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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997
/ / TRANSITION REPORT PURSUANT TO SECTION 13(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______________ TO ______________
COMMISSION FILE NUMBER: 1-12718
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FOUNDATION HEALTH SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 95-4288333
(State or other jurisdiction of (I.R.S. Employer identification
incorporation or organization) No.)
21600 OXNARD STREET, WOODLAND HILLS, CA 91367
(Address of principal executive offices) (Zip Codes)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (818) 676-6978
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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Class A Common Stock, $.001 par value New York Stock Exchange, Inc.
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None
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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. (x)
The aggregate market value of the voting stock held by non-affiliates of the
registrant at March 16, 1998 was $3,061,505,816 (which represents 106,719,157
shares of Class A Common Stock held by such non-affiliates multiplied by
$28.6875, the closing price of such stock on the New York Stock Exchange on
March 16, 1998).
The number of shares outstanding of the registrant's Class A Common Stock as
of March 16, 1998 was 111,308,582 (excluding 3,194,374 shares held as treasury
stock), and 10,297,642 shares of the registrant's Class B Common Stock were
outstanding as of such date.
DOCUMENTS INCORPORATED BY REFERENCE:
Part III of this Form 10-K incorporates information by reference from the
registrant's definitive proxy statement to be filed with the Securities and
Exchange Commission within 120 days after the close of the year ended December
31, 1997.
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FOUNDATION HEALTH SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
PAGE NO.
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PART I
Item 1. Business............................................................................ 1
Item 2. Properties.......................................................................... 17
Item 3. Legal Proceedings................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders Other Information............... 19
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters............... 30
Item 6. Selected Financial Data............................................................. 32
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations........................................................................ 33
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.......................... 44
Item 8. Financial Statements and Supplementary Data......................................... 46
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure........................................................................ 83
PART III
Item 10. Directors and Executive Officers of the Registrant.................................. 83
Item 11. Executive Compensation.............................................................. 83
Item 12. Security Ownership of Certain Beneficial Owners and Management...................... 83
Item 13. Certain Relationships and Related Transactions...................................... 83
PART IV
Item 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K.................. 83
PART I
ITEM 1. BUSINESS
Foundation Health Systems, Inc. (the "Company" or "FHS") is an integrated
managed care organization which administers the delivery of managed health care
services. The Company's health maintenance organizations ("HMOs"), insured
preferred provider organizations ("PPOs") and government contracts subsidiaries
provide health benefits to 6.2 million individuals in 21 states through group,
individual, Medicare risk, Medicaid and CHAMPUS programs. The Company's
subsidiaries also offer managed health care products related to behavioral
health, dental, vision and prescription drugs, and offer managed health care
product coordination for multi-region employers and administrative services for
medical groups and self-funded benefits programs. Over the past several years,
the Company has developed a diversified product line and has achieved geographic
expansion throughout the United States. The Company operates and conducts its
HMO and other businesses through its wholly and majority owned subsidiaries.
The current operations of the Company are the result of the April 1, 1997
merger transaction (the "FHS Combination") involving Health Systems
International, Inc. ("HSI") and Foundation Health Corporation ("FHC"). Pursuant
to the Agreement and Plan of Merger (the "Merger Agreement") that evidenced the
FHS Combination, FH Acquisition Corp., a wholly owned subsidiary of HSI, merged
with and into FHC and FHC survived as a wholly owned subsidiary of HSI, which
changed its name to "Foundation Health Systems, Inc." and thereby became the
Company. Under the Merger Agreement, FHC stockholders received 1.3 shares of the
Company's Class A Common Stock for every share of FHC common stock held. The
shares of the Company's Class A Common Stock issued to FHC's stockholders in the
FHS Combination constituted approximately 61% of the outstanding stock of the
Company after the FHS Combination and the shares held by the Company's
stockholders prior to the FHS Combination (i.e., the prior stockholders of HSI)
constituted approximately 39% of the outstanding stock of the Company after the
FHS Combination.
The FHS Combination was accounted for as a pooling of interests for
accounting and financial reporting purposes. The pooling of interests method of
accounting is intended to present, as a single interest, two or more common
stockholder interests which were previously independent and assumes that the
combining companies have been merged from inception. Consequently, in this
Annual Report on Form 10-K, the Company's consolidated financial statements have
been prepared and/or restated as though HSI and FHC always had been combined on
a calendar year basis.
The Company currently operates in the managed health care industry segment,
and in 1997 the Company operated in five different Divisions within such
segment, including three regional Health Plan Divisions and two additional
Specialty Divisions. Such Divisions encompass the following three primary lines
of business in which the Company continues to operate: (i) health plan
operations (through the three regional Health Plan Divisions described below);
(ii) government contracts (through the Government Operations Division described
below); and (iii) specialty services (through the Specialty Services Division
described below). As set forth below, the Company has discontinued its
risk-based operations in the Workers' Compensation segment.
The Company is one of the largest managed health care companies in the
United States, with more than 4.3 million full-risk and administrative services
only ("ASO") members through its Health Plan Divisions. The Company provides a
comprehensive range of health care services through HMOs organized into three
Health Plan Divisions located in the following geographic regions: the
California Division (encompassing only the state of California), the Eastern
Division (Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and
West Virginia) and the Western Division (Arizona, Colorado, Idaho, Louisiana,
New Mexico, Oklahoma, Oregon, Texas, Utah and Washington). The Company also
operates PPO networks providing access to health care services to over 4 million
individuals in 37 states and owns six health and life insurance companies
licensed to sell insurance in 38 states and the District of Columbia.
1
The Company's HMOs market traditional HMO products to employer groups and
Medicare and Medicaid products directly to employer groups and individuals.
Health care services that are provided to the Company's commercial and
individual members include primary and specialty physician care, hospital care,
laboratory and radiology services, prescription drugs, dental and vision care,
skilled nursing care, physical therapy and mental health. The Company's HMO
service networks include approximately 43,000 primary care physicians and 74,000
specialists.
In addition to the Company's HMO and PPO operations in its three regional
Health Plan Divisions, the Company conducted business in 1997 through the
following two Specialty Divisions.
The Company's Government Operations Division oversees the provision of
contractual services to federal government programs such as the Civilian Health
and Medical Program of the Uniformed Services ("CHAMPUS"). The Company receives
revenues for administrative and management services and, under most of its
contracts, also accepts financial responsibility for a portion of the health
care costs.
The Company's Specialty Services Division oversees the provision of
supplemental programs to enrollees in the Company's HMOs, as well as to members
whose basic medical coverage is provided by non-FHS companies, including vision
coverage, dental coverage, managed behavioral health programs, and a
prescription drug program. The Specialty Services Division consists both of
operations in which the Company assumes underwriting risk in return for premium
revenue, and operations in which the Company provides administrative services
only, including certain of the behavioral health and pharmacy benefits
management programs. Such Division also provides certain bill review and third
party administrative services as described elsewhere in this Annual Report.
Finally, the Company's Workers' Compensation segment consists of operations
in which the Company assumes workers' compensation claims risk in return for
premium revenue, and certain non-risk operations including providing access to
managed care networks, utilization review services and third party
administrative services. As noted below in the section of this Annual Report on
Form 10-K entitled "Discontinued Operations and Anticipated Divestitures," the
Company has recently determined to discontinue its risk-based workers'
compensation operations and to transfer its non-risk workers' compensation
services to its Speciality Services Division.
The Company utilizes sophisticated medical management systems to reduce
excess utilization of health care services. The Company continues to develop a
new generation medical management system which utilizes clinical protocols and
triage procedures to direct members to the most appropriate provider. The
Company believes that this new system, which it calls "Fourth Generation Medical
Management" (the "4-G System"), has the potential to represent a major advance
in applying sophisticated information systems to the practice of medicine. The
Smithsonian Institution has added the 4-G System to its Permanent Research
Collection of Information Technology Innovation at the National Museum of
American History, and the 4-G System was also a finalist for the 1997
Computerworld Smithsonian Award in Medicine.
The Company continues to evaluate the profitability realized or likely to be
realized by its existing businesses and operations, and the opportunities to
expand its businesses in profitable markets. In this connection, the Company is
reviewing from a strategic standpoint which of its businesses or operations
should be divested, and has targeted the Northeastern United States for
expansion due to the relatively low penetration of managed health care in the
region and such region's relatively higher average premiums as compared to the
Company's California and western regions. Consistent with this Northeast
expansion strategy, in 1997 the Company acquired Advantage Health, the trade
name for a group of managed health care companies headquartered in Pittsburgh,
with operations in West Virginia, Ohio and western Pennsylvania; Physicians
Health Services, Inc. ("PHS"), a group of managed health care companies
headquartered in Connecticut; and FOHP, Inc. ("FOHP"), a group of managed health
care companies located in Neptune, New Jersey. In 1997 the Company also acquired
PACC Health Plans, Inc. and PACC HMO, Inc. (collectively, "PACC"), a group of
managed care companies operating in Washington and Oregon.
2
The Company was incorporated in 1990. Prior to the FHS Combination, the
Company was the successor to the business conducted by Health Net, now the
Company's HMO subsidiary in California, which became a subsidiary of the Company
in 1992, and HMO and PPO networks operated by QualMed, Inc. ("QualMed"), which
combined with the Company in 1994 to create HSI. FHC was incorporated in
Delaware in 1984. After the FHS Combination, the executive offices of the
Company remained at 21600 Oxnard Street, Woodland Hills, CA 91367. Except as the
context otherwise requires, the term the "Company" refers to FHS and its
subsidiaries.
HEALTH PLAN DIVISIONS
HMO AND PPO OPERATIONS. The Company's HMOs offer members a comprehensive
range of health care services, including ambulatory and outpatient physician
care, hospital care, pharmacy services, eye care, behavioral health and
ancillary diagnostic and therapeutic services. The Company offers a full
spectrum of managed health care products.
The integrated health care programs offered by the Company's HMOs include
products offered through both traditional Network Model HMOs (in which the HMOs
contract with individual physicians, physician groups and independent or
individual practice associations ("IPAs")) and IPA Model HMOs (in which the HMOs
contract with one or more IPAs that in turn subcontract with individual
physicians to provide HMO patient services) which offer quality care, cost
containment and comprehensive coverage; a matrix package which allows employees
to select their desired coverage from alternatives that have interchangeable
outpatient and inpatient co-payment levels; point-of-service programs which
offer a multi-tier design that provides both conventional HMO and indemnity-like
(in-network and out-of-network) tiers; a PPO-like tier which allows members to
self-refer to the network physician of their choice; and a managed indemnity
plan, which is provided for employees who reside outside of their HMO service
areas. The Company's PPO subsidiaries consist of networks of health care
providers which offer their services to health care third party payors, such as
insurers and self-funded employers.
The Company's strategy is to offer a wide range of managed health care
products and services to employers to assist them in containing health care
costs. The pricing of the products offered is designed to provide incentives to
both employers and employees to select and enroll in the products with greater
managed health care and cost containment elements. In general, the Company's HMO
subsidiaries provide comprehensive health care coverage for a fixed fee or
premium that does not vary with the extent or frequency of medical services
actually received by the member. PPO enrollees choose their medical care from
among the various contracting providers or choose a non-contracting provider and
are reimbursed on a traditional indemnity plan basis after reaching an annual
deductible. The Company assumes both underwriting and administrative expense
risk in return for the premium revenue it receives from its HMO and PPO
products. The HMOs and PPOs have contractual relationships with health care
providers for the delivery of health care to the Company's enrollees. While a
majority of the Company's members are covered by conventional HMO products, the
Company is continuing to expand its other product lines, thereby enabling it to
offer flexibility to an employer and to tailor its products to an employer's
particular needs.
