TROVER SOLUTIONS INC - 10-K Annual Report

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 þ No o.

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 the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. o

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ.

The aggregate market value of Registrant’s Common Stock held by non-affiliates of the Registrant as of the last day of the Registrant’s most recently completed second fiscal quarter was approximately $48,867,855 (based on the last sale price of a share of Common Stock as of June 30, 2003 ($5.79)), as reported by The Nasdaq National Market.

As of March 15, 2004, 8,494,977 shares of the Registrant’s Common Stock, $0.001 par value, were outstanding.

THIS FORM 10-K AND OTHER STATEMENTS ISSUED OR MADE FROM TIME TO TIME BY THE COMPANY OR ITS MANAGEMENT TEAM CONTAIN STATEMENTS WHICH MAY CONSTITUTE “FORWARD-LOOKING STATEMENTS” WITHIN THE MEANING OF THE SECURITIES ACT OF 1933, AS AMENDED, AND THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED BY THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995, 15 U.S.C.A. SECTIONS 77Z-2 AND 78U-5 (SUPP. 1996). THOSE STATEMENTS INCLUDE STATEMENTS REGARDING THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF THE COMPANY AND MEMBERS OF ITS MANAGEMENT TEAM, AS WELL AS THE ASSUMPTIONS ON WHICH SUCH STATEMENTS ARE BASED. PROSPECTIVE INVESTORS ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE RISKS AND UNCERTAINTIES, AND THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY SUCH FORWARD-LOOKING STATEMENTS. IMPORTANT FACTORS CURRENTLY KNOWN TO MANAGEMENT THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN FORWARD-LOOKING STATEMENTS ARE SET FORTH IN THE SAFE HARBOR COMPLIANCE STATEMENT FOR FORWARD-LOOKING STATEMENTS INCLUDED AS EXHIBIT 99.1 TO THIS FORM 10-K, AND ARE HEREBY INCORPORATED HEREIN BY REFERENCE. THE COMPANY UNDERTAKES NO OBLIGATION TO UPDATE OR REVISE FORWARD-LOOKING STATEMENTS TO REFLECT CHANGED ASSUMPTIONS OR CIRCUMSTANCES, THE OCCURRENCE OF UNANTICIPATED EVENTS OR CHANGES TO FUTURE OPERATING RESULTS OVER TIME.

Trover Solutions, Inc. (hereinafter referred to as the “Company”), a Delaware corporation, believes, based on its experience and assessment of its market, that it is a leading independent provider of outsourcing of subrogation and certain other medical claims recovery and cost containment services to the U.S. private healthcare payor industry and of outsourcing of subrogation recovery services to the U.S. property and casualty insurance industry. The Company’s primary business is medical claims recovery, and its primary product is subrogation recovery, which generally entails the identification, investigation and recovery of accident-related medical benefits incurred by its clients on behalf of their insureds, but for which other persons or entities have primary responsibility. The Company’s clients’ rights to recover the value of these medical benefits, arising by law or contract, are generally known as the right of subrogation and are generally paid from the proceeds of liability or workers’ compensation insurance. The Company’s other medical claims recovery services include (1) the auditing of the bills of medical providers, particularly hospitals, for accuracy, correctness and compliance with contract terms (“provider bill audit”), (2) the recovery of overpayments attributable to duplicate payments, failures to coordinate benefits and similar errors in payment (“overpayments”), and (3) the auditing of physician evaluation and management claims for consistency with medical records, in accordance with federal guidelines (“MD audit”). The Company offers its healthcare recovery services on a nationwide basis to health maintenance organizations (“HMOs”), indemnity health insurers, self-funded employee health plans, companies that provide claims administration services to self-funded plans (referred to as “third-party administrators”), Blue Cross and Blue Shield organizations and provider organized health plans. Current clients include Humana Inc., Kaiser Permanente, Wellpoint Health Network Inc. and The Principal Financial Group. The Company had 39.9 million and 41.6 million lives under contract from its clientele at December 31, 2003 and 2002, respectively.

The Company has three segments: (1) Healthcare Recovery Services, which encompasses its four healthcare recovery products: healthcare subrogation, provider bill audit, overpayments, and MD audit; (2) Property and Casualty Recovery Services, which is subrogation recovery services for property and casualty insurers, sold under the brand name TransPaC Solutions; and (3) Software, which is subrogation recovery software in a browser-based application service provider (ASP) form, sold under the name Troveris. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Healthcare Recovery Services”, “— Property and Casualty Recovery Services”, “— Software” and Item 8. “Financial Statements and Supplementary Information — Note 15 — Segment Information” for financial information about the Company’s segments. See Exhibit 99.1 for a discussion of certain risk factors relating to the Company.

On February 20, 2004, the Company announced that it had entered into a definitive agreement to be acquired in an all-cash transaction in which TSI Acquisition Co., Inc., a wholly-owned subsidiary of TSI Holding Co., Inc., will be merged into the Company. TSI Holding Co., Inc. is an affiliate of Tailwind Capital Partners LLC (Tailwind), which manages Thomas Weisel Capital Partners, L.P., a private equity fund. As a result of the merger (the “Proposed Transaction”), every stockholder of the Company will receive $7.00 per share in cash, except that certain members of management will obtain new stock option grants by TSI Holding Co., Inc. (which will be the parent corporation of the surviving entity), may exchange unexercised “in the money” stock options of the Company for stock options of TSI Holding Co., Inc., and may purchase shares of common stock of TSI Holding Co., Inc. at $7.00 per share. Immediately following the Proposed Transaction, TSI Holding Co., Inc. will be owned by Tailwind, certain members of management of the Company, and certain co-investors.

If completed, the Proposed Transaction will constitute a going private transaction and will result in the Company no longer being publicly traded and no longer filing annual, quarterly and current reports with the Securities and Exchange Commission (“SEC”). The Proposed Transaction must be approved by the Company’s stockholders at a special meeting of the stockholders, which the Company expects will occur in the second quarter of 2004. The Proposed Transaction is also subject to customary closing conditions. The obligation of Tailwind to proceed under the definitive agreement expires if the Company is unable to close the Proposed Transaction by July 15, 2004. More information on the Proposed Transaction is included in the proxy statement that the Company will mail to its stockholders in connection with the special meeting of the stockholders at which the Proposed Transaction will be voted on.

The Company, which was co-founded by its present Chief Executive Officer, was incorporated on June 30, 1988 under the laws of the State of Delaware. The Company became publicly held as a result of an initial public offering in May 1997 and is traded on The Nasdaq National Market under the symbol “TROV”.

The Company has been pursuing a two-fold growth strategy. First, with respect to its existing healthcare recovery services and property and casualty recovery segments, the Company focuses on (i) servicing its existing client base, (ii) selling and installing the additional business covered by contracts with existing clients and (iii) selling and installing new clients and cross-selling expanded product offerings. During 2000, the Company placed in service and began to earn revenue from an internally developed service that offers its clients the ability to detect, audit and recover a variety of claims overpayments. During 2002, the Company began a new division that audits physician evaluation and management claims.

Under the second aspect of its growth strategy, the Company has been extending its systems-driven, process-oriented approach, through acquisitions and internal development, to new outsourcing products and services in the insurance industry, including both healthcare and property and casualty. The defining characteristics of the Company’s business model are (i) the ability to automate clerical and administrative tasks, using sophisticated and proprietary computer applications; and (ii) the ability to standardize and scale work using process management and classical work measurement techniques. Using this model, the Company believes that it can dramatically increase the productivity of the skilled knowledge workers who make up its labor force, and successfully implement pricing strategies that will reward the Company for those productivity gains.

The Company believes that any future development opportunities are likely to be characterized by outsourcing business services that will produce predictable and recurring revenue streams; competitive advantages from effective process management, proprietary systems and the provision of knowledge-rich services; the development of niche markets; value-based pricing; and a non-exclusive focus on healthcare information services.

The Company’s main focus of business is the provision, through its three segments, of cost containment services and software for the insurance industry. The first of these segments, Healthcare Recovery Services, offers four recovery services on an outsourcing basis to healthcare payors, specifically indemnity insurers, managed care and health maintenance organizations, and self-funded employers. The second segment, Property and Casualty Recovery Services, provides subrogation recovery services to the property and casualty (“P&C”) industry, with a focus on full outsourcing. With respect to its healthcare recovery services and P&C recovery services, the Company believes that in recent years businesses have increasingly delegated (“outsourced”) non-core specialized business functions to third parties. Because of expertise and economies of scale, companies that provide specialized services are often able to deliver the requisite service at lower costs or with greater effectiveness than could be achieved by their clients. The Company’s third segment is

Software, which offers to healthcare payors and P&C insurers an on-line subrogation recovery system in an application service provider (ASP) model. See Item 8. “Financial Statements and Supplementary Information — Note 15 — Segment Information” for financial information about the Company’s segments.

