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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the Fiscal Year Ended December 31, 1998, OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
Commission File No.0-13591
PROVIDENT AMERICAN CORPORATION
(Exact name of registrant as specified in its charter)
Pennsylvania 23-2214195
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2500 DeKalb Pike, Norristown, Pennsylvania 19404
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (610) 279-2500
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.10 Par Value
(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates
of the Registrant, based upon the closing sale price of the Common Stock on
March 25, 1999 as reported on the NASDAQ National Market System, was
approximately $77,764,815. Shares of Common Stock held by each officer and
director and by each person who owns 5% or more of the outstanding Common Stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
As of March 25, 1999, Registrant had 11,624,780 shares of Common Stock
outstanding.
The Exhibit Index is located on Page 78
PROVIDENT AMERICAN CORPORATION
Table of Contents
Page
I. Part I. ----
Item 1. Business 2-43
Item 2. Properties 44
Item 3. Legal Proceedings 44
Item 4. Submission of Matters to a Vote of Security Holders 44
II. Part II.
Item 5. Market for Registrant's Common Equity
and Related Stockholder Matters 45-49
Item 6. Selected Financial Data 50
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations 51-59
Item 8. Financial Statements and Supplementary Data 60
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 61
III. Part III.
Item 10. Directors and Executive Officers of the Registrant 62-64
Item 11. Executive Compensation 65-71
Item 12. Security Ownership of Certain Beneficial
Owners and Management 72-74
Item 13. Certain Relationships and Related Transactions 74-75
IV. Part IV.
Item 14. Exhibits, Financial Statement Schedules
and Reports on Form 8-K 76-77
Exhibit Index 79-89
PART I
Item 1. Business
Provident American Corporation ("PAMCO") is a Pennsylvania corporation
organized in 1982 and regulated as an insurance holding company by the states in
which its wholly owned insurance subsidiaries are licensed. The operations of
PAMCO and its subsidiaries (the "Company") are principally those of its majority
owned subsidiary HealthAxis.com, Inc. ("HealthAxis") and PAMCO's insurance
operations. PAMCO's insurance operations are currently conducted through its
wholly owned subsidiary, Provident Indemnity Life Insurance Company ("PILIC")
and PILIC's subsidiaries which, during 1996 through 1998, were Provident
American Life and Health Insurance Company ("PALHIC"), Montgomery Management
Corporation ("MMC") and NIA Corporation ("NIA"). Hereinafter, PAMCO and all of
its subsidiaries are collectively referred to as the Company and PILIC and all
of its subsidiaries are referred to as the Company's Insurance Operations.
During 1998, the Company sold 80% of MMC's outstanding common stock and on
December 31, 1998 sold 100% of the outstanding common stock of PALHIC and NIA.
Revised Strategy and Recent Developments
The Company markets and underwrites medical insurance and life
insurance and derived a majority of its revenue from group association major
medical products sold to individuals. A smaller proportion of revenue is derived
from traditional life (whole life and limited pay) products. During 1998 the
Company revised its business strategy to focus predominately on HealthAxis, the
Company's E-Commerce Insurance Marketing subsidiary along with a more focused
strategy for PILIC. The following are the financial highlights for the Company:
(Dollars in thousands)
1998 1997 1996
---- ---- ----
Gross premiums $ 119,533 $ 97,267 $ 68,503
Total revenue $ 77,499 $ 62,030 $ 74,147
Net income (loss) $ (12,156) $ (18,425) $ 16,120
Total assets $ 116,689 $ 98,365 $ 93,054
2
Total revenue for each year was net of premium ceded to reinsurers.
Gross premium growth was the result of sales of the Company's primary managed
care products, The Provident Solution and HealthQuest. The net loss in 1998 and
1997 was attributable primarily to higher group medical policy benefits. The net
loss in 1998 was also impacted by $4.9 million of expenses related to HealthAxis
while 1997's net loss was also impacted by the write off of certain deferred
acquisition costs related principally to its group health business, impairment
of certain assets, principally goodwill, and transition costs associated with
the transfer of insurance servicing operations to Health Plan Services ("HPS").
Total revenues and net income in 1996 included a litigation settlement of $22.4
million.
In early 1998 the Company determined that the Internet provided the
opportunity to sell medical insurance directly to the consumer thereby reaching
individuals under-served by insurance agents at a cost potentially lower than
the Company's current traditional agency marketing channel. During 1998, the
Company entered into various agreements in order to sell and service insurance
business via the Internet. Accordingly a new subsidiary, HealthAxis.com, Inc.
was formed in March 1998 to conduct this new venture. HealthAxis is not licensed
as an insurance company but rather an Internet-based distributor of health
insurance products. As of February 1, 1998 (as amended November 13, 1998) the
Company entered into an Amended and Restated Interactive Marketing Agreement
(the "AOL Agreement") with America Online, Inc. ("AOL"). HealthAxis became AOL's
exclusive third-party direct marketer for specified insurance products along
with vision, dental, prescription, critical care insurance and long-term care
insurance coverage for individuals and groups of less than fifty individuals in
the United States. HealthAxis is advertising these products to AOL subscribers
on AOL's online network under the HealthAxis.com brand name. HealthAxis markets
medical insurance products underwritten by PALHIC and plans to market medical
and related insurance products underwritten by other companies.
Additionally, in June 1998, HealthAxis entered into promotional
agreements with CNet, Inc. ("CNet") and Lycos, Inc. ("Lycos") whereby CNet and
Lycos will exclusively promote HealthAxis health insurance and other related
products on CNet's and Lycos' web sites. During the first quarter of 1999,
advertising began on a limited basis on the Lycos network of web sites.
In light of the continued losses experienced in the Company's group
medical products and the need to devote capital and focus to HealthAxis, the
Company entered into various agreements to sell a portion or all of PILIC's
subsidiaries MMC, PALHIC and NIA and additionally ceded 100% of its group
medical and life business during 1998.
3
In February 1998, the Company sold for $4 million, 49% of Montgomery
Management Corporation ("MMC") Common Stock along with a warrant to purchase an
additional 31% of MMC's Common Stock for a nominal amount, which warrant was
exercised in the fourth quarter of 1998. The Company recognized a pre-tax gain
of approximately $4 million on the sale and, accordingly, accounts for its
remaining 20% interest in MMC on the equity basis. PILIC, continues to assume
via reinsurance approximately 30% of the premiums, benefits and expenses of the
stop-loss business administered by MMC and receives 20% of MMC's net income in
the form of dividends.
On December 31, 1998 the Company executed a series of transactions
whereby PALHIC reinsured 100% of its insurance inforce to PILIC, which, in turn,
reinsured, all of the Company's group medical and group life business to the
Reassurance Company of Hannover ("RCH") via a 100% co-insuance agreement,. In
addition, PILIC sold PALHIC and NIA to CRLC for $5.6 million which approximates
PALHIC's capital and surplus. The Company also transferred all rights and
control regarding the Company's agents and entered into non-compete and
non-solicitation agreements regarding the Company's agents with respect to the
future sale of health insurance products by agents for a 3-year period ending
December 31, 2001. The Company received regulatory approval for all of these
transactions for statutory reporting purposes. The Company's expectation is that
these transactions should provide PILIC the necessary statutory basis capital to
pursue its more focused strategy, see "Revised Strategy for Insurance
Operations".
4
The $10 million ceding commission paid by CRLC to PILIC consisted of a
$5 million non-refundable payment plus a $5 million contingent payment, whereby
PAMCO guaranteed that CRLC will earn at least $10 million in future profits from
the purchased inforce business, plus 12% interest on $10 million and other
amounts due (the "guaranteed amount"). If at the end of 5 years CRLC fails to
earn the guaranteed amount, PAMCO must repay CRLC the lesser of the guaranteed
amount less CRLC's actual profits on the inforce business, or $5 million plus
12% interest on $5 million and other amounts due. As security for PAMCO's
guarantee, PAMCO executed a Guarantee Agreement and Stock Pledge Agreement in
favor of RCH and CRLC which allows CRLC and RCH to take ownership of PILIC if
PAMCO defaults on its guarantee to CRLC. The Guarantee Agreement and Stock
Pledge Agreement prevent PAMCO from selling or otherwise disposing of PILIC's
stock. Furthermore these agreements prevent PAMCO from paying dividends,
incurring debt, making loans and from selling substantially all of PILIC's
assets without CRLC and RCH's approval. These agreements do not directly involve
HealthAxis. If CRLC's future profits exceed the guaranteed amount PILIC would be
entitled to receive additional payments from CRLC equal to the lesser of CRLC's
future profits less the guaranteed amount, or 2/3 of the policy fees collected
during 1999 and 1/3 of the policy fees collected during 2000. The $10 million
ceding commission has been recognized as ceding commission revenue by PILIC, and
PAMCO has recognized $5 million ceding commission liability.
5
Special Considerations and Risk Factors
All statements and information herein, other than statements of
historical fact, are forward looking statements that are based upon a number of
assumptions concerning future conditions that may ultimately prove to be
inaccurate. Many phases of the Company's operations are subject to influences
outside its control. Any one, or any combination of factors could have a
material adverse effect on the Company's results of operations. These factors
include: changes in governmental regulation, claims experience and reserve
adequacy, rating changes, competitive pressures, economic conditions, changes in
consumer spending, interest rate fluctuations, and other conditions affecting
capital markets. The following factors should be carefully considered, in
addition to other information contained in this document. This document contains
certain forward-looking statements within the meaning of section 27A of the
Securities Act of 1933 as amended ("Act") and section 21E of the Securities
Exchange Act of 1934, as amended. The Statements include among other things,
statements regarding trends, strategies, plans, beliefs, intentions,
expectations, goals and opportunities. Also they include uncertainty of future
operating results, new business challenges, risks associated with brand
development, competition, funding; need for additional capital, management of
potential growth; new management team, dependence on key personnel, dependence
on the Internet, dependence on strategic alliances with Internet partners,
liability for information transmitted through the Internet, uncertain acceptance
of the Internet as a medium for health insurance sales and risk capacity
constrains; reliance on internally developed systems; system development and
other risks, dependence on third party technology, rapid technological change,
risk of system failure; A.M. Best's insurance ratings, dependence on key
suppliers of insurance products, dependence upon third party claims
administration services, changes in the insurance industry, insurance industry
factors, health care reform legislation, government regulation and legal
uncertainties, potential conflicts of interest, intercompany agreements not
subject to arm's length negotiations, risk associated with the Year 2000,
absence of dividends, statements regarding change in strategic focus, greater
control of costs, conversion and expansion of administrative infrastructure and
varying significance of particular states within which the Company can write
insurance; beliefs regarding attractiveness of products; enhancements to claims
system; increased processing capacity; investments in computer hardware and
funding of capital expenditures; sufficient liquidity to fund growth fulfill
statutory requirements and meet all cash requirements, funding surrenders,
benefit payments and loan payments. Actual events, developments and results
could differ materially from those anticipated or projected in the forward
looking statements as a result of uncertainties set forth below and elsewhere in
this document. Any investment in the Company's securities involves a high degree
of risk.
