FINANCIAL HIGHLIGHTS
Foundation Health Systems, Inc.
Year Ended December 31,
(Amounts in thousands, except per share data) 1998 1997 1996 1995 1994
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STATEMENT OF OPERATIONS DATA:
REVENUES
Health plan premiums $7,440,981 $5,829,444 $5,395,125 $4,557,214 $3,863,965
Government contracts 989,409 949,168 908,730 279,380 209,980
Specialty services 366,645 342,107 316,993 210,533 139,853
Investment and other income 99,041 114,300 88,392 66,510 51,698
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Total revenues 8,896,076 7,235,019 6,709,240 5,113,637 4,265,496
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EXPENSES
Health plan services 6,547,747 4,912,532 4,598,074 3,643,463 3,091,890
Government contracts health care services 757,047 711,757 706,076 174,040 147,629
Specialty services 307,675 290,319 289,744 182,380 121,299
Selling, general and administrative 1,042,556 851,826 859,996 657,275 536,209
Amortization and depreciation 128,093 98,353 112,916 89,356 66,741
Interest 92,159 63,555 45,372 33,463 23,081
Asset impairment, merger, restructuring
and other charges 274,953 395,925 44,108 20,164 125,379
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Total expenses 9,150,230 7,324,267 6,656,286 4,800,141 4,112,228
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Income (loss) from continuing
operations before income tax (254,154) (89,248) 52,954 313,496 153,268
Income tax provision (benefit) (88,996) (21,418) 14,124 124,345 70,169
Income (loss) from continuing operations (165,158) (67,830) 38,830 189,151 83,099
Discontinued operations:
Income (loss) from operations, net of tax - (30,409) 25,084 3,028 18,434
Gain (loss) on disposition, net of tax - (88,845) 20,317
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Net income (loss) $ (165,158) $ (187,084) $ 84,231 $ 192,179 $ 101,533
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BASIC EARNINGS (LOSS) PER SHARE:
Continuing operations $ (1.35) $ (0.55) $ 0.31 $ 1.54 $ 0.73
Income (loss) from discontinued
operations, net of tax (0.25) 0.20 0.02 0.16
Gain (loss) on disposition of discontinued
operations, net of tax (0.72) 0.16
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Net $ (1.35) $ (1.52) $ 0.67 $ 1.56 $ 0.89
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DILUTED EARNINGS (LOSS) PER SHARE:
Continuing operations $ (1.35) $ (0.55) $ 0.31 $ 1.53 $ 0.72
Income (loss) from discontinued
operations, net of tax (0.25) 0.20 0.02 0.16
Gain (loss) on disposition of discontinued
operations, net of tax (0.72) 0.16
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Net $ (1.35) $ (1.52) $ 0.67 $ 1.55 $ 0.88
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Operating cash flow $ 100,867 $ (125,872) $ (6,666) $ 51,417 -(ii)
Weighted average shares outstanding:
Basic 121,974 123,333 124,453 122,741 113,723
Diluted 121,974 123,333 124,966 123,674 115,658
BALANCE SHEET DATA:
Cash & cash equivalents and investments
available for sale $1,288,947 $1,112,361 $1,122,916 $ 871,818 $ 840,332
Total assets 3,929,541 4,076,350 3,423,776 2,733,765 2,218,506
Notes payable and capital leases-noncurrent 1,254,278 1,308,979 791,618 547,522 301,356
Stockholders' equity(i) 744,042 895,974 1,183,411 1,068,255 877,466
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(i) No cash dividends were declared in each of the years presented.
(ii) Information not available.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Foundation Health Systems, Inc. (together with its subsidiaries, the
"Company") is an integrated managed care organization which administers
the delivery of managed health care services. The Company's operations
consist of two operating segments: Health Plan Services and Government
Contracts/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 Health Plan Services segment consists of HMOs organized into
four operational divisions located in the following geographic regions:
the California Division, the Northeast Division, the Central Division and
the Arizona Division. These health plans are located in Arizona,
California, Colorado, Connecticut, Florida, Idaho, Louisiana, New Jersey,
New Mexico, New York, Ohio, Oklahoma, Oregon, Pennsylvania, Texas, Utah,
Washington and West Virginia. The Company's health plans provide a wide
range of managed health care services throughout the United States with
approximately 4.2 million at risk and administrative services only
members. The Company's 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 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.
The Government Contracts/Specialty Services segment administers
large, multi-year managed health care government contracts. This segment
subcontracts to affiliated and unrelated third parties the administration
and health care risk of parts of these contracts and currently administers
health care programs covering approximately 1.6 million eligible
individuals under the Civilian Health and Medical Program of the Uniformed
Services ("CHAMPUS") through the TRICARE program. Currently, the Company
provides these services under three TRICARE contracts that cover Alaska,
Arkansas, California, Hawaii, Oklahoma, Oregon, Texas, Washington and
parts of Arizona, Idaho and Louisiana. This segment also offers behavioral
health, dental, and vision services as well as managed care products
related to bill review, administration and cost containment for hospitals,
health plans and other entities.
This discussion and analysis contains "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of
1995. Forward-looking statements involve risks and uncertainties [detailed
from time to time in the Company's filings with the Securities and
Exchange Commission (the "Commission")] which may cause actual results to
differ materially from those projected or implied in these statements. The
risks and uncertainties faced by the Company include, but are not limited
to, those set forth under "Additional Information Concerning the Company's
Business," "Cautionary Statements" and other sections within the Company's
filings with the Commission.
CONSOLIDATED OPERATING RESULTS
The Company's net loss from continuing operations for the year ended
December 31, 1998 was $165.2 million, or $1.35 per diluted share, compared
to a net loss from continuing operations for the same period in 1997 of
$67.8 million, or $.55 per diluted share.
During the year ended December 31, 1998, the Company recorded asset
impairment, restructuring and other charges totaling $410.9 million on a
pre-tax basis (the "1998 Charges"), or $2.13 per diluted share, net of
taxes. The Company recorded $395.9 million and $44.1 million related to
asset impairment, merger, restructuring and other charges during 1997 and
1996, respectively. These charges are further described in "Asset
Impairment, Merger, Restructuring and Other Charges" below. Excluding
these charges and the results of discontinued operations, the basic and
diluted earnings per share for the years ended December 31, 1998, 1997 and
1996 were $.78, $1.89 and $.57, respectively.
The table below and the discussion that follows summarize the
Company's performance in the last three fiscal years.
Year Ended December 31,
---------------------------------------------
(Amounts in thousands) 1998 1997 1996
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Total revenues $8,896,076 $7,235,019 $6,709,240
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Expenses:
Health plan services expenses(i) 6,547,747 4,912,532 4,598,074
Government contracts and specialty services expenses 1,064,722 1,002,076 995,820
Selling, general and administrative 1,042,556 851,826 859,996
Amortization and depreciation 128,093 98,353 112,916
Interest 92,159 63,555 45,372
Asset impairment, restructuring, merger, and other charges(i) 274,953 395,925 44,108
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Total expenses 9,150,230 7,324,267 6,656,286
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Income (loss) from continuing operations before income taxes $ (254,154) $ (89,248) $ 52,954
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Overall medical care ratio 86.5% 83.1% 84.5%
Administrative expense ratio 12.4% 12.6% 13.6%
HEALTH PLAN SERVICES SEGMENT:
Health plan premiums $7,440,981 $5,829,444 $5,395,125
Health plan medical care ratio 88.0% 84.3% 85.2%
Health plan premiums per member per month $ 143.43 $ 137.96 $ 135.17
Health plan services per member per month $ 126.24 $ 116.26 $ 115.20
GOVERNMENT CONTRACTS/SPECIALTY SERVICES SEGMENT:
Government contracts and specialty services revenues $1,356,054 $1,291,275 $1,225,723
Government contracts and specialty services
expenses medical care ratio 78.5% 77.6% 81.2%
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(i) 1998 Charges of $275.0 million are included in asset impairment,
restructuring, merger and other charges and $135.9 million are included
primarily in health plan services expenses.
ENROLLMENT INFORMATION
Year Ended December 31, Percent Percent
(Amounts in thousands) 1998 1997 Change 1996 Change
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Health Plan Services:
Commercial 3,287 3,522 (6.7)% 2,774 27.0%
Medicare Risk 326 308 5.8% 237 30.0%
Medicaid 586 442 32.6% 315 40.3%
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4,199 4,272 (1.7)% 3,326 28.4%
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Government Contracts:
CHAMPUS PPO and Indemnity 784 1,090 (28.1)% 1,035 5.3%
CHAMPUS HMO 783 801 (2.2)% 543 47.5%
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1,567 1,891 (17.1)% 1,578 19.8%
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REVENUES AND HEALTH CARE COSTS
The Company's revenues grew by $1.7 billion or 23% for the year ended
December 31, 1998 as compared to 1997. Growth in health plan revenues of
$1.6 billion for the year was due primarily to the acquisitions that
occurred in the fourth quarter of 1997, including Physicians Health
Services, Inc. ("PHS"), FOHP, Inc. ("FOHP") and PACC HMO, Inc. and PACC
Health Plans, Inc. (collectively "PACC"). Excluding these acquisitions,
revenues grew by $1 billion for the year ended December 31, 1998. The
growth from existing health plan businesses was due to increases in
premium rates in virtually all markets and significant increases in
Medicaid enrollment in California. Growth in government contracts revenues
totaled $40.3 million and growth in specialty services revenues totaled
$24.5 million. See "Segment Reporting" for discussion of Government
Contracts/Specialty Services.
The Company's revenues grew by $525.8 million or 7.8% for the year
ended December 31, 1997 as compared to 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 in the Northeast, and the partial
year impact of acquisitions that occurred in the second and fourth
quarters of 1997. Investment and other income was $99.0 million, $114.3
million and $88.4 million in 1998, 1997 and 1996, respectively. The
increase in 1997 was primarily related to non-recurring gains from the
sale of certain holdings and Medicaid contracts.
The overall medical care ratio ("MCR") (medical costs as a
percentage of revenue) for the year ended December 31, 1998 was 86.5% as
compared to 83.1% for the year ended December 31, 1997. The increase was
primarily due to higher pharmacy costs in all divisions, benefit cost
increases which exceeded premium rate increases, increased utilization and
continued pricing pressures throughout the Company's health plans.
Excluding the 1998 Charges, the MCR was 85.0%.
The overall MCR 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.
SELLING, GENERAL AND ADMINISTRATIVE COSTS
The Company's selling, general and administrative ("SG&A") expenses
increased by $190.7 million or 22.4% for the year ended December 31, 1998
as compared to 1997. The increase in SG&A expenses during 1998 is
primarily due to the SG&A expenses associated with the businesses acquired
during 1997. The administrative expense ratio (SG&A as a percentage of
health plan and government contracts revenue) decreased to 12.4% for the
year ended December 31, 1998 from 12.6% for the year ended December 31,
1997. This decrease is primarily attributable to the Company's ongoing
efforts to aggressively control its SG&A expenses and synergy savings
associated with the integration of its 1997 acquisitions which were
partially offset by increased expenditures related to consolidation and
integration of the Company's administrative facilities. Excluding the 1998
Charges, the administrative expense ratio was 12.2%.
The Company's SG&A expenses decreased by $8.2 million or 1.0% for
the year ended December 31, 1997 as compared to 1996. The administrative
expense ratio decreased to 12.6% for the year ended December 31, 1997 as
compared to 13.6% for the year ended December 31, 1996. This decrease
reflects the Company's ongoing efforts to aggressively control its SG&A
expenses and synergy savings associated with the integration of Health
Systems International, Inc. and Foundation Health Corporation after the
merger transaction (the "FHS Combination") involving such entities. This
decrease was offset partially by additional SG&A expenses associated with
the new acquisitions during 1997.