As of December 31, 1997, the Company owned and operated HMOs and PPOs in
three regional Health Plan Divisions of the United States: The California
Division, the Western Division (Arizona, Colorado, Idaho, Louisiana, New Mexico,
Oklahoma, Oregon, Texas, Utah and Washington) and the Eastern Division
(Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and West
Virginia). The following table contains certain information relating to
commercial HMO and PPO members,
3
Medicare members and employer groups under contract as of December 31, 1997 in
each region in which the Company operates (excluding point-of-service):
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
---------- --------- ---------
Commercial HMO and PPO Members............................. 1,658,234 760,641 948,850
Medicare Members (risk only)............................... 153,485 72,559 85,937
Medicaid Members........................................... 294,591 53,982 94,470
In addition, the following sets forth certain data regarding the Company's
employer groups in its commercial managed care operations of its Health Plan
Divisions:
Number of Employer Groups........................................... 68,793
Largest Employer Group as % of enrollment........................... 4.9%
10 largest Employer Groups as % of enrollment....................... 15.6%
% of Members in Employer Groups with fewer
than 50 Eligible Members.......................................... 11.0%
CALIFORNIA DIVISION. The California market is characterized by a
concentrated population. In early 1998, the Company merged the operations of two
of its California HMO subsidiaries, Health Net and Foundation Health, a
California Health Plan. The resulting HMO, Health Net, is believed by the
Company to be the second-largest HMO in the state of California in terms of
membership. The Company's commercial HMO membership in California as of December
31, 1997 was 1,658,234 which represented a decrease of 1% during 1997. The
Company's Medicare risk membership in California as of December 31, 1997 was
153,485 which represented an increase of 10% during 1997. The Company's Medicaid
membership in California as of December 31, 1997 was 294,591 members.
EASTERN DIVISION. The Eastern Division currently includes Company
operations in Connecticut, Florida, New Jersey, New York, Ohio, Pennsylvania and
West Virginia. During 1997 the Company acquired Advantage Health, the trade name
for a group of managed health care companies headquartered in Pittsburgh, with
operations in Ohio, Pennsylvania and West Virginia; PHS, a group of managed
health care companies headquartered in Connecticut with operations in
Connecticut, New Jersey and New York; and FOHP, a group of managed health care
companies now headquartered in Neptune, New Jersey with operations in New
Jersey.
The Company believes its Pennsylvania HMO and PPO operations make it the
fourth largest HMO managed care provider in terms of membership in the
Commonwealth of Pennsylvania. The Company's commercial HMO membership in
Pennsylvania was 67,215 as of December 31, 1997 which represented an increase of
59% during 1997. The Company's Medicare risk membership in Pennsylvania was
15,070 as of December 31, 1997 which represented an increase of 10% during 1997.
The Company believes its Connecticut HMO and PPO operations make it the
largest HMO managed care provider in terms of membership in the state of
Connecticut. The Company's commercial HMO membership in Connecticut was 339,307
as of December 31, 1997 (including approximately 180,000 members from its
year-end acquisition of PHS. The Company's commercial HMO membership in
Connecticut at the end of 1996 was 129,047. The Company's Medicare risk
membership in Connecticut was 26,229 as of December 31, 1997 and the Company's
Medicaid membership in Connecticut was 47,175 as of December 31, 1997.
The Company believes its New Jersey HMO and PPO operations make it the
fourth-largest HMO managed care provider in terms of membership in the state of
New Jersey. The Company's commercial HMO membership in New Jersey was 299,021
(including approximately 68,000 PHS members) as of
4
December 31, 1997. The Company's Medicare risk membership in New Jersey was
13,383 as of December 31, 1997 and the Company's Medicaid membership in New
Jersey was 21,442 as of December 31, 1997.
The Company believes its Florida HMO and PPO operations make it the
eighth-largest HMO managed care provider in terms of membership in the state of
Florida. The Company's commercial HMO membership in Florida was 93,714 as of
December 31, 1997 which represented an increase of 37% during 1997. The
Company's Medicare risk membership in Florida was 23,900 as of December 31, 1997
which represented a decrease of 6% during 1997. The Company's Medicaid
membership in Florida was 23,274 as of December 31, 1997, an 11% increase in
1997.
In New York, the Company's operations resulted from the acquisition of PHS.
The Company now has approximately 149,000 members in New York. The Company's HMO
and PPO operations in West Virginia and Ohio at this time are much smaller in
scope than its operations in the other states making up the Eastern Division.
WESTERN DIVISION. The Western Division currently includes Health Plan
operations in Arizona, Colorado, Idaho, Louisiana, New Mexico, Oklahoma, Oregon,
Texas, Utah and Washington. The Western Division also oversees the Company's six
health and life insurance companies licensed to sell insurance in 38 states and
the District of Columbia.
The Company's Washington HMO services Seattle and Spokane and also services
a limited number of residents who reside in the state of Idaho. The Company's
Oregon HMO services Portland and its vicinity. During 1997, the Company acquired
PACC, a Portland-based HMO with operations in Oregon and Washington. Portland,
Seattle and Spokane have experienced population growth rates greater than the
national average over the last several years. In addition, an increasing
percentage of the population in each of these areas has enrolled in HMOs in the
last several years. In Washington and Oregon, the Company believes that it ranks
sixth and fifth, respectively, with respect to total membership; the Company
believes that it ranks first in Washington and third in Oregon with respect to
the size of its primary care physician and specialist networks. The Company's
commercial HMO and PPO membership in Oregon was 163,406 (including 108,000 prior
PACC members) as of December 31, 1997. At year end 1996 the Company had 50,809
commercial members in Oregon. The Company's commercial HMO and PPO membership in
Washington was 94,937 as of December 31, 1997 which represented a decrease of 1%
during 1997. The Company's Medicare risk membership in Washington was 3,194 as
of December 31, 1997 which represented an increase of 14% during 1997. The
Company's Medicaid membership in Washington was 25,076 as of December 31, 1997
which represented an increase of 56% during 1997.
The Western Division also services the southwest region of the United
States, with operations in Arizona, Colorado, Louisiana, New Mexico, Oklahoma,
Texas and Utah. The Company's employer groups in the southwest consist
predominantly of companies with fewer than 50 employees, except for Arizona, in
which the Company's operations are dominated by large employer groups. During
1997, the Company merged its two Colorado HMOs, QualMed Plans for Health of
Colorado, Inc. and Foundation Health, A Colorado Health Plan, Inc. The Company
believes that the resulting HMO is the fourth largest HMO in Colorado as
measured by total membership. The Company's commercial HMO membership in
Colorado (including both the QualMed and Foundation plans) was 76,255 as of
December 31, 1997 which represented an increase of 5% during 1997. The Company's
Medicare membership in Colorado was 12,272 as of December 31, 1997 which
represented an increase of 6% during 1997. In New Mexico, the Company believes
that its ranks fourth, as measured by total membership and the size of its
provider network. The Company's commercial HMO membership in New Mexico was
34,130 as of December 31, 1997 which represented a decrease of 11% during 1997.
The Company's Medicare risk membership in New Mexico was 2,310 as of December
31, 1997 which represented an increase of 12% during 1997.
In Arizona, the Company believes that its commercial managed care operations
rank it first as measured by total membership and second as measured by the size
of its provider network. The Company's commercial HMO membership in Arizona was
304,653 as of December 31, 1997. The Company's
5
Medicare risk membership in Arizona was 47,455 as of December 31, 1997 which
represented an increase of 10% during 1997.
Collectively, the Company's commercial HMO membership in Texas, Oklahoma,
Louisiana and Utah was 43,279 as of December 31, 1997. The Company's Medicaid
risk membership in these states was 24,714 as of December 31, 1997, a 26%
decrease in 1997. As noted below in the section of this Annual Report on Form
10-K entitled "Discontinued Operations and Anticipated Divestitures," the
Company is presently reviewing possible exit strategies for its HMO operations
in Texas, Oklahoma and Louisiana.
MEDICARE RISK. The Company expanded its Medicare risk business in 1997
through the addition of 49,419 Medicare risk enrollees and, as of December 31,
1997, the Company's Medicare risk plans had a combined membership of
approximately 309,333. The Company expects its Medicare risk business to
continue to increase in the future.
The Company offers its Medicare risk products directly to individuals and to
employer groups. To enroll in a Company Medicare risk plan covered persons must
be eligible for Medicare. Health care services normally covered by Medicare are
provided or arranged for by the Company, in conjunction with a broad range of
preventive health care services. The federal Health Care Financing
Administration ("HCFA") pays to the Company for each enrolled member a monthly
fee based, in part, upon the "Adjusted Average Per Capita Cost," as determined
by HCFA's analysis of fee-for-service costs related to beneficiary demographics.
Depending on plan design and other factors, the Company may charge a member a
premium or prepaid charge.
The Company's California Medicare risk product, Seniority Plus, was licensed
and certified to operate in 36 California counties as of December 31, 1997. The
Company's other HMOs are licensed and certified to offer Medicare risk plans in
8 counties in Colorado, 5 counties in New Mexico, 6 counties in Washington, 6
counties in Pennsylvania, 18 counties in Oregon, 8 counties in Connecticut, 6
counties in Arizona, 3 counties in Florida and 41 counties in New York and New
Jersey.
MEDICAID PRODUCTS. As of December 31, 1997, the Company had an aggregate of
approximately 443,043 Medicaid members, principally in California. To enroll in
these Medicaid products, an individual must be eligible for Medicaid benefits
under the appropriate state regulatory requirements. These HMOs offer, in
addition to standard Medicaid coverage, certain additional services including
dental and vision benefits. The applicable state agency pays the Company's HMOs
a monthly fee for each Medicaid member enrolled on a percentage of
fee-for-service costs. The Company has Medicaid members and operations in
California, Connecticut, Florida, New Jersey, New York, Oklahoma, Oregon, Texas
and Washington.
ADMINISTRATIVE SERVICES ONLY BUSINESS. The Company also provides third
party administrative services to large employer groups throughout its service
areas. Under these arrangements, the Company provides claims processing,
customer service, medical management and other administrative services without
assuming the risk for medical costs. The Company is generally compensated for
these services on a fixed per member per month basis.
INDEMNITY INSURANCE PRODUCTS. The Company offers indemnity products as part
of multiple option products in various markets. These products are offered by
the Company's six health and life insurance subsidiaries which are licensed to
sell insurance in 38 states and the District of Columbia. Through these
subsidiaries, the Company also offers HMO members certain auxiliary non-health
products such as group life, accidental death and disability and short-term
disability insurance, in conjunction with its managed care products.
Although the Western Division oversees the Company's health and life
insurance operations, such operations' products are provided throughout all of
the Company's service areas. The following table contains certain information
relating to such health and life insurance companies' insured PPO, point of
6
service ("POS"), indemnity, group life and disability products as of December
31, 1997 in each of the three Health Plan Divisions in which the Company
operates:
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
----------- --------- -----------
Insured PPO Members.......................................... 32,530 78,349 6,770
Point of Service Members..................................... 90,864 30,786 0
Indemnity Members............................................ 9,277 9,855 0
Group Life Members........................................... 80,876 70,594 811
Disability Product Members................................... 442 12,997 0
SPECIALTY SERVICES DIVISION
The Company's Specialty Services Division offers behavioral health, dental,
vision, and pharmaceutical products and services as well as managed care
products related to bill review, administration and cost containment for
hospitals, health plans and other entities.