The following factors, in addition to the other information contained
in this report, should be considered carefully in evaluating an investment in
the Company.
6
Historical and Anticipated Losses; Uncertainty of Future Results: The
Company has incurred losses in its Insurance Operations related primarily to its
group medical products and in HealthAxis to develop and enhance its technology,
to create, introduce and enhance its web site, to establish marketing, insurance
carrier and claims administration relationships. As a result, the Company has
incurred significant losses and expects to continue to incur losses on a
quarterly and annual basis at least through fiscal 2000. The Company currently
intends to increase substantially HealthAxis operating expenses as a result of
strategic alliances, to fund increased sales and marketing, to enhance its
existing web site and to fund increased salaries and other costs. To the extent
that such expenses precede or are not subsequently followed by increased
revenues, the Company's business, results of operations and financial condition
will be materially adversely affected. There can be no assurance that the
Company will be able to generate sufficient revenues from the sale of insurance
products over the Internet to achieve or maintain profitability on a quarterly
or annual basis in the future. The Company expects negative cash flow from
operations to continue for the foreseeable future as it continues to develop and
market its Internet-based health insurance business.
Control of the Company: Alvin H. Clemens, Chairman and Chief Executive
Officer of the Company ("Mr. Clemens"), acquired control of the Company in
October 1989. Mr. Clemens is the largest shareholder of the Company. As of March
16, 1999, Mr. Clemens owned, either directly or beneficially, 2,006,068 shares,
or 19.8% of the Company's Common Stock, and 1,100,000 shares, or 99.4%, of the
Company's Preferred Stock which includes the right to acquire 364,176 shares of
common and 550,000 preferred pursuant to the exercise of stock options. As of
March 16, 1999, Mr. Clemens controlled 30.5% of the Company's outstanding voting
rights and, if he were to exercise all of his outstanding options, he would
control 40.0% of the Company's voting rights. In addition, pursuant to terms of
an agreement to grant options dated March 10, 1997, Mr. Clemens has the right to
be granted an option to acquire 55% of the common stock of the Company, subject
to the conditions set forth therein. Accordingly, Mr. Clemens could greatly
influence the outcome of any matter requiring shareholder approval, even if such
matters were deemed by the shareholders, other than Mr. Clemens, to be in their
best interests.
7
New Business Challenges: As a result of the various insurance related
transactions described in the preceding sections, HealthAxis, the Company's
Internet-based distributor of health insurance products, has become a major
operating unit of the Company which began selling a limited line of health
insurance products over the Internet in December 1998. Accordingly, the Company
has a very limited operating history in the Internet health insurance sales
business upon which an evaluation of HealthAxis and its prospects can be based.
The Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in new, unproven and rapidly
evolving markets. To address these risks, the Company must, among other things,
develop and expand its customer base, respond to competitive developments,
continue to attract, retain and motivate qualified employees, maintain its
current relationships with Internet service providers, continue to upgrade its
technologies and, finally, attract significant sources of capital to fund its
start-up activities. There can be no assurance that the Company will be
successful in addressing such risks. If the Company is not successful in
developing and expanding its Internet-based health insurance sales business, the
Company's ability to achieve profitability will be materially adversely
affected.
Risks Associated with Brand Development: The Company believes that
HealthAxis' ability to create and continue to strengthen its brand identity is
critical to achieving widespread acceptance of HealthAxis, particularly in light
of the competitive nature of the Company's business. Promoting and positioning
its brand identity will depend largely on the success of the Company's marketing
efforts and the ability of the Company to provide high quality insurance
products and services. In order to promote its brand identity, the Company will
need to increase its marketing efforts and budget and otherwise increase its
financial commitment to creating and maintaining brand loyalty among Internet
users. There can be no assurance that brand promotion activities will yield
increased revenues or that any such revenues would offset the expenses incurred
by the Company in building its brand identity. Further, there can be no
assurance that any new Internet users attracted to HealthAxis will conduct
transactions with HealthAxis on an ongoing basis. If the Company fails to
promote and maintain its brand identity or incurs substantial expenses in an
attempt to promote and maintain its brand identity or if the Company's existing
or future strategic relationships fail to promote the Company's brand identity
and increase brand awareness, the Company's financial position and projected
results of operations would be materially adversely affected.
8
Competition: Since the Internet's commercialization in the early
1990's, the number of web sites on the Internet competing for consumers'
attention and spending has proliferated. Although the Company believes that it
is the first transaction-enabled, Internet-based direct distributor of health
insurance , there are limited barriers to entry and the Company expects that
various others may attempt to establish similar web sites. In addition, in the
area of health insurance sales, the Company will compete with large insurance
and financial service companies with established insurance agent networks as
well as the independent insurance agents and brokers. Substantially all of the
HealthAxis' potential competitors have longer operating histories, significantly
greater financial, marketing and other resources, greater name recognition and
significantly larger existing customer bases than the Company. These competitors
may be able to respond more quickly to changes in customer preferences and to
devote greater resources to the development, promotion and sale of their
products or claims processing services than the Company. There can be no
assurance that the Company will be able to compete successfully with these
competitors. The Company's success will depend heavily upon its ability to
provide health insurance products at prices below those currently being provided
by traditional sources, along with expedited claims processing and access to
claims information via the Internet. Other factors that will affect the
Company's success include the Company's continued ability to attract experienced
technical, marketing, sales and management talent. The Company believes that the
principal competitive factors in the online health insurance market will be
price, name recognition, product selection, Internet access to claims
information, ease of use, site content, quality of claims processing services
and technical experience. HealthAxis' failure to compete successfully in the
health insurance business would have a material adverse effect on the Company's
business, results of operations and financial condition.
Funding; Need for Additional Capital: The Company's funding needs for
fiscal 1999 are estimated to be approximately $15.0 million for HealthAxis. In
fiscal 1999, HealthAxis' obligations to AOL, Lycos and CNet approximate $3.8
million. In order to implement its business plan in 1999, in addition to
payments to AOL, Lycos and CNet, HealthAxis anticipates incurring expenses of
approximately $4.0 million to advertise HealthAxis' offline, $1.0 million for
upgrades of its web site and $4.6 million for salary and other operating
expenses.
The Company's capital needs for HealthAxis during fiscal 1998 were
funded through the sale of a $5.0 million convertible note to HPS, $750,000
received from HPS in payment for the exclusive rights to administer the
insurance claims process for PALHIC products sold through HealthAxis, $3.0
million from the sale of additional shares of HealthAxis Common Stock to PAMCO,
the sale of $2.4 million of Series A Preferred Stock to PILIC and $2.75 million
from the sale of shares of Series B Preferred Stock to AOL.
9
HealthAxis expects to use a portion of the net proceeds of any private
or public offering to make payments to AOL, Lycos and CNet. HealthAxis expects
to utilize the remaining proceeds for working capital and other general
corporate purposes, including marketing expenses, web site enhancements and
salary and other operating expenses. Such net proceeds, together with cash
generated by operations, which are expected to be minimal, are unlikely to be
sufficient to fund future operating losses and the Company expects that it will
be required to raise additional funds to sustain and expand its sales, marketing
and development activities, particularly if a well-financed competitor emerges
or if technological enhancements are necessary in order for HealthAxis to remain
competitive. Future funding commitments beyond 1999 will be approximately $48.9.
(The renewal terms are optional for AOL and CNet. The Lycos renewal term is
based upon policies sold). Although, the Company believes that the $14.0 million
net proceeds will be sufficient to fund HealthAxis' operations through December
31, 1999, no assurances can be given that such funding will be sufficient. As a
result of these funding needs, the Company will need to seek additional debt
and/or equity financing. Adequate funds for these and other purposes on terms
acceptable to the Company, whether through additional equity financing, debt
financing or other sources, may not be available when needed or may result in
significant dilution to existing HealthAxis shareholders, including PAMCO. The
inability to obtain sufficient funds from operations and external sources would
have a material adverse effect on the Company.
10
Management of Potential Growth; New Management Team: HealthAxis
believes that it may experience a period of expansion and anticipates that
future expansion will be required to address potential growth in its customer
base and market opportunities. To the extent HealthAxis experiences a period of
rapid and significant growth, including a substantial increase in the number of
applications received, such growth may place significant demands on HealthAxis'
management, operations, systems and financial resources. To the extent that
HealthAxis grows rapidly, the Company will be faced with risks, including risks
associated with the assimilation of new personnel and products, and increasing
the capacity of its web site. From inception to December 1998, HealthAxis
expanded from one to 26 full time employees. HealthAxis expects to add
additional key personnel in the future. To manage the expected growth of its
operations and personnel, HealthAxis will be required to improve existing and
implement new transaction processing, operational and financial systems,
procedures and controls, and to expand, train and manage its growing employee
base. HealthAxis also will be required to expand its finance, administrative and
operations staff. Further, HealthAxis may be required to enter into
relationships with various strategic partners, web sites and other online
service providers and other third-parties necessary to support HealthAxis'
business. There can be no assurance that HealthAxis' current and planned
personnel, systems, procedures and controls will be adequate to support
HealthAxis' future operations, that management will be able to hire, train,
retain, motivate and manage required personnel or that HealthAxis' management
will be able to identify, manage and exploit existing and potential strategic
relationships and market opportunities. HealthAxis' ability to compete
effectively will depend, in part, upon its ability to overcome these growth
related risks and to revise, improve and effectively use its operational,
management, marketing and technical systems. Furthermore, there can be no
assurance that HealthAxis will be able to effectively manage such growth. Any
failure of HealthAxis to effectively manage its growth and to respond to changes
in its business would have a material adverse effect on HealthAxis' and the
Company's business, results of operations and financial condition.
11
Dependence on Key Personnel: HealthAxis' performance will be
substantially dependent on the continued services and on the performance of its
senior management and other key personnel, all of whom are employed on an
at-will basis. HealthAxis is negotiating employment agreements for several key
senior management personnel. HealthAxis' performance also will depend on
HealthAxis' ability to retain and motivate its other officers and key employees.
The loss of the services of any of its executive officers or other key employees
could have a material adverse effect on HealthAxis. As of December 31, 1998,
HealthAxis did not have employment agreements with any of its key personnel and
maintains no "key person" life insurance policies on such individuals.
HealthAxis' future success also will depend on its ability to identify, attract,
hire, train, retain and motivate other highly skilled technical, managerial,
financial, marketing and customer service personnel. Competition for such
personnel is intense, and there can be no assurance that HealthAxis will be able
to successfully attract, integrate or retain sufficiently qualified personnel,
including software developers and other technical experts. The failure to
attract and retain the necessary personnel could have a material adverse effect
on HealthAxis and the Company.
Dependence on Strategic Alliances with Internet Partners: HealthAxis
relies on its strategic alliances with AOL, Lycos and CNet to attract customers
to its web site and to promote sales of insurance products over the Internet.