AMORTIZATION AND DEPRECIATION
Amortization and depreciation expense increased by $29.7 million in 1998
due to increases in intangible assets and fixed assets as a result of the
acquisitions that occurred in the fourth quarter of 1997 and increased
expenditures primarily related to the consolidation and integration of the
Company's administrative facilities.
Amortization and depreciation expense declined by $14.6 million for
the year ended December 31, 1997 as compared to 1996 due to
certain intangible assets becoming fully amortized by the end of 1996,
fixed assets becoming fully depreciated in early 1997 and fixed asset
write-offs primarily associated with the Company's restructuring plans
discussed below.
INTEREST EXPENSE
Interest expense increased by $28.6 million due to increased borrowings
under the revolving credit facility coupled with a higher borrowing rate
in 1998 as compared to 1997. Interest expense increased by $18.2 million
in 1997 as compared to 1996 due to higher debt levels associated with the
Company's revolving lines of credit partially offset by lower interest
rates.
ASSET IMPAIRMENT, MERGER, RESTRUCTURING AND OTHER CHARGES
On July 19, 1998, FPA Medical Management, Inc. ("FPA") filed for
bankruptcy protection under Chapter 11 of the Federal Bankruptcy Code.
FPA, through its affiliated medical groups, provided services to
approximately 190,000 of the Company's affiliated members in Arizona and
California. FPA has discontinued its medical group operations in these
markets. As a result, the Company is seeking new tenants for, or will
sell, the 13 healthcare facilities it leased to FPA in these markets and
has made other arrangements for provider services to the Company's
affiliated members. To date, the Company has sold three of these
healthcare facilities.
Management's analysis of this situation indicated that the likely
replacement lease terms from these properties will be inadequate to enable
the Company to sell the facilities and recover their carrying value. Based
on management's best estimate of recovery for the real estate and the
impairment of notes receivable and other Company assets due to the FPA
bankruptcy filing, the Company recorded a charge of $50.0 million during
the second quarter ended June 30, 1998. The Company recorded an additional
$28.1 million during the third quarter ended September 30, 1998 which was
primarily related to additional impairment of the value of real estate
assets leased to FPA and an additional $6.0 million during the fourth
quarter ended December 31, 1998 which was related to the FPA bankruptcy.
Elements of the second, third and fourth quarter charges included
approximately $63.0 million for real estate asset impairments,
approximately $10.0 million for a note receivable impairment and $11.1
million for other items related to FPA.
During the third quarter ended September 30, 1998, excluding the
charges totaling $28.1 million related to the FPA bankruptcy, the Company
recorded $146.9 million of restructuring and other charges. These charges
included (i) $87.0 million related primarily to premium deficiency
reserves for the Company's Medicare operations in the Northeast division,
payment disputes with various provider groups, and costs associated with
contract terminations and exiting rural markets which were recorded as
health care costs; (ii) $21.2 million related to severance and benefits
related to staff reductions in selected health plans and the
centralization and consolidation of Corporate functions; (iii) $18.6
million related to the bankruptcy of a large hospital system; and (iv)
$20.1 million of other costs primarily related to premium deficiency
reserves established for certain of the Company's non-core health plan
operations. As of December 31, 1998, $40.9 million of the total $175.0
million of the third quarter charges described above has resulted in cash
outlays and $27.5 million is expected to require future outlays of cash.
During the fourth quarter ended December 31, 1998, the Company
initiated a formal plan to dispose of certain Central Division health
plans included in the Company's Health Plan Services segment. It is
anticipated that the divestiture of these plans will be completed during
the first half of 1999. The Company evaluated the carrying values of the
assets of these health plans and determined that the carrying value
exceeded estimated fair value by $112.4 million. As a result, the Company
recorded an impairment charge which is attributable to the following
assets: Goodwill totaling $30.0 million, furniture and equipment totaling
$40.3 million, building improvements totaling $20.9 million and other
impairments totaling $21.2 million. In addition, the Company recorded
$48.9 million primarily as health care costs. These costs were primarily
related to anticipated bad debts totaling $17.4 million, premium
deficiency reserves of $22.1 million for certain health plans whose health
care costs exceed contractual premium revenues and additional claims
reserves and other costs totaling $9.4 million. The Company also recorded
an additional $18.6 million of other charges. As of December 31, 1998,
$6.0 million of the total $185.9 million of the fourth quarter charges
resulted in cash outlays and $50.1 million is expected to require future
outlays of cash.
As set forth above, the total 1998 Charges recorded by the Company
were $410.9 million.
Restructuring, merger and other charges of $395.9 million were
recorded during the year ended December 31, 1997 related to the FHS
Combination and the restructuring of the Company's Eastern Division health
plans. The principal elements of these charges included (i) restructuring
costs of $146.8 million for 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 to standardized systems; (ii) $69.6 million in merger related
costs primarily for investment banking, legal, accounting and other costs;
(iii) premium deficiency reserves of $57.5 million related to the
Company's Gem Insurance Company ("Gem") and (iv) other charges of $122.0
million primarily related to other costs for certain of the Company's
non-core operations. As of December 31, 1998, $86.9 million of the net
1997 restructuring charge has resulted in cash outlays and $13.8 million
is expected to require future outlays of cash.
During 1996, the Company recorded $44.1 million of restructuring
and other charges. These charges were primarily comprised of restructuring
costs of $27.4 million and $16.7 million of other costs including loss
contract accruals related to governmental employer groups in the Company's
non-California markets, consulting and other costs.
INCOME TAX PROVISION AND BENEFIT
The effective tax benefit rate of 35.0% on losses from continuing
operations for the year ended December 31, 1998 increased compared to the
effective tax benefit rate on continuing operations of 24.0% for the year
ended 1997. The increased tax benefit rate was due primarily to
nondeductible merger and restructuring costs during 1997. The 1996
effective tax provision rate on income of 26.7% differs from the statutory
tax rate primarily due to various items including tax exempt interest
income and a settlement of an Internal Revenue Service examination.
SEGMENT REPORTING
HEALTH PLAN SERVICES
Health plan revenues increased by $1.6 billion or 27.6% primarily due to
enrollment increases in the commercial, Medicare and Medicaid lines of
business in the Northeast Division that was acquired in the fourth quarter
of 1997. These acquisitions contributed approximately $977.8 million in
revenues during the year ended December 31, 1998. In addition, Medicaid
enrollment growth in the California division and premium rate increases
for all divisions contributed to the overall increase in revenues for the
health plans.
Revenues generated by the Company's health plan operations
increased $434.3 million or 8.1% for the period ended December 31, 1997
compared to the same period in 1996. 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 in New Jersey, and PACC in Oregon.
Health plan health care costs increased by 33.3% for the year ended
December 31, 1998 as compared to 1997 primarily as a result of enrollment
increases in the Northeast Division, Medicaid enrollment growth in the
California Division, pharmacy cost increases in all divisions and
additional health care costs from the 1998 Charges totaling $104.3
million. The health plans MCR increased from 84.3% in 1997 to 88.0% in
1998 due to higher medical costs particularly in physician and hospital
fee for service costs, increase in pharmacy costs and increased
utilization. Excluding the 1998 Charges, the health plans MCR was 86.6%.
Health plan health care costs increased by 6.8% for the year ended
December 31, 1997 as compared to 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, increased 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 Company's commercial product lines are profitable. Premium rate
increases in the commercial line of products contributed to revenue
increases for the year ended December 31, 1998 as compared to the same
period in the prior year in all divisions of the Company, but were
partially offset by enrollment decreases in commercial HMO markets in
California and the health plans in the western and central states.
Commercial health care costs on a per member per month basis have
increased 8.1% during the year ended December 31, 1998 as compared to the
year ended December 31, 1997.
The Company's Medicare product lines in the California market are
profitable, but are experiencing lower margins than in the prior year. The
Medicare products in the Company's Northeast health plans have shown an
underwriting loss of approximately $32.9 million for the year ended
December 31, 1998. Medicare premium rates and enrollment have increased in
the Northeast markets, but enrollment rates are expected to slow. Medicare
health care costs in the California and Northeast markets continue to
increase faster than premium rates.
Medicaid enrollment in the California division has increased
significantly resulting in a 53.9% increase in member months during the
year ended December 31, 1998, compared to 1997. However, Medicaid premium
rates have decreased in all markets. Medicaid health care costs have
remained steady or decreased on a per member per month basis in all of the
Company's markets except for several of its Western health plans, which
have experienced higher costs due to several high cost claims.
GOVERNMENT CONTRACTS/SPECIALTY SERVICES
Government contracts revenue increased by $40.2 million or 4.2% during the
year ended December 31, 1998 as compared to 1997 primarily due to the full
year effect of the retroactive pricing adjustment in the third quarter of
1997 which reduced 1997 contract prices, as well as from growth in 1998
due to actuarial adjustments in risk share revenue and favorable equitable
adjustments resulting from governmental audits. Government contracts
revenue increased by $40.4 million or 4.4% for the year ended December 31,
1997, compared to 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.
Specialty services revenues increased by $24.5 million or 7.2%
during the year ended December 31, 1998 as compared to 1997. These
increases are primarily the result of higher drug manufacturer rebates,
new business as a result of the FHS Combination, and continued growth in
the Company's managed behavioral health network and bill review cost
containment businesses. Specialty services revenues increased by $25.1
million or 7.9% for the year ended December 31, 1997 as compared to the
same period in 1996 primarily due to the impact of a full year's revenue
from Managed Health Network, Inc. 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. The Company expects continued market pressure to maintain
modest increases in premiums for behavioral health, dental and vision
products.
The government contracts/specialty services MCR increased to 78.5%
for 1998 compared to 77.6% for 1997. Excluding the 1998 Charges, this
ratio was 77.4%. This increase for 1998 is primarily due to (i) the effect
of the 1998 Charges (ii) increased pharmacy costs and higher health care
claim costs on CHAMPUS contracts and (iii) the elimination of the Medicaid
contract administration business which was sold in 1997 which contributed
to revenues with no offsetting health care costs. The government
contracts/specialty services MCR decreased to 77.6% for 1997 compared to
81.2% in 1996. This decrease for 1997 is primarily due to improved health
care and subcontractor performance on the CHAMPUS contracts and due to
adverse reserve development recognized in the fourth quarter of 1996 which
resulted in a higher than usual MCR during 1996.
DISCONTINUED OPERATIONS
WORKERS' COMPENSATION INSURANCE BUSINESS
In December 1997, the Company adopted a formal plan to sell its workers'
compensation segment. In December 1997, the Company estimated the loss on
the disposal of the workers' compensation segment would approximate $99.0
million (net of an income tax benefit of $21.0 million) which included the
anticipated results of operations during the phase-out period from
December 1997 through the date of disposal. On December 10, 1998, the
Company completed the sale of the workers' compensation segment. The
assets sold consisted primarily of investments, premiums and reinsurance
receivables. The selling price was $257 million in cash.
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 "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.
The results were primarily due to insufficient patient volume being
served by the Medical Practices. The 1996 loss was reduced by a gain of
$10.8 million related to the sale of various independent practice
associations.
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.
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.
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. In addition, the Year 2000 problems of the Company's
providers and customers, including governmental entities, can affect the
Company's operations, which are highly dependent upon information
technology for processing claims, determining eligibility and exchanging
information.
PROJECT STATUS-The Year 2000 effort for the Company has the
highest priority of technology projects and has the full support of the
Company's management. The project has dedicated resources with multiple
teams to address its unique systems environment. Uniform project
management techniques have been adopted with overall oversight
responsibility residing with the Company's Chief Technology Officer,
assisted by a special project manager hired by the Company. An
executive management committee is also actively and directly involved
in an oversight capacity in the Company's Year 2000 project and
receives monthly reports from the project manager. In addition, the
project manager regularly meets with the Company's audit committee to
further discuss the Company's Year 2000 issues.
