certain transactions between the Company's continuing operations
subsidiaries and the discontinued operations segments are not eliminated (see
Note 15).
73
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14--MERGER, RESTRUCTURING AND OTHER COSTS AND GEM COSTS
The following sets forth the principal components of merger, restructuring
and other costs for the ended December 31:
1997 1996 1995
--------- --------- ---------
(IN MILLIONS)
Severance and benefit related costs................................ $ 62.0 $ 5.4 $ 12.2
Provider network consolidation costs............................... 35.4
Asset impairment costs............................................. 44.3 17.4
Real estate lease termination costs................................ 7.7 4.6
--------- --------- ---------
Total restructuring costs........................................ 149.4 27.4 12.2
Merger related costs............................................... 70.4 8.0
Other costs........................................................ 118.6 16.7
--------- --------- ---------
Total merger, restructuring and other costs...................... $ 338.4 $ 44.1 $ 20.2
--------- --------- ---------
--------- --------- ---------
1997 COSTS
RESTRUCTURING COSTS
In connection with the FHS Combination, the Company adopted a restructuring
plan effective June 30, 1997 (the "June 1997 Plan"), the principal elements of
which include: a workforce reduction of approximately 1,050 employees, the
consolidation of employee benefit plans, the consolidation of facilities in
geographic locations where office space is duplicated, the consolidation of
overlapping provider networks, and the consolidation of information systems at
all locations to standardized systems. The June 1997 Plan, which the Company
anticipates will be completed by the end of 1998, resulted in a restructuring
charge of $188.1 million for the quarter ended June 30, 1997.
Severance and benefit related costs include a terminations benefits plan and
contractually required change of control payments to senior executives. Also
included are the costs of settlements of benefit plans terminated as a result of
the restructuring plan to conform benefits for the merged companies. Provider
network consolidation costs include costs to consolidate overlapping provider
networks, primarily in California, and the costs of exiting existing provider
contracts as legally, regulatory or administratively required. Real estate lease
termination costs include facilities consolidation costs primarily in geographic
regions where there is overlapping office space usage. Asset impairment costs
are primarily a result of the Company's plan to be on common operating systems
and hardware platforms. These costs include impairment of hardware, software and
other systems related assets.
During the quarter ended December 31, 1997, the Company adopted a
restructuring plan (the "December 1997 Plan") and recorded a $6.0 million
restructuring charge related to the Company's Eastern Division health plans. The
plan relates to the integration of the Company's Eastern Division operations in
connection with its acquisition of PHS and FOHP in the quarter ended December
31, 1997.
The Company also recorded a credit of $44.7 million for previously recorded
restructuring charges during the fourth quarter. The credit consisted of $42.0
million for the June 1997 Plan and $2.7 million for the December 1996 Plan (see
"1996 Costs").
74
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14--MERGER, RESTRUCTURING AND OTHER COSTS AND GEM COSTS (CONTINUED)
The restructuring credits to the June 1997 Plan resulted from the following:
$22.2 million from the Company's determination to continue to operate certain
facilities originally identified for lease termination, $9.7 million from
reductions to initially anticipated involuntary severance costs, $8.1 million
from reductions to certain anticipated provider network consolidation and other
contract termination costs and $2.0 million in reductions to asset impairment
costs primarily related to the reclassification of workers' compensation
insurance subsidiaries related charges to discontinued operations.
Of the $149.4 million in net restructuring costs recorded during the year
ended December 31, 1997, $61.7 million represented cash payments and $15.8
million noncash activities as of December 31, 1997 and $45.2 million is expected
to require future outlays of cash and $26.7 million represents future noncash
activities.
MERGER COSTS
In connection with the June 1997 Plan, $70.4 million in merger costs were
recorded. The significant components of the charge include the following: $22.6
million of transaction costs, primarily consisting of investment banking, legal,
accounting, filing and printing fees; $22.7 million of merger consulting costs;
$5.9 million of former senior executive consulting costs; $2.4 million of
directors and officers liability coverage required by the merger agreement; $9.6
million in costs to consolidate debt facilities; and $7.2 million of other
merger related costs.
OTHER COSTS
During the quarters ended June 30, and December 31, 1997, $86.3 million and
$32.3 million, respectively, in other costs were recorded and included the
following components: $30.5 million for receivables related to provider
contracts that will not be renewed; $17.2 for government receivables related to
prior contracts and adjustments on current contracts being negotiated with the
Department of Defense; $15.1 million for litigation settlement estimates
primarily related to former FHC subsidiaries; $12.6 million for the loss on sale
of the United Kingdom operations; $16.1 million for loss contract accruals,
including $10.1 million related to the Company's health plans in Texas,
Louisiana and Oklahoma; $7.7 million related to contract termination costs; $8.2
million in other receivables; and $11.2 million of other costs.
These costs were shown as other costs on the Company's consolidated
statement of operations because of their unusual nature. If not for their
unusual nature, approximately $53.8 million of these costs would have been
recorded as health plan services, $35.0 million as selling, general and
administrative and $17.2 million as government health care services.
GEM COSTS
The Company established a premium deficiency of $57.5 million related to the
Company's Gem Insurance Company ("Gem") during the year ended December 31, 1997.
During the quarter ended June 30, 1997, the Company had reached a definitive
agreement regarding a reinsurance transaction with The Centennial Life Insurance
Company ("Centennial"). Pursuant to this agreement, Centennial was to reinsure
and manage Gem's accident and health, life and annuity policies in exchange for
a reinsurance premium. The cost of the reinsurance along with the write-down of
certain Gem assets that were not recoverable based on the terms of the agreement
totaled $57.5 million. The transaction was not ultimately consummated due to the
unanticipated failure to satisfy certain closing conditions, including the
failure to
75
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 14--MERGER, RESTRUCTURING AND OTHER COSTS AND GEM COSTS (CONTINUED)
receive certain regulatory approvals. Gem established a reserve for the
estimated premium deficiency related to these policies. As of December 31, 1997,
$14.0 million remained in this reserve which is expected to be adequate to cover
future premium deficiencies.
1996 COSTS
During the quarter ended December 31, 1996, the Company recorded
restructuring costs of $27.4 million which included $5.4 million of executive
and other involuntary severance costs, $17.4 million of software, hardware and
other asset impairment costs, and $4.6 million of facilities consolidation costs
(the "December 1996 Plan"). As stated above under "1997 Costs," $2.7 million in
reductions to the December 1996 Plan were recorded during the quarter ended
December 31, 1997 as a result of the Company's determination to continue to
operate certain facilities originally identified for lease termination. Of the
$27.4 million in restructuring costs recorded during the year ended December 31,
1996, $7.3 million has been paid and $17.4 million represented noncash
write-offs as of December 31, 1997.
The Company also recorded $16.7 million of other costs in the quarter ended
December 31, 1996 including loss contract accruals related to governmental
employer groups in the Company's non-California markets, consulting and other
costs. If not for their unusual nature, approximately $8.5 million of these
costs would have been recorded as health plan services and $8.2 million as
selling, general and administrative expenses.
1995 COSTS
In connection with the Company's terminated merger agreement with Wellpoint
Health Networks, Inc. and Blue Cross of California announced December 28, 1995,
the Company incurred restructuring and merger-related costs of $20.2 million
during the year ended December 31, 1995. Such costs included $8.0 million of
legal, accounting and consulting fees, as well as severance related costs of
$12.2 million resulting from agreements with certain key executives in
contemplation of the proposed merger.
