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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1997
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ______________
COMMISSION FILE NUMBER 000-21949
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PACIFICARE HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 95-4591529
(State or other jurisdiction (IRS Employer Identification
of incorporation or organization) Number)
3120 LAKE CENTER DRIVE, SANTA ANA, CALIFORNIA 92704
(Address of principal executive offices, including zip code)
(Registrant's telephone number, including area code) (714) 825-5200
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
CLASS A COMMON STOCK, PAR VALUE $0.01
CLASS B COMMON STOCK, PAR VALUE $0.01
PREFERRED STOCK, PAR VALUE $0.01
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K / /
The aggregate market value of common stock held by non-affiliates of the
Registrant on February 28, 1998, was approximately $1,982,670,072.
The number of shares of Class A Common Stock and Class B Common Stock
outstanding at February 28, 1998, was 14,792,144 and 26,814,098, respectively.
DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT WHERE INCORPORATED
Portions of the Registrant's definitive
Proxy Statement
to be filed by April 30, 1998 Part III
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PART I
ITEM 1. BUSINESS
PacifiCare-Registered Trademark- Health Systems, Inc. (the "Company" or
"PacifiCare") is one of the nation's leading managed health care services
companies, serving nearly 3.8 million HMO members in its commercial and
government product lines as of December 31, 1997. The Company is also a leader
in the management, development and marketing of diversified health maintenance
organization ("HMO") products and related services. The Company operates HMOs in
10 states and Guam, and as of December 31, 1997, had a combined commercial HMO
membership of nearly 2.8 million members. Through internal growth and strategic
acquisitions, the Company believes it has built a strong competitive position in
the western United States and has expanded its operations into new and existing
geographic markets.
The Company's Secure Horizons-Registered Trademark- programs operate the
largest and one of the fastest growing Medicare risk programs in the United
States (as measured by membership and membership growth, respectively) with over
1.0 million members enrolled as of December 31, 1997. The Company believes that
its Secure Horizons programs are attractive to Medicare beneficiaries because
they provide a more comprehensive package of benefits than those available under
traditional Medicare and they substantially reduce the members' administrative
responsibilities.
The Company believes that its ability to offer a comprehensive range of
products and services, combined with its long-term relationships with health
care providers, will enable the Company to respond effectively to the changing
needs of the health care marketplace. The Company anticipates that it will
continue to be among the nation's leading managed health care services
companies.
RECENT DEVELOPMENTS
On February 14, 1997, the Company consummated the acquisition of FHP
International Corporation ("FHP") for a total purchase price, including
transaction costs, of approximately $2.2 billion (the "FHP Acquisition"). With
the FHP Acquisition, the Company conducts business in five additional states and
has experienced an increase in its commercial and government membership. The FHP
Acquisition has been accounted for as a purchase and the Company's consolidated
results of operations include the results of FHP from the date of the FHP
Acquisition (see Note 4 of the Notes to Consolidated Financial Statements).
Also during 1997, the Company consummated the sales of its Florida, Illinois
and New Mexico subsidiaries (see Note 4 of the Notes to Consolidated Financial
Statements). It also announced an exit strategy for its Utah subsidiary,
including its potential sale (see Note 9 of the Notes to Consolidated Financial
Statements).
OPERATIONS, PRODUCTS AND SERVICES
HMO OPERATIONS
The Company's total membership has grown from nearly 1.0 million members at
December 31, 1992 to approximately 3.8 million members at December 31, 1997,
including the impact of the FHP Acquisition,
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a 31 percent compound annual growth rate. The Company's membership at December
31, 1997 by state and program is as follows:
GOVERNMENT
(MEDICARE & PERCENT
COMMERCIAL MEDICAID) TOTAL OF TOTAL
----------- ------------ ---------- -----------
Arizona.............................................. 109,500 88,700 198,200 5.2%
California........................................... 1,650,000 605,300 2,255,300 59.5
Colorado............................................. 286,700 52,600 339,300 9.0
Guam................................................. 42,800 -- 42,800 1.1
Nevada............................................... 40,700 24,200 64,900 1.7
Ohio................................................. 54,200 13,200 67,400 1.8
Oklahoma............................................. 108,700 26,200 134,900 3.6
Oregon............................................... 116,500 40,600 157,100 4.1
Texas................................................ 128,400 68,600 197,000 5.2
Utah................................................. 154,200 25,000 179,200 4.7
Washington........................................... 98,300 56,700 155,000 4.1
----------- ------------ ---------- -----
Total membership..................................... 2,790,000 1,001,100 3,791,100 100.0%
----------- ------------ ---------- -----
----------- ------------ ---------- -----
COMMERCIAL PROGRAMS
The Company's commercial membership has grown from approximately 0.7 million
members at December 31, 1992 to approximately 2.8 million members at December
31, 1997, a 30 percent compound annual growth rate. The Company offers a
comprehensive range of products, including HMOs, Preferred Provider Organization
("PPO") and Point of Service ("POS") plans. POS plans combine the features of an
HMO (a defined provider network providing care to members with reduced
deductibles and co-payments) with the features of a traditional indemnity
insurance product (the option to use any physician, with higher deductibles and
co-payments).
For the commercial employer market, the Company offers a range of benefit
plan designs that vary in the amount of member co-payments. The Company believes
that nominal co-payments are useful in helping contain the costs of health care
without providing a barrier to members seeking needed health care services. The
Company offers a variety of specialty managed health care products as either
supplements to its commercial programs or as stand-alone products. These
products include pharmacy benefit management, life and health insurance,
behavioral health services and dental and vision services. These optional
services are generally provided through subcontracting or referral relationships
with other health care providers. The Company is not dependent on any one
employer group or group of employers to sustain its commercial product revenue
stream.
SECURE HORIZONS PROGRAMS
The Company offers health care services to Medicare beneficiaries through
its Secure Horizons programs. The Secure Horizons programs represent the largest
and one of the fastest growing Medicare risk programs in the United States (as
measured by membership and membership growth, respectively). Secure Horizons
membership has grown from approximately 0.2 million members at December 31, 1992
to over 1.0 million members at December 31, 1997, a 34 percent compound annual
growth rate.
The Company believes the Medicare market continues to offer significant
growth opportunities since only approximately 15 percent of the country's
Medicare beneficiaries are enrolled in Medicare risk HMO programs such as those
offered by the Company. The Company anticipates continued growth in the Medicare
risk arena by entering into new geographic markets with its Secure Horizons
programs. Also, recently adopted federal legislation repeals the requirement
that at least half of a Medicare health plan's enrollment be drawn from
commercial contracts (the "50/50 Rule") beginning January 1, 1999, and gives
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the Department of Health and Human Services ("HHS") broad authority to waive the
50/50 Rule for certain plans beginning January 1, 1998. The Company believes
that the repeal of the 50/50 Rule will allow it to develop Medicare risk
programs in markets where it does not have operations through expansion of its
Secure Horizons programs and affiliations between Secure Horizons USA, Inc.
("SHUSA") its Medicare risk management subsidiary and health plans or providers
in such markets (see "Specialty Managed Care Products and Services--Medicare
Risk Management" and "Competition").
The Company has been offering Secure Horizons programs since 1985, pursuant
to annual risk contracts with the Health Care Financing Administration ("HCFA").
HCFA requires that an HMO be federally qualified or meet similar requirements as
a competitive medical plan to be eligible for Medicare risk contracts. These
Medicare risk contracts entitle the Company to a fixed per-member premium, which
is currently based upon the average cost of providing traditional
fee-for-service Medicare benefits to the Medicare population in each county. The
risk contracts are subject to periodic unilateral revisions by HCFA based upon
updated demographic information relating to the Medicare population and the cost
of providing health care in a particular geographic area. Recent legislation has
revised the formula by which Medicare risk premiums will be calculated, which
could result in lower average Medicare premiums paid to the Company. The Company
believes that any reduction in premiums will be offset by other features of this
new legislation which encourages the use of managed care plans by Medicare
beneficiaries (see "Government Regulation"). The Company's Medicare risk
contracts are automatically renewed every 12 months unless the Company or HCFA
elects to terminate them. HCFA may unilaterally terminate the Company's Medicare
risk contracts if the Company fails to continue to meet compliance and
eligibility standards. Termination of the Company's Medicare risk contracts
would have a material adverse effect on the Company. The Company, however, has
no reason to believe that such termination will occur. Each Secure Horizons
member enrolls individually and may disenroll by providing 30 days' notice. The
Company believes that its Secure Horizons programs have one of the lowest
disenrollment rates among Medicare risk plans.
Because the average use of health care services by Medicare beneficiaries
greatly exceeds the use of services by those who are under the age of 65, the
Company's Medicare risk plans generate substantially larger per member revenue
than the Company's commercial plans. Premium revenue for each Secure Horizons
member is usually more than three times that of a commercial member reflecting
in part, the higher medical and administrative cost of serving a Medicare
member. As a result, although membership in the Secure Horizons programs
represented only approximately 26 percent of the Company's membership at
December 31, 1997, it accounted for approximately 58 percent of the consolidated
premium revenue for the year ended December 31, 1997 and an even larger
percentage of the Company's operating profit. The Secure Horizons programs are
subject to certain risks relative to commercial programs, such as higher
comparative medical costs, higher levels of utilization, government and
regulatory reporting requirements, the possibility of reduced or insufficient
government reimbursement in the future and higher marketing and advertising
costs associated with selling to individuals rather than to groups.
In response to the needs of employers to provide cost-effective health care
coverage to their retired employees who may or may not be currently entitled to
Medicare, the Company developed the Secure Horizons retiree product. This
product takes advantage of the Company's expertise in providing health care to
seniors. The provider networks are similar to those offered to the Company's
Secure Horizons enrollees and the premium is based on the revenue requirements
needed to provide services to Secure Horizons enrollees. Moreover, the retiree
product provides the Company with access to individuals who, once familiar with
the Company's services and delivery system, may enroll in Secure Horizons
programs when they become entitled to Medicare benefits.
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SPECIALTY MANAGED CARE PRODUCTS AND SERVICES
In addition to its HMO operations, the Company provides a range of specialty
managed care products and services. These products and services are offered to
HMOs, insurers, employers, governmental entities, providers and PPOs:
MEDICARE RISK MANAGEMENT. The Company formed SHUSA in March 1993 to take
advantage of the Company's expertise in the Medicare risk area. SHUSA provides
management services and best practices to HMOs and health care delivery systems
that want to engage in Medicare risk contracting. SHUSA has approximately 90,000
members under licensure in New Mexico through Presbyterian Healthcare Services
and in New England through Tufts Associated Health Maintenance Organization,
Inc. SHUSA is currently engaged in discussions with a number of health plans and
delivery systems regarding future business development opportunities in the
Medicare risk market.