The Company is addressing its Year 2000 issues in several ways.
Selected systems are being 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 remaining purchased software is Year 2000 compliant. The
remaining systems' compliance with Year 2000 will be addressed by internal
technical staff. The Company has engaged IBM Global Services to assist in
the program management of the project. In addition, the Company is in the
process of assessing its third party relationships with respect to
non-information technology assets and services. The Company has also
retained legal consultants to assist in the review of insurance and the
Company's obligations and rights, and IBM's The Wilkerson Group, technical
consultants specializing in health care, to help develop contingency
plans.
The Company has divided its Year 2000 effort into five phases: (1)
Assessment and Strategy, (2) Detailed Analysis and Planning, (3)
Remediation, (4) Testing and Implementation, and (5) Certification. The
Company's geographical and specialty service divisions are conducting a
detailed self-assessment as to their compliance, needs, risks, and
contingency planning, which will then be reviewed and prioritized at the
corporate level. During the fourth quarter of 1998, the Company continued
moving forward in its efforts to address Year 2000 issues, though its
overall progress was less significant due to organizational changes and
restructuring. The Year 2000 project is experiencing increased progress at
the start of 1999. The Company has established the third quarter of 1999
to complete all phases and is endeavoring to accelerate completion ahead
of that time. The following table sets forth the estimated percentage
completion of each of the Company's Year 2000 phases as of February 1999
with respect to its core applications and information technology
infrastructure, and its Year 2000 project overall.
Phase 1 Phase 2 Phase 3 Phase 4 Phase 5
-------------------------------------------------------------------------
Core applications
and IT
infrastructure 100% 94% 56% 15% 0%
Overall 100% 83% 54% 11% 0%
-------------------------------------------------------------------------
THIRD PARTIES-The Company has commenced an inventory of third party
relationships, identifying them and analyzing their strategic importance
to the Company and their Year 2000 readiness. The strategically important
third party relationships identified by the Company are general purpose
utility vendors, care delivery organizations (such as providers), and
customer service vendors. The Company now anticipates completing its risk
assessment for third parties in the second quarter of 1999. There can be
no assurance that the systems of other companies on which the Company
relies will be compliant on a timely basis, or that the failure by a third
party to be compliant would not have a material adverse effect on the
Company.
COSTS-The Company is evaluating on an on-going basis the related
costs to resolve its potential Year 2000 problems. The Company currently
estimates that the total cost for the project will be approximately $42.7
million, excluding the costs to accelerate the replacement of hardware or
software otherwise required to be purchased by the Company. Through 1998,
the Company expended approximately $13.6 million relating to, among other
things, the cost to repair or replace software and related hardware
problems, cost of assessment, analysis and planning and internal and
external communications. The Company estimates that the percentages of its
total expenditures for Year 2000 issues will be approximately as follows:
35% for internal costs, 37% for outside consultants and contractors, 6.5%
for software-related costs, and 21.5% for hardware-related costs. The
Company has established a line-item in its overall operating budget
specifically for Year 2000 costs. The operating subsidiaries for each line
of business of the Company, however, are paying for the costs of
assessment, planning, remediation and testing of Year 2000 issues for
their respective operations.
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 from utilizing numerous
assumptions of future events including the continued availability of
certain resources, third party modification plans and other factors. There
can be no assurances that these estimates will be achieved and actual
results and costs could differ materially from these estimates.
Certain insurance coverages for defense costs associated with Year
2000 litigation have already been secured under the Company's Directors
and Officers Liability Insurance policy and will be re-evaluated upon
renewal of that policy. 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 costs and liabilities under its other insurance
policies. The Company is currently analyzing the availability of such
coverage under other existing and future insurance policies and products.
CONTINGENCY PLANNING. An important part of the Company's Year 2000
project involves identifying worst case scenarios and seeking to develop
contingency plans. Each geographical and specialty services division of
the Company is prioritizing its mission critical business functions in
order to address the most critical issues first in remediation efforts and
to develop alternatives to these critical processes as part of contingency
planning. A mission critical business activity or system is one that
cannot be without an automated or functional system for a period of 21
days without causing significant business impact to the particular line of
business. Among other things, the Company's divisions are assessing
potential negative impacts on a valid member's ability to receive
services, the ability to generate revenue, the need for additional
expenditures, compliance with legal, regulatory or accreditation
requirements, meeting contractual obligations and reimbursing providers,
vendors and agents. The Company is currently projecting to complete the
assessment of its most critical business functions by the end of the first
quarter of 1999 and the documentation and validation of its contingency
plans by the end of the second quarter of 1999. The Company currently
anticipates that its contingency plans will include the use of manual as
well as on-line files of its members to avoid disruption in the
verification of membership and eligibility for the provision of health
care services to its members.
RISKS-The Company is highly dependent upon its own information
technology systems and that of its providers and customers. Failure by the
Company or a third party to correct a material Year 2000 problem could
result in a failure of or an interruption in the Company's business
activities and operations. Such interruptions and failures could
materially and adversely affect the Company's results of operations,
liquidity and financial condition. Due to the general uncertainty inherent
in the Year 2000
problem, resulting in part from the uncertainty of the readiness of third
party providers and customers, the Company is not able at this time to
determine whether the Year 2000 problems will have a material adverse
effect on the Company's results of operations, liquidity or financial
condition. The Company's Year 2000 project is expected to reduce
significantly the Company's level of uncertainty and the possibility of
significant or long-lasting interruptions of the Company's business
operations; however, the Company believes that it is impossible to predict
all of the areas in which material problems may arise.
The Company has initiated formal communications with others with
whom it does significant business to determine their Year 2000 issues. The
Company is currently projecting to complete its assessment of third party
risks by the end of the second quarter of 1999. 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.
Forward-looking statements contained in this Year 2000 section
should be read in connection with the Company's cautionary statements
identifying important risk factors that could cause the Company's actual
results to differ materially from those projected in these forward-looking
statements, which cautionary statements are contained in the Company's
Annual Report on Form 10-K for the year ended December 31, 1998.
LIQUIDITY 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 or payable. Since these amounts are
subject to government audit and negotiation, amounts ultimately collected
may vary from current estimates. Additionally, the timely collection of
such receivables is also impacted by government audit and negotiation.
For the year ended December 31, 1998, cash provided by operating
activities was $100.9 million compared to cash used in operating
activities of $125.9 million in the prior year. This change was due
primarily to the timing of payments of accounts payable and other
liabilities, including payments for merger, restructuring and other costs
associated with the 1998 Charges. Net cash provided by investing
activities was $147.0 million during 1998 as compared to cash used in
investing activities of $134.8 million during 1997. This increase during
1998 was primarily due to cash received from the sale of the workers'
compensation segment. Net cash used in financing activities was $43.3
million in 1998 as compared to cash provided by financing activities of
$332.1 million during the same period in 1997. The decrease in 1998 was
due to the repayment of funds drawn under the Company's Credit Facility
(as defined below), which were partially offset by additional drawings
under the Credit Facility.
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 by Amendments in April, July, November 1998
and March 1999 with the Lenders (the "Amendments"). 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. As of December 31,
1998, the Company was in compliance with the financial covenants of the
Credit Facility, as amended by the Amendments. The Credit
Facility is available for five years, until July 2002, but it may be
extended under certain circumstances for two additional years. The
outstanding balance under the Credit Facility has decreased from $1.265
billion at December 31, 1997 to $1.225 billion at December 31, 1998. As of
March 18, 1999, the amount outstanding under the Credit Facility totaled
$1.175 billion with interest at LIBOR plus 1.50%.
In February 1999, the Company entered into an agreement to sell its
pharmacy benefits management business to an unrelated third party for $70
million in cash. The Company intends to use the net proceeds from the sale
to reduce corporate debt. The Company has initiated a formal plan to
dispose of certain non-core health plans included in the Company's Health
Plan Services segment. It is anticipated that the sales of these health
plans will be completed during the first half of 1999.
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 promissory notes
issued to the California Wellness Foundation in connection with the Health
Net conversion to for-profit status is subordinated to Health Net meeting
tangible equity requirements under applicable California statutes and
regulations. During 1998, the Company contributed $132.1 million to its
subsidiaries to meet risk-based or other capital requirements of the
regulated entities. As of December 31, 1998, the Company's subsidiaries
were in compliance with minimum capital requirements.
Legislation has been or may be enacted in certain states in which
the Company's subsidiaries operate imposing substantially increased
minimum capital and/or statutory deposit requirements for HMOs in such
states. Such statutory deposits may only be drawn upon under limited
circumstances relating to the protection of policyholders. The Company's
HMO subsidiary operating in New Jersey was required to increase its
statutory deposits by approximately $51 million in 1998 pursuant to such
legislation.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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 $3.4 million at December 31, 1998.
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 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 $1,256 million and the related average interest rate is
6.30% (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, 1998.
These cash flows include both expected principal and interest payments
consistent with the terms of the outstanding debt as of December 31, 1998.
(Dollars in thousands) Year 1 Year 2 Year 3 Year 4 Year 5 Beyond Total
- ------------------------------------------------------------------------------------------------------------
Long-term Borrowings
Fixed Rate $ 4,005 $13,049 $ 2,148 $ 2,167 $2,186 $16,196 $ 39,751
Floating Rate 75,830 75,830 75,830 1,262,915 -- -- 1,490,405
- -------------------------------------------------------------------------------------------------------------
Total $79,835 $88,879 $77,978 $1,265,082 $2,186 $16,196 $1,530,156
- -------------------------------------------------------------------------------------------------------------
REPORT OF THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS OF
FOUNDATION HEALTH SYSTEMS, 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 1998, 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.
/s/ Earl B. Fowler
Earl B. Fowler, Chairman
Audit Committee
March 31, 1999
REPORT OF INDEPENDENT AUDITORS
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,
1998 and 1997, and the related consolidated statements of operations,
stockholders' equity, and cash flows for each of the three years in the
period ended December 31, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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, 1998 and 1997, and
the results of their operations and their cash flows for each of the three
years in the period ended December 31, 1998 in conformity with generally
accepted accounting principles.
/s/ Deloitte & Touche LLP
Los Angeles, California
March 31, 1999
CONSOLIDATED BALANCE SHEETS
Foundation Health Systems, Inc.
(Amounts in thousands)
December 31, 1998 1997
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
ASSETS:
Current Assets:
Cash and cash equivalents $ 763,865 $ 559,360
Investments - available for sale 525,082 553,001
Premium receivables, net of allowance for
doubtful accounts (1998 - $28,522; 1997 - $22,900) 230,157 224,383
Amounts receivable under government contracts 321,411 272,060
Deferred taxes 160,446 213,695
Reinsurance and other receivables 147,827 130,875
Other assets 91,096 188,606
Net assets of discontinued operations -- 267,713
- ----------------------------------------------------------------------------------------------------------------------
Total current assets 2,239,884 2,409,693
Property and equipment, net 345,269 427,149
Goodwill and other intangible assets, net 977,910 1,044,727
Other assets 366,478 194,781
- ----------------------------------------------------------------------------------------------------------------------
Total assets $3,929,541 $4,076,350
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Reserves for claims and other settlements $ 961,399 $ 967,815
Unearned premiums 288,683 244,340
Notes payable and capital leases 1,760 3,593
Amounts payable under government contracts 69,792 78,441
Accounts payable and other liabilities 503,797 470,483
- ----------------------------------------------------------------------------------------------------------------------
Total current liabilities 1,825,431 1,764,672
Notes payable and capital leases 1,254,278 1,308,979
Other liabilities 105,790 106,725
- ----------------------------------------------------------------------------------------------------------------------
Total liabilities 3,185,499 3,180,376
- ----------------------------------------------------------------------------------------------------------------------
Commitments and contingencies (Note 12)
Stockholders' equity
Preferred stock ($0.001 par value, 10,000 shares
authorized, none issued and outstanding) -- --
Class A common stock ($0.001 par value, 350,000
shares authorized; issued 1998 - 120,362; 1997 - 114,449) 120 114
Class B non-voting convertible common stock
($0.001 par value, 30,000 shares authorized;
issued and outstanding 1998 - 5,048; 1997 - 10,298) 5 10
Additional paid-in capital 641,820 628,611
Treasury Class A common stock, at cost
(1998 - 3,194 shares; 1997 - 3,194 shares) (95,831) (95,831)
Accumulated other comprehensive loss (7,308) (7,324)
Retained earnings 205,236 370,394
- ----------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 744,042 895,974
- ----------------------------------------------------------------------------------------------------------------------
Total liabilities and stockholders' equity $3,929,541 $4,076,350
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
Foundation Health Systems, Inc.