HealthAxis' ability to generate sufficient revenues from insurance sales over
the Internet to fund its operations generally depends on increased traffic and
purchases that HealthAxis expects to generate partially through these strategic
alliances with Internet content and service providers. Pursuant to its agreement
with AOL, HealthAxis has the exclusive rights, subject to certain exceptions, to
offer certain health insurance products to AOL subscribers. In November 1998,
HealthAxis renegotiated its agreements with AOL, CNet and Lycos in order to
obtain additional time needed to develop and test its web site and to secure
additional funds necessary to enable HealthAxis to make payments that were
coming due and/or past due under these agreements. AOL, CNet and Lycos each
agreed to extend the launch date for HealthAxis' web site and the due dates for
HealthAxis' payment of fees. The inability of HealthAxis to enter into new, and
to maintain any one or more of its existing, strategic alliances with AOL and
others could have a material adverse effect on HealthAxis' and the Company's
business, results of operations and financial condition.
12
Liability for Information Transmitted through the Internet: A
significant barrier to online insurance sales and communications is the secure
transmission of confidential information over public networks. Computer viruses,
break-ins or other security breaches could lead to misappropriation of personal
or proprietary information and interruptions, delays or cessation in service to
HealthAxis' customers. Although HealthAxis relies on encryption and
authentication technology licensed from third parties to provide the security
and authentication necessary to effect secure transmission of confidential
information, such as customer credit card numbers and claims information, there
can be no assurance that advances in computer capabilities, new discoveries in
the field of cryptography, or other events or developments will not result in a
compromise or breach of the algorithms used by HealthAxis to protect application
information and policyholder claims data. If any such compromise of HealthAxis'
security were to occur, it could have a material adverse effect on HealthAxis. A
party who is able to circumvent HealthAxis' security measures could
misappropriate proprietary information or cause interruptions in HealthAxis'
operations or cessation of service to HealthAxis' policyholders and applicants.
In addition, such a party could also cause HealthAxis to download to third
parties personal medical information, viruses or other objectionable materials.
HealthAxis may be required to expend significant capital and other resources to
protect against such security breaches or to alleviate problems caused by such
breaches or viruses. Consumer concerns over the security of transactions
conducted on the Internet and other online services and the privacy of users may
also inhibit the growth of the Internet and other online services generally, and
the Web in particular, especially as a means of conducting commercial
transactions such as health insurance sales and claims processing, where
consumers are required to send credit card and highly personal health
information over the Internet. To the extent that activities of HealthAxis and
HPS involve the storage and transmission of proprietary information, such as
medical and claims information, security breaches could damage HealthAxis'
reputation and expose HealthAxis to a risk of loss or litigation and possible
liability. There can be no assurance that HealthAxis' security measures will
prevent security breaches or that failure to prevent such security breaches will
not have a material adverse effect on HealthAxis. Although HealthAxis carries
general liability insurance, HealthAxis' insurance may not cover potential
claims of this type or may not be adequate to cover all costs incurred in
defense of potential claims or to indemnify HealthAxis for all liability that
may be imposed. HealthAxis does not intend to secure errors and omissions
insurance to enhance its existing coverage. Any costs or imposition of liability
that is not covered by insurance or in excess of insurance coverage could have a
material adverse effect on HealthAxis' and the Company's business, results of
operations and financial condition.
13
Uncertain Acceptance of the Internet as a Medium for Health Insurance
Sales: HealthAxis initiated a "soft launch" of the fully functional version of
its web site in December 1998 which included a limited number of impressions
from AOL. HealthAxis expects to increase marketing efforts and drive higher
volumes of transactions through its web site during the second quarter of 1999.
As a result, HealthAxis has limited experience in the on-line insurance sales
business. Use of the Internet by consumers to purchase health insurance products
is a relatively new development, and market acceptance of the Internet as a
medium for insurance sales is subject to a high level of uncertainty.
HealthAxis' future success will depend on its ability to significantly increase
revenues, which will require the development and widespread acceptance of the
Internet as a medium for insurance sales. There can be no assurance that
consumers who are willing to purchase relatively simple, low cost and low risk
items such as compact discs, flowers, books and groceries over the Internet will
be willing to purchase complicated and higher cost items such as health and
related insurance policies in such manner or may prefer to discuss insurance
decisions with an insurance agent as opposed to Internet purchases with no agent
involvement. Finally, consumers may be unwilling to divulge highly personal
medical information through the Internet. There can be no assurance that
HealthAxis' products, application process, pricing and Internet-based claims
processing will be attractive to a sufficient number of users to generate
significant revenues. There can also be no assurance that HealthAxis will be
able to anticipate, monitor and successfully respond to rapidly changing
technology and consumer preferences so as to continually attract and retain a
sufficient number of customers. If HealthAxis is unable to develop and implement
competitively priced products that allow it to attract, retain and expand its
customer base, it and the Company could be materially adversely affected.
In addition, HealthAxis will be primarily reliant upon the Internet as
a means of marketing and selling its insurance policies. The Internet in general
as well as online services could lose their viability due to delays in the
development or adoption of new standards and protocols required to handle
increased levels of Internet or other online service activity, or due to
increased governmental regulation. Changes in or insufficient availability of
telecommunications services to support the Internet or other online services
also could result in slower response times and adversely affect usage of the
Internet and other online services generally and the HealthAxis services in
particular. Accordingly, any adverse change or a failure in the character of the
Internet will have a corresponding adverse effect on HealthAxis' sales and the
Company's financial condition.
14
Risk of Capacity Constraints; Reliance on Internally Developed Systems;
System Development and Other Risks: A key element of HealthAxis' strategy is to
generate a high volume of traffic on, and use of, its web site to generate
insurance sales. Accordingly, the satisfactory performance, reliability and
availability of HealthAxis' web site, transaction processing systems and network
infrastructure is critical to HealthAxis' reputation and its ability to attract
and retain customers and maintain adequate policyholder service levels.
HealthAxis' revenues depend on the number of customers who purchase insurance
products from its web site and the volume of renewals received. In addition,
from time to time, HealthAxis and its key suppliers may experience capacity
constraints and failures of their information systems which could result in
decreased levels of service delivery or interruptions in service. While
HealthAxis continually will review and seek to upgrade its technical
infrastructure and provide for certain system redundancies and backup power to
limit the likelihood of systems overload or failure, any damage, failure or
delay that causes interruptions in HealthAxis' operations could have a material
adverse effect on HealthAxis. Any system interruptions that result in the
unavailability of HealthAxis' web site, reduced applications processing or the
unavailability of claims information would reduce the volume of policies sold or
claims processed and the attractiveness of HealthAxis' insurance products.
HealthAxis believes that as part of doing business on the Internet, it
will, from time to time, experience periodic system interruptions. Any
unexpectedly high volume of traffic on the HealthAxis site or in the number of
applications placed by customers may require HealthAxis to expand and upgrade
further its technology, transaction processing systems and network
infrastructure. There can be no assurance that HealthAxis will be able to
accurately project the rate or timing of increases, if any, in the use of its
web site. Further, there can be no assurance that HealthAxis will be able to
expand and upgrade its systems and infrastructure to accommodate such increases
in a timely manner. Moreover, HealthAxis is entirely dependent upon the ability
of third parties to increase the capacity of its back end systems and a failure
by such third parties would have a material adverse impact upon HealthAxis'
operations.
The source code and design of HealthAxis' software will be protected by
HealthAxis through applicable trade secret law and, it is intended, through the
use of confidentiality agreements with its employees. Policing the unauthorized
use of HealthAxis' software and other proprietary materials is difficult and
HealthAxis believes that the unregulated open access provided to third parties
via the Internet creates a substantial risk that HealthAxis' technology may be
duplicated.
15
Dependence on Third Party Technology: The Company relies upon a variety
of technology that it licenses from third parties, including its data base and
Internet server software, which is used in the HealthAxis' web site to perform
key functions. There can be no assurance that these third party technology
licenses will continue to be available to HealthAxis on commercially reasonable
terms. The loss of or inability of HealthAxis to maintain or obtain upgrades to
any of these technology licenses could result in delays in completing its
proprietary software enhancements and new development until equivalent
technology could be identified, licensed or developed, and integrated. Any such
delays would materially affect HealthAxis and the Company. In this regard it is
noted that certain disputes have arisen between the Company, HealthAxis and HPS.
See "Back End Processing Technology" and "Insurance Operations - Claims."
Rapid Technological Change; Risk of System Failure: The Internet is
characterized by rapid technological change, changes in user and customer
requirements and preferences, frequent new product and service introductions
embodying new technologies and the emergence of new industry standards and
practices that could render the HealthAxis' existing web site, technology and
systems obsolete. To remain competitive as other providers enter the Internet
insurance market, HealthAxis must continue to enhance and improve the
responsiveness, functionality and features of the HealthAxis web site.
HealthAxis' success will depend, in part, on its ability to add and delete
additional carriers or products, enhance its existing services, develop new
services and technology that address the increasingly sophisticated and varied
needs of its prospective customers, and respond to technological advances and
emerging industry standards and practices on a cost-effective and timely basis.
There can be no assurance that HealthAxis will successfully use new technologies
effectively or adapt HealthAxis' web site, technology and systems to customer
requirements or emerging industry standards. If HealthAxis is unable, for
technical, legal, financial or other reasons, to adapt in a timely manner in
response to changing market conditions or customer requirements it would be
materially adversely affected.
In addition, HealthAxis' operations are dependent on its ability and
the ability of its key business partners to maintain their computer and
telecommunications equipment in effective working order and to protect their
systems against damage from fire, natural disaster, power loss,
telecommunications failure or similar events. In addition, the growth of
HealthAxis' customer base may strain or exceed the capacity of its or its key
business partners' computer and telecommunications systems and lead to
degradations in performance or systems failure. In addition, critical elements
of HealthAxis' computer and telecommunications operations, (and those of its key
business partners) including their processing operations, is located at single
site facilities. In the event of a catastrophic loss at any of single site
facilities of HealthAxis or its key business partners' sites, resulting in the
destruction of HealthAxis' (or its key business partners') computer and
telecommunications operations, HealthAxis would experience a significant
interruption of its business until such time as a second site backup is
established. Although HealthAxis maintains insurance and is in the process of
developing a second backup site, such insurance may not be adequate to
compensate HealthAxis for all property damage and business interruption losses
that may occur.
16
Dependence on Key Suppliers of Insurance Products: Although HealthAxis
has entered into agreements with additional insurance companies to offer their
products in the future, HealthAxis is currently dependent upon maintaining its
existing relationship with PALHIC, which currently is HealthAxis' sole provider
of insurance products. Concurrently, HealthAxis is continuing to attempt to
establish new relationships with additional insurance providers in order to
diminish its reliance upon any one carrier's products and to expand its product
offerings. There can be no assurance that HealthAxis will be successful in
establishing relationships with additional insurance providers on terms
satisfactory to HealthAxis. PALHIC's inability to underwrite a sufficient number
of policies, absent the development of relationships with additional insurance
providers, could materially adversely affect HealthAxis. In addition, to the
extent that PALHIC or the HealthAxis' other Carrier Partners, hereinafter
defined are unable to underwrite an increasing number of policies for
HealthAxis, such capacity constraint would have a material adverse effect on
HealthAxis' and the Company's business, results of operations and financial
condition.
