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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002
Commission file number 1-14177
COBALT CORPORATION
(Exact name of registrant as specified in its charter)
Wisconsin 39-1931212
(State of incorporation) (I.R.S. Employer Identification No.)
401 West Michigan Street
Milwaukee, Wisconsin 53203-2896
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (414) 226-6900
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
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Common Stock, no par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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 Registration 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. [_]
As of February 28, 2003, there were outstanding 41,817,960 shares of Common
Stock.
The aggregate market value of the shares of our common stock held by
non-affiliates of the registrant on June 28, 2002 was $220,040,131 assuming
solely for purposes of this calculation that the Wisconsin United for Health
Foundation, Inc. and all directors and executive officers of the Registrant are
"affiliates." This determination of affiliate status is not necessarily a
conclusive determination for other purposes.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [_]
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Cobalt Corporation Proxy Statement dated on or about
April 24, 2003 (Part III)
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COBALT CORPORATION
INDEX TO
ANNUAL REPORT ON FORM 10-K
For the Year Ended December 31, 2002
PART I
Item 1 Business...........................................................3
Item 2 Properties........................................................15
Item 3 Legal Proceedings.................................................15
Item 4 Submission of Matters to a Vote of Security Holders...............15
Item 4a Executive Officers of the Registrant..............................16
PART II
Item 5 Market for Registrant's Common Equity.............................19
Item 6 Selected Consolidated Financial Data..............................20
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................21
Item 7a Quantitative and Qualitative Disclosures about Market Risk........49
Item 8 Financial Statements and Supplementary Data.......................50
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.........................................92
PART III
Item 10 Directors and Executive Officers of the Registrant.................92
Item 11 Executive Compensation.............................................92
Item 12 Security Ownership of Certain Beneficial Owners and Management.....92
Item 13 Certain Relationships and Related Transactions.....................92
Item 14 Controls and Procedures............................................92
PART IV
Item 15 Exhibits, Financial Statement Schedules, and Reports
on Form 8-K.......................................................93
Schedule II - Condensed Financial Information of Registrant.......95
Schedule IV - Reinsurance.........................................100
Schedule V - Valuation and Qualifying Accounts....................101
Signatures...................................................................102
Certifications...............................................................103
Index to Exhibits............................................................105
PART I
ITEM 1. Business
Available Information
Cobalt Corporation's ("Cobalt," the "Company," or "we") Internet address is
http://www.cobaltcorporation.com/. We make available free of charge through our
Internet website our Annual Report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and amendments to those reports, on the same day
they are electronically filed with, or furnished to, the Securities and Exchange
Commission. We are not including the information contained on or available
through our website as a part of, or incorporating such information by reference
into, this Annual Report on Form 10-K.
Overview
This report and other documents or oral presentations prepared or delivered
by and on behalf of the Company contain or may contain "forward-looking
statements" within the meaning of the safe harbor provisions of the United
States Private Securities Litigation Reform Act of 1995. Forward-looking
statements are statements based upon management's expectations at the time such
statements are made and are subject to risks and uncertainties that could cause
the Company's actual results to differ materially from those contemplated in the
statements. Readers are cautioned not to place undue reliance on the
forward-looking statements. When used in written documents or oral
presentations, the terms "anticipate," "believe," "estimate," "expect,"
"forecast," "objective," "plan, " "possible," "potential," "project," and
similar expressions are intended to identify forward-looking statements.
Cobalt (formerly known as United Wisconsin Services, Inc. ("UWS")) was
created as a result of the combination of UWS and Blue Cross & Blue Shield
United of Wisconsin ("BCBSUW") on March 23, 2001 (the "Combination"). On that
date, BCBSUW converted from a service insurance corporation to a stockholder
owned corporation. Upon conversion, BCBSUW became a wholly-owned subsidiary of
UWS through a combination of the two companies. At the time of the conversion
and combination, BCBSUW owned 46.6% of UWS' outstanding common stock. In
exchange for the ownership of BCBSUW, Cobalt issued 31,313,390 shares of newly
issued Cobalt common stock to the Wisconsin United for Health Foundation, Inc.
(the "Foundation"). The Foundation was established for the sole purpose of
benefiting public health in Wisconsin from its earnings in the investment in
Cobalt.
Cobalt's principal executive offices are located at 401 West Michigan
Street, Milwaukee, Wisconsin 53203 and its telephone number at that address is
(414) 226-6900.
We are the leading managed care company in Wisconsin based on 2001 premium
statistics published by the Office of the Commissioner of Insurance of the State
of Wisconsin ("OCI") and offer a broad portfolio of managed care and insurance
products to employers, individuals and government entities. We have an exclusive
license to utilize the Blue Cross(R) and Blue Shield(R) service marks in
Wisconsin, giving us a unique position in that market. As of December 31, 2002,
we serviced 800,361 insured and self-funded members in our medical programs and
472,374 insured and self-funded members in our dental programs (including Claim
Management Services, Inc. ("CMSI") members as described below).
BCBSUW offers underwritten products, including preferred provider
organizations ("PPO"), traditional indemnity products, and self-funded or
administrative services only programs. Compcare Health Services Insurance
Corporation ("CompcareBlue") operates the oldest health maintenance organization
("HMO") in Wisconsin, which operates under the service mark CompcareBlue(SM).
CMSI, a third party administrator ("TPA"), was acquired on December 31, 2002 to
enhance and expand our competitive position in the self-funded market. As of
December 31, 2002, CMSI provided administrative services for 211,654 medical and
135,823 dental members, approximately 70% of which are located in Wisconsin.
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We offer one of the largest provider networks in Wisconsin. Our customers
have the ability to access the leading physicians and hospitals in their
respective service areas, including Mayo Health System ("Mayo"), University
Health Care, Inc. ("UHC"), and Aurora Health Care, as demonstrated by the fact
that:
o the majority of the hospitals in our networks have received
accreditation by the Joint Commission on Accreditation of Healthcare
Organizations, an organization nationally recognized for its rigorous
standards with respect to patient safety and quality initiatives;
o our network includes approximately 89% of board certified primary care
physicians in our service areas, which exceeds the national average of
82%, based on the National Committee for Quality Assurance ("NCQA")
Quality Compass 2002(R); and
o as of December 31, 2002, approximately 86% of our managed care
membership is insured through subsidiaries which have earned NCQA
accreditation for having met certain NCQA quality parameters.
We believe that our ability to offer a full spectrum of products and a
broad provider network to meet the needs and objectives of a wide range of
customers provides us with a competitive advantage.
We offer a variety of specialty products, including dental, life, and
disability insurance. We are one of the largest providers of dental HMO and
dental indemnity coverage in Wisconsin. We also offer workers' compensation
insurance and a variety of specialty managed care services, including cost
containment, health care electronic data interchange and receivables management
services. These specialty products and services are designed to complement our
customers' employee benefit packages. We also process Medicare claims as a
Medicare Part A fiscal intermediary and a Regional Home Health intermediary for
providers in numerous states and several United States territories and as a
national intermediary for the Federally Qualified Health Centers in all 50
states.
We market our medical and dental products through a salaried sales force
located throughout Wisconsin, as well as through independent agents and brokers,
and directly to customers via the internet. By integrating the marketing of our
medical products, we are able to offer a broad range of product choices to
health care consumers. We sell our specialty managed care products and services
through a variety of distribution channels to employer groups and providers,
principally in Wisconsin.
Our Strategy
Over the past two years, we have taken steps that have resulted in
significant increases in profitability, including: discontinuing unprofitable
business lines; repricing or terminating unprofitable customer contracts;
improving underwriting discipline and pricing products appropriately to reflect
underlying cost trends; negotiating improved terms in our provider contracts;
and bolstering management in key areas. We intend to continue to pursue
improvements in our operating results through the implementation of the
following strategies:
o CAPITALIZE ON THE STRENGTH OF THE BLUE CROSS AND BLUE SHIELD BRANDS.
We believe that our right to the exclusive use of the Blue Cross and
Blue Shield brands in Wisconsin gives us a significant marketing
advantage, and we intend to continue emphasizing these brands among
prospective customers and members. According to the BlueCross
BlueShield Association (the "Association"), the number of members
insured by plans bearing the Blue Cross and Blue Shield brands has
increased by approximately 29% nationwide since 1995. We leverage the
strength of the Blue Cross and Blue Shield brands on a national basis
by participating in the Association's BlueCard PPO program, a network
of Blue Cross and Blue Shield plans ("Blue Plans"). The BlueCard PPO
program allows us to compete with national health insurers for groups
with employees outside of the Wisconsin market and provides our
members and members of other Blue Cross and Blue Shield affiliates the
opportunity to access care while away from home.
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o FOCUS ON CORE BUSINESS. We have made a strategic decision to focus on
our core Blue Cross and Blue Shield branded and HMO businesses, where
we believe significant opportunities exist for earnings growth. These
businesses, which include both insured and self-funded products,
together produced approximately 82% of our revenues and approximately
73% of our pre-tax operating income reported by our four segments for
the year ended December 31, 2002. On March 29, 2002, we sold our
behavioral health and medical management subsidiary, Innovative
Resource Group, LLC ("IRG"). In the future, we may sell other non-core
specialty businesses. In addition, between March 1, 2002 and December
31, 2002, we reduced our ownership of our former affiliate American
Medical Security Group, Inc. ("AMSG"), a small group and individual
health insurer, from 45.2% to 10.7% of AMSG's outstanding common
stock, relieving us of a substantial capital requirement relating to
AMSG. On January 3, 2003, we sold our remaining shares of AMSG common
stock.
o EXPAND OPERATING MARGINS AND REALIZE OPERATING EFFICIENCIES. We intend
to focus on expanding operating margins in our core businesses by
continued improvement in underwriting techniques and product design,
product pricing, and provider arrangements. We intend to pursue
additional operating efficiencies through consolidation of
administrative functions of BCBSUW, CompcareBlue, and certain
specialty businesses.
o INCREASE MARKET SHARE. We intend to focus on increasing market share
in Wisconsin through improving relationships with independent agents
and brokers and through an increased emphasis on our core business
(including the BlueCard PPO program) and our Medicare supplement
product offerings, as well as the introduction of new products. We
expect to accomplish this by leveraging our diverse customer base by
cross-selling product offerings and pursuing opportunistic
acquisitions of health insurers and managed care providers in
Wisconsin.
Products and Services
Insured and Self-Funded Medical Products
We offer a wide range of insured and self-funded medical products,
including HMOs, PPOs, point-of-service ("POS") plans, indemnity products, and
Medicare supplement products. We design our products to meet the needs and
objectives of a wide range of customers, including employers, individuals, and
government entities. Our customers either contract with us to assume
underwriting risk or they self fund underwriting risk and rely on us for network
management and administrative services. Our products vary with respect to the
level of benefits provided, the costs to be paid by employers and members,
including deductibles and copayments, and the extent to which our members'
access to providers is subject to referral or preauthorization requirements.
We provide our Blue Cross and Blue Shield branded products through BCBSUW
and our Blue Cross and Blue Shield branded HMO, CompcareBlue, which operates
primarily in the Milwaukee metropolitan area. We also provide private branded
products through our HMO subsidiaries, Valley Health Plan, Inc. ("Valley") and
Unity Health Plans Insurance Corporation ("Unity"), and TPA subsidiary, CMSI.