The Company anticipates that with the repeal of the 50/50 Rule and the drive
to enroll Medicare beneficiaries in HMOs, SHUSA may enter into licensing
arrangements in a variety of geographic areas thereby expanding the Company's
presence in new markets. Recent legislation permits, beginning in 1999, provider
sponsored organizations (networks of doctors, hospitals and providers-"PSOs") to
enter into Medicare risk contracts directly with HCFA (see "Competition"). The
Company believes that PSOs will provide an opportunity for the Company, through
SHUSA, to expand into new Medicare risk markets or alternatively, could become
an additional source of competition for the Company. While the Company currently
expects the opportunities of this legislation to outweigh the potential threats,
HCFA has not adopted final regulations in connection with this legislation and
it is too early to predict the ultimate effect, if any, this legislation will
have on the Company.
PHARMACY BENEFIT MANAGEMENT. Prescription Solutions-Registered Trademark-
was established in May 1993 to offer pharmacy benefit management services.
Clients of Prescription Solutions have access to a pharmacy provider network
that features independent and chain pharmacies, as well as a variety of cost and
quality management capabilities. Prescription Solutions also provides its
clients with an array of fully integrated services, including mail order
distribution, an extensive network of retail pharmacies, claims processing and
sophisticated drug utilization reporting. Prescription Solutions is one of the
industry's largest pharmacy benefit management companies.
LIFE AND HEALTH INSURANCE. PacifiCare Life and Health Insurance
Company-SM-("PLHIC") and PacifiCare Life Assurance Company ("PLAC"), the
Company's life and health insurance subsidiaries, offer employer groups managed
health care insurance products which have been integrated with the Company's
existing HMO products to form multi-option health benefits programs. Together,
PLHIC and PLAC are licensed to operate in the District of Columbia and 38 states
and Guam, including the states in which the Company's HMOs operate.
BEHAVIORAL HEALTH SERVICES. PacifiCare Behavioral Health of California,
Inc. is a licensed specialized health care service plan which provides
behavioral health care services, including chemical dependency benefit programs,
in California directly to corporate customers and indirectly through the
Company's California HMO to its commercial members. Outside of California,
PacifiCare Behavioral Health, Inc. contracts with various HMOs, insurers and
employers to manage their respective mental health and chemical dependency
benefit programs.
DENTAL AND VISION SERVICES. California Dental Health Plan dba PacifiCare
Dental and Vision ("PDV") is a licensed specialized health care service plan
which provides prepaid dental and optometry benefits for individuals, including
members of PacifiCare's California commercial and Secure Horizons programs and
employer groups. PDV continues to market independently of the Company's
California HMO and to provide dental and vision benefits to its members.
Recently, PacifiCare Dental of Colorado, Inc. received approval to offer
stand-alone dental care plans to people in selected areas of Colorado.
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The stand-alone dental care plan works like an HMO and will allow employers to
offer the dental plan to members of any medical carrier.
BUSINESS STRATEGY
The current business strategy of the Company has a strong operational focus.
During 1998, the Company expects to:
- improve commercial gross margins through premium increases and improved
health care cost management through capitated arrangements with strong
provider organizations which align the interest of providers with that of
the Company;
- focus on management tools, including medical and pharmacy management and
effective medical information reporting;
- exit Utah and sell certain specialty businesses which do not fit within
this strategy;
- improve efficiency by further leveraging the Company's economies of scale
to lower the percentage of revenue spent on marketing, general and
administrative expenses;
- continue to integrate FHP's operations to the Company's common
information systems operating platform; and
- increase the quality and service of its basic HMO products measured
through expanded National Committee for Quality Assurance ("NCQA")
accreditation in 1998 (see "Quality Assurance").
The Company continually evaluates opportunities to expand its business
through acquisitions and development of new products. With recent changes in
federal legislation related to Medicare, the Company anticipates expanded growth
in its Secure Horizons Medicare programs and its Medicare risk management
programs into new markets. The Company also evaluates whether certain products
or markets should be discontinued when they do not fit within the Company's core
business strategy. Through the implementation of this business strategy, the
Company believes it can solidify its position as one of the nation's leading
managed health care services companies.
HEALTH CARE PROVIDER RELATIONSHIPS
The profitability of the Company and the success of its long-range business
plans depends upon its ability to attract and retain qualified health care
providers. The Company's ability to expand is dependent, in part, on its ability
to secure cost effective contracts and delivery system models with additional
physicians or to ensure that existing physician groups expand their operations
to accommodate the Company's new HMO membership. Achieving such objectives with
respect to physician contracts is becoming more difficult due to increasing
competition. In addition, increased competition in the health care industry has
resulted in the consolidation of health care providers, resulting in larger
provider groups being created and fewer groups with which the Company can
contract. Contracts with health care providers are commonly negotiated on an
annual basis. Generally, there is no requirement that the provider continue its
relationship with the Company upon expiration of the annual period. To ensure
the quality and stability of the provider network, the Company has entered into
a number of provider service contracts with terms of up to ten years. Some of
the significant provider contracts include multiple five-year contracts with
MedPartners for specified "medical care ratios" (health care expenses as a
percentage of premium revenue) in most of the states where the Company does
business (most significantly, California). MedPartners provides services to over
0.4 million members or 16 percent of the Company's total commercial membership
and approximately 0.1 million or 14 percent of the Company's total government
membership. In addition, the Company has a national letter of intent with FPA
Medical Management ("FPA") that sets forth operating principles between FPA and
the Company for the next ten years. FPA provides health care services to the
Company's members in five states, including California.
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The Company's inability to contract with providers, loss of contracts with
providers, inability of providers to provide adequate care or insolvency of
providers could materially and adversely affect the Company. These contracting
and insolvency risks include: a loss of membership; the incurring of additional
expenses to meet the requirement to continue to arrange for health care
services, among other things, for members; the inability to obtain reimbursement
due the Company from providers; the expenditure of additional funds to maintain
adequate provider networks and the assertion of claims by third parties against
the Company. The effect of these risks could result in the recognition of a
charge in a future period.
HEALTH CARE COSTS
The Company manages health care costs primarily by entering into contractual
arrangements with the majority of its health care providers, including primary
care physicians, specialists, hospitals and other ancillary services providers,
to pay a fixed monthly fee, or capitation payment, for each HMO member
regardless of the services provided to each member. The primary care physician
or group influences medical utilization and cost control in the Company's HMOs
through referrals, hospitalization and other services and is responsible for any
related payments to those referred providers. The Company's HMOs share the risk
of certain health care costs not covered by capitation arrangements and provide
additional incentives to the physicians or groups for appropriate utilization of
hospital inpatient, outpatient surgery and emergency room services. The Company
may also make incentive payments to providers based on performance relative to
budgeted targets. Nearly all of the Company's Medicare contracts are based on a
percentage of premium. Percentage of premium entails provider compensation
fluctuating directly with the amount of premiums paid for Medicare risk
beneficiaries by HCFA.
In certain of the Company's markets, health care providers are not under
capitation arrangements. Fee-for-service contracts increase health care costs
when utilization is not appropriately managed. The Company has or is in the
process of renegotiating these contracts to move the providers to a capitated
payment plan.
The Company also operates a utilization review system, under which routine
hospital admissions and lengths of stay are reviewed by either the Company or
utilization review committees comprised of several physicians at each physician
group. The committees approve non-emergency hospitalizations in advance. After
admission, the committees, together with the Company's medical services
utilization staff, carefully monitor the member's continued stay. The Company,
through its medical services departments, becomes actively involved in the
utilization review of longer, more costly hospitalizations and emergencies.
These departments also become involved in the field to monitor catastrophic
cases in an effort to provide members appropriate medical care and suggest
treatment options that may be more appropriate and cost-effective than a
long-term hospital stay.
QUALITY ASSURANCE
The Company believes that providing access to quality health care services
is an essential ingredient for success. To achieve this goal, the Company has
established a peer review procedure at each HMO, which is implemented by a
Quality Assurance Committee chaired by the HMO's Medical Director and comprised
of physicians and representatives of the physician groups at each HMO. When a
new physician or physician group is considered by one of the Company's HMOs as a
potential provider, the Quality Assurance Committee of the HMO evaluates, among
other things, the quality of the physician or group's medical facilities,
medical records, laboratory and x-ray licenses and the capacity to handle
membership demands. Once selected, a physician or group is periodically reviewed
to monitor whether members are receiving quality medical care.
The Company has developed a comprehensive array of initiatives to improve
the quality of service and clinical outcomes affecting members. Such initiatives
include, among other things, NCQA accreditation,
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Health Plan Employer Data Information Set ("HEDIS") improvements, a
standardized, streamlined specialty referral process, a complaint management
program to coordinate problem resolution, member satisfaction surveys at the
HMO-level, chronic care initiatives, a senior health risk assessment, a smoking
cessation program, sophisticated report cards and a comprehensive information
technology strategy.
Approximately 88 percent of the Company's membership is enrolled in plans
with NCQA accreditation. NCQA is an independent, non-profit organization that
reviews and accredits HMOs. NCQA performs site reviews of standards established
for quality assurance, utilization management, credentialing process, commitment
to members' rights and preventative health services. HMOs that comply with
NCQA's review requirements and quality standards receive NCQA accreditation. The
Company's HMOs in Arizona, California, Colorado, Nevada and Oklahoma have
received full three-year NCQA accreditation status and the Company's HMOs in
Oregon and Utah have received one-year NCQA accreditation status.
RISK MANAGEMENT
In addition to the Company's cost control systems, the use of underwriting
criteria is an integral part of its risk management efforts. Underwriting is the
process by which a health plan assesses the risk of enrolling employer groups
(or individuals) and establishes appropriate or necessary premium rates. The
setting of premium rates directly affects a health plan's profitability and
marketing success (see "Health Care Costs"). Underwriting techniques are not
employed for the Secure Horizons programs because of regulations that require
the Company to accept nearly all Medicare-entitled applicants.
The Company shifts part of the risk of catastrophic losses by maintaining
reinsurance coverage for certain hospital costs incurred in the treatment of
catastrophic illnesses of its members. The Company also maintains general
liability, property and medical malpractice insurance coverage in amounts that
the Company believes are adequate. The Company requires contracting physicians,
physician groups and hospitals to maintain individual malpractice insurance
coverage.