Dependence Upon Third Party Claims Administration Services: The Company
does not have the ability to service claims for group medical and group life
policies and, accordingly, will be dependent upon maintaining its existing
relationship with HPS, a provider of health claims administration services, or
establishing a new claims administration relationship with a comparable claims
services company. There can be no assurance that the Company will maintain its
relationship with HPS (the current term of which expires in October 1999 for
HealthAxis and for the Company's Insurance Operations on December 31, 2002). The
termination of such relationship would, absent establishing a substitute
relationship with another claims servicer, or HPS' inability to timely and
efficiently process an increasing number of claims will have a material adverse
effect on the Company. In addition, the failure of HPS or another third party
claims administration company to adequately, efficiently and timely service
claims related to policies sold by HealthAxis or the Company's Insurance
Operations could have an adverse effect on HealthAxis' future sales and renewals
and PILIC's profitability.
Changes in the Insurance Industry: The Company's success will depend in
part upon HealthAxis ability to develop and provide new products that meet
customers' changing health insurance needs and changes in government
requirements. During recent years, the health insurance industry has experienced
substantial changes, primarily caused by healthcare legislation, originally at
the state level, and more recently at the federal level and the introduction of
managed care organizations. Additionally, over the past several years the rapid
growth of Health Maintenance Organizations ("HMOs") and Preferred Provider
Organizations ("PPOs") as well as the organization of healthcare providers in
new ways such as Physician Hospital Organizations ("PHOs") has dramatically
changed the sales of health insurance products. The Company's future success
will depend, in part, on its ability to effectively enhance its current products
and claims processing capabilities and to develop new products in the changing
health care environment on a timely and cost-effective basis.
17
Health Care Reform Legislation: In the past, there have been, and
currently there are, a number of proposals introduced in the United States
Congress and currently there are proposals pending in state legislatures to
reform the current health care system. Many states have already enacted
comprehensive health care reform legislation and a number of legislative and
regulatory proposals are currently being considered at the state and federal
level. Legislative proposals have included requirements with respect to mandated
universal health insurance coverage, restrictions on preexisting condition
limitations, community rating standards, guaranteed issue and renewal
requirements and restrictions on premium increases. Several states have passed
and many other states are considering legislation that includes voluntary health
care purchasing alliances, differential limitations in rates for new and renewal
business or for demographic groups, and underwriting practice restrictions.
These reforms generally include the formation of voluntary purchasing alliances
for small employers (typically with less than 50-100 employees) and require
insurers to accept all qualified small employer groups as a condition of
providing small group insurance, prohibit the imposition of preexisting
condition limitations or medical condition terminations, and phase out
experience-rating for small employer groups. Certain jurisdictions also have
enacted so-called "any willing provider" laws which may decrease the demand for
managed care plans. While the Company cannot predict whether any of the
proposals currently being considered will be enacted or whether any new federal
or state proposals will be considered, and thus cannot predict what specific
effects health care reform may have on the Company's business, the Company may
be adversely affected by changes to the health care system.
Government Regulation and Legal Uncertainties: The insurance industry
is one of the most highly regulated fields. As a result, the Company is subject,
both directly and indirectly, to various laws and governmental regulations
relating to its business. Currently state laws regulate product marketing and
advertising on the Internet. Although the Company believes it is in compliance
with such laws, no assurance can be given that compliance with future rules and
regulations will not have a materially adverse effect on the Company. The
insurance products offered by the HealthAxis must be approved by HealthAxis'
Carrier Partners in the various states in which such products are offered. The
Carrier Partners are also subject to extensive supervision and regulation at the
state level. The Company could be adversely affected if HealthAxis' Carrier
Partners are unable to obtain approval for the products which HealthAxis plans
to offer on its web site or are otherwise adversely affected by actions taken by
state regulatory authorities against any Carrier Partner.
18
A. M. Best's Insurance Ratings: The ratings assigned by A.M. Best
Company Inc. ("Best") are an important factor influencing the competitive
position of insurance companies. Best's ratings are based on an analysis of the
financial condition and operating performance of the companies rated. Best's
classifications are A++/A+ (superior), A/A- (excellent), B++/B+ (very good),
B/B- (adequate), C++/C+ (fair), C/C- (marginal), D (below minimum standards) and
E (under state supervision). Best's ratings are based upon factors of concern to
policyholders and insurance agents, and are not necessarily directed toward the
interests of investors in the rated insurance company and/or its parent and
therefore should not be relied upon as a basis for investment decisions. There
can be no assurance that Best will reaffirm PILIC's ratings in the future.
In 1997, PILIC and PALHIC Best's ratings were upgraded from a B- to a
"B" (adequate) rating, reflecting the Company's improved capital and surplus
position as a result of a litigation settlement resulting in a net gain of $19.0
million. This "B" (adequate) rating was reaffirmed in February, 1998. In 1999
the Company was notified by Best that PILIC's Best rating will be downgraded to
a B- due to PILIC's reduced capital and surplus position as a result of
operating losses on group medical products. The Company's goal is to strengthen
the financial position of PILIC, including the reinsurance of its group medical
business with RCH, which the Company believes will result in an improved rating
over time; although there can be no assurance that PILIC will be successful in
improving or maintaining its current rating.
Dividends: Dividends paid by the Company over and above the financial
assets of PAMCO are dependent on the ability of HealthAxis and PILIC to pay
dividends to PAMCO. The terms of HealthAxis' Certificate of Designation for
Series C Cumulative Convertible Preferred Stock restrict HealthAxis' ability to
pay dividends to shareholders including PAMCO. PAMCO's Guarantee Agreement with
RCH restricts PAMCO's ability to enter into new agreements and the payment of
dividends. Under Pennsylvania law, PILIC is currently unable to pay dividends
without the prior approval of the Pennsylvania Insurance Commissioner as a
result of PILIC's statutory unassigned deficit of $20.1 million, which excludes
common stock and additional paid-in capital amounts. The Company has not paid a
cash dividend on its common stock since its inception in 1982 and intends on
using capital and surplus to fund its growth and liquidity needs.
Possible Adverse Impact of Inadequate Loss Reserves or Deferred
Acquisition Costs: Policy claims and the related policy benefit expenses are
based upon a variety of estimation methods which are continually revised,
incorporating the Company's benefit experience. The Company's Insurance
Operations has, in the past, underestimated its loss reserves with regard to
these products The need for increased reserves could have a materially adverse
affect on the Company's results of operations.
19
The Company's Insurance Operations deferred policy acquisition costs as
of December 31, 1998 and 1997 related to the Company's individual life business
and were based on management's estimation that these costs will be recoverable
against future profits on these products. Increased lapsation over current
levels or unprofitability in these products could result in an increase in the
amortization rate of deferred acquisition costs which could have a material
adverse impact on the Company's financial condition.
Reinsurance: The Company's Insurance Operations ceded approximately
47.5% of group medical benefits incurred during 1996 through 1998 via quota
share agreements. The Company's medical quota share and excess reinsurance
agreements with Swiss Re were terminated effective December 31, 1997. Swiss Re's
obligation to assume its proportionate share of medical paid losses incurred
prior to January 1, 1998 remains in effect. The Company is currently in
negotiation with a group of reinsurers and has placement slips regarding a
replacement Quota Share Agreement and Excess of Loss Agreement effective January
1, 1998 through December 31, 1998. The Company is negotiating specific terms
regarding the risk attaching provisions for those policies inforce as of
December 31, 1997 until such time that those policies were rate increased during
1998. While the Company believes that the Company will execute a final
reinsurance agreement with its reinsurers there can be no assurance that the
terms will not be unfavorable to the Company which would have a material adverse
effect on the Company's results of operations and financial condition.
Effective December 31, 1998 PILIC entered into a reinsurance agreement
with the RCH whereby the Company guaranteed that RCH will earn at least $10
million in future profits from the ceded inforce business, plus 12% interest
(the "Guaranteed Amount"). If RCH fails to earn the Guaranteed Amount within
five years of the date of the closing of the CRLC transaction, PAMCO must repay
RCH the lesser of the Guaranteed Amount less RCH's actual profits on the inforce
business, or $5 million, plus 12% interest on $5 million. As of December 31,
1998 the Company has recorded a $5 million ceding commission liability related
to PAMCO's guarantee and is accruing interest at the guaranteed rate over the
five year term.
As security for PAMCO's guarantee, PAMCO executed a security agreement
in favor of RCH secured by a pledge of the stock of PILIC. This agreement
provides that RCH may foreclose on the stock of PILIC if PAMCO defaults on its
guarantee to RCH. PAMCO provides various affirmative covenants regarding
corporate existence; compliance with laws; furnishing various notices to RCH;
inspection and audit rights and insurance coverage. Additionally, PAMCO provides
certain negative covenants with regard to selling, assigning, leasing or
otherwise disposing of PAMCO or PILIC assets; entering into agreements
materially and adversely effecting PAMCO's or PILIC's ability to carry on
business; entering into an agreement materially and adversely effecting PAMCO or
PILIC ability to perform obligations under the agreements with RCH and CRLC.
There also exist various provisions regarding PAMCO or PILIC incurring or
creating indebtedness or declaring dividends. There can be no assurance that RCH
will earn future profits from the ceded inforce business or that the PAMCO will
have sufficient funds in the future to satisfy PAMCO's guarantee to RCH.
20
Year 2000 compliance: Year 2000 issues are the result of computer
programs being written using two digits rather than four to define the
applicable year. In other words, date-sensitive software may recognize a date
using "00" as the year 1900 rather than the Year 2000. This could result in
system failures or miscalculations causing disruptions in operations, including,
among other things, a temporary inability to process transactions, send
invoices, or engage in similar normal business activities.
The Company utilizes various computer software programs, operating
systems and vendors whose software programs and communication links ("Computer
Systems") are used in the Company's insurance and HealthAxis e-commerce
businesses. For the Company's insurance business these Computer Systems include
health insurance administration provided by HPS, life insurance administration,
health claims discount repricing provided by First Health Group Corporation of
Downers Grove, Illinois ("FHG") along with financial accounting and actuarial
systems. For HealthAxis, these Computer Systems include the www.healthaxis.com
web site, links to AOL along with the AOL online network, HPS, FHG, along with
HealthAxis' data warehouse. In 1999, the Company expects to have links to CNET,
Lycos, and Snap.com, as well as various insurance companies who will offer their
products through the HealthAxis web site ("Carrier Partners"). To the extent
that the Company's Computer Systems contain source codes that are unable to
appropriately interpret the Year 2000 then some level of modification, or even
replacement of such applications may be necessary. The result of these Year 2000
issues may, if not resolved, have a significant negative impact on Company's
business.