Since the late 1980s, healthcare payors have experienced increasing (i) price competition, (ii) regulatory complexity and related administrative burdens, (iii) costs of healthcare claims, and (iv) average age of the insured population. These factors, resulting from the rapid growth of managed care, improvements in medical technology, consumer-oriented political pressure and an aging U.S. population, tend to result in healthcare payors concentrating their resources on their core business. This situation, in turn, provides on-going opportunities for enterprises, like the Company, which are able to perform non-core business functions on behalf of healthcare payors.

The recovery process is complex and although many healthcare payors operate internal recovery departments, the Company believes that these departments are not generally as effective per insured life as the Company’s operations. The Company believes that (i) the relatively small size of recoverable funds as a percentage of claims paid, (ii) the need for healthcare payors to focus on core competencies and (iii) the complexity of the recovery process and economies of scale will continue to provide opportunities for growth of the Company.

The industry conditions described above have contributed to the growing need for a cost-effective provider of subrogation and other recovery products and services. The Company’s success is a result of the implementation of its recovery processes, the skill and knowledge of its employees, its approach to sales and marketing, its client base, and its proprietary information management systems, all as described below.

The Company utilizes recovery processes to implement its cost containment services, which include subrogation, provider bill audit, overpayments, and physician bill audit recovery services. The Company uses proprietary and other software and various business processes to identify those claims that have recovery potential. Client-specific threshold dollar amounts are utilized to identify files where its clients may have a recovery right for subrogation for the medical benefits provided. In the case of provider bill audit services, the Company utilizes specific threshold dollar amounts to investigate proper payment for medical procedures. To identify overpayment recovery opportunities, the Company typically analyzes all paid claims for a fixed period on a rolling quarterly basis. Physician bill audit services uses payment claims from doctors for their patient evaluation and management visits to initiate the process of identifying potential billing errors.

Following the identification and investigation of identified claims, the Company proceeds to recover from the financially responsible party the value of those covered medical benefits provided. The Company has automated this complex processing of all raw data and the management, follow-up and generation of correspondence. The use of automated processes substantially increases productivity and enables specially trained personnel to focus more intensely on matters requiring their professional judgment and expertise. The automated processes also allow the Company to pursue claims that would otherwise be deemed too small to pursue economically. The Company believes that its ability to effectively recover a broad range of claim sizes is an important competitive advantage in the market. In addition to automating the recovery processes, the Company’s proprietary software and other systems generate significant operations and management information, which enables the Company to employ production and quality standards in the context of providing specialized services.

The Company dedicates staff with specialized skills to individual services to optimize recoveries. The recovery process for each healthcare recovery service is described below.

Subrogation Recovery Rights of Healthcare Payors. By contract and state law, healthcare payors are generally entitled to certain rights with respect to paid healthcare claims that may be the primary obligation of

other insurance carriers. For example, an HMO may pay the hospitalization and related health expenses of a member who is injured in an automobile accident. However, the party responsible for the accident is generally liable to the injured person for the damages arising from the injury, which include lost wages, property loss, pain and suffering and medical benefits. The responsible party usually has a liability insurance policy that will pay covered damages, including medical benefits, upon the acceptance of the injured party’s claim. The healthcare payor actually providing or paying for the medical benefits conferred on the injured party (in this example, an HMO) may have a variety of rights through which it is entitled to recover the value of such medical benefits from the responsible party and the responsible party’s liability insurer.


	(i) the right of subrogation, which allows the healthcare payor to recover accident-related medical claims directly from the responsible party or the responsible party’s insurance carrier;

	(ii) the right of reimbursement, which allows the healthcare payor to recover from the injured party any payment received by him or her from the responsible party or the responsible party’s insurance carrier relating to this injury;

	(iii) the right of reimbursement for medical benefits provided for work-related injuries, which are typically excluded from the healthcare insurer’s coverage; and

	(iv) other recovery rights against automobile insurers and other liability insurers arising from coordination of benefits provisions in healthcare and property and casualty insurance coverages.

Automated Identification of Claims with Recovery Potential. The Company’s specialty is using systematic identification methods to determine which files to pass on to the investigation stage. The automated selection, analysis and processing of raw claims data are handled primarily through the Company’s proprietary selection software. Information regarding diagnoses, the cost of treatments, insured demographics (names, addresses and telephone numbers, etc.) and related claims is provided to the Company electronically by the healthcare payor. The automated systems include direct connections to the Company’s clients’ claims information systems, subject to various security controls to limit access internally. The Company’s trained staff identifies, sorts, vets and organizes raw claims data into usable form, essentially engaging in “data mining”.

The primary vehicle for the identification of injured insureds is an automated analysis of the clients’ claims data. This system identifies potentially recoverable claims and, using client-specific protocols, opens an on-line electronic file for such claims. After files are opened, the systems automatically track the addition of medical expenses to these files, so that they are updated as additional expenses are paid. Since its inception, the Company has automatically opened over 56.5 million of such on-line files.

Investigation of Potentially Recoverable Claims. By focusing investigations only on those cases with the greatest potential for recovery, the Company minimizes member contacts and maximizes recovery potential. Subrogation recoveries are typically related to accidental injuries. Claims may involve automobile accidents, property and premises injuries, workers’ compensation, product liability or medical malpractice. When a file of claims reaches a value predetermined by the Company, the system automatically generates a series of inquiry letters that are sent to the injured insured. These individuals respond by calling the Company’s customer service department to provide the facts of the accident. The Company also initiates phone calls if the insured does not respond to the inquiry letters in a reasonable period of time. Historically, approximately 90% of the injured insureds ultimately respond to the Company’s inquiries and approximately 16% of the claims investigated by customer service representatives are classified as recoverable. Once a file of related claims is identified as recoverable, the system updates the backlog and assigns the file to the appropriate recovery person who begins the assertion and management of recoverable claims. Since its inception, the Company has investigated over 10.2 million accidents.

Assertion and Management of Potentially Recoverable Claims. The workflow performed by the various recovery personnel is directed and guided step-by-step by the Company’s proprietary and other software. The Company’s systems document activity on the claim files and provide an interconnected record of correspondence and notes taken by the recovery personnel with respect to each file. The Company’s recovery personnel

annotate the files on-line, as necessary, to document progress, developments and status and otherwise maintain the history of each claim. All of these healthcare subrogation recovery personnel perform their work on Troveris, the internally-developed recovery software that replaced the legacy subrogation system. See “— Software”.

Once a file of claims is classified as recoverable, the Company’s recovery personnel, who receive extensive training, proceed to assert the recovery rights of the Company’s clients and track the claims’ history and development. The employees contact all necessary parties to inform them of the existence and value of the recovery claim. These parties generally include the liability insurer for the responsible party, the insured and the insured’s attorney, if any, in conjunction with the claim. Recovery personnel maintain contact with the parties involved, including the responsible party (or insurance carrier), until the claim is settled. Settlement may not occur until several years after the claim was originally paid. During this phase of the recovery process, approximately 45% of the amounts initially entered into backlog (the dollar amount of potentially recoverable claims that the Company is pursuing) as recoverable are rejected, in which case further activity is terminated and backlog is reduced.

Negotiation and Settlement of Claims. The recovery process culminates in the negotiation and settlement of claim files. Within the settlement guidelines established by each client and the Company’s standard operating procedures, recovery personnel close recoverable files and remove them from backlog by making recoveries or by rejecting files and terminating recovery efforts. Once a settlement is made and recorded in the system, receipt of cash is anticipated and monitored by the responsible employee. Cash receipts are posted to the credit of the appropriate client.