(Amounts in thousands, except per share data)
Years Ended December 31, 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
REVENUES
Health plan premiums $7,440,981 $5,829,444 $5,395,125
Government contracts 989,409 949,168 908,730
Specialty services 366,645 342,107 316,993
Investment and other income 99,041 114,300 88,392
- ----------------------------------------------------------------------------------------------------------------------
Total revenues 8,896,076 7,235,019 6,709,240
- ----------------------------------------------------------------------------------------------------------------------
EXPENSES
Health plan services 6,547,747 4,912,532 4,598,074
Government contracts health care services 757,047 711,757 706,076
Specialty services 307,675 290,319 289,744
Selling, general and administrative 1,042,556 851,826 859,996
Amortization and depreciation 128,093 98,353 112,916
Interest 92,159 63,555 45,372
Asset impairment, merger, restructuring and other charges 274,953 395,925 44,108
- ----------------------------------------------------------------------------------------------------------------------
Total expenses 9,150,230 7,324,267 6,656,286
- ----------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations before income taxes (254,154) (89,248) 52,954
Income tax provision (benefit) (88,996) (21,418) 14,124
- ----------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations (165,158) (67,830) 38,830
Discontinued operations:
Income (loss) from operations, net of tax -- (30,409) 25,084
Gain (loss) on disposition, net of tax -- (88,845) 20,317
- ----------------------------------------------------------------------------------------------------------------------
Net income (loss) $ (165,158) $ (187,084) $ 84,231
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
Basic and diluted earnings (loss) per share:
Continuing operations $ (1.35) $ (0.55) $ 0.31
Income (loss) from discontinued operations, net of tax -- (0.25) 0.20
Gain (loss) on disposition of discontinued operations, net of tax -- (0.72) 0.16
- ----------------------------------------------------------------------------------------------------------------------
Net $ (1.35) $ (1.52) $ 0.67
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
Weighted average shares outstanding:
Basic 121,974 123,333 124,453
Diluted 121,974 123,333 124,966
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Foundation Health Systems, Inc.
(Amounts in thousands)
Years Ended December 31, 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(165,158) $(187,084) $ 84,231
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Amortization and depreciation 128,093 98,353 112,916
Loss on disposal of United Kingdom operations -- 12,676 --
Loss on early redemption of Senior Notes -- 9,586 --
Impairment of assets 193,966 8,456 14,963
Other changes in net assets of discontinued operations -- (5,395) (78,589)
(Gain) loss on disposition of discontinued operations -- 88,845 (20,317)
(Income) loss from discontinued operations -- 30,409 (25,084)
Other changes 15,041 (7,061) (1,049)
Changes in assets and liabilities, net of effects of acquisitions:
Premium receivable and unearned subscriber premiums 38,569 3,105 35,941
Other assets (75,271) (112,302) (239,013)
Amounts receivable/payable under government contracts (58,000) (16,155) (101,711)
Reserves for claims and other settlements (6,416) (55,450) 165,695
Accounts payable and accrued liabilities 30,043 6,145 45,351
- ----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) operating activities 100,867 (125,872) (6,666)
- ----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Sale or maturity of investments 718,446 597,691 441,550
Purchase of investments (692,305) (406,818) (513,734)
Purchases of property and equipment (147,782) (131,669) (95,751)
Proceeds from notes receivables -- 93,011 825
Other 11,504 6,633 (17,784)
Sale of net assets of discontinued operations 257,100 -- --
Acquisition of businesses, net of cash acquired -- (293,625) 108
- ----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities 146,963 (134,777) (184,786)
- ----------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and employee stock purchases 13,209 21,506 31,756
Proceeds from sale of stock -- -- 95,828
Proceeds from issuance of notes payable and other financing arrangements 155,575 566,240 331,576
Repayment of debt and other non-current liabilities (212,109) (144,341) (4,939)
Stock repurchase -- (111,334) (105,418)
- ----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities (43,325) 332,071 348,803
- ----------------------------------------------------------------------------------------------------------------------
Net increase in cash and cash equivalents 204,505 71,422 157,351
Cash and cash equivalents, beginning of year 559,360 487,938 330,587
- ----------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 763,865 $ 559,360 $ 487,938
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
Foundation Health Systems, Inc.
(Amounts in thousands)
Years Ended December 31, 1998 1997 1996
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL CASH FLOWS DISCLOSURE:
Interest paid $ 85,981 $ 56,056 $ 43,337
Income taxes paid (refunded) (87,799) (3,534) 65,698
- ----------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Capital lease obligations $ 2,530 $ 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 1,197 70,654 --
Profit sharing plan shares issued -- -- 4,558
ACQUISITION OF BUSINESSES:
Fair value of assets acquired -- $849,487 $ 23,650
Liabilities assumed -- 438,448 12,903
Issuance of common stock -- -- 6,631
- ----------------------------------------------------------------------------------------------------------------------
Cash paid for acquisitions -- 411,039 4,116
Less cash acquired in acquisitions -- 117,414 4,224
- ----------------------------------------------------------------------------------------------------------------------
Net cash paid for acquisitions -- $293,625 $ (108)
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOUNDATION HEALTH SYSTEMS, INC.
Common Stock
- ------------------------------------------------------------------------------------------------------- Additional
Class A Class B Paid-in
(Amounts in thousands) Shares Amount Shares Amount Capital
- ----------------------------------------------------------------------------------------------------------------------
Balance at January 1, 1996 97,505 $ 97 25,684 $ 26 $585,292
Comprehensive income:
Net income
Change in unrealized depreciation on
investments, net
- ----------------------------------------------------------------------------------------------------------------------
Total comprehensive income
- ----------------------------------------------------------------------------------------------------------------------
Issuance of common stock 1,468 3 4,386
Retirement of treasury stock, net (878) (2) (704)
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
- ----------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 109,179 109 19,298 19 721,482
Comprehensive income:
Net income
Change in unrealized depreciation on
investments, net
- ----------------------------------------------------------------------------------------------------------------------
Total comprehensive income
- ----------------------------------------------------------------------------------------------------------------------
Redemption of common stock (4,550) (4) (111,330)
Retirement of treasury stock, net (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
- ----------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997 114,449 114 10,298 10 628,611
Comprehensive income:
Net income
Change in unrealized depreciation on
investments, net
- ----------------------------------------------------------------------------------------------------------------------
Total comprehensive income
- ----------------------------------------------------------------------------------------------------------------------
Exercise of stock options including
related tax benefit 497 1 9,584
Conversion of Class B to Class A 5,250 5 (5,250) (5)
Employee stock purchase plan 166 3,625
- ----------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 120,362 $120 5,048 $ 5 $ 641,820
- ----------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOUNDATION HEALTH SYSTEMS, INC.
Common Stock Accumulated
Held in Treasury Other
----------------------- Retained Comprehensive
(Amounts in thousands) Shares Amount Earnings Income (Loss) Total
- ------------------------------------------------------------------------------------------------------------------------
Balance at January 1, 1996 (130) $ (3,047) $ 482,129 $ 3,757 $1,068,254
Comprehensive income:
Net income 84,231 84,231
Change in unrealized depreciation on
investments, net (556) (556)
- ------------------------------------------------------------------------------------------------------------------------
Total comprehensive income 84,231 (556) 83,675
- ------------------------------------------------------------------------------------------------------------------------
Issuance of common stock 4,389
Retirement of treasury stock, net 878 9,588 (8,882) --
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 (4,072) (105,419) (105,419)
- ------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996 (3,324) (98,878) 557,478 3,201 1,183,411
Comprehensive income:
Net income (187,084) (187,084)
Change in unrealized depreciation on
investments, net (10,525) (10,525)
- ------------------------------------------------------------------------------------------------------------------------
Total comprehensive income (187,084) (10,525) (197,609)
- ------------------------------------------------------------------------------------------------------------------------
Redemption of common stock (111,334)
Retirement of treasury stock, net 130 3,047 --
Exercise of stock options including
related tax benefit 19,310
Conversion of Class B to Class A --
Employee stock purchase plan 2,196
- ------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1997 (3,194) (95,831) 370,394 (7,324) 895,974
Comprehensive income:
Net income (165,158) (165,158)
Change in unrealized depreciation on
investments, net 16 16
- ------------------------------------------------------------------------------------------------------------------------
Total comprehensive income (165,158) 16 (165,142)
- ------------------------------------------------------------------------------------------------------------------------
Exercise of stock options including
related tax benefit 9,585
Conversion of Class B to Class A --
Employee stock purchase plan 3,625
- ------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1998 (3,194) $ (95,831) $ 205,236 $ (7,308) $ 744,042
- ------------------------------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998, 1997 AND 1996
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.
The consolidated financial statements give retroactive effect to
the FHS combination which was accounted for as a pooling of interests and
to the sale of the Company's workers' compensation business which was
accounted for as discontinued operations (see Note 3).
CONTINUING OPERATIONS
The Company is an integrated managed care organization which administers
the delivery of managed health care services. Continuing operations
consist of two segments: Health Plan Services and Government
Contracts/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 Health Plan Services segment consists of HMOs organized into
four operational divisions located in the following geographic regions:
the California Division, the Northeast Division, the Central Division, and
the Arizona Division. These health plans are located in Arizona,
California, Colorado, Connecticut, Florida, Idaho, Louisiana, New Jersey,
New Mexico, New York, Ohio, Oklahoma, Oregon, Pennsylvania, Texas, Utah,
Washington, and West Virginia. The Company's health plans provide a wide
range of managed health care services throughout the United States with
approximately 4.2 million at-risk and administrative services only
members. 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.
The Government Contracts/Specialty Services segment administers
large, multi-year managed care government contracts. This segment
subcontracts to affiliated and unrelated third parties the administration
and health care risk of parts of these contracts and currently administers
health care programs covering 1.6 million eligible individuals under the
Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS")
through the TRICARE program. Currently, there are three TRICARE contracts
that cover Alaska, Arkansas, California, Hawaii, Oklahoma, Oregon, Texas,
and Washington, and parts of Arizona, Idaho and Louisiana. This segment
also 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.
DISCONTINUED OPERATIONS
The consolidated financial statements give retroactive effect to the
following (see Note 3):
WORKERS' COMPENSATION INSURANCE SEGMENT - In December 1997, the
Company revised its strategy of maintaining a presence in the workers'
compensation insurance business and adopted a formal plan to discontinue
and sell this segment through divestiture of its workers' compensation
insurance subsidiaries. The Company completed its sale of this segment on
December 10, 1998.
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.
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 3. The accompanying
consolidated financial statements have been restated for the FHS
Combination accounted for as a pooling of interests and for the
discontinued operations as discussed in Note 1.
RECLASSIFICATIONS
Certain amounts in the 1997 and 1996 consolidated financial statements and
notes have been reclassified to conform to the 1998 presentation.
REVENUE RECOGNITION
Health plan services premium revenues include 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.
Government contracts revenues are 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, although the final determination of these
amounts could extend significantly beyond the period during which the
services were provided. 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.