The Company has begun an assessment of the Company's Year 2000
readiness and has identified applications owned by the Company, which are not
Year 2000 compliant. Furthermore, the Company believes that the Computer Systems
of many of its vendors or Carrier Partners that provide critical services to the
Company are not currently Year 2000 compliant.
To date, the Company has experienced very few Year 2000 problems, with
those problems centering on life administration processing. The cost of
programming changes as of December 31, 1998 has been less than $20,000. The
Company is in the process of evaluating alternatives to its life administration
Year 2000 issues including the modification of the life administration system at
a cost yet to be estimated or the effective replacement of the system via
outsourcing of the life system at an estimated incremental annual cost of
approximately $300,000 per year and a one time conversion cost of approximately
$300,000. The Company anticipates selecting a Year 2000 plan to address its life
administration Year 2000 issues by the end of the second quarter of 1999. To
date, the Company has replaced its general ledger and accounts payable
accounting systems, which were not Year 2000 compliant, in January 1998 at a
cost of approximately $180,000, which has been capitalized.
21
The Company intends to conduct an analysis to determine whether its
vendors, Carrier Partners and other business partners (in so far as they are
material to the Company's business) have any Year 2000 issues. As part of this
process, the Company intends to request its vendors provide the Company with
information regarding their progress in identifying and addressing their Year
2000 problems. Based on information reported in quarterly SEC filings, AOL and
HPS anticipate being Year 2000 compliant no later than December 31, 1999 and
June 30, 1999, respectively.
To date the Company has eliminated its health administration system via
the Company's outsourcing of its health administration and claims processing to
HPS effective February 1998 and assigned responsibility of the oversight of
HPS's health administration and claims processing along with the Company's
former health agent and underwriting Computer Systems to CRLC effective December
31, 1998.
In the event that the Computer Systems of the Company or any of the
Company's vendors Carrier Partners or other business partners fail or exhibit
significant problems as a result of Year 2000 processing the Company's service
to its customers could be disrupted for a significant amount of time and result
in significant lost income to and possible liability for damages by the Company.
There are risks associated with the Company's Year 2000 exposure
relating to some external vendors with whom the Company depends on material
sales and service processing. Because the Company does not control these vendors
or their resources, the Company can provide no assurance that such vendors will
complete their respective Year 2000 solutions in time for the Company to fully
test system interfaces with them. Although the Company is coordinating its
efforts with vendors to minimize this impact of Year 2000 issues, the Company is
currently unable to predict the extent to which Year 2000 issues will affect its
operations, or the extent to which it would be vulnerable to the failure of its
vendors, Carrier Partners or other business partners to remediate any Year 2000
issues on a timely basis.
The Company has begun the process of developing a contingency plan to
address possible Year 2000 risks to its Computer Systems. There is no assurance
that the Company will successfully implement its contingency plan or make all of
its systems Year 2000 compliant. The Company does not currently have a
contingency plan in place in the event any third party in which it engages in
business is not Year 2000 compliant.
The Company has not yet fully developed a comprehensive contingency
plan addressing situations that may result if the Company is unable to achieve
Year 2000 readiness of its critical operations. Contingency plan development is
in process and the Company expects to finalize its plan during the remainder of
1999. There can be no assurance that the Company will be able to develop a
contingency plan that will adequately address issues that may arise in the year
2000.
Description of the Business and Recent Significant Developments
PAMCO is a Pennsylvania corporation organized in 1982 and regulated as
an insurance holding company by the states in which its wholly owned insurance
subsidiaries are licensed. The operations of PAMCO and its subsidiaries are
principally those of its majority owned subsidiary HealthAxis.com, Inc. and its
insurance operations. PAMCO's insurance operations are currently conducted
through its wholly owned subsidiary, Provident Indemnity Life Insurance Company
and PILIC's subsidiaries which, during 1996 through 1998, were Provident
American Life and Health Insurance Company , Montgomery Management Corporation
and NIA Corporation . During 1998, the Company sold 80% of MMC's outstanding
common stock and on December 31, 1998 sold 100% of the outstanding common stock
of PALHIC and NIA.
22
Revised Strategy and Recent Developments
The Company markets and underwrites medical insurance and life
insurance and derived a majority of its revenue from group association major
medical products sold to individuals. A smaller proportion of revenue is derived
from traditional life (whole life and limited pay) products. During 1998 the
Company revised its business strategy to focus predominately on HealthAxis, the
Company's E-Commerce subsidiary along with more focused strategy for PILIC. The
following are financial highlights for the Company:
(Dollars in thousands)
1998 1997 1996
---- ---- ----
Gross premiums $ 119,533 $ 97,267 $ 68,503
Total revenue $ 77,499 $ 62,030 $ 74,147
Net income (loss) $ (12,156) $ (18,425) $ 16,120
Total assets $ 116,689 $ 98,365 $ 93,054
Total revenue for each year was net of premium ceded to reinsurers.
Gross premium growth was the result of sales from The Provident Solution and
HealthQuest managed care products. The net loss in 1998 and 1997 was
attributable primarily to higher group medical policy benefits. The net loss in
1998 was also impacted by $4.9 million of expenses related to HealthAxis while
1997's net loss was also impacted by the write off of deferred acquisition
costs, impairment of certain assets, and transition costs associated with HPS.
Total revenues and net income in 1996 included a litigation settlement of $22.4
million.
In early 1998 the Company determined that the Internet provided the
opportunity to sell medical insurance direct to the consumer thereby reaching
individuals under-served by insurance agents at a cost potentially lower than
the Company's current traditional agency marketing channel. During 1998 the
Company entered into various agreements in order to sell and service insurance
business via the Internet. During 1998 the Company formed a new subsidiary,
HealthAxis.com, Inc. to conduct this new venture. HealthAxis is not licensed as
an insurance company but rather an Internet-based distributor of health
insurance products. As of February 1, 1998 (as amended November 18, 1998) the
Company entered into an Amended and Restated Interactive Marketing Agreement
with AOL. HealthAxis is AOL's exclusive third-party direct marketer for health
insurance products along with vision, dental, prescription, critical care
insurance and long-term care insurance coverage for individuals and groups of
less than fifty individuals in the United States. HealthAxis is advertising
these products to AOL subscribers on AOL's online network under the
HealthAxis.com brand name. HealthAxis markets medical insurance products
underwritten by PALHIC and plans to market medical and related insurance
products underwritten by other companies. In June 1998 HealthAxis entered into
promotional agreements with CNet, Inc. and Lycos, Inc. whereby CNet and Lycos
will exclusively promote HealthAxis' health insurance and other related products
on CNet's and Lycos' web sites. HealthAxis' strategy is discussed later in
greater detail. Advertising has begun in a limited fashion on the Lycos network
of web sites.
23
In light of the continued losses experienced in the Company's group
medical products and the need to devote capital and focus to HealthAxis, the
Company entered into various agreements to sell PILIC's subsidiaries MMC, PALHIC
and NIA and cede 100% of the group medical and group life business during 1998.
In February 1998 the Company sold for $4 million, 49% of Montgomery
Management Corporation Common Stock along with a warrant to purchase an
additional 31% of MMC's Common Stock for one dollar. During the fourth quarter
of 1998 the buyer exercised the warrant to purchase the additional 31% of MMC's
Common Stock for $8,000. The Company recognized an approximate $4 million
pre-tax gain on the sale of MMC and no longer includes MMC in the Company's
consolidated financial statements. PILIC continues to assume via reinsurance
approximately 30% of the premiums, benefits and expenses of the stop-loss
business administered by MMC and receives 20% of MMC's net income in the form of
dividends.
On December 31, 1998 PILIC reinsured 100% of its group medical and
group life inforce business and sold the Company's group medical marketing,
sales distribution rights and PALHIC to CRLC. The Company's expectation is that
these transactions should provide PILIC the necessary statutory basis capital to
pursue its more focused strategy discussed later in greater detail. See "Revised
Strategy for Insurance Operations".
On December 31, 1998 the Company executed a series of transactions
whereby PALHIC reinsured 100% of its business to PILIC, which in turn reinsured
via a 100% quota share reinsurance agreement all of the Company's group medical
and group life business to RCH. In addition PILIC sold PALHIC and NIA to CRLC
for $5.6 million which approximates PALHIC's capital and surplus. The Company
also transferred all rights and control regarding the Company's agents and
entered into non-compete and non-solicitation agreements regarding the Company's
agents with respect to the future sale of health insurance products by agents
for a 3-year period ending December 31, 2001. The Company received regulatory
approval for these transactions for statutory purposes.
24
The $10 million ceding commission paid from CRLC to PILIC consisted of
a $5 million non-refundable payment plus a $5 million contingent payment,
whereby PAMCO guarantees that CRLC will earn at least $10 million in future
profits from the purchased inforce business, plus 12% interest on $10 million
and other amounts due. If at the end of 5 years CRLC fails to earn the
guaranteed amount, PAMCO must repay CRLC the lesser of the guaranteed amount
less CRLC's actual profits on the inforce business, or $5 million plus 12%
interest on $5 million and other amounts due. As security for PAMCO's guarantee,
PAMCO executed a Guarantee Agreement and Stock Pledge Agreement in favor of RCH
and CRLC which allows CRLC and RCH to take ownership of PILIC if PAMCO defaults
on its guarantee to CRLC. The Guarantee Agreement and Stock Pledge Agreement
prevent PAMCO from selling PILIC or entering into agreements that may cause it
to sell PILIC in the future. Furthermore these agreements prevent PAMCO from
paying dividends, incurring debt, making loans and from selling substantially
all of PILIC's assets without CRLC and RCH's approval. The terms and
restrictions contained in the agreements do not involve HealthAxis. If CRLC's
future profits exceed the guaranteed amount PILIC would be entitled to receive
an additional payment from CRLC equal to the lesser of CRLC's future profits
less the guaranteed amount, or 2/3 of the policy fees collected during 1999 and
1/3 of the policy fees collected during 2000.
HealthAxis Strategy, Description of Business and Operations
HealthAxis is in the electronic health insurance distribution business
serving the health insurance needs of the individual and small group markets.
HealthAxis also seeks to utilize its exclusive distribution agreements with AOL,
Lycos and CNet, to create a distinct branded identity for its online health
insurance "store." HealthAxis provides around-the-clock, online access to health
insurance products. By selling directly to consumers via the Internet,
HealthAxis is attempting to reduce the cost of product distribution by
circumventing the traditional sales agent. The Company augments its online
presence with telephone-based customer support from a toll-free service center
("Customer Call Center") where seven (7) days a week customer service
representatives are available to answer questions pertaining to the product and
provide technical assistance in navigating the web site and operating a web
browser. After the sale, the HealthAxis Web site functions as the primary point
of interaction between the policyholders and their policy information. Thus,
customers purchasing insurance products through the HealthAxis web site are able
to purchase directly from the distributor, share in substantial savings and have
access to a variety of policyholder policy information. The Company believes
that the services provided by HealthAxis represent a complete end-to-end
personalized solution to an individual's health insurance needs.