Claims remain the property of the Company’s clients and litigation is commenced solely at their written direction. Similarly, clients may terminate litigation or other recovery efforts at any time for any reason. The Company customarily bears the cost of legal services as part of the services to its clients. The Company has established what it believes are cost-effective relationships with providers of legal services, including its relationship with Sharps & Associates, PSC, a law firm solely owned by Douglas R. Sharps, the Company’s Executive Vice President — Finance and Administration, Chief Financial Officer and Secretary. This arrangement exists solely for the benefit of the Company and its purpose is to minimize the costs of legal services purchased by the Company on behalf of its clients. This law firm employs 27 attorneys, 13 paralegals and 1 administrative assistant at its offices in Louisville, Kentucky; Pleasanton, California; Chicago, Illinois; Tampa, Florida; Dallas, Texas; Milwaukee, Wisconsin; and Locust Grove, Virginia. Mr. Sharps receives no financial or other personal benefits from his ownership of the firm, and the Audit Committee of the Company’s Board of Directors reviews and approves all payments to Sharps & Associates, PSC. See Item 8. “Financial Statements and Supplementary Data — Note 5 — Related Party Transactions”.

Although some healthcare subrogation recoveries will be made during the first year of service, the average time to make a recovery is 18 to 24 months from installation, with substantially all recoveries made by the sixth year. The timing of recoveries is driven by the P&C payment cycle of claims (which is the source of recoveries made by the Company) and circumstances specific to each claim (e.g., identification of responsible party, responsiveness of responsible party, cooperation of parties involved, factual complexity and litigation). The amount of claims recoveries made by the Company on behalf of a client is generally less than the amount of backlog generated on behalf of such client. This happens for a number of reasons, including (i) the inadequacy of insurance coverage or other available source of funds to pay the claim; (ii) the absence of third-party liability; or (iii) the settlement of the claim for less than full value in accordance with the Company’s established policies.

Historically, approximately 67% of the Company’s recoveries on behalf of clients involved automobile liability insurance, 14% involved premises liability insurance, 8% involved workers’ compensation insurance and 11% involved product liability or other insurance.

Provider Bill Audit Rights of Healthcare Payors. By contract, healthcare payors are generally entitled to certain audit rights with respect to healthcare claims presented to them for payment by medical providers.

Providers may bill healthcare payors under a variety of pricing regimes, including standard fee-for-service charges, discounted fee-for-service charges, case rates, per diem rates, and charges based on stop-loss insurance thresholds. In addition, Medicare risk claims that are paid under a variety of arrangements, including federally mandated payment methodologies, are also generally subject to audit by the payor.

Automated Identification of Claims with Recovery Potential. The Company’s database of information captures over 500 data elements of financial, demographic and clinical data from members, providers and payors. The Company utilizes this data to project potential savings outcomes and pre-screen claims for its various audit services. Provider contract terms are also programmed into the system, which then reviews claims against the specific contract provisions to identify discrepancies. The database of statistical information is refined to include the results of each completed audit. Provider bill claims are selected for audit based upon statistical analysis and a comparison to previously audited claims. Typically, claims with billed charges greater than specified thresholds are selected for audit. Every claim is automatically reviewed in a complete, focused audit to refine selection criteria.

Investigation of Potentially Recoverable Claims. The Company’s provider bill audit service is a process for establishing accurate billing based on the care and services documented by healthcare professionals and ordered by the physician in the medical record as compared to the itemized billed charges. When a claim is identified, it is automatically assigned to a nurse auditor who will conduct an audit of all the line items that make up the claim at the site of the provider. Based on historical experience, approximately 93% of reviewed claims generate recoveries.

Assertion and Management of Potentially Recoverable Claims. The workflow performed by the various audit personnel is directed and guided step-by-step by the Company’s proprietary and other software. Registered nurses review provider bills line by line to determine if inaccuracies exist. This review is completed on-site at the provider facility where the medical record exists. These audits benefit any health plan that pays a portion of a claim based on a percent of billed charges. Nurse auditors review the total claim file to compare the medical record to the line item bill to ascertain that a physician ordered the service performed, the supplies billed were actually used and the medication billed was actually administered. The nurse auditor also verifies that the billing is in compliance with the provider contract and that stoploss or outlier provisions are correctly billed. Historically, provider bill audits have resulted in savings of approximately 5% to 6% of the aggregate amount of billed charges audited.

Negotiation and Settlement of Claims. Once the audit is completed, the Company reviews its findings with a provider representative to reach agreement. If there is no response from the provider within forty-five days, the audit results are considered final and the claim is closed. The savings are reported to the client for recoupment or the Company will collect them from the provider.

Automated Identification of Claims with Recovery Potential. Healthcare payors are generally entitled to recover from contract providers amounts that have been paid in error or where the payor’s obligation is secondary to that of another payor (i.e., coordination of benefits). Examples of errors include payment of claims outside the coverage contract, duplicate payments, and payments on claims for persons no longer covered by the payor. The automated selection, analysis and processing of raw claims data are handled primarily through the Company’s proprietary selection software. This software identifies potential claims adjudication errors based on the provisions contained in the clients’ various health plan and provider contracts.

Investigation of Potentially Recoverable Claims. Suspected overpayments are identified and classified by type, then reviewed and researched by experienced claims analysts, who specialize in particularly complex types of overpayments, including coordination of benefits and Medicare. Based on historical experience, approximately 10% of reviewed claims generate recoveries.

Assertion and Management of Potentially Recoverable Claims. The workflow performed by the claims recovery personnel is directed and guided step-by-step by the Company’s proprietary and other software. Suspected overpayments are verified based upon the claims analysts’ research.

Negotiation and Settlement of Claims. Once an overpayment is verified, it is forwarded to a unit specializing in collections for recovery. Historically, approximately 70% of verified overpayments have been collected. The Company recovers the money for its clients through its collection function or reports the overpayments to the client for recoupment from claims paid to that provider prospectively, where the right of off-set is present in the payor’s contract.

Automated Identification of Claims with Recovery Potential. The physician bill audit product involves a review of physician claims to identify instances of potential over-billing of evaluation and management (“E&M”) claims. E&M claims represent physician requests for payment based on the components of care rendered in connection with office and hospital visits. In general, physicians charge for E&M visits based on the intensity level and location (i.e., office vs. hospital) of the services, and bill using a standardized method for ranking the intensity level that is susceptible to error. Healthcare payors are generally entitled to review the claims from physicians and the associated patient medical records and to seek correction of billing errors. The Company has created proprietary software that automates the selection of appropriate E&M claims for review and assists in the management of the audit process.

Investigation of Potentially Recoverable Claims. Certified Professional Coders, using the Company’s on-line operational software, audit the relevant patient medical records in order to verify any billing errors. The audit process involves applying standardized descriptions of the five intensity levels for E&M claims, derived from federal evaluation and management guidelines, to the physicians’ own records of such visits.

Negotiation and Settlement of Claims. Once a physician overcharge is verified, at the client’s option, it can be either referred back to the client for recovery or it can be retained by the Company for collection.

The Company operates in the subrogation outsourcing market that serves property and casualty (“P&C”) insurers. The Company offers its services to the P&C market under the brand name “TransPaC Solutions”.

The Company believes that the market for P&C subrogation outsourcing in the United States is substantial and that the potential savings from subrogation recoveries will vary depending upon the P&C line of business. The Company believes that total potential subrogation recoveries in the automobile insurance market exceed $6 billion per year. Based on its research and early experience, the Company believes that there is an opportunity to increase total subrogation recoveries across a wide spectrum of automobile insurers. The Company’s marketing strategy is to offer its services to automobile insurers and multi-line carriers that lack the resources to maximize subrogation recoveries.

The Company believes that it has an opportunity to leverage its healthcare subrogation expertise and resources to provide service to the P&C markets. The primary difference between the two markets is in the acquisition of claims data for investigation of subrogation potential. The P&C industry does not have standard data definitions regarding claims as does the health insurance industry. Nevertheless, the Company used its healthcare subrogation expertise to build data interfaces with several of its P&C customers, and it has created proprietary business processes to acquire paper-based and/or imaged claims data from its customers’ claims adjusting offices and archives.

Subrogation Recovery Rights of P&C Insurers. By contract and law, P&C insurers typically have a standard set of subrogation rights that are recognized in court proceedings or in arbitration. These rights may lie against the persons causing the damages directly or against the insurers of those persons. The Company is primarily engaged in making subrogation recoveries for its clients on automobile physical damage and premises damage claims.

P&C Subrogation Recovery Process. The recovery process has been refined to four major, interrelated steps: (i) acquisition of claims data on potential subrogation claims from clients; (ii) investigation of potentially recoverable subrogation claims; (iii) assertion and management of potentially recoverable subrogation claims; and (iv) negotiation and settlement of claims.