Valley operates primarily in northwestern Wisconsin, including the city of Eau
Claire, whereas Unity operates primarily in south central and southwestern
Wisconsin, including the city of Madison. CMSI operates in the Midwest, with the
majority of its operations in Green Bay, Wisconsin.
We also participate in the BlueCard PPO program, a national network of Blue
Cross and Blue Shield plans. The BlueCard PPO program permits members of our
Blue Cross and Blue Shield branded health plans to receive health care services
from providers in the networks of other Blue Cross and Blue Shield plans. This
allows us to compete with national health insurers for groups with employees
outside the Wisconsin market. This also allows members to access care while away
from home. Through electronic communications, the "host" plan verifies
eligibility, pays the claim based on its local fee arrangement, and is then
reimbursed by the "home" plan for the claim as well as an administrative fee.
Absent an agreement between two plans, the Association determines the amount of
the administrative fee. Under this
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arrangement, we are also able to generate revenue from provider network
management and claims repricing.
As of December 31, 2002, our medical plan membership consisted of the
following (in numbers of covered individuals):
Insured Self-Funded
Medical Medical
Product Offerings Members Members(1)
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HMO.............................. 151,627 4,674
PPO.............................. 166,078 279,494
POS.............................. 61,126 10,806
Indemnity........................ 19,758 48,551
Medicaid......................... 4,351 --
Medicare Supplement.............. 53,896 --
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Total Medical............... 456,836 343,525
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(1) Does not include member equivalents relating to host plan members who access
medical care under the BlueCard PPO program.
Specialty Managed Care Products and Services
We are one of the largest providers of insured dental coverage in
Wisconsin. In Wisconsin, our dental HMO coverage is offered through
CompcareBlue, and dental indemnity coverage is offered through BCBSUW. These
dental HMO and indemnity benefit products are currently marketed under the
DentalBlue(R) brand name. We also offer dental indemnity coverage outside of
Wisconsin through another subsidiary. As of December 31, 2002 we had 300,329
insured dental members and 172,045 self-funded dental members.
We offer group term life and accidental death and dismemberment coverages,
as well as dependent life benefits. Short and long-term disability products
provide income replacement for an employee who becomes disabled through a
non-work related event. As of December 31, 2002, we insured 114,151 disability
members and 132,524 life members.
We provide worker's compensation insurance products and managed care
services to employees in Wisconsin, Illinois and Iowa. We also provide cost
containment services, including hospital bill audit, provider discount network
repricing, negotiations, diagnosis-related group validation, claims
administration audit, subrogation and recovery, electronic audit, collection and
fraud investigation, and recovery services to assist customers in reducing their
expenses and provide more cost effective health care delivery. Additionally, we
provide software and claim submission services for Medicare, Medicaid, private
insurers, third-party administrators, and re-pricers. We also provide
collections and receivables management services to hospitals and other
commercial clients. We generally provide these specialty managed care products
and services through wholly-owned subsidiaries.
Government Services
Through our subsidiary, Government Health Services, LLC ("GHS"), we provide
health care program administration and program safeguard services for the
Centers for Medicare & Medicaid Services, which we refer to as "CMS." In
connection with providing these services, we serve as the Medicare Part A
Intermediary and Regional Home Health Intermediary for numerous states and
territories, and serve as the national Intermediary for the Federally Qualified
Health Centers in all 50 states. In addition to providing services to the
Medicare program, we provide claim processing and administrative services in
conjunction with the Wisconsin Medicaid program and the Health Insurance Risk
Sharing Plan. Finally, we provide certain audit services under a separate
contract with the Association and certain state Medicaid agencies.
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The Association contracts with CMS to process Medicare Part A claims. We
have subcontracted with the Association to provide those services in various
states and territories. Until May 2002, that subcontract was held by BCBSUW,
which further subcontracted those services to our wholly-owned subsidiary,
United Government Services, LLC ("UGS").
In May 2002, BCBSUW was granted a contract novation by CMS, enabling BCBSUW
to transfer the Medicare contract to UGS. We are the first Medicare Part A
processor to receive such a novation, and it is our understanding that we
received the novation based on the strength of our compliance program. The
novation provides for certain limitations on our liability relating to acts
subsequent to the novation. Also, the novation will facilitate the transfer of
the Medicare Part A processing business to another Blue Cross and Blue Shield
plan, should we determine to do so.
Trust Solutions, LLC ("TS"), a wholly-owned subsidiary of GHS, provides
integrity, consulting and safeguard services in connection with publicly funded
health programs.
Sales and Marketing
Marketing dual choice group health insurance products is generally a
two-step process. Presentations are made first to employers. Once selected by an
employer, we then directly solicit members from the employee base. During
periodic "open enrollments," when employees are permitted to change health care
programs, we use advertising and work site presentations to attract new members.
Virtually all of the group contracts are renewable annually. On full replacement
products such as POS and PPO, the marketing of the product consists of issuing a
quote or bid through the distribution channel and allowing the prospect to elect
to choose one of our product options. Presentations of our products are either
handled by the agent representing our company, or in combination with the agent
and the Cobalt company representative. After the employer elects a Cobalt
product, then we do worksite presentations to install, implement, and explain
the program to the employees of the new customer.
Significant factors in product selection by employers and employees include
the composition of provider networks, quality of services, price, choice and
scope of benefits, and market presence. To the extent permitted by the OCI and
the federal government, we can offer an employer a wide spectrum of benefit
options. To address rising health care costs, some employers now consider a
variety of health care options to encourage employees to use the most
cost-effective form of health care services.
We market our medical and dental products through a salaried sales force
located throughout Wisconsin, as well as through independent agents and brokers,
and directly to customers via the internet. By integrating the marketing of our
insured health and specialty managed care products and services, we are able to
offer a wide range of products and services to our customers. We sell our
specialty managed care products and services through a variety of distribution
channels to employer groups and providers throughout the United States.
Our sales and marketing efforts have traditionally been organized
geographically. We have recently replaced this structure to pursue a coordinated
market segment approach that we believe will better enable us to increase market
share.
Our pricing strategy is targeted to cover current and anticipated changes
in health care costs and operating costs and to achieve targeted profit margins.
To that end, in May 2002, we transferred primary responsibility for our
underwriting department to our Chief Actuary. We believe that the active role
our actuarial staff plays in the underwriting process will allow us to grow our
business while effectively managing the financial risks associated with our
products.
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Our Provider Network
BCBSUW offers one of the largest provider networks in Wisconsin and
provides a diverse selection of primary care and specialty care physicians to
meet the health care needs of our members. CompcareBlue has an extensive
provider network in southeastern Wisconsin, and is the only HMO that contracts
with all eight of the largest multi-specialty clinics in Milwaukee, including
Aurora Health Care, the largest multi-specialty provider in Wisconsin, for the
provision of health care services to its members.
A majority of Valley's medical and other benefits are provided under an
arrangement with Midelfort Clinic, Ltd. ("Midelfort") and its affiliate, Luther
Hospital, which are affiliated with Mayo and which we believe, based on the
national reputation of Mayo, are the leading medical service providers in Eau
Claire, Wisconsin. Unity contracts with Community Physicians' Network ("CPN"),
an independent physician association, and UHC. UHC contracts on behalf of the
University of Wisconsin Hospital and Clinics, the University of Wisconsin
Medical Foundation, and the University of Wisconsin School of Medicine. CPN and
UHC provide the majority of physician services for Unity's membership throughout
its 19 county service area.
Our two largest HMOs have received NCQA accreditation. All of our HMOs
maintain higher than average satisfaction scores on clinical services. As a
result of our aggressive credentialing efforts, the percentage of our HMO
practitioners who are board certified is at or above the NCQA averages.
BCBSUW contracts primarily on a discounted fee-for-service and fee schedule
basis. In discounted fee-for-service arrangements, we retain the risks
associated with utilization. However, such arrangements provide us with greater
pricing flexibility and opportunities to benefit by application of underwriting
on a group-specific or individual basis. Furthermore, fee schedule-based
compensation allows us to better target improvement in loss ratios through
product development, benefit modification, and medical management. CompcareBlue,
Valley, and Unity manage the cost of health care provided to members through
various methods of payment and risk-sharing programs with physician groups and
hospitals and through their respective utilization management programs. The
methods of payment consist of a combination of fee schedules, discounted
fee-for-service, and capitation arrangements. Capitation is an arrangement
whereby we pay medical providers a set fee per member per month in exchange for
providing health care services.
Approximately 28% of the insured medical benefits provided by CompcareBlue,
Valley, and Unity were provided under capitated arrangements in 2000. In 2001,
this number decreased to 14% and in 2002 this number increased to 18%, as a
result of the cancellation of unprofitable non-capitated business in 2002. For
BCBSUW insured medical business, no significant benefits were provided under
capitated arrangements during 2000 through 2002.
Pursuant to the provider agreements between Unity and Community Health
Systems, LLC ("CHS") and UHC, CHS has the option, exercisable on December 31,
2004, to repurchase its proportionate share of Unity for the current net worth
of the business being repurchased. UHC has the option, also exercisable on
December 31, 2004, to purchase its share of Unity for $0.5 million plus the
proportionate share of the net worth of Unity attributable to the UHC business,
less any unpaid amount of a maximum performance bonus specified in the
agreement. Exercise of the repurchase option ends the agreement with respect to
that party. If both repurchase options are exercised, we would have no ongoing
interest in Unity.
Valley and Midelfort have entered into an extension of their arrangement
through December 31, 2005. Under the terms of the extension, Valley will no
longer be capitated for professional medical services. The extension grants
Midelfort an option to repurchase the capital stock of Valley for $0.4 million
plus 100% of the net equity of Valley as of the date of repurchase and
eliminates profit sharing between the parties.
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Medical Management
We utilize a broad range of focused traditional cost containment and
advanced care management processes across our various product lines to improve
member health, to avoid health risks, and to lower costs. These include case
management, disease management, evidence based medical policy, return on
investment evaluation, targeted opportunities, and quality improvement programs.
Our case management philosophy is built on helping members confront a complex
care system to find the appropriate care in a timely and cost effective manner.
We believe this approach builds positive relationships with providers and
members, and helps us achieve cost savings.
Our population-based disease management programs attempt to identify
members who have or are at risk to develop high cost chronic diseases and
conditions. Targeted members typically have high utilization of health care
services, which can result in significant costs. By identifying high risk
members and enrolling them in specialized programs involving patient education,
lifestyle modification, and intensive care management, we seek to improve
patient satisfaction, manage medical costs, and improve medical outcomes. These
programs currently include diabetes, congestive heart failure, asthma, and high
risk pregnancy. We plan to expand them in the future.
We outsource the majority of our behavioral health, utilization, disease
and case management services to our former subsidiary, IRG, which we sold to APS
Healthcare Bethesda, Inc. ("APS") on March 29, 2002. Under APS, IRG manages our
local pharmacy network, pharmacy customer service, and pharmacy clinical
programs. WellPoint Pharmacy Management manages the majority of our pharmacy
claims processing and pharmaceutical manufacturer rebates.