Specialty services revenues are 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
services are 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 health care 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 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
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, hospital per diems, and case rates under which providers
bill the HMOs for each individual service provided to enrollees.
CASH AND CASH EQUIVALENTS
Cash equivalents include all 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, 1998 and 1997, cash and cash equivalent
balances of $65.5 million and $37.9 million, respectively, are restricted
and included in other noncurrent assets.
INVESTMENTS
Investments classified as available for sale are reported at fair value
based on quoted market prices, with unrealized gains and losses excluded
from earnings and reported as other comprehensive income, 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.
Certain debt investments are held by trustees or agencies pursuant
to state regulatory requirements. Such investments which are classified as
held to maturity are carried at an amortized cost of $61.8 million in 1998
and $14.6 million in 1997 and are included in other noncurrent assets (see
Note 11). Market values approximate carrying value at December 31, 1998
and 1997.
REVENUES RELATED TO GOVERNMENT CONTRACTS
Amounts receivable or payable under government contracts are based on
three TRICARE contracts in five regions which include both amounts billed
(net receivables of $75.0 million and $108.8 million at December 31, 1998
and 1997, respectively) and estimates for amounts to be received under
cost and performance incentive provisions, price adjustments and change
orders for services not originally specified in the contracts. Such
estimates are determined based on information available as well as
historical performance. Differences, which may be material, between the
amounts estimated and final amounts collected are recorded in the period
when determined.
Additionally, the reserves for claims and other settlements
include approximately $162.4 million and $204.8 million relating to
health care services provided under these contracts as of December 31,
1998 and 1997, respectively.
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. The useful life for buildings and improvements is
estimated at 40 years, and the useful lives for furniture, equipment and
software range from three to eight years (see Note 5).
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, the recorded cost
and the 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 arise primarily as a result of
various business acquisitions and consist of identifiable intangible
assets acquired and the excess of the cost of the acquisitions over the
tangible and intangible assets acquired (goodwill). Other intangible
assets consist of the value of employer group contracts and provider
networks. Goodwill and other intangible assets are amortized using the
straight-line method over the estimated lives of the related assets listed
below. Fully amortized goodwill and other intangible assets and the
related accumulated amortization are removed from the accounts. The
Company evaluates the carrying value of its goodwill and other intangible
assets periodically based on estimated fair value or undiscounted
operating cash flows whenever significant events or changes occur which
might impair recovery of recorded costs. In such circumstances, recorded
costs of the assets are written down to estimated fair value when recorded
costs, prior to impairment, are higher. Impairment charges for goodwill in
1998 amounted to $30.0 million (see Note 15).
Goodwill and other intangible assets consisted of the following at
December 31, 1998 (dollars in thousands):
Accumulated Amortization
Cost Amortization Net Balance Period
- ---------------------------------------------------------------------------------------------------
Goodwill $1,029,301 $136,088 $ 893,213 27-40 years
Provider network 23,987 9,716 14,271 5-20 years
Employer group contracts 138,323 90,828 47,495 11-22 years
Other 50,540 27,609 22,931 4-15 years
- --------------------------------------------------------------------------------
Total $1,242,151 $264,241 $ 977,910
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Goodwill and other intangible assets consisted of the following at
December 31, 1997 (dollars 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 138,323 80,660 57,663 11-22 years
Other 50,836 28,247 22,589 4-15 years
- --------------------------------------------------------------------------------
Total $1,236,837 $192,110 $1,044,727
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Amortization expense on goodwill and other intangible assets,
excluding the 1998 asset impairment charge of $30.0 million, was $42.3
million, $40.3 million and $45.2 million for the years ended December 31,
1998, 1997 and 1996, respectively.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash equivalents,
investments and premiums receivable. 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 17% and 36% of receivables and 12% and 16%
of premium revenue as of December 31, 1998 and 1997, respectively, and for
the years then ended.
EARNINGS PER SHARE
The Company adopted in 1997, Statement of Financial Accounting Standards
("SFAS") No. 128, "Earnings Per Share." As required by SFAS No. 128, 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 was required. Common stock equivalents
arising from dilutive stock options are computed using the treasury stock
method, and in 1996 amounted to 513,000 shares. Such shares amounting to
207,000 and 488,000 were anti-dilutive in 1998 and 1997, respectively.
Options to purchase an aggregate of 13.4 million, 9.6 million and
4.1 million shares of common stock during 1998, 1997 and 1996,
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
The preparation of financial statements in conformity with generally
accepted accounting principles ("GAAP") 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. Principal areas requiring the use of estimates include
the determination of allowances for doubtful accounts, reserves for claims
and other settlements, reserves for professional and general liabilities,
amounts receivable or payable under government contracts, remaining
reserves for restructuring and other charges, and net realizable values
for assets where impairment charges have been recorded.
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 amounts
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.
The fair value estimates are based on pertinent information
available to management as of December 31, 1998 and 1997. 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
The Financial Accounting Standards Board issued SFAS No. 123, "Accounting
for Stock-Based Compensation" ("SFAS 123"). As permitted under SFAS 123,
the Company has elected 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).
COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted SFAS No. 130 "Reporting
Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for
reporting and presenting comprehensive income and its components.
Comprehensive income includes all changes in stockholders' equity (except
those arising from transactions with stockholders) and includes net income
and net unrealized appreciation (depreciation), after tax, on investments
available for sale.
The adoption of SFAS 130 had no impact on total stockholders'
equity. Accumulated other comprehensive income at December 31, 1998, 1997
and 1996 consisted entirely of unrealized gains (losses), net of income
taxes. The changes in unrealized gains (losses) during each of the three
years ended December 31, 1998 include reclassification adjustments for
gains (losses) realized in net income relating to unrealized gains
(losses) previously recognized. Such reclassification adjustments net of
income tax, are not material to the financial statements.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS
133"), which is required to be adopted in years beginning after June 15,
1999. Management does not anticipate that the adoption of SFAS 133 will
have a significant effect on the financial position of the Company or its
results of operations.
The American Institute of Certified Public Accountants issued
Statement of Position 97-3, "Accounting by Insurance and Other Enterprises
for Insurance-Related Assessments" ("SOP 97-3") in December 1997,
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1") in March 1998 and
Statement of Position 98-5 "Reporting on the Costs of Start-Up Activities"
("SOP 98-5") in April 1998, all of which are effective for the Company's
1999 financial statements. SOP 97-3 provides guidance for determining when
an insurance company or other enterprises should recognize a liability for
guaranty-fund assessments and guidance for measuring the liability. SOP
98-1 requires certain computer software and related costs for internal use
to be capitalized and amortized. SOP 98-5 requires costs of start-up
activities and organization costs to be expensed as incurred. The adoption
of SOP 97-3 and SOP 98-1 is not expected to have a significant effect on
the financial position of the Company or its results of operations. The
initial application of SOP 98-5 in the first quarter of 1999 will result
in a charge of approximately $10 million before income taxes representing
the write-off of existing start-up and organization costs which will be
reported as a cumulative effect of a change in accounting principle.
NOTE 3 - ACQUISITIONS AND DISPOSITIONS
The following summarizes acquisitions, strategic investments, and
dispositions by the Company during the three years ended December 31,
1998.
1998 TRANSACTIONS
WORKERS' COMPENSATION - In December 1997, the Company adopted a formal
plan to sell its workers' compensation segment which was accounted for as
discontinued operations. On December 10, 1998, the Company completed the
sale of the workers' compensation segment. The net assets sold consisted
primarily of investments, premiums and reinsurance receivables, and
reserves for claims. The selling price was $257.1 million in cash.
Total revenues for the workers' compensation segment amounted to
$560.9 million and $518.7 million in 1997 and 1996, respectively. Net
income (loss) amounted to a $30.4 million loss in 1997 and income of $22.2
million in 1996 after applicable income tax benefits of $32.7 million and
expense of $1.2 million, respectively.
In December 1997, the Company estimated that the loss on the
disposal of the workers' compensation segment would approximate $99.0
million (net of income tax benefit of $21.0 million) which included an
anticipated loss from operations during the phase-out period from December
1997 through the date of disposal. The pre-tax loss in 1998 was an
additional $30.2 million. This was offset by an increase in the rate of
the tax benefit of the transaction to 35%. Accordingly, the accompanying
statement of operations for the year ended December 31, 1998 does not
reflect any additional net gain or loss from the disposition.
LOUISIANA, OKLAHOMA, AND TEXAS - In November 1998, the Company
entered into a definitive agreement to sell its health plan subsidiaries
in Louisiana, Oklahoma and Texas. The transaction is subject to various
closing conditions, including the receipt of all necessary regulatory
approvals and certain financial contingencies, and is expected to close in
the first half of 1999. Impairment charges recorded in 1998 include a
write down of the carrying value of these plans to their expected net
realizable value.
CALL CENTER OPERATIONS - In December 1998, the Company sold the
clinical algorithms used in its call center operations for $36.3 million
in cash, net of transaction costs, and recorded a gain of $1.2 million. In
addition, the Company entered into a long-term services agreement with the
buyer to provide such services to its members for a period of ten years.
1997 TRANSACTIONS
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 was
recorded using purchase accounting and the excess of the purchase price
over the fair value of the net liabilities assumed of $19.7 million was
recorded as goodwill. In December 1998, the Company adjusted the carrying
value of the goodwill to its estimated fair value (see Note 15). Advantage
Health remains a party to long-term provider agreements with the seller.
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 purchase price of approximately $43.7 million in
cash. The acquisition was 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
being amortized on a straight-line basis over 40 years.
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 and is being amortized on a
straight-line basis over 40 years. On December 31, 1997, the Company
purchased nonconvertible debentures in the amount of $24 million from
FOHP. On December 31, 1998, the Company
converted approximately $1.2 million of its remaining principal amount of
convertible debentures of FOHP into common stock of FOHP. As a result, the
Company now owns approximately 99.6% of the outstanding equity of FOHP.
The Company is currently in the process of consummating the purchase of
the remaining minority interest in FOHP.
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 straightline basis over 40 years.
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, was being amortized on a straightline basis over 20 years.
As previously discussed, the workers' compensation segment is reported as
discontinued operations and includes CGIC. The remaining goodwill was
reflected in the calculation of the net loss on the sale of this segment.
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) (0.02)
Net (2.39) 0.37
- -----------------------------------------------------------------------------------
1996 TRANSACTIONS
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 in a pooling of interests transaction valued at
approximately $45 million.
PHYSICIAN PRACTICE MANAGEMENT COMPANIES - 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, a $22 million bridge note
receivable and $104 million of Medical Practices' notes payable to the
Company which were assumed by FPA. 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.
This segment was accounted for as discontinued operations in 1996.
Total revenues (unaudited) for the eleven-month period ended November 30,
1996 were $153.5 million (before intercompany eliminations of $129.5
million) with corresponding net losses from operations of $44.7 million
after a tax benefit of $32.4 million. After considering the losses
previously accrued, the net income from discontinued operations was $2.9
million.
