Back to GetFilings.com
1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER 000-21949
------------------------
PACIFICARE HEALTH SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 95-4591529
(STATE OR OTHER JURISDICTION (IRS EMPLOYER IDENTIFICATION NUMBER)
OF INCORPORATION OR ORGANIZATION)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) (714) 825-5200
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
CLASS A COMMON STOCK, PAR VALUE $0.01
CLASS B COMMON STOCK, PAR VALUE $0.01
------------------------
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of common stock held by non-affiliates of the
Registrant on January 29, 1999 was approximately $2,645,900,000.
The number of shares of Class A Common Stock and Class B Common Stock
outstanding at January 29, 1999 was approximately 14,800,000 and 30,800,000
respectively.
DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT WHERE INCORPORATED
PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY PART III
STATEMENT TO BE FILED BY APRIL 30, 1999
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2
PACIFICARE HEALTH SYSTEMS, INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 1998
PAGE
----
PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 9
Item 3. Legal Proceedings........................................... 9
Item 4. Submission of Matters to a Vote of Security Holders......... 9
PART II
Item 5. Market for the Company's Common Equity and Related
Stockholders Matters........................................ 10
Item 6. Selected Financial Data..................................... 11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 13
Item 7A. Quantitative and Qualitative Disclosures About Market
Risk........................................................ 26
Item 8. Consolidated Financial Statements and Supplementary Data.... 27
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 27
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 27
Item 11. Executive Compensation...................................... 27
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 27
Item 13. Certain Relationships and Related Transactions.............. 27
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K......................................................... 28
i
3
PART I
ITEM 1. BUSINESS
OVERVIEW
PacifiCare Health Systems, Inc. is one of the nation's leading managed health
care services companies, serving approximately 3.5 million members in nine
states and Guam as of December 31, 1998. We operate health maintenance
organizations ("HMOs") and offer HMO related products and services.
HMOS AND HMO RELATED PRODUCTS AND SERVICES. PacifiCare offers HMO and
HMO-related products and services primarily to the Medicare and commercial
markets. An HMO is a health care organization that combines aspects of a health
care insurer with those of a health care provider by arranging for health care
services for its members through a defined provider network at a reduced
deductible or a nominal copayment. Our Medicare programs and commercial plans
are designed to deliver quality health care and customer service to members at
cost-effective prices.
- - SECURE HORIZONS(R). For Medicare beneficiaries, PacifiCare offers health care
services through its Secure Horizons(R) programs. Secure Horizons programs are
the largest Medicare+Choice programs in the United States (as measured by
membership). Secure Horizons membership has grown from approximately 0.3
million members at December 31, 1993 to approximately 1.0 million members at
December 31, 1998.
- - COMMERCIAL. For the commercial employer market, PacifiCare offers a range of
products and benefit plan designs that vary in the amount of member
copayments. These options allow employers flexibility in selecting
cost-effective benefit packages for their employees. PacifiCare's commercial
membership has grown from approximately 0.8 million members at December 31,
1993 to 2.5 million members at December 31, 1998. We also offer a variety of
specialty HMO managed care and HMO related products and services that
employers can purchase as a supplement to our basic commercial plans or as
stand-alone products. These products include behavioral health services, life
and health insurance, dental and vision services and pharmacy benefit
management. We generally provide these specialty services through subcontracts
or referral relationships with other health care providers.
NATURE OF OPERATIONS
PacifiCare's membership at December 31, 1998 was as follows:
SECURE PERCENT
HORIZONS COMMERCIAL TOTAL OF TOTAL
-------- ---------- --------- --------
Arizona........................................ 86,500 107,100 193,600 5.5%
California..................................... 599,800 1,595,000 2,194,800 62.2
Colorado....................................... 58,500 296,600 355,100 10.1
Guam........................................... -- 39,800 39,800 1.1
Nevada......................................... 22,900 38,900 61,800 1.7
Ohio........................................... 16,600 44,000 60,600 1.7
Oklahoma....................................... 26,900 96,300 123,200 3.5
Oregon......................................... 39,300 114,700 154,000 4.4
Texas.......................................... 61,900 127,100 189,000 5.4
Washington..................................... 60,400 94,600 155,000 4.4
------- --------- --------- -----
Total membership............................... 972,800 2,554,100 3,526,900 100.0%
======= ========= ========= =====
SECURE HORIZONS PROGRAMS
GENERAL. We have offered Secure Horizons programs to Medicare beneficiaries
since 1985 through participation in the Medicare risk program with the Health
Care Financing Administration or HCFA. Beginning January 1, 1999, we participate
in the new Medicare+Choice program which replaced the Medicare risk program. To
participate in the Medicare+Choice program, HCFA requires that HMOs be either
federally qualified or meet similar requirements as a competitive medical plan
to be eligible for Medicare+Choice contracts. All of our HMO operations meet
these requirements. Our Medicare+Choice
1
4
contracts entitle us to annual fixed per-member premiums. Under current law, our
premiums are based upon the average cost of providing traditional
fee-for-service Medicare benefits to the Medicare population in each county,
subject to annual limits on the growth of our premiums. Our premium growth is
also limited by an overall cap on the growth of all payments under all
Medicare+Choice contracts. Future premiums from HCFA will be impacted by new
payment methods being developed by HCFA. See Government Regulation -- "HCFA."
Our per-member premium revenue for the Secure Horizons programs usually is, and
will continue to be, more than three times higher than for our commercial plans
primarily because of the higher medical and administrative costs of serving a
Medicare member. As a result of the premium differences, the Secure Horizons
programs accounted for approximately 59 percent of our consolidated premium
revenue for the year ended December 31, 1998, and an even larger percentage of
our operating profit, even though it represented only 28 percent of our total
membership. The Secure Horizons programs are subject to certain risks relative
to our commercial plans, such as higher comparative medical costs, higher levels
of utilization, government and regulatory reporting requirements, the
possibility of reduced or insufficient government reimbursement in the future
and higher marketing and advertising costs associated with selling to
individuals rather than to employer groups. These risks may adversely affect our
operating margins on these programs and our overall profitability. In addition,
each Secure Horizons member enrolls individually in our program, and may
disenroll by providing 30 days notice. We believe that our Secure Horizons
programs have one of the lowest disenrollment rates among Medicare+Choice plans.
HCFA may unilaterally revise our Medicare+Choice contracts based on updated
demographic information relating to the Medicare population and the cost of
providing health care in a particular geographic area. PacifiCare's
Medicare+Choice contracts are automatically renewed every 12 months unless we or
HCFA elect to terminate them. HCFA may also terminate our Medicare+Choice
contracts if we fail to continue to meet compliance and eligibility standards.
Termination of our Medicare+Choice contracts would have an effect on our
financial position, results of operations, cash flows or business prospects. We
have had these contracts in some states for at least 13 years. We have no reason
to believe that these terminations will occur.
COMMERCIAL PROGRAMS
GENERAL. PacifiCare's commercial plans offer a comprehensive range of products
to employer groups, including HMO, Preferred Provider Organization ("PPO") and
Point of Service ("POS") plans. A PPO is a selected group of providers, such as
medical groups, that offers discounted fee-for-service health care. POS plans
combine the features of an HMO with the features of a traditional indemnity
insurance product, allowing members to choose from a network of providers at a
lower cost or from other physicians at a higher deductible or copayment. Our
HMOs also have commercial contracts with the United States Office of Personnel
Management ("OPM") to provide managed health care services to approximately
204,000 members under the Federal Employee Health Benefits Program ("FEHBP") for
federal employees, annuitants and their dependents.
COMMERCIAL RETIREE PRODUCTS. In response to the needs of employers to provide
cost-effective health care coverage to their retired employees who may or may
not be currently entitled to Medicare, we offer the Secure Horizons retiree
product. This product draws on our Medicare expertise by offering provider
networks that are similar to those offered to our Secure Horizons enrollees. We
set our premiums generally based on the same revenue requirements needed to
provide services to Secure Horizons members. The retiree product gives us access
to individuals who, once familiar with our services and delivery system, may
enroll in Secure Horizons programs when they become eligible for Medicare
benefits.
HMO RELATED PRODUCTS AND SERVICES. In addition to our HMO operations, PacifiCare
provides a range of specialty managed care products which supplement our HMO
products and are primarily sold in our commercial programs. These include:
- - Behavioral Health Services. PacifiCare Behavioral Health of California, Inc.
is a California licensed specialized health care service plan that provides
behavioral health care services, including chemical dependency benefit
programs, primarily to our California and other HMO commercial members.
Outside of California, PacifiCare Behavioral Health, Inc. contracts with our
HMOs, other insurers and employers to manage their respective mental health
and chemical dependency benefit programs.
2
5
- - Life and Health Insurance. PacifiCare's life and health insurance
subsidiaries, PacifiCare Life and Health Insurance Company and PacifiCare Life
Assurance Company, offer managed health care insurance products to employer
groups. We integrate these products with our existing HMO products to form
multi-option health benefits programs, including our PPO and POS plans.
Together, our insurance subsidiaries are licensed to operate in 38 states,
including each of the states where our HMOs operate, the District of Columbia,
and Guam.
- - Dental and Vision Services. PacifiCare Dental and Vision is a California
licensed, specialized health care service plan that provides prepaid dental
and optometry benefits directly to individuals and employer groups and
indirectly to our California Secure Horizons and commercial HMO members.
- - Pharmacy Benefit Management. PacifiCare Pharmacy Centers, Inc., dba
Prescription Solutions(R), is one of the industry's largest pharmacy benefit
management companies. Prescription Solutions offers pharmacy benefit
management services to HMOs and employer groups that are self-insured for
prescription drugs. Clients of Prescription Solutions have access to a
pharmacy provider network that features independent and chain pharmacies and a
variety of cost and quality management capabilities. Prescription Solutions
also provides its clients with an array of fully integrated services,
including mail order distribution, an extensive network of retail pharmacies,
claims processing and sophisticated drug utilization reporting.
- - Medicare+Choice Management. Formed to promote our expertise in the Medicare
risk area, Secure Horizons USA, Inc., ("SHUSA") licenses the Secure Horizons
name and provides management services to HMOs and health care delivery systems
that seek participation in the Medicare+Choice program. SHUSA's management
services include, marketing, provider contracting and administrative services.