Management Information Services
Information systems management for our core health business is primarily
delivered under a facilities management agreement with Blue Cross Blue Shield of
South Carolina and Electronic Data Systems Corporation ("EDS"). Blue Cross Blue
Shield of South Carolina is responsible for administering information systems
supporting our claims processing. By working with another plan in the Blue Cross
and Blue Shield system, we are able to leverage system enhancements that support
the interchange of data across Blue Cross and Blue Shield plans, such as the
coordination of provider network arrangements on a national basis. We use EDS
information systems primarily to support our membership enrollment database. Our
specialty businesses use a variety of internal information systems specifically
designed for various product lines. Our agreement with Blue Cross Blue Shield of
South Carolina is in effect until October 2005, and our agreement with EDS is in
effect until October 2003.
In 1999, and again in 2002, we received a letter from the holder of a
patent asserting that certain components of our information systems, including
our claims processing systems, infringe this patent. We are reviewing the merits
of this assertion. If we are found to infringe this patent, we could be required
to discontinue the infringing activity, which could disrupt our operations, and
could be required to pay damages for past activities and pay royalties for
future use, which could be substantial. As to certain components of our systems
that have been claimed to infringe the patent, we have a contractual right to
indemnification from the vendor of the systems for losses resulting from patent
infringement. However, we cannot be assured that the indemnification would be
sufficient to protect us in the event that a patent infringement claim is made
against us and is determined to be valid.
9
Competition
The managed care industry is highly competitive. We believe the principal
competitive features affecting our ability to retain and increase our membership
include the strength of the Blue Cross and Blue Shield brands, our ability to
offer our customers a broad continuum of insured and self-funded products, and
access to a network of high quality providers. Portions of the Wisconsin market
are dominated by a small number of provider-owned health plans, with a
correspondingly large influence on the markets in which we compete. These
provider-owned health plans can often obtain favorable financial arrangements
that are not available to us. Some of our other competitors are larger, have
considerably greater financial resources and distribution capabilities, and
offer more diversified types of insurance coverage. Our key competitors include
Humana Inc., United Healthcare Insurance Company, Dean Health Plan, and
Physicians Plus.
Blue Cross and Blue Shield Licenses
We are a licensee of the Association. The Association is a national trade
association of Blue Cross and Blue Shield licensees which strives to promote and
preserve the integrity of the Blue Cross and Blue Shield names and service marks
as well as provide certain coordination among plan and provider services. As a
licensee of the Association, we have the exclusive right to use the Blue Cross
and Blue Shield names and service marks for all of our products in Wisconsin.
The licenses require us to pay an annual fee to the Association equal to
total association expenses allocated to Association members based upon
enrollment and premium. Each Association licensee is an independent legal
organization and is not responsible for obligations of other Association member
organizations. We do not have the right to use the Blue Cross and Blue Shield
names and service marks outside of our Blue Cross and Blue Shield service area,
except in certain limited circumstances.
Each of BCBSUW, CompcareBlue, and UGS is also a licensee of the Association
by virtue of being a controlled affiliate of Cobalt. As required by the
Association, Cobalt has provided each of BCBSUW and CompcareBlue a guarantee of
their contractual and financial obligations to their customers. We have also
agreed to indemnify the Association and other Blue Cross and Blue Shield plans
against any claims asserted against such entities resulting from our activities
or the activities of any of our Blue Cross and Blue Shield licensed affiliates.
Our license agreements require us to pay the Association a specific amount
upon termination of the license agreements, subject to certain limited
exceptions. The amount payable upon termination of our license agreement is
equal to $25 multiplied by the number of our members receiving products or
services sold or administered under the Blue Cross or Blue Shield names or
service marks. The fee would be reduced to the extent the payment of the fee
would cause us to fall below certain capital requirements established by the
Association.
The Association could terminate our license agreements if we do not satisfy
its financial and service performance requirements or upon the occurrence of
other events described in the license agreements, some of which are outside of
our control. Termination events include, but are not limited to:
o failure to meet minimum capital and surplus thresholds and liquidity
requirements of the Association;
o violation of the ownership limitations contained in our Amended and
Restated Articles of Incorporation;
o termination of the voting trust and divestiture agreement between us
and the Foundation before the Foundation's ownership of our common
stock falls to less than 5%;
10
o the acquisition of our company without the prior consent of a majority
of the other disinterested licensees of the Association and a majority
of the then current weighted vote of the other disinterested licensees
of the Association;
o failure by the Foundation to divest its shares of our common stock by
the deadlines specified by the voting trust and divestiture agreement;
o a determination by the Association that fewer than 80% of our
directors are independent; and
o failure to brand medical and dental business as required by the
Association.
Our Amended and Restated Articles of Incorporation and Amended and Restated
Bylaws include various provisions required by the Association for its for-profit
licensees. These provisions are designed to protect the independence of the
Association's for-profit licensees from any single stockholder.
Because of our prior financial performance, the Association had included
BCBSUW, CompcareBlue and Cobalt in its Plan Performance Response Monitoring
Process ("PPRMP"). Based on our strong financial performance in 2002 and
increased capital and liquidity levels, the Association removed BCBSUW,
CompcareBlue and Cobalt from its PPRMP in early 2003.
As of December 31, 2002, BCBSUW, CompcareBlue and Cobalt exceeded the
minimum capital and surplus thresholds and liquidity requirements of the
Association. The Association is entitled to terminate our license agreement with
the Association, including the right to use the Blue Cross and Blue Shield names
and service marks, if we fall below the licensure minimum statutory capital and
surplus thresholds or liquidity requirements.
Regulation
General
Government regulation of employee benefit plans, including health care
coverage, health plans, and our specialty managed care products, is a changing
area of law that varies from jurisdiction to jurisdiction and generally gives
responsible administrative agencies broad discretion. To comply with these
regulations, it may be necessary for us to make changes from time to time in our
services, products, structure, or operations. Additional government regulation
or future interpretation of existing regulations could increase the cost of our
compliance or otherwise affect our operations, products, profitability, or
business prospects.
Federal legislation has significantly expanded regulation of group health
plans and health care coverage. The laws place restrictions on the use of
pre-existing conditions and eligibility restrictions based upon health status
and prohibit cancellation of coverage due to claims experience or health status.
Federal regulations also prohibit insurance companies from declining coverage to
small employers. Additional federal laws, which took effect in 1998, include
prohibitions against separate, lower dollar maximums for mental health benefits
and requirements relating to minimum coverage for maternity inpatient
hospitalization.
Increasingly, states are considering various health care reform measures
which, if passed, may limit our ability and our health plans' ability to control
which providers are part of their networks and hinder their ability to manage
utilization and cost effectively. "Patient Protection" laws, which became
effective in Wisconsin in late 1998, established a prudent layperson standard
for coverage of emergency room care and provided extended access to providers
who are no longer part of the plan's network. A number of other states are
considering similar legislation. In his January 2003 State of the Union address,
President Bush expressed support for creating national association health plans,
known as "AHPs." AHPs would allow small businesses to buy into group health
insurance plans anywhere in the country. To facilitate such arrangements,
federal legislation would be necessary to supersede varying state insurance laws
that would otherwise make the operation of AHPs impracticable. Due to the fact
that AHPs would not be required to
11
accept all applicants regardless of health status, as health insurers are under
state insurance laws, AHPs could gain a competitive advantage. In addition,
President Bush also discussed an alternative Medicare HMO plan that would
include prescription drug coverage. If such a program were available to the
Medicare eligible population, it could negatively impact enrollment in our
Medicare Supplement products. At this time, we cannot predict whether
legislation enacting either or both of these proposals will ultimately be
adopted, precisely what form the legislation would take, or its specific impact
on our business.
HIPAA
The Health Insurance Portability and Accountability Act of 1996 ("HIPAA")
includes administrative provisions imposing significant requirements relating to
maintaining the privacy of medical information ("Privacy"), establishing uniform
health care provider and employer identifiers, requiring use of standardized
transaction formats ("Transactions"), and seeking protections for
confidentiality and security of patient data ("Security"). The Privacy and
Transactions provisions require implementation in 2003. Final HIPAA Security
rules were published on February 20, 2003, and the implementation and compliance
date is April of 2005. HIPAA is far-reaching and complex, and proper
interpretation and practice under the law continue to evolve. Consequently, our
efforts to measure, monitor, and adjust our business practices to comply with
HIPAA are ongoing. Compliance with HIPAA could require us to make significant
changes to our operations and failure to comply could subject us to civil and
criminal penalties. The costs of complying with HIPAA are likely to be
substantial.
HMOs
Wisconsin has enacted statutes regulating the activities of HMOs. The
implementing regulations provide for periodic financial reports from HMOs and
impose minimum capital or reserve requirements. In addition, certain of our
subsidiaries are required by state regulatory agencies to maintain restricted
cash reserves represented by interest-bearing instruments which are held by
trustees or state regulatory agencies to ensure that adequate financial
resources are maintained or to act as a fund for insolvencies of other HMOs in
the state.
As a federally qualified HMO, CompcareBlue must file periodic reports with,
and is subject to periodic review by CMS. Our HMOs that have Medicaid contracts
are subject to both federal and state regulation regarding services to be
provided to Medicaid enrollees, payment for those services, and other aspects of
the Medicaid program. Medicaid has in force and/or has proposed regulations
relating to fraud and abuse, physician incentive plans, and provider referrals,
which may affect our operations.
In the past, we have contracted with the Office of Personnel Management
("OPM") to cover federal employees under the Federal Employees Health Benefit
Plan. These contracts were subject to extensive regulation, including complex
rules relating to the premiums charged. OPM has the authority to retroactively
audit the rates charged and may seek premium refunds and other sanctions against
health plans participating in the program. Our health plans that have contracted
with OPM are subject to such audits and have in the past and may in the future
be requested to make such refunds. Given our participation in this and other
federal health care programs, we have implemented and place great importance
upon an effective compliance program.
Capital Requirements
Our insurance subsidiaries are subject to minimum capital requirements
imposed under the laws of the State of Wisconsin. These minimum capital
requirements are calculated under a prescribed compulsory and security surplus
computation based upon a percentage of underwritten premiums by line of
business. Wisconsin insurance laws also include minimum capital requirements
based on the Risk Based Capital for Insurers Model Act adopted by the National
Association of Insurance Commissioners ("NAIC"). The formula for calculating
such risk-based capital requirements is designed to take into account asset
risks, insurance risks, interest rate risks, and other relevant risks with
respect to the individual insurance company's business. Under these laws, our
insurance subsidiaries must submit a report of their risk-based
12
capital level as of the end of each calendar year. Insurers having less capital
than required by the risk-based capital model formula will be subject to varying
degrees of regulatory action depending on the level of capital inadequacy. The
regulatory action that may be imposed on an insurer includes requiring adoption
of a comprehensive financial plan, its examination and the issuance of a
corrective order by the state insurance commission, or placing the insurer under
state regulated control.
At the request of the OCI, we prepared a plan of action in early 2002 for
strengthening the capital position of our insurance subsidiaries. We executed on
the plan and significantly improved our capital ratios during 2002. In early
2003, the OCI removed us from its heightened level of scrutiny. See Item 7,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Management's Plan." Our insurance subsidiaries are currently in
compliance with the minimum capital requirements imposed under Wisconsin
insurance laws.