MARKETING
The Company's marketing strategy and implementation is coordinated by the
Company's corporate marketing staff. Primary marketing responsibility for each
of the Company's HMOs and specialty managed care products and services resides
with a marketing director and a direct sales force. Commercial marketing is a
two-step process in which the Company first markets to employer groups and then
provides information directly to employees once the employer has selected the
HMO. The Company solicits new employer groups of various sizes through direct,
personal selling efforts and through contacts with insurance brokers and
consultants. Many employer groups under contract with the Company are
represented by insurance brokers and consultants who work with the employer to
recommend or design employee benefits packages. Brokers are paid on a commission
basis by the Company over the life of the contract, while consultants generally
are paid by the employer. The Company has also developed a marketing strategy to
strengthen and increase its market share by increasing penetration in existing
employer groups and by increasing access to new populations through small group
marketing and expansion of its delivery network to more effectively meet the
needs of multi-state employers. A significant portion of the Company's
commercial membership growth comes from existing employer groups.
During "open enrollment" periods when employees are permitted to change
health care programs, the Company utilizes various techniques to attract
commercial members, including work site presentations, direct mail, medical
group tours and local advertising. Marketing efforts are also supported by an
advertising program that generally includes television, radio, billboard and
print media.
The Company markets the Secure Horizons programs to Medicare beneficiaries
primarily through direct mail, telemarketing, television, radio and cooperative
advertising with participating medical groups. The Company anticipates further
growth opportunities in the Medicare risk program based on the
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Company's current marketing strategies and the growing senior population in the
United States (see "--Operations, Products and Services--Secure Horizons
Programs" and "Specialty Managed Care Products and Services--Medicare Risk
Management"). Most Secure Horizons members deal directly with the plan and
generally without the involvement of insurance brokers except when associated
with an employer group retiree offering.
MANAGEMENT INFORMATION SYSTEMS
The Company uses computer-based management information systems for various
purposes, including marketing and sales tracking, underwriting, billing, claims
processing, utilization management, medical cost and utilization trending,
financial and management accounting, reporting, planning and analysis. These
systems also support member, group and provider service functions, including
on-line access to membership verification, claims and referral status and
information regarding hospital admissions and lengths of stay. In addition,
these systems support extensive analyses of cost and outcome data. The Company
is dependent upon the operations of these systems for sales and marketing,
electronic claims receipt, utilization management authorization processing,
claims adjudication and payment, eligibility verification, bill processing and
general corporate accounting. To preserve its investment in existing systems,
exploit new technologies, improve the cost effectiveness and quality of services
provided and allow for effective new product introduction capabilities, the
Company's computer information systems which support its managed care operations
and specialty managed products are continually being enhanced and upgraded.
System enhancements and upgrades include upgrading mainframe computers,
enhancing existing software functionality, implementing purchased software and
migrating to more suitable software database environments. Following the FHP
Acquisition, the Company has been engaged in an extensive review of its
information systems, including integration of multiple systems. Simplification,
integration and expansion of the systems servicing the Company's business is an
important component of controlling health care and administrative expenses and
improving member and provider satisfaction. To the extent that these systems
fail to operate properly or the integration efforts are not successful, the
Company's financial results may be adversely affected.
YEAR 2000
In 1996, the Company developed and began execution of an enterprise wide
plan to ensure application software and systems compliance for the year 2000.
The Company currently expects the project to be complete by the end of 1998 and
to cost less than $10 million. This estimate includes internal costs, but
excludes the costs to upgrade and replace systems in the normal course of
business. As of December 31, 1997, approximately $2 million had been expensed
related to this project. An additional component of this project is the written
confirmation from all systems vendors ensuring year 2000 compliance in
conjunction with the Company's target deadlines. The Company is currently
assessing the impact, if any, of year 2000 issues it may encounter with entities
with which it electronically interacts, including HCFA. If HCFA or certain other
entities experience significant failures or erroneous applications, it could
have a material adverse effect on the Company's financial position, results of
operations or cash flows.
COMPETITION
The health care industry is highly competitive, both nationally and in the
Company's various markets. Consolidation in the health care industry has
resulted in fewer but larger competitors of the Company including insurance
carriers, other HMOs, employer self-funded programs and PPOs, many of which have
substantially larger enrollments or greater financial resources than the
Company. As a result of this consolidation, the Company has become one of the
largest HMOs in the country. The Company also faces competition from hospitals,
health care facilities and other health care providers who have combined and
formed their own networks to contract directly with employer groups and other
prospective customers for the delivery of health care services. In California,
the largest market in which the Company competes, the
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Company encounters competition from a few large HMOs and to a lesser extent
smaller HMOs, PPOs, self-funded employers and health care providers. In other
markets in which the Company operates, the Company faces competition from local
HMOs, PPOs and other local health care providers as well as other national HMOs
and insurance carriers. In addition, new federal legislation permits for the
first time, beginning in 1999, PSOs to directly contract with HCFA for Medicare
risk contracts. PSOs, if successful, will increase the Company's competition for
new Medicare enrollees (see "Specialty Managed Care Products and
Services--Medicare Risk Management" and "Government Regulation"). Competition
for members in the Company's markets has resulted in an increase in benefits and
price competition. In such an increasingly competitive environment, the Company
believes that a comprehensive range of products and services, along with a
strong provider network, must be provided to remain competitive. Other factors
which the Company believes generally help it in regard to competitors are the
strength of its underwriting and pricing practices and staff, its significant
market position in certain geographic areas, its financial strength, its
experience and its generally favorable marketplace reputation. Increased
competition could result in a decline in revenue or in price reductions, which
could have a material adverse effect on the Company's financial position,
results of operations or cash flows.
GOVERNMENT REGULATION
The Company's HMO subsidiaries are affected by several state and federal
laws and regulations, including the federal Health Maintenance Organization Act
of 1973 (the "HMO Act") and statutes regulating or affecting HMOs in each of the
states in which it does business. As a result, the Company is subject to
extensive regulation regarding the scope of benefits provided to its members,
financial solvency requirements, quality assurance and utilization review
procedures, member grievance procedures, provider contracts, marketing and
advertising. All of the Company's HMO operations are federally qualified or meet
similar requirements as a competitive medical plan.
The Company's Secure Horizons programs are provided under contracts with,
and are subject to regulations by, HCFA and certain state agencies (see
"Operations, Products and Services--HMO Operations-Secure Horizons Programs").
As a result of HCFA's regulations governing the Company's Medicare risk
programs, the medical care ratio, as determined prospectively through formulas
established by HCFA for the Company's Medicare risk contracts in a particular
region, is not allowed to be less than the medical care ratio for the Company's
non-Medicare risk contracts in such regions. If the Company were to fall out of
compliance with these regulations, it would have to provide additional benefits,
reduce the supplemental premiums charged to its Medicare members or accept a
lower payment from HCFA to increase the medical care ratio for the Medicare risk
contracts to the level of the medical care ratio for the non-Medicare contracts.
This regulation could have a material adverse effect on the Company's financial
position, results of operations or cash flows.
Currently, Secure Horizons' premiums are determined through formulas
established by HCFA for the Company's Medicare risk contracts in a particular
region. If these premiums are reduced or if premium rate increases in a
particular region are lower than the rate of increase in health care service
expenses of Secure Horizons members in such region, the Company's operations,
profitability or business prospects could be affected. The Company has mitigated
this risk by paying nearly all of the health care service expenses of the Secure
Horizons programs on a percentage of premium basis.
On August 5, 1997, President Clinton signed into law the Balanced Budget Act
of 1997, which enacted numerous revisions to the Medicare program. The law
replaces the risk contract program with a new "Medicare+Choice" program, which
is intended to increase Medicare enrollment in private health plans. During
1998, HCFA is expected to promulgate regulations that will allow participation
in the Medicare+Choice program by HMOs, preferred provider organizations,
point-of-service plans, PSOs and fee-for-service plans and provide for a new
medical savings accounts demonstration project for Medicare beneficiaries. The
law also revises the formula used by HCFA to calculate payments to Medicare
health plans by establishing minimum payment levels and annual increases and
limiting the overall rate of
10
payment growth. Further, the law enacts new requirements for risk adjustment,
information disclosure, quality measurement and improvement and beneficiary
enrollment, among other provisions. The Company believes that any slowdown in
the rate of premium growth may be offset by the effect of this new legislation
encouraging managed health care for Medicare beneficiaries. The loss of Medicare
contracts or termination or modification of the HCFA risk-based Medicare program
could have a material adverse effect on the revenue, profitability and business
prospects of the Company.
In 1996, HCFA promulgated regulations ("physician incentive regulations")
enforcing Sections 4204(a) and 4731 of the Omnibus Budget Reconciliation Act of
1990 ("OBRA 90"). OBRA 90 and the physician incentive regulations prohibit HMOs
with Medicare risk contracts from knowingly making incentive payments to
physicians as an inducement to reduce or limit medically necessary services to
Medicare beneficiaries. HCFA requires plans to meet these regulations annually
by submission of consolidated survey responses from contracted physician groups.
Under the physician incentive regulations, HMOs must, among other things,
disclose to HCFA their physician compensation plan in such detail as to allow
HCFA to determine compliance with the regulations, and provide stop-loss
insurance to a physician or physician group, if the HMO places the physician at
"substantial financial risk" for services provided to Medicare beneficiaries.
Revision of the physician incentive regulations in several specific areas is
currently under serious consideration by HCFA. The Company is taking steps to
comply with the physician incentive regulations.
In the normal course of business, the governmental agencies with which
PacifiCare contracts periodically review the premiums paid to the Company under
these programs to detect whether any excess premiums have been paid. If such
agencies discover, in connection with any such review, that excess premiums were
paid to the Company, adjustments to current or future premiums would be made. If
such adjustments were significant, they could materially and adversely affect
the profitability, operations or business prospects of the Company.
PacifiCare's HMOs have commercial contracts with the United States Office of
Personnel Management ("OPM") to provide managed care health services to
employees and retirees of the federal government and their dependents under the
Federal Employees Health Benefit Program ("FEHPB"). In the normal course of
business, OPM audits health plans with which it contracts to, among other
things, verify that the premiums calculated and charged to OPM are established
in compliance with the best price community rating guidelines established by
OPM. OPM typically audits plans once every five or six years and each audit
covers the prior five or six year period. Depending on the type of contract the
Company has with OPM, OPM will audit one or more health plans at the same time.
OPM has notified PacifiCare of its intent to audit or has recently completed an
audit of the majority of the Company's health plans. While the government's
initial on-site audits are usually followed by a post-audit briefing in which
the government indicates its preliminary results, final resolution and
settlement of the audits have historically taken a minimum of three to five
years.
In addition to claims made by the auditors as part of the normal audit
process, the OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In False Claims Act actions, the
government may impose trebled damages and a civil penalty of not less than
$5,000 nor more than $10,000 for each separate alleged false claim. In November
1997, the Company was notified that the 1995 audit of the operations of the
Company's Oklahoma HMO subsidiary, had been referred to the DOJ. The Company is
negotiating to settle this matter with the DOJ.