The Company dedicates staff with specialized skills to individual services to optimize recoveries. The workflow performed by the various recovery personnel is directed and guided step-by-step by the Company’s proprietary and other software. The Company’s systems document activity on the claim files and provide an interconnected record of correspondence and notes taken by the recovery personnel with respect to each file. The Company’s recovery personnel annotate the files on-line, as necessary, to document progress, developments and status and otherwise maintain the history of each claim.

Once a file of claims is classified as recoverable, the Company’s recovery personnel, who undergo extensive training, proceed to assert the recovery rights of the Company’s clients and track the claims’ history and development. The employees contact all necessary parties to inform them of the existence and value of the recovery claim. These parties generally include the liability insurer for the responsible party or the responsible party itself when it is uninsured. Recovery personnel maintain contact with the parties involved, including the responsible party (or insurance carrier), until the claim is settled. Settlement may not occur until several years after the claim was originally paid.

The recovery process culminates in the negotiation and settlement of claim files. Within the settlement guidelines established by each client and the Company’s standard operating procedures, recovery personnel close recoverable files and remove them from backlog by making recoveries or by rejecting files and terminating recovery efforts. Once a settlement is made and recorded in the system, receipt of cash is anticipated and monitored by the responsible employee. Cash receipts are posted to the credit of the appropriate client.

Although some subrogation recoveries will be made during the first year of service, the average time to make a recovery is 18 to 24 months from date of loss, with substantially all recoveries made within 36 months for automobile coverages. The recovery process for bodily injury claims and property claims with complex facts may take up to five to six years from the date of loss to recover. The timing of recoveries is driven by the P&C payment cycle of claims (which is the source of recoveries made by the Company) and circumstances specific to each claim (e.g., identification of responsible party, responsiveness of responsible party, cooperation of parties involved, factual complexity and litigation). The amount of claims recoveries made by the Company on behalf of a client is generally less than the amount of backlog generated on behalf of such client. This happens for a number of reasons, including (i) the inadequacy of insurance coverage or other available source of funds to pay the claim; (ii) the absence of third-party liability; or (iii) the settlement of the claim for less than full value in accordance with the clients’ settlement guidelines and the Company’s established operating policies.

The Company has developed a web-enabled subrogation software application. The Company sells this product as an application service provider (ASP), under the trade name “Troveris”, to participants in both the health insurance and benefits market and the P&C market which historically have not outsourced subrogation recoveries. In the private health insurance and benefits market, the Company currently estimates that 40% to 50% of these participants do not outsource subrogation recoveries. In the public health insurance and benefits market, i.e., Medicaid and Medicare, the Company believes that there is virtually no outsourcing of subrogation recoveries because these programs typically rely on their claims administration contractors to provide subrogation services as part of a bundled service contract. In the P&C market, the Company believes that certain participants are by their nature less likely to outsource subrogation services. For example, the Company believes that mutual insurers have organizational and cultural biases against outsourcing and that larger P&C insurers have sufficient resources to develop relatively sophisticated internal departments.

In June 2002, the Company made its first sale of the Troveris software to an outside client, and a second sale was made in December 2003. Additionally, the Company has received indications of interest from other potential purchasers.

The Troveris marketing strategy combines the opportunity for an internal subrogation department to gain operating efficiency through the functionality of state-of-the-art desktop software and to leverage its ability to produce recoveries through the purchase of unbundled components (such as investigation, training, etc.) of the Company’s traditional subrogation outsourcing services. The Troveris software application allows the Company to administer these customized relationships using the same proprietary processes as it uses for those customers who purchase turnkey subrogation outsourcing services.

In addition to being offered for sale as an on-line subrogation recovery system in an ASP-model, Troveris also constitutes the systems platform for the Company’s recovery operations. All of those operations are currently conducted on Troveris. The Company began to migrate its internal healthcare subrogation operations to a version of Troveris during the fourth quarter of 2001, at which time it anticipated reducing its technology expense, net of the expense of maintaining the Troveris application, by at least $600,000 per year. At present, substantially all of that expense reduction has been captured and is reflected in the Company’s 2003 financial results.

The Company employs, and facilitates the development of, skilled knowledge-workers. The Company maintains an in-house training program, which it believes is attractive to employees and essential in developing the necessary industry-specific skills. The Company employed 591 persons as of December 31, 2003 and 666 persons as of December 31, 2002.

The Company requires all employees to enter into confidentiality and nondisclosure agreements, which generally prohibit them from divulging confidential information and trade secrets after employment is terminated. Employees are also required to enter into non-compete agreements, preventing them from working for a competitor during the first year after employment is terminated. In addition, the Company’s customers generally agree not to employ the Company’s employees during the client’s contract term plus a specified period.

The Company’s employees are not represented by a labor union or a collective bargaining agreement. The Company regards its employee relations as good.

The Company primarily markets its healthcare recovery services and healthcare subrogation software to and contracts with healthcare payors, including HMOs, other types of managed healthcare plans, indemnity health insurers, self-funded employee health plans, insured healthcare plans, third-party administrators, Blue Cross and Blue Shield organizations and provider organized health plans.

The Company primarily markets its P&C subrogation recovery service and P&C subrogation software to P&C insurers that are personal lines automobile carriers or that are multi-lines carriers which focus on automobile coverage. Although its focus is on selling full outsource subrogation recovery services, the Company does provide referral services and closed claims services, both of which are more limited in scope and revenue potential than is the full outsourcing product.

The Company employs a staff of sales managers, a marketing manager and client services managers for its healthcare recovery services and healthcare subrogation software and a separate staff of sales managers and client services managers for its P&C subrogation recovery service and P&C subrogation software. Sales are made directly through contacts with prospective clients, trade show presentations and employer seminars. Additional business is also generated from existing clients, which have expanded their business by growth or acquisitions or which have business segments not already under contract with the Company.

Due to the nature of its outsourcing businesses, the operating cycle for some of its products and the industries to which it markets its products, the sales process is lengthy and involves demonstrating to prospective clients that the Company’s economies of scale, proprietary processes and value-added services allow (i) the Company to generate and return to the clients a greater dollar amount of recoveries than the clients’ in-house recovery department and (ii) the clients to focus greater resources on core business functions. New customer relationships can also be established through pilot programs, which have typically lasted 12 to 18 months.

Complementing the technical aspects of the recovery process, the client support function is primarily responsible for communications with clients and problem resolution. To facilitate strong working relationships, individual members of the client services staff are assigned to specific clients. The Company believes that its investment in resources to resolve a wide variety of business issues with clients is an important factor in obtaining customers and maintaining good business relationships.

During the year ended December 31, 2003, clients terminated healthcare recovery services from the Company covering 9.0 million lives; certain of these same clients, however, kept in place or bought from the Company other healthcare recovery services with respect to 1.4 million lives. During the three-year period ended December 31, 2003, clients terminated healthcare recovery services from the Company covering 23.9 million lives; these same clients, however, kept in place or bought from the Company other healthcare recovery services covering 4.1 million lives. The terminations occurred due to, among other things, consolidations of healthcare payors, bankruptcy, the selection of another vendor, or because the process was taken in-house. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Healthcare Recovery Services — Results of Operations — Key Operating Indicators”.

During the year ended December 31, 2003, the Company had four contract terminations involving three property and casualty clients. One of the client terminations involved referral business (i.e., less than full outsourcing) that never produced significant revenues. A second client terminated its contract because it took the recovery process in-house. The third client terminated its two contracts after the Company completed the projects (which involved analysis of claims that had already been reviewed by the client).

Healthcare Recovery Services. The Company provides services to healthcare plans that as of December 31, 2003 covered approximately 39.9 million lives. The Company’s clients are national and regional healthcare payors, large third-party administrators or self-insured corporations.

The Company currently has one client, Wellpoint Health Network (“Wellpoint”), that individually accounts for more than 10% of its revenue. It also has a former client, UnitedHealth Group (“UHG”), that historically accounted for more than 10% of the Company’s revenue. For the years ended December 31, 2003, 2002 and 2001, UHG generated 24%, 28% and 27% of the Company’s revenue, respectively, and Wellpoint generated 17%, 14% and 11% of the Company’s revenue, respectively.