In addition, the Association requires some of our insurance subsidiaries to
meet certain risk-based capital requirements, which are generally more stringent
than those imposed under Wisconsin insurance laws. As of December 31, 2002,
BCBSUW, CompcareBlue and Cobalt exceeded the minimum risk-based capital
requirements of the Association to maintain their licenses. See "Business - Blue
Cross and Blue Shield Licenses."
Insurance Regulation
Each of our insurance subsidiaries is subject to regulation by the
department of insurance in each state in which it is licensed. Regulatory
authorities exercise extensive supervisory power over insurance companies
relating to the licensing of insurance companies; the amount of capital which
must be maintained; the approval of forms and insurance policies used; the
nature of, and limitation on, an insurance company's investments; periodic
examination of the operations of insurance companies; the form and content of
annual statements and other reports required to be filed on the financial
condition of insurance companies; and the establishment of capital requirements
for insurance companies. In addition, our insurance subsidiaries are subject to
specific taxes and assessments, which can be subject to increase. Our insurance
company subsidiaries are required to file periodic statutory financial
statements in each jurisdiction in which they are licensed. Additionally, such
companies are examined periodically by the insurance departments of the
jurisdictions in which they are licensed to do business.
We actively market insurance products to Medicare eligible individuals.
Medicare supplement (or Medigap) policies are regulated by the OCI and are the
subject of increasing regulation at the state level, as well as additional
legislation at the federal level. We continue to monitor and alter procedures to
comply with new laws and regulations.
Under Wisconsin law, insurance companies must provide the OCI with advance
notice of any dividend that is more than 15% larger than any dividend for the
corresponding period of the previous year. In addition, the OCI may disapprove
any "extraordinary" dividend, defined as any dividend which, together with other
dividends paid by an insurance company in the prior twelve months, exceeds the
lesser of: (i) 10% of statutory capital and surplus as of the preceding December
31; (ii) with respect to a life insurer, net income less realized gains for the
calendar year preceding the date of the dividend; or (iii) with respect to a
non-life insurer, the greater of (A)(ii) above or (B) the aggregate net income
less realized gains for the three calendar years preceding the date of the
dividend less distributions made within the first two of those three years.
13
Insurance Holding Company Regulations
Cobalt is an insurance holding company and conducts business through
subsidiaries. As a result, it is subject to insurance holding company laws and
regulations that, among other things, generally require registration with the
department of insurance of the holding company's domiciliary state and the
filing of certain reports describing capital structure, ownership, financial
condition, certain intercompany transactions, and general business operations.
Various notice and reporting requirements generally apply to transactions
between companies within an insurance holding company system, depending on the
size and nature of the transactions. Certain state insurance holding company
laws and regulations require prior notice or, in certain circumstances, prior
approval, of certain acquisitions, and transactions between the regulated
companies, their parent holding companies and affiliates.
Under Wisconsin law, acquisition or control of us, and thereby indirect
control of our insurance subsidiaries, requires the prior approval of the OCI.
"Control" is defined as the direct or indirect power to direct or cause the
direction of the management and policies of a person. Any purchaser of 10% or
more of the voting securities of a corporation is presumed to have acquired
control of the corporation and its subsidiaries unless the OCI, upon
application, determines otherwise.
ERISA
The provision of services to or through certain employee health benefit
plans is subject to the Employee Retirement Income Security Act of 1974
("ERISA"). ERISA is a complex set of federal laws and regulations that are
subject to periodic interpretation by the federal courts and the United States
Department of Labor. ERISA places certain controls on how our business units may
do business with employers covered by ERISA, particularly employers that
maintain self-funded plans. The Department of Labor is charged with the
enforcement of ERISA. There have been continued attempts to limit ERISA's
preemptive effect on state laws through proposed state and federal legislation,
regulations, and litigation. If such limitations were to be imposed, they might
increase our liability exposure relating to employee health benefits offered by
our health plans and specialty businesses and may permit greater state
regulation of other aspects of those businesses' operations.
Trademarks
Blue Cross and Blue Shield are federally registered service marks of the
Association. Compcare(R) is a federally registered service mark of Cobalt. We
have filed for and maintain various other service marks and trade names at the
federal level and in Wisconsin. Although we consider our registered service
marks, trademarks, and trade names important in the operation of our business,
our business is not dependent on any individual service mark, trademark, or
trade name owned by us. CompcareBlue and BCBSUW use the Blue Cross and Blue
Shield service marks in their businesses, pursuant to a license agreement with
the Association, as our controlled affiliates. Termination of this license could
have a material adverse effect on us.
Employees
As of December 31, 2002, we employed 3,259 full-time and 105 part-time
employees, of whom 458 were managerial and supervisory personnel. In addition,
we lease the services of 74 people who manage and operate one of our
subsidiaries. We consider our relations with our employees to be good.
Financial Information About Segments
Certain financial information about our business segments may be found in
Note 20 to the consolidated financial statements included in Item 8.
14
ITEM 2. Properties
Our corporate headquarters are located in Milwaukee, Wisconsin in a 216,541
square foot leased building that is shared by our four reportable business
segments: insured medical products, specialty managed care products and
services, government services, and self-funded products. Each segment is charged
a proportionate share of the cost of this facility under service agreements.
Three business segments (insured medical products, specialty managed care
products and services, and self-funded products) also share common facilities
and are charged a proportionate share of the cost of such facilities under
service agreements. These facilities are located in Eau Claire, Fond du Lac,
Evansville, and Oshkosh in approximately 88,500 combined leased square feet,
50,540 leased square feet in Waukesha, Wisconsin, 52,237 square feet in New
Berlin, Wisconsin, 36,750 square feet in West Allis, Wisconsin, 22,602 square
feet in Platteville, Wisconsin, 20,973 square feet in Stevens Point, Wisconsin,
15,270 square feet in Brookfield, Wisconsin, and one other location under 5,000
square feet. In addition, we lease and occupy 18,198 square feet in two
locations in Illinois and 10,776 square feet in four locations in Michigan. We
also own and occupy a 61,090 square foot facility in Pewaukee, Wisconsin, a
39,300 square foot facility in Sauk City, Wisconsin, and one additional location
under 5,000 square feet.
Our government services segment leases and occupies 64,693 square feet in
three locations in California, and approximately 32,000 square feet in three
locations in Virginia and West Virginia. In addition, this segment leases and
occupies a total of seven other locations, all of which are under 5,000 square
feet. These facilities are located in Minnesota, New York, Wisconsin, Illinois,
and Michigan.
In addition, in conjunction with our acquisition of the insurance
operations of Family Health Plan Cooperative ("FHP") in November 2000, we
assumed a 10-year lease for a 60,000 square-foot facility with an additional
10,000 square feet of storage space in Brookfield, Wisconsin. On March 29, 2002,
we assigned this lease to APS. However, we would remain liable in the event that
APS would default on this lease.
In conjunction with the acquisition of CMSI on December 31, 2002, we
assumed a lease in Green Bay, Wisconsin for approximately 9,173 square feet of
office space. In addition, we acquired three properties owned by CMSI. Two of
the properties are located in Green Bay, Wisconsin, one of which is 15,340
square feet and the other is 16,700 square feet. The third property is located
in West Bend, Wisconsin and is 18,056 square feet. CMSI is included in our
self-funded segment.
ITEM 3. Legal Proceedings
We are currently, and from time to time, subject to claims and suits
arising in the ordinary course of business. Although the results of litigation
proceedings cannot be predicted with certainty, we believe that the ultimate
resolution of all current proceedings will not have a material adverse effect on
our financial condition or results of operations.
ITEM 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth
quarter of 2002.
15
ITEM 4a. Executive Officers of the Registrant
Prior to September 25, 1998, UWS was a Wisconsin corporation that included
the operations of what is now Cobalt as well as the operations of AMSG. United
Wisconsin Services, Inc. prior to such date is referred to herein as the
"Predecessor". Cobalt was organized in May of 1998 for the purpose of owning and
operating the managed care companies and specialty business of the Predecessor.
On May 27, 1998, the board of directors of the Predecessor approved a formal
plan to contribute the managed care companies and specialty business to Cobalt
and spin off Cobalt to its shareholders (the "spin-off"). On September 25, 1998,
upon its formation in connection with the spin-off, Cobalt was originally named
Newco/UWS, Inc. It was subsequently renamed United Wisconsin Services, Inc.
following the spin-off, and was again renamed Cobalt Corporation in 2001. The
Predecessor was renamed American Medical Security Group, Inc. in connection with
the spin-off. The following table sets forth certain information with respect to
each of our executive officers.
As of February 28, 2003, our executive officers were as follows:
Name Age Title
---- --- -----
Stephen E. Bablitch 49 Chairman of the Board and Chief Executive Officer
Michael E. Bernstein 42 President and Chief Operating Officer; and President of
CompcareBlue
Mark A. Caron 45 Senior Vice President and Chief Information Officer
Timothy F. Cullen 59 Senior Vice President, Corporate & Public Affairs; and
Chairman of Government Health Services, LLC
Dennis G. Fallon 51 Senior Vice President, Sales and Marketing
Lorna J. Granger 49 Senior Vice President, General Counsel and Corporate
Secretary
Gail L. Hanson 47 Senior Vice President, Treasurer and Chief Financial Officer
Kathy A. Ledvina 44 Senior Vice President of Health Operations
Michael J. Murray 43 Senior Vice President and Chief Actuary
Kathryn K. Potos 51 Senior Vice President of Human Resources
Penny J. Siewert 45 Senior Vice President of Individual and Specialty Risk
Officers are elected to serve, subject to the discretion of the Board of
Directors, until their successors are appointed. There are no family
relationships among any of the directors and/or executive officers of Cobalt,
and there is no arrangement or understanding between any executive officer and
any other person pursuant to which such officer was or is to be selected as an
officer.
Stephen E. Bablitch is the Chairman of the Board and Chief Executive
Officer of Cobalt. Mr. Bablitch was elected as Chairman of the Board and Chief
Executive Officer of Cobalt in December of 2002. Mr. Bablitch joined the
Predecessor in 1996 as General Counsel, Vice President, and Secretary. He was
elected Senior Vice President of Cobalt in May of 2001. He has served in various
capacities with subsidiaries of the Predecessor and Cobalt since 1996. Mr.
Bablitch was elected Chairman of the Board of BCBSUW in December of 2002 and a
director in March of 2001. Prior to being elected Chairman of the Board of
BCBSUW, Mr. Bablitch served as Senior Vice President since 2000. He also served
as General Counsel and Secretary of BCBSUW since 1996. Prior to joining the
Predecessor and BCBSUW, Mr. Bablitch was an attorney with Dewitt, Ross, and
Stevens, Madison, Wisconsin from 1991 to 1996. Prior to 1991, Mr. Bablitch had a
career in government as a prosecutor and served in the cabinet of a former
Wisconsin Governor.
16
Michael E. Bernstein is President and Chief Operating Officer of Cobalt.
Mr. Bernstein was elected as President and Chief Operating Officer of Cobalt in
December of 2002. Prior to his election as President and Chief Operating
Officer, Mr. Bernstein served as Senior Vice President since February of 2000.