DENTAL AND VISION. Through DentiCare of California, Inc. ("DentiCare"), the
Company operates a dental HMO in California, Hawaii and Oklahoma and dental
administrative services in California and Colorado, serving approximately
633,000 enrollees as of December 31, 1997. This enrollment includes 206,000
enrollees who are beneficiaries under Medicaid dental programs, 142,000
enrollees who are also enrollees of affiliated Health Plan companies, 41,000
enrollees who are beneficiaries of Hawaii's Medicaid program and 23,000
enrollees who are beneficiaries under Medicaid contracts held by non-affiliated
third parties. DentiCare is also a participant in California's Healthy Families
Program, with initial beneficiary enrollment and service delivery commencing in
July 1998. Acquired by the Company in 1991, DentiCare has grown from total
revenues in 1992 of $24 million to $49 million for the year ended December 31,
1997.
Operating on administrative and information system platforms in common with
DentiCare is Foundation Health Vision Services, Inc., d.b.a. AVP Vision Services
("AVP"). AVP operates in four states and provides at-risk and administrative
services under various programs that result in the delivery of vision benefits
to over 675,000 enrollees. Total revenues from AVP operations for the year ended
December 31, 1997 exceeded $14 million. Since its acquisition by the Company in
1992, AVP has grown from 30,000 covered enrollees to 415,000 enrollees in
full-risk products and 262,000 enrollees covered under administrative services
contracts as of December 31, 1997.
Both DentiCare and AVP are licensed in California under the Knox-Keene
Health Care Service Plan Act of 1975, as amended (the "Knox-Keene Act") as
Specialized Health Care Service Plans, and compete with other HMOs, traditional
insurance companies, self-funded plans, PPOs and discounted fee-for-service
plans. The two companies share a common strategy to maximize the value and
quality of managed dental and vision care services while appropriately balancing
financial risk assumption among providers, enrollees and other entities to
achieve the effective and efficient use of available resources.
BEHAVIORAL HEALTH. The Company's subsidiaries organized under Managed
Health Network ("MHN") and Foundation Health PsychCare Services, Inc. ("FHPS"),
each licensed in California under the Knox-Keene Act as Specialized Health Care
Service Plans, offer managed behavioral health, employee assistance programs
("EAP") and substance abuse programs. MHN and FHPS, directly and through
Specialty Division affiliates, offer these programs on an insured and
self-funded basis to employers, governmental entities and other payors in
various states.
These products and services were provided to over 7.5 million individuals in
the year ended December 31, 1997, with approximately 2.96 million individuals
under risk-based programs, approximately 1.1 million individuals under
self-funded programs and approximately 3.47 million individuals under EAP
programs.
7
The Company expects to effect the corporate merger of FHPS and MHN in 1998,
pending regulatory approvals.
MHN provides managed behavioral health programs to employers, governmental
agencies and public entitlement programs, such as CHAMPUS and Medicaid. Employer
group sizes range from Fortune 100 to mid-sized companies with 200 employees.
MHN's strategy is to continue its market share achievement in the Fortune 500,
health plan and CHAMPUS markets through a combination of direct and consultant/
broker sales. MHN intends to achieve additional market share by capitalizing on
competitor consolidation, remaining CHAMPUS procurement opportunities and the
growing state and county Medicaid behavioral carve-outs, funded on either a risk
or ASO basis.
PHARMACY BENEFIT MANAGEMENT. The Company has developed a significant,
free-standing capability to manage drug benefit quality and cost through its
pharmacy benefit management ("PBM") subsidiary, Integrated Pharmaceutical
Services, Inc. ("IPS"). Through its formulary programs, its national network of
contract pharmacies and its discount-rebate contracts with drug manufacturers,
IPS provides PBM services to over 13 million individuals enrolled in various
contracted health benefit and insurance programs. By linking utilization data
with formulary and rebate contracts with manufacturers, IPS strives to effect
the equivalent of significant bulk purchase discounts for its customers and
their enrollees. IPS has maintained pharmacy cost trends at 10% for the past two
calendar years for the Company's California health plan while pharmacy trends
for the state and the nation were significantly higher.
The management of IPS believes there currently exist significant growth
opportunities for PBMs that excel at flattening the drug cost trend for managed
care organizations and employer groups. The components of excellence are
knowledge-based programs such as turn key clinical intervention programs and
successfully leveraging pharmacy buying power. These are the strengths upon
which IPS is attempting to build.
BILL REVIEW SERVICES. The Company also provides third party administration
and bill review services with respect to workers's compensation claims primarily
to self-insured employers, and operates a medical review and cost-containment
business for the workers' compensation industry primarily within California.
These operations were previously part of the Company's Workers' Compensation
Division, the risk-based operations of which division the Company has recently
determined to discontinue.
GOVERNMENT OPERATIONS DIVISION
CHAMPUS. The Company's wholly-owned subsidiary, Foundation Health Federal
Services, Inc. ("Federal Services"), administers large, multi-year managed care
federal contracts for the United States Department of Defense (the "DoD").
Federal Services currently administers health care contracts for DoD's
TRICARE program covering 1.9 million eligible individuals under the Civilian
Health and Medical Program of the Uniformed Services ("CHAMPUS"). Through the
federal government's TRICARE program, Federal Services provides CHAMPUS families
with improved access to primary health care, lower out-of-pocket expenses and
fewer claims forms. Federal Services currently administers three TRICARE
contracts for five regions that cover the following states:
- Region 11: Washington, Oregon and part of Idaho
- Region 6: Texas, Arkansas, Oklahoma and part of Louisiana
- Regions 9, 10 & 12: California, Hawaii, Alaska and part of Arizona
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Region 11 contract increased by 9% to 113,748 while the
total estimated number of eligible beneficiaries decreased by 2% to 237,488.
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Region 6 contract increased by 28% to 266,899 while the
8
total estimated number of eligible beneficiaries decreased by 1% to 626,267.
During 1997, enrollment of CHAMPUS beneficiaries in the HMO option of the
TRICARE program for the Regions 9, 10 and 12 contract increased by 45% to
332,103 while the total estimated number of eligible beneficiaries increased by
7% to 759,472 due to the addition of Alaska to the contract.
Under the TRICARE contracts, Federal Services shares health care cost risk
with the DoD for both gains and losses. Federal Services subcontracts to
affiliated and unrelated third parties for the administration and health care
risk of parts of these contracts. If all option periods are exercised by the DoD
and no extensions of the performance period are made, health care delivery ends
on February 29, 2000 for the Region 11 contract, on October 31, 2000 for the
Region 6 contract and on March 31, 2001 for the Regions 9, 10 and 12 contract.
Federal Services expects to compete for the rebid of all of these contracts.
Federal Services protested to the U.S. General Accounting Office (the "GAO")
concerning the awards of TRICARE contracts for Region 1 (northeast states) and
for Regions 2 and 5 (mid-Atlantic and mid-west states) to competitors of Federal
Services. The GAO sustained the protests and recommended that the DoD conduct
another round of competition for these contracts. The DoD filed petitions for
reconsideration of the protest decision by the GAO and the GAO is currently
considering those petitions. If the petitions are denied and the protest
decisions are upheld, Federal Services expects to compete again for these
contracts.
MEDICARE AND MEDICAID. As described earlier in this Annual Report on Form
10-K, the Company also contracts with federal and state governments to provide
managed Medicare and Medicaid health care programs. As of December 31, 1997, the
total number of Medicare risk enrollees in the Company's Medicare HMO operations
exceeded 309,000 members. As of December 31, 1997, the total number of Medicaid
risk enrollees in the Company's Medicaid HMO operations exceeded 443,000
members.
During 1997, Federal Services administered contracts with the states of
Massachusetts, New Jersey, Georgia, Maryland and Maine to enroll Medicaid
eligible individuals in managed care programs within such states. Federal
Services is not at risk for the provision of any health care services under
these contracts. The contract with the state of Maine expired on December 31,
1997. Federal Services entered into an agreement with MAXIMUS, Inc., effective
December 24, 1997, to sell the contracts for Massachusetts, New Jersey, Georgia
and Maryland. Federal Services is presently in discussions with these four
states to transfer these contracts to MAXIMUS, Inc.
WORKERS' COMPENSATION SEGMENT
The Company's Workers' Compensation segment applies the Company's managed
care concepts, such as use of specialized preferred provider networks and health
care utilization review, to the operations of its workers' compensation
subsidiaries. The Company's workers' compensation insurance companies consist of
the following entities: California Compensation Insurance Company, a specialty
workers' compensation carrier writing business primarily in California; Business
Insurance Company, a national workers' compensation specialty carrier;
Commercial Compensation Insurance Company, licensed to write multiple lines of
business in approximately 47 states; and Combined Benefits Insurance Company,
writing single source workers' compensation and group health insurance primarily
in California. As noted below in the section of this Annual Report on Form 10-K
entitled "Discontinued Operations and Anticipated Divestitures," the Company has
recently determined to discontinue its risk-based workers' compensation
operations.
PROVIDER RELATIONSHIPS AND RESPONSIBILITIES
PHYSICIAN RELATIONSHIPS. Upon enrollment in most of the Company's HMO
plans, each member selects a participating physician group ("PPG") or primary
care physician from the HMO's provider panel. The primary care physicians and
PPGs assume overall responsibility for the care of members. Medical care
provided directly by such physicians includes the treatment of illnesses not
requiring referral, as well as physical examinations, routine immunizations,
maternity and child care and other preventive health
9
services. The primary care physicians and PPGs are responsible for making
referrals (approved by the HMO's or PPG's medical director) to specialists and
hospitals. Certain Company HMOs offer enrollees "open panels" under which
members may access any physician in the network without first consulting a
primary care physician.
The following table sets forth the number of primary care and specialist
physicians with whom the Company's HMOs (and certain of such HMOs' PPGs)
contracted as of December 31, 1997 in each of the three Health Plan Divisions of
the Company:
CALIFORNIA WESTERN EASTERN
DIVISION DIVISION DIVISION
----------- ----------- -----------
Primary Care Physicians....................................... 11,797 9,692 22,360
Specialist Physicians......................................... 23,613 26,795 23,783
----------- ----------- -----------
Totals........................................................ 35,410 36,487 46,143
PPG and physician contracts are generally for a period of at least one year
and are automatically renewable unless terminated, with certain requirements for
maintenance of good professional standing and compliance with the Company's
quality, utilization and administrative procedures. In California and Arizona,
PPGs or primary care physicians generally receive a monthly "capitation" fee for
every member served. The capitation fee represents payment in full for all
medical and ancillary services specified in the provider agreements. The
non-physician component of all hospital services is covered by a combination of
capitation and/or per diem charges. In such capitated arrangements, in cases
where the capitated provider cannot provide the health care services needed,
such providers generally contract with specialists and other ancillary service
providers to furnish the requisite services pursuant to capitation agreements or
negotiated fee schedules with specialists. Many of the Company's HMOs outside
California and Arizona reimburse physicians according to a discounted
fee-for-service schedule, although several HMOs have commenced capitation
arrangements with certain providers and provider groups in their market areas.
HOSPITAL RELATIONSHIPS. The Company's HMOs arrange for hospital care
primarily through contracts with selected hospitals in their service areas. Such
hospital contracts generally provide for multi-year terms, with limited annual
reimbursement increases, and provide for payments on a variety of bases,
including capitation, per diem rates, case rates and discounted fee-for-service
schedules.