The Company’s revenues are earned under written contracts with its clients that generally provide for contingency fees from recoveries under a variety of pricing regimes. The pricing arrangements offered by the Company to its clients include a fixed fee percentage, a fee percentage that declines as the number of lives covered by the client and subject to the Company’s service increases and a fee percentage that varies with the Company’s recovery performance.

either party, although in a few cases the contracts extend over a period of years. The Company’s contracts generally provide that in the event of termination, the Company is entitled to complete the recovery process on the existing backlog or to receive a cash payment designed to approximate the gross margin that would otherwise have been earned from the recovery on the backlog of the terminating client. On December 31, 2003 and 2002, the Company had Healthcare Recovery Services backlog of $1,521.8 million and $1,559.0 million, respectively.

During 2002, UHG management informed the Company of its intention to terminate subrogation services with respect to all but 1.8 million lives of the 9.7 million lives then subject to the Company’s services under a contract with UHG. UHG’s termination of these services resulted from its decision to bring subrogation recovery services back inside UHG, where they are being performed by its Ingenix strategic business unit. The Company’s contract with UHG expired in accordance with its terms on February 1, 2003, except with respect to the 1.8 million lives. In December 2003, UHG gave notice of the termination of the remaining business under contract, effective February 1, 2004. The Company expects to continue recovering on the backlog as to which UHG terminated the Company’s services, a process that the Company expects will be completed in 5 to 6 years from the dates of termination.

Property and Casualty Recovery Services. As of December 31, 2003, the Company provides services to 19 P&C insurers, of which five are clients for full outsourcing with the remainder being clients for either referral services, in which the Company supplements the capacity of an internal recovery unit, or closed claims reviews, in which the Company recovers subrogation claims missed or ignored by an internal recovery unit. Three of the Company’s P&C Recovery Services clients account for greater than 69% of this segment’s backlog at December 31, 2003.

The Company’s P&C Recovery Services revenues are earned under written contracts with its clients that generally provide for contingency fees from recoveries. The pricing arrangements offered by the Company to its clients also include tiered pricing based on the Company’s service levels.

The Company performs its recovery services on a reasonable efforts basis and does not obligate itself to deliver any specific result. Contracts with its customers are generally terminable on 60 to 180 days’ notice by either party. The Company’s contracts generally provide that in the event of termination, the Company is entitled to complete the recovery process on the existing backlog. On December 31, 2003 and 2002, the Company had P&C Recovery Services backlog of $17.9 million and $15.3 million, respectively.

Software. As of December 31, 2003, the Company had two software clients. One, a Cincinnati-based third party administrator of healthcare claims for self-funded employers, became a client in June 2002, and the second, a Blue Cross Blue Shield organization, became a client in late December 2003. The Software segment earns software revenues based on an external client’s level of utilization, and from the Healthcare Recovery Services and P&C Recovery Services segments based on their use of the Troveris software. Moreover, the Software segment may also earn commission revenue from the Healthcare Recovery Services and the P&C Recovery Services segments on any revenue that the Company derives from healthcare subrogation services or P&C subrogation services that are delivered by such segments to an external client through Troveris.

Healthcare Recovery Services. The Company competes primarily with the internal recovery departments of potential customers and other outsource healthcare recovery service vendors. To the Company’s knowledge, in addition to the Company there are four smaller, but significant, independent providers of healthcare subrogation recovery services, four different vendors that provide competitive overpayment recovery outsourcing services, and three national companies that provide provider bill auditing services.

Property and Casualty Recovery Services. The Company has assessed the competitive environment for P&C subrogation outsourcing and believes that the competition is fragmented and characterized by claims adjusting companies that operate on a local or regional basis and by law firms that specialize in a low volume of legally complex subrogation claims. The Company has identified five competitors that attempt to serve a

national market. Two of these competitors are owned and controlled by P&C insurers, and the Company believes that this fact may deter potential buyers of these competitors’ services if those potential buyers also compete against the competitors’ parent organizations.

With respect to both its healthcare recovery services and its P&C recovery services, the Company believes that there are barriers to entry in the bulk of its market, including process expertise, capital requirements necessitated by the unusually long revenue cycle in the recovery industry, assembling and training a qualified and productive employee base possessing appropriate industry expertise, and an information processing system designed to aid investigators and examiners engaged in the recovery process. However, there are participants in the healthcare, insurance, transaction processing and software development industries that possess sufficient capital, and managerial and technical expertise to develop competitive services.

Software. The Company is not aware of any competition in subrogation software in an ASP model for the healthcare payor industry, and it has identified only one large competitor in the P&C insurance industry. This competitor is partially owned and controlled by a major P&C insurer, and the Company believes that this relationship will reduce the ability of the competitor to sell its services to other P&C insurers.

With respect to its software segment, the Company believes that there are barriers to entry in its market, including process expertise. However, there are participants in the healthcare, insurance, transaction processing and software development industries that possess sufficient capital and managerial and technical expertise to develop competitive software.

General. The Company’s computer systems consist of inter-related proprietary software programs that function as automated data and process management systems. The Company holds a copyright on certain of its software and has applied to the United States Patent Office for patents on certain inventions contained in the Troveris software.

Quality and Management Controls. The computer systems control, measure and generate reports on the recovery processes. From data recorded in these systems, a series of financial reports are generated for clients that allow them to monitor the Company’s success in making recoveries on their behalf. The data used for financial reports are also used to produce a wide array of accounting and management information used by the Company to operate its business. The Company employs a variety of quality control techniques to ensure consistently high-quality service.

During the years ended December 31, 2003 and 2002, the Company incurred no research and development expense. The Company incurred approximately $537,000 in research and development expense during the year ended December 31, 2001 in connection with the development of the Troveris software which was placed in service during 2002.

The healthcare industry is subject to numerous laws and regulations which may affect the Company’s business. In addition to laws and regulations affecting healthcare and insurance, changes in the federal fair debt collection laws and laws governing the privacy of personal health information may also adversely affect the Company’s business.

General. From time to time, legislation is introduced in Congress and various state legislatures which would materially, and potentially adversely, affect the Company’s business. Moreover, courts (particularly the United States Supreme Court, the federal appellate courts and the state supreme and appellate courts) have the power to create and interpret laws in ways that may also materially and adversely affect the Company’s business. The most significant legislation, laws and regulations may, for clarity, be grouped into three categories: (i) legislation that would substantially limit the ability of healthcare insurers to recover from third-parties accident-related medical benefits incurred by injured insureds (“Health Insurance Primacy Laws”);

(ii) legislation that would substantially limit the Company’s ability to receive and utilize individual claim information from healthcare insurers (“Confidentiality Laws”); and (iii) other federal and state laws and certain legal doctrines. The following identifies specific risks in these three categories:

Auto Choice Reform Act. In May 2001, Congress proposed, but failed to enact, legislation known as the Auto Choice Reform Act of 2001 (the “Proposed Act”). Similar bills were introduced but not enacted in each of the two previous Congresses. Under the Proposed Act, in those states not opting out of its provisions, individual drivers would have been able to choose to be covered by an auto insurance system in which healthcare insurers, with some exceptions, might have been unable to recover for healthcare costs incurred by those injured in automobile accidents. Consequently, even if the insured’s injuries were caused by the negligence of another driver, the healthcare insurer might not have had any rights of recovery against the negligent party or that party’s liability insurer. Revenue generated from recoveries against automobile liability insurers historically has represented approximately 65% of the Company’s revenues. Should similar legislation be enacted, it could have a material adverse effect on the Company’s business, results of operations and financial condition.

Proponents of the Proposed Act asserted that (i) the costs of operating a motor vehicle are excessive due to legal and administrative costs associated with the processing of claims under the fault-based liability system; and (ii) the costly fault-based liability insurance system often fails to provide compensation commensurate with loss and takes too long to pay benefits. Even if the Proposed Act is not introduced in Congress again in the future, these policy reasons may result in future legislation designed to significantly alter the fault-based liability system used in most states, eliminate recovery rights of healthcare insurers and materially adversely affect the Company’s business.

Certain No Fault Insurance Systems. Certain states have adopted versions of automobile “no fault” insurance systems in which the injured party’s health insurance carrier or provider is primarily responsible for healthcare related expenses (and not the responsible party and his or her insurer or the injured insured’s automobile liability insurer). In 1996, California voters rejected a no-fault automobile insurance measure, Proposition 200, which would have required drivers with bodily injuries to be compensated by their healthcare insurers. Although Proposition 200 was rejected by the voters, there can be no assurance that similar measures will not again be presented in a ballot initiative or as legislation in California or elsewhere in the future. Growth in the number of states adopting similar systems could significantly reduce the amounts otherwise recoverable by the Company in connection with automobile injuries in such states.