NOTE 4 - INVESTMENTS
As of December 31, the amortized cost, gross unrealized holding gains and
losses and fair value of the Company's available-for-sale investments were
as follows (in thousands):
1998
- ------------------------------------------------------------------------------------------------------------------------
Gross Gross
Unrealized Unrealized
Amortized Holding Holding Fair
Cost Gains Losses Value
- ------------------------------------------------------------------------------------------------------------------------
Asset-backed securities $135,819 $2,120 $ (39) $137,900
U.S. government and agencies 59,527 1,385 (48) 60,864
Obligations of states and other political subdivisions 181,464 2,964 (17) 184,411
Corporate debt securities 57,468 1,539 (36) 58,971
Equity securities 27,103 -- (18,762) 8,341
Other securities 74,409 209 (23) 74,595
- ------------------------------------------------------------------------------------------------------------------------
$535,790 $8,217 $(18,925) $525,082
- ------------------------------------------------------------------------------------------------------------------------
1997
- ------------------------------------------------------------------------------------------------------------------------
Gross Gross
Unrealized Unrealized
Amortized Holding Holding Fair
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
Obligations of states and other political subdivisions 184,399 1,742 (144) 185,997
Corporate debt securities 73,521 704 (122) 74,103
Equity securities 27,943 -- (12,871) 15,072
Other securities 67,087 58 -- 67,145
- ------------------------------------------------------------------------------------------------------------------------
$563,731 $4,213 $(14,943) $553,001
- ------------------------------------------------------------------------------------------------------------------------
At December 31, 1998, the contractual maturities of the Company's
available-for-sale investments were as follows (in thousands):
Estimated
Cost Fair Value
- ----------------------------------------------------------------------
Due in one year or less $104,855 $105,144
Due after one year through five years 170,234 173,512
Due after five years through ten years 61,541 63,490
Due after ten years 36,238 36,695
- ----------------------------------------------------------------------
372,868 378,841
Asset-backed securities 135,819 137,900
Equity securities 27,103 8,341
- ----------------------------------------------------------------------
Total available for sale $535,790 $525,082
- ----------------------------------------------------------------------
Proceeds from sales and maturities of investments available for
sale during 1998 were $718.4 million, resulting in realized gains and
losses of $3.6 million and $0.3 million, respectively. Proceeds from sales
and maturities of investments available for sale during 1997 were $597.7
million, resulting in realized gains and losses of $4.7 million and $0.1
million, respectively. Proceeds from sales and maturities of investments
available for sale during 1996 were $441.6 million, resulting in realized
gains and losses of $2.5 million and $0.3 million, respectively.
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment comprised the following at December 31 (amounts in
thousands):
1998 1997
- ---------------------------------------------------------
Land $ 25,195 $ 28,302
Construction in progress 17,824 19,472
Buildings and improvements 157,056 159,571
Furniture, equipment and software 533,897 526,781
- ---------------------------------------------------------
733,972 734,126
Less accumulated depreciation 388,703 306,977
- ---------------------------------------------------------
$345,269 $427,149
- ---------------------------------------------------------
Depreciation expense on property and equipment was $85.8 million,
$58.1 million and $67.7 million for the years ended December 31, 1998,
1997 and 1996. Impairment charges in 1998 amounted to $61.2 million (see
Note 15).
NOTE 6 - NOTES PAYABLE, CAPITAL LEASES AND OTHER FINANCING ARRANGEMENTS
Notes payable, capital leases and other financing arrangements comprised
the following at December 31 (amounts in thousands):
1998 1997
- ------------------------------------------------------------------------------------------------------------------------
Revolving credit facility, variable interest at LIBOR plus 1.50% at
December 31, 1998, unsecured $1,225,000 $1,265,000
Note payable, due December 2000, interest at 7.95%, unsecured 10,500 22,500
Note payable to the California Wellness Foundation, due quarterly with a balloon
payment due 2006, variable interest of 2.5% above 3 year Treasury Note auction
rate, 8.16% and 10.27% at
December 31, 1998 and 1997, respectively, secured by a cash collateral pledge 17,646 18,754
Capital leases and other notes payable 2,892 6,318
- ------------------------------------------------------------------------------------------------------------------------
Total notes payable and capital leases 1,256,038 1,312,572
Less notes payable and capital leases - current portion 1,760 3,593
- ------------------------------------------------------------------------------------------------------------------------
Notes payable and capital leases - noncurrent portion $1,254,278 $1,308,979
- ------------------------------------------------------------------------------------------------------------------------
REVOLVING CREDIT FACILITY
The Company established in July 1997, a $1.5 billion credit facility (the
"Credit Facility") with Bank of America [as Administrative Agent for the
Lenders thereto, as amended in April, July and November 1998 and March
1999 (the "Amendments")]. All previous revolving credit facilities were
terminated and rolled into the Credit Facility. 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 (6.19% and 5.98% at December 31, 1998 and 1997, respectively).
Under the Amendments, the Company's public issuer rating becomes the
exclusive means of setting the facility fee and borrowing rates under the
Credit Facility. In addition, certain covenants including financial
covenants were amended. The Credit Facility is available for five years,
until July 2002, but it may be extended under certain circumstances for
two additional years. The weighted average annual interest rate on the
Company's notes payable and capital leases was approximately 6.30%, 6.24%
and 6.39% for the years ended December 31, 1998, 1997 and 1996. The
maximum amount outstanding under the Credit Facility during 1998 was $1.39
billion.
As of December 31, 1998, the Company was in compliance with the
financial covenants of the Credit Facility, as amended in March 1999.
Scheduled principal repayments on notes payable, capital leases and
other financing arrangements for the next five years are as follows (in
thousands):
1999 $ 1,760
2000 11,282
2001 865
2002 1,225,958
2003 1,060
Thereafter 15,113
- ---------------------------------------------------------
Total notes payable and capital leases $1,256,038
- ---------------------------------------------------------
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 substantially all full-time employees of the Company are
eligible to participate. The stockholders have approved all of these
plans except for the 1998 Stock Option Plan which was adopted by the
Company's Board of Directors.
Under the 1989, 1990, 1991, 1992, 1993, 1997 and 1998 employee
stock option plans and the non-employee director stock option plan, the
Company grants options at prices at or above the fair market value of
the stock on the date of grant. The options carry a maximum term of up
to 10 years and in general vest ratably over three to five years. The
Company has reserved a total of 23.2 million shares of its Class A
Common Stock for issuance under the stock option plans.
Under the 1997 Employee Stock Purchase plans, the Company provides
employees with the opportunity to purchase stock through payroll
deductions. Eligible employees may purchase on a monthly basis 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 month.
Stock option activity and weighted average exercise prices for the
years ended December 31 is presented below:
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------------
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 9,636,831 $29.94 7,051,940 $27.75 6,519,232 $24.44
Granted 8,021,018 14.05 3,912,040 32.18 2,338,031 32.50
Exercised (514,064) 18.64 (830,021) 22.66 (1,237,312) 19.52
Canceled (3,725,312) 30.28 (497,128) 28.61 (568,011) 27.32
- ---------------------------------------------------------------------------------------------------------------------------
Outstanding at December 31 13,418,473 $20.87 9,636,831 $29.94 7,051,940 $27.75
- ---------------------------------------------------------------------------------------------------------------------------
Exercisable at December 31 4,140,362 5,116,533 4,640,576
- ---------------------------------------------------------------------------------------------------------------------------
The following table summarizes the weighted average exercise price
and weighted average remaining contractual life for significant option
groups outstanding at December 31, 1998:
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
- ------------------------------------------------------------------------------------------------------------------------
$9.88 - $12.25 507,338 9.69 years $11.88 10,338 $11.66
12.57 - 12.94 6,570,228 6.07 years 12.94 11,576 12.61
13.50 - 32.50 5,387,657 7.35 years 28.11 3,165,198 27.29
32.79 - 52.81 953,250 6.33 years 39.45 953,250 39.45
- ------------------------------------------------------------------------------------------------------------------------
$9.88 - $52.81 13,418,473 6.74 years $20.87 4,140,362 $30.01
- ------------------------------------------------------------------------------------------------------------------------
The weighted average fair value for options granted during 1998,
1997 and 1996 was $6.00, $9.95 and $10.46, respectively. The fair
values were estimated using the Black-Scholes option-pricing model. The
following weighted average assumptions were used in the fair value
calculation for 1998, 1997 and 1996, respectively: (i) risk-free
interest rate of 4.57%, 5.71% and 6.23%; (ii) expected option lives of
1.9 years, 3.7 years and 2.7 years; (iii) expected volatility of 44.5%,
30.0% and 37.6%; and (iv) no expected dividend yield.
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 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 (amounts in thousands,
except per share data):
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------
Net income (loss) As reported $(165,158) $(187,084) $84,231
Pro forma (171,022) (193,638) 69,226
Basic earnings (loss) per share As reported (1.35) (1.52) 0.67
Pro forma (1.40) (1.57) 0.56
Diluted earnings (loss) per share As reported (1.35) (1.52) 0.67
Pro forma (1.40) (1.56) 0.55
- ---------------------------------------------------------------------------------------------------------------
On December 4, 1998, options representing approximately 1.9
million shares of stock granted during 1990 through 1997 at exercise
prices ranging from $11.70 to $35.25 were exchanged for options
representing approximately 1.4 million shares of stock at an exercise
price of $12.94, which was the fair market value of the underlying
shares at the grant date.
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 California Wellness Foundation (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 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. In addition,
effective June 18, 1998, the Company gave its consent to permit the CWF
to sell (and the CWF sold) 5,250,000 shares of Class B Common Stock to
an unrelated third party. Pursuant to the Company's Certificate of
Incorporation, all of such shares of Class B Common Stock automatically
converted into shares of Class A Common Stock in the hands of such
third parties.
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 Sections 401(k) and 415 of
the Code, with Company contributions based on matching or other formulas.
The Company's expense under the plans totaled $7.4 million, $4.2 million
and $5.1 million for the years ended December 31, 1998, 1997 and 1996,
respectively.
DEFERRED COMPENSATION PLANS
Effective May 1, 1998, the Company adopted a deferred compensation plan
pursuant to which certain management and highly compensated employees
are eligible to defer between 5% and 50% of their regular compensation
and between 5% and 100% of their bonuses, and non-employee Board
members are eligible to defer up to 100% of their directors
compensation. The compensation deferred under such plan is credited
with earnings or losses measured by the rate of return on investments
elected by plan participants. Each plan participant is fully vested in
all deferred compensation and earnings credited to his or her account.
Prior to May 1997, certain members of management, highly
compensated employees and non-employee Board members were permitted to
defer payment of up to 90% of their compensation under a prior deferred
compensation plan (the "Prior Plan"). As part of the FHS Combination,
the Prior 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 Prior Plan
remain unchanged. At December 31, 1998 and 1997, the liability under
these Plans amounted to $27.9 million and $29.3 million, respectively.
The Company's expense under these Plans totaled $6.1 million, $7.8
million and $3.7 million for the years ended December 31, 1998, 1997
and 1996, respectively.
PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS
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 his or
her 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.
POSTRETIREMENT HEALTH AND LIFE PLANS - Certain subsidiaries of
the Company sponsor postretirement defined benefit health care plans
that provide postretirement medical benefits to directors, 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.
On December 31, 1998, the Company adopted SFAS No. 132 "Employers'
Disclosures about Pensions and Other Postretirement Benefits" ("FAS 132"),
which revises employers' disclosures about pension and other
postretirement benefit plans. FAS 132 standardizes the disclosure
requirements. The Company has chosen to disclose the information required
by FAS 132 by aggregating retirement plans into one category and
postretirement plans into another category.