The fee charged by SHUSA is generally based on a percentage of a licensee's
revenue. SHUSA has agreements in New Mexico with Presbyterian Healthcare
Services, Inc., in New England with Tufts Associated Health Maintenance
Organization, Inc., and in Hawaii with Queens Health Plans. We anticipate that
Queens Health Plan will offer a product similar to Secure Horizons beginning
in the summer of 1999, if HCFA approval is received. We anticipate that with
the repeal of the 50/50 Rule (the requirement that 50 percent of a
Medicare+Choice health plan's enrollment be drawn from commercial contracts)
and the drive to enroll Medicare beneficiaries in HMOs, SHUSA may expand into
new markets by entering into licensing arrangements in a variety of geographic
areas.
BUSINESS STRATEGY
Our current business strategy continues to focus on growing and improving our
operating performance. During 1999 we will seek to increase operating income by:
- - Increasing commercial membership at improved commercial premium prices;
- - Managing health care costs through capitated arrangements with strong provider
organizations that align the interests of our providers with ours and our
members; and
- - Improving our administrative and marketing efficiencies to reduce the
percentage of revenue spent on marketing, general and administrative expenses.
Our ability to increase operating income is subject to various risks and
uncertainties described throughout this document and other documents filed by
PacifiCare with the Securities and Exchange Commission.
We will also focus on improving quality and service in 1999. See Nature of
Operations -- "Quality Improvement." Our goals include:
- - Increasing Medicare and commercial member satisfaction;
- - Improving the quality and service on our basic HMO products;
- - Receiving National Committee for Quality Assurance ("NCQA") accreditation in
Texas, where 1999 is our initial year of application;
- - Maintaining NCQA accreditation in all other states; and
- - Participating in the Coalition for Affordable Quality Healthcare to inform and
educate the public about managed care.
3
6
We are also having continuing discussions with HCFA regarding the
Medicare+Choice changes. See Government Regulation -- "HCFA."
We continue to evaluate opportunities in new and existing geographic markets
that may be available through acquisitions and the development of new products.
We also continuously assess our geographic markets and product lines to
determine if any do not fit within our profitability objectives and current
business strategy. We believe that our ability to offer a comprehensive range of
products and services, combined with long-term relationships with our health
care providers, will enable us to respond effectively to the changing needs of
the health care marketplace.
COMPETITION
The health care industry is highly competitive, both nationally and in
PacifiCare's various markets. Consolidation in the health care industry has
resulted in fewer but larger competitors, including insurance carriers, other
HMOs, employer self-funded programs and PPOs, some of which have substantially
larger enrollments or greater financial resources than PacifiCare. Also, because
of this consolidation, we have become one of the largest HMOs in the country.
Other competitors include hospitals, health care facilities and other health
care providers. These competitors have combined to form their own networks to
contract directly with employer groups, and other prospective customers for the
delivery of health care services. We face competition in all our markets from
national HMOs, insurance carriers, local HMOs, PPOs and other local health care
providers. In this increasingly competitive environment, we believe that we
should continue to provide a comprehensive range of products and services, along
with a strong provider network, to remain competitive. Other factors which give
us some competitive advantages in this environment are:
- - Strong underwriting and pricing practices and staff;
- - Significant market position in certain geographic areas;
- - Financial strength;
- - Experience; and
- - A generally favorable marketplace reputation with providers, members and
employers.
RISK MANAGEMENT
We use underwriting criteria as an integral part of our commercial risk
management efforts. Underwriting is the process by which a health plan assesses
the risk of enrolling employer groups (or individuals) and establishes
appropriate or necessary premium rates. The setting of premium rates directly
affects a health plan's profitability and marketing success. See "Health Care
Costs." We cannot employ underwriting techniques for the Secure Horizons
programs because of regulations that require us to accept nearly all Medicare
beneficiaries. We shift part of our risk of catastrophic losses by maintaining
reinsurance coverage for certain hospital costs incurred in the treatment of
catastrophic illnesses. We require contracting physicians, physician groups and
hospitals to maintain individual malpractice insurance coverage. We also
maintain general liability, property and medical malpractice insurance coverage
in amounts that we believe to be adequate.
HEALTH CARE COSTS AND PROVIDER RELATIONSHIPS
GENERAL. Our profitability and the success of our business strategy depends on
our ability to attract and retain a network of qualified health care providers
in each geographic area we serve. We contract with various providers, including
primary care physicians, specialists, hospitals, and other ancillary service
providers. Our contracts typically have one year terms. However, we have entered
into multiple-year contracts with certain physician groups to ensure the quality
and stability of our provider network.
CAPITATION ARRANGEMENTS. PacifiCare typically contracts with providers on a
capitated basis (a fixed fee per member per month, regardless of the services
provided each member). Capitation payments to providers are often based on a
percentage of the premium we receive; this is especially true for our Secure
Horizons
4
7
contracts. The percentage of premium arrangement causes provider compensation to
fluctuate directly with the amount of premiums we receive. The primary care
physician group influences medical utilization and controls costs through
referrals, hospitalization and other services. With capitation contracts, there
are two possible administration arrangements for network contracting,
utilization management and claims processing:
- - DELEGATED ADMINISTRATION. In the majority of our networks, providers perform
some or all of the administrative functions associated with operating in a
capitated environment. In those situations, we provide support for their
administrative functions to help them achieve greater levels of efficiency and
autonomy while promoting the wellness of our members. We believe one of our
core competencies is our ability to manage delegated provider relationships.
- - DIRECT ADMINISTRATION. Other providers do not have the capability to manage
the administrative functions associated with operating in a capitation
environment. With such providers, we perform the administrative functions on
their behalf. In addition, we work with those providers to assist them in
developing the capability to assume a greater share of the administrative
functions. We continue to develop our own expertise in this area to ensure
that we can continue to build strong provider networks for our members in
existing and new markets where providers may not be capable of performing
these functions.
FEE-FOR-SERVICE ARRANGEMENTS. In some of our markets, some health care providers
are not contracted under capitated arrangements. Non-capitated arrangements may
increase health care costs when utilization is not appropriately managed. To the
extent possible we have renegotiated, or are in the process of renegotiating,
these contracts to move the providers to a capitated payment plan. Our ability
to renegotiate provider contracts in certain markets is limited due to a lack of
provider competition.
INCENTIVE ARRANGEMENTS. Our HMOs share the risk of certain health care costs,
primarily in capitation arrangements. We provide additional incentives to the
physicians or groups for appropriate utilization of hospital inpatient,
outpatient surgery and emergency room services. We may also pay incentives to
providers based on their performance in controlling health care costs while
providing quality health care.
UTILIZATION MANAGEMENT. We operate a utilization review system through which we
review routine hospital admissions and lengths of stay. Our utilization review
committees are composed of several physicians at each physician group. The
committees approve non-emergency hospitalizations in advance of admission.
Together with our medical services utilization staff, the committees carefully
monitor the member's continued stay after admission. Through our medical
services departments, we are actively involved in the utilization review of
chronic and complex cases. These departments also actively monitor catastrophic
cases in the field to ensure that members receive appropriate medical care and
suggest treatment options that may be more appropriate and cost-effective than a
long-term hospital stay.
NETWORK STABILITY. We work closely with our provider partners to ensure the
strength and quality of our network. We track provider stability and solvency on
an ongoing basis to avoid network disruptions for our members and to minimize
our financial risk. Provider assessments focus on solvency indicators, including
liquidity and cash management. Operational information is reviewed periodically
to assess the strength of the provider's financial management. When our
delegated providers require assistance, we provide clinical management tools,
clinical and operational best practices and performance benchmarks.
PacifiCare has multiple year contracts with MedPartners Inc. ("MedPartners").
MedPartners provides services to over 0.1 million members or 10 percent of our
total Medicare membership, and approximately 0.3 million members or 12 percent
of our total commercial membership. In November 1998, MedPartners announced its
intention to sell its physician groups and discontinue its physician practice
management business. We are implementing programs to retain our physician
networks in anticipation of these sales. The loss of physician networks could
have a material effect on our revenues, profitability and business prospects.
PROVIDER INSOLVENCY. When a delegated provider significantly slows or stops
paying claims, we may take on the administrative functions described above. We
may also shift membership to other providers, a step that is taken when a
provider has or is expected to declare bankruptcy. Our 1998 results include
significant provider insolvency costs, primarily related to FPA Medical
Management Inc., ("FPA") who declared bankruptcy in July 1998. See Management's
Discussion and Analysis. Provider insolvency reserves include write-offs of
providers' uncollectable receivables and the estimated cost of unpaid health
care claims covered by our capitation payment.
5
8
In addition to the insolvency costs, shifting membership to other providers
increases our administrative costs and may increase future health care costs.
QUALITY IMPROVEMENT
GENERAL. We believe that providing our members with reasonable access to quality
health care services is an essential ingredient for sustained success. To assure
this, we focus on provider peer review procedures, member quality initiatives
and national industry measures.
PROVIDER PEER REVIEW PROCEDURES. We have established a peer review procedure at
each HMO, governed by a quality improvement committee. The medical director for
each HMO chairs that HMO's committee. Each committee consists of health plan
clinical professionals and physician representatives from the contracted
physician groups of that HMO. When we identify a new physician or physician
group as a potential provider, the quality improvement committee of the HMO
evaluates that provider. The quality assessment includes evaluating the quality
of the providers' medical facilities, medical records, laboratory and x-ray
licenses and its capacity to handle membership demands. We also engage in
ongoing quality reviews of our existing providers to ensure that members are
receiving quality medical care.
MEMBER QUALITY INITIATIVES. To improve the quality of service and clinical
outcomes for our members, we have developed a comprehensive quality improvement
program including:
- - Offering health improvement programs, including several chronic care
management initiatives, preventive health programs, smoking cessation, and
senior health risk assessments;
- - Standardizing and streamlining our specialty provider referral process;
- - Improving our complaint management program to better coordinate problem
resolution; and
- - Monitoring member satisfaction through surveys and internal operational report
cards compared to our current established benchmarks.
In markets where these initiatives have been fully implemented, we have seen
significant improvements in member health outcomes and member satisfaction.
NATIONAL INDUSTRY MEASURES. Our HMOs provide quality and service information
under the Health Plan Employer Data Set ("HEDIS") program. Our membership and
provider quality initiatives described above are designed to improve our scores.
The NCQA is an independent, non-profit organization that reviews and accredits
HMOs. NCQA performs site reviews of standards established for quality
improvement, utilization management, physician credentialing process, a
commitment to members' rights and preventative health services. HMOs that comply
with NCQA's review requirements and quality standards receive NCQA
accreditation. At December 31, 1998, our HMOs in Arizona, California, Colorado,
Nevada, Oklahoma and Oregon (covering approximately 87 percent of our
membership) have received full three year NCQA accreditation. In 1999, we will
complete the NCQA site review in Texas.