Covered inpatient hospital care for a member is comprehensive; it includes
the services of physicians, nurses and other hospital personnel, room and board,
intensive care, laboratory and x-ray services, diagnostic imaging and generally
all other services normally provided by acute-care hospitals. HMO or PPG nurses
and medical directors are actively involved in discharge planning and case
management, which often involves the coordination of community support services,
including visiting nurses, physical therapy, durable medical equipment and home
intravenous therapy.
The Company owns and operates a 128-bed hospital located in Los Angeles,
California, the East Los Angeles Doctors Hospital, and a 200-bed hospital
located in Gardena, California, the Memorial Hospital of Gardena. As noted below
in the section of this Annual Report on Form 10-K entitled "Discontinued
Operations and Anticipated Divestitures," the Company is reviewing the
feasibility of divesting direct ownership of these hospitals.
COST CONTAINMENT. In most HMO plan designs, the primary care physician or
PPG is responsible for authorizing all needed medical care except for emergency
medical services. By coordinating care through such physicians in cases where
reimbursement includes risk-sharing arrangements, the Company believes that
inappropriate use of medical resources is reduced and efficiencies are achieved.
To limit possible abuse in utilization of hospital services in non-emergency
situations, a certification process precedes the inpatient admission of each
member, followed by continuing review during the
10
member's hospital stay. In addition to reviewing the appropriateness of hospital
admissions and continued hospital stay, the Company plays an active role in
evaluating alternative means of providing care to members and encourages the use
of outpatient care, when appropriate, to reduce the cost that would otherwise be
associated with an inpatient admission.
QUALITY ASSURANCE. Quality assurance is a continuing priority for the
Company. Most of the Company's HMOs have a quality assurance plan administered
by a committee comprised of medical directors and primary care and specialist
physicians. The committees' responsibilities include periodic review of medical
records, development and implementation of standards of care based on current
medical literature and community standards, and the collection of data relating
to results of treatment. All of the Company's HMOs also have a subscriber
grievance procedure and/or a member satisfaction program designed to respond
promptly to member grievances. Aspects of such member service programs take
place both within the PPGs and within the Company's HMOs. Set forth under the
heading "National Committee for Quality Assurance" below is information
regarding certain quality assurance accreditations received by the Company's
subsidiaries.
MANAGEMENT INFORMATION SYSTEMS
Effective information technology systems are critical to the Company's
operation. The Company's information technology systems include several computer
systems, each utilizing a combination of packaged and customized software and a
network of on-line terminals. The information technology systems gather and
store data on the Company's members and physician and hospital providers. The
systems contain all of the Company's necessary membership and claims-processing
capabilities as well as marketing and medical utilization programs. These
systems provide the Company with an integrated and efficient system of billing,
reporting, member services and claims processing and the ability to examine
member encounter information for the optimization of clinical outcomes.
In 1995, the Company embarked on a multi-year project to develop and install
a new information system designed to facilitate the seamless management of
patients throughout the entire health care continuum. This "Fourth Generation
Medical Management" project (the "4-G System") upon implementation would include
regional data repositories containing clinical and demographic data about each
of the Company's health plan members, which data serves as the basis for
enhanced clinical decision making. Physicians, hospitals and the Company's case
managers would have access to expert systems and an ever-expanding library of
clinical protocols which help in optimizing the diagnosis and treatment
decisions for each health plan member.
The Comprehensive Member Support Center ("Member Support Center"), located
in the Philadelphia area, is a sophisticated telecommunications center staffed
by experienced nurses that is the Company's initial application of the 4-G
System. Each Member Support Center nurse has access to member-specific health
information. In addition, expert clinical algorithms, developed by physicians at
leading hospitals and academic medical centers, guide nurse interactions with
members. As calls from members come into the center, the nurse can retrieve
detailed member and provider information and use the expert algorithms to guide
members to the most appropriate level of care for their condition. Outbound
activities of the call center includes clinical reminder calls to members and
consultive support for self-care protocols and educational materials. Whenever a
member accesses the center, his or her primary care physician receives a
follow-up report by fax, ensuring continuity of care.
When first introduced, the Member Support Center served only members in the
Philadelphia plan. Today, the Member Support Center serves more than three
million FHS members in 13 states. In 1998, it is anticipated that the members of
PHS and the Company's Arizona plan will be added to the center. The clinical
nurses at the center today are handling approximately 1,300 phone calls each day
from the Company's members. They interact with members 24 hours a day, seven
days a week, to help ensure that members have access to the right provider in
the right setting--no matter where they are in the United
11
States. The Company is contemplating the creation of regional centers similar to
the Member Support Center which it believes will further strengthen the
connection between members and the Company.
The Company believes the Member Support Center is the most sophisticated
telecommunications system in the managed care industry today. The Company sees
it as a critical competitive advantage, especially in the Northeastern United
States where FHS offers "open access" health plans.
The Company also recognizes that the arrival of the Year 2000 poses a
challenge to the ability of computer systems to recognize the date change from
1999 to 2000 (the "Year 2000 Issue") and has begun to assess and modify its
computer applications and business processes to provide for their continued
functionality given the Year 2000 Issue. The Year 2000 Issue is the result of
computer programs being written using two digits rather than four to define the
applicable year. Any of the Company's computer programs (both external and
internal) that have time sensitive software may recognize a date using "00" as
the year 1900 rather than the year 2000. This could result in a system failure
or material miscalculations causing disruptions of operations, including, among
other things, the inability to process transactions, prepare invoices or engage
in normal business activities.
The costs of the Company's Year 2000 Issue projects and the timetable in
which the Company plans to complete the Year 2000 Issue compliance requirements
are set forth elsewhere in this Annual Report on Form 10-K and are based on
estimates derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors.
DISCONTINUED OPERATIONS AND ANTICIPATED DIVESTITURES
The Company revised its strategy of maintaining a presence in the workers'
compensation insurance business as a result of various adverse developments
arising in 1997 in the workers' compensation insurance business, primarily
related to the workers' compensation claims environment in California. As
discussed elsewhere in this Annual Report on Form 10-K, such adverse
developments caused the Company's workers' compensation reserves to be
inadequate which required the Company to strengthen such reserves at the end of
1997. These developments also led the Company to adopt a plan to completely
discontinue this segment of its business, through divestiture of its workers'
compensation risk-assuming insurance subsidiaries. The Company is presently
conducting the sale of these businesses.
The Company is presently reviewing a possible plan to exit its HMO
operations in the states of Texas, Louisiana and Oklahoma due to inadequate
returns on invested capital. The Company is presently reviewing an exit strategy
for such states' businesses (including potential sale transactions). In December
1997 the Company also entered into a sale agreement to divest its
non-operational HMO license in Alabama to an unaffiliated third party.
The Company has decided to review the possibility of divesting its direct
ownership of two Southern California hospitals, a 128-bed hospital located in
Los Angeles, California, the East Los Angeles Doctors Hospital, and a 200-bed
hospital located in Gardena, California, the Memorial Hospital of Gardena.
Direct ownership of these two hospitals is not consistent with the Company's
business philosophy to manage health care through contracts with independent
providers of medical services. The Company is presently responding to inquiries
of parties which have expressed an interest in purchasing these hospitals.
12
The Company is also analyzing the strategic fit of its Denticare managed
dental operations with the ongoing operations and operating strategy of the
Company and, in this connection, whether a sale of such operations could be
completed consistent with the Company's interests.
In addition, effective June 30, 1997, the Company divested its United
Kingdom operations.
As set forth elsewhere in this Annual Report on Form 10-K, the Company
continues to evaluate the profitability realized or likely to be realized by its
existing businesses and operations, and is reviewing from a strategic standpoint
which of such businesses or operations should be divested.
ADDITIONAL INFORMATION CONCERNING THE COMPANY'S BUSINESS
MARKETING AND SALES. Marketing for group Health Plan business 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 a Company HMO.
The Company typically uses its internal sales staff to serve the large employer
groups while independent brokers work with the Company's internal sales staff to
develop business with smaller employer groups. Once selected by an employer, the
Company solicits enrollees from the employee base directly. In 1997, the Company
marketed its programs and services primarily through its direct sales staff and
independent brokers, agents and consultants. During "open enrollment" periods
when employees are permitted to change health care programs, the Company uses
direct mail, work day and health fair presentations, telemarketing, and outdoor,
print, radio and television advertisements to attract new enrollees. The
Company's sales efforts are supported by its marketing division which includes
research and product development, corporate communications, public relations and
marketing services.
Premiums for each employer group are generally contracted for on a yearly
basis, payable monthly. Numerous factors are considered by the Company in fixing
its monthly premiums, including employer group needs and anticipated health-care
utilization rates as forecasted by the Company's management based on the
demographic composition of, and the Company's prior experience in, its service
areas. Premiums are also affected by applicable regulations that prohibit
experience rating of group accounts (i.e., setting the premium for the group
based on its past use of health care services) and by state regulations
governing the manner in which premiums are structured.
The Company believes that the importance of the ultimate health care
consumer (or member) in the health care product purchasing process is likely to
increase in the future. Accordingly, the Company intends to focus its marketing
strategies on the development of distinct brand identities and innovative
product service offerings that will appeal to potential Health Plan members.
COMPETITION. HMOs operate in a highly competitive environment in an
industry currently subject to significant changes from business consolidations,
new strategic alliances, legislative reform and market pressures brought about
by a better informed and better organized customer base. The Company's HMOs face
substantial competition from for-profit and nonprofit HMOs, PPOs, self-funded
plans (including self-insured employers and union trust funds), Blue Cross/Blue
Shield plans and traditional indemnity insurance carriers, some of which have
substantially larger enrollments and greater financial resources than the
Company. The Company believes that the principal competitive features affecting
its ability to retain and increase membership include the range and prices of
benefit plans offered, provider network, quality of service, responsiveness to
user demands, financial stability, comprehensiveness of coverage, diversity of
product offerings and market presence and reputation. The relative importance of
each of these features and key competitors vary by market. The Company believes
that it competes effectively with respect to all of these factors.
Kaiser Foundation Health Plan ("Kaiser") is the largest HMO in California
and in the United States and the Company's principal competitor in the
California HMO industry. In addition to Kaiser, the Company's other HMO
competitors include PacifiCare of California (which recently purchased FHP
Health Plan), California Care (Blue Cross) and CIGNA Healthplans of California,
Inc. In addition, there
13
are a number of other types of competitors including self-directed plans,
traditional indemnity insurance plans and other managed care plans.
The Company competes in California for employers and members against other
HMOs, self-funded plans, traditional health insurers and a variety of PPOs. The
establishment of PPOs has been encouraged by legislation in California that
enables insurance companies to negotiate fees with health care providers and to
extend economic incentives to insureds to utilize such providers without
significant legal restrictions. However, the California Department of
Corporations (the "DOC"), which regulates all California HMOs, has interpreted
California law to prohibit California PPOs that lack an HMO license from
compensating providers on a capitated or other prepaid or periodic basis unless
those providers themselves have an HMO license. Thus, only HMOs may legally
enter into such financial arrangements with providers, while PPOs are limited to
fee-for-service arrangements.