NOTE 15--DISCONTINUED OPERATIONS
Discontinued operations include the Company's workers' compensation
insurance and physician practice management segments. The loss on the sale of
discontinued operations, net of $18.2 million of taxes, of $88.8 million for the
year ended December 31, 1997 includes an estimated loss to be incurred when the
workers' compensation insurance segment is sold of approximately $99 million,
and an offsetting credit of $10.2 million related to the sale of the Company's
physician practice management segment.
WORKERS' COMPENSATION INSURANCE COMPANIES
The Company revised its strategy of maintaining a presence in the workers'
compensation insurance business. As a result of this decision, the Company
adopted a plan to completely discontinue this segment of its business through
divestiture of its workers' compensation insurance subsidiaries. The Company is
currently in negotiation for the sale of the business. As a result, the Company
is reporting its workers' compensation insurance segment as discontinued
operations for each year presented in the consolidated financial statements and
related footnotes.
76
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED)
The following sets forth the summarized balance sheet and results of
operations for the workers' compensation insurance companies to be sold as of
December 31, 1997 and 1996, and for each of the three years ended December 31
(in thousands):
1997 1996
------------ ------------
Assets:
Cash and investments................................................................ $ 723,350 $ 713,668
Premiums and reinsurance receivables................................................ 305,985 224,354
Other assets........................................................................ 231,000 142,288
------------ ------------
Total assets...................................................................... 1,260,335 1,080,310
------------ ------------
Liabilities:
Reserves for claims................................................................. 728,421 590,584
Note payable to Parent.............................................................. 122,621 129,157
Other liabilities................................................................... 149,773 83,123
------------ ------------
Total liabilities................................................................. 1,000,815 802,864
------------ ------------
Net assets............................................................................ 259,520 277,446
Amounts to reconcile to net assets from discontinued operations:
Elimination of net notes payable to Parent and other net receivables from Parent and
subsidiaries...................................................................... 107,193 104,126
Loss on disposition................................................................. (99,000)
------------ ------------
Net assets of discontinued operations................................................. $ 267,713 $ 381,572
------------ ------------
------------ ------------
1997 1996 1995
---------- ---------- ----------
Revenues
Premiums................................................................... $ 511,268 $ 480,830 $ 390,973
Investment and other income................................................ 49,675 37,844 26,147
---------- ---------- ----------
Total revenues........................................................... 560,943 518,674 417,120
---------- ---------- ----------
Expenses
Losses and loss adjustment................................................. 443,204 381,898 246,857
Other underwriting......................................................... 161,114 105,873 94,924
Interest................................................................... 9,107 4,330
Other...................................................................... 10,673 3,202 2,810
---------- ---------- ----------
Total expenses........................................................... 624,098 495,303 344,591
---------- ---------- ----------
Income (loss) before income taxes............................................ (63,155) 23,371 72,529
Income tax provision (benefit)............................................... (32,746) 1,197 20,591
---------- ---------- ----------
Income (loss) from discontinued operations................................... $ (30,409) $ 22,174 $ 51,938
---------- ---------- ----------
---------- ---------- ----------
Cash and investments at December 31, 1997 consist primarily of the following
based on market values: U.S. government and agencies of 6%, obligations of
states and other political subdivisions of 80%, and cash and cash equivalents of
14%. The cost and market value of cash and investments at December 31, 1997 are
$716 million and $723 million, respectively, and $711 million and $714 million
at December 31,
77
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED)
1996. Investment income includes realized gains on sale of investments of $44
million, $31 million and $25 million for the year ended December 31, 1997, 1996
and 1995, respectively.
The workers' compensation insurance subsidiaries limit their exposure by
reinsuring certain levels of risk with other insurers. In the event that all or
any of the reinsuring companies might be unable to meet their obligations under
the reinsurance agreement, the workers' compensation insurance companies would
be liable for such obligations. The workers' compensation insurance companies
regularly evaluate the financial condition of their reinsurers. Based on this
evaluation, management believes the reinsurers are creditworthy and that any
potential losses on these agreements will not have a material impact on the
Company's consolidated financial statements. At December 31, 1997 and 1996,
reinsurance receivable balances on ceded reserves and paid losses totaled $221.2
million and $136.1 million, respectively.
The effect of reinsurance on workers' compensation insurance companies
premiums written, premiums earned and losses incurred for the three years ended
December 31, 1997 is summarized as follows:
PREMIUMS PREMIUMS LOSSES
WRITTEN EARNED INCURRED
----------- ----------- -----------
Year Ended December 31, 1997
Direct................................................................... $ 647,427 $ 652,706 $ 593,192
Assumed.................................................................. 13,006 11,202 8,496
Ceded.................................................................... (141,981) (152,640) (158,484)
----------- ----------- -----------
Net.................................................................. $ 518,452 $ 511,268 $ 443,204
----------- ----------- -----------
----------- ----------- -----------
Year Ended December 31, 1996
Direct................................................................... $ 619,462 $ 607,089 $ 461,312
Assumed.................................................................. 12,945 12,775 7,221
Ceded.................................................................... (150,228) (139,034) (86,635)
----------- ----------- -----------
Net.................................................................. $ 482,179 $ 480,830 $ 381,898
----------- ----------- -----------
----------- ----------- -----------
Year Ended December 31, 1995
Direct................................................................... $ 408,737 $ 402,633 $ 252,151
Assumed.................................................................. 11,041 11,041 3,585
Ceded.................................................................... (22,701) (22,701) (8,879)
----------- ----------- -----------
Net $ 397,077 $ 390,973 $ 246,857
----------- ----------- -----------
----------- ----------- -----------
78
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED)
Activity in the reserves for losses and loss adjustment expenses related to
the workers' compensation insurance companies, for the years ended December 31,
1997 and 1996 are summarized as follows (in thousands):
1997 1996
----------- -----------
Beginning balance....................................................................... $ 590,584 $ 443,370
Less-ceded losses and loss adjustment expense reserves.................................. (121,326) (76,309)
----------- -----------
Net beginning balance................................................................... 469,258 367,061
----------- -----------
Incurred related to:
Current calendar year................................................................. 367,825 361,533
Prior calendar years.................................................................. 75,379 20,365
----------- -----------
Total incurred...................................................................... 443,204 381,898
----------- -----------
Paid related to:
Current calendar year................................................................. (135,056) (106,540)
Prior calendar years.................................................................. (255,856) (173,161)
----------- -----------
Total paid.......................................................................... (390,912) (279,701)
----------- -----------
Net ending balance...................................................................... 521,550 469,258
Plus-ceded losses and loss adjustment expense reserves.................................. 206,871 121,326
----------- -----------
Ending balance.......................................................................... $ 728,421 $ 590,584
----------- -----------
----------- -----------
The workers' compensation insurance companies results of operations include
certain transactions with the Company's continuing operations subsidiaries which
have not been eliminated from the Company's consolidated statement of
operations. Such transactions include the following amounts recorded by the
workers' compensation insurance companies for the years ended December 31, 1997,
1996 and 1995: interest expense related to the note payable to Parent of $8.3
million, $4.3 million and $0, respectively; and other underwriting expenses
related to services provided primarily by the Company's bill review services
subsidiary of $14.5 million, $10.1 million and $5.6 million, respectively.