The Company believes that the health insurance industry is uniquely
suited for online retailing. HealthAxis had no financial activity prior to 1998.
HealthAxis' financial impact on the Company in 1998 was a net loss of $4,790,
from inception (March 26, 1998) to December 31, 1998, and total assets of
$14,969 as of December 31, 1998.
25
The traditional insurance distribution system involves multiple tiers
of sales agents, each adding incremental cost to the product, with the ultimate
result being a health insurance product heavily burdened by significant
distribution related costs. The Company believes the insurance agents' total
cost typically represents approximately 20% of the premiums over the life of a
health insurance product, the second largest component of the insurance
carrier's cost structure. The Company believes this cost burden offers
HealthAxis a substantial disintermediation opportunity, especially in the market
place for individual and small group insurance. The Company estimates this
market represents over $74 billion in aggregate annual premiums. HealthAxis
expects to earn additional revenues through sales of ancillary products such as
prescription, vision, dental, critical care, long-term care, long term
disability and life insurance policies.
The Company believes that a large portion of the uninsured population
has elected to forego or remain unisured with health insurance coverage due to
the cost of the product. The ability of the Company to reduce health insurance
costs through re-structuring of the distribution process is expected to expand
the marketplace for the Company's insurance products to include these presently
uninsured individuals.
HealthAxis utilizes a direct selling model to complete sales and
process transactions electronically via the Internet.
HealthAxis is not an insurance quoting service; rather HealthAxis
enables the customer to complete the entire insurance purchase transaction in an
online environment. The prospective purchaser is able to research products,
receive price quotations, complete applications, request customer service and
purchase a policy online.
Since its inception, HealthAxis has incurred significant costs to
develop and enhance its technology, to create its web site and to establish
Internet marketing, insurance carrier, and claims administration relationships.
HealthAxis began delivering preliminary online services in December 1998 when it
initiated a "soft launch" of its web site. As part of the "soft launch",
individual health insurance products of PALHIC, formerly a subsidiary of the
Company, were offered for sale on the web site in 19 states.
During 1998, HealthAxis entered into various strategic alliances with
Internet companies such as AOL, Lycos and CNet, in order to establish channels
for its sale of insurance policies via the Internet. HealthAxis also seeks to
form and has formed alliances with insurance carriers committed to utilizing the
Internet as a distribution channel for the sale of their insurance products. To
date, HealthAxis has entered into distribution relationships with several
insurance carriers, including CRLC, Fortis Insurance Company ("Fortis"),
Security Life Insurance Company of America ("SLICOA"), Ameritas Life Insurance
Corporation ("ALIC") and United Insurance Companies, Inc. ("UICI"). HealthAxis
seeks to continue to expand its product portfolio in geographic scope and
product offerings.
26
HealthAxis will also manage the entire process of bringing Carrier
Partners online. Through HealthAxis' strategic partner, HPS, HealthAxis will
have the ability to offer new Carrier Partners claims processing services. In
many cases, Carrier Partners may prefer to handle their own claims
administration. In this event, the HealthAxis technology team will assist the
Carrier Partner in writing the appropriate system interfaces. In either case,
HealthAxis will provide a totally automated back-end solution for Internet-based
insurance products. Accordingly, the Carrier Partner can focus primarily on
underwriting the risk while HealthAxis will manage and assist in the resolution
of many other technological issues. Namely, HealthAxis will assist in the
process of writing proprietary software to interface between the Carrier
Partner's legacy systems, and the HealthAxis web environment. It is intended
that this software will provide a seamless connection whereby pertinent
information downloaded and uploaded from each of the Carrier Partners will be
accessible through the HealthAxis web site.
Competition
Overview: HealthAxis competes with other insurance online providers and
traditional, agent-based insurance distribution system participants. The online
commerce market is new, rapidly evolving and intensely competitive. It is
anticipated that online commerce competition will continue to intensify in the
future. Barriers to entry are limited, and current and new competitors can
launch web sites at a relatively low cost. Although HealthAxis believes it is
the first direct transaction-enabled distributor of health insurance via the
Internet capable of accepting online applications and online claims processing
and information, it expects that others may attempt to provide similar services
in the future, many of whom may have greater resources than HealthAxis.
Online Insurance Competition: HealthAxis' principal online competitors
provide information on various types of insurance providers, an agent referral
and offer rates or price quotes via the Internet. These multi-category insurance
providers do not presently focus on the health category and have business
models, which are agent-referral driven. By contrast, HealthAxis provides a
transaction-based model that intentionally avoids agent referrals in order to
deliver its products to consumers at reduced costs.
Traditional Competitors: HealthAxis competes with some of the largest
financial services companies in the world as well as independent insurance
agents and brokers. Most of HealthAxis' potential competitors, both online and
traditional insurance companies selling insurance products over the Internet,
have longer operating histories, significantly greater financial, marketing and
other resources, greater name recognition and significantly larger customer
bases than the Company. These competitors may be able to respond more quickly to
changes in customer preferences and devote greater resources to the development,
promotion and sales of their products and claims processing services than the
Company. Most health insurance carriers of significance maintain their own web
site; however, these sites exist chiefly to focus business to the traditional,
agent-based system.
27
The Company believes that the principal competitive factors in the
online insurance market will be price and convenience as well as name
recognition and reputation, product selection, Internet access to claims
information, ease of use, site content, quality of claims processing services
and technical experience. The Company also believes that it possesses a
competitive advantage in the distribution and pricing areas of health insurance
sales. Since large traditional insurance providers rely heavily on revenues
generated from policy sales derived from their agent distribution network, the
Company believes such insurers may be reluctant to sell their products directly
to the consumer and risk disenfranchising their lucrative agent distribution
systems. As a result, the Company believes that the large carriers are unlikely
to enter the market as direct competitors in the online distribution of
insurance products. An intermediary, like HealthAxis, represents a less
controversial online distribution vehicle than does direct self-distribution by
the large carriers, who also lack the selection planned by HealthAxis. See "Risk
Factors - Competition."
Regulation
Internet Related: Although there are currently few laws and regulations
directly applicable to the Internet, it is likely that new laws and regulations
will be adopted in the United States and elsewhere covering issues such as
copyrights, privacy, pricing, sales taxes and characteristics and quality of
Internet services. The adoption of restrictive laws or regulations could slow
Internet growth or expose the Company to significant liabilities associated with
content available on its web sites. The application of existing laws and
regulations governing Internet issues such as property ownership, libel and
personal privacy is also subject to substantial uncertainty at this time. There
can be no assurance that current or new government laws and regulations, or the
application of existing laws and regulations (including laws and regulations
governing issues such as property ownership, content, taxation, defamation and
personal injury), will not expose the Company to significant liabilities,
significantly slow Internet growth or otherwise cause a material adverse effect
on the Company.
Insurance Related: As a result of the business activities presently
being conducted by the Company, the Company has organized HealthAxis Insurance
Services, Inc., a Pennsylvania corporation, which has also organized subsidiary
companies in four states (the "HealthAxis Agency"), the purpose of which is to
cause the HealthAxis Agency to become licensed with state insurance departments
to sell insurance and receive commissions from the sale of insurance. HealthAxis
Agency has filed or is in the process of filing for licenses in all 50 states.
As a licensed agency, HealthAxis Agency will be subject to the supervision
regulation and examination by the insurance departments or commissions in the
states in which HealthAxis Agency is licensed. The Company, either directly, or
through wholly-owned subsidiaries doing business in certain states, is subject
to the laws and regulations of such insurance departments or commissions which
laws and regulations are primarily intended to benefit purchasers of insurance
and generally grant supervisory agencies broad administrative powers, including
the power to restrict the carrying on of business for failure to comply with
such laws and regulations. In such event, the possible sanctions which may be
imposed include the suspension of licenses to sell insurance, limitations on
engaging in business for specific periods, censures and fines. Advertisements in
connection with insurance products sold through HealthAxis' web site are
pre-approved by the state insurance departments and commissions by the
applicable insurer sponsoring the particular product. See "Risk Factors -
Insurance Industry Factors" and "Government Regulation and Legal Uncertainty."
28
HealthAxis Web Site and Operations
General: The HealthAxis web site provides a fully transactional
platform for the sale of health insurance over the Internet. The HealthAxis web
site guides a consumer through every step in the health insurance purchase
process from education and price quotation through enrollment and post sale
service. The Company believes that no other insurance web site currently has the
breadth of functionality - covering all pre- and post-sale activities.
Quoting Process: The HealthAxis' price quotation service is offered
through a user friendly quoting tool called "ClickQuoteTM". With the entry of
minimal information, the customer is able to obtain an accurate price quote in
as little as thirty seconds, depending on connection speeds. The quote is
customizable by the change of the claims deductible, which the consumer can
adjust using a single mouse click. If so inclined, the consumer can proceed
directly from the ClickQuoteTM to an application to purchase the desired policy.
Upon the addition of multiple carriers to the HealthAxis web site, customers
will be prompted to select from among competing brands and/or plan types. Users
can also use the ClickQuoteTM as a launch point from which to discover more
information about the products available on HealthAxis.
Enrollment Process: HealthAxis believes that it can significantly
enhance the ease of enrollment, traditionally the most onerous task in the
insurance purchasing process. HealthAxis believes it has created several
features that will make the application process as simple to use as possible.
First, HealthAxis' enrollment forms come with extensive, context-sensitive
"help" modules to assist consumers in understanding the application questions.
HealthAxis also provides a progress bar which allows consumers to monitor their
progress through the application. HealthAxis believes this kind of tool helps
manage expectations and reduces the application abandonment rate. Also,
HealthAxis' unique `save application' feature allows consumers to "save" their
work without losing the information already provided. Saved applications reside
in a password protected personal space which only the specific user can access.
Users are able to return to their saved applications at any time to finish their
work and subsequently submit their enrollment information. Upon completion of
the enrollment forms, a consumer simply clicks the "send" button to submit the
application to HealthAxis. Certain Carrier Partners, at their own discretion,
may charge application fees which will be assessed by way of electronic funds
transfer, credit card or check.
29
Customer Call Center: HealthAxis provides a toll free telephone
Customer Call Center to aid customers in the purchase of health insurance via
the HealthAxis web site. HealthAxis' Customer Service Representatives are
on-site, seven days a week, at the Customer Call Center located at the Company's
Norristown headquarters. Many of the Customer Service Representatives are
licensed insurance agents and all are versed in the products sold on the web
site. Customer Service Representatives answer questions pertaining to product
information, corporate information, as well as technical assistance regarding
the web site and operating a web browser. HealthAxis currently employs 16
Customer Service Representatives and intends to increase the number of Customer
Service Representatives as web site traffic requires increases. The Customer
Call Center will also have product specialists who will handle more detailed
questions regarding the products offered. These product specialists will be
expensed to the Carrier Partner whose product they represent.