He was elected President of Compcare in July of 2001. He has served in various
capacities with Cobalt's subsidiaries since 1987. Mr. Bernstein was elected
President and Chief Operating Officer of BCBSUW in December of 2002 and a
director in March of 2001. Prior to his current position with BCBSUW, Mr.
Bernstein served as Senior Vice President of BCBSUW since March of 2000. Before
rejoining Cobalt and BCBSUW, Mr. Bernstein served as Executive Vice President
for the University of Wisconsin Medical Foundation in Madison, Wisconsin from
1998 through 1999. From 1996 to 1998, Mr. Bernstein was Senior Vice President at
University Health Care, Inc., Madison, Wisconsin. From 1987 to 1996, Mr.
Bernstein held a variety of positions with Cobalt's subsidiaries, beginning with
staff attorney and concluding with Regional Vice President.
Mark A. Caron is Senior Vice President and Chief Information Officer of
Cobalt. Mr. Caron was elected a Senior Vice President in July of 2002. He has
served in various capacities with Cobalt's subsidiaries since 2002. Prior to
joining Cobalt, Mr. Caron served as a managing partner at Spring Valley
Technologies in Springvale, Maine from 2000 to 2002. From 1997 to 2000, Mr.
Caron served as Senior Vice President and Chief Information Officer of BlueCross
BlueShield of Massachusetts.
Timothy F. Cullen is Senior Vice President of Corporate and Public Affairs
for Cobalt. Mr. Cullen was elected as Senior Vice President in December of 2002.
He previously served as Vice President since May of 2001. He was elected
President and Chief Operating Officer of the government programs division of
BCBSUW in 1991, and was elected Chairman of UGS in January of 1999. Mr. Cullen
currently serves as Chairman of Government Health Services, LLC, and was elected
to that position in August of 2002. Mr. Cullen has served in various capacities
with subsidiaries of the Predecessor and Cobalt since 1988. Prior to joining
Cobalt and BCBSUW, he was secretary of health and social services for the State
of Wisconsin from 1987 to 1988. From 1974 to 1986, Mr. Cullen was a Wisconsin
state senator and served three terms as senate majority leader.
Dennis G. Fallon is Senior Vice President of Sales and Marketing for
Cobalt. He was elected Senior Vice President in December of 2002. He has served
in various capacities with Cobalt's subsidiaries since 2002. Prior to joining
Cobalt, Mr. Fallon was regional vice president of sales for Cigna HealthCare in
Atlanta, Georgia from 1997 to 2001. From 1995 to 1997, Mr. Fallon served as Vice
President and Chief Sales Officer at Empire Blue Cross Blue Shield, and also
held various director and officer level sales positions from 1992 to 1995. Prior
to joining Empire Blue Cross Blue Shield, Mr. Fallon was the Director of
Corporate General Sales of Horizon Blue Cross Blue Shield of New Jersey.
Lorna J. Granger is Senior Vice President, General Counsel, and Corporate
Secretary of Cobalt. Ms. Granger's responsibilities include overseeing the legal
staff for Cobalt Corporation and its subsidiary, BCBSUW. She also serves as an
officer and director of various Cobalt subsidiaries, including BCBSUW and
Compcare. Prior to joining Cobalt in February 2003, Ms. Granger was the Managing
Partner of the Milwaukee and Waukesha offices of Michael Best & Friedrich LLP
since July of 2001, and was Partner from 1989 to July of 2001.
Gail L. Hanson is Senior Vice President, Treasurer, and Chief Financial
Officer. Ms. Hanson is a Certified Public Accountant, holds a Chartered
Financial Analyst designation, and received an MBA from the University of
Chicago. Ms. Hanson was Treasurer of the Predecessor since 1987 and has been
Treasurer of Cobalt since its formation in 1998. She was elected a Vice
President of the Predecessor in 1996. Ms. Hanson was named Chief Financial
Officer of Cobalt effective August 1, 1999. She was elected Senior Vice
President in May of 2001. Ms. Hanson has also served in various capacities with
subsidiaries of the Predecessor and Cobalt since 1984. Ms. Hanson has been
Senior Vice President of BCBSUW since December of 2000; and Treasurer since
1987. Ms. Hanson had been Vice President of BCBSUW since 1996, Chief Financial
Officer since 1999, and Assistant Vice President since 1987, having joined
BCBSUW in 1984 as the Controller of United Wisconsin Insurance Company ("UWIC").
Prior to joining BCBSUW, Ms. Hanson was an audit manager with
PricewaterhouseCoopers LLP.
17
Kathy A. Ledvina is Senior Vice President of Health Operations for Cobalt.
She was elected Senior Vice President in December of 2002. She has served in
various capacities with Cobalt's subsidiaries since 2002. Prior to joining
Cobalt, Ms. Ledvina was Director of Finance at Aurora Health Care from 1995 to
2002. Prior to joining Aurora Health Care, Ms. Ledvina served as Director of
Finance at CompcareBlue from 1993 to 1995 and Manager of Internal Audit of the
Predecessor from 1991 to 1993.
Michael J. Murray is Senior Vice President and Chief Actuary of Cobalt. Mr.
Murray is a Fellow of the Society of Actuaries and a member of the American
Academy of Actuaries. Mr. Murray was elected a Senior Vice President in December
of 2002. He was elected as Vice President in June of 2001. Prior to joining
Cobalt, Mr. Murray was Vice President and Chief Actuary of HealthNow New York
Inc. in Buffalo, New York, (the parent company of Blue Cross & Blue Shield of
Western New York and Blue Shield of Northeastern New York) from 1996 to 2000.
Mr. Murray started his career in 1981 as an actuary with Aetna Insurance
Company, and held various positions directing the pricing, underwriting, and
reserving of group medical, dental, and HMO lines of business.
Kathryn K. Potos is Senior Vice President of Human Resources for Cobalt.
Ms. Potos was elected as Senior Vice President in December of 2002. She was
elected as Vice President in May of 2001. Ms. Potos was Director of Human
Resources of the Predecessor from 1993 to 1998, having joined the Predecessor in
1992 as a staff attorney. Ms. Potos was previously employed with BCBSUW from
1998 to 2001 as Regional Vice President.
Penny J. Siewert is Senior Vice President of Individual and Specialty Risk
for Cobalt. Ms. Siewert was elected Vice President of Regional Services of the
Predecessor in 1995 and Senior Vice President of Cobalt in May of 2001. Ms.
Siewert joined BCBSUW in 1977 and has served in various capacities. Ms. Siewert
was elected Vice President of Operations for BCBSUW in 1990, Vice President of
Special Markets in 1992, Vice President of Regional Services in 1995, and Senior
Vice President in March of 1999.
18
PART II
ITEM 5. Market For Registrant's Common Equity
Cobalt's common stock is traded on the New York Stock Exchange ("NYSE")
under the symbol "CBZ". The following table sets forth the per share high and
low sale prices for Cobalt's common stock as reported on the NYSE for the
periods after the March, 2001 combination of BCBSUW and UWS and for the UWS
common stock (NYSE: UWZ) for all periods prior to the Combination, along with
the cash dividends paid per share for those periods, respectively.
High Low Cash Dividends Paid
---- --- -------------------
Year ended December 31, 2002:
First Quarter $9.05 $5.33 -
Second Quarter 23.45 8.65 -
Third Quarter 23.40 14.11 -
Fourth Quarter 18.70 12.15 -
Year ended December 31, 2001:
First Quarter $7.99 $3.38 -
Second Quarter 8.00 4.90 -
Third Quarter 9.05 4.37 -
Fourth Quarter 7.00 3.99 -
As of March 7, 2003, there were 216 shareholders of record of common stock.
Based on information obtained from Cobalt's transfer agent and from participants
in security position listings and otherwise, Cobalt has reason to believe there
are more than 3,300 beneficial owners of shares of common stock.
19
ITEM 6. Selected Consolidated Financial Data
The following selected financial data are derived from our consolidated
financial statements. The data should be read in conjunction with our
consolidated financial statements, the related notes thereto, "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
other financial information included herein.
We were formed in March 2001 as the successor to substantially all of the
operations of BCBSUW and UWS. Under accounting principles generally accepted in
the United States, our financial statements reflect the business and assets of
BCBSUW, without UWS, for periods through March 31, 2001, and the combined
businesses of BCBSUW and UWS for periods after that date. This presentation
limits the comparability of the financial and operating data set forth below.
Years Ended December 31,
-------------------------------------------------------------------
1998 1999 2000 2001 2002
---------- ---------- ---------- ------------ -----------
Statement of Operations Data(1): (Dollars in thousands, except per share data)
Revenues:
Premium $361,965 $418,949 $538,080 $1,255,391 $1,373,760
Government services 31,667 52,259 70,305 117,192 111,719
Other 25,302 25,970 24,715 40,655 48,167
---------- ---------- ---------- ------------ -----------
Total health services revenue 418,934 497,178 633,100 1,413,238 1,533,646
Investment income, net 11,886 10,496 10,092 11,637 14,845
Net realized investment gains (losses) 1,615 8,014 (509) 845 (1,141)
---------- ---------- ---------- ------------ -----------
Total revenues 432,435 515,688 642,683 1,425,720 1,547,350
Expenses:
Medical and other benefits 297,885 376,814 497,822 1,119,218 1,166,671
Selling, general, administrative and other 133,153 158,187 176,878 303,208 323,239
Other(2) 115 744 922 5,697 675
---------- ---------- ---------- ------------ -----------
Total expenses 431,153 535,745 675,622 1,428,123 1,490,585
---------- ---------- ---------- ------------ -----------
Operating income (loss) from continuing
operations 1,282 (20,057) (32,939) (2,403) 56,765
Income tax (expense) benefit 78 - (548) 1,871 (7,304)
Income (loss) from investment in
affiliates, net of tax(3) 3,991 (22,690) (6,526) (22,724) 15,556
---------- ---------- ---------- ------------ -----------
Income (loss) from continuing operations 5,351 (42,747) (40,013) (23,256) 65,017
Income from discontinued operations - - - 951 8,938
---------- ---------- ---------- ------------ -----------
Net income (loss) $ 5,351 $(42,747) $(40,013) $ (22,305) $ 73,955
========== ========== ========== ============ ===========
Diluted earnings (loss) per share from
continuing operations(4)(5) $0.17 $(1.37) $(1.28) $(0.61) $1.54
Total diluted earnings (loss) per
share(4)(5) 0.17 (1.37) (1.28) (0.58) 1.75
Operating Statistics(1):
Total consolidated loss ratio(6) 82.3% 89.9% 92.5% 89.2% 84.9%
Selling, general, administrative and other
expense ratio(7) 31.8% 31.8% 27.9% 21.5% 21.1%
Net income (loss) margin(8) 1.2% (8.3)% (6.2)% (1.6)% 4.2%
As of December 31,
1998 1999 2000 2001 2002
---------- ---------- ---------- ------------ -----------
Balance Sheet Data (1): (In thousands)
Cash and investments(9) $109,447 $57,383 $45,678 $243,368 $436,360
Total assets 443,186 381,400 394,205 727,322 869,899
Long-term debt, including current portion - - - 7,500 29,950
Total shareholders' equity 250,991 200,109 168,943 208,222 302,519
____________
(1) Prior to March 31, 2001, data reflect only the operations of BCBSUW, accounting for UWS and AMSG as investments in
affiliates.