Confidentiality Provisions of the Health Insurance Portability and Accountability Act of 1996 and Related Regulations. The Company’s activities involve the receipt and use of confidential health information from or on behalf of its clients. In December 2000, the Secretary (the “Secretary”) of Health and Human Services (“HHS”) promulgated the Standards for Privacy of Individually Identifiable Health Information, 45 C.F.R. Parts 160 and 164 (as modified, the “Privacy Rule”), which deals with the use and disclosure of health information and implements certain requirements of the Administrative Simplification subtitle of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). The Privacy Rule became effective on April 14, 2001 and health plans, health care clearinghouses, and certain health care providers covered by the Privacy Rule (“Covered Entities”) generally were required to comply by April 14, 2003. The Privacy Rule prescribes the manner in which Covered Entities are permitted or required to use and disclose individually identifiable health information subject to the Privacy Rule’s requirements, known as “protected health information”. The Privacy Rule also requires Covered Entities to implement certain “administrative” requirements, such as establishing relevant policies and procedures, designating a privacy official responsible for the development and implementation of the policies and procedures, and training affected members of the workforce regarding the policies and procedures. The Privacy Rule establishes a complex regulatory framework on a variety of subjects, including, but not limited to, (a) disclosures and uses of protected health information, (b) individuals’ rights to access, amendment, and accounting regarding their protected health

The Privacy Rule affects other entities that are not necessarily Covered Entities under the Privacy Rule, but which perform certain functions or activities on behalf of Covered Entities. Entities performing certain functions or activities on behalf of a Covered Entity are treated as “business associates” of a Covered Entity under the Privacy Rule. The Company’s activities make it a business associate of customers that are Covered Entities, such as health plans. The Privacy Rule requires the Covered Entity and its business associates to enter into contracts that meet certain requirements. Therefore, although a business associate to a Covered Entity is not directly subject to the Privacy Rule, it will be subject to certain similar requirements imposed through its business associate contracts. Significantly, however, the Privacy Rule does not require business associate contracts to obligate business associates to implement certain organizational requirements the Privacy Rule imposes upon Covered Entities, such as appointing a privacy officer or establishing and distributing a notice of privacy practices. The business associate provisions of the Privacy Rule do require a Covered Entity that becomes aware of a pattern of activity or practice of a business associate that constitutes a material violation of the business associate’s obligations under the contract to take reasonable steps to end the violation and, if such steps are not successful, terminate the contract with the business associate, if feasible.

In August 2000, HHS issued pursuant to HIPAA, a final rule establishing transaction standards and code sets for the electronic transmission of health information, 45 C.F.R. Part 162 (the “Transaction Standards”). The Transaction Standards adopt uniform standards that must be used if one health care provider or health plan conducts certain electronic transactions with another health care provider or health plan. Moreover, the Transaction Standards establish certain code sets to be used in connection with the standard transactions. Health plans and other entities subject to the Transaction Standards were generally required to comply by October 16, 2003. The Company currently does not engage in any transactions covered by the Transaction Standards. However, additional transactions, possibly including transactions engaged in by the Company, will be covered by the Transaction Standards in the future.

In addition to the Privacy Rule and the Transactions Standard, in February 2003 HHS published, pursuant to HIPAA, a final rule governing the security of health information maintained or transmitted electronically by health plans and certain clearinghouses and providers (the “Security Standards”). The Security Standards impose extensive additional administrative, physical, technological, and organizational requirements on Covered Entities and their business associates. As noted above, certain of the Company’s activities make it a business associate of the Company’s clients; therefore the Company will have some contractual obligations related to the Security Standards. The Security Standards have a compliance date of April 21, 2005.

HIPAA, the Privacy Rule, the Transactions Standard and the Security Standard (collectively, the “Rules”) could impair the Company’s subrogation recovery practices by creating administrative burdens (for example, by requiring business associates of Covered Entities to amend health information in certain circumstances or to restrict subsequent uses of protected health information) or liability risks that lead health plans to voluntarily restrict their subrogation recovery practices. The provisions of the Rules or of future federal legislation and regulations could impair or prevent the acquisition and use by the Company of claims and insurance information necessary to process recovery claims on behalf of its clients. However, the Company believes that it will be able to comply with the Rules on a timely basis and without material adverse effect.

In addition to the federal protection of health information, state laws governing privacy of medical or insurance records and related matters may significantly affect the Company’s business. Most states have enacted health care information confidentiality laws that limit the disclosure of confidential medical information. The Rules do not preempt state laws regarding health information privacy that are more restrictive than the Rules. The costs and efforts associated with compliance with the various state laws could increase in the future if states begin to enact additional and more comprehensive privacy legislation and may have a material adverse effect on the Company.

Changes in a variety of laws could also affect the Company’s business. One such area is insurance law, which comprises a complex network of state and federal laws, such as the federal Employee Retirement Income Security Act of 1974 (ERISA), the regulations and orders promulgated under those laws, and the pertinent case law created by state and federal courts. Similarly, federal or state laws that would bar or impair healthcare subrogation or an injured party’s ability to collect insured damages (that is, an injured person would be prevented from recovering from the wrongdoer damages for accident-related medical benefits covered by health insurance) could similarly adversely affect the Company’s business. Existing debt collection laws also may be amended or interpreted in a manner that could adversely affect the Company’s business. Additionally, although the Company does not believe that it engages in the unauthorized practice of law, changes in the law or a judicial or administrative decision defining some of the Company’s activities as the practice of law, could have a material adverse effect on the Company’s business.

With respect to recoverable claims, the rights of healthcare subrogation and reimbursement may be limited in some cases by three principles of general application. The first of these is the “made whole doctrine”, which subordinates the healthcare provider’s ability to recover to that of the injured party when the settlement damage award received by the injured party is inadequate to cover the injured party’s damages. The second is the “common fund doctrine”, which permits plaintiff’s attorneys to deduct their fees for the claim based on the entire amount covered by a damage award and may, in some cases, proportionally diminish the amount recoverable by the Company on behalf of the healthcare payor out of that damage award. Finally, federal courts have in some venues, most notably the Ninth Circuit which covers California and several other western states, begun to apply a doctrine under ERISA that prevents or hinders health plans (and their recovery agents) from bringing healthcare reimbursement actions in federal court.

The Company makes its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments and exhibits to these reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), available (free of charge) on or through its Internet website located at http://www.troversolutions.com, as soon as reasonably practicable after they are filed with or furnished to the SEC. The address of the Company’s website is provided solely for the readers’ convenience and is not intended to be an active link.

As of December 31, 2003, the Company leased property at the following four locations: (i) approximately 105,718 square feet of space for its executive offices and main operations in Louisville, Kentucky, under a lease agreement and amendment expiring in 2009; (ii) approximately 10,206 square feet at a regional operating office in Pittsburgh, Pennsylvania, under a lease agreement expiring in 2006; (iii) approximately 8,125 square feet at its Encino, California location under a lease agreement expiring in 2004; and (iv) approximately 20,500 square feet at its New Berlin, Wisconsin location under a 5-year term expiring in 2006. The Company is currently in negotiations to extend the lease for the Encino, California office for a five-year term expiring in 2009, with substantially the same terms as the current lease.

The Company is engaged in the business of identifying and recovering subrogation and related claims of its clients, many of which arise in the context of personal injury lawsuits. As such, the Company operates in a litigation-intensive environment. Consequently, since its founding in 1988 the Company has been involved with many litigation matters related to its subrogation business, sometimes as a defendant and sometimes through a defendant client. The plaintiffs’ attorneys attempting to defeat the clients’ subrogation liens often threaten litigation against the Company and its clients as a negotiating tactic. Most of the lawsuits that have

been filed against the Company or its clients concern the entitlement to recover a specific, individual subrogation claim or the amount of the subrogation claim. Typically, these actions do not ask for punitive damages, are not pled as class actions, and do not have wide implications with respect to the Company’s ongoing business practices.

To date, however, the Company has encountered eight noteworthy instances in addition to the pending lawsuits described under “Current Litigation”, in which lawsuits were filed against it or its clients that sought punitive damages, were pled as class actions, or otherwise made claims or requested relief that could have materially affected the Company’s business practices. The risk profile for this sort of business practices litigation includes not only the usual considerations of the potential amount, effect, and likelihood of loss, but also specifically the potential for punitive damages and class certification, the possible effects of an adverse verdict on the Company’s business practices, and the likelihood of specific plaintiffs’ attorneys bringing similar actions in other jurisdictions.