PHYSICIAN PRACTICE MANAGEMENT COMPANIES
During 1995 and 1996, changes were occurring in the physician practice
management industry which led the Company to adopt a plan to completely
discontinue the operations of the Medical Practices. In connection with this
changed environment and with its plan to discontinue this segment, the following
transactions were entered into with FPA and certain of its affiliated entities,
none of which are affiliated with the Company.
On June 28, 1996, the Company and the sole shareholder of the Medical
Practices executed a Stock and Note Purchase Agreement whereby the Company sold
all the outstanding stock of its management services organization and the sole
shareholder sold all of the outstanding stock of the holding company for the
Medical Practices to FPA. The aggregate consideration consisted of $2 million
cash, $75 million of FPA common stock, $22 million bridge note receivable and
$104 million of Medical Practices' notes payable to the Company assumed by FPA.
At December 31, 1996, the $75 million of FPA common stock was included in
investments available for sale and the $126 million of notes receivable was
included in other current
79
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED)
assets. During the year ended December 31, 1997, the FPA common stock was sold
and the notes receivable were repaid by FPA.
The transaction was consummated in November 1996 and the Company recognized
a gain on sale of $20.3 million, net of $17.6 million of taxes, during the
quarter ended December 31, 1996. During the year ended December 31, 1997, the
Company recognized an additional $10.1 million gain on sale, net of $2.8 million
of taxes, based on the final settlement of certain contractual provisions
related to the disposition of the Medical Practices.
During January and June of 1996, the Company completed the sale of its
affiliated independent practice associations ("IPAs") in California, Florida and
Arizona to FPA for total consideration of $30 million in cash and notes. Gains
of $10.8 million were recognized by the Company during the year ended December
31, 1996 and are included in income from discontinued operations.
As part of these transactions, the Company's affiliated health plans entered
into 30-year provider agreements with the IPAs and Medical Practices to ensure
that the Company's enrollees have continued and uninterrupted access to the
providers of the IPAs and Medical Practices. At December 31, 1997 and 1996,
obligations under these agreements of $7.7 million and $33.8 million,
respectively, are included in other current liabilities.
The following sets forth the summarized results of operations for the
Medical Practices for the year ended December 31, 1995 and the eleven months
ended November 30, 1996, (in thousands):
11 MONTHS YEAR ENDED
NOVEMBER 30, DECEMBER 31,
1996 1995
------------ ------------
(UNAUDITED) (UNAUDITED)
Revenues
Premiums from affiliates........................................................... $ 129,488 $ 100,015
Other.............................................................................. 23,963 31,745
------------ ------------
Total revenues................................................................... 153,451 131,760
------------ ------------
Expenses
Health care services............................................................... 208,336 184,485
Interest to Parent................................................................. 10,830 10,038
Other.............................................................................. 11,334 13,408
------------ ------------
Total expenses................................................................... 230,500 207,931
------------ ------------
Loss before income taxes............................................................. (77,049) (76,171)
Income tax benefit................................................................... (32,359) (29,511)
------------ ------------
Loss from Medical Practices.......................................................... (44,690) (46,660)
Deferral of losses subsequent to Measurement Date.................................... 36,800 --
Gain (loss) on sale of independent practice associations............................. 10,800 (2,250)
------------ ------------
Income (loss) from discontinued operations........................................... $ 2,910 $ (48,910)
------------ ------------
------------ ------------
The Medical Practices' results of operations include certain transactions
with the Company's continuing operations subsidiaries which have not been
eliminated from the Company's consolidated statement of
80
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 15--DISCONTINUED OPERATIONS (CONTINUED)
operations. Such transactions include the following amounts recorded by the
Medical Practices' for the eleven months ended November 30, 1996 and the year
ended December 31, 1995: premiums received from certain of the Company's health
plans of $129.5 million and $100.0 million, respectively; and interest expense
related to a note payable to Parent of $10.8 and $10.0 million, respectively.
NOTE 16--QUARTERLY INFORMATION (UNAUDITED)
The following restated interim financial information presents the 1997 and
1996 results of operations on a quarterly basis (in thousands, except per share
data) (see Note 1):
QUARTER ENDED
------------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
------------ ------------ ------------ ------------
1997:
Total revenues........................................... $ 1,770,019 $ 1,773,422 $1,793,379 $1,898,199
Income (loss) from continuing operations before income
taxes.................................................. 78,683 (313,108) 97,081 48,096
Income (loss) from continuing operations................. 47,624 (205,792) 59,803 30,535
Net income (loss)........................................ 58,481 (200,128) 68,901 (114,338)
BASIC EARNINGS (LOSS) PER SHARE
Continuing operations.................................. 0.38 (1.64) 0.49 0.25
Net.................................................... 0.47 (1.60) 0.57 (0.94)
DILUTED EARNINGS (LOSS) PER SHARE
Continuing operations.................................. 0.38 (1.64) 0.49 0.25
Net.................................................... 0.47 (1.60) 0.57 (0.94)
QUARTER ENDED
------------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
------------ ------------ ------------ ------------
1996:
Total revenues........................................... $ 1,544,992 $ 1,712,207 $1,729,287 $1,722,754
Income (loss) from continuing operations before income
taxes.................................................. 82,701 67,456 70,321 (167,524)
Income (loss) from continuing operations................. 51,105 44,234 40,701 (97,210)
Net income (loss)........................................ 62,277 66,488 57,518 (102,052)
BASIC EARNINGS (LOSS) PER SHARE
Continuing operations.................................. 0.42 0.35 0.33 (0.78)
Net.................................................... 0.51 0.53 0.46 (0.82)
DILUTED EARNINGS (LOSS) PER SHARE
Continuing operations.................................. 0.41 0.35 0.33 (0.78)
Net.................................................... 0.50 0.53 0.46 (0.82)
81
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item is set forth in the Company's
definitive proxy statement, which will be filed with the Securities and Exchange
Commission within 120 days of December 31, 1997. Such information is
incorporated herein by reference and made a part hereof.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is set forth in the Company's
definitive proxy statement, which will be filed with the Securities and Exchange
Commission within 120 days of December 31, 1997. Such information is
incorporated herein by reference and made a part hereof.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is set forth in the Company's
definitive proxy statement, which will be filed with the Securities and Exchange
Commission within 120 days of December 31, 1997. Such information is
incorporated herein by reference and made a part hereof.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is set forth in the Company's
definitive proxy statement, which will be filed with the Securities and Exchange
Commission within 120 days of December 31, 1997. Such information is
incorporated herein by reference and made a part hereof.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K
(A) FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS
1. FINANCIAL STATEMENTS
The following consolidated financial statements are included in this Annual
Report on Form 10-K:
Report of Deloitte & Touche LLP
Consolidated balance sheets at December 31, 1997 and 1996
Consolidated statements of operations for each of the three years in the
period ended December 31, 1997
Consolidated statements of stockholders' equity for each of the three
years in the period ended December 31, 1997
Consolidated statements of cash flows for each of the three years in the
period ended December 31, 1997.
Notes to consolidated financial statements
82
2. FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules are filed as a part of this
Annual Report on Form 10-K:
Schedule I--Condensed Financial Information of The Company
Section 403.04B Schedule--Reconciliation of Beginning and Ending Loss and
Loss Adjustment Expense
All other schedules are omitted because they are not applicable, not
required, or because the required information is included in the consolidated
financial statements or notes thereto.