MARKETING
Primary marketing responsibility for each of our HMOs and HMO related products
and services resides with a marketing director and direct sales force.
SECURE HORIZONS MARKETING. We market our Secure Horizons programs to Medicare
beneficiaries primarily through direct mail, telemarketing, television, radio
and cooperative advertising with participating medical groups. Most Secure
Horizons members enroll directly in a plan, generally without the involvement of
insurance brokers, except when enrolling as part of an employer group retiree
offering. We anticipate further growth opportunities in the Medicare+Choice
program based on our current marketing strategies, and the growing senior
population in the United States. See "Nature of Operations -- Secure Horizons
Programs" and "Commercial Programs and Medicare+Choice Management."
6
9
COMMERCIAL MARKETING. Commercial marketing is a two-step process where we first
market to employer groups, and then provide information directly to employees
once the employer has selected our HMO. We solicit new employer groups of
various sizes through direct, personal selling efforts and through contacts with
insurance brokers and consultants. Insurance brokers and consultants represent
many employer groups under contract with PacifiCare. These brokers and
consultants work directly with employers to recommend or design employee
benefits packages. We pay insurance brokers commissions over the life of the
contract, while employers generally pay consultants directly. A significant
portion of our commercial membership growth comes from existing employer groups.
With each open enrollment, we identify our specific approach with certain
employer groups to increase our penetration. We use various techniques to
attract commercial members, including work site presentations, direct mail,
medical group tours and local advertising. We also use television, radio,
billboard, and print media to market our programs.
MANAGEMENT INFORMATION SYSTEMS
GENERAL. PacifiCare uses computer-based management information systems for
various purposes, including marketing and sales tracking, underwriting, billing,
claims processing, utilization management, medical cost and utilization
trending, financial and management accounting, reporting, planning, and
analysis. These systems also support member, group and provider service
functions, including on-line access to membership verification, claims and
referral status, and information regarding hospital admissions and lengths of
stay. In addition, these systems support extensive analyses of cost and outcome
data.
We continually enhance and upgrade our computer information systems to preserve
our investment in existing systems, embrace new technologies, improve the cost
effectiveness and quality of our services, and introduce new products. Ongoing
system enhancements include upgrading mainframe computers, enhancing existing
software, implementing purchased software, and migrating to more suitable
software database environments. Simplification, integration, and expansion of
the systems servicing our business is an important component of controlling
health care and administrative expenses and improving member and provider
satisfaction. We have recovery plans in place to mitigate the effect of
information systems outages, if necessary. To the extent that these systems fail
to operate, however our financial results may be adversely affected. We have
also developed a program to address Year 2000 issues. See "Management Discussion
and Analysis -- Forward Looking Information under the Private Securities
Litigation Act of 1995."
GOVERNMENT REGULATION
GENERAL. PacifiCare's HMOs are subject to extensive federal and state regulation
which govern the scope of benefits provided to its members, financial solvency
requirements, quality assurance and utilization review procedures, member
grievance procedures, provider contracts, marketing and advertising. Certain
federal and/or state regulatory agencies also require our HMOs to maintain
restricted cash reserves represented by interest-bearing investments that are
held by trustees or state regulatory agencies. These requirements, which limit
the ability of our subsidiaries to transfer funds to us, may limit our ability
to pay dividends. From time to time, we advance funds, to our subsidiaries to
assist them in satisfying federal or state financial requirements. Our
behavioral health, dental and insurance subsidiaries are also subject to
extensive federal and state regulation.
HCFA. PacifiCare's Secure Horizons programs are subject to regulations by HCFA
and certain state agencies. These agencies govern the benefits provided,
premiums paid, quality assurance procedures, marketing and advertising. See
"Nature of Operations-Secure Horizons Programs." As part of its drive to
encourage Medicare beneficiaries to enroll in private health care plans, the
1997 Balanced Budget Act replaced the Medicare risk contract program with the
Medicare+Choice program. On June 26, 1998, HCFA published interim final
regulations to implement the Medicare+Choice program. The regulations establish
new or expanded requirements for organizations participating in the
Medicare+Choice program. They also establish new or expanded standards for
quality assurance, beneficiary protection, coordinated open enrollment, program
payments, information disclosure and provider participation. While the new
regulations became effective on July 27, 1998, most provisions did not affect us
until we moved to the Medicare+Choice program on January 1, 1999. Compliance
with and implementation of the new Medicare+Choice program regulations will
increase our Medicare administration costs. We continue to evaluate the
operational and financial impact of the new Medicare+Choice program.
7
10
The Balanced Budget Act also revised the formula used by HCFA to calculate
payments to Medicare health plans. It established minimum payment levels,
limiting annual increases and the overall rate of payment growth. Further, the
Balanced Budget Act required HCFA to develop a risk adjusted payment methodology
by March 1, 1999 and to implement the payment process for periods beginning
January 1, 2000. On January 15, 1999, HCFA released the Year 2000 premium
payment rate changes and the risk adjusted payment program. The proposed
methodology relies on retrospective hospital inpatient data to establish risk
premiums for individual Medicare enrollees. The new proposed risk adjusted
program is scheduled to be implemented over a five-year period according to the
following schedule: 10 percent in 2000, 30 percent in 2001, 55 percent in 2002,
80 percent in 2003, and 100 percent in 2004. Phase-in of the risk adjusted
payments will mitigate the near term financial impact on us. However, the
proposed method may have a longer-term adverse impact on us since the proposal
would provide larger premiums to health plans with higher inpatient utilization.
Managed care organizations, such as PacifiCare, have achieved lower inpatient
utilization and have developed programs to avoid unnecessary hospitalizations
through the use of other, less costly sites for providing healthcare. If this
approach is implemented as proposed, we may receive lower premiums because of
our lower inpatient utilization.
We have provided comments to the proposed methodology and are engaged in various
efforts with HCFA and others to modify the proposed process. We believe the
payment formula should not create incentives for increased inpatient utilization
and should not penalize health plans that have developed programs to reduce
unnecessary hospitalizations. However, there can be no assurance that we will be
successful in our efforts to obtain changes to the proposed methodology. The
loss of Medicare contracts or terminations or modification of the HCFA
risk-based Medicare program could have a material effect on our revenue,
profitability and business prospects.
EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974 ("ERISA"). ERISA regulates
insured and self-insured health coverage plans offered by employers, FEHBP, and
federal and state fraud and abuse laws and laws relating to health care
management and delivery. ERISA controls how PacifiCare may do business with
employers covered by ERISA, particularly employers that maintain self-funded
plans. The Department of Labor is engaged in an ongoing ERISA enforcement
program which may result in additional constraints on how ERISA-governed benefit
plans conduct their activities. There have been recent legislative attempts to
limit ERISA's preemptive effect on state laws. If such limitations are enacted,
they might increase our exposure under state law claims that relate to employee
health benefits offered by PacifiCare, and may permit greater state regulation
of other aspects of those business operations.
OPM. PacifiCare's HMOs have commercial contracts with OPM to provide managed
care health services to federal employees, annuitants and their dependents under
the FEHBP. In the normal course of business, OPM audits health plans with which
it contracts, among other things, to verify that the premiums calculated and
charged to OPM are established in compliance with the best price community
rating guidelines established by OPM. OPM typically audits plans once every five
or six years and each audit covers the prior five or six year period. OPM
recently completed audits of the majority of our health plans through 1996.
OPM's initial on-site audits are usually followed by post-audit briefings where
OPM indicates preliminary results. However, final resolution and settlement of
the audits have historically taken a minimum of three to five years. In
connection with the sale of our health plans in New Mexico, Illinois and Utah,
we have agreed to indemnify the buyers for potential OPM liabilities that relate
to the years when FHP owned these plans. PacifiCare intends to negotiate with
OPM on all unresolved matters to attain a mutually satisfactory result.
In addition to claims made by the OPM auditors as part of the normal audit
process, OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In actions under the False Claims Act,
the DOJ may impose trebled damages and a civil penalty of not less than $5,000
nor more than $10,000 for each separate alleged false claim. In November 1997,
we were notified that the 1990-1995 OPM audit of our Oklahoma HMO had been
referred to the DOJ. In January 1999, we preliminarily agreed to settle the
1990-1995 Oklahoma OPM audits for $9 million, an amount which had previously
been reserved.
8
11
TRADEMARKS
PacifiCare owns the federally registered service marks PacifiCare(R) and
SecureHorizons(R). These service marks are material to our business.
EMPLOYEES
At December 31, 1998, PacifiCare had approximately 8,700 full and part-time
employees. None of our employees are presently covered by a collective
bargaining agreement. We consider relations with our employees to be good and
have never experienced any work stoppage.
ITEM 2. PROPERTIES
As of December 31, 1998, PacifiCare leased approximately 220,000 aggregate
square feet of space for its principal corporate headquarters and executive
offices in Santa Ana and Costa Mesa, California. In connection with our
operations, as of December 31, 1998, we leased approximately 2.2 million
aggregate square feet for office space, subsidiary operations, customer service
centers and space for computer facilities. Such space corresponds to areas in
which our HMOs or specialty managed care products and services operate, or where
we have satellite administrative offices. Our leases expire at various dates
from 1999 through 2009.
We own 32 buildings encompassing approximately 914,000 aggregate square feet of
space. Six of the buildings, representing approximately 348,000 aggregate square
feet of space, are primarily used for administrative operations and are located
in California and Guam. The remaining 26 buildings are medical office buildings
leased under a master lease agreement. All 26 medical buildings are being
marketed for sale. We also own nine parcels of vacant land for a total of 46
acres, all of which are being marketed for sale.
Our facilities are in good working condition, are well maintained and are
adequate for our present and currently anticipated needs. We believe that we can
rent additional space at competitive rates when current leases expire, or if we
need additional space.
ITEM 3. LEGAL PROCEEDINGS
As previously reported, a securities class action lawsuit, Madruga et al. v.
PacifiCare Health Systems, Inc., et al. (No. SAVC-97-974 LHM, Central District
of California) was brought on behalf of all purchasers of PacifiCare stock
between February 14, 1997 and November 24, 1997. The complaint accuses
PacifiCare and certain of its officers and directors of making false and
misleading statements about the cost savings and synergies resulting from the
FHP acquisition. Plaintiffs also claim we made fraudulent earnings forecasts for
1997 and 1998 and misstated financial results for the first, second and third
quarters of 1997. The complaint alleges violations of certain sections of the
Securities Exchange Act of 1934. On May 11, 1998, we filed a motion to dismiss
the entire complaint under the Private Securities Litigation Reform Act of 1995.