The Company's Colorado HMO competes primarily against other HMOs including
Kaiser and PacifiCare of Colorado, as well as with a Blue Cross/Blue Shield HMO,
other commercial carriers and various hospital or physician-owned HMOs. The
Company's largest competitor in New Mexico is Presbyterian Health Plan. The
Company's New Mexico HMO also competes with Lovelace Health Plan (an HMO owned
by CIGNA Corporation) and Blue Cross/Blue Shield. The Company's largest
competitor in Arizona is Health Partners. The Company's Arizona HMO also
competes with CIGNA, PacifiCare, Aetna, and Blue Cross/Blue Shield. In Utah, the
Company competes with Intermountain Health Plan and PacifiCare, among other
companies.
The Company's Oregon HMO competes primarily against other HMOs including
Kaiser, PacifiCare of Oregon, The Good Health Plan, and a Blue Cross/Blue Shield
HMO, and with various PPOs. The Company's Washington HMO competes primarily with
Group Health Cooperative of Puget Sound, Kaiser, HealthPlus (Blue Cross), and
with commercial carriers, self-funded plans and other Blue Cross/Blue Shield
organizations.
The Company's HMOs in Connecticut compete for business with commercial
insurance carriers, Blue Cross and Blue Shield of Connecticut and more than ten
HMOs. The Company's main competitors in Pennsylvania, New York and New Jersey
are Aetna/U.S. Healthcare, Independence Blue Cross, Empire Blue Cross, Oxford
Health Plans, AmeriHealth and Keystone East. The Company's HMO operations in
Florida compete for business with Humana Medical Plan, United HealthCare, Health
Options, and Prudential HealthCare, among others.
GOVERNMENT REGULATION. The Company believes it is in compliance in all
material respects with all current state and federal regulatory requirements
applicable to the business to be conducted by its subsidiaries. Certain of these
requirements are discussed below.
FEDERAL HMO STATUTES. Under the Federal Health Maintenance Organization Act
of 1973 (the "HMO Act"), services to members must be provided substantially on a
fixed, prepaid basis without regard to the actual degree of utilization of
services. Although premiums established by an HMO may vary from account to
account through composite rate factors and special treatment of certain broad
classes of members, traditional experience rating of accounts (i.e.,
retrospective adjustments for a group account based on that group's past use of
health care services) is not permitted under the HMO Act; prospective rating
adjustments are, however, allowed. Several of the Company's HMOs are federally
qualified in certain parts of their respective service areas under the HMO Act
and are therefore subject to the requirements of such act to the extent
federally qualified products are offered and sold.
Additionally, there are a number of proposed federal laws currently before
Congress to further regulate managed health care. The Company cannot predict the
ultimate fate of any of these legislative proposals. The Company's Medicare risk
contracts are subject to regulation by HCFA. HCFA has the right to audit HMOs
operating under Medicare contracts to determine the quality of care being
rendered and the degree of compliance with HCFA's contracts and regulations.
14
CALIFORNIA HMO REGULATIONS. California HMOs such as Health Net and certain
of the Company's specialty plans are subject to state regulation, principally by
the DOC under the Knox-Keene Health Care Service Plan Act of 1975, as amended
(the "Knox-Keene Act"). Among the areas regulated by the Knox-Keene Act are: (i)
adequacy of administrative operations, (ii) the scope of benefits required to be
made available to members, (iii) manner in which premiums are structured, (iv)
procedures for review of quality assurance, (v) enrollment requirements, (vi)
composition of policy making bodies to assure that plan members have access to
representation, (vii) procedures for resolving grievances, (viii) the
interrelationship between HMOs and their health care providers, (ix) adequacy
and accessibility of the network of health care providers, (x) provider
contracts and (xi) initial and continuing financial viability. Any material
modifications to the organization or operations of Health Net are subject to
prior review and approval by the DOC. This approval process can be lengthy and
there is no certainty of approval. In addition, under the Knox-Keene Act, Health
Net and certain other Company subsidiaries must file periodic reports with, and
are subject to periodic review by, the DOC.
Currently, the California legislature is considering a number of significant
managed health care measures which could materially alter California's
regulatory environment. Among such measures are proposals to establish an
entirely new regulatory structure for managed care, in lieu of the DOC. Other
legislative proposals focus on medical care dispute resolution mechanisms,
medical malpractice liability, and plan enrollee notification about plan
provisions and coverage. The Company cannot predict the ultimate fate of any of
these legislative proposals in California.
OTHER HMO REGULATIONS. In each state in which the Company does business,
HMOs must file periodic reports with, and their operations are subject to
periodic examination by, state licensing authorities. In addition, each HMO must
meet numerous state licensing criteria and secure the approval of state
licensing authorities before implementing certain operational changes, including
the development of new product offerings and, in some states, the expansion of
service areas. To remain licensed, each HMO must continue to comply with state
laws and regulations and may from time to time be required to change services,
procedures or other aspects of its operations to comply with changes in
applicable laws and regulations. HMOs are required by state law to meet certain
minimum capital and deposit and/or reserve requirements in each state and may be
restricted from paying dividends to their parent corporations under certain
circumstances from time to time. Several states have increased minimum capital
requirements, which increases are typically phased in over a period of time.
Regulations in these and other states may be changed in the future to further
increase equity requirements. Such increases could require the Company to
contribute additional capital to its HMOs. Any adverse change in governmental
regulation or in the regulatory climate in any state could materially impact the
HMOs operating in that state. The HMO Act and state laws place various
restrictions on the ability of HMOs to price their products freely. The Company
must comply with certain provisions of certain state insurance and similar laws,
especially as it seeks ownership interests in new HMOs, PPOs and insurance
companies, or otherwise expands its geographic markets or diversifies its
product lines.
INSURANCE REGULATIONS. State departments of insurance (the "DOIs") regulate
insurance and third party administrator business conducted by certain
subsidiaries of the Company (the "Insurance Subsidiaries") pursuant to various
provisions of state insurance codes and regulations promulgated thereunder. The
Insurance Subsidiaries are subject to various capital reserve and other
financial requirements established by the DOIs. The Insurance Subsidiaries must
also file periodic reports regarding their activities regulated by the DOIs and
are subject to periodic reviews of those activities by the DOIs. The Company
must also obtain approval from or file with the DOIs for all of its group and
individual policies prior to issuing those policies. The Company does not
believe that the requirements imposed by the DOIs will have a material impact on
the ability of the Insurance Subsidiaries to conduct their business profitably.
NATIONAL COMMITTEE FOR QUALITY ASSURANCE ("NCQA"). NCQA, an independent,
non-profit organization that reviews and accredits HMOs, assesses an HMO's
quality improvement, utilization management,
15
credentialing process, commitment to members' rights and preventive health
services. HMOs that comply with NCQA's review requirements and quality standards
receive NCQA accreditation. After an NCQA review is completed, NCQA will issue
one of four designations. These are (i) accreditation for three years; (ii)
accreditation for one year; (iii) provisional accreditation for twelve to
eighteen months to correct certain problems with a follow-up review to determine
qualification for accreditation; and (iv) not accredited. Intergroup, the
Company's HMO in Arizona, has received NCQA accreditation for three years.
Health Net, PHS, Foundation Health, a Florida Health Plan, QualMed Pennsylvania,
QualMed Plans for Health of Colorado, and QualMed, a Washington Health Plan have
all received one year accreditation from NCQA. Certain of the Company's other
Health Plan subsidiaries are in the process of applying for NCQA accreditation.
SERVICE MARKS
The Company's service marks and/or trademarks include, among others: THE
ACUTE CARE ALTERNATIVE-Registered Trademark-, Alliance 2000-SM-, Alliance
1000-SM-, Asthmawise-SM-, AVP-SM-, AVP Vision Plans-SM-, BabyWell-SM-, BEING
WELL-Registered Trademark-, CARECAID-Registered Trademark-,
CMP-Registered Trademark-, COMBINED CARE-REGISTERED TRADEMARK-, COMBINED CARE
PLUS-SM-, COMMUNITY MEDICAL PLAN, INC. and design-Registered Trademark-, A CURE
FOR THE COMMON HMO-Registered Trademark-, Feetbeat Worksite Walking Program-SM-,
FIRM SOLUTIONS-Registered Trademark-, FLEX ADVANTAGE-Registered Trademark-, FLEX
NET-SM-, FOUNDATION HEALTH and design-Registered Trademark-, FOUNDATION HEALTH
GOLD-Registered Trademark-, Foundation Health Systems-SM-, GOOD HEALTH IS JUST
AROUND THE CORNER-Registered Trademark-, HANK-Registered Trademark-, HANK and
design-Registered Trademark-, HEALTH NET-Registered Trademark-, Health Net
ACCESS-SM-, Health Net Comp.24-SM-, Health Net ELECT-SM-, Health Net
INSIGHT-SM-, Health Net OPTIONS-SM-, Health Net SELECT-SM-, Health Net Seniority
Plus-SM-, Health Smart and design-SM-, Healthworks (stylized)-SM-, Heart &
Soul-SM-, IMET and design-Registered Trademark-, Indian
design-Registered Trademark-, INDIVIDUAL PREFERRRED PPO-Registered Trademark-,
InterCare-SM-, InterComp-SM-, InterFlex-SM-, Inter Mountain Employers Trust-SM-,
InterPlus-SM-, LIFE WITH DIGNITY AND HOPE-Registered Trademark-, MAKING QUALITY
HEALTH CARE AFFORDABLE-Registered Trademark-, M.D. Health Plan Personal Medical
Management-SM-, On the Road to Good Health-SM-, PHYSICIANS HEALTH
SERVICES-Registered Trademark-, Premier Medical Network-SM-, Premier Medical
Network It's Your Choice-SM-, QUALASSIST-Registered Trademark-,
QUALADMIT-Registered Trademark-, QUALCARE-Registered Trademark-, QUALCARE
PREFERRED-Registered Trademark-, QUAL-MED-Registered Trademark-, QUALMED-SM-,
QUALMED HEALTH & LIFE INSURANCE COMPANY-Registered Trademark-, QUALMED PLANS FOR
HEALTH-Registered Trademark-, Rapid Access-SM-, SENIOR
SECURITY-Registered Trademark-, SENIOR VALUE-Registered Trademark-, Someone at
Your Side-SM-, Sun/Mountain design-Registered Trademark-,The Final Piece of the
Healthcare Puzzle-SM-, VitalLine-SM-, VITALTEAM-Registered Trademark-, WELL
MANAGED CARE RIGHT FROM THE START-Registered Trademark-, WELL
REWARDS-Registered Trademark-, Well Woman-SM-, Wise Choice-SM-, WORKING WELL
TOGETHER-Registered Trademark- and Your Partner in Healthy Living-SM- and
certain designs related to the foregoing.
The Company utilizes these and other marks in connection with the marketing
and identification of products and services. The Company believes such marks are
valuable and material to its marketing efforts.
EMPLOYEES
The Company currently employs approximately 15,200 employees. Such employees
perform a variety of functions, including administrative services for employers,
providers, and members, negotiation of agreements with physician groups,
hospitals, pharmacies and other health care providers, handling claims for
payment of hospital and other services and providing data processing services.
The Company's employees are not unionized and the Company has not experienced
any work stoppage since its organization. The Company considers its relations
with its employees to be very good.
As set forth elsewhere in this Annual Report on Form 10-K, in connection
with the FHS Combination the Company adopted a significant restructuring plan
which provides for a workforce reduction, the consolidation of employee benefit
plans and the consolidation of certain office locations.
16
ITEM 2. PROPERTIES
The Company owns its offices in Pueblo, Colorado and leases office space for
its principal executive offices in Woodland Hills and its offices in Rancho
Cordova, California.