3. EXHIBITS
The following exhibits are filed as part of this Annual Report on Form 10-K
or are incorporated herein by reference:
2.1 Agreement and Plan of Merger, dated October 1, 1996, by and among Health
Systems International, Inc., FH Acquisition Corp. and Foundation Health
Corporation (filed as Exhibit 2.5 to the Company's Annual Report on Form 10-K
for the year ended December 31, 1996, which is incorporated by reference
herein).
2.2 Agreement and Plan of Merger, dated May 8, 1997, by and among the Company, PHS
Acquisition Corp. and Physicians Health Services, Inc. (filed as Exhibit 2.2
to the Company's Quarterly Report on Form 10-Q for the quarter ended March
31, 1997, which is incorporated by reference herein).
2.3 Amendment No. 1 to Agreement and Plan of Merger, dated October 20, 1997, by and
among the Company, PHS Acquisition Corp. and Physicians Health Services, Inc.
(filed as Exhibit 2.3 to the Company's Quarterly Report on Form 10-Q for the
quarter ended September 30, 1997, which is incorporated by reference herein).
3.1 Fourth Amended and Restated Certificate of Incorporation of the Registrant
(filed as Exhibit 4.1 to the Company's Registration Statement on Form S-8
(File No. 333-24621), which is incorporated by reference herein).
3.2 Fifth Amended and Restated Bylaws of the Registrant (filed as Exhibit 3.2 to
the Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
1997, which is incorporated by reference herein).
4.1 Form of Class A Common Stock Certificate (included as Exhibit 4.2 to the
Company's Registration Statements on Forms S-1 and S-4 (File nos. 33-72892
and 33-72892-01, respectively) which is incorporated by reference herein).
4.2 Form of Class B Common Stock Certificate (included as Exhibit 4.3 to the
Company's Registration Statements on Forms S-1 and S-4 (File nos. 33-72892
and 33-72892-01, respectively) which is incorporated by reference herein).
4.3 Form of Indenture of Foundation Health Corporation ("FHC") (filed as an exhibit
to FHC's Registration Statement on Form S-3 (File No. 33-68684), which is
incorporated by reference herein).
4.4 Form of Senior Notes of FHC (filed as an exhibit to FHC's Registration
Statement on Form S-3 (File No. 33-68684), which is incorporated by reference
herein).
*10.1 Employment Agreement, dated August 28, 1993, by and among QualMed, Inc., HN
Management Holdings, Inc. and Malik M. Hasan, M.D. (filed as Exhibit 10.18 to
the Company's Registration Statements on Forms S-1 and S-4 (File nos.
33-72892 and 33-72892-01, respectively) which is incorporated by reference
herein).
83
*10.2 Employment Agreement, dated August 28, 1993, by and among QualMed, Inc., HN
Management Holdings, Inc. and Dale T. Berkbigler, M.D. (filed as Exhibit
10.20 to the Company's Registration Statements on Forms S-1 and S-4 (File
nos. 33-72892 and 33-72892-01, respectively) which is incorporated by
reference herein).
*10.3 Severance Payment Agreement, dated as of April 25, 1994, among the Company,
Health Net and James J. Wilk (filed as Exhibit 10.9 to the Company's Annual
Report on Form 10-K for the year ended December 31, 1994, which is
incorporated by reference herein).
*10.4 Severance Payment Agreement dated March 31, 1997 between the Company and Health
Net and James J. Wilk (filed as Exhibit 10.4 to the Company's Quarterly
Report on Form 10-Q for the quarter ended March 31, 1997, which is
incorporated by reference herein).
*10.5 Severance Payment Agreement, dated as of April 25, 1994, among the Company,
QualMed, Inc. and B. Curtis Westen (filed as Exhibit 10.10 to the Company's
Annual Report on Form 10-K for the year ended December 31, 1994, which is
incorporated by reference herein).
*10.6 Letter Agreement dated April 23, 1997 between B. Curtis Westen and the Company
(filed as Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q for the
quarter ended March 31, 1997, which is incorporated by reference herein).
*10.7 Amendment No. 1 to Employment Agreement dated as of April 25, 1994, by and
among the Company, QualMed, Inc. and Malik Hasan, M.D. (filed as Exhibit
10.16 to the Company's Annual Report on Form 10-K for the year ended December
31, 1994, which is incorporated by reference herein).
*10.8 Amended and Restated Employment Agreement, dated March 10, 1997, by and between
the Company and Malik M. Hasan, M.D. (Filed as Exhibit 10.3 to the Company's
Annual Report on Form 10-K for the year ended December 31, 1996, which is
incorporated by reference herein).
*10.9 Amendment No. 1 to Employment Agreement dated as of April 27, 1994, by and
among the Company, QualMed, Inc. and Dale T. Berkbigler, M.D. (filed as
Exhibit 10.17 to the Company's Annual Report on Form 10-K for the year ended
December 31, 1994, which is incorporated by reference herein).
10.10 Office Lease, dated as of January 1, 1992, by and between Warner Properties III
and Health Net (filed as Exhibit 10.23 to the Company's Registration
Statements on Forms S-1 and S-4 (File Nos. 33-72892 and 33-72892-01,
respectively) which is incorporated by reference herein).
*10.11 The Company's Second Amended and Restated 1991 Stock Option Plan (filed as
Exhibit 10.30 to Registration Statement on Form S-4 (File No. 33-86524) which
is incorporated by reference herein).
*10.12 The Company's Second Amended and Restated Non-Employee Director Stock Option
Plan (filed as Exhibit 10.31 to Registration Statement on Form S-4 (File No.
33-86524) which is incorporated by reference herein).
*10.13 The Company's Employee Stock Purchase Plan (filed as Exhibit 10.33 to the
Company's Registration Statements on Forms S-1 and S-4 (File nos. 33-72892
and 33-72892-01, respectively) which is incorporated by reference herein).
*10.14 The Company's Performance-Based Annual Bonus Plan (filed as Exhibit 10.35 to
Registration Statement on Form S-4 (File No. 33-86524) which is incorporated
by reference herein).
84
*10.15 Deferred Compensation Agreement dated as of March 3, 1995, by and among Malik
M. Hasan, M.D., the Company and the Compensation and Stock Option Committee
of the Board of Directors of the Company (filed as Exhibit 10.31 to the
Company's Annual Report on Form 10-K for the year ended December 31, 1994,
which is incorporated by reference herein).
*10.16 Trust Agreement for Deferred Compensation Arrangement for Malik M. Hasan, M.D.,
dated as of March 3, 1995, by and between the Company and Norwest Bank
Colorado N.A. (filed as Exhibit 10.32 to the Company's Annual Report on Form
10-K for the year ended December 31, 1994, which is incorporated by reference
herein).
10.17 Registration Rights Agreement dated as of March 2, 1995 between the Company and
the Foundation (filed as Exhibit No. 28.2 to the Company's Current Report on
Form 8-K dated March 2, 1995, which is incorporated by reference herein).
*10.18 The Company's 1995 Stock Appreciation Right Plan (filed as Exhibit 10.12 to the
Company's Quarterly Report on Form 10-Q for the quarter ended September 30,
1995, which is incorporated by reference herein).