Underwriting Process: Applications submitted are electronically
transmitted to HPS, the third party administrator currently used by HealthAxis
for all PALHIC products, or to another third party processor designated by the
Carrier Partner. Professional underwriters review submitted applications to
determine if additional information is required. In the event additional
information is required, an underwriter will contact the applicant and request
further information. If medical records are required, the applicant can download
an authorization form from the web site, sign it, and send it in to HPS or
another administrator designated by the Carrier Partner. If the application is
complete, the underwriting determination shall be made by HPS using the
pre-established criteria agreed upon by HPS and the Carrier Partner. Carrier
Partners will have the option of using their existing underwriting and
processing operations or appointing HPS or another third-party administrator to
handle the transaction. Management believes that HealthAxis' ability to sell and
service policies is not impaired by a Carrier Partner's selection of an
underwriter/administrator. Each Carrier Partner will be able to adhere to its
own underwriting procedures and standards.
Policy Issuance Process: Once a policy is underwritten, the new
HealthAxis policyholder is mailed a plastic identification card with an
accompanying welcome letter. The letter directs the policyholder to his or her
HealthAxis personal space where HealthAxis has deposited an electronic copy of
the policy certificate.
Customer Inquiry Process: HealthAxis provides its customers with a
robust, online customer service facility. Customers have access to their policy
information, billing data, claims history and claims status reports. These
records are viewable on www.healthaxis.com via the customer's personal space.
All records are kept in a fully secure, online environment.
HealthAxis believes that empowering customers with the ability to
self-service administrative issues provides a cost savings to the delivery of
the post-sale insurance services and improves customers' access to their own
personal data. Under the traditional agent-based system, the customer would be
required to call either the agent who sold the product or the underwriter's
customer service center. HealthAxis' 24 hour a day, seven-day a week online
access provides convenient and immediate access for HealthAxis customers
relative to the availability of either underwriter call centers or insurance
agents. Further, a customer can review his or her policy information in a
private environment, without having to engage in conversation with either an
underwriter's customer service representative or the local insurance agent.
30
Policy Maintenance Process: HealthAxis provides customers with the
ability to modify personal data such as address, phone numbers, billing
preferences and other information. This tool further empowers the customer with
the ability to manage his or her insurance relationship. Policy maintenance is
another example of HealthAxis' ability to utilize the functionality of the
Internet to lower the cost of selling and servicing health insurance.
Billing Process: Customers can select from multiple payment methods
including credit card or an automatic debit from their checking account. The
traditional "direct bill" (personal check every month) will be available in the
future. The web site is fully enabled to process both credit card and monthly
debit transactions.
Sales and Marketing
Insurance Product Offerings: HealthAxis' mission is to offer consumers
a select list of affordable insurance products from trusted, reputable vendors
which meet HealthAxis' value criteria. These specific product offerings will
vary by state based on the availability of product supply, which is generally
dictated by the state regulatory environment. The HealthAxis web site utilizes
customer zip code information to determine which set of products to offer to a
given customer. HealthAxis intends to offer a selection of products supplied by
leading insurance carriers. HealthAxis currently offers products of PALHIC and
has entered into Carrier Partners agreements with CRLC, Fortis, SLICOA, ALIC and
UICI to offer their insurance products online in the future. HealthAxis is
committed to offering its customers a choice of products in order to position
HealthAxis as a "trusted advisor" rather than a salesperson for a particular
product.
Product Portfolio: Currently HealthAxis offers the individual health
insurance underwritten by PALHIC through its web site. Following the addition of
additional carrier partner products, HealthAxis' insurance product portfolio
expects to include the following:
Individual Health Critical Care College Student Health
Small Group Health Long Term Disability Senior Health
Prescription Long Term Care Senior Life
Vision Life
Dental Short Term Health
As HealthAxis increases its product mix, HealthAxis will seek to take
advantage of cross-selling opportunities for companion products. Although, these
policies are relatively inexpensive, they are important additions to general
health coverage. HealthAxis also intends to utilize its data warehouse to
identify these customer cross-sale opportunities.
31
General Marketing Strategy: HealthAxis' marketing strategy is designed
to promote awareness of the HealthAxis name, increase customer traffic to the
web site, encourage purchases of HealthAxis' insurance products over the
Internet, build customer loyalty through efficient claims processing and the
availability of access to claims related and other information over the
Internet, and maximize annual renewals. Commencing in the second quarter of
1999, HealthAxis intends to employ a combination of online and off-line
advertising and promotion campaigns to stimulate web site traffic and increase
its brand name recognition. The marketing efforts will also educate consumers as
to the opportunity offered by online insurance purchasing, promote HealthAxis'
brand name, and reduce its reliance on any one source of consumer traffic.
Web Site Promotion and Strategic Alliances: HealthAxis' core
promotional strategy involves the development of exclusive distribution
relationships with major Internet gateways. HealthAxis' principal Distribution
Partners are AOL, CNet, and Lycos. The Company expects these strategic
relationships to raise brand awareness and to provide access to millions of
online users. Based upon International Data Corp's ("IDC") estimate of 65
million U.S. Internet users, HealthAxis' relationship with AOL, alone, provides
the Company with access to over 13.5 million members, representing approximately
20% of all U.S. Internet users.
Use of Related Online Channels: HealthAxis Distribution Partners are
expected to add value to HealthAxis not just by the placement of banners and
buttons, but by building information-rich environments attractive to HealthAxis'
potential customer base. As these online services increasingly enhance their
"insurance centers" and related product offerings, the Company believes overall
customer traffic to HealthAxis should increase. The Company intends to
prominently place itself not just in "insurance centers," but across multiple
Internet channels to enhance the likelihood of attracting potential customer
interest. Examples of such non-insurance channels may include, but are not
limited to, health, money and business and shopping.
Online and Offline Marketing: HealthAxis marketing efforts will extend
beyond the confines of its marketing arrangements with its Distribution
Partners. HealthAxis intends to execute a variety of incremental media purchases
both on the web and in traditional advertising mediums such as direct mail,
radio, print and billboards. On the World Wide Web, HealthAxis plans to drive
traffic to its site by buying spot media space both on additional portals and
web sites that target the Company's core audience. The combination of exclusive
distribution relationships and spot media purchases across multiple advertising
mediums is intended to stimulate HealthAxis traffic and enhance the brand
awareness among the target customer market.
32
Online Demographics: The demographics of the Company's potential
customers are closely aligned with those of the online community. Generally,
Internet subscribers are (i) predominately younger than the average for the
general population; (ii) have higher household incomes than the national
average; (iii) obtain higher educational levels than the national average; and
(iv) include a high proportion of self-employed, small office and home office
individuals. Based upon statistical information provided by AOL, the average AOL
subscriber is 37 years old, has a household income of $60,000 or greater, has a
college education and is self-employed.
Target Marketing Strategy: The primary target markets are the small
group and the individual market. Within the individual market, the targeted
customers are individuals who are not covered by a corporate sponsored health
plan. Potential individual customers include (but are not limited to) people who
are self-employed, part-time employees or full-time independent contractors or
other individuals who are not covered by a corporate sponsored health plan.
Initially within the small group market, the Company intends to focus its
marketing efforts on groups of four or less, including small office and home
office-based individuals. The Company believes its combination of cost advantage
and customer-centric shopping environment will prove a compelling proposition
for its targeted customer segments.
The small office/home office community is a highly attractive market to
HealthAxis. HealthAxis expects to exploit this market with both its individual
and small group products. The cost savings resulting from buying direct can be
substantial when experienced by multiple employees, even for very small groups.
HealthAxis expects the average size of a group sale to increase over time.
Product Pricing: HealthAxis believes that pricing will represent its
single most important competitive advantage relative to the competing health
insurance distribution channels. Offering product to consumers via the Internet
will allow the Company to re-engineer a multi-layered distribution system that
has historically added significant cost to the typical health insurance product.
Depending on the policy, consumers may enjoy savings of up to 15% as compared to
product offered through the traditional insurance distribution system. The
Company plans to continually monitor its price competitiveness across the
country. HealthAxis evaluates pricing environments on a zip code by zip code
basis, to ensure the competitiveness of its products. HealthAxis plans to strive
to be a cost leader at any given level of plan benefits in the markets in which
it participates.
Life Cycle Marketing: The Company's market research indicates that the
purchase of health insurance is generally associated with a variety of
identifiable life events. These events represent situations in which a potential
customer may recognize a heightened need for insurance and include, among other
things, loss of job, new job, graduation from college, marriage, birth of a
child, divorce, relocation, starting a new business and discontinuing operations
of an existing business. These life events generally result in the destruction
of existing health care relationships and require the establishment of new ones.
Identifying these events and targeting individuals experiencing such events are
important elements of the Company's marketing strategy.
Direct Marketing: HealthAxis plans to use direct marketing techniques
to target new and existing customers with promotions. HealthAxis plans to send
e-mail letters to potential customers highlighting HealthAxis products and the
advantages of Internet based insurance product purchases. The Company's
agreement with AOL gives HealthAxis the right to send a mailing to AOL's
customer base. The Internet allows rapid and effective experimentation and
analysis, instant user feedback and efficient personalization of insurance
products for each customer, all of which the Company seeks to incorporate in its
marketing activities. Direct e-mail to HealthAxis customers also will be an
important driver of the Company's cross-selling efforts. HealthAxis' customer
relationship will allow the Company to target existing customers with offers for
related, ancillary health care insurance products. For example, following the
customer's initial purchase of an individual health insurance policy, the
Company might send that Customer an e-mail introducing a long-term disability
product.
33
Intellectual Property and Technology
Patent, Trademark and Copyright Protection: The Company's ability to
compete is dependent to a significant degree upon its proprietary systems,
technology, and intellectual property. The Company relies upon a combination of
trademark, copyright, confidentiality agreements and trade secret laws as well
as other measures to protect its proprietary rights. The Company does not have
any patents or patent applications and currently does not plan to file any
patent applications. The Company has registered the names "HealthAxis.com" with
Internic, a private corporation organized by U.S. government which administers
Internet domain names. The Company has applied for registration of the
trademarks "HealthAxis.com" and "ClickQuote" with the United States Patent and
Trademark Office. The Company has determined not to file registrations for these
marks in foreign countries at this time. The Company's sales materials, content
and software is protected by copyright. The Company intends to take the
additional step of registering these copyrights with the United States Copyright
Office.
Third Party Technology, Web Site Ownership And Maintenance: The Company
also relies on a variety of technology that it licenses from third parties,
including its database and Internet server software, which is used in
HealthAxis' web site to perform key functions. The Company's technology is
centered around its interactive web site "www.healthaxis.com" which was
constructed by Vivid Studios, a division of Platinum Technology, Inc. of San
Francisco, CA. The Company considers all of the content contained in its web
site and much of the software contained in the web site to be proprietary and
has negotiated confidentiality and non-compete provisions with Vivid Studios.