No discovery has been taken and all discovery has been stayed pending the
resolution of our motion to dismiss. We believe that we have good defenses to
these claims and are contesting the claims vigorously.
We are involved in legal actions in the normal course of business, some of which
seek monetary damages, including claims for punitive damages which are not
covered by insurance. Based on current information and review, including
consultation with our lawyers, we believe any ultimate liability which may arise
from these actions (including all purported class actions) would not materially
affect our consolidated financial position, results of operations, cash flows or
business prospects. However, our evaluation of the likely impact of these
actions could change in the future and an unfavorable outcome, depending upon
the amount and timing, could have a material effect on the results of operations
or cash flows of a future quarter.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the three months
ended December 31, 1998.
9
12
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
PacifiCare's Class A and B common stock are listed on the Nasdaq National Market
under the symbols PHSYA and PHSYB, respectively. The following tables indicate
the high and low reported sale prices per share as furnished by Nasdaq.
CLASS A CLASS B
COMMON COMMON
STOCK STOCK
----------- ------------
HIGH LOW HIGH LOW
---- --- ---- ----
YEAR ENDED DECEMBER 31, 1998
First Quarter......................................... 74 46 3/4 75 5/8 49
Second Quarter........................................ 85 7/8 68 3/8 89 3/8 69 7/16
Third Quarter......................................... 88 7/8 53 3/4 93 1/4 55 5/8
Fourth Quarter........................................ 78 7/8 53 3/4 84 3/4 58 1/4
YEAR ENDED DECEMBER 31, 1997
First Quarter......................................... 85 5/8 68 3/4 89 1/2 72 7/8
Second Quarter........................................ 83 55 1/2 87 3/4 58 3/4
Third Quarter......................................... 71 60 1/4 74 3/4 62
Fourth Quarter........................................ 71 1/4 48 1/8 72 1/2 50 7/8
PacifiCare has never paid cash dividends on its common stock. We expect that we
will not declare dividends on our common stock in the future, retaining all
earnings for business development. Any possible future dividends will depend on
our earnings, financial condition, and regulatory requirements. If we decide to
declare common stock dividends in the future, such dividends may only be made in
shares of PacifiCare's common stock, according to the terms of our credit
facility. See Note 6 of the Notes to Consolidated Financial Statements.
As of December 31, 1998 there were 286 shareholders of record of our Class A
common stock and 335 shareholders of record of our Class B common stock. As of
December 31, 1998 there were approximately 21,000 beneficial holders of our
Class A and B common stock.
10
13
ITEM 6. SELECTED FINANCIAL DATA
In February 1997, PacifiCare's board of directors approved a change in our
fiscal year end from September 30 to December 31. This resulted in a transition
period for October 1, 1996 through December 31, 1996. The following selected
financial and operating data are derived from our audited consolidated financial
statements, or from our unaudited internal financial data. For clarity of
presentation and comparability, the following selected financial and operating
data includes the unaudited period for the twelve months ended December 31,
1996. The selected financial and operating data should be read in conjunction
with "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations," and also with "Item 8. Consolidated Financial Statements
and Supplementary Data."
INCOME STATEMENT DATA
(TRANSITION
(UNAUDITED) PERIOD)
TWELVE THREE
YEAR ENDED YEAR ENDED MONTHS ENDED MONTHS ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1998(1) 1997(2) 1996(3) 1996
------------ ------------ ------------ ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Operating revenue..................... $9,521,482 $8,982,680 $4,807,856 $1,234,875
---------- ---------- ---------- ----------
Expenses:
Health care services................ 8,002,260 7,658,879 4,017,383 1,039,345
Other operating expenses............ 1,166,011 1,125,299 605,546 154,996
Impairment, disposition,
restructuring and other charges... 15,644 154,507 75,840 --
Office of Personnel Management
(credits) charges................. (4,624) -- 25,000 --
---------- ---------- ---------- ----------
Operating income...................... 342,191 43,995 84,087 40,534
Net investment income and interest
expense............................. 43,383 16,129 44,696 12,302
---------- ---------- ---------- ----------
Income before income taxes and
cumulative effect of a change in
accounting principle................ 385,574 60,124 128,783 52,836
Provision for income taxes............ 183,147 81,825 53,052 21,079
---------- ---------- ---------- ----------
Income (loss) before cumulative effect
of a change in accounting
principle........................... 202,427 (21,701) 75,731 31,757
Cumulative effect on prior years of a
change in accounting principle...... -- -- -- --
---------- ---------- ---------- ----------
Net income (loss)..................... $ 202,427 $ (21,701) $ 75,731 $ 31,757
========== ========== ========== ==========
Preferred dividends................... (5,259) (8,792) -- --
---------- ---------- ---------- ----------
Net income (loss) available to common
shareholders........................ $ 197,168 $ (30,493) $ 75,731 $ 31,757
========== ========== ========== ==========
Basic earnings (loss) per share(5).... $ 4.50 $ (0.75) $ 2.43 $ 1.01
========== ========== ========== ==========
Diluted earnings (loss) per
share(5)............................ $ 4.40 $ (0.75) $ 2.39 $ 1.00
========== ========== ========== ==========
OPERATING STATISTICS
Medical care ratio (health care
services as a percent of premium
revenue)
Consolidated........................ 85.0% 85.7% 84.5% 85.1%
Government.......................... 86.5% 85.6% 85.6% 85.5%
Commercial.......................... 82.8% 85.8% 82.8% 84.4%
Marketing, general and administrative
expenses as a percent of operating
revenue............................. 11.4% 11.7% 12.4% 12.4%
Operating income...................... 3.6% 0.5% 1.7% 3.3%
Effective tax rate(6)................. 47.5% 136.1% 41.2% 39.9%
Return on average shareholders'
equity.............................. 9.4% (1.5)% 9.3% 3.9%
YEAR ENDED YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1996(3) 1995 1994(4)
------------- ------------- -------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Operating revenue..................... $4,637,305 $3,731,022 $2,893,252
---------- ---------- ----------
Expenses:
Health care services................ 3,872,747 3,077,135 2,374,258
Other operating expenses............ 585,081 505,644 398,064
Impairment, disposition,
restructuring and other charges... 75,840 -- --
Office of Personnel Management
(credits) charges................. 25,000 -- --
---------- ---------- ----------
Operating income...................... 78,637 148,243 120,930
Net investment income and interest
expense............................. 44,143 33,857 24,538
---------- ---------- ----------
Income before income taxes and
cumulative effect of a change in
accounting principle................ 122,780 182,100 145,468
Provision for income taxes............ 50,827 74,005 60,875
---------- ---------- ----------
Income (loss) before cumulative effect
of a change in accounting
principle........................... 71,953 108,095 84,593
Cumulative effect on prior years of a
change in accounting principle...... -- -- 5,658
---------- ---------- ----------
Net income (loss)..................... $ 71,953 $ 108,095 $ 90,251
========== ========== ==========
Preferred dividends................... -- -- --
---------- ---------- ----------
Net income (loss) available to common
shareholders........................ $ 71,953 $ 108,095 $ 90,251
========== ========== ==========
Basic earnings (loss) per share(5).... $ 2.31 $ 3.69 $ 3.30
========== ========== ==========
Diluted earnings (loss) per
share(5)............................ $ 2.27 $ 3.62 $ 3.22
========== ========== ==========
OPERATING STATISTICS
Medical care ratio (health care
services as a percent of premium
revenue)
Consolidated........................ 84.4% 83.6% 83.1%
Government.......................... 85.4% 84.3% 85.2%
Commercial.......................... 83.1% 82.5% 80.5%
Marketing, general and administrative
expenses as a percent of operating
revenue............................. 12.4% 13.4% 13.6%
Operating income...................... 1.7% 4.0% 4.2%
Effective tax rate(6)................. 41.4% 40.6% 41.8%
Return on average shareholders'
equity.............................. 9.3% 18.9% 24.6%
See footnotes following "Balance Sheet Data."
Continued on next page.
11
14
FINANCIAL STATEMENT CHANGE STATISTICS
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1997(7) 1996(3) 1995 1994(4)
------------ ------------ ------------- ------------- -------------
Operating revenue............................... 6.0% 86.8% 24.3% 29.0% 30.3%
Net income (loss)............................... 1,032.8% (128.7)% (33.4)% 19.8% 44.0%
Earnings (loss) per share....................... 686.7% (131.4)% (37.3)% 12.4% 43.1%
Total assets.................................... (6.7)% 217.8% (6.2)% 25.3% 59.4%
Total shareholders' equity...................... 8.5% 139.8% 12.5% 77.1% 29.5%
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1996 1996 1995 1994
------------ ------------ ------------ ------------- ------------- -------------
MEMBERSHIP DATA
Government (Medicare & Medicaid)..... 972,800 1,001,100 593,600 596,200 541,000 409,100
Commercial........................... 2,554,100 2,790,000 1,451,500 1,434,500 1,216,100 949,100
---------- ---------- ---------- ---------- ---------- ----------
Total membership..................... 3,526,900 3,791,100 2,045,100 2,030,700 1,757,100 1,358,200
========== ========== ========== ========== ========== ==========
Percent change in membership......... (7.0%) 85.4% 0.7% 15.6% 29.4% 23.8%
========== ========== ========== ========== ========== ==========
BALANCE SHEET DATA
(IN THOUSANDS)
Cash and equivalents and marketable
securities......................... $1,600,189 $1,545,382 $ 962,482 $ 700,093 $ 811,525 $ 710,608
Total assets......................... $4,630,944 $4,963,046 $1,561,472 $1,299,462 $1,385,372 $1,105,548
Medical claims and benefits
payable............................ $ 645,300 $ 721,500 $ 282,500 $ 268,000 $ 288,400 $ 302,900
Long-term debt, due after one year... $ 650,006 $1,011,234 $ 1,370 $ 5,183 $ 11,949 $ 101,137
Shareholders' equity................. $2,238,096 $2,062,187 $ 860,102 $ 823,224 $ 732,024 $ 413,358
- ---------------
(1) The 1998 results include $11 million of net pretax charges ($6 million, or
$0.12 diluted loss per share, net of tax) for the disposal of unprofitable
subsidiaries and potential OPM claims. See Notes 4 and 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax credits and charges was 3.7 percent. Return
on average shareholders' equity before pretax credits and charges was 9.4
percent.