Each of these cases has been completely resolved, by decision of a court or settlement by the parties, but prior to resolution the Company did not regard all of these cases as being material in and of themselves. In management’s opinion, these eight cases share a common profile with each other and with the lawsuits described below under the caption “Current Litigation”.

Five of the eight lawsuits named the Company as a defendant and were pled as class actions. Two of these five cases, one in federal court and the other in state court, alleged that the Company violated state and federal laws on fair debt collection practices. In the state court action, the court granted the Company’s motion for summary judgment on all claims in the complaint, which the court of appeals affirmed. In the federal court action, the Company settled the matter, prior to the court’s ruling on the Company’s motion for summary judgment, for a nominal amount.

Three of those five lawsuits, pled as class actions and naming the Company as a defendant, were filed in federal court and charged the Company with a variety of violations of laws and sought punitive damages. The complaints alleged, among other things, that the Company committed negligence, fraud and breach of its duties under ERISA by attempting to recover and actually recovering, by subrogation, the reasonable value of medical benefits which were provided by the Company’s clients under capitation or discounted-fee-for-service arrangements. One of these lawsuits was dismissed in a ruling on the merits. Another was settled, after the court denied class certification, for a nominal amount paid by the Company’s client, a co-defendant in the case. The third case, DeGarmo et al. v. Healthcare Recoveries, Inc., was concluded in mid-July 2001 for a settlement payment of $3 million and nonmonetary terms that management regards as immaterial to the Company’s ongoing business.

The remaining three lawsuits did not name the Company as a defendant. These three lawsuits did, however, involve the Company’s clients and implicate important Company business practices. The complaints in these cases alleged, among other things, violation of state law with respect to the payment of plaintiffs’ attorneys’ fees and unfair trade practices, violation of the federal Health Maintenance Organization Act of 1973, misrepresentation of the rightful amounts of subrogation claims, and impermissible enforcement of recovery rights. Two of these cases resulted in judgments in favor of the Company’s clients after litigation of the merits before trial and appellate courts. The other case was settled for an immaterial amount.

Management believes that the lawsuits described above will not, as a general matter, have precedential value for either the cases described below under the caption “Current Litigation” or for any future litigation matters (all these cases being referred to as the “Pending and Potential Cases”). Indeed, the courts hearing the Pending and Potential Cases may not even become aware of the outcomes in the eight lawsuits described above. Management expects that each of the Pending and Potential Cases will be decided on its own merits under the relevant state and federal laws, which will vary from case to case and jurisdiction to jurisdiction. The descriptions of the outcomes in the eight cases dealing with business practices are included here in order to describe the context for these kinds of litigation and the Company’s relative successes in handling past business practices litigation, but are not necessarily predictive of the outcomes of any of the Pending and Potential Cases.

Moreover, there can be no assurance that the Company will not be subject to further class action litigation similar to that described below under the caption “Current Litigation”, that existing and/or future class action litigation against the Company and its clients will not consume significant management time and/or attention or that the cost of defending and resolving such litigation will not be material.

On October 28, 1999, a class action plaintiff’s Original Petition (“Petition”) was filed against the Company and one of the Company’s clients in the District Court for the 150th Judicial District, Bexar County, Texas, Joseph R. Cajas, on behalf of himself and all others similarly situated v. Prudential Health Care Plan, Inc. and Healthcare Recoveries, Inc. The plaintiff asserts that the Company’s subrogation recovery efforts on behalf of its client Prudential Health Care Plan, Inc. (“Prudential”) violated a number of common law duties, as well as the Texas Insurance Code and the Texas Business and Commerce Code. The Petition alleges that the Company, as the subrogation agent for Prudential, made fraudulent misrepresentations in the course of unlawfully pursuing subrogation and reimbursement claims that the plaintiff asserts are unenforceable because (1) prepaid medical service plans may not exercise rights of subrogation and reimbursement; (2) the subrogation and reimbursement claims asserted by the Company are not supported by contract documents that provide enforceable recovery rights and/or do not adequately describe the recovery rights; and (3) the sums recovered pursuant to such claims unlawfully exceed the amount Prudential paid for medical goods and services. The Company was served with the Petition in November 1999, and has answered, denying all allegations. After the defendants filed a motion for summary judgment in January 2002, the plaintiff moved the court to delay consideration of the motion until the plaintiff could complete additional discovery. The plaintiff’s motion to delay consideration was granted. On October 25, 2002, the plaintiff filed an amended petition naming one additional plaintiff as a purported class representative. The amended petition did not add any new claims. The defendants filed a motion for summary judgment on January 24, 2003, and the plaintiffs filed a cross motion for summary judgment. On February 25, 2003, a state court judge denied the defendants’ motion for summary judgment that the defendants were entitled to enforce the terms of Prudential’s policies. The same judge granted the plaintiffs’ partial motion for summary judgment to the effect that Prudential could not recover more than its costs. That ruling is not final nor yet appealable. The plaintiffs have not yet moved the court to certify the case as a class action.

In December 1999, a purported class action complaint (“Complaint”) was filed against the Company and one of the Company’s clients in the Court of Common Pleas of Richland County, South Carolina, Estalita Martin et al. vs. Companion Health Care Corp., and Healthcare Recoveries, Inc. In January 2000, the defendant Companion Healthcare Corp. (“CHC”) filed an Answer and Counterclaim and the plaintiff Martin filed a First Amended Complaint (“Amended Complaint”). The Amended Complaint asserts that the Company’s subrogation recovery efforts on behalf of its client, CHC, violated a number of common law duties, as well as the South Carolina Unfair Trade Practices Act. The Amended Complaint alleges that the Company, as the subrogation agent for CHC, made fraudulent misrepresentations in the course of unlawfully pursuing subrogation and reimbursement claims that the plaintiffs assert are unenforceable because (1) prepaid medical service plans may not exercise rights of subrogation and reimbursement; (2) the subrogation and reimbursement claims asserted by the Company are not supported by contract documents that provide enforceable recovery rights and/or do not adequately describe the recovery rights; and (3) the sums recovered pursuant to such claims unlawfully exceed the amount CHC was entitled to collect for such medical goods and services. The Amended Complaint further alleges that the Company and CHC unlawfully pursued subrogation and reimbursement claims by (1) failing to pay pro rata costs and attorney’s fees to attorneys who represented purported class members with respect to tort claims underlying the subrogation and reimbursement claims; and (2) failing to include in subrogation and reimbursement claims all applicable discounts that CHC received for such medical goods and services. The plaintiffs, on behalf of the purported class, demand compensatory damages, punitive damages, and treble damages, disgorgement of unjust profits, costs,

prejudgment interest and attorneys’ fees. The Company was served with the original Complaint in late December 1999 and answered denying all allegations. The Company filed a motion to dismiss in August 2000 and in June 2001 the court granted the Company’s motion to dismiss. The plaintiffs filed a notice of appeal in July 2001. On March 1, 2004, the Court of Appeals of South Carolina filed an order and opinion affirming the trial court’s order dismissing the case. The time period in which the plaintiff may move for a rehearing in the Court of Appeals or pursue a further appeal to the South Carolina Supreme Court has not expired.

On March 12, 2001, a Complaint (“Complaint”) was filed against the Company in the United States District Court for the Eastern District of Louisiana, in a putative class action brought by Kyle M. Hamilton. In that action, Hamilton v. Healthcare Recoveries, Inc., No. 01-650, the plaintiff asserts that the Company’s subrogation recovery efforts on behalf of its clients violate certain Louisiana state laws, the federal Fair Debt Collection Practices Act and the Louisiana Unfair Trade Practices Act. The Complaint alleges that the Company intentionally and negligently interfered with the plaintiff’s and the putative class members’ rights to settle certain personal injury claims. The Complaint further alleges that the Company unlawfully pursued subrogation and reimbursement claims that the plaintiff asserts are unenforceable because the clauses in the Company’s clients’ coverage documents that create such recovery rights are rendered null and void by Louisiana statutes that generally prohibit coordination of benefits with individually underwritten insurance coverages. The plaintiff purports to represent a class consisting of all persons covered under group health policies that were issued or delivered in the State of Louisiana and who received any communication from the Company attempting to enforce any clauses that allegedly were rendered null and void by Louisiana law. The plaintiff seeks on behalf of the purported class compensatory and statutory damages, interest, costs, attorneys’ fees and such additional damages and relief as may be allowed by any applicable law. In July 2001, the court granted a motion for summary judgment filed by the Company as concerned the plaintiff’s Fair Debt Collection Practices Act (“FDCPA”) claim, dismissing those claims with prejudice. The court denied the Company’s motion for summary judgment, without prejudice to the right of the Company to reassert its motion, with respect to the plaintiff’s state law claims. The court ordered that the parties submit memoranda addressing whether the court still had subject matter jurisdiction, given dismissal of the federal claim. In August 2001, the court ruled that it lacked subject matter jurisdiction, thus dismissing the remaining claims, without prejudice. The plaintiff filed an appeal to the United States Fifth Circuit Court of Appeals. In November 2002, the Court of Appeals rendered its opinion reversing the dismissal of the FDCPA claims. The court also affirmed the trial court’s determination that diversity jurisdiction did not exist in the case. The court remanded the case to the federal district court for further proceedings. On April 29, 2003, the Company filed a Petition for Writ of Certiorari asking the U.S. Supreme Court to accept an appeal of the Court of Appeals ruling. The Supreme Court denied the Petition on June 9, 2003.