PacifiCare intends to negotiate with OPM and the DOJ on all matters to
attain a mutually satisfactory result. There can be no assurance, however, that
these negotiations will be concluded satisfactorily, that additional audits will
not be referred to the DOJ, or that additional, possibly material, liability
will not be incurred. The Company has also entered into discussions with OPM and
implemented centralized internal
11
review processes to reduce the likelihood of liability for contract years
beginning with January 1999. The Company believes that any ultimate liability in
excess of amounts accrued would not materially affect the Company's consolidated
financial position. However, such liability could have a material adverse effect
on results of operations or cash flows of a future quarter if resolved
unfavorably.
The Company's HMOs are subject to state regulations which require periodic
financial reports from HMOs licensed to operate in their state and, in certain
cases, impose minimum equity, capital, deposit and/or reserve requirements.
Certain federal and/or state regulatory agencies also require the Company's HMOs
to maintain restricted cash reserves represented by interest-bearing instruments
which are held by trustees or state regulatory agencies. These requirements,
which limit the ability of the Company's subsidiaries to transfer funds to the
Company, may limit the ability of the Company to pay dividends. From time to
time, the Company advances funds, in the form of a loan, to its subsidiaries to
assist them in satisfying federal or state financial requirements.
The National Association of Insurance Commissioners (the "NAIC") has an
effort underway that would impose new minimum capitalization requirements for
HMOs, health care insurance entities and other risk bearing health care
entities. The requirements would take the form of risk-based capital rules
similar to rules for certain non-health care insurance companies. If the
capitalization requirements were enacted, certain of the Company's subsidiaries
would have to increase their capital requirements. If and when the requirements
are enacted, the Company expects to fund the subsidiaries to meet the new
requirements. The Company does not believe that the amount of funds that may be
paid by subsidiaries to the Company will be materially affected after meeting
the new capitalization criteria.
The Company has six insurance subsidiaries, which are subject to regulation
in each jurisdiction in which they are licensed. Regulatory authorities exercise
extensive supervisory power over insurance companies. The Company's insurance
subsidiaries are required to file periodic statutory financial statements in
each jurisdiction in which they are licensed. Additionally, the insurance
departments of the jurisdiction in which they are licensed to do business
periodically examine such subsidiaries.
Certain of the Company's HMOs and each of the Company's insurance
subsidiaries are subject to regulation under state insurance holding company
regulations. Such insurance holding company laws and regulations generally
require registration with the appropriate state department of insurance and the
filing of certain reports describing capital structure, ownership, financial
condition, certain intercompany transactions and general business operations.
Various notice and reporting requirements generally apply to transactions
between companies within an insurance holding company system, depending on the
size and nature of the transactions. Certain state insurance holding company
laws and regulations require prior regulatory approval or, in certain
circumstances, prior notice of certain material intercompany transfers of assets
as well as certain transactions between the regulated companies, their parent
holding companies and affiliates, and acquisitions.
In 1997, the Departments of Health and Human Services, Labor and Treasury
promulgated regulations enforcing the "Health Insurance Portability and
Accountability Act of 1996" which took effect in January 1998. The regulations
require certain guaranteed issuance and renewability of health coverage for
individuals and small groups, limit preexisting condition exclusions and provide
for a demonstration project for medical savings accounts for individuals who
obtain individual medical insurance and small businesses. Regulations were also
promulgated to enforce other federal legislation, which became effective in
January 1998, requiring health plans to provide parity for mental health
benefits and minimum lengths of stay for mothers and their newborns. The Company
is continuing to analyze the operational impact, if any, to the Company of these
regulations; however, the Company believes that these regulations will have an
administrative impact on the Company.
The provision of goods and services to or through certain types of employee
health benefit plans is subject to the Employee Retirement Income Security Act
of 1974 ("ERISA"). ERISA is a complex set of laws and regulations that are
subject to periodic interpretation by the United States Department of Labor.
12
ERISA places controls on how the Company's health plans and specialty managed
care products and services may do business with employers covered by ERISA,
particularly employers that maintain self-funded plans. The Department of Labor
is engaged in an ongoing ERISA enforcement program which may result in
additional constraints on how ERISA-governed benefit plans conduct their
activities. There have been recent legislative attempts to limit ERISA's
preemptive effect on state laws. If such limitations were to be enacted, they
might increase the Company's liability exposure under state law claims relating
to employee health benefits offered by the Company's health plans and specialty
managed care products and services and may permit greater state regulation of
other aspects of those business operations.
State and federal lawmakers may continue to consider and enact laws and
regulations which could impact the Company, including prohibition or limitation
of capitated arrangements or provider financial incentives, benefit mandates,
limitations on the ability to manage utilization of services, and requirements
for information disclosure, provider contracting and dispute resolution. The
adoption of such legislation or regulations may make it more difficult for the
Company to control health care costs and could adversely affect financial
results. Although the Company intends to maintain its HMOs' federal
qualifications, state licenses and Medicare contracts, there can be no assurance
that it can do so.
STOCK MARKET
The market prices of the Company's Class A Common Stock, par value $0.01 per
share (the "Class A Common Stock"), Class B Common Stock, par value $0.01 per
share (the "Class B Common Stock"), and the Series A Cumulative Preferred Stock,
par value $0.01 per share (the "Series A Preferred Stock") and the market prices
of the publicly traded shares of the Company's competitors have shown
significant volatility and sensitivity to many factors, including legislative or
regulatory actions, health care cost trends, premium pricing trends, levels of
competition, earnings results of industry participants and acquisition activity.
There can be no assurances regarding the stability of the various share prices
of the Company at any time or the impact of these or any other factors on the
share prices of the Company. See Item 5-- "Market for the Company's Equity and
Related Stockholder Matters."
TRADEMARKS
The federally registered service marks PacifiCare-Registered Trademark- and
SecureHorizons-Registered Trademark- are owned by the Company and are material
to its business.
EMPLOYEES
At December 31, 1997, the Company had 9,770 full and part-time employees.
None of the Company's employees are presently covered by a collective bargaining
agreement and the Company has not experienced any work stoppage since its
organization. The Company considers its relations with its employees to be good.
ITEM 2. PROPERTIES
As of December 31, 1997, the Company leased approximately 220,000 aggregate
square feet of space for its principal corporate headquarters and executive
offices in Santa Ana and Costa Mesa, California. In connection with its
operations, as of December 31, 1997, the Company leased approximately 2.2
million aggregate square feet for office space, subsidiary operations, customer
service centers and space for computer facilities. Such space corresponds to
areas in which the Company's HMOs or specialty managed care products and
services operate or where it has satellite administrative offices. The Company's
leases expire at various dates through 2007.
The Company owns 32 buildings encompassing approximately 914,000 aggregate
square feet of space. Six of the buildings, which represent approximately
348,000 aggregate square feet of space are primarily used for administrative
operations and are located in California, Utah and Guam. The remaining 26
13
buildings are medical office buildings leased under a master lease agreement.
All 26 medical buildings are being marketed for sale. The Company also owns nine
parcels of vacant land for a total of 46 acres, all of which are being marketed
for sale.
The Company considers its facilities to be in good working condition, well
maintained and adequate for its present and anticipated needs. The Company
believes that additional space can be obtained at competitive rates upon the
expiration of current leases or in the event additional space is needed.
ITEM 3. LEGAL PROCEEDINGS
The Company has been served with several purported class action suits
alleging violations of federal securities laws by the Company and by certain of
its officers and directors. The complaints relate to the period from the date of
the FHP Acquisition through the Company's November 25, 1997 announcement that
earnings for the fourth quarter of 1997 would be lower than expected. These
complaints primarily allege that the Company previously omitted and/or
misrepresented material facts with respect to its costs, earnings and profits.
These suits are at a very early stage and no discovery has occurred. The Company
believes it has good defenses to the claims in these suits and is contesting
them vigorously.
The Company is also involved in legal actions in the normal course of
business, some of which seek monetary damages, including claims of punitive
damages which are not covered by insurance. After review, including consultation
with counsel, based on current information, management believes any ultimate
liability in excess of amounts accrued which would likely arise from these
actions (including the purported class actions) would not materially affect the
Company's consolidated financial position, results of operations or cash flows.
However, management's evaluation of the likely impact of these actions could
change in the future and an unfavorable outcome, depending upon the amount and
timing, could have a material adverse effect on the Company's results of
operations or cash flows for a future quarter.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the three
months ended December 31, 1997.
14
PART II
ITEM 5. MARKET FOR THE COMPANY'S EQUITY AND RELATED STOCKHOLDER MATTERS
The Class A Common Stock, the Class B Common Stock, and the Series A
Preferred Stock are listed on the Nasdaq National Market under the symbols
PHSYA, PHSYB, and PHSYP, respectively. The following tables set forth, for the
indicated periods, the high and low reported sale prices per share of the Class
A and Class B Common Stock and the Series A Preferred Stock (from February 14,
1997) as furnished by Nasdaq.
CLASS A CLASS B SERIES A
COMMON STOCK COMMON STOCK PREFERRED
STOCK
-------------- -------------- --------------
HIGH LOW HIGH LOW HIGH LOW
------ ------ ------ ------ ------ ------
YEAR ENDED DECEMBER 31, 1997
First Quarter......................... 85 5/8 68 3/4 89 1/2 72 7/8 34 7/8 32
Second Quarter........................ 83 55 1/2 87 3/4 58 3/4 34 3/8 25 1/8
Third Quarter......................... 71 60 1/4 74 3/4 62 29 5/8 27
Fourth Quarter........................ 71 1/4 48 1/8 72 1/2 50 7/8 28 1/2 20 3/8
TWELVE MONTHS ENDED DECEMBER 31, 1996
First Quarter......................... 98 3/4 75 1/4 99 1/2 78 1/2 -- --
Second Quarter........................ 83 3/4 63 7/8 86 3/4 65 1/4 -- --
Third Quarter......................... 84 3/4 59 5/8 91 59 3/4 -- --
Fourth Quarter........................ 86 1/4 63 1/4 90 1/2 65 3/4 -- --
The Company has never paid any cash dividends on its common stock and
presently anticipates for the foreseeable future that no cash dividends on its
common stock will be declared and that all of its earnings will be retained for
development of the Company's business. Any dividends will depend upon future
earnings, the financial condition of the Company and regulatory requirements. If
the Company were to decide to make dividend payments, the Company could only
make dividend payments in shares of its common stock pursuant to the
restrictions on dividend payments which exist in the credit facility (see Note 5
of the Notes to Consolidated Financial Statements).
As of December 31, 1997 there were approximately 344 and 364 shareholders of
record of the Company's Class A Common Stock and Class B Common Stock,
respectively. These numbers do not include individual participants in security
position listings. Based on available information, the Company believes there
are at least 15,000 beneficial holders of its Class A and Class B Common Stock.