(2) Includes interest and amortization of goodwill.
(3) Includes UWS (prior to March 31, 2001) and AMSG.
(4) When we report a net loss, potentially dilutive securities are not included in the calculation of earnings per
share because their inclusion would have an antidilutive effect.
(5) The 31,313,390 shares of our common stock issued to the Foundation in the Combination were used to calculate earnings per
share for all periods prior to March 31, 2001.
(6) Includes all insured products (medical, dental, disability, etc.). UWS is included in all periods subsequent to
March 31, 2001. Prior to March 31, 2001, the ratio is based on BCBSUW only.
(7) Represents selling, general, administrative and other expenses as a percentage of health services revenue.
(8) Represents income (loss) from continuing operations as a percentage of total revenues.
(9) Excludes investments in affiliates.
20
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following presents our management's discussion and analysis of our
financial condition and results of operations as of the dates and for the
periods indicated. You should read this discussion in conjunction with our
consolidated financial statements and notes thereto and the information set
forth under the caption "Risk Factors." This discussion contains forward-looking
statements that involve risks and uncertainties. Actual results could differ
significantly from those anticipated in these forward-looking statements.
Overview
Cobalt Corporation ("Cobalt," the "Company," or "we") is the leading
managed care company in Wisconsin based on 2001 premium statistics published by
the Office of the Commissioner of Insurance of the State of Wisconsin ("OCI")
and we offer a broad portfolio of managed care and insurance products to
employers, individuals, and government entities. We have an exclusive license to
utilize the Blue Cross and Blue Shield service marks in Wisconsin, giving us a
unique position in that market. As of December 31, 2002, we serviced 800,361
insured and self-funded members in our medical operations and 472,374 insured
and self-funded members in our dental programs (including in both cases members
obtained in the December 31, 2002 acquisition of Claim Management Services, Inc.
("CMSI")).
During 1999 and 2000, we experienced large operating losses. These losses
were due primarily to our Medicare+Choice line of business and self-funded
business. Additionally, United Wisconsin Services, Inc. ("UWS") reported losses
in 2001 arising from its federal employee contracts and a conversion of certain
of its provider arrangements from capitation to a fee-for-service model. During
this period we also experienced difficulties in implementing new information
systems, which impaired our ability to identify trends indicating increasing
medical costs, leading to writing unprofitable contracts. These factors led to
increased medical loss ratios and resulting losses. In addition, the resulting
adverse effect on our capital position led to discussions with the OCI and the
BlueCross BlueShield Association (the "Association") regarding our plans for
capital improvement.
To address these issues, we developed a plan to improve our core business
while divesting non-core businesses and assets. In our core business, we focused
on:
o discontinuing unprofitable business lines;
o repricing or terminating unprofitable customer contracts;
o improving underwriting techniques and pricing products appropriately
to reflect underlying cost trends;
o negotiating improved terms in our provider contracts; and
o bolstering management in key areas.
In implementing this plan, we exited the Medicare+Choice line of business
as of January 1, 2002 and elected to not renew certain unprofitable customer
contracts. We have also strengthened our senior actuarial and underwriting
staff, adopted more stringent underwriting standards, and applied these
standards to achieve better pricing for new contracts, as well as those
contracts up for renewal. In addition, we have negotiated more favorable
provider contracts and have improved our product mix by increasing enrollment in
our Medicare supplement business and reducing unprofitable self-funded
membership.
21
We have divested certain non-core assets. We sold our behavioral health and
medical management subsidiary, Innovative Resource Group, LLC ("IRG"), for
approximately $27.0 million, resulting in a pre-tax gain of approximately $11.0
million. Additionally, during 2002, we reduced our investment in American
Medical Security Group, Inc. ("AMSG") common stock from 45.2% of the shares
outstanding to 10.7%, relieving us of our statutory capital requirement relating
to AMSG. On January 3, 2003, we sold our remaining shares of AMSG common stock.
Through this strategy, we have improved our core operations. Although
resulting in decreased membership and premium revenue for Blue Cross & Blue
Shield United of Wisconsin ("BCBSUW") and our health maintenance organizations
("HMOs"), our strategy has substantially improved loss ratios and overall
profitability. Our income from continuing operations improved to $65.0 million
in 2002 from losses of $23.3 million in 2001 and $40.0 million in 2000. Had the
Combination occurred at the beginning of 2000 and the operations of the UWS
business been included for all periods presented, the improvement in overall
profitability between years would have been even greater. (See Item 8, Note 1 -
"Organization, Accounting for Conversion and Combination, and Basis of
Presentation.") During 2001, we experienced significant improvement in our core
operations, although we recorded a substantial loss, primarily due to a $25.2
million write-down of our minority investment in AMSG. We intend to continue our
strategy of focusing on our core business and pursuing opportunities to expand
margins, increase market share and divest additional non-core assets.
For financial reporting purposes, we have been able to reduce income tax
expense through utilization of certain net operating loss carryforwards that
were subject to a full valuation allowance. The majority of such net operating
loss carryforwards were exhausted during the fourth quarter of 2002 for book
purposes, and our effective tax rate will therefore increase in 2003.
Capitated and Other Service Arrangements
Compcare Health Services Insurance Corporation ("CompcareBlue"), Valley
Health Plan, Inc. ("Valley"), and Unity Health Plans Insurance Corporation
("Unity") utilize capitation and risk-sharing programs with certain physician
groups and hospitals to manage the cost of health care provided to members.
BCBSUW has not employed capitation or risk sharing arrangements to any
significant extent. Capitation is an arrangement whereby we pay medical
providers a set fee per member per month in exchange for providing health care
services.
As of December 31, 2000 and for the year then ended, medical and other
benefits expense in the consolidated statements of operations and medical and
other benefits payable in the consolidated balance sheets do not include any
significant amounts relating to capitated arrangements as these periods were
prior to the combination of UWS and BCBSUW on March 23, 2001 (the
"Combination"). For the year ended December 31, 2001, medical and other benefits
expense included $94.3 million relating to capitated medical and dental
arrangements, representing 8% of the total medical and other benefits expense,
and medical and other benefits payable at December 31, 2001 included $4.3
million relating to capitated arrangements. For the year ended December 31,
2002, medical and other benefits expense included $105.2 million relating to
capitated medical and dental arrangements, representing 9% of total medical and
other benefits expense, and medical and other benefits payable at December 31,
2002 included $1.1 million relating to capitated arrangements.
Costs associated with utilizing risk-sharing arrangements represented less
than 1% of total medical and other benefits expense for all periods presented.
22
Summary of Membership, Revenue, and Ratios
The number of "members" is equivalent to the number of persons covered by
contracts in force. A covered person may be counted in more than one category.
Member equivalents relating to individuals who access medical care under the
BlueCard preferred provider organizations ("PPO") program are not included.
As of December 31,
2000 2001 2002
------------ ------------ -------------
Membership at end of period:
Insured medical products 255,289 530,480 456,836
Self-funded medical products 184,819 131,671 343,525
Insured dental products 145,955 317,071 300,329
Self-funded dental products 50,785 37,975 172,045
Other insured products - 275,495 246,675
------------ ------------ -------------
Total 636,848 1,292,692 1,519,410
============ ============ =============
Year Ended December 31,
2000 2001 2002
--------------- -------------- -------------
(In thousands, except ratios)
Revenue:
Insured medical products $510,638 $1,150,420 $1,240,082
Self-funded products 24,716 28,067 30,638
Specialty managed care products and services 29,922 142,009 185,110
Government services 70,305 117,192 111,719
Other operations(1) (2,481) (24,450) (33,903)
--------------- -------------- -------------
Total health services revenue 633,100 1,413,238 1,533,646
Investment income, net 10,092 11,637 14,845
Net realized investment gains (losses) (509) 845 (1,141)
--------------- -------------- -------------
Total $642,683 $1,425,720 $1,547,350
=============== ============== =============
Health services revenue (as a percentage of the total):
Insured medical products 80.7% 81.4% 80.9%
Self-funded products 3.9 2.0 2.0
Specialty managed care products and services 4.7 10.0 12.0
Government services 11.1 8.3 7.3
Other operations(1) (0.4) (1.7) (2.2)
--------------- -------------- -------------
Total 100.0% 100.0% 100.0%
=============== ============== =============
Insured medical products:
Loss ratio(2) 93.5% 90.6% 86.4%
Selling, general, administrative, and other
expense ratio(3) 12.0% 9.6% 11.2%
__________
(1) Consists primarily of intracompany eliminations.
(2) Insured medical benefit as a percentage of insured medical products revenue.
(3) Insured selling, general, administrative, and other expenses as a percentage of insured medical products revenue.
Results of Operations
All financial data in the Results of Operations section are gross numbers
and, therefore, are not net of intracompany eliminations.
23
Comparison of Results of Fiscal Year 2002 with Fiscal Year 2001
Results for the fiscal year 2002 include the combined operations of BCBSUW
and UWS (also known as Cobalt) for the entire year, with BCBSUW's investment in
AMSG accounted for under the equity method as an investment in affiliate through
May 31, 2002. Results for the fiscal year 2001 include the operations of BCBSUW
for the entire year and UWS for the nine-month post-combination period, with
BCBSUW's investment in AMSG accounted for under the equity method as an
investment in affiliate.
Total Revenues
Total revenues in 2002 increased 8.5% to $1,547.4 million compared to
$1,425.7 million in 2001. This increase was primarily due to the Combination and
resultant inclusion of an additional quarter of the UWS business. Premium rate
increases on continuing insured medical products business, partially offset by a
decline in insured membership, was another factor contributing to the increase.
Insured Medical Products
Insured medical products revenue in 2002 increased 7.8% to $1,240.1 million
from $1,150.4 million in 2001. The increase in premium revenue in 2002 is
primarily due to the Combination and resultant addition of one quarter of the
UWS business. The number of insured medical members as of December 31, 2002
decreased to 456,836 from 530,480 as of December 31, 2001. The decrease in
membership in 2002 is primarily due to BCBSUW's exit from the Medicare+Choice
program, effective January 1, 2002, and cancellations of unprofitable business
in the Milwaukee market.
Self-Funded Products
Self-funded administrative fees in 2002 increased 8.9% to $30.6 million
from $28.1 million in 2001. Self-funded medical and dental membership increased
to 515,570 as of December 31, 2002 from 169,646 as of December 31, 2001. The
large increase in membership in 2002 is attributable to the acquisition of CMSI
on December 31, 2002. No revenue relating to CMSI was recorded during 2002. The
increase in administrative fees is attributable to increased volume in the
BlueCard PPO program, offset by cancellations of commercial groups. BlueCard PPO
program administrative fees in 2002 increased 60.0% to $13.4 million from $8.4
million in 2001. Under the BlueCard PPO program, we do not maintain membership
but receive an administrative fee and percentage of discounts for members from
other Blue Cross and Blue Shield plans ("Blue Plans") that access medical care
in Wisconsin.
Specialty Managed Care Products and Services
Specialty managed care products and services revenue in 2002 increased
30.4% to $185.1 million from $142.0 million in 2001 primarily due to the
Combination and resultant addition of one quarter of the UWS business. Premium
rate increases, offset by decreases in total membership due to cancellations in
the dental, disability, life, and accidental death and dismemberment lines, were
other factors contributing to the 2002 results.