After the case was remanded to the trial court, the Company filed a second Motion for Summary Judgment. On May 13, 2003, the Court entered an Order granting the Company’s Motion for Summary Judgment, dismissing with prejudice the Plaintiff’s claims under the FDCPA and dismissing without prejudice the Plaintiff’s remaining state law claims. On May 27, 2003, the plaintiff filed a Notice of Appeal to the United States Fifth Circuit Court of Appeals, which heard oral argument of the appeal on December 3, 2003. The Court has not yet ruled on the appeal.

The Company disputes the plaintiff’s allegations regarding the applicability of the FDCPA and intends to vigorously defend its position in this case.

In addition to filing the appeal in federal court, the Hamilton plaintiff in October 2001 filed a new complaint in the Civil District Court for the Parish of Orleans, Louisiana, in a putative class action styled Hamilton v. Healthcare Recoveries, Inc., 2001-15989. This state court action asserts claims substantially similar to those in the federal court action. In November 2001, the Company filed preliminary exceptions to this new complaint. There were no further proceedings in the case until March 2003 when the Company filed a motion to stay any further proceedings in that case due to the related case pending in federal court. On April 25, 2003, the state court entered an order granting the Company’s motion to stay the lawsuit. Thereafter, the Company removed the case from state court to Federal court on August 5, 2003. On September 4, 2003,

On October 30, 2002, plaintiffs’ counsel in the Cajas and Franks cases filed a class action lawsuit in the United States District Court for the District of New Jersey on behalf of two Texas residents against the Company, Prudential Insurance Company, one of the Company’s clients, PruCare HMO, a subsidiary of Prudential Insurance Company, and Aetna, a company which had acquired the business of another of the Company’s clients. The complaint was served on the Company on February 27, 2003.

In the complaint, plaintiffs Kimberly Bruun and Ashley Emanis, on behalf of themselves and similarly situated persons, asserted claims on behalf of a putative nationwide class of persons who were members of PruCare HMO health plans governed by ERISA from whom the Company, under its contract with the client, recovered reimbursement. The complaint alleged that reimbursement recoveries made by PruCare HMO and the Company violate the terms of the standard PruCare HMO plan documents, and that reimbursement recoveries violate the Conformity with Law provision in the standard plan documents because subrogation and reimbursement are prohibited under the federal HMO Act. The complaint further alleged that the defendants’ subrogation and reimbursement recoveries resulted in a double recovery to PruCare HMO because PruCare HMO did not account for subrogation and reimbursement recoveries as offsets to expenses when setting premium rates. The complaint further alleged that the defendants improperly recovered in subrogation or reimbursement for services provided by capitated providers, or that in the alternative, the defendants improperly recovered more for capitated services than was paid for the services, or alternatively, that the defendants improperly collected amounts that exceeded the reasonable cash value of capitated services. The plaintiffs allege that PruCare HMO, Prudential, Aetna and the Company are fiduciaries and that they each have breached their fiduciary duty to the plaintiffs. Alternatively, the plaintiffs allege that if Aetna, Prudential and the Company are not fiduciaries, that they knowingly participated in PruCare HMO’s breach of fiduciary duty.

The plaintiffs, on behalf of the class, demand enforcement of the plan documents under certain sections of ERISA. The plaintiffs also demand restitution and disgorgement of sums recovered by defendants and the establishment of a constructive trust. The plaintiffs also demand an accounting of PruCare HMO’s and Aetna’s rate documents, the subrogation and reimbursement claims for capitated services, and/or the actual costs paid by PruCare HMO and Aetna for the capitated services.

On April 16, 2003, the defendants filed motions seeking to dismiss the lawsuit or to change the venue of the lawsuit to a federal court in Texas. On October 16, 2003, the court entered an order granting the defendants’ motions to dismiss and dismissing all of the plaintiff’s claims. On November 13, 2003, the plaintiffs filed a Notice of Appeal to the United States Third Circuit Court of Appeals. The plaintiffs filed their appellate brief on February 23, 2004. The Company has not yet filed briefs or argued the appeal.

On March 14, 2003, Lawrence Godair, the plaintiff in a putative class action against a motor vehicle insurer, amended his complaint to add the Company, and a client of the company, HMO Partners, as defendants in Lawrence Godair v. American Home Assurance Company, Trover Solutions, Inc. and HMO Partners, Inc., No. 4:02 CV 00407 SMR, United States District Court for the Eastern District of Arkansas, Western Division. In the amended complaint (the “Amended Complaint”), the plaintiff makes allegations on behalf of himself and a purported class of others similarly situated. The complaint asserts that the Company, as subrogation agent for HMO Partners, unlawfully demanded payment of a subrogation claim against proceeds of a medical payments insurance policy issued to the plaintiff by American Home. The Amended Complaint also alleges that the Company was unjustly enriched because the plaintiff was not fully compensated (“made whole”) for his injuries in violation of the Arkansas no-fault motor vehicle insurance statute and because the payment constituted a double recovery to the Company and to HMO Partners, in


(Mark One)




[X]		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the fiscal year ended December 31, 2003
		OR




[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period from to






Delaware		61-1141758
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)





1600 Watterson Tower Louisville, Kentucky		40218
(Address of principal executive offices)		(Zip Code)




(502) 454-1340 (Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act





Title of Each Class		Name of Each Exchange On Which Registered

None


Item:		Page





Part I




1.	Business		1




2.	Properties		15




3.	Legal Proceedings		15




4.	Submission of Matters to a Vote of Security Holders		21




	Supplementary Item. Certain Risk Factors		21




Part II




5.	Market for Registrant’s Common Equity and Related Stockholder Matters		21




6.	Selected Financial Data		22




7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		23




7A.	Quantitative and Qualitative Market Risk Disclosures		40




8.	Financial Statements and Supplementary Data		41




9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures		65




9A.	Controls and Procedures		65




Part III




10.	Directors and Executive Officers of the Registrant		65




11.	Executive Compensation		69




12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		77




13.	Certain Relationships and Related Transactions		81




14.	Principal Accountant Fees and Services		82




Part IV




15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K		83
EX-4.3 FIRST AMENDMENT TO RIGHTS AGREEMENT
EX-23.1 CONSENT OF PRICEWATERHOUSECOOPERS LLP
EX-31.1 SECTION 302 CERTIFICATION OF THE CEO
EX-31.2 SECTION 302 CERTIFICATION OF THE CFO
EX-32 SECTION 906 CERTIFICATION OF THE CEO & CFO
EX-99.1 SAFE HARBOR COMPLIANCE STATEMENT

Table of Contents

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Table of Contents


	Overview of the Healthcare Recovery Services Operations; Outsourcing


	Overview of Property and Casualty Recovery Services Operations; Outsourcing


HealthNet Humana Inc. Group Health, Inc. FIRST HEALTH		The Principal Financial Group Kaiser Permanente Wellpoint Health Network Inc.


	Cajas et al. v. Prudential Health Care Plan and Healthcare Recoveries


	Martin et al. v. Companion Health Care and Healthcare Recoveries


	Bruun et al. v. Prudential Health Care Plan, Prudential Insurance Company of America, Aetna, Inc. and Trover Solutions


	Godair v. American Home Assurance Company, Trover Solutions, and HMO Partners


	*General*


	*Healthcare Recovery Services*


	Overpayment Recovery Services


	Physician Bill Audit Services