10.19 Amended and Restated Credit Agreement dated as of April 26, 1996 among the
Company, Bank of America National Trust and Savings Association, as Agent,
and financial institutions party thereto (filed as Exhibit 10.1 to the
Company's Current Report on Form 8-K dated May 3, 1996, which is incorporated
by reference herein).
10.20 Amendment No. 1 to Credit Agreement dated as of May 10, 1996 among the Company,
Bank of America National Trust and Savings Association, as Agent, and
financial institutions party thereto (filed as Exhibit 10.32 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1996, which is
incorporated by reference herein).
10.21 Amendment No. 2 to Credit Agreement dated as of May 28, 1996 among the Company,
Bank of America National Trust and Savings Association, as Agent, and
financial institutions party thereto (filed as Exhibit 10.33 to the Company's
Quarterly Report on Form 10-Q for the quarter ended June 30, 1996, which is
incorporated by reference herein).
10.22 Amendment No. 3 to Credit Agreement dated as of January 31, 1997 among the
Company, Bank of America National Trust and Savings Association, as Agent,
and financial institutions party thereto (filed as Exhibit 10.33 to the
Company's Annual Report on Form 10-K for the year ended December 31, 1996,
which is incorporated by reference herein).
10.23 Credit Agreement dated July 8, 1997 among the Company, the banks identified
therein and Bank of America National Trust and Savings Association in its
capacity as Administrative Agent (providing for an unsecured $1.5 billion
revolving credit facility) (filed as Exhibit 10.23 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1997, which is
incorporated by reference herein).
10.24 Guarantee Agreement dated July 8, 1997 between the Company and First Security
Bank, National Association (filed as Exhibit 10.24 to the Company's Quarterly
Report on Form 10-Q for the quarter ended September 30, 1997, which is
incorporated by reference herein).
*10.25 Employment Letter Agreement dated May 28, 1996 between Michael D. Pugh and
QualMed, Inc. (filed as Exhibit 10.35 to the Company's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1996, which is incorporated by
reference herein).
85
*10.26 Employment Letter Agreement dated June 4, 1996 between Arthur M. Southam and
the Company and Health Net (filed as Exhibit 10.36 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1996, which is
incorporated by reference herein).
*10.27 Employment Letter Agreement dated July 3, 1996 between Jay M. Gellert and the
Company (filed as Exhibit 10.37 to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 1996, which is incorporated by
reference herein).
*10.28 Employment Letter Agreement dated September 30, 1996 between Douglas C. Werner
and the Company (filed as Exhibit 10.38 to the Company's Quarterly Report on
Form 10-Q for the quarter ended September 30, 1996, which is incorporated by
reference herein).
*10.29 Rights Agreement dated as of June 1, 1996 by and between the Company and Harris
Trust and Savings Bank, as Rights Agent (filed as Exhibit 99.1 to the
Company's Registration Statement on Form 8-A (File No. 001-12718) which is
incorporated by reference herein).
*10.30 First Amendment to the Rights Agreement dated as of October 1, 1996, by and
between the Company and Harris Trust and Savings Bank, as Rights Agent (filed
as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year
ended December 31, 1996, which is incorporated by reference herein).
*10.31 Amended and Restated Employment Agreement, dated December 16, 1996, by and
among the Company, Foundation Health Corporation and Daniel D. Crowley (filed
as Exhibit 10.1 to the Company's Registration Statement on Form S-4 (File No.
333-19273), which is incorporated by reference herein).
*10.32 Employment Agreement Termination Agreement, dated as of May 1, 1997, by and
between Daniel D. Crowley, the Company and FHC (filed as Exhibit 10.32 to the
Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997,
which is incorporated by reference herein).
*10.33 Amended and Restated Employment Agreement, dated December 16, 1996, by and
among the Company, Foundation Health Corporation and Kirk A. Benson (filed as
Exhibit 10.2 to the Company's Registration Statement on Form S-4 (File No.
333-19273), which is incorporated by reference herein).
*10.34 Amended and Restated Employment Agreement, dated December 16, 1996, by and
among the Company, Foundation Health Corporation and Jeffrey L. Elder (filed
as Exhibit 10.4 to the Company's Registration Statement on Form S-4 (File No.
333-19273), which is incorporated by reference herein).
*10.35 Amended and Restated Employment Agreement, dated December 16, 1996, by and
among the Company, Foundation Health Corporation and Allen J. Marabito (filed
as Exhibit 10.5 to the Company's Registration Statement on Form S-4 (File No.
333-19273), which is incorporated by reference herein).
*10.36 Consulting Agreement, dated as of May 1, 1997, between the Company, FHC and
Allen J. Marabito, (filed as Exhibit 10.35 to the Company's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1997, which is incorporated by
reference herein).
*10.37 Foundation Health Corporation Employee Stock Purchase Plan (filed as Exhibit
4.3 to the Company's Registration Statement on Form S-8 (File No. 333-24621),
which is incorporated by reference herein).
86
*10.38 Foundation Health Corporation Profit Sharing and 401(k) Plan (Amended and
Restated effective January 1, 1994) (filed as Exhibit 4.4 to the Company's
Registration Statement on Form S-8 (File No. 333-24621), which is
incorporated by reference herein).
*10.39 1990 Stock Option Plan of Foundation Health Corporation (filed as Exhibit 4.5
to the Company's Registration Statement on Form S-8 (File No. 333-24621),
which is incorporated by reference herein).
*10.40 1992 Nonstatutory Stock Option Plan of Foundation Health Corporation (filed as
Exhibit 4.6 to the Company's Registration Statement on Form S-8 (File No.
333-24621), which is incorporated by reference herein).
*10.41 1989 Stock Plan of Business Insurance Corporation (as Amended and Restated
Effective September 22, 1992) (filed as Exhibit 4.7 to the Company's
Registration Statement on Form S-8 (File No. 333-24621), which is
incorporated by reference herein).
*10.42 Managed Health Network, Inc. Incentive Stock Option Plan (filed as Exhibit 4.8
to the Company's Registration Statement on Form S-8 (File No. 333-24621),
which is incorporated by reference herein).
*10.43 Managed Health Network, Inc. Amended and Restated 1991 Stock Option Plan (filed
as Exhibit 4.9 to the Company's Registration Statement on Form S-8 (File No.
333-24621), which is incorporated by reference herein).
*10.44 1993 Nonstatutory Stock Option Plan of Foundation Health Corporation (as
amended and restated September 7, 1995) (filed as Exhibit 4.10 to the
Company's Registration Statement on Form S-8 (File No. 333-24621), which is
incorporated by reference herein).
*10.45 FHC Directors Retirement Plan (filed as an exhibit to FHC's Form 10-K for the
year ended June 30, 1994 filed with the Commission on September 24, 1994,
which is incorporated by reference herein).
*10.46 Foundation Health Systems, Inc. 1997 Stock Option Plan (filed as Exhibit 10.45
to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30,
1997, which is incorporated by reference herein).
*10.47 Foundation Health Systems, Inc. Third Amended and Restated Non-Employee
Director Stock Option Plan (filed as Exhibit 10.46 to the Company's Quarterly
Report on Form 10-Q for the quarter ended June 30, 1997, which is
incorporated by reference herein).
*10.48 Foundation Health Systems, Inc. Employee Stock Purchase Plan (filed as Exhibit
10.47 to the Company's Quarterly Report on Form 10-Q for the quarter ended
June 30, 1997, which is incorporated by reference herein).