The authorized preferred stock of the Company includes 11,000,000 shares of
Series A Preferred Stock. Each share of Series A Preferred Stock entitles its
owner to convert it at any time to 0.374 shares of Class B Common Stock,
assuming no unpaid accrued dividends in arrears. Series A Preferred Stock
shareholders also have a preference of $25.00 per share over the common stock in
the event of involuntary or voluntary liquidation. Dividends on the Series A
Preferred Stock accrue at an annual rate of $1.00 per share, are cumulative and
payable quarterly in arrears when, as and if declared by the board of directors.
During 1997, the Company paid $9 million in dividends to its preferred
shareholders. There were no unpaid dividends on the Series A Preferred Stock at
December 31, 1997.
On or after June 17, 1998, the Series A Preferred Stock may be redeemed at
the option of the Company for cash plus unpaid dividends. The redemption price
ranges from 103 percent to 100 percent of the stated value of the Series A
Preferred Stock, or $25.00 per share, in one-half percent decrements for each
successive anniversary of June 17, 1998 through 2004. Series A Preferred Stock
ranks senior to the Class A and B Common Stock with respect to dividend and
liquidation rights, and holders of Series A Preferred Stock generally have no
voting rights; however, there are certain exceptions including the right to
15
elect two additional directors if the equivalent of six quarterly dividends
payable on the Series A Preferred Stock are in default.
ITEM 6. SELECTED FINANCIAL DATA
In February 1997, PacifiCare's board of directors approved a change in the
Company's fiscal year end from September 30 to December 31. This resulted in a
transition period of October 1, 1996 through December 31, 1996. The following
selected financial and operating data are derived from the audited financial
statements of the Company and its subsidiaries or from the Company's unaudited
internal financial data. For clarity of presentation and comparability, the
following selected financial and operating data includes the unaudited period
for the twelve months ended December 31, 1996. The selected financial and
operating data should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
also with "Item 8. Financial Statements and Supplementary Data."
16
INCOME STATEMENT DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(TRANSITION
(UNAUDITED) PERIOD)
TWELVE THREE
YEAR ENDED MONTHS ENDED MONTHS ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1997(1) 1996(2) 1996 1996(2) 1995 1994(3)
------------ ------------- ------------- ------------- ------------- -------------
Operating revenue............ $8,982,680 $ 4,807,856 $ 1,234,875 $ 4,637,305 $ 3,731,022 $ 2,893,252
------------ ------------- ------------- ------------- ------------- -------------
Expenses:
Health care services....... 7,658,879 4,017,383 1,039,345 3,872,747 3,077,135 2,374,258
Other operating expenses... 1,125,299 605,546 154,996 585,081 505,644 398,064
Impairment, disposition,
restructuring and other
charges.................. 154,507 75,840 -- 75,840 -- --
Office of Personnel
Management charge........ -- 25,000 -- 25,000 -- --
------------ ------------- ------------- ------------- ------------- -------------
Operating income............. 43,995 84,087 40,534 78,637 148,243 120,930
Interest income, net......... 16,129 44,696 12,302 44,143 33,857 24,538
------------ ------------- ------------- ------------- ------------- -------------
Income before income taxes
and cumulative effect of a
change in accounting
principle.................. 60,124 128,783 52,836 122,780 182,100 145,468
Provision for income taxes... 81,825 53,052 21,079 50,827 74,005 60,875
------------ ------------- ------------- ------------- ------------- -------------
Income (loss) before
cumulative effect of a
change in accounting
principle.................. (21,701) 75,731 31,757 71,953 108,095 84,593
Cumulative effect on prior
years of a change in
accounting principle....... -- -- -- -- -- 5,658
------------ ------------- ------------- ------------- ------------- -------------
Net income (loss)............ $ (21,701) $ 75,731 $ 31,757 $ 71,953 $ 108,095 $ 90,251
------------ ------------- ------------- ------------- ------------- -------------
------------ ------------- ------------- ------------- ------------- -------------
Preferred dividends.......... (8,792) -- -- -- -- --
------------ ------------- ------------- ------------- ------------- -------------
Net income (loss) available
to common shareholders..... $ (30,493) $ 75,731 $ 31,757 $ 71,953 $ 108,095 $ 90,251
------------ ------------- ------------- ------------- ------------- -------------
Basic earnings (loss) per
share (4).................. $ (0.75) $ 2.43 $ 1.01 $ 2.31 $ 3.69 $ 3.30
------------ ------------- ------------- ------------- ------------- -------------
Diluted earnings (loss) per
share(4)................... $ (0.75) $ 2.39 $ 1.00 $ 2.27 $ 3.62 $ 3.22
------------ ------------- ------------- ------------- ------------- -------------
------------ ------------- ------------- ------------- ------------- -------------
OPERATING STATISTICS
Medical care ratio (health
care services as a
percent of premium
revenue)
Consolidated............. 85.7% 84.5% 85.1% 84.4% 83.6% 83.1%
Commercial............... 85.8% 82.8% 84.4% 83.1% 82.5% 80.5%
Government............... 85.6% 85.6% 85.5% 85.4% 84.3% 85.2%
Marketing, general and
administrative expenses as
a percent of operating
revenue.................... 11.7% 12.4% 12.4% 12.4% 13.4% 13.6%
Operating income............. 0.5% 1.7% 3.3% 1.7% 4.0% 4.2%
Effective tax rate(5)........ 136.1% 41.2% 39.9% 41.4% 40.6% 41.8%
Return on average
shareholders' equity....... (1.5)% 9.3% 3.9% 9.3% 18.9% 24.6%
YEAR ENDED
SEPTEMBER 30,
1993
-------------
Operating revenue............ $ 2,221,073
-------------
Expenses:
Health care services....... 1,850,469
Other operating expenses... 283,360
Impairment, disposition,
restructuring and other
charges.................. --
Office of Personnel
Management charge........ --
-------------
Operating income............. 87,244
Interest income, net......... 21,083
-------------
Income before income taxes
and cumulative effect of a
change in accounting
principle.................. 108,327
Provision for income taxes... 45,631
-------------
Income (loss) before
cumulative effect of a
change in accounting
principle.................. 62,696
Cumulative effect on prior
years of a change in
accounting principle....... --
-------------
Net income (loss)............ $ 62,696
-------------
-------------
Preferred dividends.......... --
-------------
Net income (loss) available
to common shareholders..... $ 62,696
-------------
Basic earnings (loss) per
share (4).................. $ 2.30
-------------
Diluted earnings (loss) per
share(4)................... $ 2.25
-------------
-------------
OPERATING STATISTICS
Medical care ratio (health
care services as a
percent of premium
revenue)
Consolidated............. 84.1%
Commercial............... 82.5%
Government............... 85.6%
Marketing, general and
administrative expenses as
a percent of operating
revenue.................... 12.6%
Operating income............. 3.9%
Effective tax rate(5)........ 42.1%
Return on average
shareholders' equity....... 24.2%
See footnotes described following "Balance Sheet Data"
17
FINANCIAL STATEMENT CHANGE STATISTICS
YEAR ENDED YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1997(6) 1996 1995 1994
--------------- ----------------- ----------------- -----------------
Operating revenue................................. 86.8% 24.3% 29.0% 30.3%
------ ----- --- ---
Net income (loss)(2,3)............................ (128.7)% (33.4)% 19.8% 44.0%
------ ----- --- ---
Earnings (loss) per share(2,3).................... (131.5)% (37.3)% 12.4% 43.1%
------ ----- --- ---
Total assets...................................... 211.8% (6.2)% 25.3% 59.4%
------ ----- --- ---
Total shareholders' equity........................ 139.8% 12.5% 77.1% 29.5%
------ ----- --- ---
YEAR ENDED
SEPTEMBER 30,
1993
-----------------
Operating revenue................................. 31.7%
---
Net income (loss)(2,3)............................ 43.8%
---
Earnings (loss) per share(2,3).................... 26.4%
---
Total assets...................................... 39.3%
---
Total shareholders' equity........................ 60.5%
---
DECEMBER 31, DECEMBER 31, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
1997 1996 1996 1995 1994 1993
------------ ------------ ------------- ------------- ------------- -------------
MEMBERSHIP DATA
Commercial.................................. 2,790,000 1,451,500 1,434,500 1,216,100 949,100 806,900
Government (Medicare & Medicaid)............ 1,001,100 593,600 596,200 541,000 409,100 290,100
------------ ------------ ------------- ------------- ------------- -------------
Total membership............................ 3,791,100 2,045,100 2,030,700 1,757,100 1,358,200 1,097,000
------------ ------------ ------------- ------------- ------------- -------------
------------ ------------ ------------- ------------- ------------- -------------
Percent change in membership................ 85.4% 0.7% 15.6% 29.4% 23.8% 14.7%
------------ ------------ ------------- ------------- ------------- -------------
------------ ------------ ------------- ------------- ------------- -------------
BALANCE SHEET DATA
(IN THOUSANDS)
Cash and equivalents and marketable
securities................................ $1,545,382 $ 962,482 $ 700,093 $ 811,525 $ 710,608 $ 437,231
Total assets................................ $4,867,958 $1,561,472 $ 1,299,462 $ 1,385,372 $ 1,105,548 $ 693,646
Medical claims and benefits payable......... $ 715,600 $ 278,800 $ 268,000 $ 288,400 $ 302,900 $ 255,000
Long-term debt, excluding current
maturities................................ $1,011,234 $ 1,370 $ 5,183 $ 11,949 $ 101,137 $ 21,821
Shareholders' equity........................ $2,062,187 $ 860,102 $ 823,224 $ 732,024 $ 413,358 $ 319,294
- ------------------------
(1) The 1997 results include the results of operations for the FHP Acquisition
from February 14, 1997 (see Note 4 of the Notes to Consolidated Financial
Statements). The 1997 results include $155 million of pretax charges ($129
million or $3.18 diluted loss per share, net of tax) for the impairment of
long-lived assets, restructuring and certain other charges (see Note 9 of
the Notes to Consolidated Financial Statements). Operating income as a
percentage of operating revenue before pretax charges was 2.2 percent.
Return on average shareholders' equity before pretax charges was 7.3
percent.
(2) The 1996 results include $101 million of pretax charges ($62 million or
$1.96 and $1.97 diluted loss per share, net of tax for the year ended
September 30 and the twelve months ended December 31, respectively) for the
impairment of long-lived assets, potential government claims, dispositions
and certain restructuring charges (see Note 9 of the Notes to Consolidated
Financial Statements). Operating income as a percentage of operating revenue
before pretax charges for 1996 was 3.8 and 3.9 percent, respectively for the
year ended September 30 and the twelve months ended December 31. Return on
average shareholders' equity before pretax charges for the year ended
September 30, 1996 and the twelve months ended December 31, 1996 was 17.2
percent and 17.0 percent, respectively.