The Pueblo facility, with approximately 72,000 square feet, is subject to a
mortgage in the aggregate principal amount of approximately $1 million. The
Company is also renovating three Pueblo properties which it obtained in 1996
with approximately 188,400 aggregate square feet and intends to receive public
funds for certain of such properties' renovation from the City and County of
Pueblo in return for certain employment commitments.
The Woodland Hills facility, with approximately 300,000 square feet, is
leased pursuant to a ten year base lease expiring in 2001 on an anchor
full-service gross basis with annual rent in 1997 of approximately $8.6 million.
The Company and its subsidiaries also lease an aggregate of approximately
550,000 square feet of office space in Rancho Cordova, California. The Company's
aggregate rent obligations under these leases were approximately $9.2 million in
1997. These leases expire at various dates through July 2002.
In addition to the Company's office space in Pueblo, Woodland Hills and
Rancho Cordova, the Company and its subsidiaries lease approximately 220 sites
in 27 states, comprising roughly 2.2 million square feet of space.
The Company owns in total approximately 1.7 million square feet of space.
The Company owns approximately 535,000 aggregate square feet of space for health
care centers in California and Arizona and approximately 249,000 square feet of
space for two hospitals in Southern California. The Company also owns
approximately a dozen office buildings, in Arizona, California, Colorado and
Connecticut, which collectively encompass about 840,000 square feet of space.
Management believes that its ownership and rental costs are consistent with
those available for similar space in the applicable local area. The Company's
properties are well maintained, considered adequate and are being utilized for
their intended purposes.
ITEM 3. LEGAL PROCEEDINGS
RESTRICTED STOCK DISPUTE
Following the conversion of Health Net to a for-profit subsidiary of the
Company (the "Conversion"), a restricted stock plan (the "Restricted Stock
Plan") was adopted and restricted shares of the Company ("Restricted Shares")
were issued to certain management employees of Health Net. In February 1993, the
DOC informed Health Net that it believed the issuance of Restricted Shares of
the Company to persons who were stockholders of the Company as of the date of
the Conversion (the "Restricted Share Recipients") violated certain provisions
and terms imposed by the DOC in connection with the Conversion. In March 1993,
the DOC insisted that such restricted shares be rescinded and stated that the
DOC would take steps necessary to revoke the approval of the Conversion if the
issuance of the Restricted Shares was not rescinded (the "Conditional Revocation
Order"). In April 1993 the Restricted Share Recipients agreed to rescind all of
the Restricted Shares issued to them, under express protest to the DOC.
Subsequently, certain of the Restricted Share Recipients filed a formal protest
with the DOC requesting a hearing regarding the correctness of the decision.
On September 14, 1994, Health Net, the Company and certain of the Restricted
Share Recipients, on behalf of all the Restricted Share Recipients (the
"Petitioners"), filed a Petition for Writ of Administrative Mandamus in the
Superior Court of the County of Los Angeles (Case No. BS030426) (the "Writ
Proceeding"). The Writ Proceeding sought to overturn the Conditional Revocation
Order and to require the Commissioner of the DOC to follow procedures set forth
in the Administrative Procedures Act which would result in an administrative
hearing regarding the correctness of the Conditional Revocation Order
17
or, in the alternative, to treat the Conditional Revocation Order as a final
agency action and to have the Court order the Commissioner of the DOC to rescind
the Conditional Revocation Order.
On May 25, 1995, the Petitioners filed an amended petition expanding the
original claims and adding a new cause of action for a declaratory judgment that
would revoke the rescission of the issuance of the Restricted Shares. The DOC
and the CWF filed new demurrers to the amended petition on July 3, 1995. At a
hearing on July 28, 1995, the Court sustained the demurrers without leave to
amend. On August 7, 1995, the Petitioners filed objections to the Court's
Statement of Decision. On August 15, 1995, the Court overruled the objections of
the Petitioners to the Court's Statement of Decision. On September 8, 1995, the
Court entered an Order of Dismissal, and the Amended Petition for Writ of
Mandate and Complaint for Declaratory Relief of the Petitioners was dismissed.
On September 19, 1995, the DOC served notice of the entry of the Order of
Dismissal. On October 18, 1995, the Petitioners filed a Notice of Appeal. The
opening brief was filed on March 15, 1996, and the Respondents' briefs were
filed on or around June 13, 1996. The reply briefs to the Respondents' briefs
were timely filed on August 19, 1996 and the Court set oral arguments on the
appeal for November 13, 1996.
On November 26, 1996, the California Court of Appeals entered an order
affirming the trial court decision. During the first week of January 1997, the
Petitioners filed a petition for review asking the California Supreme Court to
consider the matter. The DOC and the CWF filed oppositions to the petition for
review on January 21, 1997 and January 23, 1997, respectively. On March 12,
1997, the California Supreme Court issued a ruling denying the petition for
review. This case is now resolved.
MEDAPHIS CORPORATION
On November 7, 1996 the Company's predecessor HSI filed a lawsuit against
Medaphis Corporation ("Medaphis") and its former Chairman and Chief Executive
Officer Randolph G. Brown, entitled HEALTH SYSTEMS INTERNATIONAL, INC. V.
MEDAPHIS CORPORATION, RANDOLPH G. BROWN AND DOES 1-50, case number BC 160414,
Superior Court of California, County of Los Angeles. The lawsuit arises out of
the acquisition of Health Data Sciences Corporation ("HDS") by Medaphis. In July
1996, HSI, the owner of 1,234,544 shares of Series F Preferred Stock of HDS,
representing over sixteen percent of the total outstanding equity of HDS, voted
its shares in favor of the acquisition of HDS by Medaphis. HSI received as the
result of the acquisition 976,771 shares of Medaphis Common Stock in exchange
for its Series F Preferred Stock. Pursuant to the Merger Agreement, the Company
succeeded to the interests of HSI in the Medaphis lawsuit, and the Company has
been substituted for HSI as plaintiff in the suit.
In its complaint, the Company alleges that Medaphis was actually a poorly
run company with sagging earnings in its core business, and had artificially
maintained its stock prices through a series of acquisitions and accounting
maneuvers which provided the illusion of growth while hiding the reality of its
weakening financial and business condition. The Company alleges that Medaphis,
Brown and other insiders deceived the Company by presenting materially false
financial statements and by failing to disclose that Medaphis would shortly
reveal a "write off" of up to $40 million in reorganization costs and would
lower its earnings estimate for the following year, thereby more than halving
the value of the Medaphis shares received by the Company. The Company alleges
that these false and misleading statements were contained in oral communications
with the Company, as well as in the registration statement and the prospectus
provided by Medaphis to all HDS shareholders in connection with the HDS
acquisition. Further, despite knowing of the Company's discussions to form a
strategic alliance of its own with HDS, Medaphis and the individual defendants
wrongfully interfered with that prospective business relationship by proposing
to acquire HDS using Medaphis stock whose market price was artificially inflated
by false and misleading statements. The Company alleges that the defendants'
actions constitute violations of both federal and state securities laws, as well
as fraud and other torts under state law. The Company is seeking either
rescission of the transaction or damages in excess of $38 million. The
defendants have denied the allegations in the complaint, and the Company is
vigorously pursuing its claims against Medaphis.
18
Recently the Company moved to disqualify the law firm representing certain
of the individual defendants. The trial court granted the Company's motion, and
the law firm and its clients have appealed such decision. In addition, the trial
court granted a stay of the case until June 4, 1998 in order to permit the law
firm to appeal. The Company intends to press for an expedited appeal. Prior to
the stay the case was in the early stages of discovery. No trial date has yet
been set.
MONACELLI VS. GEM INSURANCE COMPANY
On December 29, 1994, a lawsuit entitled MARIO AND CHRISTIAN MONACELLI V.
GEM INSURANCE COMPANY, ET AL (Case No. CV94-20715) was initiated in Maricopa
County (Arizona) Superior Court against Gem Insurance Company, a subsidiary of
the Company ("Gem"), for bad faith and misrepresentation. Plaintiffs
subsequently asserted claims in the same action against their insurance agent,
Mark Davis, for negligence and misrepresentation. The Plaintiffs' claims arose
from the rescission of their health insurance policy based on their alleged
failure to disclose an X-ray, taken one year before the Plaintiffs filled out
their insurance application, which revealed an undiagnosed mass on Mr.
Monacelli's lung. Plaintiffs incurred approximately $70,000 in medical expenses
in connection therewith. Prior to trial, the agent recanted certain portions of
his deposition testimony and admitted that the Plaintiffs had told him that Mr.
Monacelli had undergone certain tests which were not revealed on the
application. Based on this new information, Gem paid the Plaintiffs' medical
expenses with interest.
The case went to trial in April of 1997 against Gem and the agent. A jury
verdict was ultimately rendered awarding the Plaintiffs $1 million in
compensatory damages and assessing fault 97% to Gem and 3% to the agent, Mark
Davis. In addition, the jury awarded $15 million in punitive damages against
Gem. Thereafter, the plaintiffs filed a motion seeking to recover an additional
$4 million in attorneys' fees, and Gem filed post-trial motions for judgment
notwithstanding the verdict, for a new trial and for remittitur of the jury
verdict. Gem's motion for judgment notwithstanding the verdict was denied. The
court granted Gem's motion for remittitur and remitted the jury verdict to an
award of $1 million in compensatory damages and $2 million in punitive damages.
The court further ordered that if the plaintiffs did not accept the remittitur
order, Gem's motion for new trial would be granted. The plaintiffs accepted the
court's remittitur. Their motion for attorneys' fees is currently pending.
Notwithstanding the plaintiffs' acceptance of the court's remittitur, Gem plans
to appeal the verdict.
In addition, on July 15, 1997 Gem filed a complaint against Mr. Davis and
his spouse in Maricopa County (Arizona) Superior Court (Case No. CV97-13053)
asserting a claim for indemnity against Mr. Davis with respect to the Monacelli
case.
MISCELLANEOUS PROCEEDINGS
The Company and certain of its subsidiaries are also parties to various
legal proceedings, many of which involve claims for coverage encountered in the
ordinary course of its business. Based in part on advice from litigation counsel
to the Company and upon information presently available, management of the
Company is of the opinion that the final outcome of all such proceedings should
not have a material adverse effect upon the Company's results of operations or
financial condition.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the security holders of the
Company, either through solicitation of proxies or otherwise, during the fourth
quarter of the year ended December 31, 1997.
19
OTHER INFORMATION
REVOLVING CREDIT FACILITY
On July 8, 1997 the Company entered into a Credit Agreement with the banks
identified therein (the "Banks") and Bank of America National Trust and Savings
Association ("Bank of America"), in its capacity as the Administrative Agent,
pursuant to which the Company obtained an unsecured five-year $1.5 billion
revolving credit facility maturing on July 7, 2002. The Credit Agreement
replaced (i) the Company's prior Amended and Restated Credit Agreement, dated as
of April 26, 1996, with Bank of America, as agent, providing for a $700 million
unsecured revolving credit facility and (ii) FHC's prior (A) Revolving Credit
Agreement, dated as of December 5, 1994, with Citicorp USA, Inc., as agent,
providing for a $300 million unsecured revolving credit facility and (B)
Revolving Credit Agreement, dated as of December 17, 1996, with Citibank, N.A.,
as administrative agent, providing for a $200 million unsecured revolving credit
facility.