*10.49 Foundation Health Systems, Inc. Performance-Based Annual Bonus Plan (filed as
Exhibit 10.48 to the Company's Quarterly Report on Form 10-Q for the quarter
ended June 30, 1997, which is incorporated by reference herein).
10.50 Participation Agreement dated as of May 25, 1995 among Foundation Health
Medical Services, as Construction Agent and Lessee, FHC, as Guarantor, First
Security Bank of Utah, N.A., as Owner Trustee, Sumitomo Bank Leasing and
Finance, Inc., The Bank of Nova Scotia and NationsBank of Texas, N.A., as
Holders and NationsBank of Texas, N.A., as Administrative Agent for the
Lenders; and Guaranty Agreement dated as of May 25, 1995 by FHC for the
benefit of First Security Bank of Utah, N.A. (filed as an exhibit to FHC's
Form 10-K for the year ended June 30, 1995, filed with the Commission on
September 27, 1995, which is incorporated by reference herein).
87
*10.51 FHC's Deferred Compensation Plan, as amended and restated (filed as an exhibit
to FHC's Form 10-K for the year ended June 30, 1995, filed with the
Commission on September 27, 1995, which is incorporated by reference herein).
*10.52 FHC's Supplemental Executive Retirement Plan, as amended and restated (filed as
an exhibit to FHC's Form 10-K for the year ended June 30, 1995, filed with
the Commission on September 27, 1995, which is incorporated by reference
herein).
*10.53 FHC's Executive Retiree Medical Plan, as amended and restated (filed as an
exhibit to FHC's Form 10-K for the year ended June 30, 1995, filed with the
Commission on September 27, 1995, which is incorporated by reference herein).
10.54 Agreement and Plan Reorganization dated January 9, 1996 by and between FHC and
Managed Health Network, Inc. (filed as Annex 1 of Proxy Statement/Prospectus
contained in FHC's Registration Statement on Form S-4 (File No. 333-00517),
which is incorporated by reference herein).
10.55 Stock and Note Purchase Agreement by and between FHC, Jonathan H., Schoff,
M.D., FPA Medical Management, Inc., FPA Medical Management of California,
Inc. and FPA Independent Practice Association dated as of June 28, 1996
(filed as Exhibit 10.109 to FHC's Annual Report on Form 10-K for the year
ended June 30, 1996, which is incorporated by reference herein).
10.56 $300 Million Revolving Credit Agreement (the "FHC Credit Agreement") dated as
of December 5, 1994, among FHC, as Borrower, Citicorp USA, Inc., as
Administrative Agent, Wells Fargo Bank, N.A. and NationsBank of Texas, N.A.,
as Co-Agents and Citicorp Securities, Inc., as Arranger, and the Other Banks
and Financial Institutions Party thereto (filed as an Exhibit to FHC's
quarterly report on Form 10-Q for the quarter ended December 31, 1994 filed
with the Commission on February 14, 1994, which is incorporated by reference
herein).
10.57 First Amendment Agreement (to the FHC Credit Agreement) dated as of August 9,
1995 among FHC, as Borrower, the Lenders parties to the FHC Credit Agreement,
Citicorp USA, Inc., as Administrative Agent, Wells Fargo Bank, N.A. and
NationsBank of Texas, N.A., as Co-Agents, and Citicorp Securities, Inc., as
Arranger (filed as Exhibit 10.52 to the Company's Quarterly Report on Form
10-Q for the quarter ended March 31, 1997, which is incorporated by reference
herein).
10.58 Second Amendment Agreement (to the FHC Credit Agreement), dated as of June 28,
1996 among FHC, the Lenders and Citicorp USA, Inc. (filed as Exhibit 10.53 to
the Company's Quarterly Report on Form 10-Q for the quarter ended March 31,
1997, which is incorporated by reference herein).
10.59 Third Amendment Agreement and Waiver (to the FHC Credit Agreement) dated
December 13, 1996 among FHC, the Lenders and Citibank, N.A. (as successor to
Citicorp USA, Inc.), as Administrative Agent (filed as Exhibit 10.54 to the
Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997,
which is incorporated by reference herein).
10.60 Fourth Amendment Agreement and Waiver (to the FHC Credit Agreement) dated
January 28, 1997 among FHC, the Lenders and Citibank, N.A. (as successor to
Citicorp USA, Inc.), as Administrative Agent (filed as Exhibit 10.55 to the
Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997,
which is incorporated by reference herein).
88
10.61 Fifth Amendment Agreement (to the FHC Credit Agreement) dated April 1, 1997
among FHC, the Lenders and Citibank, N.A. (as successor to Citicorp USA,
Inc.), as Administrative Agent (filed as Exhibit 10.56 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, which is
incorporated by reference herein).
10.62 $200 million Revolving Credit Agreement (the "FHC Revolving Credit Agreement")
dated as of December 17, 1996 among FHC, the Lenders and Citibank, N.A., as
Administrative Agent for the Lenders (filed as Exhibit 10.57 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, which is
incorporated by reference herein).
10.63 First Amendment Agreement and Waiver (to the FHC Revolving Credit Agreement)
dated as of January 28, 1997 among FHC, the Lenders and Citibank, N.A., as
Administrative Agent for the Lenders (filed as Exhibit 10.58 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, which is
incorporated by reference herein).
10.64 Second Amendment Agreement and Waiver (to the FHC Revolving Credit Agreement)
among FHC, the Lenders and Citibank, N.A., as Administrative Agent for the
Lenders (filed as Exhibit 10.59 to the Company's Quarterly Report on Form
10-Q for the quarter ended March 31, 1997, which is incorporated by reference
herein).
10.65 Lease Agreement between HAS-First Associates and FHC dated August 1, 1998 and
form of amendment thereto (filed as an exhibit to FHC's Registration
Statement on Form S-1 (File No. 33-34963), which is incorporated by reference
herein).
10.66 Agreement and Plan of Reorganization dated as of June 27, 1994 by and among
FHC, CareFlorida Health Systems, Inc., and the other parties signatory
thereto (filed as an exhibit to FHC's Current Report on Form 8-K filed with
the Commission on June 28, 1994, which is incorporated by reference herein).
10.67 Agreement and Plan of Merger dated as of July 28, 1994 between FHC and
Intergroup Healthcare Corporation (filed as an exhibit to FHC's Current
Report on Form 8-K filed with the Commission on August 9, 1994, which is
incorporated by reference herein).
10.68 Agreement and Plan of Merger dated as of July 28, 1994 between FHC and Thomas-
Davis Medical Centers, P.C. (filed as an exhibit to FHC's Current Report on
Form 8-K filed with the Commission on August 9, 1994, which is incorporated
by reference herein).
*+10.69 Amended Letter Agreement between the Company and Jay M. Gellert dated as of
August 22, 1997, a copy of which is filed herewith.
+10.70 Form of Credit Facility Commitment Letter, dated March 27, 1998, between the
Company and the Majority Banks (as defined therein), a copy of which is filed
herewith.
*+10.71 Employment Letter Agreement between the Company and Dale Terrell dated December
31, 1997, a copy of which is filed herewith.
*+10.72 Employment Letter Agreement between the Company and Steven P. Erwin dated March
11, 1998, a copy of which is filed herewith.
*+10.73 Employment Agreement, dated as of December 31, 1997, between the Company and
Maurice Costa, or copy of which is filed herewith.