(2) The 1997 results include the results of operations for the FHP International
Corporation ("FHP") acquisition from February 14, 1997. The 1997 results
also include $155 million of pretax charges ($129 million or $3.18 diluted
loss per share, net of tax) for the impairment of long-lived assets,
restructuring and certain other charges. See Notes 4 and 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax charges was 2.2 percent. Return on average
shareholders' equity before pretax charges was 6.9 percent.
(3) The 1996 results include $101 million of pretax charges ($62 million or
$1.96 diluted loss per share, net of tax for the fiscal year ended September
30 and $1.97 diluted loss per share for the twelve months ended December 31)
for the impairment of long-lived assets, potential government claims,
dispositions and certain restructuring charges. See Note 9 of the Notes to
Consolidated Financial Statements. Operating income as a percentage of
operating revenue before pretax charges for 1996 was 3.8 percent for the
fiscal year ended September 30 and 3.9 percent for the twelve months ended
December 31. Return on average shareholders' equity before pretax charges
for the fiscal year ended September 30 was 17.2 percent and 17.0 percent for
the twelve months ended December 31.
(4) The fiscal 1994 results reflect the cumulative effect on prior fiscal years
of a change in accounting principle. Diluted earnings per share before
cumulative effect of a change in accounting principle for fiscal 1994 was
$3.02 per share. The cumulative effect of a change in accounting principle
for fiscal 1994 was $0.20 per share. The fiscal 1994 change in net income
was 34.9 percent and the change in earnings per share was 34.2 percent
before cumulative effect of a change in accounting principle.
(5) Earnings per share were restated to conform with the provisions of Statement
of Financial Accounting Standards No. 128, "Earnings per Share." See Note 2
of the Notes to Consolidated Financial Statements.
(6) Effective income tax rate includes the effect of non-deductible pretax
charges.
(7) Changes as compared to the unaudited period for the twelve months ended
December 31, 1996.
12
15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
OVERVIEW. PacifiCare sells HMO and HMO-related products primarily to members in
two groups: the Secure Horizons program for Medicare beneficiaries and the
commercial programs for members of employer groups and individuals. Our
specialty managed care HMOs and HMO related products and services supplement our
commercial programs. These include behavioral health services, life and health
insurance, dental and vision services and pharmacy benefit management.
Events significant to our business that occurred during 1998 included:
- - In November 1997, we announced our intention to sell our Utah HMO and workers'
compensation subsidiaries. We sold our Utah HMO subsidiary on September 30,
1998, and our workers' compensation subsidiary on October 31, 1998.
- - In July 1998, FPA, one of our contracted health care providers, declared
bankruptcy. As a result, we terminated all of our FPA contracts. Significant
provider insolvency reserves were recognized in 1998.
- - In December 1998, we recognized net pretax credits related to preliminary
favorable settlements of OPM claims.
- - During 1998, we borrowed $30 million to repurchase shares of our common stock
and repaid $390 million of the outstanding balance on our credit facility.
- - In January 1998, our board of directors approved a plan to repurchase shares
of our outstanding common stock. During 1998, we repurchased 784,000 shares
for an aggregate amount of $45 million.
- - In June 1998, substantially all of our 10.5 million shares of Series A
preferred stock were converted to 3.9 million shares of Class B common stock.
- - In 1998, with the sale of our Utah HMO, we exited the Medicaid line of
business.
The information below includes both the Medicare and Medicaid line of business
as part of the government program for the 1998 and prior periods presented.
1998 COMPARED WITH 1997
MEMBERSHIP. Total membership decreased seven percent to approximately 3.5
million members at December 31, 1998, from approximately 3.8 million members at
December 31, 1997. The disposition of Utah accounted for 68 percent of the
membership decline. California contributed 23 percent of the decline as we
continue to emphasize renewing commercial contracts with sufficient price
increases to improve gross margin. This decline was consistent with our shift in
strategic focus from rapid growth to improved margin performance. The remaining
nine percent was attributable to our exit of certain rural counties, where
government and commercial premiums were neither sufficient to support the cost
of health care nor our profitability requirements. Government membership
declined three percent year over year. 1998 commercial membership decreased nine
percent from 1997.
PREMIUM REVENUE. During 1998, premium revenue increased five percent from the
prior year, primarily due to six additional weeks of results in 1998 from the
FHP acquisition. Discontinued indemnity and workers' compensation products that
were not meeting profitability expectations partially offset this increase.
Government premiums increased seven percent or $380 million over the prior year
as a result of:
- - Increases of $301 million from the inclusion of six additional weeks of
results in 1998 from the FHP acquisition;
- - Increases of $208 million from premium rate increases that averaged
approximately four percent; offset by
13
16
- - Decreases of $129 million from net membership losses caused by our exit of
certain rural geographic areas and Medicaid lines of business primarily in
California, Utah and Texas.
Commercial premiums increased three percent or $95 million over the prior year.
The net increase was due to:
- - Increases of $231 million from the inclusion of six additional weeks of
results in 1998 from the FHP acquisition;
- - Increases of $130 million from premium rate increases that averaged
approximately five percent; offset by
- - Decreases of $224 million from net membership losses caused by our disposition
of Utah and by our premium rate increases primarily in California, Oklahoma
and Ohio; and
- - Decreases of $42 million, primarily from discontinued indemnity and workers'
compensation products.
OTHER INCOME. Other income increased 134 percent in 1998 from the prior year due
primarily to higher revenues from Prescription Solutions and SHUSA.
CONSOLIDATED MEDICAL CARE RATIO AND PROVIDER INSOLVENCY RESERVES. The 1998
consolidated medical care ratio (health care services as a percentage of premium
revenue) declined by 0.7 percent compared to 1997. The improved commercial
product performance was partially offset by increased provider insolvency
reserves. Excluding these reserves, the consolidated medical care ratio was 84
percent. Provider insolvency reserves were immaterial in 1997 and totaled $95
million in 1998 as follows:
QUARTER GOVERNMENT COMMERCIAL TOTAL
------- ---------- ---------- -----
(IN MILLIONS)
First................................. $ 3 $ 3 $ 6
Second................................ 25 10 35
Third................................. 14 6 20
Fourth................................ 20 14 34
--- --- ---
Total....................... $62 $33 $95
=== === ===
Provider insolvency reserves include the write-offs of the providers'
uncollectable receivables and estimated cost of unpaid health care claims
covered by our capitation payment. Depending on state law, we may be held liable
for unpaid health care claims, which were the responsibility of the capitated
provider.
The majority of the insolvency reserves relate to specific provider
bankruptcies. However, the estimate also includes reserves for potentially
insolvent providers, where conditions indicate claims are not being paid or have
slowed considerably.
FPA declared bankruptcy in July 1998. FPA served approximately 200,000
PacifiCare members in Arizona, California, Nevada and Texas. Reserves for the
FPA bankruptcy totaled $57 million, with $41 million attributable to our Nevada
HMO. Nevada law specifically requires that we pay all health care services
claims for our members including those previously covered by capitation
payments. The second quarter FPA insolvency reserves were partially offset by
unrelated favorable provider settlements. We periodically make changes in
estimates as prior year contract issues are resolved. Increases to FPA reserves
were made in the third and fourth quarters as additional claims information was
presented for payment. The remaining FPA reserves of $16 million primarily
relate to non-contracted claims and receivable write-offs in the remaining HMOs.
Unpaid FPA reserves at December 31, 1998 were approximately $20 million.
Reserves for other providers totaled $38 million. Approximately $17 million of
the reserves recognized in the third and fourth quarters related to another
provider that has ceased paying claims in Nevada and Arizona. This provider has
not declared bankruptcy. The membership was transitioned to other providers
between December 1998 and January 1999. The remaining $21 million is the
estimated liability for smaller bankrupt providers and potentially insolvent
providers, primarily in California. Other provider insolvency reserves unpaid at
December 31, 1998 were approximately $38 million.
GOVERNMENT MEDICAL CARE RATIO. The government medical care ratio for the year
ended December 31, 1998 increased 0.9 percent compared to the prior year because
we recognized $62 million of provider insolvency
14
17
reserves. Government insolvency reserves for FPA were $40 million, with the
majority of these charges recognized in the second and third quarters. Other
provider insolvency reserves of $22 million were recorded, primarily in the
fourth quarter. Higher costs incurred for FPA membership shifted into new
provider relationships were offset by the disposition of Utah. Excluding
government provider insolvency reserves, the government medical care ratio was
85.4 percent.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio includes the
specialty HMOs and indemnity insurance results. The commercial medical care
ratio for the year ended December 31, 1998 decreased due to the following:
- - Improved provider contracts;
- - A favorable pricing environment;
- - Improved performance from the specialty HMOs;
- - Sale of our Utah HMO and workers' compensation subsidiaries; offset by
- - Provider insolvency reserves of $33 million.
Commercial insolvency reserves for FPA totaled $17 million, primarily recognized
in the second and third quarters. Other provider insolvency reserves of $16
million were recognized in the fourth quarter and related to Arizona,
California, Nevada, Texas and Washington. Excluding commercial provider
insolvency reserves, the commercial medical care ratio was 82.0 percent.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating
revenue, marketing, general and administrative expenses decreased slightly
compared to the prior year because we realized the benefits of restructuring and
a full year of synergies as a result of the FHP acquisition.
PRETAX CHARGES. The following is a summary of our net pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/
RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE
----------- ---------------- ---------- ------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
1998
Sale of Utah HMO and workers'
compensation subsidiaries.............. Third $ (15.6) $ (8.2) $(0.18)
OPM charges.............................. Third (3.8) (2.0) (0.04)
------- ------- ------
Total Third (19.4) (10.2) (0.22)
OPM credits.............................. Fourth 8.4 4.4 0.10
------- ------- ------
$ (11.0) $ (5.8) $(0.12)
======= ======= ======
1997
Impairment of long-lived assets:
Utah HMO............................... Fourth $ (62.4) $ (55.7) $(1.37)
Washington health plan................. Fourth (40.5) (36.1) (0.89)
Discontinued workers' compensation
products............................ Fourth (21.1) (18.9) (0.47)
------- ------- ------
Total impairment of long-lived
assets....................... (124.0) (110.7) (2.73)
Loss contracts........................... Fourth (15.4) (9.2) (0.23)
Restructuring............................ Fourth (15.1) (9.0) (0.22)
------- ------- ------
$(154.5) $(128.9) $(3.18)
======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements.