Government Services
Government services revenue in 2002 decreased 4.7% to $111.7 million from
$117.2 million in 2001. The decrease in revenues between 2002 and 2001 is
largely due to a $7.4 million decrease in Medicare reimbursement partially
offset by an approximately $1.9 million increase in Medicaid claim processing
services. The decrease in Medicare revenue is largely attributable to
implementing several expense reduction measures that saved the Medicare program
$5.7 million between December 31, 2001 and December 31, 2002. Additionally, we
recorded a one-time reimbursement of $1.7 million in 2001. The Medicaid revenues
increased approximately $1.9 million due to new funding levels obtained from a
contract extension effective January 1, 2002.
24
Investment Income and Realized Investment Gains (Losses)
Net investment income and realized investment gains (losses) in 2002
increased 9.6% to $13.7 million from $12.5 million in 2001. Included in net
realized investment gains (losses) in 2002 are $3.2 million in losses relating
to fixed income investments for which impairment in value was deemed to be
other-than-temporary. The increase in net investment income and realized
investment gains (losses) in 2002 is primarily due to an increase in invested
assets resulting from several factors, including the addition of one quarter of
earnings on the UWS invested assets due to the Combination, and investment
income on proceeds from the sales of AMSG shares and IRG. Partially offsetting
the increase in investment income from invested assets was the elimination of
BCBSUW investment income related to intracompany financing arrangements with
UWS, subsequent to March 31, 2001, due to the Combination and a decrease in
interest rates on new investment purchases. Average annual investment yields,
excluding net realized investment gains, investment income from affiliates, and
other interest income, were 4.4% in 2002 and 5.8% in 2001.
Average invested assets in 2002 increased 98.2% to $330.0 million from
$166.5 million in 2001. The improvement in 2002 is primarily due to favorable
cash flow from operations and proceeds from the sale of AMSG shares and the sale
of IRG.
At December 31, 2002, lower than investment grade bonds represented 4.3% of
our investment portfolio.
Expense Ratios
Loss Ratio
The insured medical products loss ratio in 2002 was 86.4% compared with
90.6% in 2001. The continued improvement in the insured medical products loss
ratio is primarily due to the exiting of unprofitable business in the Milwaukee
market and improved underwriting discipline.
Selling, General, Administrative, and Other Expense Ratio
For our insurance subsidiaries, the selling, general, administrative, and
other ("SGA") expense ratio includes commissions, administrative expenses,
premium taxes and other assessments, and claim interest expense. For
non-insurance subsidiaries, the SGA expense ratio includes operating expenses
only.
The insured medical products SGA expense ratio in 2002 was 11.2% compared
with 9.6% in 2001. The increase in the SGA expense ratio in 2002 resulted
primarily from a decrease in revenue from cancellation of unprofitable business
that was not matched by a decrease in staff due to efforts to maintain service
levels. Fourth quarter 2002 SGA expenses included $2.5 million related to the
consolidation of operating centers, of which $2.3 million related to the insured
medical segment.
The expense ratio for self-funded products in 2002 improved to 91.8% from
113.9% in 2001. The improved expense ratio is primarily the result of an
increase in the volume of business serviced under the BlueCard PPO program.
Costs associated with servicing this business are significantly lower than the
costs associated with servicing other self-funded accounts. In addition,
increases in administrative fees on existing self-funded business have
contributed to the improvement in the expense ratio.
The combined loss and expense ratio for specialty managed care products and
services in 2002 improved to 95.6% from 98.0% in 2001. The improvement in 2002
is primarily due to a decrease in the combined loss and expense ratio for the
specialty insurance lines, which is a result of the loss ratio for our
disability business improving in 2002 to 64.3% from 85.6% in 2001. This
significant improvement is due to rate increases and favorable claims
experience.
25
The operating expense ratio for government services in 2002 improved to
98.6% from 99.3% in 2001. The improved expense ratio is primarily a result of
the increased funding on an existing subcontract for the Medicaid claim
processing services. The increased funding resulted from a contract extension
that became effective January 1, 2002.
SGA expenses recorded at the corporate holding company in 2002 include an
accrual for a $1.0 million contribution due the Wisconsin United for Health
Foundation, Inc. (the "Foundation") on February 1, 2003. In addition, during the
fourth quarter of 2002, $1.2 million of offering expenses were recorded due to
our decision not to sell any shares of Cobalt stock in the Foundation's offering
in early 2003. Offsetting these charges was a favorable vendor settlement of
$3.8 million recorded during the first quarter of 2002.
Other Expenses
As a result of the adoption of Statement of Financial Accounting Standards
("SFAS") No. 142 on January 1, 2002, there was no goodwill amortization recorded
in 2002. This compares with goodwill amortization of $5.1 million recorded in
2001.
Income (Loss) from Investment in Affiliates
In 2002, the income from investment in affiliates improved to $15.6 million
compared to a loss of $22.7 million in 2001. The results in 2002 were primarily
comprised of our equity in AMSG net income of $3.8 million combined with a net
gain of $10.0 million on the sale of 4.4 million shares of AMSG stock during the
first two quarters. As a result of the sale of these shares, our percentage
ownership of AMSG stock decreased below 20% and therefore, the remaining
investment was no longer reported under the equity method of accounting as of
June 1, 2002. A gain on the subsequent sale of an additional 0.5 million shares
was recorded in realized investment gains. In addition, we recognized income of
$1.6 million in the second quarter of 2002, which relates primarily to our
proportionate share of tax benefit recorded by Family Health Systems, Inc.
("FHS"), a 50% owned affiliate, due to a change in tax laws regarding the
carry-back of net operating losses.
The $22.7 million loss in 2001 is primarily comprised of equity in AMSG
earnings of $2.0 million for 2001 and BCBSUW's share of UWS earnings of $0.4
million for the first quarter of 2001 (prior to the Combination), offset by a
$25.2 million write-down of the investment in AMSG to its market value as of
December 31, 2001. This write-down was deemed appropriate based on management's
decision to no longer classify the investment in AMSG as a strategic long-term
asset. The decrease in the investment in affiliates balance between 2002 and
2001 in the accompanying consolidated balance sheets primarily results from the
sale of AMSG shares and the reclassification of our remaining investment in
AMSG, which is no longer reported under the equity method of accounting.
Effective with the June 2002 balance sheet, the investment in AMSG is reported
as an available-for-sale investment at fair market value.
Income Taxes
Income tax expense for financial reporting purposes in 2002 was reduced
through utilization of certain net operating loss carryforwards that were
subject to a valuation allowance that had been established by a charge to income
tax expense. The majority of such net operating loss carryforwards were
exhausted for book purposes during the fourth quarter of 2002, and our effective
tax rate for financial reporting purposes will therefore increase in 2003. In
2002, we recorded current tax expense of $7.8 million offset by a deferred tax
benefit of $0.5 million. In 2001, we recorded a current income tax benefit of
$2.2 million offset by deferred tax expense of $0.3 million.
Income (Loss) from Discontinued Operations
Income from discontinued operations in 2002 consisted of the first quarter
net operating loss of IRG of $0.7 million and an after-tax gain on the sale of
IRG on March 29, 2002 in the amount of $9.6 million.
26
Net Income (Loss)
In 2002, net income improved to $74.0 million compared to a net loss of
$22.3 million for 2001. The enhanced operating results reflect improvement of
$59.2 million in operating income from continuing operations, improvement of
$38.3 million in income from investment in affiliates, and improvement of $8.0
million in income from discontinued operations, offset by a $9.2 million
increase in income taxes. The improvement in operating income from continuing
operations primarily reflects improvement in the insured medical products loss
ratio (resulting from exiting the Medicare+Choice program, cancellations of
unprofitable business, and premium rate increases), increased volume in the
BlueCard PPO program, and the $3.8 million favorable vendor settlement recorded
as a reduction to SGA expenses, offset by the $1.0 million contribution to the
Foundation, and $1.2 million in offering expenses. The improvement in income
from investment in affiliates reflects net realized gains of $10.0 million on
the sale of certain AMSG shares, along with the $1.6 million in income related
to FHS and improved 2002 operating results at AMSG. The income from discontinued
operations primarily reflects the net realized gain of $9.6 million on the sale
of IRG.
Comparison of Results of Fiscal Year 2001 with Fiscal Year 2000
The results for 2001 include the operations of the combined UWS and BCBSUW
entities effective March 31, 2001 with AMSG continuing to be accounted for using
the equity method. Prior to March 31, 2001, the results include the operations
of BCBSUW and its investment in UWS and AMSG accounted for using the equity
method. The comparison between 2001 and 2000 is largely explained by the
addition of UWS results for the last three quarters of 2001 following the
Combination.
Total Revenues
Total revenues in 2001 increased 121.8% to $1,425.7 million from $642.7
million in 2000. The increase in 2001 is due primarily to the Combination and
the resultant addition of the UWS business. UWS contributed $686.8 million in
revenue in 2001 or 106.9% of the total 121.8% increase for the year. Other
factors contributing toward the increase in 2001 include premium rate increases
on the insured medical product business, the re-pricing of self-funded products,
and new government fee based contracts.
Insured Medical Products
Insured medical products revenue in 2001 increased 125.3% to $1,150.4
million from $510.6 million in 2000. The increase in 2001 is primarily due to
the Combination and the resultant addition of UWS business.
The addition of UWS premiums resulted in an increase to premium revenue for
2001 of $574.4 million or 112.5% of the total 125.3% increase. The number of
insured medical members in 2001 increased 107.8% to 530,480 from 255,289 in
2000. The total membership increase of 275,191 reflects a decrease of 18,474
members in BCBSUW insured medical membership, offset by the addition of 293,665
members from the UWS insured medical business.
27
Self-Funded Products
Self-funded administrative fees in 2001 increased 13.8% to $28.1 million
from $24.7 million in 2000. The increase in 2001 results from an increase of
approximately 60% in the administrative fee per member per month due to the
targeted re-pricing of self-funded business in order to eliminate unprofitable
business. The pricing increases were partially offset by a reduction in non-HMO
self-funded membership.
Specialty Managed Care Products and Services
Specialty managed care products and services revenue in 2001 increased
374.9% to $142.0 million from $29.9 million in 2000. The increase in 2001
primarily resulted from the addition of $113.4 million in revenues from the UWS
specialty business, which includes life, accidental death and dismemberment,
dental, disability, workers' compensation products, along with electronic claim
submission, cost containment, and receivables management services. The number of
specialty managed care members in 2001 increased to 592,566 from 145,955 in
2000. The total increase in membership of 446,611 reflects a decrease of 13,981
members in BCBSUW insured dental membership, offset by the addition of 460,592
members from the UWS specialty risk business.
Government Services
Government services revenue in 2001 increased 66.7% to $117.2 million from
$70.3 million in 2000. The increase from 2000 to 2001 is attributable to
significant growth in the volume of Medicare claims processed, due to being
awarded additional government contracts. Effective December 1, 2000, United
Government Services, LLC, ("UGS") became the Medicare Part A Intermediary for
certain additional states and U.S. territories. In addition, also effective
December 1, 2000, UGS became the Regional Home Health Intermediary for certain
additional states and U.S. territories.