The following table sets forth the plans' funded status and amounts
recognized in the Company's financial statements:
Pension Benefits Other Benefits
------------------------- -------------------------
(in thousands) 1998 1997 1998 1997
- ---------------------------------------------------------------------------------------- -------------------------
Change in benefit obligation:
Benefit obligation, beginning of year $ 7,018 $ 5,540 $1,084 $ 1,142
Service cost 1,463 1,122 -- --
Interest cost 674 417 73 86
Plan amendments 1,501 -- 23 --
Benefits paid (188) -- (138) (43)
Actuarial loss (gain) 3,479 (61) (46) (101)
- ---------------------------------------------------------------------------------------- -------------------------
Projected benefit obligation, end of year $ 13,947 $ 7,018 $ 996 $ 1,084
- ---------------------------------------------------------------------------------------- -------------------------
Change in fair value of plan assets:
Plan assets, beginning of year $ -- -- $-- $--
Actual return on plan assets -- -- -- --
Employer contribution 188 -- 138 43
Benefits paid (188) -- (138) (43)
- ---------------------------------------------------------------------------------------- -------------------------
Plan assets, end of year -- -- -- --
- ---------------------------------------------------------------------------------------- -------------------------
Funded status of plans $(13,947) $(7,018) $ (996) $(1,084)
Unrecognized transition obligation -- -- -- --
Unrecognized prior service cost 5,417 4,209 539 552
Unrecognized (gain)/loss 834 (713) (432) (421)
- ---------------------------------------------------------------------------------------- -------------------------
Net amount recognized $ (7,696) $(3,522) $ (889) $ (953)
- ---------------------------------------------------------------------------------------- -------------------------
Prepaid benefit cost:
Accrued benefit liability $ (9,391) $(4,572) $ (889) $ (953)
Intangible asset 1,695 1,050 -- --
- ---------------------------------------------------------------------------------------- -------------------------
Net amount recognized $ (7,696) $(3,522) $ (889) $ (953)
- ---------------------------------------------------------------------------------------- -------------------------
The components of net periodic benefit costs for the years ended
December 31, 1998, 1997 and 1996 are as follows:
Pension Benefits Other Benefits
-------------------------------------- -------------------------------------
(in thousands) 1998 1997 1996 1998 1997 1996
- -------------------------------------------------------------------------- -------------------------------------
Service cost $1,463 $1,122 $1,066 $-- $-- $ 94
Interest cost 674 418 348 74 86 48
Amortization of unrecognized
transition obligation -- -- -- -- 10 14
Amortization of unrecognized
prior service cost 293 293 293 37 37 22
Amortization of unrecognized
(gain)/loss 37 (17) -- (24) (6) 3
- -------------------------------------------------------------------------- -------------------------------------
2,467 1,816 1,707 87 127 181
Cost of subsidiary plan
curtailment 1,896 -- -- (13) 531 --
- -------------------------------------------------------------------------- -------------------------------------
Net periodic benefit cost $4,363 $1,816 $1,707 $74 $658 $181
- -------------------------------------------------------------------------- -------------------------------------
The projected benefit obligation, accumulated benefit obligation
and plan assets for the pension plan were $13,947,000, $9,391,000, and $0
at December 31, 1998, respectively, and $7,018,000, $4,572,000, and $0 at
December 31, 1997, respectively.
The weighted average annual discount rate assumed was 6.75% and
7.25% for the years ended December 31, 1998 and 1997, respectively, for
both pension benefit plans and other postretirement benefit plans.
Weighted average compensation increases of 6% for the years ended December
31, 1998 and 1997 were assumed for the pension benefit plans.
For measurement purposes, a 6.25% annual rate of increase in the
per capita cost of covered health care benefits was assumed for 1998, and
6.5% was assumed for 1997. These rates were assumed to decrease gradually
to 4.5% in 2006 for 1998 and 2005 for 1997 and remain at that level
thereafter.
The Company has multiple postretirement benefit plans. The Company
acquired PACC effective September 30, 1997, including its frozen
post-retirement benefit plan. The PACC plan is non-contributory. The FHC
plan is contributory by certain participants. The account for the FHC plan
anticipates future cost-sharing changes to the plan consistent with the
Company's expressed intent to increase retiree contributions at the same
rate as the Company's premium increases.
A one-percentage-point change in assumed health care cost trend
rates would have the following effects (amounts in thousands):
1-percentage 1-percentage
point increase point decrease
- --------------------------------------------------------------------
Effect on total of service and
interest cost, 1998 11 (9)
Effect on postretirement benefit
obligation, 12/31/98 102 (84)
- --------------------------------------------------------------------
The Company has no minimum pension liability adjustment to be
included in comprehensive income.
PERFORMANCE BASED ANNUAL BONUS PLAN
In 1998, the Company adopted a Performance-Based Annual Bonus Plan that
qualified under Section 162(m) of the Code (the "162(m) Plan"). Under the
162(m) Plan, if the Company achieved greater than $250 million in
consolidated income from operations before taxes (as determined under GAAP
consistently applied, excluding any nonrecurring or extraordinary
charges), certain executives were potentially eligible to receive cash
bonuses from a pool of $7.5 million 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 $250 million
performance goal for the 162(m) Plan was not met for 1998.
NOTE 10 - INCOME TAXES
Significant components of the provision (benefit) for income taxes
are as follows for the years ended December 31:
(in thousands) 1998 1997 1996
- -----------------------------------------------------------------------------------
Current:
Federal $ 6,346 $(12,894) $13,687
State 3,897 3,183 2,593
- -----------------------------------------------------------------------------------
Total current 10,243 (9,711) 16,280
- -----------------------------------------------------------------------------------
Deferred:
Federal (121,800) (57,150) 7,420
State (7,630) (5,478) 1,123
- -----------------------------------------------------------------------------------
Total deferred (129,430) (62,628) 8,543
- -----------------------------------------------------------------------------------
Total provision (benefit) for income taxes $(119,187) $(72,339) $24,823
- -----------------------------------------------------------------------------------
Income tax expense (benefit) is included in the consolidated
financial statements as follows for the years ended December 31:
(in thousands) 1998 1997 1996
- --------------------------------------------------------------------
Continuing operations $ (88,996) $(21,418) $14,124
Discontinued operations (30,191) (50,921) 10,699
- --------------------------------------------------------------------
Total provision (benefit)
for income taxes $(119,187) $(72,339) $24,823
- --------------------------------------------------------------------
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:
1998 1997 1996
- --------------------------------------------------------------
Statutory federal income tax rate (35)% (35)% 35%
State and local taxes, net
of federal income tax effect (1) (3) 3
Tax exempt interest income (1) (2) (3)
Goodwill amortization 6 6 6
Valuation allowance adjustment -- (2) (5)
Merger transaction costs (3) 8 --
Pooling transactions -- -- (4)
IRS settlement -- -- (4)
Other, net (1) 4 (1)
- --------------------------------------------------------------
Effective income tax rate (35)% (24)% 27%
- --------------------------------------------------------------
Significant components of the Company's deferred tax assets and
liabilities as of December 31 are as follows:
(in thousands) 1998 1997
- -----------------------------------------------------------------------------
DEFERRED TAX ASSETS:
Accrued liabilities $ 91,993 $ 70,547
Accrued compensation and benefits 31,097 28,150
Restructuring reserves 30,462 30,057
Net operating loss carryforwards 190,913 140,862
Other, net 9,283 1,524
- -----------------------------------------------------------------------------
Deferred tax assets
before valuation allowance 353,748 271,140
Valuation allowance (48,452) (57,445)
- -----------------------------------------------------------------------------
Net deferred tax assets $305,296 $213,695
- -----------------------------------------------------------------------------
DEFERRED TAX LIABILITIES:
Depreciable and amortizable property $ 26,077 $ 66,608
Other, net 14 839
- -----------------------------------------------------------------------------
Deferred tax liabilities $ 26,091 $ 67,447
- -----------------------------------------------------------------------------
As of December 31, 1998, the Company had federal net operating loss
carryforwards of approximately $469.0 million of which $111.0 million may
be subject to carryover limitations under Section 382 of the Internal
Revenue 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 2018.
Noncurrent deferred tax assets of $144.9 million at December 31,
1998 are included, net of noncurrent deferred tax liabilities of $26.1
million, in other noncurrent assets. Noncurrent deferred tax liabilities
at December 31, 1997 of $67.4 million are included in other noncurrent
liabilities.
The valuation allowance increase of $56.2 million in 1997
(decreased by $9.0 million in 1998) was 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. In the event that the deferred tax assets
related to this subsidiary are realized, the future tax benefits will be
allocated to reduce the associated goodwill.
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 and in certain cases, maintain minimum investment amounts for
the restricted use of the regulators which as of December 31, 1998 totaled
$127.3 million. Also, under certain government contracts, certain
subsidiaries are required to maintain a current ratio of 1:1.
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.
Management believes that as of December 31, 1998, substantially all of the
Company's health plans and insurance subsidiaries met their respective
regulatory requirements.
NOTE 12 - COMMITMENTS AND CONTINGENCIES
LEGAL PROCEEDINGS
Complaints have been filed in federal and state courts seeking an
unspecified amount of damages on behalf of an alleged class of persons who
purchased shares of common stock, convertible subordinated debentures and
options to purchase common stock of FPA at various times between February
3, 1997 and May 15, 1998. The complaints allege that
the Company and certain former officers violated federal and state
securities laws by misrepresenting and failing to disclose certain
information about a 1996 agreement between the Company and FPA, about
FPA's business and about the Company's 1997 sale of FPA common stock
held by the Company. Management believes these suits are without merit
and intends to vigorously defend the actions.
The Company is involved in various other 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 $35.3 million under this
agreement at December 31, 1998.
Future minimum lease commitments for noncancelable operating leases
at December 31, 1998 are as follows (amounts in thousands):
1999 $ 47,933
2000 41,084
2001 36,161
2002 22,453
2003 12,203
Thereafter 9,582
- ------------------------------------------
Total minimum lease commitments $169,416
- ------------------------------------------
Rent expense totaled $50.3 million, $48.7 million and $46.8 million
in 1998, 1997 and 1996, 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 $1.0 million,
$1.1 million, and $1.0 million in 1998, 1997, and 1996, respectively.
One current director is an officer of IBM which the Company paid $8.0
million for services in 1998, and one current director is also a
director of a temporary staffing company which the Company paid $20.4
million for services in 1998. 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 and $58.7
million in 1997 and 1996, respectively. Such contracted hospital is
also an employer group of the Company from which the Company receives
premium revenues at standard rates.
NOTE 14 - ASSET IMPAIRMENT, MERGER, RESTRUCTURING AND OTHER CHARGES
The following sets forth the principal components of merger, restructuring
and other costs for the year ended December 31:
(amounts in millions) 1998 1997 1996
- -----------------------------------------------------------
Severance and benefit
related costs $ 21.2 $ 61.4 $ 5.4
Provider network
consolidation costs -- 36.2 --
Asset impairment costs -- 44.0 17.4
Real estate lease
termination costs -- 5.2 4.6
- -----------------------------------------------------------
Total restructuring costs 21.2 146.8 27.4
Asset impairments and other
charges related to FPA
Medical Management 84.1 -- --
Asset impairment charges
and other 112.4 -- --
Merger related costs -- 69.6 --
Gem costs -- 57.5 --
Other costs 57.3 122.0 16.7
- -----------------------------------------------------------
Total $275.0 $395.9 $44.1
- -----------------------------------------------------------
1998 CHARGES
On July 19, 1998, FPA Medical Management, Inc. ("FPA") filed for
bankruptcy protection under Chapter 11 of the Federal Bankruptcy Code.
FPA, through its affiliated medical groups, provided services to
approximately 190,000 of the Company's affiliated members in Arizona and
California. FPA has discontinued its medical group operations in these
markets. As a result, the Company is seeking new tenants for, or will
sell, the 13 healthcare facilities it leased to FPA in these markets and
has made other arrangements for provider services to the Company's
affiliated members.
Based on these events and circumstances, management believes that
the likely replacement lease terms from these properties or the net
proceeds from a sale of the facilities will be inadequate
to enable the Company to recover their carrying value. Based on
management's best estimate of recovery for the real estate and the
impairment of notes receivable and other Company assets due to the
FPA bankruptcy filing, the Company recorded charges totaling
approximately $84.1 million which was comprised of $63.0 million
for real estate asset impairments, $10.0 million for a note
receivable impairment and $11.1 million for other items.