We recognized $11 million of net pretax charges in 1998, primarily for
dispositions of unprofitable operations. Favorable OPM settlements in the fourth
quarter offset increased reserves recognized in the third quarter. In 1997,
Utah, Washington and the workers' compensation subsidiary charges related to the
impairment of goodwill. Restructuring reserves recognized in 1997 were spent in
1998.
15
18
NET INVESTMENT INCOME. Net investment income increased approximately 29 percent
in 1998 compared to the prior year, due primarily to gains on sales of
marketable securities experienced throughout 1998 and more efficient investment
through account consolidation.
INTEREST EXPENSE. Interest expense decreased approximately six percent in 1998
compared to the prior year, due to continued repayment of our credit facility
and declining interest rates. The decrease was partially offset by interest on
the FHP acquisition borrowings that were outstanding for six weeks longer in
1998.
PROVISION FOR INCOME TAXES. The effective income tax rate was 47.5 percent in
1998, compared with 136.1 percent in 1997. The rate declined significantly for
two reasons:
- - The 1997 effective rate was disproportionately high because most of the pretax
charges recorded in the fourth quarter of 1997 were not deductible for tax
purposes. The 1997 effective income tax rate without the effect of the pretax
charges was approximately 50 percent.
- - Nondeductible goodwill amortization was a smaller percentage of taxable
income.
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1998, income
excluding the pretax charges described above was $208 million or $4.52 diluted
earnings per share. For the year ended December 31, 1997, income excluding the
pretax charges was $107 million or $2.43 diluted earnings per share. The
increase in income was due to:
- - Increased other income;
- - Improved commercial medical care ratio;
- - Efficiency in marketing, general and administrative expenses;
- - Increased investment income; and
- - Decreased interest expense.
1997 COMPARED WITH 1996
OVERVIEW. In 1997, we began reporting on calendar year end. We previously
reported a fiscal year ending September 30. This resulted in an audited
transition period from October 1, 1996 to December 31, 1996. For clarity of
presentation and comparability, the discussion of results of operations compares
the year ended December 31, 1997 to the unaudited twelve months ended December
31, 1996, which is referred to as the prior year.
On February 14, 1997, we finalized the FHP acquisition for a total purchase
price, including transaction costs, of $2.2 billion. The FHP acquisition was
accounted for as a purchase. Our consolidated results of operations include the
results of FHP from the date of the FHP acquisition. See Note 4 of the Notes to
Consolidated Financial Statements.
MEMBERSHIP. Total membership increased 85 percent to approximately 3.8 million
members at December 31, 1997, from approximately 2.0 million members at December
31, 1996. The FHP acquisition increased membership by approximately 0.4 million
government members and 1.5 million commercial members.
PREMIUM REVENUE. During 1997, total premium revenue increased 88 percent from
the prior year, a direct result of the FHP acquisition. Six percent of the
increase in premiums resulted from enrollment gains (net of the FHP acquisition)
in both government and commercial programs. The remainder of the premium
increase was mainly attributable to the government programs, along with our
specialty managed care products and services.
16
19
Government premiums in 1997 increased 85 percent compared to the prior year.
Approximately 81 percent of the total increase was due to the FHP acquisition.
The balance of the net increase was due to the following:
- - HCFA premium rate increases effective January 1, 1997 averaging over six
percent;
- - Increased government per member premium rates due to our exit of Medicaid
lines of business in certain markets that had lower average per member
premiums;
- - Lower member paid supplemental premiums in several of our markets; and
- - Enrollment gains in the government programs, net of acquisition membership.
Commercial premiums increased 97 percent compared to the prior year.
Approximately 92 percent of the total increase related to the FHP acquisition.
The remainder of the net increase was due to the following:
- - Enrollment gains in the commercial programs, net of acquisition membership,
accounted for seven percent, while premium rates remained relatively flat;
offset by
- - Decreased membership growth, excluding the FHP acquisition, due to the sale of
our Florida operations and a shift in focus from one of rapid growth to
improved profit margins through the use of a more disciplined product pricing
strategy.
CONSOLIDATED MEDICAL CARE RATIO. The consolidated medical care ratio increased
1.2 percent from the prior year as a result of higher FHP commercial costs. The
government medical care ratio for the year ended December 31, 1997 remained flat
compared to the prior year. This consistency was largely due to FHP, which had
lower cost provider contracts and generally higher reimbursement for Medicare
membership. Additionally, the wind down of the Medicaid business contributed to
slight decreases in the government medical care ratio. These decreases were
partially offset by enhanced prescription drug benefits provided to enrollees
combined with lower member paid supplemental premiums. The increase in the
commercial medical care ratio included higher cost FHP provider contracts,
increased non-capitated physician costs and increased out of area emergency room
costs compared to the prior year. The commercial medical care ratio includes the
specialty managed care health care costs.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES. As a percentage of operating
revenue, marketing, general and administrative expenses decreased slightly
compared to the prior year. These cost savings were caused by lower than
expected staffing, and greater than expected efficiencies resulting from the
integration of the FHP administrative functions and information systems.
17
20
PRETAX CHARGES. The following is a summary of our pretax charges:
QUARTER PRETAX NET OF TAX DILUTED (LOSS)/
RECOGNIZED (CHARGE)/CREDIT AMOUNT EARNINGS PER SHARE
------------ --------------- ---------- ------------------
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
1997
Impairment of long-lived assets:
Utah HMO.............................. Fourth $ (62.4) $ (55.7) $(1.37)
Washington health plan................ Fourth (40.5) (36.1) (0.89)
Discontinued workers' compensation
products........................... Fourth (21.1) (18.9) (0.47)
------- ------- ------
Total impairment of long-lived
assets...................... (124.0) (110.7) (2.73)
Loss contracts.......................... Fourth (15.4) (9.2) (0.23)
Restructuring........................... Fourth (15.1) (9.0) (0.22)
------- ------- ------
$(154.5) $(128.9) $(3.18)
======= ======= ======
1996
OPM charges............................. Second $ (25.0) $ (14.9) $(0.47)
Florida disposition..................... Second (9.3) (8.3) (0.26)
Restructuring........................... Second (7.8) (4.7) (0.15)
------- ------- ------
Total Second (42.1) (27.9) (0.88)
Impairment of long-lived
assets - Florida...................... Third (58.7) (34.1) (1.08)
------- ------- ------
$(100.8) $ (62.0) $(1.96)
======= ======= ======
See Note 9 of the Notes to Consolidated Financial Statements.
We recognized $155 million of pretax charges in 1997, $124 million related to
the write-off of goodwill for our Utah and Washington HMOs and our workers'
compensation subsidiary. In 1996, we recognized Florida goodwill impairment of
$59 million plus $42 million of OPM, restructuring and Florida disposition
losses. Restructuring reserves recognized in 1996 were spent in 1996 and 1997.
NET INVESTMENT INCOME. Net investment income increased approximately $34 million
for the year ended December 31, 1997 compared to the prior year. The increase
was due primarily to additional investments over the prior year because of the
FHP acquisition.
INTEREST EXPENSE. Interest expense increased approximately $63 million for the
year ended December 31, 1997 compared to the prior year. The increase was due to
increased borrowings on our credit facility to finance the FHP acquisition.
PROVISION FOR INCOME TAXES. The majority of the pretax charges were not
deductible for income tax purposes. Therefore, we did not record an income tax
benefit for most of these charges. The magnitude of these charges, combined with
the inability to record a related income tax benefit, resulted in a
disproportionately high effective income tax rate. The effective income tax
rate, without the effect of the pretax charges, was approximately 50 percent, an
increase over the prior year. This increase reflected the additional goodwill
amortization expense attributed to the FHP acquisition.
DILUTED EARNINGS PER SHARE. For the year ended December 31, 1997, income
excluding the pretax charges described above was $107 million or $2.43 diluted
earnings per share. For the year ended December 31, 1996, income excluding
pretax charges was $138 million or $4.36 diluted earnings per share. The
decrease over the prior year was due to increases in the following:
- - Commercial medical care ratio;
- - Amortization expense;
- - Interest expense related to the FHP acquisition; and
- - Increased shares used to calculate earnings per share.
18
21
The convertible preferred stock and potentially dilutive securities (including
stock options) used to calculate diluted loss per share in the fourth quarter
and for 1997 were anti-dilutive. Anti-dilution results when diluted earnings per
share is a greater value than basic earnings per share. The net loss per share
reported in 1997 was due mainly to the pretax charges recognized in the fourth
quarter and the high effective tax rate. Because the actual diluted loss per
share was less than the basic loss per share, the calculation of the diluted
loss per share reported was equal to the basic loss per share.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING CASH FLOWS IN 1998. PacifiCare's consolidated cash, equivalents and
marketable securities increased to $1.6 billion at December 31, 1998 from $1.5
billion at December 31, 1997. The combined increase in cash, equivalents and
marketable securities was directly related to current-year earnings that were
invested. This increase was partially offset by long-term debt principal
payments.
Cash flows from operations increased by $43 million to $456 million in 1998 from
$413 million in 1997 as follows:
- - Increases of $224 million in net income; offset by
- - Decreases of $138 million in impairment, disposition, restructuring and other
charges; and
- - Net decreases of $43 million, primarily related to changes in deferred income
taxes.
INVESTING ACTIVITIES IN 1998. Net cash used in investing activities was $19
million in 1998. Purchases of property, plant and equipment of $42 million were
offset by $41 million of proceeds from the sale of property, plant and
equipment. In 1998, we sold several medical clinics and related personal
property acquired in the FHP acquisition. Disposition proceeds were
approximately $17 million and were offset by increased investments in all
marketable securities totaling $35 million.
INVESTING ACTIVITIES IN 1997. Net cash used by investing activities in 1997 was
$1.0 billion for the acquisition of FHP. The proceeds from the subsidiary
dispositions and property, plant and equipment in 1997 were $80 million. This
was offset by $69 million of property, plant and equipment purchases and $24
million of marketable securities purchases, including restricted.
FINANCING ACTIVITIES IN 1998. Financing activities used $393 million of cash in
1998, primarily because we paid $391 million on our credit facility and other
notes during the year. We also borrowed $30 million under the credit facility to
repurchase shares of our outstanding common stock. As of December 31, 1998, we
had repurchased 784,000 shares of our Class A and Class B common stock for $45
million. Cash received for the issuance of common and treasury stock was $19
million and was partially offset by $6 million of preferred stock dividends and
cash paid on redemption of preferred stock.