Investment Income and Realized Investment Gains (Losses)
Net investment income and realized investment gains (losses) in 2001
increased 30.2% to $12.5 million from $9.6 million in 2000. The addition of UWS
increased the 2001 investment income and realized investment gains (losses) by
$7.9 million. However, offsetting this increase was the elimination of BCBSUW
investment income related to intracompany financing arrangements with UWS,
subsequent to March 31, 2001, due to the Combination. This intracompany
investment income amounted to $5.5 million in 2000, as compared to $1.3 million
in 2001, based on the amount recorded through March 31, 2001. Average annual
investment yields, excluding net realized investment gains, intracompany
investment income and other interest income were 5.8% and 7.0% for 2001 and
2000, respectively.
Average invested assets in 2001 increased 254.3% to $166.5 million from
$47.0 million in 2000. The improvement in 2001 is due primarily to the
Combination and resultant addition of UWS at the end of the first quarter of
2001.
At December 31, 2001, lower than investment grade bonds represented 0.4% of
our investment portfolio.
Net investment gains (losses) are realized in the normal investment process
in response to market opportunities. Realized gains were $0.8 million in 2001
compared to realized losses of $0.5 million in 2000.
28
Expense Ratios
Loss Ratio
The insured medical products loss ratio for 2001 (which consists of the
BCBSUW insured medical business for the full twelve months, and the HMO business
after March 31, 2001) was 90.6%, compared with 93.5% for 2000 (which includes
only the BCBSUW business). The decrease in the medical loss ratio in 2001 is
primarily the result of pricing increases and other cost control measures
instituted in response to higher than anticipated medical utilization and cost
trends. In addition, the higher loss ratio for 2000 also reflects the effect of
a premium deficiency reserve of $3.6 million recorded during the second half of
2000 on the Medicare+Choice business. The premium deficiency reserve amount
recorded as of December 31, 2000 represented estimated losses throughout 2001.
The remainder of the premium deficiency reserve was reversed in 2001, as a
result of our exiting the business effective January 1, 2002.
The BCBSUW medical loss ratio for 2001 (excluding HMO business) was 85.7%,
compared with 93.5% for 2000. This improvement is partially attributable to a
reduction in the medical loss ratio in the Medicare+Choice business to 94.8% in
2001 from 127.3% in 2000, on comparable revenues. The loss ratio for 2001 for
the HMO business was 94.4% compared with 95.2% in 2000. The slight improvement
is the result of our re-pricing efforts and reduction of unprofitable business.
Selling, General, Administrative, and Other Expense Ratio
The insured medical products SGA expense ratio for 2001 was 9.6% compared
with 12.0% for 2000. The improved SGA expense ratio in 2001 is the result of
additional expense control measures instituted, combined with a higher premium
base in 2001 due to pricing increases. In addition, the insured medical products
SGA ratio in 2000 includes the effect of a $2.4 million write-off of deferred
acquisition costs related to the Medicare+Choice business.
The self-funded products expense ratio for 2001 improved to 113.9% from
144.7% in 2000. This improvement is due to continued efforts to eliminate
unprofitable business through price increases.
The combined loss and expense ratio for specialty managed care products and
services in 2001 improved to 98.0%, compared with 100.0% for 2000. The 2000
ratio includes only the BCBSUW dental business, whereas the 2001 ratio includes
both BCBSUW dental and the UWS specialty managed care products and services
business. The UWS specialty business includes cost containment services and
electronic claims services, which typically run at a lower overall operating
expense ratio, thus improving the combined ratio.
The expense ratio for government services in 2001 and 2000 remained
constant at 99.3%.
Other Expenses
Goodwill amortization totaling $5.1 million and $0.6 million was recorded
for 2001 and 2000, respectively. Of the total $5.1 million of goodwill
amortization recorded for 2001, $3.3 million relates to $65.6 million of
goodwill recorded in 2001 for the Combination as a result of purchase
accounting, which until the effective date of SFAS No. 142 was being amortized
on a straight-line basis over a period of 15 years. In addition, the 2001
amortization expense includes amortization related to the 1999 purchase by
BCBSUW of 1.4 million additional shares of UWS stock, which had been amortized
on a straight-line basis over a period of 15 years. Amortization expense for
2000 included amortization related to the purchase by BCBSUW of the 1.4 million
additional shares of UWS stock discussed above. In addition, goodwill
amortization has been recorded for various past acquisitions of subsidiaries and
additional insurance business.
29
Loss from Investment in Affiliates
The loss from investment in affiliates increased to $22.7 million in 2001
from $6.5 million in 2000. The $22.7 million loss in 2001 is comprised of our
pro rata share of AMSG's net income of $2.0 million for 2001, BCBSUW's share of
UWS income of $0.4 million for the first quarter of 2001, and other affiliate
net income of $0.1 million, offset by a $25.2 million write-down of the
investment in AMSG to its market value as of December 31, 2001. This write-down
was deemed appropriate based on management's decision to no longer classify the
investment in AMSG as a strategic long-term asset. The 2000 loss from investment
in affiliates of $6.5 million is comprised of a $7.6 million loss related to
UWS, offset by a $1.1 million equity share in the net income of AMSG.
Income Taxes
We recorded an income tax benefit of $1.9 million in 2001 compared to tax
expense of $0.5 million in 2000. The tax benefit recorded in 2001 was greater
than a benefit calculated at the federal statutory income tax rate due primarily
to the reversal of an accrual during 2001 in the amount of $1.5 million that was
no longer deemed necessary. This accrual had been established by UWS prior to
the Combination to cover estimated income tax exposures for the 1987 to 1994 tax
years. Based on an analysis of tax liabilities performed at the end of 2001,
management determined that the $1.5 million accrual was redundant with our full
valuation allowance against net deferred tax assets, and the accrual was
reversed into income.
We recorded income tax expense of $0.5 million in 2000 compared to a tax
benefit of $11.5 million calculated at the federal statutory rate, due primarily
to the recording of a valuation allowance of $14.9 million on net deferred tax
assets. The valuation allowance was recorded because management could not
conclude that it was "more likely than not" that tax benefits from the 2000 loss
would be realized due to a history of prior losses at BCBSUW.
Income from Discontinued Operations
Income from discontinued operations for 2001 of $1.0 million includes IRG's
net operating results for the nine months ended December 31, 2001.
Net Loss
Consolidated net results improved in 2001 to a loss of $22.3 million
compared to a loss of $40.0 million in 2000. The $22.3 million net loss in 2001
was the combination of an operating loss of $2.4 million and a loss from
investment in affiliates of $22.7 million as discussed above, offset by an
income tax benefit of $1.9 million and an after-tax gain on discontinued
operations of $1.0 million. The improved 2001 operating results reflect
improvement in the insured loss and SGA ratios, increases in administrative fees
on the self-funded business and continued growth in government contract business
over the prior year.
As of December 31, 2001, a full valuation allowance was established against
net deferred tax assets. We had a current income tax benefit of $2.2 million in
2001 compared to no current income tax expense or benefit in 2000. We recorded a
deferred tax expense of $0.4 million in 2001 and $0.5 million in 2000, which
related to a valuation allowance from a prior period.
Liquidity and Capital Resources
Our sources of cash flow consist primarily of health services revenues and
investment income. The primary uses of cash include medical and other benefit
payments, as well as operating expense payments. Positive cash flows are
invested pending future payments of medical and other benefits and other
operating expenses. Our investment policies are designed to maximize yield,
preserve principal, and provide liquidity to meet anticipated payment
obligations.
30
Our operating cash flow improved in 2002 compared to 2001. Cash provided by
continuing operations improved to $55.6 million for the year ended December 31,
2002 from $11.1 million in cash provided by continuing operations for the year
ended December 31, 2001. This reflects improved operating results in all four of
our reporting business segments and improved cash collections related to
balances due from clinics and providers. Cash used in investing activities for
the year ended December 31, 2002 includes net proceeds of $73.9 million from the
sale of 4.9 million shares of AMSG common stock, of which $68.6 million is
reflected in proceeds from sale of investment in affiliate in our 2002 audited
consolidated statement of cash flows. In addition, $17.0 million in cash
proceeds were received from the sale of IRG. Cash used in investment activities
for 2002 included $15.3 million cash used to acquire CMSI offset by $2.2 million
cash acquired, and $10.8 million of net investments in property and equipment.
Cash provided from financing activities during 2002 included net borrowings made
of $22.1 million and proceeds received from the exercise of stock options of
$7.3 million. The majority of the strong positive cash inflows for the year
ended December 31, 2002 were used to purchase available-for-sale securities.
To meet periodic cash flow requirements, we make borrowings under our bank
line of credit ("LOC"). The line of credit is with a commercial bank and has an
interest rate equal to the London Interbank Offered Rate ("LIBOR"), plus 2.0%,
adjusted monthly with interest payments due monthly. The LOC permits aggregate
borrowings among certain subsidiaries, excluding the corporate holding company,
up to $20.0 million. At December 31, 2002, the outstanding balance on this LOC
was $7.5 million. The LOC terminates, and all borrowings then outstanding are
due, on April 30, 2003.
We also currently have a three-year revolving credit facility ("revolver")
from M&I Marshall & Ilsley Bank that originated on August 7, 2002 and provides
up to $30.0 million of available credit to us with the availability declining by
$5.0 million after one year and an additional $10.0 million after two years. The
revolver bears interest at a rate of LIBOR plus 1.50% to 2.50% depending on the
timing and amount of borrowings. We have pledged the stock of our BCBSUW and
CompcareBlue subsidiaries as collateral for the revolver. Our outstanding
balance on the revolver was $30.0 million as of December 31, 2002.
In addition, we had a term business note ("term note") with a commercial
bank for $7.5 million originated on December 31, 2001, which was repaid in full
in the third quarter of 2002. The term note had a rate of interest equal to
LIBOR plus 1.5%, with payment of principal and interest due in quarterly
installments beginning June 30, 2002.
Interest expense on the LOC, revolver and the term note discussed above
totaled $0.7 million and $0.6 million for the years ended December 31, 2002 and
2001, respectively.
The Association requires BCBSUW and CompcareBlue to maintain a prescribed
liquidity ratio of certain liquid assets to average monthly expenses, as
defined, in accordance with licensure requirements of the Association. BCBSUW
and CompcareBlue maintained these required levels as of December 31, 2002.
Our investment portfolio consists primarily of investment-grade bonds and
government securities, and has a limited exposure to equity securities. At
December 31, 2002, $350.6 million or 90.7% of our total investment portfolio was
invested in bonds and government securities compared with $178.2 million or
93.0% at December 31, 2001. Our investment in AMSG common stock represented
approximately 5.0% of the total investment portfolio as of December 31, 2002. On
January 3, 2003, we sold our remaining investment in AMSG shares, netting
proceeds of $18.7 million, which were reinvested in bonds and government
securities. The bond portfolio had an average quality rating by Moody's Investor
Service of "Aa3" at December 31, 2002 and "Aa2" at December 31, 2001. At
December 31, 2002, $373.9 million or 96.7% of our total investment portfolio was
classified as available-for-sale compared with $180.7 million or 94.3% at
December 31, 2001. The market value of the total investment portfolio was
greater than amortized cost by $14.3 million and $0.3 million at De