The Credit Agreement contains customary representations and warranties,
affirmative and negative covenants and events of default. Specifically, Section
7.11 of the Credit Agreement provides that the Company and its subsidiaries may,
so long as no event of default exists: (i) declare and distribute stock as a
dividend; (ii) purchase, redeem or acquire its stock, options and warrants with
the proceeds of concurrent public offerings; and (iii) declare and pay dividends
or purchase, redeem or otherwise acquire its capital stock, warrants, options or
similar rights with cash subject to certain specified limitations.
Under the Credit Agreement, as amended pursuant to a Letter Agreement dated
March 27, 1998 (the "Credit Facility Letter Agreement") with the Banks, the
Company is: (i) obligated to maintain certain covenants keyed to the Company's
financial condition and performance (including a Total Leverage Ratio and Fixed
Charge Ratio); (ii) obligations to limit liens; (iii) subject to customary
covenants, including (A) disposition of assets only in the ordinary course and
generally at fair value and (B) restrictions on acquisitions, mergers,
consolidations, loans, leases, joint ventures, contingent obligations and
certain transactions with affiliates; (iv) permitted to sell the Company's
workers' compensation insurance business, provided that the net proceeds shall
be applied towards repayment of the outstanding Loans under the Credit
Agreement; and (v) permitted to incur additional indebtedness in an aggregate
amount not to exceed $1,000,000,000 upon certain terms and conditions, including
mandatory prepayment of the outstanding Loans with a certain portion of the
proceeds from the issuance of such indebtedness, resulting in a permanent
reduction of the aggregate amount of commitments under the Credit Agreement by
the amount so prepaid. The Credit Facility Letter Agreement, a copy of which is
filed as Exhibit 10.70 to this Annual Report on Form 10-K, also provided for an
increase in the interest and facility fees under the Credit Agreement.
SHAREHOLDER RIGHTS PLAN
On May 20, 1996, the Board of Directors of the Company declared a dividend
distribution of one right (a "Right") for each outstanding share of the
Company's Class A Common Stock and Class B Common Stock (collectively, the
"Common Stock"), to stockholders of record at the close of business on July 31,
1996 (the "Record Date"). The Board of Directors of the Company also authorized
the issuance of one Right for each share of Common Stock issued after the Record
Date and prior to the earliest of the Distribution Date (as defined below), the
redemption of the Rights and the expiration of the Rights and in certain other
circumstances. Rights will attach to all Common Stock certificates representing
shares then outstanding and no separate Rights Certificates will be distributed.
Subject to certain exceptions contained in the Rights Agreement dated as of June
1, 1996 by and between the Company and Harris Trust and Savings Bank, as Rights
Agent (the "Rights Agreement"), the Rights will separate from the Common Stock
in the event any person acquires 15% or more of the outstanding Class A Common
Stock, the Board of Directors of the Company declares a holder of 10% or more to
the outstanding Class A Common Stock to be an "Adverse Person," or any person
commences a tender offer for 15% of the Class A Common Stock (each event causing
a "Distribution Date").
20
Except as set forth below and subject to adjustment as provided in the
Rights Agreement, each Right entitles its registered holder, upon the occurrence
of a Distribution Date, to purchase from the Company one one-thousandth of a
share of Series A Junior Participating Preferred Stock, at a price of $170.00
per one-thousandth share. However, in the event any person acquires 15% or more
of the outstanding Class A Common Stock, or the Board of Directors of the
Company declares a holder of 10% or more of the outstanding Class A Common Stock
to be an "Adverse Person," the Rights (subject to certain exceptions contained
in the Rights Agreement) will instead become exercisable for Class A Common
Stock having a market value at such time equal to $340.00. The Rights are
redeemable under certain circumstances at $.01 per Right and will expire, unless
earlier redeemed, on July 31, 2006.
A copy of the Rights Agreement has been filed with the Securities and
Exchange Commission as Exhibit 99.1 to the Company's Registration Statement on
Form 8-A (File No. 001-12718). In connection with its execution of the Merger
Agreement for the FHS Combination, the Company entered into Amendment No. 1 (the
"Rights Amendment") to the Rights Agreement to exempt the Merger Agreement and
related transactions from triggering the Rights. In addition, the Rights
Amendment modifies certain terms of the Rights Agreement applicable to the
determination of certain "Adverse Persons," which modifications become effective
upon consummation of the transactions provided for under the Merger Agreement.
This summary description of the Rights does not purport to be complete and is
qualified in its entirety by reference to the Rights Agreement.
THE CALIFORNIA WELLNESS FOUNDATION
Pursuant to the Amended Foundation Shareholder Agreement, dated as of
January 28, 1992 (the "CWF Shareholder Agreement"), by and among the Company,
the CWF and certain stockholders (the "HNMH Stockholders") of HN Management
Holdings, Inc. (a predecessor to the Company) ("HNMH") named therein, the CWF is
subject to various volume and manner of sale restrictions specified in the CWF
Shareholder Agreement which limit the number of shares that the CWF may dispose
of prior to December 31, 1998.
Under the relevant provisions of California law, when a corporation converts
from nonprofit to for-profit corporate status, the equivalent of the fair market
value of the nonprofit corporation must be contributed to a successor charity
that has a charitable purpose consistent with the purposes of the nonprofit
entity. The CWF was formed to be the charitable recipient of the conversion
settlement when Health Net (a subsidiary of the Company) effected a conversion
from nonprofit to for-profit status, which occurred in February 1992 (the
"Conversion"). In connection with the Conversion, Health Net issued to the CWF
promissory notes in the original principal amount of $225 million (the "CWF
Notes") and shares of Class B Common Stock (which immediately prior to the
business combination involving HNMH and QualMed, Inc. were split to become
25,684,152 shares of Class B Common Stock then held by the CWF). While such
shares are held by the CWF, they are entitled to the same economic benefit as
Class A Common Stock, but are non-voting in nature. If the CWF sells or
transfers such shares to an unrelated third party, they automatically convert to
Class A Common Stock.
In addition, the CWF Shareholder Agreement, in conjunction with the Letter
Agreement executed by the Company and the Trustees of a Trust (holding shares on
behalf of the HNMH Stockholders) on March 9, 1995 and ratified by the Company's
Board of Directors on March 16, 1995 (the "Letter Agreement") requires the CWF
to offer its shares of Class B Common Stock to the Company prior to selling such
shares to any other person. In this respect, the CWF Shareholder Agreement
permits the CWF to offer and sell up to 80% of the CWF's interest in the Class B
Common Stock (or all but 5,136,830 of such shares) to the Company prior to
December 31, 1998. The CWF Shareholder Agreement, in conjunction with the Letter
Agreement, requires the CWF to provide the Company with notice on or before
January 31 of each year setting forth the number of shares, if any, being
offered to the Company. The Company then has 45 days following receipt of such
notice to notify the CWF of its intention to purchase such number of shares.
21
On January 27, 1997, the CWF provided the Company with notice of its offer
to sell 3,852,653 shares of Class B Common Stock, provided that at the Company's
option the number of shares could be increased to not more than 5,000,000
shares. Pursuant to such offer and subsequent letter agreements (collectively,
the "1997 Notice Materials") the CWF agreed to extend until June 20, 1997 the
time by which the Company could notify the CWF of its intention to purchase or
redeem such number of shares of Class B Common Stock. Accordingly, after
appropriate notice was given and effective June 27, 1997, the Company redeemed
4,550,000 shares of Class B Common Stock from the CWF at a price of $24.469 per
share.
In addition, on June 18, 1997, the Company provided its consent under the
CWF Shareholder Agreement to permit the CWF to sell 3,000,000 shares of Class B
Common Stock to an unrelated third party. Pursuant to the 1997 Notice Materials,
the CWF also retained the right to sell the balance of the 5,000,000 shares not
redeemed by the Company (or up to 450,000 shares) to unrelated third parties.
Sales of such 450,000 shares to unrelated third parties were consummated
throughout August of 1997. On November 6, 1997, the Company also provided its
consent under the CWF Shareholder Agreement to permit the CWF to sell 1,000,000
shares of Class B Common Stock to an unrelated third party. Pursuant to the
Company's Certificate of Incorporation, such 3,000,000 shares, 450,000 shares
and 1,000,000 shares of Class B Common Stock automatically converted into shares
of Class A Common Stock in the hands of such third parties.
As a result of such transactions, the CWF now holds 10,297,642 shares of
Class B Common Stock and, as of December 31, 1997, approximately $18.8 million
in principal of the CWF Notes remained outstanding.
On February 25, 1998, the CWF notified the Company of its intention to sell
up to 8,026,000 additional shares of Class B Common Stock pursuant to the CWF
Registration Rights Agreement in an underwritten public offering. Pursuant to
the terms of the CWF Registration Rights Agreement, the Company upon receipt of
a notification under such agreement must prepare and file a registration
statement with respect to such shares with the Securities and Exchange
Commission as expeditiously as possible but in no event later than 90 days
following receipt of the notice, subject to certain exceptions. The Company is
responding to the CWF notification in accordance with the terms of the CWF
Registration Rights Agreement. Any shares of Class B Common Stock sold by CWF to
third parties will automatically convert on a one-for-one basis into shares of
Class A Common Stock.
REDEMPTION OF THE FHC PUBLIC DEBT
FHC, a subsidiary of the Company, consummated a cash tender offer on June
27, 1997 of all of its $125 million outstanding principal amount of 7 3/4%
Senior Notes due 2003 (the "FHC Notes").
The price paid for each tendered FHC Note was based on a fixed spread of 25
basis points over the reference yield of the 6 1/4% U.S. Treasury Notes due
February 15, 2003, plus accrued and unpaid interest to the applicable settlement
date. Accordingly, the reference yield was 6.365%, the reference yield plus the
fixed spread was 6.615% and the purchase price per $1,000 principal amount of
the FHC Notes was $1,054.77, plus accrued and unpaid interest.
CAUTIONARY STATEMENTS
In connection with the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995, the Company is hereby filing cautionary
statements identifying important risk factors that could cause the Company's
actual results to differ materially from those projected in forward-looking
statements of the Company made by or on behalf of the Company.
The Company wishes to caution readers that these factors, among others,
could cause the Company's actual financial or enrollment results to differ
materially from those expressed in any projected, estimated or forward-looking
statements relating to the Company. The following factors should be considered
in
22
conjunction with any discussion of operations or results by the Company or its
representatives, including any forward-looking discussion, as well as comments
contained in press releases, presentations to securities analysts or investors,
or other communications by the Company.
In making these statements, the Company is not undertaking to address or
update each factor in future filings or communications regarding the Company's
business or results, and is not undertaking to address how any of these factors
may have caused changes to discussions or information contained in previous
filings or communications. In addition, certain of these matters may have
affected the Company's past results and may affect future results.
HEALTH CARE COSTS. A large portion of the revenue received by the Company
is expended to pay the costs of health care services or supplies delivered to
its members. The total health care costs incurred by the Company are affected by
the number of individual services rendered and the cost of each service. Much of
the Company's premium revenue is set in advance of the actual delivery of
services and the related incurring of the cost, usually on a prospective annual
basis. While the Company attempts to base the premiums it charges at least in
part on its estimate of expected health care costs over the fixed premium
period, competition, regulations and other circumstances may limit the Company's
ability to fully base premiums on estimated costs. In addition, many factors may
and often do cause actual health care costs to exceed those costs estimated and
reflected in premiums. These factors may include increased utilization of
services, increased cost of individual services, catastrophes, epidemics,
seasonality, new mandated benefits or other regulatory changes and insured
population characteristics.
The managed care industry is labor intensive and its profit margin is low.