FINANCING ACTIVITIES IN 1997. In 1997, our financing activities provided $912
million of cash. Of the $912 million of cash, $885 million was the net effect of
borrowing $1.1 billion under our credit facility to finance the FHP acquisition,
offset by $235 million of credit facility payments in 1997. Proceeds from the
issuance of common stock provided $43 million of cash in 1997 while preferred
stock dividend payments used $9 million of cash. Finally, in the first quarter
of 1997, we made capital contributions totaling $67 million to Talbert Medical
Management Corporation, a former subsidiary of FHP. In the second quarter of
1997, we received $60 million from the sale of the Talbert stock.
OTHER BALANCE SHEET CHANGE EXPLANATIONS
RECEIVABLES, NET. Receivables, net decreased by $30 million from 1997 as
follows:
- - $31 million increase in provider and pharmacy rebate receivables; offset by
- - $33 million decrease in premiums and reinsurance receivables;
- - $19 million decrease for subsidiary dispositions and discontinued indemnity
products; and
- - $9 million decrease in other receivables, including the timing of net
investment income receivable.
19
22
Provider receivables increased by $19 million. In 1998, we reduced the claims
payable backlog from 33 days at the beginning of the year to 30 days at the end
of the year. Accelerated claims payments often result in provider receivables
that are collected through capitation withhold adjustments and other incentive
settlements. Pharmacy rebate receivables increased by $12 million as 1998
prescription drug utilization increased. Premium receivables decreased $26
million. Improved collection efforts in California and Oregon contributed $17
million of the decrease. Outstanding reinsurance receivables declined by $7
million in 1998.
GOODWILL AND INTANGIBLE ASSETS, NET. Goodwill and intangible assets decreased by
$145 million from 1997 as follows:
- - $76 million of goodwill and intangible amortization expense; and
- - $69 million for FHP acquisition exit costs in excess of original estimates.
See Note 4 of Notes to Consolidated Financial Statements.
MEDICAL CLAIMS AND BENEFITS PAYABLE. Medical claims and benefits payable
decreased by $76 million from 1997 as follows:
- - $55 million increase in provider insolvency reserves;
- - $11 million increase in provider capitation liabilities; offset by
- - $92 million decrease in claims payable, both our risk and claims administered
on behalf of providers; and
- - $50 million decrease for dispositions, including Utah's loss contract
reserves, and discontinued indemnity products.
Claims payable decreased as our claims inventory fell by 47 percent from the
December 1997 level.
ACCOUNTS PAYABLE. We experienced a $73 million decline in accounts payable at
December 31, 1998 compared to the prior year. This decrease was planned and is
related to accounts payable systems changes effective January 1, 1999. We made
an effort to decrease accounts payable inventory to ease the number of items
that would be converted in the reorganization of the accounts payable system.
INCOME TAXES. Income taxes changed from a receivable in the prior year to a
payable in 1998. The change was attributable to the income tax provision on the
1998 income, partially offset by the estimated income tax payments made during
the year.
OTHER LIABILITIES. Other liabilities decreased by $47 million from 1997. The
decrease was primarily attributable to the disposition of our workers'
compensation subsidiary.
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor"
for forward looking statements. The Act was designed to encourage companies to
provide prospective information about themselves without fear of litigation. The
prospective information must be identified as forward looking and must be
accompanied by meaningful cautionary statements identifying important factors
that could cause actual results to differ materially from those projected in the
statements. The statements about our plans, strategies, intentions, expectations
and prospects contained throughout the document are based on current
expectations. These statements are forward looking and actual results may differ
materially from those predicted as of the date of this report in the forward
looking statements, which involve risks and uncertainties. In addition, past
financial performance is not necessarily a reliable indicator of future
performance and investors should not use historical performance to anticipate
results or future period trends. Stockholders are also directed to the other
risks discussed in other documents filed by PacifiCare with the Securities and
Exchange Commission.
MEMBERSHIP. We expect government membership to increase three to four percent by
December 31, 1999 compared to 1998. For 1999, we plan to expand our membership
retention programs and target group retiree members in our existing markets. We
expect membership increases from enhanced drug benefits and new enrollment as
competitors exit markets in which Secure Horizons will remain. We also
anticipate offering our
20
23
Secure Horizon programs in new geographic markets. These increases will be
partially offset by the exit of rural markets.
We expect commercial membership for the year ended December 31, 1999 to increase
four to five percent compared to 1998. The majority of the growth will be in
California where we plan to:
- - Strengthen our sales fundamentals;
- - Streamline and enhance our product mix;
- - Improve underwriting practices;
- - Increase the efficiency and effectiveness of our distribution channels; and
- - Maximize membership renewal growth opportunities.
MEMBERSHIP RISK FACTORS. An unforeseen loss of profitable membership could have
an effect on our financial position, results of operations and cash flows.
Factors that could contribute to the loss of membership include:
- - Failure to obtain new customers or retain existing customers;
- - The effect of premium increases;
- - Reductions in work force by existing customers;
- - Negative publicity and news coverage;
- - Inability of marketing and sales plans to attract new customers; or
- - The loss of key executives or key employees.
PREMIUMS. Effective January 1, 1999, we received Medicare premium rate increases
of two percent. We expect to continue to improve our gross margin by renewing
commercial employer contracts with price increases. The price increases in our
commercial product line are expected to range from zero to 12 percent depending
upon competition, employer size, benefit design, geographic market and other
factors. We plan to exit markets where our premium revenue does not cover the
cost of providing care. While we expect to increase commercial premiums without
experiencing significant membership losses, we may have to alter our pricing
strategy to avoid such losses. Reduction in Medicare premiums, such as the
proposed risk adjusted payment program, could have an effect on our financial
position as every one percent change in premium represents approximately $56
million dollars of annual revenue. To counteract this impact, we would need to
generate additional revenue or cost savings of approximately $56 per person per
year. We could achieve this by increasing member premiums, office copayments,
hospital deductibles or prescription copayments.
OTHER INCOME. In 1999, we expect other income to be lower than 1998 because of
lower SHUSA revenues. In addition, 1999 rental income is expected to be less
than 1998 because several medical clinics were sold in the last half of 1998.
HEALTH CARE PROVIDER CONTRACTS. Our profitability depends, in part, on our
ability to control health care costs while providing quality care. Maintaining
capitated arrangements with solvent providers, especially in the Nevada market,
will be important to improve 1999 results of operations. Securing cost-effective
contracts with existing and new physician groups has become more difficult due
to increased competition. Failure to secure cost-effective contracts may result
in a loss in membership or a higher medical care ratio. Additionally, the
negotiation of provider contracts, generally as of January 1, may be impacted by
unfavorable state and federal legislation and regulation discussed below. Our
inability to contract with providers, loss of contracts with providers,
inability of providers to provide adequate care, or insolvency of providers
could materially affect us. Based on current information, we believe that our
contingency plans are adequate to cover the potential impact of contract
terminations.
We continue to evaluate the financial stability of our providers, focusing on
providers with significant membership in key geographic areas and providers that
have been identified as a poor risk. We are also seeking to improve our
performance in 1999 by taking steps to minimize our risk associated with
providers. We
21
24
believe that the December 31, 1998 provider insolvency reserves are adequate to
cover the cost of health care services rendered through 1998 that may not be
paid by insolvent or unstable providers. We believe our contingency plans for
shifting the membership or assisting the provider to obtain and maintain
stability are adequate to cover the risk. We have and may continue to incur
additional costs as a result of entering into new contracts, especially for FPA
and potentially for MedPartners. The effect of these risks and the need for
additional provider reserves could have a material effect on our results of
operations or cash flows. We believe, however, that such reserves would not
materially affect our consolidated financial position.
GOVERNMENT MEDICAL CARE RATIO. We expect the government medical care ratio in
1999 to remain flat or slightly increase from 1998. Price increases,
recontracting efforts in Nevada and California, and our exit of rural markets in
four states plus the disposition of Utah are expected to improve the medical
care ratio. However, these improvements will be offset by changes in premium
mix, increases in capitation, decreases in non-capitated contracts and changes
in pharmacy costs. The implementation of the Medicare reform provisions that
limit program spending and allow the entry of new providers and plans that could
increase competitive pressures could also offset any increases. See Legislation
and Regulation below.
COMMERCIAL MEDICAL CARE RATIO. In 1999, we expect the commercial medical care
ratio to be consistent with, or improve slightly from 1998. We expect
improvements as we continue to renegotiate provider contracts and implement
capitated contracts and price increases. Moreover, higher premium rates offered
during renewal periods should continue to result in the elimination of some high
medical care ratio business. We also plan to exit markets where price increases
do not cover the cost of health care.
MEDICAL CARE RISK FACTORS. The government and commercial medical care ratio
expectations discussed above could be affected by various uncertainties,
including:
- - Medical and prescription drug costs that have been rising faster than premium
increases;
- - Increases in utilization and costs of medical services;
- - The effect of actions by competitors or groups of providers; or
- - Termination of provider contracts, provider insolvency or renegotiation of
such contracts at less cost-effective rates or terms of payment.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1999, marketing, general and
administrative expenses as a percentage of operating revenue are expected to
decline slightly because we expect to realize additional efficiencies from the
FHP acquisition. Additionally, California's final conversion from FHP
information systems to PacifiCare systems was completed in June 1998, so 1999
will be the first full year of integrated operations. The need for additional
advertising, marketing, administrative, or management information systems
expenditures, and the inability of marketing and sales plans to attract new
customers, could impact marketing, general and administrative expenses.
1999 DISPOSITIONS. Dispositions could be announced as we continue to evaluate
whether certain subsidiaries or products fit within our core business strategy.
There can be no assurance that the dispositions will not result in additional
pretax charges. We believe, however, that any disposition operating losses would
not materially affect our consolidated financial position. However, the
disposition losses could have a material effect on the results of operations or
cash flows of a future period.
IMPAIRMENT OF LONG-LIVED ASSETS. As circumstances warrant, we determine whether
the realizable value of long-lived assets such as property and equipment, real
estate and goodwill, are less than the value carried on the consolidated
financial statements. We believe that any impairment of such long-lived assets
would not materially affect our consolidated financial position. However,
impairment charges, if material, could have an effect on our results of
operations or cash flows of a future period.