(3) The 1994 results reflect the cumulative effect on prior fiscal years of a
change in accounting principle. Diluted earnings per share before cumulative
effect of a change in accounting principle for the year ended September 30,
1994 was $3.02 per share. The cumulative effect of a change in accounting
principle for the fiscal year ended September 30, 1994 was $0.20 per share.
The fiscal year 1994 changes in net income and earnings per share before
cumulative effect of a change in accounting principle are 34.9 percent and
34.2 percent, respectively.
(4) Earnings per share have been restated to conform with the provisions of
Statement of Financial Accounting Standards No. 128, "Earnings per Share."
Basic earnings per share excludes the effect of all potentially dilutive
securities. Diluted earnings per share includes the effect of the
potentially dilutive securities (see Note 2 of the Notes to Consolidated
Financial Statements). For the years ended September 30, 1993 through
September 30, 1996 and for the three months and twelve months ended December
31, 1996 the current presentation of diluted earnings per share is identical
to the Company's former presentation of primary earnings per share. The
potentially dilutive securities were not included in the calculation of
diluted loss per share for 1997 because they were anti-dilutive.
(5) Effective income tax rate includes the effect of non-deductible pretax
charges.
(6) Changes as compared to the unaudited period for the 12 months ended December
31, 1996.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
In February 1997, PacifiCare's board of directors approved a change in the
Company's fiscal year end from September 30 to December 31. This resulted in a
transition period from October 1, 1996 to December 31, 1996, which has been
audited. However, for clarity of presentation and comparability, the discussion
of results of operations compares the year ended December 31, 1997 to the
unaudited twelve months ended December 31, 1996, followed by a comparison of the
fiscal year ended September 30, 1996 to the fiscal year ended September 30,
1995. For purposes of the comparison of the year ended December 31, 1997 to the
twelve months ended December 31, 1996, the unaudited twelve months ended
December 31, 1996 are referred to as the prior year.
On February 14, 1997 the Company consummated the FHP Acquisition for a total
purchase price including transaction costs of $2.2 billion. The FHP Acquisition
has been accounted for as a purchase. The Company's consolidated results of
operations include the results of FHP from the date of the FHP Acquisition (see
Note 4 of the Notes to Consolidated Financial Statements).
1997 COMPARED WITH 1996
Total operating revenue increased 87 percent to $9.0 billion for the year
ended December 31, 1997 from $4.8 billion for the same period in the prior year.
FHP contributed approximately $3.6 billion or 85 percent of the increase in
revenue. Enrollment gains (net of the FHP Acquisition) in both the government
and commercial programs increased revenue by six percent. Premium increases,
mainly in the government programs, along with the Company's specialty managed
care products and services, contributed the remainder of the increase. Total HMO
membership increased 85 percent to approximately 3.8 million members at December
31, 1997, from approximately 2.0 million members at December 31, 1996, due
primarily to the FHP Acquisition. The Company acquired approximately 1.5 million
and 0.4 million commercial and government members, respectively, as part of the
FHP Acquisition.
Commercial premiums increased 97 percent over the prior year with
approximately 92 percent of the total increase related to the FHP Acquisition.
Enrollment gains in the commercial programs, net of acquisition membership,
accounted for seven percent, while premium rates remained relatively flat.
Excluding the FHP Acquisition, the Company has experienced a decrease in the
rate of membership growth compared to the prior year. This decrease is partly
due to the disposition of the Company's Florida operations. Additionally, the
Company has shifted its focus from one of rapid growth to improved profit
margins through the use of a more disciplined product pricing strategy.
Government premiums increased 85 percent as compared to the twelve months
ended December 31, 1996 with 81 percent of the total increase related to the FHP
Acquisition. On January 1, 1997, the Company received premium rate increases
from HCFA averaging over six percent. Government per member premium rates also
increased as a result of the Company's exit of its Medicaid lines of business in
certain of the Company's markets, which have lower average per member premiums.
These increases were offset slightly by reductions in member paid supplemental
premiums in several of the Company's markets. The combined increases in the per
member premium rates increased revenue by almost 14 percent as compared to the
prior year. Enrollment gains in the government programs, net of acquisition
membership, accounted for an additional five percent of the increase in
government premiums.
The increase in the commercial medical care ratio includes higher cost FHP
provider contracts, increased non-capitated physician costs and increased out of
area emergency room costs as compared to the prior year.
19
The government programs' medical care ratio for the year ended December 31,
1997 remained flat as compared to the prior year. This consistency largely
reflects the FHP Acquisition, which had lower cost provider contracts and
generally higher reimbursement for Medicare risk membership. Additionally, the
wind down of the Medicaid business contributed to slight decreases in the
government medical care ratio. These decreases were partially offset by enhanced
prescription drug benefits provided to enrollees combined with lower member paid
supplemental premiums.
As a percentage of operating revenue, marketing, general and administrative
expenses decreased slightly as compared to the prior year, excluding the pretax
charges for 1997 and 1996 as discussed below. The decrease reflects reduced or
eliminated FHP marketing, continued administrative savings, including lower than
expected staffing and greater than expected efficiencies resulting from the
integration of the FHP administrative operations and information systems.
The Company recognized pretax charges totaling $155 million ($129 million or
$3.18 diluted loss per share, net of tax) for the year ended December 31, 1997
and $101 million ($62 million or 1.97 diluted loss per share, net of taxes) for
the twelve months ended December 31, 1996. The 1997 pretax charges included
fourth quarter write-offs associated with the impairment of goodwill in certain
of the Company's markets, restructuring charges and certain other charges. The
1996 pretax charges included an impairment of goodwill, a disposition loss
restructuring and OPM charges.
During the fourth quarter of 1997, the Company recognized a $124 million
($111 million or $2.73 diluted loss per share, net of tax) charge for goodwill
and intangible assets which were impaired and no longer recoverable from future
operations. These pretax charges relate to the following markets and products:
- $63 million for the Utah HMO;
- $40 million for the Washington health plan; and
- $21 million primarily for discontinued workers' compensation products.
As discussed in the second quarter, Utah's operating losses were related to
lower than expected 1997 premium rate increases coupled with a shift of
membership from capitated to non-capitated health care providers as a
significant health care provider contract switched from capitation to
fee-for-service. The Company agreed to continue this contract to ensure an
adequate infrastructure to service the Utah membership. At the same time, the
Utah information systems migrated to the standard FHP system in anticipation of
the conversion of the FHP system into the Company's common system. As a result,
increased utilization under the new fee-for-service contract was not visible
until the fourth quarter of 1997 when conversion reconciliations discovered
significant unpaid claims as well as claims paid inaccurately. The Company
expects that economic and competitive conditions in Utah will continue to
minimize premium increases and will make provider capitation contracting
difficult. Because the 1997 losses and the cash flow analysis did not support
the recoverability of goodwill, the Company recorded an impairment charge and
announced that it will exit or otherwise dispose of the Utah operations.
Since its acquisition, the Washington market has had a history of operating
losses. While capitated contracts have been implemented, claims payment issues
continue as most providers are not able to administer the claims process.
Utilization also continues to be higher than expected. The Company determined
that goodwill and intangibles were no longer recoverable and recorded an
impairment charge in light of the historical and increasing losses in the market
and expected future cash flows.
The Company owns a subsidiary which provides workers' compensation benefits.
In developing its 1998 business plan, the Company determined that California
legislation did not allow workers' compensation products to be priced at a
competitive rate that would result in the required return on investment. Without
a profitable California revenue stream, the remaining business did not support
the recoverability of the goodwill and the impairment was recorded.
20
The Company is committed to the successful integration of FHP and as part of
that process continually assesses the efficiency of its operations and
determines whether duplicative functions or facilities exist. As a result of
that commitment, the Company identified opportunities to restructure and
streamline operations which resulted in recording a restructuring charge in the
fourth quarter of 1997 in the amount of $15 million ($9 million or $0.22 diluted
loss per share, net of tax). The restructuring charges include work force
reductions, facility consolidation and other related cost accruals. To improve
efficiency and reduce costs, the Company experienced a work force reduction.
Work force costs of $8 million primarily include employee severance related to
involuntary termination programs. Lease terminations of $5 million pretax were
associated with the consolidation of administrative and operations office space.
Other related charges totaled $2 million, pretax. Cash flows from operations are
expected to fund all of the restructuring charges. The restructuring should be
complete by December 1998.
Approximately $16 million ($9 million, or $0.23 diluted loss per share, net
of tax) of other charges were recorded for contracts for which the anticipated
future health care costs exceed the premiums. Approximately $13 million ($8
million, or $0.19 diluted loss per share, net of tax) related to PacifiCare of
Utah due to the continuing losses anticipated by the plan. The remaining charge
for loss contract accruals pertains to a workers' compensation insurance company
and an HMO plan.
During 1996, the Company decided that its PacifiCare of Florida ("Florida")
subsidiary would not launch the Secure Horizons program and withdrew its HCFA
application after considering the effects of enhanced state regulation, reduced
Medicaid reimbursement, and continued losses experienced in the Florida market.
The business strategy for Florida profitability was based on launching of the
Company's Secure Horizons program. Accordingly, the Company recognized a $59
million ($34 million or $1.10 diluted loss per share, net of tax) charge for the
impairment of goodwill and decided to sell its Florida operations.
Effective June 1, 1996, Florida sold the assets of its staff-model medical
clinics resulting in a pretax loss of $9 million ($8 million or $0.26 diluted
loss per share, net of tax).
During 1996, management approved a plan relating for the discontinuation of
certain specialty heath care products and services that do not meet the
Company's strategic and economic return objectives, including a reduction in
work force and the establishment of regional customer service centers. A
restructuring charge of $8 million ($5 million or $0.15 diluted loss per share,
net of tax) was recognized which included employee severance related to an
involuntary work force reduction of approximately $4 million, write-offs of
assets designated for disposition of approximately $3 million, and other related
costs of approximately $1 million. The restructuring was financed by cash flows
from operations and actual expenditures did not differ materially from amounts
accrued.
In June 1996, a pretax charge was recognized of $25 million ($15 million, or
$0.46 diluted loss per share, net of tax) for an increase of reserves in
anticipation of negotiations relating to potential governmental claims for
contracts with OPM. The Company's HMO subsidiaries have commercial contracts
with OPM to provide managed health care services to members under FEHBP. In the
normal course of business, OPM audits health plans with which it contracts to,
among other things, verify that the premiums calculated and charged to OPM are
established in compliance with the best price community rating guidelines
established by OPM. OPM typically audits plans once every five or six years and
each audit covers the prior five or six year period. Depending on the type of
contract the Company has with OPM, OPM will audit one or more health plans at
the same time. OPM has notified PacifiCare of its intent to audit or has
recently completed an audit of the majority of the Company's health plans. While
the government's initial on-site audits are usually followed by a post-audit
briefing in which the government indicates its preliminary results, final
resolution and settlement of the audits have historically taken a minimum of
three to five years.