During the third quarter ended September 30, 1998, excluding $28.1
million related to the FPA bankruptcy as discussed above, the Company
recorded $146.9 million of restructuring and other charges. These charges
were primarily related to severance costs of $21.2 million related to
staff reduction in selected health plans and the corporate centralization
and consolidation; other special charges totaling $38.7 million which
included the adjustment of amounts due from a hospital system that filed
bankruptcy totaling $18.6 million, premium deficiency reserves for certain
of the Company's non-core health plans totaling $12.0 million and $8.1
million related to other items. Other charges not included in the table
above totaling $87.0 million were mostly related to contractual
adjustments and were primarily included in health care costs within the
consolidated statement of operations. As of December 31, 1998, $40.9
million of the total $175 million has resulted in cash outlays and $27.5
million is expected to require future outlays of cash.
During the fourth quarter ended December 31, 1998, the Company
recorded impairment and other charges totaling $185.9 million. Of this
amount, $112.4 million related to impairment of certain long-lived assets
to be disposed of (see Note 15). The Company recorded $18.6 million of
other charges primarily related to litigation in the normal course of
business. The Company also recorded other charges not included in the
table above totaling $54.9 million primarily related to bad debts,
claims and premium deficiency reserves for certain health plans whose
health care costs exceeded the contractual premiums. These charges are
included as part of health plan services and selling, general and
administrative expenses within the consolidated statement of operations.
1997 CHARGES
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 is substantially completed
as of December 31, 1998, resulted in a restructuring charge of $185.5
million for the quarter ended June 30, 1997.
Severance and benefit related costs include a termination 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 December 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 before a
$2.7 million reduction for the December 1996 Plan (see "1996 Charges").
The plan relates to the integration of the Company's Eastern Division
operations in connection with its acquisition of PHS and FOHP in 1997.
The Company also recorded a credit of $44.7 million for previously
recorded restructuring charges during the fourth quarter of 1997. The
credit consists of $42.0 million for the June 1997 Plan and $2.7 million
for the December 1996 Plan (see "1996 Charges").
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 $146.8 million in net restructuring costs recorded as part
of the 1997 plans, $86.9 million represented cash payments and $42.2
million noncash
activities through December 31, 1998. As of December 31, 1998, $13.8
million is expected to require future outlays of cash and $3.9 million
represents future noncash activities.
MERGER COSTS - In connection with the June 1997 Plan, $69.6 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 $6.4 million of other merger related
costs.
OTHER COSTS - During the quarters ended June 30, and December 31,
1997, $89.7 million and $32.3 million, respectively, in other costs were
recorded. The significant components of the charge included the following:
$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 $14.6 million of other
costs.
These costs are shown as other costs on the Company's consolidated
statement of operations because of their nature. If not for their nature,
approximately $53.8 million would have been recorded as health plan
services, $38.4 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
receive certain regulatory approvals. Gem established a reserve for the
estimated premium deficiency related to these policies for the
intervening period. As of December 31, 1998, this charge was
substantially completed.
1996 CHARGES
During 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 1997 as a result
of the Company's decision to continue to operate certain facilities
originally identified for lease termination.
The Company also recorded $16.7 million of other costs in 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. No further costs are
expected.
NOTE 15 - IMPAIRMENT OF LONG-LIVED ASSETS
During 1998, the Company initiated a formal plan to dispose of certain
Central Division health plans included in the Company's Health Plan
Services segment in accordance with previously disclosed anticipated
divestitures program. It is anticipated that the sales of these health
plans will be completed during the first half of 1999. Pursuant to SFAS
No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of," the Company evaluated the carrying
values of the assets for these health plans and determined that they
exceeded their estimated fair values. Accordingly, in the fourth quarter
of 1998, the Company adjusted the carrying value of these long-lived
assets to their estimated fair value, resulting in a noncash asset
impairment charge of approximately $112.4 million (see Note 14). This
asset impairment charge of $112.4 million consists of $40.3 million for
write-down of furniture, equipment and software, $20.9 million write-down
of buildings and improvements, $30.0 million for write-down of goodwill
and $21.2 million for other impairments and other charges. The fair value
is based on expected net realizable value.
NOTE 16 - SEGMENT INFORMATION
As of December 31, 1998, the Company adopted SFAS No. 131, "Disclosures
About Segments of an Enterprise and Related Information" ("SFAS 131").
SFAS 131 establishes annual and interim reporting standards for an
enterprise's reportable segments and related disclosures about its
products, services, geographic areas and major customers. Under SFAS 131,
reportable segments are to be defined on a basis consistent with reports
used by management to assess performance and allocate resources. The
Company's reportable segments are business units that offer different
products to different classes of customers. The Company has two reportable
segments: Health Plan Services and Government Contracts/Specialty
Services. The Health Plan Services segment provides a comprehensive range
of health care services through HMO and PPO networks. The Government
Contracts/Specialty Services segment administers large, multi-year managed
care government contracts and also offers behavioral, dental, vision, and
pharmaceutical products and services.
The Company evaluates performance and allocates resources based on
profit or loss from operations before income taxes. The accounting
policies of the reportable segments are the same as those described in the
summary of significant accounting policies, except intersegment
transactions are not eliminated.
Presented below are segment data for the three years in the period
ended December 31, 1998 (amounts in thousands):
Government
Contracts/
Health Plan Specialty
1998 Services Services Other Total
- ----------------------------------------------------------------------------------------------------------
Revenues from external sources $7,440,981 $1,356,054 $ -- $8,797,035
Intersegment revenues 16,388 234,380 -- 250,768
Investment and other income 69,760 18,110 16,011 103,881
Interest expense 11,937 805 1,927 14,669
Depreciation and amortization 87,579 15,104 2,074 104,757
Asset impairment costs(i) 147,596 5,200 15,162 167,958
Restructuring, merger and other charges(i) 7,107 -- 19,871 26,978
Segment profit (loss)(i) (154,613) 113,832 (33,161) (73,942)
Segment assets 2,799,484 1,099,368 142,143 4,040,995
- --------------------------------------------------------------------------------------------------------------
(i) Asset impairment, restructuring, merger and other charges exclude $135.9
million of other charges which were primarily included in health plan services
expenses.
Government
Contracts/
Health Plan Specialty
1997 Services Services Other Total
- -----------------------------------------------------------------------------------------------------------
Revenues from external sources $5,829,444 $1,291,275 $ -- $7,120,719
Intersegment revenues 28,487 304,678 -- 333,165
Investment and other income 72,351 19,248 13,906 105,505
Interest expense 8,474 1,443 2,243 12,160
Depreciation and amortization 67,952 9,648 2,019 79,619
Restructuring, merger and other charges 181,165 40,399 315 221,879
Segment profit (loss) 14,864 58,332 655 73,851
Segment assets 3,457,663 527,859 87,052 4,072,574
- -----------------------------------------------------------------------------------------------------------
Government
Contracts/
Health Plan Specialty
1996 Services Services Other Total
- -----------------------------------------------------------------------------------------------------------
Revenues from external sources $5,395,125 $1,225,723 $ -- $6,620,848
Intersegment revenues 20,108 297,378 -- 317,486
Investment and other income 63,211 8,808 11,180 83,199
Interest expense 5,460 1,071 672 7,203
Depreciation and amortization 88,369 9,505 348 98,222
Restructuring, merger and other charges 19,708 4,500 -- 24,208
Segment profit (loss) 45,777 18,052 -- 63,829
- ------------------------------------------------------------------------------------------------------------
The following are reconciliations of reportable segment revenues,
profit or loss, segment assets, and other significant items for the three
years in the period ended December 31, 1998 (amounts in thousands):
1998 1997 1996
- ---------------------------------------------------------------------------------------------------------------------------
Revenues:
Total external revenues $ 8,797,035 $ 7,120,719 $6,620,848
Total intersegment revenues 250,768 333,165 317,486
Eliminations (250,768) (333,165) (317,486)
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 8,797,035 $ 7,120,719 $6,620,848
- ---------------------------------------------------------------------------------------------------------------------------
Profit or Loss:
Total for reportable segments $ (73,942) $ 73,851 $ 63,829
Other (180,212) (163,099) (10,875)
- ---------------------------------------------------------------------------------------------------------------------------
Total income before taxes $ (254,154) $ (89,248) $ 52,954
- ---------------------------------------------------------------------------------------------------------------------------
Assets:
Total for reportable segments $ 4,040,995 $ 4,072,574
Other 2,125,045 1,461,276
Eliminations (2,236,499) (1,457,500)
- ------------------------------------------------------------------------------------------------------
Consolidated $ 3,929,541 $ 4,076,350
- ------------------------------------------------------------------------------------------------------
Investment and other income:
Total for reportable segments $ 103,881 $ 105,505 $ 83,199
Other 28,698 38,815 19,904
Eliminations (33,538) (30,020) (14,711)
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 99,041 $ 114,300 $ 88,392
- ---------------------------------------------------------------------------------------------------------------------------
Interest expense:
Total for reportable segments $ 14,669 $ 12,160 $ 7,203
Other 95,396 62,998 45,407
Eliminations (17,906) (11,603) (7,238)
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 92,159 $ 63,555 $ 45,372
- ---------------------------------------------------------------------------------------------------------------------------
Depreciation and amortization:
Total for reportable segments $ 104,757 $ 79,619 $ 98,222
Other 23,336 18,734 14,694
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 128,093 $ 98,353 $ 112,916
- ---------------------------------------------------------------------------------------------------------------------------
Asset impairment:
Total for reportable segments $ 167,958 $ -- $ --
Other 31,538 44,300 17,400
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 199,496 $ 44,300 $ 17,400
- ---------------------------------------------------------------------------------------------------------------------------
Merger, restructuring and other charges:
Total for reportable segments $ 26,978 $ 221,879 $ 24,208
Other 48,479 129,746 2,500
- ---------------------------------------------------------------------------------------------------------------------------
Consolidated $ 75,457 $ 351,625 $ 26,708
- ---------------------------------------------------------------------------------------------------------------------------
The reconciling amounts to adjust total reportable segment amounts
to consolidated amounts represent amounts from non-reportable operating
segments comprised primarily of corporate units.
NOTE 17 - QUARTERLY INFORMATION (UNAUDITED)
The following restated interim financial information presents the 1998 and
1997 results of operations on a quarterly basis (in thousands, except per
share data) (see Note 1):
March 31 June 30 September 30 December 31
- ---------------------------------------------------------------------------------------------------------------------------
1998:
Total revenues $2,175,374 $2,236,971 $2,213,954 $2,269,777
Income (loss) from continuing operations
before income taxes 43,262 1,529 (127,572) (171,373)
Income (loss) from continuing operations 26,238 956 (88,619) (103,733)
Net income (loss) 26,238 956 (88,619) (103,733)
BASIC AND DILUTED EARNINGS (LOSS) PER SHARE
Continuing operations 0.22 0.01 (0.73) (0.85)
Net 0.22 0.01 (0.73) (0.85)
- ---------------------------------------------------------------------------------------------------------------------------
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 AND DILUTED EARNINGS (LOSS) PER SHARE(I)
Continuing operations 0.38 (1.64) 0.49 0.25
Net 0.47 (1.60) 0.57 (0.94)
- ---------------------------------------------------------------------------------------------------------------------------
(i) The sum of quarterly earnings (loss) per share amounts may not equal the
year-to-date earnings (loss) per share amounts due to transactions affecting the
weighted average number of shares outstanding in each quarter.
NOTE 18 - SUBSEQUENT EVENTS
In February 1999, the Company entered into a definitive agreement to sell
all of the outstanding shares of its pharmacy benefit management
subsidiary, Foundation Health Pharmaceutical Services, Inc., for $70
million in cash. Completion of the transaction is subject to certain
closing conditions, and is expected to close in the first half of 1999.
In March 1999, the Company signed a letter of intent to sell its
Colorado health plan subsidiary. The completion of the transaction will be
subject to reaching a definitive agreement and various conditions,
including the receipt of all necessary regulatory approvals and other
customary closing conditions.
In March 1999, the Company also entered into a definitive agreement
to sell all of the outstanding shares of its New Mexico health plan
subsidiary. Completion of the transaction is subject to various conditions
and certain regulatory approvals.