EFFECTIVE TAX RATE. We expect the 1999 effective tax rate to decrease three to
five percent from 1998. Consistent with our integration strategies, we will
complete a legal reorganization of the Company and its subsidiaries. The full
year benefit of certain tax strategies is expected to be realized in 1999. The
tax strategies are expected to reduce the effective tax rate by one to three
percent. The 1998 effective tax rate includes more
22
25
than one percent related to the dispositions of Utah and the workers'
compensation subsidiary that is not expected to recur. Finally, the impact of
nondeductible goodwill on the effective tax rate is expected to decrease by
approximately one percent because 1999 pretax income is projected to increase
from 1998. There can be no assurance that these tax strategies will be
successful or that pre-tax income will increase as projected, for various
reasons set forth in this document and other documents we have filed with the
Securities and Exchange Commission. As a result, there can be no assurance our
tax rate will decrease in 1999.
YEAR 2000. PacifiCare has implemented a Year 2000 compliance program to address
all major computing information systems, including core application systems,
networks, desktop systems, infrastructure, and critical information supply
chains. In addition to all major information systems, we are verifying that all
date fields and calculations used in critical business processes will be Year
2000 compliant. Under the program we are also addressing our external Year 2000
related risks which arise from the year 2000 readiness of third parties with
whom we maintain ongoing relationships.
The Year 2000 Compliance Program includes the following five phases which are
listed in logical order, but are being addressed concurrently as appropriate:
- - Awareness and Communication. There is an on-going company-wide communication
and education effort to ensure that there is a clear understanding of the Year
2000 problem and associated risks.
- - Inventory and Assessment. A company-wide inventory has been taken of all
computer information systems and their components, including infrastructure
equipment and hardware, software applications and information supply chains.
Through the inventory, we are assessing the business risks and Year 2000
compliance status of each system component. For components which are not Year
2000 compliant, a remediation plan is being developed which includes the Year
2000 remediation action required and the time and resources needed to
accomplish it. Priorities are also established based on the relative business
critical function of each system component.
- - Remediation. Based upon the remediation plan developed as part of the
assessment phase, appropriate action is taken to correct or remediate the Year
2000 issues associated with the system and its components to render it Year
2000 compliant. Except for the FHP core system, we expect all affected system
components to be remediated by March 31, 1999. Contingency plans for critical
business functions will be completed as part of this phase as well.
- - Testing and Certification. Following the completion of the remediation phase,
each computer information system and its components are tested. Actual test
results are reviewed and compared to expected test results based on accepted
industry standards and methodologies. If the actual test results are
acceptable, the system and/or component are certified as Year 2000 compliant.
Testing and certification for the PacifiCare core computer system are 90
percent complete. We expect all other systems (except the FHP core system) to
be tested and certified as Year 2000 compliant by June 30, 1999. Testing and
certification of the FHP core computer systems will occur during 1999 and are
expected to be completed in December 1999.
- - Implementation and Close. There will be a final review and confirmation that
the remediated systems and components have met all Year 2000 compliance
objectives.
When our Year 2000 compliance program was first established in 1996, we focused
on existing systems and did not contemplate acquisitions of other companies.
These core computing programs became Year 2000 compliant in 1998. The total cost
to make our pre-FHP core computing information systems Year 2000 compliant was
approximately $6 million.
With the February 1997 FHP acquisition, we originally expected the Arizona,
Colorado, Nevada and Ohio HMOs to shift to our pre-FHP core computing
information systems throughout 1998 and 1999 as providers moved to delegated
capitation arrangements. In the second quarter of 1998, we determined that while
we had successfully moved some of these providers to capitation arrangements,
the provider networks did not have sufficient infrastructure to administer the
claims under a fully delegated capitated arrangement. We concluded that our HMOs
in these states will need to continue to administer claims on behalf of
providers.
23
26
Because the claims-based FHP core systems function more effectively than our
core computing systems for claims administration on behalf of non-delegated
delivery systems, we decided to maintain the FHP systems. As a result, the scope
of our Year 2000 compliance activities was expanded to include the FHP computer
system. We have a detailed project plan for modifying the FHP systems to be Year
2000 compliant in phases during 1999. Based upon an outside consultant's
recommendations and internal analysis, we estimate that the total cost to make
the FHP systems Year 2000 compliant ranges from $5 to $9 million.
Our Year 2000 compliance program establishes priorities to achieve resolution of
the most business critical issues first. The program incorporates a regular
reporting process which helps us to monitor and measure our progress toward Year
2000 compliance against defined goals. Through this reporting process we can
focus resources on, any Year 2000 issue, as necessary.
We are also contacting our third party vendors, provider and hospital networks,
business partners, contractors, and service providers, including HCFA, to assess
their Year 2000 level of readiness. In some cases, we are seeking reasonable
assurances with respect to Year 2000 compliance. Our priority is to assess the
readiness of our providers with delegated responsibility and other third parties
with which we electronically exchange data or interact. Because we do not
control the products, services, or systems of our providers, vendors or
customers, we cannot ensure their Year 2000 compliance. We anticipate developing
business process contingency plans by June 1999 for external sources that appear
to be at risk.
If HCFA or certain other third parties experience significant failures or
erroneous applications, it could have a material effect on our financial
position, results of operations, cash flows, and business prospects. For
example, if HCFA, OPM, or our commercial customers experience system failures,
this could cause a delay in our receipt of payments from these customers,
including a significant HCFA payment due in January 2000. Therefore, we are
developing a cash receipts contingency plan.
We also could have difficulties processing Medicare and other claims within
required periods, collecting accurate claims and other data on which we depend,
or enrolling new members. In preparing contingency plans, we are developing risk
reduction strategies. However, some risks may be beyond our control. Further,
our marketing, general and administrative expenses could increase due to Year
2000 compliance expenditures.
OPM. OPM generally audits health plans which it contracts with every five or six
years. We currently have several audits with OPM that are in various stages. We
intend to negotiate with OPM and DOJ on all unresolved matters to attain a
mutually satisfactory result. We cannot assure that the negotiations will
conclude satisfactorily, or that there will not be additional liability upon
completion of the audits. However, we believe that any ultimate liability in
excess of amounts already set aside would not materially affect our consolidated
financial position. The liability, if material, could have an effect on results
of operations or cash flows of a future quarter. See Note 10 of the Notes to
Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES. Additional borrowings on our credit facility
may be necessary if HCFA and OPM are unable to remit funds as a result of Year
2000 compliance issues. We also may continue to repurchase shares of outstanding
stock, resulting in reduced cash or additional borrowings on our credit
facility. Additional borrowings on the credit facility may make us subject to
earlier mandatory reduction of the outstanding balance. Additionally, should the
credit facility be drawn, our ability to repay amounts owed under the credit
facility and other long-term debt will depend on cash receipts from our
subsidiaries' restricted cash reserves. These subsidiary receipts represent fees
for management services rendered by us to the subsidiaries and cash dividends by
the subsidiaries to us. Nearly all of the subsidiaries are subject to HMO
regulations or insurance regulations and may be subject to substantial
supervision by one or more HMO or insurance regulators. Subsidiaries subject to
regulation must meet or exceed various capital standards imposed by HMO or
insurance regulations, which may from time to time impact the amount of funds
the subsidiaries can pay to us. Additionally, from time to time, we advance
funds in the form of a loan or capital contribution to our subsidiaries to
assist them in satisfying federal or state financial requirements. If a federal
or state regulator has concerns about the financial position of a subsidiary, a
regulator may impose additional financial requirements on the subsidiary, which
may require additional funding from us. We believe that
24
27
cash flows from operations, existing cash equivalents, marketable securities and
other financing sources will be sufficient to meet the requirements of the
credit facility.
RISK-BASED CAPITAL REQUIREMENTS. The National Association of Insurance
Commissioners has proposed that states adopt risk-based capital standards that,
if implemented, would require new minimum capitalization limits for health care
coverage provided by HMOs and other risk-bearing health care entities. To date,
Washington is the only state where we have HMO operations that has adopted these
standards. We do not expect this legislation to have a material impact on our
consolidated financial position in the near future if other states where we
operate HMOs adopt these standards. Further, we believe that cash flows from
operations or, if necessary, borrowings under our credit facility, will be
sufficient to fund any additional risk-based capital requirements.
LEGISLATION AND REGULATION. Federal and state legislation and regulation
significantly affect us. During 1998 our government programs, the majority of
which are Medicare business, contribute 59 percent of our revenue and an even
greater percentage of our profits. Changes in state and federal legislation or
regulation could cause actual results to differ materially from the expected
results discussed throughout this document. Changes that could effect us
materially include:
- - Limitations on premium levels;
- - Increases in minimum capital and reserves and other financial viability
requirements;
- - Prohibition or limitation of capitated arrangements or provider financial
incentives;
- - Benefit mandates (including mandatory length of stay and emergency room
coverage, many of which become effective in 1999);
- - Limitations on the ability to manage care and utilization of any willing
provider and direct access laws; and
- - Adoption on the federal and/or state level of a "Patients Bill of Rights."
Legislation and regulation could also include adverse actions of governmental
payors, including reduced Medicare premiums; discontinuance of or limitation on
governmentally funded programs; recovery by governmental payors of previously
paid amounts; the inability to increase premiums or prospective or retroactive
reductions to premium rates for federal employees; and adverse regulatory
actions.
OTHER. Results may differ materially from those projected, forecast, estimated
and budgeted by us due to adverse results in ongoing audits or in other reviews
conducted by federal or state agencies or health care purchasing cooperatives;
adverse results in significant litigation matters; and changes in interest rates
causing changes in interest expense and net investment income.
25
28
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
The principal objective of our asset/liability management activities is to
maximize net investment income, while maintaining levels of interest rate risk
and facilitating our funding needs. Our net investment income and interest
expense are subject to the risk of interest rate fluctuations. To mitigate the
impact of fluctuations in interest rates, we manage the structure of the
maturity of debt, investments and derivatives. We use derivative financial
instruments, primarily interest rate swaps, with maturities that correlate to
balance sheet financial instruments. This results in a modification of existing
interest rates to levels deemed appropriate based on our current economic
outlook.
The following table provides information about our financial instruments that
are sensitive to changes in interest rates as of December 31, 1998. For
investment securities and debt obligations, the table presents principal cash
flows and related weighted average interest rates by expected maturity dates.
Additionally, we have assumed our marketable securities and marketable
securities-restricted, comprised primarily of U.S. government, state, municipal,
and corporate debt securities, are similar enough to aggregate into fixed rate
and variable rate securities for presentation purposes. For interest rate swaps,
the table presents notional amounts by contractual maturity dates. Notional
amounts are used to calculate the contractual cash flows to be exchanged under
the contract.
1999 2000 2001 2002 2003 BEYOND TOTAL FAIR VALUE
-------- -------- ------- -------- -------- -------- -------- ----------
(DOLLARS IN THOUSANDS)
Assets:<