In addition to claims made by the auditors as part of the normal audit
process, the OPM may also refer their results to the United States Department of
Justice ("DOJ") for potential legal action under the False Claims Act. The DOJ
has the authority to file a claim under the False Claims Act if it believes that
21
the health plan knowingly overcharged the government or otherwise submitted
false documentation or certifications. In False Claim Act actions, the
government may impose trebled damages and a civil penalty of not less than
$5,000 nor more than $10,000 for each separate alleged false claim. In November
1997, the Company was notified that the 1995 audit of the operations of the
Company's Oklahoma HMO subsidiary, had been referred to the DOJ. The Company is
negotiating to settle this matter with the DOJ.
Interest income, net of interest expense, decreased approximately $29
million for the year ended December 31, 1997 compared to the prior year due
primarily to increased borrowings to finance the FHP Acquisition.
The majority of the pretax charges the Company recorded in the fourth
quarter of 1997 are not deductible for income tax purposes. Therefore, the
Company did not record an income tax benefit for most of these charges. The
magnitude of these charges, in conjunction with the inability to record a
related income tax benefit, resulted in the Company reporting a
disproportionately high effective income tax rate. The effective income tax rate
without the effect of the pretax charges was approximately 50 percent, which is
an increase over the prior year. This increase reflects the additional goodwill
amortization expense over the prior year related to the FHP Acquisition.
For the year ended December 31, 1997 income excluding the pretax charges
described above was $107 million or $2.43 diluted earnings per share. For the
year ended December 31, 1996 income exclusive of the pretax charges was $138
million or $4.36 diluted earnings per share. The decrease over the prior year
reflects the increase in the commercial medical care ratio, increased
amortization expense, the increase in interest expense related to the FHP
Acquisition and an increase in the shares used to calculate earnings per share.
For the year ended December 31, 1997 the Company adopted the provisions of
Statement of Financial Accounting Standards ("SFAS")No. 128, "Earnings Per
Share". This statement requires a dual presentation of earnings per share, basic
and diluted and restatement of earnings per share for prior years. The adoption
of this statement did not materially change the Company's calculation of
earnings (loss) per share for any reported period.
Due mainly to the pretax charges in the fourth quarter, and the high
effective tax rate which resulted in the Company reporting a net loss per share,
the convertible preferred stock and stock options or potentially dilutive
securities included in the calculation of diluted loss per share in the fourth
quarter and for 1997 were anti-dilutive. Since the potentially dilutive
securities were anti-dilutive, the calculation of the diluted loss per share is
identical to the basic loss per share.
The Class A Common Stock, Class B Common Stock and Series A Preferred Stock
issued in conjunction with the FHP Acquisition (see Note 4 of the Notes to
Consolidated Financial Statements) caused a significant increase in the shares
outstanding used in computing earnings per share between the fiscal quarters.
Due to the significant increase in shares outstanding and the anti-dilutive
effect of the potentially dilutive securities during the fourth quarter, the sum
of the quarterly earnings (loss) per share does not equal the 1997 year-to-date
loss per share.
FISCAL YEAR 1996 COMPARED WITH FISCAL YEAR 1995
Total operating revenue increased $906 million to $4.6 billion for the
fiscal year ended September 30, 1996 from $3.7 billion for the same period in
the prior fiscal year. Enrollment gains in both the government and commercial
programs, offset slightly by decreases in commercial premium rates, provided an
increase in total operating revenue of $787 million. The remaining operating
revenue increase was contributed by the incremental operations of acquisitions
described in Note 4 of the Notes to Consolidated Financial Statements and the
Company's specialty managed care products and services.
Commercial premiums increased $355 million or 23 percent to $1.9 billion for
the fiscal year ended September 30, 1996 from $1.5 billion in fiscal 1995.
Commercial HMO membership increased by 0.2 million to 1.4 million due to
continued growth in all markets except Florida. Commercial HMO membership growth
provided $281 million of the increase, more than offsetting average premium rate
22
decreases of one percent, primarily in California. The effects of acquisitions
described above and the commercial specialty managed care products and services
provided the remainder of the increase in commercial premiums.
Government premiums rose $550 million or 25 percent to $2.7 billion for the
fiscal year ended September 30, 1996 from $2.2 billion in fiscal 1995.
Enrollment gains, predominantly in the Secure Horizons programs, accounted for
$430 million or 78 percent of the increase. The remainder of the premium
increase is attributable to incremental acquisitions and premium rate increases
averaging four percent.
The increase in the commercial medical care ratio for the fiscal year ended
September 30, 1996 was primarily attributable to increased PPO and indemnity
costs of the Company's specialty managed care products and services combined
with higher physician and prescription drug costs in the Company's HMOs.
Exclusive of the Company's PPO and indemnity products, the commercial medical
care ratio decreased slightly through improved contracting arrangements. Many of
the Company's newer markets experienced more membership growth than the Company
as a whole. However, with provider networks less sophisticated in managed care,
these newer markets contributed to a higher medical care ratio. The more mature
commercial markets experienced slightly improved medical care ratios from fiscal
year 1995.
The increase in the medical care ratio for the government programs reflected
increased physician and hospital costs on a per member basis due to higher
membership growth in areas with higher provider costs combined with lower member
supplemental premiums and enhanced benefits to enrollees. These increased costs
are partially offset by January 1, 1996 HCFA premium rate increases.
Marketing, general and administrative expenses increased $78 million to $576
million for the fiscal year ended September 30, 1996 from $498 million for
fiscal year 1995. However, as a percentage of operating revenue, marketing,
general and administrative expenses decreased by one percent. The decrease was
primarily attributable to the Company's reduction of performance based employee
incentives due to current fiscal year operating results not meeting anticipated
fiscal year 1996 targets. Additionally, the Company realized the benefit derived
from prior investments in the Company's infrastructure which have proven
adequate to support the growth in membership.
As discussed previously, the Company recognized pretax charges for the
fiscal year ended September 30, 1996 totaling $101 million ($62 million or $1.96
diluted loss per share, net of tax) (see Note 9 of the Notes to Consolidated
Financial Statements).
Net interest income increased by approximately $10 million compared to the
prior fiscal year primarily due to increased cash available for investment
purposes at higher interest rates than fiscal year 1995 and lower interest
expense associated with decreased debt service.
The increased consolidated effective income tax rate for the fiscal year
ended September 30, 1996 was attributable to the charges for the disposition and
goodwill impairment described in Note 9 of the Notes to Consolidated Financial
Statements, some of which are not deductible for income tax purposes.
Income exclusive of the impairment, disposition, restructuring and OPM
charges described above was $134 million or a 24 percent increase over fiscal
year 1995. Diluted earnings per share before impairment, disposition,
restructuring and OPM charges, increased 17 percent or $0.61 to $4.23 for the
fiscal year ended September 30, 1996. The increases reflect membership growth in
both the commercial and government programs and lower marketing, general and
administrative costs, partially offset by increases in health care service
expenses.
LIQUIDITY AND CAPITAL RESOURCES
The Company has significant short-term liquidity with 1997 year-end cash,
equivalents and marketable securities of $1.5 billion, a 61 percent increase
from December 31, 1996 primarily attributable to the FHP Acquisition and results
of operations. The Company's cash flow requirements for 1997 were met by funds
provided from operations. Financing activities, including the issuance of common
and preferred equity
23
securities, provided funds for the FHP Acquisition. The Company issued 2,339,402
shares of Class A Common Stock, 7,352,965 shares of Class B Common Stock and
10,517,044 shares of Series A Preferred Stock in connection with the FHP
Acquisition.
Net cash used in investing activities included $1.0 billion, $5 million and
$135 million for acquisitions and $68 million, $23 million and $25 million for
property, plant and equipment purchases in 1997, fiscal 1996 and fiscal 1995,
respectively. In 1997, net cash provided by financing activities included $1.1
billion in borrowings under its $1.5 billion credit facility. Cash payments of
$210 million reduced the credit facility balance to $910 million at December 31,
1997 (see Note 5 of the Notes to Consolidated Financial Statements). The cash
received from the sale of the Talbert stock in 1997 substantially offset the
capital contributions made to Talbert (see Note 4 of the Notes to Consolidated
Financial Statements). Cash received for the issuance of common stock provided
cash in 1997, fiscal 1996 and fiscal 1995 of $44 million, $13 million and $201
million, respectively. The Company issued 991,813 shares, 381,418 shares and
338,608 shares of common stock for benefit plans in 1997, fiscal 1996 and fiscal
1995, respectively. The Company paid approximately $9 million of preferred stock
dividends in 1997.
In January 1998 the Company's board of directors approved a plan to
repurchase shares of the Company's equity instruments. The Company successfully
renegotiated terms of the credit facility to increase the maximum amount of
repurchases permitted to $500 million. The Company will purchase stock using
cash flows from operations and additional borrowings under its credit facility.
Shares repurchased will be available for reissuance in connection with the
Company's employee benefit plans or for other corporate purposes. As of February
28, 1998, the Company had repurchased 42,000 shares of its Class A Common Stock
and 406,000 shares of its Class B Common Stock for an aggregate amount of $23
million.
NEW ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board ("FASB") has issued several
pronouncements regarding disclosure that the Company will adopt in 1998.
SFAS No. 129, "Disclosure of Information about Capital Structure,"
consolidates the existing guidance relating to an entity's capital structure.
The required capital structure disclosures include liquidation preferences of
preferred stock, information about the pertinent rights and privileges of the
outstanding equity securities and the redemption amounts of all issues of
capital stock that are redeemable at fixed or determinable prices on fixed or
determinable dates.
SFAS No. 130, "Reporting Comprehensive Income," establishes new rules for
the reporting and display of comprehensive income and its components in a
complete set of general-purpose financial statements as well as in interim
period financial statements.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," significantly changes the way public companies report segment
information in annual financial statements and also requires those companies to
report selected segment information in interim financial reports. Under
Statement 131, public companies will report financial and descriptive
information about their operating segments. Operating segments are
revenue-producing components of the enterprise for which separate financial
information is produced internally and are subject to evaluation by the chief
operating decision maker in deciding how to allocate resources to segments.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants is expected to issue Statement of
Position ("SOP"), "Accounting for the Costs of Computer Software Developed For
or Obtained For Internal-Use." Under the SOP, effective in 1999, certain
computer software costs are required to be capitalized and amortized to income
over the software's estimated useful life. The Company will adopt the SOP in
1999.