Hence, it is especially sensitive to inflation. Health care industry costs have
been rising annually at rates higher than the Consumer Price Index. Increases in
medical expenses without corresponding increases in premiums could have a
material adverse effect on the Company.
PHARMACEUTICAL COSTS. The costs of pharmaceutical products and services are
increasing faster than the costs of other medical products and services. Thus,
the Company's HMOs face ever higher pharmaceutical expenses. Though the
Specialty Services Division's managed pharmaceutical care operations endeavor to
keep pharmaceutical costs low for the Company's HMOs, there can be no assurances
that the Company will be able to do so in the face of rapidly rising prices.
Also, statutory and regulatory changes may significantly alter the Company's
ability to manage pharmaceutical costs through restricted formularies of
products available to the Company's health plan members.
MEDICAL MANAGEMENT. The Company's profitability is dependent, to a large
extent, upon its ability to accurately project and manage health care costs,
including without limitation, appropriate benefit design, utilization review and
case management programs, and its risk sharing arrangements with providers,
while providing members with quality health care. For example, high
out-of-network utilization of health care providers and services may have
significant adverse affects on the Company's ability to manage health care costs
and member utilization of health care. There can be no assurance that the
Company through its medical management programs will be able to continue to
manage medical costs sufficiently to restore and/ or maintain profitability in
all of its product lines.
MARKETING. The Company markets its products and services through both
employed sales people and independent sales agents. Although the Company has a
number of such sales employees and agents, if certain key sales employees or
agents or a large subset of such individuals were to leave the Company, its
ability to retain existing customers and members could be impaired. In addition,
certain of the Company's customers or potential customers consider rating,
accreditation or certification of the Company by various private or governmental
bodies or rating agencies necessary or important. Certain of the Company's
health plans or other business units may not have obtained or may not desire or
be able to obtain or maintain such accreditation or certification which could
adversely affect the Company's ability to obtain or retain business with such
customers.
23
The managed health care industry has recently received a significant amount
of negative publicity. Such general publicity, or any negative publicity
regarding the Company in particular, could adversely affect the Company's
ability to sell its products or services or could create regulatory problems for
the Company. Furthermore, recently, the managed care industry has experienced
significant merger and acquisition activity. Speculation or uncertainty about
the Company's future could adversely affect the ability of the Company to market
its products.
COMPETITION. The Company competes with a number of other entities in the
geographic and product markets in which it operates, some of which other
entities may have certain characteristics or capabilities which give them an
advantage in competing with the Company. The Company believes there are few
barriers to entry in these markets, so that the addition of new competitors can
occur relatively easily. Certain of the Company's customers may decide to
perform for themselves functions or services formerly provided by the Company,
which could result in a decrease in the Company's revenues. Certain of the
Company's providers may decide to market products and services to Company
customers in competition with the Company. In addition, significant merger and
acquisition activity has occurred in the industry in which the Company operates
as well as in industries which act as suppliers to the Company such as the
hospital, physician, pharmaceutical and medical device industries. This activity
may create stronger competitors and/or result in higher health care costs.
Provider service organizations may be created by health care providers to offer
competing managed care products. To the extent that there is strong competition
or that competition intensifies in any market, the Company's ability to retain
or increase customers, its revenue growth, its pricing flexibility, its control
over medical cost trends and its marketing expenses may all be adversely
affected.
PROVIDER RELATIONS. One of the significant techniques the Company uses to
manage health care costs and utilization and monitor the quality of care being
delivered is contracting with physicians, hospitals and other providers. Because
of the large number of providers with which the Company's health plans contract,
the Company currently believes it has a limited exposure to provider relations
issues. In any particular market, however, providers could refuse to contract
with the Company, demand higher payments or take other actions which could
result in higher health care costs, less desirable products for customers and
members or difficulty in meeting regulatory or accreditation requirements.
In some markets, certain providers, particularly hospitals,
physician/hospital organizations or multi-specialty physician groups, may have
significant market positions or even monopolies. Many of these providers may
compete directly with the Company. If such providers refuse to contract with the
Company or utilize their market position to negotiate favorable contracts or
place the Company at a competitive disadvantage, the Company's ability to market
products or to be profitable in those areas could be adversely affected.
ADMINISTRATION AND MANAGEMENT. The level of administrative expense is a
partial determinant of the Company's profitability. While the Company attempts
to effectively manage such expenses, increases in staff-related and other
administrative expenses may occur from time to time due to business or product
start-ups or expansions, growth or changes in business, acquisition, regulatory
requirements or other reasons. Such expense increases are not clearly
predictable and increases in administrative expenses may adversely affect
results.
The Company currently believes it has a relatively experienced, capable
management staff. Loss of certain managers or a number of such managers could
adversely affect the Company's ability to administer and manage its business.
RESTRUCTURING COSTS. In connection with the FHS Combination, the Company
adopted a restructuring plan during the quarter ended June 30, 1997, the
principal elements of which include: a workforce reduction; the consolidation of
employee benefit plans; the consolidation of facilities in geographic locations
where office space is duplicated; the consolidation of overlapping provider
networks; and the consolidation of information systems at all locations to
standardized systems. The Company anticipates the
24
plan will be substantially completed by the end of 1998. During the quarter
ended December 31, 1997, the Company adopted an additional restructuring plan
and recorded a restructuring charge related to the integration of the Company's
Eastern Division health plans in connection with its acquisition of PHS and
FOHP. Although the Company believes it is "on track" to timely complete its
restructuring plans, there can be no assurances that unforeseen difficulties in
accomplishing any one or more of the elements of the plans will substantially
delay the completion of the plans and materially adversely affect the Company's
future profitability.
MANAGEMENT INFORMATION SYSTEMS. The Company's business is significantly
dependent on effective information systems. The information gathered and
processed by the Company's management information systems assists the Company
in, among other things, pricing its services, monitoring utilization and other
cost factors, processing provider claims, billing its customers on a timely
basis and identifying accounts for collection. The Company has many different
information systems for its various businesses. The Company is in the process of
attempting to reduce the number of systems and also to upgrade and expand its
information systems capabilities. Any difficulty associated with or failure to
successfully implement such updated management information systems, or any
inability to expand processing capability in the future in accordance with its
business needs, could result in a loss of existing customers and difficulty in
attracting new customers, customer and provider disputes, regulatory problems,
increases in administrative expenses or other adverse consequences. In addition,
the Company may, from time-to-time, obtain significant portions of its
systems-related or other services or facilities from independent third parties
which may make the Company's operations vulnerable to such third parties'
failure to perform adequately.
The Company also recognizes that the arrival of the Year 2000 poses a unique
worldwide challenge to the ability of virtually all computer systems to
recognize the date change from 1999 to 2000 (the "Year 2000 Issue") and has
begun to assess and modify its computer applications and business processes to
provide for their continued functionality given the Year 2000 Issue. The Year
2000 Issue is the result of computer programs being written using two digits
rather than four to define the applicable year. Any of the Company's computer
programs (both external and internal) that have time sensitive software may
recognize a date using "00" as the year 1900 rather than the year 2000. This
could result in a system failure or material miscalculations causing disruptions
of operations, including, among other things, the inability to process
transactions, prepare invoices or engage in normal business activities.
There can be no assurance that the systems of the Company or of other
companies on which the Company's systems rely will be timely converted and/or
modified, and such failure could have a material adverse effect on the Company
and its operations. The costs of the Company's Year 2000 Issue projects and the
timetable in which the Company plans to complete the Year 2000 Issue compliance
requirements set forth elsewhere in this Annual Report on Form 10-K are based on
estimates derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. There can be no assurance that these estimates will be achieved
and actual results could differ materially from these plans and estimates.
At this time it is also unclear as to the extent of existing insurance
coverage, if any, the Company may have to cover these potential Year 2000 Issue
liabilities.
MANAGEMENT OF GROWTH. The Company has made several large acquisitions in
recent years, and has an active ongoing acquisition program. Failure to
effectively integrate acquired operations could result in increased
administrative costs or customer confusion or dissatisfaction. The Company may
also not be able to manage this growth effectively, including not being able to
continue to develop processes and systems to support its growing operations.
There can be no assurance that the Company will be able to maintain its
historical growth rate.
POTENTIAL DIVESTITURES. The Company continues to evaluate the profitability
realized or likely to be realized by its existing businesses and operations, and
is reviewing from a strategic standpoint which of its
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businesses or operations should be divested. In this regard the Company (i) has
decided to divest its workers' compensation insurance business, (ii) is
considering divestiture of direct ownership of two southern California
hospitals, (iii) is currently reviewing plans to exit its HMO operations in the
states of Texas, Louisiana and Oklahoma and (iv) is analyzing the strategic fit
of its Denticare managed dental operations with the ongoing operations and
operating strategy of the Company. There can be no assurance that the Company
will complete any of these transactions. Further, entering into and evaluating
these transactions may entail certain risks and uncertainties in addition to
those which may result from any such change in the Company's business
operations, including but not limited to, extraordinary transaction costs,
unknown indemnification liabilities or unforeseen administrative needs, any of
which could result in reduced revenues, increased charges, post transaction
administrative costs or could otherwise have a material adverse effect on the
Company's business, financial condition or results of operations. See "Item 1.
Business--Discontinued Operations and Anticipated Divestitures."
GOVERNMENT PROGRAMS AND REGULATION. The Company's business is subject to
extensive federal and state laws and regulations, including, but not limited to,
financial requirements, licensing requirements, enrollment requirements and
periodic examinations by governmental agencies. The laws and rules governing the
Company's business and interpretations of those laws and rules are subject to
frequent change. For example, as described earlier in this Annual Report on Form
10-K, in the section entitled "California HMO Regulations," the California
legislature may in 1998 make significant changes in the laws regulating HMOs
operating in that state. Existing or future laws and rules could force the
Company to change how it does business and may restrict the Company's revenue
and/or enrollment growth and/or increase its health care and administrative
costs. In particular, the Company's HMO and insurance subsidiaries are subject
to regulations relating to cash reserves, minimum net worth, premium rates and
approval of policy language and benefits. Although such regulations have not
significantly impeded the growth of the Company's business to date, there can be
no assurance that the Company will be able to continue to obtain or maintain
required governmental approvals or licenses or that regulatory changes will not
have a material adverse effect on the Company's business. Delays in obtaining or
failure to obtain or maintain such approvals, or moratoria imposed by regulatory
authorities, could adversely affect the Company's revenue or the number of its
members, could increase costs, or could adversely affect the Company's ability
to bring new products to market as forecasted.
A significant portion of the Company's revenues relate to federal, state and
local government health care coverage programs, such as Medicare and Medicaid
programs. Such contracts carry certain risks such as higher comparative medical
costs, government regulatory and reporting requirements, the possibility of
reduced or insufficient government reimbursement in the future, and higher
marketing and advertising costs per member as the result of marketing to
individuals as opposed to groups. Such risk contracts also are generally subject
to frequent change including changes which may reduce the number of persons
enrolled or eligible, reduce the revenue received by the Company or increase the
Company's administrative or health care costs under such programs. In the event
government reimbursement were to decline from projected amounts, the Company's
failure to reduce the health care costs associated with such programs could have
a material adverse effect upon the Company's business. Changes to such
government programs in the future may also affect the Company's willingness to
participate in such programs.
The Company is also subject to various governmental audits and
investigations. Such activities could result in the loss of licensure or the
right to participate in certain programs, or the imposition of fines, penalties
and other sanctions. In addition, disclosure of any