Vivid Studios granted the Company sole ownership of all content developed by
Vivid Studios that is contained in its web site. The Company intends to continue
to use Vivid Studios to provide maintenance to its web site, but in the event
the Company opts to perform such services itself or through another contractor,
the Company has obtained a perpetual license to all source code and other
proprietary materials required for it to maintain and enhance its web site. The
Company anticipates updating its web site on an ongoing basis. See "Risk Factors
- - - Dependence on Third Party Technology."
34
Web Site Technology. The technology supporting the web site itself
consists of a scalable client/server architecture in a fully load balanced
environment using redundant Sun Enterprises servers. The Company's applications
are specifically designed for the web site and are written in the programming
language Java under a Sun Enterprises implementation of the Unix operating
system. The Company uses RAID technology to provide a greater degree of
reliability for data contained in its Oracle 8 based database. The host for the
web site is Best Communications, located in San Francisco, California. The
infrastructure, web applications software and the web servers are owned by the
Company. The Company continually monitors web site statistics, network
performance and service levels using CA unicenters from Computer Associates.
Back End Processing Technology: Underwriting, policy administration and
claims systems will be neither processed by the Company nor its web site, but
instead by HPS at a site in Tampa, Florida or at sites maintained by Carrier
Partners. HPS` Tampa site consists of large IBM mainframe systems running CICS.
For PALHIC product currently on the web site, the provider network information
is operated by another third party, FHG. Both HPS and FHG own the strategic
software applications which they operate on their own systems in secure,
environmentally controlled rooms twenty-four hours per day. Additionally, the
Company has created an executive information system operating in an Oracle 8
environment under an HP 9000 computer running Unix. The Company's systems have
back up and disaster recovery programs in place. The Company uses multiple web
servers within a single site but plans to distribute its servers to multiple
sites for greater redundancy.
On May 29, 1998, HealthAxis, PAMCO, and Provident Health Services, inc.
("PHS"), a subsidiary of Provident, entered into an Internet claims
administration agreement with HPS (the "E-Commerce Agreement"). The E-Commerce
Agreement provides HPS with the right to be the exclusive administrator of all
insurance business sold over HealthAxis' web site and any other form of
electronic commerce ("e-commerce") used by HealthAxis to sell insurance which is
underwritten by PILIC and PALHIC during the term of the E-Commerce Agreement.
HealthAxis also agreed to use its best efforts to provide HPS with the right of
first refusal to provide claims administration services for insurance business
sold by HealthAxis but not underwritten by PILIC and PALHIC that may require the
services of a third party administrator.
HPS has advised HealthAxis and the Company that certain actions taken
by HealthAxis are inconsistent with HealthAxis' obligations under certain
agreements between the parties. HealthAxis and the Company disagree with the
position adopted by HPS.
Communications: All of the above installations are interconnected using
high-speed private telecommunications links. All transmissions between the
consumer, web site, and HPS are secured using "Secured Socket Layer" (SSL
version 3). Domestic encryption is used where applicable (i.e., 128 bit)
including all server to server communications. A minimum export encryption is
also used (i.e., 40 bit).
35
Revised Strategy for Insurance Operations
The Company's Insurance Operations market and underwrite medical
insurance and life insurance and derived a majority of its revenue from group
association major medical products sold to individuals. Recent significant
developments for the Company's Insurance Operations were:
o The sale of an 80% interest in MMC at a gain of $4 million. See Revised
Strategy and Business Components for the net profit and loss impact table.
o The Company sold its group medical products through its agency marketing
channel effective January 1, 1999. The Company transferred all rights and
control regarding the Company's agents and entered into non-compete and
non-solicitation agreements regarding the Company's agents with respect to
the future sale of health insurance products by agents for a 3-year
period.
o The cession via a 100% co-insurance reinsurance agreement of all of the
Company's group medical and group life business to RCH for a $10 million
ceding commission. See Revised Strategy and Business Components for the
net profit and loss impact table.
o The sale of PALHIC and NIA to CRLC for PALHIC's statutory basis capital
and surplus. See Revised Strategy and Business Components for the net
profit and loss impact table.
As a result, the Company is focusing on its military life business and
its Internet distribution of insurance products.
Highly Competitive Nature of the Insurance Industry
The Company operates in a competitive industry with regard to products,
prices and services. Many competitors have considerably greater financial
resources than the Company. In the United States more than 2,200 life insurance
companies compete for life and health insurance business, and no one company
dominates the marketplace. Most of the Company's direct competitors are small to
medium sized life insurance companies and regional Blue Cross/Blue Shield
organizations. Additionally, competition in the insurance industry may affect
the Company's ability to achieve greater critical mass in its chosen product
lines, while remaining competitive in compensation and product pricing.
36
Product Profile
The following table sets forth the Company's gross earned premium by
product during each of the three years ended December 31:
(Dollars in thousands) 1998 1997 1996
-------- -------- --------
Managed Care:
The Provident Solution $ 37,534 $ 44,204 $ 22,634
HealthQuest 40,019 23,062 6,136
-------- -------- --------
77,553 67,266 28,770
-------- -------- --------
Non-Managed Care:
Small Group 2,795 4,784 7,258
Individual 25,099 12,414 18,463
-------- -------- --------
27,894 17,198 25,721
-------- -------- --------
Group Life 1,772 2,655 2,406
-------- -------- --------
Subtotal (Ceded to RCH) 107,219 87,119 56,897
Excess Loss Insurance 5,279 3,248 2,704
-------- -------- --------
Total Health Products 112,498 90,367 59,601
-------- -------- --------
Individual Life 7,035 6,900 8,902
-------- -------- --------
Gross Premium $119,533 $ 97,267 $ 68,503
======== ======== ========
Health Products: The Company ceded all of its managed care and non
managed care medical insurance business to RCH on December 31, 1998 via a 100%
quota share reinsurance agreement. Effective January 1, 1999 PILIC no longer
sells or directly underwrites group medical products sold either through the
Company's former agency sales force or through HealthAxis. Premium earned
through the excess loss or stop loss business is not affected by the
transactions with CRLC and RCH.
PILIC's managed care comprehensive major medical product designs
incorporate both freedom of choice and financial incentives to utilize network
health care providers. PILIC has a long-term agreement with FHG, the largest
independent PPO in the country. Other regional networks are used if and when the
primary network is not a practicable option. FHG also provides utilization and
cost management services such as pre-certification of hospital admissions and
large case management which, when taken together with the discounts PILIC enjoys
through all of its PPO arrangements, are intended to allow for better control of
claim costs and, ultimately, competitively priced products.
37
The administrative support for all of the Company's medical products,
including billing and collection of premium, claim adjudication, and on-going
policy services are provided by HPS pursuant to the HPS Outsourcing Agreement.
See Insurance Operations - Claims for additional information regarding HPS.
In 1996, PILIC entered into a marketing agreement with the country's
largest third party administrator, HPS. In October 1997, the Company announced
an outsourcing arrangement with HPS, whereby HPS provides administrative support
for all of PILIC's medical products, including billing and collection of
premium, claims adjudication and ongoing policyholder services (the "HPS
Outsourcing Agreement"). The HPS Outsourcing Agreement, which commenced February
1, 1998, is for a five-year term. PILIC has agreed to pay a base monthly fee and
a sliding scale percentage of premiums, which will decrease as the volume of
business increases. The Company transitioned all functions covered by the
outsourcing agreement to HPS effective February 1998. Agreements between the
Company and CRLC call for CRLC to assume responsibility for the HPS Outsourcing
Agreement with the exclusion of the base service fee, loss ratio management fee
and claims changes for claims incurred prior to February, 1998, effective
January 1, 1998. HPS will continue to process the Company's claims incurred on
or before December 31, 1998.
Also see Claims discussed later in Insurance Operations.
PILIC's principal managed care products were "The Provident Solution"
and "HealthQuest" which together offer a variety of deductibles, coinsurance
amounts and managed care options. Minimum amounts of group term life are
required with many of the medical products. "The Provident Solution" relies on
FHG for access to network providers and advantageous fee schedules, while
"HealthQuest" relies on regional PPOs. At December 31, 1998 PILIC had a total of
45,000 in-force group medical certificates compared to 50,000 at December 31,
1997. PILIC has systematically withdrawn from the small group indemnity markets
as healthcare reform at the state level has rendered those products obsolete.
The book of small group indemnity business has been in a runoff mode since 1992
and the Company's individual indemnity products have only generated modest sales
since 1994, when "The Provident Solution" was developed. The following table
illustrates the composition of annualized premium in-force for the last three
years:
(Dollars in thousands) 1998 1997 1996
-------- -------- --------
Managed Care:
The Provident Solution $ 41,867 $ 43,244 $ 33,169
HealthQuest 47,034 34,913 12,718
Non-Managed Care:
Small group 2,188 5,681 7,009
Individual 11,633 12,983 17,797
-------- -------- --------
$102,722 $ 96,821 $ 70,693
======== ======== ========
38
The states which generated the largest share of health premiums during
each of the last three years were as follows:
1998 1997 1996
------ ------ ------
Georgia 28.0 28.7 24.4
Florida 17.6 20.5 21.8
Texas 9.8 6.7 7.5
South Carolina 7.7 4.4 2.6
Louisiana 6.6 8.1 7.3
Colorado 4.5 2.6 .4
Pennsylvania 3.0 6.9 13.2
Ohio 2.7 2.3 2.3
Virginia 2.1 2.1 2.3
West Virginia 1.9 2.2 3.5
All other 16.1 15.5 14.7
------ ------ ------
100.0% 100.0% 100.0%
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The acquisition of PALHIC in 1996 significantly increased the number of
states within which the Company wrote its insurance business through 1999. As
part of the terms of PILIC's sale of PALHIC to CRLC, PILIC can continue to write
military life business in PALHIC through 1999. Thereafter the Company must
negotiate a new agreement with CRLC or another insurance company to underwrite
military life business in states that PILIC is not licensed. PILIC is licensed
to underwrite life, annuity and health business in the 25 states, the District
of Columbia and the U.S. Virgin Islands.
As part of its health product portfolio, the Company's Insurance
Operations derived premiums (and prior to 1998 both premiums and fees) through
the sale and underwriting of high-deductible medical excess loss insurance
(a.k.a. "stop loss") for self-insured employers. MMC sells and services these
insurance products which are issued by unrelated insurance companies. PILIC
assumes a portion of the insurance risk and earns premiums and prior to 1998
earned profit sharing fees. During the first quarter of 1998 the Company sold
80% of MMC to HPS. The sale resulted in a realized gain of $4 million in the
first quarter of 1998. The Company continues to assume the premium administered
by MMC.
Life Products: PILIC's pre-need insurance products, single premium and
limited payment life insurance, provide funding in conjunction with pre-arranged
funerals. The policies sold average $2,8