24
DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward looking statements to encourage companies to provide
prospective information about themselves without fear of litigation so long as
those statements are identified as forward looking and are accompanied by
meaningful cautionary statements identifying important factors that could cause
actual results to differ materially from those projected in the statements. The
statements contained in this section, and throughout the document, are based on
current expectations. These statements are forward looking and actual results
may differ materially from those projected in the forward looking statements,
which statements involve risks and uncertainties. In addition, past financial
performance is not necessarily a reliable indicator of future performance and
investors should not use historical performance to anticipate results or future
period trends. Shareholders are also directed to the other risks discussed in
other documents filed by the Company with the SEC.
FORWARD LOOKING INFORMATION UNDER THE PRIVATE SECURITIES LITIGATION ACT OF 1995
MEMBERSHIP. The Company's membership for the year ended December 31, 1998
is expected to decline in the commercial program. In accordance with the
Company's strategic focus shifting from one of rapid growth to improved margin
performance, the Company's emphasis is on renewing employer contracts with
sufficient price increases to improve gross margin. Specifically, the Company
has implemented commercial price increases including increases of more than 10
percent in conjunction with open enrollment in all markets, including
concentrated efforts in Utah and Washington which may result in net membership
attrition. In addition to pricing increases, the Company has or intends to exit
certain geographical areas where the premiums are insufficient to support the
cost of health care in that area. Combined with continued increases in
competition and the disposition of its Utah subsidiary which currently has
approximately 154,000 commercial members, the Company expects to see minimal
growth or declines in commercial membership in 1998.
The rate of increase in government membership is expected to decline in 1998
as compared to 1997 as competition increases and the Company continues the
migration of FHP senior members into the Company's benefit structures and the
combined provider network. Additionally, the government membership will decrease
by the approximately 25,000 government members serviced by Utah when the
disposition is complete.
An unforeseen loss of profitable membership could have a material adverse
effect on the Company. Factors which could contribute to the loss of membership
include issues related to the integration of the Company and FHP in retaining
FHP's members as the Company combines the PacifiCare and FHP health plans, sale
of certain managed care operations, failure to obtain new customers or to retain
existing customers, effect of premium increases, reductions in workforce by
existing customers, adverse publicity and news coverage, inability to carry out
marketing and sales plans, or the loss of key executives or key employees.
HEALTH CARE PROVIDER CONTRACTS. The Company's profitability depends, in
part, on its ability to maintain effective control over health care costs while
providing members with quality care. Specifically, capitating providers in Utah,
Nevada and Washington and recontracting with providers in Oregon will be
critical to improved results of operations for those markets. Securing cost
effective contracts with existing and new physician groups is more difficult due
to increased competition. The negotiation of provider contracts, generally as of
January 1, may be impacted by adverse state and federal legislation and
regulation discussed below. Failure to secure cost effective contracts may
result in a loss in membership or a higher medical care ratio. The Company's
inability to contract with providers, loss of contracts with providers,
inability of providers to provide adequate care or insolvency of providers could
materially and adversely affect the Company. These contracting and insolvency
risks include: a loss of membership; incurring additional expenses to meet the
requirement to continue to arrange for health care services,
25
among other things, for members; the inability to obtain reimbursement due the
Company from providers; the expenditure of additional funds to maintain adequate
provider networks and assertion of claims by third parties against the Company.
The effect of these risks could result in the recognition of a charge in a
future period.
COMMERCIAL MEDICAL CARE RATIO. The commercial medical care ratio for the
year ended December 31, 1998 is expected to decrease as compared to 1997. The
Company expects improvements as it continues renegotiation of provider
contracts, implements capitated contracts and implements price increases. Price
increases on a consolidated company basis are expected to increase by an average
of four percent, with increases ranging from zero to over ten percent. Moreover,
higher premium rates offered during open enrollment periods should result in the
elimination of some high medical care ratio membership. During 1998, the Company
will concentrate its efforts on continued renegotiations with providers,
including the acquired FHP contracts. Successful renegotiation of these
contracts should reduce the medical care ratio. Finally, the disposition of
Utah, which currently runs a higher than average medical care ratio, should help
to improve the commercial medical care ratio. These improvements are expected to
be slightly offset by increased prescription drug costs.
GOVERNMENT MEDICAL CARE RATIO. In 1998, the government medical care ratio
is expected to remain consistent with that of 1997. The Company has received
notice from HCFA that in 1998 it will be receiving premium rate increases
ranging from two percent in the Company's largest markets to six percent in
smaller markets resulting in overall weighted average premium rate increases of
a little over two percent. Competitive pressures in the Medicare market may
require enhanced benefits. The implementation of Medicare reform provisions
which curtail program spending and allow the entry of new forms of competitor
plans could further increase competitive pressures (see Legislation and
Regulation below). The 1998 HCFA rate increases and lower FHP government medical
care ratio are expected to be offset by these competitive pressures.
MEDICAL CARE RISK FACTORS. The commercial and government medical care ratio
expectations discussed above could be affected by various uncertainties,
including increases in medical and prescription drug costs which have been
escalating faster than premium increases in recent years, increases in
utilization and costs of medical services and the effect of actions by
competitors or groups of providers, termination of provider contracts or
renegotiation thereof at less cost-effective rates or terms of payment, or the
inability to complete a timely, successful disposition of the Company's Utah
subsidiary. In addition, the commercial and government medical care ratio
expectations for the HMOs acquired in the FHP Acquisition could be impacted by
the conversion to PacifiCare computer systems over the next eighteen months
which may result in reduced timely visibility of actual claims costs.
MARKETING, GENERAL AND ADMINISTRATIVE SUPPORT. In 1998, marketing, general
and administrative expenses as a percentage of operating revenue are expected to
decrease slightly from 1997. The Company expects to experience additional costs
associated with the integration of FHP largely related to upgrading and
converting information systems to maintain and enhance the Company's competitive
edge in information technology. These additional costs are expected to be offset
as the Company realizes the benefits of restructuring and a full year of
synergies as a result of the FHP transaction.
Marketing, general and administrative expenses could be adversely impacted
by the need for additional advertising, marketing, administrative, or management
information systems expenditures and the inability to carry out marketing and
sales plans. The ability of PacifiCare to realize the anticipated benefits and
synergies related to the FHP Acquisition is subject to the following additional
uncertainties, among others: the ability to eliminate duplicative functions
while maintaining acceptable performance levels and the possibility that the
continued integration will result in a loss of providers, employers, members or
key employees.
26
1998 DISPOSITIONS. While the Company has previously announced its intention
to dispose of its Utah and workers' compensation operations in 1998, other
dispositions could be announced as the Company continues to evaluate whether
certain subsidiaries or products fit within its core business strategy. There is
no guarantee that the Company will be successful in selling all or a portion of
the Utah or workers' compensation operations at a price sufficient to avoid
disposition losses. Such losses could include restructuring expenses for
severance, lease and contract terminations as well as impairment of long-lived
assets. There can be no assurance that the dispositions will not result in
additional pretax charges. The Company believes, however, that any disposition
operating losses would not materially affect the Company's consolidated
financial position. However, the disposition losses could have a material
adverse effect on the results of operations or cash flows of a future quarter.
IMPAIRMENT OF LONG-LIVED ASSETS. The Company assesses the recoverability of
its long-lived assets (including goodwill and intangibles) on an annual basis or
whenever adverse events or changes in circumstances or the business climate
indicate that expected undiscounted future cash flows for individual business
units may not be sufficient to support the recorded asset. Based on the 1997
annual analysis, certain of the Company's operations will require more frequent
monitoring in 1998. In addition, at December 31, 1997 certain of the Company's
property, plant and equipment was determined to be recoverable because of
long-term operating lease agreements. Should there be a change in the rental
income stream, an impairment for these assets may be necessary. The Company
believes that this impairment would not materially affect the Company's
consolidated financial position. However, the impairment charges could have a
material adverse effect on the results of operations or cash flows.
YEAR 2000. In 1996, the Company developed and began execution of an
enterprise wide plan to ensure application and systems compliance for the year
2000. The Company currently expects the project to be complete by the end of
1998 and to cost less than $10 million. This estimate includes internal costs,
but excludes the costs to upgrade and replace systems in the normal course of
business. As of December 31, 1997, approximately $2 million had been expensed
related to this project. An additional component of this project is the written
confirmation from all systems vendors ensuring year 2000 compliance in
conjunction with the Company's target deadlines. The Company is currently
assessing the impact, if any, of year 2000 issues it may encounter with entities
with which it electronically interacts, including HCFA. If HCFA or certain other
entities experience significant failures or erroneous applications, it could
have a material adverse effect on the Company's financial position, results of
operations or cash flows.
OFFICE OF PERSONNEL MANAGEMENT CONTINGENCIES. The Company intends to
negotiate with OPM and DOJ on all matters to attain a mutually satisfactory
result. While there is no assurance that the negotiations will be concluded
satisfactorily or that additional liability will not be incurred, management
believes that any ultimate liability in excess of amounts accrued, which could
arise upon completion of the audits by OPM of the health plans, would not
materially affect the Company's consolidated financial position. However, such
liability could have a material adverse effect on results of operations or cash
flows of a future quarter if resolved unfavorably (see Note 10 of the Notes to
Consolidated Financial Statements).
LIQUIDITY AND CAPITAL RESOURCES. The Company's credit facility requires
mandatory reductions of the outstanding principal balance beginning January 1999
and is required to be paid in full by January 1, 2002. As of December 31, 1997,
the outstanding balance on the credit facility would not require a reduction
until July 1, 2001. The Company believes cash flows from operations, existing
cash equivalents, marketable securities and other financing sources will be
sufficient to meet the requirements of the credit facility and will provide
sufficient liquidity for operations in the foreseeable future.
Cash flows could be adversely affected because the Company is subject to
greater operating leverage due to its higher levels of indebtedness as a result
of the FHP Acquisition. The Company's plan to repurchase shares of outstanding
stock may result in the reduction of cash and equivalents or in additional
borrowings on its credit facility. Additional borrowings on the credit facility
may result in the Company
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being subject to earlier mandatory reduction of its outstanding balance.
Additionally, should the credit facility be fully drawn, the Company's ability
to make a payment on, or repayment of, its future obligations under the credit
facility and $100 million of senior notes of FHP assumed by the Company will be
significantly dependent upon the receipt of funds from the Company's
subsidiaries. These subsidiary payments represent fees for management services
rendered by the Company to the subsidiaries and cash dividends by the
subsidiaries to the Company. Nearly all of the subsidiaries are subject to HMO
regulations or insurance regulations and may be subject to substantial
supervision by one or more HMO or insurance regulators. Subsidiaries subject to
regulation must meet or exceed various fiscal standards imposed by HMO or
insurance regulations, which may from time to time, impact the amount of funds
that may be paid by subsidiaries to the Company. Additionally, from time to
time, the Company advances funds, in the form of a loan or capital contribution,
to its subsidiaries to assis