*+10.74 Employment Agreement, dated as of December 31, 1997, between the Company and
Robert L. Natt, a copy of which is filed herewith.
89
*+10.75 Employment Letter Agreement, dated October 10, 1997, between the Company and
Alex Labak, a copy of which is filed herewith.
*10.76 Employment Letter, dated June 9, 1995, between Philip Katz, Ph.D. and Health
Net (filed as Exhibit 10.38 to the Company's Annual Report on Form 10-K for
the year ended December 31, 1995, which is incorporated by reference herein).
+11.1 Statement relative to computation of per share earnings of the Company
(included in the notes to the Financial Statements contained in this Annual
Report on Form 10-K).
+21.1 Subsidiaries of the Company, a copy which is filed herewith.
+23.1 Consent of Deloitte & Touche LLP, a copy of which is filed herewith.
+27.1 Financial Data Schedule for 1997, 1996 and 1995 Annual Data, a copy of which
has been filed with the EDGAR version of this filing.
+27.2 Financial Data Schedule for 1997 Quarterly Data, a copy of which has been filed
with the EDGAR version of this filing.
+27.3 Financial Data Schedule for 1996 Quarterly Data, a copy of which has been filed
with the EDGAR version of this filing.
- ------------------------
* Management contract or compensatory plan or arrangement required to be filed
(and/or incorporated by reference) as an exhibit to this Annual Report on
Form 10-K pursuant to Item 14(c) of Form 10-K.
+ A copy of the exhibit is being filed with this Annual Report on Form 10-K.
(b) Reports on Form 8-K
The following Current Reports on Form 8-K were filed by the Company
during the quarterly period ended December 31, 1997:
1. A Current Report on Form 8-K dated October 23, 1997 announcing the
Company's completion of its acquisition of PACC HMO and PACC Health
Plan (together, "PACC") and the merger of PACC with the Company's
existing HMO in Oregon.
2. A Current Report on Form 8-K dated December 31, 1997 announcing (i)
the Company's acquisition of Physicians Health Services, Inc. ("PHS")
effective December 31, 1997 pursuant to an Agreement and Plan of
Merger dated as of May 8, 1997, by and between the Company, PHS
Acquisition Corp., a wholly-owned subsidiary of the Company, and PHS;
and (ii) that the Company had purchased additional subordinated
debentures of FOHP, Inc. ("FOHP"), and that the Company had recently
converted approximately $70 million in principal amount of
subordinated convertible debentures into approximately 98% of the
outstanding equity of FOHP.
No other Current Reports on Form 8-K were filed by the Company during
the quarterly period ended December 31, 1997.
90
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Company has duly caused this Report to be
signed on its behalf by the undersigned thereunto duly authorized, on March 30,
1998.
FOUNDATION HEALTH SYSTEMS, INC.
By: /s/ MALIK M. HASAN, M.D.
-----------------------------------------
Malik M. Hasan, M.D.
CHAIRMAN OF THE BOARD OF DIRECTORS AND
CHIEF EXECUTIVE OFFICER (PRINCIPAL
EXECUTIVE OFFICER)
By: /s/ STEVEN P. ERWIN
-----------------------------------------
Steven P. Erwin
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
(PRINCIPAL ACCOUNTING AND FINANCIAL
OFFICER)
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this Report has been signed below by the following persons on behalf of
the Company and in the capacities indicated on March 30, 1998.
SIGNATURE TITLE
- ------------------------------ --------------------------
/s/ J. THOMAS BOUCHARD
- ------------------------------ Director
J. Thomas Bouchard
/s/ GOV. GEORGE DEUKMEJIAN
- ------------------------------ Director
Gov. George Deukmejian
/s/ THOMAS T. FARLEY
- ------------------------------ Director
Thomas T. Farley
/s/ PATRICK FOLEY
- ------------------------------ Director
Patrick Foley
/s/ ADMIRAL EARL B. FOWLER
- ------------------------------ Director
Admiral Earl B. Fowler
91
SIGNATURE TITLE
- ------------------------------ --------------------------
/s/ ROGER F. GREAVES
- ------------------------------ Director
Roger F. Greaves
/s/ RICHARD W. HANSELMAN
- ------------------------------ Director
Richard W. Hanselman
/s/ MALIK M. HASAN, M.D. Director, Chairman of the
- ------------------------------ Board of Directors and
Malik M. Hasan, M.D. Chief Executive Officer
/s/ RICHARD J. STEGEMEIER
- ------------------------------ Director
Richard J. Stegemeier
/s/ RAYMOND S. TROUBH
- ------------------------------ Director
Raymond S. Troubh
92
SUPPLEMENTAL SCHEDULE I
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
FOUNDATION HEALTH SYSTEMS, INC.
CONDENSED BALANCE SHEETS
(IN THOUSANDS)
DECEMBER 31
--------------------------
1997 1996
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents........................................................... $ 16,740 $ 9,460
Investments available for sale...................................................... 9,007 24,130
Other assets........................................................................ 46,902 23,197
Due from subsidiaries............................................................... 473,431
Net assets of discontinued operations............................................... 267,713 381,572
------------ ------------
Total current assets.................................................................. 813,793 438,359
Property and equipment, net........................................................... 22,895 3,515
Goodwill and other intangible assets, net............................................. 559,368 203,309
Investment in subsidiaries............................................................ 829,822 998,313
Other assets.......................................................................... 70,342 358
------------ ------------
Total assets...................................................................... $2,296,220 $1,643,854
------------ ------------
------------ ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Due to subsidiaries................................................................. $ 73,283 $ 106,907
Other current liabilities........................................................... 35,907 9,984
------------ ------------
Total current liabilities......................................................... 109,190 116,891
Notes payable......................................................................... 1,287,500 342,373
Other liabilities..................................................................... 3,556 1,179
------------ ------------
Total liabilities................................................................. 1,400,246 460,443
------------ ------------
Stockholders' equity:
Common stock and additional paid-in capital......................................... 628,735 721,610
Common stock held in treasury, at cost.............................................. (95,831) (98,878)
Retained earnings................................................................... 370,394 557,478
Unrealized investment gains (losses), net of taxes.................................. (7,324) 3,201
------------ ------------
Total stockholders' equity........................................................ 895,974 1,183,411
------------ ------------
Total liabilities and stockholders' equity...................................... $2,296,220 $1,643,854
------------ ------------
------------ ------------
See accompanying notes
93
SUPPLEMENTAL SCHEDULE I
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
FOUNDATION HEALTH SYSTEMS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31
-----------------------------------
1997 1996 1995
----------- ---------- ----------
Investment and other income.................................................. $ 6,485 $ 5,171 $ 2,966
Expenses:
General and administrative................................................. 17,288 11,879 4,811
Amortization and depreciation.............................................. 8,526 7,217 1,899
Interest................................................................... 42,118 22,063 13,234
Merger, restructuring and other costs...................................... 42,189 2,500 20,164
----------- ---------- ----------
110,121 43,659 40,108
----------- ---------- ----------
Loss from continuing operations before income taxes and equity in net income
of subsidiaries............................................................ (103,636) (38,488) (37,142)
Income tax benefit........................................................... 39,533 11,861 14,596
Equity in net income of subsidiaries......................................... (3,727) 65,457 211,697
----------- ---------- ----------
Loss from continuing operations.............................................. (67,830) 38,830 189,151
Discontinued operations:
Income (loss) from operations, net of tax.................................. (30,409) 25,084 3,028
Gain (loss) on disposition, net of tax..................................... (88,845) 20,317
----------- ---------- ----------
Net income (loss)........................................................ $ (187,084) $ 84,231 $ 192,179
----------- ---------- ----------
----------- ---------- ----------
See accompanying notes
94
SUPPLEMENTAL SCHEDULE I
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
FOUNDATION HEALTH SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31
-------------------------------------
1997 1996 1995
----------- ----------- -----------
NET CASH FLOWS FROM OPERATING ACTIVITIES................................... $ (521,154) $ 11,091 $ (112,815)
CASH FLOWS FROM INVESTING ACTIVITIES:
Sales or maturity of investments available for sale...................... 11,400
Purchases of investments available for sale.............................. (309) (20,160) (15,574)
Purchases of property and equipment, net................................. (20,695) (3,273) (743)
Other assets............................................................. (130,755) (2,941)
Acquisition of businesses net of cash acquired........................... (293,625) (4,113) (139,462)
----------- ----------- -----------
Net cash used by investing activities...................................... (433,984) (30,487) (155,779)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and employee stock plan
purchases.............................................................. 21,506 17,485 4,524
Proceeds from sale of stock.............................................. 95,828
Proceeds from issuance of notes payable.................................. 946,000 9,000 310,000
Principal payments on notes payable...................................... (873)
Advances to repurchase common stock...................................... (16,330)
Redemption of common stock............................................... (111,334) (105,418) (24,418)
Cash dividends received from subsidiaries................................ 140,994
Capital contributions to subsidiaries.................................... (33,875) (700) (539)
----------- ----------- -----------
Net cash provided by financing activities.................................. 962,418 16,195 273,237
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents....................... 7,280 (3,201) 4,643
Cash and cash equivalents, beginning of period............................. 9,460 12,661 8,018
----------- ----------- -----------
Cash and cash equivalents, end of period................................... $ 16,740 $ 9,460 $ 12,661
----------- ----------- -----------
----------- ----------- -----------
95
SUPPLEMENTAL SCHEDULE I
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
FOUNDATION HEALTH SYSTEMS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The Company's investment in subsidiaries is stated at cost plus equity in
undistributed earnings of subsidiaries. The Company's share of net income of its
unconsolidated subsidiaries is included in consolidated income using the equity
method. Parent company only financial statements should be read in conjunction
with the Company's consolidated financial statements.
Certain prior year amounts have been reclassified to conform with current
year presentation.
2. GUARANTEES
Health Net, the Company's California health plan, has $18.8 million of
long-term debt outstanding as of December 31, 1997 due to the California
Wellness Foundation. Such debt was incurred in connection with the conversion of
Health Net to for-profit status. In connection with the issuance of the original
debt totaling $225 million, the Company has guaranteed the performance of Health
Net under the debt agreements, including payment of all principal and interest.
96
SECTION 403.04B SCHEDULE
FOUNDATION HEALTH SYSTEMS, INC.
RECONCILIATION OF BEGINNING AND ENDING LOSS AND LOSS ADJUSTMENT EXPENSE
RESERVES AND EXHIBIT OF REDUNDANCIES (DEFICIENCIES)--UNAUDITED
(AMOUNTS IN THOUSANDS)
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------------------
1987 1988 1989 1990 1991 1992 1993 1994
--------- --------- --------- --------- --------- --------- --------- ---------
Liability for unpaid losses and loss
adjustment expenses.................... $ 53,170 $ 55,089 $ 76,296 $ 158,268 $ 206,993 $ 219,464 $ 268,191 $ 322,394
Paid (cumulative) as of:
One year later......................... 14,186 11,649 20,541 59,110 103,361 106,693 115,189 129,284
Two years later........................ 21,998 20,780 36,151 106,334 167,932 191,397 184,304 204,245
Three years later...................... 27,849 28,389 44,665 130,826 211,087 233,537 214,676 243,210
Four years later....................... 33,527 31,492 50,240 146,186 233,168 249,012 226,187
Five years later....................... 35,630 34,015 53,896 154,514 241,693 252,921
Six years later........................ 37,448 35,975 56,301 161,152 244,308
Seven years later...................... 39,121 37,374 58,577 164,606
Eight years later...................... 40,346 38,970 59,858
Nine years later....................... 41,854 39,780
Ten years later........................ 42,637
Liability re-estimated as of:
One year later......................... 53,321 51,147 75,988 160,141 218,747 251,012 262,032 295,856
Two years later........................ 51,382 51,991 65,376 162,040 242,231 257,134 256,135 270,293
Three years later...................... 54,349 43,651 61,098 172,981 242,533 262,582 250,238 296,016
Four years later....................... 47,241 41,513 66,135 172,269 245,877 268,031 254,791
Five years later....................... 46,116 44,701 66,174 173,581 249,220 270,478
Six years later........................ 47,011 45,364 66,569 174,892 257,332
Seven years later...................... 47,928 45,452 66,963 175,053
Eight years later...................... 47,883 45,541 67,786
Nine years later....................... 47,839 46,906
Ten years later........................ 49,371
Redundancy (deficiency).................. $ 3,799 $ 8,183 $ 8,510 ($ 16,785) ($ 50,339) ($ 51,014) $ 13,400 $ 26,378
Net reserve--end of period............... $ 322,394
Reinsurance recoverable on unpaid losses and loss adjustment expenses................................................. 90,366
---------
Gross reserve--end of period.......................................................................................... 412,760
Net re-estimated reserve--end of period............................................................................... 296,016
Re-estimated reinsurance recoverable.................................................................................. 91,848
---------
Gross re-estimated reserve--end of period............................................................................. 387,864
---------
Gross cumulative redundancy (deficiency).............................................................................. $ 24,896
---------
---------
1995 1996 1997
--------- --------- ---------
Liability for unpaid losses and loss
adjustment expenses.................... $ 367,061 $ 469,258 $ 521,550
Paid (cumulative) as of:
One year later......................... 173,161 255,856
Two years later........................ 288,885
Three years later......................
Four years later.......................
Five years later.......................
Six years later........................
Seven years later......................
Eight years later......................
Nine years later.......................
Ten years later........................
Liability re-estimated as of:
One year later......................... 387,426 544,637
Two years later........................ 410,082
Three years later......................
Four years later.......................
Five years later.......................
Six years later........................
Seven years later......................
Eight years later......................
Nine years later.......................
Ten years later........................
Redundancy (deficiency).................. ($ 43,021) ($ 75,379)
Net reserve--end of period............... $ 367,061 $ 469,258 $ 521,550
Reinsurance recoverable on unpaid losses 76,309 121,326 206,871
--------- --------- ---------
Gross reserve--end of period............. 443,370 590,584 728,421
---------
---------
Net re-estimated reserve--end of period.. 410,082 544,637
Re-estimated reinsurance recoverable..... 83,202 134,668
--------- ---------
Gross re-estimated reserve--end of period 493,284 679,305
--------- ---------
Gross cumulative redundancy (deficiency). ($ 49,914) ($ 88,721)
--------- ---------
--------- ---------
Note: The loss and loss adjustment expense reserves relate to the Company's
discontinued workers' compensation insurance businesses.
97